International Trade Theory

Contents - Saumya
INTERNATIONAL TRADE........................................................................................................................2
What is it?..........................................................................................................................................2
Classical Theories...............................................................................................................................2
New Trade Theories...........................................................................................................................2
TRADE BENEFITS...................................................................................................................................2
CLASSICAL COUNTRY-BASED TRADE THEORIES....................................................................................2
1. Mercantilism (Pre, Mid and Modern)........................................................................................2
2. Absolute Advantage...................................................................................................................3
Theory of Absolute Cost................................................................................................................3
Theory of Absolute Advantage.....................................................................................................3
Illustration of the benefits of ‘Absolute Advantage’....................................................................3
Absolute Advantage’s Flaw...........................................................................................................4
3. Theory of Comparative Advantage............................................................................................4
Theory...........................................................................................................................................4
Differences between Comparative and Absolute Advantage......................................................4
Opportunity Cost..........................................................................................................................4
Comparative Advantage with Money...........................................................................................5
HECKSCHER (1919)-OHLIN (1933) THEORY...........................................................................................5
Factor Endowments...........................................................................................................................5
Advanced Factor Endowments..........................................................................................................5
PORTER’S DIAMOND OF NATIONAL COMPETITIVE ADVANTAGE........................................................6
Determinants of National Competitive Advantage............................................................................6
Relationship of Basic to Advanced Factors........................................................................................6
Demand Conditions...........................................................................................................................7
Related and Supporting Industries....................................................................................................7
Firm Strategy, Structure and Rivalry..................................................................................................7
Evaluating Porter’s Theory.................................................................................................................7
TERMS ON TRADE BALANCE.................................................................................................................7
MODERN FIRM-BASED TRADE THEORIES.............................................................................................8

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 Notes
INTERNATIONAL TRADE
What is it?
Exchange of raw materials and manufactured goods (and services) across
national borders

Classical Theories
Explain national economy conditions--country advantages--that enable such
exchange to happen.

New Trade Theories

Explain links among natural country advantages, government action, and
industry characteristics that enable such exchange to happen.

TRADE BENEFITS
 Welfare
 Inputs to production
 Economies of scale
 Engine of growth
 Survive in the competition
 Asset movement

CLASSICAL COUNTRY-BASED TRADE THEORIES

1. Mercantilism (Pre, Mid and Modern)
a. Mercantilism (pre-16th century)
 Takes an us-versus-them view of trade; other country’s gain is our country’s loss
 Neo-mercantilism views persist today

b. Mercantilism (mid-16th century)

 A nation’s wealth depends on accumulated “treasure”
o Gold and silver are the currency of trade

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  Mercantilists argued their countries should run a trade surplus
o Maximize export through subsidies
o Minimize imports through tariffs and quotas
 Flaw: “zero-sum game”
o Mercantilists neglected to see the benefits of trade

c. Mercantilism (mid-16th century)

 Neomercantilists or protectionists
o American Federation of Labor-Congress of Industrial Organizations
 Textile manufacturers
 Steel companies
 Sugar growers
 Peanut farmers

2. Absolute Advantage
 A country enjoys an absolute advantage over another country in the
production of a product when it uses fewer resources to produce that
product than the other country does.

Theory of Absolute Cost

It is a theoretical explanation to the cause of international trade which was introduced

by Adam Smith in his “Wealth of Nations”.

Theory of Absolute Advantage

Adam Smith argued: Capability of one country to produce more of a product with the
same amount of input can vary

 A country should produce only goods where it is most efficient, and trade for
those goods where it is not efficient
 Idea of ‘mutual benefit’. —Specialize in the good in which it had the absolute
advantage

Illustration of the benefits of ‘Absolute Advantage’

 India – Tea
 Cuba – Sugar
 Both have 200 units of resources
 India – 10 units to produce 1 ton of tea 20 units to produce 1 ton of sugar

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  Cuba – 25 units to produce 1 ton of tea 5 units to produce 1 ton of sugar

Absolute Advantage’s Flaw

o What happens to trade if one country has an absolute advantage in both

products?
o No trade would occur

3. Theory of Comparative Advantage

What if a country has an absolute advantage in all products or in no
products at all?

