Trade and Investment Theories

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

1.Interventionist Theories
MERCANTILISM
Mercantilism is a trade theory holding that a country’s wealth is
measured by its holdings of “treasure”, which usually means its gold.
This theory formed the foundation of economic thought from about
1500 to 1800.
According to the theory, countries should export more than they
import, and if successful, receive gold from countries that run deficits.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

National states were emerging during the period from 1500 to 1800,
and gold empowered central governments that invested it in armies
and national institutions.
These nation-states sought to solidify the peoples primary allegiances
to the new nation and lessen their bonds to such traditional units as
city-states, religions and guilds.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

Governmental Policies
To export more than they imported, governments imposed restrictions
on most imports and they subsidized production of many products that
could otherwise not compete in domestic or export markets.
Some countries used that colonial possessions to support this trade
objectives.
Colonies supplied many commodities that the colonizing country might
otherwise have had to purchase from a non associated country.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

Second, the colonial powers sought to run trade surpluses with their
own colonies as an way to obtain revenue.
They did this not only by monopolizing colonial trade but also by
preventing the colonies from engaging in manufacturing.
The colonies had to export less highly valued raw materials and import
more highly valued manufactured products.
Mercantilist theory was intended to benefit the colonial powers.
The imposition of regulations based on this theory caused much
discontent in colonies and was one cause of the American Revolution.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

As the influence of the mercantilist philosophy weakened after 1800,
the governments of colonial powers seldom aimed directly to limit the
development of industrial capabilities within their colonies.
However, their home based companies had technological leadership,
ownership of raw material production abroad, and usually some degree
of protection from foreign competition.
This combination continued to make colonies dependent on raw
material production and to tie their trade to their industrialized mother
countries.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

Concept of Balance of Trade:
The concept of balance of trade emerged during mercantilist era.
A favourable balance of trade indicates that a country is exporting more
than it is importing.
An unfavorable balance of trade indicates the opposite, which is known
as a deficit.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

NEOMERCANTILISM
Neomercantilism describes the approach of countries that try to run
favorable balances of trade in an attempt to achieve some social or
political objectives.
For instances, a country may try to achieve full employment by setting
economic policies that encourage its companies to produce in excess
of the demand at home and to send the surplus abroad.
Or a country may attempt to maintain political influence in an area by
sending aid or loans to a foreign government to use for the purchase of
the granting country's excess production.
Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH
2. Free Trade Theories
The two free trade theories are:
(i)Absolute advantage and
(ii) Comparative Advantage
 The theory insists that nations should neither artificially limit imports
nor promote exports.
 Both the free trade theories imply specialization.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

(i)Absolute advantage
The theory of absolute advantage was put forth by economist Adam
Smith in the year 1776.
The theory says that different countries produce some goods more
efficiently than other countries; thus global efficiency can increase
through free trade.
Smith reasoned that if trade were unrestricted, each country would
specialize in those products that gave it a competitive advantage.
Each country’s resources should shift to the efficient industries because
the country could not compete in the inefficient ones.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

Through specialization, countries could increase their efficiency
because of 3 reasons:
1. Labour could become more skilled by repeating the same tasks.
2. Labour would not lose time in switching from the production of one
kind of product to another.
3. Long production runs would provide incentives for the development
of more effective working methods.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

Smith believed that a country’s advantage would be either natural or
acquired.
a. Natural Advantage:
A country may have a natural advantage in producing a product
because of climatic conditions, access to certain natural resources, or
availability of certain labour forces.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

b. Acquired advantage:
Country’s that produce manufactured goods and services
competitively have an acquired advantage, usually in product or
process
Product advantage emerges due to superior product technology
adopted by a country to produce a unique product or one that is easily
distinguished from those of competitors.
Process advantage emerges due to process technology a country is able
to innovate and practice.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

 Both the country has 200 units of resources.
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 20
South Korea 40 10
Production and Consumption without trade by equally deploying the resources
Ghana 10 5
South Korea 2.5 10
Total Production 12.5 15
Production with Specialization by deploying all 200 units of resources in its
specialized products
Ghana 20 0
South Korea 0 20
Total Production 20 20
After consumption Ghana Trades 6 tons of Cocoa for 6 tons of South Korean Rice
Ghana 14 6
South Korea 6 14
Dr.R.K.Sudhamathi, Associate Professor,
MBA, NGPiTECH
Comparative Advantage
• In 1817, David Ricardo proposed comparative advantage theory

• According to this theory countries should:

