CSTMQT C2 - Theory of International Trade - Preclass Handouts

International Trade Policy PhD.
Tran Nguyen Chat
INTERNATIONAL TRADE POLICY
Lecturer: PhD. Tran Nguyen Chat

Division: International Business and Trade
Email: trannguyenchat.cs2@ftu.edu.vn
FOREIGN TRADE UNIVERSITY

HOCHIMINH CITY CAMPUS
1
Chapter 2
THEORY OF
INTERNATIONAL TRADE
FTU-HCMC 1
International Trade Policy PhD. Tran Nguyen Chat
Chapter outline
2.1. Classical Theories of International

Trade
2.2. New theories of international trade
2.3. The benefits of international trade
2.4. International trade in an open-small
scale economy
Chapter 2
INTERNATIONAL TRADE THEORY

• Classical and Neo-classical theories
• Recent developments of trade theories
• Gain from trade
✓ Countries
✓ Firms
✓ Trade in a small and open economy
• Trade performance indicators
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Chapter 2
Classical Trade Theories
1. Mercantilism (Pre-16th century)
2. Absolute Advantage (A. Smith, 1776)
3. Comparative Advantage (D. Ricardo, 1817)
Neo-classical Trade Theory
➢ Factor-Endowment (Heckscher - Ohlin, 1919)
3 New Trade Theories
1. Economies of Scale & Int’l Trade (P. Krugman, 1980s)

2. International Product Life Cycle (R. Vernon, 1966)
3. National Competitive Advantage (M. Porter, 1990)
Historical development of trade theory
• Mercantilism
– Regulation to ensure a positive trade balance
– Critics: possible only for short term; assumes static
world economy
• Absolute advantage (Adam Smith)
– Countries benefit from exporting what they produce
more efficently than anyone else
– But: nations without absolute advantage do not gain
from trade
• Comparative advantage (David Ricardo)
– Nations can gain from specialization, even if they lack
an absolute advantage
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What Is Mercantilism?
Mercantilism suggests that it is in a country’s

best interest to maintain a trade surplus—to
export more than it imports
advocates government intervention to achieve a
surplus in the balance of trade
Mercantilism views trade as a zero-sum

game—one in which a gain by one country
results in a loss by another
7
Adam Smith’s Theory

Of Absolute Advantage
Adam Smith (1776) argued that a country has

an absolute advantage in the production of a
product when it is more efficient than any other
country in producing it
countries should specialize in the production of
goods for which they have an absolute advantage
and then trade these goods for goods produced by
other countries
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Absolute Advantage Theory
Principle of Absolute Advantage

• In a two-nation, two-product world,
international specialization and trade will be
beneficial when one nation has an absolute
cost advantage in one good and the other
nation has an absolute cost advantage in the
other good.
• Absolute cost advantage means using
less labor to produce a unit of output.
Absolute Advantage Theory
Sources of Absolute Advantage

• Natural advantages
Climate, soil, and mineral wealth.
Ex: Vietnamese rice, Brazilian coffee…
• Acquired advantages
Special skills and techniques.
Ex: Swiss watches, Danish silver plates…
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Ricardo’s Theory
Of Comparative Advantage
David Ricardo asked what happens when one

country has an absolute advantage in the
production of all goods
The theory of comparative advantage (1817)—

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
11
11
Comparative Advantage Theory
The Law of Comparative Advantage

The less efficient nation should specialize in
and export the good in which it is relatively
less inefficient (where its absolute
disadvantage is least). The more efficient
nation should specialize in and export that
good in which it is relatively more efficient
(where its absolute advantage is greatest).
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Ricardo’s Theory
Of Comparative Advantage
Comparative advantage theory provides a
strong rationale for encouraging free trade
total output is higher
both countries benefit
Trade is a positive sum game
13
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Comparative Advantage Theory
Assumptions
• The world consists of two nations, each using a
single input to produce two commodities.
• In each nation, labor is the only input.
• Labor can move freely among industries within a
nation but is incapable of moving between nations.
• The level of technology is fixed.
• Costs don’t vary with the level of production & are
proportional to the amount of labor used.
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Comparative Advantage
and Opportunity Cost
• Generalizes theory to include all factors, not

