C-AE5:
INTERNATIONAL BUSINESS AND TRADE
MODULE NO. 3: MODERN THEORIES OF INTERNATIONAL TRADE
FJJNG
Two important landmarks that happened in history as far
as the international trade in concerned:
ͦ NAFTA – North American Free Trade Agreement
Participated by the US, Canada, & Mexico
ͦ GAT – General Agreement on Tariffs and Trade
Human Capital Approach Theory
• This theory, which is also sometimes known as Skills
Theory of International Trade, has been advocated
by a number of economists, especially Becker,
Kennen and Kessing. Whereas the Factor
Proportions Theory considers labor as a
homogenous factor, however, it is not so in the real
world.
ͦ States that earnings start out low when people are
young because younger people are more likely to
invest in human capital and will have to forego
earnings as they invest.
ͦ Theory of earnings (one of the major determinants of
poverty).
ͦ Work = compensation = basic needs.
ͦ Human is the most important capital
Organizations are created because there are people
working. Businesses are created because there are
people who will be manufacturing or producing
products (manpower).
Identical Preferences Theory
• This theory is based on the role of demand as an
explanatory variable used by Linder. A domestic
industry can flourish and reach commercially optimal
level of production if the domestic demand is large
enough.
ͦ States that given the consumers’ budget, they will
select the same bundle of goods as long as the
bundle remains affordable.
Strategic Trade Theory
• With the dramatic growth in trade in the last few
decades, and the growth in the role of MNEs in
international trade, there has been a resurgence of
interest in taking a fresh look at theories of
international trade. In the last two decades, a new set
of models has come into being, using the
perspectives of game theory and theories of industrial
organization. While there is no one overarching
model, this broad collection of theories and ideas has
come to be known as “strategic trade theories”.
ͦ Describes the policy that certain countries adapt in
order to affect the outcome of strategic interaction
between firms in an international oligopoly.
ͦ Consideration of different vendors to make some
choices ~ compare prices, quality, and brands.
ͦ Oligopoly – an industry dominated by a small number
of firms.
ͦ Monopoly – an industry dominated by as single seller
or producer.
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BSA 3 ‘22’23
Some of the main insights from this literature are as follows:
1. Increasing returns to scale provide a justification for
trade for reasons other than comparative advantage,
since firms will have the incentive to produce and
export in order to lower costs by attaining greater
scale economies; an example of a industry where this
is an important issue is the commercial airframes
industry.
* Comparative advantage – producing
something that can be produced at a lower
cost compared with others.
2. Product differentiation can result in intra industry
trade, since, within the same industry, the same
product can have different brand identities; for
example, the US will export certain types of
automobiles (Ford Escort) and it will import other
types of automobiles (BMWs).
* Product differentiation – process of
distinguishing a product or service from
others to make it more attractive to a
particular target market; product
uniqueness; distinct; novel.
3. Imperfect competition creates rents and trade policy
could shift rents from the foreign country to the home
country. For example, the imposition of quotas will
increase domestic prices and thus can create rents
for foreign producers; the home-country government
may try to counterbalance it with a subsidy to
domestic producers, so as to put price pressure on
foreign producers.
* Imperfect competition – refers to a
situation where the characteristics of an
economic market do not fulfill all the
necessary conditions of a perfectly
competitive market that will result into
market failure.
* There is perfect competition if the prices
of the different companies are not really
different from one another.
* There is also perfect competition when
one is fighting against its rivals or
competitors through quality.
4. Externalities and spillover effects (particularly in
innovation and R & D) may sometimes provide a
justification for industry protection for reasons other
than industry infancy or national security.
* Externalities occur when some of the
benefits or costs of production are not fully
reflected in market demand or supply
schedule. Also called as the third-party
effect which means that there would be
some of the benefits or costs of a good that
may spillover to a third party.
* Innovation – copy/imitate existing but with
improvements in any form; Invention – first
one to come up ~ patent; R&D – requires
large budget.
 C-AE5:
INTERNATIONAL BUSINESS AND TRADE
5. Irreversible investments induce an asymmetry
between entry and exit costs, and can therefore lead
to “hysteretic” responses to price or quantity shifts.
* There is irreversible investment when the
capital of a firm has invested in itself (ex.
Capital fixture).
