International Trade

International trade, economic transactions that are made between countries.

Among the items commonly traded are consumer goods, such as television sets and
clothing; capital goods, such as machinery; and raw materials and food. Other
transactions involve services, such as travel services and payments for foreign
patents. International trade transactions are facilitated by international financial
payments, in which the private banking system and the central banks of the trading
nations play important roles.
International trade and the accompanying financial transactions are generally
conducted for the purpose of providing a nation with commodities it lacks in
exchange for those that it produces in abundance; such transactions, functioning
with other economic policies, tend to improve a nation’s standard of living.
Theories of International Trade
 Classical Theories
 Mercantilism
Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop
an economic theory. This theory stated that a country’s wealth was determined by the
amount of its gold and silver holdings. In it’s simplest sense, mercantilists believed that a
country should increase its holdings of gold and silver by promoting exports and
discouraging imports. The objective of each country was to have a trade surplus, or a
situation where the value of exports are greater than the value of imports, and to avoid
a trade deficit, or a situation where the value of imports is greater than the value of exports.
• The mercantilists believed that a nation’s wealth and prosperity is
reflected in its stock of precious metals (also known as specie),
namely, gold and silver. At that time, as gold and silver were the
currency of trade between nations, a country could accumulate gold
and silver by exporting more and importing less. The more gold and
silver a nation had, the richer and more powerful it was. They argued
that government should do everything possible to maximize exports
and minimize imports. However, since all nations could not
simultaneously have an export surplus and the amount of gold and
silver was limited at any particular point of time, one nation could
gain only at the expense of other nations. In other words,
mercantilists believed that trade was a zero sum game (i.e. one’s gain
is the loss of another). For mercantilists, the objective of foreign trade
was considered to be achievement of surplus in the balance of
payments. Hence, they advocated achieving as high trade surplus as
possible.
 Absolute Cost Advantage
Adam Smith was the first to put across the possibility that international
trade is not a zero sum game.
Adam Smith propounded the theory of absolute cost advantage as the
basis of foreign trade; under such circumstances an exchange of goods
will take place only if each of the two countries can produce one
commodity at an absolutely lower production cost than the other
country.
The concept of absolute advantage was developed by Adam Smith in
his book Wealth of Nations to show how countries can gain from trade
by specializing in producing and exporting the goods that they can
produce more efficiently than other countries. Countries with an
absolute advantage can decide to specialize in producing and selling a
specific good or service and use the funds that good or service
generates to purchase goods and services from other countries.
• According to Adam Smith, mutually beneficial trade is based on the
principle of absolute advantage. His theory is based on the
assumptions that there are two countries, two commodities and one
factor (labour) of production. Adam Smith’s theory is based on labour
theory of value, which asserts that labour is the only factor of
production and that in a closed economy goods exchange for one
another according to the relative amounts of labour they embody.
The principle of absolute cost advantage points that a country will
specialize and export a commodity in which it has an absolute cost
advantage.
 Comparative Cost Advantage
A comparative advantage occurs when a country can produce a good or
service at a lower opportunity cost than another country. The theory of
comparative advantage is attributed to political economist David
Ricardo, who wrote the book Principles of Political Economy and
Taxation.
Comparative advantage occurs when a country cannot produce a
product more efficiently than the other country; however,
it can produce that product better and more efficiently than it does
other goods. The difference between these two theories is subtle.
Comparative advantage focuses on the relative productivity differences,
whereas absolute advantage looks at the absolute productivity.
• It is important to note that the United States enjoys an absolute advantage in the
production of cloth and wine. With one labor hour, a worker can produce either 20 cloths
or 20 wines in the United States compared to France’s 5 cloths or 10 wines.
• The United States enjoys an absolute advantage in the production of cloth and wine.
• To determine the comparative advantages of France and the United States, we must first
determine the opportunity cost for each output:

• France:
• Opportunity cost of 1 cloth = 2 wine
• Opportunity cost of 1 wine = ½ cloth

• The United States:

• Opportunity cost of 1 cloth = 1 wine
• Opportunity cost of 1 wine = 1 cloth
• When comparing the opportunity cost of 1 cloth for both France
and the United States, we can see that the opportunity cost of
cloth is lower in the United States. Therefore, the United States
enjoys a comparative advantage in the production of cloth.
