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International Business

MMS – Sem III

International Trade Theories

An Overview Of Trade Theory
• Mercantilism
Encourage exports

Free Trade
Unrestricted Free Trade

Comparative Advantage

Heckscher-Ohlin Theory

through quotas or duties. • The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish). Others are not so easy to understand (Japan and cars). • The history of Trade Theory and Government Involvement presents a mixed case for the role of government in promoting exports and limiting imports. . what its citizens can buy from another country or what they can produce and sell to another country. • The Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country.An Overview of Trade Theory • Free Trade occurs when a government does not attempt to influence. Later theories appear to make a case for limited involvement.

• Explain the pattern of international trade observed in the world economy. .• Explain why it is beneficial for a country to engage in international trade.

• Theory says you should have a trade surplus. .  Maximize exports through subsidies.  Minimize imports through tariffs and quotas.Mercantilism: mid-16th century • A nation’s wealth depends on accumulated treasure • Gold and silver are the currency of trade.

e. • Capability of one country to produce more of a product with the same amount of input than another country. Ghana/cocoa. • Assumes there is an absolute advantage balance among nations. • Produce only goods where you are most efficient.Theory of Absolute Advantage Adam Smith: Wealth of Nations (1776).. trade for those where you are not efficient.g. .

. High tariffs. Nkrumah espoused pan African socialism.1st British African colony to win independence (1957). Anti export (trade) policy.

1950s: 77% of employment in agriculture. Created incentives to export (trade). Manufacturing GNP went from 10% to over 30%.Kept lowering tariffs on manufactured goods. . Reduced subsidies. Reduced quotas. Now 20%.

The Theory of Absolute Advantage G 20 Cocoa 15 10 A K 5 B G’ K’ 15 20 0 5 10 Rice .

0 6.0 10. Korea Korea 0 14.0 14.5 .0 2.0 10 10 40 20 20 10 5.0 4.5 12.0 1. S.The Theory of Absolute Advantage and the Assume 200 units Gains from Trade Resources Required to Produce 1 Ton of Cocoa and Ricece Ghana Ghana S Ghana Korea Cocoa to Produce Rice Resources Required 1 Ton of Cocoa and Rice Production and Consumption without Trade 10.0 Ghana Korea 4.0 0 20 20 Each country devotes half resource Ghana Korea Total production Ghana Ghana 20 Korea Total production 10.0 206.0 3.0 15.0 5.5 20 0 0 20 Production with Specialization Production with Specialization Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice Increase in Consumption as a Result of Specialization and Trade Ghana S.

Theory of Comparative Advantage David Ricardo: Principles of Political Economy (1817). It makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries even if this means buying goods from other countries that it could produce more efficiently itself. .

5 0 5 15 20 Rice .The Theory of Comparative Advantage G 20 Cocoa 15 C A 10 5 K B K’ 10 G’ 2.

75 10.Comparative Advantage and the Gains from Trade Resources Required to Produce 1 Ton of Cocoa and Rice Ghana has absolute advantage Cocoa Rice Ghana S. Korea Ghana S.5 12. Korea 10 40 10.5 5.0 1.0 15 11 4 13.75 7.5 0.0 2.33 20 7.25 1.0 .0 13.75 6 Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice Increase in Consumption as a Result of Specialization and Trade Ghana S.0 12. Korea 1. Korea Total production Ghana S.5 Production and Consumption without Trade Ghana Comparative advantage is in Cocoa Production with Specialization 3. Korea Total production Ghana S.5 15 0.

at some point. will require more resources (diminishing returns to specialization). and Increase the efficiency of resource utilization. However: Free trade might increase a country’s stock of resources (as labor and capital arrives from abroad). Different goods use resources in different proportions.Extensions of the Ricardian Model Immobile resources: Resources do not always move easily from one economic activity to another. Diminishing returns: More a country produces. .

Ghana’s PPF under Diminishing Returns G Cocoa G’ 0 Rice .

