Lecture Notes # 5.

Theories of International Trade

Abdulghany Mohamed, Ph.D

Sprott School of Business
Carleton University

Fall 2014

Table of Contents

Table of Figures..............................................................................................................................ii
1.0 Introduction..............................................................................................................................1
2.0 Theories of International Trade..............................................................................................2
2.1 Mercantilism.........................................................................................................................4
2.2 Theory of Absolute Advantage............................................................................................4
2.3 Theory of Comparative Advantage.....................................................................................5
2.4 Factor Endowment Models..................................................................................................6
2.4.1 Factor Proportions Theory (Heckscher-Ohlin Model)...................................................7
(a)
The Heckscher-Ohlin Theorem................................................................................8
(b)
Rybczynski Theorem................................................................................................9
(c)
Stolper-Samuelson Theorem..................................................................................10
(d)
Factor Price Equalization Theorem........................................................................11
(e)
General Shortcomings of the H-O Model:.............................................................12
2.4.2 Specific Factor Model..................................................................................................13
2.5 New Trade Theories............................................................................................................15
2.6 The Theory of Competitive Advantage (Michael Porter)...............................................17
2.6.1 A Brief Introduction to the Theory of Competitive Advantage....................................17
2.6.2 Implications of Porters Model for the National Environment (this section draws on
Mohamed and Kiggundu, 2006)...................................................................................20
2.6.3 Stages of Competitive Development............................................................................22
2.6.4 Criticisms and Refinements of Porters Model............................................................24
(a)
Dunning (2002) and the Role of Multinational Business Activities.......................24
(b)
Mohamed and Kiggundu (2006)............................................................................25
3.0 Conclusions.............................................................................................................................28
Bibliography..................................................................................................................................29

Table of Figures
Figure 1: Theories of International Trade....................................................................................3
Figure 2: Factor Endowment Models...........................................................................................6
Figure 3: Successful Factors of National Competitiveness (Porter, 1990)...............................17
Figure 4: Microeconomic Business Environment (Porter 2004)..............................................18
Figure 5: Determinants of Productivity and Productivity Growth..........................................22
Figure 6: Stages of Competitive Development...........................................................................24
Figure 7: Successful Factors of National Competitiveness (Porters 1990 model as modified
by Dunning, 2002).................................................................................................................26
Figure 8: International Competitiveness: A Proposed Analytical Framework.......................28

Theories of International Trade and Production

1.0 Introduction
In this set of notes we explore (albeit briefly) some of the main theories pertaining to
international trade. The reader may already be familiar with some of the theories that I have
chosen to highlight in this set of notes but not with the others. It is crucial for students of the
environment of international business (and of international business in general) to have a better
grasp of these theories/perspectives for a number of reasons. To begin with, it is important to
understand why nations trade in the first place. Secondly, these theories may help us understand
the patterns of international trade. Thirdly, they may assist us in deciphering (with varying
degrees of success) the manifestations, dynamics and impacts/implications of the environment of
international business. Lastly, to the extent that each of the extant theories explains only some
portion of international business activity, we hope that this brief survey will help identify what
aspects are explained by what theory/theories and what aspects of international trade are undertheorized, inadequately theorized or not theorized at all.
Furthermore, it is hoped that this brief presentation will nudge the student beyond the
traditional theories of absolute advantage and comparative advantage by introducing some
modern theories of international trade and thus will equip the student to follow the material and
debates on the environment of international business as well as point the student in the right
direction in the exploration of advanced understanding of the theories presented in these and
other notes.

2.0 Theories of International Trade

There are several theories of international trade. For the purposes of these notes we will
particularly briefly explore the following:
(a) Mercantilism,
(b) Theory of Absolute Advantage (a la Adam Smith),
(c) Theory of Comparative Advantage (a la David Ricardo),
(d) Factor Endowment Models, including the:
(i) Factor Proportions (Heckscher-Ohlin) Model, and,
(ii) Specific Factor Model,
(e) New Trade Theories, and,
(f) The Theory of Competitive Advantage (a la Michael Porter).

These perspectives are depicted in Figure 1 below.

