INTERNATIONAL BUSINESS AND TRADE

INTERNATIONAL TRADE AND MOBILITY THEORY

CHAPTER OVERVIEW
This provides a conceptual foundation for the exploration of the international
trade process. First, it examines the basic theories of mercantilism, absolute
advantage, and comparative advantage. Then it explores patterns of trade in light of
the theories of country size, factor proportions, and country similarity. It also considers
the role of distance and explains the relevance of Product Life Cycle Theory and
Porter’s Diamond of national competitive advantage. The chapter concludes with a
discussion of factor mobility and its relationship to the international trade process.

CHAPTER OUTLINE
OPENING CASE: COSTA RICAN TRADE, FOREIGN INVESTMENT, AND
ECONOMIC TRANSFORMATION (FOR READING ONLY)
Costa Rica, a Central American country of barely 4 million people, has successfully
transformed its primarily agricultural economy to one that includes strong technology
and tourism sectors as well. Bordering both the Pacific Ocean and the Caribbean arm
of the Atlantic, Costa Rica used international trade and factor mobility policies to help
achieve its economic objectives. Although exports of coffee and bananas are still
important, high-tech manufactured products (electronics, software, and medical
devices) are now the backbone of Costa Rica’s economy and export earnings. As in
all countries, Costa Rica’s policies continually evolved, but generally fall into four
periods and categories:
 1800s–1960: a liberal trade regime that promoted the exports of coffee and
bananas
 1960–1982: a more protectionist regime that promoted import substitution, i.e.,
a policy of developing domestic industries to manufacture goods and provide
services that would otherwise be imported (although results were mixed, the
processing of coffee and cotton seeds increased the value of Costa Rican
exports, and considerable substitution occurred in the pharmaceutical industry)
 1983–Early 1990s: a less protectionist regime that promoted the liberalization
of imports, encouraged export promotion, and provided incentives to attract
foreign capital and expertise
 Early 1990s-Present: a liberal trade regime that seeks the production of
electronics, software, and medical devices via strategic trade policy, i.e., the
identification and development of targeted domestic industries in order to
improve their competitiveness at home and abroad
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I. INTERVENTIONIST THEORIES
Interventionist trade theories prescribe government section with respect to
the international trade process.
A. Mercantilism
The concept of mercantilism (a zero-sum game) served as the
foundation of economic thought for nearly three hundred years (1500-
1800). It purports that a country’s wealth is measured by its holdings of
treasure (usually gold). To amass a surplus (a favourable balance of
trade), a country must export more than it imports and then collect gold
and other forms of wealth from countries that run a deficit (an
unfavourable balance of trade).
B. Neomercantilism
Neomercantilism represents the more recent strategy of countries that
use protectionist trade policies in an attempt to run favourable balances
of trade and/or accomplish particular social or political objectives.

II. FREE TRADE THEORIES

The explanatory power of the theories of absolute and comparative
advantage is limited to the demonstration of how economic growth can
occur via specialization and trade. The concept of free trade (a positive-sum
game) purports that nations should neither artificially limit imports nor
artificially promote exports. The invisible hand of the market will determine
which competitors survive, as customers buy those products that best serve
their needs. Free trade implies specialization—just as individuals and firms
efficiently produce certain products that they then exchange for things they
cannot produce efficiently, nations as a whole specialize in the production
of certain products, some of which will be consumed domestically, and some
of which may be exported; export earnings can then in turn be used to pay
for imported goods and services.

A. Theory of Absolute Advantage

In 1776 Adam Smith asserted that the wealth of a nation consisted of the
goods and services available to its citizens. His theory of absolute
advantage holds that a country can maximize its own economic well-
being by specializing in the production of those goods and services that
it can produce more efficiently than any other nation and enhance global
efficiency through its participation in (unrestricted) free trade. Smith
reasoned that: (i) workers become more skilled by repeating the same
tasks; (ii) workers do not lose time in switching from the production of one
kind of product to another; and (iii) long production runs provide greater
incentives for the development of more effective working methods. Smith
also asserted that country-specific advantages can either be natural or
acquired.
1. Natural Advantage
A country may have a natural advantage in the production of
particular products because of given climatic conditions, access
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to particular resources, the availability of labor, etc. Variations in

natural advantages among countries help to explain where
particular products can be produced most efficiently.
2. Acquired Advantage
An acquired advantage represents a distinct advantage in skills,
technology, and/or capital assets that yields differentiated product
offerings and/or cost-competitive homogeneous products.
Technology, in particular, has created new products, displaced
old products, and altered trading-partner relationships.
3. Resource Efficiency Example
Real income depends on the output of products as compared to
the resources used to produce them. By defining the cost of
production in terms of the resources needed to produce a product,
the production possibilities curve shows that through the use of
specialization and trade, the output of two countries will be
greater, thus optimizing global efficiency.

