Trade Theories

• International trade theory

• explains why it is beneficial for countries to engage in international trade
• Common sense suggests some trade is beneficial: can’t expect Iceland to grow mangoes,
beneficial to exchange with fish
• helps countries formulate their economic policy
• explains the pattern of international trade in the world economy
• Some patterns of trade are fairly easy to explain - it is obvious why Saudi Arabia exports
oil, Ghana exports cocoa, and Brazil exports coffee
• But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry?
 An Overview of Trade Theory

• Mercantilism (16th and 17th centuries) promoted the idea of encouraging exports
and discouraging imports
• In 1776, Adam Smith promoted the idea of unrestricted free trade
• Free trade refers to 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
• In the 19th century, David Ricardo built on Smith ideas, and in the 20th century, Eli
Heckscher and Bertil Ohlin refined Ricardo’s work
• Ricardo’s theory of comparative advantage suggests that existing trade patterns are
related to differences in labor productivity
• Heckscher and Ohlin’s theory explains trade through the interplay between the
proportions in which the factors of production are available in different countries
and the proportions in which they are needed for producing particular goods
• The theories of Smith, Ricardo and Heckscher-Ohlin show why it is beneficial for a
country to engage in international trade even for products it is able to produce for
itself
• Ray Vernon suggested that trade patterns could be explained by looking at a product’s
life cycle: grew out of failure to explain observed pattern of IT
• For the same reason , Paul Krugman developed new trade theory which suggests that
the world market can only support a limited number of firms in some industries, and
so trade will skew toward those countries that have firms that were able to capture
first mover advantages
• International trade allows a country to specialize in the manufacture and export of
products that can be produced most efficiently in that country, and import products
that can be produced more efficiently in other countries
• While the theories all suggest that trade is beneficial, they lack agreement in their
recommendations for government policy
• Mercantilism makes a case for government involvement in promoting exports and
limiting imports
• Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade
• First Theory of International Trade: Mercantilism
• Emerged in England in the mid-16th century
• Principal assertion that gold and silver were mainstays of national wealth
• Gold ,Silver being currency of trade
• Asserted that it is in a country’s best interest to maintain a trade surplus, to export
more than it imports
• Export and maintain trade surplus, leading to accumulation of gold and silver and
consequent increase in wealth , prestige and power
• Advocated govt intervention – policies to maximize exports and minimize imports
• Did not see any virtue in Free Trade
• Tariffs and Quotas to minimize imports, and subsidies to maximize exports
• Inherent inconsistency in Mercantilist doctrine pointed out by David
Hume in 1752
• In long run no country can sustain trade surplus
• Trade surplus would increase gold leading to increase in money supply
and inflation, and in the other country to lowering of prices(with outflow
of gold and silver)
• So less of goods bought from country with inflation, and more from
country where prices have gone down
• Surplus would then be eliminated
• So no country can sustain surplus in the long run
• Flaw with the theory of Mercantilism: viewed it as a zero-sum game( that is gain in one as
loss of another)
• Trade as positive sum game with win-win situation for trading countries
• Adam Smith and Ricardo
• Still in today’s world Neo-mercantilists equate political and economic power with trade
surplus
• Is China a Neo-Mercantilist?
• China’s policy of having trade surplus, keeping its currency value low against the dollar to boost its
exports and amass foreign exchange
• Huge foreign exchange reserves, trade surplus, no free float
• Mercantilism is problematic and not economically valid, yet many political views today have
the goal of boosting exports while limiting imports by seeking only selective liberalization of
trade
• Adam Smith’s theory of Absolute Advantage
• Wealth of Nations: In 1776, Adam Smith attacked the mercantilist
assumption that trade is a zero-sum game
• Argued that countries differ in their ability to produce goods efficiently, and
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
• England with superior manufacturing processes, world’s most efficient
textile manufacturers, France with favourable climate, good soils and
accumulated expertise most efficient wine industry
• England absolute advantage in production of textiles and France absolute
advantage in production of wine
• Countries should specialize in the production of goods for which they have
an absolute advantage and then trade these goods for the goods produced
by other countries
• Not to produce goods at home that can be bought at lower prices from
abroad
• Nations should concentrate on goods they could make more cheaply
• Productivities of factor inputs, may be based on climate, natural or
acquired advantages like skills leading to cost advantage
• Concept of cost based on labor theory of value, ie, labor is the only factor
of production and cost depends exclusively on amount of labor used
• Two nation two product model, where one nation has an absolute cost
advantage in one good and the other in another: US in cloth and UK in
wine
• US produces cloth and imports wine, and UK produces wine and imports cloth
Absolute advantage; each nation is more efficient in producing one good

