Int'l Business

Theories & Institutions; Trade and
Investment
Chapter 6
Nereen Abu Keer & Mera Al
Horani
1 Theories & Instituitions: Trade & Investment 01/19/10

Introduction
 This is a theoretical chapter that
collects many of the free trade
theories and patterns; which also
tries to explain the factor affecting
the production, how mobile they are,
and how they lead to the efficient
global trade between markets.
Eventually, understanding all these
theories will help us understand the

core concept of international trade,
2
and define the factors that affect 01/19/10
Theories & Instituitions: Trade & Investment
the
Outlin
e
Laissez-Faire versus Interventionist

Approaches to Exports & Imports

Interventionist:
vMercantilism
vNeomercantilism
Free-trade theories:
vAbsolute advantage
vComparative advantage

Outline
Theories of trade patterns;

Trade Patterns:
vCountry Size Theory
vFactor Proportions Theory
vCountry Similarity Theory
Trade Competitiveness:
vProduct Life Cycle Theory
vPorter Diamond Theory

Case: Costa Rica

Case: Costa Rica
Costa Rica is known as the rich cost
with regard to its fertile soil

The World bank classifies it as

upper middle income with a per
capita GDP of 12,500 $

Costa Rica is highly dependent on

agricultural commodities
6 
Theories & Instituitions: Trade & Investment 01/19/10
Case: Costa Rica
Costa Rica’s evolution of
international trade and factor
mobility policies:
1.1800’s-1960: Liberal Trade- a policy
calling for minimal government
interference in trade and
investment
2.1960-1982: Import Substitution-a
policy calling for the local
production of goods and services
that would otherwise have to be
7
Case: Costa Rica
3. 1983-early 1990’s: liberalization of

imports, export promotion, and

incentives for foreign investments.

4. Early 1990’s-present: strategic


trade and investment- a policy

calling for the production of specific
types of products- and openness to
imports

Case: Costa Rica
Progress Report:
Setting out to attract investments
in electronics and software, Costa
Rica such high Tech investors as
Intel.
Although Bananas and coffee are
still important to the nation’s
economy, as of 2005 about two
thirds of Costa Rica’s exports
have been manufactured goods,
with high tech products
9
constituting the backbone of the
Laissez Faire- versus Interventionist
Approach

Interventionist:
Mercantilism
Neomercantilism
Free-trade theories:
Absolute advantage
Comparative advantage


Theories of trade patterns
Explaining trade patterns: that explain
how much countries depend on
trade, what products they trade,
and with whom they primarily trade
Country size
Factor proportions
Country similarity
Trade competitiveness: theories that
deal with dynamics of countries
Product life cycle theory
11 01/19/10
Porter diamond
Interventionist Theories
• Mercantilism : is a trade theory
holding that a countries wealth is
measured by its holdings of treasure
which usually means its gold.
• Mercantilist theory proposed that a
country should try to achieve a
favorable balance of trade (export
more than it imports)
• Neomercantilist policy also seeks a
favorable balance of trade, but its
12
purpose
Theories & Instituitions:is to
Trade achieve some social
& Investment or
01/19/10
Free Trade Theories
Theories that hold that nations
should neither artificially limit
import nor promote export

The so-called invisible hand will

determine which producer survive
as customer buy those products
that best serves their needs .

13
 Both
Theories theories
& Instituitions: implies specialization
Trade & Investment 01/19/10
Absolute Advantage Theory
The real wealth of country consist of
the goods and services available to its
citizens
Different countries produce some
goods more efficiently than other
countries : thus global efficiency can
increase through free trade.
If trade was unrestricted; each country
would specialize in the products that
gave it a competitive advantage.

Absolute Advantage
Reasons for increased efficiency
through specialization
1.Labor could become more skilled by
repeating the same tasks.
2.Labor would not lose time in
switching from one kind of product
to another .
3.Long production runs would provide
incentives for the development of
more effective working methods .
15
Theories & Instituitions: Trade & Investment 01/19/10
Absolute Advantage
In what product should a country
specialize ?
 Either by :

1. natural advantage

A country may have a natural

advantage of producing a product
because a climatic conditions, access
to certain natural resources or
availability of certain labor forces .

