International Trade Theory

THAPAR UNIVERSITY,
24 July 2019
• Free trade - a situation where a government does not attempt to
influence through quotas or duties what its citizens can buy from
another country or what they can produce and sell to another
country
 Trade Theory
• Mercantilism (16th & 17th century)
• Adam Smith’s Theory of Absolute Advantage (1776)
• David Ricardo’s Theory of Comparative Advantage (19th century)
• Heckscher-Ohlin Theory (20th century)
• Raymond Vernon’s Product Life Cycle Theory (1960s)
• Paul Krugman’s New Trade Theory (1970s)
• Michael Porter’s Theory of National Competitive Advantage

THAPAR UNIVERSITY,
24 July 2019
 Trade Theory
• Trade theory shows why it is beneficial for a country to engage in international trade
even for products it is able to produce for itself
• The mercantilist philosophy makes a crude case for government involvement in
promoting exports and limiting imports
• Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade
• New trade theory and Porter’s theory of national competitive advantage justify limited
and selective government intervention to support the development of certain export-
oriented industries

THAPAR UNIVERSITY,
24 July 2019
Mercantilism

THAPAR UNIVERSITY,
24 July 2019
Mercantilism
• Mercantilism (mid-16th century) suggests that it is in a country’s best interest to
maintain a trade surplus—to export more than it imports.

• The countries should design policies that lead to an increase in their holdings of
gold and silver.

• This can usually be done by increasing exports and limiting imports. This economic
philosophy was used by Europeans from about the 1500s to the late 1700s.

• Nations should increase their wealth by maintaining trade surpluses.

• It advocates government intervention to achieve a surplus in the balance of trade

by limiting imports through tariffs and quotas and subsidizing exports.
Mercantilism
• David Hume in 1752 pointed how in long run no country can sustain surplus in
balance of trade and so gold and silver cant be accumulated as described in the
theory of mercantilism.

• The key problem with the mercantilist view is that it views trade as a zero sum game,
where if one country benefits the other must lose. Rather, international trade can be
positive sum game in which all countries can benefit as explained by Adam Smith.
Hence, as an economic philosophy, mercantilism is flawed.

• Yet many political views today have the goal of boosting exports while limiting imports
by seeking only selective liberalization of trade.
Adam Smith’s Theory of
Absolute Advantage
Adam Smith’s Theory of Absolute Advantage

• Adam Smith’s Wealth of Nation (1776) attacked mercantilist assumption that trade is a
zero-sum game, rather he said trade is a positive-sum game.

• 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 in producing it.

• Countries should specialize in the production of goods for which they have an absolute
advantage and then trade these goods for goods produced by other countries e.g.
Textiles by England & Wine by France. Hence, Textiles is traded for Wine.

• No country should produce those goods at home that it can buy at lower price from other
countries .

• Adam Smith showed that by specializing in production of goods in which each country
has absolute advantage, both countries benefit by entering in trade. (Production
Possibility Frontier)
Adam Smith’s Theory of Absolute Advantage
Resources in each country = 500 units Brazil China Production
Resource units required to Coffee 20 25
produce 1 ton
Tea 50 10
Production (in ton) Coffee =500/20 = 25 ton of =500/25 = 20 ton of
coffee & no tea coffee & no tea
Tea = 500/50 = 10 ton of tea = 500/10 = 50 ton of tea
& no coffee & no coffee
Production & Consumption Coffee = 250/20 = 12.5 = 250/25 = 10 22.5
without Trade (in ton)
Tea = 250/50 = 5 = 250/10 = 25 30
Production with Coffee 25 0 25
Specialization (in ton)
Tea 0 50 50
(absolute advantage)
Consumption after Brazil Coffee 14 11
trades 11 ton of coffee for 11
Tea 11 39
ton of Chinese tea
(Specialization & Trade)
(in ton)
Adam Smith’s Theory of Absolute Advantage
• After trade
• Brazil would have 14 tons of Coffee left, and 11 tons of tea
• China would have 39 tons of tea left and 11 tons of coffee

Increase in Consumption as a result of Specialization & Trade (in ton)

Brazil China
Coffee 14-12.5= 1.5 11- 10 = 1
Tea 11-5 = 6 39- 25 = 14

• If each country specializes in the production of the good in which it has an

absolute advantage and trades it for the other, both countries gain. Hence,
trade is a positive sum game.
David Ricardo’s Theory of
Comparative Advantage
David Ricardo’s Theory of Comparative Advantage

• David Ricardo’s Principles of Political Economy (1817) asked what happens when one
country has an absolute advantage in the production of all goods. Does it mean it shall
not go for international trade?

