TRADE THEORY

Basis for Trade

 Export – if domestic opportunity
cost of producing an additional unit
of output < border price.
 Import – if domestic opportunity
cost of producing additional unit >
border price.
Economic Theories For
International Trade

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Economic Theories For International
Trade

Traditional Trade Theories

 Mercantilism
 Absolute Advantage
 Comparative Advantage
 Factor Proportion Theory

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Economic Theories For International
Trade

Modern Trade Theories

 Country Similarity Theory
 Global Horizon Theory
 Product Life Cycle Theory
 Global Strategic Rivalry Theory
 Competitive Advantage of Nations

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Traditional Trade Theories

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 Mercantilism

• 16th century economic trade theory that

nations should accumulate financial wealth,
usually in the form of gold and silver, by
encouraging exports and discouraging
imports.

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 Mercantilism

• The practice of mercantilism has three essential pillars:

– Trade surpluses:
• A country takes in more gold/silver from its exports
than it pays out for its imports.
– Government intervention:
• National governments actively intervene in
international trade to maintain a trade surplus e.g.
tariffs and import taxes
– Colonization:
• Mercantilist nations required colonies to serve as
inexpensive sources of raw materials and as markets
for higher priced finished goods.
• Theory flawed as assumed world’s wealth was limited
therefore aim was to increase one’s share of the pie – a zero-
sum game. Absolute advantage theory showed this was
incorrect.
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 Absolute Advantage

• Scottish economist Adam Smith in 1776

suggested that:
– “Different countries can produce some
goods more efficiently than others, thus
global efficiency can be increased through
free trade”.
– Smith suggested:
• International trade should not be banned or
restricted by tariffs and quotas
• Free trade would allow countries to concentrate
on producing the goods they held an absolute
advantage in
• Countries could then trade with other nations to
obtain goods they needed but did not produce
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 Absolute Advantage

– Theory suggests trade is a positive-sum

game. Governments should keep out of
trade and focus on living standards not
how much gold and silver is on reserve.
– Problem is what if a country does not hold
an absolute advantage in any products?
New theory: Comparative advantage.

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Theory of Absolute
Advantage

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Absolute Advantage and the
Gains From Trade

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Comparative Advantage
 David Ricardo in 1817
 Addressed the problem of what to do if a
country had an absolute advantage in all
goods.
 He suggested it makes sense for a country
to specialize in the production of goods
that it produced most efficiently and to
buy the goods it produced less efficiently
from other countries, even if it meant
buying goods from other countries that it
could produce more efficiently itself.

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Comparative Advantage
 David Ricardo in 1817
 Why?: because otherwise there may not be
trade and each country can only produce
what it can consume.
 Theory is positive sum game in which all
countries that participate realise some
economic gain.

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 Theory of
Comparative Advantage

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Comparative Advantage and the
Gains From Trade

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Problems with Comparative
Advantage Theory
• Countries were treated as independent.
• Only applied to goods not services.
• Technology, Management & Marketing Skills
were not recognised only that labour
productivity provided comparative advantage.
• Did not consider transportation costs between
countries or such things as exchange rates.
• Does not take into account the amount of
resources each has available nor efficiencies
each can gain over time.
• Does not recognise that both diminishing and
increasing returns to specialisation exist.
• Does not consider effects of income
distribution within a country.
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 Factor Proportions Theory
Heckscher and Ohlin’s theory
(1933) “a country will have a comparative advantage
in producing products that intensively use resources
(factors of production) it has in abundance.”
 explained differences in factor costs.

 these economists proposed that if labour were

abundant in relation to land and capital, labour
costs would be low and land and capital costs
high.

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Factor Proportions Theory
(cont.)

 If labour were scarce, labour costs

would be high relative to land and
capital costs.
 The tendency is for a country to
export goods that use relatively
abundant factors intensively and
import those that use scarce factors
intensively.

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Invalid Assumptions
of H-O Theory
 Nations use the same technology in
production
 Nations produce commodities under
constant return to scale
 Perfect competitions in both
commodity and factor markets
Factor Proportions Theory
(cont.)

 Leontief tested the theory a number of

times and reached the opposite to
expected results. This created the
Leontief paradox.
 Some economists suggest this was due to
his failure to include land, human capital
and technology as factors of production.
 It was found that if you control for the
differences of technology on productivity
that countries do indeed export those goods
that make intensive use of factors of
production that are abundant locally.

