Benefits of Trade

Major Theories of
International Trade

The Practice of Trade Policy

Current Practice of
“Managed” Trade

Chapter 2 The Evolution of

International Business and Trade
The Evolution of International Business
Learning Objectives:
1. Describe the relation between
international trade volume and world
output and identify overall trade patterns.
2. Describe mercantilism and explain its
impact on world powers and their
colonies.
3. Explain the theories of absolute advantage
and comparative advantage.
4. Explain the factor proportions and
international product life cycle theories.
5. Explain the new trade and national
competitive advantage theories.
 Overview of International Trade

The purchase, sale or exchange of goods and

services across national borders is called
International Trade. This is in contrast to domestic
trade which occurs between different states, regions,
or cities within a country.
In recent years, nations that embrace
globalization are seeing trade grow in importance for
their economies. One way to measure the
importance of trade to a nation is the examine the
volume of an economy’s trade relative to its total
output.
The Benefits of International Business and
Trade
 Major Theories of International Trade
• Wealth Accumulation as a Basis for Trade Theory: Mercantilism

• Specialization as a Basis for Trade Theory: Absolute and

Comparative Advantage

• International Product Life Cycle Theory

• Factor Endowments as a Basis for Trade Theory: Heckscher-

Ohlin and Factor Price Equalization

• New Trade Theory

• Porter’s “Diamond” Model of National Competitive Advantage.

 Evolution of the Trade Theories

https://slideplayer.com/slide/7270391 /
 Mercantilism
The trade theory that nations should accumulate
financial wealth usually in the form of gold, by
encouraging exports and discouraging imports is
called Mercantilism.
It states that other measures of a nation’s well-
being, such as living standards or human
development, are irrelevant. Nation-states in Europe
followed this economic philosophy from 1500 to the
late 1700s. The most prominent mercantilist nations
included Britain, France, the Netherlands, Portugal
and Spain.
Trade Surplus
Condition that results when the
value of a nation’s exports is
greater than the value of its
imports.

Trade Deficit
Condition that results when the
value of a country’s imports is
greater than the value of its
exports.
The Theory of Absolute Advantage

Scottish economist Adam Smith first put forth the

theory of Absolute Advantage in 1176. The Ability of
a nation to produce a good more efficiently than any
other nation is called an Absolute Advantage.
In other words, a nation with absolute advantage
can produce greater output of a good or service than
other nations using the same amount of or fewer,
resources.
• The differentiation between the varying abilities of
companies and nations to produce goods efficiently
is the basis for the concept of absolute advantage.
Absolute advantage looks at the efficiency of
producing a single product.

• This analysis helps countries avoid the production of

products that would yield little or no demand,
leading to losses. A country’s absolute advantage, or
disadvantage, in a particular industry, can play an
important role in the types of goods it chooses to
produce.

https://www.investopedia.com/ask/answers/
• As an example, if Japan and Italy can both produce
automobiles, but Italy can produce sports cars of a
higher quality and at a faster rate with greater profit,
then Italy is said to have an absolute advantage in
that particular industry.

• In this example, Japan may be better served to

devote the limited resources and manpower to
another industry or other types of vehicles, such as
electric cars, in which it may enjoy an absolute
advantage, rather than trying to compete with Italy's
efficiency.
• https://www.investopedia.com/ask/answers/
The Theory of Comparative Advantage
An English economist named David Ricardo developed
the theory of comparative advantage in 1817. He
proposed that, if one country held absolute advantages
in the production of both products, specialization and
trade could still benefit both countries.
A country has a Comparative Advantage when it is
unable to produce good more efficiently than other
nations but produces the good more efficiently than it
does any other good. In other words, trade is still
beneficial even if one country is less efficient that in the
production of two goods, as long as it is less inefficient
in the production of one of the goods.
• Comparative advantage takes a more holistic view,
with the perspective that a country or business has
the resources to produce a variety of goods. The 
opportunity cost of a given option is equal to the
forfeited benefits that could have been achieved by
choosing an available alternative in comparison.