Figure 1: Theories of International Trade

Mercantilism
(1500s-1700s)

Theory of Absolute Advantage

(Adam Smith, 1776)

Theory of Comparative Advantage

(David Ricardo, 1817)

Factor Endowment Models

Factor Proportions Theory

Specific Factor Theory

(1937)

Stolper-Samuelson Theorem
(1941)

Factor Price Equalization Theorem

(1948)

New Trade Theories

1970s/1980s
Heckscher-Ohlin Model (1930s)

Rybczynski Theorem (1955)

Theory of Competitive Advantage

(Michael Porter, 1990)
The Leontief Paradox
(Wassily Leontief, 1950)
Linders Hypothesis
1961

2.1 Mercantilism
A central notion of the theories of the Mercantilist thinkers (16th and first half of 18th
century) was that the accumulation of financial wealth (through the encouragement of exports
and curbing of imports) was paramount. In other words, a favourable balance of trade (i.e., an
excess of exports over imports) should be the objective of national economic policy. The
underlying reason for this position was the idea that a nation with trade surplus would receive
gold from the nations in deficit. This was viewed in a positive light because gold was then
viewed as the essence of national wealth, hence of power and prestige. The main purpose of this
theorizing was to support a policy of national self-sufficiency (autarky) pursued by some
European rulers at the time (Britain, France, The Netherlands, Portugal and Spain).
This perspective has a number of flaws; suffice to note just two of them here. First,
mercantilist belief that the worlds wealth was limited and that a nation could increase its share of
the pie only at the expense of other countries (i.e., international trade was a zero-sum game) was
wrong. Secondly, if all countries curbed imports (and promoted exports) international trade
would be severely restricted because in order for one country to export, it requires another
country to import! Restricting imports would thus be counter-productive. A notable critic of the
mercantilist perspective was Adam Smith (1723-1790 AD) who advanced a different theory we
discuss next.

2.2 Theory of Absolute Advantage

Adam Smith (1723-1790) was very critical of the mercantilist position. In contrast to the
mercantilist perspective that favoured autarky, Smith advocated economic/market openness
whereby countries would specialize in the goods they could produce more efficiently. Smiths

position put forth in 1776 is known as the theory of absolute advantage. Smiths theory
destroyed the mercantilist idea that international trade is a zero sum game by showing that there
are gains to be made by countries that are party in an exchange. In short, international trade
according to Adam Smith was a positive-sum game.
In spite of its powerful message, the theory also has it limitations. The main shortcoming
being that it does not provide room for trade for those countries that cannot produce any
good/service more cheaply than other countries. In other words, Smiths perspective does not
provide for the gains in trade for a country that can produce all goods cheaply than any other
country because in this perspective when a country happens to have an absolute advantage in all
goods then it will produce for itself all those goods leaving no room for exchange and its
associated benefits. This perspective is rectified in Ricardos theory of Comparative Advantage
we discuss next.

2.3 Theory of Comparative Advantage

David Ricardo (1772-1823), unlike Adam Smith, offered in 1817 a theory that provided
room for international trade even when one country can produce all goods/services
efficiently/cheaply than the rest. His theory of comparative advantage remains the
cornerstone of the modern theory of international trade. According to Ricardo, comparative
advantage is based on relative labour costs, which are measured by the person-hours of labour
required to produce each unit of output. In other words, production possibilities are determined
by the allocation of a single resource, labour, between sectors.
The strength of Ricardos theory lies in its ability to show that gains from trade can be
made even when one country has absolute advantage on all goods. It is also worth noting,

however, that Ricardos formulation has also come under criticism because it focuses on only a
comparison of relative labour costs. In other words, comparative advantage (a la Ricardo) is only
understood in relation to advantages based on only one factor, i.e., labour. Moreover, while this
theory conveys the essential idea of comparative advantage, it does not allow us to talk about the
distribution of income in the economy and how international trade affects an economy. These
shortcomings are addressed (in varying degrees of success) in the following set of
theories/perspectives.

2.4 Factor Endowment Models

Factor Endowment Models are comprised of two basic types: a long-term perspective
(as represented by the Factor Proportions Theory also known as the Heckscher-Ohlin Model)
and a short-/medium-term perspective (represented by what is known as the Specific Factor
Model) as depicted in Figure 2 below. We discuss these in turn.
Figure 2: Factor Endowment Models
Factor Endowment Models

Factor Proportions Theory

Specific Factor Theory

Stolper-Samuelson Theorem
Rybczynski TheoremFactor
(1955)Price Equalization Theorem
Heckscher-Ohlin Model (1930s)
(1941)
(1948)

The Leontief Paradox

(Wassily Leontief, 1950)

Linders Hypothesis
(1961)