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Modern Trade Theories

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Country Similarity Theory
 In 1961 Steffan Linder suggested
that most trade in manufactured
goods is between countries of
similar per capita income.
 ie consumers have a similarity of
preference when at the same stage
of economic development.

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Global Horizons Theory
 As part of a firm’s growth, their
geographical horizons change.
 Change is caused by:
 INTERNAL
 Executives, Technology, Product, Raw
Material Supply
 EXTERNAL
 Customer, Government
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Product Life
Cycle (Vernon)
• Concept is related to product life cycle
• and concerns the role of innovation in trade
patterns.

• Phase 1:
– New Product., Domestic Market

• Phase 2:
– Export Mature Product., Other
Industrialized Countries

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Product Life
Cycle (cont.)
 Phase 3:
 Foreign Production
• Export to Developing Countries
 Phase 4:
 Move Production to Developing Countries
 Phase 5:
 Export of Product Back to Home Country

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Global Strategic Rivalry
theory
 In the 1980s economists such as Paul
Krugman and Kelvin Lancaster developed
a new way of looking at the growth of
MNCs. According to these theories firms
struggle for a sustainable competitive
advantage to exploit to dominate the
global marketplace.

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Global Strategic Rivalry theory
cont.
 Focus is on strategic decisions adopted as
firms compete globally. Sustainable
competitive advantage is achieved by:
 owning intellectual property rights

 investing in research and development

 achieving economies of scale or scope

 exploiting the experience curve

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Porter’s National Competitive
Advantage theory (Porter’s
diamond)

• In 1990 Michael Porter stated that

success in international trade came
from the interaction of four country and
firm specific factors:
– factor conditions
• land, labour, capital, education, infrastructure
etc.
• International rivals will differ in the mix and cost
of available factors and the rate of factor
creation.

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Porter’s National Competitive
Advantage theory (Porter’s
diamond)

– demand conditions
• Competitors from other nations face differing
segment structures to home demand, differing
buyer needs and differing levels of buyer
sophistication.
• Large sophisticated domestic consumer base
often stimulates innovative products.
• Understanding competitors home demand
conditions helps you predict their foreign
strategies and product development.

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Porter’s National Competitive
Advantage theory (Porter’s diamond)
Cont
– Related and supporting industries
• Competitors based in other nations will differ in availability of
domestic suppliers, quality of interaction with suppliers, and
presence of related industries.
• being close to local suppliers leads to improved communication,
cost-savings, innovations transferable overseas.
– Firm strategy, structure and rivalry
• the domestic environment shapes firms ability to compete
internationally. According to Porter you need vigorous competition,
and strong local investment in areas that provide sustainable
advantages e.g. R&D, quality control, brand imaging, employee
training).
– Other diamond components
• Chance
• Government

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Porter’s National Competitive
Advantage theory (Porter’s
diamond) Cont

 Porter’s rules for innovation:

 Sell to the most sophisticated and
demanding buyers and channels
• Stimulates fast improvement
• Sets valuable benchmarks
• Challenges ability to compete
 Seek out the buyers with the most
difficult needs
• Enhances ability to deal with pressure
• Encourages research and development
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Porter’s National Competitive Advantage
theory (Porter’s diamond) Cont

 Establish norms of exceeding the toughest regulatory

hurdles or product standards
 Encourages early upgrading
 Source from the most advanced and international
home-based suppliers
 Deal with those with a competitive advantage and
insights that may assist you
 Treat employees as permanent
 Requires focus to improve productivity via training and
rewards
 Establish outstanding competitors as motivators
 Provide benchmarks to compare and exceed

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Porter’s National Competitive Advantage
theory (Porter’s diamond) Cont

• Developing clusters
– Use home nation clusters of buyers, suppliers
and related industries to gain competitive
advantages.

– Use home based suppliers and buyers as

international allies
• Regular senior management contact
• R&D interchanges
• Reciprocity in serving as test sites for new
products and services
• Cooperation in penetrating international markets

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TPPA
 The Trans-Pacific Partnership (TPP) is an
FTA initiative involving eleven (11)
countries, Australia, Brunei, Canada,
Chile, Malaysia, Mexico, New Zealand,
Peru, Singapore, United States and Viet
Nam.

 17 rounds of negotiations have been held

 The objective of the negotiations is to develop an FTA agreement
which will be able to adapt and incorporate current issues,
concerns and interests. Among the areas are:
 Market Access
 Technical Barriers to Trade
 Environment
 Capacity building
 Financial Services
 Telecommunications