Classification of Trade Theories: Assumptions and Implications of Various Trade Theories

Introduction

Trade theories refer to economic principles that explain the origin, assumptions, and implications of international trade. The first international trade theory was recorded in the 16th century (Krugman, Obstfeld, & Melitz 2019). Ever since then, there have been multiple theories, each criticizing and trying to outdo its predecessor. The theories of international trade are classified into the following broad categories: Mercantilism, Classical theories of trade, Modern theories of trade and Neo theories of trade.

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Mercantilism

Mercantilism is an economic system that was very popular in Europe from the 16th to the 18th century. This system proposes that for a nation to make strides economically, it has to have a favorable balance of trade, whereby its exports far exceed the value of its imports. The underlying belief of this economic theory is that there is only a fixed amount of wealth on earth. Therefore, for a nation to increase its share of wealth, it has to take away resources from other nations. In order for this to occur, the government has to promote the domestic industry by regulating the economy and restricting imports (Ballinger 2011).

Assumptions of Mercantilism

1. The world has a finite amount of wealth.
2. A nation can only accumulate wealth at the expense of others.
3. Colonies are used for the economic benefit of the mother country.
4. Colonies provide raw materials, cheap labor and also a market for the mother country in exchange for military security and administrative duties.

Implications of Mercantilism

1. It promoted the scramble for colonies.
2. European nations placed trade restrictions, such as Navigation Acts by England, which banned her colonies from trading with other European nations.
3. Colonies specialized in producing various raw materials like tobacco, sugar, rice, and spices.

Absolute Advantage

Adam Smith came up with the economic concept of absolute advantage. According to Smith, a nation has the ability to produce products at a lower cost per unit than other nations producing the same good or service (Schumacher 2012). The nation with the absolute advantage uses either a superior production technique or fewer units to produce the same amount of goods/services, like other nations (Krugman & Wells 2018). As a result, it produces cheaper or superior products/services. Under this economic principle, Adam argues that nations should concentrate on commodities that they have an absolute advantage, as this will foster international trade due to mutual benefits (Schumacher 2012).

Assumptions of Absolute Advantage

1. There is no mobility of factors of production between nations. This is a skewed assumption because factors of production can be moved to other nations with better taxation and cheaper production costs.
2. Production position of each nation will not change after the trade. This assumption is also unrealistic as nations may come up with better methods of production and absolute advantage may shift to a nation with superior methods of production, as opposed to the ones with the natural resources.
3. There are no trade barriers. Not all nations are willing to adopt free trade. Many governments create trade barriers to improve the domestic industry and encourage a favorable balance of trade.
4. There is a trade balance, whereby exports equal imports. For this trade theory to work, there should be no trade imbalances where there are surpluses (exports exceed imports) or deficits (imports exceed exports). This is another unrealistic assumption.

The theory of Absolute Advantage received massive criticism since it assumed that only two commodities could be exchanged between two nations. This theory therefore neglects the concept of multilateral trade at the international stage.

Comparative Advantage

David Ricardo introduced the comparative advantage theory stipulating that a situation where a nation enjoys a lower opportunity cost than other country producing the same goods or services (Krugman et al. 2019). The nation, therefore, foregoes production of other products in favor of the one that it has a lower opportunity cost. Consequently, it will export the products or services in which it enjoys comparative advantage and vise versa. Ricardo uses an example of the textile industry in England versus the wine industry in Portugal. While England is able to manufacture cheap clothes, it lacks the right climate to produce cheap wine. England, therefore, concentrates on producing the finest clothes and then trades them for cheap wine from Portugal (Krugman & Wells 2018).

For the black nation, the opportunity cost of producing 1 unit of Good X is 0.71 or 5/7units of Good Y. On the other hand, the opportunity cost of producing 1 unit of Good X is 0.67 or 10/15units of Good Y for the red nation. This means therefore that the red nation has a comparative advantage when it comes to the production of Good Y than the black nation.

Assumptions of the Ricardian Theory

1. There are only two nations producing the same commodities. It completely neglects other nations producing different types of goods and services. This is unrealistic in an international setting.
2. The theory only factors in labor costs in production and disregards all non-labor costs, such as transport costs that contribute significantly to the overall price of the commodities.
3. It further assumes that production costs are constant. However, costs reduce with increase in production, which also increases the comparative advantage.
4. Ricardo assumes factors of production are mobile, both internally and externally. However, this is not always the case, especially in highly specialized industries.
5. The theory also assumes there is free world trade. However, in the real world, many nations impose tariffs and trade barriers to discourage overreliance on imports (Krugman et al. 2019).

