Lesson 3: Theories of International

Trade & Investment

TRADE involves the voluntary exchange of goods, services, or money between

one person or organization and another.

International trade is trade between residents (individuals, businesses,

nonprofit organizations, or other associations) of two countries

CLASSICAL COUNTRY BASED TRADE THEORIES

1. MERCANTILISM

● sixteenth-century economic philosophy that held that a nation’s wealth is

measured by its stock of precious metals (gold and silver).
● According to the theory, nations should try to enlarge their silver and gold
holdings by maximizing the difference between exports and imports
through a policy that encourages exports and discourages imports.
This policy would have the effect of enabling a country to become ever
richer.
● The philosophy was popular to some because it enabled a country to
expand its borders, because export-oriented manufacturers benefited
from policies such as subsidies and tax breaks that encouraged exports
and because domestic manufacturers were protected from imports.
● Most members of society do not benefit from mercantilism, however.
Taxpayers, for example, must pay for the subsidies and tax breaks offered to
exporting firms, and customers may pay higher prices for products when
domestic firms are protected from foreign competition.
● Mercantilism, because it does benefit certain members of society, still exists
today in the form of policies to restrict imports or promote exports.
Supporters of such policies are called neo mercantilists or protectionists.
Most nations in the world have adopted some neo mercantilist policies to
protect key industries

2. ABSOLUTE ADVANTAGE

● The major difficulty with the theory of absolute advantage is that it suggests
that if one country has an absolute advantage in the production of both
goods, no trade will occur. David Ricardo solved this problem by developing
the theory of comparative advantage which states that a country should
produce and export those goods and services in which it has a relative
production advantage and import those goods and services in which other
nations are relatively more productive. The opportunity cost of a good is the
value of what is given up to get the good.
● The difference between the theory of comparative advantage and the
theory of absolute advantage is that the latter looks at absolute
differences in productivity, while the former looks at relative
productivity differences.

3. COMPARATIVE ADVANTAGE

● The lesson of the principle of comparative advantage is: you’re better off
specializing in what you do relatively best. Produce (and sell) those goods
and services at which you’re relatively best, and buy other goods and
services from people who are relatively better at producing them than you
are.

● The theory is limited in that the world economy produces more than two
goods and services and is made up of more than two nations. Furthermore,
barriers to trade, distribution costs, and inputs other than labor must be
considered. Even more important, the world economy uses money as
a medium of exchange. The text provides a demonstration of
comparative advantage with money.

● It should be noted that in the example with money, people made their
decisions to import and export based on price differences, not because they
were following the theory of comparative advantage. However, prices set in
a free market will reflect the comparative advantage of a nation.
4. RELATIVE FACTOR ENDOWMENTS

● Hecksher and Ohlin developed the theory of relative factor endowments to

answer the questions of what determines the products for which a
country will have a comparative advantage in the first place. The
theory proposes that factor endowments (or types of resources) vary
among countries. Further, goods vary in the types of factors that are used to
produce them. Therefore, a country will have a comparative advantage in
producing a product that intensively uses resources that the country has
in abundance. The text provides an example of the theory using
wheat, oil, and clothing

● Leontief tested the Hecksher-Ohlin theory using the United States as

the unit of analysis. Leontief, believing the United States to be a
capital-intensive, labor-scarce country, reasoned that the country would
export capital-intensive goods and import labor-intensive goods. However,
he found that exactly the reverse was true. Leontief’s findings have
come to be known as the Leontief paradox.

● There have been numerous attempts to explain Leontief’s findings.

Some economists have suggested that Leontief’s work is flawed by
measurement problems. His work assumes there are only two factors
of production, labor and capital, and ignores other factors such as land,
human capital, and technology. This assumption may have caused Leontief
to mismeasure the amount of labor that goes into products the United States
imports and exports.
MODERN FIRM-BASED TRADE THEORIES

Firm-based theories have developed for several reasons, including the

growing importance of multinational corporations in the postwar international
economy; the inability of the country-based theories to explain and predict the
existence and growth of intra industry trade; and the failure of researchers like
Leontief to empirically validate the country-based Hecksher-Ohlin theory. In
addition, firm-based theories incorporate factors such as quality, technology,
brand names, and customer loyalty.

