Theory of International Trade

Why Trade?
Countries benefit from foreign trade They can import resources they lack at home Higher standards of living and greater satisfaction They can import goods for which they are a relatively inefficient producer Specialization often results in increased output and economies of scale Contributes to global interdependence

• • • • •

Concepts of Trade
Mutual Gains From Trade • When trade is voluntary:
– Both sides must expect to gain from it, otherwise they would not trade

Scarcity and Choice • Wants exceed resources
– Choices are necessitated by scarcity

Theory of Mercantilism

Theory Of Mercantilism
• The first theory of international trade called Mercantilism in England, in mid-16th century. • Gold and silver were the currency of trade • Country’s interests was to maintain a trade surplus, to export more than it imported • By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth and prestige—by an English mercantilist writer Thomas Mun in 1630.

• Problems with this theory is that it excludes the fact that in some cases it is good to import • If the import is completely refused, the population will have to do without certain consumer items

Theory of Absolute Advantage

Theory of Absolute Advantage
• Proposed by Adam Smith in 1776 in his book ‘The Wealth of Nations’ • He was a Scottish Classical Economist • Some of his great books are ‘The theory of Moral Sentiments’ and ‘The Wealth of Nations’


• He said, ‘ A country has an absolute advantage in the production of a product more efficiently than any other country

• He said, ‘Countries should specialize in the production of goods for which they have absolute advantage and then trade these for goods produced by other countries.

• Smith’s basic argument that a country should never produce goods that can buy at a lower cost from other countries Examples: • England should specialize in the production of textiles and French in wine and then trade these • Ghana and South Korea doing trade of cocoa and rice

• Smith’s theory can not explain if there should be trade when a country has absolute advantage on all goods over other country • In this case, a country might derive no benefits from international trade

Comparative Cost Theory

Comparative Cost Theory
• It is attributed to David Ricardo an English political economist in 1817 in his book ‘Principles of Political Economy and Taxation’ • He was also a member of Parliament, Businessman, Financier and Speculator

• Some countries have the advantage of producing some goods at a lower cost compared to other countries.  The countries in the long run should specialize in the business in which they enjoy comparatively low cost advantage and export the product while it will import other goods in which other countries have comparatively low cost advantage, if free trade is allowed e.g. Japan in producing electronics and India in textile

The Theory of Comparative Advantage
G 20




A 10 K 5









G’ 15





Cost Per Unit In Man Hrs

Cost Per Unit In Man Hrs

England Portugal

15 10

30 15

The basic message of this theory

• Potential world production is greater with unrestricted free trade than it is with restricted • Consumers in all nations can consume more if there are no restrictions on trade • Trade is a positive sum game in which all countries that participate realize economic gains.

Assumptions of this theory

• The only element of the cost of production is labour • There are no trade barriers • Trade is free from cost of transportation

• An advanced nation may gain an advantage by shifting labour and resources to more profitable goods such as microchips and away from less profitable goods like potato chips. Thus there is a chance that the advanced nation may buy all the potato chips it wants as it has more wealth for microchips • Advanced industrial countries may keep undeveloped countries on agriculture instead of developing their own manufactures (which would have made them competition for the industrialized nations)

Hecksher-Ohlin Theory

Hecksher-Ohlin Theory
• Swedish economists-Eli Heckscher(1919) & Bertil Ohlin(1933) • Ohlin-student of Hecksher

Eki Heckscher

Bertil Ohlin

H-O Theory is based upon two postulates: 1.The factor endowments are different in different countries.
– E.g. Land-Argentina & Australia – Labour- INDIA & China – Capital-U.S.A & U.K.

2.Different commodities require for their production different proportions of the factors of production.

• They gave a different explanation of comparative advantage • They argued that comparative advantage arises from differences in national factor endowments (land, labor, capital) • Different factor endowments among countries explain differences in factor costs. • The more abundant a factor, the lower its cost • Export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are scarce.

• It is based on the neo-classical theory which considers land ,labour and capital as the factors of production. • Factor endowments vary in quantity but are homogenous qualitatively. • Resources are fully employed in the trading countries. • The production are fully employed in the trading countries. • Technologies are same across countries.

