International Trade Theories

An Overview of Trade Theory

• 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.
• The Pattern of International Trade displays patterns that
are easy to understand (Saudi Arabia/oil or Mexico/labor
intensive goods). Others are not so easy to understand
(Japan and cars).
 An Overview of Trade Theory
• The basic nature of international trade is to improve the
productivity of industry and welfare of consumers while
the purpose of a theory is to simplify reality so that the
basic elements of logic can be seen.
• In their attempts to understand the nature of
international trade-why do nations trade?
• What goods do they trade?
• Why some countries grow faster and wealthier than
others through trade?
• How are the gains from trade divided?
• Different theorists emerged.
International Trade Theory
•Overview
•Mercantilism
•Absolute Advantage
•Comparative Advantage
•Heckscher-Ohlin Theory
•Product Life Cycle Theory
•FDI Theory
•Porter’s Diamond
 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 exports through
subsidies.
•Minimize imports through tariffs
and quotas.
 Theory of Absolute Advantage
•Adam Smith: Wealth of Nations (1776).
•Capability of one country to produce more of a
product with the same amount of input than
another country.
•Produce only goods where you are most efficient,
trade for those where you are not efficient.
•Trade between countries is, therefore,
beneficial.
•Assumes there is an absolute advantage
balance among nations.
 Theory of Absolute Advantage
Wheat Maize

Kenya 2 4

Tanzania 4 2
 Theory of Absolute Advantage & Comparative
Advantage

• Example: Two countries Spain and Portugal produce two

products automobile and bread. Suppose Spain is better
than Portugal at making automobiles, and Portugal is
better than Spain at making bread. It is obvious that both
would benefit from trade if Spain specialized in
automobiles, while Portugal specialized in bread and they
traded their products. That is a case of absolute
advantage.
• But, suppose that one of the countries is bad at making
everything? Will trade drive all producers out of business?
The answer, according to David Ricardo, …..
 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
 Theory of Comparative Advantage
Wheat Maize

Kenya 3 2

Tanzania 4 4
 Theory of Absolute Advantage & Comparative
Advantage
• Example: The reason is the principle of comparative
advantage. According to this theory, Spain and Portugal
still stand to benefit from trading with each other even if
Spain is better than Portugal at making everything.
• If Spain is much more superior at making automobiles
and only slightly superior at making bread, then Spain
should still invest resources in what it does best —
producing automobiles — and export the product to
Portugal. Portugal should still invest in what it does best —
making bread — and export that product to Spain, even if
it is not as efficient as Spain. Both would still benefit from
the trade. A country does not have to be best at anything
to gain from trade. That is comparative advantage
 Heckscher (1919)-Ohlin (1933) Theory
• However, both Smith and Ricardo showed how the output
can be increased by production specialization. The
question remained as to why a country would be
relatively more efficient in the production of certain
goods-what is the source of comparative advantage?
• Swedish economist Eli Heckscher and his former graduate
student Bertil Ohlin asserted that this was due to the
differences in countries’ endowments of factors of
production and is considered as an extension of classical
theories of efficiency absolute advantage and
comparative advantage.
 Heckscher (1919)-Ohlin (1933) Theory
•Export goods that intensively use factor
endowments which are locally abundant.
•Import goods made from locally scarce
factors.
•Patterns of trade are determined by
differences in factor endowments - not
productivity.
Challenges to Heckscher-Ohlin Theory
•Factor endowments can be impacted by
government policy - minimum wage.
•US tends to export labor-intensive
products, but is regarded as a capital
intensive country.
 Heckscher vs Ricardo
•Economists prefer Heckscher on theoretical
grounds but is a relatively poor predictor of
trade patterns.
•Ricardo’s Comparative Advantage Theory,
regarded as too limited for predicting trade
patterns, actually predicts them with
greater accuracy.
•In the end, differences in productivity may
be the key to determining trade patterns.
 Product Life-Cycle Theory (Raymond Vernon, 1966)
•According to PLC theory, as products mature;
Both location of sales and optimal production
changes.
 It affects the direction and flow of imports and
exports.
•However, globalization and integration of the
economy makes this theory less valid.
• In this theory, technology and marketing factors
combine to explain standardization, which drives
location decisions.
 Product Life-Cycle Theory (Raymond Vernon, 1966)
•As illustrated below, one nation is initially an
exporter then loses its export markets and finally
become an importer of the product.
•The characteristics of the four familiar stages of
the PLC according to Vernon include;
 introduction
Growth
maturity and
decline.
 Product Life-Cycle Theory (Raymond Vernon, 1966)
•The first phase of the PLC theory is introduction,
whereby,
product innovations are most likely to be
developed in response to domestic needs,
in high income, advanced nations such as USA,
Japan, UK, Germany, and France.
 where domestic demand is strong and R&D
resources concentrated.
Product is manufactured locally, feedback
obtained from the market and consequent
improvements made.
 Product Life-Cycle Theory (Raymond Vernon, 1966)