Absolute Advantage
2. Acquired advantage :

Product technology : enables a

country to produce a unique product
or one that is easily distinguished
from those of competitors.

Process technology : a country’s

ability to produce a homogeneous
17
product
Theories efficiently
& Instituitions: Trade & Investment . 01/19/10

Absolute
Advantage
 Assumptions for Costa Rica:
1.100 units of resources available
2.10 units to produce a ton of Wheat
3.4 units to produce a ton of Coffee
4.Uses half of resources per product (when no
foreign trade)
Assumptions for Australia:

18 foreign trade)
Quantity of Coffee ( tons )
Absolute Advantage
Quantity of Wheat
( tons )

Absolute
Advantage
 Production Coffee
Wheat
 (tons)
(tons)
Without Trade:
Costa Rica (point A) 12 ½

5
Australia (point B) 2½
10
Total 15
15

With Trade:
Costa Rica (point A) 25
0
Comparative Advantage
The global efficiency gains may

still result from trade if a country
specializes in those products it
can produce more efficiently than
other products- regardless of
whether other countries can
produce those same products
even more efficiently

Comparative
Advantage
 Assumptions for Costa Rica:
foreign trade)
Assumptions for Australia:

22
foreign trade)
Comparative
Advantage
Quantity of Coffee
( tons )
Quantity of Wheat ( tons )

Absolute
Advantage
 Production Coffee Wheat
 (tons) (tons)
Without Trade:
Costa Rica (point A) 5 5
Australia (point B) 10 12 ½
Total 15 17

With Trade: (increasing coffee production)

Australia (point B) 6 17 ½
Total 16 17 ½
With Trade: (increasing Wheat production)
Australia (point B) 5 18 ¾
Total 15 18 ¾



Theories of Specialization:
Assumptions and Limitations
1.Full employment
2.Economic efficiency
3.Division of gains
4.Two countries, Two commodities
5.Transport Costs
6.Statistics and Dynamics
7.Services
8.Production Networks
9.Mobility


How can I define the trade pattern
theory for a country?
Trade pattern theories are defined by
answering the following questions;
How much does a country trade?
This depends on the country’s size & the type
of good being traded (non tradable good)

What types of products does a country trade?
Products of natural advantage or goods of
acquired advantage
With whom do countries trade?
Neighboring countries, or similar countries, or
friend countries.

How much does a country
trade?
 It depends on the;
vTheory of Country Size
vSize of the country’s
economy

Country Size Theory
q
qAn international trade theory which
holds that countries with large land
areas are more apt to have varied
climates and natural resources, and
therefore, are generally more self
sufficient than smaller countries; such
as Brazil, US, and Russia.
qLarge countries import much less of
their consumption and export much
28
less& of
Theories their
Instituitions: production
Trade & Investment than do 01/19/10
Con’t

Moreover, large countries production and
market centers are located at a greater
distance from other countries; raising the
transport costs on foreign trade.
Naturally, countries with large economies
are so dominant in the trade world; not
only because they export a lot and
produce a lot but also because their
nations’ incomes are high and the people
buy a lot from domestic & foreign
sources. Unlike the case for developing
What types of products does a
country trade?
Factors Proportion

Theory;

 Labor, land, Technology , and

Capital

Factors Proportion Theory

Developed by Hescker and Ohlin the Swedish
economists.
Its states that a country’s relative
endowments of land, labor, and capital will
determine the relative costs of these factors.
These factors cost, in turn, determine which
goods the country will produce most
efficiently.
According to the factor proportions theory,
factors in relative abundance are cheaper
than factors in relative scarcity. Therefore,
31 these
Theories &relative factor
Instituitions: Trade costs will lead countries
& Investment 01/19/10
Cont’d

