UNIT 1

Global Trade and Investment

PART – 1

• Mercantilism
• Absolute Advantage Theory
• Comparative Advantage Theory
• Heckscher Ohlin Theory
• Porter’s Diamond Model
Dr. Hema Prakash
Assistant Professor
 Mercantilism
• First theory of international trade emerged in England in the mid-16 th century.

• During 17th and 18th centuries merchants, bankers, philosophers wrote essays and
pamphlets on international trade that advocates the philosophy – mercantilism.

• England, Spain, France, Portugal, and the Netherlands developed their trade
philosophy around mercantilism.

• Mercantilist believes that to maintained that the way for nation to become rich
and powerful was to export > import.
Continued…
• Export earning was viewed as inflow of precious metals, primarily gold and silver.

• More gold and silver a nation had, the richer, prestigious and powerful one.

• Mercantilist doctrine advocated governments interventions to achieve a surplus in the

balance of trade.

• No virtue in large trade.

• Rather, emphasise government policies to maximise export and minimize import

• Imposition of Tariff and Quotes to minimise the import, and subsidies to maximize
export
Continued….

David Hume (1752) pointed out the pointed out inconsistency in the mercantilist philosophy for
international trade.

England – More Export France- Import and export

• Inflow of wealth • Outflow of wealth
• Increases money supply • Contracts money supply
• Increases inflation, price increases • Prices decreases

This change in relative prices of France and England would

certainly encourage France to buy fewer product from England, as the import is becoming costlier.

Whereas England buy more French product, as the French goods becoming cheaper due to increased money
supply in the England

This deteriorates the England balance of trade while improving the France balance of trade, until the surplus trade
eliminates from the England.
Continued…

Mercantilism saw trade as a Zero-sum game (when one’s gain results in the loss by another)

Further, Adam Smith and David Ricardo underlined the short-sightedness of mercantilism
and demonstrate that trade is a positive-sum game ( a situation in which all can benefits).

Note: Zero sum game and Positive sum game is a conceptual part of Game Theory given
by Nobel Laureate Dr. John Nash (Mathematician and Economists).
 Absolute Advantage
• “The wealth of nation” book written by Adam Smith (1776) criticised the
mercantilist philosophy of trade

• underlined the inconsistency in the mercantilism that trade should not be zero-sum
game. Rather, positive sum game.

• Adam Smith proposed that the trade between the two nation is based absolute
advantage.

• A country is in absolute advantage- when the country is specialised or efficient in

producing one commodity (commodity X) that the other country.
Continued…
• When one nation is more efficient in production of one commodity(X) but is less efficient than the other
nation in producing the second commodity ( Y), then both the nation can gain in trade from each nation
specialised in the producing goods by trade.

• Resources are utilised in more efficient way – leads to increase in the output of the both the
commodities.

• Hence there will be a positive sum game in the trade

• Each country integrated in trade will have a favourable trade balance.

 Continued….
Canada Nicaragua
• Efficient in growing wheat • Efficient in growing banana
• Inefficient in growing banana • And inefficient in growing in wheat

• (due to climatic condition and the availability of resources • (due to climatic condition and availability of resources required).
required).
• Absolute advantage in growing banana and producing more than
• Absolute advantage in growing wheat and producing more the the domestic need.
domestic need.
Thus, Canada has an absolute advantage over Nicaragua in the cultivation and production of wheat.

Similarly, Nicaragua has an absolute advantage over Canada in the cultivation and production of banana.

Under this condition, both the nation would gain benefit by exchanging or trading the surplus of the production of the
commodity in which they are specialised, each other.
This leads to more production of both the commodities that eventually favourable for both the nation in terms of trade gain.
Countries are producing the commodity X and Y with 1 unit of labour which is
equal to 1 hour of labour

Commodity X Commodity Y

Ghana 5 unit 20 units

Bangladesh 15 unit 6 units

Continued…

• different to mercantilist philosophy, Adam Smith advocates the free trade and laissez-faire policy.

• Believe that free trade would enables country to utilize its resources in most efficiently.

• Smith theory mainly consider the labour as a factor of production.