2.4.1 Factor Proportions Theory (Heckscher-Ohlin Model)

Developed by Swedish economists Eli Heckscher and Bertil Ohlin, the factor
proportions theory also referred to as Heckscher-Ohlin theory (or H-O model) emphasizes the
interplay between the proportions in which factors of production in a country are used in
producing different goods (Ohlin, 1933). This model postulates that international trade is largely
driven by differences in countries resource/factor endowments, i.e., trade will occur between
economies which are most dissimilar (Pellegrin, 2001:130). In other words, it is the relative
endowments of the factors of production (labour, land and capital) that determine a countrys
comparative advantage. According to the H-O model, therefore, a country enjoys a comparative
advantage in (and will therefore export) the good whose production is relatively intensive in the
factor with which that country is relatively well endowed (Pellegrin, 2001: 130). In this model
comparative advantage is influenced by the interaction between nations resources (the relative
abundance of factors of production) and the technology of production (which influence the
relative intensity with which different factors of production are used in the production of different
goods). In a nutshell, the model essentially suggests that countries will export products that
utilize their abundant factor(s) of production and import products that utilize the countries scarce
factor(s). For instance, if a country has abundant labour resources and scarce capital it will
produce and export labour-intensive products and import capital-intensive products.
The H-O Model refined the Ricardian theory such that comparative advantage could be
derived from relatively low costs of any factor of production such as capital or land, not just from
relatively low labour costs as assumed in the standard Ricardian model. The model also assumes
that multiple factors of production can move between sectors but not across countries. Indeed, the
factor proportions theory differs considerably from the theories of absolute and comparative

advantages. In contrast to the two theories (that focus on the productivity of the production
process for a particular good), the factor proportions theory says that a country specializes in
producing and exporting goods using the factors of production that are most abundant and thus
cheapest not the goods in which it is most productive (Wild, Wild, & Han, 2010:156;
emphasis in original).
The H-O model has spawned a number of theorems notable among them include: (a) The
Heckscher-Ohlin Theorem, (b) Rybczynski Theorem, (c) Stolper-Samuelson Theorem, (d)
Factor Price Equalization Theorem. Lets take a brief tour of each of these theorems.

(a) The Heckscher-Ohlin Theorem

As noted above the H-O Theorem postulates that the pattern of trade is determined by
factor endowments in the sense that nations tend to export the goods that are relatively intensive
in the use of the factors with which they are relatively well endowed. As such, a capital abundant
country will tend to export capital-intensive products and import labour intensive products from
labour abundant countries. Conversely, a country that has abundant labour (labour-abundant) will
export labour-intensive goods and import capital-intensive products.
From the perspective of the environment of international business, we can safely say that
this theorem is referring to how international trade patterns are influenced by the particular
resourcefulness (i.e., munificence in labour or capital) of the given environments (in this case
countries involved in the exchange). This resourcefulness can be depicted or manifested in, for
instance, labour or capital abundance. Thus, from spatial and temporal perspectives, a certain
country at some particular period in time can have a relatively large supply of labour (abundant
factor) while having a smaller supply of capital (scarce factor). To be sure, this situation is not

static. For instance, emigration out of the country could lead to a shortage of labour, while
immigration into a particular jurisdiction could lead to a higher labour supply/pool. Similarly, an
inflow of foreign reserves (e.g., from surplus international trade revenues) could turn a capitalstarved country into a capital-rich one, and vice versa.

(b) Rybczynski Theorem

The Rybczynski Theorem (1955) named after Polish-born English Economist Tadeusz
Rybczynski (1923-1998) deals with how changes in the structure of a countrys endowment
affects the structure of production and outputs when full employment is maintained. Changes in
endowment could be a result of population changes (internal population growth or decline;
immigration/emigration) and capital flows (e.g., foreign direct investment).
In general, the Rybczynski theorem postulates that an increase in a countrys endowment
of a factor will cause an increase in output of the good which uses that factor intensively, and a
decrease in the output of the other good. For instance, assuming fixed capital, an increase in
population will shift the relative factor abundance in favour of labour (vis--vis capital); and
likewise, assuming constant labour, an import of capital will shift the relative factor abundance in
favour of capital (in relation to labour) and vice versa.
From the perspective of the environment of international business, we can say that this
theorem is referring to how international trade patterns are influenced by the dynamism
(changing nature) of the particular environments (in this case countries involved in the
exchange), in the sense that as the particular environments resourcefulness (munificence)
changes so will the type of products made/exported and/or imported. This perspective is
particularly useful in this era of globalization when resource endowments can and do change due

to increasing regional and global integration. With increasing mobility of people

(immigration/emigration) and increasing capital flows (such as foreign direct investment,
portfolio investment, etc.) resource endowments of any given jurisdiction can no longer be held
constant. For example, in a two product, two factor situation, an increase in the endowment of a
particular factor/resource (e.g. an increase in labour due to international mobility) will lead to a
more than proportional increase in production in those sectors that use the factor intensively
(labour-intensive industries) and a decline in production in those sectors that use the other factor
intensively (production decline in capital-intensive industries) -- assuming full employment is
maintained/sustained.