• Comparative advantage refers to a country’s ability to produce a particular good with

a lower opportunity cost than another country.

• The theory of comparative advantage (1817)—a country should specialize in the

production of good A that it can produce more efficiently and buy from foreign country
such good B that it produces less efficiently than good A - even if this means buying
good B from the foreign country that it could produce more efficiently (than
foreign country) at home.

• Assume Brazil is more efficient than China in the production of both coffee &
tea. It takes less resources in Brazil than in China to produce both coffee & tea.
.
Coffee per ton in Brazil (20 resources) & China (100 resources),
and tea per ton in Brazil (25 resources) & China (50 resources)
David Ricardo’s Theory of Comparative Advantage
Resources in each country = 500 units Brazil China Production

Resource units required to produce 1 ton Coffee 20 100

Tea 25 50
Production in ton Coffee =500/20 = 25 ton of =500/100 = 5 ton of
coffee & no tea coffee & no tea
Tea = 500/25 = 20 ton = 500/50 = 10 ton of
of tea & no coffee tea & no coffee
Production & Consumption without Trade Coffee = 250/20 = 12.5 = 250/100 = 2.5 15
( in ton)
Tea = 250/25 = 10 = 250/50 = 5 15
Production with Specialization in ton with Coffee =350/20= 17.5 0 17.5
Brazil exploiting its comp. advantage in coffee
production & using 100 resources more for coffee
production. China specializing in tea production & Tea = 150/ 25 = 6 = 500/50= 10 16
only produces tea
Consumption after Brazil trades 4.5 ton of Coffee 13 4.5
coffee for 4.5 ton of Chinese tea
(Specialization & Trade) in ton Tea 10.5 5.5
David Ricardo’s Theory of Comparative Advantage
Production & Consumption without Trade data shows
• Brazil has absolute advantage in production of both tea and coffee as it
can produce 5 times more coffee and 2 times more tea than China.

• So why will Brazil trade with China?

Brazil is comparatively more efficient at producing coffee than it is at

producing tea
David Ricardo’s Theory of Comparative Advantage
• After trade
• Brazil would have 13 tons of Coffee left, and 10.5 tons of tea
• China would have 5.5 tons of tea left and 4.5 tons of coffee

Increase in Consumption as a result of Specialization & Trade (in ton)

Brazil China
Coffee 13-12.5= 0.5 4.5-2.5= 2
Tea 10.5-10= 0.5 5.5-5=0.5

• If each country specializes in the production of the good in which it has a

comparative advantage and trades it for the other, both countries gain.

• Comparative advantage theory provides a strong rationale for encouraging free

trade as total output is higher & both countries benefit
David Ricardo’s Theory of Comparative Advantage
• Potential world production is greater with free trade than it is with restricted
trade

• All nations can consume more if there are no restrictions on trade. This
occurs even in countries that lack absolute advantage in production of any
good.

• The theory suggests to a greater degree than theory of absolute advantage

that trade is a positive sum game in which all the countries that participate
realize economic gains.

• The theory provides strong rationale for encouraging free trade.

Assumptions
The simple example of comparative advantage discussed makes a number of
assumptions:

• only two countries and two goods;

• zero transportation costs;
• similar prices and values of resources in two countries, no mention of exchange rate
• resources are mobile between goods within countries, but not across countries;
• constant returns to scale;
• fixed stocks of resources; and
• no effects on income distribution within countries.

