Describe the Classic Theories of International Trade. Which Theories Do You Believe Are Relevant Today?

5-9.        Describe the classic theories of international trade. Which theories do you believe are relevant today?

Generally, theories of international trade are simply the theories that explain the concept of exchanging goods and services between two people or entities in different countries. It explains the rational for trade among nations around the world. There are six types of classical theories and the first one is the theory of ‘Mercantilism’. This theory was developed in the sixteenth century and is considered to be the oldest theory of international trade. During that time, gold and silver holds the status of currency. This group of theories believed that a country’s wealth can be determined by the amount of its gold and silver holdings and every country should increase the holdings of gold and silver by increasing its exports and reducing its imports. It’s the Adam Smith whom created the term ‘Mercantile System’ and he also criticised this theory. Even until today, this theory is being followed to some extent by export economies like Germany, Japan, and Singapore etc. Some have dubbed the policy of these countries to be a kind of neo-mercantilism in which supports the idea that the nations should run a trade surplus which means the value of exports should be greater than the value of imports.

        In response to Mercantilism theory, Adam Smith offered his own theory called ‘Absolute Advantage’. This theory believed that a nation should specialize in producing those goods that it can produce at a cheaper cost than that of other nations. These goods should be exchanged with other goods that are being cheaply produced by the other nations. According to this theory, absolute cost advantage will exist as specialization of labour that in turn will lead to higher productivity and less of cost of labour. On top of that, economies of scale will also exist as one country would produce one type of goods at a large scale and this will significantly reduce the cost of goods. In addition, by following this theory, a country would produce those goods that are naturally favouring its climatic conditions. The type of goods produced in certain countries would also depend upon the availability of natural resources. It’s an advantage to countries that has plenty of natural resources in producing the goods.

Third theory named ‘Comparative Advantage’ arises in 1817 by famous Economist, David Ricardo. According to this theory, if a country had absolute advantage in two or more products or in no product, specialization and trade could still occur between the countries. Comparative advantage exists when a country is able to produce a commodity better and more efficiently than it does other commodities. It focuses on the relative productivity different compared to Absolute Advantage theory, which focused only on absolute productivity. In order to make it more clear, we can take one example. A farmer could produce either wheat or rice on his land. However, in producing both crops, rice gives him more profit that wheat, for example wheat gives him RM 400 per hectare and rice gives him only RM 300 per hectare. This farmer has absolute advantage in both crops but according to the theory, he should produce wheat instead of producing both crops as by producing both, he will be giving up RM 100 per hectare. The productivity of his farmland will be highest if he specializes only in producing wheat. The same goes to countries. It will specialize in doing what it does relatively better. This theory demonstrates that trade between two countries is possible even when a country is able to produce all its goods at a cheaper cost than other countries. This is possible when the cost advantage is comparatively more in some goods than in the others. The country is compensated more by focusing its skill and knowledge on producing those goods in which it has a better cost advantage. On top of that, this theory has potential to incorporate costs other than labour and takes into account the ‘Opportunity cost’ of producing the goods. A lower opportunity cost than another country would signify comparative advantage available to a particular country.

Fourth theory of international trade named ‘Factor Proportions Theory’ was put forth by Eli Hecksher and Bertil Ohlin. It was built upon the foundations created by the theory of Comparative Advantage as propounded by David Ricardo. Based on this theory, other production factors such as land, labour and capital and not just labour cost alone. This model stated that factors of production that are in greater supply to the existing demand would be inexpensive and cost-effective and the factors of production that are greater in demand relative to the supply would be more expensive. Thus the countries must export and produce products that use their plentiful and inexpensive factors and import products that use the rare and uncommon factors.

Fifth theory of international trade named ‘International Product Life Cycle’ theory was developed by the economist Raymond Vernon in 1966, is still a widely used model in economics and marketing. According to Raymond Vernon, each product has a certain life cycle that begins with its development and ends with its decline. There are three stages in a product’s life cycle: “introduction”, “maturity” and “standardization”. The length of a stage varies for different products. It might last some weeks or decades. Introduction stage started when an organization has developed a product successfully, it will be introduced into the national and international outlet. In order to create demand, investments are made with respect to consumer awareness and promotion of the new product in order to get sales going. At this stage, profits are low and there are only few competitors. When more items of the product are sold, it will enter the next stage automatically. Following this, the demand for the product increases sales. Thus, production costs decrease and high profits are generated. The product becomes widely known, and competitors will enter the market with their own version of the product. Usually, they offer the product at a much lower sales price. To attract as many consumers as possible, the company that developed the original product will still increase its promotional spending. When many potential new customers have bought the product, it will enter the next stage which is the maturity stage. In the maturity stage, the product is widely known and is bought by many consumers. Competition is intense and a company will do anything to remain a stable market leader. This is why the product is sold at record low prices. Also, the company will start looking for other commercial opportunities such as adaptations or innovations to the product and the production of by-products. Furthermore, consumers will also be encouraged to replace their current product with a new one. There is fear of decline of the product and therefore all the stops will be pulled out in order to boost sales. The marketing and promotion costs are therefore very high in this stage. Then, the last stage which is the standardization stage occurred when at some point, however, the market becomes saturated and the product becomes unpopular. This stage of the Product life cycle can occur as a natural result but can also be stimulated by the introduction of new and innovative products. Despite its decline in sales, companies continue to offer the product as a service to their loyal customers so that they will not be offended.