ECO 303 – International Economics by Ologundudu, M.M. is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License.

ECO 303
 LECTURE ONE
1.0 INTERNATIONAL TRADE GENERAL REVIEW

WHAT IS INTERNATIONAL TRADE?

 Trade is the concept of exchanging goods and services
between two people or entities.

 Original form of trade was barter

 Bilateral trade: when two people or countries are

involved.

 Multilateral trade: if more than two people or two

countries are
involved.
 International trade is a concept of
exchange between people or entities
in two different countries.

 The fundamental of trade is to explain

why
two people or two nations trade with
each
other respectively.

 The answer is simply that Nature is not

evenly
distributed on the surface of earth.
TYPES OF TRADE
Trade

Home Foreign
Trade Trade

Wholesale Retail Import Export Intra-port

Trade Trade Trade Trade Trade
INTERNAL TRADE: Trade within the
political and geographical boundaries of
a country. (Wholesale or Retail).

Wholesale Trade: Commodities are

bought in large quantities from the
manufacturer and then sold to the
retailers for resale to consumers.

 Retail Trade: Commodities are

bought in small quantities from the
wholesalers for resale to the final
consumers.
EXTERNAL TRADE: Trade across the political and
geographical boundaries of a country (import, Export
and intraport).

 Import Trade: When commodities are

sold to home country from another or
foreign country i.e. USA goods to Nigeria
resident.
Export Trade: When commodities are
sold from home country to another or
foreign country i.e. Nigeria good to U.S.A
resident.
 IntraPort Trade: It occur when imported
goods are re-exported back to the source
country after modifying the goods to
 LECTURE TWO
2.0 INTERNATIONAL TRADE THEORIES
 It is important to understand how countries

trade with one another historically.

 The main historical theories are called

classical which are country based.

 By mid 20’s, the theories began to shift to

explain trade from firm perspective and are
called company based.
 Tabular presentation of both Classical and
Modern based theories are depicted below:
Classical Country-Based Modern Firm-Based
Theories Theories
Mercatilism Country Similarity
Absolute Advantage Vernon’s Product cycle Theory

Comparative Advantage Global Strategic Rivalry

Heckscher-Ohlin Porter’s National Competitive

Advantage
Leontief Paradox Kravis Theory of Availability

Linder’s Theory of the Volume

of Trade
Kanen’s Theory of Human
Capital
Gravity Model
Posher’s Technological Gap
Theory
 CLASSICAL TRADE THEORIES
 BASIS for International Trade among countries
 Why do nation trade?

 Is International trade beneficial to all?

 International trade theories are

simply different theories that explain
reason (s) for international trade among
the countries in the world.
 1. MERCANTALISM TRADE PHILOSOPHY
 Mercantalism was one of the earliest efforts to
develop an economic theory dated back as to
sixteen century.

 This theory stated that a country’s wealth was

determined by the amount of gold and silver
holding.

 Mercantalist believed that a country should

increase its holdings of gold and silver by
promoting exports and discouraging imports.

 World History from the 1500s to late 1800s

revealed
 Within these period, there was a sudden rise of new nation.
States whose rulers wanted to strengthen their nations by
building larger armies and national institutions.

 Export trade were increased and more gold and silver were
amassed.

This was achieved through export promotion strategy.

 Later, modern thinkers such as Japan, China, Singapore,

Taiwa
and even Germany embraced the concept of mercantilism
in what is called Neo-mercantilism.

 This was done by adding other features of trade protection

and combining
(i) Protectionist policies
(ii) Trade restriction policies
 Nearly every country has implemented some
form
of protectionist policy to guide key industries in
its
economy at one point or the other.

 The drawback of this system of trade are

many:
(i) Only export-oriented companies are direct
beneficiaries of protectionist policies.

(ii) Consumers are hurt by protectionist

 They pay higher taxes (Govt. Subsides)
 It trigger higher prices for consumer
 2. PHYSIOCRACY TRADE PHILOSOPHY
 In the middle of 18th Century, a new system of economic
thought developed in France by the name of physiocrates.

 This system is known as physiocracy

 The physiocrates argued that mercantalist blindly

supported foreign trade without understanding the real or
natural order.

 The physiocrates did not under played the importance of

international trade or trade generally for the betterment of
society but laid more emphasize on the importance of
agriculture.

