Theories

of
International
Trade
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Learning Objectives
 To understand the traditional arguments
of how and why international trade
improves the welfare of all countries
 To review the history and compare the
implications of trade theory from the
original work of Adam Smith to the
contemporary theories of Michael Porter
 To examine the criticisms of classical trade
theory and examine alternative viewpoints
of which business and economic forces
determine trade patterns between countries

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Evolution of Trade Theories

 Mercantilism
 Absolute advantage (Classical)
 Comparative advantage
 Factor Proportions Trade
 International Product Cycle
 New Trade Theory
 National competitive advantage
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Mercantilism: mid-16th century

 A nation’s wealth depends on accumulated

treasure
 Gold and silver are the currency of
trade
 Theory says you should have a trade surplus.
 Maximize export through subsidies.
 Minimize imports through tariffs
and quotas
 Flaw: restrictions, impaired growth
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Defining mercantilism …

 … trade theory holding that nations

should accumulate financial wealth,
usually in the form of gold (forget
things like living standards or
human development) by encouraging
exports and discouraging imports

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Theory of absolute advantage

 Adam Smith: Wealth of Nations (1776) argued:

 Capability of one country to produce more of
a product with the same amount of input than
another country
 A country should produce only goods where it
is most efficient, and trade for those goods
where it is not efficient
 Trade between countries is, therefore, beneficial
 Assumes there is an absolute balance among
nations
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Theory of absolute advantage

 … destroys the mercantilist idea since there
are gains to be had by both countries party to
an exchange
 … questions the objective of national
governments to acquire wealth through
restrictive trade policies
 … measures a nation’s wealth by the living
standards of its people

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Theory of absolute advantage

PPF – Production Possibility Frontier

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Theory of comparative advantage

 David Ricardo: Principles of Political Economy (1817)

 Extends free trade argument
 Efficiency of resource utilization leads to more
productivity
 Should import even if country is more efficient in the
product’s production than country from which it is
buying.
 Look to see how much more efficient. If only
comparatively efficient, than import.
 Makes better use of resources
 Trade is a positive-sum game
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Theory of comparative advantage

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Comparative advantage and the gains

from trade

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Comparative advantage: Bollywood

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Assumptions and limitations

 Driven only by maximization of production
and consumption
 Only 2 countries engaged in production and
consumption of just 2 goods?
 What about the transportation costs?
 Only resource – labour (that too, non-
transferable)
 No consideration for ‘learning theory’
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Factor proportions theory

 Heckscher (1919) - Olin (1933) Theory

 Export goods that intensively use factor endowments
which are locally abundant
 Corollary: import goods made from locally
scarce factors
 Note: Factor endowments can be impacted by
government policy - minimum wage
 Patterns of trade are determined by differences in
factor endowments - not productivity
 Remember, focus on relative advantage, not absolute
advantage

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Factor proportions theory

 … trade theory holding that countries produce
and export those goods that require resources
(factors) that are abundant (and thus cheapest)
and import those goods that require resources
that are in short supply
 Example:
 Australia – lot of land and a small population
(relative to its size)
 So what should it export and import?
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Factor Proportions Trade Theory

Considers Two Factors of Production

 Labor

 Capital

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Factor Proportions Trade Theory

A country that is relatively labor

abundant (capital abundant)
should specialize in the production
and export of that product which is
relatively labor intensive (capital
intensive)
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The Leontief Paradox

The Test:
Could Factor Proportions Theory be used
to explain the types of goods the United
States imported and exported?

The Method:
Input-output analysis

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The Leontief Paradox

The Findings:
The U.S. exported labor-intensive
products and imported capital-intensive
products.

The Controversy:
Findings were the opposite of what was
generally believed to be true!
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Product life-cycle Theory

R.Vernon (1966)
 … trade theory holding that a company will
begin by exporting its product and later
undertake foreign direct investment as the
product moves through its lifecycle
 As products mature, both location of sales and
optimal production changes
 Affects the direction and flow of imports and
exports
 Globalization and integration of the economy
makes this theory less valid
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Product life cycle theory

Fig 4.5

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The Product Cycle and Trade

Implications
 Increased emphasis on technology’s
impact on product cost
 Explained international investment
 Limitations
 Most appropriate for technology-based
products
 Some products not easily characterized by
stages of maturity
 Most relevant to products produced
through mass production
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New trade theory

In industries with high fixed costs:

 Specialization increases output, and the
ability to enhance economies of scale
increases
 Learning effects are high. These are cost
savings that come from ‘learning by
doing’
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New trade theory - applications

 Typically, requires industries with high, fixed
costs
 World demand will support few competitors
 Competitors may emerge because of “ First-
mover advantage”
 Economies of scale may preclude new entrants
 Role of the government becomes significant
 Some argue that it generates government
intervention and strategic trade policy
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Theory of national competitive advantage

 The theory attempts to analyze the reasons for a
nations success in a particular industry
 Porter studied 100 industries in 10 nations
 postulated determinants of competitive advantage
of a nation based on four major attributes
 Factor endowments
 Demand conditions

 Related and supporting industries

 Firm strategy, structure and rivalry

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Porter’s diamond

 Success occurs where

these attributes exist.
 More/greater the
attribute, the higher
chance of success
 The diamond is
mutually reinforcing

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Factor endowments

 Factor endowments:- A nation’s position in

factors of production such as skilled labor or
infrastructure necessary to compete in a given
industry
 Basic factor endowments
 Advanced factor endowments

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Basic factor endowments

 Basic factors: Factors present in a country

 Natural resources
 Climate
 Geographic location
 Demographics
 While basic factors can provide an initial
advantage they must be supported by
advanced factors to maintain success
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Advanced factor endowments

 Advanced factors: Are the result of

investment by people, companies,
government and are more likely to lead to
competitive advantage
 If a country has no basic factors, it must
invest in advanced factors

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Advanced factor endowments

 communications
 skilled labor
 research
 Technology
 education

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Demand conditions

 Demand:
 creates capabilities
 creates sophisticated
and demanding
consumers

 Demand impacts quality

and innovation

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Related and supporting industries

 Creates clusters of supporting industries that

are internationally competitive

 Must also meet requirements of other parts

of the Diamond

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Firm Strategy, Structure and Rivalry

 Long term corporate vision is a determinant

of success
 Management ‘ideology’ and structure of the
firm can either help or hurt you
 Presence of domestic rivalry improves a
company’s competitiveness

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Determinants of Competitive Advantage

in nations
Fig 4.8
Chance
Company Strategy,
Structure,
and Rivalry

Two external
factors that Factor Demand
influence the Conditions Conditions
four
determinants.
Related
and Supporting
Industries
Government

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Porter’s Theory-predictions

 Porter’s theory should predict the pattern of

international trade that we observe in the real
world

 Countries should be exporting products from

those industries where all four components of
the diamond are favorable, while importing in
those areas where the components are not
favorable
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Implications for business

 Location implications:
 Disperse production activities to countries
where they can be performed most efficiently
 First-mover implications:
 Invest substantial financial resources in building
a first-mover, or early-mover advantage
 Policy implications:
 Promoting free trade is in the best interests of the
home-country, not always in the best interests of
the firm, even though, many firms promote open
markets
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India in the global competitiveness report

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