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Lesson#6
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Classical Country Based Theories
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INTERNATIONAL TRADE & INVESTMENT 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.
Mercantilism:
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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19
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
country)
– 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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