• Additionally, when comparing the opportunity cost of 1 wine for
France and the United States, we can see that the opportunity
cost of wine is lower in France. Therefore, France enjoys a
comparative advantage in the production of wine.
Modern Theories
 Heckscher- Ohlin Theory or Two Factor Theory or Factor Endownment
As a matter of fact, Ohlin’s theory begins where the Ricardian theory of
international trade ends. The Ricardian theory states that the basis of
international trade is the comparative costs difference. But he did not
explain how after all this comparative costs difference arises.
Ohlin’s theory is usually expounded in terms of a two-factor model
with labour and capital as the two factors of endowments.
Some countries have plenty of capital; others have an abundance of
labour. The Heckscher-Ohlin theorem is: countries which are rich in
labour will export labour intensive goods and countries which have
plenty of capital will export capital-intensive products.
• Leontief Paradox
• In the early 1950s, Russian-born American economist Wassily
W. Leontief studied the US economy closely and noted that the
United States was abundant in capital and, therefore, should
export more capital-intensive goods. However, his research
using actual data showed the opposite: the United States was
importing more capital-intensive goods. According to the factor
proportions theory, the United States should have been
importing labor-intensive goods, but instead it was actually
exporting them. His analysis became known as the Leontief
Paradox because it was the reverse of what was expected by the
factor proportions theory.
 Country Similarity Theory or Linder Hypothesis
Swedish economist Steffan Linder developed the country similarity theory in 1961,
as he tried to explain the concept of intra industry trade. Linder’s theory proposed
that consumers in countries that are in the same or similar stage of development
would have similar preferences. In this firm-based theory, Linder suggested that
companies first produce for domestic consumption. When they explore exporting,
the companies often find that markets that look similar to their domestic one, in
terms of customer preferences, offer the most potential for success. Linder’s
country similarity theory then states that most trade in manufactured goods will be
between countries with similar per capita incomes, and intra industry trade will be
common. This theory is often most useful in understanding trade in goods where
brand names and product reputations are important factors in the buyers’ decision-
making and purchasing processes.
Developed countries trade more with developed countries
Countries in same cultural milieu trade more amongst themselves
Countries with similar political and economic interests trade more
 Product Life Cycle
Raymond Vernon, a Harvard Business School professor, developed the product life
cycle theory in the 1960s. The theory, originating in the field of marketing, stated
that a product life cycle has three distinct stages: (1) new product, (2) maturing
product, and (3) standardized product. The theory assumed that production of the
new product will occur completely in the home country of its innovation. In the
1960s this was a useful theory to explain the manufacturing success of the United
States. US manufacturing was the globally dominant producer in many industries
after World War II.
• It has also been used to describe how the personal computer (PC) went through
its product cycle. The PC was a new product in the 1970s and developed into a
mature product during the 1980s and 1990s. Today, the PC is in the standardized
product stage, and the majority of manufacturing and production process is done
in low-cost countries in Asia and Mexico.
• The Product Cycle Theory then introduces five stages of production: Introduction,
Growth, Maturity, Saturation, Decline.
• Stage 1: Introduction
• The first for any producer is to promote a new product in the market.
At this stage customers are not aware of the product; hence sales and
profits will below. The competition will also be low in the market.
Stage 2: Growth
• At this stage, the popularity of the product in the market will have
increased. The production company has to increase its promotional
budget. The number of sales will also increase hence the cost of
production decreases.
Stage 3: Maturity
• Compared to the growth stage, the increase in the sale volume and
demand level is relatively low at this stage. Many consumers are
aware of the product and finding new customers is difficult. Even
though the number of competitors have increased at this stage,
business is still juicy at this stage; everything seems to be favorable to
the producers. Foreign demand will also increase at this stage
especially in the developed countries. The increase in foreign demand
will see the producer country setting up similar companies in foreign
countries.
Stage 4: Saturation
• At this stage, competing companies will have taken some portion of
the market. Producer companies do their best to attract new
customers, but there will neither be an increase nor decrease in the
sales volume at this stage.