• H-O model takes these factors-land, labour & capital–as against the one factor (labour) of the classical model. • It is cast within the framework of the general equilibrium theory of value.

• It is more realistic because it is based on the relative prices of factors which in turn influences the relative prices of the goods, while Ricardian theory considers the relative price of goods only. • Considers differences in relative productivity of labor and capital as a basis of international trade.

• Theory explains trade being due to differences in factor proportions between countries. This implies that no trade will take place between countries endowed with similar factor endowments • Theory ignores factors such as-transport cost, economies of scale, etc. • Wijanholds-price of commodity not determined by factors of production • S.Linder(Swedish economist)-It is not applicable to manufactured goods, where the costs largely depend upon technology, management, scale of production, etc.

• Assumption that don’t hold good in a dynamic world
– fixed factor endowments – Technology

• J.H.Williams-contends the assumption of immobility of factors between countries • Theory is not supported by empirical evidence

The Leontief Paradox

The Leontief Paradox
• Wassily.W.Leontief (19061999) • 20th century Russian born U.S. Economist. • Ph.D in Berlin. • Father of input output analysis. • Winner of Nobel Prize in economics in 1973. -

What was tested?
• Heckscher-Ohlin theory states that each country exports the commodity which uses its abundant factor intensively. • The first serious attempt to test the theory was made by Professor Wassily W. Leontief in 1954.

• Leontief reached a conclusion that the US—the most capital abundant country in the world exported labor-intensive commodities and imported capital- intensive commodities. • This result has come to be known as the Leontief Paradox.

How the test was performed?
• Leontief used the 1947 input-output table of the US economy. • 200 groups of industries was aggregated into 50 sectors. • Computed the labour & capital requirements. • This was done for 1 million dollars worth of exports and import replacements.


• US exports were labour intensive. • US imports were capital intensive

Leontief's Second Test
• Leontief was criticized on statistical groundsSwerling complained that 1947 was not a typical year: the postwar disorganization of production overseas was not corrected by that time. • In 1956 Leontief repeated the test for US imports and exports which prevailed in 1951. • He aggregated industries into 192 industries. • He found US imports were still 6% more capitalintensive.

Trade Patterns of Other Countries




1 2 3 4

and Ichimura, 1959) Canada(Wahl, 1961) East Germany (Stolper and Roskamp,1961) India(Bharawaj, 1962)

Capital-intensive Labour-intensive

• MethodologyIt was basically concerned with export industries and competitive import replacements rather than actual imports. • He did not measure or compare factor endowments of America with those of other trading nations.

Hecksher-Ohlin theory was defended by some other economists(R.Jones and Hoffmeyer)

• Very high domestic demand of capital intensive goods. • Difference in characteristics of labour across countries. Example: US tends to specialize in technology intensive products that require more highly educated labour. • He did not deal adequately with natural resource component of goods.

• Ohlin’s theory is irrefutable because it cannot be put to perfect empirical test on account of its unrealistic and restrictive assumptions. • When we consider the impact of technology on productivity is not taken into consideration,the Heckcher-Ohlin theory gains predictive power.

Product Life Cycle Theory

PLC Theory
• • Proposed by: Raymond Vernon in mid-1960s Raymond Vernon was part of the team that overlooked the Marshall plan, the US investment plan to rejuvenate Western European economies after the Second World War. He played a central role in the postworld war development of the IMF and GATT organisations. He became a professor at Harvard Business School from 1959 to 1981 and continued his career at the John F. Kennedy School of Government.

