Contents

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

Sports Shoes Violin

Thailand has 1000 12 £/unit 2 £/unit

production units

UK has 1000 10 £/unit 6 £/unit

production units
 ASSUMPTIONS OF THE THEORIES
OF SPECIALIZATION
Both absolute and comparative advantage theories are
based on specialization. They hold that output will
increase through specialization and that countries will
be best off by trading the output from their own
specialization for the output from other countries'
specialization. However, these theories make some
assumptions that are not always valid. They are as
follows:
1. Full Employment: The theories of absolute and
comparative advantage both assume that resources
are fully employed. When countries have many
unemployed or unused resources, they may seek to
restrict imports to employ or use idle resources.
2. Economic Efficiency Objective: It is assumed that
al works would be in order to maximization of profit, or
maximize economic efficiency.
3. Division of Gains: Many people, including
government policy makers, are concerned with relative
and absolute economic growth. If they perceive that a
trading partner is gaining too large a share of benefits,
they may forgo absolute gains for themselves so as to
prevent relative losses.
4. Two Countries, Two Commodities: Smith and
Ricardo originally assumed a simple world composed
of only two countries and two commodities. We have
made the same assumption. Economists have also
applied the same reasoning to demonstrate efficiency
advantages in multi-product and multi-country trade
relationships.
5. Transport Costs: If costs more to transport the
goods than is saved through specialization, then the
advantages of trade are negated. For example,
geographically isolated countries such as Fiji and
Mauritius, trade less than would be expected from their
sizes because transportation costs increase the price
of traded goods substantially.
6. Mobility: The theories of absolute and
comparative advantage assume that resources
can move domestically from the production of
one good to another.
7. Statics and Dynamics: The theories of
absolute and comparative advantage address
countries' advantages by looking at them at one
point in time. Thus, the theories view the
advantages statically and the relative conditions
that give countries advantages or
disadvantages in the production of given
products are dynamic (constantly changing).
8. Services: The theories of absolute and
comparative advantage deal with commodities
rather than services.
 LIMITATIONS OF THE THEORIES
1. Full Employment: The theories of absolute and
comparative advantage both assume that resources
are fully employed. But it is impossible.
2. Economic Efficiency Objective: It is assumed that
the objective of specialization is to maximization of
profit, or maximum economic efficiency. Countries also
often pursue objectives other than output efficiency.
They may avoid overspecialization because of the
vulnerability created by changes in technology and by
price fluctuations.
3. Division of Gains: Although specialization brings
potential benefits to all countries that trade, but they
did not indicate how countries will divide increased
output.
4. Two Countries, Two Commodities: This
assumption does not diminish the theories' usefulness.
Economists have applied the same reasoning to
demonstrate efficiency advantages in multi-product
and multi-country trade relationships.
5. Mobility: The theories of absolute and comparative
advantage assume that resources can move
domestically from the production of one good to
another. But this assumption is not completely valid.
For example, a steelworker in the eastern part of the
United States might not move easily into a software
development job on the West Coast. For example,
thousands of Bangladeshi go abroad to work.
However, it is safe to say that there is more domestic
mobility of resources than there is international
mobility.
6. Statics and Dynamics: The theories of
absolute and comparative advantage address
countries' advantages by looking at them at one
point in time. Thus, the theories view the
advantages statically. However, the relative
conditions that give countries advantages or
disadvantages in the production of given
products are dynamic (constantly changing).
One should not assume that future absolute or
comparative advantages will remain as they are
today.
7. Services: The theories of absolute and
comparative advantage deal with commodities
rather than services. However, an increasing
portion of world trade is in services.
 THEORY OF COUNTRY SIZE
The theories of absolute and comparative advantage do not deal with
country-by-country differences regarding how much and what
products will be traded through specialization. Large countries differ
