THEORIES

OF
INTERNATIONA
L TRADE
 AIM OF THEORIES
• The aim of the trade theories is to understand or answer the
following questions that become quite apparent in international
trade

 Why do countries trade?

 Do countries trade or do firms trade?
 Do the elements that create competitiveness of firms, industries or
countries arise from inherent endowments of the country or do they change
with time and circumstances?
 Once these elements are identified, can they be exploited, manipulated or
managed by firms or governments to benefit the traders?
 EVOLUTION OF TRADE
THEORIES
The Theory of Absolute Advantage
Adam Smith Classical
Trade
Theory
The Theory of Competitive Advantage
David Ricardo

The Theory of Factor Proportions

Eli Heckscher & Bertil Ohlin

The Leontief Paradox Overlapping Product Range Theory

Wassily Leontief Staffan Linder

Product Cycle Theory Imperfect Markets and Trade Theory

Raymond Vernon Paul Krugman

The Competitive Advantage of Nations

Michael Porter
 THEORY OF ABSOLUTE
ADVANTAGE
• Theorized in the year 1776 by Adam Smith

• “Each country should specialize in the production and export of those

goods which it produces most efficiently, i.e, with the lowest number of
labor-hours”

• Speaks of two main areas: “absolute advantage” and “division of labor”

• Production needs labor - the primary element of value in society

• Some countries due to the skills of their workers or quality of natural

resources can produce the same product in lesser man-hours leading to
efficiency called “absolute advantage”
 THEORY OF ABSOLUTE
ADVANTAGE
• Prior to the Industrial Revolution, a worker performed all stages of a
production process limiting output

• The Industrial Revolution led to separation of the production process

into different stages, each performed by one individual thus leading to
“division of labor”

• This led to increase in the production of workers and industry

• This further led to division of labor and specialized product across

countries

• Each country, specializing in products where it possessed “absolute

advantage”, produced more and exchanged the excess for products that
were cheaper than those produced at home
 THEORY OF COMPARATIVE
ADVANTAGE

• Theorized in the year 1819 by David Ricardo

• “Even if one country was most efficient in the production of two

products, it must be relatively more efficient in the production of
one good. It should, therefore, specialize in the production and
export of that good in exchange for the importation of the other
good, leading to comparative advantage”
 THEORY OF COMPARATIVE
ADVANTAGE
Country Wheat Cloth
England 2 man-hours 4man-hours
India 4 man-hours 2 man-hours

• This takes the theory of absolute advantage one step further

• Comparative advantage is about giving up production of one

product where it does not have comparative advantage.

• This leads to trade between countries of products where they have

or do not have comparative advantage
 THEORY OF COMPARATIVE
ADVANTAGE
• When the total man-hours available for production within a
country are devoted to the full production of the product, an idea
can be obtained of the “production possibilities frontiers” of each
country

• This helps to understand the amount of trade-off of producing

one product over another

• When costs or prices are allocated to these trade-offs, it indicates

the opportunity costs, which is the value of a factor of production
in it’s next best use
 GAINS FROM INTERNATIONAL
TRADE
• Without trade, a country consumes what it produces

• Once comparative advantage has been identified, focus should shift to

production of the good it produces best

• This could lead to production exceeding consumption creating surplus

which can be traded internationally

• This could also allow the country to consume more than was earlier
possible leading to welfare of society

• A country can also achieve consumption levels beyond what it can

produce by itself
 FACTOR PROPORTIONS TRADE
THEORY
• Created by Eli Heckscher and Bertil Ohlin

• “A country that is relatively labor-abundant/capital-abundant

should specialize in the production and export of only that
product which is relatively labor-intensive/capital-intensive”

• Considers two factors of production - labor & capital – and

technology would decide the way they combine to produce a
good. Different goods require different proportions of the two
factors of production.
 Factor Proportions Trade Theory
Considers Two Factors of Production

• Labor

• Capital
11
 FACTOR PROPORTIONS TRADE
THEORY
• These factor intensities or proportions are relative and depend on
the basis of what product “X” relative to product “Y”

• e.g leather goods v/s computer memory chips

• Factor intensities depend on the state of technology used,

assuming that the same level of technology is used across
countries

• Hence, does not believe that differences in the efficiency of

production create differentiation in cost of production and
thereby, international trade
 FACTOR PROPORTIONS TRADE
THEORY
• While assuming that labor and capital are immobile and cannot
move across borders, this theory believes that if there is no
difference in technology or productivity, it is the price of the
factors that determine the cost differences

• These prices are dependent on the endowments of labor and

capital that the country possesses.