10
 Absolute Advantage

• Assume two countries, Ghana and South Korea,

• Both have 200 units of resources that could either be used to produce rice or cocoa
• Ghana takes 10 units of resources to produce one ton of cocoa and 20 units of
resources to produce one ton of rice
• Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa,
or some combination of rice and cocoa between the two extremes
• South Korea takes 40 units of resources to produce one ton of cocoa and 10
resources to produce one ton of rice
• South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no
cocoa, or some combination in between
• Ghana has an absolute advantage in the production of cocoa
• South Korea has an absolute advantage in the production of rice
 Absolute Advantage
The Theory of Absolute Advantage
• Without trade– If resources distributed as 100 each on the two products
• Ghana would produce 10 tons of cocoa and 5 tons of rice
• South Korea would produce 2.5 tons of cocoa and 10 tons of rice
• If each country specializes in the product in which it has an absolute advantage and trades for the
other product
• Ghana would produce 20 tons of cocoa
• South Korea would produce 20 tons of rice
• Suppose
• Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice
• That is the price of 1 ton of cocoa is equal to the price of 1 ton of rice
• After trade
• Ghana would have 14 tons of cocoa left, and 6 tons of rice
• South Korea would have 6 tons of cocoa and 14 tons of rice left
• Both countries gained from trade due to specialization
• Ghana 4 tons of cocoa, and 1 ton of rice
• S Korea 3.5 tons of cocoa, and 4 tons of rice
• Consumers in both nations would be able to consume more
• 40 tons of cocoa and rice against 27.5 tons earlier
• Ricardo’s Theory of Comparative Advantage
• What if nation is more efficient than its trading partners in all the goods
• Even if absolute cost advantage in production of both goods, beneficial trade
may still exist
• Less efficient nation should export goods in which it is relatively less
inefficient, and more efficient should export goods in which it is relatively more
efficient(where its absolute advantage is greater)
• Assumptions:
• The world consists of two nations, each use a single input, produce two goods
• In each nation, labor is the only input , fully employed and homogeneous
• Labor can move freely among industries within a nation
• Technology - fixed for both nations different nations may use different technologies
• Costs do not vary with the level of production, proportional to the amount of labor used
• Perfect competition, no transport costs, no government barriers, etc
Comparative advantage, U.S. -absolute advantage in producing both goods

16
• US is more efficient in production of both goods: 4 times more efficient in
production of cloth and 2 times in that of wine; but relatively speaking
more efficient in cloth
• US has greater absolute advantage in cloth than wine- nation exports that
good in which it has comparative advantage, ie, that in which labor
productivity is high
• No reason for one country to produce both if efficient in both ,and
resources idle in another country- world output would reduce
• If relax assumption of only labor as factor of production, then one can
analyze through the PPF: various maximum combinations of two goods
which can be produced using inputs; slope being the OC
 .

• Marginal rate of transformation, MRT: the amount of one product a nation

must sacrifice to get one additional unit of the other product
• Absolute value of the slope of production possibilities schedule
• Constant opportunity costs: straight line production possibilities schedules
• Factors of production, perfect substitutes for each other, all units of a given factor are of
the same quality
• Canada 160 units of y or 80 units of x, assuming all resources being used either
on two goods; or different combinations of two goods
• US likewise 60 of y or 120 of x; or different combinations of two goods
• US relative cost of each x is 0.5 of y, which is the MRT
• Canada relative cost of each x is 2 of y, which is the MRT
• In absence of trade assume US prefers to produce at A, with 40 each of y and x
; and Canada prefers at A’ with 40 of x and 80 of y
• Given trade US would like to use all its resources in producing commodity x as it
can produce more, and Canada in producing y: point B and B’ respectively
• Suppose the exchange of x by US is for y of Canada in the ratio of 1:1, the line tt
• This exchange ratio is known as terms of trade: relative prices at which two
products trade in the market
• If US decides to exchange 60 of x with 60 of y, the new point would be C and C’
• Both countries are now consuming more of 20 x and 20 more of y
• Triangle BCD shows US exports along x axis, imports along y axis and terms of
trade (slope) is called trade triangle; Canada’s trade triangle is B’C’D’
• Both countries have gained together net increase in production of 40 units of x
and 40 units of y
• These gains have come from using existing resources and is therefore called static
gains- and can consume more, at a point outside the PPF
 Trading under constant opportunity costs