Stage 5: Decline
• At this stage, the product begins a downward decline in terms of sales
which eventually affects the profit margins. The economic viability of
continuing with the business declines drastically. At this point, the
company can choose to discontinue the production or sell
the company. Another possible scenario is for the production
company to shift its business to a developing country.
 Global Strategic Rivalry Theory

• Global strategic rivalry theory emerged in the 1980s and was based on the work
of economists Paul Krugman and Kelvin Lancaster. Their theory focused on MNCs
and their efforts to gain a competitive advantage against other global firms in
their industry. Firms will encounter global competition in their industries and in
order to prosper, they must develop competitive advantages. The critical ways
that firms can obtain a sustainable competitive advantage are called the barriers
to entry for that industry. The barriers to entry refer to the obstacles a new firm
may face when trying to enter into an industry or new market. The barriers to
entry that corporations may seek to optimize include:
• research and development,
• the ownership of intellectual property rights,
• economies of scale,
• unique business processes or methods as well as extensive experience in the
industry, and
• the control of resources or favorable access to raw materials.
 Porter’s National Competitive Advantage Theory
• Michael Porter’s Diamond Model (also known as the Theory of
National Competitive Advantage of Industries) is a diamond-
shaped framework that focuses on explaining why certain
industries within a particular nation are competitive
internationally, whereas others might not. And why is it that
certain companies in certain countries are capable of consistent
innovation, whereas others might not? Porter argues that any
company’s ability to compete in the international arena is based
mainly on an interrelated set of location advantages that certain
industries in different nations posses, namely: Firm Strategy,
Structure and Rivalry; Factor Conditions; Demand
Conditions; and Related and Supporting Industries.
• Firm Strategy, Structure and Rivalry
• The national context in which companies operate largely determines how companies are
created, organized and managed: it affects their strategy and how they structure
themselves. Moreover, domestic rivalry is instrumental to international competitiveness, since
it forces companies to develop unique and sustainable strenghts and capabilities. The more
intense domestic rivalry is, the more companies are being pushed to innovate and
improve in order to maintain their competitive advantage. In the end, this will only help
companies when entering the international arena. A good example for this is the Japanese
automobile industry with intense rivalry between players such as Nissan, Honda, Toyota,
Suzuki, Mitsubishi and Subaru. Because of their own fierce domestic competition, they
have become able to more easily compete in foreign markets as well.
• Factor Conditions
• Factor conditions in a certain country refer to the natural, capital
and human resources available. Some countries are for example
very rich in natural resources such as oil for example (Saudi
Arabia). This explains why Saudi Arabia is one of the largest
exporters of oil worldwide. With human resources, we mean
created factor conditions such as a skilled labor force, good
infrastructure and a scientific knowledge base. Porter argues
that especially these ‘created’ factor conditions are important
opposed to ‘natural’ factor conditions that are already present. It
is important that these created factor conditions are continously
upgraded through the development of skills and the creation of
new knowledge. Competitive advantage results from the presence
of world-class institutions that first create specialized factors and
then continually work to upgrade them. Nations thus succeed in
industries where they are particularly good at factor creation.
• Demand Conditions
• The home demand largely affects how favorable industries
within a certain nation are. A larger market means more
challenges, but also creates opportunities to grow and become
better as a company. The presence of sophisticated demand
conditions from local customers also pushes companies to grow,
innovate and improve quality. Striving to satisfy a demanding
domestic market propels companies to scale new heights and
possibly gain early insights into the future needs of customers
across borders. Nations thus gain competitive advantage in
industries where the local customers give companies a clearer or
earlier picture of emerging buyer needs, and where demanding
customers pressure companies to innovate faster and achieve
more sustainable competitive advantages than their foreign
rivals.
• Related and Supporting Industries
• The presence of related and supporting industries provides the
foundation on which the local industry can excel. As we have
seen with the Value Net, companies are often dependent on
alliances and partnerships with other companies in order to
create additional value for customers and become more
competitive. Especially suppliers are crucial to enhancing
innovation through more efficient and higher-quality inputs, timely
feedback and short lines of communication. A nation’s companies
benefit most when these suppliers themselves are, in fact, global
competitors. It can often take years (or even decades) of hard
work and investments to create strong related and supporting
industries that assist domestic companies to become globally
competitive.