According to this school of thought trade remains and will

always remain relevant due to the importance attached to
natural
order and endowment from country to country.
 3. ADAM SMITH TRADE MODEL
 In 1776, Adam Smith questioned the leading mercantiles
and physiocrates philosophies of trade in his book Wealth of
Nations; and Inquiry into the nature of causes of wealth of
nations.

 He propounded a new trade theory called absolute

advantage which focused on the ability of a country to
produce a good more efficiently than another nation.

 According to the theory, trade between two countries should

not be regulated or restricted by government policy or
intervention.

Trade should flow naturally according to the market forces.

 In a hypothetical two country world, if A could produce a good cheaper
or faster or both than country B, then country A had a greater advantage
and could then focus on specializing in producing that goods.

 Similarly, if country B was better at producing another good, it could

focus on specializing on producing that goods.

By specialization, countries would generate efficiencies because their

labour force would be more skilled by doing the same task.

 Production would also become more efficient.

 The theory conclude that with increased efficiencies, people in both

countries would benefit and the world output will increase, hence trade
should be encouraged.

 In conclusion, Adam Smith theory of absolute advantage states that a

nation’s wealth should not be judged by how much gold and silver it had
but rather by the living standard of its people.
 4. RICHARDIAN TRADE MODEL
 The challenge to the absolute advantage theory
was that some countries may be better at
producing both goods and therefore, have absolute
advantage in many areas.

 In contrast, another country may not have any

useful absolute advantages at all.

 In this situation, should trade not take place at all?

 David Richardo, an English Economist, answer this

question by introduced the theory of comparative
advantage in 1817.
Ricardo opined that even if country A had the
absolute advantage in the production of both
products, specialization and trade could still occur
between the two countries.

 Comparative advantage occur when a country can

not produce a product more efficiently than the
other country.

But she can produce the other product better and

more
efficiently than the other product.

 While comparative advantage focuses on the

relative prices or productivity differences, absolute
advantage focus on the absolute price or
productivity.

Therefore, a country will specialize in
doing what they do relatively faster and
better and the overall productivity of the
countries involved in the trade would be
greatly enhanced.

 Trade can benefit both countries on the

basis of cost of production which is not
described in the absolute advantage
model
 LECTURE THREE
3.0 NEO-CLASSICAL TRADE THEORIES

 The classical trade theories was castigated on he basis

of some of its restrictive and unrealistic assumptions.

The Neo Classical model of trade advocated for theory

which can be extended up longer and whose concept can
be easily understood by all.

 They therefore started their theory with the basic

concepts like opportunity cost and productivity
possibility frontier.

 The neo classical economist such as Haberler, Leontiet,

lerner Marshall, Edgeworth, and meade had contributed
1. THE OPPORTUNITY COST APPROACH. (HEBELLER’S THEORY)
 This study of opportunity cost was to reformulate the
theory of comparative cost advantage propounded by
David Ricardo

 According to this theory, if country can produce either of

commodity x or y, the opportunitycost of the commodity
x is the amount of other commodity y that must be given
up in order to get one additional unit of commodity x

 The exchange ratio between the two commodities is

expressed in terms of opportunity costs.

 The theory of comparative cost was based on labour

theory of value (LTV)

 LTV states that the value of commodity is equal to the

amount of labour time involve in the production of that
commodity.
 LTV according to Ricardo assumes that labour is the only
factor of production of the commodity and that it is
homogeneous and fixed in the same proportion in the
production of all commodities.

 The inherent shortcoming in this theory was resolved by

the opportunity cost theory which explain the doctrine of
comparative cost in terms of what Samnelson called
production possibility curve.

 The theory of opportunity cost was based on the

following assumptions:
(i) Only two countries A and B can participate ion trade.
(ii) Two commodities and two factors of production (Labour and
Capital)
(iii) The supply of factors is fixed
(iv) There is full employment
(v) Free trade exists between the two countries
(vi) The price of each factor equals its marginal value production in
 Under these theory, heavy gain from trade can be
determined by different cost conditions. i.e. constant,
increasing and decreasing opportunity cost.

2. MILLS THEORY OF RECIPROCAL DEMAND

 J.S Mill postulated the theory of reciprocal demand

 The term reciprocal demand was introduced by MILL to

explain the determination of the equilibrium terms of trade.

