Chapter 5

TRADING
INTERNATIONALLY

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Learning Objectives

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by Mike Peng and Klaus Meyer
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 OPENING CASE:
Port of Rotterdam: gateway to the world
Why does trading
make the
Netherlands one of
the richest nations in
the world – even if
intermediaries such
as the Port of
Rotterdam take a
substantial share
of the benefits?

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 International Trade
International trade is a hot topic in politics as the benefits
of trade are often unevenly distributed.
This chapter starts by outlining the theoretical foundations
for international trade. These theories provide a structured
way of thinking and analyzing issues that are central to both
businesses and government policy.
We begin by outlining how the two core perspectives
introduced in earlier chapters –resource-based and
institution-based views – can help us understand the crucial
issue of why nations trade.
The remainder of the chapter deals with (1) theories and (2)
institutions shaping international trade.

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International Trade

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by Mike Peng and Klaus Meyer
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 Why Nations Trade
• Most nations actively participate in international trade – consisting of exporting
(selling abroad) and importing (buying from abroad). (Table 5.1)
• Trade is undertaken by ‘firms from different nations” – rather than by governments
• Trade contribute to the trade deficit (a surplus of imports over exports) or to the
trade surplus (a surplus of exports over imports) of nation states.
• The theories of international trade are examined in the order in which they evolved:
– Mercantilism,
– Absolute advantage,
– comparative advantage,
– product life cycle,
– strategic trade
– national competitive advantage.
• The first three are often regarded as classical trade theories
• The last three are viewed as modern trade theories.

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 Mercantilism
• Theory of mercantilism 1600 and 1700s
– Wealth of the world (measured in gold and silver) is fixed
and that a nation that exports more and imports less
would enjoy the net inflows of gold and silver and thus
become richer; international trade is viewed as a zero-sum
game.
• Protectionism
– Idea that governments should actively protect domestic
industries from imports and vigorously promote exports.

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 Absolute Advantage
• Free trade (Adam Smith 1776)
– Buying and selling of goods
and services with little or no
government intervention
• Theory of absolute advantage
– Nation gains by specialising
in economic activities in
which that nation has an
absolute advantage.
• Absolute advantage
– To be more efficient than
anyone else in the
production of any good or
service

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Table 5.2 Absolute Advantage

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 Comparative Advantage
• Nation A has an absolute advantage in production of all goods
compared to Nation B.
• As long as Nation B is not equally less efficient in the
production of both goods, Nation B can still choose to
specialise in the production of one good in which it has
comparative advantage.
• Comparative advantage
– Relative (not absolute) advantage in one economic activity
that one nation enjoys in comparison with other nations.
• Opportunity cost
– Cost of pursuing one activity at the expense of another
activity, given the alternatives.

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 Figure 5.3 Comparative Advantage
Ricardo in 1817. suggests that
even if America has an absolute
advantage over Europe in both
cars and aircraft, as long as
Europe is not equally less
efficient in the production of
both goods, Europe can still
choose to specialise
in the production of one good
(such as cars) in which it has
comparative advantage –
defined as the relative (not
absolute) advantage in one
economic activity that one
country enjoys in comparison
with other country.

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 Where do absolute and comparative
advantages come from?
• Smith looked at absolute productivity differences, and Ricardo
emphasised relative productivity differences. But what leads to
such productivity differences?
• Swedish economists Heckscher and Ohlin argued that
absolute and comparative advantages stem from different
resource endowments – namely, the extent to which different
countries possess various resources, such as labour, land and
technology.
• These resources are known as ‘factors of production’.
• The factor endowment theory suggests that nations tend to
export goods whose production requires a lot of those
resources that the country has a lot of.
• Nations develop comparative advantage based on their locally
abundant factors.

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 Classical Theories
• In summary, classical theories, (1) mercantilism, (2) absolute
advantage and (3) comparative advantage (which includes
resource endowments), evolved from approximately 300 years
ago to the beginning of the 20th century.

• More recently, three modern theories, outlined next, emerged.

– Product life cycle
– Strategic trade theory
– National competitive advantage of industries

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 Product Life Cycle
• Vernon developed the product life cycle theory, which was the first
dynamic theory to account for changes in the patterns of trade over
time.
• Vernon divided the world into three categories:
– lead innovation nation (which, according to him, is typically the
– USA),
– other developed nations
– developing nations.
• This theory has been criticised on two accounts:
– it assumes that the USA will always be the lead innovation nation
for new products (sic).
– It assumes a stage-by-stage migration of production that takes at
least several years (if not decades).
• An increasing number of firms now simultaneously launching new
products (such as iPods or game consoles) around the globe.

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 Strategic Trade Theory
• This suggests that strategic intervention by governments in
certain industries can enhance their odds for international
success.

How did strategic

trade policy
contribute to the
creation of the
Airbus A380?

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Government Subsidy
Strategic trade
theorists do not
advocate a
mercantilist policy
to promote all
industries.

They propose to
help a few
strategically
important ones.

