Global Trade

Chapter 6
Chapter Contents

1. Mercantilism Theory
• Mercantilism: Zero-Sum Game
2. Absolute Advantage Theory
3. Comparative Advantage Theory
4. Heckscher – Ohlin Theory
• Country-Similarity Theory
• Degree of Dependence
5. Product Life-Cycle Theory
6. New Trade Theory
7. National Competitive Advantage Theory
 Overview of Trade Theory
• Free Trade occurs when a government does not attempt to influence,
through quotas or duties, what its citizens can buy from another country or
what they can produce and sell to another country.
• The Benefits of Trade allow a country to specialize in the manufacture and
export of products that can be produced most efficiently in that country.
• USA is specialized in production and export of commercial jet aircraft as the
required resources, such as highly skilled manpower and cutting-edge
technological know how, are abundant there.
• Again, USA can produce textile products but they should import those
products from, probably China or India, countries where labor force is
cheap which is required for efficient production of textiles.
1.Mercantilism Theory
• Mercantilism is the economic doctrine that government control of
foreign trade is of paramount importance for ensuring the security
of the country.
• In particular, it demands a positive balance of trade.
• Mercantilism dominated Western European, especially England,
economic policy and discourse from the 16th to late-18th
centuries.
• According to Mercantilism, a nation’s wealth depends on the country’s
accumulated treasure.
– Gold and silver are the currency of trade
• Theory says, a country should have a trade surplus.
– Maximize export through subsidies
– Minimize imports through tariffs and quotas
 1. Mercantilism: Zero-Sum Game
• Mercantilism leads to a “Zero-Sum Game”.
• In 1752, David Hume pointed out that:
– Increased exports lead to inflation and higher prices
– Increased imports lead to lower prices
– Result: Country A sells less because of high prices and Country B
sells more because of lower prices
– In the long run, no one can keep a trade surplus.
• Example
 Assume, that two countries, Bangladesh & England, each has an economy
of 1000 gold bars where both the countries can produce only one product;
Bangladesh – Rice, England – Wheat. In year 1, England imports rice
which costs 500 gold bars and Bangladesh imports wheat which costs 400
gold bars. Now, find out what will happen in Year 2.
 Inflation and Deflation

• Inflation is a rise in the general level of prices of goods and services

in an economy over a period of time. When the general price level

rises, each unit of currency buys fewer goods and services.

Consequently, inflation also reflects an erosion in the purchasing

power of money

• Deflation is a decrease in the general price level of goods and

services. Deflation occurs when the inflation rate falls below 0% (a

negative inflation rate).
 2. Absolute Advantage Theory
• Adam Smith argued (Wealth of Nations, 1776): Capability of
one country to produce more of a product with the same
amount of input than another country can vary.

– A country should produce only goods where it is most

efficient, and trade for those goods where it is not efficient
• Trade between countries is, therefore, beneficial
– In absolute advantage, both nations would gain from trade.
• Assumptions
– Perfect competition
– No transportation costs
– There is only two countries and two products in the world
 Absolute Advantage Theory
• Example
 Assume, that Malaysia and Indonesia are only existing countries and each
has 500 units of resources are available in each country to produce either
coffee or wheat. In Malaysia, assume it takes 4 units to produce a ton of
coffee and 10 units per ton of wheat. On the other side, in Indonesia, it
takes 20 units per ton of coffee and 5 units per ton of wheat.
• Find out the maximum possible level of production.
• Draw the Production Possibility Frontier.
• What would be the production amount if there is no trade and they are using half of
the total resources per product?
• If the countries produce only the products where they are specialized and trade 45
tons of products, then what would be the scenario after trade?
• If the countries specialize and trade between them instead of producing both, how
much each country would gain from this transaction?
Theory of Absolute Advantage
Absolute Advantage and the
Gains From Trade
3. Comparative Advantage Theory

• David Ricardo demonstrated comparative advantage theory in

Principles of Political Economy in 1817.
• A country having absolute advantage in the production of two
goods compared to another nation and having a comparative
advantage in producing one product than other, would devote more
resources for the more productive sector and trade for the less
productive sector’s product.
• The other nation which does not have any absolute advantage in
neither of the product compared to another nation, would produce
the product in which it can produce comparatively better using all
its resources and then trade to get the non-producing product.
Comparative Advantage Theory

• According to this theory:

– Extends free trade argument

– Efficiency of resource utilization leads to more productivity

– Should import even if country is more efficient in the product’s

production than country from which it is buying
– Look to see how much more efficient

• If only comparatively efficient, than import

– Makes better use of resources

– Trade is a positive-sum game

Comparative Advantage Theory

• Assumptions of this theory:

– A simple world with only two countries with two goods
– No transportation costs between countries
– No differences in prices of resources in different countries and
ignored exchange rate implications
– Resources can move freely to produce one good to another within
a country
– Constant return to scale. In reality both diminishing or increasing
return is possible
– Fixed stock of resources and no increase in efficiency in usage
– Ignored effects of trade on income distribution within a country
 Comparative Advantage Theory
• Example
 Assume, that Cuba and USA are only existing countries and each has 100

units of resources to produce either sugar or coffee. In Cuba, it takes 10

units to produce a ton of sugar and 8 units per ton of coffee. On the other
side, in USA, it takes 4 units per ton of sugar and 5 units per ton of coffee.
• Find out the maximum possible level of production.
• Draw the Production Possibility Frontier.
• What would be the production amount if there is no trade and they are using half of
the total resources per product?
• Let’s assume, USA decides to use 80 of their resources in sugar production and rest
in coffee. Cuba chooses to specialize in coffee production. Find out the new amount
of total production.
• If the countries decide to stick to their new resource usage decision and want to
trade 6 tons of products in-between, then illustrate the scenario after trade.
• How much the countries would gain or lose from the trade?
Assumptions & Limitations of Theories of Specialization

• Both absolute and comparative advantage theories are based on

specialization
• Countries should trade output based on their own specialization for the output
from other countries specialization
• Full employment - not valid assumption
• Economic efficiency objective - countries’ goals may not be limited to
economic efficiency
• Division of gains - if trading partner is perceived to be gaining too large a
share of benefits, other partner may forgo absolute gains to prevent relative
losses
• Two countries, two commodities - original two-country, two-product logic
applies to more complex situations
• Transport costs - may negate advantages of trading
 Theory of
Comparative Advantage
Comparative Advantage and the
Gains From Trade
Extensions of the Ricardian Model
(Comparative Advantage Theory)
• Immobile resources
– Resources do not always move easily from one economic activity
to another
• Diminishing returns
– Diminishing returns to specialization suggests that after some
point, the more units of a good the country produces, the greater
the additional resources required to produce an additional item
– Different goods use resources in different proportion
• Free trade (open economies)
– Free trade might increase a country’s stock of resources (as labor
and capital arrives from abroad)
– Increase the efficiency of resource utilization
PPF Under Diminishing Returns
Influence of Free Trade on PPF
4. Heckscher – Ohlin Theory

• Swedish economist Eli Heckscher in 1919 and Bertil Ohlin in

1933 given a different explanation of comparative advantage.
• Export goods that intensively use factor endowments which are
locally abundant.
– Outcome: Import goods made from locally scarce factors.
• Factor endowments can be impacted by government policies, such
as, minimum wage rate, working hour law, interest rate limit, etc.
• Patterns of trade are determined by differences in factor
endowments - not productivity.
‒ Kuwait sells oil and Japan sells car.
• Remember, focus on relative advantage, not absolute advantage.
 Heckscher – Ohlin Theory

Assumptions
• The price of factors depend only on the factor endowment.
This is untrue, because:
• Factor prices are not set in a perfect market.
‒ E.g. Legislated wages and benefits ultimately increases the price.
• Tax credits reduces the cost of capital.
• Given technology is universally available.
• Untrue again. Superior technology can permit a nation to produce
goods at a lower cost than that of a country better endowed with
the required factor.
‒ E.g. Developed countries can build infrastructure at a lower cost using
better technology.
 Leontief Paradox

• Study in 1953 by economist Wassily Leontief disputed the

usefulness of the Heckscher-Ohlin Theory as a predictor of the

direction of trade.
• Found that the USA, one of the most capital-intensive countries in

the world, was exporting labor intensive products.

• For instance, USA is exporting computer software and importing

heavy manufacturing products.

• According to Leontief’s findings, comparative advantage explains

the trade pattern better.

Country-Similarity Theory

Economic similarity of industrial countries

• Country similarity theory says, once a company has developed a
new product to serve needs in a local market, it will turn to markets it
sees as most similar to those at home.
• Most of the world’s trade occurs among countries that have similar
characteristics.
• Most trade takes place among industrial countries because:
‒ Growing importance of acquired advantage than natural advantage
‒ Markets in industrial countries can support products and their variations
‒ Importance of industrial markets due to their size
‒ Incomes are high and people buy more
‒ Few emerging countries trade with each other
Country-Similarity Theory

• Similarity of location
• Distances among countries accounts for many world trade
relationships.
• Methods to overcome distance disadvantages are difficult to
maintain.
• Cultural similarity
• Importers and exporters find it easier to do business in a country
perceived as being similar.
• Similarity of political and economic interests
• Political relationships and economic agreements among countries
may discourage or encourage trade between them or their
companies.
• Military conflicts disrupt trade patterns.
• Political animosity may interfere with trading channels.
Degree of Dependence
• Independence - complete economic independence
• Country has no reliance on other countries for goods, services, or
technologies.
• Cost of independence refers to the situation that the community have to
give up the use of products that cannot be produced domestically.
• Hinders country’s ability to borrow and adapt existing technologies.
• Interdependence - trade based on mutual need
• Neither trading partner is likely to cut off supplies or markets for fear of
retaliation.
• Governments may be pressured to sustain trade.
• Dependence - developing countries rely heavily on:
• The sale of one commodity for export earnings.
– 25 % of emerging countries sell one commodity
• One country as supplier or customer
• Industrialized countries
5. Product Life-Cycle Theory

