Chapter 2

Lesson 2.1. International Trade Theories

 Over time, economists have developed theories to explain the mechanisms of international business and
trade.
 International trade theories are simply different theories to explain international trade.
 Trade is the concept of exchanging goods and services between two people or entities,
 International trade, therefore, is, the concept of this exchange between people of entities in two different
countries.
 People or entities trade because they believe that they can satisfy their needs and benefit from the exchange.
 While at the surface this may sound very simple, there is a great deal of theory, policy, and business strategy
that influence international trade..

 International trade theories are various theories that analyze and explain the patterns and mechanisms of
international trade.
 They deal with how countries exchange goods and services and help countries in deciding what should be
exported and what should be imported, in what quantity, and with whom trade should be done globally.

 These theories were initially company-based and were called classical theories, Classical economists were
oriented primarily toward growth economics, and their main concern was to explain how the "wealth of
nations" could be increased.
 The classical theories of each country are just as important as modern theories as they explain how nations
expanded around the globe and built their wealth through trade.

According to Reyes (2012), the main points of the classical theories of international trade are the following:

1. Trade is an important stimulator of economic growth. It enlarges a country's consumption capacities, increases
world output, and provides access to scarce resources and worldwide markets for products, without which poor
countries would be unable to grow.

2. Trade tends to promote greater international and domestic equality by equalizing factor prices, raising real incomes
of trading countries, and making efficient use of each nation's and the world's resource endowments, Le, raising
relative wages in later abundant countries and lowering them in labor-scarce countries.

3. Trade helps countries to achieve development by promoting and rewarding those sectors of the economy where
individual countries have a comparative advantage, whether in terms of later efficiency or factor endowments.

4. In a world of free trade, international prices and costs of productions determine how much a country should trade
in order to maximize its national welfare. Countries should follow the dictates of the principle of comparative
advantage and not try to interfere with the free workings of the market.
5. In order to promote growth and development, an outward-looking international policy is required. in all cases, self-
reliance based on partial or complete isolation is asserted to be economically inferior to participation in a world of
free unlimited trade.

A number of explicit and implicit assumptions that in many ways are often contrary to the reality of contemporary
international economic relations have been instrumental in the development of the traditional international trade
theories. These theories, therefore, often lead to conclusion is not in accordance with both the historical and the
contemporary trade experiences of many developed and developing countries. Be that as it may, there is no denying
that international business and trade, more so a world of free trade, is beneficial to everyone involved. In the real world,
a variety of national production and international noncompetitive pricing policies are present. It is, therefore, incumbent
upon governments and nations to carefully study their own environments and the international environment to
determine what policies to institute and what strategies to take to promote their own economic development and
growth.

 In the mid-twentieth century, economists shifted from country-based to firm-based or company-based

theories, which were called modern theories.
 The modern theories are useful and can help with international trade by helping a business determine the
right country to expand into and how to make goods more efficiently than other firms.
 These theories incorporate more factors than the country-based classical theories.

LESSON SUMMARY 2.1

1. International trade theories are various theories that analyze and explain the patterns and mechanisms of
international trade, how countries exchange goods and services and help countries in deciding what should be
exported and what should be imported, in what quantity, and with whom trade should be done globally.

2. Trade is the concept of exchanging goods and services between two people or entities

3. International trade, therefore, is, the concept of this exchange between people of entities in two different
countries

 International trade theories were initially company-based and were called classical theories, Classical
economists were oriented primarily toward growth economics, and their main concern was to explain how the
"wealth of nations" could be increased.

4. The main points of the classical theories of international trade are the following:
a. Trade is an important stimulator of economic growth.
b. Trade tends to promote greater international and domestic equality.
c. Trade helps countries to achieve development.
d. In a world of free trade, international prices and costs of productions determine how much a country
should trade in order to maximize its national welfare
e. In order to promote growth and development, self-reliance based on partial or complete isolation is
asserted to be economically inferior to participation in a world of free unlimited trade.
5. In the mid-twentieth century, economists shifted from country-based to firm-based or company-based
theories, which were called modern theories. The modern theories are useful and can help with international
trade by helping a business determine the right country to expand into and how to make goods more
efficiently than other firms.

LESSON SUMMARY 2. 2
1. The "Commercial Revolution" brought a revolutionary change in the economy of Europe: the transition from
local economies to national economies, from feudalism to capitalism, and from a rudimentary trade to a
globally larger international trade.