• Therefore, a country that is relatively labor-abundant should

specialize in the production of relatively labor-intensive goods
and should export those labor-intensive goods in exchange for
capital-intensive goods.
• And vice versa
 FACTOR PROPORTIONS TRADE
THEORY
• Assumptions:
– Assumes that two countries, two products and two factors of production
called as 2x2x2 assumption
– Markets for the inputs and the output are perfectly competitive where labor
and capital were exchanged in markets that paid them only what they were
worth
– Trade of output was competitive so that one country had no market over
the other
– Increasing production of a product leads to diminishing returns. Thus,
increased specialization would require more inputs per unit of output
– Both countries use identical technology, producing each product in the
same way. This confirms that the only way a good can be produced
cheaper in one country than another only if either the labor or capital is
cheaper
 THE LEONTIEF PARADOX
• Wassily Leontief tested the factor proportions theory in 1950

• Tried to explain whether the factor proportions theory could be

used to understand the type of gods exported by the USA

• Devised a method to determine the relative amounts of labor and

capital in a good and called it “input-output analysis”

• A technique that breaks up a good into values and quantities of

labor, capital and other factors employed in the manufacture of
goods
 THE LEONTIEF PARADOX
• Hypothesized that US exports should be more capital intensive than US
imports

• However, he found that the products that the US exported were more
labor-intensive than the products imported by the US
This is called as the “Leontief Paradox”

• It was found that Leontief did not analyze the labor and capital
components of the imports but analyzed the labor and capital contents
of the domestic equivalents of these imports

• Others then debated the need to distinguish different types of labor and
capital, differentiating labor into skilled and unskilled labor and
similarly for capital
 OVERLAPPING PRODUCT RANGES
THEORY
• “The type, complexity and diversity of product demands of a
country increase as the country’s income increases. International
trade patterns would follow this principle so that countries with
similar per-capita income levels will trade more intensely having
overlapping product demands”

• This theory focuses not on the production or supply side but on

the preferences of the consumers – the demand side

• Linder accepted that in natural resource based industries, trade

was determined by relative costs of production and factor
endowments.
 OVERLAPPING PRODUCT RANGES
THEORY
• However, he believed trade in manufactured goods was dictated
not by cost concerns but by the similarity in product demand
across countries

• Theory based on 2 principles:

– As per capita income rises, the complexity and quality level of products
demanded by the population also rises. The total range of product
sophistication demanded by a country’s residents is dependent on its level
of income
– Entrepreneurs that produce the needs of society are more knowledgeable
about their domestic markets than the international markets and hence
cannot serve a foreign market due to lack of experience
 OVERLAPPING PRODUCT RANGES
THEORY
• “International trade in manufactured goods is influenced by a
similarity of demands. The countries seeing the most intensive
trade are those with similar per-capita incomes and possess a
greater likelihood of overlapping product demands”

• The overlapping ranges of product sophistication represent

products that entrepreneurs know well from their home markets
and can therefore potentially export and compete with in
international markets
• e.g: US and Canada v/s US and Mexico

• The overlapping product ranges are today known as “market

segments”
 PRODUCT CYCLE THEORY
• Theory created by Raymond Vernon in 1966

• “The country that possesses comparative advantage in the

production and export of an individual product changes over time
as the technology of manufacturing the product matures”

• Vernon focused on the product, the country and technology of

manufacture and not the factor proportions
 PRODUCT CYCLE THEORY
• While using the assumptions of the factor proportion theory,
Vernon added 2 technology based premises
– Technical innovations leading to new and profitable products require large
quantities of capital and highly skilled labor, which are predominantly
available in highly industrialized, capital-intensive countries
– These technical innovations of both product and methods of manufacture,
go through 3 stages of maturation as the product becomes more
commercialized.
As the manufacturing process becomes more standardized and low-skill labor
intensive, the comparative advantage in production and exports shifts
across countries
Product Cycle Theory
Is supply-side and demand-side in
orientation.

Three stages:
1. New Product - Highly skilled labor and large
capital investment, flexible, high cost of
production.

2. Maturing Product - Standardized process,

decline in flexibility and highly skilled labor,
sales and competition increases.

3. Standardized Product - Product produced by

country with cheapest unskilled labor, low
profitability, fierce competition, end of product
cycle.