 It is used to indicate a country’s demands for one commodity

in terms of quantities of other commodities it is prepared to
give up in exchange.

 After restating the Ricardian theory of comparative cost, Mill

allocated a given amount of labour to each country but
different outfit.

 This is called Comparative effectiveness of labour as

 These theory of Reciprocal Demand was based on
the following assumptions:
 Two countries, two commodities and only one
factor of production (2x2x1 model)

 There are constant return to scale

 Transportations costs are totally absent

 There is perfect competition

 Full employment exists in both the country

 Absence of trade restriction.

 LECTURE FOUR
HECKSCHER-OHLINTRADE MODEL

4.0 INTRODUCTION
 The theories of Smith and Ricardo did not help
countries determine which products would give a
country an advantage

 Both theories assumed that free and open markets

producers to determine which goods they could
produce more efficiently

 According to the two swedish economists, ELI

Hecksher and berlin Ohlin, they asserted that the
relative availability of factor supplies mainly
determine pattern of production, specification and
trade among the regions.
Some countries have abundant in capital and
some have much abundance in labour.

 They determined that the cost of any factor

or resource is a function of supply and demand.

 The theory says that the countries that are

rich in capital endowment will export capital
intensive goods and the countries which that
are rich will export labour intensive goods.
4.1 ASSUMPTIONS
 The following assumptions have been
made in order to simply H-O theorem.
(i) The model is based on 2 countries, 2
commodities and 2 factors of
production.
(ii) The existing factors and commodity
market is perfect competition.
(iii) Production functions are different for
different commodities.
(iv) Each commodity is produced by
constant return to scale.
(v) Transportation and insurance costs
are free.
 (vi) Factor of production between the countries
are immobile but freely mobile within
countries.
(vii) There is full employment of both the
factors of production in each countries.
(viii) The technological knowledge remain
unchanged
(ix) Identical demand patterns and preferences
of consumers in both the countries.
 The H-O theorem as discussed above were:
(i) Factor abundance (or scarcity) in terms of
the price criterion; and
(ii) Factor abundance (or scarcity) in terms of
physical criterion.
  However, the classical and modern
theories of international trade had
provided meaningful concept of
international trade but both the
classical and modern concepts of trade
are diagnosed by several limitations.
 The theorem thus is quite limited in its
applications because of several
unrealistic assumptions.
4.2 leontiff paradox
 In the early 1950s, a economist wassily
W. economy closely and noted that the
united states was abundant in capital.
 By implication such country should
produced and export capital intensive
goods.
 His research using actual data showed
the opposite: the united states was
importing more capital intensive goods
 According to H-O theorem, the united
states should have been importing
labour intensive goods but rather it
was actually exporting them.
 This contribution became known as the
leontiet paradox because it was the
reverse of what was expected by the
H-O theory.
 The question is: Does the H-O theory
still have any relevance in international
trade?
 Over the decades many economists
have used different theories and data to
explain and minimize the impact of the
paradox in international transaction.
(i) Criticism of the data and methodology
used in the input-output test.
(ii) The unbalanced trade problem
(iii) Human capital explanation
(iv) Natural resources explanation
(v) Demand reversals
(vi) Factor intensity reversals
 LECTURE FIVE
MODERN TRADE THEORIES
5.0 INTRODUCTION
 The classical theory of international trade
bitterly criticized by Bertel Ohlin in his
famour book “Interregional and
international trade” (1933) and then
formulated the General equilibrium or
factor Endowment theory of international
trade.

 Ohlin and his teach Hecksher (known as

H-O) carried the theory forward to build
the theory of modern international trade.
5.1 THE KRAVIS THEORY OF AVAILABILITY
 In 1956, I.B Kravis, an Amrerican
Economist questioned the assumptions of
the classical theory that technology was
the same in all trading countries.

 While testing the H-O theory, he

wanted to find out whether labour
intensive export were produced with
cheap labour.

He found out that in almost every

country, the exporting industries pay a
vert high wages to labourer.
 According to him, a country produces
and exports those goods which are
(available) developed by its innovators
and entrepreneurs.

 Kravis propounded the theory that the

composition of community of trade is
determined primarily by “availablity
which means an elastic supply.

