International Trade – Economic Theories

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    INTRODUCTION

    As per traditional concepts, trade was understood to refer to the exchange of goods. However, in the present era, it relates to lending, movements of goods, transactions linked with the flow of goods, promotion of buying and selling advance, borrowings, discount bills and mercantile documents, banking, and other forms of supply of funds. International Trade is the trade between two or more states, i.e., trade across borders. It may either be between the residents of two different states, or between two different states, or between a state and a resident. 

    The changing political and economic dynamics of the world may be credited with the evolution of international trade over centuries. International Trade has continued to evolve along with the changing perceptions surrounding it, and so have perceptions of various economists relating to the possible interests and advantages associated with it. 

    MERCANTILISM

    The theory of mercantilism advocates the regulation of international trade to generate wealth and strengthen a nation’s power. It suggests that merchants work together with national governments to reduce the trade deficit and create a surplus. Mercantilism is, essentially, a form of economic nationalism. The purpose of mercantilism was to focus on using trade for strengthening one’s economy by creating a surplus in trade. The theory paid no heed to the development and maintenance of international relations. It emphasized on self-sufficiency by means of a favourable balance of trade.

    It advocates the formulation of trade policies, in this regard, that protect the domestic countries. Here, governments aim at strengthening the various factors of production. They establish monopolies, grant tax-free statuses, and pensions to the favoured industries. Further, governments import tariffs on imports to prevent foreign companies from incurring any profits from their economy. In return to this preferred treatment, businesses funnel their riches earned from international expansion back to their governments. This mutuality enables increased national growth and political power. Since it focuses on the maximization of exports and minimization of imports, mercantilism may well be viewed as a form of economic protectionism. [1]

    Mercantilism dominated 16th and 17th century Europe, where merchants supported national governments to help them beat down foreign competitors. The advent of industrialization and capitalism laid the stage for it. Since wealth was limited, nations focused most of their economic energies on the accumulation of wealth. Mercantilism believed in the conviction that national interests are inevitably in conflict, i.e., one country can increase its trade only at the expense of others. Trade policies, as dictated by mercantilists, encouraged exports while discouraging imports.

    However, during the late 1700s, the coming of democracy and rise in popularity of free trade destroyed mercantilism. Adam Smith criticized mercantilism by arguing that foreign trade strengthens the economies of both the countries involved in the trade. The ideas of mercantilism seem to be intellectually shallow. Further, the suggested trade policies lay too much emphasis on the rationalization of interests of a rising merchant class.

    THEORY OF ABSOLUTE DIFFERENCES IN COST

    Adam Smith, the father of economics, put forth the theory of absolute differences in cost, or the absolute cost advantage theory, in support of international trade. He suggested that trade between nations would be mutually beneficial if one country could produce one commodity at an absolute advantage over the other state, and the other country could, in turn, produce another commodity in an absolute advantage over the first. Based on the concept of free trade, the theory focuses on explaining the benefits of international trade. 

    Smith reasoned that trade between nations shouldn’t be regulated or restricted by any governmental policy or intervention and instead, should flow naturally following the market forces. A country’s advantage may either be natural or acquired. He suggested that three kinds may accrue to a state from international trade, namely, productivity gain, absolute cost gain, and vent for surplus gain. [2]

    For example, in a two-country model, if country-A could produce wine cheaper, or faster, or both, in comparison to country-B, and country-B can produce meat quicker or less expensive than country-A. In such a situation, country-A has an absolute advantage in the production of wine and, therefore, should specialize in the production of wine and may meet its requirement for meat through import from country-B. By specialization, countries could generate efficiencies since their labour force would become better skilled and would allow a more efficient production. Smith argued that a nation’s wealth should be judged based on the living standards of its people, and with increased efficiencies,  people in both countries would benefit and which would ultimately, encourage trade. 

    COMPARATIVE COST THEORY

    The Comparative Cost theory or the Comparative Advantage theory was put forth by David Ricardo in support of international trade. Ricardo challenges the absolute advantage theory in terms that some countries may be better at producing both goods and will have an advantage in many areas, and therefore, in response to this, proposed the comparative advantage theory.  

