Chapter 5

The Theory of Trade and

Investment

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 Learning Objectives
To understand the traditional arguments
of how and why international trade
improves the welfare of all countries
To review the history and compare the
implications of trade theory from the original
work of Adam Smith to the contemporary theories
of Michael Porter
To examine the criticisms of classical trade theory
and examine alternative viewpoints of which
business and economic forces determine trade
patterns between countries
To explore the similarities and distinctions
between international trade and international
investment
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 Evolution of Trade Theory
The Age of Mercantilism
Classical Trade Theory
Factor Proportions Trade
Theory
International Investment
and Product Cycle Theory
The New Trade Theory:
Strategic Trade
The Theory of International
Investment
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 The Age of Mercantilism
The evolution of trade into the form
we see today reflects three events:
The Collapse of Feudal Society

The Emergence of the Mercantilist Philosophy

The Life Cycle of the Colonial Systems of the

European Nation-States

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 Mercantilism
Mixed exchange through
trade with accumulation
of wealth
Conducted under
authority of government
Demise of mercantilism
inevitable

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 Classical Trade Theory
The Theory of Absolute Advantage
The ability of a country to produce a
product with fewer inputs than another
country

The Theory of Comparative

Advantage
The notion that although a country may
produce both products more cheaply than
another country, it is relatively better at
producing one product than the other
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Classical Trade Theory Contributions
Adam Smith—Division of Labor
Industrial societies increase output using same
labor-hours as pre-industrial society
David Ricardo—Comparative
Advantage
Countries with no obvious reason for trade can
specialize in production, and trade for products
they do not produce
Gains From Trade
A nation can achieve consumption levels
beyond what it could produce by itself
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Factor Proportions Trade Theory

Developed
Developedby
byEli
EliHeckscher
Heckscher

Expanded
Expandedby
byBertil
BertilOhlin
Ohlin

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 Factor Proportions Trade Theory
Considers Two Factors of Production

Labor

Capital
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Factor Proportions Trade Theory
A country that is relatively labor
abundant (capital abundant) should
specialize in the production and
export of that product which is
relatively labor intensive (capital
intensive).

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 The Leontief Paradox
The Test:
Could Factor Proportions Theory
be used to explain the types of
goods the United States imported
and exported?

The Method:
Input-output analysis
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 The Leontief Paradox
The Findings:
The U.S. exported labor-intensive
products and imported capital-
intensive products.

The Controversy:
Findings were the opposite of what
was generally believed to be true!
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Overlapping Product Ranges Theory:
Staffan Burenstam Linder
Trade in manufactured goods
dictated not by cost concerns, but
by similarity in product demands
across countries.
Work focused on preferences of
consumer demand.
Today, termed market segments.

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 Product Cycle Theory

Raymond Vernon
Focus on the product,
not its factor
proportions
Two technology-based
premises

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 Product Cycle Theory:
Vernon’s Premises
Technical innovations leading to new
and profitable products require large
quantities of capital and skilled labor

The product and the methods for

manufacture go through three stages
of maturation

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 Stages of the Product Cycle
The New Product

The Maturing Product

The Standardized Product

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 The Product Cycle and Trade
Implications
Increased emphasis on technology’s
impact on product cost
Explained international investment
Limitations
Most appropriate for technology-based products
Some products not easily characterized by stages
of maturity
Most relevant to products produced through mass
production

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 The New Trade Theory:
Strategic Trade
Two New Contributions
Paul Krugman-How trade is altered
when markets are not perfectly
competitive

Michael Porter-Examined
competitiveness of industries on a
global basis
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 Strategic Trade
Krugman’s Economics of Scale:

Internal
InternalEconomies
Economiesof
ofScale
Scale

External
ExternalEconomies
Economiesof
ofScale
Scale

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 Strategic Trade
Government can play a beneficial
role when markets are not purely
competitive
Theory expands to government’s
role in international trade
Four circumstances exist that
involve imperfect competition in
which strategic trade may apply

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 Strategic Trade
The Four Circumstances Involving
Imperfect Competition:

Price Cost
Cost
Price

Externalities
Externalities
Repetition
Repetition

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 Strategic Trade
Porter’s Diamond of National
Advantage
Innovation is what drives and sustains
competitiveness
Four components of competition
Factor Conditions
Demand Conditions
Related and Supporting Industries
Firm Strategy, Structure, and Rivalry
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Michael Porter’s Competitive Clusters

Critical masses of
unusual competitive
success in particular
fields, located in one
place

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 The Theory of International
Investment
The movement of capital has
allowed foreign direct
investments across the globe

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 The Theory of International
Investment
Firms as Seekers
Seeking Resources
Seeking Factor Advantages
Seeking Knowledge
Seeking Security
Seeking Markets

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 The Theory of International
Investment
Firms as Exploiters of Imperfections
Imperfections in Access
Imperfections in Factor Mobility
Imperfections in Management
Firms as Internalizers
Establish their own multinational operations-
internalize production
Competitive advantage due to confidentiality
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