Modern Investment Theory
• Other theories explain investing overseas by firms, as
a response to the availability of opportunities not
shared by their competitors, that is, to take advantage
of imperfections in markets and only enter foreign
spheres of production when their comparative
advantages outweigh the costs of going overseas.
ͦ A theory on how risk averts investors.
ͦ The modern investment can construct portfolios to
maximize expected return based on a given level of
market risk.
ͦ The Modern Investment Theory can be used to
construct a portfolio that minimizes risk for a given
level of expected return.
International Product Life Cycle Theory
• The international product life cycle theory puts forth
a different explanation for the fundamental
motivations for trade between and among nations. It
relies primarily on the traditional marketing theory
regarding the development progress, and life span
of products in markets. This theory looks at the
potential export possibilities of a product in four
discrete stages in its life cycle.
ͦ Authored by Raymond Vernon.
ͦ It explains the cycle the products go through when
exposed to an international market.
ͦ The cycle describes how a product matures and
declines as a result of internalization.
1. Introductory – introduction stage
2. Growth stage
3. Maturity stage
4. Decline(d) stage
ͦ International product life cycle:
1. New product introduction – advertising the
product; most expensive stage.
2. Maturity stage – consider opening up
production plants locally in each developed
country to meet the demand; there is the
successful introduction of the product.
3. Product standardization/streamlining of
manufacturing – expert’s donations (?) to
(with?) the less developed economy will
begin. (ex. allowing other countries to make
use of the firm’s best practices.); per batch.
Stages and Characteristics
There are five distinctive stages in IPLC. The Table 3.1
shows the major characteristics of the IPLC stages with
the US as the developer of the innovation in question. It
shows that three life cycle curves for the same
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BSA 3 ‘22’23
innovation: one for the initiating country (US), one for
other advanced nations and one for LDCs.
Stage 0 – Local Innovation:
• Stage 0 depicted as time 0 on the left of the
vertical importing/ exporting axis, representing a
regular and highly familiar product life cycle in
operation within its original market. Innovations
are most likely to occur in highly developed
countries because consumers in such countries
are affluent and have relatively unlimited want.
From the supply side, the firms in advanced
nations have both the technological know-how
and abundant capital to develop new products.
ͦ Refers to the domestic concentration of firms
and associated nonmarket institutions that
combine to create new products or services in
specific lines of business.
* Product lines – related or relative products.
* Product mix/assortment – varieties of
product offerings.
Stage 1 – Overseas Innovation:
• As soon as the new product is well developed, its
original market well cultivated, and local demand
adequately supplied, the innovating firm will look
to overseas market in order to expand its sales
and profits. Thus this stage is known as
“Pioneering or International Introduction”
stage. The technological gap is first noticed in
other advanced nations because of their similar
needs and high-income levels.
Stage 2 – Maturity:
• Growing demand in advanced nations provides an
impetus for firms there to commit themselves to
starting local production, often with the help of
their governments’ protective measures to
preserve infant industries (neophyte
businessmen/businesses). Thus, these firms can
survive and thrive in spite of the relative
inefficiency.
ͦ Otherwise, these infant industries will be left
behind and will not progress.
ͦ Competition does not mean initiating the country’s
export level.
Stage 3 – Worldwide Imitation:
• This stage means tough times for the innovating
nations because of its continuous decline in
exports. There is no more new demand anywhere
 C-AE5:
INTERNATIONAL BUSINESS AND TRADE BSA 3 ‘22’23
to cultivate. The decline will inevitably affect the
US innovating firms’ economies of scale and its
production costs thus begin to rise again.
Consequently, firms in other advanced nations
use their lower prices (coupled with product
differentiation techniques) to gain more consumer
acceptance abroad at the expense of the US firm.
As the product becomes more and more widely
disseminated, imitation picks up at a faster pace.
Stage 4 – Reversal:
• Not only must all good things end, but misfortune
frequently accompanies the end of a favorable
situation. The major functional characteristics of
this stage are product standardization and
comparative disadvantage. The innovating
country’s comparative advantage has
disappeared, and what is left is comparative
disadvantage. This disadvantage is brought about
because the product is no longer capital-intensive
or technology-intensive but instead has become
labor intensive – a strong advantage possessed
by LDCs.
Critical Evaluation of International Trade Theories
The Validity
• Several studies have investigated the validity of the
classical trade theories. The evidence collected by
MacDougall shortly after the World War II showed
that comparative cost was useful in explaining trade
patterns. Other studies using different data and time
periods have yielded results similar to MacDougall.
