MODULE 2: CLASSICAL INTERNATIONAL TRADE THEORIES

2.1 Learning objectives:

 Discuss various classical internal trade theories
 Describe the implications of classical trade theories
 Identify the criticisms of classical trade theories

2.2 Description of the module:

Module 2 provides insights to the classical international theories of trade. This

module discusses historical trade concepts and the implications of such.
Furthermore, modern theories such as absolute and comparative advantage are
explained with concrete examples. Lastly, the implications and various criticisms of
these theories are provided herein.

2.3 Content:

Introduction

International trade plays an important role in the formulation of the world

economy. One should know how monetary systems work because they relate directly
to the ability of overseas customers to buy from an international marketer. One
should also be aware of how various governments and international organisations
seek to regulate international trade because this affects how and where one’s goods
may be exported.

Why do nations trade? A nation trades because it expects to gain something

from its partner. One may ask whether trade is like a zero-sum game, in the sense
that one must lose so that another will gain. The answer is no, because though one
does not mind gaining benefits at someone else’s expense but no one wants to
engage in a transaction that includes a high risk of loss. For trade to take place both
nations must anticipate gain from it. In other words, international trade is a positive
sum game. There are basically two sets of theories of International Trade: The
Classical Trade Theories, explaining how inter-country trade takes place; and
theories of International Trade, explaining inter-country investment in manufacturing
and service activities and the management of these activities. In this unit, we will
cover the classical trade theories.

2.1 Theory of Mercantilism (1500-1700)

Mercantilism became popular in the late seventeenth and early eighteenth

centuries in Western Europe and was based on the notion that governments (not
individuals who were deemed untrustworthy) should become involved in the transfer
of goods between nations in order to increase the wealth of each national entity.
Wealth was defined, however, as an accumulation of previous metals, especially
gold.

Consequently, the aims of the governments were to facilitate and support all
exports while limiting imports, which was accomplished through the conduct of
trader by government monopolies and intervention in the market through the
subsidization of domestic exporting industries and the allocation of trading rights.
Additionally, nations imposed duties or quotas upon imports to limit their volume.
During this period colonies were acquired to provide sources of raw materials or
precious metals. Trade opportunities with the colonies were exploited, and local
manufacturing was repressed in those offshore locations. The colonials were often
required to buy their goods from their mother countries.

The concept of mercantilism incorporates two fallacies. The first was the
incorrect belief that old or precious metals have intrinsic value, when actually they
cannot be used for either production or consumption. Thus, nations subscribing the
mercantilism notion exchanged the products of their manufacturing or agricultural
capacity for this non-productive wealth. The second fallacy is that the theory of
mercantilism ignores the concept of production efficiency through specialisation.
Instead of emphasizing cost-effective production of goods, mercantilism emphasises
sheet amassing of wealth with acquisition of power.

Neo-mercantilism corrected the first fallacy by looking at the overall favourable

or unfavourable balance of trade in all commodities, that is, nations attempted to
have a positive balance of trade in all goods produced so that all exports exceeded
imports. The term “balance of trade” continues in popular use today as nations
attempt to correct their trade deficit positions by increasing exports or reducing
imports so that outflow of goods balances the inflow.

The second fallacy, a disregard for the concept of efficient production, was
addressed in subsequent theories, notably the classical theory of trade, which rests
on the doctrine of comparative advantage.

2.2Theory of Economic Development

The trade structure is also sought to be explained in terms of scale economies.

According to this theory, there is a relationship between the size of the internal
market and average unit cost of production and export competitiveness. A firm
operating in a country where the domestic market is large will be able to reach a
high output level thereby reaping the advantage of large-scale production. The lower
cost of production will increase its competitiveness enabling the firm to make an
easy entry to the export market. While prima-facie this logic appears to be valid, this
hypothesis cannot be generalized because it is possible that the pull of the domestic
market will be so strong that the export would not be promoted, as is the case with
India in certain products.

2.3Rostow’s Stages of Economic Growth Theory

A more recent and applicable theory of economic development was provided in

the 1960s by Walter W. Rostow, who attempted to outline the various stages of a
nation’s economic growth and based his theory on the notion that shifts in economic
development coincided with abrupt changes within the nations themselves. He
identified five different economic stages for a country – traditional society,
preconditions for take off, take off the drive to maturity, and the age of high mass
consumption.
 Stage 1: Traditional Society

Rostow saw traditional society as a static economy, which he likened to the pre-
1700s attitudes and technology experienced by the world’s current economically
developed countries. He believed that the turning point for these countries came
with the work of Sir Isaac Newton, when people began to believe that the world was
subject to a set of physical laws but was malleable within these laws. In other words,
people could effect change within the system of descriptive laws as developed by
Newton.