 Commercial Trade Policy
• A commercial policy or trade policy is a governmental policy governing
trade with other countries. Commercial policy is the part a country’s
economic policy, that is related with measures and instruments
that influence exports and imports, either through quantities,
prices or which goods will be traded or not. Commercial policy
consists of tariffs and other restrictions on international trade.
• Regulations and policies made by the government to regulate how
companies and individuals undertake trade with other countries.
• Countries that are part of an economic union often have a single
commercial policy that determines how member countries can interact
with non-member countries.
• In modern times, the commercial policy of every country is generally
based on the encouragement of exports and the discouragement of
imports. The exports are encouraged by giving preferential freight
rates on exports, subsidies, etc. Imports are hindered by erecting the
tariffs walls, exchange controls, quota system, etc.
 Instruments of Commercial Policy/ Protectionism
1. Tariff
Tariff, also called customs duty, tax levied upon goods as they
cross national boundaries, usually by the government of the
importing country. The words tariff, duty, and customs can be used
interchangeably. Tariffs may be levied either to raise revenue or to
protect domestic industries.
• A tariff is a tax or duty levied on the traded commodity as it crosses a
national boundary. An import tariff is a duty on the imported commodity,
while an export tariff is a duty on the exported commodity.
• Tariffs can be ad valorem, specific, or compound. The phrase "ad
valorem" is Latin for "according to value," and this type of tariff is
levied on a good based on a percentage of that good's value.
An example of an ad valorem tariff would be a 15% tariff levied
by Japan on U.S. automobiles.
• The specific tariff is expressed as a fixed sum per physical unit of the
traded commodity. Specific tariffs are never referenced as
percentages. They are always referred to in reference to a unit or
quantity of units/weight.
• Finally, a compound tariff is a combination of an ad valorem and a
specific tariff. For example, Pakistan charges Rs. 0.88 per
liter of some petroleum products plus 25 percent ad
valorem.
 2. Quotas
• An import quota is a direct restriction on the quantity of some good that
may be imported. The restriction is usually enforced by issuing licenses to
some groups of individuals or firms.
• For example, the United States has a quota on imports of foreign cheese.
• The only firms allowed to import cheese are certain trading companies,
each of which is allocated the right to import a maximum number of
pounds of cheese each year.
3. Embargo
An embargo is a government-ordered restriction of commerce or
exchange with one or more countries. During an embargo, no
goods or services may be imported from or exported to the
embargoed country or countries.
4. Export Subsidies
• An export subsidy is a payment to a firm or individual that ships a good
abroad.
• The state may subsidize certain industries which replace imports or
increase exports. Governments can also give technological support
and promote certain industries as part of it’s commercial policy.
5. Voluntary Export Restraint
• A voluntary export restraint (VER) or voluntary export
restriction is a government-imposed limit on the quantity of
some category of goods that can be exported to a specified
country during a specified period of time. They are sometimes
referred to as 'Export Visas'. Typically VERs arise when
industries seek protection from competing imports from
particular countries.
• VERs are typically implemented on exports from one specific
country to another.
• The United States negotiated voluntary export restraint on Japanese
automobile exports in 1981.
6. Exchange Control
• Exchange control refers to the restrictions on the purchase and sale of
foreign exchange. It is operated in various forms by many countries, in
particular those who experience shortages of hard currencies. The
chief function of most systems of exchange control is to prevent
or redress an adverse balance of payments by limiting foreign-
exchange purchases .
• A government can use exchange controls to limit the number of
products that importers can purchase with a particular currency. For
example, in 1985, China placed strict restrictions on foreign exchange
spending.
7. Export Credit Subsidies
• Export subsidy is a government policy to encourage export of
goods and discourage sale of goods on the domestic
market through direct payments, low-cost loans, tax relief for
exporters, or government-financed international advertising.
• This is like an export subsidy except that it takes the form of a
subsidized loan to the buyer. The United States has a government
institution, the Export-Import Bank, that is devoted to providing at
least slightly subsidized loans to aid exports.
7- Anti Dumping Duty