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Subject COMMERCE
Paper No and Title 11 and International Business
Module No and Title Module 6: International Trade Theory: Traditional
Theories of Trade
Module Tag COM_P11_M6
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. International Trade & Trade Theory
3.1 International Trade
3.2 Need for International Trade
3.3 Trade Theory
4. Theory of Mercantilism
5. Absolute and Comparative Advantage Theory
5.1 Absolute Advantage Theory
5.2 Comparative Advantage Theory
6. Factor Proportions Theory of Trade
7. Summary
1. Learning Outcomes
After studying this module, you shall be able to
Appreciate the need to study the trade theory.
Understand the ideas of mercantilism.
Distinguish between absolute and comparative advantage.
Understand the factor proportions theory of trade.
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
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2. Introduction
History of trade is as old as mankind. People have traded for thousands of years. It is evident
from early civilizations like that of Egypt (Mesopotamia) where people traded among themselves
and with others. Then gradually trade took place over land and sea. In 15th century Europeans
explored sea route to trade in Asia. Later on in 1700s, Industrial Revolution started in Britain
(England). It is very evident that slowly and gradually the international trade has grown and is
still on the verge of growing in almost every part of the world. At present there are about 159
countries as members of WTO (world trade organization), an international organization that sets
up the rules for world trade with a view to promote free & fair trade globally.
3. International Trade & Trade Theory
3.1 International Trade
Trade in simple terms means sale, purchase or exchange of goods and services between people or
entities. From the international perspective trade would arise when sale, purchase or exchange of
goods and services takes place across national boundaries (borders).
3.1.1 Why do nations engage in International Trade?
The main question in economics of trade is –‘Why nations trade?’ What needs to be clarified is as
to why they trade. The availability of middlemen and transport can only facilitate trade – not
cause it. Why, in the first place do they do so? What is it that makes people who live far away,
speak different languages, and operate under different legal and economic systems take the
trouble of exchanging goods and services?
There are three views about why nations trade:
The Economic View: There must be economic gains from trade for both sides.
Resource-based view: Nations trade because some firms in one nation generate exports
that are valuable, unique and hard to imitate.
Institution-based view: There are different rules that govern trade which determine how
gains are shared amongst nations.
3.2 Trade Theory
The answer to the question, why nations engage in international trade is there in the trade theory.
Trade theory starts with why different nations or countries trade and ends by discussing the
benefits to countries engaged in such trade. International trade theory helps in explaining the
pattern of trade as well as the distribution of gains arising from such trade. It also helps in
explaining the observed trade and deduces the effect of trade on the domestic economy. Thus,
trade theory provide answers to questions like why do nations trade? What do they trade? Is trade
a good thing?
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
____________________________________________________________________________________________________
4. Mercantilism
The term “Mercantile System” was first coined by Adam Smith that describes a political
economy in which nations encourage exports and restrain imports in order to increase financial
wealth. The goal of mercantilism lies in achieving favorable BOT(Balance of Trade) that would
bring in more gold and silver into the economy, because possession of wealth, gold and silver
considered as the sign of a strong nation. In short, increasing gold holding by augmenting exports
and restricting imports laid the root of this theory.
The mercantile system was dominant in the Western Europe especially in Holland, France, UK,
Belgium, Portugal and Spain from sixteenth to the late eighteenth centuries. These nations
adopted the policies of government intervention, colonization and trade surpluses to accomplish
the goal of mercantilism. These three policies worked together. At that time the possession of
wealth, gold and silver was considered as the sign of a strong nation.
5. Absolute Advantage and Comparative Advantage
5.1 Absolute Advantage Theory
This theory was given by Adam Smith in the second half of eighteenth century as he strongly
criticized the mercantilist assumption that trade is a zero sum game and advocated free trade as it
enlarges a country’s wealth. Absolute advantage theory simply implies that a country should
import goods that are cheaper abroad i.e., when the cost of importing goods from other country
is less than the cost of producing it domestically and export goods which it can produce more
efficiently than other countries.
It will become clearer with the help of an example. Suppose there are two countries India and
Bangladesh, both countries are capable of producing radios and fans. The underlying assumption
is that both use just one factor of production, that is, labor. Both countries are endowed with ten
labor hours each, that can be utilized produce these two commodities. Here India has absolute
advantage in the production of radios and Bangladesh in the production of fans because India
can produce can 30 units of radios and 20 units of fan with ten labor hours available for each.
On the other Bangladesh can produce 10 units of radios and 50 units of fans.
It is very clear from the example shown in given figure depicting the production possibility
frontiers (PPF) & the table that there is gain from trade when India is producing radio and
Bangladesh producing fans with available entire resources because after trade the aggregate
production of both the countries increased from 40 units to 60 units for radios and from 70 units
to 100 units.
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
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Table I. Products(output per 10 hours of labor)
Before Trade After Specialization & Trade
Country Radio Fan Radio Fan
India 30 20 60 Nil
Bangladesh 10 50 Nil 100
Total 40 70 60 100
So, India should produce radio and export it to Bangladesh and import fans from there. On the
other Bangladesh should produce fans and export to India and import radio from there. This
trade leads to complete specialization where India is specialized in the production of radios and
Bangladesh in the production of fans.