With constant opportunity costs, a nation will specialize in the product of its comparative
advantage. The principle of comparative advantage implies that with specialization and free
trade, a nation enjoys production gains and consumption gains. A nation’s trade triangle denotes
its exports, imports, and terms of trade. In a two nation, two product world, the trade triangle of
one nation equals that of the other nation; one nation’s exports equal the other nation’s
imports, and there is one equilibrium terms of trade.
20
Gains from specialization & trade: constant opportunity costs

21
• Ricardo’s model does not determine the actual terms of trade; only outer
limits can be provided as it ignores the role of demand which would also
go in determining prices
• Domestic cost ratios, however, set the limits for the equilibrium terms of
trade: US would not accept any terms of trade less than the domestic cost-
ratio line of 0.5:1; otherwise it’s a loser with trade because it can do so
better domestically- lying within PPF
• Likewise for Canada a minimum of 1 x for 2 y
• These two ratios determine the limits of trade boundary: the region of
mutually beneficial trade is bounded by these two ratios
• With prices the terms of trade measures the relation between the prices a
nation gets for its exports and the prices it pays for its imports
 Equilibrium terms-of-trade limits

The supply-side analysis of Ricardo describes the outer limits within which the equilibrium terms
of trade must fall. The domestic cost ratios set the outer limits for the equilibrium terms of trade.
Mutually beneficial trade for both nations occurs if the equilibrium terms of trade lies between
the two nations’ domestic cost ratios. According to the theory of reciprocal demand, the actual
exchange ratio at which trade occurs depends on the trading partners’ interacting demands.
23
• Improvement in a nation’s terms of trade rise in its export prices relative
to its import prices
• Deterioration in a nation’s terms of trade rise in its import prices relative
to its export prices
• Trade leads to better utilization of resources. So over a period of time the
country can have more income leading to higher savings and investment,
leading to further economic growth- dynamic gains from trade
• Trade also enables larger market leading to reaping economies of scale,
which is another dynamic gain from trade
• Comparative advantage do change over time depending on the dynamics
of the economy, may have comparative advantage in new products or
lose the same in existing products, as for example, US lost its competitive
edge in semi-conductors to Japan/ China
• If the assumption of CRS is dropped then the PPF becomes concave to the
origin- increasing OC because all factors are not equally suited for
production of all goods.
• As more and more resources are diverted to production of a particular
good, the increase in production of one good x would require more and
more resources to be diverted from another good y, which means more
and more of y to be given up for equal unit of x
• Increasing OC because inputs are imperfect substitutes of one another
• Case of diminishing marginal productivity: addition of successive units of
labor to capital
• Diminishing MRT and different at different points, and point at which
production will happen would take into account the demand factors
 Production possibilities schedule; increasing-cost conditions

Increasing opportunity costs lead to a production possibilities schedule that is concave,

viewed from the diagram’s origin. The marginal rate of transformation equals the (absolute)
slope of the production possibilities schedule at a particular point along the schedule.
26
• US at point A with 1x for 0.33y, and Canada at point A’ with 1x for 3 y
• x relatively cheaper in US and y relatively cheaper in Canada
• specialization will continue until relative cost of x is same in both countries
and so also for y
• Trade with 1x for 1y; at points B and B’: US will give 1x and will gain 1y
instead of 0.33 y; Canada will gain 1x by giving only 1y instead of 3y in case of
domestic production
• There will gains in production and consumption for both countries with trade
• More Than Two Products: rank the goods by the degree of comparative cost
• Each country exports the product(s) it has the greatest comparative advantage
• Each country imports the product(s) it has greatest comparative disadvantage
• Cutoff point between exports and imports is relative strength of international demand
 FIGURE 2.5 Trading under increasing opportunity costs

With increasing opportunity costs, comparative product prices in each country are
determined by both supply and demand factors. A country tends to partially specialize in the
product of its comparative advantage under increasing cost conditions.
28
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product
Gains from specialization and trade: increasing opportunity costs

29
 Hypothetical spectrum of comparative advantages, U.S. and Japan

When a large number of goods is produced by two countries, operation of the

comparative-advantage principle requires the goods to be ranked by the degree of
comparative cost. Each country exports the product(s) in which its comparative advantage
is strongest. Each country imports the product(s) in which its comparative advantage is
weakest.

