Unit 2 International Trade Theories & Their Application: Structure
Unit 2 International Trade Theories & Their Application: Structure
Unit 2 International Trade Theories & Their Application: Structure
Unit 2
Unit 2
Structure:
2.1 Introduction
2.2 Why do nations trade
2.3 Theories of international trade
Mercantilism
Absolute advantage theory
Comparative advantage theory
Heckscher-Ohlin trade theory
Product lifecycle theory
Porters diamond model
2.4 Summary
2.5 Glossary
2.6 Terminal questions
2.7 Answers
2.8 Case-let
2.1 Introduction
From ancient civilizations, world history is essentially a story of wars and
trade. Major wars were primarily fought mainly for economic reasons rather
than conflict of political, cultural or social ideas. For example, Britons set up
their colonies world over for trade, U.S. invaded Iraq and Libya mainly for
economic reasons. Africa was colonised for trade and commerce and so
was the story of Latin America. Historians, world over, generally agree that
most wars are fought for trade-related reasons. Theories of international
trade and their application help us understand the motives and reasons
behind such wars explaining trade pattern and the benefits that flow from
trade. An understanding of international trade theory helps us as investors
or consumers/buyers or sellers/companies and governments to determine
how to act for their own benefit within the global trading system.
In the previous unit, you understood the concept of international business
along with various reasons and techniques for entering a foreign market. In
this unit, you will study about international trade theories. This helps us
explain the trade patterns, trade motives, trade trends and observed trade. It
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Figure 2.1
The answer to the above questions would be that countries world over are
endowed with different natural, human, and capital resources. Each country
varies from the other in combining these resources (land, labour and
capital). In a globalised set-up, every country cannot be as efficient as the
best in producing the goods and services that their residents demand. As a
result, they have to trade off their decisions to produce any good or service
based on opportunity cost. Opportunity cost model helps us understand the
choice of producing one good or another. The production decision of the
country depends on whether it is more efficient to produce the goods and
services with lower opportunity cost with increased and specialised
production, or to trade those goods, with goods of higher opportunity cost.
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If a country can produce more of any goods or services with the same
resources used by any other country, it is said to have an absolute cost
advantage in the production of those goods or services. For example, India
has absolute cost advantage in cutting and polishing of diamond. Around
68% of the diamonds from all over the world are cut and polished in India.
India is the largest producer of diamond jewellery in the world. On the other
hand, India would import items which can be imported at a lower cost than it
would take to manufacture these items locally, for example Swiss watches
where Switzerland has absolute advantage. Thus countries trade their
production decision based on absolute cost advantages.
Trade in globalised set-up has been used as an instrument for enhancing a
countrys economic growth and is usually beneficial to both the exporting
and importing countries.
Nations even if they have an absolute cost advantage in the production of
goods that are to be traded vis a vis its counterpart, would like to specialise
in higher opportunity cost products. The production size and scale may be
limited by other constraints. For example India and Thailand have signed a
Free Trade Agreement. Thailand is cost efficient in both auto component
and pharmaceuticals. India would like to import auto component and would
export pharmaceuticals to Thailand. This will be beneficial to India as it will
benefit from economies of scale with higher production of pharmaceuticals.
Opportunity cost and efficiency in production varies from country to country
as countries have different endowments of productive resources like land,
labour and capital. For example, US, a capital rich country will specialise in
production of aeroplanes and India, rich in labour pool will specialise in
rendering of information technology services. Trade is also affected as
different countries are endowed with different natural resources and climate
zones, longer growing seasons for a produce, abundance of natural
resources such as oil, mica, coal, iron ore, and highly educated and skilled
workers, and larger quantities of sophisticated machinery. For example
Saudi Arabia will export oil, India will export mica, iron ore and information
technology, Brazil will export coffee and Thailand will export rice.
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Activity 1
Why is India-EU FTA considered as a win-win situation for both India and
EU. Discuss if the trade of India and EU are complementary?
Hint: Refer the website http://commerce.nic.in/trade/international_ta.asp
and read the draft of India-EU FTA
Self Assessment Questions 1
1. Trade theories help forecasts and diagnose country trade pattern &
trends. (True or False)
2. Opportunity cost and efficiency in production does not vary from
country to country. (True or False)
3. Trade occur as result of:
a. Choice differential.
b. Habit differential.
c. Taste differential.
d. Resource differential.
