Theories of International Trade

Importance of International Trade

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Why do countries trade?

Causes for trade:
Availability of products (natural resources, new products, etc.) International price differential as a consequence of:
Productivity differential Differences in technology Differences in factor endowments Economies of scale

Product differentiation and market structure

Mercantilist's view on trade

The Mercantilists View on Trade In the 17th century a group of men (merchants, bankers, government officials, and philosophers) wrote essays on international trade that advocated an economic philosophy known as Mercantilism. In their view, a country becomes rich if it exports more than it imports. The surplus in trade balance will result in an inflow of precious metals; gold and silver. The more precious metals means a richer and more powerful nation. Countries have to do their best to increase exports and restrict imports.

Mercantilist's view on trade

Since all countries cannot have surplus at the same time and because the stock of metals is fixed in the short run, a country gains from trade only at the expense of others. Wealth of nations was measured by the stock of metals they possess. In contrast, today we measure wealth of a nation by its stock of human, man-made, and natural resources available for producing goods and services. Mercantilits advocated strict government control of economic activity because gain from trade comes at the expense of other nations (i.e. zero-sum-game).

Absolute Advantage and the Division of Labor

Theory first introduced by Adam Smith 1776 Absolute advantage - produce a product using the fewest labor hours. Division of labor - specialization in the production process dividing the process into distinct stages performed by exclusively by one individual. Applied to countries based on their product specialization and ability to produce more for less.

Absolute Advantage Theory: Adam Smith

A tailor does not make his own shoes; He exchanges a suit for shoes Each nation specialize and exchange commodities which have absolute advantage. Both nations will gain from trade.

Absolute Advantage Theory: Adam Smith

India is efficient in growing Cotton, but inefficient in growing Wheat. On the other hand, US, is efficient in growing Wheat, but inefficient in Cotton. India has an absolute advantage over US in the cultivation of Cotton. India specialize in Cotton and US in Wheat.

Absolute Advantage Theory: Adam Smith

US
5C

India
6W

Wheat (Bushels/man hour) Cloth (Yards/man hour)

US Exchanges, 6 bushels W = 5 yard C, US gains 1 yard C, or man hour India Exchanges, 5 yard C = 6 bushels W, India gains 5 bushel W, or 5 man hours Both countries gain

Comparative Advantage Theory: David Ricardo

Followed Smith David Ricardo: Principles of Political Economy (1817). If one country is efficient in both products than other, what happens? For example, Portugal can produce both wine and cloth cheaper than England Portugal has an absolute advantage in both Opportunity Cost

Comparative Advantage Theory: David Ricardo

Labour Cost of production (in hours)

1 Unit of Wine

1 Unit of Cloth

Portugal England

80 120

90 100

Comparative Advantage Theory: Gains from Trade

If no trade, in England
120 hours = 1 W 100 hours = 1 C 1 wine will cost 120/100 or 1.2 cloth

Comparative Advantage Theory: Gains from Trade

In Portugal
80 hours = 1 W 90 hours = 1 C 1 wine will cost 80/90 or 0.89 cloth

Comparative Advantage Theory: Gains from Trade

Opportunity Cost of production

1 Unit of Wine

1 Unit of Cloth

Portugal

80/90 = 8/9

90/80 = 9/8

England

120/100 = 12/10

100/120 = 10/12

Comparative Advantage Theory: Gains from Trade

1.13 0.83

In Portugal, 1 wine will cost 80/90 or 0.89 cloth

If Portugal could import more than 0.89 units of cloth in exchange of 1 unit of wine, she would gain.

Comparative Advantage Theory: Gains from Trade

1.13 0.83

In England,1 wine will cost 120/100 or 1.2 cloth

Portugal can export 1 unit of wine to England and get an exchange between 0.89 1.2 cloth

Comparative Advantage Theory: Gains from Trade

1.13 0.83

In international market, if 1Wine exchanges for 1 cloth, advantageous for England. England export cloth and import wine, because, in the absence of trade, she has to give up 1.2 Cloth for 1 Wine and save 0.2 cloth.

Comparative Advantage Theory: Gains from Trade

1.13 0.83

Without trade, Portugal has to give up 1.13 wine to get 1 unit cloth. Portugal export wine and import cloth. Now she can make 1 Wine by 80 hours of labour and exchange 1Wine for 1Cloth. Save 10 labour. Both nations gains from trade than isolation

Heckscher (1919)Ohlin(1933) Trade Model

A country that is relatively labor abundant should specialize in the production of relatively laborintensive goods. It should then export that labor intensive good in exchange for capital-intensive goods. A country that is relatively capital abundant should specialize in the production of relatively capitalintensive goods. It should then export it in exchange for labor-intensive goods.