Stage 2: Preconditions for takeof

Rostow identified the preconditions for economic takeoff as growth or radical

changes in three specific, non-industrial sectors that provided the basis for economic
development:

1. Increased investment in transportation, which enlarged prospective markets

and increased product specialisation capacity.
2. Agricultural developments providing for the feeding and nourishing of larger,
primarily urban, population.
3. An expansion of imports into the country.

These preconditioning changes were to be experienced in concert with an

increasing national emphasis on education and entrepreneurship.

Stage 3: Takeof

The takeoff stage of growth occurs, according to Rostow, over a period of

twenty to thirty years and is marked by major transformations that stimulate the
economy. These transformations could include widespread technological
developments, the effective functioning of an efficient distribution system, and even
political revolutions. During this period barriers to growth are eliminated within the
country and indeed the concept of economic growth as a national objective becomes
the norms. To achieve the takeoff, however, Rostow believes that three conditions
must be met:

1. Net investment as a percentage of net national products must increase sharply.

2. At least one substantial manufacturing sector must grow rapidly. This rapid
growth and larger output trickles down as growth in ancillary and supplier
industries.
3. A supportive framework for growth must emerge on political, social and
institutional fronts.

For example, banks, capital markets, and tax systems should develop and
entrepreneurship should be considered a norm.

Stage 4: The Drive to Maturity

Within Rostow’s scheme, this stage is characterised as one where growth

becomes self-sustaining and a widespread expectation within the country. During
this period, Rostow believes that the labour pool becomes more skilled and more
urban and that technology reaches heights of advancement.
 Stage 5: The Age of Mass Consumption

The last stage of development, as Rostow sees it, is an age of mass

consumption when there is a shift to consumer durables in all sectors and when the
populace achieves a high standard of living as evidenced through the ownership of
such sophisticated goods as automobiles, televisions and appliances.

Since its introduction in the 1960s, Rostow’s framework has been criticized as
being overly ambitious in attempting to describe the economic paths of many
nations. Also, history has not proved the framework to be true.

Example: Many lesser-developed countries exhibit dualism that is, state of

the art technology is used in certain industries and primitive production
methods are retained in others. Similarly, empirical data has shown that there
is no twenty-to-thirty year growth period. Such countries as the United
Kingdom, Germany, Sweden, and Japan are more characterised by slow, steady
growth patterns than by abrupt takeoff periods.

2.4Theory of Absolute Advantage

Here, we will discuss the principles of absolute and relative advantage.

2.4.1 Principle of Absolute Advantage

Adam Smith was the first economist to investigate formally the rationale
behind foreign trade. In his book, Wealth of Nations, Smith used the principle of
absolute advantage as the justification for international trade. According to this
principle, a country should export a commodity that can be used at a lower cost
than can other nations. Conversely, it should import commodity that can only be
produced at a higher cost than can other nations.

Example: Consider, for example, a situation in which two nations are each
producing two products following Table provides hypothetical production figures
for the United States and Japan based on two products – the computer and
automobile. The United States can produce 20 computers or 10 automobiles or
some combination of both. In contrast, Japan is able to produce only half as
many computers (Japan produces 10 for every 20 computers that United States
produces). The disparity might be the result of better skills by American
workers in making this product. Therefore, the United States has an absolute
advantage in computers. But the situation is reversed for automobiles because
the United States makes 10 cars for every 20 units manufactured in Japan. In
this instance, Japan has an absolute advantage.
 An analogy may help demonstrate the value of the principle of absolute
advantage. A doctor is absolutely better than a mechanic in performing surgery is
whereas the mechanic is absolutely superior in repair cars. It would be impracticable
for the doctor to practice medicine as well as to repair the cars when repairs are
needed. Similar case is with mechanic because he cannot even attempt to practice
medicine or surgery. Thus, for practicality each person should concentrate on and
specialize in the craft that person has mastered. Similarly, it would not be practical
for consumers to attempt to produce all the things they desire to consume. One
should practice what one does well and leave the production of other things to
people who produce them well.

2.4.2 Principle of Relative Advantage

One problem with the principle of absolute advantage is that it fails to explain
whether trade will take place if one nation has absolute advantage for all products
under consideration. Case 2 of Table shows this situation.