(c) Stolper-Samuelson Theorem

Derived in 1941 from within the framework of Heckscher-Ohlin model by Paul
Samuelson and Wolfgang Stolper, the Stolper-Samuelson theorem describes a relation between
the relative prices of output goods and relative factor rewards, specifically, real wages and real
returns to capital. According to the theorem, (assuming constant return to scale, perfect
competition, and two-factor of production situation labour and capital), a rise in the relative
price of a good will lead to a rise in the return to the factor that is used most intensively in the
production of that particular good (e.g., labour) and a fall in the return to the other factor (e.g.,
capital). For instance, if the world price of capital-intensive goods increases, it will increase
relative to the rental rate (price of capital). Likewise, if the price of labour-intensive goods
increases, it will increase relative to the wage rate. Conversely, the Stolper-Samuelson Theorem
postulates that a drop in the relative price of the labour intensive good will result in a fall in
wages, and in a rise in the rental rate (direction effect). Moreover, the wage rate fall is more than

proportional to the relative price fall, so landowners gain in consumption terms (i.e., in terms of
price of both goods) and labour loses in terms of the price of both goods (magnification effect).
In short, the Stolper-Samuelson theorem shows how changes in the prices of outputs (e.g., by
changes in tariffs) have an effect on the prices of the inputs/factors used in the production of such
outputs.
The Stolper-Samuelson Theorem is an important one for students of international business
environment because it helps to connect the prices of goods to factor rewards. It identifies the
pain of trade with particular factors. In short, it helps to highlight the potential gains
(opportunities) and costs of trade (risks) of international trade and by extension the potential
reaction of the actors involved. In other words, by helping to identify those who might win and
those who might lose in the process of international trade, this theorem helps to link the outcomes
of international trade with the likely reactions of the various actors involved as one can plausibly
expect that those who stand to gain will likely support certain policies/moves (i.e., more trade in
the goods/services they supply/produce), while those who lose may oppose such policies/moves.

(d) Factor Price Equalization Theorem

Advanced by Paul Samuelson in 1948, the factor-price equalization theorem postulates
that in international trade when the prices of the output goods are equalized between countries (as
it tends to occur when trade barriers are removed e.g., in a free trade situation), the prices of the
factors of production (capital and labour) involved in the production of the subject output goods
will also be equalized between countries involved (Samuelson, 1948). In other words, free and
competitive trade will tend to make factor prices to converge as the prices of traded goods
converge/equalize. The intuition here is that: if all countries have the same technology and the

same goods prices, and trade is freely conducted (i.e., without barriers) among them then these
countries must have the same factor prices. In short, if trade leads to convergence/equalization of
product prices, factor prices should be equalized as well. But, if technology among the trading
partners differs then it is unlikely that factors prices will converge/equalize even if the prices of
the output goods/commodities tend to equalize. The scope of this set of notes and the lecture does
not allow me to go into further details pertaining to all the other conditions/assumptions that need
to obtain for this theorem to work.
As with the preceding theorems, this theorem has relevance to understanding the
dynamics of and inter-linkages among various environments of international business (countries
in this case) and their implications as reflected in the movement of product and factors prices.
With increasing integration among economies around the world, and thus, changing environment
of international business it is crucial that business managers have some intellectual tool for
understanding/comprehending how such changes (e.g., due introduction of freer trade among
countries and hence of convergence in product prices) might affect the level of factor prices in the
countries they be involved in.

(e) General Shortcomings of the H-O Model:

The limitations of the H-O Model are manifested in a number of areas. To begin with, in
the H-O model, c
omparative advantage is a static notion (Pellegrin, 2001:130). Secondly, the
H-O model cannot account for international vertical chains (Pellegrin, 2001:130). Thirdly,
empirical evidence does not support H-O model (Leontieffs Paradox). An econometric test of the
H-O model by Wassily W. Leontief in 1954 found that the US, despite having a relative

abundance of capital during that time, tended to export labour-intensive goods and import capitalintensive goods contrary to what the model would have predicted (Leontief, 1954). The H-O
model in this respect would have predicted that the US would be exporting capital-intensive
goods (not labour intensive goods) and importing labour-intensive goods because during that
period the US was relatively abundantly endowed with capital vis--vis other countries. What
might account for such a paradox?
Various explanations of the paradox have emerged. One such explanation is Linders
Hypothesis which suggests that the US did not fit well into the H-O model because countries
tended to trade in goods based on similar demand rather than on the basis of differences in supply
side factors (Linder, 1961). As such, international trade patterns were not based on or driven by
factor endowments but rather by the nature of demand in the various markets.

