International trade is the exchange of capital, goods, and services across international borders or territories. International trade has existed throughout history (for example Uttarapatha, Silk Road, Amber Road, salt roads), its economic, social, and political importance has been on the rise in recent centuries. To understand the pattern in international trade, different trade theories are postulated. Some famous trade theories are:

  1. Mercantilism
  2. Absolute Advantage Theory
  3. Comparative Advantage Theory
  4. Hecksher-Ohlin Factor endowment theory
  5. Product Life Cycle Theory
  6. New Trade Theory
  7. 10/2/2016 Porter‘s Diamond Theory for competitive advantage.

Theory of Mercantilism:

Mercantilism is an economic theory that advocates government regulation of international trade to generate wealth and strengthen national power. Merchants and the government work together to reduce the trade deficit and create a surplus. It funds corporate, military, and national growth. Mercantilism is a form of economic nationalism. It advocates trade policies that protect domestic industries.

In mercantilism, the government strengthens the private owners of the factors of production. The four factors are entrepreneurship, capital goods, natural resources, and labor. It establishes monopolies, grants tax-free status, and grants pensions to favored industries. It imposes tariffs on imports. It also prohibits the emigration of skilled labor, capital, and tools. It doesn't allow anything that could help foreign companies.

In return, businesses funnel the riches from foreign expansion back to their governments. Its taxes pay for increase national growth and political power.


Mercantilism was the dominant theory in Europe between 1500 and 1800. Countries wanted to export more than they imported. In return, they received gold. It powered the evolution of nation-states out of the ashes of feudalism. Holland, France, Spain, and England competed on the economic and military fronts. These countries created skilled labor forces and armed forces.

The advent of industrialization and capitalism set the stage for mercantilism. They strengthened the need for a self-governing nation to protect business rights. Merchants supported national governments to help them beat foreign competitors.

Mercantilism depended upon colonialism. The government would use military power to conquer foreign lands. Businesses would exploit the natural and human resources. The profits fueled further expansion benefiting both the merchants and the nation.

Mercantilism also worked hand-in-hand with the gold standard. Countries paid each other in gold for exports. The nations with the most gold were the richest. They could hire mercenaries and explorers to expand their empires. They also funded wars against other nations who wanted to exploit them. As a result, all countries wanted a trade surplus rather than a deficit.

Mercantilism relied upon shipping. Control of the world's waterways was vital to national interests. Countries developed strong merchant marines. They imposed high port taxes on foreign ships. England required all trade to be carried out in its vessels.


Mercantilism is a philosophy of a zero sum game. Mercantilism which stresses government regulation.

Mercantilism leads to tit for tat policies high tariffs on imports leads to retaliation. The End of Mercantilism Democracy and free trade destroyed mercantilism in the late 1700s. American and French revolutions formalized large nations ruled by democracy. They endorsed capitalism.

Adam Smith ended mercantilism with his 1776 publication of "The Wealth of Nations." He argued that foreign trade strengthens the economies of both countries. Each country specializes in what it produces best, giving it a comparative advantage. He also explained that a government which put business ahead of its people would not last. Smith's laissez-faire capitalism coincided with the rise of democracy in the United States and Europe.

In 1791, mercantilism was breaking down, but free trade hadn't yet developed. Most countries still regulated free trade to enhance domestic growth. U.S. Treasury Secretary Alexander Hamilton was a proponent of mercantilism. He advocated government subsidies to protect infant industries necessary to the national interest. The industries needed government support until they were strong enough to defend themselves. Hamilton also proposed tariffs to reduce competition in those areas.

The Rise of Neomercantilism

World War II's devastation scared Allied nations into desiring global cooperation. They created the World Bank, the United Nations, and the World Trade Organization. They saw mercantilism as dangerous and globalization as its salvation.

But other nations didn't agree. The Soviet Union and China continued to promote a form of mercantilism. The main difference was that most of their businesses were state-owned. Over time, they sold many state- owned companies to private owners. This shift made those countries even more mercantilist.

Neomercantilism fit in well with their communist governments. They relied on   a   centrally- planned command economy. It allowed them to regulate foreign trade. They also controlled their balance of payments and foreign reserves. Their leaders selected which industries to promote. They engaged in currency wars to give their exports lower pricing power. For example, China bought U.S. Treasurys to fuel its trade with the United States. As a result, China became the largest foreign owner of U.S. debt.

China and Russia planned for rapid economic growth. With enough financial strength, they would increase their political power on the world stage.

Drawbacks of Mercantilism theory or Neo-Mercantilism theory

  1. Mercantilism weakens a country
  2. Restrictions on free trade decreases country‘s wealth
  3. Overlooks other factors such as natural resources, manpower and its skill level, capital
  4. Restrictive Policies promoting exports and restrict imports creating trade barriers
  5. Colonial Exploitation

Global Strategic Rivalry Theory

Global strategic rivalry theory developed by Paul Krugman & Kelvin Lancaster in 1980 to examine the impact on trade flows arising from global strategic rivalry between MNCs. According to this theory, a firm has to develop a competitive strategy to sustain in the global competition.

