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To discuss the implications of trade theories on international business To know the origin of international trade theories To explain various theories of international trade and the underlying assumptions. To examine gains from international trade under various trade theories.
 To analyze the international trade theories from the point of

view of labour cost;  To understand the IT theories based on various factors of production /factor endowments;  To distinguish country based theories from industry based theories and company based theories  To appreciate porter’s national competitive advantage;  To explain the theoretical framework for shifting patterns of 09/29/11production and trade or to draw comprehensive basis for


On Valentine’s Day in 1996, Mr. Patrick Buchanan, a Republic Presidential Candidate for the USA while purchasing a dozen roses to present his wife, understood that his country is importing roses from South America. He took the occasion to prepare a speech denouncing the increasing import of flowers from South America causing problems to the US farmer, in order to draw the attention of the voters.  Next day morning he indicated the same to his wife. His wife was a professor of International Business. She told him, “ this is the reason for international trade”. She further clarified that to supply American sweethearts with fresh roses in February (winter roses) is very hard. Growing roses in winter is at a great expense in terms of energy, capital and other scarce resources. The US economy is producing computers with these resources rather than roses. 09/29/11 The US economy has been exporting computers to


Cost provided a grater advantage to both the USA and South America as Us has comparative advantage in producing computers and South America in cases of roses. The conclusion is that IT becomes possible for the mutual benefit to the two countries due to difference in opportunity cost.



 It is imperative for international Business

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managers to find out answers to some basic issues: Why do nations trade with each other? Is trading a zero-sum game or mutually beneficial activity? Why do trade patterns among countries exhibit wide variations? Can government policies influence trade?

Theories of International trade provide answer to most of these queries? 09/29/11






EIC established first port in 1608 at Surat to carry trade with India to take advantage of rich resources. These colonies served as cheap source for primary commodities such as raw cotton, spices, grains, herbs, tea, coffee and fruits both for consumption and also as raw material for industries. So this policy of mercantilism greatly paved way for the colonial powers in accumulating wealth.


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Under this theory, accumulation of wealth takes place at the cost of another trading partner. So no contribution to the global wealth. Favorable balance of trade only in short run. Presently gold is only a minor proportion of national foreign exchange. Overlooks other factors in a country’s wealth. Following restrictive trade policies to control imports will not facilitate IT. Mercantilist policies were used as a weapon of exploitation by colonial powers.


Scottish Economist, Adam Smith criticized mercantilist theory,:

“ the wealth of the nation does not lie in building huge stockpiles of gold and silver in its treasury, but the rea wealth of a nation is measured by the level of improvement in the quality of living of its citizens a reflected by the per capita income.”



Adam smith laid emphasis on productivity and advocated free trade as a means of increasing global efficiency. The main idea of his theory is that a country’s standard of living can be enhanced by international trade with other countries either by importing goods not produced by it or by producing large quantities of goods through specialization and exporting the surplus.
 Instead of producing all products, each country should

specialize in producing those goods that it can produce more efficiently. Such efficiency is gained through:  Repetitive production of a product, which increases the skills of the labour force.  Switching production from one produce to another to save labour time.  Long product runs to provide incentives to develop 09/29/11more effective work methods over a period of time.


Trade between two countries takes place when one country produces one product at less cost than that of the another country and the other country has an absolute cost advantage over the first country in producing in any other product. Reasons for Absolute cost advantage:
 Due to skilled labour  Specialization advantage  Natural Advantage  Acquired advantage



 Trade is between two nations  Only two commodities are traded  Free trade exists between two countries.  The only element of cost of production is labour.

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Illustration International trade between India and Japan Two commodities Pen and Audio tape recorder





Explanation through production possibility curve



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By trading two countries can have more quantities of both the products. Living standards of the people of both the countries can be increased by trading between the countries. Inefficiency in producing certain products in some countries can be avoided Global effeciency and effectiveness can be increased by trading. Global labour productivity and other resources productivity can be maximised.


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No absolute advantage Country Size Variety of resources Transport cost Scale economies Absolute advantage for many products.



Absolute cost advantage fails to explain the situation when one country has absolute cost advantage in producing many products.
 David Ricardo expanded this theory of

absolute cost advantage to clarify this situation and developed the Theory of comparative cost advantage.  Comparative cost advantage theory states that a country should produce and export those products for which it is relatively more productive than that of other 09/29/11


 The assumptions of CCA theory include:
I. There exists full employment II. The only element of cost of production is labour III. There are no trade barriers. IV. Trade is free from cost of production. V. Trade takes place only between two countries. VI. Only two products are traded. VII. Zero cost of transport.



