The Theory of

International Trade
THEORIES OF
INTERNATIONAL TRADE AND INVESTMENT
The economic justification for international commerce and
investment has been the subject of theories (i.e., logical
explanations) presented by economists, managers, and
academic researchers for millennia.
Debatable topics include “why countries should encourage
trade and investment with other countries and how to
build and maintain comparative advantage”.
An Overview Of Trade Theory

A voluntary exchange of commodities, services, resources, or

money between two people or organizations is referred to as
trade.
When a government refrains from attempting to control what its
citizens can purchase from or create and sell to another country
through quotas or duties, this is referred to as free trade.
An Overview Of Trade Theory

International Trade Theory deals with the

different international trade models that have been
developed to explain the diverse ideas of exchange
of goods and services across the global boundaries.
The theories of international trade have undergone a
number of changes from time to time.
The basic principle behind international trade is not very
much different from that involved in domestic trade. The
primary objective of trade is to maximize the gains from
trade for the parties engaged in the exchange of goods
and services.
International
Trade Theories
Comparative Advantage

Ability of a firm or individual to produce goods and services at a

lower opportunity cost than other firms of individuals. It gives a
company the ability to sell goods and services at a lower price than
its competitors and focus to realize more on stronger sales margin.

Hence, in comparative advantage, the company focuses on

low cost products/services to sell at low price.
Comparative Advantage

Popularized by David Ricardo, comparative advantage

argues that free trade works even if one partner in a
deal holds the absolute advantage in all areas of
production that is, one partner makes products cheaper,
better, and faster than its trading partner.
Absolute Advantage

The ability of a country, individual, company or region to

produce a good or service at a lower cost per unit than the
cost a which any other entity produces that good or service.
Entities with absolute advantages can produce a product or
service. Entities with absolute advantages can produce a
product or service using a smaller number of inputs and/or
using a more efficient process than another party producing
the same product or service.
Famous International Trade Theories

● Ricardian Model
● Heckscher-Ohlin Model
● Gravity Model of Trade
Ricardian Model

It is developed on the theory of comparative advantage. According

to this model, countries involved in trade specialize in producing the
products in which they have a comparative advantage.
The Ricardian model is a general equilibrium model. This means
that it describes a complete circular flow of money in exchange for
goods and services. Thus the sale of goods and services generates
revenue to the firms that in turn is used to pay for the factor
services ( ex. wages to workers) used in production.
Heckscher-Ohlin Model

It puts stress on the endowments of factors of production as the basis

for international trade. As per this theory, countries will specialize in
and export those products, making use of the domestically abundant
factors of production more intensively than those that are scarcely
available in the home country.
Heckscher-Ohlin Model

The Heckscher-Ohlin model is an economic theory that

proposes that countries export what they can most
efficiently and plentifully produce. Also referred to as the
H-O model or 2x2x2 model, it's used to evaluate trade and,
more specifically, the equilibrium of trade between two
countries that have varying specialties and natural resources.
Gravity Model of Trade

Provides an empirical explanation of international trade. According to this

model, the economic sizes and distance between nations are the primary
factors that determine the pattern of international trade.

Predicts bilateral trade flows based on the economic sizes and

distance between two units.

Trade tends to fall with distance.

Balance of Trade
Balance of Trade

The balance of trade of a nation is the difference between the values of its
exports and import. When exports are greater than imports, the nation is
said to have a balance of trade surplus. On the other hand, if imports are
greater than exports, the nation is said to have a balance of trade deficit.
Determinants of Balance of Trade

● Foreign Exchange Rate

● Domestic and Foreign Income
● Foreign Price Level
Foreign Exchange Rate

● The balance of trade (which reflects higher or lower demand for

a currency) can affect currency exchange rates.
● A country with a high demand for its goods tends to export more
than it imports, increasing demand for its currency.
● A country that imports more than it exports will have less
demand for its currency.
● Trade balances and, as a result, currencies can swing back and
forth, assuming currencies are floating rather than fixed
Domestic and Foreign Income

● An increase in foreign countries' income leads to an increase in

Philippine exports, causing the foreign trade deficit to rise (assuming
other factors do not change).
● If national income in foreign countries falls, Philippines exports to
these countries will decline, leading to a decline in the foreign trade
deficit as well.
Foreign Price Level

● Changes in price levels can affect Philippine's net exports; in general, an

increase in Philippines price levels will hurt Philippines exports.
● An increase in Philippine's price level will also affect Philippines imports
of foreign goods and services.
● The price increases serve as a double-edged sword that reduces exports to
decline; that is, the foreign trade deficit becomes worse of the magnitude
of the foreign trade surplus declines.
Balance of Payments
The balance of payments as a comprehensive set of accounts that track all
sorts of payments coming in to and going out of a nation for a wide
variety of reasons.

