INTERNATIONAL TRADE THEORIES

MODULE-3

Module Overview

Theory of MercantilismAbsolute Advantage TheoryComparative Advantage TheoryHecksher-Ohlin TheoryThe new product life cycle theoryThe new Trade TheoryPorter’s Diamond ModelImplications for International Business

IntroductionInternational 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

An Overview of Trade Theory

Question: What is free trade?

• Free trade refers to 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

MercantilismA nation’s wealth depends on ‘build up wealth’ of

Gold and silver as they were the currency of trade in that age.

Mercantilism (mid-16th century England) asserted that it is in a country’s best interest to maintain a trade surplus, to export more than it imports Maximize export through subsidiesMinimize imports through tariffs and quotasit advocated government intervention to achieve

a surplus in the balance of trade it viewed trade as a zero-sum game (one in which

a gain by one country results in a loss by another)Stayed from 1500-1800, and trade strategy of

many nations were boost exports and limit import.

Limitation of Mercantilism: Zero-Sum GameIn 1752, David Hume pointed out that:

• Increased exports lead to inflation and higher prices• Increased imports lead to lower prices

Result: Country A sells less because of high prices and Country B sells more because of lower prices

In the long run, no one can keep a trade surplusMercantilism is problematic and not

economically valid, yet many political views today have the goal of boosting exports while limiting imports

Theory of Absolute Advantage

In 1776, Adam Smith in his book The Wealth Of Nations argued:

Countries differ in their ability to produce goods efficiently.

A country has an “absolute advantage” when it is the most efficient in producing a particular product.(Countries should specialize in producing products for which they have an absolute advantage, and trade these goods for those produced more efficiently by other countries.)

Such trade will be beneficial to both countries. Thus it is a “positive-sum game”

Adam Smith 1723-1790

Absolute Advantage: An Example

0 5 10 15 20

5

1

0

15

20

A

BK

G

K’G’

Rice

Coc

oa

Ghana (G) has the resources to produce any combination of cocoa and/or rice that lies on its Production Possibility Frontier (PPF).

South Korea (K) has the resources to produce these combinations of cocoa and/or rice.

Without trade, each country devotes half of its resources to each product (points A and B).

Ghana and South Korea can each produce and consume cocoa and rice. Each country has 200 units of resources

»

2.5

Cocoa Rice

Ghana 10 20

S. Korea 40 10

Ghana 10.0 5.0

S. Korea 2.5 10.0

Total Production

12.5 15.0

Ghana 20.0 0.0

S. Korea 0.0 20.0

Total Production

20.0 20.0

Ghana 14.0 6.0

S. Korea 6.0 14.0

Ghana 4.0 1.0

S. Korea 3.5 4.0

Resources Required to Produce 1 Ton of Cocoa and Rice.

Production and Consumption without Trade.

Increase in Consumption as a result of Specialization and Trade

Production with Specialization

Consumption After Ghana Trades 6 Tons of Cocoa for 6 Tons of S. Korean Rice

Absolute Advantage: An Example of Gains from Trade

David Ricardo and Theory of Comparative Advantage

A country should specialize in the production of goods that it produces more efficiently in comparison to other goods — even if the country doesn’t hold an absolute advantage for that good.

The country should import the goods it produces less efficiently, even if it can produce that good all by itself.

Due to increased efficiency (better use of limited resources), potential world production is greater with unrestricted free trade.

Comparative Advantage maximize countries combined output

In 1817, David Ricardo in his book The Principles of Political Economy extended Smith’s free trade argument:

Therefore, free trade is universally beneficial (a positive-sum game) even when nations do not have an absolute advantage.

The Theory of Comparative Advantage

0 5 10 15 20

0

5

10

15

2

0C

ocoa

Rice

3.75 7.5

2.5

G

C

A

G’

B

K

K’

Ghana (G) produces both cocoa and rice, with a comparative advantage in cocoa.

Without trade, each country would devote half of its resources to each product (points A and B).

South Korea (K) is more efficient in producing rice than cocoa — a comparative advantage in rice.

Ghana and South Korea can each produce and consume cocoa and rice.

Ghana is more efficient than S. Korea in the production of both cocoa and rice — an absolute advantage in both products.

With trade, and specialization in cocoa, Ghana can produce at point C.

Cocoa Rice

Ghana 10 13.3

S. Korea 40 20

Ghana 10.0 7.5

S. Korea 2.5 5.0

Total Production

12.5 12.5

Ghana 15.0 3.75

S. Korea 0.0 10.0

Total Production

15.0 13.75

Ghana 11.0 7.75

S. Korea 4.0 6.0

Ghana 1.0 0.25

S. Korea 1.5 1.0

Resources Required to Produce 1 Ton of Cocoa and Rice.

Production and Consumption without Trade (points A and B).

Increase in Consumption as a result of Specialization and Trade

Production with Specialization (points C and K’)

Consumption After Ghana Trades 4 Tons of Cocoa for 4 Tons of S. Korean Rice

Comparative Advantage:An Example of Gains from

Trade

Absolute Advantage Versus Comparative Advantage

Absolute advantageComparative advantage

Adam Smith's Absolute Advantage can gain by production of one good

A country enjoys an absolute advantage over another country in the production of a product if it uses fewer resources to produce that product than the other country does.

