This article has been written by Diksha Paliwal, a practising advocate in the High Court of Indore and a student of LL.M. (Constitutional Law). This article aims to provide an understanding of the concept of international trade and its theories.
It has been published by Rachit Garg.
Table of Contents
Introduction
International trade acts as a major contributing factor in global economic activity and a catalyst of economic growth in developing as well as developed countries. Differences in various conditions, like resource availability, natural climatic conditions, cost of production, etc., act as the motive behind trade between the countries. International trade has made it all possible and has provided a large number of employment opportunities as well as several goods and services for the consumer. Not just this, it has been a major reason for the rising living standards of people all over the globe. International trade has been a part of human civilization for a very long time; however, the past few decades have seen rapid development in cross-border trading. Imports and exports have largely contributed to the growth of GDP, and the credit for the same goes to imports and exports.
The article, in its first section, will deal with the concept of international trade and its historical development. Whereas, the next parts will deal with the different theories of international trade that have been formulated to deepen our understanding of this significant global phenomenon.
International trade: an overview
In layman’s language, international trade is the exchange of goods and services between different countries. The term “exchange” includes the import as well as export of goods and services. As quoted by Wasserman and Haltman, international trade can be connoted as transactions among the inhabitants of different countries. Edgeworth, an Irish-based statistician, defined the term as the phenomenon of trade between countries. The term ‘international trade’ is an example of economic linkage and can be referred to as an economic transaction between countries.
International trade stands as a crucial determinant of openness among countries and has been a remarkable factor in economic growth. In recent years, overseas trade has become a strategy of paramount importance for the growth of the national economy. However, the significance of international trade is not just limited to this, it also helps in encouraging social and international relations among countries. Increased foreign trade has augmented the process of globalisation.
In the early years, political economists like Adam Smith and Ricardo were among the few people who acknowledged the significance of international trade, which has been practically affirmed by visible global growth and economic development. Global trade gives consumers the opportunity to experience and enjoy a variety of goods and services that, for whatever reason, are not available in their country or which might be a bit costly in their country compared to others. Foreign trade also, to a great extent, curbs the issue of irregular availability and distribution of resources all over the world by facilitating a smooth flow of raw materials as well as finished products. The optimum use of abundant raw materials is one more benefit expedited by trading globally.
Classification of International trade activities
The activity of international trade has been broadly classified under 3 subheads, namely, international trade operations, strategic alliances, and direct foreign investments. They are discussed as follows:
International trade operations: This category specifically includes the operations constituting international business via import and export, import-export combined operations, and transit. Although the parties, in several instances, might have dissimilar interests, to gain a mutual advantage, they harmonise their differences and arrive at a mutual consensus by prioritising benefits. These international trade operations are legally considered under the category of bilateral contracts, which consist of international sales contracts as the legal instrument. In most cases, these transactions are short-term, however, the relationships between the parties can be long-term or short-term depending on their choice.
Strategic alliances: This category mainly includes activities like franchising, sub-contracting, joint ventures (private or government), etc. It connotes the operation involving cooperation among the various partners from different countries, pertaining to the transfer of technologies globally.
Foreign direct investment: The strategy closely resembles the categories of involvement, risk, and profit, each one of them at its maximum potential. It is an alternative to stepping foot into the global market. It comes under the category of cross-border investment, wherein, the interested residents of one economy invest or influence significantly in enterprises based in another country.
History and evolution of theories of international trade
Global trade has been a very crucial part of human civilization, and owing to its dynamic nature, the concepts involving trading have also evolved drastically. International trade has a long history. The simple concept of the exchange of goods and services between different countries has been interpreted in a number of ways by different philosophers and economists. These theories that provide different explanations and definitions of the concept of international trade are called international trade theories. These trade theories basically study the changing patterns of international trade, its origins, and its impact, along with its practicability.
The study of international trade has been a subject of research from the ancient Greeks to the present governments of different countries, political economists, and intellectuals. The determinants and factors affecting trade among the countries and its pros and cons have been a subject matter of study. The most important question of the research is the determination of policies for different countries as per their situation, in order to have efficient and smooth global trade.
In the early period, theoreticians and philosophers did not have a very systematic approach towards the study of trade theories. Their theories were a bit clouded by ethical and political considerations. The four most remarkable periods of development in trade theories in the middle ages were:
- Ancient Greek ideas,
- Scholastic and Christian thought,
- Mercantilism and
- Physiocracy.