Specifically, the balance of payments is the difference between all

payments coming into a nation and those going out of the nation. It is the
balance of international monetary transactions for a nation
Measure of Balance of Payments

B=R-P
Where:
B- balance of payments
R- total receipts
P- total payments
Foreign Exchange Rate Policies
Flexible Exchange Rate

A flexible exchange rate means that a country is NOT trying to manipulate

currency prices to achieve some change in exports or imports. This policy
is based on the presumption that the free interplay of market forces is
most likely to generate a desirable international trade pattern.
Fixed Exchange Rate

To fix an exchange rate, the government must be willing to buy and sell
currency in the foreign exchange market in whatever amount are necessary to
keep the exchange rate fixed. A fixed exchange rate typically disrupts the
balance of trade and balance of payments for a country. But in many cases, this
is exactly what a country is seeking to do.
Managed Flexible Exchange Rate

It is an exchange rate that is generally allowed to adjust due to the interaction

of supply and demand in the foreign exchange market, but with occasional
intervention by government.

With this alternative, an exchange rate is free to rise and fall, but it is subject to
government control if it moves too high or too low. With managed float, the
government steps into the foreign exchange market and buys or sells whatever
currency is necessary to keep the exchange rate within desired limits.
The Leontief Paradox

The Leontief paradox is the idea that countries with a large

amount of capital import capital-intensive products and
export labor-intensive products. This contradicts to Heckscher-
Ohlin Trade Theory.
International Investment
Theories
Different Approach of Investment

Direct Investment Portfolio Investment

Is building or purchasing Is the purchase of securities of

businesses and their foreign countries, such as
associated infrastructure in a stocks and bonds, on an
foreign country. exchange.

Is seen as a long-term Can be viewed as a short-term

investment in the country's move to make money.
economy
Financial Theory

The worth of any asset is the present value of all future

cash flows associated with that asset, discounted at a
rate that reflects the riskiness of such flows. A firm can
therefore maximize the value of its assets and thus its
own overall value either by increasing its net future
cash flows or by decreasing the riskiness of those cash
flows.
Diversification Theory

Companies invest overseas in order to increase their

value by reducing the risks which they face. A company
might accomplish diversification by undertaking
investments in several countries, whose economies are
dissimilar in structure or in the nature of their output
and are not closely tied to one another or to the
economy of the company’s home country.
Product Life Cycle Theory

Asserts that the development of new products or substantial

improvements of existing products will most likely occur in
economically advanced countries such as the United
States. Advanced countries are more apt to possess the
potential demand, risk capital, technological expertise, and
research capabilities needed to support product innovation
and the introduction of new products to the market.
Product Life Cycle Theory

● Introduction and Growth (New Product)

Stage
● Maturity (Mature Product) Stage
● Decline (Standardized Product) Stage
Market Imperfection Theories

● Monopolistic Advantage Theory

● Internalization Theory
Monopolistic Advantage Theory

It centers around the idea that business

firms acquire certain capabilities in the
course of their evolution and operations
in their home market.
Monopolistic Advantage Theory

Also emphasizes the oligopolistic nature

and behavior of industries and firms that
tend to engage most heavily in foreign
direct investment
Internalization Theory

It asserts that markets external to the

firm often do not provide an efficient
means for the firm to profit from the
resources and capabilities that it has
accumulated.
References
https://www.economywatch.com/ricardian-model-of-international-trade-an-overview

https://www.bing.com/search?q=Heckscher-Ohlin+Model&cvid=e924b6ce28a24826a24f8532d13
11033&aqs=edge..69i57j0l8.2200j0j9&FORM=ANAB01&PC=HCTS

https://saylordotorg.github.io/text_international-trade-theory-and-policy/s05-03-ricardian-model-a
ssumptions.html#:~:text=The%20Ricardian%20model%20is%20a%20general%20equilibrium%2
0model.,to%20workers%20in%20this%20case%29%20used%20in%20production
.

https://link.springer.com/chapter/10.1007/978-3-030-34529-7_4

https://www.investopedia.com/ask/answers/041515/how-does-balance-trade-impact-currency-ex
change-rates.asp

https://gocardless.com/guides/posts/product-life-cycle-stages-examples/#:~:text=Here%20are%
20a%20few%20product,are%20in%20the%20mature%20phase
.

https://www.investopedia.com/ask/answers/060115/what-difference-between-foreign-portfolio-investment