30
 Multilateral trade: U.S., Japan, and OPEC

When many countries are involved in international trade, the home country will likely find it
advantageous to enter into multilateral trading relations with a number of countries. This
figure illustrates the process of multilateral trade for the United States, Japan, and OPEC.
31
• Limitations of the Ricardian model
• Labor is not the only factor input
• Production and distribution costs
• Differences in product quality
• Comparative advantage weakened if resources can move to wherever they
are most productive
• Heckscher-Ohlin theory
• Ricardo did not explain what causes comparative advantage
• Factor-Endowment theory : a nation will export the product that uses a
large amount of its relatively abundant resource, and will import product
which uses relatively scarce resource
• Assumption: technology and demand are approximately the same between
countries
• India will export labor intensive products like shoes and shirts, while US
with its relative abundance of capital will export machines, etc
• Effect of resource endowments on comparative advantage
• Heckscher and Ohlin argued that comparative advantage arises from differences in
national factor endowments (the extent to which a country is endowed with
resources such as land, labor, and capital)
• The more abundant a factor, the lower its cost
• Countries will export goods that make intensive use of those factors that are
locally abundant, and import goods that make intensive use of factors that are
locally scarce
• Relative not absolute factor endowments which is important- country may have
larger absolute amounts of land and labor than another country, but be relatively
abundant in one of them.
• USA exporting agricultural goods because abundance of arable land, China in labor
intensive manufacturing goods like textiles and footwear.
• Like Ricardo, argues that free trade is beneficial, but the pattern of trade is
determined by differences in factor endowments, rather than differences in
productivity
 The Leontief Paradox
• Wassily Leontief (1954) argued that since the U.S. was relatively abundant
in capital, it would be an exporter of capital intensive goods and an
importer of labor-intensive goods.
• Based on trade data for 1947 looked at some 200 export and import
competing industries in US
• Leontief found however, that U.S. exports were less capital intensive
than U.S. imports
• Possible explanations for these findings include
• that the U.S. has a special advantage in producing products made with
innovative technologies that are less capital intensive
• May be exporting goods that heavily use skilled labor and innovative
entrepreneurship , such as computer software while importing heavy
manufactured goods that use large amount of capital
• However, empirical data for large number of countries do confirm the
paradox
• Ricardo better predictor of trade pattern than H-O, that trade patterns are
largely driven by international differences in productivity
• USA exports commercial aircraft and imports textiles not because its
factor endowments are especially suited to aircraft manufacture, but
because it is relatively more efficient at producing aircraft than textiles.
• differences in technology lead to differences in productivity which then
drives trade patterns
• Japan’s success in exporting autos based not just on relative abundance
of capital , but also on developing innovative manufacturing technology
which enabled it to achieve higher productivity
• Once differences in technology across countries are controlled for , then
countries export goods that make intensive use of factors that are locally
abundant, and importing goods using factors that are locally scarce
• Key assumption in H-O theory is that technologies are same across countries
• Theory seems to gain predictive power
• Comparative Advantage does not explain why countries with similar
productivity trade
• New trade theory (1980s) suggests
• nations may benefit from trade even when they do not differ in resource endowments or
technology
• pattern of trade because of ability of firms to attain economies of scale and first mover advantage
• Economies of scale are unit cost reductions associated with a large scale of
output-
• Without trade
• a small nation may not be able to support the demand necessary for producers to
realize required economies of scale, and so certain products may not be produced
• With trade
• a nation may be able to specialize in producing a narrower range of products and
then buy the goods that it does not make from other countries
• each nation then simultaneously increases the variety of goods available to its
consumers and lowers the costs of those goods
• A key aspect of increasing returns to scale and economies of scale is the home
market effect : countries will specialize in products having a large domestic demand
• Theory also says that trade depends on first mover advantage which may arise
because of chance factors like luck, entrepreneurship, government being pro-active
• First mover advantage arises in those cases where economies of scale are
substantial and represent significant portion of world demand
• In those industries when the output required to attain economies of scale
represents a significant proportion of total world demand, the global market may
only be able to support a small number of firms
• Commercial aero space industry where fixed costs of developing a new jet aircraft is
huge ($14b for 550 A 380)- for break even would require at least 250 planes and 350
for profit, but demand over the next 20-30 years is only 400-600 planes
• Global market can support only one producer- so European union leading exporter
of very large aircraft
• First mover advantage can only support few firms, because limited world demand-
ex: commercial aircraft industry by Boeing and airbus- even if Japan wants to enter
it cannot do so and may ally as subcontractor
 Product Life-Cycle Theory
•Raymond Vernon proposed the theory in mid – 1960s
•Theory based on observation that most of 20th century large
proportion of world’s new products developed by US firms and sold
in US market ( eg. Auto, TV, photocopiers, PC, Chips)
•Because of wealth and size of US market, gave US firms strong
incentive to develop new consumer products
•New product risky so keep production close to market/demand
•Demand not price-sensitive so no need to look for low cost centers
•Also exported to developed countries because of demand by high-
income group
•Subsequently demand increased in developed countries ( UK,
Germany, Japan)
• Foreign producers start producing in their home markets
• US firms also start locating in those advanced countries
• Limits exports from USA
• Cost considerations important so that domestic industry loses
competitive advantage :higher wages in US, so may start
importing
• Also as market in US and other advanced nations matures,
product becomes more standardized
• Wage increases in other developed countries
• Shift to developing countries and then developed countries also
start importing
• Life-cycle
• Initial made in USA, and export from USA to developed countries
• Maturing product- export by developed countries and import by USA
• Standardized product
• Export by developing countries and import by developed countries and USA
• Ex: photocopiers- originally Xerox produced in USA, then shifted to
Japan( Fuji-Xerox) and GB(Rank-Xerox)/
• Patent expired ; others like Canon , Olivetti in Italy entered/ US started buying
from Japan/ Japan found manufacturing cost too high
• Shifted to developing countries like Thailand and Singapore
• A lesson for firm desiring to maintain its competitiveness
• To prevent rivals from catching up it must continuously innovate so as to become more
efficient: Toyota regarded as industry leader in production efficiency
• Intra-Industry Trade
• Two way trade in a similar commodity: IBM sold abroad, but US also imports
computers
• Appears to be incompatible with models of comparative advantage- does not
simultaneously import and export the same product
• A nation may import and export the same product because of transportation cost-
cheaper to import in one part from neighboring country, rather than from a far away
domestic place of manufacturing
• Seasonal agricultural goods can be another example: exporting in one season , and
importing in another season
• For differentiated products it could be that for majority consumer demand it is
produced locally, whereas for minority demand it is met through imports- cars
• Economies of scale could be another reason with one country having a cost advantage
in one variety of same product, and another in some other variety of same product
• Does not cause workers exit from industry, or unemployment
Intra-industry trade examples: selected U.S. exports
and imports, 2007 (in millions of dollars)

