Module 3 : International Trade

Theory
Dr. Sovna Mohanty
Assistant Prof
Manipal School of Commerce and Management
Content

• Trade theories-Mercantilism, Absolute Advantage; Comparative

Advantage; Heckscher-Ohlin Theory (The Leontif Paradox);
• Instruments of trade policy; The case for Government Intervention; The
revised Case for free trade;
• Regional Economic Integration; Levels of Economic Integration; case for
Regional Integration; Regional Economic Integration in Europe; Regional
Economic Integration in the Americas; Regional Economic Integration
Elsewhere (ASEAN, SAARC, BRIC, APEC etc.).
 • International trade refers to the exchange of goods and services between
countries. Nations trade primarily because it allows them to use their resources
more efficiently through specialization.

• Every country has different resources, skills, and technological capabilities,

which means some goods can be produced more efficiently in certain countries

Why Do
than in others.

• When countries specialize in producing goods in which they are efficient and trade

Nations
them internationally:
• Industries become more productive
• Production costs decrease

Trade?
• Consumers gain access to a wider variety of goods
• Overall living standards increase

• For example:
• Saudi Arabia exports oil because it has abundant petroleum resources.
• Brazil exports coffee because of its favorable climate and fertile land.
• Without international trade, many countries would struggle to produce
enough food, energy, clothing, and technology to meet their population’s
needs.
 • Economists have developed several theories to explain why countries
trade and how trade patterns develop.
• The six classical perspectives that explain international trade are:
Classical • Mercantilism
• Absolute Advantage Theory
Theories • Comparative Advantage Theory
• Factor Proportions Theory
Explaining • International Product Life Cycle Theory

International • These theories help explain:

• Why nations export certain products

Trade • Why nations import other products

• How international trade improves economic welfare
• Each theory represents an evolution in economic thinking about
global trade.
 • Mercantilism was the earliest theory of international trade,
developed in Europe during the 1500s and 1600s.
• During this period, wealth was measured by the amount of gold
and silver a country possessed.
• According to mercantilist thinkers:
• Nations should maximize exports
• Nations should minimize imports

Mercantilism
• This creates a positive balance of trade (trade surplus).
• Trade Surplus = Exports > Imports
• Governments often supported mercantilism through
policies such as:
• High tariffs on imported goods
• Restrictions on foreign trade
• Subsidies to domestic exporters
• Mercantilism assumed that international trade was a
zero-sum game, meaning one country's gain was another
country's loss.
 • Although mercantilism encouraged exports, it had several
disadvantages.
• Problems with Mercantilism
• Restricting imports reduces consumer choice

Limitations
• Import restrictions can lead to higher prices and inflation
• Domestic industries may become inefficient due to lack of
competition
of • Trade conflicts may arise between countries
• Because of these issues, economists later promoted free trade.
Mercantilism • Free Trade

and Free • Free trade refers to a situation where there are minimal government
restrictions on international trade.

Trade • Benefits of free trade include:

• Lower prices for consumers
• Increased competition
• Greater efficiency in production
• Improved economic growth
• Most modern economies support free trade policies, although
some protectionist measures still exist.
 Absolute • The concept of absolute advantage was introduced by the Scottish
economist Adam Smith in his famous book The Wealth of Nations

Advantage (1776).
• Smith argued that countries should specialize in producing goods that

(Adam they can produce more efficiently than other countries.

• Definition

Smith – • A country has an absolute advantage when it can produce a product

using fewer resources or lower cost than another country.

1776)
Absolute Advantage
(Adam Smith – 1776)
• Dairycountry can produce more milk
and more wheat using the same Milk Wheat
resources, meaning it has an absolute Country
Production Production
advantage in both products.
• However, this raises an important
question:
Dairycountry 10 gallons 8 pounds
• If one country is better at producing
everything, is trade still beneficial? Farmcountry 2 gallons 4 pounds
• This question led economists to
develop the theory of comparative
advantage.
 • British economist David Ricardo introduced the theory of comparative advantage in 1817.
• Ricardo demonstrated that two countries can benefit from trade even if one country is
more efficient at producing all goods.

Comparative • Definition
• Comparative advantage occurs when a country can produce a good at a lower
opportunity cost than another country.

Advantage • Opportunity cost refers to the value of the next best alternative that must be given
up.
• Countries should specialize in producing goods in which they have the lowest

(David •
opportunity cost, rather than absolute efficiency.
Example:

Ricardo – • Dairycountry is much better at producing milk.

