Theories of International

Trade &
Investment

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 Lesson Plan
■ International Trade Theories:
– Mercantilism
– Theory of Absolute Advantage
– Theory of Comparative Advantage
– Heckscher-Ohlin Theory of Factor Endowment
■ Investment Theories
– Monopolistic Advantage theory
– Product and Factor market Imperfection
– International Product life-Cycle

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TRADE THEORIES

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Trade Theories

■ The history of trade is old

■ However, only in 15th century people tries to explain –

Trade Theory – Why Trade occurs &

– How trade benefits both parties to an exchange.

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 Time Line of Trade Theory Evolution

1500 1600 1700 1800 1900 2000

Year

Absolute Advantage
Mercantilism Comparative Advantage
Factor Proportions Theory
International Product Life Cycle Theory
New Trade Theory
National Competitive Advantage

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MERCANTILISM

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 Mercantilism
■ Mercantilism is an economic system
– Used by European countries during 1500 to 1700
■ M. belief that nations prosperity is the result of a positive
balance of trade, achieved by maximizing exports and
minimizing imports
– Silver & Gold were the currency of trade between countries
■ Country’s Wealth = Silver + Gold
■ Hence, everything govt did was to make sure that the country
gain more gold & silver
■ Export = Increase of Wealth
■ Import = Decrease of Wealth
Earning gold & silver was main motive of trade
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Mercantilism contd…

■ Main tenet of the theory = Country’s

should try for Trade Surplus
■ Export more than import = Trade
Surplus => country can accumulate more
gold & silver and increase its wealth

In order to avoid Trade Deficit, Govt.

intervention was advocates.
In order to discourage import, govt.
imposed tariffs, quota
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 Mercantilism contd…
Profit

■ In order to get gold &

silver, the govt. needed to Revenue
Expenses
ensure favorable Balance of
Trade
– Export is more than import =
BoT
The same concept of profit , as we
use today

Instead of cash profit they wanted

gold/silver

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 Mercantilism contd…

■ Colonies played significant role in East India Company

…
■ Colonies were the source of many
essential raw materials (tea, sugar,
tobacco).
■ These resources were shipped to
mercantilist nations, where they
were converted into finished goods
■ Finished goods were then shipped
to the colonies for sale

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 Mercantilism contd…

■ Mercantilist nation made huge profits by

– buying raw materials cheap and selling finished goods
dear – that is how they built their Trade Surplus.
Criticisms:
– It harms firms that imports – especially that firm which
imports raw materials
– It harms consumers, because
■ Consumers have less choice for products
■ High price of products due to product shortage

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 THEORY OF
ABSOLUTE ADVANTAGE

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 Trade Theories: Absolute Advantage theory

 Adam Smith first brought the idea of absolute cost advantage

theory in his book “ An Inquiry into the Nature and Causes of the
Wealth of Nation” in 1776
 Criticizing Mercantilism, smith argues that
 M deprives individual of the ability to trade freely and to
benefit from voluntary exchange
 By trying minimize imports, a country wastes much of its
national resources in the production of goods it is not suited
to produce efficiently
 thus countries end up reducing wealth of the nation as a whole
while enriching a limited number of individuals & interest
groups
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Trade Theories: Absolute Advantage theory continues …….

 Instead, Adam Smith suggested that nations benefit most from free
trade
o Market forces, not government controls should determine the
direction, volume and composition of international trade.
o Under free, unregulated trade each national should specialize in
producing those goods it could produce most efficiently.
 According to Absolute Adv principles – a country benefits by
producing primarily those products in which it has an absolute
advantage.
o meaning goods it can produce using fewer resources than another
country.
 Each country thus increases its welfare by specializing in the
production of certain products, consume more than it otherwise
could, generally at a lower cost

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Trade Theories: Absolute Advantage theory continues …….

More efficiency

The basic idea of this theory is that,

Nations would benefit if they specialize in export good in which
they have advantages in production, and import those goods
which other nations can produce effectively or cheaply
He saw that, advantages coming from
Efficiency ( For ex: England – Textile)
Natural Advantages (fir ex: France -Wine)
Thus trade should take place between England and
France:
England (Export Textile, import wine (cheap);
France – export wine and import textile (cheap)

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Trade Theories: Absolute Advantage theory continues …….