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favourable laws. Telmex spends millions for lobbying so that MPs do not
allow opening the sector for foreign competition. This will eliminate
possible
competitors
and
generally
oppose
progress
of
telecommunication sector in Mexico. The results are poor telephone
services, high prices, and angry consumers. Telmex thus believes in
zero sum game of increasing its profits at the cost of customer services.
Source: Adapted from Mercantilism Is Alive and Well in Mexico, By Nancy
Conroy at http://mexidata.info/id494.html, downloaded on 20 March 2012
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Portugal
England
Cost comparison
Labour cost of production (in hours)
1 unit of wine
1 unit of cloth
70
80
110
90
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Portugal
England
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H-O theory explains that a country will specialise in the production of goods
and services that it is particularly endowed with and are suited for
production in that country. Countries that have abundant capital but are
scarce in labour force, therefore specialise in production of goods and
services that, in particular, require more capital. H-O theory propounds that
specialisation in production and trade among countries generates higher
economies of scale and scope and ensures higher standard of living for the
countries involved. Same can be understood with the example given below:
Specialised Export Basket
Factor
Endowment
India
Labour
Gems &
Jewellery
Wheat
Egypt
Labour
U.S.
Land and
Capital
UK
Capital
Russia
Land
Aeroplanes
Cotto
n
Source: Author
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the product and came up with his theory which identified three distinct
stages:
New product stage The need for a new product in the domestic market is
identified and it is developed, manufactured and marketed in limited
numbers. It is not exported in sizeable quantities, since it is primarily for the
national market.
Maturing product stage Once the product has become popular in the
domestic market, foreign demand increases and manufacturing facilities
abroad may be set up to meet demand there. After success in the foreign
markets and towards the end of the product maturity stage, the
manufacturers try and produce it in the developing countries.
Standardised product stage In the last stage of the life-cycle theory, the
product becomes a commodity, the price becomes optimised and the
makers look for countries where it can be made with the least production
costs. One of the results of this is the product being imported into the firms
home country. Dell manufactures hardware in Asia, which is then
transported to the US, its country of origin. Hence a product which started
as export commodity of a country may end up becoming an import product.
2.3.6 Porters diamond model
In 1990, Michael Porter analysed the reason behind some nations success
and others failure in international competition. His thesis outlined four broad
attributes that shape the environment in which local firms compete and
these attributes promote the creation of competitive advantage. They are
explained as follows:
Factor endowments Characteristics of production were analysed in
detail. There are basic factors like natural resources, climate, and
location and so on and advanced factors like communications
infrastructure, research facilities.
Demand conditions The role of home demand in improving
competitive advantage is emphasised since firms are most sensitive
about the needs of their closest customers. For example, the Japanese
camera industry which caters to a sophisticated and knowledgeable
local market.
Relating and supporting industries The presence of suppliers or
related industries is advantageous since the benefits of investment in
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He said that these four attributes constituted the diamond and he argued
that firms are most likely to succeed in industries where the diamond is most
favourable. He also stated that the diamond is a mutually reinforcing system
and the effect of one attribute depends on the state of others. For example,
favourable demand conditions will not result in a competitive advantage
unless the state of rivalry is enough to elicit a response from the firms.
Figure 2.2 gives you an illustration of Porters diamond model.
FIRM
ENTRY
STRATEGY
& RIVALRY
DEMAND
CONDITIONS
FACTOR
CONDITIONS
RELATED &
SUPPORTED
INDUSTRIES
GOVERNMENT
CHANCES
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Activity 2
Make a list of 5 businesses that manufacture goods outside the country
of origin and import those goods for the domestic market. Include the
name of the firm, country of origin, product and its country of
manufacture.
Refer this link for guidance:
http://www.businesslink.gov.uk/bdotg/action/layer?topicId=1077717231
2.4 Summary
Let us now summarise the salient features discussed in this unit about
international business environment:
International Trade Theories help us understand why countries trade.
Trade, in globalised set-up, has been used as an instrument for
enhancing countrys economic growth and is usually beneficial to both
exporting as well as importing countries.
Opportunity cost and efficiency in production varies from country to
country as countries have different endowments of productive
resources.
