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Chapter 4 International Trade Theory
Chapter 4 International Trade Theory
1. Introduction
2. Mercantilism
3. Absolute Advantage
4. Natural Advantage
5. Acquired Advantage
6. Comparative Advantage
7. Some Assumptions and Limitations of the Theories of
Specialization
8. Theory of Country Size
9. Factor-Proportions Theory
10. The Product Life Cycle Theory of Trade
11. Country Similarity Theory
12. Degree of Dependence
13. Why Companies Trade Internationally?
14. Companies’ Role in Trade
15. Case Study
Introduction
International trade theory is a sub-field
of economics which analyzes the patterns of international
trade, its origins, and its welfare implications. International
trade policy has been highly controversial since the 18th
century. International trade theory and economics itself have
developed as means to evaluate the effects of trade policies.
International trade theories are simply different theories to
explain international trade. Trade theory focuses on three
basic questions:
1. What products to import and export?
2. How much to trade?, and
3. With whom to trade?
Basis Theories
Interventionist Mercantilism
Theory
Free Trade 1. Absolute Advantage
Theories 2. Comparative Advantage
Trade Pattern 1. Country Size
Theories 2. Country Similarity
Theory
The Statics and 1. Product Life Cycle
Dynamics of Trade 2. Porter's Diamond
Model
Factor Mobility Factor-Proportions Theory
Theory
Mercantilism
According to this theory, countries should
export more than they import.
To export more than they imported, govts. impose
restrictions on imports, and they subsidese production
of many products that could otherwise not produce in
domestic or export markets. Some countries use their
colonial possessions, such as Sri Lanka under British
rule, to support this objective.
A favorable balance of trade still indicates that a
country is exporting more than it is importing. An
unfavorable balance of trade indicates the opposite,
which is known as a deficit.
Recently the term neo-mercantilism has emerged to
describe the approach of countries that try to run
favorable balance of trade in an attempt to achieve
some social and political objective.
Absolute Advantage
The concept of absolute advantage is generally attributed to Adam
Smith for his 1776 publication An Inquiry into the Nature and
Cause of Wealth of Nations in which he countered mercantilists’
ideas.
A country can:
i) maximize its own economic well being by specializing in the
production of those goods and services that it produces
more efficiently than any other nation and
ii) enhance global efficiency through its participation in free trade.
Smith reasoned that:
•• workers become more skilled by repeating the same tasks
•• workers do not lose time in switching from the production of
one kind of product to another
•• longer production runs provide greater incentives for the
development of more effective working methods
In economics, absolute advantage refers to the ability of a
party (an individual, or firm, or country) to produce more of a
good or service than competitors, using the same amount of
resources.
Example
• Country A can produce 1,000 parts/hour with 200
workers.
• Country B can produce 2,500 parts/hour with 200
workers.
• Country C can produce 10,000 parts/hour with 200
workers.
Considering that labor and material costs are all
equivalent, Country C has the absolute advantage over
both Country B and Country A because it can produce
the most parts per hour at the same cost as other
nations. Country B has an absolute advantage over
Country A because it can produce more parts per hour
with the same number of employees. Country A has no
absolute advantage because it can't produce more
goods than either Country B or Country C given the
same input.
So, Country C has the absolute advantage
Types of Absolute Advantage
A natural advantage may exist because of:
• given climatic conditions
• access to particular resources
• the availability of labor, etc.
Example:
• Wheat production in US
• Coffee in Costa Rica
• Tea in Sri Lanka
Acquired Advantages
Countries that are competitive in manufactured goods (but may lack
agricultural goods and natural resources) have an acquired advantage
An acquired advantage may exist because of:
• superior skills
• better technology
• greater capital assets, etc.
Denmark exports silver tableware not because there are rich Danish
silver mines but because Danish companies have developed distinctive
products
Real income depends on the output of products as
compared to the resources used to produce them.
Comparative Advantage
In economics, the law of comparative advantage
refers to the ability of a party (an individual, a
firm, or a country) to produce a particular good
or service at a lower opportunity cost than
another party.
It is the ability to produce a product most
efficiently given all the other products that could
be produced.
It can be contrasted with absolute advantage
which refers to the ability of a party to produce
a particular good at a lower absolute cost than
another.
Origin of the Theory
Comparative advantage was first described by Robert
Torrens in 1815 in an essay on the Corn Laws. He
concluded that, it was to England’s advantage to trade
with Portugal in return for grain, even though it might be
possible to produce that grain more cheaply in England
than Portugal.
However the term is usually attributed to David Ricardo
who explained it in his 1817 book On the Principles of
Political Economy and Taxation in an example
involving England and Portugal. In Portugal it is
possible to produce both wine and cloth with less labor
than it would take to produce the same quantities in
England. However the relative costs of producing
those two goods are different in the two countries.
A country can:
i) maximize its own economic well-being by
specializing in the production of those goods and
services it can produce relatively efficiently and
ii) enhance global efficiency via its participation in
free trade.
Ricardo also reasoned that:
i) a country can simultaneously have an absolute and
a comparative advantage in the production of a given
product
ii) by concentrating on the production of the product
in which it has the greater advantage, a country can
further enhance both global output and its own
economic well-being
Example of Comparative Advantage
• Assume the following…..
• Production unit is a mix of land, labor, capital and
technology.
Examples Production capacity