CHAPTER 2

The Theory of International Trade

 Chapter objectives

 What is international trade?

 Summarize the classical, country-based international trade theories.
 What are the modern, firm-based international trade theories?
 International trade theories with examples.
 Describe how a business may use the trade theories to develop its business
strategies. Use Porter’s four determinants in your explanation.
 Terminology

 International trade is the exchange of goods and services between countries. Trading globally gives consumers and
countries the opportunity to be exposed to goods and services not available in their own countries, or which would be
more expensive domestically.
 In business, Home country refers to the country where the headquarters is located whereas host country refers to the
foreign countries where the company invests.
 International companies are importers and exporters, they have no investment outside of their home country.
 Multinational companies have investment in other countries, but do not have coordinated product offerings in each
country.
 Transnational companies are much more complex organizations. A transnational corporation is an enterprise that is
involved with the international production of goods or services, foreign investments, or income and asset management in
more than one country.
 Global companies have invested and are present in many countries. They market their products through the use of the
same coordinated image/brand in all markets. Generally one corporate office that is responsible for global strategy.
Emphasis on volume, cost management and efficiency.
 Examples

 Examples of international firms  List of Top Multinational

include: Apple, a company that Companies (MNC) in
produces consumer electronics such Bangladesh: 
as computers, tablets, mobile  Unilever Bangladesh (FMCG)
phones, etc. Apple sells its products
 British American
around the world, but the
Tobacco Bangladesh (TOBAC
headquarters and all product
CO).
development are located within the
U.S.  Chevron (Petroleum)
 Standard Chartered Bank (Bank)
 What Are the Advantages of International Trade?

 Increased revenues.
 Decreased competition.
 Longer product lifespan.
 Easier cash-flow management.
 Better risk management.
 Benefiting from currency exchange.
 Access to export financing.
 Disposal of surplus goods.
 The Theory of International Trade

 International trade theories are simply different theories to explain international trade.
 Trade is the concept of exchanging goods and services between two people or entities.
  International trade is then the concept of this exchange between people or entities in
two different countries
 There are two main categories of international trade—
1. classical, country-based
2. modern, firm-based.
The Theory of International Trade
 What Is Mercantilism?