2.4.2 Specific Factor Model

The second category of the factor endowment models is the Specific Factor model
originally discussed by Jacob Viner (Viner, 1937). The model is a variant of the Ricardian Model
and hence it is sometimes referred to as the Ricardo-Viner model. The model was later
developed by other economists including: (a) Paul Samuelson (1971) who formalized it
mathematically by assuming an economy that produces two goods and that can allocate its labour
supply between two sectors; and (b) Ronald Jones (1971) who called it a 2 goods, 3 factors
model.
Unlike the Ricardian model (and akin to the H-O model discussed above), the specific
factor model allows for the existence of factors of production besides labour and goes further to

distinguish the factors of production by the degree of mobility in response to changes in

economic or market conditions (recall: environmental dynamism in our framework for the EIB).
Indeed, economic or market conditions can change in a number of ways. For instance, through
the establishment of a free trade agreement, implementation of a tariff or quota, change of labour
endowment (e.g., through immigration or emigration), changes in capital endowment (e.g.,
through FDI or capital flight), and technological changes. On this basis, factors are broadly
distinguished into two types: between (a) mobile (i.e., those factors that can move freely and
costlessly between economic sectors), and (b) immobile or industry-specific factors, (i.e., those
factors that in the short-run are not substitutable in production). For instance, in this model,
labour is assumed to be a mobile factor that can move between sectors, while other factors
(capital and land) are assumed to be specific in the sense that in the short-run they can be used
only in the production of particular goods.
It is important to note that the distinction between mobile and specific factors is a
question of speed of adjustment whereby factors that are mobile can be re-deployed from one
sector to another much quickly than the specific ones which may take longer to re-deploy
between industries. On this view, any factor can assume the mobile or specific character or
feature at some point in time. Even labour which is considered mobile may be specific under
certain circumstances. For example, a highly skilled professional (brain surgeon) may not be as
mobile (i.e., cannot be easily or quickly re-deployed into another job/career) as a worker who
has fairly general skills. Moreover, factor specificity may not be a permanent condition as it may
be just a matter of time before ways are found to re-deploy a seemingly specific (immobile)
factor.

The Specific Factor Model is interesting to students of the environment of international

business for the following reasons. First, it focuses on the environmental conditions and the
effects of changes in those conditions (i.e., environmental dynamism). Secondly, and perhaps the
key strength of this theory lies in its insight on the impacts of international trade on income
distribution. This model helps to highlight the point that although everyone could potentially gain
from international trade it does not necessarily mean that everyone actually does. It shows that in
the real world international trade tends to result in the presence of both winners and losers. And,
that this is attributable to the nature of the factors of production. Generally, this model
demonstrates that trade benefits the factor that is specific to the export sector of each country,
but hurts the factor specific to the import-competing sectors with ambiguous effects on mobile
factors (Krugman & Obstfeld, 2003:55). Also worth noting, however, is the fact that, while this
model is ideal for understanding income distribution, it is awkward for discussing the patterns of
international trade.

2.5 New Trade Theories

The new trade theories (1970s & 1980s) are associated with Paul Krugman (1981)
--who was recently awarded the 2008 Nobel Prize for Economics -- and other economists
including: K. Lancaster (1980), Elhanan Helpman, James Brander, and Jim Markusen. The new
trade theories relax the assumptions of old trade theories (Ricardo, Ricardo-Viner and the
Heckscher-Ohlin Model) which assume perfect competition and constant returns to scale and
instead these theories base international trade on increasing returns to scale (especially economies
of scale) and imperfect competition (e.g., monopolistic competition; product differentiation).

While there is intrinsically not much novelty in these theories (as a number of classical
and neoclassical economists had qualitatively discussed/alluded to the issue of increasing returns
to scale) Krugman, et al. provided mathematical rigour to the theories that the earlier economists
had not. That is what gives these perspectives the label new trade theories.
The new trade theories help to explain why international production tends to be
geographically concentrated. The theories argue that some industries tend to perform better as
their volume of production increases (Cavusgil, Knight & Reisenberger, 2008:108). This is
because the effect of increasing returns to scale allows the nation to specialize in a small number
of industries in which it may not necessarily hold factor or comparative advantage (Cavusgil,
Knight & Reisenberger, 2008:108).
These theories also lend support to infant industry protection argument in the sense that
they demonstrate that industries shielded from competition (free trade) and allowed to enjoy
economies of scale until they are ready to compete can withstand the challenges of international
competition. In a nutshell, the new trade theories postulate that:
(a)

there are gains to be made from specialization and increasing economies of

scale (Wild, Wild & Han, 2010:160);

(b)

the companies first to enter a market can create barriers to entry (Wild., Wild
& Han, 2010:160), in other words, they can enjoy what are termed first-mover
advantage; and,

(c)

government may play a role in assisting its home-based companies (Wild,

Wild & Han, 2010:160)

