International Trade Theories
To better understand how modern global trade has evolved, it’s important to understand how countries traded with one another historically. Over time, economists have developed theories to explain the mechanisms of global trade.
The mercantilism theory was the first international trade theory which emerge in England around the mid-16th century which states that a nation should accumulate financial wealth usually in the form of gold and silver by encouraging export through government subsidies and discouraging imports via tariffs and quotas. The mercantilism theory is viewed as a zero sum game which meant that world wealth was limited and that countries only could increase their share at expense of their neighbours. This theory has then been revised by Adam Smith and David Ricardo which showed that international trade is a positive sum game.
During the year 1776, Scottish economist Adam Smith introduced his theory of absolute advantage as he strongly criticized the mercantilist assumption that trade is a zero sum game and advance free trade as it enlarges a country’s wealth. Absolute advantage implies that a country should import goods that are cheaper abroad and export goods it can produce more efficiently than other countries. He stated that countries differ in their ability to produce goods efficiently and that a country should never produce a good at home that it can buy at a lower cost from other countries. In addition, Smith stated that when countries specialize in the production of goods in which each has an absolute advantage, both countries can benefit by engaging in international trade activities.
In 1817, David Ricardo took Adam Smith’s theory one step further by exploring what might happen when one country has an absolute advantage in the production of all goods. He postulated that even if countries do not have an absolute advantage, they can still derive benefits from international trade by allocating resources based on their comparative advantage and trade with each other. This theory states that nations should concentrate on what it could produce cheaply and efficiently and should trade its product for those good that it’s less able to produce economically.
In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a country could gain comparative advantage by producing products that utilized factors that were in abundance in the country. They argued that countries that have different factor endowment of labour, land and capital input should specialize in and export those products which intensively use the factors of production which they are most endowed. Total output and economic welfare can be increased if each country specializes in those goods and services where they have an advantage. For example, China and India are home to cheap, large pools of labor. Hence these countries have become the optimal locations for labor-intensive industries like textiles and garments.
In the continuing evolution of international trade theories, Michael Porter developed a new model to explain national competitive advantage in 1990. His theory attempts to determine why some countries succeed while other fails in international competition. Porter theorizes that four attributes also known as Porter’s Diamond was responsible for this success or failure. These attributes are, Factor Endowments, Demand Conditions, Relating and Supporting Industries, Firm’s strategy, structure and domestic rivalry. Porter argued that firms are most likely to succeed in industries that the diamond is most favourable.