International

Trade Theory
 Introduction

International trade theory

explains why it is beneficial for countries to
engage in international trade
helps countries formulate their economic
policy
explains the pattern of international trade in
the world economy

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Why Is Free Trade Beneficial?
 Free trade - a situation where 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
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

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Why Is Free Trade Beneficial?
 International trade allows a country
to specialize in the manufacture and export of
products and services that it can produce
efficiently
import products and services that can be
produced more efficiently in other countries
limits on imports may be beneficial to
producers, but not beneficial for consumers

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 The Pattern of International Trade

 International trade theory helps explain

trade patterns
Some patterns of trade are fairly easy to
explain - it is obvious why Saudi Arabia
exports oil, Ghana exports cocoa, and Brazil
exports coffee
But, why does Switzerland export chemicals,
pharmaceuticals, watches, and jewelry? Why
does Japan export automobiles, consumer
electronics, and machine tools?
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 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

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 What Is Smith’s Theory
Of Absolute Advantage?
 Adam Smith (1776) argued that a country
has an absolute advantage in the
production of a product when it is more
efficient than any other country in
producing it
countries should specialize in the production
of goods for which they have an absolute
advantage and then trade these goods for
goods produced by other countries

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 Absolute Advantage

 Assume that two countries, Ghana and South

Korea, both have 200 units of resources that
could either be used to produce rice or cocoa
In Ghana, it takes 10 units of resources to
produce one ton of cocoa and 20 units of
resources to produce one ton of rice
So, Ghana could produce 20 tons of cocoa and
no rice, 10 tons of rice and no cocoa, or some
combination of rice and cocoa between the two
extremes

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 Absolute Advantage

In South Korea it takes 40 units of resources to

produce one ton of cocoa and 10 resources to
produce one ton of rice
So, South Korea could produce 5 tons of cocoa
and no rice, 20 tons of rice and no cocoa, or
some combination in between
 Ghana has an absolute advantage in the
production of cocoa
 South Korea has an absolute advantage in
the production of rice
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 Absolute Advantage

 Without trade
Ghana would produce 10 tons of cocoa and 5 tons
of rice
South Korea would produce 10 tons of rice and 2.5
tons of cocoa

 If each country specializes in the product in

which it has an absolute advantage and trades
for the other product
Ghana would produce 20 tons of cocoa
South Korea would produce 20 tons of rice

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 Absolute Advantage

 Suppose
Ghana could trade 6 tons of cocoa to South Korea for 6
tons of rice

 After trade
Ghana would have 14 tons of cocoa left, and 6 tons of rice
South Korea would have 14 tons of rice left and 6 tons of
cocoa

 Both countries gained from trade

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 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

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 Comparative Advantage

 Assume
Ghana is more efficient in the production of
both cocoa and rice
In Ghana, it takes 10 resources to produce
one tone of cocoa, and 13 1/3 resources to
produce one ton of rice
So, Ghana could produce 20 tons of cocoa
and no rice, 15 tons of rice and no cocoa, or
some combination of the two

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 Comparative Advantage

In South Korea, it takes 40 resources to

produce one ton of cocoa and 20 resources to
produce one ton of rice
So, South Korea could produce 5 tons of cocoa
and no rice, 10 tons of rice and no cocoa, or
some combination of the two
 If each country specializes in the production
of the good in which it has a comparative
advantage and trades for the other, both
countries will gain
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 Comparative Advantage

 With trade
Ghana could export 4 tons of cocoa to South
Korea in exchange for 4 tons of rice
Ghana will still have 11 tons of cocoa, and 4
additional tons of rice
South Korea still has 6 tons of rice and 4 tons
of cocoa

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 What Is The
Heckscher-Ohlin Theory?
 Eli Heckscher (1919) and Bertil Ohlin (1933) -
comparative advantage arises from differences in
national factor endowments (the extent to which a
country is endowed with resources such as land,
labor, and capital)
the more abundant a factor, the lower its cost
 Heckscher and Ohlin predict that countries will
export goods that make intensive use of locally
abundant factors
import goods that make intensive use of factors
that are locally scarce
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 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

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 What Is 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
 Countries may specialize in the production and
export of particular products because in certain
industries, the world market can only support a
limited number of firms
 new trade theory emerged in the 1980s
 Paul Krugman won the Nobel prize for his
work in 2008

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 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

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 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

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 Factor Endowments

 A nation's position in factor endowments

(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)
 Basic factors can provide an initial
advantage that is then reinforced and
extended by investment in advanced factors

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 Demand Conditions

 Demand conditions - the nature of home

demand for an industry’s product or
service
influence the development of capabilities
 Sophisticated and demanding customers
pressure firms to be more competitive and
to produce high quality, innovative
products

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 Related and Supporting Industries

 Related and supporting industries - the

presence supplier industries and related
industries that are internationally competitive
investing in these industries can spill over and
contribute to success in other industries
 Successful industries tend to be grouped in
clusters in countries which then prompts
knowledge flows between firms
having world class manufacturers of semi-conductor
processing equipment can lead to (and be a result
of having) a competitive semi-conductor industry

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 Firm Strategy, Structure, and Rivalry

 Firm strategy, structure, and rivalry - the

conditions in the nation governing how
companies are created, organized, and
managed, and the nature of domestic rivalry
nations are characterized by different management
ideologies which influence the ability of firms to
build national competitive advantage
 There is a strong association between
vigorous domestic rivalry and the creation and
persistence of competitive advantage in an
industry

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What Is Porter’s Diamond Of
Competitive Advantage?
Determinants of National Competitive Advantage: Porter’s Diamond

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 The Diamond
 Success occurs where these attributes
exist.
More/greater the attribute, the higher
chance of success.
 The diamond is mutually reinforcing.

© McGraw Hill Companies, Inc.,2000 4-32

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 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

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 What Are The Implications Of
Trade Theory For Managers?
1. Location implications - a firm should disperse
its various productive activities to those
countries where they can be performed most
efficiently
2. First-mover implications - a first-mover
advantage can help a firm dominate global
trade in that product
3. Policy implications - firms should work to
encourage governmental policies that support
free trade

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 What Is The
Balance Of Payments?
 A country’s balance of payments accounts
keep track of the payments to and receipts
from other countries for a particular time period
1. The current account records transactions of
goods, services, and income, receipts and
payments
 current account deficit
 current account surplus
2. The capital account records one time changes
in the stock of assets
3. The financial account records transactions that
involve the purchase or sale of assets

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