Like the preceding theories, the specific factor model is also relevant in the study of the
international business environment as it provides useful tools for understanding the role and
ramifications of the involvement of the state/government in the economy as well as it helps to
understand the economic environment when the industries embedded in it feature increasing
returns to scale such as the current new knowledge-based/information economy).
2.6 The Theory of Competitive Advantage (Michael Porter)
2.6.1 A Brief Introduction to the Theory of Competitive Advantage
A recent addition to the list of theories of international trade is Michael Porters (1990)
theory of national competitive advantage. Porter attributes four key variables for the success in
international trade: (a) factor conditions, (b) demand conditions, (c) related and supporting
industries, and, (d) firm strategy, structure, and rivalry. To these four, Porter has also added
two other factors, namely, the roles of government and chance. These factors are presented in
the form of a baseball diamond and are depicted in the Figure 3 below:

Figure 3: Successful Factors of National Competitiveness (Porter, 1990)

Firm strategy, structure and rivalry

Chance

Demand conditions
Factor conditions

Related and supporting industries

Government

Source: Porter (1990:127)

Although in the above figure Porter has included the roles of government and chance
he sometimes tends to omit them or at best not explicitly factor them as demonstrated in a recent
application of his model in the Global Competitiveness Report (Figure 4 below). Nevertheless,
Porter (2004) spills considerable ink in illustrating the critical role governments play in economic
development particularly as it relates to how governments shape and condition the environment
in which businesses operate.

Figure 4: Microeconomic Business Environment (Porter 2004)

Context for Firm Strategy and Rivalry
* A local context and rules that encourage investment and
sustained upgrading (e.g., Intellectual property protection)
* Meritocratic incentive systems across institutions
* Open and vigorous competition among locally based rivals
Factor (Input) Conditions Demand Conditions
Presence of high quality, specialized inputsSophisticated and
available to firmsdemanding local customer(s)
* Human resources* Local customer needs that anticipate
* Capital resourcesthose elsewhere
* Physical infrastructure* Unusual local demand in specialized
* Administrative infrastructure segments that can be served nationally
* Information infrastructure and globally
* Scientific and technological infrastructure
* Natural resources
Related and Supporting Industries
* Access to capable, locally based
suppliers and firms in related fields
* Presence of clusters instead
of isolated industries

Source: Porter (2004:32; emphasis in the original.)

With that note, lets briefly describe the factors below:

(a) Factor conditions:

Porter differentiates between basic and advanced factors whereby basic factors
comprise of the traditional factors of production (e.g., labour, natural resources, climate, etc.),
while advanced factors consist of a nations workforce skill levels and the quality of
(technological) infrastructure.

(b) Demand conditions:

According to Porter, the existence of sophisticated domestic buyers tends to
stimulate/pressure firms to continuously improve their product/service offerings which in turn
helps to give these firms an edge internationally as well.

(c) Related and Supporting Industries

The emergence of and competition among local suppliers to cater to the production,
marketing and distribution needs of firms in a particular industry, according to Porter, tends to
lead to lower input costs, higher quality products/services, and innovations in the input market
hence reinforcing/enhancing the industrys international competitiveness.

(d) Firm strategy, structure, and rivalry

The ability to compete internationally is also predicated on the characteristics of the
domestic environment. To survive, firms facing vigorous competition domestically must
continuously strive to reduce costs, boost product quality, raise productivity, and develop
innovative products. Firms that have been tested in this way often develop the skills needed to
succeed internationally (Griffin & Pustay, 2007:162).
(e) Roles of Government and Chance
Industry competitiveness can also be positively/negatively affected by government
policies. Moreover, unforeseen events such as disease outbreaks, earthquakes, etc. could easily
wipe out any advantage an industry might have had.

2.6.2 Implications of Porters Model for the National Environment (this section draws on
Mohamed and Kiggundu, 2006)
According to Porter (2004), national wealth is created in the microeconomic level of the
economy, rooted in the sophistication of company strategies and operating practices, as well as in
the quality of the microeconomic business environment in which a nations firms operate. Thus,
to improve productivity Porter contends: the traditional focus on macroeconomic stabilization
and market opening is insufficient (Porter, 2004:35). He argues that while Stable political,
legal, and social institutions and sound macroeconomic policies create the potential for improving
national prosperity wealth is actually created at the microeconomic level in the ability of
firms to create valuable goods and services using efficient methods. Only in this way can a nation
support high wages and the attractive returns to capital necessary to support sustained
investment (Porter, 2004:31). For Porter (2004), the microeconomic foundations of

productivity rest on two interrelated areas: (1) the sophistication with which domestic companies
or foreign subsidiaries operating in the country compete, and (2) the quality of the
microeconomic business environment in which they operate (Porter, 2004:31). Based on the
conceptual framework, (depicted in Figure 5 below), Porter (2004) has built the Business
Competitiveness Index (BCI) reported in the annual Global Competitiveness Reports of the
Geneva-based World Economic Forum.
Figure 5: Determinants of Productivity and Productivity Growth
Macroeconomic, Political, Legal, and Social Context for Development (Porter 2004)
SophisticationQuality of the
of CompanyMicroeconomic
Operations and Business
StrategyEnvironment