The crucial ideas relating to these trade theories were put forward by Plato, Xenophon, and Aristotle in the Greek period. They emphasised the benefits of the division of labour and the exchange of goods and stated that not limiting them within the boundaries of the city would be mutually beneficial to both parties. Plato, in his work, “The Republic”, talked about the fact that it is practically impossible to attain self-sufficiency in terms of goods and services for a city, and explained the benefits of division of labour and how it would result in higher output and productivity. Xenophon, in his various studies, has also talked about the benefit of expanding the trading system internationally. However, despite various attempts made by the Greek philosophers, the Greeks were not much of a supporter of international trade. Aristotle also argued that as a part of efficient ruling, the rulers must decide which imports and exports are necessary and, not only should they do this, but they should also maintain fairness in these exchanges, possibly by forming some treaties with the countries.
The above-discussed ideas, mainly the Aristotelian philosophies, emerged as the basis of Scholastic and Christian thought, which came around the period of the 13th and 15th centuries. This period of intellectual legacy came to be known as the birth of economic science as a branch of ethics. Philosophers and theologians of this period were of the view that international trade could possibly be compatible with principles of moral philosophy. They acknowledged the possibility of differences in the availability of resources and accepted the fact that nature has not provided each region of the world with every possible resource and, hence, international trade, at least to a certain extent, is essential and unavoidable. But they were very much aware of the fact that this international commerce must be kept in check and that this might have adverse moral consequences. They acknowledged the possibility of fraud and other malicious practices in the event of global trading. However, with time, the importance of foreign trade was widely accepted and soon it became an established fact that this is an inalienable right that an individual has, and should not be snatched away from him, although a security check must be kept to avoid adverse consequences.
With the passing of time and the origination of national states, increasing commercial relations became of prime importance for both scholars and statesmen. However, with this growing popularity and acceptance of international trade, the national movement of mercantilism spread, which stated that before everything else, priority must be given to the welfare of one’s own nation and that countries are often in conflict with each other, hence, we must first flourish our own nation. Thus, this aim could only be achieved by discouraging the welfare of other nations and focusing on oneself first. This aim was mainly achieved by collecting and increasing the country’s treasure by accumulating gold and silver. Promotion of exports, the balance between import and export, and prioritising only the import of essential raw materials, were some of the main strategies behind the movement of mercantilism. However, this doctrine gradually lost its popularity and was severely criticised by the liberals.
After the failure of mercantilism, the theory of Physiocrats emerged, who believed in the liberalisation of trade. They advocated the importance of free and equally free trade in all branches.
Theories of international trade
International trade theories were mainly developed under two categories, namely, classical or country-based theories and modern or firm-based theories, both of which are further divided into various categories.
Let’s have a brief overview of the various theories of international trade.
Classical or country-based theories
The founders of the various theories of the classical country-based approach were mainly concerned with the fact that the priority should be increasing the wealth of one’s own nation. They were mainly of the view that focus should be on economic growth on a priority basis. The main classical theories in reference to international trade are discussed below.
Mercantilism
The Mercantilism theory is the first classical country-based theory, which was propounded around the 17-18th century. This theory has been one of the most talked about and debated theories. The country focused on the motto that, on a priority basis, it must look after its own welfare and therefore, expand exports and discourage imports. It stated that an attempt should be made to ensure that only the necessary raw materials are imported and nothing else. The theory also propounded the view that the first thing a nation must focus on is the accumulation of wealth in the form of gold and silver, thus, strengthening the treasure of the nation.
To put it simply, it can be stated that the classical economists behind the theory of Mercantilism firmly believed that a country’s wealth and financial standing are largely demonstrated by the amount of gold and silver it holds. Hence, economists believe that it is best to increase the reserve of precious metals to maintain a wealthy status. For this theory to work, the aim to be fulfilled was that a country must produce goods in such a large quantity that it exports more and should be less dependent on buying goods and other materials from others, thereby strongly encouraging exports and strictly discouraging imports.
A large number of countries in the past benefited from strictly following the theory of Mercantilism. History is evident that by implementing this theory, many nations benefited by strictly following the theory of Mercantilism. Various studies done by economists prove why this theory flourished in the early period. In the early period, i.e., around 1500, new nations and states were emerging and the rulers wanted to strengthen their country in all possible ways, be it the army, wealth, or other developments. The rulers witnessed that by increasing trade they were able to accumulate more wealth and, thus, certain countries became very strong because of the massive amount of wealth they stored. The rulers were focused on increasing the number of exports as much as possible and discouraging imports. The British colony is the perfect example of this theory. They utilised the raw materials of other countries by ruling over them and then exporting those goods and other resources at a higher price, accumulating a large amount of wealth for their own country.
This theory is often called the protectionist theory because it mainly works on the strategy of protecting oneself. Even in the 21st century, we find certain countries that still believe in this method and allow limited imports while expanding their exports. Japan, Taiwan, China, etc. are the best examples of such countries. Almost every country at some point in time follows this approach of protectionist policies, and this is definitely important. But supporting such protectionist policies comes at a cost, like high taxes and other such disadvantages.
