International Trade Theories and Models

This assignment provides an in-depth analysis of international trade theories, including Adam Smith's theory of absolute advantage, Ricardo's comparative advantage, Heckscher-Ohlin model, and Krugman's new trade theory. The discussion covers how these theories explain the allocation of scarce resources globally, highlighting the benefits of increasing return to scale and specialization based on factor endowment. Additionally, it touches on intra-industry trade, Porter's diamond trade model, and the implications of firms in international trade for policy-making.

Running Head: FUNDAMENTALS OF ECONOMICS
Fundamentals of Economics
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Assignment 1: Comparative advantage; production, allocation and consumption of
scarce resources
The allocation of resources is one central problem of economies. The origin of the problem
lies in the fact that people in the economy have unlimited wants. However, to satisfy these
wants only limited resources are available. From this arises the issue of scarcity. The scarce
resources need to be used optimally to meet desire of people as much as possible. Trade is an
efficient way of allocating resources globally (Costinot et al. 2015). The direction of trade
among nations is determined following different models of trade. Each nation has its own
trade pattern. The first model of trade was initiated by Adam Smith and is known as theory of
absolute advantage. The theory of absolute advantage was followed by Ricardo’s model of
comparative advantage. With passes of time, countries across the globe adapt different trade
pattern and each is explained with a different trade theory. The essay focuses on resource
allocation with the help of different contemporary trade theories.
Scarcity and resource allocation: The scarcity in economies indicates the most vital aspect
of any economy- limited means and unlimited ends. The ‘means’ here defines available
resources while ‘ends’ implies desires of people. The unlimited wants of the people cannot be
satisfied with limited resource (Stiglitz 2017). Hence, come the question of optimal allocation
of resources. The scarcity problem leads to the choice problem where people has to make
choices among the available alternatives. The optimal resource allocation points to three most
important questions of any economy-what to produce, how to produce and for whom to
produce. These three questions in turn points to choices of commodity, efficient production
technique and distribution of the produced goods.
The stock of resources and available technologies vary across nations. Therefore, countries
have specialization skills over different goods. The global welfare is maximized when

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countries specializing in different goods exchange goods. This line of specialization can be
determined based on absolute cost advantage, relative cost advantage, relative factor
abundance and others ((Feenstra 2015). Each of this aspect is taken care of separate trade
theories.
Absolute and comparative advantage: Adam Smith developed the theory of absolute
advantage. The theory states that when a country is able to produce one good at a lower cost
as compared other nations then the country is said to have an absolute advantage over the
good. When a country has absolute advantage in a good then it can make the good by
employing a relatively smaller amount of resource (Costinot et al. 2015). Countries thus
when specialize following principles of absolute advantage and trade with each other;
resources are used optimally raising world welfare.
The problem arises when one country has absolute advantages over others on all product. The
Smith’s theory then fails to explain any trade pattern between countries. When absolute cost
difference cannot determine the trade direction then the alternative approach is to compute
the opportunity cost. David Ricardo first develops trade theory in terms of opportunity cost.
The trade model developed by Ricardo is known as theory of comparative advantage. The
comparative advantage of a nation is the ability to produce a good a lower opportunity cost
than other nation. Involving in trade following principles of comparative advantage is
mutually beneficial for both the trade partners. Both the participating nations are benefitted
from comparative advantage and world output as a whole increase (Feenstra 2015). Countries
when specializes in goods that has a lower opportunity cost then the resource waste is
minimized. Following an efficient resource allocation and higher world output, more goods
are available for consumption satisfying more wants and thus stimulate world’s welfare.