People & Land; in countries where people is
abundant relative to the land, then they
produce goods that needs human resource.
In countries where little capital is available for
investment & where the amount of
investment is low per worker, managers
seek shelter in the countries where labor is
abundant and consequently can export
competitiveness in products that require
large amounts of labor relative to capital.
However, labor skills vary among countries;
where in developed countries they receive
higher education and training, hence, they
32
are more qualified & professional, therefore;
01/19/10
Cont’d

The variation in labor skills among countries
leads to international specialization in
production. Thus, a country may locate its
research activities & management
activities between educated population & it
may locate its production work in countries
with cheap labor and less skilled one.
Moreover, bigger countries depend more on
products requiring longer production runs;
so as to minimize the transportation costs
33 and the
Theories high expenditures
& Instituitions: Trade & Investment on research01/19/10
&
Trade Competitiveness
qProduct Life Cycle Theory

qPorter Diamond Theory


With whom do countries
trade?
 It depends on;
vCountry Similarity Theory
vDistance Between Countries

Country Similarity Theory
This theory has been developed by the Swedish
economist Steffan Linder .
It rests on the concept of “Intra industry trade”;
that is trade between two countries of goods
produced by the same industry. Intra industry
trade accounts for approximately 40 per cent
of world trade.
Therefore the country similarity theory
consists of the value that most trade in
manufactured goods should be between
nations with similar per capita income, and
that intra industry trade in manufactured
36 01/19/10
goods should be common
Cont’d

Countries at the same stage of economic
development that shared the same
consumer preferences – have greatest
potential for trade
Most trade today occurs among high-income
countries because they share similar market
segments and because they produce and
consume so much more than emerging
economies
Much of the pattern of two-way trading
partners may be explained by cultural
37
similarity between
Theories & Instituitions: the countries, political
and economic agreements, and by the
Country Similarity Theory;
why do developed countries trade

together?
vProduce more & consume more
vEmphasize and specialize to gain
acquired advantage
vProduce differentiated products and
services
vCultural similarity
38 vGood
Theories political
& Instituitions: relationship and
Discuss
More recent developments in


theoretical approaches in Economics to

International Trade move away from a
COUNTRY BASED approach and move
towards a FIRM BASED approach.


Product Life Cycle Theory

This theory has been developed by the economist
Raymond Vernon in response to the failure of the
Hescker Ohlin module.
It applies to established companies in
industrialised countries who expand their
product range
The theory states that companies will manufacture
products first in the countries in which they were
researched and developed; almost always
developed countries
Over the product’s life cycle, production will shift
40
toTheories
foreign locations, especially to developing
& Instituitions: Trade & Investment 01/19/10
economies as the product reaches the stages of
Cont’d
The theory is broken up
into five major stages
Release (Introduction)
Export (Growth )
Foreign Production (Growth)
Foreign Competition in Export
Markets (Maturity)
Import Competition in Home
Markets (Decline)
Release (Introduction; PLC
Theory)
1) Release:

Competition in Industrialised countries

tends to be fierce
Producers look for better ways to
satisfy customer needs
Customer feedback from previous
models - the core element of research
Once the product enters the domestic
market and begins to create a
positive reputation – the demand
increases

Exports (Growth, PLC Theory)
2)Exports:
As the product receives positive
customer response, the
international demand for the
product begins
The manufacturer begins
exporting to increase its
market share
Increase capital intensity
43
 More
Theories competition
& Instituitions: Trade & Investment 01/19/10
Foreign Production (Growth; PLC
Theory)
3)Foreign Production begins:

As demand increases with the new global market 

feasible to begin local production in various
countries
By sharing technology on the manufacturing of the
product, the company has lost an advantage
High cost of start up production
The end of this stage signifies the highest point in the
International Product Life Cycle Theory.


