International trade theory explains why countries trade and what each country ends up exporting and importing. Four ideas cover most of the ground: absolute advantage (Adam Smith, 1776), comparative advantage (David Ricardo, 1817), the Heckscher-Ohlin model, which looks at each country’s supply of land, labour and capital, and the new trade theory, which adds economies of scale.
The examples below use the United States, China and Japan to illustrate the ideas. They are simplified textbook illustrations, not statements about how productive those countries actually are.
The theory of absolute advantage
A country has an absolute advantage in a product when it can make that product with fewer resources than another country. Adam Smith used this idea in The Wealth of Nations (1776) to argue that countries gain when each specialises in what it makes most efficiently and buys the rest.
Suppose the United States makes cars and computers with fewer resources than China, and China makes shoes with fewer resources than the United States. Each country has an absolute advantage in something, so the United States should make cars and computers, China should make shoes, and they should trade.
The limit of the theory is the case it cannot handle: a country that is more efficient at everything. Absolute advantage alone suggests that such a country has nothing to gain from trade. Ricardo showed that this is wrong.
The theory of comparative advantage
Comparative advantage is the central idea of international trade theory. A country has a comparative advantage in a product when its opportunity cost of making it, measured in the other goods it gives up, is lower than another country’s. Trade pays even if one country is better at making everything, as long as each country specialises in the goods where its opportunity cost is lowest.
Ricardo’s own example, from 1817, used England and Portugal. Portugal could make both wine and cloth with less labour than England, so it had an absolute advantage in both. England’s disadvantage was smaller in cloth, so England had the comparative advantage in cloth and Portugal in wine. When each specialised and traded, total output rose and both could consume more than without trade (summary of Ricardo’s example).
Return to the United States and China. Even if the United States were more efficient at making cars, computers and shoes, it would still gain by concentrating on the goods where its lead is largest and buying shoes from China, where its lead is smallest. China gains as well, because it gets cars and computers for less than it would cost to make them at home.
The Heckscher-Ohlin model
The Heckscher-Ohlin model, developed by the Swedish economists Eli Heckscher and Bertil Ohlin, explains comparative advantage through differences in factor endowments: how much land, labour and capital each country has. It predicts that a country exports goods that use its abundant factors intensively and imports goods that use its scarce factors intensively.
In a simple illustration, China has a lot of labour relative to capital and the United States has the opposite. The model predicts that the United States will export capital-intensive goods and import labour-intensive ones, and that China will do the reverse. Both gain from the exchange. The Heckscher-Ohlin model page sets out the formal assumptions.
The new trade theory
The older theories struggle to explain why most trade takes place between similar, rich countries that exchange similar goods. The new trade theory, associated with Paul Krugman, who received the 2008 Nobel Memorial Prize in Economic Sciences for this work, adds economies of scale and imperfect competition. When producing in large volumes lowers the cost of each unit, it pays to concentrate production of a product in a few places and sell to the world market. Because consumers like variety, countries can both export and import goods of the same kind; the Nobel committee’s summary gives the example of Sweden both exporting and importing cars.
As an illustration, a country such as Japan can lower its production costs and raise profits by specialising in cars and selling to a global market. Once a producer has that scale, competitors in other countries may find it hard to match its costs.
Trade and economic growth
Trade can drive economic growth. It increases demand for a country’s goods, which raises output and employment and, over time, living standards. It also spreads technology, knowledge and skills between countries.
The gains are not automatic or evenly shared. Trade imbalances, the rise of protectionist policies and unequal gains between and within countries all cause friction. The tools governments use to protect their own producers are explained in the article on tariffs and trade barriers, and the way these theories play out in practice is described in how global trade works.