Chapter 6

International Trade Theory

Md. Afnan Hossain
Lecturer, School of Business & Economics
An Overview of Trade Theory

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
The Benefits of Trade

Smith, Ricardo and Heckscher-Ohlin show why it is beneficial for a country to

engage in international trade even for products it is able to produce for itself

International trade allows a country:

to specialize in the manufacture and export of products that it can produce
efficiently
import products that can be produced more efficiently in other countries
The Patterns of International Trade

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?
The Patterns of International Trade

Why does Ford assemble cars made for the

American market in Mexico, while BMW and
Nissan manufacture cars for Americans in the
U.S.?

Now, the U.S. buys a lot of its textiles from

places like Honduras and Guatemala; and of
course, Bangladesh too !!
Trade Theories

1. Mercantilism
2. Absolute Advantage
3. Comparative Advantage
4. Heckscher-Ohlin Theory
5. Product Life Cycle Theory
6. Porter’s Diamond Theory
Mercantilism
Mercantilism suggests that it is in a country’s best interest to maintain a trade
surplus -- to export more than it imports
Countries conducted trade in exchange of gold and silver in the mid 16th century
in England.
A country could earn gold and silver by exporting, thereby increasing their gold
and silver reserve-an increase in national wealth, prestige and power.
The contrary takes place when a country imports.
So, this theory advocated government intervention to achieve a surplus in the
balance of trade.
Mercantilism
The policy was to maximize exports and minimize imports - imports were limited by
tariffs & quotas, while exports were subsidized.
This theory is however criticized because trade surplus increase money supply in a
country. An increase in money supply raises the demand and consequently the price of
goods. The result of this is inflation.
It views trade as a zero-sum game, one in which a gain by one country results in a loss
by another, rather than a positive-sum game, a situation where all countries in trade
can benefit.
Absolute Advantage
A nation has an Absolute advantage if it can produce a product more efficiently than
any other nation.

Adam Smith was against mercantilism. According to Smith, countries should specialize
in the production of goods for which they have an absolute advantage and then trade
these goods for the goods produced by other countries.

A country should never produce goods at home that it can buy at a lower cost from
other countries.
How Does The Theory Of Absolute Advantage Work?
Assume that two countries, Ghana and South Korea, both have 200 units of resources that
could either be used to produce rice or cocoa.
Comparative Advantage
 A country has a comparative advantage if it can produce one product more efficiently and
at a lower cost than other products, in comparison to other nations.

David Ricardo extended Adam Smith’s Theory by exploring what might happen
when one country has absolute advantage in production of all goods. He extended
the free trade argument and proved that trade is a positive-sum game.

 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
 How Does The Theory Of Comparative Advantage Work?
Assume that two countries, Ghana and South Korea, both have 200 units of resources that
could either be used to produce rice or cocoa.
Comparative Advantage
If each country specializes in the production of the good in which it has a comparative
advantage and trades for the other, both countries gain.

Potential world production is greater with unrestricted free trade than it is with
restricted trade.

Comparative advantage theory provides a strong rationale for encouraging free trade.

The theory therefore suggests that trade is a positive-sum game (to an even greater
degree than that suggested by the theory of absolute advantage).
Heckscher-Ohlin Theory
Eli Heckscher and Bertil Ohlin - 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 more abundant a factor, the lower its cost

The pattern of trade is determined by factor endowments

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
Heckscher-Ohlin Theory
 Factor endowments determines cost of operation there
 EG: China in textile, footwear; USA in high tech product, Australia in agro and
dairy products.

Chinese Textile
Australian Meat
and Dairy
Srilankan Tea
Product Life Cycle Theory

According to the product life-cycle theory

◦ the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new
products

◦ initially, the product would be produced and sold in the U.S.

◦ as demand grew in other developed countries, U.S. firms would begin to export

◦ demand for the new product would grow in other advanced countries over time making it
worthwhile for foreign producers to begin producing for their home markets

◦ U.S. firms might set up production facilities in advanced countries with growing demand,
limiting exports from the U.S.
Product Life Cycle Theory
Cont…
◦ As the market in the U.S. and other advanced nations matured, the product would
become more standardized, and price would be 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 United States

◦ If cost pressures were intense, developing countries would acquire a production

advantage over advanced countries

◦ Production became concentrated in lower-cost foreign locations, and the U.S. became an
importer of the product
Product Life Cycle Theory

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
Porter’s Diamond Of Competitive Advantage
Determinants of National Competitive Advantage: Porter’s Diamond
Factor Endowments
Factor endowments refer to a nation’s position in factors of production necessary to compete in a given
industry => competitive advantage
These factors can be either basic (natural resources, climate, location, demographics) or advanced
(sophisticated & skilled labor, research facilities, communication infrastructure, technological know-how)
Advanced factors are a product of investment by individuals, companies & governments.
Demand Conditions
Demand conditions refer to the nature of home demand for the industry’s product or service that
influences the development of capabilities
Sophisticated and demanding customers pressure firms to be competitive, by creating pressures for
innovation and quality
E.g. Japanese camera industry; wireless telephone equipment industry of Scandinavia and Sweden
Relating and Supporting Industries

The presence of supplier industries and related industries that are internationally competitive can spill over
and contribute to other industries
E.g. Until the mid-1980s, the technological leadership in the U.S. semiconductor industry provided the
basis for U.S. success in personal computers and several other technically advanced electronic products.
E.g. Adoption of the automobile took off in the USA after the construction of a national system of highways
and gas stations.
Firm Strategy, Structure and 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.
E.g. predominance of engineers in top management at German and Japanese firms-improvement in
manufacturing processes and product design
E.g. predominance of finance people in top management at the US firms-overemphasis on
maximizing short term financial return
Vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to
invest in upgrading advanced features