The Influence of Free Trade on the PPF PPF2 PPF1 Cocoa G’ 0 Rice .

a one percentage point increase in the ratio of a country’s trade to its GDP increases income/person by at least 0.49%/year. Closed economy developing countries grew 0.5%.74%/year.69%/year. . Frankel and Romer: On average.A Link Between Trade and Growth Sachs and Warner: 1970 to 1990 study Open economy developing countries grew 4. For every 10% increase in the importance of international trade in an economy. average income levels will rise by at least 5%.29%/year. Closed economy developed countries grew 0. Open economy developed countries grew 2.

• Patterns of trade are determined by differences in factor endowments . not absolute advantage.Heckscher (1919)-Olin (1933) Theory • Labor is not the only Factor of production. We need to account for land. • Export goods that intensively use factor endowments which are locally abundant.not productivity. and technology. and capital. • Remember. • Factor endowments: extent to which a country is endowed with such resources as land. focus on relative advantage. • Corollary: import goods made from locally scarce factors. capital. labor. .

The Leontief Paradox. • US tends to export labor-intensive products.minimum wage. but is regarded as a capital intensive country . • Factor endowments can be impacted by government policy . 1953 • Disputes Heckscher-Olin in some instances.

1966) • Article in the Quarterly Journal of Economics.Product Life-Cycle Theory (Raymond Vernon. both location of sales and optimal production changes. . • Globalization and integration of the economy makes this theory less valid. • As products mature. • Affects the direction and flow of imports and exports.

ability to enhance economies of scale increase.The New Trade Theory • Began to be recognized in the 1970s. – Specialization increases output. learning effects also exist. . • Deals with the returns on specialization where substantial economies of scale are present. • In addition to economies of scale. – Learning effects are cost savings that come from “learning by doing”.

requires industries with high. . • World demand will support few competitors. • First-mover advantage. • Competitors may emerge because “they got there first”. fixed costs.Application of the New Trade Theory • Typically. • Some argue that it generates government intervention and strategic trade policy.

First-Mover Advantage • The economic and strategic advantages that accrue to early entrants into an industry. • Role of the government. • Economies of scale may preclude new entrants. .

• Question: “Why does a nation achieve international success in a particular industry?” .Porter’s Diamond (Harvard Business School. 1990) • The Competitive Advantage of Nations. – Thought existing theories didn’t go far enough. • Looked at 100 industries in 10 nations.

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

• The Diamond • Success occurs where these attributes exist. • The diamond is mutually reinforcing. – More/greater the attribute. . the higher chance of success.

Structure and Rivalry Factor Endowments Demand Conditions Related and Supporting Industries .Porter’s Diamond Determinants of National Competitive Advantage Firm Strategy.

and Rivalry Two external factors that influence the four determinants.Determinants of National Competitive Advantage Chance Company Strategy. Structure. Factor Conditions Demand Conditions Related and Supporting Industries Government .

Factor Endowments Taken from Heckscher-Olin Basic factors: natural resources climate location demographics Advanced factors: communications skilled labor research technology .

. Demand Conditions Demand creates the capabilities.Relationship of Basic to Advanced Factors Basic can provide an initial advantage. Look for sophisticated and demanding consumers. impacts quality and innovation. then must invest in advanced factors. Must be supported by advanced factors to maintain success. No basics.

Must also meet requirements of other parts of the Diamond.Related and Supporting Industries Creates clusters of supporting industries that are internationally competitive. . Firm Strategy. Presence of domestic rivalry improves a company’s competitiveness. Structure and Rivalry Management ‘ideology’ can either help or hurt you.

. Too soon to tell.Evaluating Porter’s Theory If Porter is right. Countries should be exporting products from those industries where all four components of the diamond are favorable. while importing in those areas where the components are not favorable. we would expect his model to predict the pattern of international trade that we observe in the real world.

advantage.Implications for Business Location implications:makes sense to disperse production activities to countries where they can be performed most efficiently. First-mover implications:It pays to invest substantial financial resources in building a first-mover. or early-mover. although not always in the best interests of the firm. Policy implications:promoting free trade is generally in the best interests of the home-country. Even though. . many firms promote open markets.