• In general, when the profit from two products is

identified, analysts would calculate the opportunity
cost of choosing one option over the other.
https://www.investopedia.com/ask/answers/
• For example, assume that China has enough resources to
produce either smart phones or computers. China can
produce 10 computers or 10 smart phones. Computers
generate a higher profit.

• Therefore, the opportunity cost is the difference in value lost

from producing a smart phone rather than a computer. If
China earns $100 for a computer and $50 for a smart phone
then the opportunity cost is $50. If China has to choose
between producing computers over smart phones it will
select computers.
https://www.investopedia.com/ask/answers/
Absolute Advantage – the ability of one country to produce
a good or service more efficiently than another. (the focus in
on productivity)

Comparative Advantage – the ability of one country that

has an absolute advantage in the production of two or more
goods (or services) to produce one of them relatively more
efficiently than the other. (the focus is on OPPORTUNITY
COST ).

While absolute advantage refers to the superior production

capabilities of one entity versus another in a single area,
comparative advantage introduces the concept
of opportunity cost. https://www.investopedia.com/ask/answers/
 In microeconomic theory, opportunity cost, or
alternative cost, is the loss of potential gain from
other alternatives when one particular alternative is
chosen over the others. In simple terms, opportunity
cost is the loss of the benefit that could have been
enjoyed had a given choice not been made. Wikipedia
 The New Trade Theory
During the 1970s and 1980s, another theory
emerged to explain trade patterns. The New Trade
Theory states that (1) there are gains to be made
from specialization and increasing economies of
scale (2) the companies first to market create barriers
to entry, and (3) government may play a role in
assisting its home companies. Because the theory
emphasizes productivity rather than a nation’s
resources, it is in the line with the theory of
comparative advantage but at odds with factor
proportions theory.
First – Mover advantage and Economies of
Scale
A first-mover advantage is the economic and strategic
advantage gained by being the first company to enter
the industry. The first-mover advantage can create a
formidable barrier to entry for potential rivals.
Economies of scale are cost advantages reaped by
companies when production becomes efficient. 
Companies can achieve economies of scale by
increasing production and lowering costs. This
happens because costs are spread over a larger
number of goods. Costs can be both fixed and variable.
https://www.investopedia.com/terms/e/economiesofscale.asp
First – Mover advantage and Economies of
Scale
Economies of Scale
The size of the business generally matters when it
comes to economies of scale. The larger the
business, the more the cost savings.

Economies of scale can be both internal and external.

Internal economies of scale are based on
management decisions, while external ones have to
do with outside factors.
 Factor Proportions Theory
In the early 1900s, an international trade theory
emerged that focused attention on proportion (supply)
of resources in a nation. The cost of any resource is
simply the result of supply and demand: factors in great
supply relative to demand with be less costly than
factors in short supply relative to demand.
Factor Proportions Theory states that countries produce
and export goods that requires resources (factors) that
are abundant and import goods that require resources in
short supply. The theory resulted from the research of
two economist. Eli Hecksher and Bertil Ohlin, and is
therefore sometimes called the Heckscher-Ohlin Theory.
International Product Life Cycle Theory
Raymond Vernon put forth an international trade
for manufactured goods in mid 1960s. His
International Product Life Cycle Theory says that a
company will begin by exporting its product and later
undertake foreign direct investment as the products
moves through its life cycle. The theory also says
that, for a number of reasons, a country’s export
eventually becomes its import.
Although Vernon developed his model around the
United States, we can generalize it to apply to any
developed and innovative market such as Australia,
the European Union, and Japan.
International Product Life Cycle

https://slideplayer.com/slide/4781706/
National Competitive Advantage Theory

Michael Porter put forth a theory in 1990 to

explain why certain countries are leaders in the
production of certain products. His National
Competitive Advantage Theory states that a nation’s
competitive industry depends on the capacity of the
industry to innovate and upgrade.
Porter’s work incorporates certain elements of
previous international trade theories but also to
make some important new discoveries.
National Competitive Advantage Theory
Porter is not preoccupied with explaining the export and
import patterns of nations but rather with explaining
why some nations are more competitive with certain
industries. He identifies four elements present to varying
degrees in every nation that form the basis of national
competitiveness. The Porter’s Diamond consist of the
following:

1. Factor conditions
2. Demand conditions
3. Related and supporting industries
4. Firm strategy, structure and rivalry
 The Practice of Trade Policy

Trade Policy – all government actions that seek

to alter the size of merchandise and / or service
flows form and to a country.