2. This commercial revolution gave birth to mercantilism. According to the mercantilists, it is the goal of the
economy politics to ensure that the state is enriched by increasing the entry of gold and silver and stocking the
country with the same through creating the highest possible export/trade surplus because exports bring an
inflow of gold, whereas imports lead to the outflow of gold. This is the reason mercantilism was also known as
"bullionism."

3. Mercantilism believes that the state should actively intervene in the economy. Countries employed a policy of
protectionism-protecting the export industries that bring in the gold and silver through customs tariffs, quotas,
and the like to curtail imports.

4. The period also marked the rise of new nation-states, whose rulers were able to amass more gold and wealth
for their countries by increasing exports and trade. These nation-states expanded their wealth by using their
colonies around the world in an effort to control more trade and amass more riches.

5. Mercantilism aimed to encourage production within the national territories through the concession of
monopolistic privileges granted to the export producing enterprises, granting government subsidies, and
giving tax exemptions. The importation of advanced technology (mostly to benefit the export industries),
acquisition of manufacturing secrets, and encouraging immigration of skilled workers that will bring in
remittances to the country were done. Nation-states also placed lots of importance on the development of
merchants and naval fleets, which would facilitate exports.

6. In mercantilism, the government strengthens the private owners of the factors of production, which are the
following:
a) Labor refers to the work performed by a person for a monetary consideration. It is the monetary
consideration that forms part of the cost of production.

b) Natural resources are those found in nature, including land, trees, and mines.

c) Capital goods (capital) - consist of those goods which are produced by the economic system and are
used as inputs in the production of further goods and services. Capital refers to the money or funds
used to purchase the goods used in the production process.
 d) Entrepreneurship - the entrepreneur is the one that combines the factors in the correct proportion and
mobilizes them.

7. Although mercantilism is one of the oldest trade theories, it remains part of our modern life. Countries such as
Japan, China, Singapore, Taiwan, and even Germany still favor exports and discourage imports through a form
of neo- mercantilism, protectionism through tariffs and import barriers and domestic industry protection
through subsidies and tax exemptions.

8. Free trade advocates highlight how free trade benefits all members of the global community, while
mercantilism's protectionist policies only benefit select industries at the expense of both consumers and other
companies both within and outside the industry. Free trade is when international trade is free from barriers,
such as tariffs, quotas, or other restrictions, and can flourish on its natural growth. It requires less government
regulatory power.

9. The proponents of the theory were Sir William Petty and Sir Thomas Mun in England, Jean-Baptiste Colbert,
Jean Bodin, Irish-born Richard Cantillon, and Lord Antoine de Montchrétien in France, and Antonio Serra and
Giovanni Botero in Italy, although they never used the term themselves. It was the Scottish economist Adam
Smith, in his Wealth of Nations (1776), who gave currency to the term.

10. Adam Smith viewed mercantilism as not freely initiated and did not bring benefits to all parties. He refuted the
general notion that the wealth of a nation should be measured by the country's treasury. Through his book,
Adam Smith workers that will bring in remittances to the country were done. Nation-states also placed lots of
importance on the development of merchants and naval fleets, which would facilitate exports.

11. Free trade is a system that allowed for liberalization which would pave the way for a freely initiated trade and
engage the maximum possible number of people bringing benefits to most parties and lead to further
development of all participants in the long run.

12. Laissez-faire economics is a theory that restricts government intervention in the economy. Smith
demonstrated that the free market would translate into an all-encompassing economic development in a
significantly wider sense than mercantilism.

13. Smith also developed the concept of specialization leading to the development of economies of scale, creating
efficiency with the ultimate effect of achieving sustainable growth. For him, the collusive relationship between
the government and the business class observed in the mercantile system was detrimental to the citizenry.

14. Adam Smith described mercantilism as having the following characteristics:

 a. It was used to enhance the economic power of states through building wealth, an important measure
of which was precious metals, especially silver and gold.
b. It led to massive and rapid unification of control of countries under strict economic and political
policies, in sharp contrast with what was observed under feudalism resulting in economic nationalism.
c. The countries aggressively sought to have a favorable balance of trade by selling more than they
imported so as to have a surplus of precious metals and accumulate it over time.

15. Jean-Baptiste Colbert was considered as a more profound influence on the development of mercantilism in
France, where it was known as "Colbertism". Jean-Baptiste's system was very similar in concept and
application to mercantilism described by Adam Smith. He carried out the program of economic reconstruction
that helped make France the dominant power in Europe.

