Theories of International Trade

A. Mercantilism
By Laura LaHaye
Mercantilism is economic nationalism for the purpose of building a wealthy and powerful state.
Adam Smith coined the term “mercantile system” to describe the system of political economy
that sought to enrich the country by restraining imports and encouraging exports. This system
dominated Western European economic thought and policies from the sixteenth to the late
eighteenth centuries. The goal of these policies was, supposedly, to achieve a “favorable”
balance of trade that would bring gold and silver into the country and also to maintain domestic
employment. In contrast to the agricultural system of the physiocrats or the laissez-faire of the
nineteenth and early twentieth centuries, the mercantile system served the interests of merchants
and producers such as the British East India Company, whose activities were protected or
encouraged by the state.
The most important economic rationale for mercantilism in the sixteenth century was the
consolidation of the regional power centers of the feudal era by large, competitive nation-states.
Other contributing factors were the establishment of colonies outside Europe; the growth of
European commerce and industry relative to agriculture; the increase in the volume and breadth
of trade; and the increase in the use of metallic monetary systems, particularly gold and silver,
relative to barter transactions.
During the mercantilist period, military conflict between nation-states was both more frequent
and more extensive than at any other time in history. The armies and navies of the main
protagonists were no longer temporary forces raised to address a specific threat or objective, but
were full-time professional forces. Each government’s primary economic objective was to
command a sufficient quantity of hard currency to support a military that would deter attacks by
other countries and aid its own territorial expansion.
Most of the mercantilist policies were the outgrowth of the relationship between the governments
of the nation-states and their mercantile classes. In exchange for paying levies and taxes to
support the armies of the nation-states, the mercantile classes induced governments to enact
policies that would protect their business interests against foreign competition.
These policies took many forms. Domestically, governments would provide capital to new
industries, exempt new industries from guild rules and taxes, establish monopolies over local and
colonial markets, and grant titles and pensions to successful producers. In trade policy the
government assisted local industry by imposing tariffs, quotas, and prohibitions on imports of
goods that competed with local manufacturers. Governments also prohibited the export of tools
and capital equipment and the emigration of skilled labor that would allow foreign countries, and
even the colonies of the home country, to compete in the production of manufactured goods. At
the same time, diplomats encouraged foreign manufacturers to move to the diplomats’ own
countries.
Shipping was particularly important during the mercantile period. With the growth of colonies
and the shipment of gold from the New World into Spain and Portugal, control of the oceans was
considered vital to national power. Because ships could be used for merchant or military
purposes, the governments of the era developed strong merchant marines. In France, Jean-
Baptiste Colbert, the minister of finance under Louis XIV from 1661 to 1683, increased port
duties on foreign vessels entering French ports and provided bounties to French shipbuilders.
In England, the Navigation Act of 1651 prohibited foreign vessels from engaging in coastal trade
in England and required that all goods imported from the continent of Europe be carried on either
an English vessel or a vessel registered in the country of origin of the goods. Finally, all trade
between England and its colonies had to be carried in either English or colonial vessels. The
Staple Act of 1663 extended the Navigation Act by requiring that all colonial exports to Europe
be landed through an English port before being re-exported to Europe. Navigation policies by
France, England, and other powers were directed primarily against the Dutch, who dominated
commercial marine activity in the sixteenth and seventeenth centuries.
During the mercantilist era it was often suggested, if not actually believed, that the principal
benefit of foreign trade was the importation of gold and silver. According to this view the
benefits to one nation were matched by costs to the other nations that exported gold and silver,
and there were no net gains from trade. For nations almost constantly on the verge of war,