Microeconomic Foundations of Development

Source: Porter (2004:31)

Based on the above framework, Porter argues that the productivity of a country is
ultimately set by the productivity of its companies. An economy cannot be competitive unless
companies operating there are competitive, whether they are domestic firms or subsidiaries of
foreign companies. However, the sophistication and productivity of companies are inextricably
intertwined with the quality of the national business environment (Porter, 2004:31). In this
respect, he contends that More productive company strategies require more highly skilled
people, better information, more efficient government processes, improved infrastructure, better
suppliers, more advanced research institutions, and more intense competitive pressure, among
other things (Porter, 2004:31). It is in such a context that Porter advanced/postulated his theory

of competitive advantage in which he posits that the business environment can be understood in
terms of four interrelated areas: the quality of factor (input) conditions, the context for firm
strategy and rivalry, the quality of local demand conditions, and the presence of the related and
supporting industries (Porter, 2004:32). (See figures 3 & 4 above.)
One can draw three key insights from Porters work. First, Porter delineates the key
domestic variables involved in promoting national competitiveness. Second, this helps to explain
that the key variables and the way they interact vary among countries. Third, the model helps to
build the case that the main thrust in improving a countrys competitiveness must come from the
better use of domestic capabilities and resources. That is, countries and their corporations should
utilize their existing capabilities and resources more efficiently and if lacking in core
competences, a country should upgrade the quality and quantity of its resources and capabilities.
In a nutshell, Porter sees the home base as playing a critical role in building up the
competitive advantage of national industries. In the language of this course, the domestic/national
environment is critical. Porter also points out that no nation can have a competitive advantage in
every good or service. Consequently, competitive advantage must be interpreted at the industry
level. On this view, Porter advocates the promotion of industrial clusters.

2.6.3 Stages of Competitive Development

Another important contribution by Porter (for our purposes) pertains to his postulation
about the types or stages of competitiveness a country can undergo. To the extent that Porter sees
successful economic development as a process of successive upgrading, in which a nations
environment evolves to support and encourage increasingly sophisticated and productive ways of
competing by firms based there (Porter, 2004:34), he posits that As nations develop, they

progress in terms of their competitive advantages and modes of competing. (Porter 2004:34). As
such, Porter, frames economic development as a sequential process of building interdependent
microeconomic capabilities, shifting company strategies, improving incentives and increasing
rivalry. (Porter, 2004: 35). On this view, Porter delineates four distinct stages of national
competitive development: factor-driven stage, investment-driven, innovations-driven stage, and
wealth driven. In short, Porter is saying, the national environment does change and that this
change process occurs in stages as depicted in the Figure 6 below.
Figure 6: Stages of Competitive Development

Factor-Driven Economy
Input Cost

Efficiency

Investment-Driven EconomyInnovation-Driven EconomyWealth Driven Economy

Unique ValueDecline

Source: Porter (1990:546; 2004:34)

In the Factor-driven stage, basic conditions such as low cost labour and unprocessed
natural resources are the dominant sources of competitive advantage and exports. A Factordriven economy is highly sensitive to world economic cycles, commodity prices, and exchange
rate fluctuations (Porter, 2004:35). In the Investment-driven stage, efficiency in producing
standard products and services becomes the dominant source of competitive advantage An
investment-driven economy is concentrated in manufacturing and on outsourced service exports
(Porter, 2004:35). Such an economy, according to Porter, is susceptible to financial crises and
external sector-specific shocks (Porter, 2004:35) In the Innovation-driven stage, the ability to
produce innovative products and services at the global technology frontier, using the most
advanced methods, becomes the dominant source of competitive advantage. The national

business environment is characterized by strengths in all areas, together with the presence of deep
clusters (Porter, 2004:35). In the wealth-driven economy, the driving force is the wealth that
has already been achieved (Porter, 1990:556). This stage is one of drift and ultimately decline
(Porter, 1990:546). Due to a number of reasons (e.g., ebbing of rivalry, misguided investments,
diminishing innovation, etc.) firms begin to lose competitive advantage in international industries
(Porter, 1990:556).
It is also worth noting that, Nations do not inevitably progress (Porter, 1990:563-4). In
fact, Porter posits that Many nations never move beyond factor-driven or investment driven
stage (Porter, 1990:564) Indeed, nations may falter or fall backward too (Porter, 1990:561).
Moreover, Porter argues, it is not inevitable that nations pass through the stages (Porter,
1990:545; emphasis in original). The process of moving through the stages can take many paths,
and there is no single progression (Porter, 1990:563). As a reflection of each nations unique
circumstances each nation goes through its own unique process of development (Porter,
1990:562).