Example
Production without Trade
Coffee Melons
Kenya 20 10
Indonesia 5 20
Total output 25 30

•With the same amount of resources Kenya produces 20 units of coffee and
Indonesia produces only 5 units
•With the same amount of resources Indonesia produces 20 units of melons
and Kenya produces only 10units
•So based on absolute cost of production:
• Kenya has absolute advantage in producing coffee; and Indonesia in
Melon 16
 Coffee Melons
Kenya 20 10
Indonesia 5 20
Total output 25 30

Now what would happen if trade takes place,

Kenya stops producing melon and concentrate on producing coffee and

Indonesia on the other hand concentrates on melon and stop producing

coffee??
Coffee Melons
Kenya (20+20) =40 0
Indonesia 0 (20+20) =40
Total Before 25 30
Total After trade 40 40
World gains (40-25)=15 (40-30)=10

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 Coffee Melons

Kenya 20 10
Trade
20+20Theories
= 40 Sincecontd….
the production capacity Indonesia 5 20
released from melon…will add up to coffee
Total 25 30

Production with SPECIALIZATION

Coffee Melons

BEFORE 25 30

AFTER 40 40

GAINS 15 10

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Trade Theories: Absolute Cost Advantage theory continues …….
Assume LABOR is
the only factor of
production used in
 Another example: making both goods

ONE Ton of
Cloth Wheat

France 6 8

Germany 10 4

 It indicates, France has an absolute advantage in the production of Cloth (Since

it takes 6 labor days to produce one ton of cloth, whereas Germany takes 10
labor days; & Germany in Wheat; since Germany takes 4 labor days to produce
one ton of wheat and France takes 8 labor days).
 If trade takes place by specialization in each product & exchange goods to one
to one ratio, then:
 France will be able to save 2 labor days (8-6). Since it can export 1 ton cloth
to Germany with 6 labor days, and import one ton of wheat from Germany…
and thus saved 2 labor days….same for Germany

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Trade Theories contd….

Practice
Production without Trade

England Bangladesh Total

Textile 2 4 6
Corn 3 1 4

1. England has absolute advantage in ______________

2. Bangladesh has absolute advantage in ____________
3. If International trade takes place then, draw how the table
would look like

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 England Bangladesh Total

Textile 2 4 6
Trade Theories contd….
Corn
Practice _Solution 3 1 4

1. England has absolute advantage in Corn

2. Bangladesh has absolute advantage in Textile
3. If International trade takes place then, draw how the table
would look like
Production with Specialization &Trade
Total
England Bangladesh International
Gain
Textile 0 8 (8-6)=2
Corn 6 0 (6-4)=2

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 THEORY OF
COMPARATIVE ADVANTAGE

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Trade Theories – Comparative Advantage

 Whilst Absolute advantage theory deals with cases

where between two nations two products, both are
advantageous in one.
 However, in reality there might also be the case
where between two countries & two products, one
might be advantages in both the products
Furniture Cloth

Bangladesh 15 50

France 1 25

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Trade Theories – Comparative theory

 Then DO YOU THINK

 Country should produce both?
 Can International Trade still take or
should take place between them?

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Trade Theories – Comparative advantage theory

■ David Ricardo – in his book “Principles of Political Economy & Taxation”1817

– The notion that although a country may produce both products more cheaply
than another country, it is relatively better at producing one product than the
other
– According to Ricardo, it is not the absolute cost of production that matters,
rather what really matter is the relative efficiency with which the two
countries can produce products.
■ The main tenet of the theory states that
– This theory thus suggest that nations should produce those goods for which they
have the greatest relative advantage - & they should buy the other
– And it can be beneficial for two countries to trade without barriers as long as
one is relatively more efficient at producing goods or services needed by the
other.
– A nation having absolute disadvantage in the production of two goods with
respect to another nation has a comparative or relative advantage in the
production of the good in which its absolute disadvantage is less

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Trade Theories – Comparative Advantage theory

■ David Ricardo – also stated that

– In comparative advantage theory trade decision is taken
by opportunity cost
■ That means what does the country has to give up in order to make
a good. – if it is less than what other country has to give up then
the country is considered to have comparative advantage.
■ Even though one nation held an absolute advantage over another
in the production of each of two different goods, International
Trade could still create benefit for each country.
■ Thus represent a Positive-Sum Game – in which both countries
“win” from engaging in foreign trade

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Trade Theories contd….

