UNIT 2: INTERNATIONAL TRADE AND INVESTMENT

I. MERCANTILIST'S VERSION
 Mercantilism stretched over about three centuries enduring in the last quarter of the
18th century.
 It was the period when the nation-states were consolidating in Europe.
 For the purpose of consolidation, they required gold that could best be accumulated
through trade surplus.
 In order to achieve trade surplus, the governments monopolized the trade activities,
provided subsidies and other incentives for export.
 On the other hand, it restricted imports.
 Since the European governments were mainly the empire, they imported low-
cost raw material from the colonies and exported high-cost manufacturer to the
colonies.
 They also prevented colonies from producing manufacturers.
 All this was done in order to generate export surplus.
 Thus, in short, increasing gold holding through export augmentation and import
restriction lay at the root of the Mercantilist Theory of International Trade.
 I. MERCANTILIST'S VERSION
 Again, the Mercantilists had a static view of the world economy. They did
not realize that the gains from trade of a particular country were
possible only at the expense of the other country.

 In fact, trade should promote the welfare of the world economy and not
simplify of a particular nation.

 Moreover, the exponents of this theory ignored the concept of production

efficiency through specialization.

 In fact, it is the production efficiency that brings in gains from trade.

 II. ABSOLUTE AND COMPARATIVE ADVANTAGE
 The classical economists refuted the Mercantilist notion of precious metals and
specie being the source of wealth.

 They thought domestic production was the prime source of wealth.

 And so they took into account the productive efficiency as the motivating factor
behind trade.

 Two such theories need to be mentioned here;

1. Theory of Absolute Advantage propounded by Adam Smith

2. Comparative Advantage propounded by David Ricardo

 II. Theory of Absolute Advantage

• Adam Smith was one of the forerunners of the classical school of thought.

• He propounded a theory of international trade in 1776. It is popularly referred as the

“Theory of Absolute Cost Advantage.”

• He is of the opinion that “the productive efficiency among different countries differs

because of diversity in the natural and acquired resources possessed by them.”

• The difference in natural advantage manifests in varying climate, quality of land,

availability of minerals, of water and other natural resources, while the difference in

acquired resources manifests in different levels of technology and skills available.

 II. Theory of Absolute Advantage
• Adam Smith and His Theory:
 Adam Smith was an 18th-century philosopher renowned as the father of modern
economics, and a major proponent of laissez-faire economic policies.
 In his first book, "The Theory of Moral Sentiments," Smith proposed the idea of the
invisible hand - the tendency of free markets to regulate themselves by means of
competition, supply and demand, and self-interest.
 Smith is also known for his theory of compensating wage differentials, meaning that
dangerous or undesirable jobs tend to pay higher wages to attract workers to these
positions.
 But, he is most famous for his 1776 book "An Inquiry into the Nature and Causes
of the Wealth of Nations."
 He is creator of the modern economics and argument mercantilism to become the
father of concept now known as Gross Domestic Product (GDP).
•

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 II. Theory of Absolute Advantage

 A particular country should specialize in producing only those goods that it is able to

produce with greater efficiency, that is at lower cost; and exchange those goods with

other goods of their requirements from a country that produces those other goods

with greater efficiency or at lower cost.

 II. Theory of Absolute Advantage

• The theory of absolute cost advantage explains how trade helps increase the

total output in the two countries.

• But, it falls to explain whether trade will exist if any of the two countries

produces both the goods at lower cost.

• In fact, this was the deficiency of this theory that led David Ricardo to

formulate the Theory of Comparative Advantage.

 III. Theory of Comparative Advantage

• Ricardo focuses not on absolute efficiency but on the relative efficiency of the
countries for producing goods.

• This is why his theory is known as the Theory of Comparative Cost Advantage.

• In a two-country, two-commodity model, Ricardo argues that a country will

produce only that product which it is able to produce more efficiently.

• The comparative cost advantage that leads to trade and specialize in production
and thereby to increase in the total output in the two countries.
 III. Theory of Comparative Advantage

• Assumptions:

 There is free trade.

 There is no transport cost.

 Labour is homogenous.

 Cost of production is expressed in terms of labour.

 Production is subject to constant returns scale.

 III. Theory of Comparative Advantage

Limitations:

 Assumes that countries will specialize.

 Assumes no trade barriers.

 Assumes no transportation costs.

 Assumes consumers not willing to pay for choice.

 Assumes that Factors of Production and technology are fixed.

III. Theory of Comparative Advantage
 IV. Factor Proportions Theory

• Almost after a century and a quarter of the classical version of the theory of international

trade, the two Swedish economists, Eli Heckscher and Bertil Ohlin propounded a theory that is

known as FACTOR ENDWONMENT theory or the FACTOR PROPORTIONS THEORY.

• Eli Heckscher (1919): Country’s competitive advantage based on relative abundance (scarcity)

of factors of production.

• Bertil Ohlin (1933): Notion of relative factor abundance into a theory of the pattern of

international trade.
 V. NEO- FACTOR PROPORTIONS THEORIES

• Many Economists emphasizes son the point of abundance and scarcity of a particular factor and
the quality of that factor or production that influences the pattern of international trade.