 Country “A” should specialize in the good which it can produce more efficiently than
another good, without regard to country “B”
 Key: each country should specialize in the goods it produces most efficiently and buy
those goods it produces less efficiently
 Very strong argument for Free Trade

Theory

 Produce and export those goods and services for which it is relatively more
productive than other countries
 Import those goods and services for which other countries are relatively more
productive than it is

Differences between Comparative and Absolute Advantage

 Absolute versus relative productivity differences

 Comparative advantage incorporates the concept of opportunity cost
o Value of what is given up getting the good

Opportunity Cost

The cost of pursuing one activity in terms of the foregone return on the next-best
alternative activity

Examples

 The opportunity cost of going to college is what you could have earned working
full-time instead
 The opportunity cost of using a plant to manufacture one product is what the
company could have earned manufacturing another product at the plant instead.

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 Comparative Advantage with Money

 One is better off specializing in what one does relatively best

 Produce and export those goods and services one is relatively best able to
produce
 Buy other goods and services from people who are better at producing them

HECKSCHER (1919)-OHLIN (1933) THEORY

 The pattern of international trade depends on differences in factor
endowments not on differences in productivity
 Absolute amounts of factor endowments matter

Factor Endowments

 Taken from Heckscher-Ohlin

 Basic factors:
i. Natural Resources
ii. Climate
iii. Location
iv. Demographics
 Advanced factors:
i. Communications
ii. Skilled Labour
iii. Research
iv. Technology

Advanced Factor Endowments

 More likely to lead to competitive advantage.
 Are the result of investment by people, companies, government.

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PORTER’S DIAMOND OF NATIONAL COMPETITIVE
ADVANTAGE

Determinants of National Competitive Advantage

 Factor endowments: nation’s position in factors of production such as
skilled labour or infrastructure necessary to compete in each industry.
 Firm strategy, structure, and rivalry: the conditions in the nation
governing how companies are created, organized, and managed and the
nature of domestic rivalry.
 Demand conditions: the nature of home demand for the industry’s
product or service.
 Related and supporting industries: the presence or absence in a nation
of supplier industries or related industries that are nationally
competitive.

Relationship of Basic to Advanced Factors

 Basic can provide an initial advantage.
 Must be supported by advanced factors to maintain success.
 No basics, then must invest in advanced factors.

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 Demand Conditions
 Demand creates the capabilities.
 Look for sophisticated and demanding consumers impacts quality and
innovation

Related and Supporting Industries

 Creates clusters of supporting industries that are internationally
competitive.
 Cost-effective input, information, exchange of ideas and information.
 Source of innovation and upgrading.

Firm Strategy, Structure and Rivalry

 The nation’s condition that firms are born, organizing, and
competing.: Management ‘ideology’ can either help or hurt you.
 Presence of domestic rivalry improves a company’s competitiveness.

Evaluating Porter’s Theory

 No empirical support (hard to test)
 Not explaining all trade flows
 too soon to tell.
 Useful as a conceptual framework for practitioners (guiding the
decision-making).
 Investigative tool in pursuing a deeper understanding of the business
situation.

TERMS ON TRADE BALANCE

i. Trade Deficit - An economic condition in which a nation imports more
than it exports
ii. Trade Surplus - An economic condition in which a nation exports more
than it imports
iii. Balance of Trade - The aggregation of buying (importing) and selling
(exporting) by both sides leads to the country-level trade surplus or
deficit.

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MODERN FIRM-BASED TRADE THEORIES
 Country Similarity Theory
 Product Life Cycle Theory
 Global Strategic Rivalry Theory
 Porter’s National Competitive Advantage

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