The Modern Theory of International Trade
The Modern Theory of International Trade are simply different theories to
explain international trade. Trade is the concept of exchanging goods and
services between two people or entities. The modern theory of international trade. International trade is then
the concept of this exchange between people or entities in two different
countries.
People or entities trade because they believe that they
benefit from the exchange. They may need or want the goods or services. The modern theory of international trade. While
at the surface, this many sound very simple, there is a great deal of theory,
policy, and business strategy that constitutes international trade.
In this section, you’ll learn about the different trade
theories that have evolved over the past century and which are most relevant
today. The modern theory of international trade. Additionally, you’ll explore the factors that impact international trade
and how businesses and governments use these factors to their respective
benefits to promote their interests.
To better understand how modern global trade has evolved,
it’s important to understand how countries traded with one another
historically. The modern theory of international trade. Over time, economists have developed theories to explain the
mechanisms of global trade. The main historical theories are
called classical and are from the perspective of a country, or country-based.
By the mid-twentieth century, the theories began to shift to explain trade from
a firm, rather than a country, perspective. These theories are referred to
as modern and are firm-based or company-based. Both of these
categories, classical and modern, consist of several international theories.
Classical or Country-Based Trade Theories
Mercantilism
The Modern Theory of International Trade Developed in the sixteenth
century, mercantilism was one of the earliest efforts to develop an
economic theory. This theory stated that a country’s wealth was determined by
the amount of its gold and silver holdings. The modern theory of international trade. In it’s simplest sense,
mercantilists believed that a country should increase its holdings of gold and
silver by promoting exports and discouraging imports. In other words, if people
in other countries buy more from you (exports) than they sell to you (imports),
then they have to pay you the difference in gold and silver. The objective of
each country was to have a trade surplus, or a situation where the value
of exports are greater than the value of imports, and to avoid a trade
deficit, or a situation where the value of imports is greater than the value of
exports.
A closer look at world history from the 1500s to the late
1800s helps explain why mercantilism flourished. The 1500s marked the rise of
new nation-states, whose rulers wanted to strengthen their nations by building
larger armies and national institutions. The modern theory of international trade. By increasing exports and trade, these
rulers were able to amass more gold and wealth for their countries. One way
that many of these new nations promoted exports was to impose restrictions on
imports. This strategy is called protectionism and is still used
today.
Nations expanded their wealth by using their colonies around
the world in an effort to control more trade and amass more riches. The modern theory of international trade. The British
colonial empire was one of the more successful examples; it sought to increase
its wealth by using raw materials from places ranging from what are now the
Americas and India. France, the Netherlands, Portugal, and Spain were also
successful in building large colonial empires that generated extensive wealth
for their governing nations.
Although mercantilism is one of the oldest trade theories, it remains part of modern thinking. Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor exports and discourage imports through a form of neo-mercantilism in which the countries promote a combination of protectionist policies and restrictions and domestic-industry subsidies. The modern theory of international trade. Nearly every country, at one point or another, has implemented some form of protectionist policy to guard key industries in its economy. While export-oriented companies usually support protectionist policies that favor their industries or firms, other companies and consumers are hurt by protectionism. Taxpayers pay for government subsidies of select exports in the form of higher taxes. The modern theory of international trade. The Modern Theory of International Trade Import restrictions lead to higher prices for consumers, who pay more for foreign-made goods or services. Free-trade advocates highlight how free trade benefits all members of the global community, while mercantilism’s protectionist policies only benefit select industries, at the expense of both consumers and other companies, within and outside of the industry.
Absolute Advantage
In 1776, Adam Smith questioned the leading mercantile theory
of the time in The Wealth of Nations.Adam Smith, An Inquiry into the
Nature and Causes of the Wealth of Nations (London: W. Strahan and T.
Cadell, 1776). Recent versions have been edited by scholars and
economists. Smith offered a new trade theory called absolute
advantage, which focused on the ability of a country to produce a good more
efficiently than another nation. Smith reasoned that trade between countries
shouldn’t be regulated or restricted by government policy or intervention. He
stated that trade should flow naturally according to market forces. In a
hypothetical two-country world, if Country A could produce a good cheaper or
faster (or both) than Country B, then Country A had the advantage and could
focus on specializing on producing that good. Similarly, if Country B was
better at producing another good, it could focus on specialization as well. By
specialization, countries would generate efficiencies, because their labor
force would become more skilled by doing the same tasks. Production would also
become more efficient, because there would be an incentive to create faster and
better production methods to increase the specialization.
Smith’s theory reasoned that with increased efficiencies,
people in both countries would benefit and trade should be encouraged. His
theory stated that a nation’s wealth shouldn’t be judged by how much gold and
silver it had but rather by the living standards of its people.
International Trade Comparative Advantage
The challenge to the absolute advantage theory was that some
countries may be better at producing both goods and, therefore, have an
advantage in many areas. In contrast, another country may not
have any useful absolute advantages. The modern theory of international trade. To answer this challenge, David
Ricardo, an English economist, introduced the theory of comparative advantage
in 1817. Ricardo reasoned that even if Country A had the absolute advantage in
the production of both products, specialization and trade could still
occur between two countries.
Comparative advantage occurs when a country cannot produce
a product more efficiently than the other country; however,
it can produce that product better and more efficiently than it does
other goods. The difference between these two theories is subtle. Comparative
advantage focuses on the relative productivity differences, whereas absolute
advantage looks at the absolute productivity.
Let’s look at a simplified hypothetical example to illustrate
the subtle difference between these principles. Miranda is a Wall Street lawyer
who charges $500 per hour for her legal services. It turns out that Miranda can
also type faster than the administrative assistants in her office, who are paid
$40 per hour. Even though Miranda clearly has the absolute advantage in both
skill sets, should she do both jobs? No. For every hour Miranda decides to type
instead of do legal work, she would be giving up $460 in income. The modern theory of international trade. Her
productivity and income will be highest if she specializes in the higher-paid
legal services and hires the most qualified administrative assistant, who can type
fast, although a little slower than Miranda. By having both Miranda and her
assistant concentrate on their respective tasks, their overall productivity as
a team is higher. The modern theory of international trade. This is comparative advantage. A person or a country will
specialize in doing what they do relatively better. In reality, the
world economy is more complex and consists of more than two countries and
products. Barriers to trade may exist, and goods must be transported, stored,
and distributed. However, this simplistic example demonstrates the basis of the
comparative advantage theory.
Heckscher-Ohlin Theory (Factor Proportions Theory)
The Modern Theory of International Trade , The theories of Smith and Ricardo didn’t help countries determine which products would give a country an advantage. Both theories assumed that free and open markets would lead countries and producers to determine which goods they could produce more efficiently. In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a country could gain comparative advantage by producing products that utilized factors that were in abundance in the country. The modern theory of international trade. Their theory is based on a country’s production factors—land, labor, and capital, which provide the funds for investment in plants and equipment. They determined that the cost of any factor or resource was a function of supply and demand. Factors that were in great supply relative to demand would be cheaper; factors in great demand relative to supply would be more expensive. Their theory, also called the factor proportions theory, stated that countries would produce and export goods that required resources or factors that were in great supply and, therefore, cheaper production factors. The modern theory of international trade In contrast, countries would import goods that required resources that were in short supply, but higher demand.
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