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The author of this theory is David Ricardo
Time framework: developed in 1817
Classification: classical trade theory
Basic assumptions of the model:
Labor theory of value
Constant costs
Perfect competition
Full employment
Free trade
Zero transport costs
Perfect mobility of labor between industries within a country and no
international mobility
Fixed but different technology between countries
Fixed resources, technology, tastes, etc.
Thesis: This is the theory of comparative advantages that basically says that
a country should specialist in production of a product it can produce more
efficiently compared to other products, even if the country does not have an
absolute advantage in that product.

2.Classical trade theories


Common assumptions:
o Model 2x2x1 (2 countries, 2 products, 1 factor of productionlabour)
o Labour theory of value
o Constant costs
o Perfect competition
o Full employment
o Free trade

o Zero transportation costs

o Product price expressed in physical units rather in monetary
Theory of absolute advantage introduced by Smith and he
states that each country should specialise and produce that product
for which it has absolute advantage, meaning that each country will
produce and export that product which they can produce most
efficiently (at lowest costs). According to this theory, international
trade is positive sum game because each country benefits from this
trade. Besides common assumptions, theory of absolute advantages
has following assumptions: perfect mobility of production factors
(labour) within and between countries and only considers supply
side of the market.
Theory of comparative advantages introduced by Ricardo and
he states that each country should specialise and produce that
product for which it has comparative (relative) advantage. Each
country will export those products and import those for whose
production it has comparative disadvantage. In this theory
international trade is positive sum game because there is equal
distribution of gains among countries.
Theory of reciprocal demand was introduced by Mill who states
that each country's production and export price depends on
reciprocal demand which is demand of one country for goods of
another country. In this way, countries that have lower productivity
can reach better terms of trade. According to this theory countries
trade because they are different and they want to take advantage of
their differences. The only additional assumption for this theory is
that it considers demand side of the market.

3. Neoclassical trade theories:


Common assumptions:
o Abandonment of labour theory of value (2/3 factors of
o Costs expressed in monetary units
o Both constant and variable costs
o Complete and incomplete specialisation
o Transportation costs (not in H-O theory)
Opportunity costs theory was introduced by Haberler. Other
assumptions: 2x2x3, increasing costs, existence of marginal costs.
Haberler stated that a country has a comparative advantage if it can

produce an additional unit at lower opportunity costs expressed in

terms of other product, which means that country will specialise and
produce those products for which it has lower marginal costs. A country
will export the goods in which it has a lower opportunity cost of
production and import goods in which it has a higher opportunity cost
of relative to another country. With the opportunity costs theory, a
country gains from trade by either completely specializing or partially
Heckscher Ohlin theroy (H-O theory; general-equilibrium theory,
factor-endowment theory,theory of factor proportions) states that there
are 2 key determinants of comparative advantages:
Differences in relative factor endowment: by physical units of
factors (supply side elements) and by factor prices (both supply
and demand side elements)
Differences in relative factor intensity: a product is capital
intensive if the ratio of capital to labour is bigger than ratio in
production of another product
According to this theory a country will export the commodity
whose production requires the intensive use of factor which is
relatively abundant and cheap in that country and import those
commodities whose production requires the intensive use of
factor which is relatively scarce and expensive in the country.
o 2 x 2 (two countries, two comodities)
o Perfect competition both in commodity market and factor
o Free trade
o Homogenous products
o Identical tastes and preferences (identical demand conditions)
o Constant average costs
o Perfect mobility of labour within countries, no international
o Given and fixed technology
o Zero transportation costs
o Two-factor model and different factor intensity of products
o Identical production functions for the same product in
different countries
o Identical technology in different countries

4. Model of a Two-Factor Economy:

The model of a two-factor economy was first introduced by Frank William
Taussig. He says that there are two production factors: labor and capital. This
idea (two or more production factors) was prevalent in neoclassical theories
of trade.
This model assumes that an economy can produce goods with two inputs
that are limited in supply. Each good that is produced uses more of one input
than the other (i.e. labor-intensive, capital-intensive goods).
Two-Factor Economy in the Heckscher-Ohlin Theory:
An economy can produce two goods: A and B. The production of these goods
requires two inputs that are in limited supply: labor and land.

