Chapter Five

Trade Theories
 Why Is Free Trade Beneficial?
• Free trade - a situation where 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

• trade theory shows why it is beneficial for a country to engage in international trade even for products it is
able to produce for itself.

• International trade allows a country,

• to specialize in the manufacture and export of products and services that it can produce
efficiently
• import products and services that can be produced more efficiently in other countries

• limits on imports may be beneficial to producers, but not beneficial for consumers
 Why Do Nations Trade?

• Nearly all economic theories suggest that Why Nations Trade? Some Answers
the benefits of international trade far
• Nations trade because trade allows
exceed the costs.
them to specialize in the
• “Specialization and international trade
production of the goods in which
increase the productivity of a nation’s
they have absolute advantage
resources and allow for greater total
• Specialization increases world output
output than would otherwise be possible. “
• Nations trade because trade allows
McConnell and Brue, 16th edition
them to get a product at a lower
cost than if it is produced at home.
 What Determines Which Goods

• The relative amount of productive factors that a nation uses to

produce a goods,
• Productivity (efficiency) of factors

Direction of Trade

• A country should specialize in the production of a goods in which it

has Absolute Advantage.
• EXPORT the surplus output (of the goods in which it has AA) in exchange for
the IMPORT of the good in which it has Absolute disadvantage.
 Mercantilism Theory
• Mercantilism (mid-16th century) suggests
that it is in a country’s best interest to • A system of government
maintain a trade surplus -to export more
than it imports institutions and policies designed
• A nation’s wealth depends on accumulated to restrict international trade,
treasure
• Gold and silver are the currency • Maximize exports through subsidies
of trade. • Minimize imports through tariffs
• advocates government intervention to achieve
a surplus in the balance of trade. and quotas
• Mercantilism views trade as a zero-sum • The theory therefore says that a
game,
• one in which a gain by one country results in country should always have a
a loss by another
trade surplus.
 Mercantilism…

It argues that;

• A nation’s wealth depends on accumulated treasure, usually, gold, silver,

precious stones, metals, etc.

• To increase wealth, nations should increase exports and reduce imports.

• It relies on the fact that exports bring in money, so it is positive, and

imports cause outflow of money, so it is negative.

o Trade surplus in gold and silver would make a nation wealthier.