just labor
• Shows combinations of products that can be
made if all factors are used efficiently
• Slope, or marginal rate of transformation,
shows the opportunity cost of making more of
one good (how much of one good must be
given up to make more of another)
15
15
Comparative Advantage
and Opportunity Cost
• A country has a comparative advantage in
producing a good if the opportunity cost of producing
that good is lower in the country than it is in other
countries.
• A country with a comparative advantage in
producing a good uses its resources most efficiently
when it produces that good compared to producing
other goods.
16
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RCA
Revealed Comparative Advantage
E XA E XW
RCA = :
E A Ew
EXA: Country A’s exports of commodity X
EA: Country A’s total exports
EXW: The World’s exports of commodity X
EW: The World’s total exports
❑ RCA  1: A has a revealed comparative advantage in X
❑ RCA < 1: A has a revealed comparative disadvantage in X
17
Summary of Ricardian model

(Paul Krugman)
1. We examined the Ricardian model, the

simplest model that shows how differences
between countries give rise to trade and gains
from trade. In this model, labor is the only
factor of production, and countries differ
only in the productivity of labor in different
industries.
18
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(Paul Krugman)
2. In the Ricardian model, countries will export

goods that their labor produces relatively
efficiently and will import goods that their labor
produces relatively inefficiently. In other
words, a country’s production pattern is
determined by comparative advantage.
19
19

(Paul Krugman)
3. We can show that trade benefits a country
in either of two ways.
First, we can think of trade as an indirect method
of production. Instead of producing a good for
itself, a country can produce another good and
trade it for the desired good. The simple model
shows that whenever a good is imported, it must
be true that this indirect “production” requires less
labor than direct production.
Second, we can show that trade enlarges a
country’s consumption possibilities, which
implies gains from trade.
20
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(Paul Krugman)
4. The distribution of the gains from trade

depends on the relative prices of the
goods countries produce. To determine these
relative prices, it is necessary to look at the
relative world supply and demand for goods.
The relative price implies a relative wage rate
as well.
21
21

(Paul Krugman)
5. The proposition that trade is beneficial is
unqualified. That is, there is no requirement
that a country be “competitive” or that the
trade be “fair.”
In particular, we can show that three
commonly held beliefs about trade are wrong.
First, a country gains from trade even if it has lower
productivity than its trading partner in all industries.
Second, trade is beneficial even if foreign industries are
competitive only because of low wages.
Third, trade is beneficial even if a country’s exports
embody more labor than its imports.
22
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(Paul Krugman)
6. Extending the one-factor, two-good

model to a world of many commodities does
not alter these conclusions. The only
difference is that it becomes necessary to
focus directly on the relative demand for
labor to determine relative wages rather
than to work via relative demand for goods.
Also, a many-commodity model can be used
to illustrate the important point that
transportation costs can give rise to a situation
in which some goods are nontraded. 23
23

(Paul Krugman)
7. While some of the predictions of the

Ricardian model are clearly unrealistic, its
basic prediction—that countries will tend to
export goods in which they have relatively
high productivity—has been confirmed by a
number of studies.
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Neo-classical trade theory
HECKSCHER – OHLIN MODEL

(Factor Endowments)
25
25
What Is The
Heckscher-Ohlin Theory?
• While trade is partly explained by differences in
labor productivity, it also can be explained by
differences in resources across countries.
• The Heckscher-Ohlin theory argues that
international differences in labor, labor skills,
physical capital or land (factors of production) create
productive differences that explain why trade occurs.
– Countries have relative abundance of factors of
production.
– Production processes use factors of production with
relative intensity.
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Two Factor Heckscher-Ohlin Model
1. Labor and land are resources important for

production.
2. The amount of labor and land varies across countries,
and this variation influences productivity.
3. The supply of labor and land in each country is
constant.
4. Competition allows factors of production to be paid a
“competitive” wage, a function of their productivities
and the price of the good that it produces, and allows
factors to be used in the industry that pays the highest
wage/rate.
5. Only two countries are modeled: domestic and foreign 27
27
Two Factor Heckscher-Ohlin Model
Eli Heckscher (1919) and Bertil Ohlin

