International Trade Theory

MOTIVES FOR WORLD TRADE AND FOREIGN

INVESTMENT

TRADE THEORIES INVESTMENT THEORIES

u. Comparative Advantage x. Product Life Cycle
v. Factor Endowment y. Portfolio Theory
w. Product Life Cycle z. Oligopoly

Eclectic Theory
TRADE THEORIES

• Countries gain from trade by producing products they have a

comparative advantage.
• Countries gain from specializing in the production and export of any
good that uses larger amounts of their own abundant factors.
• Explain trade patterns on the basis of stages in a product's life.
INVESTMENT THEORIES

• Explain changes in the location of production on the basis of states

in a product's life.
• Improve its risk-return performance by holding an internationally
diversified portfolio of assets.
• Invest abroad to exploit their quasi-monopoly advantages.
TRADE THEORIES

• Countries gain from trade by producing products they have a

comparative advantage.
• Countries gain from specializing in the production and export of any
good that uses larger amounts of their own abundant factors.
• Explain trade patterns on the basis of stages in a product's life.
ECLECTIC THEORY

• Exploit foreign markets through exports first and

then invest abroad at some point in the future.
• Location specific advantages, such as natural
resources and low labor cost.
• Ownership specific advantages, such as capital funds
and technology.
• Internationalization advantages are location and
ownership advantages magnified by international
investment.
Doctrine of Absolute Advantage
Number of units of factors of production required per unit of final product

Coal Wheat
US 2 units/ton 1 unit/ton
Germany 1 unit/ton 4 units/ton

Since the US is more efficient in the production of wheat, it will produce

wheat; Germany is more efficient in the production of coal; hence it will
produce coal. The US will export wheat to the Germany and import coal.
Assumptions: 1) Factors of production cannot move freely across countries.
2) Factors of production are not specialized.
P.V. Viswanath 8
Doctrine of Comparative Advantage
Number of units of factors of production required per unit of final product

Coal Wheat
US 2 units/ton 1 unit/ton
UK 3 units/ton 4 units/ton

Even though the US is more efficient in the production of both wheat and coal, it has
a comparative advantage in the production of wheat; hence, it will produce wheat;
the UK has a comparative advantage in producing coal; hence it will produce coal.
The US will export wheat to the UK and import coal.

P.V. Viswanath 9
Gains from Trade
• Prior to the introduction of trade, the exchange rate between wheat and coal in the US and UK
must be as follows:
US 1 ton wheat = 0.5 tons of coal
UK 1 ton wheat = 1.33 tons of coal

Clearly, UK producers of coal will find it advantageous to sell their coal to

the US, since they can get more than 0.75 tons of wheat for each ton of
coal. Similarly, US producers of wheat can get more if they sold to the UK
than the 0.5 ton of coal they could get in the US. Hence, the final terms of
trade, i.e. the common exchange rate after trade is introduced will be
somewhere between the two exchange rates, above. For example, it
might be 1 ton of wheat = 1 ton of coal. Exactly where it will be, will
depend upon the demand and supply schedules for coal and wheat.

P.V. Viswanath 10
Specialized Factors of Production
• If some factors are specialized, i.e. relatively more efficient in the production of
one commodity rather than the other, the prices of the factors that specialize in
the commodity that is exported will gain because of greater demand, once trade
begins.
• This is because demand for a factor is a derived demand and is based on demand
for the goods that the factors produce.
• US producers of coal that cannot switch to wheat production will be hurt, since
the demand for their product will drop.
• The greater the gains from trade for a country overall, the greater the cost of
trade to those factors of production that specialize in producing the commodity,
now imported.

P.V. Viswanath 11
Leontif Paradox