 Adam Smith’s Theory Of Absolute Advantage
• Adam Smith (1776) argued that a
country has an absolute advantage in
the production of a product when it is
more efficient than any other country
in producing it.
• countries should specialize in the
production of goods for which they have
an absolute advantage and then trade
these goods for goods produced by other
countries.
• Individual: exists when a person can
produce more of a certain good/service
than someone else in the same amount
of time (or can produce a good using
the least amount of resources.)
• National: exists when a country can
produce more of a good/service than
another country can in the same time
period.
♠ Is Absolute Advantage the only basis for
trading?
What if a person or a nation has an
absolute advantage in producing
everything….would there still be a reason
to specialize and trade?
 David Ricardo’s Theory Of Comparative Advantage
• David Ricardo asked what happens when
one country has an absolute advantage in
the production of all goods.
• The theory of comparative advantage (1817)
- countries should specialize in the
production of those goods they produce
most efficiently and buy goods that they
produce less efficiently from other countries.
• Trade is a positive sum game
• If a country does not have an
absolute advantage in producing
neither of the goods,
• but it can produce one good
more efficiently than the
others, it is still beneficial if it
trades.
• Comparative advantage arises
when a country produces one
goods better and more efficiently
than it is producing other goods.
Comparative Advantage
• A person or a nation has a
comparative advantage in the
production of a product,
• when it can produce the product
at a lower domestic opportunity
cost than can a trading partner.
• Comparative advantage is the basis
for all trade between individuals,
regions, and nations.
• A person or nation will specialize in
the production of a product for
which it has a lower opportunity
cost and trade to obtain those
products for which its opportunity
cost is higher.
Specialization and Trade
• Gains from trade are based on comparative
advantage, not absolute advantage
• Specialization and trade increase
productivity within a nation and increase a
nation’s output and standard of living.
• Everyone can benefit when people trade
with one another. Not only can people
enjoy a greater quantity of goods and
services, but they can also enjoy a greater
variety of goods.
• Key to the understanding of comparative advantage is a
solid grasp of opportunity cost. Put simply, an  • People succeed in life by specializing at what they do best. If
opportunity cost is the potential benefit that someone
loses out on when selecting a particular option over
another. In the case of comparative advantage, the
opportunity cost (that is to say, the potential benefit which
has been forfeited) for one company is lower than that of
another. The company with the lower opportunity cost,
and thus the smallest potential benefit which was lost,
holds this type of advantage. Another way to think of
comparative advantage is as the best option given a trade-
off. If you're comparing two different options, each of
which has a trade-off (some benefits as well as some
disadvantages), the one with the best overall package is
the one with the comparative advantage.
• Comparative advantage refers to the ability to produce
goods and services at a lower opportunity cost, not
necessarily at a greater volume or quality.
• A trade-off is a situational decision that involves
diminishing or losing one quality, quantity or property of a
set or design in return for gains in other aspects. In simple
terms, a tradeoff is where one thing increases and another
must decrease.
• A technique of reducing or forgoing one or more desirable
outcomes in exchange for increasing or obtaining other
desirable outcomes in order to maximize the total return
they do something where they do not have an advantage
over others, then they will not be nearly as successful
because of the competition. Likewise, for countries. A
country can maximize its own wealth and the wealth of the
world by specializing in what it does best, where it has the
greatest advantages or the least opportunity costs. These
are the products and services it should export. So, for
instance, since Saudi Arabia has an abundance of oil, it
exports oil, and since the United States has an abundance of
fertile land, it exports agricultural products. On the other
hand, Saudi Arabia is mostly desert, so it cannot grow
enough food to feed its population, and the United States
consumes more oil than what can be economically provided
from its own resources. Both countries would be better off if
Saudi Arabia traded oil for agricultural products and if the
United States traded its agricultural products for oil.
• A country has an absolute advantage in producing a good if
it can either produce a product with fewer resources or with
a lower cost of resources. The opportunity cost of a product
or service is the difference in value between the value of
what is actually produced with a given set of resources
minus the maximum value that can be produced with those
resources. A country has a comparative advantage in
producing a good if it has a lower opportunity cost of
producing that good compared to whatever else it could
produce with its resources.
 Bake Make
Cakes Pizza

Ms. 2 cakes/hr. 6 pizzas/hr.

Gray

Mr. 4 cakes/hr. 8 pizzas/hr.

Pinson

Who has the absolute advantage in producing cakes? Mr. Pinson

Who has the absolute advantage in producing pizza? Mr. Pinson
Would Mr. Pinson be better off if he specializes and trades?
 Mr. Pinson should specialize and trade if he has a
comparative advantage (lower opportunity cost)
in the production of one of the products.

Bake Make
Cakes Pizza

Ms. 2 cakes/hr. 6 pizzas/hr.

Gray (1c = 3p) (1p = 1/3c)

Mr. 4 cakes/hr. 8 pizzas/hr.

Pinson (1c = 2p) (1p = 1/2c)

Mr. Pinson has a lower opportunity cost in producing cakes; therefore, he should
specialize in the production of cakes. Ms. Gray has a lower opportunity cost in
producing pizza; therefore, she should specialize in the production of pizza.
 Terms of trade
Bake Make
Cakes Pizza
Pinson will specialize in cakes. Gray will specialize in pizzas.

Ms. Gray 1c = 3p 1p = 1/3c

For one cake, Gray would be willing For one pizza, Gray will want more
to pay anything up to 3 pizzas. than 1/3 cakes.