Important to match the product by its

maturity stage to location of production to
maintain competitiveness.
 PRODUCT CYCLE THEORY

• The New Product:

– Innovation requires highly skilled labor and large amount of capital for
R&D
– Product is designed and normally manufactured near the parent firm
– The product is non-standardized
– The production process requires a high degree of flexibility
– Costs of production are quite high
– Innovator is a monopoly and hence gets high profit margins
– Price elasticity is low and high income users buy the product irrespective
of the high cost
 PRODUCT CYCLE THEORY

• The Maturing Product:

– Since production expands, the process becomes more standardized

– Due to standardization, the need for highly skilled labor declines
– The innovating country increases exports
– Competitors develop, putting pressure on prices and profit margins
– The innovating firm has to decide on ways to maintain market share
– The challenge now is to decide whether to accept losing market share or to
invest abroad and maintain market share by exploiting factor production
costs
 PRODUCT CYCLE THEORY
• The Standardized Product:
– The product is completely standardized in manufacture
– The country of production becomes the one with the cheapest unskilled
labor
– Competition is fierce and profit margins are low
– The country manufacturing the product at this stage has benefits of net
trade surplus

• Hence, as knowledge and the technology continually change, the

country of the product’s comparative advantage also changes.
 PRODUCT CYCLE THEORY
• Contributions of the theory:
– Speaks of the increasing emphasis of technology on product costs
– Explains international investment
– Recognizes the mobility of capital across countries
– Shifted focus from the country to the product
– Matches product by it’s maturity stage with it’s location of production

• Limitations:
– Most appropriate for technology base products
– Does not take into account products that are resource based or services
– Relevant to products that eventually end up in mass production and hence
cheap labor forces
 THE IMPERFECT MARKETS TRADE
THEORY
• Floated by Paul Krugman in the 1990s

• Trade is altered when markets are not perfectly competitive or

when production of specific products possess economies of scale.
Explains changing trade pattern, including intra-industry trade,
based on the imperfection of both – factor markets and product
markets.

• Focuses on 2 types of economies of scale:

– Internal economies of scale
– External economies of scale
 THE IMPERFECT MARKETS TRADE
THEORY
• Internal Economies of Scale:

– When the cost per unit of output depends on the size of the firm, the larger
the firm the greater the scale benefits and lower the cost per unit
– A firm with internal economies of scale can monopolize an industry creating
an imperfect market, both domestically and internationally
– With lower cost per unit, it lowers market price and sell more since it sets
market prices
– For a firm to expand to enjoy its economies of scale, it has to take away
resources from other domestic industries
– The country then has a narrower range of products in which it specializes,
providing an opportunity to other countries to specialize in the products
abandoned called “abandoned product ranges”
– Then using comparative advantage, countries again search and exploit these
situations
 THE IMPERFECT MARKETS TRADE
THEORY
• This theory also explains the concept of “Intra-industry trade”
• Intra-industry trade: When a country exports and imports the same
product
• Measured with the Grubel-Lloyd Index:
Intra Industry Trade Index (i) = 1 – (X-M)
(X+M)
• The closer the index value to 1, the higher the intra industry trade
in the product category
• The closer the index value to O, the more one-way the trade
between countries exists
• Currently comprises about 25% of global trade
 THE IMPERFECT MARKETS TRADE
THEORY
• External Economies of Scale:

– When the cost per unit depends on the size of the industry and not the size of
the firm, the industry of that country may produce at lower costs than the
same industry smaller in size in another country.

– A country can dominate in world markets in a particular product, not

because it has one massive firm producing huge quantities, but because it
has many small firms together creating a competitive, critical mass

– External economies of scale may not lead to imperfect markets but may
result in an industry retaining dominance in its field in world markets

– This provides an explanation as to why tall industries do not always move to

the country with lowest cost of energy, resources or labor
 THE COMPETITIVE
ADVANTAGE OF NATIONS
•
THEORY
Floated by Michael Porter explaining sustenance of critical mass
for a firm or nation

• “A nation’s competitiveness depends on the capacity of its

industry to innovate and upgrade. Companies gain competitive
advantage because of pressure and challenge. Companies benefit
from having strong domestic rivals, aggressive home-based
suppliers and demanding local customers.”

• Competitive advantage is created and sustained through a highly

localized process. Innovation is what drives and sustains
competitiveness.
 THE COMPETITIVE
ADVANTAGE OF NATIONS
THEORY
PORTER’s DIAMOND OF NATIONAL ADVANTAGE

Firm Strategy,
Structure and Rivalry

Factor Demand
Conditions Conditions

Related and Supporting

Industries
 THE COMPETITIVE
ADVANTAGE OF NATIONS
THEORY
• Factor conditions:

– The appropriateness of the nation’s factors of production to compete

successfully in a specific industry

– Though important, these factors are not the only source of competitiveness.