from small countries in export and import.
•• Large countries tend to export a smaller portion of their output and
import a small portion of their consumption.
Large countries are more apt to have varied climates and a greater
assortment of natural resources than smaller countries, thus
making large countries more selfsufficient.
•• Large countries tend to have higher transportation costs for exported
and imported products.
Given the same types of terrain and modes of transportation, the
greater the distance, the higher the associated transport costs.
Thus, firms in large countries often face higher transport costs in
terms of sourcing inputs from and delivering outputs to distant
foreign markets than do their closer foreign competitors.
However, research based on country size helps explain these
differences.
1. Variety of Resources: The theory of country size says that
countries with large land areas are apt (fit) to have varied
climates and an assortment of natural resources, making them
more self-sufficient than smaller countries. Most large
countries, such as Brazil, China, India, the United States, and
Russia, import much less of their consumption needs and
export much less of their production output than do small
countries, such as Uruguay, the Netherlands, and Iceland.
2. Transport Costs: Although the theory of absolute
advantage ignores transport costs in trade, these costs affect
large and small countries in different ways. Normally, the
farther the distance, the higher the transport costs. Thus, more
geographically isolated countries tend to depend less on trade
with other countries than do less geographically isolated
countries. However, among countries that border each other,
the smaller country tends to depend more on trade than the
larger country because of transportation costs.
3. Size of Economy and Production Scales:
Although land area is the most obvious way of
measuring a country's size, countries also can
be compared on the basis of economic size.
Countries with large economies and high per
capita incomes are more likely to produce
goods that use technologies requiring long
production runs. This is because these
countries develop industries to serve their large
domestic markets, which, in turn, tend to be
competitive in export markets.
 Country Similarity Theory
Swedish economist Steffan Linder developed the country
similarity theory in 1961, as he tried to explain the concept
of intraindustry trade. Linder’s theory proposed that
consumers in countries that are in the same or similar stage
of development would have similar preferences. In this firm-
based theory, Linder suggested that companies first produce
for domestic consumption. When they explore exporting, the
companies often find that markets that look similar to their
domestic one, in terms of customer preferences, offer the
most potential for success. Linder’s country similarity
theory then states that most trade in manufactured goods
will be between countries with similar per capita
incomes, and intraindustry trade will be common. This
theory is often most useful in understanding trade in goods
where brand names and product reputations are important
factors in the buyers’ decision-making and purchasing
processes.
When a firm develops a new product in response to
observed conditions in its home market, it is likely to
turn to those foreign markets that are most similar to
its domestic market when commencing its initial
international expansion activities. This tendency is
reflective of:
•• the cultural similarity of nations
•• the similarity of national political/economic
interests
•• the economic similarity of industrialized countries
Countries that are near to one another enjoy
relatively lower transportation costs than those that
are more distant, but they may or may not be similar
with respect to culture, level of economic
development, and/or political/economic interests.
 FACTOR-PROPORTIONS THEORY
Smith's and Ricardo's theories did not help to identify
the types of products that would most likely give a
country an advantage. Those theories assumed that
the workings of the free market would lead producers
to the goods they could produce more efficiently and
away from those they could not produce efficiently.
About a century and a quarter later, Eli Heckscher and
Bertil Ohlin developed the factor-proportions theory,
a theory that is based on countries' production
factors—land, labor, and capital (funds for investment
in plant and equipment). This theory said that
differences in countries' endowments (Gun) of labor
compared to their endowments of land or capital explained
differences in the cost of production factors.
Differences in a country’s relative endowments of
land, labor, and capital explain differences in the
cost of production factors.