While these are all unrealistic, the general proposition that countries will produce and
export those goods that they are the most efficient at producing has been shown to
be quite valid.
Is Unrestricted Free Trade
Always Beneficial?
• Unrestricted free trade is beneficial, but the gains may not be as great as the simple
model of comparative advantage would suggest. If some assumptions of absolute/
comparative advantage model are relaxed, then……..
• immobile resources as resources don’t move that freely from one economic
activity to another & process creates suffering and friction
• diminishing returns as all resources are not of same quality & goods use
resources in different proportions
• dynamic effects on country’s stock of resources; economic growth due to
increased supply of labour, capital, and increased efficiency due to economies of
scale, better technology, improved efficiency of land, labour or domestic industry

• Views of Paul Samuelson: the dynamic gains from trade may not always be
beneficial as free trade may ultimately result in lower wages in the rich country.
 Studies have confirmed prediction of theory of comparative
advantage that countries which trade internationally have
more growth, and thus increased income per person and
improved lifestyle

THAPAR UNIVERSITY,
24 July 2019
Heckscher-Ohlin Theory
• Eli Heckscher (1919) and Bertil Ohlin (1933) - comparative advantage arises
from differences in national factor endowments

• National Factor Endowment is the extent to which a country is endowed

with resources like land, labor, and capital

• The more abundant a factor, the lower its cost

• The pattern of trade is determined by factor endowments

• Heckscher and Ohlin predict that countries will export goods that make
intensive use of locally abundant factors, and import goods that make
intensive use of factors that are locally scarce
Product Life-Cycle Theory
• Proposed by Ray Vernon in the mid-1960s
• The product life-cycle theory - as products mature both the location of sales and the
optimal production location will change affecting the flow and direction of trade
• According to the product life-cycle theory
• the size and wealth of the U.S. market gave U.S. firms a strong incentive to
develop new products
• initially, most of the world’s new products were developed by U.S. firms and
sold first in the U.S.
• as demand for a particular new product grew in other developed countries, U.S.
firms would begin to export
• demand for this new product would grow in other advanced countries over time
making it worthwhile for foreign producers to begin producing for their home
markets
• U.S. firms might set up production facilities in advanced countries with growing
demand, limiting exports from the U.S.
Product Life-Cycle Theory
• As the market in the U.S. and other advanced nations matured, the product
would become more standardized, and price would be the main competitive
weapon
• Producers based in advanced countries where labor costs were lower than the
United States might now be able to export to the United States
• If cost pressures were intense, developing countries would acquire a
production advantage over advanced countries
• Production became concentrated in lower-cost foreign locations, and the U.S.
became an importer of the product
Does Product Life- Cycle Theory Hold?

• The globalization and integration of the world economy has made this theory
less valid today
• the theory is ethnocentric
• production today is dispersed globally
• products today are introduced in multiple markets simultaneously
 New Trade Theory
(EoS & First Mover Advantage)
• New trade theory suggests that the ability of firms to gain economies of scale (unit cost
reductions associated with a large scale of output) can have important implications for
international trade
• Countries may specialize in the production and export of particular products because in
certain industries, the world market can only support a limited number of firms
• new trade theory emerged in the 1980s
• Paul Krugman won the Nobel prize for this work in 2008
• Through its impact on economies of scale, trade can increase the variety of goods available to
consumers and decrease the average cost of those goods
• without trade, nations might not be able to produce those products where economies of
scale are important
• with trade, each country can specialize in production of narrow range of products &
markets are large enough to support the production necessary to achieve economies of
scale
• so, trade is mutually beneficial because it allows for the specialization of production, the
realization of scale economies, and the production of a greater variety of products at
global level at lower prices
New Trade Theory
• In those industries when output required to attain economies of scale represents a
significant proportion of total world demand, the global market may only be able to
support a small number of enterprises
• First-mover advantages - the economic and strategic advantages that accrue to early
entrants into an industry. First movers can gain a scale based cost advantage that later
entrants find difficult to match

• Nations may benefit from trade even when they do not differ in resource endowments or
technology
• a country may dominate in the export of a good simply because it was lucky
enough to have one or more firms among the first to produce that good
Porter’s Diamond of National Competitive Advantage
Determinants of National Competitive Advantage: Porter’s Diamond
Porter’s Diamond of National Competitive Advantage