– More important is the ability of the nation to continually create, upgrade

and deploy its factors of production
 THE COMPETITIVE
ADVANTAGE OF NATIONS
THEORY
• Demand Conditions:

– The degree of health and competition the firm must face from its original
home market

– Firms that can survive and flourish in highly competitive and demanding
local markets are more likely ot gain a competitive edge

– It is the character (demanding customers) of the market and not its size, hat
promotes the continual competitiveness of the firm
 THE COMPETITIVE
ADVANTAGE OF NATIONS
THEORY
• Related and Supporting Industries:

– The competitiveness of all related industries and suppliers to the firm

– A firm operating within a mass of related firms and industries gains and
maintains advantages through close working relationships, proximity to
suppliers and timeliness of product and information flows

– The constant and close interaction is successful when it occurs not only in
terms of physical proximity but also through the firms willingness to work
at it
 THE COMPETITIVE
ADVANTAGE OF NATIONS
THEORY
• Firm Strategy, Structure and Rivalry:

– The conditions of the home nation that either hinder or aid in the firm’s
creation and sustaining of international competitiveness

– No one managerial or operational strategy is universally appropriate

– It needs to be understood in context of the fitness and flexibility of what

works for an industry in a certain nation at a specific time
 THE THEORY OF
INTERNATIONAL INVESTMENTS
• It is a firm (not a country) and a buyer (not a country) that are the
subjects of trade whether domestic or international

• A firm attempts to access a market and its buyers

• The firm wants to utilize its competitive advantage for growth and
profit and can reach this goal through international investments.
• Some other reasons might be:
– Sales into a country are difficult due to high import tariffs
– Need for natural resources that are available in the host country
– Competition pushing for higher efficiency and lower costs of production
would lead a firm to go to a country where factors of production are cheaper
THE FOREIGN DIRECT INVESTMENT
DECISION SEQUENCE
Firma and it’s
Competitive Advantage
1
Change Competitive Exploit Competitive
Advantage Advantage Abroad
2

Produce at home (export) Produce Abroad

Licensing Management
Control Assets Abroad
Contract
4

Joint Venture Wholly Owned Affiliate

5

Acquire Foreign
Greenfield Investment
Enterprise
 THE THEORY OF
INTERNATIONAL INVESTMENTS
Firms as Seekers:

– Seeking Resources :- Copper in Chile, Diamonds in Africa, Petroleum in the

Middle East, Linseed oils from Indonesia
– Seeking Factor Advantages :- Resources could be accompanied by lower cost
labor and other advantages inherent in the country of production
– Seeking Knowledge :- Acquire companies for their technical or competitive
skills. Companies could also relocate around centers of industrial enterprise ,
Silicon Valley, Shoe manufacturing, etc
– Seeking Security :- Firms move internationally seeking political stability or
security. NAFTA has helped Mexico in increasing trade with US and Canada
– Seeking Markets :- A great motivation for MNCs is the ability to gain and
maintain access to newer markets.
 THE THEORY OF
INTERNATIONAL INVESTMENTS
Firms as Exploiters of Imperfections:
• Most of the policies of governments create imperfections covering
the entire range of supply and demand, trade policy, tax policies,
incentives, restrictions, etc

– Imperfections in Access :- “Import Substitution Policies” which restrict

imports of competitive products to allow smaller domestic firms to survive
and prosper. MNCs have set up smaller firms in these countries.
– Imperfection in Factor Mobility :- Restriction by governments on the
mobility of factors of production – low cost labor or capital. MNCs have
exploited this through FDIs combining mobility of capital with immobility
of low-cost labor
– Imperfections in Management :- Cost advantage, economies of scale,
product differentiation, managerial or marketing technique and knowledge.
MNCs have set up businesses using local management
 THE THEORY OF
INTERNATIONAL INVESTMENTS
Firms as Internalizers:

– MNCs normally focus on non-transferable sources of competitive

advantage which is proprietary information possessed by the firm and its
people
– Advantages center around their knowledge to produce a good r provide a
service
– By establishing own multinational operations and by internalizing the
production process, the firm ensures the information core to its
competitiveness is kept confidential
– Management contracts or licensing agreements do not allow effective
transmission of knowledge or are a threat to the loss of knowledge that
leads to competitive advantage for the firm