(1933) - 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
28
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Factor endowment theory
Comparative advantage is explained entirely

by different national supply conditions,
especially resource endowments
Nations export products that use inputs which
are relatively abundant (cheap) at home, and
import products which need inputs which are
relatively scarce (expensive) at home
29
29
Trade in the Heckscher-Ohlin Model
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
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Factor endowment theory:

implications
• Factor price equalization
– The shift within each nation towards use of cheaper
factors, and away from expensive ones, leads to more
equal factor prices (if factors are mobile)
• Distribution of income
– Trade changes domestic distribution of income as demand
for different factors changes
• Tests of factor endowment theory
– Emphasize the importance of varieties of different factors
(such as human capital) and accounting for changes in
resource endowment; other explanations are also
important
31
31
Does The Heckscher-Ohlin

Theory Hold?
➢ Wassily Leontief (1953) theorized that since the

U.S. was relatively abundant in capital compared
to other nations,
➢ the U.S. would be an exporter of capital intensive
goods and an importer of labor-intensive goods.
➢ However, he found that U.S. exports were less capital
intensive than U.S. imports
➢ Since this result was at variance with the
predictions of trade theory, it became known as
the Leontief Paradox.
32
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Summary of H-O model

(Paul Krugman)
1. To understand the role of resources in

trade, we develop a model in which two
goods are produced using two factors of
production.
The two goods differ in their factor intensity,
that is, at any given wage-rental ratio,
production of one of the goods will use a
higher ratio of capital to labor than production
of the other.
33
33

(Paul Krugman)
2. As long as a country produces both goods,

there is a one-to-one relationship between the
relative prices of goods and the relative
prices of factors used to produce the goods.
A rise in the relative price of the labor-
intensive good will shift the distribution of
income in favor of labor, and will do so very
strongly: The real wage of labor will rise in
terms of both goods, while the real income of
capital owners will fall in terms of both goods.
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(Paul Krugman)
3. An increase in the supply of one factor of

production expands production possibilities,
but in a strongly biased way: At unchanged
relative goods prices, the output of the good
intensive in that factor rises while the output of
the other good actually falls.
35
35

(Paul Krugman)
4. A country that has a large supply of one

resource relative to its supply of other
resources is abundant in that resource.
A country will tend to produce relatively more
of goods that use its abundant resources
intensively.
The result is the basic Heckscher-Ohlin theory
of trade: Countries tend to export goods that
are intensive in the factors with which they are
abundantly supplied.
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(Paul Krugman)
5. Because changes in relative prices of

goods have very strong effects on the relative
earnings of resources, and because trade
changes relative prices, international trade
has strong income distribution effects.
The owners of a country’s abundant factors gain
from trade, but the owners of scarce factors lose.
In theory, however, there are still gains from trade,
in the limited sense that the winners could
compensate the losers, and everyone would be
better off.
37
37

(Paul Krugman)
6. In an idealized model, international trade

would actually lead to equalization of the
prices of factors such as labor and capital
between countries.
In reality, complete factor-price equalization is
not observed because of wide differences in
resources, barriers to trade, and international
differences in technology.
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(Paul Krugman)
7. Empirical evidence is mixed on the

Heckscher-Ohlin model, but most researchers
do not believe that differences in resources
alone can explain the pattern of world trade or
world factor prices. Instead, it seems to be
necessary to allow for substantial international
differences in technology.
Nonetheless, the Heckscher-Ohlin model
does a good job of predicting the pattern of
trade between developed and developing
countries. 39
39
Theory of Reciprocal Demand

