Theories of International

Trade
TOPIC-2
 SUB TOPICS

• Theory of Absolute cost advantage

• Comparative cost advantage theory
• Product Life cycle theory
• Porter’s National Competitive advantage
theory
•
 Theory of mercanatlism
• -emerged in 16th century
• -theory states that gold & silver are wealth of nations
• -essential for medium of exchange for exchange of goods for 2 centuries
• -export- inflow of gold/silver
• Import- outflow of gold/ silver
• Accumulation of gold/silver- sign of wealth/ prosperity
• In order to get gold, imports were discouraged, esp high cost items
• Also high taxes and quantity restrictions were imposed
• Exports were encouraged and cash subsidies were given by countries
• WTO discourages mercantalism as one country’s gain is another country’s
loss
• Still many country’s practise this- push exports by giving direct & indirect
incentives and discourage imports by levying high custom duties
• Between 1950-90, India imposed heavy custom duties.
• Most of the imports needed “ Import License” and considerable
documentation were required
 Theory of Absolute Advantage
• Adam Smith- Principle of Political Economy “ in
1817.
• Talked about that nation should produce goods
in which it has greatest relative advantage.
• Trade can happen between two countries if one
country is able to produce at absolute low price
and offer to the other country
• Each country will import goods from cheapest
overseas source. Similarly, in case of exports
too, where export goods have cost advantage
• Also called “ Classical Trade Theory”
 Contd.
• Country Rice Electronic Chips

• Taiwan 60 30

• India 18 71

• Adam Smith in his theory said, “ An intelligent head of a family never

attempts to make at home that will cost him more to make than to
buy. A tailor doesn’t attempt to make his shoes . He buys from a
shoe maker”
• It applies in case of nations as well.
Theory of Comparative Advantage
• In case of Absolute advantage, David
Recardo believed that absolute cost
advantage was possible in case of either
natural or technical advantage to a
country.
• David Recardo- gave comparative cost
Advantage theory
• In few countries there may not be low cost
advantage, but still they trade.
 Contd.
• Recardo Theory has following implications:
• -Only two countries and two products
• Labour cost is the cost of production
• Production has constant return irrespective of level of
output
• There are no other costs , other than cost of production.
No transport, packing or handling cost,
• Labour is treated as mobile
• There are perfect markets
• Free trade and does not depend on other factors
• Trade is only carried by the barter system
• No economic or technology change
 Contd.
• Country man hrs per unit output
Cloth Wine
– Portugal 9 8

– England 10 12

– Domestic exchange ratio-

– Portugal: 1 unit of cloth= 8/9 = .88
– England: 1 unit of cloth= 12/10= 1.2
– Portugal= cost difference is in case of wine is higher ie 12-8=4
– England= cost difference in case of cloth is lower10-9=1
– Hence portugal should focus on Wine and England on Cloth
 THEORY OF FACTOR
ENDOWMENT
• SWEDISH ECONOMIST ELI HECKSCHER(1919) & BERTILI
OHLIN(1993)
• -COMPARATIVE ADVANTAGE COMES FROM DIFFERENCE IN
NATIONAL FACTOR ENDOWMENTS
• -FACTOR ENDOWMENTS MEANS ASSETS OR RESOURCES OF
THE COUNTRY LIKE LAND, LABOUR, CAPITAL ETC.
• EACH NATION HAS ITS OWN FACTOR ENDOWMENTS
• MORE THE FACTOR ENDOWMENTS IMPLIES LESS THE COST
OF PRODUCE OF THE COUNTRY.

• EG. CHINA EXPORTING MANUFACTURED GOODS DUE TO

CHEAP LABOUR
• INDIA PROVIDING BPO SERVICES DUE TO AVAILABILITY OF
HIGHLY SKILLED LABOUR
 THEORY OF PRODUCT LIFE
CYCLE
• THEORY GIVEN BY VERNON
• -THEORY DISCUSSES ABOUT THE STAGES OF
PRODUCTION OF A PRODUCT AND ‘KNOW-
HOW’(KNOWLEDGE)
• PRODUCT LIFE CYCLE- 4 STAGES
• A. NEW PRODUCT DEVELOPMENT
• B.MATURING STAGE
• C.STANDARDISED PRODUCT AND
• D.DECLINING STAGE
• EG. STEEL PRODUCTION TECHNOLOGIES. INDIA
GOT STEEL PRODUCTION TECHNOLOGIES FROM
GERMANY & UK AND RUSSIA EARLIER. TODAY
TISCO IS THE CHEAP PRODUCER OF STEEL.
 CONTD.
• NEW PRODUCT INITIALLY SELL AT HIGH PREMIUM
AND SOLD TO THOSE WHO ARE WILLING TO BUY.
AS PRODUCTION EXCEEDS EXPORT STARTS.
• MATURE STAGE OF PRODUCTION MORE EXPORTS
TAKES PLACE.
• IN STANDARDIZED STAGE THE TECHNOLOGY IS
KNOWN TO MANY. PRODUCTION SHIFTS TO LOW
COST COUNTRIES.
• THE ORIGINAL MANUFACTURER TRIES TO
DIFFERENTIATE THE PRODUCT THROUGH
INNOVATION OR VALUE ADDITION THROUGH R&D.
• EG. HYUNDAI OF KOREA SHIFTING ITS SMALL CAR
MANUFACTURING TO CHENNAI INDIA.
 THEORY OF NATIONALCOMPETITIVE
ADVANTAGE
• MICHAEL PORTER OF HARVARD BUSINESS SCHOOL
• CONDUCTED A RESEARCH IN 1990 TO FIND SUCCESS OF
FEW COUNTRIES IN INT BUSINESS AND FAILURES OF
OTHERS.

• GAVE FOUR FACTORS

• 1. FACTOR ENDOWMENTS; INCLUDES INPUTS IN
PRODUCTION SUCH AS SKILLED LABOUR, INFRASTRUCTURE,
RAW MATERIALS FOR THE COUNTRY
• 2.DEMAND CONDITIONS
• 3.RELATED SUPPORTING INDUSTRIES.
• 4STRATEGY OF THE FIRM STRUCTURE AND RIVALRY
DETERMINANTS OF NATIONAL
COMPETITIVE ADVANTAGE

FIRM STRATEGY,
STRUCTURE &
RIVALRY
FACTOR DEMAND
ENDOWMENTS CONDITIONS

RELATED &
SUPPORTING
INDUSTRIES