Absolute advantage
In 1776, the economist Adam Smith criticised the theory of mercantilism in his publication, “The Wealth of Nations”, and propounded the theory of Absolute advantage. Smith firmly believed that economic growth in reference to international trade firmly depends on specialisation and division of labour. Specialisation ensures higher productivity, thereby increasing the standard of living of the people of the country. He proposed that the division of labour in small markets would not cater for specialisation, which would otherwise become easy in the case of larger markets. This increase in size fostered a more refined specialisation and thus increased productivity all around the globe.
Smith’s theory proposes that governments should not try to regulate trade between countries, nor should they restrict global trade. His theory also encapsulated the consequences of the involvement and restraint of the government in free trade. Also, he firmly believed that it is the standard of living of the residents of a country that should determine the country’s wealth and the amount of gold and silver that a country’s treasure has. He states that trading should depend on market factors and not the government’s will.
Smith was firmly against the mercantilist theory, and he argued that diminishing importation and just focusing on exports was not a great idea, and thus restricting global trade is not what needs to be done. He proposed that even though we might succeed in forcing our country’s people to buy our own goods, however, we may not be able to do so with foreigners, and hence it is better that we make it a two-way trade and just focus on exports.
In relation to the restrictions imposed on import, Smith stated that even though the restrictions on import may benefit some domestic industries and merchants when looked at from a broad spectrum, it will result in decreasing competition. Along with this, it will increase the monopoly of some merchants and companies in the market. Another disadvantage is that the increase in the monopoly will cause inefficiency and mismanagement in the market.
Smith completely denied the promotion of trade by the government and restrictions on free trade. He reiterated that it is wasteful and harmful to the country. He proposed that free trade is the best policy for trading unless, otherwise, some unfortunate or uncertain situations arise.
Comparative advantage
The theory of comparative advantage flourished in the 19th century and was propounded by David Ricardo. This theory strengthened the understanding of the nature of trade and acknowledges its benefits. The theory suggests that it is better if a country exports goods in which its relative cost advantage is greater than its absolute cost advantage when compared with other countries. For instance, let’s take the examples of Malaysia and Indonesia. Let’s say Indonesia can produce both electrical appliances and rubber products more efficiently than Malaysia. The production of electrical appliances is twice as much as that of Malaysia, and for rubber products, it is five times more than that of Malaysia. In such a condition, Indonesia has an absolute productive advantage in both goods but a relative advantage in the case of rubber products. In such a case, it would be more mutually beneficial if Indonesia exported rubber products to Malaysia and imported electrical appliances from them, even if Indonesia could efficiently produce electrical appliances too.
What Ricardo proposed is that even though a country may efficiently produce goods, it may still import them from another country if a relative advantage lies therein. Similar is the case with export, even if a country is not very efficient in certain goods from other countries, it may still export that product to other countries. This theory basically encourages trade that is mutually beneficial.
Heckscher-Ohlin theory (Factor Proportions theory)
The theories founded by Smith and Ricardo were not efficient enough for the countries, as they could not help the countries determine which of the products would benefit the country. The theory of Absolute Advantage and Comparative Advantage supported the idea of how a free and open market would help countries determine which products could be efficiently produced by the country. However, the theory proposed by Heckscher and Ohlin dealt with the concept of comparative advantage that a country can gain by producing products that make use of the factors that are present in abundance in the country. The main basis of their theory is on a country’s production factors like land, labour, capital, etc. They proposed that the approximate cost of any factor of resource is directly related to its demand and supply. Factors which are present in abundance as compared to demand will be available at a cheaper cost, and factors which are in great demand and less availability will be expensive. They proposed that countries produce goods and export the ones for which the resources required in their production are available in a much greater quantity. Contrary to this, countries will import goods whose raw materials are in shorter supply in their own country as compared to the one from which they are importing.
For example, India has a large number of labourers, so foreign countries establish industries that are labour-intensive in India. Examples of such industries are the garment and textile industries.
Modern or firm-based theory
The emergence of modern or firm-based theories is marked after the period of World War II. The founders of these theories were mainly professors of business schools and not economists. These theories majorly came up after the rising popularity of multinational companies. The Country based classical theories were mainly focused on the country, however, the modern or firm-based theories address the needs of companies. The following are the modern or firm based theories propounded by various business school professors:
Country similarity theory
Steffan Linder, a Swedish economist, was the founder of this theory. The theory marked its emergence in the year 1961 and explained the concept of in-train industry trade. Linder suggested that countries that are in a similar phase of development will probably have similar preferences. The suggestion proposed by Linder was that companies first produce goods for their domestic consumption and later expand production, thereby exporting those products to other countries where customers have similar preferences. Linder suggested that most of the trade in manufactured goods, in most circumstances, will be between countries with similar per capita incomes, and that the in-train industry trade will thus be common among them. This theory is generally more applicable in understanding trade where buyers mainly decide on the basis of brand names and product reputations.