(Stuart Mill)
• Actual trading prices depend on the
interaction of trading partners’ demands
• Final terms of trade will be closer to the
domestic price ratio of the nation with stronger
demand for the imported good
• Applies to nations of equal economic size,
which will share gains nearly equally
• Small nations trading with large ones can
receive the bulk of the gains from trade
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What Is New Trade Theory?
New trade theory suggests that the

ability of firms to gain economies of
scale (unit cost reductions associated
with a large scale of output) can have
important implications for international
trade
41
41
What Is New Trade Theory?
Countries may specialize in the production

and export of particular products because in
certain industries, the world market can only
support a limited number of firms
new trade theory emerged in the 1980s
Paul Krugman won the Nobel prize for his work in
2008
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Economies of Scale
• When defining comparative advantage, the
Ricardian model and the Heckscher-Ohlin model
both assume constant returns to scale:
– If all factors of production are doubled then output will
also double.
• But a firm or industry may have increasing returns

to scale or economies of scale:
– If all factors of production are doubled, then output will
more than double.
– Larger is more efficient: the cost per unit of output falls as
a firm or industry increases output.
43
43
Types of Economies of Scale
Economies of scale could mean either that larger

firms or that a larger industry (e.g., one made of
more firms) is more efficient.
• External economies of scale occur when cost
per unit of output depends on the size of the
industry.
• Internal economies of scale occur when the
cost per unit of output depends on the size of a
firm.
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Types of Economies of Scale
• External economies of scale may result if a

larger industry allows for more efficient provision
of services or equipment to firms in the industry.
– Many small firms that are competitive may comprise a
large industry and benefit from services or equipment
efficiently provided to the large group
of firms.
• Internal economies of scale result when
large firms have a cost advantage over small
firms, which leads to an imperfectly competitive
market.
45
45
Economies of Scale
Through its impact on economies of scale, trade can

increase the variety of goods available to consumers
and decrease the average cost of those goods
without trade, nations might not be able to
produce those products where economies of scale
are important
with trade, markets are large enough to support
the production necessary to achieve economies of
scale
so, trade is mutually beneficial because it allows
for the specialization of production, the realization
of scale economies, and the production of a
greater variety of products at lower prices 46
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Economies of scale & specialization
• Economies of scale provide incentives for

specialization, since per unit costs go down as
production increases
• Trade provides a larger potential market for
products, making higher production levels
possible
47
47
What Are The Implications Of

New Trade Theory For Nations?
Nations may benefit from trade even when

they do not differ in resource endowments or
technology
a country may dominate in the export of a good
simply because it was lucky enough to have one or
more firms among the first to produce that good
Governments should consider strategic trade
policies that nurture and protect firms and
industries.
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Summary of Economies of Scale

(Paul Krugman)
1. Trade need not be the result of comparative

advantage. Instead, it can result from increasing
returns or economies of scale, that is, from a
tendency of unit costs to be lower with larger output.
Economies of scale give countries an incentive to
specialize and trade even in the absence of
differences in resources or technology between
countries.
Economies of scale can be internal (depending on the
size of the firm) or external (depending on the size of
the industry). 49
49

(Paul Krugman)
2. Economies of scale can lead to a

breakdown of perfect competition, unless
they take the form of external economies,
which occur at the level of the industry instead
of the firm.
50
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(Paul Krugman)
3. External economies give an important role

to history and accident in determining the
pattern of international trade.
When external economies are important, a
country starting with a large advantage may retain
that advantage even if another country could
potentially produce the same goods more
cheaply.
When external economies are important,
countries can conceivably lose from trade. 51
51
What Is The International

Product Life-Cycle Theory?
The product life-cycle theory - as products

mature both the location of sales and the
optimal production location will change
affecting the flow and direction of trade
proposed by Ray Vernon in the mid-1960s
At this time most of the world’s new products
were developed by U.S. firms and sold first in
the U.S.
52
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International Product Life Cycle
Exports
I II III
Inventing country Developed country Least developed country
t3
t0
t1 t2 t4
Time
New product stage Maturing product stage Standardized product stage
Imports
53

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
54
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U.S. firms might set up production facilities in

advanced countries with growing demand,
limiting exports from the U.S.
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
55
55

