FIN30013/FIN30015

International Trade and

Finance/International Finance

Dr Yii Kwang Jing

kyii@swinburne.edu.my
B341
 Modern Trade Theory
Topic 2
The objectives of this lecture are to:

Review the most important theories of international trade.

 Mercantilism (1500’s – 1700’s)
 Absolute Advantage - Adam Smith 1776
 Comparative Advantage - David Ricardo 1817
 Heckscher-Ohlin Theory 1930’s
 Product Life Cycle Theory - Raymond Vernon 1966
 New Trade Theory.
 National Competitive Advantage - Porter’s Diamond
 Discuss the characteristics of foreign direct investment
 Identify some of the theories relating to FDI
 Identify the implications for business arising from the different
trade theories and FDI.

3
Why do nations trade?
 Mercantilism

 Developed in England during the C16.

 It is the belief that national prosperity is the result of a positive
balance of trade, achieved by maximising exports and minimising
imports.
 Gold and Silver were essential for a country’s national wealth and
commerce.
• Exporting Countries - inflow of gold and silver.
• Importing Countries - outflow of gold and silver.

 Aim of Mercantilism:
Maintain a trade Accumulate
Increase National
Surplus: X > M Gold and
Wealth and Prestige
Silver.

5
Mercantilism is the intellectual ancestor of protectionism – idea
that governments should actively protect domestic industries
from imports and promote exports.

 Neo-Mercantilism: idea that the nation should run a trade

surplus.
 trade surplus: the nation exports more goods than it imports.

Problems with Mercantilism:

 David Hume 1752 identified an inherent flaw in the

Mercantilism
 Doctrine.
 Trade viewed as a zero-sum game - a gain in one country
results
 in a loss by another.
 Sometimes called today ‘economic nationalism”. 6
 Absolute Advantage

In 1776 Adam Smith in his book The Wealth of Nations argued

that countries differed in their ability to produce goods
efficiently,
and should specialise in the production of the goods they can
produce the most efficiently = absolute advantage.

Countries should specialize in the production of goods in which

they have an absolute advantage and then trade these goods for
goods produced by other countries.

Based on this theory Smith suggested:

 UK should specialise in textiles (cloth)
 France should specialise in wine, and
both countries would benefit from trade. 7
 UK FRANCE

Cloth 20 5

Wine 10 20

Cloth
20 UK
Production Possibility Frontier
(Constant returns – straight line)

5
F
10 20 Wine 8
Assume both the UK and France have the same amount of
resources to produce either cloth or wine.

Assume 200 units of resources are available in each country.

Assume in the UK it takes:

10 resources to produce one meter of cloth (C).
200/10 = 20C
20 resources to produce one liter of wine (W).
200/20 = 10W
Assume in France it takes:
40 resources to produce one meter of cloth.
200/40 = 5C
10 resources to produce one liter of wine.
200/10 = 20W
9
 UK has an absolute advantage in cloth - more resources needed
to produce a meter of cloth in France than UK.

France has an absolute advantage in wine. More resources

needed to Produce 1 litre of wine in the UK.

Cloth
20 UK

10

5 G: France Production
2.5 F
5 10 20 Wine 10
Assume no trade between countries. Each country devotes half its
resources to producing both goods.

A situation in which a country does not trade with other countries

is called autarky.

TOTAL
UK FRANCE PRODUCTION
Cloth 10 + 2. 5 = 12.5

Wine 5 + 10 = 15.0

11
Assume trade between countries. Each country specializes in
producing the good for which it has an absolute advantage.

UK produces 20 meters of cloth // France produces 20 liters of wine

TOTAL
UK FRANCE PRODUCTION

Cloth 20 0.0 20.0

Wine 0.0 20 20.0

By specializing, the production of both goods increase.

12
Both countries trade, swapping 1 cloth for 1 wine – rate of exchange.

Assume UK exports 6 cloth and imports 6 wine in return.

Final UK consumption after trade is 14 cloth and 6 wine.

In the UK, this is 4 cloth more than it could have consumed before
specialisation and trade, and 1 wine more.

France’s consumption after trade would be 6 cloth (3.5 C more) and

14 wine (4W more).
UK FRANCE

Cloth 14 6

Wine 6 14
13
As a result of specialisation and trade, output of both cloth and
wine is increased, and consumers in both nations
are able to consume more.

