International Trade Theories

Contents
1. Mercantilism Theory:.................................................................................................................1
2. Theory of Absolute Advantage:..................................................................................................1
3. Theory of Comparative Advantage:............................................................................................2
Example...............................................................................................................................................2
Criticism...............................................................................................................................................2
4. Theory of Factor Endowments...................................................................................................2
- Criticism.....................................................................................................................................3
5. Product Life Cycle Theory – Vernon..........................................................................................4
Example...............................................................................................................................................4
Limitation.............................................................................................................................................4
6. Porter’s Diamond........................................................................................................................5
7. New Trade Theory – Krugman...................................................................................................6

Mercantilism Theory:
- Theory brought from 16-18th century of Mercantilism. A nation should maximise wealth by
maintaining trade surplus with other countries.
- Mercantilism = exports> imports
o Government should restrict imports and maximise exports.
- Criticism: Can cause relationship problems between countries (if there are too many tariffs),
trade can benefit both countries so context matters.
Theory of Absolute Advantage:
A country has an absolute advantage in the production of a product when its more efficient than any
other country in producing it.

Ghana has absolute advantage in cocoa but

Korea has in rice, so ideally Ghana should product more cocoa and korea should product more rice.
Theory of Comparative Advantage:
the country needs to be able to produce at lower opportunity cost relative to another country even if tis
is more efficient in producing all goods.
- OC = forgone opportunity to produce some other goods.
- Countries should specialise in the production of goods they produce most efficiently and buy
goods that they produce less efficiently from other countries
- Theory: Assumes constant returns to specialization or, the units required to produce cocoa or
rice are to remain constant in producing additional unit od cocoa or rice.
For example:

Ghana 13.5 – rice 10 – cocoa

Korea 20 - rice 40 – cocoa
In this case Ghana should produce cocoa and Korea rice even if Ghana is more efficient in producing
both. This is called specializing.
no . of units lost
Per unit opportunity cost:
no . of units gained
Terms of trade: the range of how much you should be trading with the other country so that you are
both better off.
Diminishing returns to scale
- Not all resources are the same quality
o Some land is more productive, so if we keep using the same land it is likely to lose its
fertility and yield lesser every year causing the producer to seek/use more land.
- Diminishing returns as each product uses resources in different proportions. Cocoa requires
more land, less labour compared to rice.
Example:
Some architectural work also is being outsourced to lower-cost locations. Flour Corp., a Texas-
based construction company, employs engineers and drafters for a Saudi Arabian chemical plant. It
employed 200 young engineers based in the Philippines earning less than $3,000 a year who
collaborated in real time over the internet with elite U.S. and British engineers who make up to
$100,000 a year. Why did Flour do this? According to the company, the answer was simple. Doing so
reduces the prices of a project by 15 percent, giving the company a cost-based competitive advantage
in the global market for construction design.
Criticism to absolute advantage and comparative advantage theory:
- Not everyone benefits from offshoring – job losses in domestic market.
- Ignores implications of wider stakeholders – very arbitrary and based on assumptions
o Based on perfect competition
- Diminishing returns to scale ->gains of trade is not as significant.
Theory of Factor Endowments
- Comparative advantage arises from differences in national resource endowments.
o Export goods that make intensive use of locally abundant resources
 The more abundant the resource is the lesser the cost.
o Import goods that make intensive use of scarce resources.
- Criticism :
o Lack of consideration of transportation cost
o Assumes capital and labor are immobile internationally
o Assumes perfect competition

Product Life Cycle Theory – Vernon

- Vernon theorized that there are three stages in the life of the product and at each state the
proportion of export to import of the product varies in different countries
-

New product stage Standardized product

Maturing product
(starts from advanced stage (focus shifts to
stage
countries) developing countries)

- New product stage:

o Higher exports from the place of origin to other developed countries
o Normally an advanced country where there is a higher level of innovation and people
are likely to test and buy new products since they have higher disposable incomes.
o It is easier to make important changes in the product in its infancy stage.
o Market is likely to be small
- Maturing product stage
o Product is established
o There is growing demand for it
o There is a need to set up production plants in other parts of the world to satisfy this
demand. And also reduce the production cost. (lesser product cost also)
o Begins to reach less developed economies – demand from these places starts to grow
- Standardized product stage
o Product is everywhere and home country does not have a competitive edge.
o Driving down production cost ny moving production to places that have lower
income
o Demand in the original nation reduces
o Market is saturated
o Since employees from lower income countries are exposed to this new technology
and how to make it, competitors are starting to rise in these nations also.
Example:
1. 1960 - Xerox started to export from US to Japan and other developed countries
2. 1970s - They started a joint venture with Japan (Fuji Xerox)
3. 1980s – Xerox patent expires and local japnese company starts their own photocopier
machine – Canon.
4. 1990s – Japanese found that the manufacturing cost is too high in their own country and they
moved manufacturing to other developing countries like Vietnam.
Limitation:
 1. Most new products are not always introduced in the US or developed countries
2. New products are now introduced simultaneously in developed and developing countries.
Porter’s Diamond

Diamond explains that countries with a favourable diamond are highly competitive internationally and
are attractive locations for MNCs activities.
Factor conditions:
- Basic: Natural resources, climate, location
- Advanced: Communication infrastructure, skilled labour, research facilities, technological
know-how
Demand conditions:
- Firms cain competitive advantage if their domestic consumers are sophisticated and
demanding.
Related and supporting industries:
- If there are investments in advanced FOP by related and supporting industries than the whole
industry can achieve a strong competitive advantage globally.
- Successful industries tend to be grouped into clusters of related industries.
Firm strategy, structure and rivalry:
- Domestic rivalry can lead to the creation of competitive advantage.
Government
- Factor endowments: subsidies, policies toward capital markets, education
- Can shape domestic demad through local standards, regulation, taxes
- Can influence rivalry through capital market regulation, tax policies, antitrust laws.
New Trade Theory – Krugman
- Basically, the only reason to trade is EOS, countries may be similar in abilities but
differentiated by the scale of production of a certain goods.
- Returns to scale: rate of increase in production is related to the increase in FOP
- Assumes imperfect competition, not a single firm that takes control of the market.
- Economies of scale – cost advantages due to size
- Increased size of market causes economies of scale and low cost of production
- Increased product variety benefits customers.
- It also says that in a country if the industry that has a lot of eos contributes to a significant
portion of the world’s demand, then onmly a few can actually be supported. So here first
mover advantage is crucial.