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
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Porter’s Diamond Of
Competitive Advantage
57
57
Michael Porter (1990) tried to explain why a

nation achieves international success in a
particular industry
identified four attributes that promote or impede
the creation of competitive advantage
1. Factor conditions - a nation’s position in
factors of production necessary to compete in
a given industry
➢ can lead to competitive advantage
➢ can be either basic (natural resources, climate,
location) or advanced (skilled labor, infrastructure,
technological know-how)
58
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2. Demand conditions - the nature of home demand

for the industry’s product or service
➢ influences the development of capabilities
➢ sophisticated and demanding customers pressure
firms to be competitive
3. Related and supporting industries - the presence
or absence of supplier industries and related
industries that are internationally competitive
➢ can spill over and contribute to other industries
➢ successful industries tend to be grouped in clusters in
countries
59
59
4. Firm strategy, structure, and rivalry - the

conditions governing how companies are created,
organized, and managed, and the nature of
domestic rivalry
➢ different management ideologies affect the
development of national competitive advantage
➢ vigorous domestic rivalry creates pressures to
innovate, to improve quality, to reduce costs, and to
invest in upgrading advanced features
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Chapter 2
2.3. The benefits of international trade

2.4. International trade in an open-small
scale economy
- What are the benefits of international trade?
- What will happen with international trade in
an open-small scale economy?
61
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Trade performance indicators
What is trade performance?
What is effectiveness of
trade performance?
How to measure it?
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The trade performance of a country tends to be a

good indicator of economic performance since well
performing countries tend to record higher rates of
GDP growth.
Trade performance indicators are used to assess
and monitor the multi-faceted dimensions of trade
performance and competitiveness by sector and
by country over time.
63
63
International Trade Center: www.intracen.org

- Trade Map https://www.trademap.org/
- Export Potential Map
https://exportpotential.intracen.org/en/
- Trade Competitiveness Map
https://tradecompetitivenessmap.intracen.org/TPIC
.aspx
64
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World Integrated Trade Solution (WITS)

https://wits.worldbank.org/
Trade Outcomes Indicators

https://wits.worldbank.org/trade_outcomes.html
65
65
Please be sure that

YOU ARE READY FOR A CLASS!!!
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International Trade Policy PhD.

Tran Nguyen Chat

INTERNATIONAL TRADE POLICY

Lecturer: PhD. Tran Nguyen Chat

FOREIGN TRADE UNIVERSITY

2.1. Classical Theories of International

INTERNATIONAL TRADE THEORY

3 New Trade Theories

1. Economies of Scale & Int’l Trade (P. Krugman, 1980s)

Historical development of trade theory

Mercantilism suggests that it is in a country’s

Mercantilism views trade as a zero-sum

Adam Smith’s Theory

Adam Smith (1776) argued that a country has

Absolute Advantage Theory

Principle of Absolute Advantage

Absolute Advantage Theory

Sources of Absolute Advantage

David Ricardo asked what happens when one

The theory of comparative advantage (1817)—

Comparative Advantage Theory

The Law of Comparative Advantage

Trade is a positive sum game

Comparative Advantage Theory

• Generalizes theory to include all factors, not

Revealed Comparative Advantage

Summary of Ricardian model

1. We examined the Ricardian model, the

Summary of Ricardian model

2. In the Ricardian model, countries will export

Summary of Ricardian model

Summary of Ricardian model

4. The distribution of the gains from trade

Summary of Ricardian model

Summary of Ricardian model

6. Extending the one-factor, two-good

Summary of Ricardian model

7. While some of the predictions of the

Neo-classical trade theory

HECKSCHER – OHLIN MODEL

Two Factor Heckscher-Ohlin Model

1. Labor and land are resources important for

Two Factor Heckscher-Ohlin Model

Eli Heckscher (1919) and Bertil Ohlin

Factor endowment theory

Comparative advantage is explained entirely

Trade in the Heckscher-Ohlin Model

The pattern of trade is determined by factor

Factor endowment theory:

Does The Heckscher-Ohlin

➢ Wassily Leontief (1953) theorized that since the

Summary of H-O model

1. To understand the role of resources in

Summary of H-O model

2. As long as a country produces both goods,

Summary of H-O model

3. An increase in the supply of one factor of

Summary of H-O model

4. A country that has a large supply of one

Summary of H-O model

5. Because changes in relative prices of

Summary of H-O model

6. In an idealized model, international trade