About the theory: • Based on the observation that new products had been developed by U.S firms and sold first in U.S market • Two fundamental principles1. Technology 2. Market size and structure

Overview: • It was a trade theory beyond Ricardo’s theory • It is an internationalization process • Products advanced in technology are produced & sold in the home market • Bypasses the trade barriers • In the end the innovator becomes the importer of the product • It is produced by lesser developed countries or, if the innovator has developed an MNC there

• Three stages:
1. 2. 3. New-product stage Maturing-product stage Standardized-product stage
New-product stage

Maturing-product stage

Standardized-product stage

1. New-Product Stage: • Conditions for success:
– Availability of sufficient scientists and engineers – Higher per capita income

• • • • •

Flexibility in production Demand is relatively price inelastic Product features given more priority than price Close contact with the market Few players in the domestic market as competitors

• How to meet increase in demand?
– Exports – Foreign production

2. Maturing-Product Stage: • Transition from New-Product Stage– Price competition – Technology is diffusing

• Price elastic demand for the product • Standardization of production process • Change in company strategy away from focus on production toward market protection. • Product differentiation

• Market growth slows • Toward the end of this stage, foreign production may even be exported to the home country

3. Standardized-Product Stage: • Technology becomes widely available • Price competition • Production shifted to less developed countries • Offshore assembly • Strategy to combat price competition-Product differentiation • Principal markets gets saturated • Innovator’s original advantage gets eroded

International Product Life Cycle

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 Imports

production consumption

Other Advanced Countries


Developing Countries
Exports Imports
New Product Maturing Product Standardized Product

Stages of Production Development

PLC Theory-Examples
Japan & Western Europe Photocopiers-Xerox(1960) Exported to advanced countries Growth in demand Joint venture-production Fuji-Xerox(Japan) Rank-Xerox(Great Britan) Expiry of Xerox’s patent Entry of competitors Canon(Japan) Olivetti(Italy) Import from low-cost foreign sources (developing countries)


• Pocket calculator
Sunlock Comptometer Corp. $1000

1970s Competitors-HP, Texas Instruments

1975 Standardizedproduct stage $10/$15


Polaroid Land camera
1948 1976 1987 Late Newproduct/early Maturity stage 1992 47% sales-foreign operations(18 countries) Price competition

Introduced by Polaroid Corp.

Competition from Kodak

• The New-Product stage lasted approximately for 30 years.

Finland’s Nokia • Finland
– sparsely populated – Extremely cold climatic condition

• How it developed competitive edge?

German Cars: • Germany is the leader in production of cars. • It produces cars like VW, Mercedes – Benz, BMW, Formula one cars etc • It sells its products in the home market • It exports to the advanced countries like USA, UK, France, etc & even in Asia • It has not yet reached the third stage

PLC Theory-Merits
• Helps organizations going for international expansion • New product development in a country does not occur by chance • The model is best applied to consumer oriented physical products like electronic items

PLC Theory-Demerits
• Duration of each stage is not known • Doesn’t explicitly state to make the choice between-export and foreign plant • It doesn’t explain which country’s firms are most likely to produce in any given market or which firms will move first. • Vaguely defines ‘product’

Other Demerits: • Its main assumption was that the diffusion of new technology occurs slowly. By the late 1970’s he recognized that this assumption was no longer valid • It assumed integrated firms producing in one nation, then exporting and building facilities abroad. But now the business landscape has become more interrelated • He emphasized the product level and not the consumer side • Foreign markets are composed of not only one set of income earners but multiple income segment


• Global web of productive activities • Factors considered
– Comparative advantage – Factor endowments
(France) Manufacture (Singapore)

• Gives competitive advantage

Assembly (China)

Example: Laptop production • Stages involved
1. 2. R&D Manufacture-std. electronic comp.
   capital-intensive Semi-skilled labour Intense cost pressure Mexico
Std. electronic comp.


Japan & US


Manufacture-advanced comp.
   capital-intensive Skilled labour Less cost pressure Low-skilled labour Intense cost pressure



Singapore, Taiwan,


 

Japan & US

Advanced comp.

Malaysia, South Korea

• By dispersing production activities to different locations around the globe, the U.S manufacturer is taking advantage of the differences between countries identified by the various theories of international trade.

Implications-Govt. Policy
• The theories of international trade claim that promoting free trade is generally in the best interests of a country • US Govt.-placed tariff on Japanese imports of LCD screens(1991)
– Protested by IBM and Apple Computer – It was later reversed

• In contrast, US Govt. was forced by US firms to place restrictions on imports of steel

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