Chapter Two

International Trade theories

 Points should be covered on this chapter
 Define trade and free trade
 What is benefit and barriers of trade
 Identify different types trade theory
1) Mercantilism trade theory
2) Absolute Advantage theory
3) Comparative Advantage theory
4) Heckscher & Ohlin Model
5) Product life cycle theory
6) Porter theory National Competitive Advantage
 What is free trade?
• Free trade is also called international trade
• Free trade occurs when a government does
not attempt to influence through quotas or
duties on what its citizens can buy from
another country or what they can produce and
sell to another country.
• Trade theory shows why it is beneficial for a
country to engage in international trade even
for products it is able to produce for itself
 The benefits of trade
• Increased revenues.
Trade creates jobs,
• Decreased competition. attracts investments,
• Longer product lifespan attracts new technology
• Easier cash-flow management. and materials, and
• Better risk management. offers consumers with a
• Benefiting from currency wider choice in products
exchange. and services with less
• Access to export financing. cost.
• Disposal of surplus goods.

4
 Barriers to Trade
 Trade barriers may includes
1. Tariffs
2. Quotas
3. Export subsidies
4. Product standards and others
 Tariff
• Tax on imported goods or services
• Reasons for tariffs
Raise tax revenues
Reduce consumption of the imported
good or service
• Effect: Price of import rises, “cheaper”
domestic goods become more attractive
 Quota

• Limits the amount of an imported good

allowed into the country
• Supply is decreased and price increases
• Voluntary Export Restrictions (VER’s) are
similar
 Export Subsidy
• Government financial assistance to a firm that
allows a firm to sell its product at a reduced
price
• Benefits and harms
Consumers (both at home and abroad)
benefit from lower prices
Foreign producers are harmed because of
lower world prices
Taxpayers in the producing country pay the
subsidy
 Product Standards
• A type of “hidden” trade barrier
• Types of standards
Product safety
Content
Packaging
 Theories of International trade
• As AcFn students we learn Trade theories for:

1. To differentiate what products should be

imported and exported
2. How much should be traded
3. With whom should we trade
 Cont’d

 It was not until the fifteenth century that

people tried to explain why trade occurs.
 Efforts continue to refine existing trade
theories and develop new ones.
 An Overview of Trade Theory
 Free Trade occurs when a government does not
attempt to influence, through quotas or duties,
what its citizens can buy from another country or
what they can produce and sell to another country.
 The Benefits of Trade allow a country to specialize
in the manufacture and export of products that
can be produced most efficiently in that country
and import products and services that can be
produced more efficiently in other countries
 The Pattern of International Trade displays patterns
that are easy to understand (Saudi Arabia/oil or
Mexico/labor intensive goods). Others are not so
easy to understand (Japan and cars).
 1. 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.
It advocates government intervention to achieve a
surplus in the balance of trade Maximize exports
through subsidies.
 Minimize imports through tariffs and quotas.
Flaw: “Zero-sum game”.
one in which a gain by one country
results in a loss by another
 2. Theory of Absolute Advantage
• Adam Smith: Wealth of Nations (1776).
• Capability of one country to produce more of a product
with the same amount of input than another country.
• Produce only goods where you are most efficient,
trade for those where you are not efficient.
Trade between countries is, therefore, beneficial.
• Assumes there is an absolute advantage
balance among nations.
 3. 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.
 Comparative Advantage
•David Ricardo asked what might happen when
one country has an absolute advantage in the
production of all goods
•Ricardo’s theory of comparative advantage
suggests that 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
 Qualifications And Assumptions
 The simple example of comparative advantage
assumes:
•only two countries and two goods
•zero transportation costs
•similar prices and values
•resources are mobile between goods within
countries, but not across countries
•constant returns to scale
•fixed stocks of resources
•no effects on income distribution within countries
 4. Heckscher (1919)-Ohlin (1933) Theory

• Export goods that intensively use factor

endowments which are locally abundant.
 Corollary: import goods made from locally scarce
factors.
• Patterns of trade are determined by differences
in factor endowments - not productivity.
• Remember, focus on relative advantage, not
absolute advantage.
 Heckscher-Ohlin Theory
•Ricardo’s theory suggests that comparative advantage
arises from differences in productivity
•Eli Heckscher and Bertil Ohlin argued that comparative
advantage arises from differences in national factor
endowments – the extent to which a country is
endowed with resources like land, labor, and capital
•The Heckscher-Ohlin theory predicts that countries
will export goods that make intensive use of those
factors that are locally abundant, while importing
goods that make intensive use of factors that are
locally scarce
 Does The Heckscher-Ohlin
Theory Hold?
• Wassily Leontief (1953) theorized that since the
U.S. was relatively abundant in capital compared to
other nations, the U.S. would be an exporter of
capital intensive goods and an importer of labor-
intensive goods.
However, he found that U.S. exports were less
capital intensive than U.S. imports
• Since this result was at variance with the
predictions of trade theory, it became known as
the Leontief Paradox
 5. The Leontief Paradox, 1953

• Disputes Heckscher-Ohlin in some

instances.
• Factor endowments can be impacted by
government policy - minimum wage.
• US tends to export labor-intensive
products, but is regarded as a capital
intensive country.
 6. Product Life-Cycle Theory
(Raymond Vernon, 1966)

• Article in the Quarterly Journal of Economics.