 Trade only take place in those

commodities which are not available
at home.
 By implications, the country will:
(i) Import those goods which are not
available in the country in absolute
sense e.g. diamonds.
(ii) Export those goods which are
available more than the domestic
needs.

 However, there are some factors

responsible for the availability as
explained by Kravis:
(i) Natural Resources, Technical change,
product differentiation and
government policy.
(ii) The trade pattern of a country is determined
by the availability of scarce natural resources.

(iii) Availability of Technical knowledge possessed

by a country labour force.

(iv) Temporary monopoly of production by the

product differentiation by which the producing
countries can export its commodities.

 The government policies has proved to an

obstruction which leads the trade o a negative
path.
5.2 LINDER’S THEORY OF THE VOLUME OF TRADE
 The swedish economist, S.B Linder
propounded a theory that explains the volume
of trade in manufactures as proportion of nation
income between different pairs of trading
countries.

 According to Linder, trade experts could be

explained in terms of relative natural
endowment whereas manufactures exports
cannot be explained like that.

 For manufactures experts, there are many

complex factors such as technology superiority,
managerial skills and economics of scale which
are considered to be imprecise and
 In his theory, Linder asserted that the pre-
condition for trade in manufacture export is a
function of home demand.

The following reasons was given for his

assertion:
(i) Foreign trade is only the extension of
domestic trade.
(ii) Existing industries are fully equipped with
innovating centres.
(iii) Foreign market is risky and the domestic
market is safe.

 The country will only export those

commodities for which the domestic
 According to Linder, the country will
preferably export to those countries whose
income levels and demand patterns are
similar to the exporting country (Preference
similarity)

 Preference similarity occurs in different

countries and the different countries
overlap.

 Therefore, trade relations among the

countries took place and a variety of
manufactured goods are produced after
meeting its domestic demand.
5.3 POSNER’S TECHNOLOGICAL GAP THEORY
 Unlike other international trade theorists
like Ricardo, and Heckscher-Ohlin, who failed
to analyze the effort of technological change
on trade, but Kravis comprehensively pointed
out the effect of technological change on
available exports.

 M.V posner reformulated the theory of

Kravis and analyzed the effect of technology
on trade.

 According to him, the process of

technological change leads to the imitation
gap which influence the patterns of
 Posner’s theory was based on the
following assumptions:
(i) There are two countries
(ii) The factors endowments are similar in
both countries.
(iii) Condition of demand is similar in both
countries.
(iv) Both countries have different
technologies.

 The technological gap theory explain the

sequence of innovation and imitation as
it affect the pattern of trade.
 Innovation of new product that is
profitable in the domestic market leads to
temporary monopoly.

 If extended to importing countries (foreign

market) imitation is inevitable.

 But the exporting countries will still have

comparative advantage in its production
even during and after the imitation gap.

 In spite of the above analysis, Posner

proposed that the technological gap theory
has three basic components:
(i) Foreign reaction lag: It is the time taken
by the innovating firm to start the
production of new product.

(ii) Domestic reaction lag: learning period

which is the time taken by the domestic
producers to learn about the techniques
of producing the new products and then
selling it into the domestic market.

(iii) Demand Lag: it is the time taken by the

consumers to acquire the taste of the
new products.
  Technological gap theory is more realistic
than the traditional theories because it
analysed the effect of technology on the
trade pattern.

5.4 VERNON’S PRODUCT CYCLE THEORY

 Raymond Vernon, a Harvard Business School
Professor developed the product life cycle in the
1960s.

 The Theory stated that a product life cycle has

three distinct stages:
(i) New product
(ii) Maturing product
(iii) Standardized product
 This theory was based on the experience of
U.S Economy and it was based o the following
assumptions:
(i) The development of new products by the
firms made on the basis of real or
imagined conferred a monopolistic
advantages.
(ii) The innovators are provided by the
stimulus to innovate new product by the
need and opportunities of the domestic
market.
(iii) The innovators are unaware about the
conditions and situations in the foreign
markets.
(iv) The new products are firstly produced in
  This model comprehensively demonstrates the
dynamic comparative advantage.

 The country have comparative advantage in the

production of the new product changes from
innovating country to the developing countries.

 However, the model is usually applied to the labour

saving and capital using products developed in the
high income groups.

 The product life cycle is further elaborated with the

aid of five stages:
(i) Introduction
(ii) Growth
(iii) Maturity
(iv) Saturation