ITL - M1

MODULE 1

INTERNATIONAL TRADE: BASIC DEFINITION, CONCEPTS AND
CLASSIFICATIONS

1.1 INTRODUCTION TO THE ABSTRACT OF TRADE

There have been multiple definitions of trade, a term sought to be defined by a multitude of
scholars, economists, academicians etc. in order to encompass within this definition its
inclusivity. Perhaps the simplest definition of trade is that it is the “buying and selling or the
exchange of goods and services”. However, as the concept has developed the definition has
changed to help maintain its inclusiveness.

The exact time bar as to when trading activities came into being dates back to 2500 BC, when
trade by sea flourished in Northern Mesopotamia. The Greek empire made a great deal of profit
from the exchange of olive oil and wine for metal and grain. Many facets of modern commerce
developed during this time period which formed the basis of what we have today. However,
during that period trade was mainly done by enhancing the process of commodity exchange,
adding new features to it as and when suitable. The concept of currency as a unit for barter
came about much later. Until this time, the trading activity was mainly done to satisfy wants
based on exchange of commodities. In fact, trade had become such a popular activity that
merchants and traders began expeditions to lands far away from their home terrain in order to
trade. This also led to not only the discovery of nations as we know of them today but to the
capturing of a number of colonies. One of the prime examples of this is the discovery of
America in 1492 and that of the sea routes to India in 1498. Europe was regarded as the centre
of trade as goods such as sugar, tobacco, coffee and food as well as luxury products were easily
available. The capturing of colonies as well as the rise in economic power associated with trade
was soon realised. This was perhaps the main motivation behind trading activity performed by
nation states in that time. The increase in economic power of some states and specially that of
Europe gave rise to the era of colonization ultimately resulting in the Industrial Revolution in
1750 which laid down stringent guidelines for trading activities.

Britain emerged as a dominant colonial power professing the free trade philosophy as being
the most beneficial to trade. The two World Wars saw massive destruction of the global

economic structure and a strong need was the establishment of a new international trade regime.
The conglomeration of several conferences, conventions and treaties at this time helped to
unify a global strategy to bring about world peace and to provide a common ground for the
development of all nation states. Nation states were not all backed by the same economic
power. Some were less powerful due to years of colonization or other facts as compared to
others. The super powers such as USA, Britain etc. had a dominant role in the world and trade
was no exception. The advantages of trade was no secret then and neither is it now. Economic
stability, gain of power and the wealth associated with the generation of trade were just a few
of the benefits that accrued. Very often trade relations help to maintain and even strengthen
economic relations between nation states. The need of the hour then was to create a platform
wherein nation states can trade. There was a need to bridge the gap between the free trade
economies and the nations that advocated protectionism. This ultimately lead to the setting up
of the Havana Charter, which embodied the setting up of the International Trade Organisation.
However, due to USA denying ratification of this charter, the ITO never saw the light of day.
To create a temporary framework, till a more permanent solution came about, the General
Agreement on Tariffs and Trade, or the GATT in 1948 was instituted. This temporary solution
lasted about 48 years when ultimately the Uruguay Round culminated in the establishment of
the World Trade Organisation.

International trade has thus played a major role in shaping world history. The main advantage
realised from this activity is that it enables manufacturers and distributors to indulge in the
buying and selling of goods in another country. The differences of production of various
commodities between states helps to bridge the gap between production levels and realise the
cost advantages, ultimately leading to the realisation of wealth. The acquisition of goods and
services raises economic growth and enables nations to learn and mutually help each other.
Employment and income is generated all adding to the wealth of the country.

This module seeks to highlight the various aspects in terms of the characteristics, concepts and
the theories of trade.

1.2 CLASSIFICATION OF TRADE

The activity of trade can take many forms. The basic classification divides it into domestic
trade and foreign or international trade. The primary basis of such difference lies in the
geographical terrain where such an activity takes place. Trade within the territorial boundaries
of a nation state is known as domestic trade or internal trade or home trade. Trade beyond the

boundaries of a nation’s geographical terrain relates to international trade. Internal trade is
further divided into wholesale trade and retail trade. The former refers to the buying in bulk or
large quantities from the manufacturers or producers of these products and selling them to the
consumers interested in these products. Thus the chain of trade is linked by the wholesaler who
occupies an important position and is an intermediary between the producer and the retailer.
Retail trade, contrary to wholesale, involves buying in smaller quantities. Usually for personal
use this type of trade is usually the last link of internal trade as retailers have direct contact
with the consumers.

