MODULE-3

INTERNATIONAL TRADE THEORIES

 Module Overview
 Theory of Mercantilism
 Absolute Advantage Theory
 Comparative Advantage Theory
 Hecksher-Ohlin Theory
 The new product life cycle theory
 The new Trade Theory
 Porter’s Diamond Model
 Implications for International Business
Introduction
 International trade theory
 explains why it is beneficial for countries to engage in
international trade
 helps countries formulate their economic policy
 explains the pattern of international trade in the world
economy
An Overview of Trade Theory
Question: What is free trade?

• Free trade refers to a situation where a government does

not attempt to influence through quotas or duties what
its citizens can buy from another country or what they
can produce and sell to another country
Mercantilism
 A nation’s wealth depends on ‘build up wealth’ of Gold and
silver as they were the currency of trade in that age.
 Mercantilism (mid-16th century England) asserted that it is in a
country’s best interest to maintain a trade surplus, to export more
than it imports
 Maximize export through subsidies
 Minimize imports through tariffs and quotas
 it advocated government intervention to achieve a surplus in
the balance of trade
 it viewed trade as a zero-sum game (one in which a gain by one
country results in a loss by another)
 Stayed from 1500-1800, and trade strategy of many nations
were boost exports and limit import.
Limitation of Mercantilism: Zero-Sum Game
In 1752, David Hume pointed out that:
• Increased exports lead to inflation and higher prices
• Increased imports lead to lower prices
 Result: Country A sells less because of high prices and
Country B sells more because of lower prices
In the long run, no one can keep a trade surplus
Mercantilism is problematic and not economically valid, yet
many political views today have the goal of boosting exports
while limiting imports
Theory of Absolute Advantage
Adam Smith 1723-1790
In 1776, Adam Smith in his book The Wealth Of Nations argued:
● Countries differ in their ability to produce goods efficiently.
● A country has an “absolute advantage” when it is the most efficient in
producing a particular product.
(Countries should specialize in producing products for which they have
an absolute advantage, and trade these goods for those produced more
efficiently by other countries.)
● Such trade will be beneficial to both countries. Thus it is a “positive-
sum game”
 Absolute Advantage: An Example
20

Ghana and South Korea can each produce and consume

G cocoa and rice. Each country has 200 units of resources
● Ghana (G) has the resources to produce any
15

combination of cocoa and/or rice that lies

on its Production Possibility Frontier (PPF).

● South Korea (K) has the resources to

10

produce these combinations of cocoa and/or

Cocoa

A rice.

● Without trade, each country devotes half of

K its resources to each product (points A and
5

»
B B).
2.5
G’ K’
0 5 10 15 20
Rice
Absolute Advantage: An Example of Gains from Trade
Cocoa Rice
Ghana 10 20
Resources Required to Produce 1
Ton of Cocoa and Rice. S. Korea 40 10

Production and Consumption Ghana 10.0 5.0

without Trade. S. Korea 2.5 10.0
Total Production 12.5 15.0

Ghana 20.0 0.0

Production with Specialization
S. Korea 0.0 20.0
Total Production 20.0 20.0
Consumption After Ghana Trades 6 Ghana 14.0 6.0
Tons of Cocoa for 6 Tons of S.
S. Korea 6.0 14.0
Korean Rice
Increase in Consumption as a result Ghana 4.0 1.0
of Specialization and Trade S. Korea 3.5 4.0
David Ricardo and
Theory of Comparative Advantage
In 1817, David Ricardo in his book The Principles of Political Economy
extended Smith’s free trade argument:
 A country should specialize in the production of goods that it produces more
efficiently in comparison to other goods — even if the country doesn’t hold an absolute
advantage for that good.
 The country should import the goods it produces less efficiently, even if it can produce
that good all by itself.
 Due to increased efficiency (better use of limited resources), potential world production
is greater with unrestricted free trade.
 Comparative Advantage maximize countries combined output

Therefore, free trade is universally beneficial (a positive-sum game) even when nations do
not have an absolute advantage.
 The Theory of Comparative Advantage
Ghana and South Korea can each produce and consume cocoa and rice.
● Ghana (G) produces both cocoa and rice, with a
20

G comparative advantage in cocoa.

