MNGT6: International Business and Trade 1
LESSON 2
TRADE THEORIES AND CONCEPTS
Learning Objectives:
1. Compare and contrast different trade theories.
2. Determine which international trade theory is most relevant today and how it continues to
evolve.
Reasons for trade
A. Proximity
The proximity of Canada to the United States means lower transportation costs relative to
trade between the United States and countries in Asia or Europe. This close distance
between two neighboring countries may explain why Canada is not only one of the top
exporters of snowboards to the United States but also its largest trading partner. Proximity
may also the reason why European countries mainly trade with each other, whereas Japan
and China is the largest trading partner for many Asian countries. Countries located in
close proximity of one another often join into a free trade area to promote trade by
eliminating barriers to trade such as tariffs and quotas.
[Link]
Land, labor and capital are often referred to as factors of production because these
resources are used to produce goods and services. Taiwan is able to sell at considerably
low prices because the snowboards imported from this country are unfinished. The
process of spreading production across several countries by a company that imports the
unfinished goods for further processing at lower price is known as outsourcing. The
available resources of China is the reason why it became the top exporter of snowboard in
United States.
Classical Theories of International Trade
1. Mercantilism
Developed in the sixteenth century, mercantilism was one of the earliest efforts to
develop an economic theory. This theory stated that a country’s wealth was determined
by the amount of its gold and silver holdings. This mercantile system was based on the
premise that national wealth and power were best served by increasing exports and
collecting precious metals in return.
2. Smith’s Theory of Absolute Advantage
The ability of a party (individual, firm or country) to produce a greater quantity of goods
and services than competitors using the same resources. This theory was developed by
18th century economist Adam Smith in his book “The Wealth of Nation”.
3. Comparative advantage (Ricardian Model)
To determine trade partners, we need to examine the relative rather than absolute
differences between countries. A country with maximum absolute advantage in the
creation of more than one product as compared to other, can still trade with another
country.
MNGT6: International Business and Trade 2
4. Heckscher-Ohlin Trade theory of Factor Proportions
According to this theory, one condition for trade is that the countries differ with respect to
the availability of the factors of production. The Heckscher-Ohlin Theory suggests that a
country specializes in the production of goods that it is particularly suited to produce.
5. Leontief Paradox
The observation by Wassily Leontief (1906–1999) that in spite of being the world's most
capital-rich country, the US appeared on average to have exports that were slightly more
labor-intensive than its imports. This was thought to be paradoxical because the
Heckscher–Ohlin model of international trade led people to expect that US exports would
be capital-intensive and its imports would be labor-intensive.
Modern or Firm-Based Trade Theories
1. Country Similarity Theory
This theory was developed by Swedish economist Steffan Linder. The idea
that countries with similar qualities are most likely to trade with each other. These
qualities may include level of development, savings rates, and natural resources, among
others.
2. Product Life Cycle Theory
Raymond Vernon, a Harvard Business School professor, developed the product life cycle
theory in the 1960s. The theory, originating in the field of marketing, stated that a product
life cycle has three distinct stages: (1) new product, (2) maturing product, and (3)
standardized product. The theory assumed that production of the new product will occur
completely in the home country of its innovation.
3. Global Strategic Rivalry Theory
Global strategic rivalry theory emerged in the 1980s and was based on the work of
economists Paul Krugman and Kelvin Lancaster. Their theory focused on MNCs and their
efforts to gain a competitive advantage against other global firms in their industry.
4. Porter’s National Competitive Advantage Theory
In the continuing evolution of international trade theories, Michael Porter of Harvard
Business School developed a new model to explain national competitive advantage in
1990. Porter’s theory stated that a nation’s competitiveness in an industry depends on the
capacity of the industry to innovate and upgrade. His theory focused on explaining why
some nations are more competitive in certain industries.
Porter identified four determinants:
local market resources and capabilities
local market demand conditions
local suppliers and complementary industries, and
local firm characteristics.