Heckscher-Ohlin Trade Model

One unit of Good X is produced with 4 units of labor and 1 unit of capital . Since it requires more units of labor, it is classified as a labor intensive good. On the other hand to produce one unit of Good Y 2 units of labour and 4 units of capital are required. Since it uses more amount of capital when compared to Good X, it is called as capital intensive good. Example: Leather goods are labor intensive while computer chips are capital intensive.

Leontief Paradox (1953)

Wassily Leontief (1950) Tested the Factor Proportions theory on goods imported and exported by the United States. Leontief reached a paradoxical conclusion that the USthe most capital abundant country in the world by any criterionexported labor-intensive commodities and imported capital- intensive commodities. Input-Output Analysis: A method for estimating market activities. Considered potential that measures the factor inflows into production and the resultant outflow of products.

Product Life-Cycle Theory (Raymond Vernon, 1966)

Article in the Quarterly Journal of Economics. As products mature, both location of sales and optimal production changes. Affects the direction and flow of imports and exports. Most appropriate for technology-based products. Most relevant to products that eventually fall victim to mass production. Globalization and integration of the economy makes this theory less valid.

Product Cycle Theory

Is supply-side and demand-side in orientation. Three stages: 1. New Product - Highly skilled labor and large capital investment, flexible, high cost of production. 2. Maturing Product - Standardized process, decline in flexibility and highly skilled labor, sales and competition increases. 3. Standardized Product - Product produced by country with cheapest unskilled labor, low profitability, fierce competition, end of product cycle. Important to match the product by its maturity stage to location of production to maintain competitiveness.

The Product Life-Cycle Theory

160 140 120 100 80 60 40 20 0 160 140 120 100 80 60 40 20 0 160 140 120 100 80 60 40 20 0

United States

Exports
Other Advanced Countries

Imports

Exports

Imports
Developing Countries

Exports
Imports
New Product Maturing Product Standardized Product

production consumption

Stages of Production Development

Product Life Cycle Theory

Exports

May be only manufacturer of new

product Overseas customers learn of product, export market develops

Foreign competition
Foreign manufacturers gain experience Compete in export markets

Foreign production

Export volume grows Production technology becomes

Import competition
Foreign producers obtain economies of scale Compete in quality and undersell domestic company in domestic market

stable Reduced costs for transportation Exports diminish

New Trade Theory

Began to be recognized in the 1970s. Deals with the returns on specialization where substantial economies of scale are present. Specialization increases output, ability to enhance economies of scale increase. In addition to economies of scale, learning effects also exist. Learning effects are cost savings that come from learning by doing.

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Application of the New Trade Theory

Typically, requires industries with high, fixed costs. World demand will support few competitors. Competitors may emerge because they got there first.
First-mover advantage. Economies of scale may preclude new entrants.

Some argue that it generates government intervention and strategic trade policy.

New Trade Theory

Imperfect Markets and Trade Theory Paul Krugman
Krugmans Economics of Scale
Internal Economies of Scale External Economies of Scale

New Trade Theory

A firm possessing internal economies of scale can monopolize an industry (creating an imperfect market) - produce more products, lower and set market prices, sell more products. Other firms enter the market on the abandoned market ranges. Intra-industry trade and product differentiation usually occurs as a firm narrows its product line.

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Porters Diamond
(Harvard Business School, 1990)

The Competitive Advantage of Nations. Looked at 100 industries in 10 nations. Thought existing theories didnt go far enough. Question: Why does a nation achieve international success in a particular industry?

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Porters Diamond
Determinants of National Competitive Advantage
Firm Strategy, Structure and Rivalry

Factor Endowments

Demand Conditions

Related and Supporting Industries

Porter claims that four kinds of variables will impact a local firms ability to use a countrys resources to gain a competitive advantage

Determinants of National Competitive Advantage

Factor endowments: nations position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry. Demand conditions: the nature of home demand for the industrys product or service. Related and supporting industries: the presence or absence in a nation of supplier industries or related industries that are nationally competitive. Firm strategy, structure and rivalry: the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.

 Thank you.