• Cattlecountry is relatively better at producing diary.

1817)
• Therefore:
• Dairycountry specializes in milk production
• Cattlecountry specializes in beef production
• Through trade, both countries gain access to more goods at lower cost.
• Comparative advantage remains the foundation of modern international trade theory.
Factor Proportions Theory • The Factor Proportions Theory was developed by
economists Eli Heckscher and Bertil Ohlin in the
(Heckscher-Ohlin Theory) 1920s.
• The theory is based on two main ideas:
• Different products require different combinations of
factors of production.
• Countries possess different amounts of these
Abundant production factors.
Country Exported Goods
Factor • Factors of production include:
• Labor
Capital and Aircraft,
USA • Capital
technology pharmaceuticals
• Land
Textiles, • Natural resources
China Labor
electronics • According to the theory:
• Countries will export goods that use their abundant
Agricultural resources intensively and import goods that require
Argentina Land
products resources they lack.
International Product Life Cycle Theory
• The International Product Life Cycle (IPLC) Theory was proposed by economist
Raymond Vernon in 1966.
• According to this theory, products go through three stages during their life cycle.
• Stage 1: Introduction
• New products are invented in developed countries
• Production occurs close to research and development centers
• The product is expensive and targeted at high-income consumers
• Stage 2: Maturity
• Demand increases globally
• Firms begin exporting the product to other developed countries
• Competition increases
• Stage 3: Standardization
• Production becomes standardized
• Manufacturing shifts to developing countries with lower labor costs
• The original innovating country may begin importing the product
• Example: Television manufacturing shifted from the United States to countries such as China
and Mexico.
New Trade Theory and National Competitive
Advantage
• In the 1970s, economists such as Paul Krugman developed the New Trade
Theory.
• This theory focuses on the role of economies of scale in international trade.
• Economies of scale occur when:
• Large-scale production reduces the average cost per unit
• Industries with high fixed costs benefit significantly from economies of scale.
• Examples include:
• Commercial aircraft manufacturing
• Automobile production
• Pharmaceutical manufacturing
• New trade theory suggests that countries can become successful exporters
even without natural resource advantages, simply by developing large,
efficient industries.
 Government Intervention and
Regional Economic Integration
Protectionism & Government Intervention in
Trade
• What is Protectionism?
• Protectionism refers to government policies that restrict or
regulate international trade in order to protect domestic
industries from foreign competition. These policies include
tariffs (taxes on imports), quotas (limits on imports), and
subsidies (financial support to local firms).
• Why Do Governments Intervene?
• Governments intervene in trade because:
• Domestic firms may struggle to compete with cheaper imports
• Employment levels may be affected
• Countries want to maintain economic stability and growth
• Trade policy is not purely economic — it is influenced by political
pressure, social concerns, and long-term national goals.
 • Fighting Unemployment
• One of the strongest reasons governments adopt protectionism is to
protect domestic jobs.
Economic Rationale- • When imports increase:

Government • Domestic firms lose market share

• Production declines
Intervention • Workers may lose jobs
• Why This Creates Pressure:
• Unemployed workers are often:
• More vocal politically
• More dependent on government support
• Less able to find alternative employment
• Real-World Context:
• For example, if cheaper imported garments flood the market,
local textile manufacturers may shut down, leading to job
losses.
 • 1. Retaliation by Other Countries
• When one country restricts imports, other countries often
respond with their own restrictions.
• Example: If the U.S. restricts imports, China may reduce
imports from the U.S.

Economic
• Result: Export industries suffer
• 2. Job Loss in Other Sectors

Rationale- • Protection in one sector can harm others:

• Fewer imports → fewer logistics/shipping jobs

Government • Higher input costs → reduced production elsewhere

• If steel imports are restricted → steel prices rise →

Intervention automobile production becomes expensive → fewer cars

sold → job losses in auto industry
• 3. Imports Support Exports
• Imports increase foreign income, which allows foreign
consumers to buy exports from your [Link]
imports can indirectly reduce exports.
Infant Industry Argument
• What is the Infant Industry Argument? Economic Rationale-
• It suggests that new or emerging industries need
temporary protection from foreign competition Government
until they become strong enough to compete
globally.
Intervention
• Why Protection is Needed Initially:
• High production costs
• Lack of experience
• Small scale of operations
• Over time:
• Firms learn and become efficient
• Costs fall due to economies of scale
• Industry becomes competitive
• Example:
• Countries like Brazil protected their automobile
industry in early stages.
• Developing an Industrial Base
• Many countries use protectionism to shift from agriculture to Economic Rationale-
manufacturing, aiming for long-term economic growth.
Government
• Why Focus on Industrialization?
• Manufacturing generates higher income than agriculture Intervention
• Creates more stable economic growth
• Builds infrastructure and skills
• Key Assumptions:
• Surplus workers can move from rural to industrial jobs
• Foreign investment (FDI) brings technology and capital
• Manufacturing markets grow faster than agriculture
• Challenges:
• Rural-to-urban migration can create unemployment and poor
living conditions
• Industrial sectors may remain inefficient
• Agriculture may still be important for growth
• Industrialization helps development, but must be balanced
with efficiency and sustainability
Non-Economic Rationales for Government
Intervention
What are Non-Economic Rationales?

• These are reasons other than pure economic benefits (like profit or
efficiency) that motivate governments to control trade.

However, most of these still have economic

consequences indirectly.

Major Non-Economic Reasons:

• Maintaining essential industries (defense/security)

• Promoting acceptable practices abroad
• Maintaining or extending spheres of influence
• Preserving national culture
 1. Essential Industry Argument
• Governments protect certain industries because they are
critical during war or crisis.
• Countries do not want to depend on foreign suppliers for:
• Weapons
• Technology (e.g., semiconductors)
• Raw materials (e.g., rare earth elements)
• 2. Promoting Acceptable Practices Abroad (Sanctions)

Non Economic • Governments use trade restrictions to influence other countries’

behavior:

Rationale • Economic sanctions

• Export/import bans
• Financial restrictions
• These are used to:
• Stop nuclear programs (e.g., Iran)
• Promote human rights
• Protect the environment (e.g., ivory trade bans)
• Countries may find alternative trade partners or develop their own
industries, reducing the effectiveness of such policies.
 • 3. Maintaining or Extending Spheres of Influence
• Countries use trade policies to increase their global power and influence.
• This is done by:
• Offering trade benefits to allies
• Restricting trade with rival nations
• Linking foreign aid with trade agreements
• Example: Large economies influence smaller countries through trade deals
and economic dependence.
• Trade becomes a strategic tool to shape international relations and

Non Economic geopolitical power.

Rationale • 4. Preserving National Culture

• Governments restrict trade to protect their cultural identity, traditions, and
values.
• Measures include:
• Limiting foreign media (films, TV, books)
• Restricting foreign ownership in cultural industries
• Protecting traditional sectors
• Canada limits foreign control of publishing and media
• Japan and South Korea historically restricted rice imports to protect cultural
heritage
Instruments of Trade Control – Meaning and Types

• Governments use different instruments to influence the flow of imports and exports. The choice of
instrument matters because each one affects prices, quantities, producers, consumers, and even
international relations differently. Broadly, trade-control instruments can be divided into two groups.
• The first group includes measures that indirectly affect the quantity traded by directly influencing
prices. When the price of an imported good rises because of a tax, fee, or policy, demand for that
imported product usually falls. This is how governments can reduce imports without directly banning
them.
• The second group includes measures that directly control the quantity of goods traded. These
instruments place a direct limit on how much can be imported or exported in a given period.
• Therefore, trade control instruments are not all the same. Some operate through price changes, while
others operate through quantity restrictions. This distinction is important because a tariff, subsidy,
quota, or embargo may all reduce trade, but they do so in different ways and create different effects on
government revenue, business decisions, and consumer welfare.
 Tariffs – The Most Common Trade Control Instrument

• A tariff, also called a duty, is a tax levied on goods that are traded internationally. It is charged when a product crosses an official border. Tariffs are one of
the oldest and most common forms of trade control.
• There are three main types of tariffs:
• Export tariff – collected by the exporting country
• Transit tariff – collected by a country through which the goods pass
• Import tariff – collected by the importing country
• Among these, import tariffs are the most common. Their main effect is to raise the price of imported goods. Once imports become more expensive,
domestic goods gain a relative price advantage, even if they are otherwise less efficient. In this way, tariffs protect domestic producers from foreign
competition.
• Tariffs also serve as a source of government revenue, especially in developing countries where collecting income taxes may be more difficult. In
developed countries, tariffs are usually less important as a revenue source and are used more as a protective measure.
• Governments may assess tariffs in different ways:
• Specific duty – a fixed amount per unit, such as per kilogram or per item
• Ad valorem duty – a percentage of the product’s value
• Compound duty – a combination of both
• An important issue with tariffs is that they can discourage developing countries from exporting higher-value manufactured goods. For example, raw coffee
beans may enter a developed country duty-free, but processed instant coffee may face a tariff. This makes it harder for developing countries to move up
the value chain from raw materials to manufactured products.
 Nontariff Barriers that Influence Prices