B. Comparative Advantage
In 1817 David Ricardo reasoned that there would still be gains from trade
if a country specialized in the production of those things it can produce
most efficiently, even if other countries can produce those same things
even more efficiently. Put another way, Ricardo’s theory of comparative
advantage holds that a country can maximize its own economic well-
being by specializing in the production of those goods and services it can
produce relatively efficiently and enhance global efficiency through its
participation in (unrestricted) free trade.
1. An Analogous Explanation
Would it make sense for the best physician in town, who also
happens to be the most talented medical secretary, to handle all
of the administrative duties of an office? No. The physician can
maximize both output and income by working as a physician and
employing a less skilled secretary. In the same manner, a country
will gain if it concentrates its resources on the production of the
goods and services it can produce most efficiently.
2. Product Possibility Example
A country can simultaneously have a comparative advantage and
an absolute advantage in the production of a given product.
Assume that the United States is more efficient than Costa Rica
in the production of both wheat and tea; however, the U.S. has a
comparative ad-vantage in wheat production. By concentrating on
the production of the product in which it has the greater advantage
(wheat) and allowing Costa Rica to produce the product in which
the United States is comparatively less efficient (coffee), global
output can be increased, and specialization and trade will benefit
both countries.
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III. Some Assumptions and Limitations of the Theories of

Specialization
The theories of absolute and comparative advantage are based upon the
economic gains from specialization, i.e., concentration on the production of
a limited number of products. Each holds that specialization will maximize
output and that subsequent trade will maximize consumer welfare.
However, both theories make certain assumptions that may not always be
valid.
1. Full Employment
Both theories assume that resources are fully employed. When
countries have many unemployed or underemployed resources,
they may seek to restrict imports in order to employ their own
available workers and other assets.
2. Economic Efficiency Objective
Individuals and countries often pursue objectives other than
economic efficiency. Individuals may prefer activities and/or
occupations that are economically less productive, and nations
may choose to avoid overspecialization because of the
vulnerability created by potential changes in technology and price
fluctuations.
3. Division of Gains
Although specialization does maximize output, it is unclear how
those gains will be divided. If one country believes that a trading
partner is receiving too large a share of the benefits, it may
choose to forego its relatively smaller gains in order to prevent the
partner country from receiving larger gains.
4. Two Countries, Two Commodities
The world is comprised of multiple countries and multiple
commodities. Nonetheless, the theories are still useful;
economists have applied the same reasoning and demonstrated
the economic efficiency advantages in multi-product and multi-
country production and trade relationships.
5. Transport Costs
If it costs more to deliver products than can be saved via
specialization, then the gains from trade are negated.
6. Statics and Dynamics
Although the theories of absolute and comparative advantage
consider gains at a given time (a static view), the relative
conditions that surround a country’s particular advantage or
disadvantage are dynamic (constantly changing). Thus, one
cannot assume that future advantages will remain constant. (This
idea will also be relevant to the discussion of the dynamics of the
location of production and export sources.)
7. Services
Although the theories of absolute and comparative advantage
were developed from the perspective of trade in commodities,
much of the same reasoning can be applied to trade in services.
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8. Mobility
Neither the assumption that resources can move domestically
from the production of one good to another and at no cost, nor the
assumption that resources cannot move internationally, is entirely
valid. Nonetheless, domestic mobility is greater than the
international mobility of resources. Clearly, the movement of
resources such as capital and labor is a very real alternative to
trade.

IV. THEORIES EXPLAINING TRADE PATTERNS

The explanatory power of the theories of absolute and comparative
advantage is limited to the demonstration of how economic growth can
occur via specialization and trade. The theories of country size, factor
proportions, and country similarity all contribute to the explanation of what
types of products are traded and with which partner nations countries will
primarily trade.
A. How Much Does A Country Trade?
Apart from nontradable products, i.e., goods and services that are
impractical to export, country size helps to explain why some countries
are more dependent on trade than others and why some account for
larger portions of world trade than others.
1. Theory of Country Size
The theory of country size holds that large countries tend to export
a smaller portion of their output and import a smaller portion of
their consumption. Large countries are more apt to have varied
climates and a greater assortment of natural resources than
smaller economies, thus making the large countries more self-
sufficient. Further, given the same types of terrain and modes of
transportation, the greater the distance, the higher the associated
transport costs. Thus, firms in large countries often face higher
transportation costs in terms of sourcing inputs from and
delivering output to distant foreign markets than do their closer
foreign competitors.
2. Size of Economy
Counties can be compared on the basis of their economic size,
using indicators that include the value and share of world trade.
Ten of the world’s top trading nations are high income countries.
Despite its low per capita income, China also has a large
economy because of its very large population. Together, the top
ten nations account for more than one-half of all of the world’s
trade.