1. Product Life-Cycle Theory

● developed by Vernon, consists of three stages. In the first stage (the

new product stage), a company develops and introduces an innovative
product in response to a perceived need in the local market. Initially, the
company must closely monitor whether the product indeed satisfied customer
needs, and so typically, the product is introduced in the country where
the product was developed. In addition, because the firm is initially
likely to minimize its manufacturing investment, most output is sold in the
domestic market.
● Demand for the product expands dramatically as the product moves into the
second stage (maturing product) and customers recognize its value.
The innovating firm expands its capacity and begins to consider
exporting to other markets. Competitors, domestic and foreign, begin to
emerge.
● The market stabilizes in the third stage (standardized product) as the
product becomes more of a commodity. Price becomes an issue, and
the company considers shifting production to a country where labor costs
are low. At this point, the innovating country begins to import the product.

2. Country Similarity Theory

● Country-level theories explain interindustry trade among nations.

Interindustry trade is the exchange of goods produced by one industry
for goods produced in another industry. Country-level theories do not
explain intraindustry trade, in which two countries exchange goods
produced in the same industry.
● Linder developed a theory to explain intraindustry trade that suggests
that international trade in manufactured goods is caused by similarities
of preferences among consumers in countries at the same stage of
economic development. The theory proposes that although firms
originally develop products to sell to their domestic markets, when they
 begin to export, they realize that the best markets are in countries where
consumer preferences are similar to those in their own domestic market.
● Linder’s country similarity theory suggests that most trade in
manufactured goods should be between countries with similar per capita
incomes.

3. New Trade Theory

● Helpman, Krugman and Lancaster have recently examined the impact

of global strategic rivalry between multinational firms on trade flows.
This view argues that firms struggle to develop some sustainable
competitive advantage, which can then be exploited to dominate the
global marketplace. The theory focuses on the strategic decisions firms
make as they compete in the global marketplace. Firms can develop
sustainable competitive advantages in several different ways.
First, intellectual property rights, such as trademarks, brand names,
patents, and copyrights, can give a firm an advantage over rivals. Second,
firms that make large investments in research and development may
gain first-mover advantages for goods that are R&D intensive. This
advantage is magnified if a firm has a large domestic marketplace
because feedback from customers may be quicker and richer. Third, firms
that achieve economies of scale or scope gain a competitive
advantage over rivals. Economies of scale occur when a product’s
average costs decrease as the number of units produced increase.
Economies of scope occur when a firm’s average costs decrease as the
number of different products it sells increases. Finally, firms that
successfully exploit the learning curve gain firm-specific advantages.

4. Porter’s Theory of National Competitive Advantage

 ● Porter has developed a theory of international trade called the
diamond of competitive advantage. The theory proposes that success
in an industry is a function of four characteristics: factor conditions;
demand conditions; related and supporting industries; and company
strategy, structure, and rivalry.

● Factor conditions refer to a nation’s endowment of factors of production.

Demand conditions refer to the existence of a large, sophisticated domestic
consumer base that stimulated the development and distribution of
innovative products.

● Related and supporting industries refer to the development of local

suppliers eager to meet an industry’s production, marketing, and
distribution needs.

● Firm strategy, structure, and rivalry refer to the environment in which

firms compete. Porter also argues that firms’ international strategies
and opportunities may be affected by national policies. Porter’s model
combines the traditional country-level theories (and their focus on
factor endowments) with firm-level theories that focus on the actions
of individual companies.

● Further, he includes the role that nations play in creating an environment that
may or may not be conducive to a firm’s success. No single theory of
international trade explains all trade between nations. Classical,
country-level theories are useful in explaining interindustry trade, while
firm-based theories are better at explaining intraindustry trade.
Porter’s model synthesizes many of the existing features of country-level
and firm-based theories

AN OVERVIEW OF INTERNATIONAL INVESTMENT

International investments: in which residents of one country supply capital to a

second country, is another major form of international investment. Trade and
investment may be substitutes for one another, or they may be complementary.

