What is trade theories?

Trade theories are simply different theories to explain international trade.

International Trade is the concept of exchanging goods and services between
two countries.

Trade theories explains how goods are traded among various nations & which
goods are advantageous for trading.

For example- USA have advantage in car manufacturing, India in spices, etc.
Theories of International Trade and Investment

2
Timeline of International Business Theories

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 Classification Of Trade Theories

Traditional
Modern Theories
Theories

1. Mercantilism theory 6. Product life cycle

2. Absolute advantage theory 7. New trade theory
3. Comparative advantage
8. Porter`s diamond theory
4. Factor endowment

5. Leontief paradox
 1. MERCANTILISM THEORY
1. This theory was given by Thomas Mun.

2. Popular in the 16th and 18th Century.

3. It is based on zero sum game. During that time,

Wealth of nations was measured by stock of
gold and other kinds of metals.

4. Primary goal is to increase the wealth of nation

by acquiring gold. This theory says that a
country should increase gold by promoting
exports and discouraging imports.
 Assumptions
1. There is a finite amount of wealth in the world.
2. A nation can only grow rich at the expense of other nations.
3. A nation should try to achieve & maintain a favorable trade
balance ( exporting more than its import).

Disadvantages
1. Mercantilism hardly paid attention to the welfare of ordinary
workers.
2. Mercantilism was one way traffic. It focus on export but not
import, it is not easy to be self-sufficient. Many countries of
Europe fails to be self-sufficient which increased their miseries.
 2. ABSOLUTE ADVANTAGE THEORY
1. This theory was given by Adam Smith in 1776 and argued mercantilist
theory. This trade theory is based on positive sum game and
expansion of trade.

2. Absolute advantage is when a country can produce a product more

effectively than other country. Export goods of production advantage
and import goods of production disadvantage.

3. Example – India has an absolute advantage in producing cotton and

Brazil has in producing coffee. In this both countries should supply
production advantage to each other.
 Limitations
1. Fails to explain how free trade can be advantageous to two
countries when one country can produce all goods.

2. Country not having absolute advantage can’t gain from free

trade

3. Differences in climatic conditions & natural resources won’t

lead to absolute advantage
 3. COMPARATIVE ADVANTAGE THEORY
1. It is developed by David Ricardo in 1817.
2. This theory is the extension of absolute advantage theory. i.e. If a country has
advantage in production of both commodities, then compare the efficiency of both
goods.
3. Produce and Export of the good which can be produced more efficiently.
4. Example – India can produce both truck and car efficiency but for export, India need
to compare these goods with each other to find which goods has more efficiency. If
car producing has more efficiency then India should produce and export
manufactured cars.
 Limitations
1. Ricardo's Theory was based on only two countries & only two commodities, but
international trade is among many countries with many commodities

2. Assumption of full employment helps theory to explain trade on the basis of

comparative advantage. Cost of production in terms of labor, may change as
countries, at different levels of employment move towards full employment.

3. Even if any country stopped production, nobody in the industry wants to lose their
job.

4. Another serious defect is that transportation costs are not considered in

determining comparative cost differences
 4. FACTOR ENDOWMENT THEORY
1. Given by Eli Heckscher and Berlin Ohlin in 1993. Also known as factor
Proportion theory or Heckscher & Ohlin theory.

2. This theory is based on a country’s available production factors i.e. land,

labor, etc. in the country.

3. It stated that countries would produce and export those goods which make
intensive use of factors that are locally available in large quantities. In
contrast, import those factors that are in short supply or locally scarce.

4. Example – India has large quantities in labour so India should export labour
intensive goods i.e. coal mining and import capital intensive goods i.e. oil.
 Limitations
1. 1.Ignores price differences, transport costs, economies of scale, external
economies etc

2. 2. Gives undue importance to supply & less importance to demand

3. 3. Assumes that there is no unemployment

 5. LEONTIEF PARADOX
⮚Given by Wassily Leontief in 1973. Findings were contradictory to
predictions of Heckscher-Ohlin theory.