A product is capital-intensive if the ratio of capital to labor in its

production is bigger than that ratio in production of another product.
(K/L)x> (K/L)y

This model concludes that a capital-abundant country will export capitalintensive products and a labor-abundant country exports labor-intensive

5. Empirical Evidence of the H-O Model

Heckscher and Ohlin considered the Factor-Price Equalization theorem an
econometric success because the large volume of international trade in the
late 19th and 20th centuries coincided with the convergence of commodity
and factor prices worldwide. Modern econometric estimates have shown the
model to perform poorly.
The Leontief Paradox:
In 1954, an econometric test by Leontief of the H-O model found that the
United States, despite having a relative abundance of capital, tended to
export labor-intensive goods and import capital-intensive goods. This
problem became known as the Leontied paradox.

6. Technological Theories
1. Theory on economic growth and trade was introduced by Rybczyski
(I think) and it states that if there is growth in potential output PPF will
shift outwards. This theory analyses three types of effects:
a. Effect of growth in factor supply
b. effect of technological change on economic growth
c. Effects of economic growth on international trade
2. Technological gap theory was introduced by Posner and it proposes
that changes in international trade are directed by the relative
technological sophistication of countries. In this theory international
trade is based on differences in technological changes over time
among countries where some countries progress faster, which creates
technological gap allowing a temporary monopoly in world market.
Technological inovations create dynamic comparative advantages
which means that comparative adnvatages can be changed over time
due to technological changes or diffusion of technology.
3. Product life cycle theory was introduced by Vernon and it's based
on both, demand and supply side of the market. It focuses on product
and role of technological innovation rather than on country, and states
that each product goes through three phases during its life cycle:
i. new product phase
Product-growth phase
Product maturity phase
In last two phases there is lack of innovation and emphasis is on factor
endowments. When a life cycle goes towards its end explanation of
comparative advantages becomes closer to H-O theory.

Different technologies between countries

Technology changes over time
Capital moves among countries
Focus on a product
Limited usibility (only for technology intensive products)
Analysis both supply and demand side of the market
Dynamic comparative advantages

Linders Theory

This theory states that developed countries trade more among each other
than with developing countries and that they trade in similar products. He
differs bases for trade in primary and secondary (industrial) products, where
trade for primary products is supply- side based and depends on differences
in relative factor endowment. Trade for secondary products is based on
demand-side where basis for trade depends upon similarities in consumer's
preferences and incomes. This is also one of the first theories on intra-trade
where Linder states that same products can be traded in both directionsimported and exported at the same time. In this theory Linder indicates
types of countries that will trade but not their trade directions or patterns.

7. Theory of Economy of Scale

This theory was introduced by Krugman. It is based on economies of scale
which states that average costs of product will decrease in long term based
on increase of output. Krugman states there are 2 different economies of
Economies of scale can be classified into two main types: Internal arising
from within the company; and External arising from extraneous factors
such as industry size

Internal economy of scale- which states that average costs of a product

depend on a size of an individual company but not necessarily on that
of the industry, so each company will specialyze in production of one or
few variations of a product. Such company where internal exonomy of
scale is large can monopolise an industry therefore internal economy
of scale creates imperfect competition in industry.
External economies of scale- states that average costs of a product
depend on size of the industry but not necessarily on the size of
company, therefore single companies need not to be large, but they
cooperate within the industry creating perfect competition (if there is a
lot of small companies) therefore country can dominate at world

8.Theory of Comparative Advantages of nations(M. Porter)