• The quality is so important in their view that they analyze the trade theory in a three-factor
framework instead of two-factor framework taken into account by Heckscher and Ohlin. The
third factor manifests in the form of:

- Human Capital

- Skill-intensity

- Economies of Scale

- Research and Development (R&D) including technology and innovation

 VI. PORTER’S DIAMOND MODEL

 The American strategy professor Michael E Porter developed an economic model for
(small-sized) businesses to help them understand their competitive position in global
markets.
 This Porter Diamond Model, also known as the Porter Diamond Theory of National
Advantage, has been given this name because all factors that are important in global
business competition resemble the points of a diamond.
 Michael E Porter assumes that the competitiveness of businesses is related to the
performance of other businesses.
 Furthermore, other factors are tied together in the value-added chain in a long distance
relation or a local or regional context.

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 VI. PORTER’S DIAMOND MODEL - DIAMOND MODEL CLUSTERS

 Michael E Porter uses the concept of clusters of identical product groups in which there is

considerable competitive pressure.

 Businesses within clusters usually stimulate each other to increase productivity, foster innovation

and improve business results.

 Companies operating in such clusters work according to Porter Diamond Model.

 In addition, they have the advantage that they can move very well on the international market and

that they can maintain their presence and handle international competition.

 Examples of large clusters are the Swiss watch industry and the Hollywood film industry.

•
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 VI. PORTER’S DIAMOND MODEL - DIAMOND MODEL CLUSTERS

 Organizations can use the Porter Diamond Model to establish how they can translate

national advantages into international advantages.

 The Porter Diamond Model suggests that the national home base of an organization

plays an important role in the creation of advantages on a global scale.

 This home base provides basic factors that support an organization, including

government support but they can also hinder it from building advantages in global

competition.

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 Determinants of the Model

1. Factor Conditions:

 This is the situation in a country relating to production factors like knowledge and
infrastructure. These are relevant factors for competitiveness in particular
industries.

 These factors can be grouped into material resources - human resources

(labour costs, qualifications and commitment) - knowledge resources and
infrastructure.

 But they also include factors like quality of research or liquidity on stock markets
and natural resources like climate, minerals, oil and these could be reasons for
creating an international competitive position.
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 Determinants of the Model

2. Related and supporting Industries:

 The success of a market also depends on the presence of suppliers and

related industries within a region. Competitive suppliers reinforce
innovation and internationalization.

 Besides suppliers, related organizations are of importance too.

 If an organization is successful this could be beneficial for related or

supporting organizations. They can benefit from each other’s know-how
and encourage each other by producing complementary products.

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 Determinants of the Model

3. Home Demand Conditions:

 In this determinant the key question is: What reasons are there for a successful
market? What is the nature of the market and what is the market size?

 There always exists an interaction between economies of scale, transportation costs

and the size of the home market.

 If a producer can realize sufficient economies of scale, this will offer advantages to
other companies to service the market from a single location.

 In addition the question can be asked: what impact does this have on the pace and
direction of innovation and product development?

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 Determinants of the Model

4. Strategy, Structure and Rivalry:

 This could provide both advantages and disadvantages for companies in a

certain situation when setting up a company in another country.

 According to Michael Porter domestic rivalry and the continuous search for
competitive advantage within a nation can help organizations achieve
advantages on an international scale.

 In addition to the above-mentioned determinants Michael Porter also mentions

factors like Government and chance events that influence competition between
companies.
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 Determinants of the Model
4. Strategy, Structure and Rivalry:

 This factor is related to the way in which an organization is organized and

managed, its corporate objectives and the measure of rivalry within its own
organizational culture.

 The Furthermore, it focuses on the conditions in a country that determine

where a company will be established.

 Cultural aspects play an important role in this.

 Regions, provinces and countries may differ greatly from one another and
factors like management, working morale and interactions between companies
are shaped differently in different cultures.
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 Determinants of the Model

5. Government:

 Governments can play a powerful role in encouraging the development of

industries and companies both at home and abroad.

 Governments finance and construct infrastructure (roads, airports) and invest

in education and healthcare.

 Moreover, they can encourage companies to use alternative energy or

alternative environmental systems that affect production.

 This can be effected by granting subsidies or other financial incentives.

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 Advantages of the Model

 By using the Porter Diamond Model, an organization may identify what factors
can build advantages at a national level.

 The Porter diamond model is therefore often used during internationalization

efforts.

 Michael E Porter is of the opinion that all factors are decisive for the
competitiveness of a company with respect to their foreign competitors.

 By considering these factors a company will be better able to formulate a

strategic goal.

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 Intra industry Trade
• Ricardo’s comparative advantage theory and Heckscher-Ohlin theorem both had
conceived of inter-industry trade.
• Over the past few decades, intra-industry trade has attained huge proportions.
• “The goods produced in the same industry, irrespective of the fact whether they are
identical from every angle or differentiate on account of brand, etc. come under the
purview intra industry trade.
• It occurs mostly in differentiated products. The products are either vertically
differentiated or horizontally differentiated.
• Vertically differentiated goods have different physical features and different prices.
• Horizontally differentiated goods have similar prices.
• In fact, the trade of such goods takes place under imperfect market conditions. The
market conditions may take varying form, such as monopoly, duopoly, oligopoly,
monopolistic competition, etc.
 Gains from Intra-Industry Trade
• Cost Reduction through different means.

• The benefit of the cost reduction reaches the consumers in form of lower price.

• The consumers get an added advantage. They may have many varieties or brands of a
single product. It is because the different brands have some unique product features.
 Outsourcing and Off-Shoring

• The conventional theories discussed in the trade in final products.

• But, in view of large volume trade in intermediate products emerging on

account of growth of multinational firms and development of transport and
communication in recent decades, the very concept behind such trade needs to
be discussed.