draining one another of valuable gold and silver was thought to be almost as desirable as the
direct benefits of trade. Adam Smith refuted the idea that the wealth of a nation is measured by
the size of the treasury in his famous treatise The Wealth of Nations, a book considered to be the
foundation of modern economic theory. Smith made a number of important criticisms of
mercantilist doctrine. First, he demonstrated that trade, when freely initiated, benefits both
parties. Second, he argued that specialization in production allows for economies of scale, which
improves efficiency and growth. Finally, Smith argued that the collusive relationship between
government and industry was harmful to the general population. While the mercantilist policies
were designed to benefit the government and the commercial class, the doctrines of laissez-faire,
or free markets, which originated with Smith, interpreted economic welfare in a far wider sense
of encompassing the entire population.
While the publication of The Wealth of Nations is generally considered to mark the end of the
mercantilist era, the laissez-faire doctrines of free-market economics also reflect a general
disenchantment with the imperialist policies of nation-states. The Napoleonic Wars in Europe
and the Revolutionary War in the United States heralded the end of the period of military
confrontation in Europe and the mercantilist policies that supported it.
Despite these policies and the wars with which they were associated, the mercantilist period was
one of generally rapid growth, particularly in England. This is partly because the governments
were not very effective at enforcing the policies they espoused. While the government could
prohibit imports, for example, it lacked the resources to stop the smuggling that the prohibition
would create. In addition, the variety of new products that were created during the industrial
revolution made it difficult to enforce the industrial policies that were associated with
mercantilist doctrine.
By 1860 England had removed the last vestiges of the mercantile era. Industrial regulations,
monopolies, and tariffs were abolished, and emigration and machinery exports were freed. In
large part because of its free trade policies, England became the dominant economic power in
Europe. England’s success as a manufacturing and financial power, coupled with the United
States as an emerging agricultural powerhouse, led to the resumption of protectionist pressures in
Europe and the arms race between Germany, France, and England that ultimately resulted in
World War I.
Protectionism
remained important in the interwar period. World War I had destroyed the international monetary
system based on the gold standard. After the war, manipulation of the exchange rate was added
to governments’ lists of trade weapons. A country could simultaneously lower the international
prices of its exports and increase the local currency price of its imports by devaluing its currency
against the currencies of its trading partners. This “competitive devaluation” was practiced by
many countries during the Great Depression of the 1930s and led to a sharp reduction in world
trade.
A number of factors led to the reemergence of mercantilist policies after World War II. The
Great Depression created doubts about the efficacy and stability of free-market economies, and
an emerging body of economic thought ranging from Keynesian countercyclical policies to
Marxist centrally planned systems created a new role for governments in the control of economic
affairs. In addition, the wartime partnership between government and industry in the United
States created a relationship—the military-industrial complex, in Dwight D. Eisenhower’s
words—that also encouraged activist government policies. In Europe, the shortage of dollars
after the war induced governments to restrict imports and negotiate bilateral trading agreements
to economize on scarce foreign exchange resources. These policies severely restricted the
volume of intra-Europe trade and impeded the recovery process in Europe in the immediate
postwar period.
The economic strength of the United States, however, provided the stability that permitted the
world to emerge from the postwar chaos into a new era of prosperity and growth. The Marshall
Plan provided American resources that overcame the most acute dollar shortages. The Bretton
Woods agreement established a new system of relatively stable exchange rates that encouraged
the free flow of goods and capital. Finally, the signing of the GATT (General Agreement on
Tariffs and Trade) in 1947 marked the official recognition of the need to establish an
international order of multilateral free trade.