International trade is divided into export, import and entre-port. Import refers to the purchasing
of goods and services from a producer or manufacturer placed in another country. The benefits
of imports are multiple. They provide a range of choices to consumers having a direct effect
on the increase of the standard of living of the consumers of a nation. One of the main benefits
of imports is that it helps to fill the lacuna, if any, in the home country by enabling the
consumers to enjoy products of another. An imported product from one country is an exported
product of another. Export is the economic activity of trade involving the selling of goods or
services form one country to another. The benefits of exports are the effect it has on the
economic wealth of a country. When goods are imported for the purposes of export, it is known
as Entrepot trade To strike a balance between imports and exports is the main aim of a nation.
All these three categories are dependent on government policies, laws and legislations. On the
international front, if the nation state is a member of the WTO, the rules and regulations of the
WTO would govern this process. However, even within a country, laws and legislations are
made to ease the process of internal trade. In India for example, the Foreign Trade
(Development & Regulation) Act, 1992 and the rules and orders issued therein seek to regulate
international trade. Payments for import and export transactions are governed by Foreign
Exchange Management Act, 1999. The Customs Act, 1962 governs the movement of goods
and services through various modes of transportation. (such as rail, airways, roadways, sea way
or multi-modal forms) The Exports (Quality control & inspection) Act, 1963 is another piece
of legislation that seeks to help maintain a level of exportation. Further, Export-Import (EXIM)
policies are adopted and/or amended at periodic durations to help maintain a rough framework
and set goals and rules and regulations.

The difference between Internal and International trade is further classified into various heads
transcending geographical barrier difference. Inland trade assumes that the buyers and sellers
are of the same nation state. A foreign national, within the geographical country acting as a

buyer or seller partakes in internal trade as well. International trade usually involves sellers and
buyers of a different nationality. Since currency valuation is different across different countries,
international trade concerns itself with trade carried out in different currencies with ranging
valuations. This usually leads to good being more expensive or less expensive in a particular
country. The differences of currency valuation is a major contributor towards wealth
generation. In developed countries, the currency valuation is far more than developing and least
developed countries. This difference in currency is one of the major factors that contribute
towards making an export import decision. Since international trade concerns itself with
different nation states each having their own rules and regulations and sometimes even trade
restrictions, this process becomes more complex. Internal trade has a simpler regime as it has
to pertain to domestic law. This makes the process far easier and simpler with fewer
complexities. International trade is not only affected by the legal systems of nations trading
with each other, but also by the global scheme of trade which involves regulations made by
treaties, laws and international government bodies. Many a time two or more nation states may
formulate agreements relating to trade to help simplify this process. A major example of this
is NAFTA, an agreement for free trade between Canada, Mexico and USA that came into being
in 1994. Such agreements also have a direct bearing on international trade. Thus domestic or
internal trade is a simpler process as compared to that of the international trading regime which
has far more players. The latter also involves a number of parties which may act as middle men
who help render services to make this a smooth flowing process. Multiple firms have come
across to ensure that international trade flows smoothly. These can be formal or informal
associations that help ease the risk factor associated with this economic process. An example
of this is the institution of P&I Clubs that were formed to provide insurance to wayfarers
undertaking the sea route for trading activities. They are associations formed by those who act
as both the insurer and assured/insured by paying a sum towards the cause in accordance to the
club’s rules. These clubs are an example of associations and guilds formed to minimise the risk
element which is pertinent in international trade. Despite the risk factor and it being a more
complex process, international trade has several benefits associated with it. It is perhaps in the
efforts to realise these advantages that form the driving forces for nations to perform trading
activities. A detailed analysis of the advantages of international trade will be discussed in the
following section.

1.3 ADVANTAGES OF INTERNATIONAL TRADE

It is an established fact that no nation can survive on its own. In order to realise a nation’s true
value and potential it requires the aid of other nations to be part of the trading network. Isolation
and self-sufficiency are fond myths which do not exist in reality. Therefore, for a nation to truly
benefit out of trade it has to be co-dependent. Nations that have a strong hold on economic
power are seen to be the strong actors in the international trading regime as well as establishing
a direct link between development and international trade.

