Theory of Absolute Advantage

 When one nation is more efficient (or has an absolute

advantage over the other in the production of one commodity)
but is less efficient than (absolute disadvantage with respect to)
the other nation in producing a second commodity, then both
nation can gain by each specializing in the production of the
commodity of its absolute advantage and exchanging part of it
output with the commodity of its absolute disadvantage.
Theory of Comparative Advantage
(David Ricardo)

• states that even if one nation is less efficient than ( has absolute
disadvantage with respect to) the other nation in the production of
both commodities, there is still a basis for mutually beneficial
trade.
 The first nation should specialize in the production and export the
commodity in which the absolute disadvantage is smaller ( the
commodity with comparative advantage) and import the commodity in
which its absolute disadvantage is greater ( the commodity with
comparative disadvantage)
Table 1.

Commodity US UK
Wheat (bushel/man-hour) 6 1
Cloth (yard/man-hour) 4 5

Table 2.

Commodity US UK
Wheat (bushel/man-hour) 6 1
Cloth (yard/man-hour) 4 2
 Comparative Advantage and Opportunity Costs

Ricardo’s assumptions:
1. Only two nations and two commodities
2. Free trade
3. Perfect mobility of labor within each nation but immobility between two nations.
4. Constant costs of production
5. No technical change
6. No transportation costs.

Opportunity costs – the cost of the commodity is the amount of the second commodity
that must be given up to produce one additional unit of the first commodity.
Hypothetical PPS of Wheat and Cloth Production

US UK
Wheat Cloth Wheat Cloth
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
Factor Endowments as a Basis for Trade Theory:
Heckscher-Ohlin and Factor Price Equalization

Heckscher - Ohlin (H-O) attributes the comparative advantage of a

nation to its factor endowments:
 land (quantity, quality, and mineral resources)
 labor (quantity and skills)
 capital (cost)
 technology (quality)
Factor price equalization theory
 states that when factors are allowed to move freely
among trading nations, efficiency further increases
which leads to superior allocation of the production of
goods and services among nations.
Porter's Diamond Model of Competitive Advantage.

Porter explains his model in terms of a diamond that consist of four groups
of company specific and country specific characteristics positioned at the
edge of a diamond.
 the interaction of the four groups characteristics will determine a
country’s competitive advantage in the global arena.
Four groups of company specific and country specific
characteristics:
1. factor conditions
2. demand conditions
3. related and supporting industries
4. firm strategy, structure and rivalry.

2 Crucial Variables outside the diamond:

1. chance- refers to external shock or development that could
change the course of economic development.
2. role of government
 The Practice of Trade Policy
Trade policy - refers to all government actions that seek to alter the free
flow of merchandise or services from or to a country.

Instruments of Trade Policy

1. Tariffs - taxes on imports, also known as customs duties.
 Specific tariff - describes an import tax that assigns a fixed dollar
amount per physical unit.
 Ad-valorem tariff - tax on imports levied as a constant percentage of the
monetary value of one unit of the imported good

2. Preferential duties - refer to low tariffs applied to specific imports

coming from certain countries, especially from developing world.
 Generalized System of Procedures (GSP) – where a large number of
developed countries have agreed to permit duty free imports of selected
list of products that originate from specific countries.
3. Export subsidy – a negative tariff or tax break aimed at boosting
exports by lowering export prices.
4. Export taxes - taxes meant to raise export cost and divert production
for home consumption.

Most Favored Nation (MFN) principle –

 any tariff concession granted by one member country to any other
country will automatically be extended to all other countries of WTO.
Nontariff barriers:
1. Import quotas
 also known as Quantitative Restrictions (QR’s) limit the amount of number
of units of products that can be imported to a country.
 it is worse than import tariffs.

2. Voluntary export restraint (VER)

 occurs when an efficient exporting nation agrees to temporarily limit
exports of a product to another country to allow competitors in the
importing country to become more efficient within set period of time.

3. Domestic content provisions

 countries require that a certain percentage of the value of import be
domestically sourced.
Managed Trade
 refers to agreements, sometimes temporary, between countries that aim to achieve
certain trade outcomes.

Socio-economic Rationale:
 Countertrade
 Export cartels
 Infant industry argument
 Questionable labor practices and environmental conditions
 Food safety

Geopolitical Rationale:
 National security
 Protection of critical industries
 Embargoes
Countertrade
 agreement in which an exporter of goods or services to another country
commits to import goods or services of corresponding value from that
country.

Export cartels
 a group of economies that could effectively control export volume to keep
their export prices, revenues, and economic growth stable or high.

Infant industry argument

 temporary provision of protection to nascent industries that have good
prospects of becoming globally competitive in the medium term.

Embargoes
 trade sanctions that are imposed upon a nation to restrict trade with that
country.