DON HONORIO VENTURA STATE UNIVERSITY
Bacolor, Pampanga
College of Business Studies
Bachelor of Science in Business Administration (Major in Accounting)
Academic Year 2022-2023
2nd Semester
INTERNATIONAL BUSINESS AND TRADE (BA FIN 102)
Chapter 2: International Trade Theories
Learning Objectives:
At the end of the lesson, the students should be able to:
1. Understand international trade.
2. Compare and contrast different trade theories.
3. Determine which international trade theory is most relevant today and how it continues to evolve.
Topic Outline:
International Trade Theories
Classical or Country Based Trade Theories
Mercantilism
Absolute Advantage
Comparative Advantage
Factor Proportions Theory
Modern or Firm-Based Trade Theories
Country Similarity Theory
Product Life Cycle Theory
Global Strategic Rivalry Theory
Porter’s National Competitive Advantage Theory
Free Trade
Opposition to Free Trade
Types of Trade Barriers
Tariffs
Non-Tariffs
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International Trade Theories
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 is
then the concept of this exchange between people or entities in two different countries.
People or entities trade because they believe that they benefit from the exchange. They may
need or want the goods or services. While at the surface, this many sound very simple, there is a great
deal of theory, policy, and business strategy that constitutes international trade.
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 main historical theories are called classical and are from the
perspective of a country, or country-based. By the mid-twentieth century, the theories began to shift to
explain trade from a firm, rather than a country, perspective. These theories are referred to
as modern and are firm-based or company-based. Both of these categories, classical and modern,
consist of several international theories.
Classical CountryBased Theories
Modern FirmBased Theories
Mercantilism
Country Similarity
Absolute Advantage
Product Life Cycle
Comparative Advantage
Hecksher-Ohlin Theory
(Factor Proportions Theory)
Global Strategic Rivalry
Porter's National
Competetive Advantage
Classical or Country Based Trade Theories
Mercantilism – 16th century
This theory stated that a country’s wealth was determined by the amount of its gold and silver
holdings. In its simplest sense, mercantilists believed that a country should increase its holdings of gold
and silver by promoting exports and discouraging imports. In other words, if people in other countries
buy more from you (exports) than they sell to you (imports), then they have to pay you the difference in
gold and silver. The objective of each country was to have a trade surplus, or a situation where the value
of exports are greater than the value of imports, and to avoid a trade deficit, or a situation where the
value of imports is greater than the value of exports. By doing so, a country would accumulate gold and
silver and, consequently, increase its national wealth, prestige, and power.
The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in
which a gain by one country results in a loss by another.) It was left to Adam Smith and David Ricardo to
show the shortsightedness of this approach and to demonstrate that trade is a positive-sum game, or a
situation in which all countries can benefit.
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Absolute Advantage – Adam Smith, 1776
This theory focused on the ability of a country to produce a good more efficiently than another
nation. On this theory it was reasoned that trade between countries 0shouldn’t be regulated or
restricted by government policy or intervention. He stated that trade should flow naturally according to
market forces. In a hypothetical two-country world, if Country A could produce a good cheaper or faster
(or both) than Country B, then Country A had the advantage and could focus on specializing on
producing that good. Similarly, 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 by doing the same tasks. Production would also become more efficient,
because there would be an incentive to create faster and better production methods to increase the
specialization.
A country enjoys an absolute advantage over another country in the production of a product if
it uses fewer resources to produce that product than the other country does.
Example:
The English, by virtue of their superior manufacturing processes, were the world’s most efficient
textile manufacturers. The French, due to the combination of favorable climate, good soils, and
accumulated expertise, they had the world’s most efficient wine industry. The English had an absolute
advantage in the production of textiles, while the French had an absolute advantage in the production of
wine. Thus, a country has an absolute advantage in the production of a product when it is more
efficient than any other country in producing it.
Comparative Advantage – David Ricardo, 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. According to Ricardo’s
theory of comparative advantage, it makes sense for a country to specialize in the production of those
goods that it produces most efficiently and to buy the goods that it produces less efficiently from other
countries, even if this means buying goods from other countries that it could produce more effectively
itself.
The challenge to the absolute advantage theory was that some countries may be better at
producing both goods and, therefore, have an advantage in many areas. In contrast, another country
may not have any useful absolute advantages. To answer this challenge, the theory of comparative
advantage was introduced. This theory reasoned that even if Country A had the absolute advantage in