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The concept of comparative advantage and the involved opportunity cost will become clearer
with the help of the following example.
The table below shows the required labor hours for producing wheat and cotton in two
nations namely China and US.
Labor hours
(for producing 1 unit )
Wheat Cotton
China 10 5
US 8 2
For producing 1 unit of wheat and cotton the required labor hours for China are 10 and 2
respectively. While US requires a relatively less labor hour for producing both wheat and
cotton. For wheat, the required labor hour is 8 while for cotton it is 2. This implies US has
absolute advantage over China for both Wheat and Cotton. No trade relation therefore can be
defined from the theory of absolute advantage. Trade however is possible by taking into
consideration the associated opportunity cost.
Opportunity cost
(for producing 1 unit )
Wheat Cotton
China 10/5 = 2 5/10 = 0.5
US 8/2 = 4 2/8 = 0.25
For China, the opportunity cost of wheat is only 2 units of cotton while for US the involved
opportunity cost for wheat is 4 units of cotton. Following a lower opportunity cost China
should specialize in Wheat. For cotton however US has a lower opportunity cost (0.25 < 0.5)
and hence should specialize in cotton.

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From specialization, China gains 5 hours of labor that it requires to produce cotton. US gains
6 units of labor hours. Both the countries when specializes as per their comparative advantage
then the additional labor hours can be used to produce additional output leading to an
increase in total world output.
The theory proposed by Smith and Ricardo though initially explained trade pattern quite well
but as trade evolves between nations countries new factors came in front that the two
pioneering model had not considered ((Ethier and Hillman 2017). The first is the presence of
transportation cost. In reality, exchange of goods among nations requires significant
transportation cost because of physical distance between the trade partners. Both the model
considered factor cost of only one input that is labor. In real world, capital also plays an
important role in production (Grossman, Helpman and Kircher 2017). However, none of the
models considered any factors other than labor.
Heckscher-Ohlin theory: Based on the Ricardian comparative advantage Heckscher and
Ohlin developed a trade model in terms of factor endowment of nations. According to the
theory, goods are classified as labor-intensive and capital-intensive. Therefore, nations
having abundant labor should specialize and export labor intensive goods. While countries
rich in capital should specialize in capital intensive goods (Guillo and Perez‐Sebastian 2015).
The specialization as explained by this theorem is due to the relation between factor
abundance and factor prices. The country faces a cheaper price for its relatively abundant
factor and a higher price for scarce factor of production. Thereby, difference in factor
endowment leads to a difference in comparative advantage (Ethier and Hillman 2017).
An empirical test performed on US economy during 1947, revealed inconsistency with
Heckscher-Ohlin model. In 1947, US had seemed to be endowed with more capital. The
theory therefore predicts export orientation towards capital-intensive good. However, in

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reality it was found that imports of US were 30% more capital intensive as compared to US
export (Paraskevopoulou, Tsaliki and Tsoulfidis 2016). This contradictory finding is known
as Leontief Paradox.
Porter Diamond’s trade theory: This theory was developed by Micheal Porter to determine
advantage of a nation. The theory stress that in determining comparative advantage in the
international market, the prevailing condition in the home market plays an important role
(Riasi 2015). The different factor affecting nation advantage is presented resembling the
shape of a diamond and hence, the model is known as Porter’s diamond model.
Figure 1: Porter’s diamond model
(Source: Fainshmidt, Smith and Judge 2016)
In the model factors refer to the necessary inputs for production of goods and services. The
factors include natural resources and labor as well as advanced factor such as infrastructure
and community. Countries lacking natural resources tend to develop advanced methods of
production for attaining national advantage. One example is South Korea. Demand condition
in the model is indicated by size of the domestic market. High demand in the domestic

