Global Dimensions of

International Business

Alliance School of Business

Ramesh N
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Chapter 5 Trading Across Borders

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Theories International Trade
Classical Theories:

Mercantilism A theory that says the wealth of the

world (measured in gold and silver) is fixed and that
a nation that exports more and imports less would
enjoy the net inflows of gold and silver and thus
become richer.

Mercantilism, in its new avatar is the modern day

protectionism where governments actively protect
domestic imports and vigorously encourage exports.

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Theories International Trade
Absolute Advantage A theory that suggests that
under free trade, each nation gains by specializing in
economic activities in which it has absolute
advantage.

Advocated by Adam Smith in 1776, in his famous

work The Wealth of Nations, this theory suggests that
By specializing in the production of goods for which each has
an absolute advantage, both can produce more
By trading, both can benefit more

It is a win-win game, not a zero-sum game.

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Theories International Trade
Comparative Advantage A theory that focuses on the
relative (not absolute) advantage in one economic activity
that one nation enjoys in comparison with other nations.

What if one country is inferior to other in production of both?

Developed by British economist David Ricardo in 1817, this

theory suggests even though one country has absolute
advantage in production of both the products, as long as
other country is not equally less efficient in production of
both goods, it can still choose to specialize in the production
of one good in which it has comparative advantage.

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Comparitive Advantage
In the absence of trade a country must consume the goods and services it produces. The production possibilities
frontier shows combinations of goods a country can produce. Without trade countries must consume at a point on their
PPF's. With trade, a country can consume at a point outside of its PPF.
Suppose the best point for the U.S. was 3 trucks and 4 computers while Mexico's best point was 2 trucks and 1
computer.
Having assumed that a country is better off if it gets no less of each of the goods and more of at least one good than
its intitial best point, combinations to the northeast of the initial best point are better than the initial best point. To get
to a point off the PPF the countries must trade with one another. Also, if they are going to trade they both must alter
their production away from what they produced at their initial best points.
To see how the countries should change their production we need to see which country has a comparative advantage
in which product. Let's calculate the opporunity costs of producing computers. Assume that both countries go from
producing all trucks and no computers to producing no trucks and all computers. The United States would give up 5
trucks and gain 10 computers for an opporunity cost of 1/2 truck. Mexico would give up 4 trucks and gain 2 computers
for an opporunity cost of 2 trucks per computer. So, the United States has a comparative advantage in computers while
Mexico must have the comparative advantage in trucks.
The United States should move down its PPF towards producing more computers, say to producing 1 truck and 8
computers. Mexico should concentrate on producing trucks: 4 trucks and 0 computers.
Suppose the United States trades 3 computers to Mexico in exchange for 2 trucks.
The United States now consumes 3 trucks (the 1 it produced plus the 2 acquired from Mexico) and 5 computers (the 8
it produced minus the 3 traded to Mexico). Compare this to the United States' best intial point. The United States is
consuming the same number of trucks and more computers. The United States is better off.
Mexico consumes 2 trucks (the 4 it produced minus the 2 traded away) and 3 computers (all 3 acquired from the
United States). Mexico is consuming the same number of trucks as at its initial best point and more computers. Mexico
is better off.
Trade allows both countries to consume combinations of trucks and computers that lie in the impossible regions of their
PPF's.
PPF_ Production Possibility Frontier

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Comparative Advantage

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Theories International Trade
COUNTRY
1. lead innovation nation

2. other developed

nations
3. developing nations.

PRODUCT
Stage 1: development
Stage 2: Introduction
Stage 3: Growth
Stage 4: Maturity
Stage 5: Decline
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Theories International Trade
Theory of National Competitive advantage
of Industries a theory that suggests that the
competitive advantage of certain industries in
different nations depends on four aspects that
form a diamond.

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Theories International Trade

Firm strategy,
structure and
rivalry

Domestic
Country demand
factor conditions
endowments

Related and
supporting
industries

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Theories International Trade
Opportunity cost given the alternatives
(opportunities), the cost of pursuing one activity
at the expense of another activity.

Factor endowments the extent to which

different countries possess various factors, such
as labor, land and technology.

Factor Endowment Theory states that nations

will develop comparatively advantage based on
their locally abundant factors.

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Mechandise Vs. Services

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International Trade -
Factors

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International Trade Theory
Trade deficit An economic condition in which
nations imports more than it exports.

Trade surplus An economic condition in which

nations exports more than it imports.

Balance of Trade an aggregate of importing and

exporting that leads to the country-level trade
surplus or deficit.

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Political Economy of Trade Theory
It is important to understand the importance of
political and economic realities governing
international trade.

Political realities of the world suggests that as rules

of the game, plenty of trade barriers exist.

There are two broad types of trade barriers:

(1) tariff barriers

(2) nontariff barriers

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Political Economy of Trade Theory
1. Tariff Barrier

Trade barriers that rely on tariffs to discourage imports.

Import tariff is a tax imposed on imports.

Deadweight Costs : Net losses that occur in an economy

as the result of tariffs.

Following is an example of rice tariffs in Japan that leads to

deadweight costs.

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Political Economy of Trade Theory
2. Nontariff Barrier (NTB)

Trade barriers that rely on nontariffs to discourage

imports.

Subsidies, import quotas, export restraints, local content

requirements, administrative policies, anti dumping
duties are examples.

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Political Economy of Trade Theory
Subsidies government payments to domestic firms

Import quota restrictions on quantity of imports

Voluntary Export Restraints (VER) an international

agreement that shows that exporting countries
voluntarily agree to restrict their exports

Local content requirement a requirement that

certain proportion of the value of the goods made in
one country originate from that country

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Political Economy of Trade Theory
Administrative policy bureaucratic rules that
make it harder to import foreign goods

Antidumping duty costs levied on imports that

have been dumped (selling below costs to
unfairly drive domestic firms out of business).
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Trade Deficit and Trade Surplus

Trade deficit: A nation has a trade deficit

if the total value of goods and services
it imports is greater than the total value
of those it exports.

Trade surplus: If the total value of a

nation's exports exceeds the total value
of imports, the nation has a trade
surplus.

Balance of Payment: The balance of

payments is the sum of all transactions
between a nation and all of its
international trading partners.

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Trade Deficit and Trade Surplus

Current account deficit (CAD): The current

account deficit is a broader measure that
includes the trade deficit, factor income and
financial transfers.

Factor income is determined by subtracting income

made by citizens of a country on their foreign
investments from income earned by foreigners on
their investments within the country.

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