• 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.
 The Product Life Cycle Theory

•The product life-cycle theory, proposed by Raymond

Vernon, suggested that as products mature both the
location of sales and the optimal production location
will change affecting the flow and direction of trade
•Vernon argued that the size and wealth of the U.S.
market gave U.S. firms a strong incentive to develop
new products
•Vernon argued that initially, the product would be
produced and sold in the U.S., later, as demand grew
in other developed countries, U.S. firms would begin
to export
 Cont’d
• Over time, demand for the new product
would grow in other advanced countries
making it worthwhile for foreign producers
to begin producing for their home markets
• U.S. firms might also set up production
facilities in those advanced countries where
demand was growing limiting the exports
from the U.S.
 The Product Life Cycle Theory
•As the market in the U.S. and other advanced nations
matured, the product would become more standardized,
and price the main competitive weapon
•Producers based in advanced countries where labor costs
were lower than the United States might now be able to
export to the U.S.
•If cost pressures became intense, developing countries
would begin to acquire a production advantage over
advanced countries
•The United States switched from being an exporter of the
product to an importer of the product as production
becomes more concentrated in lower-cost foreign locations
 International Product Trade Cycle Model
High Income Countries production

Exports Imports consumption

Q
u 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

a Medium Income Countries

Exports
n
ti
t Imports
y 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Low Income Countries

Exports
Imports
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Time
New Product Maturing Product Standardized Product

Stages of Production Development

The Product Life Cycle Theory

Figure 5.5: The Product Life

Cycle Theory
 The Product Life Cycle Theory
•The product life cycle theory accurately
explains what has happened for products like
photocopiers and a number of other high
technology products developed in the US in the
1960s and 1970s
•But, the increasing globalization and
integration of the world economy has made this
theory less valid in today's world
 the theory is ethnocentric
 production today is dispersed globally
 products today are introduced in multiple markets
simultaneously
 7. The New Trade Theory

• Began to be recognized in the 1970s.

• Deals with the returns on specialization
where substantial economies of scale are
present.
Specialization increases output, ability to
enhance economies of scale increase.
 New Trade Theory
•New trade theory suggests that the ability of firms to
gain economies of scale (unit cost reductions
associated with a large scale of output) can have
important implications for international trade

New trade theory suggests that:

•through its impact on economies of scale, trade can
increase the variety of goods available to consumers
and decrease the average cost of those goods
•in those industries when output required to attain
economies of scale represents a significant proportion
of total world demand, the global market may only be
able to support a small number of enterprises
 Increasing Product
Variety And Reducing Costs

•Without trade, nations might not be able to produce

those products where economies of scale are
important
•With trade, markets are large enough to support the
production necessary to achieve economies of scale
•So, trade is mutually beneficial because it allows for
the specialization of production, the realization of
scale economies, and the production of a greater
variety of products at lower prices
 Economies Of Scale, First Mover Advantages, And The Pattern Of Trade

•The pattern of trade we observe in the world

economy may be the result of first mover
advantages (the economic and strategic advantages
that accrue to early entrants into an industry) and
economies of scale
•New trade theory suggests that for those products
where economies of scale are significant and
represent a substantial proportion of world
demand, first movers can gain a scale based cost
advantage that later entrants find difficult to match
 What Are The Implications Of
New Trade Theory For Nations?
• Nations may benefit from trade even when they
do not differ in resource endowments or
technology
a country may dominate in the export of a good
simply because it was lucky enough to have one
or more firms among the first to produce that
good
• Governments should consider strategic trade
policies that nurture and protect firms and
industries where first mover advantages and
economies of scale are important
Application of the New Trade Theory

• Typically, requires industries with high, fixed

costs.
• World demand will support few competitors.
• Competitors may emerge because “they got
there first”.
first-mover advantage.
• Some argue that it generates government
intervention and strategic trade policy.
 First-Mover Advantage
• Economies of scale may preclude new
entrants.
• Role of the government.
• Founded 1915 by William Boeing
• Largest commercial airplane
manufacturer.
• 9,000 commercial jetliners in service.
• Established 1967
• Western Europe buying 25% of
aircraft ,but selling only 10%.
• France, Germany, Great Britain
• To date: 3,203 orders - 1,890 deliveries.
 Airbus vs Boeing
Airplane Orders
800
700
600
500
Boeing
400
Airbus
300
200
100
0
85 86 87 88 89 90 91 92 93 94 95 96 97
 8. Porter’s Diamond
(Harvard Business School, 1990)

• The Competitive Advantage of Nations.

