Doing Business with International Agreements It aims to protect a nation’s wealth from the outflow to other nations by

different restricting means which is also called protectionism. It also

Lesson 3 assumes a zero-sum game which means if two nations participate in
Theories of International Trade international trade one should face a loss equal to the benefit of the next
nation and vice versa.

Theories of International Trade:

Absolute Cost Advantage Theory
 Mercantilism Theory

 Absolute Cost Advantage Theory

Adam Smith, the father of economics propounded the absolute cost
advantage theory by addressing the weakness of mercantilism theory. He
 Comparative Cost Advantage Theory introduced the concept of free trade policy which was totally ignored by
 Heckscher-Ohlin’s Factor Endowment Theory (H-O Model) mercantilism.

 International Product Life Cycle (IPLC) Theory Absolute cost advantage refers to the advantage a nation gets from
producing products more efficiently with the same input than other
 National Competitive Advantage Theory: Porter’s Diamond
nations.
 New Trade Theory (NTT)
It suggests a nation should specialize its production in the product in which
it gets absolute cost advantage and ignore in which it gets absolute
disadvantage. The specialized products should be exported to another
Mercantilism Theory nation and products having the absolute disadvantage of the home country
Mercantilism can be considered the oldest theory of international trade. should be imported from another nation, as such the international trade
Mercantilism promoted international business or trades. It was occurred.
systematically developed in the 15th century by an Italian Economist,
Antonio Serra, and lasted nearly 300 years. Mercantilism talks about a
nation should increase its exports and reduce imports as far as possible. Smith also ignores the zero-sum game of mercantilism – rather he assumes
a positive-sum game which means if two countries participate in
During the mercantilism period, gold, silver, and other precious metal were international both can be benefited. And, here government plays the role
the only means of exchange of trade between nations. A nation which has of facilitator.
enough of these precious metals was considered strong.

It assumed increasing exports would earn more silver and gold and a
nation’s economy will be stronger and importing means an outflow of Comparative Cost Advantage Theory
precious metals means weakening the nation.
By criticizing Adam Smith’s absolute cost advantage theory David Ricardo
Thus, the main theme of the mercantilist theorists is to promote exports introduced the comparative cost advantage theory. He argued that
and reduce imports by means of different restrictions such as barriers, absolute advantage is not necessary rather a nation should focus on where
quotas, etc. and it is a state-controlled theory. it gets comparatively more advantage.
Ricardo suggests there can be no trade if two nations’ absolute cost International Product Life Cycle (IPLC) Theory
advantage is equal. It suggests a nation should specialize its production on
the product in which it gets comparatively more advantage or in case of The IPLC theory is created by Reymond Vernon in 1966. He explained how
disadvantage, should choose the product having less disadvantage. a new product of a nation gets domestic and international attention and
starts exporting and at the end of IPLCs the last stage how the domestic
Ricardo suggests while producing the costs should be checked carefully nation starts importing the same product.
and compared and then the product asking comparatively less cost should
be produced. Raymond explains when a country produces new products it begins to
export to foreign markets, as such, foreign nations find it cheaper to
Other principles of comparative advantage are the same as the absolute produce the same product in their home. And, where originally the new
advantage such as free trade, a positive-sum game, no government product is originated, their people find it cheaper and beneficial to use
intervention, etc. foreign same products over their domestic country.

And, originated country’s product sales decline, and the country is liable to
Heckscher-Ohlin’s Factor Endowment Theory (H-O Model) import products from foreign countries to satisfy its people’s needs.