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 National competitive advantage of
industries
Porter argues that
the dynamic
interaction of
these four aspects
explains what is
behind the
competitive
advantage of
leading industries
in different
nations.

This is the first multilevel theory to realistically connect firms, industries

and nations. Critics argue that the ‘diamond model’ places too much
emphasis on domestic conditions.
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 For use with International Business
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 For use with International Business
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 Trade Barriers: Tariffs
• There are two broad types of trade barriers: (1) tariff barriers and (2)
nontariff barriers (NTBs). As a major tariff barrier, an import tariff is a tax
imposed on imports.
• Figure 5.6 uses rice tariffs in Japan as a hypothetical example to show
that there are unambiguously net losses – known as deadweight loss.
– Panel A: In the absence of international trade, the domestic price is
P1 and domestic wheat farmers produce Q1, determined by the
intersection of domestic supply and demand curves.
– Panel B: Because the domestic rice price P1 is higher than world
price P2, foreign farmers export to Japan. In the absence of tariffs,
Japanese farmers reduce output to Q2. Japanese consumers enjoy
more rice at Q3 at a much lower price P2.
– Panel C: The government imposes an import tariff, effectively
raising price from P2 to P3. Japanese farmers increase production
from Q2 to Q4, and consumers pay more at P3 and consume less
by reducing consumption from Q3 to Q5. Imports fall from Q2Q3 in
panel B to Q4Q5 in panel C.

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 Figure 5.6 Tariff Rice Imports

• Who is better or worse off with tariffs?

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 Non-Tariff Barriers
• Taken together, trade barriers reduce or eliminate international trade.
– NTBs include (1) subsidies, (2) import quotas, (3) export
restraints, (4) local content requirements, (5) administrative
practices and (6) antidumping duties.
– Import quotas are restrictions on the quantity of imports. Import
quotas are worse than tariffs because with tariffs, foreign goods
can still be imported if tariffs are paid.
– Import quotas are protectionist and there are political costs that
countries have to shoulder in largely pro-free trade environment.
– Voluntary export restraints (VERs) have been developed to show
that on the surface, exporting countries voluntarily agree to
restrict their exports.
– The arsenal of trade warriors also includes antidumping duties
levied on imports that have been sold at less than a ‘fair’ price –
or ‘dumped’ – and thus harm domestic firms.

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 Impact of Trade Barriers

Was the EU right to slam quotas on imports of clothing from China?

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 Free Trade?
• The economic arguments against free trade include:
– the need to protect domestic industries
• At the height of the recession in 2009, British workers at the
Lindsey oil refinery went on strike to protest against IREM, an
Italian construction company, bringing its Italian and
Portuguese workers into the country to conduct expansion
work.
– the necessity to shield infant industries.
• If domestic firms are as young as ‘infants’, in the absence of
government intervention, they stand no chance of surviving
and will be crushed by mature foreign rivals. Thus, it is
imperative that governments level the playing field by assisting
infant industries.
• Political arguments against free trade advance a nation’s political, social
and environmental agenda regardless of possible economic gains from
trade. These arguments include (1) national security, (2) consumer
protection, (3) foreign policy and (4) environmental and social
responsibility.

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 Debates

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Implications for Practice

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CLOSING CASE: Canada and the
USA fight over pigs
1. Why do Canada and the
USA have the largest bilateral
trading relationship in the
world?
2. Why do Canadian products
have such a large market share
in the USA?
3. While 98% of Canada-US
trade flows smoothly, trade
disputes only affect the
remaining 2 %. Some argue
that the Canadians have
over-reacted in this case. What
do you think?

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 Chapter Summary
1. Use resource and institution-based views to explain why nations trade:
• The resource-based view suggests that nations trade because
some firms use their unique resources and capabilities to produce
goods in demand in other nations.
• The institution-based view suggests that national and international
‘rules of the game’ influence the actual flows of international trade.
2. Understand classical and modern theories of international trade:
• Classical theories include (1) mercantilism, (2) absolute
advantage and (3) comparative advantage.
• Modern theories include (1) product life cycles, (2) strategic trade
and (3) the ‘diamond model’.

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 Chapter Summary continued
3. Appreciate how economic and political institutions influence international trade:
• The net impact of various tariffs and NTBs is that the whole nation is worse off
while certain special interest groups (e.g. certain industries, firms and regions)
benefit.
• Economic arguments against free trade center on (1) protection from ‘unfair’
competition and (2) infant industries.
• Political arguments against free trade focus on (1) national security, (2)
consumer protection, (3) foreign policy and (4) environmental and social
responsibility.
4. Participate in two leading debates on international trade:
• The first deals with whether persistent trade deficit is of grave concern or not.
• The second deals with whether service trade will benefit or hurt rich countries.
5. Draw implications for action:
• Discover and leverage comparative advantage of world-class locations.
• Monitor and nurture current comparative advantage of certain
locations and take advantage of new locations.
• Be politically engaged to demonstrate, safeguard, and advance the
gains from international trade.
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Critical Discussion Questions

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Recommended Readings

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