Tariffs – taxes on imports; also known as

customs duties in some countries.
Custom Duties – taxes on imports that
are collected by a designated
government agency responsible for
regulating imports.

Import Quotas – also known as

Quantitative Restrictions (QRs are
regulations that limit the amount or
number of units of products that can
be imported to a country.
Doing Business in the Pacific Rim
To do business effectively in Asian countries that rim the
Pacific Ocean, remember that Asian are as diverse as their
cultures, and aggressive sales tactics do not work. Before
going to visit these countries, it is helpful to review some
general rules:

1. Make Use of Contacts. Asians prefer to do business

with people they know. Cold calls and other direct-
contact methods seldom work. Meeting the right people
in an Asian company often depends n having the right
introduction. If the person with whom you hope to do
business respects your intermediary, chances are that he
or she will respect you.
Doing Business in the Pacific Rim
2. Carry Bilingual Business Cards. To make good first
impression, have bilingual cards printed even though
many Asian speak English. It shows both respect for the
language and a commitment to doing business in a
country. It also translates your title into the local
language. Asians generally are not comfortable until
they know your position and whom you present.
3. Respect, harmony, Consensus. Asian cultures
command respect for their investments in music, art,
science, philosophy, business, and more. Asian business
people are tough negotiators, but they dislike
argumentative exchanges. Harmony and consensus are
the bywords in Asia, so be patient but firm.
Doing Business in the Pacific Rim
4. Drop the Legal Language. Legal documents are
subordinate to personal relationships. Asian tend not to like
detailed contracts will often insist agreements be left flexible
so adjustments can be made easily to fit changing
circumstances. It’s important to foster good relations based
on mutual trust and benefit. This importance of a contract in
many Asian societies is not what it stipulates but rather who
signed it.

5. Build Personal Rapport. Social ease and friendships are

prerequisites to doing business across much of Asia. As much
business is transacted at informal dinners as in corporate
settings, so accept invitations, and be sure to reciprocate.
Economic Sanctions and Political Barriers to
Trade
Economic Sanctions 
are commercial and financial penalties applied by
one or more countries against a targeted 
self-governing state, group, or individual. 

Economic sanctions are not necessarily imposed

because of economic circumstances—they may also
be imposed for a variety of political, military, and
social issues. Economic sanctions can be used for
achieving domestic and international purposes.
https://en.wikipedia.org/wiki/Economic_sanctions
Economic Sanctions and Political Barriers to
Trade

• Economic sanctions generally aim to create good

relationships between the country enforcing the
sanctions and the receiver of said sanctions. However,
the efficacy of sanctions is debatable and sanctions can
have unintended consequences.

• Economic sanctions may include various forms of 

trade barriers, tariffs, and restrictions on 
financial transactions. An embargo is similar, but usually
implies a more severe sanction, often with a direct 
no-fly zone or naval blockade.
https://en.wikipedia.org/wiki/Economic_sanctions
  Embargoes can mean limiting or the act of banning
export or import, creating quotas for quantity, imposing
special tolls, taxes, banning freight or transport vehicles,
freezing or seizing freights, assets, bank accounts, limiting
the transport of particular technologies or products (high-
tech).
  In response to embargoes, a closed economy or autarky
 often develops in an area subjected to heavy embargo.
Effectiveness of embargoes is thus in proportion to the
extent and degree of international participation.
Embargoes can be an opportunity to some countries to
develop faster a self-sufficiency. However, Embargo may be
necessary in various economic situations of the State
forced to impose it, not necessarily therefore in case of
war.
 What is Trade Embargo ???
An embargo (from the Spanish embargo, meaning hindrance,
obstruction, etc. in a general sense, a trading ban in trade
terminology and literally "distraint" in juridic parlance) is the
partial or complete prohibition of commerce and trade with a
particular country/state or a group of countries.