Caution Note that only difference between Case 1 and Case 2 is that United
States is capable of making 30 automobiles instead of 10 in Case 1. In the
second instance, the United States has absolute advantage for both the
products resulting in absolute disadvantage for Japan for both. The efficiency of
the United States enables it to produce more of both products at lower costs.

At first glance it may appear that United States has nothing to gain from
trading with Japan. But 19th Century British Economist David Ricardo fully
appreciates the relative cost as a basis for trade and he argues that absolute
production costs are irrelevant. More meaningful are relative production costs, which
determine whether trade should take place and what items to export or import.
According to Ricardo’s Principle of Relative (or Comparative) Advantage, a country
may be better than another countries in producing many products but should only
produce what it produces the best. Essentially it should either concentrate on a
product with the greatest comparative advantage or a product with the least
comparative disadvantage. Conversely, it should import either a product for which it
has the greatest comparative disadvantage or one for which it has the least
comparative advantage.

Consider again the analogy of the doctor and the mechanic. The doctor may
take up automobile repair as a hobby. It is even possible, though not probable that
the doctor may eventually be able to repair an automobile faster and better than the
mechanic. In such an instance the doctor would have absolute advantage in both
the practice of medicine and automobile repair whereas the mechanic would have
an absolute disadvantage for both the activities. This situation does not mean that
the doctor would better of repairing automobiles as well as performing surgery
because of relative advantages involved. When compared to mechanic, the doctor
may be superior in surgery but only slightly better in automobile repair. Hence the
doctor should concentrate only on surgery. When a doctor has automobile problems,
only the mechanic should make the repairs because the doctor has slight relative
advantage in the skill thereby doctor is using time more productively while
maximizing the income.

In 1776, Adam Smith noted that, if a country could produce a good cheaper
than other countries, it had an absolute advantage in the production of that good;
he then argued that, in order to maximize national income, countries should produce
and export surpluses of what they have absolute advantage in, and buy whatever
else they need from the rest of the world. In this way, be theorized, specialization,
and hence efficiency, would be encouraged as a result of the increased competition
and scale economies. Of course, the question that was left unanswered was, “what if
a country had absolute advantage in all products; or even worse, in no products at
all?” the theory would imply that the former country need not trade, while the latter
could not trade!

Forty years later, David Ricardo unambiguously answered the question with
what has become one of the most important ideas in all of economics: He showed
that both countries should, and indeed, will trade in order to increase their national
welfare, as long as each has a comparative advantage in the production of one good
versus another. In other words, incentives for trade would exist even when one
country has absolute cost advantage in everything or another country has the
absolute cost advantage in nothing. The key, he noted, was that a country should
have the ability to produce one good, relative to another good, that is different from
another county’s try’s relative ability to produce the same two goods. The best way
to see this argument before we see the intuitive reasoning behind this powerful idea
is through an example.

2.5Theory of Comparative Advantage

This question was considered by David Ricardo, who developed the important
concept of comparative advantage in considering a nation’s relative production
efficiencies as they apply to international trade. In Ricardo’s view, the exporting
country should look at the relative efficiencies of production for both commodities
and make only those goods it could produce most efficiently.

Example: Suppose, for example, in our illustration that Greece developed

an efficient manufacturing capacity so that martini glasses could be produced
by machine rather than being hand-blown. In fact, since the development of
the productive capacity and capital plants were newer than those in Sweden,
Greece could produce 100 crates of martini glasses using only 200 resource
units as opposed to the 300 units required by Sweden. Thus, Greece’s
comparative costs would fall below that of Sweden for both products and its
 comparative advantage vis-à-vis those products would be higher. Therefore, the
resource units required to produce olives and glasses would now be:

Logically, Greece should be the producer of both olives and martini glasses,
and Sweden’s capital and labour used in making these happy-hour supplies should
be directed to Greece, so that maximum production efficiencies are achieved.
Neither capital nor labour is entirely mobile, however, so each country should
specialize – Greece in olives at 100 resources units per 500 crates and Sweden in
glass production at 300 resource units per 100 crates. Greece is still better off at
maximising its efficiencies in olive production. By doing so, it produces twice as
many goods for export with the same amount of resources than if it allocated
production level.

While Sweden’s production costs for glasses are still higher than those of
Greece at 300 units the resources of Sweden are better allocated to this production
than to expensive olive growing. In this way, Sweden minimizes its inefficiencies and
Greece maximizes its efficiencies. The point is not that a country should produce all
the goods it can more cheaply, but only those it can make cheapest. Such trading
activity leads to maximum resource efficiency.