• Not all trade barriers are tariffs. Governments also use nontariff barriers, many of which affect trade by changing prices rather than directly limiting quantities.
• One major example is subsidies. Subsidies are financial assistance given by governments to domestic firms to improve their competitiveness. These may take the form of
grants, tax breaks, low-interest loans, or other forms of support. Subsidies help domestic companies lower costs, charge lower prices, or survive competition from foreign
producers.
• A well-known area of subsidy use is agriculture in developed countries. Governments often justify agricultural subsidies by saying that food supply is too important to be left
entirely to market forces. However, these subsidies often create surplus production, distort world trade, and disadvantage developing-country farmers who cannot compete
with heavily supported producers in richer nations.
• Another price-related measure is aid and loans, especially tied aid. In tied aid, the recipient country must use the funds to buy goods or services from the donor country. This
allows firms from the donor country to win contracts abroad even when they might not otherwise be the most competitive suppliers.
• Governments also influence prices through customs valuation. Since tariffs depend on a product’s declared value, customs officials must determine whether invoices are
genuine and whether goods have been properly classified. If customs authorities value a product highly, the importer pays more duty. This can act as a hidden barrier to trade.
• In addition, countries may impose other direct-price influences such as:
• customs clearance fees
• documentation charges
• advance customs deposits
• minimum selling price requirements after customs clearance
• These measures may seem technical, but they increase the cost of imported goods and can reduce trade significantly.
Nontariff Barriers that Control Quantity –
Quotas, VERs and Embargoes
• Some trade barriers directly control the amount of goods traded rather than working through prices. The most common of
these is the quota.
• A quota is a numerical limit on the quantity of a good that may be imported or exported during a specific period, usually one
year. Import quotas reduce supply in the domestic market, which usually raises prices. Unlike tariffs, quotas do not
automatically generate revenue for the government. Instead, the financial gain often goes to the firms that receive the right
to import or export under the quota.
• Governments may use import quotas to protect domestic industries or to manage dependence on foreign suppliers. They
may use export quotas to ensure domestic supply, conserve natural resources, or increase world prices by limiting supply
abroad.
• A related instrument is the Voluntary Export Restraint (VER). In a VER, the exporting country agrees to limit exports to the
importing country. It is called “voluntary,” but in reality the exporter often agrees because it wants to avoid stricter trade
restrictions. VERs are politically convenient because they appear less aggressive than direct quotas.
• An even stronger form of quantity restriction is an embargo. An embargo is a complete ban on trade in certain products or
with certain countries. Governments usually impose embargoes for political or strategic reasons rather than purely
economic ones. Embargoes are one of the strictest forms of trade control because they prohibit trade altogether.
• These quantity controls can be highly restrictive because they do not merely make trade more expensive; they may directly
prevent it.
Other Government Controls – Buy Local,
Standards, Licensing and Delays
• Governments also use several administrative and regulatory tools to restrict trade.
• One important measure is “Buy Local” legislation. Since government purchasing forms a large part of total spending in
many countries, governments often favor domestic firms in procurement contracts. They may require a certain percentage
of local content in products or allow foreign goods only if they are significantly cheaper than domestic alternatives. This
gives local firms an advantage even without an official import ban.
• Another important barrier is standards and labeling requirements. Governments may impose rules about safety, health,
packaging, ingredients, testing, technical specifications, and country-of-origin labeling. In theory, such standards protect
consumers. In practice, they may also act as barriers that make it harder and costlier for foreign firms to enter the market.
• Countries may also require import or export licenses. Before trading, firms must obtain official permission, sometimes by
submitting documents or product samples. Even if permission is eventually granted, the process adds cost, time, and
uncertainty, thereby discouraging trade.
• Similarly, foreign-exchange controls may require importers to obtain official approval for foreign currency needed to pay
suppliers abroad. If the currency is not approved, the transaction cannot proceed.
• Another subtle barrier is administrative delay. Delays at customs — whether intentional or due to inefficiency — increase
inventory costs, create uncertainty, and make imported goods less attractive. Even without an explicit ban, delay itself can
become a trade barrier.
• Together, these measures show that trade control often happens not just through taxes and quotas, but also through rules,
paperwork, approvals, and procedures.
How Firms Can
Respond to Government Intervention