B. What Types of Products Does a Country Trade?

The composition of a country’s trade depends on both its natural and
acquired advantages. With respect to the latter, both production and
product technology can be very important.
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1. Factor-Proportions Theory
Developed by Eli Heckscher (1919) and Bertil Ohlin (1933), the
factor-proportions theory holds that (i) differences in a country’s
relative endowments of land, labor, and capital explain
differences in the cost of production factors and (ii) a country will
tend to export products that utilize relatively abundant factors of
production because they are relatively cheaper than scarce
factors; e.g., countries with rich and abundant land tend to be
large exporters of agricultural products, whereas countries with
capital-intensive production lines tend to be large exporters of
manufactured goods. Nonetheless, production factors are not
homogenous, and variations (particularly in labor) have led to
international specialization by task; e.g., countries with less
skilled and lower paid workers tend to export products that
embody a higher intensity of labor.
2. Production Technology
Factor proportions analysis becomes more complicated when the
same product can be produced by different methods, such as
different mixes of labor and capital. The optimum location will
depend on comparisons of the production cost in each potential
locale. Although larger nations tend to depend more on longer
production runs, companies may locate long-run production
facilities in small countries if export barriers to other markets are
relatively low. In addition, firms tend to locate longer-run
production facilities in just a few countries. However, when long
runs are less important, there is a greater tendency to scatter
production units around the world in a way that will minimize the
transportation cost associated with exports.
3. Product Technology
While manufacturing comprises the largest sector of world trade,
commercial services is the fastest-growing sector. Because
manufacturing depends on acquired advantages (largely
technology) plus large amounts of capital investment, most new
products tends to be developed in high-income countries. On the
other hand, lower income countries depend more on the
production of primary products, which in turn depend more on
natural advantages.

C. With Whom Do Countries Trade?

High-income countries trade primarily with each other, and emerging
economies primarily export primary and labor-intensive products.
Nonetheless, it is also true that economic and cultural similarities, political
interests, and distance affect the determination of trading partners.
1. Country-Similarity Theory
The country-similarity theory states that when a firm develops a
new product in response to observed conditions in its home
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market, it is likely to turn to those foreign markets that are most

similar to its domestic market when commencing its initial
international expansion activities. So much trade takes place
among industrialized countries because of the growing
importance of acquired advantages, i.e. skills and technology. In
addition, markets in most industrialized countries are large
enough to support new product introductions and the subsequent
variants across the product life cycle. At the same time, trade in
differentiated products occurs because over time firms in different
countries develop product variants for particular market
segments. Cultural similarity also facilitates trade. In particular, a
common language and a common religion represent two major
facilitators of the international trade and investment process.
Historical and political relationships, as well as economic
agreements, may encourage or discourage trade with particular
countries.
2. Distance Among Countries
Countries that are near to one another enjoy relatively lower
transportation costs than those that are more distant. While the
disadvantages of distance can often be overcome through
innovative technology and marketing methods, such gains are
difficult to maintain in the long run.

V. THE DYNAMICS OF TRADE

Both the product life cycle theory and Porter’s Diamond of national
competitive advantage help to explain how countries develop, maintain, and
possibly lose their competitive advantages.
A. Product Life Cycle (PLC) Theory
Product life cycle theory states that the optimal location for the production
of certain types of goods and services shifts over time as they pass
through the stages of market introduction, growth, maturity, and decline.
1. Changes Through The Cycle
A great majority of the new technology that results in new
products and production methods originates in industrial
countries.
 Introduction
Innovation, production, and sales occur in the domestic
(innovating) country. Because the product is not yet
standardized, the production process tends to be relatively
labor-intensive, and innovative customers tend to accept
relatively high introductory prices.
 Growth
As demand grows, competitors enter the market. Foreign
demand, competition, exports, and often direct investment
activities also begin to accelerate.
 Maturity
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Global demand begins to peak, production processes are

relatively standardized, and global price competition forces
production site relocation to lower-cost developing
countries.
 Decline
Market factors and cost pressures dictate that almost all
production occur in developing countries. The product is
then imported by the country where it was initially
developed—the importing firm may or may not be the
innovating firm.
2. Verification and Limitations of PLC Theory
Exceptions to the typical pattern of the product life cycle theory
would include: products that have very short life cycles, luxury
goods and services, products that require specialized labor,
products that can be differentiated from direct competitors, and
product for which transportation costs are relatively high.

