With time, economists have established theories that explain global trade. These
theories explain what exactly happens in International Trade. There are 6
economic theories under International Trade Law which are classified in four:
(I) Mercantilist Theory of trade (II) Classical Theory of trade (III) Modern
Theory of trade (IV) New Theories of trade. Both of these categories, classical
and modern, consist of several international theories.
MercantilismThis theory was popular in the 16th and 18th Century. During that time the
wealth of the nation only consisted of gold or other kinds of precious metals so
the theorists suggested that the countries should start accumulating gold and
other kinds of metals more and more. The European Nations started doing so.
Mercantilists, during this period stated that all these precious stones denoted
the wealth of a nation, they believed that a country will strengthen only if the
nation imports less and exports more. They said that this is the favorable
balance of trade and that this will help a nation to progress more.
Mercantilism thrived during the 1500's because there was a rise in new
nation-states and the rulers of these states wanted to strengthen their nations.
The only way to do so was by increasing exports and trade, because of which
these rulers were able to collect more capital for their nations. These rulers
encouraged exports by putting limitations on imports. This approach is
called “protectionism” and it is still used today.
Though, Mercantilism is one the most old-fashioned theory, it still remains a
part of contemporary thinking. Countries like China, Taiwan, Japan, etcetera
still favor Protectionism. Almost every country, has implemented protectionist
policy in one way or another, to protect their economy. Countries that are
export oriented prefer protectionist policies as it favors them. Import
restrictions lead to higher prices of good and services. Free-trade benefits
everyone, whereas, mercantilism's protectionist policies only profit select
Absolute Cost Advantage
This theory was developed by Adam Smith, he was the father of Modern Economics.
This theory came out as a strong reaction against the protectionist mercantilist
views on international trade. Adam Smith supported the necessity of free trade
as the only assurance for expansion of trade. He said that a country should only
produce those products in which they have an absolute advantage. According to
Smith, free trade promoted international division of labour. By specialization
and division of labour producers with different absolute advantages can always
gain over producing in remoteness. He emphasised on producing what a country
specializes in so that it can produce more at a lower cost than other countries.
This theory says that a country should export a product in which it has a cost
Adam's theory specified that a country's prosperity should not be premeditated
by how much gold and other precious metals it has, but rather by the living
standards of its citizens.
Comparative Cost Advantage TheoryThe comparative cost theory was first given by David Ricardo. It was later
polished by J. S. Mill, Marshall, Taussig and others. Ricardo said absolute
advantage is not necessary. He also said a country will produce where there is
The theory suggests that each country should concentrate in the production of
those products in which it has the utmost advantage or the least disadvantage.
Hence, a state will export those supplies in which it has the most benefit and
import those supplies in which it has the least drawback.
Comparative advantage arises when a country is not able to yield a commodity
more competently than another country; however, it has the resources to
manufacture that commodity more proficiently than it does other commodities.
Hecksher 0hlin Theory (H-0 Theory)Smith and Ricardo's theories didn't help the countries figure out which products
would give better returns to the country. In 1900s, two economists, Eli Hecksher
and Bertil Ohlin, fixated on how a country could profit by making goods that
utilized factors that were in abundance in the country. They found out that the
factors that were in abundance in relation to the demand would be cheaper and
that the factors in great demand comparatively to its supply would be more
The H-0 Theory is also known as the Modern Theory or the General Equilibrium
Theory. This theory focused on factor endowments and factor prices as the most
important determinants of international trade. The H - 0 is divided in two
theorems: The H - 0 theorem, and the Factor Price Equalization Theorem. The H -
0 theorem predicts the pattern of trade while the factor-price equalization
theorem deals with the effect of international trade on factor prices. H - 0
theorem is further divided in two parts: factor intensity and factor abundance.
Factor Abundance can be explained in terms of physical units and relative factor
prices. Physical units include capital and labor, whereas, relative factor price
includes the adjoining expenses like rent, labor cost, etcetera. On the other
hand, factor intensity means capital, labor or technology, etcetera, any factor
that a country has.
National Competitive Theory or Porter's diamondThe diamond theory was given by Micheal Porter. This theory states that the
qualities of the home country are vital for the triumph of a corporation. This
theory was given its name because it is in the shape of a diamond. It describes
the factors that influence the success of an organization. There are Six Model
Factors in this theory which are also known as the determinants.
are the determinants:
- Factor Condition;
- Demand Conditions;
- Related and Supporting Industries;
- Firm Strategy, Structure, and Rivalry;
- Chance; and
Product Life Cycle TheoryThis theory was developed by Raymond Vernon in the Mid 1960's, he was a Harvard
Business School professor. This theory was developed after the failure of
Hecksher Ohlin's Theory. The theory, detailed that a product goes through
various stages in the course of its progress. These stages are: (1) new product
stage, (2) maturing product stage, and (3) standardized product stage. This
theory assumed that the production of a new product would take place in the
nation where it was innovated.
In the 1960's this was a very useful theory. At that time, United States of
America was dominating the whole globe in terms of manufacturing after the World
Stage I: New Product
The stage begins with introducing a new product in the market. A corporation
will begin from developing a new good. The market for which will be small and
sales will be comparatively low. Vernon assumed that innovation or invention of
products will mostly be done in developed nations, because of the economy of the
nation. To balance the effect of less sales, corporations would keep the
manufacturing local. As the sales would increase, the corporations would start
to export the goods to different nations in order to increase the revenue and
Stage II: Mature Product Stage
The product enters this stage when it has established demand in developed
nations. The manufacturer, would need to open manufacturing plants in each
nation where the product has demand. Due to local production, labour costs and
export costs will decline which will in result reduce the per unit cost and
increase the revenue.
This stage may include product development. Demand for the product will continue
to rise in this stage. demand can also be expected from less developed nations.
Local competition with other cooperation's will begin.
Stage III: Standardized Product Stage
In this stage exports to nations various developed and under developed nations
will begin. Foreign product competition will reach its peak due to which the
product will start losing its market. The demand in the nation from where the
product originated will start declining and eventually diminishes as a new
product grabs the attention of the people. The market for the product is now
Then, the cycle of a new product begins.
The theories discussed above have aided economists, government and industries to
comprehend trade internationally in a healthier way.
view dominated in the 17th and 18th century.
Mercantilists held that trade is not free and its main was to achieve surplus.
However, they failed to address various issues. Adam Smith opposed the
Mercantilist Theory and highlighted the importance of free trade in increasing
the prosperity of nations. Smith's theory was criticized by David Ricardo and
others. According to Ricardo, each nation should focus in the production of
those goods that yield the most. Heckscher - 0hlin explained the basis trading
in respect to factor endowments. Vernon's theory scrutinized the effect of
technical changes on the pattern of international trade.
The Mercantalists theory, Cost Adavantage and Comparative Advantage theory
assumed only two commodities, factors and countries, and the rest of the factors
as constant. On the other hand, the New theories that consists of Product Life
Theory and Porter's Diamond are based on more explainable assumptions, that
talked about changes in factors. Therefore, the new theories are better at
explaining the pattern of world trade today.