⮚ Found out that the United States—the most capital-abundant country

in the world—exported commodities that were more labor-intensive
than capital-intensive.

⮚ Leontief conclude from this result that the U.S. should adapt its
competitive policy to match its economic realities.
Limitations
1. Leontief considered only capital & labor inputs, leaving out natural
resource inputs.

2. But in reality capital & natural resources are used together in

production
 6. PRODUCT LIFE CYCLE THEORY

⮚ It is given by Raymond Vernon in the Mid 1960’s and Theory consist of technology
based products.
⮚ A product goes through the life cycle i.e. Introduction, Growth, Maturity, Decline.
⮚ Country where the product is first launched is Innovator and At the end of cycle the
innovator becomes the importer.
⮚ Example- America has started production of any new product that is introduction
phase, after some time company has reached into growth phase where the demand has
increased and started export. In last, that product becomes global standard product so to
meet global demand and to decrease cost of goods. America starts to produce goods in
developing country like India for mass production and starts importing of goods from
India to meet demand.
 Limitations
⮚ Most appropriate for technology-based products
⮚ Some products not easily characterized by stages of maturity
⮚ Most relevant to products produced through mass production
 7. NEW TRADE THEORY
⮚It is given by Paul Krugman in 1980.

⮚This theory tells about some of the necessary factor. A

countries having these factor can become exporter.

⮚Those three necessary factors are

1. Economies of sale – Reduction in per unit cost

2. Product differentiation i.e. color, durability, brand etc.

3. First mover advantage i.e. Capturing market

 Limitations
1. Can only treat a situation when there are many firms with different production
processes.

2. Assumes that all firms are well-formed, which may not be true in every case.
 8. PORTER’S DIAMOND MODEL
⮚Developed by Michael Porter in his book ‘The Competitive Advantage of
Nations’ in 1990. It is also known as National Advantage Trade Theory.
Factor
Conditions
⮚Explains factors that are available to a nation.

Related &
Demand DIAMOND
Supporting
⮚Four factors together forms “PORTER’S DIAMOD MODEL”. Conditions MODEL Industries

⮚These factors can give competitive advantage to the economy of country.

Strategy,
Structure, Rivalry
⮚Export goods from that industry where the diamonds is favorable.
 The Political Economy of International Trade

INTRODUCTION

Free trade refers to a situation where a government does not attempt to restrict
what its citizens can buy from another country or what they can sell to another
country.

While many nations are nominally committed to free trade, they tend to intervene in
international trade to protect the interests of politically important groups.
 The Political Economy of International Trade
INSTRUMENTS OF TRADE POLICY

There are seven main instruments of trade policy:

• Tariffs

• Subsidies

• Import quotas

• Voluntary export restraints

• Local content requirements

• Antidumping policies

• Administrative policies
 The Political Economy of International Trade
Tariffs

A tariff is a tax levied on imports that effectively raises the cost of imported products
relative to domestic products.

• Specific tariffs are levied as a fixed charge for each unit of a good imported

• Ad valorem tariffs are levied as a proportion of the value of the imported good

• Tariffs increase government revenues, provide protection to domestic producers against

foreign competitors by increasing the cost of imported foreign goods, and force consumers
to pay more for certain imports

• So, tariffs are unambiguously pro-producer and anti-consumer, and tariffs reduce the
overall efficiency of the world economy
 The Political Economy of International Trade
Subsidies
A subsidy is a government payment to a domestic producer. Subsidies help
domestic producers in two ways:
• they help them compete against low-cost foreign imports

• they help them gain export markets

Consumers typically absorb the costs of subsidies.

 The Political Economy of International Trade
Import Quotas and Voluntary Export Restraints

An import quota is a direct restriction on the quantity of some good that may be imported
into a country.

