Unraveling the Mysteries of Global Exchange: Exploring Theories of International Trade

The Theories Of International Trade

Real facts About The Theories Of International Trade.

International trade has been the most significant and ancient form of interdependence between nations, as well as with non-state economic entities.

A comprehensive understanding of theories of international trade is crucial for developing a deeper appreciation of the breadth, content, dynamics, and intricacies of global economic and business relations. However, given the complexity of international economic relations, no single theory can provide an adequate framework to fully comprehend the subject matter.

The various theories, although interconnected, are essential in providing a multidimensional perspective to better grasp the subject matter. In a rapidly evolving world economic system, international economic relations have undergone numerous phases, ranging from free trade and economic nationalism to oligopolistic policies, economic bloc formation, and strategic trade policies. This is especially important to note.

Advanced countries or states have implemented intentional political measures to promote and safeguard the strategic trade policies of their corporations. The United States of America (USA), Japan, and the European Union have taken the lead in advocating for increased openness in the global economy, particularly in terms of capital flow, trade, foreign direct investment, science and high-technology, and market integration.

In this chapter, the theories of international trade are presented in an evolutionary rather than a structural approach. This is not to suggest that there is an absolute distinction between what is evolutionary and what is structural. The theories will be presented as follows:

a) The Liberal or Orthodox Theory
b) The Comparative Advantage Theory
c) The Neoclassical Theory of Comparative Advantage
d) The Strategic Trade Policy Approach

e) The Mercantilist Theory or Economic Nationalist Theory
f)The Theory of Regionalism
g) The Theory of Globalization.

A) The Liberal Theory

The liberal theory advocates for unrestricted trade policies and practices without protectionist measures. It was first introduced by Adam Smith in his renowned book, “An Inquiry into the Nature and Causes of the Wealth of Nations” in 1776. Smith believed that free trade policies were crucial to a nation’s wealth and power as they fostered economic growth and competitive development.

The fundamental principle of the liberal theory of trade is that countries should have the freedom to specialize in the areas where they are most proficient through the process of division of labor. Some of the discernible elements of the liberal theory include:

  • Labor is a measure of ability, specific to the work being performed, and often disregards other factors of production.
  • Unrestricted free trade leads to an absolute advantage that arises primarily from a territorial division of labor.
  • In free trade, an absolute advantage is a result of the market’s scale.
  • In a free economic system, the state’s role is that of a referee or an umpire. As Adam Smith once stated, a government that intervenes the least governs the best.

(This is the cornerstone of the capitalist philosophy).

The liberal theory of trade assumes that each nation possesses comparable competitive labor abilities. However, the excessive emphasis on labor theory during the 18th and early 19th centuries was inadequate in accommodating other factors of socio-economic formation in our intricate economic system.

David Ricardo advanced the liberal theory in the 19th century.

B) The Comparative Advantage Theory

The comparative advantage theory represents a more scientific adaptation of the liberal theory of trade. It does not entirely negate the idea of free trade but rather challenges the concept of an absolute advantage.

In his book “Principles of Political Economy and Taxation,” David Ricardo asserted that trade is mutually advantageous. Through his law of comparative advantage, Ricardo proved that the direction of trade between nations is determined by the relative, rather than absolute, cost of producing goods.

Read Also: The Study of International Economic Relations

The international division of labor is determined by comparative cost, wherein countries tend to specialize in commodities with the lowest relative cost and highest possible profits. David Ricardo observed this approach during the industrial revolution of the 19th century, which led to rapid industrial growth.

The theory of comparative cost argues that specialization brings universal benefits, creating a positive-sum game instead of a zero-sum game. International trade allows every productive country to gain relative advantages, diffusing general benefits and promoting greater interdependence between nations.

Thus, every nation has something to offer in terms of international division of labor and exchange relations. Each country becomes an exporter and importer, creating a world community of international producers and consumers. Ricardo himself noted that under a system of free trade, each country naturally allocates its capital and labor to the most beneficial employments, which stimulates industry and rewards ingenuity.

This process distributes labor effectively and economically, increases the general mass of productions, and binds together the universal society of nations throughout the civilized world.

The theory of comparative cost is based on the principle that countries tend to specialize in producing goods that they can produce at a lower cost compared to other countries, with the aim of maximizing profits. David Ricardo developed this theory as a modification of the liberal theory of trade in the 19th century. The theory of comparative advantage emphasizes that trade among countries is mutually beneficial and is determined by the relative costs of producing goods rather than absolute costs.

