INTERNATIONAL TRADE THEORIES

INTERNATIONAL TRADE THEORIES​

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. International Trade Theory refers to the concepts, models, and explanations justifying why countries undertake trade with one another and how they benefit from it. Such theories are useful in understanding the global trade flows, the resource distribution in the production efficiencies, and the competitiveness of nations. Trade is not simply an exchange of goods-it is the result of economic logic indicating what to produce, for whom, and how. These models are widely used in policy formulation, trade negotiations, and competitive business strategies. 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 or Country-Based Trade Theories

MERCANTILISM MEANING, TYPES, PROS AND CONS.

Mercantilism is the oldest international trade theory that formed the foundation of economic thought during about 1500 to 1800. According to this theory the holdings of a country’s treasure primarily in the form of gold constituted its wealth. This theory specifies that country’s should export more than they import and receive the value of trade surplus in the form of gold from those countries which experience trade deficits.

Governments imposed restrictions on imports and encouraged exports in order to prevent trade deficit and experience trade surplus. Colonial powers like the British used to trade with their colonies like India, Sri Lanka etc., by importing the raw materials from and exporting the finished goods to colonies. The colonies had o export less valued goods and import more valued goods. Thus, colonies were prevented from manufacturing. This practice allowed the colonial powers to enjoy trade surplus and forced the colonies to experience trade deficits. The theory benefited the colonial powers and caused much discontent in the colonies. In fact, this was the background situation for the American Revolution.

The Mercantilism theory suggests for maintaining favourable balance of trade in the form of import of gold for export of goods and services. But the decay of gold standard reduced the validity of this theory. Consequently, this theory was modified in Neo-mercantilism.

Neo-mercantilism proposes that countries attempt to produce more than the demand in the domestic country in order to achieve a social objective like full employment in the domestic country or a political objective like assisting a friendly country.

Although mercantilism is one of the oldest trade theories, it remains part of modern thinking. Countries such as Japan, China, Singapore, Taiwan, and even Germany still favour exports and discourage imports through a form of neo-mercantilism in which the countries promote a combination of protectionist policies and restrictions and domestic-industry subsidies.

Types of mercantilism

There are several types of mercantilism, including:

  1. Export-led mercantilism:This type of mercantilism emphasizes the promotion of exports and the accumulation of gold and silver through a favorable balance of trade. It typically involves the use of tariffs and other trade barriers to protect domestic industries and to encourage exports.
  2. State-led mercantilism:This type of mercantilism involves the active intervention of the state in the economy, including through the regulation of trade, the promotion of certain industries, and the protection of domestic producers.
  3. Colonial mercantilism:This type of mercantilism involves the expansion of a country’s colonies and the exploitation of their resources and labor in order to benefit the mother country.
  4. Industrial mercantilism:This type of mercantilism involves the promotion of domestic manufacturing and the protection of domestic industries through the use of tariffs and other trade barriers.
  5. Financial mercantilism:This type of mercantilism involves the manipulation of financial policies, such as the control of interest rates and the manipulation of exchange rates, in order to promote exports and accumulate gold and silver.

Pros and Cons of mercantilism:

Pros:

 

  • Mercantilism helped to increase a country’s wealth by encouraging exports and discouraging imports.
  • It promoted self-sufficiency and reduced a country’s reliance on foreign sources of goods.
  • It brought industrial growth. There was need of surplus for export. The growth of industry led to more production which could meet the demand of the people and create surplus which was exported.
  • Mercantilism helped the countries to increase foreign relation. When trade increased with foreign countries, commercial and cultural relation also developed.
  • Mercantilism also helped in the increase of colony. To export surplus, a country needed market. So, the European countriestried to conquer new countries to establish their colony in those places and wanted to gather more and more wealth.
  • Mercantilism made a country powerful. The merchants became favourite friends of the ruler because they brought more wealth to the country. This wealth helped the king to maintain a large army which was its strength.

Cons:

  • Mercantilism had led to protectionist policies, such as tariffs and quotas, which raised the cost of goods for consumers and lead to trade conflicts with other countries.
  • It discouraged innovation and efficiency by protecting domestic industries from competition.
  • To put much emphasis on money was very bad. The merchants put much emphasis on gold and silver which were never true wealth of a country. The natural resources and factories were the true wealth of a country. The European Mercantilism ran after gold and silver and could not serve people properly.
  • Mercantilism gave birth to Colonialism. The European countries needed markets for sailing of their surplus. England, France, Germany, Italy, Spain, Portugal etc. were in this race. This created enmity among different countries.
  • Mercantilism was one way traffic. It put emphasis on export but not import, it is not easy to be self-sufficient. Many countries of Europe became failure by trying to be self-sufficient which increased their miseries.
  • It created economic imbalances and distort the international trade system.
  • Mercantilism only put emphasis on trade and commerce. It neglected other aspects of life like education, agriculture etc. So, Mercantilism was criticised later on.
  • Finally, Mercantilism followed a strong principle that a country can rise at the interest of the other. This was not justified. It was only because this strained the relation between the two countries. Hatred for a country against the other came due to Mercantilism.

In every sense of the term, Mercantilism created a new chapter in the annals of European history. It played a vital role in making the European countries progressive. On the other hand, it sowed the seeds of many rises and fall. This gave birth to colonialism which made the entire Europe a Military Camp.

2.THEORY OF ABSOLUTE COST ADVANTAGE

This theory was proposed by the Scottish economist namely Adam Smith in 1776. It is based on the principle of Division of labour. According to him application of this principle to international scenario helps the countries to specialise in the production of those goods in which they have cost advantage over other countries.

According to Adam Smith, every country should specialise in producing those products which it can produce at less cost than that of other countries and exchange these products with other products produced cheaply by other countries. Trade between two countries takes place when one country produces one product at less cost than that of another country and the other country has an absolute cost advantage over the first country in producing any other product.

ASSUMPTIONS OF THE THEORY

Adam Smith proposed the absolute cost advantage theory based on certain assumptions;

  • Trade is between two countries.
  • Only two commodities are traded.
  • Free trade exists between the countries.
  • The only element of cost of production is labour.