• Michael Porter (1990) tried to explain why a nation achieves international success
in a particular industry
• identified four attributes that promote or impede the creation of competitive
advantage
1. Factor endowments - a nation’s position in factors of production necessary to
compete in a given industry
• can lead to competitive advantage
• can be either basic (natural resources, climate, location) or advanced
(skilled labor, infrastructure, technological know-how)
2. Demand conditions - the nature of home demand for the industry’s
product or service
• influences the development of capabilities
• sophisticated and demanding customers pressure firms to be competitive
Porter’s Diamond of National Competitive Advantage

3. Relating and supporting industries - the presence or absence of supplier

industries and related industries that are internationally competitive
• can spill over and contribute to other industries
• successful industries tend to be grouped in clusters in countries

4. Firm strategy, structure, and rivalry - the conditions governing how companies
are created, organized, and managed, and the nature of domestic rivalry
• different management ideologies affect the development of national
competitive advantage
• vigorous domestic rivalry creates pressures to innovate, to improve quality,
to reduce costs, and to invest in upgrading advanced features
Does Porter’s Theory Hold?

• Government policy can

• affect demand through product standards
• influence rivalry through regulation and antitrust laws
• impact the availability of highly educated workers and advanced transportation
infrastructure.
• The four attributes, government policy, and chance work as a reinforcing system,
complementing each other and in combination creating the conditions appropriate for
competitive advantage
• So far, Porter’s theory has not been sufficiently tested to know how well it holds up
Implications of Trade Theory For Managers

1. Location implications - a firm should disperse its various productive

activities to those countries where they can be performed most
efficiently
• firms that do not may be at a competitive disadvantage

2. First-mover implications - a first-mover advantage can help a firm

dominate global trade in that product

3. Policy implications - firms should work to encourage governmental

policies that support free trade
Why Do Governments
Intervene In Markets?
• There are two main arguments for government intervention in the market

1. Political arguments - concerned with protecting the interests of certain groups

within a nation (normally producers), often at the expense of other groups
(normally consumers)
- Job protection, protection of sensitive industries from security point of view,
forcing other countries to remove trade barriers, consumer protection from unsafe
products, to punish rogue states or to benefit friendly countries, environment
protection, etc.

2. Economic arguments - concerned with boosting the overall wealth of a nation –

benefits both producers and consumers
- protecting infant industry, help domestic firms gather a dominant position &
strategic advantage, etc.
Instruments of Trade Policy
• Governments use various methods to intervene in markets including

1. Tariffs - taxes levied on imports that effectively raise the cost of imported products
relative to domestic products . can be levied on exports too.
• Specific tariffs - levied as a fixed charge for each unit of a good imported
• Ad valorem tariffs - levied as a proportion of the value of the imported
good

2. Subsidies - government payments to domestic producers

• Subsidies help domestic producers
• compete against low-cost foreign imports
• gain export markets
Instruments of Trade Policy
3. Import Quotas - restrict the quantity of some good that may be imported into a
country
• Tariff rate quotas - a hybrid of a quota and a tariff where a lower tariff is
applied to imports within the quota than to those over the quota
• Quota rent - The govt. may assign import quota to specific no. of importers
who may be required to pay quota rent

4. Voluntary Export Restraints - quotas on trade imposed by the exporting country,

typically at the request of the importing country’s government

• Import quotas and voluntary export restraints

• benefit domestic producers
• raise the prices of imported goods
Instruments of Trade Policy
5. Local Content Requirements - demand that some specific fraction of a good be produced
domestically
• benefit domestic producers
• consumers face higher prices
6. Administrative Policies - bureaucratic rules designed to make it difficult for imports to enter a
country
• polices hurt consumers by limiting choice
7. Antidumping Policies–also called countervailing duties–punish foreign firms that engage in
dumping and protect domestic producers from “unfair” foreign competition
• dumping - selling goods in a foreign market below their costs of production, or selling
goods in a foreign market below their “fair” market value
• enables firms to unload excess production in foreign markets
• may be predatory behavior - producers use profits from their home markets to
subsidize prices in a foreign market to drive competitors out of that market, and then
later raise prices