This theory was introduced by Porter and it emphasis on productivity as the
key determinent of international competitivenes where he puts focus on
industry or single company. This theory comines thesis and characteristics
form both-conventional and new theories. It analyses micro and macro view
of competitiveness and international trade, also it combines elements of
supply-side and demand-side of the market. Porter explained this theory
throught diamond of nation advantages which illustrates 4basic
interconnected groups of determination of competitive advantages and 2
additional variables.
4 basic interconnnected groups:

factor conditions
demand conditions
related and supporting industries
firm structure, strategy and rivalry

2 additional variables:


9. Inter- and Intra-Industry Trade

Interindustry(manufactures for food) trade reflects comparative
advantage. The
pattern of interindustry trade is that Home, the capital-abundant country, is
a net exporter
of capital-intensive manufactures and a net importer of labor-intensive food.
So comparative
advantage continues to be a major part of the trade story.
Intraindustrytrade (manufactures for manufactures) does not reflect
advantage. Even if the countries had the same overall capital-labor ratio,
their firms
would continue to produce differentiated products and the demand of
consumers for
products made abroad would continue to generate intraindustry trade. It is
economies of
scale that keep each country from producing the full range of products for
itself; thus
economies of scale can be an independent source of international trade.

The pattern of intraindustry trade itself is unpredictable. All we know is that

the countries will produce different products. The relative importance of
intraindustry and interindustry trade depends onsimilar countries are. If
Home and Foreign are similar in their capital-labor ratios, thenthere will be
little interindustry trade, and intraindustry trade, based ultimately on
economies of scale, will be dominant. On the other hand, if the capital-labor
ratios are
very different, so that, for example, Foreign specializes completely in food
there will be no intraindustry trade based on economies of scale. All trade
will be based
on comparative advantage.


Definition: a tariff is a tax levied on a product when it crosses national
boundaries. It is a trade restriction.

Tariffs by type of trade flow:
Import tariffs
Export tariffs
Transit tariffs
Tariffs by main function
Protective tariffs
Revenue tariffs
Tariffs by trade relations
Autonomous (maximal) tariffs
Conventional (minimal) tariffs
Tariffs by way of determination
Ad valorem tariffs
Specific tariffs
Compound tariffs

Tariffs by country of origin

Unitary tariffs
Differential tariffs
Tariffs for equalizing
Anti- dumping
Countervailing tariffs

Effects of tariffs:
Effect on import
Tariffs reduce import indirectly through the impact on the product
price. Tariffs increase import price which causes import demand
to decrease, which in turn causes imports to decrease
Effect on domestic production
Tariffs increase the price of imported goods which increases the
demand for domestic goods that are substitutes for those
products, which increases the domestic production.
Effect on domestic consumption
Tariffs can decrease domestic production or divert domestic
Revenue effect
Increases budget revenues. These revenues can be used to
increase budget surplus, increase government spending, and
increase private spending. It decreases the deflationary effect
and increases the protective effect because of increased
consumption of domestic goods.

Redistributive effect
Redistribution of income from domestic consumers to domestic
producers (consumers will pay more money because they will be
paying higher prices and this money will go to domestic
Effect on employment
A tariff will have a short run impact on employment. It leads to
reallocation of resources to protected industries if there are not
unemployed capacities. A tariff will decrease import which will

increase the consumption of domestic goods which results in an

increase of domestic production and finally an increase of income
in protected industries because people will be paying more for
their products.
Effect on balance- of- payments
Decrease in import and outflow of foreign currencies

11. Costs and Benefits of Tariffs

Tariffs increase the cost of imports, leading to a decline in consumer surplus.
Maybe in the long run consumers benefit from the protection of domestic
industries if these industries use the tariffs to improve
Domestic Producers, who produce the good, will benefit from the introduction
of tarrifs. This is because it makes their domestic production relatively more
attractive compared to the imports.
In the long run, domestic firms may not make the necessary improvements
that they would have done without tariffs
Also the introduction of tariffs usually leads to retaliation. Therefore, some
exporting firms will lose out and sell less exports.
Costs and benefits of tariffs depend on the size of the nation, therefore we
A small country case:
When a nation is small, it has no effect on the foreign (world) price of a
good, because its demand of the good is an insignificant part of the world
demand.(price taker)
Therefore price will not fall, but will remain the same, while price in the
domestic market is going to rise.