A country will tend to export products that utilize

relatively abundant production factors because they
are relatively cheaper than scarce factors.

The composition of a country’s trade depends on

both its natural and acquired advantages. With
respect to the latter, both production and product
technology can be very important.
 Assumptions
These economists proposed that if labor were abundant in
comparison to land and capital, labor costs would be low
relative to land and capital costs. If labor were scarce, labor
costs would be high in relation to land and capital costs.
These relative factor costs would lead countries to excel in
the production and export of products that used their
abundant—and, therefore, cheaper—production factors.
1. Land-Labor Relationship: On the basis of the factor-
proportions theory, Sri Lankan authorities reasoned that
their country had a competitive advantage in products that
used large numbers of abundant semiskilled workers. The
factor-proportions theory appears logical. In countries in
which there are many people relative to the amount of land
price is very high because it's in demand. Regardless of
climate and soil conditions, a country excels in the
production of goods requiring large amounts of land.
Businesses in countries such as Australia and Canada
produce these goods because land is abundant compared
to the number of people.
2. Labor-Capital Relationship: In countries where there is little
capital available for investment and where the amount of
investment per worker is low, managers might expect to find
cheap labor rates and export competitiveness in products that
require large amounts of labor relative to capital. These
managers can anticipate the opposite when labor is scarce. For
example, Iran (where labor is abundant in comparison to
capital) excels in the production of handmade carpets that differ
in appearance as well as in production method from the carpets
produced in industrial countries by machines purchased with
cheap capital.
3. Technological Complexities: The factor-proportions
analysis becomes more complicated when the same product
can be produced by different methods, such as with labor or
capital. Canada produces wheat with a capital-intensive method
(high expenditure on machinery per worker) because of its
abundance of low-cost capital relative to labor. In contrast, India
produces wheat by using a much smaller number of machines
in comparison to its abundant and cheap labor. In the final
analysis, managers must compare the cost in each location
based on the type of production that will minimize costs there.
 PRODUCT LIFE CYCLE THEORY
Raymond Vernon's international product life cycle
(PLC) theory of trade states that the location of
production of certain kinds of products shifts as
they go through their life cycles, which consists of
four stages — introduction, growth, maturity, and
decline.
Changes Through the Cycle
Companies develop new products because there is a
nearby observed need and market for them. This
means that a U.S. company is most apt to develop a
new product for the U.S. market, a French company for
the French market, and so on. At the same time, almost
all new technology that results in new 'products and
production methods originates in industrial countries
because of a combination of factors.
Once a company has created a new product,
theoretically it can manufacture that product anywhere
in the world.
Raymond Vernon proposed the PLC in the early 1960s.
Raymond argued that the size and the wealthy market
gave American companies a strong motivation to
develop innovative consumer goods.

As the market in the US and other more developed

countries matures, the products becomes more
standardized, and price becomes the main competitive
factor.

