Chapter Five

International Trade Theory

 5-3

Overview of Trade Theory

• Free Trade occurs when a government does not

attempt to influence, through quotas or duties, 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

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Trade Theory-Overview

• 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
• Later theories appear to make a case for limited
involvement
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Mercantilism: Mid-16th Century

• A nation’s wealth depends on accumulated treasure

- Gold and silver are the currency of trade
• Theory says you should have a trade surplus
- Maximize export through subsidies
- Minimize imports through tariffs and quotas
• Flaw: “zero-sum game”

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Mercantilism-Zero-Sum Game

• In 1752, David Hume pointed out that:

- Increased exports lead to inflation and higher prices
- Increased imports lead to lower prices
• Result: Country A sells less because of high prices
and Country B sells more because of lower prices
• In the long run, no one can keep a trade surplus

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Theory of Absolute Advantage

• Adam Smith argued (Wealth of Nations, 1776):

Capability of one country to produce more of a product
with the same amount of input than another country
can vary
- A country should produce only goods where it is most
efficient, and trade for those goods where it is not efficient
• Trade between countries is, therefore, beneficial
• Assumes there is an absolute balance among
nations
- Example: Ghana/cocoa

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 5-8

Theory of Absolute Advantage

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Absolute Advantage and the

Gains From Trade

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Theory of
Comparative Advantage

• David Ricardo (Principles of Political Economy,

1817):
- Extends free trade argument
- Efficiency of resource utilization leads to more productivity
- Should import even if country is more efficient in the
product’s production than country from which it is buying
- Look to see how much more efficient
• If only comparatively efficient, than import
• Makes better use of resources
• Trade is a positive-sum game

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 5 - 11

Theory of
Comparative Advantage

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Comparative Advantage and the

Gains From Trade

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Simple Extensions of the

Ricardian Model

• Immobile resources:
- Resources do not always move easily from one
economic activity to another

• Diminishing returns:
- Diminishing returns to specialization suggests that
after some point, the more units of a good the country
produces, the greater the additional resources
required to produce an additional item
- Different goods use resources in different proportions

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Simple Extensions of the

Ricardian Model

• Free trade (open economies):

- Free trade might increase a country’s stock of
resources (as labor and capital arrives from abroad)
- Increase the efficiency of resource utilization

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 5 - 15

PPF Under Diminishing Returns

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Influence of Free Trade on PPF

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Heckscher (1919)-Olin (1933) Theory

• Export goods that intensively use factor endowments

which are locally abundant
- Corollary: import goods made from locally scarce factors
• Note: Factor endowments can be impacted by government
policy - minimum wage
• Patterns of trade are determined by differences in
factor endowments - not productivity
• Remember, focus on relative advantage, not absolute
advantage

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Product Life-Cycle
Theory - R. Vernon (1966)

• As products mature, both location of sales and optimal

production changes
• Affects the direction and flow of imports and exports
• Globalization and integration of the economy makes
this theory less valid

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 5 - 19

Product life cycle theory

Fig 4.5

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New Trade Theory

In industries with high fixed costs:

- Specialization increases output, and the ability to enhance
economies of scale increases
- Learning effects are high.
• These are cost savings that come from “learning by doing”

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New Trade Theory-Applications

• Typically, requires industries with high, fixed costs

- World demand will support few competitors
• Competitors may emerge because of “ First-mover
advantage”
- Economies of scale may preclude new entrants
- Role of the government becomes significant
• Some argue that it generates government intervention
and strategic trade policy

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 5 - 22

Theory of National
Competitive Advantage

• The theory attempts to analyze the reasons for a

nation’s success in a particular industry
• Porter studied 100 industries in 10 nations
- Postulated determinants of competitive advantage of a
nation were based on four major attributes
• Factor endowments
• Demand conditions
• Related and supporting industries
• Firm strategy, structure and rivalry

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Porter’s Diamond

• Success occurs where these attributes exist

• More/greater the attribute, the higher chance of
success
• The diamond is mutually reinforcing

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 5 - 24

Porter’s Diamond

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Factor Endowments

• Factor endowments: A nation’s position in factors

of production such as skilled labor or infrastructure
necessary to compete in a given industry
- Basic factor endowments
- Advanced factor endowments

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Basic Factor Endowments

• Basic factors: Factors present in a country

- Natural resources
- Climate
- Geographic location
- Demographics
• While basic factors can provide an initial advantage
they must be supported by advanced factors to
maintain success

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Advanced Factor Endowments

• Advanced factors: The result of investment by

people, companies, and government are more likely to
lead to competitive advantage
- If a country has no basic factors, it must invest in advanced
factors

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Advanced Factor Endowments

• Communications
• Skilled labor
• Research
• Technology
• Education

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Demand Conditions

• Demand:
- creates capabilities
- creates sophisticated and
demanding consumers

• Demand impacts quality and

innovation

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Related and Supporting

Industries

• Creates clusters of supporting industries that are

internationally competitive

• Must also meet requirements of other parts of the

Diamond

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Firm Strategy, Structure

and Rivalry

• Long term corporate vision is a determinant of success

• Management ‘ideology’ and structure of the firm can
either help or hurt you
• Presence of domestic rivalry improves a company’s
competitiveness

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Porter’s Theory-Predictions

• Porter’s theory should predict the pattern of

international trade that we observe in the real world

• 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

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Implications for Business

• Location implications:
- Disperse production activities to countries where they can
be performed most efficiently
• First-mover implications:
- Invest substantial financial resources in building a first-
mover, or early-mover advantage
• Policy implications:
- Promoting free trade is in the best interests of the home
country, not always in the best interests of the firm, even
though many firms promote open markets

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Looking Ahead to Chapter 6

• The Political Economy of International Trade

- Instruments of Trade Policy
- The Case for Government Intervention
- The Revised Case for Free Trade
- Development of the World Trading System

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