Example
Production without Trade
Coconut Coffee

Bangladesh 50 150

England 5 25

•With the same amount of resources Bangladesh is absolutely

more productive in both the products than England
•But in which product Bangladesh has greater advantage?

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Trade Theories contd….

Example
Coconut Coffee

Bangladesh 50 150

England 5 25

10 times 6 times

•Bangladesh has comparatively greater advantage in the production

of Coconut, that is BD is 10 times productive as is England, whereas
it is only 6 times productive as is England in Coffee

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Trade Theories contd….

Example
Coconut Coffee

Bangladesh 50 150
England 5 25

1/10 1/6

•England on the other hand, it has relatively greater productivity

in Coffee when compared with Bangladesh.
•England is only 1/10th as productive as Bangladesh in coconut,
but is 1/6th productive as Bangladesh in producing Coffee

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 Trade Theories – Comparative theory
Coconut Coffee

Bangladesh 50 150
England 5 25
■ David Ricardo stated 1/10 1/6
– In these situation both the countries can be mutually benefit if they
specialize on which they have relative advantage
– And the reason is cost of producing coconut is lower for
Bangladesh, and the cost of producing coffee is lower in England
– We can demonstrate by saying that
■ Bangladesh can produce 1 coconut, in the time it can produce 3 coffee

1 Coconut= 3 Coffee
■ So, If Bangladesh produces 1 coconut it gives up 3 Coffee (Opportunity
Cost)
■ So for Bangladesh, the cost of 1 coconut is 3 coffee
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Trade Theories – Comparative theory
Coconut Coffee

Bangladesh 50 150
England 5 25
– For England on the other hand, 1/10 1/6

■ It can produce 1 coconut, in the time it can produce 5 coffee

1Coconut= 5Coffee
■ So, If England produces 1 coconut it gives up 5 Coffee (Opportunity
Cost)
■ So the cost of 1 coconut is 5 coffee

– Hence, Bangladesh can produce coconut more cheaply than

England,
– And, every time Bangladesh produces 1 coffee it gives up 1/3rd
of coconut, and England gives up only 1/5th of coconut -
England can produce coffee more cheaply than Bangladesh
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Trade Theories – Comparative theory

– Why is it beneficial for both?

■ Bangladesh 1 Coconut= 3 Coffee

■ England 1 Coconut = 5 Coffee

– If, they both decide to set the international trade term to be

■ 1 Coconut = 4 Coffees,

■ Then, for Bangladesh , gain is 1 more coffee;

■ For England, it gives up producing coconut, and produces coffee.

After trading it gets back its coconut in exchange of coffee

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Trade Theories – Comparative theory

– Trade will continue to be beneficial as long as the gap in

coffee remains
■ Bangladesh 1 Coconut= 3 Coffee

■ England 1 Coconut = 5 Coffee

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Trade Theories – Comparative theory

■ The difference between absolute advantage theory and

comparative advantage theory
– Ab. Advantage theory – looks at absolute productivity
differences Comparative Advantage Theory – looks at
relative productivity differences
– The distinction occurs because comparative
advantage incorporates the concept of opportunity
cost in determining goods a country should produce
– The opportunity cost of product is the value of the
thing that is given up to get the product
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 Trade Theories – Comparative theory
■ Practice
– Let’s take the example
Hours Needed to Make
1 Car 1 Ton of Cheese
UK 15 (hours needed) 5(hours needed)

China 4 (hours needed) 2 (hours needed)

• Who has absolute advantage in both the products.