•Phase I:
Eg. U.S Export strength
Product development and inventions are likely to
be related to the needs of home market.
•Phase II
Foreign production starts.
Product familiarity in other countries increase
other manufactures produce.
 Product Life-Cycle Theory (Raymond Vernon, 1966)

•Phase III:
Foreign production becomes competitive in
export markets.
Foreign producers gain product experience labor
costs lower & become competitive.
•Phase IV
Import competition begins.
Foreign producer has cost savings, Economies of
scale are sufficient to allow him to export where
the product originates.
International Product Trade Cycle Model
High Income Countries production

Exports Imports consumption

Q
u 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

a Medium Income Countries Exports

n
t
i Imports
t 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

y Low Income Countries

Exports
Imports
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Time
New Product Maturing Product Standardized Product Figure 4.5
Stages of Production Development
 Foreign Direct Investment Theory
• Foreign Direct Investment (FDI) theory assumes that
factors of production (i.e. labor and capital) will gravitate
towards the highest return they can obtain.
• Hence, countries rich in capital resources like USA, UK
and Japan, will invest capital abroad and countries rich in
labor resources will tend to witness an out migration of
labor (for instance, Egyptians and Indians to OPEC
countries in the Middle East) which seek the highest
reward in terms of wages.
• However, even the shift in theories from trade to factors
of production fails to fully explain the complex foreign-
investment decisions of individual organizations.
 Porter’s Diamond (Harvard Business School, 1990)
•The Competitive Advantage of Nations.
•Question: “Why does a nation achieve
international success in a particular industry?”
•Determinants of National Competitive Advantage;
Factor endowments: nation’s position in factors of
production such as skilled labor or infrastructure
necessary to compete in a given industry.
•The factor endowments could be basic or advanced
factors.
 Porter’s Diamond (Harvard Business School, 1990)
•Basic factors:
natural resources, climate, location, etc.
•Advanced Factor Endowments
 More likely to lead to competitive advantage.
 Are the result of investment by people,
companies, and government.
•Advanced factors include;
communications,
skilled labor,
technology.
 Porter’s Diamond (Harvard Business School, 1990)
•Relationship of Basic to Advanced Factors
Basic can provide an initial advantage.
Must be supported by advanced factors to
maintain success.
No basics, then must invest in advanced factors.
Firm strategy, structure and rivalry: the
conditions in the nation governing how companies
are created, organized, and managed and the
nature of domestic rivalry.
 Determinants of National Competitive Advantage
Demand conditions: the nature of home demand
for the industry’s product or service.
Demand creates the capabilities.
Look for sophisticated and demanding
consumers.
Impacts quality and innovation.
Related and supporting industries: the presence
of related industries that are nationally
competitive.
Creates clusters of supporting industries that are
internationally competitive.
 Porter’s Diamond
Determinants of National Competitive Advantage

Firm Strategy,
Structure and
Rivalry

Factor Endowments Demand Conditions

Related and
Supporting
Industries
 Implications of Intern. Trade Theories for Business
•Location implications: makes sense to disperse
production activities to countries where they can
be performed most efficiently.
•First-mover implications: it pays to invest
substantial financial resources in building a first-
mover, or early-mover, advantage.
•Policy implications: promoting free trade is
generally in the best interests of the home-
country, although not always in the best interests
of the firm. Even though, many firms promote
open markets.