The mercantilist era has passed. Modern economists accept Adam Smith’s insight that free trade
leads to international specialization of labor and, usually, to greater economic well-being for all
nations. But some mercantilist policies continue to exist. Indeed, the surge of protectionist
sentiment that began with the oil crisis in the mid-1970s and expanded with the global recession
of the early 1980s has led some economists to label the modern pro-export, anti-import attitude
“neomercantilism.” Since the GATT went into effect in 1948, eight rounds of multilateral trade
negotiations have resulted in a significant liberalization of trade in manufactured goods, the
signing of the General Agreement on Trade in Services (GATS) in 1994, and the establishment
of the World Trade Organization (WTO) to enforce the agreed-on rules of international trade.
Yet numerous exceptions exist, giving rise to discriminatory antidumping actions, countervailing
duties, and emergency safeguard measures when imports suddenly threaten to disrupt or
“unfairly” compete with a domestic industry. Agricultural trade is still heavily protected by
quotas, subsidies, and tariffs, and is a key topic on the agenda of the ninth (Doha) round of
negotiations. And cabotage laws, such as the U.S. Jones Act, enacted in 1920 and successfully
defended against liberalizing reform in the 1990s, are the modern counterpart of England’s
Navigation Laws. The Jones Act requires all ships carrying cargo between U.S. ports to be U.S.
built, owned, and documented.
Modern mercantilist practices arise from the same source as the mercantilist policies of the
sixteenth through eighteenth centuries. Groups with political power use that power to secure
government intervention to protect their interests while claiming to seek benefits for the nation as
a whole. In their recent interpretation of historical mercantilism, Robert B. Ekelund and Robert
D. Tollison (1997) focused on the privilege-seeking activities of monarchs and merchants. The
mercantile regulations protected the privileged positions of monopolists and cartels, which in
turn provided revenue to the monarch or state. According to this interpretation, the reason
England was so prosperous during the mercantilist era was that mercantilism was not well
enforced. Parliament and the common-law judges competed with the monarchy and royal courts
to share in the monopoly or cartel profits created by mercantilist restrictions on trade. This made
it less worthwhile to seek, and to enforce, mercantilist restrictions. Greater monarchical power
and uncertain property rights in France and Spain, by contrast, were accompanied by slower
growth and even stagnation during this period. And the various cabotage laws can be understood
as an efficient tool to police the trading cartels. By this view, the establishment of the WTO will
have a liberalizing effect if it succeeds in raising the costs or reducing the benefits of those
seeking mercantilist profits through trade restrictions.
Of the false tenets of mercantilism that remain today, the most pernicious is the idea that imports
reduce domestic employment. Labor unions have used this argument to justify protection from
imports originating in low-wage countries, and there has been much political and media debate
about the implications of offshoring of service sector jobs for national employment. Many
opponents have claimed that offshoring of services puts U.S. jobs at risk. While it does threaten
some U.S. jobs, it puts no jobs at risk in the aggregate, however, but simply causes a reallocation
of jobs among industries. Another mercantilist view that persists today is that a current account
deficit is bad. When a country runs a current account deficit, it is either borrowing from or
selling assets to the rest of the world to finance expenditure on imports in excess of export
revenue. However, even when this results in an increase of net foreign indebtedness, and
associated future debtservicing requirements, it will promote economic wealth if the spending is
for productive purposes that yield a greater return than is forgone on the assets exchanged to
finance the spending. Many developing countries with high rates of return on capital have run
current account deficits for extremely long periods while enjoying rapid growth and solvency.
The United States was one of these for a large part of the nineteenth century, borrowing from
English investors to build railroads (see international capital flows). Furthermore, persistent
surpluses may primarily reflect a lack of viable investment opportunities at home or a growing
demand for money in a rapidly developing country, and not a “mercantile” accumulation of
international reserves at the expense of the trading partners.