16. Sir William Petty posits that surplus gain or surplus value leads to expanded reproduction and that expanded
reproduction is conditional on capital accumulation (productive capital expansion). Expanded reproduction is a
model in which a capitalist economy smoothly reproduces itself. The surplus value created by the workers is
not merely realized but reinvested.

17. Philipp Wilhelm von Hornick, in his Austria Over All, If She Only Will of 1684, detailed a nine-point program of
what he deemed effective national economy, which suns up the tenets of mercantilism comprehensively.

18. Sir Thomas Mun was most closely associated with the idea of mercantilism in England, where Mercantilism
was called commercial system or mercantile system, because it emphasized the importance of commerce and
free trade. This school of thought mainly focused on international trade and the balance of trade through
acquisition of silver and gold.

19. Antoine de Montchrétien published a book titled A Tract on Political Economy in which he laid great emphasis
on development of agriculture and described it as the basis of all wealth. He stood for the principle of self-
sufficiency and asserted that it is not the abundance of gold and silver, the quantities of pearls and diamonds,
which make a state rich and opulent, but the convenience of the things necessary to life.

20. Richard Cantillon is considered by many to be the first economic theorist. His only known book, Essai sur la
Nature du Commerce en General (the Essal), may represent one of the single largest steps forward in the social
sciences. He emphasized the need of importing raw materials and exporting finished products to maintain a
favorable balance of trade.

21. Physiocrats is an eighteenth-century group of French economists who believed that agriculture was the source
of all wealth and that agricultural products should be highly priced. Advocating adherence to a supposed
natural order of social institutions, they also stressed the necessity of free trade.

22. The price-specie-flow mechanism was originally attributed to Scottish economist David Hume to illustrate how
trade imbalances can self-correct and adjust under the gold standard. Fluctuations in prices in a country
adjusted completely or partially by an inflow or outflow of gold or specie which adjusts the price levels across
borders and equalized them bringing balance in international transactions and payments.
23. Giovanni Botero and Antonio Serra of Italy did not directly touch on mercantilism, but developed theories
using the city as a unit of analysis and finding development to be the result of industrialization

LESSON SUMMARY 2.3

1. Absolute advantage means a producer can produce a good or service better, faster, more
efficiently, at a greater volume, and with fewer resources than others. It means that a producer
can produce a good or service at lesser marginal cost than other producers. If a country has more
resources needed to produce a good or service, it has absolute advantage over a country who
does not have those resources.

2. Marginal cost is the cost incurred in producing an additional unit of a product.

3. Adam Smith is recognized as the founder of modern economics; hence, considered as the father
of economics. He is credited with using the word mercantilism first and that his book The Wealth
of Nations marked the birth of modern capitalism.

4. Capitalism, also called free market economy or free enterprise economy is an economic system,
where most means of production are privately owned and production is guided and income
distributed largely through the operation of markets, which determine prices, products, and
services rather than the government.

5. Modern capitalism emerged as a result of the appearance of the physiocrats in France. The
physiocrats were a group of economists who believed that the wealth of nations was derived
solely from agriculture; that only agriculture yielded a surplus.

6. Physiocracy is perhaps the first well-developed theory of economics. It immediately preceded the
first modern school, classical economics. The physiocrats believed that the wealth of a nation lies
not in its stocks of gold and silver, but rather in the size of its net product.

7. Net product, a measure of the income generated in a production process, is the value of outputs
minus the value of inputs.

8. Like the physiocrats, Smith recommended leaving economic decisions to the free play of self-
regulating market forces, with the state playing a highly limited role.

9. Smith did not believe that industry was unproductive and that only the agricultural sector was
capable of producing a surplus above the subsistence level. Smith saw that division of labor and
extension of markets created almost limitless possibilities for society to expand its wealth
through production and trade.
10. The theory of absolute advantage believes that countries should produce and export such
products which they have an absolute advantage on and import those goods that they produce
relatively less efficiently and at higher cost.

11. Smith used the concept of absolute advantage to explain gains from free trade in the
international market. He upheld in this theory the necessity of free trade as the only sound
guarantee for progressive expansion of trade and increased prosperity of nations.

12. According to Smith, free trade promotes international division of labor through specialization in
the production and exchange of such commodities, in case of which they command some
absolute advantage. Specialization increases productivity through technical and organizational
innovations.

