Tthe evolution of trade theory



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Tthe evolution of trade theory

The major task of the trade theory is to explain how trade is related to the basic economic problems of efficiency in allocation, efficiency in motivation, and efficiency in distribution of scarce resources domestically and world-wide. This means that the modern theory of trade should answer the following questions:




  • what goods are traded internationally and what are the fundamental laws that govern the international allocation of resources and the flow of trade? - How international trade contributes to rational utilisation of resources world-wide?

  • at what prices are the goods and services exchanged, or what are the terms of trade? - How international trade is related to the efficient use of scarce resources?

  • what are the gains from trade and where do they come from? How are these gains divided among the trading countries? - What is the impact of international trade in equitable distribution world-wide?

International trade is a factor and a product of the economic development of nations. Similarly, the evolution of the trade theory reflects the ways nations were addressing basic economic problems. During the period from the sixteenth to the middle eighteenth century Britain, Spain, France, and Netherlands were the most developed countries with a high level of government intervention in the economy. Their governments were concerned with the ways of maintaining their own power and wealth. The economic philosophy that properly reflected these goals was known as mercantilism. Mercantilists argued that the best way for a nation to enjoy faster growth was to export more than it imported. The revenue would be a real inflow of gold. Since the amount of gold was fixed in the short run, not all nations could have such inflows simultaneously and gains from trade might be enjoyed only at the expense of the other nations. That is why mercantilist advocated import restrictions and export promotion.

Mercantilists’ views were challenged by Adam Smith who advocated free trade based on absolute advantages of nations. He proved that the advantages of international division of labour and specialisation would be shared by all nations who may benefit simultaneously from free international trade. Thus, when nations specialise in industries where they have absolute factor advantages, gains from trade come to every nation and not at the expense of others and there is no need for government intervention that only deteriorates allocation of resources and productivity. This is the most important contribution of Adam Smith to international trade theory and policies. What he did not explain, was the case when a nation had absolute advantages in the production of all goods.

Smith views’ weakness was overcome by David Ricardo who developed the theory of comparative advantages to prove that mutually beneficial trade could occur even when one nation was absolutely more efficient in the production of all goods. According to Ricardo, nations specialise in industries where they have lower opportunity cost and trade based on these comparative advantages all the countries enjoy gains from international trade. This is one of the most important and still unchallenged principles of economic theory and practice. David Ricardo’s views were based on the labour theory of value that stresses on the role of labour in value creation. Ricardo did not analyse the effect of resource endowments on productivity and international specialisation and the influence of trade on the distribution of income.

In the 1930s two Swedish economists Eli Heckscher and Bertil Ohlin developed a model of factor endowment to study these issues. They asserted that international trade is based on differences in factor endowments of nations. Because of the different endowments of factors of production nations have comparative advantages in different industries and their relative price levels differ. That is why each nation will export the goods intensive in its relatively abundant and cheap factor and import the goods intensive in its relatively scarce and expensive factor. Thus, all nations will enjoy gains from trade simultaneously.

After the WWII, Heckscher-Ohin theory was challenged by the evolution of international trade that it could not explain. Significant flows of intra-industry trade based on product differentiation, exports of goods intensive in nations relatively scarce and expensive factors (the so called Leontief paradox), trade based on economies of scale, trade based on technological gaps and product cycles needed a new explanation. These issues were addresses by different theories. For example, Raymond Vernon developed the theory of international product life cycle to explain trade based on technological gaps. He asserts that the initial production of a new product usually requires skilled labour, which can be replaced by a skilled labour once the product acquires mass acceptance and is standardised. Thus, the comparative advantage held by the industrialised nations that introduce new products shifts to lower-wage nations. Vernon’s contribution to the theory of internationalisation of business is that he put together explanations of international trade and investment flows that were following trade. Later this theory was extended to explain internationalisation of industries in the international industry life cycle model.



Stefan Linder gave an explanation of intraindustry trade in his theory of overlapping demand, asserting that international trade in manufactured goods will be greater between nations with similar levels of per capita income than between those with dissimilar per capital income level.

A coherent explanation of modern international trade was given by Michael Porter who developed the theory of competitive advantages of nations. He argues that competitiveness and hence international trade is determined by four factors encapsulated in the Porter Diamond. These are Factor Conditions, Demand Conditions, the Structure of Firms and Rivalry and lastly the strength and existence of Related Firms and Supporting Industries. Hence, industry clusters appear that create and enhance competitiveness of local firms. An important contribution of Porter’s theory is that he associates competitive advantages of nations with firm’s decision making. These are really firms that conduct international trade, not countries.



In the 1990s, Alan Rugman’s approach has extended the concept of Porter’s “single” diamond in order to explain the evidence for further globalization revealed by some recent surveys, that the more international a firm was, the more it derived its competitive advantages from its foreign affiliates. This theory reflects the prevalence of trade-related investment and investment-related trade flows and it is a successful effort to put together the views explaining contemporary growth of international trade and investment. Rugman argues that the deepening structural integration of the world economy and the burgeoning of alliance capitalism are widening the geographical scope for creating or augmenting firm-specific competencies and learning experiences. Any attempt to identify the geographical sources of such advantages must embrace the diamonds of other countries, particularly those with which the home-country firms have the most dealings by way of trade, FDI and non-equity co-operative ventures.


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