Product life cycle theory
This theory was propounded by Raymond Vernon, a business professor at Harvard Business School, in the 1960s. The theory that originated in the field of marketing proposed that a product life cycle has three stages, namely, new product, maturing product, and standardised product. The theory has a presumption that the production of a new product will completely arise in the country where it was invented. This theory, up to a good extent, helps in explaining the sudden rise and dominance of the United States in manufacturing. This theory also explained the stages of computers, from being in the new product stage in the 1970s and thereby entering into their maturing stage in the 1980s and 1990s. In today’s scenario, computers are in a standardised stage and are mostly manufactured in low-cost countries in Asia. However, this theory has not been able to explain the current trading pattern where products are being invented and manufactured in almost all parts of the world.
Global strategic rivalry theory
Paul Krugman and Kelvin Lancaster were the founders of this theory. This theory emerged around the 1980s. The theory majorly focused on multinational companies and their strategies and efforts to gain a comparative advantage over other similar global firms in their industry. This theory acknowledges the fact that firms will face global competition and prove their superiority. They must surely develop a competitive advantage over each other. The ways through which the firms can gain competitive advantage were termed as barriers to entry for that particular industry. These barriers are basically the obstacles that a firm will face globally when they enter the market. The barriers that companies and firms may try to optimise are
- Mainly research and development,
- The ownership of intellectual property rights,
- Economies of scale,
- Unique business processes or methods,
- Extensive experience in the industry, and
- The control of resources or favourable access to raw materials.
Porter’s national competitive advantage theory
The theory emerged in the 1990s with the aim of explaining the concept of national competitive advantage. The theory proposes that a nation’s competitiveness majorly depends upon the capability and capacity of the industry to come up with innovations and upgrades. This theory attempted to explain the reason behind the excessive competitiveness of some nations as compared to others. The main determinants proposed in this theory were local market resources and capabilities, local market demand conditions, local suppliers and complementary industries, and local firm characteristics. The theory also mentioned the crucial role of government in forming the competitive advantage of the industry.
Conclusion
For years, theories concerning international trade have been the subject of intense research and debate. Growing international trade has its own pros and cons. The analysis of the system of international trade by way of various theories has enabled a systematic framework for better understanding. International trade contributes to the economic growth of a country, thereby increasing the standard of living of its people, creating employment opportunities, a greater variety of choices for consumers, etc. The development of trade theories has seen a major shift from the view of restricting free trade as stated in the theory of mercantilism to the various modern theories providing a better understanding to facilitate smooth international trade with increasing benefits.
Frequently Asked Questions (FAQs)
Why are international trade theories important?
The study of these theories caters to smooth and efficient trading by explaining the pits and falls, dos and don’ts to be kept in mind while trading. A vague or misguided view on such an important topic might affect a country’s financial position and its standing in the world. Hence, it is important to properly understand the theories pertaining to international trade for the benefit of the country as a whole.
Which trade theory mainly focuses on decreasing imports?
The theory of mercantilism emphasises the point that primarily the country must focus on increasing the country’s export and restrict the import to only products that are absolutely necessary.
Why was the theory of Mercantilism slowly losing popularity?
The reason behind the gradual loss is very simple as we cannot force a country to buy our exported products. Also, in the absence of relative advantage no country would accept products from countries which are themselves not acknowledging the concept of free trade.
Which is the most popular international trade theory?
International trade theories have emerged as a great helping hand in understanding the changing pattern of trade in the past few years. Even though not every theory may be applicable to every country and every situation, each one of them still has its own significance. Thus, we can say there is no particular theory that was the most popular of all the others. Instead, every single theory, in some way or another, has helped in the improvement of the tactics of international trade.
References
- https://saylordotorg.github.io/text_international-business/s06-01-what-is-international-trade-th.html
- http://bgc.ac.in/pdf/study-material/International-Trade.pdf
- https://www.economicshelp.org/blog/58802/trade/the-importance-of-international-trade/
- https://corporatefinanceinstitute.com/resources/knowledge/economics/international-trade/
- https://learn.saylor.org/mod/book/view.php?id=32092&chapterid=10524
- Horvat, B. (1999). The Evolution of International Trade Theory. In: The Theory of International Trade. Palgrave Macmillan, London
- P. T. Ellsworth, The American Economic Review, Vol. 30, No. 2, Part 1 (Jun., 1940), pp. 285-289
- H. Myint, Economica, New Series, Vol. 44, No. 175 (Aug., 1977), pp. 231-248
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