● South Korea (K) is more efficient in producing
rice than cocoa — a comparative advantage in
C
15

rice.
● Ghana is more efficient than S. Korea in the
Cocoa

production of both cocoa and rice — an

A absolute advantage in both products.
10

● Without trade, each country would devote half

of its resources to each product (points A and
K B).
5

● With trade, and specialization in cocoa, Ghana

B
2.5 can produce at point C.
K G’
’
0

3.75 7.5
0 5 10 15 20
Rice
 Comparative Advantage:
An Example of Gains from Trade
Cocoa Rice
Resources Required to Produce 1 Ghana 10 13.3
Ton of Cocoa and Rice. S. Korea 40 20

Production and Consumption Ghana 10.0 7.5

without Trade (points A and B). S. Korea 2.5 5.0
Total Production 12.5 12.5
Ghana 15.0 3.75
Production with Specialization
S. Korea 0.0 10.0
(points C and K’)
Total 15.0 13.75
Consumption After Ghana Trades 4 Production
Ghana 11.0 7.75
Tons of Cocoa for 4 Tons of S.
Korean Rice S. Korea 4.0 6.0

Increase in Consumption as a result Ghana 1.0 0.25

of Specialization and Trade
S. Korea 1.5 1.0
Absolute Advantage Versus
Comparative Advantage
Comparative
Absolute advantage advantage
 Adam Smith's Absolute  But Comparative advantage
Advantage can gain by can gain in production of
production of one good more than one good
 A country enjoys an absolute  A country enjoys a
advantage over another comparative advantage
country in the production of
in the production of a
a product if it uses fewer
resources to produce that good if that good can be
product than the other produced at a lower cost
country does. in terms of other goods.
Assumptions for Absolute advantage and
comparative advantage
The conclusion that free trade is universally beneficial is rather bold for
such a simple model as previously shown. The model has many
unrealistic assumptions, such as…

● There are only two economies, producing two goods.

● There are no transport costs.
● Resource prices are identical in the two countries.
● Trade does not affect income distribution within a country.
● Resources can move from the production of one good to another within
a country.
● There are constant returns to scale.
● That free trade does not change the efficiency with which a country uses
its resources, or the stock of resources.
Limitations of Absolute advantage theory and
comparative advantage theory

 Immobile resources:
 Resources do not always move easily from one
economic activity to another

 Diminishing returns:
 Diminishing returns to specialization suggests that after
some point, the more units of a good the country
produces, the greater the additional resources required
to produce an additional item
 Different goods use resources in different proportions
PPF Under Diminishing Returns
Influence of Free Trade on PPF
 Heckscher-Ohlin Theory
 Comparative advantage arise from differences in Productivity. Swedish
economists Eli Heckscher (in 1919), and Bertil Ohlin (in 1933) had
another explanation for comparative advantage.
 Comparative advantage did not stem from differences in productivity (as
theorized by Ricardo), but from differences in national factor
endowments. (the extent to which a country is gifted with resources
such as land, labor, capital, human resources, capital)
 A country should export goods that intensively use factor endowments
which are abundantly available in the country.
 A country should Import goods that make intensive use of factors which
are scarce.
The Limitation of Heckscher-Ohlin
Theory: The Leontief Paradox
 The Leontief Paradox: In 1953 Wassily Leontief disputed the
Hechscher-Ohlin theory in some instances.
The US is abundant in capital relative to most other nations. So,
according to Hecksher-Ohlin, the US should be an exporter of
capital-intensive goods, and an importer of labor-intensive goods.
Actually, in 1953, US exports were less capital-intensive than US
imports.
 Heckscher-Ohlin is a relatively poor predictor of real-world trade
patterns. Ricardo’s theory is more accurate. In the end, differences
in productivity may be the key to determining trade patterns.
 Product Life-Cycle Theory - Raymond. Vernon
(1966)
Most new products initially conceived & produced in the US in
20th century
● US firms kept production close to the market
▲Work out the innovations of new product introductions
▲Demand not based on price yet so low production cost not an issue
● Limited initial demand in other advanced countries
▲Exports more attractive than production in other countries
● When demand increases in advanced countries
▲Produce in foreign countries when demand necessitate
● As developed market demand matures, new demand comes from
less developed countries
▲Product becomes standardized
▲production moves to low production cost areas
▲Product now imported to US and to advanced countries
Product Life-Cycle Theory
Product Life-Cycle Theory - R. Vernon (1966)
Limitation:
 This theory was based upon what was occurring at that time
in the US. Globalization and integration of the economy
makes this theory less valid today.
The New Trade Theory
The New Trade Theory emerged in the 1970’s. It deals with the
returns on specialization where substantial economies of scale are
present
● Output increases with increased production.

