INTERNATIONAL TRADE

THEORY
The Global Trade and Investment Environment

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 INTERNATIONAL TRADE
 The purchase, sale, or exchange of goods and
services across national borders.

 Benefits:
Provides a country’s people with a greater choice
of goods and services.
Efficient Production
Important engine for job creation.

Trade in goods and services is one way by which

countries are linked economically.

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 MERCANTILISM
 Initial trade theory that formed the foundation of economic thought
from 1500 – 1800 century.
 Mercantilism dominated European economic policies which promoted
government intervention to accumulate largest possible share of wealth.

 It was believed that a nation’s

economic health could be assessed
by its level of ownership of precious
metals-Gold/Silver
 The world’s wealth was considered
static
 To accumulate financial wealth
countries started to encourage
exports (subsidized) and discourage
imports (tariff). 3
 MERCANTILISM
 At that time Britain was the epicenter of the British Empire,
however, it had relatively few natural resources
 To grow its wealth England introduced fiscal policies that
discouraged colonists from buying foreign products while
creating incentives to only buy British goods.

For Example: The Sugar Act of 1764

England raised duties on foreign
refined sugar imported by the colonies,
in an effort to give British sugar growers
a monopoly on the colonial market

 Trade policies like this effectively resulted in the favorable

balance of trade that increased Great Britain's national wealth

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PROBLEMS WITH MERCANTILISM
THEORY:
David Hume pointed out an inherent inconsistency in 1752.
In the long run, no country could sustain a surplus on the
balance of trade.
The flaw in the theory was that it viewed trade as a zero-sum
game.
Zero-sum game: where a gain by one country results in a
loss by another.
Adam Smith And David Hume showed that trade is a
positive-sum Game where all countries can benefit.
Many argue that China is following neo-mercantilist strategy
and Keeping its currency value low against U.S. dollar to
sell more goods to the USA.
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 NEO-MERCANTILISM
Current term to describe the approach of countries that try to
run favorable balances-of-trade to achieve some social or
political gains.

This belief equates political power with economic power and

economic power with balance-of-trade.

For instance, a country may try to achieve full employment by

setting economic policies that encourage its companies to
produce in excess of the demand at home & to send the surplus
abroad.

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 THEORY OF ABSOLUTE
ADVANTAGE
Adam Smith argued (Wealth of Nations, 1876):
countries should specialize in the production of a goods for
which they have an absolute advantage and then trade
these goods for goods produced by another country.
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.
 Assumes there is an absolute balance among nations

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Absolute Advantage

Production Possibility
Frontier

5-10
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Absolute Advantage
Question:

Ghana-Cocoa & South Korea-Rice

200 units of resources are available in each country
Ghana= 10 resources to produce one ton of cocoa
20 resources to produce one ton of rice
South Korea = 40 resources to produce one ton of cocoa
10 resources to produce one ton of rice

Production & Consumption without trade

Production & Consumption with trade

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 Absolute Advantage
Comparative Advantage
Resources required Cocoa Rice
Ghana 10 20
South Korea 40 10
Production & Consumption without trade-
200
Ghana 10 5
South Korea 2.5 10
Total-400 12.5 15
Production & Consumption with trade
Ghana 20 0
South Korea 0 20
Total 20 20
10
 C R
Gh-100 1 5
Sk-100 10 2

GH
SK
AT=200

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 Absolute Vs.
Comparative Advantage
If the US has higher productivity in corn production compared to
Switzerland, while Switzerland has higher productivity in chocolate
production compared to the US, economists would say the US has an
absolute advantage in corn production and Switzerland has an absolute
advantage in chocolate production. In this case, it is intuitive that if the US
concentrates on corn production and Switzerland on chocolate
production, then resources could be shifted from relatively lower
productivity industries to higher productivity industries and the total
combined output of corn and chocolates would rise. With greater output,
and after an appropriate trading pattern is introduced, both countries
could end up with more of both goods than before, meaning that both
countries can gain from trade

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 Absolute Vs.
Comparative Advantage
However, they are only partially right. For example, one might ask
what happens if the US had higher productivity in both corn and
chocolates compared to Switzerland? This is the question that
Ricardo tackled when he formalized CA. Ricardo’s simple analysis
demonstrated that even when one country is technologically
superior in both goods, it could still be advantageous for countries
to trade. In this circumstance, a comparative advantage is present
for those products that the country can produce most-best in
comparison to other countries, even if the most best product is
produced less productively than in the other country.

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 COMPARATIVE ADVANTAGE
David Ricardo (Principles of Political Economy, 1817):
•A country should specialize in the production of those
goods that it produces most efficiently and buy the goods it
produces less efficiently from other countries, even if this
means buying goods from other countries that it could
produce more efficiently itself.
•Potential world production is greater with unrestricted
free trade than it is with restricted trade.
•Trade is a positive-sum game in which all countries that
participate realize economic gain.

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Comparative Advantage
Resources required to produce 1 ton of Cocoa & Rice
Cocoa Rice
10 5
South Korea
1 2
Ghana
Production & Consumption without trade (100 units each) bt
South Korea 50/10=5 50/5=10
Ghana 50/1=50 50/2=25
Total Production 55 35
Ghana has Absolute advantage in producing both the goods. However, Ghana is
comparatively more efficient at producing Cocoa.

