Uploaded by lulum9814

Classical Trade Theories

Lindokuhle Mbele
Professor Leland Taylor
International Business
November 29, 2021
Classic Trade Theories
Classical trade theories are the basic trade patterns that people followed in the early ages
(Lucas, 1988). All of the classical theories will be covered with examples in this report.
Classical theories are the foundations of modern trade theories, and modern trade theories are
built on them (Kowalski, 2011). For a successful trade strategy, an organization must learn the
patterns and experiences that firms have used in the past (Mundell, 1957). The development of
an effective, sound, and well-defined trade policy can lead to long-term economic success, but
even the best strategy will not help the economy grow unless and until it is implemented.
Mercantilism, which emerged in the sixteenth century, was one of the first attempts to construct
an economic theory. According to this theory, a country's prosperity was determined by the amount
of gold and silver it possessed. In its most basic form, mercantilists thought that a country should
enhance its gold and silver holdings by encouraging exports and limiting imports. In other words,
if individuals in other nations buy more from you (exports) than they sell to you (imports), they
must compensate you in gold and silver. Each country's goal was to have a trade surplus, or a
scenario in which the value of exports exceeds the value of imports, and to prevent a trade deficit,
or a situation in which the value of imports exceeds the value of exports. Mercantilism flourished
from the late 1500s to the late 1800s this is because The 1500s saw the rise of new nation-states,
whose rulers sought to fortify their nations. These rulers were able to amass more gold and wealth
by increasing exports and trade. This strategy is known as protectionism, and it is still in use today.
Even though Mercantilism is the oldest, countries such as Japan, China, Singapore, Taiwan, and
even Germany still favor exports and discourage imports through a form of neo-mercantilism.
Taxpayers pay for government subsidies of select exports in the form of higher taxes; import
restrictions lead to higher prices for consumers. Free-trade advocates highlight how free trade
benefits all members of the global community, while protectionist policies only benefit select
Absolute Advantage
In 1776, Adam Smith questioned the dominant commercial theory of the time, Smith proposed
a new trade theory known as an absolute advantage, which focused on a country's ability to produce
a good more efficiently than another.
Adam Smith reasoned that government policy or intervention should not be used to regulate or
restrict trade between countries. He stated that trade should occur naturally as a result of market
forces. In a two-country world, if Country A could produce a good cheaper or faster (or both) than
Country B, then Country A had the advantage. If Country B was better at producing another good,
it could focus on specialization as well. By specialization, countries would generate
efficiencies, because their labor force would become more skilled.
Production would also become more efficient as there would be an incentive to develop faster and
better manufacturing methods in order to increase specialization.
The economist Adam Smith argued that a nation's wealth should not be measured by the amount
of gold and silver it possessed, but by the standard of living of its people. According to Smith's
theory, increased efficiencies would benefit people in both countries, and trade should be
Comparative Advantage
Comparative advantage occurs when one country cannot produce a product more efficiently than
another, but it can produce that product better and more efficiently than other goods. The
distinction between these two theories is multifaceted. The relative productivity differences are the
focus of comparative advantage, whereas absolute productivity is the focus of absolute
In 1817, David Ricardo, an English economist, proposed the theory of comparative advantage and
he reasoned that specialization and trade could still occur between two countries
Heckscher-Ohlin Theory (Factor Proportions Theory)
Smith and Ricardo's theories did not assist countries in determining which products would provide
a competitive advantage because Both theories assumed that free and open markets would lead
countries and producers to identify which goods could be produced more efficiently.
In the early 1900s, two Swedish economists Eli Heckscher and Bertil Ohlin focused their attention
on how a country could gain a comparative advantage. Their theory is based on a country's
production factors, which provide the funds for investment in plants and equipment. They
determined that the cost of any factor or resource was a function of supply and demand.
Leontief Paradox
In the 1950s, Wassily W. Leontief noted that the United States should export more capitalintensive goods. However, his research using actual data showed the opposite: the U.S. was
importing labor-intensive products and exporting them. Leontief's Leontief Paradox was a result
of his analysis of why it made sense to export labor-intensive goods from the United States to
France, Germany, and other European countries in 1800. His analysis became known as the reverse
of what was expected by the factor proportions theory. Over the decades, many economists have
used theories and data to explain and minimize the impact of the paradox. What remains clear is
that international trade is complex and is impacted by numerous and often-changing factors.
Modern or Firm-Based Trade Theories
In contrast to classical, country-based trade theories, modern, firm-based trade theories emerged
after World WarII and were largely established by business school professors rather than
economists. With the expansion of multinational corporations, firm-based theories arose (MNC).
The country-based theories couldn't adequately address the expansion of either MNCs or Intra
industry trade, an expert says. For example, Japan exports Toyota vehicles to Germany and imports
Mercedes-Benz automobiles from Germany. The firm-based theory incorporates other product and
service factors, including brand and customer loyalty and technology, into the understanding of
trade flows.
Product life cycle Theory
Product life cycle theory was a useful theory to explain the manufacturing success of the United
States in the 1960s. The theory assumes that the production of a new product will occur completely
in the home country of its innovation. US manufacturing was the globally dominant producer in
many industries after World War II. The product life cycle has three distinct stages: new product,
maturing product, and standardized product.
The product life cycle hypothesis has struggled to describe modern trade trends including global
innovation and production. Global corporations, for example, do research and development in
developing countries, where highly skilled people and facilities are typically less expensive. Even
though research and development are typically associated with the first or new product stage and
thus completed in the home country, developing or emerging-market countries such as India and
China offer both highly skilled labor and new research facilities at a significant cost advantage to
global firms.
New trade theory
According to New Trade Theory, very large economies of scale and network effects that might
develop in major industries are critical components in determining international trade patterns.
In some industries, there may be no discernible differences in opportunity cost between two
countries at any given time. However, if a country specializes in a specific industry, it may benefit
from economies of scale and other network benefits as a result of its specialization. These
economies can be so powerful that they overpower the more traditional theory of comparative
New trade theory suggests that firms who enter the market early and gain economies of scale can
then become dominant in their respective industries, leading to a form of monopolistic
competition. This is because they have the advantage of being an early entrant which means they
can't compete against other new entrants. This means that the most lucrative industries are often
dominated in capital-intensive countries, which were the first to develop these industries.
Therefore, being the first firm to reach industrial maturity gives a very strong competitive
advantage (Some may say unfair advantage).
New trade theory also becomes a factor in explaining the growth of globalization.
It means that poorer, developing economies may struggle to ever develop certain industries
because they lag too far behind the economies of scale enjoyed in the developed world.
This is not due to any intrinsic comparative advantage, but more the economies of scale the
developed firms already have.
Although international trade has had a long history, the theory of international trade explains the
advantages of exchanging commodities, technology, human resources, and any other exchangeable
item or skill in exchange for a return. The classical theory of trade was more concerned with the
conditions of trade than with the factors on which trading is dependent or the factors that drive the
economy. The modern trade theory revolves around three factors: competitive structure,
technology, and production scale.
Works Cited
Classical Theories Of Trade. (2021). Retrieved 31 October 2021, from
New Trade Theory (explained). (2021). Retrieved 31 October 2021, from
What Is International Trade Theory?. (2021). Retrieved 31 October 2021, from
What Is International Trade Theory?. (2021). Retrieved 31 October 2021, from