The concepts of absolute advantage and comparative advantage were used in

a subsequent theory development by John Stuart Mill who looked at the question of
determining the value of export goods and developed the concept of terms of trade.
Under this concept, export value is determined according to how much of a domestic
commodity each country must exchange to obtain an equivalent amount of an
imported commodity. Thus, the value of the product to be obtained in the exchange
was stated in terms of the amount of products produced domestically that would be
given up in exchange. For example, Sweden’s terms with Greece would be exporting
of 100 crates of glasses for an equivalent 500 crates of olives.

2.6Factor Endowment Theory

The Eli Heckscher and Bertil Ohlin theory of factor endowment addressed the
question of the basis of cost differentials in the production of trading nations. They
posited that each country allocates its production according to the relative allocates
its production according to the relative proportions of all its production factor
endowments – land, labour and capital on a basic level, and, on a more complex
level, such factors as management and technological skills, specialised production
facilities, and established distribution networks.
 Thus, the range of products made or grown for export would depend on the
relative availability of different factors in each country.

Example: Agricultural production or cattle grazing would be emphasised in

such countries as Canada, and Australia, which are generously endowed with
land. Conversely, in small land mass countries with high populations, export
products would center or labour-intensive articles. Similarly, rich nations might
center their export base on capital-intensive production.

In this way, countries would be expected to produce goods that require large
amounts of the factors they hold in relative abundance. Because of the availability
and low costs of these factors, each country should also be able to sell its products
on foreign markets at less than international price levels. Although this theory holds
in general, it does not explain export production that arises from taste differences
rather than factor differentials. Some of these situations can be seen in sales of
luxury-imported goods, such as Italian leather products, deluxe automobiles and
French wine, which are values for their quality, prestige, or panache. Like Classical
theory, the Heckscher-Ohlin theory does not account for transportation costs in its
computation, nor does it account for differences among nations in the availability of
technology.

Economist Paul Samuelson extended the factor endowment theory to look at

the effect of trade upon national welfare and the prices of production factors:
Samuelson posited that the effect of free trade among nations would be to increase
overall welfare by equalizing not only the prices of the goods exchanged in trade,
but also of all involved factors. Thus, according to his theory, the returns generated
by use of the factors would be the same in all countries.

In 1933, drawing upon the work of Eli Heckscher, Bertil Ohlin took the Ricardo
model a significant step further, by linking the source of a country’s comparative
advantage to the endowment of its factors of production. This theory, known as the
Heckscher-Ohlin model of international trade (or simply, the H-O model) is probably
the most widely accepted form of the comparative advantage theory today.

The H-O model focused on two assumptions: (1) Goods differ in how much they
use of certain types of factors of production – that is, different goods have different
factor intensities; for instance, the manufacture of textiles is labour intensive, while
the manufacture of semiconductor is capital intensive. (2) Countries differ with
respect to their factor endowments; for instance, one might reasonably argue that
India has an abundant supply of labour relative to capital, while the reverse is true of
the US. Further, H-O assumed (as Ricardo did) that markets are perfectly
competitive and factors are perfectly mobile, but it relaxed the assumption of
constant returns to scale in order to allow for decreasing returns to scale. Putting
these assumptions together, the main proposition of the H-O model is the following:
A country exports those goods that use intensively its relatively abundant factor of
production. That is, countries export those goods that they are best suited to
produce, given their factor endowments.

Using the examples above, H-O would argue that a country such as India would
export labour-intensive goods (and import capital-intensive goods), while a country
such as the US would export capital-intensive goods (and import labour-intensive
goods).

As with Ricardo’s theory of comparative advantage, there are some potential

weaknesses underlying the theory: (1) Endowments are supposed to be given, when
they can often be created (for example, through innovation); in other words, H-O
assumes a static supply of factor endowments. (2) If some countries kept to their
static endowment-determined advantages, they might be stuck with a second-rate
economy in the long run. (3) In an empirical insight that later came to be known as
the “Leontief Paradox,” economist Wassily Leontief found that, contrary to
predictions suggested by the H-O model, US exports were less capital intensive than
US imports.

All these shortcomings led economists to a number of other, more realistic

approaches to modeling international trade. However, the central insight of H-O
regarding the link between factor endowments and factor intensity remains widely
accepted.

2.7Implications

Both the Ricardian and the H-O theories have some powerful implications.
These implications, paradoxically, lead to equally powerful incentives – and in some
cases, commonly used arguments to justify demands for protection from the forces
of free trade.