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market encourages producers to improve quality of the product and helps to attract foreign
demand (Rothaermel 2015). The growth of related industries generates external economies of
scale and gives firms a cost advantage. Finally, strategies, structure and rivalry influence
success of an organization by influencing its operation.
Intra-industry trade: The term intra-industry trade implies trade of products within the
same industry. This term is applied to international trade when countries export and import
same products (Lee 2017). A real world example of intra industry trade is exchange of
vehicles in Japan. Japan in 2002, imported vehicles worth 0.3 million. As against this, Japan
exports vehicles worth of 4.7 million. Neither Ricardian model of comparative advantage nor
Heckscher-Ohlin model of trade can explain rationale for such intra-industry trade pattern
(Peterson and Thies 2015). Finger in 1975 attempted to explain intra-industry trade with
heterogeneous factor endowment exists in the same industry. This argument was redundant as
intra-industry trade seemed to occur even after disaggregation of industries to the final level.
Flavey & Kierzkowski (1987) gave a potential explanation by stating that identical goods are
not always produced by employing identical technologies. Goods produced with a capital-
intensive technique tend to be superior to labor intensive that produced with labor-intensive
one. The quality differences often cause intra-industry trade. This argument was dismissed on
the ground that it did not address the aspect of trade for goods that need similar kind of factor
endowment (Balassa and Bauwens 2014).
Finally, there comes the New Trade Theory asserts by Paul Krugman. Krugman explains
specialization not in terms of regional differences in factor endowment in terms of increasing
return to scale. This is supported by neo-classical trade theory. The theory suggests that
countries by producing a limited variety of commodities enjoy the benefits of increasing
return to scale (Ciuriak et al. 2015). The presence of economies of scale provides the nation a

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significant cost advantage. Because of international trade, production of limited variety of
goods does nor limit the available variety of consumption.
The discussion above shows how different trade theories explain allocation of scarce
resource globally. The very first theory of international trade is the theory of absolute
advantage constructed by Adam Smith. However, the theory fails where one nation has a
better cost condition than other does in all goods. Trade then is explained by difference in
opportunity cost. This theory is known as Ricardo’s theory of comparative advantage.
However, both the absolute and comparative cost advantage theory considers cost of only one
input namely labor. Heckscher Ohlin defined specialization based on the factor endowment.
Heckscher Ohlin theory faced difficulty when some trade pattern of some nation revealed an
inconsistent pattern to the theory. Another type of trade pattern observed in today’s world is
the intra industry trade corresponds to import and export of same product. The porter’s
diamond trade model and New Trade Theory proposed by Krugman always explains some
specific form of trade across nations.

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Reference list
Balassa, B. and Bauwens, L., 2014. Changing trade patterns in manufactured goods: An
econometric investigation (Vol. 176). Elsevier.
Ciuriak, D., Lapham, B., Wolfe, R., Collins‐Williams, T. and Curtis, J., 2015. Firms in
International Trade: Trade Policy Implications of the New New Trade Theory. Global
Policy, 6(2), pp.130-140.
Costinot, A., Donaldson, D., Vogel, J. and Werning, I., 2015. Comparative advantage and
optimal trade policy. The Quarterly Journal of Economics, 130(2), pp.659-702.
Ethier, W.J. and Hillman, A.L., 2017. The Politics of International Trade.
Fainshmidt, S., Smith, A. and Judge, W.Q., 2016. National Competitiveness and Porter's
Diamond Model: The Role of MNE Penetration and Governance Quality. Global Strategy
Journal, 6(2), pp.81-104.
Feenstra, R.C., 2015. Advanced international trade: theory and evidence. Princeton
university press.
Grossman, G.M., Helpman, E. and Kircher, P., 2017. Matching, Sorting, and the
Distributional Effects of International Trade. Journal of political economy, 125(1), pp.224-
264.
Guillo, M.D. and Perez‐Sebastian, F., 2015. Convergence in a Dynamic Heckscher–Ohlin
Model with Land. Review of Development Economics, 19(3), pp.725-734.
Lee, H.S., 2017. Inter-Industry Labor Mobility and Lobbying for Trade Protection. The
International Trade Journal, pp.1-22.

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Paraskevopoulou, C., Tsaliki, P. and Tsoulfidis, L., 2016. Revisiting Leontief’s
paradox. International Review of Applied Economics, 30(6), pp.693-713.
Peterson, T.M. and Thies, C.G., 2015. Intra-industry trade and policy outcomes. The Oxford
Handbook of the Political Economy of International Trade, p.177.
Riasi, A., 2015. Competitive advantages of shadow banking industry: An analysis using
Porter diamond model. Business Management and Strategy, 6(2), pp.15-27.
Rothaermel, F.T., 2015. Strategic management. McGraw-Hill Education.
Stiglitz, J.E., 2017. The overselling of globalization. Business Economics, 52(3), pp.129-137.

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