    He maintained that if a trade is left free, each country would eventually specialize in the production and export of those commodities in whose production it enjoys a comparative advantage in terms of real costs. He further proposed that each country should import those commodities which could not be produced at home at a comparative advantage. Such specialization is the mutual advantage of countries participating in it. The law of comparative advantage proposed that a country should specialize in the production of those goods in which it is more efficient and leave the production of the other commodity to the other country. [3]

    As per the theory, free and unrestricted trade encourages specialization on a large scale and brings the following three advantages:

    1. It allows an efficient allocation of world resources and maximization of world production.
    2. It allows redistribution of relative production demands, resulting in greater equality of product prices among trading nations.
    3. It allows redistribution of relative resources or demands to correspond with relative product demands, which results in relatively greater equality of resource prices. 

    Comparative advantage refers to when a country can produce a product more efficiently in comparison to other commodities. The theory does not relate to the efficiency of a country with that of others and instead focuses on relative productivity. 

    FACTOR ENDOWMENT THEORY

    The Factor Endowment theory, or Factor Production theory, or the General Equilibrium Theory of International Trade was developed by Eli Heckscher and Bertil Ohlin, giving it the name, Hecksher-Ohlin theory. They focused their attention on how a country could gain a comparative advantage by producing products that utilized factors that were available in abundance in that country. Simply put, a state must specialize in the production and export of commodities whose production requires a relatively large amount of the factor with which the said country has been endowed. 

    Hecksher and Ohlin traced the cause of cost differences to relative factor endowments and relative factor intensities. They have put forth a view that since countries differ in their factor endowments and also employ factors for the production of exports in different intensities, there is scope for mutual gains in international trade. It suggests that free international trade will equalize factor prices between nations relatively and substantially.

    Regions and countries differ from one another in respect of the availability of resources. While one may be rich in labour, the other might have an abundance of capital. Therefore, countries that are rich in labour will focus on exporting labour-intensive commodities, while countries that are rich in the capital will prefer exporting capital-intensive goods. International trade in this regard would help increase the demand for abundant factors, and thereby increase their prices, while also decreasing the demand for factors that are scarce in a country and therefore, result in a reduction in their prices. 

    The Ricardo and Heckscher-Ohlin theories tend to predict clear patterns of specialization in trade. A country will focus on one type of industry for exports and another type of industry for imports. In fact, the types of industries in which a country exports and the types in which it imports are not dramatically different. This fact has led to the emphasis on another theory of trade, developed by Paul Krugman and others. The idea is that patterns of specialization develop almost by accident and that these patterns persist because of positive feedback. This is known as the increasing-returns model of international trade. “Increasing returns” means that the more of something you produce, the more efficient you get at producing it.[4]

    PRODUCT LIFE CYCLE THEORY

    Raymond Vernon’s Product Life Cycle theory put forth the concept that every product has its lifespan and, thus, goes through various stages, from introduction to decline. The theory correlates a product with a national economy. Vernon established four distinct categories that, as per him, all products go through four stages, as illustrated in Exhibit I [5]:

    • Introduction

    A product’s life cycle begins when a company wishes to launch a new product in its home market. The process of introduction of a product includes imaging, specifics, planning, and innovation. The first stage focuses on the definition of the product, depending upon its customer base, company, market situation, and regulatory bodies in the state. The introduction may either be at a national or international outlet. The primary aim of this stage is to create demand for the said product. 

    • Growth

    When more and more items of the said product are sold, it enters the second stage, where the demand for sales increases and production costs are reduced, and therefore, higher amounts of profits are generated. After when the product makes its place in the market, competitors start to enter the market. When the product has successfully brought for itself various potential new customers, it comes to the next stage.

    • Maturity

    By the third stage, the product gains popularity and has a sufficiently high demand. At this level, the competition gets intense, and companies would be willing to do anything to retain their position as a market leader. For this, they start selling the product at record low prices. Companies also begin to look for other commercial opportunities, including adaptations and innovations to the product. Further, by now, customers even start seeking replacements for the current product with a new one. This stage, as well as the growth of a product, comes to an end once the product reaches saturation. 

    • Decline

    After the product’s growth, as well as its available market, reaches saturation, the product’s popularity reaches an all-time low. At this point, companies stop supplying such products because their cost of production would be higher in comparison to the price of the product, and therefore, they exit the product from the market. A product’s decline may either be a natural outcome or due to the introduction of newer and more innovative products.  