● Economies of scale increase with increased output.

● Unit costs of production should decrease along with economies of

scale.
● The world economy will profitably support only a few firms in
industries with substantial economies of scale.
 The first mover advantage.
 Early entries to an industry may gain a lock on the market as they are
first to gain economies of scale; this discourages new entries — the
first mover advantage.
 Because of economies of scale, trade can increase the variety of
goods available to consumers and decrease the average cost of
those goods
 In those industries Where demand become more crucial, the
global market may only be able to support a small number of
firms
 Important factors to first-mover advantage are:
 luck
 entrepreneurship
 innovation
 government intervention.
Limitation of first mover advantage
 There may be an economic rationale for a strategic or proactive
trade policy if it helps domestic firms become first movers in an
industry; this is in conflict with earlier free-trade theories
 National Competitive Advantage: Porter’s
Diamond

 Michael Porter (1990), of HBS, tried to explain why a nation

achieves international success in a particular industry
 Porter identified four attributes he calls the diamond that promote
or impede the creation of competitive advantage
1. Factor endowments
2. Demand conditions
3. Related and supporting industries
4. Firm strategy, structure, and rivalry
 In addition, Porter identified two additional variables (chance and
government) that can influence the diamond in important ways
 Porter’s Diamond
The conditions in the nation governing how companies
are created, organized, and managed and the nature of
domestic rivalry.

A nation’s
position in The nature of
factors of home demand
production, for the
such as skilled industry’s
labor or product or
infrastructure service.
necessary to
compete in a
given
industry.
The presence or absence in a nation of supplier
industries or related industries that are nationally
competitive.
 Factor Endowments

 Factor endowments: A nation’s position in factors of

production such as skilled labor or infrastructure necessary
to compete in a given industry
 Basic factor endowments (Natural resources, Climate,
Geographic location, Demographics)
 Advanced factor endowments
 Advanced Factor Endowments
Advanced factors: The result of investment by people,
companies, and government are more likely to lead to
competitive advantage
If a country has no basic factors, it must invest in
advanced factors
 Communications
 Skilled labor
 Research
 Technology
 Education
Demand Conditions

 Demand:
 creates capabilities
 creates sophisticated and
demanding consumers

 Demand impacts quality and

innovation
Related and Supporting Industries

 Creates clusters of supporting industries that are

internationally competitive (like suppliers or related
industries)
Firm Strategy, Structure
and Rivalry
 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 company’s
competitiveness
 Porter’s Theory-Predictions

 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
 Implications for Business
 Location implications:
 Separate production activities to countries where they can be performed
most efficiently
 Ex: If design can performed most efficiently in France, it is where design
facility should be kept.
 First-mover implications:
 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
Thank you!