What are the major theories of international trade?

What are the major theories of international trade? In your opinion, what is the applicability of those theories (select any two) in today’s environment?

International business began with international trade operations, facilitated by the lasses faire in the world economy. It improved the well-being of many nations, and the imposition of trade barriers reduced the gains from trade, giving rise to the search for alternate avenues to exporting. The latter resulted in the established of subsidiaries in foreign countries through FDI. In this context, it is pertinent to understand the determinants of and the effects of international trade and FDI on the trade trading partners, international operations of multinationals and the economies of the home and hose countries. Several theories have been formulated, from time to time which form the bases of international trade and FDI.

Theory of Mercantilsm
During the sixteenth to the three-fourths of the eighteenth centuries, the world trade was being conducted according to the doctrine of mercantilism. It comprised many modern feature like belief in nationalism and the welfare of the nation alone, planning and regulation of economic activities for achieving the national goals, curbing imports and promoting exports.

The mercantilists believed that the power of a nation lied in its wealth, which grew by acquiring gold from abroad. This was considered possible by increasing exports and impeding imports. Such reasoning gathered support on the ground that gold could finance military expeditions and wars, and the exports would create employment in the economy. Mercantilists failed to realize in all countries, and the mere possession of gold does not enhance the welfare of a people. Keeping the resources in the form of gold reduces the production of goods and services and, thereby lowers welfare. The concentration in the production of goods for domestic consumption by using resources in a less efficient nanner, would also lower production and smaller gains from international trade.

The theory of marecantilism was rejected by Adma Smith and Ricardo by stressing the importance of individual, and pointing out that their welfare was the welfare of the nation. They believed in liberalism and enlightenment, and traded the wealth of the nation in term of the “the sum of enjoyments” of the individuals in society. Any activity, which would increase the consumption of the people, was to be considered with favour. Their trade doctrines were based upon the principals of free trade and the specialization in the production of those goods where resource most suitable.

Theory of Absolute Cost Advantage

The theory of absolute cost advantage was propounded by Adam Smith (1776), arguing that countries gain from trading, if they specialize according to their production advantages. His doctrine may be understood with an example presented in Table



Table shows that, in the absence of trade, both the goods are produced in both the countries, because of their demand in the domestic markets. The cost of production is determined by the amount of labour required in the production of the respective goods. The greater the amount of labour, the higher will be the cost of production, and the commodity will have a larger value in exchange. The pre-trade exchange ratio in country I would be

If trade takes place between these two countries then they will specialize in term of absolute advantage and gain from trading with each other. Country I enjoys absolute cost advantage in the production of good A and country II in good B. One unit of good A may be produced in country I with 10 hours of labour, whereas it costs 20 hors of labour in country II. The production of the units of good B. costs 20 hors of labour in country I and 10 hors of labour in country II. After trade, the international exchange ratio would lie somewhere between the pre-trade exchange ratio of the two countries. If it is nearer to country I domestic exchange ratio then trade would be more beneficial to country II and vice versa. Assuming the international exchange ratio is established IA=IB, then both the trading partners would be able to save 10 hors of labour, which may be used either for the workers as leisure the trading partners would depend upon their economic strength and the bargaining power.

Theory of Comparative Cost Advantage

Ricardo (1875), though adhering to the absolute cost advantage doctrine of Adam Smith, pointed out that cost and advantage to both the trade partners was not a necessary condition for trade to occur. It would still be beneficial to both the trading countries even if one country can produce all the goods with less labour cost than other country. According to Ricardo, so long as the other country is not equally less productive in all lines of production, measurable in terms of opportunity cost of each community in the two countries, it will still be mutually gainful for them if they enter into trade. Ricardo’s theory may be explained by referring to table.


In Table country I enjoyed absolute cost advantage in the production of both the goods A and B as compared to their production in country II. But company I has comparative cost advantage in good B. We take the help of the concept of opportunity cost in order to know the relative comparative advantage in the production of goods in the two countries. The opportunity cost to produce one unit of good A is the amount of good B which has to be sacrificed for producing the additional unit good A.

In the example given in table, the opportunity cost of one unit of A in country I is 0.89 unit of good B and in country II it is 1.2 unit of good B. On the other hand, the opportunity cost of one unit of good B in country I is 1.125 unit of good A and 0.83 unit of good A, in country II. The opportunity cost of two goods are different in both the countries and as long as this is the case, they will have comparative advantage in the production of either good A or good B, and will gain from trade regardless of the fact that one of the trade partners may be possessing absolute cost advantage in both lines of production. Thus, country I has comparative advantage in good A as the opportunity cost of its production is lower in this country as compared to its opportunity cost in country II which has comparative advantage in production of good B on the same reasoning.

The gains from trade in terms of Ricardo’s doctrine may be understood by distinguishing the term of trade under ‘autarky’ (i.e., having no trade with outside world because of the closed economy) and in terms of trade with the outside world. The domestic exchange ratio is determined by the internal cost of production. In Table, the exchange ratio before trade in country I should be IA-0.898 and in country II IA=1. 1B. If the international exchange ratio prevails between 0.98 and 1.2, the international trade would be gainful to both the countries. Assuming it settles as 1A=IB then country I gains 10 hours of labour and country II gains an equivalent of 20 hours of labour.

Both the absolute advantage and comparative advantage theories failed to realise that the welfare of society does not depend only on the gains from the international trade but depends upon the way the gains are distributed. The individual gains under the theories are guaranteed unless the government adopt an appropriate redistribution policy. There them engaged in the exportable production. These theories have also been criticized on the ground that labour is not the only input determining the cost of production.