02-03-2020

International Trade Theories

International Business

International Trade Theories

Mercantilism & Neo mercantilism

Theory of Absolute Advantage

Theory of Comparative Advantage

Heckscher (1919)-Olin (1933) Theory

Product Life Cycle Theory

Porter’s National Competitive Advantage Theory

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International Business

Mercantilism
❑ Emerged in England in mid 17th century
❑ Principles of ‘mercantilism’
❖ Countries should export more than it imports
❖ Gold and silver were currency of trade
o accumulating these will result in national wealth and
consequent prestige and power
❖ Maintain a favorable balance of trade (trade
surplus) and avoid an unfavorable balance of
trade (trade deficit)

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International Business

Mercantilism
❑ Limitation of ‘Mercantilism’
❖ In 1752, David Hume pointed out that:
o Increased exports lead to inflation and higher prices
o 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
❖ Viewed trade as ‘zero sum’ game – gain by one country
results in loss by another
❑ Neo-mercantilism
❖ Maintain trade surplus to achieve social or political
objectives

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International Business

Theory of Absolute Advantage

❑ Proposed by Adam Smith in 1776 in his book “The
Wealth of Nations”
❖ Countries differ in their ability to produce goods efficiently
❖ A country has an “absolute advantage” in the production
of a product when it is more efficient than any other
country producing it
❖ Countries should specialise in producing goods for which
they have an absolute advantage and then trade these for
goods produced by other countries
❖ Advantage can be “natural” or “acquired”

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Theory of Absolute Advantage

International Business

Total resources available in

each country = 200 units
Assuming half the
resources – i.e., 100 units
each is allocated to rice
and cocoa in Ghana and S
Korea

Production
Possibility
Frontier (PPF)

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International Business

Theory of Comparative Advantage

❑ Proposed by David Ricardo in 1817 in his book
“The Principles of Political Economy &
Taxation”
❖ As per “Theory of Absolute Advantage” when one
country has absolute advantage in the production
of all goods, such a country might derive no
benefit from international trade
❑ Ricardo showed that this was not the case

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International Business

Theory of Comparative Advantage

❑ According to this theory,
“A country should specialise in the production of
those goods that it produces most efficiently and to
buy goods that it produces less efficiently from other
countries, even if this means buying goods from
other countries that it could produce more efficiently
itself.”
❑ Suggests that trade is a positive sum game, in
which all countries that participate realise
economic gains
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Theory of Comparative Advantage

International Business

Total resources available in

each country = 200 units

Assuming half the resources

– i.e., 100 units each is
allocated to rice and cocoa
in Ghana and S Korea

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International Business
Heckscher (1919)-Olin (1933) Theory
(Factor Proportions Theory)
❑ Comparative advantage arises from differences in
national factor endowments (land, labour and capital)
❑ More abundant a factor, lower will be its cost
❑ Countries will export those goods that make intensive
use of factors that are locally abundant, while
importing goods that make intensive use of factors
that are locally scarce.
❑ International trade is determined by differences in
factor endowments - not productivity
❑ Focus is on relative advantage, not absolute advantage
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International Business

The Leontief Paradox

❑ Wassily Leontief in 1953 postulated based on
Heckscher-Ohlin theory that the United States that
has relatively abundant in capital compared to other
countries should be an exporter of capital intensive
goods and importer of labour intensive goods
❑ He found that the US exports were less capital
intensive than imports
❑ Since this was in variance to the Heckscher – Ohlin
Theory, this came to be known as Leontief paradox

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International Business
Product Life-Cycle Theory - R. Vernon
(1966)
❑ As products mature, both location of sales and
optimal production changes
❑ Affects the direction and flow of imports and exports
❑ Globalization and integration of the economy makes
this theory less valid
❑ As products mature, both location of sales and
optimal production changes
❑ Affects the direction and flow of imports and exports
❑ Globalization and integration of the economy makes
this theory less valid
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International Business

Product life
cycle theory

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International Business

Theory of National Competitive

Advantage – Michael Porter
❑ The theory attempts to analyze the reasons for a
nation’s success in a particular industry
❑ Determinants of competitive advantage of a nation
were based on four major attributes
❖ Factor endowments
❖ Demand conditions
❖ Related and supporting industries
❖ Firm strategy, structure and rivalry

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International Business

Porter’s Diamond
❑ Success occurs where
these attributes exist
❑ More/greater the
attribute, the higher
chance of success
❑ The diamond is
mutually reinforcing

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

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International Business
Factors
Porter’s Diamond present in a
country
Natural
resources

Factor Endowments Basic Factors:

Climate

Geographic
Factor Endowments

location
A nation’s position in
factors of production Demographics
such as skilled labor or
infrastructure necessary Communications
to compete in a given
industry Skilled labor

Advanced
Research
Factors

While basic factors can provide an Technology

initial advantage they must be Result of investment by people,
supported by advanced factors to companies, and government; more
maintain success likely to lead to competitive advantage Education

If a country has no basic factors, it

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International Business

Porter’s Diamond
Demand Conditions
❖ 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
❖ Must also meet requirements of other parts of
the Diamond
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International Business

Porter’s Diamond
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

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International Business FIRM STRATEGY,

STRUCTURE AND RIVALRY
Porter’s Diamond • Large Indian companies
• Global IT services companies
• Global R&D organisations
Example - Indian • GCCs – Global Captive
Companies
IT/ITES Industry • Indian software SMEs
• 3rd largest start-up eco
system in the world

FACTOR ENDOWMENTS
• Large population DEMAND CONDITIONS
• Large no. of engineers • Rapid globalization &
• English as the medium of connectedness
instruction • Large global market
• Location suited for overnight • Companies across the globe
business processing trying to cut cost and improve
• Low salary profitability
• Adequate capital availability • Growing domestic market
• Fairly robust financial system

RELATED AND SUPPORTING

INDUSTRIES
• Well developed telecom
infrastructure
• Large no. of engineering colleges GOVERNMENT
• Well developed computer
hardware industry
• Strong eco-system of technology
companies
• Growth in Defence/ Auto industry
• IT Services→BPM→Engg
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International Business

To recap
❑ Mercantilism
❖ Accumulating gold and silver - ❑ Product Life Cycle Theory
national wealth and power
❖ Location of sales and optimal
❖ Countries should export more than
production changes as per PLC
it imports
❖ Trade – Zero sum game ❑ Porter’s National Competitive
Advantage Theory
❑ Theory of Absolute Advantage
❖ Factor endowments
❖ Efficiency and productivity
❖ Demand conditions
❑ Theory of Comparative Advantage
❖ Related and supporting industries
❖ Comparative efficiency
❖ Firm strategy, structure and rivalry
❑ Heckscher (1919)-Olin (1933) Theory
(Factor Proportions Theory)
❖ Based on national factor
endowments
❖ Liontief’s Paradox
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