Chapter

4
International Trade
Theory
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Trade theory-overview

 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

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Trade theory-overview

 The Pattern of International Trade displays

patterns that are easy to understand (Saudi
Arabia/oil or China/crawfish). Others are not so
easy to understand (Japan and cars)
 The history of Trade Theory and government
involvement presents a mixed case for the role of
government in promoting exports and limiting
imports
 Later theories appear to make a case for limited
involvement
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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: “zero-sum game”
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Mercantilism-zero-sum game

 David Hume in 1752 pointed out that:

 Increased exports leads 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
surplus
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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 can vary
 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
 Example: Ghana/cocoa

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Theory of absolute advantage

Fig 4.1

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Absolute advantage and the gains from

trade

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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

Fig 4.2

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Comparative advantage and the gains

from trade

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Simple extensions of the Ricardian

model
 Immobile 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
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Simple extensions of the Ricardian

model

 Free trade (open economies):

 Free trade might increase a country’s stock of
resources (as labor and capital arrives from
abroad)
 Increase the efficiency of resource utilization

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PPF under diminishing returns

Fig 4.3

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Influence of free trade on PPF

Fig 4.4

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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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Product life-cycle Theory- R.

Vernon,(1966)
 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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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 were 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
Fig 4.6

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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

Company Strategy,
Structure,
and Rivalry

Factor Demand
Conditions Conditions

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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