• Research to gather knowledge and intelligence. Understand trade and investment barriers abroad.
Scan the business environment to identify the nature
of government intervention.
• Choose the most appropriate entry strategies. Most firms
choose exporting as their initial Vstrategy, but if high tariffs are present, other strategies should Vbe
considered, such as licensing, or FDI and JVs that allow the firm to produce directly in the market
• Take advantage of foreign trade zones. FTZs
are areas where imports receive preferential tariff treatment, intended to stimulate local economic
development. e.g., A successful experiment with FTZs has been the maquiladoras — export-assembly
plants in northern Mexico.

• Seek favorable customs classifications for exported products. Reduce exposure to trade barriers by
ensuring that products are classified properly.
• Take advantage of investment incentives and other government support programs.
• Lobby for freer trade and investment. Increasingly, nations are liberalizing markets in order to create jobs and
increase tax revenues.
 Regional Economic Integration
The growing economic
interdependence that results when nations
within a geographic region form an alliance
aimed at reducing barriers to trade and investment.
• Over 50 percent of world trade today occurs under
some form of preferential trade agreements signed by
groups of countries.
• Cooperating nations obtain:
▪ increased product choices, productivity, living standards,
▪ lower prices, and
▪ more efficient resource use.
 Economic Bloc
A geographic area consisting of two or more countries
that agree to pursue economic integration by reducing
tariffs and other barriers to the cross-border flow of
products, services, capital, and, in more advanced
cases, labor.

• Examples: European Union,

NAFTA, MERCOSUR, APEC,
ASEAN, and many others.
• There are five possible
levels of economic integration.
Five Potential Levels of Regional Integration
 Levels of Regional Integration
• Free trade area: Simplest, most common arrangement.
Member countries agree to gradually eliminate formal
trade barriers within the bloc, while each member
maintains an independent international trade policy with
countries outside the bloc. One example is NAFTA.
• Customs union: Similar to a free trade
area except the members harmonize
their trade policies toward nonmember
countries, by enacting common tariff
and nontariff barriers on imports from
nonmember countries. MERCOSUR
is an example.
 Levels of Regional Integration (cont’d)
• Common market: Like a customs union, except
products, services, and factors of production such as
capital, labor, and technology can move freely among the
member countries. e.g., The EU countries put in place
many common labor and economic policies.
•

• Economic union: Like a common market, but members

also aim for common fiscal and
monetary policies, and standardized
commercial regulations. The EU is
moving toward an economic union
by forming a monetary union with a
single currency, the euro.
 The EU: A Full-Fledged Economic Union

1. Market access. Tariffs and most nontariff barriers have

been eliminated.
2. Common market. Barriers to cross-border movement
of production factors—labor, capital, and technology.
3. Trade rules. Cross-national customs procedures and
regulations have been eliminated, which has
streamlined transportation and logistics within Europe.
4. Standards harmonization. Technical standards,
regulations, and enforcements have been harmonized.
5. Common fiscal, monetary, taxation, and social
welfare policies is the ultimate goal over time.
Why Do Nations Pursue Economic Integration?
● Expand market size
▪ Increases size of the marketplace for firms inside the
economic bloc. Belgium has a population of just 10
million; the EU has a population of nearly 500m.
▪ Buyers can access larger selection of goods.

● Achieve economies of scale and productivity

▪ Bigger market facilitates economies of scale.
▪ Internationalization inside the bloc helps firms learn to
compete outside the bloc.
▪ Competition and efficient resource usage inside the
bloc leads to lower prices for bloc consumers.
Why Nations Pursue Economic Integration (cont’d)

● Attract direct investment from outside the bloc

▪ Compared to investing in stand-alone countries,
foreign firms prefer to invest in countries belonging
to an economic bloc. General Mills, Samsung, and
Tata have invested heavily in EU-member countries.

● Acquire stronger defensive and political posture

▪ Belonging to a bloc provides member countries with
a stronger defensive posture relative to other
nations and world regions. This was a key motive
for formation of the European Union.