Import tariff in a small nation redistributes income from domestic

producers of the commodity. This leads to inefficiencies of a tariff
A small nation always loses from the imposition of the import tariff.

A large country case:

A large nation can change world prices and its terms of trade. We say that
large nation is a price maker.

A tariff rises the price of a good in the importing country, making its
consumer surplus decrease and making it producer surplus increase.

Government revenue will increase.

If the terms of trade gain exceeds the efficiency loss, then national welfare
will increase under a tariff, at the expense of foreign countries.

12. Non-Tariff Barriers to Trade

A form of restrictive trade where barriers to trade are set up and take form
other than a tariff. Non-tariff barriers include: quotas, import licenses,
embargoes, sanctions and other restrictions and are frequently used by large
and developed economies.
The most common instruments of direct regulation of imports (and
sometimes export) are licenses and quotas. Almost all industrialized
countries apply these non-tariff methods.
Import licenses he license system requires that a state (through specially
authorized office) issues permits for foreign trade transactions of import and
export commodities included in the lists of licensed merchandises.
Quotas is a limitation in value or in physical terms, imposed on import and
export of certain goods for certain period of time.
Embargo -is a specific type of quotas prohibiting trade. As well as quotas
embargoes may be imposed on imports or exports of particular goods.

13. Free Trade: Arguments Pro et Contra

Free trade can be:
open economy an economy with high level of trade liberalisation;
closed economy an economy with numerous and very high trade barriers;
in todays world, practically all nations impose some restrictions on flows of
goods and services;

Increase total production, efficiency and productivity(reduce barriers

leads to trade creation)
Increased specialization
Increased competition
Economies of Scale
Encourage research and development
Potentially increase consumption, investment and GDP


Infant industry argument

No revenue for government
Protection against dumping
Environmental costs
Help the balance of payments

14. Theory of Economic Integration

Author: The pioneer work in the field was the Theory of Customs Union by
Jacob Viner.
Time Framework: This theory is relativley new; at the beginning it was only
a part of international trade theory. The development of the modern theory
of economic integration was after World War 2. Jacob Viner's work was of
Classification: International economic integration is a process or a stage of
institutional integrating of countries, mostly at regional level, by
liberalization of trade and/or liberalization of factor movement.It is a process
of eliminating restrictions on international trade, payments and factor
Elements of the definition:
process or stage (dynamic chategory)

institutional integrating

regional level (dominant)

liberalization of trade and other flows

Integration by subjects: Functional Integrations (subjects: TNCs), Institutional
Integrations (subjects: countries)
Integration by Sectoral scope: Sectoral integration, Total integration
Integrations by level of development of members: Integrations among
developed countries, Integrations among developing countries, Integrations
among developed and developing countries
Integrations by symmetry of obligations: Symmetrical integrations,
Asymmetrical integrations

trading aspect merchandise exchange (dominant aspect);

non-trading aspects monetary arrangement, fical aspect, labour
moving, capital moving, technology transfer;

Motives for economic integration:

political motives (hidden motives)

economic motives (visible motives)
(preferential trading agreement)
free trade area (FTA)
customs union (CU)
common market (CM)
economic union (partial or total)
Free Trade Area (FTA)
free movement of goods (elimination of all trade barriers);
individual customs tarrifs;
rules of origin;
Examples: EFTA, LAIA
Customs Union (CU)
+common customs tariff;
Examples: Benelux, MERCOSUR
Common Market (CM)
+free factor movement (free movement of labour and capital);
Example: CARICOM
Partial/Total Economic Union
+harmonized fiscal, monetary, industrial and other economic
Example: European Union (to some extent)

14. Economic Integration

International economic integration is a process or a stage of institutional integrating
of countries, mostly at the regional level, by liberalization of trade and/or
liberalization of factor movement.