• tariff rate quotas are a hybrid of a quota and a tariff where a lower tariff is applied to
imports within the quota than to those over the quota
• voluntary export restraints are quotas on trade imposed by the exporting country,
typically at the request of the importing country’s government
• a quota rent is the extra profit that producers make when supply is artificially limited by
an import quota
• import quotas and voluntary export restraints benefit domestic producers by limiting
import competition, but they raise the prices of imported goods
 The Political Economy of International Trade

Local Content Requirements

A local content requirement demands that some specific fraction of a good be

produced domestically. Local content requirements benefit domestic producers,
but consumers face higher prices

Administrative Policies

Administrative trade polices are bureaucratic rules that are designed to make it
difficult for imports to enter a country. These polices hurt consumers by denying
 The Political Economy of International Trade
Antidumping Policies
Dumping is defined as selling goods in a foreign market below their costs of production, or
as selling goods in a foreign market at below their “fair” market value. It is a method by
which firms unload excess production in foreign markets

• Some dumping may be predatory behavior, with producers using substantial profits from
their home markets to subsidize prices in a foreign market with a view to driving
indigenous competitors out of that market, and later raising prices and earning
substantial profits

• Antidumping polices (or countervailing duties) are designed to punish foreign firms that
engage in dumping and protect domestic producers from “unfair” foreign competition
 The Political Economy of International Trade
THE CASE FOR GOVERNMENT INTERVENTION

There are two types of arguments for government intervention: political and economic.

• Political arguments are concerned with protecting the interests of certain groups within a
nation (normally producers), often at the expense of other groups (normally consumers)

• Economic arguments are typically concerned with boosting the overall wealth of a nation
(to the benefit of all, both producers and consumers).

• Political arguments for government intervention include:

1. protecting jobs
2. protecting industries deemed important for national security
3. retaliating to unfair foreign competition
4. protecting consumers from “dangerous” products
5. furthering the goals of foreign policy
 The Political Economy of International Trade
Economic Arguments for Intervention
The Infant Industry Argument

The infant industry argument suggests that an industry should be protected until it can
develop and be viable and competitive internationally.

• The infant industry argument has been accepted as a justification for temporary trade
restrictions under the WTO. However, it can be difficult to gauge when an industry has
grown up

• Critics argue that if a country has the potential to develop a viable competitive position its
firms should be capable of raising necessary funds without additional support from the
government
 The Political Economy of International Trade

Strategic Trade Policy

Strategic trade policy suggests that in cases where there may be important first mover
advantages, governments can help firms from their countries attain these advantages.

Strategic trade policy also suggests that governments can help firms overcome barriers to
entry into industries where foreign firms have an initial advantage
 The Political Economy of International Trade
THE REVISED CASE FOR FREE TRADE

Two situations where restrictions on trade may be inappropriate: retaliation and politics.

Retaliation and Trade War

• Krugman argues that strategic trade policies aimed at establishing domestic firms in a dominant
position in a global industry are beggar-thy-neighbor policies that boost national income at the
expense of other countries. A country that attempts to use such policies will probably provoke
retaliation.

Domestic Politics

• Since special interest groups can influence governments, Krugman argues that strategic trade
policy is almost certain to be captured by special interest groups within an economy, who will
distort it to their own ends
 The Political Economy of International Trade

DEVELOPMENT OF THE GLOBAL TRADING SYSTEM

From Smith to the Great Depression

• Up until the Great Depression of the 1930s, most countries had some degree of protectionism

• In 1930, the U.S. enacted the Smoot-Hawley tariff, which created significant import tariffs on

foreign goods

• Other nations took similar steps and as the depression deepened, world trade fell further
 The Political Economy of International Trade

1947-79: GATT, Trade Liberalization, and Economic Growth

• After WWII, the U.S. and other nations realized the value of freer trade, and
established the General Agreement on Tariffs and Trade (GATT)

• The approach of GATT (a multilateral agreement to liberalize trade) was to gradually

eliminate barriers to trade
 The Political Economy of International Trade

1980-1993: Protectionist Trends

• During the 1980s and early 1990s, the world trading system was strained

• Japan’s economic strength and huge trade surplus stressed what had been more equal trading
patterns, and Japan’s perceived protectionist (neo-mercantilist) policies created intense political
pressures in other countries