13. An interesting aspect of Smith's analysis of trade has been his vent for surplus doctrine, which
advocates nations exchanging their overproduction for other goods which are in demand in other
countries. In addition, this doctrine implies that the foreign trade results in the fullest utilization
of the idle productive capacity that is likely to exist in the absence of trade.

14. Smith also mentioned an additional beneficial aspect of international trade- it transfers
knowledge and technology between different nations. The adoption and use of new production
techniques lead to productivity growth and, thus, to an increase in wealth and economic
development.

LESSON SUMMARY 2.4

1. Comparative advantage means a producer can produce a good or service at a lower opportunity
cost than others. If a country can produce goods or services at a lower cost than other countries,
it has comparative advantage. A country has comparative advantage when it produces a good or
service for a lower opportunity cost than other countries.

2. Opportunity cost is what is lost or missed out on when choosing one possibility over another.

3. While the theory of comparative advantage is attributed to Ricardo, Adam Smith was among the
first to put in writing the theory of comparative advantage.

4. For Smith, the specialization and division of labor, in the emerging large-scale industries of his
homeland England, provided the base for lowering labor costs, which ensured effective
competition across countries.
5. The extent of specialization and division of labor was dependent upon the size of the market. A
larger market would encourage a greater degree of specialization and division of labor; hence, the
development of international trade.

6. The classical theorists believe that each country will specialize in the production of those goods
for the production of which it is especially suited on account of its climate, of the qualities of its
soil, of its other natural resources, of Be innate and acquired capacities of its people, and of the
real capital which possesses as a heritage from its past generation, such as buildings, plants and
equipment, and means of transport.

7. Industrial capitalism is an economic system in which trade, industry, and capital are privately
controlled and operated for profit. It saw the rapid development of the factory system of
production characterized by much more rigid, complex, and intricate division of labor that Smith
was propounding

8. Free trade, as opposed to the mercantilist policies of protection, was championed by both Smith
and Ricardo as a route to achieve production efficiency at a global level. Ricardo's cost
calculations were based on labor hours, which were treated as a single homogeneous input.

9. It was comparative advantage which was considered both necessary to ensure mutually gainful
international trade across borders warranting complete specialization in the specific commodity
with a comparative advantage in terms of labor hours used per unit of output.

10. The theory of comparative advantage was formulated by David Ricardo when he investigated in
detail the advantages and alternative or relative opportunity in his 1817 book On the Principles of
Political Economy and Taxation in an example involving England and Portugal. He argued that a
country boosts its economic growth the most by focusing on the industry in which it has the most
substantial comparative advantage. According to his comparative advantage principle,
developing countries with a comparative advantage in agriculture should continue to specialize in
agriculture and import high-technology widgets from developed countries with a comparative
advantage in high technology.

11. David Ricardo started out as a successful stockbroker, making $100 million in today's dollars. After
reading Adam Smith's The Wealth of Nations, he became an economist. He pointed out that
significant increases in the money supply created inflation in England in 1809. Ricardo developed
the theory of monetarism, the theory or practice of controlling the supply of money as the chief
method of stabilizing the economy.

12. Ricardo also developed the law of diminishing marginal returns, which states that there is a point
in production where the increased output is no longer worth the additional input.
13. In older economic terms, comparative advantage has been opposed by mercantilism and
economic nationalism. They argue that while a country may initially be comparatively
disadvantaged in a given industry, countries should shelter and invest in industries until they
become globally competitive.

LESSON SUMMARY 2.5

1. David Ricardo's theory of comparative advantage posits that countries export the goods they
have abundant production factors for, while they import the goods for which they have scarce
production factors. Relative intensities of production factors (land, labor, and capital) determine
the comparative advantage of a country.

2. Using the above premise as a starting point, two Swedish economists, Eli Heckscher and his
student Bertil Ohlin, from Stockholm School of Economics, in the 1920s, studied how a country
could gain comparative advantage by producing products that utilized factors that were in
abundance in the country.

3. The Heckscher-Ohlin theory or H-O theory is based on a country's production factors-land, labor,
and capital; hence, the theory is also called the factor proportions theory or the resources and
trade theory. Hecksher and Ohlin determined that the cost of any factor or resource was a
function of supply and demand.

4. Many elaborations of the model were provided by Paul Samuelson after the 1930s an thus,
sometimes the model is referred to as the Heckscher-Ohlin- Samuelson (HOS) model.

5. In the 1950s and 1960s, some noteworthy extensions to the model were made by Jaroslav Vanek,
and so occasionally the model is called the Heckscher-Ohlin-Vanek model.