Why do nations trade?

An introduction to trade theories

Dr. Suborna Barua

Associate Professor
Department of International Business
University of Dhaka

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 Aims

1. Use the resource- and institution-based views to explain why

nations trade
2. Identify and define the classical and modern theories of
international trade
3. Explain the importance of political realities governing international
trade
4. Identify factors that should be considered when your firm
participates in international trade.

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WHY DO NATIONS TRADE?

Terms to know:
1. Exporting
2. Importing
3. Merchandise trade
4. Service trade
5. Trade deficit
6. Trade surplus
7. Balance of trade

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 WHY DO NATIONS TRADE?

• Must be economic gains from trade for both sides.

• Resource-based view: nations trade because some firms in

one nation generate exports that are valuable, unique and
hard to imitate.

• Institution-based view: different rules governing trade are

designed to determine how gains are shared or not shared.

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THEORIES OF INTERNATIONAL TRADE

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THEORIES OF INTERNATIONAL TRADE

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MERCANTILISM

• Original XVIIth century mercantilists, such as John Law, a

Scots financier, believed that a country's economic prosperity
and political power came from its stocks of precious metals.
• To maximize these stocks they argued against free trade,
favoring protectionist policies designed to minimize imports
and maximize exports, creating a trade surplus that could be
used to acquire more precious metals.
• Nation that exported more than it imported would enjoy net
inflow of money.
• Intellectual ancestor of protectionism – idea that
governments should actively protect domestic industries from
imports and promote exports.

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 MERCANTILISM

• Neo-mercantilism is a term used to describe a policy regime

which encourages exports, discourages imports, controls capital
movement and centralizes currency decisions in the hands of a
central government.
• The objective of neo-mercantilist policies is to increase the level
of foreign reserves held by the government, allowing more
effective monetary and fiscal policy.
• This is generally believed to come at the cost of lower
standards of living of the concerned nation.
• It is called "neo" because of the change in emphasis from
classical mercantilism on military development, to economic
development. It also accepted a greater level of price fixing
based on market mechanisms.

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ABSOLUTE ADVANTAGE

• Absolute advantage refers

to the ability of a person or
a country to produce a
particular good at a lower
absolute cost than another.

• With free trade, a nation

gains by specializing in
economic activities in
which it is more efficient in
than others.

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ABSOLUTE ADVANTAGE

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COMPARATIVE ADVANTAGE
• Ricardo's theory of comparative advantage is based on
differences in labour productivity
• Comparative advantage refers to the ability of a person or a
country to produce a particular good at a lower marginal cost
and opportunity cost than another person or country.
• For Eli Heckscher and Bertil Ohlin, comparative advantage
arises from differences in relative national factor endowments –
the extent to which a country is endowed with resources like
labour and capital
• The Heckscher-Ohlin-Samuelson model predicts that countries
will export goods that make intensive use of those factors that
are locally abundant, while importing goods that make intensive
use of factors that are locally scarce

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COMPARATIVE ADVANTAGE
Comparative
advantage explains
how trade can
create value for both
parties even when
one can produce all
goods with fewer
resources than the
other. The net
benefits of such an
outcome are called
gains from trade.
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COMPARATIVE ADVANTAGE

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Gains from free trade

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PRODUCT LIFE CYCLE THEORY

Dynamic theory that accounts for changes in the pattern

of trade over time.

According to Raymond Vernon's product life-cycle theory,

both the location of sales and the optimal production
location will change as products mature, affecting the
flow and direction of trade

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PRODUCT LIFE CYCLE THEORY

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PRODUCT LIFE CYCLE THEORY

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PRODUCT LIFE CYCLE THEORY

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STRATEGIC TRADE

Suggests that strategic government intervention in certain

industries can enhance their odds for international success.

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NATIONAL COMPETITIVE ADVANTAGE OF
INDUSTRIES
Competitive advantage of certain industries in different
nations depends on four factors:

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The New Trade Theory (P. Krugman)

• Tries to explain why trade is growing fastest

between industrial countries
• With similar economies and endowments of the factors of
production (intra-regional trade)
• Trading similar goods (intra-industry trade)
• Considers
• Markets of imperfect competition (oligopolies, national
monopolies)
• Increasing returns to scale
• Movement of capital (foreign direct investment)
• Business and government strategies

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The New Trade Theory (P. Krugman)

• Trade is mutually beneficial because it allows for the

specialization of production, the realization of economies of
scale, and the production of a greater variety of products at
lower prices
• The pattern of trade may result from economies of scale and
first mover advantages (economic and strategic advantages
that accrue to early entrants into an industry)
• Selected government intervention (strategic trade policy)
may support the development of strategic or export-
oriented industries

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The New Trade Theory (P. Krugman)

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FDI driving trade

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FDI driving trade: What drives FDI?

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Dunning’s eclectic theory (ILO)

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M. Porter’s Diamond

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Protectionism or free trade?
• Mercantilism promotes government involvement in
supporting exports and limiting imports
• Smith, Ricardo and Heckscher-Ohlin show that it is beneficial
for a country to engage in international trade even for
products it is able to produce for itself. International trade
allows a country:
• To specialize in the manufacture and export of products that it can
produce efficiently
• To import products that can be produced more efficiently in other
countries
• The new trade theory supports international trade but
justifies limited and selective government intervention to
support the development of certain export-oriented industries

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FACTORS WHEN CONSIDERING BUSINESS WITH
OTHER NATIONS

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Next Lecture (2)

The reality of international trade

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 Thank you

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