International BUSINESS Management Module - 1: Dr. Deepa Kapoor Amity School of Business

Amity School of Business
International BUSINESS MANAGEMENT MODULE 1

Dr. Deepa Kapoor Amity School of Business
International Trade Theories
What is international trade?

Exchange of raw materials and manufactured goods (and services) across national borders
Classical trade theories:

explain national economy conditions--country advantages--that enable such exchange to happen
New trade theories:

explain links among natural country advantages, government action, and industry characteristics that enable such exchange to happen
Classical Trade Theories

Mercantilism (pre-16th century)
Takes an us-versus-them view of trade
Other countrys gain is our countrys loss
Free Trade theories

Absolute Advantage (Adam Smith, 1776) Comparative Advantage (David Ricardo, 1817) Specialization of production and free flow of goods benefit all trading partners economies
Free Trade refined

Factor-proportions (Heckscher-Ohlin, 1919) International product life cycle (Ray Vernon, 1966)
Mercantilism: mid-16th century

A nations wealth depends on accumulated treasure
Gold and silver are the currency of trade
Theory says you should have a trade surplus.

Maximize export through subsidies. Minimize imports through tariffs and quotas
Flaw: zero-sum game
Absolute Cost Advantage Theory

Adam Smith: Wealth of Nations (1776) argued:
Capability of one country to produce more of a product with the same amount of input than another country can vary A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient Trade between countries is, therefore, beneficial
Assumptions of Classical theory

2 X 2 model There is different labour cost in different nations Labour is the only factor of production Both countries can produce both goods if they wish. Countries can exchange the products they produce at a lower cost with each other. Constant returns to scale prevails. No transportation cost. Full mobility of labour within the economy but perfect immobility outside the economy
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Absolute Advantage Theory- Smith

Two countries (India and Malaysia) Two commodities (Rubber and Textile) Let a labour in Malaysia can produce 50 units of Rubber or 25 units of textiles. Let a labour in India can produce either 25 units of rubber or 50 units of textile with given factors.
Production and Consumption levels in Autarky

Commodities
Countries Malaysia India Rubber (units/labour) 50 25 Textiles (units/labour) 25 50 GNP (units 75 75
World
75
75
150
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Production levels after International Trade

Commodities
Countries
Malaysia India World
Rubber (units of 2 labours)

100 00 100
Textiles (units of 2 labours)

00 100 100
GNP (units
100 100 200
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Complete specialization according to absolute advantage. Production gain from international trade. Consumption gain from international trade. As long as the terms of trade lie somewhere between the two internal cost ratios, both countries will share the gains from trade equally or unequally.
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Consumption shares after international trade

Suppose terms of trade prevailing in the market is 1:1
Commodities
Countries Rubber (units) Textiles (units) GNP (units
Malaysia India World
50 50 100
50 50 100
100 100 200

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Suppose terms of trade prevailing is 2:1 ( two units of rubber are exchanged for one unit of textile) Commodities
Countries Malaysia India World Rubber (units) 50 50 100 Textiles (units) 25 75 100 GNP (units 75 125 200
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Suppose terms of trade prevailing is 1:2 ( one unit of rubber is exchanged for two units of textile) Commodities
Countries Malaysia India World Rubber (units) 75 25 100 Textiles (units) 50 50 100 GNP (units 125 75 200
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Limitations of Absolute Advantage Theory

It has not advocated the aspects of quality and brand of product. It has restricted itself only to consider the labour force. Other costs like transportation, export import duties etc are not included. What if one trading nation has absolute advantage in both & the other has in neither It fails to explain the fact that even less-developed countries, which have no real absolute advantage in any commodity, are engaged in the export of goods.
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Comparative Cost advantage Theory: David Ricardo