Eli Heckscher and Bertil Ohlin propounded the theory of factor endowment Raymond mentioned four stages in which an international product walks,
and further explained Ricardo’s comparative cost advantage theory. Introduction Stage – The new or innovative product is introduced.
Here, factor endowment refers to the richness or easy availability of basic Mainly labor-intensive. Sales or export grows at the turtle’s speed.
production factors like land, labor, and capital to a nation. H-O model Growth Stage – Exports increase. The competition takes place.
suggests that a nation should specialize its production in products which it Capital intensive means are assumed.
has an abundance of production factors.
Maturity Stage – Exports reach the top and remain constant.
This theory assumes factors relative to abundance are cheaper and factors Intense competition. Availability of substitute products. Exports start to
relative to scarcity are expensive to a nation. decline.
According to this theory, if India, China, Nepal, etc. are rich in labor factors Decline Stage – Exports of new products from the home country
then they should produce labor-intensive products. And, USA, Japan, etc. rapidly decline. The nation has three options whether to exit the product,
are rich in the capital they should produce capital-intensive products. In import, or enter into a totally new market.
this way, capital-rich countries should import labor-intensive products, and
labor-rich countries import capital-intensive products as such international
trade takes place.
National Competitive Advantage Theory: Porter’s Diamond
While understanding the H-O model, it is necessary to understand the
Leontief Paradox – which means just the opposite of the principle of the H- Michael Porter 1990, introduced the national competitive advantage
O model i.e. capital-rich countries exporting labor-intensive products and theory which explains why a nation succeeds in international competition.
vice versa. He wanted to address what makes a firm achieve a competitive advantage
in a nation or a nation in a particular industry.
With research in 100 industries in 10 countries, he identified four factors Assumptions of New Trade Theory:
that help a firm to gain a national competitive advantage which he
introduced as Porter’s Diamond. And, after achieving it such factors also  Specialization increases output, and the ability of firms to enhance
strengthen the exporting capacity of the firm. economies of scale increases.
 Learning effects are high, in cost savings that come from “Learning
The Porter’s Diamond is shortly mentioned below: by doing”.
 Competitors may emerge because of “First-mover advantages”.
Demand Conditions – Stronger the demand of a domestic market the
 The role of government becomes significant (Subsidies to firms).
more high-quality products would be produced and exporting may be
 Economies of scale may make it possible to stop new entrants.
attained.

Factor Endowments – A nation having better production factors would do

NTT Makes Two Important Points
better in the international market.
Economies of Scale
Related and Supporting Industries – E.g. schools are the supporting
institutions for universities. Economies of scale are unit cost reductions associated with a large volume
of output. The major source of cost reduction in many industries may
Firm Structure, Strategy, and Rivalry – The better the firm’s strategy and
include computer software, automobiles, advanced machines, etc.
structure the better the firm will win against rivalries.

In a simple sense, economies of scale mean the minimum per-unit cost of

New Trade Theory (NTT)
production that results from large production due to which fixed costs
The New Trade Theory (NTT) is an international trade theory developed by remain constant.
Paul Krugman, a Nobel prize winner that explains the two main points
In the domestic market economies of scale may not be attained because
economies of scale and first-mover advantage.
the demand and area are limited as such unit costs are higher without it.
NTT emerged in the late 1970s, and a number of economists pointed out But, in the international market, the demand is very high and firms are
the ability of firms to attain economies of scale that focuses on the role of forced to produce goods in huge quantities.
increasing constant returns to scale and network effects.
As such, domestic firms may be able to better attain economies of scale.
New trade theory aimed to explain international trade differently than old Each country may be able to specialize in producing a narrower range of
trade theory (such as comparative advantage, factor endowment, etc.) products than it would be in the absence of trade.
which relies on productivity, factor endowments, and structure.
Each country can simultaneously increase the variety of goods lowering the
But, NTT explained without differences in factor endowments also costs of those goods. Opportunities for mutual gains may be attained even
international trade occurs because of economies of scale between similar when countries don’t differ in their resource endowments or technology.
countries. This argues countries should specialize in specific niches to
reduce per-unit cost and achieve economies of scale and such
specialization will let countries trade with each other.
First Mover Advantage

First-mover advantages are the economic and strategic advantages that a

firm gets from rising early into an industry. May dominate the global
market and trade.

The first mover industry can get benefit from a lower cost structure.
Economies of scale are significant and represent a substantial proportion
of world demand, firms export more quantity and become first movers,
which could increase the ability to capture the international market.

For example, Nokia (Home Country – Finland, products – Electrical and

electronic equipment) dominated the production and marketing of mobile
phone sets.

The first-mover implications depend on consideration of product life-cycle

and market imperfection, and ownership advantages.

NTT suggests a country may dominate in the export of goods because it

was lucky enough to produce them. The domestic firm enables to gain
economies of scale, it becomes the first mover in an industry, discourages
subsequent entry of the new firms, and creates barriers to entry to the
new firms.

Thus, a first-mover company has various advantages. It will get subsided by

the government, conducts economic rationalization, and may get a
monopoly within the industry.