Chapter 4

International Trade Theories

 International Trade

International Trade: Purchase, sale, or exchange of

goods and services across national borders
Benefits of international trade:
▪ Greater choice of goods and services
▪ Important engine for job creation in many
countries
 Why Do Certain Patterns Of Trade Exist?
 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?
 An Overview of Trade Theory
 Mercantilism (16th and 17th centuries) encouraged
exports and discouraged imports
 Adam Smith (1776) promoted unrestricted free trade
 David Ricardo (19th century) built on Smith ideas
 Eli Heckscher and Bertil Ohlin (20th century ) refined
Ricardo’s work
 The Leontief Paradox
 International Product Life-Cycle Theory
 New Trade Theory
 National Competitive Advantage: Porter’s Diamond
Framework
 Mercantilism
 Mercantilism suggests that it is in a country’s best interest to
accumulate financial wealth, usually in the form of gold, by
encouraging exports and discouraging imports.
 The practice of mercantilism rested on three main pillars:
▪ Maintain Trade Surplus
▪ Government Intervention
▪ Colonialism
 Flaws of Mercantilism:
▪ Mercantilism views trade as a zero-sum game - one in which a gain by
one country results in a loss by another.
▪ If many nations pushing for more exports and limit their imports -
restricts international trade.
▪ Not all local products are cheap, consumers had to pay higher prices.
 Theory of Absolute Advantage
 Adam Smith (1776) - countries differ in their ability to
produce goods efficiently
 Absolute Advantage: Ability of a nation to produce
a good more efficiently than any other nation.
➢ 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
 Theory of Comparative Advantage
David Ricardo asked what might happen when
one country has an absolute advantage in the
production of all goods
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
 Heckscher-Ohlin Theory
 Heckscher and Ohlin - comparative advantage arises from
differences in national factor endowments (the extent to
which a country is endowed/gifted with resources such as
land, labor, and capital)
 Countries produce and export goods that require resources
(factors) that are abundant and import goods that require
resources in short supply.
 The more abundant a factor, the lower its cost.
 The Leontief Paradox
 Wassily Leontief 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
 Possible explanations for these findings include
✓ that the U.S. has a special advantage in producing products
made with innovative technologies that are less capital
intensive
✓ differences in technology lead to differences in productivity
which then drives trade patterns
 Since this result was at variance with the predictions of trade
theory,
5-9 it became known as the Leontief Paradox
 International Product Life Cycle
 International Product Life Cycle (Raymond Vernon): Theory stating
that a company will begin by exporting its product and later
undertake foreign direct investment as the product moves through
its life cycle

International Product Life Cycle

InternationalRaymond Vernon put forth an international trade theory for
manufactured goods in the mid-1960s. His international product life
Product Life cycle theory says that a company will begin by exporting its
Cycle product and later undertake foreign direct investment as the
product moves through its life cycle. The theory also says that, for a
number of reasons, a country’s export eventually becomes its
import.
The international product life cycle theory follows the path of a
good through its life cycle (from new to maturing to standardized
product) in order to determine where it will be produced (see
Figure).
 International Product Life Cycle
• In Stage 1, the new product stage, the high purchasing power and
demand of buyers in an industrialized country drive a company to
design and introduce a new product concept. Because the exact
level of demand in the domestic market is highly uncertain at this
point, the company keeps its production volume low and based in
the home country.
• In Stage 2, the maturing product stage, the domestic market and
markets abroad become fully aware of the existence of the product
and its benefits. Demand rises and is sustained over a fairly lengthy
period of time. As exports begin to account for an increasingly
greater share of total product sales, the innovating company
introduces production facilities in the countries with the highest
demand. Near the end of the maturity stage, the product begins
generating sales in developing nations, and perhaps some
manufacturing presence is established there.
 International Product Life Cycle
• In Stage 3, the standardized product stage, competition from other
companies selling similar products pressures companies to lower
prices in order to maintain sales levels. As the market becomes more
price sensitive, the company begins searching aggressively for low-
cost production bases in developing nations to supply a growing
worldwide market. Furthermore, as most production now takes
place outside the innovating country, demand in the innovating
country is supplied with imports from developing countries and other
industrialized nations. Late in this stage, domestic production might
even cease altogether.
 International Product Life Cycle
Stages of the Product Life Cycle
▪ 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.
▪ As the market in the U.S. and other advanced nations matured, the product would
become more standardized, and price 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 United
States became an importer of the product
 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.
 The new trade theory states that:
(1) There are gains to be made from specialization and increasing
economies of scale,
(2) The companies first to market can create barriers to entry
(3) Government may play a role in assisting its home companies.
 First mover advantages - the economic and strategic advantages
that accrue to early entrants into an industry
 Firms that achieve first mover advantages will develop economies of
scale, and create barriers to market entry for potential rivals
 First movers can gain a scale based cost advantage that later
entrants find difficult to match.
 A country may dominate in the export of a certain product because it
has a home-based firm that has acquired a first-mover advantage.
5-15
 Porter’s Diamond of Competitive Advantage
 Michael Porter tried to explain why a nation achieves international success in a particular
industry and identified four attributes that promote or obstruct the creation of competitive
advantage.
1. Factor Conditions / Factor Endowments
• Basic Factors
• Advanced Factors
2. Demand Conditions
• Sophisticated Buyers
3. Related and Supporting Industries
• Clusters
4. Firm Strategy, Structure, and Rivalry
• Competitiveness
 Government and Chance
• Role of Government
• Chance Events
 Porter’s Diamond Of Competitive Advantage
• Factor Conditions: Porter acknowledges the value of a nation’s resources, which he terms
basic factors, but he also discusses the significance of what he calls advanced factors.
Advanced factors include the skill levels of different segments of the workforce and the quality
of the technological infrastructure in a nation.
• Demand Conditions: Sophisticated buyers in the home market are also important to national
competitive advantage in a product area. A sophisticated domestic market drives
companies to add new design features to products and to develop entirely new products
and technologies.
• Related and Supporting Industries: Supporting industries spring up to provide the inputs
required by the industry.
• Firm Strategy, Structure, and Rivalry: Essential to successful companies is the industry structure
and rivalry between a nation’s companies. The more intense the struggle to survive between
a nation’s domestic companies, the greater will be their competitiveness.
• Government and Chance: Apart from the four factors identified as part of the diamond, Porter identifies
the roles of government and chance in fostering the national competitiveness of industries. First,
governments, by their actions, can often increase the competitiveness of firms and perhaps even entire
industries. Second, although chance events can help the competitiveness of a firm or an industry, it can
also threaten it.
Porter’s Diamond Of Competitive Advantage

Determinants of National Competitive Advantage: Porter’s Diamond