Foreign Competition in Export
Market; Maturity in PLC
4)Foreign Competition in exports markets:

A threatening stage for the original company

Local manufactures gained experience and scale in
producing and selling their product, hence their costs
have fallen
Their initial market are filled  they begin to look
elsewhere to promote their product
àPossibly they threaten original company’s domestic
market
Increase in price competitiveness
Decline in export from the originating country & more
capital intensity


Import Competition in Home Market;
Decline in PLC
5)Import Competition in Home Market:

Competitors have a quality product which is able to

undersell the original manufactures
They have a competitive edge with their low labour
costs. ‘
Disadvantages of the IPLC theory:
- Assumption that products are released initially in the
domestic markets
- Many globalised companies tend to release their new
product lines internationally, not domestically
- NOT all products conform to the PLC theory; luxury
products for example


Porter Diamond Theory
This theory has been developed by
Michael Porter; who argued that
companies development of
internationally competitive products
depends on four conditions;
Domestic demand conditions
Domestic factor conditions
Related & supporting industries
Firm strategy, structure, and rivalry

P o rte r ’ s sin g le d ia m o n d
fra m e w o rk
Govern
Govern Structure
Structure ofof
ment Firms
Firms and
and
ment Rivalry
Rivalry
Factor
Factor Demand
Demand
Conditions
Conditions Conditions
Conditions
Related
Related and
and
Supporting
Supporting Chance
Industries Chance
Industries

Limitations of Porter & Diamond
Theory
Production factors and finished goods
are only partially mobile internationally
The cost and feasibility of transferring
production factors rather than
exporting finished goods internationally
will determine which alternative is
better
Companies do not only react to
domestic rivals but also to foreign-
based rivals they compete with at
home and abroad.
49
Factor Mobility Theory
Why production
factors move?
Economic motives;
gain more income
Political motives;
flee adverse
political situation

The Relationship
between Trade and Factor
Mobility
Capital and labor move internationally
to gain more income and flee adverse
political situations
Although international mobility of
production factors may be a
substitute for trade, the mobility may
stimulate trade through sales of
components, equipment, and
51
complementary products
Summary
Not all trade theories apply to all the
products or to all countries.
Factors of production are mobile and they
may be a substitute for trade
The size of the country and its economical
and political situation might affect its trade
pattern
Trade theories are actually useful for traders
among nations; it help achieve efficient
marketing & trade activities
Trade theories might also explain the
government role in the trade practices in a
country; whether it interferes or doesn’t.
Thank you
Mera Horani
Nereen Abu Keer

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Theories & Institutions; Trade and

1 Theories & Instituitions: Trade & Investment 01/19/10

theories will help us understand the

Approaches to Exports & Imports

5 Theories & Instituitions: Trade & Investment 01/19/10

The World bank classifies it as

Costa Rica is highly dependent on

imports, export promotion, and

4. Early 1990’s-present: strategic

trade and investment- a policy

The so-called invisible hand will

A country may have a natural

Product technology : enables a

Process technology : a country’s

1.100 units of resources available

19 Theories & Instituitions: Trade & Investment 01/19/10

Costa Rica (point A) 12 ½

The global efficiency gains may

1.100 units of resources available

Quantity of Wheat ( tons )

23 Theories & Instituitions: Trade & Investment 01/19/10

With Trade: (increasing coffee production)

of good being traded (non tradable good)

27 Theories & Instituitions: Trade & Investment 01/19/10

 Labor, land, Technology , and

30 Theories & Instituitions: Trade & Investment 01/19/10

qProduct Life Cycle Theory

34 Theories & Instituitions: Trade & Investment 01/19/10

35 Theories & Instituitions: Trade & Investment 01/19/10

why do developed countries trade

More recent developments in

theoretical approaches in Economics to

39 Theories & Instituitions: Trade & Investment 01/19/10

Competition in Industrialised countries

As demand increases with the new global market 

44 Theories & Instituitions: Trade & Investment 01/19/10

A threatening stage for the original company

45 Theories & Instituitions: Trade & Investment 01/19/10

Competitors have a quality product which is able to

46 Theories & Instituitions: Trade & Investment 01/19/10

47 Theories & Instituitions: Trade & Investment 01/19/10

48 Theories & Instituitions: Trade & Investment 01/19/10

50 Theories & Instituitions: Trade & Investment 01/19/10

53 Theories & Instituitions: Trade & Investment 01/19/10

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