2.6.4 Criticisms and Refinements of Porters Model

To be sure, Porters model has come under intense scrutiny and criticisms. The scope of
this set of notes does not permit an extensive/exhaustive discussion of these challenges. Suffice to
not that among the most critical ones (directly and indirectly) have included the contributions of
Dunning (2002), Hamalainen (2003), Krugman (1994) and Mohamed & Kiggundu (2006). We
briefly discuss below the contributions of Dunning and Mohamed & Kiggundu.

(a) Dunning (2002) and the Role of Multinational Business Activities

In the recent models, as was the case with the original 1990 model, for Porter the
determinants of competitiveness are still predicated on the domestic realm. As a corrective to
Porters 1990 model, Dunning (2002) introduces the concept of multinational business
activities (MBAs). Dunning (2002) discusses the influence of MBAs on various aspects of
Porters diamond, and by implication, on national competitiveness (see Figure 7 below). As the
figure below shows, Dunnings contribution highlights the influence of MBAs on among other
variables the government. A focus on government, however, is insufficient for it does not address
how MBAs affect other modes of governance. Moreover, Dunnings focus on MNE activities
does not encompass a variety of other international economic activities such as the increasing
flows of remittances by immigrant workers to their home countries flows that are becoming an
important source of foreign exchange and development funds for the recipient countries (Adams
& Page, 2003; Ratha 2003).

Figure 7: Successful Factors of National Competitiveness (Porters 1990 model as modified

by Dunning, 2002)
Chance

Firm strategy, structure and rivalry

MBAs

Demand conditions
Factor Conditions

Related and supporting industries

Government

Source: Dunning (2002:292)

(b) Mohamed and Kiggundu (2006)

Abdulghany Mohamed and Moses Kiggundu (2006) challenge Porters (and Dunnings)
narrow focus on government. Instead they propose a wider and deeper perspective on how
national competitiveness is fostered or impeded (see Figure 8 below). First, they suggest that
rather than simply including the role of government, a broader view be taken to include the
various modes of governance (governance by state i.e., government, as well as governance by
non-state actors e.g., private sector self governance and governance by civil society). (see Scholte
& Schnabel, 2002; Webb, 2002). Mohamed and Kiggundu (2006) also challenge Porters narrow
focus on the domestic environment at the expense of the regional and global environments. They,
thus, suggest that international competitiveness be understood in a broader/wider context that
encompasses causal factors from both the domestic and international environments. This
perspective (i.e., one that transcends Porters state-centric-cum-domestic-oriented view) is crucial
for at least three main reasons. First, the international context does play a significant role in
shaping the competitiveness of a country and its firms. Secondly, governance needs to be
understood in a multi-realm and multi-actor framework. In other words, governance takes place
in various levels and layers (local, sub-national, national, regional and global) and involves a
variety of actors including state/governmental, private sector and civil society. Lastly, this view is
relatively more useful and relevant in todays world of international business. For instance, bornglobal firms (whose customers are primarily internationally based) do not have domestic/home-

based customers to shape them up into internationally competitive firms as is suggested in

demand conditions factor of Porters Model.
In sum, the challenges to Porters framework help in a better understanding of the
contemporary environment of international trade (and investment as well).

Figure 8: International Competitiveness: A Proposed Analytical Framework

Domestic Business and Economic Activities (DBEAs)

Domestic Governance System
Private Authority

State

Civil Society

Domestic Institutional Framework

Resources

Technologies

Organizational Efficiency

Product Markets

International Institutional Framework

Private Authority

State

Civil Society

International Business and Economic Activities (IBEAs)

International Governance System

Source: (Mohamed & Kiggundu (2006:30) Figure 7)

3.0 Conclusions
These lecture notes presented an overview of the various theories of international trade. It
is our hope that this brief introduction will enable students to comprehend better the bases and
determinants of international trade as currently understood under the various perspectives. Such
an understanding, we hope, will further enhance our comprehension of the various
manifestations, dynamics and impacts/implications of the environment of international business
and vice versa.
Lastly, as emphasized in the lecture notes on the theories of international investment and
production, these notes are not offered as a substitute for the course textbook or material you may
have covered in your previous economics classes!!! For a further introduction to the theories of
trade (i.e., those not covered in the current textbook) an ample set of resources are provided in the
references below.

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