Chapter 5: International Trade Theories
• Theory of Mercantilism
• Theory of Absolute Cost Advantage
• Theory of Comparative Cost Advantage
• Heckscher-Ohlin Model
Theory of Mercantilism
This theory is during the sixteenth to the three-fourths of the eighteenth centuries.
Its beliefs in nationalism and the welfare of the nation alone, planning and regulation of economic
activities for achieving the national goals, curbing imports and promoting exports.
It believed that the power of a nation lied in its wealth, which grew by acquiring gold from abroad.
Mercantilists failed to realize that simultaneous export promotion and import regulation are not possible
in all countries, and the mere possession of gold does not enhance the welfare of a people.
Keeping the resources in the form of gold reduces the production of goods and services and, thereby,
lowers welfare.
It was rejected by Adam Smith and Ricardo by stressing the importance of individuals, and pointing out
that their welfare was the welfare of the nation.
Theory of Absolute Cost Advantage
Absolute advantage is when a producer can provide a good or service in greater quantity for the same
cost, or the same quantity at a lower cost, than its competitors.
A concept developed by Adam Smith; absolute advantage can be the basis for large gains from trade
between producers of different goods with different absolute advantages.
Theory of Comparative Cost Advantage
Comparative advantage is an economy's ability to produce a particular good or service at a lower
opportunity cost than its trading partners. Comparative advantage is used to explain why companies,
countries, or individuals can benefit from trade.
Example of Comparative Advantage
As an example, consider a famous athlete like Michael Jordan. As a renowned basketball and baseball
star, Michael Jordan is an exceptional athlete whose physical abilities surpass those of most other
individuals. Michael Jordan would likely be able to, say, paint his house quickly, owing to his abilities as
well as his impressive height.
Hypothetically, say that Michael Jordan could paint his house in eight hours. In those same eight hours,
though, he could also take part in the filming of a television commercial which would earn him $50,000.
By contrast, Jordan's neighbor Joe could paint the house in 10 hours. In that same period of time, he could
work at a fast-food restaurant and earn $100.
In this example, Joe has a comparative advantage, even though Michael Jordan could paint the house
faster and better. The best trade would be for Michael Jordan to film a television commercial and pay Joe
to paint his house. So long as Michael Jordan makes the expected $50,000 and Joe earns more than $100,
the trade is a winner. Owing to their diversity of skills, Michael Jordan and Joe would likely find this to
be the best arrangement for their mutual benefit.