But Comparative advantage can gain in production of more than one good

A country enjoys a comparative advantage in the production of a good if that good can be produced at a lower cost in terms of other goods.

Assumptions for Absolute advantage and comparative advantageThe conclusion that free trade is universally beneficial is rather bold for such a simple model as previously shown. The model has many unrealistic assumptions, such as…

There are only two economies, producing two goods.There are no transport costs.Resource prices are identical in the two countries.Trade does not affect income distribution within a country. Resources can move from the production of one good to

another within a country.There are constant returns to scale.That free trade does not change the efficiency with which a

country uses its resources, or the stock of resources.

Limitations of Absolute advantage theory and comparative advantage theoryImmobile resources:

Resources do not always move easily from one economic activity to another

Diminishing returns:Diminishing returns to specialization suggests that after

some point, the more units of a good the country produces, the greater the additional resources required to produce an additional item

Different goods use resources in different proportions

Heckscher-Ohlin Theory

Comparative advantage arise from differences in Productivity. Swedish economists Eli Heckscher (in 1919), and Bertil Ohlin (in 1933) had another explanation for comparative advantage.

Comparative advantage did not stem from differences in productivity (as theorized by Ricardo), but from differences in national factor endowments. (the extent to which a country is gifted with resources such as land, labor, capital, human resources, capital)

A country should export goods that intensively use factor endowments which are abundantly available in the country.

A country should Import goods that make intensive use of factors which are scarce.

The Limitation of Heckscher-Ohlin Theory: The Leontief Paradox

The Leontief Paradox: In 1953 Wassily Leontief disputed the Hechscher-Ohlin theory in some instances.The US is abundant in capital relative to most other nations. So, according to Hecksher-Ohlin, the US should be an exporter of capital-intensive goods, and an importer of labor-intensive goods. Actually, in 1953, US exports were less capital-intensive than US imports.

Heckscher-Ohlin is a relatively poor predictor of real-world trade patterns. Ricardo’s theory is more accurate. In the end, differences in productivity may be the key to determining trade patterns.

Product Life-Cycle Theory - Raymond. Vernon (1966)

Most new products initially conceived & produced in the US in 20th century

US firms kept production close to the marketWork out the innovations of new product introductionsDemand not based on price yet so low production cost

not an issue Limited initial demand in other advanced countries

Exports more attractive than production in other countries

When demand increases in advanced countriesProduce in foreign countries when demand necessitate

As developed market demand matures, new demand comes from less developed countries

Product becomes standardizedproduction moves to low production cost areasProduct now imported to US and to advanced countries

Product Life-Cycle Theory

Product Life-Cycle Theory - R. Vernon (1966)

Limitation:This theory was based upon what was

occurring at that time in the US. Globalization and integration of the economy makes this theory less valid today.

The New Trade TheoryThe New Trade Theory emerged in the 1970’s. It deals with the returns on specialization where substantial economies of scale are present

Output increases with increased production.

Economies of scale increase with increased output.

Unit costs of production should decrease along with economies of scale.

The world economy will profitably support only a few firms in industries with substantial economies of scale.

The first mover advantage.Early entries to an industry may gain a lock on the

market as they are first to gain economies of scale; this discourages new entries — the first mover advantage.1. Because of economies of scale, trade can increase

the variety of goods available to consumers and decrease the average cost of those goods

2. In those industries Where demand become more crucial, the global market may only be able to support a small number of firms

Important factors to first-mover advantage are: luck entrepreneurship innovation government intervention.

Limitation of first mover advantage

There may be an economic rationale for a strategic or proactive trade policy if it helps domestic firms become first movers in an industry; this is in conflict with earlier free-trade theories

National Competitive Advantage: Porter’s Diamond

Michael Porter (1990), of HBS, tried to explain why a nation achieves international success in a particular industry

Porter identified four attributes he calls the diamond that promote or impede the creation of competitive advantage1. Factor endowments2. Demand conditions3. Related and supporting industries4. Firm strategy, structure, and rivalry

In addition, Porter identified two additional variables (chance and government) that can influence the diamond in important ways

Porter’s Diamond

A nation’s position in factors of production, such as skilled labor or infrastructure necessary to compete in a given industry.

The nature of home demand for the industry’s product or service.

The presence or absence in a nation of supplier industries or related industries that are nationally competitive.

The conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.

Factor Endowments

Factor endowments: A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industryBasic factor endowments (Natural resources, Climate,

Geographic location, Demographics)Advanced factor endowments

Advanced Factor EndowmentsAdvanced factors: The result of investment by people, companies, and government are more likely to lead to competitive advantage

If a country has no basic factors, it must invest in advanced factorsCommunicationsSkilled laborResearchTechnologyEducation

Demand Conditions

Demand:creates capabilities creates sophisticated and

demanding consumers

Demand impacts quality and innovation

Related and Supporting Industries

Creates clusters of supporting industries that are internationally competitive (like suppliers or related industries)

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

Porter’s Theory-Predictions

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

Implications for Business

Location implications:Separate production activities to countries where they can be performed

most efficientlyEx: If design can performed most efficiently in France, it is where design

facility should be kept.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

Thank you!