Theories on International Trade

Theories on International Trade

This article deals with ‘Theories on International Trade .’ This is part of our series on ‘Economics’ which is important pillar of GS-3 syllabus . For more articles , you can click here .


  • International Economics is that branch of economics which is concerned with the exchange of goods and services between two or more countries .
  • The subject matter of International Economics includes large number of segments :-
    1. Pure Theory of Trade : It includes issues like causes for foreign trade, composition, direction and volume of trade,  exchange rate,  balance of trade and balance of payments .
    2. Policy Issues : It includes  policy issues such as free trade vs. protection, use of taxation, subsidies and dumping, currency convertibility, foreign aid, external borrowings and foreign direct investment.
    3. International Cartels and Trade Blocs .
    4. International Financial and Trade Regulatory Institutions : Most important of which are IMF, WTO  and World Bank.

Theories of International Trade

1 . Mercantilist Theory

  • It takes  an us-versus – them view of trade.
  • According to Mercantilist Theory, World Trade remains same. Hence, one country gains by damaging the other. Increase in trade of one country means loss of some other country. Hence, nation’s wealth and power are best served by increasing exports and receiving payments in gold, silver and precious metals.
  • From the 16th to 18th century, economists believed in mercantilism. One of the leading proponent of Theory of Mercantilism was Thomas Munn (Director of English East India Company) .

2 . Adam Smith’s Theory of Absolute Cost Advantage

  • Adam Smith was in favour of free trade.
  • According to Adam Smith, the basis of international trade was absolute cost advantage. Trade between two countries would be mutually beneficial when one country produces a commodity at an absolute cost advantage over the other country which in turn produces another commodity at an absolute cost advantage over the first country.
  • Example / Illustration

Take example of India and China in production of Wheat and Cloth . Suppose, one labourer in India can produce 20 units of wheat and 6 units of cloth while that in China can produce 8 units of wheat and 14 units of cloth.

Country Wheat production by one labourer Cloth production by one labourer
India 20 units 6 units
China 8 units 14 units

Hence, India has an absolute advantage in the production of wheat over China and China has an absolute advantage in the production of cloth over India. Therefore, India should specialize in the production of wheat and import cloth from China. China should specialize in the production  of cloth and import wheat from India. This kind of trade would be mutually beneficial to both India and China.

3 . Ricardo’s Theory of Comparative Cost Advantage

  • According to David Ricardo’s Theory of Comparative Cost Advantage , a country can gain from trade when it produces at relatively lower costs. It means, even when a country enjoys absolute advantage in both goods, the country would specialize in the production and export of those goods which are relatively more advantageous. Similarly, even when a country has absolute disadvantage in production of both goods, the country would specialize in production and export of the commodity in which it is relatively less disadvantageous .
  • Example / Illustration
Units of labour required to produce one unit Cloth  Wheat Domestic Exchange Ratios
USA 100 120 1 wheat =1.2 cloth
India 90 80 1 wheat=0.88 cloth

In the illustration,  India has an absolute advantage in production of both cloth and wheat.  However, India should concentrate on the production of wheat in which she enjoys a comparative cost advantage. For America the comparative cost disadvantage is lesser in cloth production. Hence America will specialize in the production of cloth and export it to India in exchange for wheat.

4 . Heckscher and Ohlin’s Factor – Proportions Theory

  • Capital-abundant country will export the capital –intensive goods. E.g. USA exporting Aeroplanes
  • Labour-Abundant Country will export labour-intensive goods. E.g. India exporting cotton  .
Theories on International Trade

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