Trade is a positive sum game: it produces net gains for all countries.

Hence free trade is beneficial.

But what if one country has an absolute advantage in both products?

14
 Comparative Advantage

Comparative advantage principle: The principle that it can be beneficial for two
countries to trade without barriers as long as one is more efficient at producing
goods or services needed by the other. What matters is not the absolute cost of
production, but rather the relative efficiency with which a country can produce
the product.

 Remains today the foundation and overriding justification for

international trade.

 David Ricardo developed the theory of Comparative Advantage

 in his book Principles of Political Economy in 1817.
 A country should specialise in the production of those goods
 that it produces most efficiently, and buy the goods that it
 produces less efficiently from another country, even if it could
 produce both goods more efficiently itself.

15
 Cloth
20 UK

A
10

5
2.5 B
France
5 7.5 10 15 Wine

• This slide shows the production possibilities frontiers for the UK and France.
The UK has an absolute advantage in both cloth and wine.

• Assume 200 units of resources for both countries. Assume without trade,
each country uses half its resources to produce cloth and wine. Hence Points
A (UK) and B (France). 16
 Production and Consumption without Trade (autarky).

TOTAL
UK FRANCE PRODUCTION

Cloth 10 2.5 12.5

Wine 7.5 5.0 12.5

UK has a comparative advantage in the production of cloth since it

can produce 4 times as much cloth as France (10/2.5 = 4), but only
1.5 times as much wine (7.5/5.0 = 1.5).

UK is comparatively more efficient at producing cloth

than wine.
17
Assume UK exploits its comparative advantage in cloth and
increases output from 10 to15 meters. (Uses up 150 units of
resources, leaving 50 units to produce 3.75 liters of wine). Point C.

France specializes in wine, producing 10 litres (Point F).

Cloth
20 UK
C
15

5
F
3.75 10 15 Wine
18
The combined output of both cloth and wine has now increased.

Before specialisation, the combined output was 12.5 meters of cloth

and 12.5 liters of wine. With specialisation, the new higher levels
of trade are:

TOTAL
UK FRANCE PRODUCTION

Cloth 15 0.0
15.0

Wine 3.75 10.0

13.75
19
 Gains from trade. Assume each country swaps cloth for wine on a
one for one basis. Assume each exchanges 4 units of their exports
for 4 units of the import.

Both countries will consume more cloth and wine than they
could before specialisation and trade.

UK FRANCE
Cloth 11 4.0

Wine 7.75 6.0

UK gains 1 unit of cloth and .25 unit of wine more than it had before
trade. France gains 1 unit of wine and 1.5 unit of cloth more than
it produced before trade.
20
Hence Comparative Advantage shows that potential world
production is greater with unrestricted free trade, than it is
with restricted trade.

Assumptions (many unrealistic) behind Comparative Advantage:

• 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.
• Trade has no effects on income distribution within countries.

21
Diminishing returns to specialisation suggests that after some
point, the more of a good that a country produces, the greater
will be the units of resources required to produce each
additional item.

Crops grown on increasingly less fertile land, production per unit

of input will decrease.

Diminishing returns implies a convex PPF.

In reality, countries do not specialise entirely, rather produce

a range of goods.

Worthwhile to specialise up until that point where the resulting

gains from trade are offset by diminishing returns.
22
Free trade results in two forms of dynamic gains:
(Shift out the PPF curve)
(1) Increases country’s stock of resources as increased
supplies (capital and labor) become available from
abroad from trade.

(2) Increases the efficiency of resource utilization, and

can free up resources for other uses.

Cloth PPF2

PPF1

Wine
23
Limitations of Comparative Advantage
 Government interference, e.g.
full employment, economic development,
national self-sufficiency in defence-related
industries and protection of an agricultural
sector’s way of life (Japan and rice).
Form of government interference
tariffs, quotas and other non-tariff
restrictions

24
Theory of Comparative Advantage

• Trends in production, capital and technology

• The effect of uncertainty and information
costs
• Factor mobility
• Modern factors of production (more numerous
than in this simple model).
• The role of differentiated products in
imperfectly competitive markets and
• Benefits of economies of scale.