Types of International Investments

● International investment can be divided into portfolio investment and

foreign direct investment (FDI). The former represents passive
holdings of foreign stocks, bonds, or other financial assets that entail
no active management or control of the issuer of the securities by the
foreign investor. The latter represents acquisition of foreign assets for the
purpose of control.
 ● FDI may take many forms including purchases of existing assets in a
foreign country; new investments in plant, property and equipment; or
participation in joint ventures with a local partner. The text provides
examples of each type of investment.
● Controversy often surrounds FDI because while it may increase
employment, enhance productivity, and raise wage rates, it also raises
concerns that control of the national economy is being passed to foreigners.

INTERNATIONAL INVESTMENT THEORIES

1. Ownership Advantages

Researchers trying to explain why FDI occurs initially focused on the impact of
firm-specific (or monopolistic) advantages. They argued that a firm that owned a
superior technology, a well-known brand name, or economies of scale that
created a monopolistic advantage could clone its domestic advantage to
penetrate foreign markets.

2. Internalization Theory

The theory suggests that FDI is more likely to occur (a firm will internalize its
operations) when the costs of negotiating, monitoring, and enforcing a
contract (transaction costs) with a second firm are high.

3. Dunning's Eclectic Theory

Dunning’s eclectic theory ties together location advantage, ownership

advantage, and internalization advantage. Dunning proposes that FDI will take
place when three conditions are satisfied.

● First, the firm must own some unique competitive advantage that
overcomes the disadvantages of competing with foreign firms in their
own market (ownership advantage).
● Second, it must be more profitable to undertake a business activity in
a foreign location than a domestic location (location advantage).
● Third, the firm must benefit from controlling the foreign business activity,
rather than hiring an independent local company to provide the service
(internalization advantage)

FACTORS INFLUENCING FOREIGN DIRECT INVESTMENT

1. Supply Factors
● Supply-side considerations (a firm’s attempts to control its own costs of
production) may motivate FDI.
 ● Factors that are considered include production costs, logistics, availability of
natural resources, and access to key technology.
● Locating a factory, warehouse, or customer service center in a foreign
location may be more attractive from a production cost perspective
than locating operations domestically. When a company faces significant
logistics costs, it may choose to produce its product in a foreign location,
rather than export it.
● The availability of natural resources may drive a firm to locate its operations
in a country rich in a particular resource. Access to key technology may
encourage a firm to invest in an existing foreign company rather than
develop or reproduce an emerging technology.

2.Demand Factors

● A physical presence in a market is required for many types of

businesses, particularly service businesses. For example, since customer
access is essential to KFC’s business, it must locate outlets in other countries.
● The physical presence of a firm in another country can provide many
marketing advantages. For example, such a presence may enhance
the visibility of a company’s products in the host market. If production
costs are lower in the foreign market, the firm may be able to lower prices to
host country consumers and increase sales, and the company may be able to
benefit from “buy local” attitudes.
● FDI may also allow a firm to exploit competitive advantages (for
example, trademarks, brand names, and technology-based or
experientially based advantages) it already possesses.
● Firms may invest in another country in response to customer mobility. A
supplier firm may follow its buyer to another country so that it can
continue to meet its customers’ needs promptly and attentively.

3. Political Factors

FDI may be a logical choice for companies facing trade barriers that threaten to
keep their products out of a foreign market, or to take advantage of
economic incentives being offered by host governments.

● FDI is an effective way to avoid trade barriers. The text provides an

example of how the Japanese were able to successfully deal with trade
barriers in the early 1980s and mid-1990s.
● Governments that are concerned with promoting the welfare of their
citizens may provide various economic development incentives to
attract foreign investors. Such incentives may include tax reductions or tax
holidays, infrastructure provisions, reductions in utility rates, worker training
programs, and other subsidies.
REFERENCES:

https://open.umn.edu/opentextbooks/textbooks/19

https://archive.mu.ac.in/myweb_test/M.Com.%20Study%20Material/M.Com.%20(P
art%20-%20I)%20Economics%20of%20Global%20Trade%20(Eng)%20-%20Rev.p
df

https://courses.lumenlearning.com/suny-internationalbusiness/

https://www.dmu.ac.uk/study/business-and-law/postgraduate-modules/mba-global
/international-trade-theory-and-policy.aspx

https://www.birmingham.ac.uk/postgraduate/courses/taught/econ/postgraduate-m
odules/international-trade-theory.aspx