Absolute advantage theory thus explains only the presence of trade only when two countries have
an absolute advantage respectively in two different commodities. Ordinarily in the world at large
certain countries have more efficient production. Therefore, they are able produce more with the
given resources (ten labor hours in the above example). It sees anomalous that under such
circumstances such economies still do trade with other economies which are capable of producing
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
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less for the same amount of labor input in the case of both
commodities. We know would study another theory which
would explain such a situation.
5.2 Comparative Advantage
This theory was given by the David Ricardo in 1817. He tried to explain that even if a country has
absolute advantage in the production of all the goods, such a country can still derive benefits from
international trade. According to him there is comparative advantage from trade of two or even
more products.
Comparative advantage can be explained as there are differences in labor productivity. By taking
a different example(from previous example) of India and Bangladesh producing two products
radio and fans where India has an absolute advantage in the production of both the products with
underlying assumptions that in both the countries hundred labor hours are consumed for
producing both the products equally i.e. half for radio and remaining half for fans. And the
production is based on constant cost.
Figure II depicting the production possibility frontiers (PPF) & Table II given below shows the
situation when there is no trade between the countries. India produces 250 units of radio and 300
units of fans. It is very clear that India is having the absolute advantage over the production of
both the products as it is more productive and efficient in the production of both the products.
Even in this situation India can take benefit by trading with Bangladesh.
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
____________________________________________________________________________________________________
Table II. Without Trade and
Specialization
Products(output per 100 labor hours)
Country Radio Fans
India 250 300
Bangladesh 50 250
Total 300 550
Figure III. depicting production possibility frontiers(PPF) followed by Table III & IV given
below shows how both India and Bangladesh can reap benefit through trade even if one of them
is having absolute advantage in the production all(both) goods
Before trade India was producing 250 units of radios & 300 units of fans with total 100 labor
hours. India has absolute advantage over the production of Bangladesh as Bangladesh is able to
produce only 50 units of radios and 250 units of fans with a total of 100 labor hours available.
Figure III depicting the production possibility frontiers (PPF) & Table III shows the case when
both the nations agree for the increased production of radios while the production of fans to
remain the same as before trade. In this situation the overall production of fans of both the
countries remains 550 units, as Bangladesh utilizes all the labor hours for producing 500 fans and
India utilizes 8.33 labor hours for producing 50 units of it. India however, utilizes remaining
91.67 labor hours for producing 458 radios. The gain resulting from this trade is evident as the
overall production of radios has increased by 148 units while the overall production of fans
remaining the same.
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
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Table III. With Trade and
Specialization(increasing Radio production)
Products(output per 100 labor hours)
Country Radio Fans
India 458 50
Bangladesh Nil 500
Total 458 550
The Table IV shows the situation when both the countries are engaged in trade and agree for the
increased production of fans. In this situation the overall production of radios remains same .i.e.
300 units as India utilizes 60 labor hours to produce 300 units of radios and remaining 40 labor
hours for producing 240 units of fans, while Bangladesh utilizes entire 100 labor hours for
producing 500 units of fans. So, here trade leads to increased overall production of fans, while the
overall production of radios being the same.
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
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Table IV. With Trade and
Specialization(increasing Fan production)
Products(output per 100 labor hours)
Country Radio Fans
India 300 240
Bangladesh Nil 500
Total 300 740
6. Factor Proportions Theory
The Factor Proportion theory of trade was given by Eli Heckscher and Bertil Ohlin, that’s why it
is also known as Heckscher-Ohlin Theory of Trade. The theory states that the reason for a
country to have a comparative advantage in the production of a good over the other is the
difference in their factor endowments. Since factor endowments vary from country to country,
different countries will have comparative advantage over different goods.
According to this theory, different factor endowments lead to different factor costs and different
goods require different types of factors of production. Therefore, a country will have comparative
advantage in the production of those products that use the resources or factors of production it has
in abundance. There are many examples like that of Saudi Arabia which is having abundant crude
oil, US having abundant capital, India having abundant labor and Australia having abundant land.
This theory implies that countries should export those goods that make intensive use of factors of
production that are locally available and are abundant, while they should import those goods that
make intensive use of factors that are not available and locally scarce.
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
____________________________________________________________________________________________________
7. Summary
International trade means sale, purchase or exchange of goods and services takes place
across national boundaries (borders). International trade is needed as different nations
have different capabilities and they are most often specialized in producing different
things.
Trade theory gives the reason for nations engaging in international trade and provides
answers to questions like why do nations trade? What do they trade? Is trade a good
thing? This theory starts with why different nations or countries trade and ends by
discussing the benefits to countries engaged in such trade.
The theory of mercantilism refers to that a nation should encourage exports and restrain
imports, while accumulating wealth, gold and silver as it was considered as a sign of a
strong nation.
The theory of absolute advantage implies that a country should produce those goods in
which it is more efficient than other countries and should import those goods which are
available at low cost abroad. Further there was theory of comparative advantage which
stated that a country can even reap benefits from trade if is having absolute advantage in
producing all the products.
The last traditional trade theory i.e. factor proportion theory state that different countries
have different factor endowments and goods differ according to the types of factor
endowments. Therefore, a country should export those goods that use factors that are
locally abundant and produce those goods that make use of resources that are locally
scarce.
COMMERCE PAPER No.11: InternationalBusiness
MODULE No. 6: International Trade Theory:
Traditional Theories of Trade