• Looked at 100 industries in 10 nations.
Thought existing theories didn’t go far
enough.
• Question: “Why does a nation achieve
international success in a particular
industry?”
 What Is Porter’s Diamond Of
Competitive Advantage?

• Michael Porter (1990) tried to explain why a

nation achieves international success in a
particular industry
• Porter identified four attributes that promote
or impede the creation of competitive
advantage
1. Factor endowments
2. Demand conditions
3. Relating and supporting industries
4. Firm strategy, structure, and rivalry
 Determinants of National Competitive
Advantage
• Factor endowments: nation’s position in factors of
production such as skilled labor or infrastructure necessary to
compete in a given industry.
• Demand conditions: the nature of home demand for the
industry’s product or service.
• Related and supporting industries: the presence or
absence in a nation of supplier industries or related industries
that are nationally competitive.
• Firm strategy, structure and rivalry: the conditions in the
nation governing how companies are created, organized, and
managed and the nature of domestic rivalry.
 Porter’s Diamond
Determinants of National Competitive Advantage

Firm Strategy,
Structure and
Rivalry

Factor Endowments Demand Conditions

Related and
Supporting
Industries
 Factor Endowments
•Factor endowments refer to a nation’s position
in factors of production necessary to compete in
a given industry
•A nation's position in factors of production can
lead to competitive advantage
•These factors can be either basic (natural
resources, climate, location) or advanced (skilled
labor, infrastructure, technological know-how)
 Demand Conditions
•Demand conditions refer to the nature of
home demand for the industry’s product or
service
•The nature of home demand for the
industry’s product or service influences the
development of capabilities
•Sophisticated and demanding customers
pressure firms to be competitive
 Relating And Supporting Industries

•Relating and supporting industries refer to the

presence or absence of supplier industries and related
industries that are internationally competitive
•The presence supplier industries and related industries
that are internationally competitive can spill over and
contribute to other industries
•Successful industries tend to be grouped in clusters in
countries - having world class manufacturers of semi-
conductor processing equipment can lead to (and be a
result of having) a competitive semi-conductor industry
Firm Strategy, Structure, And Rivalry
•Firm strategy, structure, and rivalry refers to the
conditions governing how companies are created,
organized, and managed, and the nature of
domestic rivalry
•The conditions in the nation governing how
companies are created, organized, and managed,
and the nature of domestic rivalry impacts firm
competitiveness
•Different management ideologies affect the
development of national competitive advantage
•Vigorous domestic rivalry creates pressures to
innovate, to improve quality, to reduce costs, and
to invest in upgrading advanced features
 Does Porter’s Theory Hold?
• Government policy can
affect demand through product standards
influence rivalry through regulation and antitrust
laws
impact the availability of highly educated workers
and advanced transportation infrastructure.
• The four attributes, government policy, and chance
work as a reinforcing system, complementing each
other and in combination creating the conditions
appropriate for competitive advantage
 So far, Porter’s theory has not been sufficiently
tested to know how well it holds up
 The Diamond
• Success occurs where these attributes
exist.
More/greater the attribute, the higher
chance of success.
• The diamond is mutually reinforcing.
 Factor Endowments
• Taken from Heckscher-Olin
• Basic factors:
– natural resources,
– climate,
– location.
• Advanced factors:
– communications,
– skilled labor,
– technology.
Advanced Factor Endowments
• More likely to lead to competitive
advantage.
• Are the result of investment by
people, companies, government.
 Relationship of Basic to Advanced
Factors

• Basic can provide an initial advantage.

• Must be supported by advanced factors
to maintain success.
• No basics, then must invest in advanced
factors.
 Demand Conditions
• Demand creates the capabilities.
• Look for sophisticated and demanding
consumers.
impacts quality and innovation.
 Related and Supporting Industries

• Creates clusters of supporting

industries that are internationally
competitive.
• Must also meet requirements
of other parts of the
Diamond.
Firm Strategy, Structure and Rivalry

• Management ‘ideology’ can either help or

hurt you.
• Presence of domestic rivalry improves a
company’s competitiveness.
 Evaluating Porter’s Theory
• If Porter is right, country exports should
reflect the presence of the four ‘diamond’
components. Countries will import goods
from industries where some or all the
components are missing.
• Too soon to tell.
r ade
World T
 Determinants of
National Competitive Advantage

Chance
Company Strategy,
Structure,
and Rivalry

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

Source: Michael Porter, The Competitive Advantage of Nations

 Porter’s diamond, but...
• ‘Double Diamond’ - look to attributes of
both countries.
Professor Alan Rugman, University of Toronto
• Home country may ‘sound’ good, but
Company can rely on the host country.
Neighboring countries can too.
Canada and the U.S.
 Implications for Business
• Location implications: makes sense to disperse
production activities to countries where they can be
performed most efficiently.
• First-mover implications: It pays to invest
substantial financial resources in building a first-
mover, or early-mover, advantage.
• Policy implications: promoting free trade is
generally in the best interests of the home-country,
although not always in the best interests of the firm.
Even though, many firms promote open markets.
End of chapter two