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).

Flaws Of Mercantailism
According to Davis Hume, in the Long run, no country could sustain a surplus on the balance of trade. Government imports restrictions are paid by consumers in the form of higher taxes. Government Subsidies of exports of certain industries are paid by tax payers in form of higher taxes.

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

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

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

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

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 showed that such a country may still derive benefits from International Trade. A country which have absolute advantage in production of all goods can specialize in the production of those goods that the country produces most efficiently & buy those goods that it produces less efficiently from other countries.

Comparative Advantage Theory

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 (Factor Proportion Theory)

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 (Factor Proportion Theory)

According to Heckscher and Ohlin, Factor Endowment (types of resources) varies from country to country. Goods differ according to the types of factors that are used to produce them. Difference in factor endowment leads to difference in factor costs.

Heckscher-Ohlin Trade Model (Factor Proportion Theory)

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.

Heckscher-Ohlin Trade Model (Factor Proportion Theory)

According to HO Theory, A country will have a comparative advantage in producing products that intensively use resources (factors of production) it has in abundance. Ex: Saudi Arabia-abundance of crude oil reserves India - abundance of unskilled labour US abundance of capital China abundance of labour Australia & Canada abundance of land

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 Life Cycle Theory

There are 4 stages in Product Life cycle: Introductory Stage Maturing Stage Standardized product Stage Declining Stage

Product Life Cycle Theory

INTRODUCTORY STAGE: Also known as Innovation stage. In this stage, A firm develops & introduces an innovative product. Early production generally occurs in the domestic market. Better to keep production facilities close to the markets & to the centre of decision making. Companies may sell a small part of their production in foreign markets Exports

Product Life Cycle Theory

MATURING STAGE: In this stage, Demand of product expands domestically & abroad. Domestic production reaches its peak Foreign competitors expands productive capacity. Set up production unit in host country to minimize distribution cost Internationalization of Production.

Product Life Cycle Theory

STANDARDIZED PRODUCT STAGE: In this stage, Product become more standardized & prices becomes the main competitive weapon. Production techniques are no longer exclusive & innovative. Stiff competition from home as well as other developed countries. Domestic production slumps.

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

New Trade Theory

Imperfect Markets and Trade Theory Paul Krugman
Economics of Scale
Internal Economies of Scale (the cost per unit depends on size of the individual firm) External Economies of Scale(the cost per unit depends on the size of the industry, not the firm)

Internal and External Economies of Scale

Internal Economies of Scale: When a company reduces costs and increases production, internal economies of scale have been achieved. External Economies of Scale: External economies of scale occur outside of a firm, within an industry. Thus, when an industry's scope of operations expands due to, for example, the creation of a better transportation network, resulting in a subsequent decrease in cost for a company working within that industry, external economies of scale are said to have been achieved. With external ES, all firms within the industry will benefit.

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.

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.

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.

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?

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

Porters Diamond
Determinants of National Competitive Advantage

FACTOR CONDITIONS: Porter differentiated between Basic factors & Advanced factors. Basic Factors: Land, Labor, Capital, Natural resources, etc. Advanced Factors: Technology, Infrastructure, Education level of work force. Porter said, Favorable Factor conditions leads to favorable competitive conditions in the markets.

Porters Diamond
Determinants of National Competitive Advantage

DEMAND CONDITIONS:
This represents the Consumer Demand, If the consumers are well aware then the firm has to develop high quality product & firm can compete internationally with good quality product & vice versa.

Porters Diamond
Determinants of National Competitive Advantage

RELATED & SUPPORTING INDUSTRY: These are the industries which gives input to the firms & have spill over effect. If the input produced by supporting Industry is superior i.e. of good quality, then the final product is also of good quality & the firm can compete internationally.

Porters Diamond
Determinants of National Competitive Advantage

FIRMS STRATEGY, STRUCTURE & RIVALRY: Different Countries have different ideologies. The more is the rivalry, the more pressure to produce good product & firm can compete internationally with good quality product. Therefore, Rivalry is important to develop world class product.

Thank you.