Unit 1: International Trade

Learning Objectives:
1. Define international trade.
2. Describe mercantilism and explain its impact on the
world powers and their economies
3. Identify the differences between absolute advantage and
comparative advantage.
4. Explain the factor proportions and international product
life cycle theories.
5. Explain the new trade and national competitive
advantage theories.
Part 1: Overview of International Trade
International Trade: the purchase, sale, or
exchange of goods and services across national
borders.
Benefits of International Trade:
- Provides a country's people with a greater choice
of goods and services.
- An important engine for job creation in many
countries.
 Exporting: Sending goods to another country for
sale or trade.
 Importing: Bringing in goods from another country
for sale or trade.
 Trade surplus: Condition that results when the
value of nation's exports is greater than the value
of its imports.
 Trade deficit: Condition that results when the
value of a country's imports is greater than the
value of its exports.
Part 2: Theories of International Trade
Theories of International Trade explain why trade occurs and
how trade can benefit both parties to an exchange.
07 Theories:
 Mercantilism
 Absolute Advantage
 Comparative Advantage
 Factor Proportion Theory
 International Product Life Cycle
 New Trade Theory
 National Competitive Advantage
Mercantilism

 Mercantilism: the trade theory saying that nations

should accumulate financial wealth, usually in the
form of gold, by encouraging exports and
discouraging imports.
 Nation-states in Europe followed this economic
philosophy from about 1500 to the late 1700.
 Mercantilism
Countries implemented mercantilism by doing three things:
 Increase their wealth by maintaining a trade surplus – the
condition that results when the value of a nation’s exports is
greater than the value of its imports. In mercantilism, trade
deficits – conditions that result when the value of a country’s
imports is greater than the value of its exports - were to be
avoided at all costs.
 National governments actively intervened in international
trade to maintain a trade surplus.
 Mercantilist nations acquired less-developed territories
(colonies) around the world to serve as sources of
inexpensive raw materials and as markets for higher-priced
finished goods.
Mercantilism assumes that a nation increases its wealth only at
the expense of other nations – a zero – sum game.
Absolute Advantage
Absolute advantage: The ability of a nation to produce a good
more efficiently than any other nation.
 According to this theory, international trade should not be
banned or restricted by tariffs or quotas, but allowed to
flow according to market forces.
 A country can concentrate on producing the goods in which
it holds an absolute advantage and then trade with other
nations to obtain the goods it needs but does not produce.
 Because there are gains to be had by both countries to an
exchange, international trade is shown to be a positive-sum
game.
 The theory measures a nation’s wealth by the living standard
of its people.
Comparative Advantage

 A nation holds a comparative advantage in the

production of a good when it is unable to produce
a good more efficiently than other nations, but
can produce it more efficiently than it can any
other good.
 As a result, trade is still beneficial even if one
country is less efficient in the production of two
goods, so long as it is less inefficient in the
production of one of the goods.
Assumptions and Limitations
Throughout the discussion of absolute and comparative
advantage, several important assumptions are made:
 Countries are driven only by the maximization of
production and consumption.
 There are only 2 countries engaged in the production and
consumption of just 2 goods.
 There are no costs for transporting traded goods from one
country to another.
 Labour is the only kind of resources for the production
process.
 Specialization in the production of one particular good
does not result in gains in efficiency.
Factor Proportion Theory
 Factor proportions theory states that countries produce
and export goods that require resources (factors) that are
abundant and import goods that require resources in short
supply.
 The factor proportions theory predicts that a country will
specialize in products that require labour if its cost is low
relative to the cost of land and capital.
 Alternatively, a country will specialize in products that
require land and capital equipment if their cost is low
relative to the cost of labour.
 The apparent paradox between predictions of the theory
and actual trade flows is called the Leontief Paradox.
International Product Life Cycle
The international product life cycle theory says that a
company will begin exporting its product and later
undertake foreign investment as the product moves through
its life cycle.
 In the new product stage, the company keeps production
volume low and based in the home country.
 In the maturing product stage, the company introduces
production facilities in the countries with the highest
demand.
 In the standardized product stage, competition forces an
aggressive search for low-cost production bases in
developing nations to supply a worldwide market.
New Trade Theory
 The New Trade Theory argues that as a company increases the
extent to which it specializes in the production of a particular
good, output rises because of gains in efficiency.
 As specialization and output increase, companies can realize
economies of scale, thereby pushing the unit costs of
production lower.
 The presence of large economies of scale can allow a firm to
gain a first-mover advantage - the economic and strategic
advantage gained by being the first company to enter an
industry.
 The theory says that by working together, government and
home-based companies can target potential new industries in
which to become first movers. It also argues that the
government may play a role in assisting its home companies.
 National Competitive Advantage
National Competitive Advantage theory states that a nation’s
competitiveness in an industry (and, therefore, trade flows) depends on
the capacity of the industry to innovate and upgrade.
The Porter diamond identifies four elements that form the basis of
national competitiveness:
 Factor conditions including the skill levels of different segments of
the work-force and the quality of technological infrastructure;
 Demand conditions such as a sophisticated domestic market;
 Related and supporting industries that spring up and form clusters of
related economic activities; and
 Firm strategy, structure, and rivalry conditions that are present in an
industry.
The actions of governments and the occurrence of chance events can
also affect the competitiveness of a nation’s companies.