• However, which is not actually existing in the economic scenario- government are playing its
critical role in deciding the import and export through various measures.

• Also, various measures of trade restriction has been considered as a tool for national welfare.
Limitations..
• The theory discusses the bilateral trade or trade between two nation

• The theory is focussed on the two commodity exchange.

• The theory explained that one country is specialised or efficient in

producing only one commodity.

• Also, ignored the trade protection measures.

 Comparative Advantage
Ricardian Theory of International Trade

• Comparative advantage is also known as Ricardian Theory of International Trade given

by David Ricardo in 1817 (book Principles of Political Economy and Taxation).

• This theory is an improvement over the absolute advantage theory of trade.

• Even when one nation is less efficient or having absolute disadvantage (inefficient) with
respect to the other country in producing both the commodities, there is still a basis for
mutually beneficial trade.

• Similar for the case, when one nation has an absolute advantage (efficient) in producing
both the commodities.
 Continued…
Countries are producing the commodity wheat and cloth with 1 unit of labour which is equal to 1 hour of
labour (man-hour)

Here, US has absolute advantage in producing both goods

US UK
whereas UK has absolute disadvantage in producing both goods.

Here, a question arise- can these two countries will not enter into trade?
Wheat
(bushel/man- 6 1 6:1 Yes, beneficial trade can take place because of the relative or comparative
hour advantage.

By taking the difference, US has comparative advantage in wheat (6:1) than in

Cloth cloth (4:2)
(yards/man- 4 2 4:2
hour)
Similarly, UK absolute disadvantage is smaller in cloth (4:2 – difference is
small) compared to wheat (6:1, difference is big), so UK has comparative
advantage in cloth.

In this case, US export wheat to UK. And UK will export cloth to US.
 Comparative advantage with labour value and Cost-
both countries are producing 10 units of wine and 10 meters of cloths.

• Here, in Portugal, the cost of labour

Country Wine Cloth
involved in the production of wine is less
than the cloth.
Portugal 80 labour 90 labour • Therefore, Portugal has comparative cost
advantage in producing wine.
Africa 120 labour 100 labour
• Here, in Africa, the cost of labour involved
in the production of cloth is less than the
wine.
• Therefore, Africa has comparative advantage
in producing cloth.
According to Ricardian cost comparative theory, both countries will have a favourable trade
if Portugal export wine to Africa and Africa export cloth to Portugal.
 Comparative advantage with opportunity cost

Opportunity cost –The cost of a commodity is the amount of a second commodity that must be given up to
release just enough resources to produce one additional unit of the first commodity.

• commodity X ---------------------------------------- Commodity Y

• How much unit of Y has to loose to produce one additional unit of X.

 cotton laptop cotton laptop

US 20 10 US 0.5 laptop give 2 tonnes of

up cotton give up
UK 16 2 UK 0.125 laptop 8 tonnes of
give up cotton give up

US: to produce 1 tonnes of cotton- 10/20=0.5 laptops have to give up

UK: to produce 1 tonnes of cotton - 2/16 = 0.125 laptops have to give up

US: to produce 1 laptop - 20/10 = 2 tonnes of cotton give up

UK: to produce 1 laptop - 16/2 = 8 tonnes of cotton give up.

So, According to Ricardo, country should produce that good in which it has low opportunity cost.
Therefore, due to this relative or comparative cost advantage- UK has comparative cost advantage
in producing cotton whereas US has comparative cost advantage in producing laptop.

Therefore, UK will export cotton and US will export laptop.

Assumption on which theory works-
• Basically, theory includes two nation trade concept. (but now a days Ricardian concept
has been adopted for multilateral trade).

• Perfect mobility of labour within each nation to produce both the commodities (goods).

• No transportation cost.

• No technical change.

• The labour theory of value.

 Heckscher Ohlin Theory
• 1919, Eli Heckscher, a Swedish economist, first presented this theory that was a step towards
“modern theory of international trade”.

• Later, in 1933, Bertil Ohlin, student of Heckscher, added to this theory.

• Since then, the theory known as Heckscher-Ohlin Theory.

• The theory explains trade between two countries having different resource specialisation.