Mr. Pinson 1c = 2p 1p = 1/2c

For one cake, Pinson will want more For one pizza, Pinson would be
than 2 pizzas. willing to pay anything up to ½
cake.
 How to Handle a Comparative Advantage Problem
• The question will have information
about two nations producing two of
the same products. This
information will be given to you in
a Production Possibilities table or
on a Production Possibilities curve
or maybe a word problem form.
1. Ask what type of problem:
Output or input?
2. Determine which nation or person
has the absolute advantage in
producing each of the two goods or
services.
3. Determine which nation or person
has the comparative advantage in
producing each of the two goods or
services.
• For each nation, determine the
opportunity cost of producing one
unit of each good.
• Identify the nation that has the lowest
opportunity cost of producing one
unit of each good. That nation has
the comparative advantage.
4. Determine the terms of trade.

• Each country will specialize in the production of the good in which it has the
comparative advantage and will export that good.

• It will import the other good. The terms of trade will be whatever is mutually
beneficial to the two countries. (They will want to be better off after trade than
before trade.)

• If the country exports Good A, it will want more of Good B than it

would get before specialization.
• If the country imports Good A, it will want to pay less in terms of
Good B than it would have to pay before specialization and trade.
 Benefits from
Specialization and Trade

• Specialization and trade increase productivity and the standard of

living within a nation.

• Because of specialization and trade, there will be a larger global

output of goods and services.

• Everyone can benefit when people trade with one another. Not only
can people enjoy a greater quantity of goods and services, but they can
also enjoy a greater variety of goods.
 The Product Life Cycle Theory
• The product life-cycle theory -as products
mature both the location of sales and the
optimal production location will change
affecting the flow and direction of trade.
• proposed by Ray Vernon in the mid-1960s
• Globalization and integration of the world
economy has made this theory less valid today
• the theory is ethnocentric
• production today is dispersed globally
• products today are introduced in multiple markets
simultaneously
• At the introductory stage, firms have invested and developed
a product. They need rich and sophisticated customers to
sell the products. So they target the customers in the
developed countries. Also at the early stages, the product has
to be close to the market, because the product is still at the
developing stage. Management can quickly react to the
customer feedback. At this stage exports increase, too.
• At the maturity stage, competitors fill the market, profits
and sales are stabilized. Firms look for cheaper ways of
producing the goods to lower the cost of production.
Exports start declining.
• At decline stage, firms start producing in overseas markets.
The product is imported from foreign markets.
 The New Trade Theory
Application of the New Trade Theory
• Began to be recognized in the
1970s.

• Deals with the returns on

specialization where substantial
economies of scale are present.
• Specialization increases
output, ability to enhance
economies of scale increase.
 Porter’s Diamond
(Harvard Business School, 1990)
• The Competitive Advantage of • Factor endowments: nation’s position in
factors of production such as skilled labor or
Nations. infrastructure necessary to compete in a given
• Looked at 100 industries in 10 industry.
nations. • Firm strategy, structure and rivalry: the
conditions in the nation governing how
• Thought existing theories companies are created, organized, and
didn’t go far enough. managed and the nature of domestic rivalry.
• Question: “Why does a • Demand conditions: the nature of home
demand for the industry’s product or service.
nation achieve international
• Related and supporting industries: the
success in a particular presence or absence in a nation of supplier
industry?” industries or related industries that are
nationally competitive.
 Porter’s Diamond
Determinants of National Competitive Advantage

Firm Strategy,
Structure and
Rivalry

Factor Endowments Demand Conditions

Related and
Supporting
Industries
 Economies of Scale and the Experience
Curve
• Countries benefit from economies of scale; that is, as plants get larger and
more efficient equipment is used, per unit cost of production declines.

Reasons for economies of scale:

• Larger and more efficient equipment is used.
• Companies get volume discounts on purchases.
• Fixed Cost allocated over larger volume of units.
• Learning curve – as firms increase production, they learn ways of
improving production technology and reduce cost of production.
 What Are The Implications Of Trade
Theory For Managers?

1. Location implications - a firm should disperse its

various productive activities to those countries where
they can be performed most efficiently

2. First-mover implications - a first-mover advantage

can help a firm dominate global trade in that product

3. Policy implications - firms should work to encourage

governmental policies that support free trade