According to this theory, the comparative difference in cost leads to trade between two nations. Each country should specialise in the production of a commodity in which it has a comparative advantage in cost. The country should export these commodities and import those commodities that it produces at a higher comparative cost.
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International trade takes place because different countries have different advantages in the production of different commodities. A country will specialise in the production of that commodity in which it has a greater comparative advantage or its comparative disadvantage is the least. One country is said to have a comparative advantage over another country in the production of a particular good if it produces that good with lower opportunity costs.
Comparative Advantage
Oil (Barrels) Whisky (Litres)
Russia Scotland
10 or 20 or
5 40
One unit of labour in each country can produce either oil OR whisky. A unit of labour in Russia can produce either 10 barrels of oil per period OR 5 litres of whisky. A unit of labour in Scotland can produce either 20 barrels of oil OR 40 litres of whisky.
Russia: if it moved 1 unit of labour from whisky to oil it would sacrifice 5 litres of whisky but gain 10 barrels of oil (OC = 5/10 = )
Moving 1 unit of labour from oil to whisky production would lead to a sacrifice of 10 barrels of oil to gain 5 litres of whisky (OC of whisky is 10/5 = 2)
Scotland: if it moved 1 unit of labour from whisky to oil it would sacrifice 40 litres of whisky but gain 20 barrels of oil (OC = 40/20 = 2)
Moving 1 unit of labour from oil to whisky production would lead to a sacrifice of 20 barrels of oil to gain 40 litres of whisky (OC of whisky is 20/40 = )
Comparative Advantage
In Russia, oil can be produced cheaper than in Scotland (Russia only sacrifices 1 litre of whisky to produce 2 extra barrels of oil whereas Scotland would have to sacrifice 2 litres of whisky to produce 1 barrel of oil.
There can be gains from trade if each country specialises in the production of the product in which it has the lower opportunity cost Russia should produce oil; Scotland, whisky.
Before trade each country divides its labour between the two products:
Oil (Barrels)
Whisky (Litres)
Russia Scotland Total Output
5 10 15
2.5 20 22.5
After specialisation each country devotes its resources to that in which it has a comparative advantage.
Oil (Barrels)
Whisky (Litres)
Russia Scotland Total Output
10 0 10
0 40 40
Limitations of Early Trade Theories

Do not take into account the cost of international transportation Tariffs and import restrictions can distort trade flows Scale economies can bring about additional efficiencies When governments selectively target certain industries for strategic investment, this may cause trade patterns contrary to theoretical explanations Today, countries can access needed low-cost capital on global markets Some services do not lend themselves to cross-border trade
Conclusion of Classical Theory

Comparative cost differences are the main reason for trade which arise due to difference in production functions among countries. Difference in production functions is the precondition for international trade to occur. Gains from trade are been divided among member nations on the basis of international terms of trade.
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Modern Theory of International Trade / Factor Endowment Theory

It has two propositions:
Heckscher-ohlin theorem, given by Swedish economists, Eli Heckscher (1919) and Bertil Ohlin (1933).
Factor Price Equalisation Theorem
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Heckscher-Ohlin theorem
The immediate cause of international trade is the differences in relative prices of commodities between the countries, and these differences in commodity prices arise on account of differences in the factor supplies in the two countries Some countries have more capital than labour. The country having abundant capital will produce and export capital intensive goods, and the countries with abundant supply of labour will produce and export labour intensive commodities.
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One factor is regarded as scarce or abundant in relation to the quantum of other factors. A country is capital abundant if and only if it is endowed with a higher proportion of capital to labor than the other country. OR A country in which capital is relatively cheap and labor is relatively expensive is regarded as capital abundant economy. Similarly a country is labour intensive if the ratio of labour is higher and labour is cheap in regards with other factors when compared with other countries.
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Assumptions
2X2X2 Two factors of production: labor and capital. Two countries: differ in factor endowments Two commodities Relative factor intensities are the same for each good in the two countries. So one commodity is capital intensive in both the countries, and other commodity is labor intensive in both countries. Both nations use the same technology in production. Both commodities are produced under constant returns to scale in both nations. There is incomplete specialization in production in both nations.
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Country A Supply of labor = 25 units Supply of capital = 20 units Capital labor ratio = 0.8 Country B Supply of labor = 12 units Supply of capital = 15 units Capital labor ratio = 1.25 Country B is capital intensive and County A is labor intensive.
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Factor Price Equalization Theorem

The effect of trade is to equalize factor prices between countries. Given all the assumptions of the HO model, free international trade will lead to the international equalization of individual factor prices. International trade increases the demand of abundant factors International trade reduces the demand of scarce factors Goods containing a large proportion of abundant factors are exported. Goods containing a large proportion of scarce factors are imported.
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Evaluation of factor Endowment theory

Better than classical theory as it keeps in consideration the reasons for difference in cost of production. Based on normal demand and supply principle. Indicates effect of trade on product and factor prices. The theory indicates that international trade will have following results: Equalisation of commodity prices Equalisation of factor prices
Criticisms of H-O theory

Factor intensity reversal argument Demand reversal argument Leontief paradox
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Superiority/ Difference of H-O Model over classical theory

Classical Theory
2 X 2 model. Based upon labor theory of value. Limited scope. Trade improves welfare of every individual. Difference in production functions of the two countries.
Modern Theory
2 X 2 X 2 model. Based upon General theory of production. Wider aspect. No comment on sure gains. Identical production functions but factor proportions are different.
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International BUSINESS Management Module - 1: Dr. Deepa Kapoor Amity School of Business

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