ͦ Extent to which a concept, conclusion, or
measurement is well-founded and likely corresponds
accurately to the real world.
Limitations Trade
• Theories provide logical explanations about why
nation trade with one another but such theories are
limited by their underlying assumptions. Most of the
world’s trade rules are based on traditional models
that assume: (1) Trade is Bilateral, (2) Trade involves
products originating primarily in the exporting country
(novel, phenomenon, original), (3) the exporting
country has a comparative advantage and (4)
competition primarily focuses on the importing
country’s market. However, today the reality is quite
different.
ͦ Limitations = restrictions or restraints when it comes
to trading.
ͦ Bilateral – exchange of goods between two nations
promoting trade and investment.
ͦ Importations occur when there is insufficiency.

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NAFTA – North American Free Trade Agreement (USA,
Canada, Mexico)
GAT – General Agreement on Tariffs and Trade
HUMAN CAPITAL APPROACH THEORY
• Earnings start out low when people are young
because younger people are more likely in human
capital and will have to forego earnings as they
invest.
• Theory of Earnings
• One of the major determinants of poverty
(employment; salaries/compensation;
organization = manpower)
IDENTICAL PREFERENCES THEORY
• Given a consumers’ budget, they will select the
same bundle of goods as long as the bundle remains
affordable.
STRATEGIC TRADE THEORY
• Describes the policy that certain countries adapt in
order to affect the outcome of strategic interactions
between firms in an international oligopoly.
• Oligopoly = industry dominated by a small number
of firms (example: 2 or 3 sellers of a product)
• Monopoly = one seller
• Some of the main insights from this literature are
as follows:
1. Comparative advantage = edge among other
competitors;
2. Product differentiation = process of
distinguishing a product or service from others
to make it more attractive to a particular target
market (product uniqueness; distinct; novel)
3. Imperfect competition = refers to a situation
where the characteristics of an economic
market do not fulfill the necessary conditions
of a perfectly competitive market that will
result into market failure
4. Externalities and spillover effects = occur
when some of the benefits or cost of
production are not fully reflected in market
demand or supply schedule; “The Third Party
Effect”
5. Irreversible investments = when the capital
of a firm has invested in itself
MODERN INVESTMENT THEORY
• A theory on how risk averts investors. The modern
investment can construct portfolios to maximize
expected return based on a given level of market
risk.
INTERNATIONAL PRODUCT LIFE CYCLE THEORY
• Authored by Raymond Vernon
• It explains the cycle the products go through when
exposed to an international market; how a product
matures and declines as a result of
internationalization
• Stages and Characteristics:
• New Product Introduction = begins with
introduction of new product; most expensive stage;
advertisements
• Maturity = manufacturer will need to consider
opening up production plans locally in each
developed country to meet the demand; successful
introduction of product; sales increase gradually
• Product Standardization = streamlining of
manufacturing; experts aims with the less
developed economy;
Stage 0 – Local Innovation: refers to the domestic
concentration of firms and associated non-market
institutions that combine to create new products and
services in specific lines of business. (product offering →
product assortment; saturate locally)
Stage 1 – Overseas Innovation: the new product is well
developed; its original market is well cultivated; and local
demand adequately supplied; the innovation will look to
overseas markets in order to expand sales and market.
Stage 2 – Maturity: growing demand in advanced nations
that will provide the firms to commit themselves to starting
local production; competition is tight;
Stage 3 – Worldwide Imitation: this stage means tough
times for the innovating nations because of its continuous
decline in exports. There is no more new demand anywhere
to cultivate.
Stage 4 – Reversal: the major functional characteristics of
this stage are product standardization and comparative
disadvantage; product
differentiation/innovation/reengineering.
Critical Evaluation of International Trade Theories
We will study this under two heads: validity and
limitations.
The Validity – extent to which a concept, conclusions, or
measurements is well founded and likely corresponds
accurately to the real world.
Limitations Trade – restrictions/restraints; you cannot
just bring your products to other countries; abide by the
rules and regulations, and ordinances;
(1) Bilateral – exchange of goods between two countries
for trade and investment
(2) Novel – original product
(3) Comparative Advantage – edge
(4) Importation - materials are not sufficient for you to
produce final output