B. The Porter Diamond

Introduced by Michael Porter in 1990, the Diamond of National
Competitive Advantage, i.e., the Porter Diamond, theorizes that national
competitive advantage is embedded in four determinants: (i) demand
conditions, (ii) factor conditions, (iii) related and supporting industries,
and (iv) firm strategy, structure, and rivalry. All four determinants are
interlinked and generally need to be favorable if a given national industry
is going to attain global competitiveness. At times, determinants can be
affected by the roles of chance and government.
1. Explanation of the Porter Diamond
 Demand Conditions
The nature and level of demand in the home market lead
to the establishment of production facilities to meet that
demand
 Factor Conditions
Resource availability (inputs, labor, capital, and
technology) contributes to the competitiveness of both
firms and countries that compete in particular industries.
 Related and Supporting Industries
The local presence of internationally competitive suppliers
and other related industries contributes to both the cost
effectiveness and strategic competitiveness of firms.
 Firm Strategy, Structure, and Rivalry
The creation and persistence of national competitive
advantage requires leading-edge product and process
technologies and business strategies.
2. Limitations of the Porter Diamond
The existence of the four favorable conditions may represent a
necessary but insufficient condition for the development of a
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particular national industry. Even when abundant, resources are

ultimately limited; thus, firms must make choices regarding their
pursuit of existing opportunities. Further, given the ability of firms
to gain market information and production inputs from abroad, the
absence of favorable conditions within a country may be
overcome by their existence internationally.
3. Using the Diamond for Transformation
Understanding and having the necessary conditions to be globally
competitive are important, but these conditions are neither static
nor purely domestic. As shown in the opening case regarding
Costa Rica’s economic transformation, the Costa Rican
government altered its educational system to tailor the country’s
human resource development to fit the needs of targeted
industries. Likewise, it developed local supplies and attracted
sufficient numbers of foreign firm so that their combined presence
assured a vibrant competitive environment.

VI. FACTOR MOBILITY

Over time factor conditions change in both quality and quantity.
Concomitantly, the mobility of capital, technology, and people also affects
the relative capabilities of countries.
A. Why Production Factors Move
Factor mobility concerns the free movement of factors of production, such
as labor and capital, across national borders. While capital is the most
internationally mobile factor, short-term capital is the most mobile of all.
Capital is primarily transferred because of differences in expected
returns, although firms may also respond to government incentives.
People transfer internationally in order to work abroad, either on a
temporary or a permanent basis. It may be difficult to distinguish between
economic and political motives associated with international labor
mobility, because poor economic conditions often accompany repressive
and/or uncertain political conditions.

B. Effects of Factor Movements

Although capital and labor are in fact different production factors, they are
intertwined. Further, neither international capital nor population
movements are new occurrences. Immigrants bring human capital, thus
adding to the base of a country’s skills and enabling competition in new
areas. Likewise, inflows of capital to those same countries can be used
to develop infrastructure and natural and other acquired advantages, thus
enabling increased participation in the international trade arena.
Countries lose potentially productive resources when educated people
leave, a situation known as brain drain, but they may in turn gain from the
remittances that citizens who are working abroad send home.
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C. The Relationship of Trade and Factor Mobility

Factor movement is an alternative to trade that may or may not be a more
efficient allocation of resources.
1. Substitution
When factor proportions vary widely among countries, pressures
exist for the most abundant factors to move to countries with
greater scarcity. Thus, in countries where labor is relatively
abundant compared to capital, workers tend to be poorly paid;
many will attempt to go to countries that enjoy full employment
and offer higher wages. Likewise, capital tends to move away
from countries where it is abundant to those where it is relatively
scarce. However, the inability to gain sufficient access to foreign
production factors may stimulate efficient methods of domestic
substitution, such as the development of alternatives for
traditional production methods.
2. Complementarity
Factor mobility via foreign direct investment may in fact stimulate
foreign trade because of the need for equipment, components,
and/or complementary products in the destination country.
Alternatively, trade may be restricted by local content laws, or
when foreign direct investment leads to import substitution.