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Absolute Advantage

The Scottish economist Adam Smith developed the trade theory of absolute advantage in 1776. A country that has an absolute advantage produces greater output of a good or service than other countries using the same amount of resources. Smith stated that tariffs and quotas should not restrict international trade; it should be allowed to flow according to market forces. Contrary to mercantilism Smith argued that a country should concentrate on production of goods in which it holds an absolute advantage. No country would then need to produce all the goods it consumed. The theory of absolute advantage destroys the mercantilistic idea that international trade is a zero-sum game. According to the absolute advantage theory, international trade is a positive-sum game, because there are gains for both countries to an exchange. Unlike mercantilism this theory measures the nation's wealth by the living standards of its people and not by gold and silver. There is a potential problem with absolute advantage. If there is one country that does not have an absolute advantage in the production of any product, will there still be benefit to trade, and will trade even occur? The answer may be found in the extension of absolute advantage, the theory of comparative advantage.

Comparative Advantage
The most basic concept in the whole of international trade theory is the principle of comparative advantage, first introduced by David Ricardo in 1817. It remains a major influence on much international trade policy and is therefore important in understanding the modern global economy. The principle of comparative advantage states that a country should specialise in producing and exporting those products in which is has a comparative, or relative cost, advantage compared with other countries and should import those goods in which it has a comparative disadvantage. Out of such specialisation, it is argued, will accrue greater benefit for all. In this theory there are several assumptions that limit the real-world application. The assumption that countries are driven only by the maximisation of production and consumption, and not by issues out of concern for workers or consumers is a mistake.

Product Life Cycle Theory

FPI can be much more volatile than FDI. FDI is more difficult to pull out or sell off.S is no longer the only innovator of products in the world.Foreign Direct Investment refers to international investment in which the investor obtains a lasting interest in an enterprise in another country. . The product life cycle theory was developed during the 1960s and focused on the U. sometimes just by failing to meet the expectations of international investors.S since most innovations came from that market. Consequently. it can be generalised and applied to any of the developed and innovative markets of the world. On the other hand. when a country's economic situation takes a downturn. the large flow of money into a country can turn into a stampede away from it. helping an emerging economy move quickly to take advantage of economic opportunity. and the lending of funds to a foreign subsidiary or branch. plants. Today. as well as the reinvestment of earnings by a wholly owned company incorporated abroad (subsidiary).S. This was an applicable theory at that time since the U. or other financial assets. it is very easy to sell off the securities and pull out the foreign portfolio investment. Although the model is developed around the U. For a country on the rise. none of which entails active management or control of the securities' issuer by the investor. or equipment. FDI is calculated to include all kinds of capital contributions. FPI can bring about rapid development.S dominated the world trade. Companies are forced to introduce the products in many different markets at the same time to gain cost benefits before its sales declines. The international product life cycle theory stresses that a company will begin to export its product and later take on foreign direct investment as the product moves through its life cycle. such as the purchases of stocks. bonds. The reinvestment of earnings and transfer of assets between a parent company and its subsidiary often constitutes a significant part of FDI calculations. FDI. in the form of property. it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility. direct investors may be more committed to managing their international investments. Eventually a country's export becomes its import. the U. Most concretely. Hence. However. and less likely to pull out at the first sign of trouble. Today companies design new products and modify them much quicker than before. FPI (Foreign Portfolio Investment) represents passive holdings of securities such as foreign stocks. creating many new jobs and significant wealth. The theory does not explain trade patterns of today. Unlike FDI.Raymond Vernon developed the international product life cycle theory in the 1960s.

less permanent and do not represent a controlling stake in an enterprise. Comes from: Tends to be undertaken by Multinational organisations Comes from more diverse sources e. financial assets e.Comparison chart Improve this chart FDI FPI What is invested: Involves the transfer of nonOnly investment of financial assets. Investment instruments that are more easily traded. in addition to financial assets.g.technology and intellectual capital.a small company's pension fund or through mutual funds held by individuals. Foreign Protfolio Investment Involvement Involved in management and direct or indirect: ownership control. No active involvement in management. long-term interest Stands for: Foreign Direct Investment . investment via equity instruments (stocks) or debt (bonds) of a foreign enterprise.g.

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