• Who has comparative advantage in which product?
•What is the opportunity cost for each product in each country?

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 Trade Theories – Comparative theory
■ Answer
Hours Needed to Make
1 Car 1 Ton of Cheese
UK 15 5
China 4 2

• China has absolute advantage in both the products.

•But Ricardo stated, when we count Opportunity cost, we will find
each country has comparative advantage in one product.
• To make 1 car,
• UK gives up 3 cheese, because each ton of cheese takes 5 hours, and in 15
hours they could make 3 tons of cheese
•China gives up 2, because each ton of cheese takes 2 hours, and in 4 hours
they could make 2 tons of cheese
• Therefore, China has the lowest opportunity cost , as they have to give up
only 2 tons of cheeses.
•and thus China has comparative advantage in Car production 36
 Trade Theories – Comparative theory
■ Answer
Hours Needed to Make
1 Car 1 Ton of Cheese
UK 15 5
China 4 2

•To make 1 ton of Cheese,

• UK gives up 1/3rd of car; China gives up ½ of Car
• Therefore, UK has the lowest opportunity cost and thus has comparative
advantage in Cheese production
•and thus UK has comparative advantage in Cheese production

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Trade Theories – Comparative Advantage theory

Example
One ton of
Cloth Wheat

France 8 6
Germany 2 4

Assume there is only one factors of production and that is labor days
In Germany, it takes
 2 labor days to produce 1 ton of cloth; & 4 labor days to produce 1 ton of
wheat
In France, it takes
 8 labor days to produce 1 ton of cloth; & 6 labor days to produce 1 ton of
wheat

So, Germany has absolute advantage in both of the products. Still the trade can
take place if we see the comparative advantage -
Comparative advantage can be calculated in two ways
1. Ratio of production cost
2. Opportunity cost 38
Trade Theories – Comparative Advantage theory

Example
One ton of
Cloth Wheat

France 8 6
Germany 2 4

Using Ratio of Production Cost

Germany, is comparatively more efficient at producing cloth than wheat. Because,
 It can produce 4 times as much cloth as France (8/2=4); But only 1.5 times
as much wheat 6/4=1.5).
 Thus Germany should devote all of its resources to produce cloth and
import all wheat it needs from France

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Trade Theories – Comparative Advantage theory

Example
One ton of
Cloth Wheat

France 8 6
Germany 2 4

Using Opportunity Cost

Opportunity cost means the forgone alternative activity
If Germany, produces 1 ton of wheat it forgoes 2 tons of cloth (2+2=4; which it could
produce if they were producing wheat);
If France produces 1 ton of wheat it forgoes only 0.75 tons of cloth (6/8=0.75 tons
which they could achieve if they were not producing wheat)

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Trade Theories – Comparative Advantage theory

One ton of
Example Cloth Wheat

France 8 6
Germany 2 4

Using Opportunity Cost

Germany in case of Cloth
 2 labor days – 1 ton of cloth
 2 labor days – ½ ton of wheat (forgoes)
Germany in case of Wheat
 4 labor days – 1 ton of wheat
 2 labor days – 2 tons of cloth (forgoes)
France in case of Cloth
 8 labor days – 1 ton of cloth
 8 labor days – 8/6=1.3 tons of wheat (forgoes)
France in case of Wheat
 6 labor days – 1 ton of wheat
 6 labor days – 6/8=0.75 tons of cloth (forgoes)

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 One ton of
Trade Theories – Comparative Advantage theory
Cloth Wheat

France 8 6
Example Germany 2 4

Using Opportunity Cost

Germany in case of Cloth
 2 labor days – 1 ton of cloth
 2 labor days – ½ ton of wheat
(forgoes)
Germany in case of Wheat Using Opportunity Cost
For
 4 labor days – 1 ton France producing wheat is more sensible
of wheat
because
 2 labor days – 2 tons only 0.75 tons they have to compromise
of cloth
(forgoes) And for Germany Cloth makes more sense
France in case of Cloth because ½ tons they have to compromise
 8 labor days – 1 ton of cloth
 8 labor days – 8/6=1.3 tons of wheat
(forgoes)
France in case of Wheat
 6 labor days – 1 ton of wheat
 6 labor days – 6/8=0.75 tons of cloth
(forgoes)
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 HECKSCHER-
OHLIN THEORY OF
FACTOR
ENDOWMENT