The export-import regime helps domestic firms to expand their business, thereby gaining the
benefits from economies of scale. Another major advantage of international trade relates to
technology and innovation. Innovation is the discovery of a new invention and its industrial
use. The rate at which technology develops is rapid. Trade contributes in spreading the use of
new and effective innovations throughout the world. This in turn leads to cost efficient
production which reduces the cost associated with manufacturing and production. This growth
aspect has risen over eighty percent in the last twenty-five years in the US. In fact, growth and
expansion aren’t lone factors. Growth in the trade industry benefits the unemployed by the
generation of both unskilled and skilled job profiles. Small and mid-level firms reap the
benefits arising out of this growth as the economy requires more production thereby increasing
opportunities. In the case of USA, exports of manufactured goods directly support more than
six million jobs. Nearly one third of US merchandise exports are by these small and mid-level
firms.

The need to strike a balance between the trading regime of import and export is perhaps one of
the major struggles of a nation state. This has led to the formulation of various trade theories
and principles.

1.4 THEORIES OF INTERNATIONAL TRADE

Uruk, in southern Mesopotamia is regarded to have being the starting point of the trading
regime. It was this city that gave to the world patterns of trade and a well-established trading
network that lasted centuries. The trading patterns of nations is a common subject of debate.
To establish a pattern of trade and explain the mechanisms of this economic process, trade
theories were brought to light. Divided into classical and modern theories, these were
developed in order to establish a sense of predictability to an otherwise complex and
unpredictable sphere. The classical trade theories, developed before the twentieth century are

from the perspective of a country as compared to modern theories that are from the perspective
of the firm. The shift in the outlook is in coherence with the economic shift that took place in
the mid twentieth century that gave rise to the modern theory. Both these theories have sub
sets. The classical theory consists of Mercantilism, the Heckscher-Ohlin theory, Absolute
Advantage theory and the Comparative Advantage theory. The Modern theory comprises of
Country Similarity, Product Life Cycle, Global Strategic Rivalry and Porter’s National
Comparative Advantage.

Mercantilism was one of the first attempts to develop an economic theory as early as the
sixteenth century. The presumption at that time was a country’s wealth was measured in the
amount of its gold and silver holdings. Therefore, in order to increase these holdings, trade
should be done by promoting exports and minimising imports. The primary stance was the
increase in the surplus of trade. This theory is regarded as being selfish. This is so as it is based
on the premise that one nation’s loss is another nation’s gain. World history is indicative to the
successful implementation and adaptation of this theory as during that time, rulers and kings
measured their power in accordance to the factors such as the capture of states, increase in
wealth and stronger armies. More gold and silver along with other riches led to more economic
power which is what this theory proposes. Though ancient, traces of this can be seen in modern
day economies such as that of Japan, China and even Germany that favour exports and
discourage imports by promoting protectionist policies and increasing domestic subsidies.
Critiques of this theory are those that follow the ideals of free trade. Protectionism and free
trade will be discussed in detail in the next segment.

Adam Smith, a critique of the theory of mercantilism, gave to the world the Absolute
Advantage Theory in his book ‘The Wealth of Nations. Adam Smith, An Inquiry into the
Nature and Causes of the Wealth of Nations’ in 1776. This theory focused on the ability of a
country to produce a product with greater efficiency than another nation. Trade should be done
by taking into consideration what can be produced at ease in one country may not be produced
with equal ease in another. Therefore, exports should comprise of all those goods and services
that are produced at ease in the nation and imports should comprise of those that are difficult
to produce. This process should take place according to the free flow of the market forces. Gold
and silver therefore are disregarded as the nation’s wealth; the focus should be on market forces
that directly affect the people instead.

Comparative Advantage, a challenge to this theory, proposed by David Ricardo focused on
the possibility that a country may have an advantage at producing more than one good whilst
another may not have the advantage at producing any good. Therefore, the exchange then
should be in accordance to the cost of production and factors of production. Relative
productivity is the focus of comparative advantage as compared to absolute advantage that
focuses on absolute productivity. The benefits of production are the gains from trade. This
principle highlights the opportunity cost of production. This theory however was also based on
the free trade principle.

In the early 1900’s, Swedish economists Heckscher and Bertil Ohlin sought to bridge the
disparities of the theories of absolute and comparative advantage. They focused on the factors
of production namely land labour and capital and the utilization of these factors by a nation
state. This theory also called the Factor Proportions Theory, that stated that those goods and
services should be exported which could be produced by cheaper production by factors that
were supplied at a greater ease. Imports should comprise of goods and services that would
require resources that were in short supply but the demand of which was high. However, in the
early 1950’s, Wassily W. Leontif, a Russian born American economist, gave to the world the
Leontief Paradox. In his study of the US economy, it was found that though US was abundant
in capital as compared to labour, more labour intensive goods were exported.