According to the theory, a new firm needs to optimize a few factors that will guide the brand in overcoming all the barriers to achievement and gaining a significant appreciation in that international market. In all these factors, a methodical study and timed developmental steps are essential. Whereas, having the total ownership rights of rational properties is also essential. In addition, the beginning of exceptional and helpful methods for industrialized as well as scheming the entrance to a raw substance will also come helpful in the way.

Owning intellectual property

Intellectual property laws confer a bundle of exclusive rights in relation to the particular form or manner in which ideas or information are expressed or manifested, and not in relation to the ideas or concepts themselves. It is done by brand name, trademark, patent/copy right, unique formula etc.

Ex-Unique formula of Coca-cola

Investing in R&D

It is the process of gaining competitive advantage by R&D techniques. Ex-Boeing is the most successful airplane industry cause it does huge amount of research for its competitors by its R&D department

Achieving economic of scale or scope

At the time of international trade, the production increased. For this reason cost per unit reduces and new sector/scope is being created for investment therefore, various sized and typed product can be produced.

Exploiting the experience or learning curve

Sometime competitive advantage can be gain by injecting the experience. Very often firms recruit experienced people for their need.

It focuses, however, on planned decisions that firms implement as they participate globally. These decisions influence both international trade and international investment. Global Rivalry Theory describes numerous ways in which Multinational Enterprises can develop a competitive advantage over its competitors. Some of the ways are by ownership or patenting of rational property rights, channeling money into research and development, the exceptional procedure of the experience curve and development of their business to international business or economics. Once again, the major aim here is for turnover maximization for those companies and the social and environmental aspects are not addressed.

Theory Of Absolute Cost Advantage

Adam Smith propounded the theory of absolute cost advantage as the basis of foreign trade; under such circumstances an exchange of goods will take place only if each of the two countries can produce one commodity at an absolutely lower production cost than the other country.

Smith argued that it was impossible for all nations to become rich simultaneously by following mercantilism because the export of one nation is another nation‘s import and instead stated that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage. Smith also stated that the wealth of nations depends upon the goods and services available to their citizens, rather than their gold reserves. While there are possible gains from trade with absolute advantage, the gains may not be mutually beneficial. Comparative advantage focuses on the range of possible mutually beneficial exchanges.

Absolute Advantage Theory: Assumptions

  •  Trade is between two countries
  • Only two commodities are traded
  • Free Trade exists between the countries
  • The only element of cost of production is labour

Important points of theory

  • Theory is based upon principle of division of labour.
  • Free Trade among countries can increase a country‘s wealth
  • Free Trade enables a country to provide a variety of goods and services to its people by specializing in the production of some goods and services and importing others.
  • Every country should specialize in producing those products at cost less than that of other countries and exchange these products with other products produced cheaply by others.
  • When one country produces a product at a lower cost and another country produces another product alt lower cost, both can exchange required quantity and can enjoy benefits of absolute cost advantage.

Suppose, there are two countries I & II and two commodities A and B. For example, country can produce a unit of commodity (A) with 10 and a unit of commodity (B) with 20 labour units, and that in country II, the production of a unit of (A) costs 20 and a unit of (15) 10 labour units. Now country I has absolute cost advantage in tin- production of (A) and it will confine itself to the production of (A) and country II in the production of (B). Exactly the same would happen if I and II were two regions of one country. We speak of an absolute- differences in costs because each country can produce one commodity at an absolutely lower cost them the other. Thus, in such a situation, a division of labour between them must lead to an increase in total output.

Absolute Cost Advantage

  • Specialization: Specialization of labour leads to higher productivity and allows to achieve less labour cost per unit of output.
  • Suitability : Suitability of the skills of labour of the country in producing certain products
  • Economies of Scale: It helps to reduce the labour cost per unit of output

Natural Advantage

  1. Natural Resources
  2. Climatic Conditions

Example: A. India - Production of Rice, wheat, sweet mangoes, grapes, Tea, Coconuts, Cashew nuts, cotton, etc.

  1. Sri Lanka - Production of Tea & Rubber
  2. USA - Production of wheat

Aquired Advantage

  1. Technology
  2. Skills

Example: Japan - Advantages in steel production through imports of steel & coal England - Production of Textiles France - Production of Wine

Absolute Advantage Theory: Significance

  1. More quantity of both products
  2. Increased standard of living for both countries
  3. Increased production efficiency
  4. Increase in global efficiency and effectiveness
  5. Maximization of global productivity and other resources productivity

Absolute Advantage Theory: Limitations

  • No absolute advantages for many countries
  • Country size varies
  • Country by country differences in specializations
  • Deals with labour only and neglects other factors of production
  • Neglected Transport cost
  • Theory is based on an assumption that Exchange rates are stable and fixed.
  • It also assumes that labor can switch between products easily and they will work with same efficiency which in reality cannot happen.