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Trade Theories – Factor Endowment theory

■ Comparative advantage theory explains two things:

– 1. Why trade is beneficial to two countries when if
one country has absolute advantage in both the
production
– It explains the patterns of trade between countries,
countries with comparative advantage will export
the other country

Hecksher-Ohlin theory still believes that free trade is

beneficial to everyone but it explains the benefits &
patterns of trade in different way

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Trade Theories – Factor Endowment theory

Hecksher-Ohlin theory looks at the Factors of

Production To some extent
Relatively evenly
Land small labor
distributed;
Labor however
Capital relatively large
Example: Country A Country B labor group

Land 60% 35%

Labor 10% 42%

Capital 30% 23%

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Trade Theories – Factor Endowment theory

Even though the land in

country B is 35% Whereas
country A’s land is 60%,
but country B is much
bigger in size
What did Hecksher-Ohlin
say about it?
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Trade Theories – Factor Endowment theory

They stated that country with

relatively abundance of a particular
factors of production would export
products that used that factor to
produce goods

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Trade Theories – Factor Endowment theory

Hence, Country A has 60% of its

factors of production as Land
whereas B has only 35% .
So they predicted that country A
would export product using Land to
country B.

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Trade Theories – Factor Endowment theory

Country A also has relative

abundance of Capital 30% of its
factors of production as opposed to
Capital of country B (23%) .
So they predicted that country A
would also export product using
Capital to country B.
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Trade Theories – Factor Endowment theory

Country B on the other hand has

relative abundance of Labor 42% of
its factors of production as opposed
to Labor of country A (10%) .
So they predicted that country B
would export Labor intensive
product to country B.
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Trade Theories – Factor Endowment theory

■ It makes sense
– Because if a country has lot of something then it
becomes cheaper

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Trade Theories – Factor Endowment theory

■ The theory states that

– Countries export products requiring large amounts
of their abundant production factors and import
products requiring large amount of their scarce
production factors.
– Thus, the goods that require a large amount of a
nations abundant – thus less costly- factors will have
lower production costs enabling those goods to be
sold for less in international market
Ex: Bangladesh export should be based on labor –
intensive products since labor is cheap in
Bangladesh compare to countries like England
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Trade Theories – Factor Endowment theory

■ Present day trading patterns can be explained by

this theory:
– Countries with relatively large lands like Australia,
Canada do export land-intensive products (such as agro
based products)
– Countries with large population like China, Indonesia,
Bangladesh also export labor-intensive products like
RMG,

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Trade Theories – Factor Endowment theory

■ LEONTIEF PARADOX:
– He is an economist, studies & disputed the usefulness of
Heckshire-Ohlin theory as a predictor of the direction of
trade – this study is known as Leontieff Paradox
– The Test:
■ Could Factor Proportions Theory be used to explain the types of goods the
United States imported and exported?

– The study found that the US, one of the most capital-
intensive countries was exporting relatively labor-intensive
products in exchange for relatively capital expensive
products

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Trade Theories – Factor Endowment theory

– Economists have speculated that this occurred because

■ the US exports technology-intensive products produced by highly
skilled labor requiring a large capital investment to educate and train
and at the same time imports goods made with mature technology
requiring capital-intensive mass-production processes operated by
unskilled labor
■ Another possible reason for this paradox in trade pattern is that many
products may be produces by either capital-or-labor-intensive processes

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 The Leontief Paradox
• The Findings:
• The U.S. exported labor-intensive products and
imported capital-intensive products.

• The Controversy:
• Findings were the opposite of what was generally
believed to be true!