5-12
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 Comparative Advantage
Production With C R
specialization (Rice)
South Korea 0 100/5=20
Ghana 55 (55/1) 45/2=22.5
Total Production 55 42.5

Production With
specialization (Cocoa)

South Korea 0 20
Ghana 70 (70/1) 15 (30/2)
Total Production 70 35

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 BASIC ASSUMPTIONS
Both absolute and comparative advantage theories are based on
specialization.
Full employment
Economic efficiency is sought
Differences in the price of resources
Constant return to scale
Two countries/two commodities
Transportation costs
Mobility of Resources

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 HECKSCHER-OHLIN THEORY

Ricardo’s theory suggests that comparative advantage

arises from differences in labor productivity
Eli Heckscher and Bertil Ohlin argued that comparative
advantage arises from differences in national factor
endowments – the extent to which a country is
endowed with resources like land, labor, and capital
The Heckscher-Ohlin theory predicts that countries
will export goods that make intensive use of those
factors that are locally abundant while importing goods
that make intensive use of factors that are locally scarce
 THE LEONTIEF PARADOX

Wassily Leontief theorized that since the U.S. was

relatively abundant in capital compared to other
nations, the U.S. would be an exporter of capital
intensive goods and an importer of labor-intensive
goods.
However, he found that U.S. exports were less capital
intensive than U.S. imports
Since this result was at variance with the predictions
of the theory, it became known as the Leontief
Paradox
 THE PRODUCT LIFE-CYCLE THEORY

Proposed by-Raymond Vernon in the mid-1960s

One early response to the failure of the Heckscher–Ohlin
theory to explain the observed pattern of international trade
was the product life-cycle theory. Proposed by Raymond
Vernon, this theory suggests that early in their life cycle, most
new products are produced in and exported from the country
in which they were developed. As a new product becomes
widely accepted internationally, however, production starts in
other countries. As a result, the theory suggests, the product
may ultimately be exported back to the country of its original
innovation
THE PRODUCT LIFE-CYCLE THEORY

Net
exporte
r
Time

New product
Net (Brands Like
importe IBM, Apple)
r
Phase I Phase II Phase III Phase IV Phase V
All Productio Japan, Japanexpor Production
production n started Great ts to shifted to
in US in other Britain US developing
US exports advanced export to countries like
to nations LDCs Thailand.
advanced US US
countries exports exports to
Figure 4.1: The product life cycle
mostly to LDCs
like Great
Source: Wells (1972), as LDCs
cited by Dicken (2003), p.203.
displaced
Britain,
Japan
 NEW TRADE THEORY
 During the 1980s, economist Paul Krugman developed
New Trade Theory to explain the pattern of
international trade
 New Trade Theory primarily focuses on two major
concepts:
1. Trade can increase the variety of goods available to
consumers and decrease the average cost of the
goods through economies of scale.
2. World trade in certain products may be dominated
by countries whose firms were the first movers in
their production. These firms may need a significant
amount of output to attain economies of scale.
 Government may play a role in assisting its home
companies.

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 NEW TRADE THEORY
Economies of Scale:
 The theory suggest that nation may benefit from trade even
when they do not differ in resource endowment.
 Trade allows a nation to specialize in the production of certain
products, attaining economies of scale and lowering the cost of
production. Simultaneously facilitates buying other products
from other nations who have similar specialization.
 Through this mechanism variety of products available to
consumers in each nation is increased at a lower cost.

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 NEW TRADE THEORY
First Movers Advantage:
 A second theme in New Trade Theory is that the pattern
of trade in the world may be the result of first movers
advantage.
 First Mover Advantage are the economic and strategic
advantage that accrue to early entrants into an industry.

New trade theory also stresses on role of luck,

entrepreneurship and innovation in giving a firm FMA.

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 NEW TRADE THEORY
NTT stresses that in some cases, countries specialize in the production
and export of particular products not because of underlying
differences in factor endowments but because in certain industries the
world market can support only a limited number of firms. (This is
argued to be the case for the commercial aircraft industry and in the
most advanced segment of the global semiconductor industry.) In such
industries, firms that enter the market first are able to build a
competitive advantage that is subsequently difficult to challenge.
Thus, the observed pattern of trade between nations may be due in
part to the ability of firms within a given nation to capture first-mover
advantages. The United States is a major exporter of commercial jet
aircraft because American firms such as Boeing were the first movers
in the world market. Boeing built a competitive advantage that has
subsequently been difficult for firms from countries with equally
favorable factor endowments to challenge (although Europe’s Airbus
has succeeded in doing that).

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 PORTERS’ DIAMOND: NATIONAL
COMPETITIVE ADVANTAGE

Michael Porter developed a theory referred to as the

theory of National Competitive Advantage. This attempts to
explain why particular nations achieve international
success in particular industries.
Porter identified four attributes that promote or impede
the creation of competitive advantage
1.Factor endowments
2.Demand conditions
3.Relating and supporting industries
4.Firm strategy, structure, and rivalry
 PORTERS’ DIAMOND: NATIONAL
COMPETITIVE ADVANTAGE

Determinants of National Competitive Advantage: Porter’s Diamond

 PORTERS’ DIAMOND: NATIONAL
COMPETITIVE ADVANTAGE

1. Factor endowments: Basic (natural resources, climate,

location) and Advanced factors (communication
infrastructure, skilled labor, research technology)
2. Demand conditions: Nations’ firms gain competitive
advantage if their domestic consumers are sophisticated
and demanding.
3. Related and supporting industries: presence of suppliers
and related industries.
4. Firm strategy, structure and rivalry: Common technical
training; Methodological product and process improvement;
Cooperative and competitive systems
 PORTERS’ DIAMOND: NATIONAL
COMPETITIVE ADVANTAGE
1. Government policy can-
-affect demand through product standards
-influence rivalry through regulation and antitrust laws
-impact the availability of highly educated workers and
advanced transportation infrastructure.

2. The four attributes, government policy, and chance work as a

reinforcing system, complementing each other and in
combination creating the conditions appropriate for
competitive advantage
Porter’s theory has not been sufficiently tested to know how
well it holds up.