Theories

of
International
Trade

4-2

Learning Objectives

To understand the traditional arguments

of how and why international trade
improves the welfare of all countries
To review the history and compare the
implications of trade theory from the
original work of Adam Smith to the
contemporary theories of Michael Porter
To examine the criticisms of classical trade
theory and examine alternative viewpoints
of which business and economic forces
determine trade patterns between countries

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4-3

Evolution of Trade Theories

Mercantilism
Absolute advantage (Classical)
Comparative advantage
Factor Proportions Trade
International Product Cycle
New Trade Theory
National competitive advantage

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4-4

Mercantilism: mid-16th century

A nations wealth depends on accumulated

treasure

Theory says you should have a trade surplus.

Gold and silver are the currency of

trade
Maximize export through subsidies.
Minimize imports through tariffs
and quotas

Flaw: restrictions, impaired growth

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4-5

Defining mercantilism

trade theory holding that nations

should accumulate financial wealth,
usually in the form of gold (forget
things like living standards or
human development) by encouraging
exports and discouraging imports

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4-6

Theory of absolute advantage

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
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
Assumes there is an absolute balance among
nations

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4-7

Theory of absolute advantage

destroys the mercantilist idea since there

are gains to be had by both countries party to
an exchange
questions the objective of national
governments to acquire wealth through
restrictive trade policies
measures a nations wealth by the living
standards of its people

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4-8

Theory of absolute advantage

PPF Production Possibility Frontier

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4-9

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Theory of comparative advantage

David Ricardo: Principles of Political Economy (1817)

413

Extends free trade argument

Efficiency of resource utilization leads to more
productivity
Should import even if country is more efficient in the
products production than country from which it is
buying.
Look to see how much more efficient. If only
comparatively efficient, than import.

Makes better use of resources

Trade is a positive-sum game

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414

Theory of comparative advantage

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Comparative advantage and the gains

from trade

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Comparative advantage:
Bollywood

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Assumptions and limitations

420

Driven only by maximization of production

and consumption
Only 2 countries engaged in production and
consumption of just 2 goods?
What about the transportation costs?
Only resource labour (that too, nontransferable)
No consideration for learning theory

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Factor proportions theory

Heckscher (1919) - Olin (1933) Theory

Export goods that intensively use factor endowments
which are locally abundant
Corollary: import goods made from locally
scarce factors

421

Note: Factor endowments can be impacted by

government policy - minimum wage

Patterns of trade are determined by differences in

factor endowments - not productivity
Remember, focus on relative advantage, not absolute
advantage

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Factor proportions theory

422

trade theory holding that countries produce

and export those goods that require resources
(factors) that are abundant (and thus cheapest)
and import those goods that require resources
that are in short supply
Example:

Australia lot of land and a small population

(relative to its size)
So what should it export and import?

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Factor Proportions Trade Theory

Considers Two Factors of Production

423

Labor

Capital
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Factor Proportions Trade Theory

424

A country that is relatively labor

abundant (capital abundant)
should specialize in the production
and export of that product which is
relatively labor intensive (capital
intensive)
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The Leontief Paradox

425

The Test:
Could Factor Proportions Theory be used
to explain the types of goods the United
States imported and exported?

The Method:
Input-output analysis
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The Leontief Paradox

426

The Findings:
The U.S. exported labor-intensive
products and imported capital-intensive
products.

The Controversy:
Findings were the opposite of what was
generally believed to be true!
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Product life-cycle Theory

427

R.Vernon (1966)

trade theory holding that a company will

begin by exporting its product and later
undertake foreign direct investment as the
product moves through its lifecycle
As products mature, both location of sales and
optimal production changes
Affects the direction and flow of imports and
exports
Globalization and integration of the economy
makes this theory less valid

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Product life cycle theory

428

Fig 4.5

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The Product Cycle and Trade

Implications
Increased emphasis on technologys
impact on product cost
Explained international investment
Limitations

429

Most appropriate for technology-based

products
Some products not easily characterized by
stages of maturity
Most relevant to products produced through
mass production

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New trade theory

430

In industries with high fixed costs:

Specialization increases output, and the

ability to enhance economies of scale
increases
Learning effects are high. These are cost
savings that come from learning by
doing

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New trade theory - applications

Typically, requires industries with high, fixed

costs

World demand will support few competitors

Competitors may emerge because of Firstmover advantage

431

Economies of scale may preclude new entrants

Role of the government becomes significant

Some argue that it generates government

intervention and strategic trade policy

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432

Theory of national competitive advantage

The theory attempts to analyze the reasons for a

nations success in a particular industry
Porter studied 100 industries in 10 nations

postulated determinants of competitive advantage

of a nation based on four major attributes
Factor

endowments
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry
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Porters diamond

433

Success occurs where

these attributes exist.
More/greater the
attribute, the higher
chance of success
The diamond is
mutually reinforcing

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Factor endowments

434

Factor endowments:- A nations position in

factors of production such as skilled labor or
infrastructure necessary to compete in a given
industry
Basic factor endowments
Advanced factor endowments

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Basic factor endowments

Basic factors: Factors present in a country

435

Natural resources
Climate
Geographic location
Demographics

While basic factors can provide an initial

advantage they must be supported by
advanced factors to maintain success

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Advanced factor endowments

436

Advanced factors: Are the result of

investment by people, companies,
government and are more likely to lead to
competitive advantage
If a country has no basic factors, it must
invest in advanced factors

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Advanced factor endowments

437

communications
skilled labor
research
Technology
education

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Demand conditions

Demand:
creates capabilities
creates sophisticated
and demanding
consumers

Demand impacts quality

and innovation

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Related and supporting industries

Creates clusters of supporting industries that

are internationally competitive

Must also meet requirements of other parts

of the Diamond

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Firm Strategy, Structure and Rivalry

440

Long term corporate vision is a determinant of

success
Management ideology and structure of the
firm can either help or hurt you
Presence of domestic rivalry improves a
companys competitiveness

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441

Determinants of Competitive Advantage

in nations
Fig 4.8

Chance

Two external
factors that
influence the
four
determinants.

Company Strategy,
Structure,
and Rivalry
Factor
Conditions

Government
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Conditions
Related
and Supporting
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Porters Theory-predictions

Porters theory should predict the pattern of

international trade that we observe in the real
world

Countries should be exporting products from

those industries where all four components of
the diamond are favorable, while importing in
those areas where the components are not
favorable

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Implications for business

Location implications:

Disperse production activities to countries where

they can be performed most efficiently

First-mover implications:

443

Invest substantial financial resources in building a

first-mover, or early-mover advantage

Policy implications:

Promoting free trade is in the best interests of the

home-country, not always in the best interests of
the firm, even though, many firms promote open
markets

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India in the global competitiveness report

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