Theory of Mercantilism
During the sixteenth to the three-fourths of the eighteenth centuries, the world trade was being conducted according to the doctrine of mercantilism. It comprised many modern features like belief 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.
The mercantilists believed that the power of a nation lied in its wealth, which grew by acquiring gold from abroad. This was considered possible by increasing exports and impeding imports. Such reasoning gathered support on the ground that gold could finance military expeditions and wars, and the exports would create employment in the economy. Mercantilists failed to realise 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. The concentration in the production of goods for domestic consumption by using resources in a less efficient manner would also mean lower production and smaller gains from international trade.
Theory of Absolute Cost Advantage
The theory of absolute cost advantage was propounded by Adam Smith (1776), arguing that the countries gain from trading, if they specialise according to their production advantages. Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation. Smith reasoned that trade between countries shouldn’t be regulated or restricted by government policy or intervention. He stated that trade should flow naturally according to market forces. In a hypothetical two-country world, if Country A could produce a good cheaper or faster (or both) than Country B, then Country A had the advantage and could focus on specializing on producing that good. Similarly, if Country B was better at producing another good, it could focus on specialization as well. By specialization, countries would generate efficiencies, because their labor force would become more skilled by doing the same tasks. Production would also become more efficient, because there would be an incentive to create faster and better production methods to increase the specialization.
Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t be judged by how much gold and silver it had but rather by the living standards of its people.
Theory of Comparative Cost Advantage
Ricardo (1817), though adhering to the absolute cost advantage doctrine of Adam Smith, pointed out that cost advantage to both the trade partners was not a necessary condition for trade to occur. It would still be beneficial to both the trading countries even if one country can produce all the goods with less labour cost than the other country. According to Ricardo, so long as the other country is not equally less productive in all lines of production, measurable in terms of opportunity cost of each commodity in the two countries, it will still be mutually gainful for them if they enter into trade.
Theory of Heckscher-Ohlin
The theories of Smith and Ricardo didn’t help countries determine which products would give a country an advantage. Both theories assumed that free and open markets would lead countries and producers to determine which goods they could produce more efficiently. In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a country could gain comparative advantage by producing products that utilized factors that were in abundance in the country. Their theory is based on a country’s production factors land, labor, and capital, which provide the funds for investment in plants and equipment. They determined that the cost of any factor or resource was a function of supply and demand. Factors that were in great supply relative to demand would be cheaper; factors in great demand relative to supply would be more expensive. Their theory, also called the factor proportions theory, stated that countries would produce and export goods that required resources or factors that were in great supply and, therefore, cheaper production factors. In contrast, countries would import goods that required resources that were in short supply, but higher demand.