1. Adam Smith’s Theory of Absolute Advantage

The mercantilist economic theory, which was widely followed between the 16th and the
18th century, came under a lot of criticism with the emergence of economists like John Locke and
David Hume. Mercantilism advocated a national economic policy designed to maximize the
nation’s trade and its gold and money reserves. Mercantilism gained influence due to the
emergence of colonial powers such as Britain and Portugal, before Adam Smith, and later Daniel
Ricardo, both staunch critics of the concept, came up with their own theories to counter
mercantilism.
Smith was the first economist to bring up the concept of absolute advantage, and his arguments
regarding the same supported his theories for a laissez-faire state. In the Wealth of Nations,
Smith first points out through opportunity costs that regulations favoring one industry take away
resources from another industry, where they might have been more advantageously employed.

Secondly, he applies the opportunity cost principle to individuals in a society, using the
particular example of a shoemaker not using the shoes he made himself because that would be a
waste of his productive resources and he would rather purchase shoes made efficiently by some
other producer. Each individual thus specializes in the production of goods and services in which
he or she has some sort of an advantage.

Thirdly, Smith applies the same principles of opportunity costs and specialization to international
economic policy, and the principle of international trade. He explains that it is better to import
goods from abroad where they can be manufactured more efficiently because this allows the
importing country to put its resources on its own most productive and efficient industries. Smith
thus emphasizes that a difference in technology between nations is the primary determinant of
international trade flows around the globe.

Assumptions of the Absolute Advantage Theory

 Smith assumed that the costs of the commodities were computed by the relative amounts
of labor required in their respective production processes.
 He assumed that labor was mobile within a country but immobile between countries.
 He took into consideration a two-country and two-commodity framework for his analysis.
 He implicitly assumed that any trade between the two countries considered would take
place if each of the two countries has an absolutely lower cost in the production of one of
the commodities.

2. David Ricardo’s Theory of Comparative Cost Advantage | Economics

David Ricardo believed that the international trade is governed by the comparative cost
advantage rather than the absolute cost advantage. A country will specialise in that line of
production in which it has a greater relative or comparative advantage in costs than other
countries and will depend upon imports from abroad of all such commodities in which it has
relative cost disadvantage.
Suppose India produces computers and rice at a high cost while Japan produces both the
commodities at a low cost. It does not mean that Japan will specialise in both rice and computers
and India will have nothing to export. If Japan can produce rice at a relatively lesser cost than
computers, it will decide to specialise in the production and export of computers and India,
which has less comparative cost disadvantage in the production of rice than computers will
decide to specialise in the production of rice and export it to Japan in exchange of computers.
The Ricardian comparative costs analysis is based upon the following assumptions:
(i) There is no intervention by the government in economic system.
(ii) Perfect competition exists both in the commodity and factor markets.
(iii) There are static conditions in the economy. It implies that factors supplies, techniques of
production and tastes and preferences are given and constant.
(iv) Production function is homogeneous of the first degree. It implies that output changes
exactly in the same ratio in which the factor inputs are varied. In other words, production is
governed by constant returns to scale.
(v) Labour is the only factor of production and the cost of producing a commodity is expressed
in labour units.
(vi) Labor is perfectly mobile within the country but perfectly immobile among different
countries.
(vii) Transport costs are absent so that production cost, measured in terms of labour input alone,
determines the cost of producing a given commodity.
(viii) There are only two commodities to be exchanged between the two countries.
(ix) Money is non-existent and prices of different goods are measured by their real cost of
production.
(x) There is full employment of resources in both the countries.
(xi) Trade between two countries takes place on the basis of barter.

3. Heckscher-Ohlin’s Theory of International Trade

The classical comparative cost theory did not satisfactorily explain why comparative costs of
producing various commodities differ as between different countries.

The new theory propounded by Heckscher and Ohlin went deeper into the underlying forces
which cause differences in comparative costs.

The different regions or countries have different factor endowments.

The different goods require different factor-proportions for their production.

It is a well-known fact that various countries (regions) are differently endowed with productive
factors required for production of goods. Some countries posses relatively more capital, some
relatively more labour, and some relatively more land.

The factor which is relatively abundant in a country will tend to have a lower price and the factor
which is relatively scarce will tend to have a higher price. Thus, according to Ohlin, factor
endowments and factor prices are intimately associated with each other.
Suppose K stands for the availability or supply of capital in a country, L for that of labour and
PK for price of capital and PL for the price of labour. Further, take two countries A and B; in
country A capital is relatively abundant and labour is relatively scarce. The reverse is the case in
country B. Given these factor-endowments, in country A capital will be relatively cheaper.