the production of both products, specialization and trade could still occur between two countries.
Comparative advantage occurs when a country cannot produce a product more efficiently than
the other country; however, it can produce that product better and more efficiently than it does other
goods. The difference between these two theories is subtle. Comparative advantage focuses on the
relative productivity differences, whereas absolute advantage looks at the absolute productivity.
A country enjoys a comparative advantage in the production of a good is that good can be
produced at a lower cost in terms of other goods.
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Factor Proportions Theory - Hecksher-Ohlin, 1900s
In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, put forward a
different explanation of comparative advantage. They argued that comparative advantage arises from
differences in national factor endowments (by factor endowments they meant the extent to which a
country is endowed with such resources such as land, labor and capital). They focused their attention
on how a country could gain comparative advantage by producing products that utilized factors that
were in abundance in the country. Their theory is based on a country’s production factors—land, labor,
and capital, 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. Factors that were in great supply
relative to demand would be cheaper; factors in great demand relative to supply would be more
expensive.
This theory stated that countries would produce and export goods that required resources or
factors that were in great supply and, therefore, cheaper production factors. In contrast, countries
would import goods that required resources that were in short supply, but higher demand. Unlike
Ricardo’s theory, the Heckscher-Ohlin theory argues that free trade is beneficial and that the pattern of
international trade is determined by differences in factor endowments, rather than differences in
productivity.
Example:
The United States has long been a substantial exporter of agricultural goods, reflecting in part its
unusual abundance of arable land. In contrast, China excels in the export of goods produced in labor
intensive manufacturing industries such as textiles and footwear. This reflects China’s relative
abundance of low-cost labor. The United States, which lacks abundant low cost labor, has been a
primary importer of these goods. Note that it is relative, not absolute, endowments that are important;
a country may have larger absolute amounts of land and labor than another country, but be relatively
abundant in one of them.
Modern or Firm-Based Trade Theories
Country Similarity Theory – Steffan Linder, 1961
Linder’s theory proposed that consumers in countries that are in the same or similar stage of
development would have similar preferences. In this firm-based theory, Linder suggested that
companies first produce for domestic consumption. When they explore exporting, the companies often
find that markets that look similar to their domestic one, in terms of customer preferences, offer the
most potential for success. Linder’s country similarity theory then states that most trade in
manufactured goods will be between countries with similar per capita incomes, and intraindustry trade
will be common. This theory is often most useful in understanding trade in goods where brand names
and product reputations are important factors in the buyers’ decision-making and purchasing processes.
Product Life Cycle Theory – Raymond Vernon, 1960s
Vernon’s theory was based on the observation that for most of the 20th century a very large
proportion of the world’s new products had been developed by U.S. firms and sold first in the U.S.
market (e.g. mass produced automobiles, televisions, instant cameras, photocopiers, personal
computers, and semiconductor chips). To explain this, Vernon argued that the wealth and size of the
U.S. market gave U.S. firms a strong incentive to develop new consumer products. In addition, the high
cost of U.S. labor gave U.S. firms an incentive to develop cost saving process innovations.
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Just because a new product is developed by a U.S. firm and first sold in the U.S. market, it does not
follow that the product must be produced in the United States. It could be produced abroad at some
low-cost location and then exported back into the United States. However, Vernon argued that most
new products were initially produced in America. Apparently, the pioneering firms believed it was
better to keep production facilities close to the market and to the firm’s center of decision making, given
the uncertainty and risks inherent in introducing new products. Also, the demand for most new
products tends to be based on non-price factors. Consequently, firms can charge relatively high prices
for new products, which obviates the need to look for low-cost production suites in other countries.
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.
Global Strategic Rivalry Theory – Paul Krugman and Kelvin Lancaster, 1980s
Their theory focused on MNCs and their efforts to gain a competitive advantage against other
global firms in their industry. Firms will encounter global competition in their industries and in order to
prosper, they must develop competitive advantages. The critical ways that firms can obtain a
sustainable competitive advantage are called the barriers to entry for that industry. The barriers to
entry refer to the obstacles a new firm may face when trying to enter into an industry or new market.
The barriers to entry that corporations may seek to optimize include:

research and development,

the ownership of intellectual property rights,

economies of scale,

unique business processes or methods as well as extensive experience in the industry, and

the control of resources or favorable access to raw materials.
Porter’s National Competitive Advantage Theory – Michael Porter, 1990
For Porter, the essential task was to explain why a nation achieves international success in a
particular industry. Why does Japan do so well in the automobile industry? Why does Switzerland excel
in the production and export of precision instruments and pharmaceuticals? Why do Germany and the
United States do so well in the chemical industry? These questions cannot be answered easily be
Heckscher-Ohlin theory, and the theory of comparative advantage offers only a partial explanation.
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. To explain his theory, Porter identified four determinants/broad
attributes of a nation that he linked together. The four determinants are (1) local market resources and
capabilities, (2) local market demand conditions, (3) local suppliers and complementary industries, and
(4) local firm characteristics.

Factor endowments – a nation’s position in factors of production such as skilled labor or the
infrastructure necessary to compete in a given industry.

Demand conditions – the nature of home demand for the industry’s product or service.
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
Relating and supporting industries – the presence or absence of supplier industries and related
industries that are internationally competitive.

Firm strategy, structure, and rivalry – the conditions governing how companies are created,
organized, and managed and the nature of domestic rivalry.
Porter speaks of these four attributes as constituting the diamond. He argues that firms are
most likely to succeed in industries or industry segments where the diamond is most
favorable. He also argues that the diamond is a mutually reinforcing system. The effect of
one attribute is contingent on the state of others.
Example:
Porter argues that favorable demand conditions will not result in competitive advantage unless
the state of rivalry is sufficient to cause firms to respond to them.
Free Trade
A free trade agreement is a pact between two or more nations to reduce barriers to imports and
exports among them. Under a free trade policy, goods and services can be bought and sold across
international borders with little or no government tariffs, quotas, subsidies, or prohibitions to inhibit
their exchange.
Opposition to Free Trade



The Sovereignty Argument
Lowest Common Denominator Argument
Trade Reciprocity
Types of Trade Barriers
International trade is carried out by both businesses and governments—as long as no one puts
up trade barriers. In general, trade barriers keep firms from selling to one another in foreign markets.
Trade barriers are government-induced restrictions on international trade. The major obstacles to
international trade are:

Tariffs
A tariff is a specified tax levied by a nation on imported goods. It may be a charge per unit, such
as per barrel of oil or per new car; it may be a percentage of the value of the goods, such as 5 percent of
a ₱5,000,000 shipment of shoes; or it may be a combination. No matter how it is assessed, any tariff
makes imported goods more costly, so they are less able to compete with domestic products.
 Specific Tariff
- levied as a fixed fee based on the type of item, such as a ₱50,000 tariff on a
car.
 Ad-Valorem Tariff
- levied based on the item's value, such as 10% of the value of the vehicle.

Non-Tariffs
Non-tariffs barriers are tools used by the government to restrict trade besides tariffs.
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 Quotas
- a restriction placed on the amount of a particular good that can be
imported.
 Export Controls
- U.S. laws and regulations that regulate and restrict the release of critical
technologies, information, and services to foreign nationals, within and
outside of the United States, and foreign countries for reasons of foreign
policy and national security.
 Dumping/Anti-dumping
- Dumping is when a country sells exports below market value just to gain
share.
- Anti-dumping duty is a protectionist tariff that a government places on
imports thought to be significantly underpriced.
 Embargoes and Boycotts
- a complete ban against importing or exporting a product.
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