All countries for all all products may not have absolute cost advantage. We modify the figures of the example given in Absolute advantage theory in order to explain comparative cost advantage:
Products Output per day of labour Japan Pens Audio tape recorder 60 6 Output per day of labour India 50 2




The implications derived from this theory are:  Efficient allocation of global resources.  Maxmisation of global production at least possible cost  Product prices become more or less equal among world markets  Demand for resources and products among world nations will be optimised  It is better for the countries to specialise in those products which they relatively do best and export them  It is better for the countries to buy other


Modern economy is money or currency dominated economy. Almost all the transactions take place in the form of money. (Buying and selling of foreign exchange). Therefore absolute differences in currency prices determine the international trade.  According to F.W. Taussig, comparative differences in labour cost of commodities can be translated into absolute differences in prices without affecting the real exchange relation between products.  We take the same table as mentioned in comapratie cost advantage theory.  Suppose the daily wage rate in India and Japan as on 1st April 2008 was Rs. 100 and Yen 360 respectively.  Suppose the exchange rate between two currencies (INR and JPY) as on 1st April 2008 was 1 Indian Rupee = 09/29/112.00 Japanese Yen. 22

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Cost of producing pens in Japan = 360/60 = Yen 6 Cost of producing Audio Tape recorder in Japan = 360/06 = Yen 60 Cost of producing audio tape recorder in India = 100/02 = Rs.50 Cost of producing pens in India = 100/50 = Rs.2 Cost of Goods in Japan Cost of Goods in India
Japan Made India MadeJapan Made India Made

Yens Pens
Audio Tape Recorder

Yens 6 60 4 100

Rupees 3 30

Rupees 2 50


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Two countries Ignoring transportation cost Two products Full employment Economic efficiency Division of Gains Mobility of resources Services.



How do countries acquire comparative advantage? Eli Heckscher and Bertil Ohlin- Swedish economistsdeveloped the theory of relative factor endowments.  Factor endowments mean rich availability of factors of production like land, labour, capital, natural resources, and climate etc. The main observations of this theory are:  There are variations in the factor endowments among countries. For ex. USA rich in capital resources, India in labour, Saudi Arabia in OIL resources, South Africa, Papua have gold mines etc.  According to these economist, the low or high price of any factor of production depends on its rich abundance in the respective country.  These relative factor costs leads countries produce the products at low costs. 09/29/11 25

Countries acquire comparative advantage based on the factors endowed and in turn the price of the factors. Countries acquire comparative advantage in those products for which the factors endowed by the country concerned are used as inputs. Countries export them which they can produce at low cost consequent upon abundance of factors and import the other products which they produce at a high cost.




Principal Exports

% of principal Exports to total Exports 48.7 57.2 18.3 22.4 31.4 22.4 55.6 62.4 72.1 30.1

USA • UK • Japan • Canada • France • Germany • Malaysia • Singapore • India • China •

Capita Goods Finished manufactured goods Automobiles Automobiles and Parts Capital Equipment Motor Vehicles Electric and Electronic Machinery Machinery and Equipment Manufacturer & Engineering Manufacturers

Adapted from WTO. 09/29/11 27

International Trade takes place between two industries of two countries But IT takes place intra industry between two countries. This amounts for 40% of the world trade.  There are various factors similarity of which encourages Inter-industry trade among nations.

 Economic Similarity of countries  Similarity of location  Similarity of political and economic Interests
09/29/11 28

The second firm based theory is the Product Life Cycle Theory propounded by Raymond Vernon of Harvard Business School. How and where international trade takes place based on the stages of product life cycle. International Product life cycle consist of four stages:
 Innovation or new product introduction stage  Growth Stage  Stage of Maturity  Stage of Decline



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Production facilities do not move to foreign countries to achieve cost reductions due to shorter life cycle as a result of rapid innovation. Cost reduction is not applicable in case of luxury products. High Cost of transportation may have negative impact on exports. The rapid technological development may not shift the production to various foreign countries Requirement of specialized knowledge reduce the chances of locating production facilities in foreign countries.. MNCs set up production process in many countries due to cheap rate of factor of production.


A recent study has drawn inference that competitive superiority is derived form four factors:
 Demand Conditions  Factor endowment  Related and supporting industries  Firm Strategy- Structure and Rivalry

Porter’s theory blends the traditional country based theories and firm based theories.





The chapter ends Here Point to remember:

 Kindly read the chapter

from the Book.



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