Thus the differences in factor endowments cause differences in factor prices and therefore ac-
count for differences in comparative costs of producing different commodities. Together with the
difference in factor-endowments, differences in factor proportions required for the production of
different commodities also constitute an important force underlying differences in comparative
costs as between different countries.

Some commodities are such that their production requires relatively more capital than other
factors; they are therefore called capital- intensive commodities. Still other commodities require
relatively more land than capital and labour and are therefore called land-intensive commodities.

It follows from above that some countries have a comparative advantage in the production of a
commodity for which the required factors are found in abundance and comparative disadvantage
in the production of a commodity for which the required factors are not available in sufficient
quantities.

Thus a country A which has a relative abundance of capital and relative scarcity of labour will
have a comparative advantage in specialising in the production of capital-intensive commodities
and in return will import labour-intensive goods. This is because (PK/PL)A < (PK/PL)B.
On the other hand, a labour-abundant country B with a scarcity of capital will have a compara-
tive advantage in specialising in the production of labour-intensive commodities and export some
quantities of them and in exchange for import capital-intensive commodities.

4. Product Life Cycle: Definition, Theory & Stages

Meaning:
A product, when it is new, advances through an arrangement of stages from incubation to
development, maturity, as well as decline. This progression is identified as the product life
cycle and is linked with alterations in the marketing condition, consequently affecting the
marketing methodology and the marketing mix.
Definition:
Product Life Cycle is defined as, “the cycle through which every product goes through from
introduction to withdrawal or eventual demise.”
 Image Title:
Product Life Cycle Stages
The life of most products can be divided into five key stages:

a) Development

b) Introduction

c) Growth

d) Maturity

e) Decline

The above diagram depicts a typical Product Life Cycle.

Stages of Product Life Cycle

1. Introduction phase
In the introduction phase, the business firm tries to fabricate product awareness plus create a
market for the product. The effect on the marketing mix is:

 Product branding as well as the quality level is launched and intellectual property
protection like trademarks and patents are received.
 Pricing is perhaps low diffusion pricing to get market share speedily, or elevated skim
pricing to recuperate development expenses.
 Distribution is specific until shoppers show acknowledgement of the product.
 Promotion is intended for pace-setters and early on accepters. Advertising correspondences
look to construct product awareness and educate possible purchasers about the product.
2. Growth phase
Sponsored
In the growth phase, the firm tries to construct brand fondness and augment market share.

 Product quality is kept up and additional characteristics plus backup services may be
included.
 Pricing is kept up, as the firm benefits from rising demand with modest competition.
 Distribution channels are included as demand boosts and consumers acknowledge the
product.
 Promotion is intended for a wider audience.
3. Maturity phase
At maturity, the steady increase in sales reduces. Competition may show up with products that
are alike. The principal aim at this stage is to preserve market share even as profit is maximized.

 Product attributes may be upgraded to distinguish the competitors’ product.

 Pricing may be lower in light of the new rivalry.
 Distribution turns into more exhaustive and inducements may be presented so that
preference can be promoted over rival products.
 Promotion underlines product differentiation.
4. Decline phase
As sales decline, the business firm has quite a lot of alternatives:

 Preserve the product, probably restoring it by including new attributes and discovering new
applications.
 Harvest the product – diminish expenses and keep on offering it, conceivably to a reliable
niche section.
 Ceasing the product, selling remaining stock, or offering it to an alternate firm that is eager
to proceed with the product, is another option.
Applications:
The Product Life Cycle idea helps advertising managers to arrange alternate marketing schemes
to deal with the challenges that the products are liable to confront. It additionally helps to check
sales returns and contrasts them with those products which have the same kind of life cycle.