According to Ricardo, every country benefits from specialization and exchange relations in international division of labor, as each country has something to offer. The theory of comparative advantage diffuses general benefits and promotes greater interdependence among nations, making it a positive-sum game rather than a zero-sum game. As Ricardo noted, “Under a system of perfectly free commerce, each country naturally devotes its capital and labor to such employments as are most beneficial to each…it diffuses general benefit, and binds together, by one common tie of interest and intercourse, the universal society of nations throughout the civilized world.”

Ricardo used the example of wine and cloth production between Portugal and England to demonstrate his theory. Portugal had a comparative advantage in producing wine because of its climate and soil, while England had a comparative advantage in producing cloth. By specializing in the production of these goods and trading with each other, both countries could increase their overall economic output and benefit from the gains of trade.

The law of comparative advantage is considered a beautiful idea in economics because it demonstrates the benefits of free trade and specialization, and how they can promote greater economic interdependence and cooperation among nations.

Ricardo’s vision of international trade was not a zero-sum game, but rather a mutually beneficial system based on specialization and comparative advantage. This principle of harmony of interest forms the basis of the liberal view of international economic relations.

Edet Akpapan uses the trading relationship between Nigeria and Cameroon as an example to demonstrate the value of comparative costs. According to the theory, it would be more advantageous for both countries if Nigeria specialized in one product, while Cote D’Ivoire specialized in the other.

To illustrate the benefits of specialization, opportunity cost ratios are calculated for both countries. The following ratios were determined with the available data:

For Nigeria:

  • To produce 1 kg of commodity C, it must give up 1.25 kg of commodity G.
  • To produce 1 kg of commodity G, it must give up 0.80 kg of commodity C.

For Cote D’Ivoire:

  • To produce 1 kg of commodity C, it must give up 1.14 kg of commodity G.
  • To produce 1 kg of commodity G, it must give up 0.8075 kg of commodity C.

For the world (of the two countries) as a whole:

  • To produce 1 kg of commodity G, Nigeria gives up 0.80 kg of commodity C, while Cote D’Ivoire gives up 0.875 kg of commodity C. Nigeria has a comparative cost advantage in the production of G because it gives up less C than Cote D’Ivoire does.
  • To produce 1 kg of commodity C, Nigeria gives up 1.25 kg of commodity G, while Cote D’Ivoire gives up 1.14 kg of commodity G. Cote D’Ivoire has a comparative advantage here because it gives up less G than Nigeria does.

Akpapan notes that, although Nigeria has an absolute advantage in the production of both goods, its comparative advantage lies in groundnut production. Therefore, Nigeria should specialize in groundnut production, and both countries should trade.

This is the way that Ricardo and his followers explained the benefits of trade and how countries could gain from it. However, there are some limitations to the theory of comparative costs, which we should be aware of.

a) it is still based on labour theory of value.
b) it omitted the cost of transportation
c) it assumed that the factors of production are immobile, and thus domestic-centred on two countries such that it could not be transformed from one country to another.

C) Neoclassical Theory Or The Factor Proportions Theory

The neoclassical theory, also known as the factor proportions theory or the standard liberal theory, was initially developed by two Swedish economists, Eli Heckscher (1919) and Bertil Ohlim (1933). Later on, Paul Samuelson (1948) modified the theory, resulting in the Hockscher-Ohlin-Samuelson (H-O-S) model of international trade. The neoclassical theory considers various factors of production, including transportation, which enhances the mobility of international division of labor and exchange relations. The theory is based on the concept of relative-factor endowment, which is seen as explanatory to trade flows.

This theory assumes that a nation’s comparative advantage is conditioned by factors of production such as capital, labor, resources, management, and technology. The concept of labor has been modified to human capital, and cost has been redefined as “opportunity cost.” As countries are not similarly endowed, they are bound to differ in comparative costs, which in turn encourages greater flows of international trade. In the 1980s, mathematical and statistical techniques were introduced to the theory.

Edet Akpapan simplified the impacts of the factor proportions theory, stating that countries with more labor than capital would have a relative cost advantage over others if they concentrate on labor-intensive production regimes. Such countries can export their surpluses to pay for imports from other countries. Similarly, countries with more capital than labor benefit more from adopting capital-intensive production of goods and services, which provides surpluses to export. Through non-restrictive trade barriers, trade spreads benefits across national borders.

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