• Persistent trade deficits by the U.S., the world’s largest economy, caused significant economic
problems for some industries and political problems for the government

• Many countries found that although limited by GATT from utilizing tariffs, there were many other
more subtle forms of intervention that had the same effects and did not technically violate GATT (e.g.
VERs)
 The Political Economy of International Trade
The Uruguay Round and the World Trade Organization

In 1986, GATT members began new negotiations to reduce tariffs-- the Uruguay Round. The
talks focused on several areas:
Services and Intellectual Property

• Going beyond manufactured goods to address trade issues related to services and
intellectual property, and agriculture

The World Trade Organization

• By establishing the WTO, it was hoped that enforcement mechanisms would make the
WTO a more effective policeman of the global trade rules
• The WTO encompassed GATT along with two sisters organizations, the General Agreement
on Trade in Services (GATS) and the Agreement on Trade Related Aspects of Intellectual
Property Rights (TRIPS)
 The Political Economy of International Trade
WTO: Experience to Date
Since its establishment, the WTO has emerged as an effective advocate and facilitator of future trade deals,

particularly in such areas as services. So far, the WTO’s policing and enforcement mechanisms are having a

positive effect. In general, countries have adopted WTO recommendations for trade disputes. Expanding Trade

Agreements

• In 1997, 68 countries that account for more than 90% of world telecommunications revenues pledged to

open their markets to foreign competition and to abide by common rules for fair competition in

telecommunications

• Similarly, 102 countries pledged to open to varying degrees their banking, securities, and insurance sectors

to foreign competition

• Like the telecommunications deal, the agreement covers not just cross-border trade, but also foreign direct
 The Political Economy of International Trade

The WTO in Seattle: A Watershed?

• The 1999 meeting of the WTO in Seattle was important not only for what happened between the
member countries, but also for what occurred outside the building

• Inside, members failed to agree on how to work toward the reduction of barriers to cross-border
trade in agricultural products and cross-border trade and investment in services

• Outside, the WTO became a magnet for various groups protesting free trade

The Future: Unresolved Issues and the Doha Round

• Three issues on the current agenda of the WTO are the rise of anti-dumping policies, the high level
of protectionism in agriculture, and the lack of strong protection for intellectual property rights in
many nations, and continued high tariffs on nonagricultural goods and services in many nations
 The Political Economy of International Trade
Anti-Dumping Actions
• The WTO is encouraging members to strengthen the regulations governing the imposition
of antidumping duties

Protectionism in Agriculture
• The WTO is concerned with the high level of tariffs and subsidies in the agricultural sector
of many economies

A New Round of Talks: Doha

• In late 2001, the WTO launched a new round of talks at Doha, Qatar

• The agenda includes cutting tariffs on industrial goods and services, phasing out
subsidies to agricultural producers, reducing barriers to cross-border investment, and
limiting the use of anti-dumping laws
 The Political Economy of International Trade

Protecting Intellectual Property

• Because members believe that the protection of intellectual property rights is
an essential element of the international trading system, TRIPS obliges WTO
members to grant and enforce patents lasting at least 20 years and copyrights
lasting 50 years

• The WTO would like to bring down tariff rates on nonagricultural goods and
services, and reduce the scope for the selective use of high tariff rates
 The Political Economy of International Trade

IMPLICATIONS FOR MANAGERS

Trade Barriers and Firm Strategy

• Trade barriers raise the cost of exporting products to a country

• Voluntary export restraints (VERs) may limit a firm’s ability to serve a country from
locations outside that country

• To conform to local content requirements, a firm may have to locate more

production activities in a given market than it would otherwise

• All of these can raise the firm’s costs above the level that could be achieved in a
world without trade barriers
 The Political Economy of International Trade

Policy Implications

• International firms have an incentive to lobby for free trade, and keep protectionist
pressures from causing them to have to change strategies

• While there may be short run benefits to having governmental protection in some
situations, in the long run these can backfire and other governments can retaliate
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