• Raymond Vernon proposed the theory in 1966

• As products mature, both location of sales and optimal

production changes
• Affects the direction and flow of imports and exports

• Countries initially starting the cycle as an exporter might end

as an importer
• Globalization and integration of the economy makes this
theory less valid
International Technology Life Cycle

• Initial Stage
– Development of new technology in an industrialized
country
• Subsequently exported to other developed countries
– Higher or increasing cost of labor make it no longer
profitable to use in developed nation
• Technology exported to developing nation
• Technology produced in developing country
• Export to others for domestic consumption
 International Product Life Cycle (IPLC)
• A theory explaining why a product that begins as a nation’s export
eventually become its import.
• Four stages of the IPLC in a developed nation. (e.g. U.S.)
• U.S. exports: Initially U.S. develop a market for a new product by
doing research work. Thus, other developed nations having similar
income level starts importing that product from U.S. So, initially U.S. is
the only producer & exporter.
• Foreign production begins: Market for that new product matures in
other regions. Thus, other countries feel that the market is big enough
to support local production. Lately other countries will start producing
the good:
• The U.S. firm might develop a subsidiary.
• Licensing
• Foreign competition in export markets
• Import competition in the U.S. market
International Product Life Cycle (IPLC)

Export
Import
Domestic
Sales in
U.S.
U.S.
Production

U.S Foreign International International

Exports Production Competition in Competition in
export Mkt U.S. Mkt
 6. New Trade Theory
• In industries with high fixed costs
 Specialization increases output, and the ability to enhance
economies of scale increases
 Learning effects are high
‒ These are cost savings that come from “learning by doing”
• Applications of New Trade Theory
 Typically, requires industries with high fixed costs
– World demand will support few competitors
 Competitors may emerge because of “ First-mover advantage”
– Economies of scale may preclude new entrants
– Role of the government becomes significant
 Some argue that it generates government intervention and strategic
trade policy
Newer Explanations of the Direction of Trade

• Economies of Scale and the Experience Curve

• As output increases cost per unit decreases
• Larger and more efficient equipment
• Firms get volume discounts from suppliers
• Fixed cost allocation over large quantity
• Production cost drops because of learning curve
• First Mover Theory
• Who entered the Market first? First movers,
• Gain more market share
• Avail economies of scale earlier
• Reach learning curves earlier
• Discourage foreign entrants
Newer Explanations of the Direction of Trade

• The Linder (Swedish Economist) Theory of Overlapping Demand

• This theory applicable for manufacturing goods
• Customers’ tastes determined by income levels. Thus a nations per
capita income determines what types of goods it will demand.

• So, the country will specialize to meet the domestic demand & thus
will export the same.

• The theory deduces that trade in manufactured goods will be greater

between nations with similar per capital incomes

• E.g. let, Nokia comes up with an advanced featured product. It will first
deliver it to other developed countries who can afford it. This trade
takes place due to competitive advantage not due to comparative
advantage.
7. National Competitive Advantage Theory

• The theory attempts to analyze the reasons for a nation’s

success in a particular industry
• Michael Porter published his study of 100 industries in
10 nations in 1990
– The determinants of competitive advantage of a nation were
based on four major attributes
• Factor endowments
• Demand conditions
• Related and supporting industries
• Firm strategy, structure and rivalry
Porter’s Diamond

• Success occurs where these attributes exist

• More/greater the attribute, the higher chance of success
• The diamond is mutually reinforcing
 Porter’s Diamond
• Factor Endowments: A nation’s position in factors of production such as skilled
labor or infrastructure necessary to compete in a given industry.
• Basic factors: Factors that are naturally present in a country.
‒ Basic factors include Natural Resources, Climate, Geographic Location and
Demographics.
‒ While basic factors can provide an initial advantage they must be supported by
advanced factors to maintain success
• Advanced factors: The result of investment by people, companies, and government
are more likely to lead to competitive advantage.
If a country has no basic factors, it must invest in advanced factors
– Communications
– Skilled labor
– Research
– Technology
– Education
 Porter’s Diamond

• Demand Conditions
 Demand creates capabilities
 Demand creates sophisticated and demanding consumers
 Demand impacts quality and innovation
• Related and Supporting Industries
 Creates clusters of supporting industries that are internationally competitive
 Must also meet requirements of other parts of the Diamond
• Firm Strategy, Structure and Rivalry
 Long term corporate vision is a determinant of success
 Management ‘ideology’ & structure of the firm can either help or hurt you
 Presence of domestic rivalry improves a company’s competitiveness
Porter’s Diamond: Predictions & Implications

• Predictions
 Porter’s theory should predict the pattern of international trade that we
observe in the real world.
 Countries should be exporting products from those industries where all four
components of the diamond are favorable, while importing in those areas
where the components are not favorable.
• Implications for Business
• Location implications
– Disperse production activities to countries where they can be performed
most efficiently.
• First-mover implications
– Invest substantial financial resources in building a first-mover, or early-
mover advantage.
• Policy implications
– Promoting free trade is in the best interests of the home country, not
always in the best interests of the firm, even though many firms promote
open markets.