Caution The first major implication of free trade is factor price equalization:
International trade will be tending to equalize factor prices across countries
that trade.

The reason is simple. The more trade that occurs in a particular good from a
country, the greater the demand for the factors used intensively in the production of
that good and the less the demand for the other factor. As a result, the price of one
of the factors will be driven up and the other driven down. The exact opposite will
happen in the other country. As a consequence, factor prices will be driven toward
equalization in the two countries. For example, in the country that exports labour-
intensive goods, the relative wages of labour will rise. Similarly, international trade
will tend to drive the costs of capital closer together in the countries that trade.

Caution The second major implication has come to be known as the Ryczynski
Theorem.

An increase in the endowment of one of the factors will reduce the production
of goods that intensively use the other factor.

Example: If the US is capital rich, and innovation increases the productivity of

capital, then labour-intensive industries in the US will get hurt. Again, the
reason is simple. With an increase in its capital endowment, the US can now
produce and export more capital-intensive goods; this would lower the demand
for labour, since resources will move away from the labour-intensive sectors of
the economy (and, by definition, the capital-intensive sectors use relatively less
labour). Indeed, in developing countries that specialize in labour-intensive
goods, the reverse implication is even more surprising: An increase in the
 productivity of labour – for example, through better education and training or
better provision of health care—will hurt capital-intensive sectors in those
economies!

If these two implications are true, then we are likely to observe demand for
protection from the effects of free trade from precisely those sectors in the economy
that are hurt. Thus, demands for protection are likely to come from segments that
represent labour in capital-intensive economies, and segments that represent capital
in labour-intensive economies. This may explain why, in countries such as the US,
labour unions often strongly oppose agreements such as NAFTA. It may also explain
why developing countries tend to be the ones that usually have stricter controls on
cross-border capital flows. But this suggests another important corollary to the
factor price equalization and Rybezynski theorems: Demands for protection are
most likely to arise from the less efficient sectors in an economy.

This takes us to another implication of comparative – advantage theories, an

implication that has come to be known as the Stolper Samuelson Theorem: Any
protection – for example, a tariff – will increase the income of factors of production
used intensively in the good that receives protection; in the process, the relative
income of the factor of production used in the other good will fall. For example, in
countries such as the US, there will be cries for – and hence the incentive for –
protection from labour – intensive sectors; such policies will prop up incomes in
those sectors, but in the process they will hurt the capital-intensive sectors and,
hence, capital. The reverse will be true in labour-intensive economies such as the
developing countries. Efforts at protecting capital (for example capital controls)
would actually end up hurting labour in those economies.

There are three main insights to take away from this discussion. One, the
incentives (and some might argue, the logic) for protection is inherent in arguments
for free trade. Two, demands for protection will usually arise from the less efficient
sectors in an economy. Three, protection will usually end up hurting the more
efficient sectors in an economy.

As with many other arguments in economics, the logic for free trade is a
conditional one. It simply says that, if a nation wants to increase its economic
efficiency, then the avenue for doing so is by focusing on its comparative advantage
and trading with other nations. But policymakers also often worry about no
efficiency aspects of free trade, in particular, aspects such as distributional (or
“equity”) considerations, short-term unemployment, preservation of a “way of life”,
and so forth. But the question that they, and the MNEs that benefit from such
protection – then have to confront is whether global economic competition makes
loss of jobs (and attendant ways of life) inevitable, and if so, whether it is better to
recognize and manage the inevitable transitions and dislocations that are bound to
occur sooner or later.

2.8Analysis

Although these more recent theories seem to go far in explaining why nations
trade, they have nonetheless come under criticism as being only partial
explanations for the exchange of goods and services between nations. Some of
these criticisms are that:
 1. The theories assume that nations trade, when in reality trade between nations
is initiated and conducted by individuals or individual firms within those
nations.
2. Traditional theory also assumes perfect competition and perfect information
among trading partners.
3. They are limited in looking at either the transfer of goods or of direct
investments. No theories explain the comprehensive dynamic flow of trade in
goods, services and financial flows.
4. They do not recognise the importance of technology and expertise in the
areas of marketing and management.

Consequently, some scholars have looked separately at the reasons why firms
enter into trade or foreign investment. One of these theories is the international
product life cycle, which looks at the path a product takes as it departs domestic
shores and enters foreign markets.

References: International Business, Lovely Professional University, 2012.

https://www.preservearticles.com/international-trade/comparison-
between-classical-theory-and-modern-theory-of-international-trade/350