Chapter 4

International Trade
and Factor-Mobility
Theory

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 Learning Objectives
 Understand how different approaches to
international trade theories help policy
makers achieve economic objectives
 Comprehend the historical and current
rationale for interventionist trade theories
 Explain why production factors, especially
labor and capital, move internationally
 Describe the relationship between foreign
trade and international factor mobility

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Laissez-Faire vs. Intervention
 In trade theory the basic questions asked are…
 Why nations (or companies in a nation) trade?
 What factors determine trade?
 How much and with whom should a nation trade?
 Should a government intervene trade?
 Two different approaches that answer these
questions are…
 Laissez-faire approach-absolute advantage and
comparative advantage
 Intervention approach-Mercantilism and
neomercantilism

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 Trade Theories
 Mercantilism (and Neomercantilism)
 Adam Smith’s Absolute Advantage
 Ricardo’s Comparative Advantage
 Heckscher-Ohlin’s Theory of Factor
Proportion
 International Product Life Cycle (IPLC)
 Porter’s Diamond and International
Competitiveness of Nations

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Trade Theories and Business
What Major Trade Theories Do and Don’t Discuss: A Checklist

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 Mercantilism
 Initial trade theory that was the foundation of
economic thought from 1500–1800 AD
 The mercantilists believed that the way for nations
to become rich and powerful was to have a
favorable balance of trade, i.e., we should export
more and import less.
 They advocated strict government control of all
economic activity and preached economic
nationalism.
 Neomercantilism preaches export surplus to
achieve a country’s social and political objective. It
also tacitly supports colonialism—it is alright to
have colonies to generate trade surplus.
 Theory of Absolute Advantage
(Adam Smith, 1776)
 Believed that countries are at different levels in
terms of trade because of natural or acquired
advantage. Resource base, country size,
technology or resource efficiencies (as absolute
advantages) is the basis (or reason) for trade.
 A country can (i) maximize its economic
wellbeing by specializing in the production of
those goods and services in which it has absolute
advantage and (ii) enhance global efficiency
through participation in free trade.
Theory of Comparative Advantage
(David Ricardo, 1817)
 Relative or comparative advantage or efficiency is
the main argument.
 Comparative advantage stems from the relative
efficiency of one nation over another. A country
will produce and export those goods and services
in which it has comparative advantage.
 Free trade fosters global efficiency. Global gains
are made through comparative efficiency.
Everyone is producing those products in which
they are best.

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 Theory of Factor Proportion
(Eli Heckscher, 1919 and Bertil Ohlin, 1933)
 Inputs, factors of production is the main issue.
 Differences in a country’s relative endowments of
land, labor, and capital explain differences in the
cost of production factors. A country will produce
and export those goods and services in which it is
relatively better endowed.
 The comparative advantage in relative prices and
factor inputs would be the basis for trade. Given
this, a capital abundant country will have
comparative advantage in capital-intensive goods
and will export those for labor-intensive goods.
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Assumptions and Limitations of the
Three Trade Theories
 The assumptions of the three trade
theories based on specialization may not
be valid
 full employment
 economic efficiency
 division of gains
 transport costs
 statics and dynamics
 services
 production networks
 mobility
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Product Life Cycle Theory
Life Cycle of the International Product

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Porter’s Diamond- International
Competitiveness of Nations
Diamond of National Advantage
The Diamond of National Competitive Advantage

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 International Competitiveness of Nations
(Michael Porter 1990)
 It is a departure from the previous trade theories.
Most trade theories are from a country perspective
but it is the companies that make decisions about
trade.
 Porter argues that the dynamic interplay of the
four factors that determine international
competitiveness are:
- Demand Conditions
- Factor Conditions
- Related and Supporting Industries
- Firm Structure and Rivalry.
 Other two factors that also influence the
competitiveness of nations are Chance and
Government.
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 Back to the questions we begun this
chapter with-Trade Pattern Theories
 How much does a country trade?
 Depends on the size of the country,
larger economies trade more
 What products does a country trade?
 Factor proportion theory (Heckscher-
Ohlin) explains that
 With whom do countries trade?
 Country Similarity Theory
 Geography/proximity also influences
 Trade and Factor Mobility-2
 Relationship among land, labor, and
capital movements will continue to evolve
 International division of labor will continue
to reshape the global specialization and
trade patterns
 Displacement of jobs will continue to be a
source of conflict
 International labor migration can be a
source conflict as demographics change:
brain drain, inward vs. outward
remittances

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 Chapter 5: Discussion Question
1. Question can be asked to explain one or more
theories of trade. For example…
1. Explain Porter’s Diamond of International
Competitiveness of Nations.
2. Elaborate the trade theories of Smith, Ricardo and
Heckscher-Ohlin and distinguish their differences.
3. Explain International Product Life Cycle Theory (IPLC).
2. Discuss the evolving pattern and future of “trade
and factor mobility” in a globalized world.