Theories of international trade

• International Trade
– Country-based theories
– Firm-based theories
 International Trade
• Trade is the voluntary exchange of goods,
services, assets, or money
• International trade is trade between
residents of two countries
• Because trade is voluntary, the buyer and
the seller must believe that they will both
gain from the transaction
• The “gains from trade” must be non-
negative (usually positive) for each party
• But the “gains from trade” do not have to be
equal for each party
 Two Categories of Trade
Theories
• Country-based theories
– developed prior to World War II
– explain inter industry trade
• Firm-based theories
– developed after World War II
– emphasize the role of the MNC
– explain intra industry trade
Country-Based Theories of International
Trade
• The Theory of Absolute Advantage
• The Theory of Comparative Advantage
(involves the concept of Opportunity Cost)
• The Theory of Relative Factor Endowments
(Heckscher-Ohlin Theory or H-O Theory)
The Theory of Absolute Advantage
Country A should:
• Export those products in which A is
absolutely more productive than other
countries
• Import products for which other countries
are absolutely more productive than A
 Without Trade
• One hour of labor in France yields
2 wines or 3 radios
2W = 3R
• One hour of labor in Japan yields
1 wine or 5 radios
1W = 5R
 Determining Price
• French wine producer can get 3/2 radios for each
wine in France.
• It must get at least 1.5 radios in Japan or won’t trade.
• Japanese radio manufacturer must give up 5 radios
for one wine in Japan.
• It is happy to buy French wine so long as it gives up
no more than 5 radios.
• Trade will occur between 1.5 radios and 5 radios per
wine.
 Absolute Advantage is Flawed
• Unfortunately, theory of absolute advantage
is flawed.
• What happens if nation has an absolute
advantage in all goods?
• Absolute advantage suggests no trade takes
place.
• David Ricardo’s Theory of Comparative
Advantage (1817) proved this wrong.
 The Theory of Comparative Advantage

Country A should:
• produce and export those products in which
A is relatively more productive than other
countries
• import those products which other countries
are relatively more productive than A
 Example of the Theory of Comparative
Advantage

• Suppose France’s labor productivity is doubled, it

has an absolute advantage in both goods, as one hour
of labour can produce 4 wines or 6 radios.
• But it is relatively better in wine than in clock radios:
it’s 4 times better than Japan in wine, but only 6/5
better than Japan in clock radios
• Bottom line:France should produce wine, Japan
should produce clock radios
• The lesson: concentrate on your areas of relative
strength.
 Heckscher-Ohlin Theory of
Relative Factor Endowments
• Factor endowments vary among countries
• Goods vary in the types of factors that are
used to produce them
• Country has comparative advantage in
producing a product which intensively uses
factors of production that the country has in
abundance
 The Heckscher-Ohlin Theorem
• A country will have a comparative advantage in
producing products that intensively use its abundant
resources.
• Corollary: A country should export products in which it
has a comparative advantage (i.e., products which
intensively use the country’s abundant factors) and import
products in which it has a comparative disadvantage (i.e.,
products which intensively use the country’s scarce
factors).
• Example: If (1) country A is labor abundant and capital
scarce, and (2) textiles is a labor intensive activity and
automobiles is a capital intensive activity, then (3) the
country has a comparative advantage in textiles and
comparative disadvantage in autos, and (4) should export
textiles and import autos.
 Thus Country-Based Theories
Seemingly Flawed
• Heckscher-Ohlin theory not confirmed by
Leontief
• Don’t explain rise of MNCs
• Not consistent with intra industry trade
(why?)
Firm-Based Theories of International Trade
Can Account for Intra-Industry Trade

• Product Life Cycle Theory

• Imitation gap Theory
 Imitation gap theory

Demand lag: Difference between the time a new

product is introduced in one country & when
consumers in other country starts demanding it.
Imitation lag: Time lag between when a product is
introduced in one country & the producers of the
other country starts producing it.
In case the demand lag is shorter then the imitation lag
the trade possible between the two countries .
 3. Product Cycle

• One interesting hypothesis is that new

products pass through a series of stages in
the course of their development, and their
comparative advantage position changes as
they move through this product cycle
 New Trade Theories cont.:
3. Product Cycle continued
Domestic production
Exports,
domestic I II III IV
production
(X-M)D

Imports, Time
foreign
production
Foreign production
 Domestic production

Exports,
domestic
production
I II III IV

(X-M) D
Time

Imports,
foreign Foreign production
production

I Product development and sale in domestic market

II Growth in exports as foreign demand springs up
III Decline in exports as foreign firms begin to produce for
their home markets
IV Country becomes a net importer as foreign prices fall
 Intra industry trade

Reason for intra-industry trade

Transportation cost.
Product differentiation & firm wise
comparative advantages rather than country
wise advantage.
 Trade barriers
• 4.1 Free Trade Versus
Protectionism
• 4.2 Trade Barriers: Tariffs,
Subsidies and Quotas
• 4.3 Other Commercial Policies
 Most Common Trade Barriers
Trade barriers -obstacles to trade- take
many forms, three most common ones are:

1. Tariffs: import duty (a tax on imports)

Can also be an export duty, but that is
less common.
2. Export Subsidies:
• Government payments made to domestic
firm to encourage exports
– can also act as a barrier to trade
• Closely related to subsidies is the
practice of dumping
– Dumping takes place when a firm or an
industry sells products on the world market
at price below the cost of production
3. Quotas and Voluntary Export
Restraints (VERs):
• A limit on the quantity of imports
– Can be mandatory or voluntary, and can be
legislated or negotiated with foreign
governments
 Economics of Tariffs
• Tariffs are the most common type of
trade restriction
• A tariff requires the importer of a good
to pay a specified fraction of the world
price to the government
• By raising the domestic price of imports,
a tariff helps domestic producers but
hurts domestic consumers
 The Effect of a Tariff
Sdom Ddom & Sdom show the domestic
Price

demand and supply for a good.

If the world price is Pw,
and there is free trade,
Pw + T domestic firms supply Qs,
domestic demand is Qd
Pw and the difference is imported.
Ddom A tariff can stimulate domestic
supply and restrict imports.
Qs Qs' Qd' Qd Quantity
At a domestic price Pw + T,
where T is the size of the tariff,
quantity of domestic demand falls to Qd',
quantity of domestic supply rises to Qs' and imports
fall.
 We can summarize the effects of
tariffs:
• Consumption effect
– domestic consumers reduce their
consumption
• Production effect
– higher prices make it profitable for domestic
producers to increase their output
– thus the tariff attracts resources into the
protected industry from other sectors of the
economy
 We can summarize the effects of tariffs
continued:
• Trade effect
– the tariff causes imports to fall
• Revenue effect
– after the imposition of the tariff, the
government collects a certain amount of money
• Redistribution effect
– the tariff redistributes income from consumers
to producers
End of session