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 Summary of International Trade Theories

• It occurs primarily due to the relative price differences

among nations.
• This price differences (in production costs) results from
• Differences in the endowment of the factors of
production
• Differences in the level of technology that determine
the factor intensities used
• Differences in the efficiencies with which these factor
intensities are utilized
• Foreign exchange rates

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International Investment Theories

■ Classical Theory states that

– Differences in interest rates for investments of equal risk
were the reason international capital moved from one
nation to another
– A perfect competition is a prerequisite
■ The major theories explaining international invetsment:
1. Monopolistic Advantage theory
2. Internationalization Theory
Monopolistic Advantage Theory

■ Stems from Stephen Hymer’s dissertation in the 1960s

■ Stated that
– FDI is made by firms in oligopolistic industries possessing technical
& other advantages over indigenous firms
– In other term, FDI occurs largely in oligopolistic industries rather
than in industries operation under near-perfect competition.
Monopolistic Advantage Theory contd………

– It means, the firms in these industries must

possess advantages not available to local firms
■ in order to overcome liabilities associated with being a foreigner. Such as lack
of knowledge about local market condition, increased cost of operating at a
distance, or differences in culture, language, laws and regulations
■ Hymer reasoned that the advantages must be
– economies of scale,
– superior technology
– Superior knowledge in marketing, management or finance
Internationalization Theory

■ An extension of the market imperfection theory:

– the concept that to obtain a higher return
on its investment, a firm will transfer its
superior knowledge to a foreign subsidiary
rather than sell it in the open market.
■ In other words,
– A firm has superior knowledge, but due to
inefficiency in external market, firm may
obtain a higher price for that knowledge by
using the knowledge itself rather than
selling it in the open market.
END

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INTERNATIONAL
PRODUCT LIFE
CYCLE THEORY

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 International Product Cycle Theory

■ Idea was formulated by Raymond Vernon in

1960s
■ Focus on the product, not its factor proportions
■ It concerns the role of innovation in trade
patterns
■ It views, a product as going through a full life
cycle from the internationalization stage to
standardization
■ Two technology-based premises

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 Stages of the Product Cycle

The New Product

The Maturing Product

The Standardized Product

69
 The Product Cycle and Trade
Implications
■ Increased emphasis on technology’s impact on
product cost

■ Explained international investment

■ Limitations
– Most appropriate for technology-based products
– Some products not easily characterized by stages of
maturity
– Most relevant to products produced through mass
production

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 The New Trade Theory:
Strategic Trade
Two New Contributions
■ Paul Krugman-How trade is altered when markets are not
perfectly competitive

■ Michael Porter-Examined competitiveness of industries on a

global basis

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 Strategic Trade

Krugman’s Economics of Scale:

Internal
InternalEconomies
Economiesof
ofScale
Scale

External
ExternalEconomies
Economiesof
ofScale
Scale

72
 Strategic Trade

■ Government can play a beneficial role when markets are not

purely competitive
■ Theory expands to government’s role in international trade
■ Four circumstances exist that involve imperfect competition
in which strategic trade may apply

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 Strategic Trade
The Four Circumstances Involving Imperfect Competition:

Price Cost
Cost
Price

Externalities
Externalities
Repetition
Repetition

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 Strategic Trade
Porter’s Diamond of National Advantage
■ Innovation is what drives and sustains
competitiveness
■ Four components of competition
– Factor Conditions
– Demand Conditions
– Related and Supporting Industries
– Firm Strategy, Structure, and Rivalry

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 Michael Porter’s Competitive Clusters

■ Critical masses of unusual competitive

success in particular fields, located in
one place

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 The Theory of International
Investment

■ The movement of capital has

allowed foreign direct investments
across the globe

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 The Theory of International Investment

■ Firms as Seekers
– Seeking Resources
– Seeking Factor Advantages
– Seeking Knowledge
– Seeking Security
– Seeking Markets

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 The Theory of International Investment

■ Firms as Exploiters of Imperfections

– Imperfections in Access
– Imperfections in Factor Mobility
– Imperfections in Management
■ Firms as Internalizers
– Establish their own multinational operations-internalize production
– Competitive advantage due to confidentiality

79
Any questions???

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