Unit 3

Trade Theories, Trade Policy and Trade

Analytics
Theories of International Trade and Investment
Timeline of International Business Theories
Mercantilism

• Argues that the nation should maximize exports and minimize

imports.

• Today referred to as ‘neomercantilism’. Goal is to achieve and

maintain a trade surplus.

• Supporters of neomercantilism: Labor unions (to protect home-

country jobs); Farmers (to keep crop prices high); Domestic
manufacturers (who rely on exports of their products); Others

• However, mercantilism ignores the overall benefits of free trade

Absolute Advantage Principle/ Smith Theory

• Refers to the ability of a nation to produce a good more efficiently than other
nations because of its superior resources. Examples: Brazil – coffee; Saudi
Arabia – oil; Canada – hydroelectric power.
• It argues that a country should produce only those products in which it has a
clear advantage or can produce using fewer resources than another country.
Emphasizes the absolute cost of production.
• Example: Based in Brazil, Vale is the world’s largest
producer of iron ore. Vale has enough iron ore at Example:
Labor Days Required for Production
its operation in Carajás in the Brazilian Amazon
Clothing
to remain a market leader for a century. 6-5 Italy 2
Spain 6
 Comparative Advantage Principle
• Argues it is beneficial for two countries to trade even if one has absolute
advantage in the production of all products.
• What matters is not the absolute cost of production but the relative
efficiency with which it can produce the product.
• Comparative advantage rises from natural endowments, deliberate
national policies, or the collective acts of the firms in an industry.
• While often lacking the ability to produce a good more efficiently than
other nations, comparative advantage implies a country has the ability to
produce that good more efficiently than it does any other good.
Example:
Labor Days Required for Production
6-6 Clothing Shoes
Italy 2 4
Spain 6 10
 Comparative Advantage Principle (cont’d)
• Each country benefits by specializing in the goods in which it has comparative
advantages and importing those goods in which it lacks such advantages. A country
maximizes its economic success by focusing on those industries in which it has the
most comparative advantages.

• In the (fictitious) example, Italy can make both clothing and shoes cheaper than
Spain, but it’s still beneficial for Italy to trade with Spain.

• The key is the ratio of production costs. Italy is comparatively more efficient in clothing
than shoes, and produces three times more clothing than Spain (6/2), but only 1.5
times as much shoes (10/4)
Example:
Labor Days Required for Production
6-7
• Italy should specialize in clothing, Spain should specialize
Clothing Shoes
in shoes, and the two countries should trade Italy 2 4
with each other. Spain 6 10
 Comparative Advantage Principle (cont’d)
• Applies to all goods and services.
• It is the foundation principle of international trade. It provides the main justification for
engaging in global trade.
• It supports global sustainability, because it shows how countries can use scarce resources
efficiently through international trade.

Example
• While Japan is good at making cars and smartphones, it is especially good at making
cars. Thus, Japan concentrates its resources on making cars.
• Other countries, such as China and South Korea, focus
on making smartphones.
• In this way, Japan makes maximal use of its resources,
and the world gets superior automobiles.
 Competitive Advantage
• The distinctive assets, competencies, and capabilities that a
company develops or acquires, especially relative to its competitors.
• Explains how companies gain and maintain distinctive competencies,
relative to competitors, that support superior performance.
• The collective competitive advantages held by the firms in a country
provide the basis for national competitive advantage.
• Examples:
-- Dell’s strengths in managing global supply chains.
-- Unilever’s abilities in distribution and international marketing.
-- Samsung’s technological capabilities in 6-9developing and producing
9

flat-panel TVs.
 Heckscher- Ohlin Theory
Assumptions:
(a) There are two countries involved. For the sake of theoretical modelling,
it is assumed that the trade is happening between two countries.
(b) Each country has two factors (labour and capital). This is an extension of
the classical theories, which considered labour as the only factor.
(c) Each country produce two commodities or goods. These can be labour
intensive and capital intensive.
(d) There is perfect competition in both commodity and factor markets.
Perfect competition leads to fair prize mechanism and normal profits for all
the players.
(e) All production functions are homogeneous of the first degree i.e.
production function is subject to constant returns to scale.
(f) Factors are freely mobile within a country but immobile between
countries, i.e. labour and capital can be utilized within the countries.
(g) Two countries differ in factor supply.
(h) Each commodity differs in factor intensity.
(i) The production function remains the same in different countries for
the same commodity. For e.g. If commodity A requires more capital in
one country then same is the case in other country.
(j) There is full employment of resources in both countries and demand
are identical in both countries.
(k) Trade is free i.e. there are no trade restrictions in the form of tariffs
or non-tariff barriers.
(l) There are no transportation costs.
Limitations:
1. Unrealistic Assumptions
2. Restrictive
3. One sided theory
4. Static in nature
5. Consumer’s Demand ignored
6. Other factors neglected
 Michael Porter’s Diamond Model (1 of 3)
Firm Strategy,
Structure and
Rivalry

Factor Demand
Conditions Conditions

Related and
Supporting
Industries
Source: Michael E. Porter (1990), The Competitive Advantage of Nations, New York: Free Press
 Diamond Model (2 of 3)
• Demand conditions at home – the strengths and sophistication of
consumer demand in an industry or country. E.g., South Korea is a long-
standing seafaring country surrounded by water. It is home to very
demanding consumers. Collectively, these conditions have led the
country to become a leading producer of superior boats and boating
accessories.
• Related and supporting industries – the existence in a given area of
suppliers, competitors, and complementary firms that excel in a given
industry. E.g., the area around Portland, Oregon is a great place to
launch a footwear company, because it is home to thousands of
knowledgeable workers and many firm in the footwear industry (e.g.,
Nike, Adidas, Keen).
 Diamond Model (3 of 3)
• Factor conditions – Quantity and quality of labor, natural
resources, capital, technology, know-how, entrepreneurship, and
other factors of production in a country or an industry. E.g.,
abundant low-cost and educated workers give China an advantage
in manufacturing home appliances.
• Firm strategy, structure, and rivalry – The nature of domestic
rivalry, and conditions that determine how a nation’s firms are
created, organized, and managed. E.g., France has many top firms
in fashion industries, such as cosmetics, clothing, and accessories.
Intense competition continuously pressures these firms to innovate,
helping make France a world leader in the fashion industry.