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Classical Country Based Theories


Classical Country Based Theories

International merchandise trade in goods in 2006 was $8 tr. & in services 3 tr. (20% of the world GDP).
Exports spark additional economic activity in domestic economy as companies of country can expand
their sales and profits by selling to foreign markets.
Imports can pressure domestic economy as foreign products flood domestic markets and result in
closing down of non-competitive local businesses.
Some countries in the world are successful in exporting manufactured and non-manufactured goods as
well as services to other countries and have become prosperous. While there are other countries that
have ton been so successful and hence have remained poor. Due to international trade’s significance to
businesses, consumers & workers, scholars have attempted to develop theories to explain & predict the
forces that motivate such trade.

This is an old 16th century economic philosophy that attempted to explain how countries may become
prosperous and strong. Salient points of this philosophy are in the following;
• Country’s wealth is measured by its holdings of gold & silver (reserves of modern era)
• Country’s goal should be to enlarge those holdings
• To do this a country should maximize difference between its exports & imports
• A country should then promote exports & discourage imports - if exports are more than imports
foreigners have to pay the difference in gold & silver
• Today’s “unfavourable balance of trade” when exports of any country are less than its exports, is the
extension of the same idea
• With larger holdings of gold and silver kings could have more wealth – and hence could afford larger
armies to expand kingdoms
• This approach would make exporters happy and domestic manufacturers of export products would
also be happy as their businesses grow

Arguments against ‘Mercantilism’ Approach:

• By following this philosophy in a country more members of society are at loss as export subsidy is
paid by taxpayers and import restriction leads to higher domestic prices
• In the age of imperialism the burden of the subsidy was shifted to colonies and colonies were made
producers of raw materials and markets for empire’s manufactured products
• Mercantilism actually weakens a country as the subsidized and protected export sector fails to
become efficient and the domestic economy suffers to provide support to the exports.
• Country’s true wealth is in fact measured by the wealth of all its citizens not just that of its king or
only the exporters
• Country’s real wealth is dependent on production of goods & services rather than accumulation of
gold reserves
• More wealth of more citizens will provide more tax base & hence a wealthy king
• Mercantilism causes inefficiencies, some special interest groups may benefit, reduces wealth of
country as a whole
• Free trade among countries enlarges a country’s wealth (specialize in production of some goods &
services while import others) (unrest in britain’s american colonies and their subsequent
independence was due to the “mercantilist” policies of uk )

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Theory of Absolute Advantage:

This theory was forwarded in 1776 by Adam Smith. Salient features of this theory are in the following;
It advocates free trade among world countries to maximize citizens’ wealth
Free trade enables a country to expand the amount of goods and services available to it by
specializing in production of some goods and services and trading of others
A country can have certain advantages over other countries
– Natural advantage: climatic conditions, natural resources, abundant cheap labor-force etc
– Acquired advantage: development of product or process, skills development etc
A country should export those goods & services for which it is more productive than others
Import those goods & services for which other countries are more productive
What if a country has absolute advantage in all products? Large countries like USA and China can have
absolute advantages in manufacturing many types of products. Extent of value addition and profits on
various products vary. Some types of products allow better return on resources deployed than others
products. Should these countries then produce and export all such products in which they have
advantage? Or concentrate more on such products where they may earn comparatively better profits?

Theory of Comparative Advantage:

Forwarded in early 19th century, the theory of Comparative Advantage resolves the above issue. A
country should produce and export such products where it has comparatively more advantage and hence
can earn better margins. Salient features of this theory are in the following;
A country should produce & export those goods & services for which it is relatively more productive
than other countries
Implement concept of opportunity cost (what a country gives up to get / produce a certain good) in
determining which goods a country should produce

Factor – Proportions concept
(identifies which products may offer comparative advantage to a
Factor (resources) vary among countries i.e. Oil cheaper in Saudi Arabia, china has cheaper labor,
Singapore has capital and funds
A country will have comparative advantage in producing products that intensively use resources
it has in abundance

Country Similarity Theory:

Most trade today occurs among apparently similar countries
– Same per-capita income
– Similar infrastructure / distribution systems
– Same language / culture / religion / tastes etc.
Similarity among countries on the above aspects allows their products and services to be sold easily in
each others markets.

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