As the world witnessed devastating tragedy during World Wars I-II, a paradigm shift took place
in the nature of trade. This shift saw the emergence of economic trade theories that focused
more on the outlook of firms. This was mainly due to the growth of multinational corporations
and trade in those goods and commodities that existed between countries that produced goods
in the same industry.

Modern theories encompass brand and customer loyalty, technology flow and development,
quality and product and service factor.

It was noted that countries are of different types-developing, least developed and countries. this
transition cycle warranted different wants of different types and requirements thereof differed.
Steffan Linder developed the country similarity theory by noting that consumers in countries
that are in the similar cycle of development have similar preferences. Firms therefore, adhere
to their domestic market trends first and expect the same trend in a similar market of a different
nation state. The more similar these markets are; the more success would naturally be expected.

Therefore, trade of manufactured goods would be more successful in nations wherein the
income levels and capita levels are similar.

However, as noted by Raymond Vermon, products too undergo a life cycle that affects trade.
Pertaining mainly to the marketing of a product, he established that a product has three stages-
that of a new product, maturing product and a standardized product. The production of a new
product would occur in the home country of its innovation. The most glaring example of this
is the development of the personal computer that gained maturity in the 1980s-1990s. Having
attainted its standardized stage, the majority of manufacturing and production is outsourced.
However, this theory falls short in explaining how countries innovate and manufacture across
the world.

Barriers to entry are one of the main obstacles to trade. They can be divided into tariff and non-
tariff barriers. The Global Strategic Rivalry theory based on the work of Paul Krugman and
Kelvin Lancaster focused on MNC’s and their effort to strengthen the barriers to trade so as to
gain advantage. This was a move towards protectionism and was critiqued for being contrary
to the world trading regime.

The capacity of a firm to innovate and upgrade primarily in the usage of the local market
resources, the demand of local market and its conditions, the local suppliers and the local firm
characteristics are regarded as explanation given to the industry specific competitiveness in
certain industries in a nation as compared to the other. Porter’s theory of National Competitive
Advantage took into account the role of the government as well that has a direct impact on the
trading activities.

Therefore, as seen, these trade theories embody the principles of trade which are broadly the
protectionist and free trade theory. The next section seeks to explain them in detail.

1.5 PRINCIPLES OF TRADE- FREE TRADE AND PROTECTIONISM

There are two underlying philosophies or principles of trade: Free Trade and Protectionism.
The era of mercantilism saw the spread of protectionism tendencies whereas Adam Smith and
Ricardo advocated Free trade. The fundamental and simplest difference between the two is that
one seeks to impose barriers of trade and the other doesn’t. Protectionism seeks to protect the
nation’s domestic market from the threats of foreign trade. This is done mainly to protect home
industries from foreign competition. Protectionism also helps build up new industries and is
meant as a safeguard. Every country at some point or the other has implemented protectionist

strategies. An example of this is the notorious Smoot Hawley Tariff Act,1930 passed by the
United States Congress which raised tariffs on imported goods. What seemed to be a
protectionist measure, led to the downfall of the US economy resulting in a massive downfall
of imports. The advocates of free trade condemn protectionist measures and project that in
order to realise the true benefits of trade, protectionism should be kept to a bare minimum or
negated completely. Free trade increases the size of the economy as a whole whilst offering
multiple benefits to the consumers ranging from choice of goods to reducing the cost of trading
which in turn reduces costs. The international organisation concerning itself with trade, the
WTO, strives to strike a balance between these philosophies that the developed countries
advocate-free trade, whilst developing and least developed countries tend to implement
protectionist measures to protect their domestic markets from foreign competition. In the latter
categories of countries, such measures are sometimes needed das these nations are not ready to
face competition from foreign markets. Such competition might lead to the destruction of the
markets of developing and least developing nations which is a risk that such nations cannot
afford. Therefore, protectionist strategies are followed. However, many a times trade deals and
even coercive methods or trade-offs, force such nations to move towards a free trade regime.
The free trade versus protectionism debate is one which is never ending. There is no concrete
proof as to which regime is better and what works best. However, one of the major factors that
contribute towards the usefulness of these strategies is in accordance to the nation’s economy
of where it is implemented.

The succeeding chapters will aim to give more insight into these aspects of trade along with
the present day scenario.

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