25
 Heckscher-Ohlin Theory

This theory argues that comparative advantage arises from differences

in national factor endowments (land, labour and capital) which result in
the differing factor costs between nations.
 Countries have different relative abundance of factors of
production.
 Production processes use factors of production with different
relative intensity.
 The more abundant a factor, the lower the cost.
 Export goods - intensive use of factor endowments that are
 locally abundant.

Import goods - require intensive use of factor endowments

that are not locally available.

26
 Differences in relative Differences in relative
factor endowments. productivity.
V Adam Smith
Heckscher-Ohlin
David Ricardo

H-O Theory seems to make sense

Australia exports agricultural goods (abundant fertile land).

Canada exports timber products (abundant forests).
South Korea exports textiles and footwear (abundant low cost labour)
Saudi Arabia exports oil.
South Africa exports gold.
Iceland/Norway export fish.

27
Trade in the Heckscher-Ohlin Model
Two countries trade cloth and food.
The countries are assumed to have the same
technology and the same tastes.
With the same technology, each economy
has a comparative advantage in producing the
good that relatively intensively uses the
factors of production in which the country is
relatively well endowed.
With the same tastes, the two countries will
consume cloth to food in the same ratio when
faced with the same relative price of cloth
under free trade.
Trade in the Heckscher-Ohlin Model (cont.)
• Since cloth is relatively labor intensive, at each relative price of cloth to
food, Home will produce a higher ratio of cloth to food than Foreign.
• Home will have a larger relative supply of cloth to food than Foreign.
• Home’s relative supply curve lies to the right of Foreign’s.
Trade Leads to a Convergence of Relative Prices
Trade in the Heckscher-Ohlin Model (cont.)
• Like the Ricardian model, the Heckscher-Ohlin model predicts a convergence of
relative prices with trade.
• With trade, the relative price of cloth rises in the relatively labor abundant
(home) country and falls in the relatively labor scarce (foreign) country.
• Relative prices and the pattern of trade: In Home, the rise in the relative price of
cloth leads to a rise in the relative production of cloth and a fall in relative
consumption of cloth.
• Home becomes an exporter of cloth and an importer of food.

• The decline in the relative price of cloth in Foreign leads it to become an

importer of cloth and an exporter of food.
 Trade in the Heckscher-Ohlin Model (cont.)
• Heckscher-Ohlin theorem: The country that is abundant in a factor exports
the good whose production is intensive in that factor.
• This result generalizes to a correlation:
• Countries tend to export goods whose production is intensive in factors with
which the countries are abundantly endowed.

• Changes in relative prices can affect the earnings of labor and capital.
• A rise in the price of cloth raises the purchasing power of labor in terms of both
goods while lowering the purchasing power of capital in terms of both goods.
• A rise in the price of food has the reverse effect.
 Trade and the Distribution of Income
(cont.)
• Thus, international trade can affect the distribution of income,
even in the long run:
• Owners of a country’s abundant factors gain from trade, but
owners of a country’s scarce factors lose.
• Factors of production that are used intensively by the import-
competing industry are hurt by the opening of trade –
regardless of the industry in which they are employed.
• Compared with the rest of the world, the United States is
abundantly endowed with highly skilled labor while low-
skilled labor is correspondingly scarce.
• International trade has the potential to make low-skilled
workers in the United States worse off - not just temporarily,
but on a sustained basis.
Trade and the Distribution of Income (cont.)
• Changes in income distribution occur with every
economic change, not only international trade.
• Changes in technology, changes in consumer preferences,
exhaustion of resources and discovery of new ones all affect
income distribution.
• Economists put most of the blame on technological change and
the resulting premium paid on education as the major cause of
increasing income inequality in the US.
• It would be better to compensate the losers from trade
(or any economic change) than prohibit trade.
• The economy as a whole does benefit from trade.
• E.g. SBTC and its impact.
 The Leontief Paradox
1953 Wassily Leontief tested the Heckscher-Ohlin theory.

He postulated that the US should be an exporter of capital-intensive

goods (has abundant capital compared to other nations) and an
importer of labour- intensive goods.

To his surprise, he found that US exports were less capital-intensive

than US imports.