Embargoes are considered strong diplomatic measures

imposed in an effort, by the imposing country, to elicit a
given national-interest result from the country on which it is
imposed. Embargoes are generally considered legal barriers
to trade, not to be confused with blockades, which are often
considered to be acts of war.
https://en.wikipedia.org/wiki/Economic_sanctions
 Economic Protectionism
What Is Protectionism?
Protectionism refers to government policies that
restrict international trade to help domestic
industries. Protectionist policies are usually
implemented with the goal to improve economic
activity within a domestic economy but can also be
implemented for safety or quality concerns.

• Protectionist policies place specific restrictions on

international trade for the benefit of a domestic
economy.
 Economic Protectionism
• Protectionist policies typically seek to improve
economic activity but may also be the result of safety
or quality concerns.
• The value of protectionism is a subject of debate
among economists and policymakers.
• Tariffs, import quotas, product standards, and
subsidies are some of the primary policy tools a
government can use in enacting protectionist
policies.

https://www.investopedia.com/terms/p/protectionism.asp
Free Trade and Trade Liberalization
What Is Trade Liberalization?
Trade liberalization is the removal or reduction of
restrictions or barriers on the free exchange of goods
between nations. These barriers include tariffs, such
as duties and surcharges, and nontariff barriers, such
as licensing rules and quotas. Economists often
view the easing or eradication of these restrictions as
steps to promote free trade.
https://www.investopedia.com/terms/t/trade-liberalization.asp
Free Trade and Trade Liberalization

• Trade liberalization removes or reduces barriers to

trade among countries, such as tariffs and quotas.
• Having fewer barriers to trade reduces the cost of
goods sold in importing countries.
• Trade liberalization can benefit stronger economies
but put weaker ones at a greater disadvantage.
https://www.investopedia.com/terms/t/trade-liberalization.asp
 Free Trade and Free Trade Area
What Is a Free Trade Area?

A free trade area is a region in which a group of

countries has signed a free trade agreement and
maintain little or no barriers to trade in the form of
tariffs or quotas between each other.
Free trade areas facilitate international trade and the
associated gains from trade along with the international
division of labor and specialization. However, free trade
areas have been criticized both for costs that are
associated with increasing economic integration and for
artificially restraining free trade.

https://www.investopedia.com/terms/f/free_trade_area.asp
 Free Trade and Free Trade Area
• A free trade area is a group of countries who have mutually
agreed to limit or eliminate trade barriers among them. 
• Free trade areas tend to promote free trade and the
international division of labor, though the provisions of the
agreement and the resulting scope of free trade is subject to
politics and international relations.
• Free trade areas have benefits and costs, and corresponding
boosters and opponents.
https://www.investopedia.com/terms/f/free_trade_area.asp

Free trade is a trade policy that does not restrict imports or

exports. It can also be understood as the free market idea
applied to international trade. Wikipedia
 What is a Cartel?

A cartel is an organization created from a formal

agreement between a group of producers of a good
or service to regulate supply in order to regulate or
manipulate prices.
In other words, a cartel is a collection of
otherwise independent businesses or countries that
act together as if they were a single producer and
thus can fix prices for the goods they produce and
the services they render, without competition.
 What is a Cartel ?

• A cartel is a collection of independent businesses or

organizations that collude in order to manipulate the price
of a product or service.
• Cartels are competitors in the same industry and seek to
reduce that competition by controlling the price in
agreement with one another.
• Tactics used by cartels include reduction of supply, price-
fixing, collusive bidding, and market carving.
• In the majority of regions, cartels are considered illegal and
promoters of anti-competitive practices.
• The actions of cartels hurt consumers primarily through
increased prices and lack of transparency.
https://www.investopedia.com/terms/c/cartel.asp
https://www.cnbc.com/video/2016/03/10/free-trade-good-or-
bad.html