 Mercantilism (mid-16th century) suggests that it is in a country’s best interest

to maintain a trade surplus -to export more than it imports
 advocates government intervention to achieve a surplus in the balance of
trade
 Mercantilism views trade as a zero-sum game
 one in which a gain by one country results in a loss by another
 What Is Ricardo’s Theory Of Comparative
Advantage?
 David Ricardo asked what happens when one country has an absolute
advantage in the production of all goods
 The theory of comparative advantage (1817) - countries should specialize
in the production of those goods they produce most efficiently and buy
goods that they produce less efficiently from other countries
 even if this means buying goods from other countries that they could
produce more efficiently at home
 Trade is a positive sum game
 Heckscher-Ohlin Theory (Factor Proportions Theory)
 In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a
country could gain comparative advantage by producing products by utilized factors that were in abundance
in the country.
 Their theory is based on a country’s production factors—land, labor, and capital, which provide the funds
for investment in plants and equipment.
 They determined that the cost of any factor or resource was a function of supply and demand.
 Factors that were in great supply relative to demand would be cheaper; factors in great demand relative to
supply would be more expensive.
 Their theory, also called the factor proportions theory, stated that countries would produce and export
goods that required resources or factors that were in great supply and, therefore, cheaper production
factors.
 In contrast, countries would import goods that required resources that were in short supply, but higher
demand.
 Leontief Paradox
 In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US economy closely and noted that
the United States was abundant in capital and, therefore, should export more capital-intensive goods.
 However, his research using actual data showed the opposite: the United States was importing more capital-intensive
goods.
 According to the factor proportions theory, the United States should have been importing labor-intensive goods, but
instead it was actually exporting them.
 His analysis became known as the Leontief Paradox because it was the reverse of what was expected by the factor
proportions theory.
 In subsequent years, economists have noted historically at that point in time, labor in the United States was both
available in steady supply and more productive than in many other countries; hence it made sense to export labor-
intensive goods.
 Over the decades, many economists have used theories and data to explain and minimize the impact of the paradox.
However, what remains clear is that international trade is complex and is impacted by numerous and often-changing
factors.
 Trade cannot be explained neatly by one single theory, and more importantly, our understanding of international trade
theories continues to evolve.
 Product Life Cycle Theory
 Raymond Vernon, a Harvard Business School professor, developed the product life cycle theory in the 1960s.
 The theory, originating in the field of marketing, stated that a product life cycle has three distinct stages:
 (1) new product,
 (2) maturing product, and
 (3) standardized product.
 The theory assumed that production of the new product will occur completely in the home country of its innovation.
 It has also been used to describe how the personal computer (PC) went through its product cycle. The PC was a new
product in the 1970s and developed into a mature product during the 1980s and 1990s. Today, the PC is in the
standardized product stage, and the majority of manufacturing and production process is done in low-cost countries in
Asia and Mexico
 The product life cycle theory has been less able to explain current trade patterns where innovation and manufacturing
occur around the world.
 For example, global companies even conduct research and development in developing markets where highly skilled labor
and facilities are usually cheaper.
 Even though research and development is typically associated with the first or new product stage and therefore
completed in the home country, these developing or emerging-market countries, such as India and China, offer both
highly skilled labor and new research facilities at a substantial cost advantage for global firms.
 Global Strategic Rivalry Theory
 Global strategic rivalry theory emerged in the 1980s and was based on the work of economists Paul
Krugman and Kelvin Lancaster.
 Their theory focused on MNCs and their efforts to gain a competitive advantage against other global
firms in their industry.
 Firms will encounter global competition in their industries and, they must develop competitive
advantages. The critical ways that firms can obtain a sustainable competitive advantage are called
the barriers to entry for that industry.
 The barriers to entry refer to the obstacles a new firm may face when trying to enter into an industry
or new market. The barriers to entry that corporations may seek to optimize include:
 research and development,
 the ownership of intellectual property rights,
 economies of scale,
 unique business processes or methods as well as extensive experience in the industry, and
 the control of resources or favorable access to raw materials.
 Porter’s National Competitive Advantage Theory
 In the continuing evolution of international trade theories, Michael Porter of Harvard Business School
developed a new model to explain national competitive advantage in 1990.
  Porter’s theory stated that a nation’s competitiveness in an industry depends on the capacity of the
industry to innovate and upgrade. His theory focused on explaining why some nations are more
competitive in certain industries.
 To explain his theory, Porter identified four determinants that he linked together. The four
determinants are:
(1) local market resources and capabilities,
(2) local market demand conditions,
(3) local suppliers and complementary industries, and
(4) local firm characteristics
Porter’s National Competitive Advantage Theory
Porter’s National Competitive Advantage Theory
1. Local market resources and capabilities (factor conditions). Porter recognized the value of the
factor proportions theory, which considers a nation’s resources (e.g., natural resources and
available labor) as key factors in determining what products a country will import or export.
Porter added to these basic factors a new list of advanced factors, which he defined as skilled
labor, investments in education, technology, and infrastructure. He perceived these advanced
factors as providing a country with a sustainable competitive advantage.
2. Local market demand conditions. Porter believed that a sophisticated home market is critical
to ensuring ongoing innovation, thereby creating a sustainable competitive advantage.
Companies whose domestic markets are sophisticated, trendsetting, and demanding forces
continuous innovation and the development of new products and technologies. Many sources
credit the demanding US consumer with forcing US software companies to continuously
innovate, thus creating a sustainable competitive advantage in software products and services.
 Porter’s National Competitive Advantage Theory
3. Local suppliers and complementary industries: To remain competitive, large global firms benefit
from having strong, efficient supporting and related industries to provide the inputs required by the
industry. Certain industries cluster geographically, which provides efficiencies and productivity.
4. Local firm characteristics: Local firm characteristics include firm strategy, industry structure, and
industry rivalry. Local strategy affects a firm’s competitiveness. A healthy level of rivalry between
local firms will spur innovation and competitiveness.

In addition to the four determinants of the diamond, Porter also noted that government and chance
play a part in the national competitiveness of industries. Governments can, by their actions and
policies, increase the competitiveness of firms and occasionally entire industries.