Further along, the U.S. switches from being an exporter

of the product to an importer of the product as
production becomes concentrated in lower cost foreign
locations.
Ex: cellular phones
 Dependency Theory
Dependency theory is the notion that resources flow from
a "periphery" of poor and underdeveloped states to a
"core" of wealthy states, enriching the latter at the
expense of the former. It is a central contention of
dependency theory that poor states are impoverished and rich
ones enriched by the way poor states are integrated into the
"world system".
Dependency theory rejects this view arguing that
underdeveloped countries are not merely primitive versions of
developed countries, but they have unique features and
structures of their own; and, importantly, are in the situation of
being the weaker members in a world market economy.
Dependency theory no longer has many proponents as an
overall theory, but some writers have argued for its continuing
relevance as a conceptual orientation to the global division of
wealth.
Cardoso summarized his version of dependency
theory as follows:
i. there is a financial and technological penetration by
the developed capitalist centers of the countries of the
periphery and semi-periphery;
ii. this produces an unbalanced economic structure
both within the peripheral societies and between them
and the centers;
iii. this leads to limitations on self-sustained growth in
the periphery;
iv. this favors the appearance of specific patterns of
class relations;
v. these require modifications in the role of the state to
guarantee both the functioning of the economy and the
political articulation of a society, which contains, within
itself, foci of inarticulateness and structural imbalance.
 Why Companies Trade Internationally?
1. Increasing sources of Revenue: For every new market you
enter, you could be doubling or trebling your revenue potential.
If a company enter into international business after fulfilling its
domestic demand, the company can able to increase its revenue.
So, for increasing sources of revenue international trade is
essential.
2. Increasing Turnover and Stability: Near about 50% of
turnover of a country is generated from foreign trade. Businesses
that export are viewed as more credible and are more likely to
stay in business than companies that are not active
internationally. So, for increasing sales and stability of the
company international trade is needed.
3. Extending the Life of Your product or Service: Your
products or services may be reaching maturity in the domestic
market so you might be considering the development of new
offerings. But other international markets might be ready to snap
up your existing products as they are. Through international
business life of the product or service will be lasted long. So, for
extending the life international trade is essential.
4. Defeating the Competitors: If your competitors have
turned their attentions to other markets, there is a good
chance that you will need to get ahead of the game too if
you want to ensure your success. The best way to turn the
business abroad. In this way the competitor will be defeated.
So, for defeating the competitors the company involves in
international business.
5. Enhancing Company’s Image: Being known as an
exporter of the company’s goods or services will make your
organization appear more progressive and forward-thinking.
So, for enhancing company’s image the company goes
abroad for business.
6. Spreading Risk: Businesses that are active in more than
one country/market are less severely affected by regional
risks and uncertainties affecting trade (e.g., tax increases in
one particular market). So for reducing risk a company go
abroad and consequently it protects the company against
domestic market swings and uncertainties.
7. Attracting Better Staff: Businesses that export are often
more attractive to potential employees. Business owners may
find themselves able to recruit staff with better qualifications
and greater levels of ambition, who wish to help the company
develop internationally. So for attracting better staff a company
goes abroad for business.
8. Gearing up the Brand/Label: In many foreign markets,
British or American products are associated with quality and
luxury. So enhancing quality of a product any company may
achieve sustainable branding or labeling through this good
reputation. So for gearing up the product brand a company
involve into international business.
9. Inspiring the Development of New Products and Services:
Dealing with global markets can lead to the development of
different products and services than those that would commonly
do well in the domestic country. So for inspiring the
development of new product a company goes abroad.
10. Boosting Economy: If a economy’s growth is driven by
businesses internationally. It will help to improve life for the
people of a country as a hole.
 Companies’ Role of International Trade
1. Increasing sales and profitability: Going global a company
can provide new sources of revenue, yield greater returns on
investments and secure long-term success for a business.
2. Entering into new markets: After fulfilling local demands
a company can look beyond its region and consider a market
overseas. Be sure to pick one that offers opportunity. You want
a market where it’s easy to enter, whose buyers desire your
product or service.
3. Creating jobs: If a company can grow its business globally,
it must support the additional workload. Hiring people is the
solution and we know that the strength of our country lies in its
ability to create jobs that help people live and prosper.
4. Offseting slow growth in your home market: If a
company goes abroad, more customers will buy its products.
International business reduces low growth in home market. A
company can protect its slow growth by exporting its products.
5. Clobbering the competitors: Taking one step to enter a new
overseas market a company can clobber the competitors with its
performance.
6. Enlarging the customer base: If the company currently has
1,000 customers, why not increase the base to 2,000 by entering
a foreign market via ecommerce or a collaborative sales
partnership? You’ll need support to get the work done so
consider adding people to get the processes in place.
7. Creating economies of scale in production: Your company is
ramping up and producing 20,000 hammers at once because an
outfit in Ireland, Japan or Australia wants to buy them and won’t
buy a single case. The more you produce, the greater the chances
of lowering the per-unit manufacturing costs.
8. Exploring untapped markets with the power of the
Internet: With an e-commerce site, customers worldwide might
eventually find you, provided you’ve made it easy for them to do
so. Move into the markets that generate a heavy concentration of
inquiries on your website. You may not have anticipated a
particular geographic area would be a ripe market, but the people
there are telling you it is.
9. Making use of excess capacity off-season: To
insulate the business from seasonal sales
fluctuations, find foreign markets to counterbalance
dips in demand. For instance, some firms gear up
for the holiday season, only to see sales nosedive in
January. Sell to other nations with peak-buying
seasons early in the new year to avoid a winter sales
slowdown.
10. Travel to new countries: Then there's the fun
factor in taking a business global. Not only will you
connect with people from all over the world, but
you'll also have an excuse to meet with them in
person to grow the relationship and the business.
Treat it as an exciting learning adventure.
Theories Ho Wh Wit Sho How Wha With
w at h uld muc t whom
muc pro who Go h prod shoul
h is duc m vt. shou ucts d
trad ts does con ld be shoul trade
ed? are trad trol trad d be take
tra e tra ed? trade place
ded take de? d?
? plac
e?
Mercantilism Yes
Absolute Advantage No
Comparative No
Advantage
Country Size
Factor Proportion
Country Similarity
Product Life Cycle
Theory of
Dependency
 THANK
YOU
SO MUCH
 Questions
1. Explain the term: international trade theory.
2. Explain the Theory of Mercantilism.
3. Explain the Theory of Absolute Advantage.
4. Explain the terms: Natural Advantage & Acquired
Advantage
5. Explain the Theory of Comparative Advantage.
6. State the assumptions of the Theories of Specialization.
7. Discuss the limitations of the Theories of Specialization.
8. Explain the Theory of Country Size.
9. Explain the Theory of Factor-Proportions.
10. Explain the Theory of Product Life Cycle of Trade
11. Explain the Theory of Country Similarity.
12. Explain the Theory of Dependency.
13. Why companies trade internationally?
14. State the role of the companies in international trade.
15. Case Study