43
 Implications for Managers
Question: What are the implications of international trade theory
for international businesses?

• There are at least three main implications for international

businesses
1. Location implications
2. First-mover implications
3. Policy implications
 Location
• Different countries have advantages in different
productive activities
• These differences influence a firm’s decision about where
to locate productive activities
• It makes sense for a firm to disperse its various productive
activities to those countries where they can be performed
most efficiently
• Say, design in France, manufacture of basic components in
Singapore, assembly in China because labor intensive
• EX: laptop computer- R&D and design in Japan and US
because of advantage in microprocessors,
• memory chips in Taiwan , Korea because capital intensive
but semi-skilled,
• processor in US, Japan because capital intensive but skilled,
• assembly in China because labor-intensive
 First-Mover Advantages
• Firms that establish a first-mover advantage in the production of a
new product may later dominate global trade in that product
• It can be worthwhile for a firm to invest resources in trying to build first-
mover advantages, even if it means losses for a few years before a venture
becomes profitable
 Government Policy
• Government policies with respect to free trade or protecting domestic
industries can significantly impact global competitiveness
• Businesses exert strong influence on Govt trade policy, lobbying to promote
free trade or trade restrictions
• Can be at loggerheads- tariff on LCD screens , protested by Apple and IBM as
was being used in computers
• Tariffs on steel raised the cost of steel hurting automobile companies
• Businesses should work to encourage governmental policies that impact each
component of diamond- education, infrastructure, promote competition
• Should also constantly invest in better training for its employees, besides
focus on R&D.