The mercantilists have a belief that it is not important to increase the
volume of foreign trade but they solely insisted on policies to maximise
exports and minimise imports.
Smith argued that countries should specialise in the production and
manufacturing of goods and services in which they have an absolute
advantage.
Ricardo argued that a country should specialise in the production of
those goods that it can produce most efficiently and import the goods
from another country which produces it less efficiently even if it has
absolute cost advantage in the production of those goods.
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2.5 Glossary
Opportunity cost: OC model helps us understand the choice of producing
one good or another.
Zero Game: Mercantilism advocated that export should be maximised and
import be minimised thus enhancing prosperity in country at the cost of
other country.
Positive Sum Game: PSG enunciates that trading countries benefits from
trade due to specialisation, opportunity cost and better efficiency. All trade
theories advocates positive sum game except Mercantilism.
Comparative Cost Advantage: A country has a comparative advantage in
producing goods if the opportunity cost is lower at home than in the other
country.
Standardised Product Stage: The stage in life-cycle theory that enunciates
that the price of commodity becomes optimised and the makers look for
countries where it can be made with the least production costs.
Embargoes: A prohibition by a government on certain or all trade with a
foreign nation.
Sanitary-phyto-sanitary barriers: A set of basic rules for food safety and
animal and plant health standards. This may act as a barrier for international
trade.
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2.7 Answers
Self Assessment Questions 1
1. True
2. False
3. Resource differential
Self Assessment Questions 2
4. Mercantilist and Comparative Cost Theory
5. Too much focus on exports only
6. Factor endowment
7. Labour is only factor of production
Terminal Questions
1. An understanding of international trade theory helps us as investors or
consumers/buyers or sellers/companies and governments to determine
how to act for their own benefit within the global trading system. Refer
to section 2.1.
2. Countries world over are endowed with different natural, human, and
capital resources. Each country varies from each other in combining
these resources. Refer to section 2.2.
3. Mercantilism theory suffered from many flaws and inconsistencies.
Refer to section 2.3.1.
4. Countries should specialise in the production and manufacturing of
goods and services in which they have an absolute advantage. Refer to
section 2.3.2.
5. Country should specialise in the production of goods that it can
produce most efficiently and import the goods from other country where
it is produced less efficiently even if it has absolute cost advantage in
the production of those goods. Refer to section 2.3.3.
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6. Theory is based on the hypotheses that countries trade with each other
as they differ with respect to the availability of the factors of production
i.e. land, labour and capital. Refer to section 2.3.4.
7. It focused on the lifecycle of the product. This theory identified three
distinct stages. Refer to section 2.3.5.
8. His thesis outlined four broad attributes that shape the environment in
which local firms compete and these attributes promote the creation of
competitive advantage. Refer to section 2.3.6.
2.8 Case-let
India is a global leader in diamond cutting and polishing. It is estimated
that 6775% of total diamonds cut and polished worldwide are done in
India. Gems and jewellery sector is one among the largest employer and
number one contributor in terms of exports of India. In the year 2011-12,
gems and jewellery exports has gone up by about 5% at Rs 2,000 billion
(US$ 36.10 billion) against Rs 1,950 billion (US$ 35.20 billion) in 201011. Gems and jewellery sector accounts for Indias 14% of the total
merchandise exports. Import figure of gems and jewellery by India is Rs
721.60 billion (US$ 13.10 billion). India has become the global hub for
diamond cutting and polishing. This can be seen by an analysis of trade
theories. India has cheap cost of labour, and being endowed with a lot of
manpower resources, skilled craftsmanship is easily available in India.
Increasing participation of women in gems and jewellery sector,
favourable government policies, adoption of Kimberly process etc. are
some of the key factors behind Indias success in gems and jewellery
sector. These factors are explained below:
Low cost of labour: Being endowed with labour factor advantage,
the cost of cutting and polishing in India is a fraction of what other
countries have. India has dedicated low cost diamond cutting clusters
like Surat, Ahmadabad, Jaipur, Kolkata, Bombay etc. Efficiency level
of these workers is much higher than that of similar countries in
global markets. Diamond jewellery that is produced at a cost of US$
60 to US$ 90 in India can fetch just double the price like 120$ to
180$ in international markets. This enables India to earn huge profits
and generate interest of retailers and workers.
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References:
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E-References:
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