5. Mill’s Theory of Reciprocal Demand

J.S. Mill made Ricardo’s theory of comparative cost determinate by stating the conditions for
equilibrium terms of trade. Comparative cost difference between the countries sets the outer
limits between which international trade can take place profitably. It does not tell where, between
the limits, international trade will actually take place. Mill provides answer to this question.
J. S. Mill propounded the theory of reciprocal demand or the law of international values to
explain the actual determination of equilibrium terms of trade. According to him, the equilibrium
terms of trade arc determined by the equation of reciprocal demand. Reciprocal demand means
the relative strength and elasticity of demand of the two trading countries for each other’s
product in terms of their own product.
A stable ratio of exchange will be determined at a level where the value of imports and exports
of each country is in equilibrium. In Mill’s own words, “The actual ratio at which goods are
traded will depend upon the strength and elasticity of each country’s demand for the other
country’s product, or upon reciprocal demand. The ratio will be stable when the value of each
country’s exports is just enough to pay for its imports.
Mill’s theory is based on the following assumptions- (i) Full employment conditions; (ii) Perfect
competition; (iii) Free foreign trade; (iv) Free mobility of factors; (v) Applicability of the theory
of comparative cost; (vi) Two country, two commodity model.
Ellsworth has summed up Mill’s theory of reciprocal demand in the following way:
(i) The possible range of barter terms is given by the respective domestic terms of trade as set by
comparative efficiency in each country.
(ii) Within this range, the actual terms depend on each country’s demand for the other country’s
produce.
(iii) Finally, only those barter terms will be stable at which the exports offered by each country
just suffice to pay for the imports it desires.
Changes in Demand and Supply Conditions:
Mill’s theory of reciprocal demand is more than a simple truism. It indicates the forces and their
modus operendi which bring about international equilibrium. Mill analysed the impact of
changes in supply and demand conditions on the terms of trade.
1. Changes in Supply Conditions:
Changes in supply conditions as a result of cost-reducing improvements in technology bring
changes in terms of trade. An improvement in the cloth industry of England increases the
productivity in that industry, makes cloth cheaper in terms of Indian wheat (i. e., the same
amount of wheat is exchanged for more cloth) and thus makes the terms of trade in favour of
India, the importer of cloth in exchange for wheat.
2. Changes in Demand Conditions:
The extent to which the barter terms of trade change depends not only on the increased
production in exporting country, but also on the importing country’s elasticity of demand for
imports in terms of its exports.
(i) If India’s elasticity of demand for England’s cloth in terms of its own wheat is more elastic,
then the barter terms of trade will change in favour of India more than the fall in price of cloth in
terms of wheat.
(ii) If India’s demand for cloth in terms of wheat is unitary elastic, then the barter terms of trade
turn in favour of India equal to the fall in the price of cloth in terms of wheat.
(iii) If India’s demand for cloth in terms of wheat is less elastic, then the barter terms of trade
will change in favour of India less than the fall in the price of cloth in terms of wheat.

6. New Trade Theory

Consider the simplest model (based on Krugman 1979). In this model there are two
countries. In each country, consumers have a preference for variety but there is a tradeoff
between variety and cost, consumers want variety but since there are economies of scale – a
firm’s unit costs fall as it produces more – more variety means higher prices. Preferences for
variety push in the direction of more variety, economies of scale push in the direction of less. So
suppose that without trade country 1 produces varieties A,B,C and country two produces
varieties X,Y,Z. In every other respect the countries are identical so there are no traditional
comparative advantage reasons for trade.
Nevertheless, if trade is possible it is welfare enhancing. With trade the scale of production can
increase which reduces costs and prices. Notice, however, that something interesting
happens. The number of world varieties will decrease even as the number of varieties available
to each consumer increases. That is, with trade production will concentrate in say A,B,X,Y so
each consumer has increased choice even as world variety declines.

Increasing variety for individuals even as world variety declines is a fundamental fact of
globalization. In the context of culture, Tyler explains this very well in his book, Creative
Destruction; when people in Beijing can eat at McDonald’s and people in American can eat at
great Chinese restaurants the world looks increasingly similar even as each world resident
experiences an increase in variety.

Thus, Krugman (1979) can be thought of as providing another reason why trade can be beneficial
and a fundamental insight into globalization.