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    PORTER’S DIAMOND NATIONAL COMPETITIVE THEORY

    Michael Porter’s Diamond Model, also known as the theory of National Competitive Advantage, laid down a diamond-shaped framework discussing aspects relating to a company’s ability to perform in the international market. The theory explores the reasons as to why certain industries within a particular nation are competitive internationally, whereas others are not.  It considers various factors or dimensions which encourage national companies to expand into the international market and the role of a national environment which encourages companies to hold in the international market. [6]

    Porter put forth the argument that a country’s ability to compete in the international market is based on a certain interrelated set of advantageous factors, which he defined to be:

     

    • Firm Strategy, structure, and rivalry

    The national context in which companies operate greatly affects the way in which companies are created, organized, and managed, and that, in turn, affects their strategies and how these companies are structured. The domestic rivalry also plays a crucial role in a particular company’s international competitiveness and forces them to innovate and develop unique and sustainable strengths. 

    • Factor Conditions

    Factor conditions refer to the natural, capital, and human resources available in a country. Porter argued that human resources, or created factor conditions such as labour force, infrastructure, etc., play an especially important role vis-a-vis the natural factor conditions and therefore, must continuously be upgraded. Competitive advantage is the result of quality and specialized factor conditions within the country, which are continuously upgraded.

    • Demand Conditions

    The demand that is meted out to a company within the home economy greatly affects its favourability within the country. A larger market, even though it would entail its challenges, opens up wider horizons for opportunities as well, and therefore, helps companies grow, innovate and further improve. A country may gain a competitive advantage in certain industries in cases where local customers help provide a clear image of buyer-needs and where demanding customers pressure the company into achieving greater and more sustainable competitive advantage over their foreign rivals.

    • Related and Supporting Industries

    Companies do not operate in isolation and are often dependent on alliances and partnerships with other companies operating in the same or similar fields. Related and supporting industries provide the foundation for a company to excel. They help create additional value for the customers and thereby, help a company in becoming more competitive internationally. 

    Porter argued that when these four conditions are satisfied, a company will be forced to innovate and upgrade, which in turn would increase a company’s competitiveness. Therefore, the theory suggests that these factors make up a country’s national competitive environment. Once these factors are favourable, the entire nation would be able to reap its benefits. 

    In addition, there are various factors which, although not initially included in the theory, are associated with it owing to their impact on a country’s national competitive environment. These include changes that are events that might affect the national environment, including any unforeseen events such as terrorist attacks or political disturbances,  natural calamities, discoveries, etc., and the role of government, by means of its policies, industrial regulations, etc. 

    CONCLUSION

    Over the years, countries have learned of the greater significance of mutuality of advantage surrounding international trade. Theories relating to the need, purpose, significance, or factors that affect international trade have been put forth by various economists out of their own understanding and the circumstances and state of the international economy surrounding them. International trade, being dynamic, cannot be circumscribed within a single theory. However, from mercantilism to national competitiveness, each theory has pointed to the need and significance of international trade and how it benefits a country. 

    REFERENCES

    [1] Mercantilism, Corporate Finance Institute,

    https://corporatefinanceinstitute.com/resources/knowledge/economics/mercantilism/.

    [2] Dr S. R. Myneni, International Trade Law, Allahabad Law Agency (2015).

    [3] Id.

    [4] Arnold Kling, International Trade, The Library of Economics and Liberty,

    https://www.econlib.org/library/Enc/InternationalTrade.html.

    [5] Theodore Levitt, Exploit the Product Life Cycle, Harvard Business Review, https://hbr.org/1965/11/exploit-the-product-life-cycle

    [6] Porter, M.E., The Competitive Advantage of Nations, Harvard Business Review (1990).

    [7] Porter’s Diamond Model: Why some Nations are Competitive And Others are Not, Business-to-you, https://www.business-to-you.com/porter-diamond-model/#:~:text=Michael%20Porter’s%20Diamond%20Model%20(also, internationally%2C%20whereas%20others%20might%20not.

    BY- Abhilasha Bhatia |Amity Law School, Delhi

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