• Heckcher Ohlin Theorem- A nation will export the commodity whose production requires the
intensive use of the nation’s relatively abundant and cheap resources.

• And import the commodity whose production requires the intensive use of the nation’s relatively
scarce and expensive factor.
• country rich in labour will export labour intensive goods and countries rich in capital
export capital intensive goods.

• As we know, the prices of goods differs in countries.

• This differences in the price of goods differ- due to factor endowment in the country.

• Nations have different factor endowment or factor abundance-

-one nation is rich in capital (K).
- other nation is rich in labour (L).

So, country rich in K, will produce K-intensive goods and export it.
And, country rich in L, will produce L-intensive goods and export it.
• Suppose there are two countries US and UK.
• US is rich in factor of production, K, producing good X
• UK is rich in factor of production, L, producing good Y

• (K/L)us > (K/L)uk US is K rich country & deficient in L

• UK is L rich country & deficient in K
• The large availability of resources lower the cost of resource.
• Therefore, (p.K/p.L) < (p.K/p.L)
•
• So, US export K-intensive goods (X)
• US import L-intensive goods (Y).
• And vice-a-versa in UK.
 Leontief Paradox
• First empirical test of the H-O Theory was conducted by Wassily Leontief in 1951.

• Since US is the K-abundant nation and Leontief expected to find that it exported K-
intensive goods and imported L-intensive goods.

• But his study found that US was also exporting L- intensive goods.

• Leontief explained that this was due to stratification of labour – skilled and unskilled
labour.

• Therefore, US tends to export skilled labour intensive goods and imports unskilled labour
intensive goods.
 Porter’s Diamond model

Why Some Nations Are Competitive And Others Are Not

• Micheal Porter in 1990, Harvard Business School, published a research analysed

that – why some nation fails and some succeed in international competition.

• Porter believes that the earlier competitive advantage theories were partial
explaining.

• His theory focused on explaining that why a nation achieves international success
in particular one industry.
Porter theorize four broad attributes of a nation that shape the environment in which local firms compete

And these attributes impedes the creation of competitive advantage in international competition.

Porters Diamond Model

Firm strategy ,
structure and
rivalry

Factor
Demand Condition
Endowments

Related and
Supporting
Industries

According to Porter- Diamond is mutually reinforcing system.

• Factor- Endowments
A nation’s position in factors of production such as skilled labour etc.

However, different to Heckscher Ohlin factor endowment concept, Porter recognised the
hierarchies among factor, by distinguishing factors into-

1. Basic factors- (climate, regional natural resources etc).

2. Advanced factors- (communication, infrastructure, skilled labour force, R & D,

technological know-how etc.)

Porter model favours the advanced factors for the competitive advantage of nations. These
factors are reinforced by investment.

Basic factors provides an initial advantage that is subsequently reinforced and extended by
investment in advanced factors
• Firm strategy , structure and rivalry

Conditions governing how companies are created organized and managed and the nature of
domestic rivalry.

-different management ideologies, which either help or do not help them to build national
competitive advantage.

-strong association between vigorous domestic rivalry and the creation and persistence of
competitive advantage in an industry.

Vigorous domestic rivalry induces forms to look for ways to improve efficiency.
• Demand Conditions
The nature of home demand for the industry’s product or services.

-firms are most sensitive to customers demand.

-Therefore, characteristics of home demand are particularly important in shaping the

attributes of domestically made products and in creating pressure for innovation and quality.

• Relating and Supporting Industries

Presence or absence of supplier industries and related industries that are internationally
competitive.

• Example- technological leadership in the US semiconductor industry provided the basis

for US success in personal computers and several other technically advanced electronic
products.
• A major finding of the porters model was that the successful industries in a country tend to be
grouped in cluster of related industries.

• Example- one of the cluster porter identified in the German textile and apparel sector, and wide
range of textile machinery.

• These cluster formation has its own significance- because valuable knowledge flows between the
firms within a geographic region.

• Also help to bring industry association and association between the employees of cluster
industries.

• Government Role- Porter also contends that government can influence each of the four
components of the diamond positively or negatively by formulating different subsidies, policies
towards capital markets, policies towards education, R & D, etc.
UNIT 1 _ PART 1