This seemed to contradict the Heckscher-Ohlin theory, hence the

Leontief Paradox.

Maybe the US produces / exports new products made with innovative

technologies and using skilled labour.
34
 Empirical Evidence on the
Heckscher-Ohlin Model

• Tests on US data
• Leontief found that U.S. exports were less capital-intensive
than U.S. imports, even though the U.S. is the most capital-
abundant country in the world: Leontief paradox.
• Tests on global data
• Bowen, Leamer, and Sveikauskas tested the Heckscher-Ohlin
model on data from 27 countries and confirmed the Leontief
paradox on an international level.
• Source: Bowen, H.P., Leamer, E.E. and Sveikauskas, L., 1987. Multicountry, multifactor tests
of the factor abundance theory. The American Economic Review, pp.791-809.

• Perhaps the main contribution of the Leontief paradox is its

suggestion that international trade is complex and cannot be
fully explained by a single theory.
Raymond Vernon and Product Life Cycle theory

• International product life cycle theory: Each product and

its associated manufacturing technologies go through
three stages of evolution— introduction, growth and
maturity.
1. Introduction: New product is produced at home and enjoys a
temporary monopoly
2. Growth: Product’s inventors mass-produce the good and seek to
export it to foreign markets
3. Maturity: Product’s manufacturing becomes more standard,
foreign competitors enter the marketplace and the monopoly
power of the inventors dissipates
37
 Five stages in product’s life cycle

There are five stages in a product's life cycle:

– Introduction
– Growths
– Maturity
– Saturation
– Decline
– The location of production depends on the
stage of the cycle.

38
 The New Trade Theory - 1970s

Questioned the assumption of diminishing returns to specialisation.

Many industries exhibit large economies of scale - derived mainly

from spreading fixed costs over a larger output. As output expands
with specialisation, unit costs of production should fall.

Boeing - commercial jet aircraft / Microsoft - computing

Benefits from economies of scale accrue to early entrants into an

industry. These early entrants secure world markets, that could
discourage new entry. Notion of First Mover Advantage.

Boeing, Airbus, and McDonnell Douglas have substantial economies

of scale which discourages new entrants.
39
New Trade Theory suggests a country exports certain goods not
because of factor endowments or specific national characteristics,
rather a firm’s first mover advantages.

It does not contradict the theory of Comparative Advantage, but

identifies a source of comparative advantage.

Implication of the New Trade Theory is that governments should

consider strategic trade policies - nurture and protect firms / industries
where first mover advantages and economies of scale are
important.

Proactive trade policy (Protectionism)

V
Advocating Free trade Policy
40
 National Competitive Advantage

Michael Porter 1990 The Competitive Advantage of Nations

Tried to explain why a nation achieves international success in

a particular industry.

Japan - automobile industry.

Switzerland - precision instruments and pharmaceuticals.
Germany and the US - chemical industry.

Four broad attributes can promote / impede the creation of

competitive advantage.

41
Porter’s Diamond
• Factor Endowments

• Demand Conditions

• Related and supporting industries

• Firm strategy, structure, and rivalry

PLUS

• Chance and Government.

42
NATIONAL COMPETITIVE ADVANTAGE OF INDUSTRIES

Competitive advantage of certain industries in different nations depends on four factors:

Source: M. Porter, “The competitive advantage of nations,” Harvard Business Review (March-April 1990): 77. Reprinted with permission.

43
The four attributes of the diamond, government policy, and
chance work as a reinforcing system, complementing each
other and creating the conditions appropriate for competitive
advantage and trade.

Country will X products – Diamond + 2 are favourable

Country will M products – Diamond + 2 are not favourable

Porter’s Theory seems to make sense.

Theory has not been subjected to independent empirical testing.

44
Yet some forms of trade are much more simply explained by
simple absolute advantage - Saudi Arabia’s oil exports.

Other trade patterns are not explained by this or any other

theory.

In reality, maybe each of these theories explain something

about the pattern of international trade.

A limitation of these trade theories is in explaining the behaviour

patterns of individual firms - it is (large) firms that dominate trade,
not countries.

Role of MNC’s in trade is extremely important.

Why do MNC’s undertake foreign direct investment?
45