It is a process of eliminating restrictions on international trade, payments,

and factor mobility.

There are different types of integration:

By subjects:
o Functional integrations trans-national corporations

o Institutional integrations countries

By sectoral scope:
o Sectoral integration
o Total integration
By level of development of members
o Among developed countries
o Among developing countries
o Among developed and developing countries
By symmetry of obligations
o Symmetrical
o Asymmetrical

There are two aspects of economic integration: trading aspect (merchandise

exchange) and non-trading aspect (monetary arrangement, factor movements).
Stages of Economic Integration:

Preferential trading agreement

Free trade area (FTA)
o Free movement of goods, individual customs tariffs, rules of origin
Customs union (CU)
o Free movement of goods, common customs tariff, dividing of tariff
revenues (Benelux, MERCOSUR)
Common market (CM)
o Free movement of goods, free factor movement, common customs
tariff (CARICOM)
Economic union (partial or total)
o Partial economic union free movement of goods, services, and factors
of production, common trade policy, harmonized fiscal, monetary,
industrial, and other economic policies.

15. Trade policies in developing countries

1. Trade policy in less-developed countries can be analyzed using the same analytical tools
used to discuss advanced countries. The particular issues characteristic of developing countries
are, however, different. In particular, trade policy in developing
countries is concerned with two objectives: promoting industrialization and coping with the
uneven development of the domestic economy.
2. Government policy to promote industrialization has often been justified by the infant industry
argument, which says that new industries need a temporary period of protectionfrom competition
from established competitors in other countries. The infant industry argument is valid only if it
can be cast as a market failure argument for intervention.

3. Using the infant industry argument as justification, many less-developed countries

have pursued policies of import-substituting industrialization in which domestic industries are
created under the protection of tariffs or import quotas. Although these policies have succeeded
in promoting manufacturing, by and large they have not delivered the expected gains in
economic growth and living standards.
4. Most developing countries are characterized by economic dualism: A high-wage,
capital-intensive industrial sector coexists with a low-wage traditional sector. Dual
economies also often have a serious problem of urban unemployment.
5. The difference in wages between the modern and traditional sectors has sometimes been
used as a case for tariff protection of the industrial sector. This is the
wage differentials case for protection. This view no longer receives much credence among
economists, however.
6. The view that economic development must take place via import substitutionand the
pessimism about economic development that spread as import substituting industrialization
seemed to failhave been confounded by the rapid economic growth of a number of Asian
economies.They are characterized both by very high ratios of trade to national income and by
extremely high growth rates. The reasons for the success of the HPAEs are highly disputed.

16. World Trade Organization (WTO)

The WTO was born out of the General Agreement on Tariffs and Trade (GATT), which was
established in 1947. A series of trade negotiations, GATT rounds began at the end of World
War II and were aimed at reducing tariffs for the facilitation of global trade on goods. The
rationale for GATT was based on the Most Favored Nation (MFN) clause, which, when
assigned to one country by another, gives the selected country privileged trading rights. As
such, GATT aimed to help all countries obtain MFN-like status so that no single country
would be at a trading advantage over others.
The purpose of the WTO is to ensure that global trade commences smoothly, freely and
predictably. The WTO creates and embodies the legal ground rules for global trade among
member nations and thus offers a system for international commerce. The WTO aims to
create economic peace and stability in the world through a multilateral system based on
consenting member states (currently there are slightly more than 140 members) that have
ratified the rules of the WTO in their individual countries as well. This means that WTO rules

become a part of a country's domestic legal system. The rules, therefore, apply to local
companies and nationals in the conduct of business in the international arena. If a company
decides to invest in a foreign country, by, for example, setting up an office in that country,
the rules of the WTO (and hence, a country's local laws) will govern how that can be done.
Theoretically, if a country is a member to the WTO, its local laws cannot contradict WTO
rules and regulations, which currently govern approximately 97% of all world trade.