Heckscher-Ohlin Theorem

This theory states that a capital-abundant nation will export capital-intensive goods. In the same vein, a nation that is labor-abundant will export goods that are labor intensive. In this model, relative factor abundance plays a major role in determining which types of goods a country produces. A nation will, therefore, export goods that it produces relatively better than other countries (Morrow 2010).

Assumptions of Heckscher-Ohlin Theorem

1. There exists perfect competition, where goods are homogenous across all nations and there are free entry and exit of nations in response to profits and loses respectively.
2. There are two nations, two goods and two factors of production, capital, and labor. One commodity is labor intensive, while the other is capital intensive.
3. Constant returns to scale can be applied in the production of both goods X and Y.
4. Both countries are represented by the same indifference curve, which means that the two nations have the same taste and preferences.
5. There is a balance of trade in both nations, exports equal imports.
6. Both nations utilize their resources fully.
7. There is perfect mobility of factors of production internally and not externally.
8. There exists free international trade with no trade barriers and tariffs (Morrow 2010).

Product Life Cycle Theory

The product life cycle theory (PLC) was formulated by Raymond Vernon (Moffett, Stonehill, & Eiteman, 2015). This theory postulates that a product goes through a life cycle in the international arena. According to the theory, there are four stages in the product life cycle namely introduction, growth, maturity and decline phase (Moffet et al. 2015). At the introduction stage, the product is still new in the market. Extensive marketing and promotion are done to create consumer awareness. Gradually, sales improve and the product moves to the next stage. At the growth stage, the product is widely known which results in increased sales and profits. Competitors enter the industry with cheaper alternatives to the product (Pilbeam 2013). However, the original product still controls the largest market share.

It then moves to the maturity stage, where the original product faces stiff competition from other players. The company is then forced to slash prices of its products to maintain its customers. At maturity, there are extensive innovations to improve the original product and to create by-products. Also, there is extensive marketing at this stage to counter the competition. Lastly, the product moves to the last phase which is the decline stage. Due to oversaturation and new innovative products, the original product is no longer popular (Pilbeam 2013). The company continues to offer this product, not to make profits, but to appease its loyal customers.

Assumptions of PLC

1. Every product has a limited lifespan, however, the lifespan differs. Some products complete their lifespans within several months, while others take years.
2. It is based on the theory of diffusion. At the initial stages, very few consumers use the product. Their number eventually increases with the majority of consumers adopting it at the later stages of the cycle.
3. All products have to go through all the phases and in a chronological manner.
4. The product does not undergo reintroduction. Once a cycle is over, it is over.

Conclusion

In conclusion, trade is very important in modern society. It facilitates the selling and buying of commodities both domestically and internationally. Trade theories are therefore fundamental building blocks that promote international trade. They are the derivatives that nations adapt to create and implement trade policies. Mercantilism, absolute advantage, comparative advantage, product life cycle, and Heckscher-Ohlin are some of the most reputable international trade theories. Every nation seeks to benefit from trade, hence a tool for economic growth and development.

Reference List

Ballinger, C 2011, 'Mercantilism and the Rise of the West: Towards a Geography of Mercantilism', SSRN Electronic Journal.

Krugman PR, Obstfeld M & Melitz MJ 2019, International Economics: Theories of Trade.

Harlow: Pearson Education Limited. Krugman PR & Wells R 2018, Macroeconomics. New York: Macmillan Education,

Worth.Moffett MH, Stonehill AI, & Eiteman DK 2015, Fundamentals of Multinational Finance. Boston: Pearson.

Morrow, P 2010, Ricardian-Heckscher-Ohlin Comparative Advantage: Theory and Evidence. SSRN Electronic Journal.Pilbeam, K 2013, International Finance. London: Palgrave Macmillan.

Schumacher, R 2012 'Adam Smith's theory of absolute advantage and the use of doxography in the history of economics', Erasmus Journal for Philosophy and Economics, vol. 5, no. 2, pp. 54.