–Specialize in the production of goods they produce most efficiently
–Buy goods that they produce less efficiently from other countries
 Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 13.33
South Korea 40 20
Production and Consumption without trade
Ghana 10 7.5
South Korea 2.5 5.0
Total Production 12.5 12.5
Production with Specialization
Ghana 15 3.75
South Korea 0 10
Total Production 15 13.75
Consumption after Ghana Trades 4 tons of Cocoa for 4 tons of South Korean Rice

Ghana 11 7.75
South Korea 4 6
Comparative Advantage
• Comparative advantage makes a number of assumptions
–Only two countries and two goods
–Zero transportation costs
–No differences in the price of resources in different countries
- Resources are mobile between goods within countries
–Constant returns to scale
–Fixed stocks of resources
–Trade has no effect on income distribution within a country
3. Trade Pattern Theories
Absolute and comparative advantage theories demonstrate only how
economic growth occurs through specialization and trade.
However, they do not deal with issues such as how much a country
will depend on trade, or what type of products countries will export
and import and with which partners countries will primarily trade.
Trade pattern theories explains all these.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

i. How much does a country trade?
Theory of country size:
The theory of country size states that large countries usually depend
less on trade than small countries.
Countries with large land areas are apt to have varies climates and an
assortment of natural resources, Making them more self-sufficient
than smaller countries.
Most of the larger countries such as Brazil, China, India, United states
and Russia import much less of their consumption needs and export
much less of their production output than the small countries like
Uruguay, Netherlands and Iceland.
Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH
Size of the Economy:
• Countries trade has also to be measured in terms of size of economy.
• A look at world’s top 10 countries involved in exports and imports
show that, these countries top in list because they produce so much
that they have more to sell.
• Also the incomes are high and people buy more from both domestic
and foreign sources.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

2. What types of products does a country trade?
(i) Heckscher–Ohlin Theory
• This theory was put forth by Eli Hecksher (1919) and Bertil Ohlin
(1933).
• They argued that comparative advantage arises from differences in
national factor endowments
• By factor endowment they mean extent to which a country is
endowed with resources like land, labour, and capital

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

• Nations have varying factor endowments and different factor endowments
explain difference in factor costs
• More abundant a factor, the lower its costs.
• The theory predicts that countries will:
 Export goods that make intensive use of those factors that are locally
abundant
 Import goods that make intensive use of factors that are locally scarce
Eg. US exports agriculture goods due to abundance of arable land.
Eg. China exports goods produced in labour intensive manufacturing
industries.
Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH
4. Product Life Cycle Theory

In 1960, Raymond Vernon, an American economist, developed an

economic theory known as the Product Life cycle theory.

The product life cycle theory of trade states that the location of
production of certain kinds of products shifts as they go through their
life cycles, which consist of 4 stages: introduction, growth, maturity and
decline.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH
INTRODUCTION STAGE
The stages of the product life cycle theory always begin with the
introduction of a new product by the developed nation in the world
market.
Considering that it is the first stage of the product life cycle, the profit
will be low, but when the demand for the product increases, the profit
will also increase simultaneously.
The producer will closely watch the market, to analyze the demand and
response for the product. As the demand for the product increased, the
profit will also increase. At this stage, there is no international trade.
Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH
GROWTH STAGE
During this stage, the demand for the product started increasing. The
sales were expanding at a higher rate.
Due to this, the cost of production decreases, and the rate of profit
increases.
Because of this mass growth, the product started gaining popularity.
At this phase, the competitors will start entering the market.
Due to the product’s popularity, the competitors will start producing
and releasing the same product with their version in the market.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

MATURITY STAGE
The 3rd stage of the product life cycle is the maturity stage.
At this stage, the product is so popular that many consumers already
own it.
The sale of the product is still there, but at a diminishing rate because
of the absence of potential customers.
At the majority stage, the original producer of the product has to spend
a lot of money to sustain their product as a market leader.
Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH
DECLINE STAGE
It is that stage where the consumer is very well versed with the product
and the producer.
The sale started declining in such a manner that neither the promotion
nor the marketing can maintain it.
The product has become very old, so, naturally, the consumer will start
losing interest in it.

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

The two options which are left with the producer are either to
discontinue the product from the market or sell their product to the
other company.
So, in this stage of the product lifecycle, the production will transfer to
the developing countries.
After transferring the product to the developing countries, the
developed countries start producing other products with unique and
different features and technology

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH

National Competitive Advantage: Porter’s
Diamond Theory

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National Competitive Advantage: Porter’s
Diamond
Factor Conditions / Factor Endowments:
• Nation’s position in factors of production necessary to compete in a
given industry Eg. Skilled labor
• Factors can be basic or advanced factors
Basic – Natural resources, location, climate, demographics
Advanced – Communication, infrastructure, sophisticated and skilled
labor, technological knowhow.

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National Competitive Advantage: Porter’s
Diamond
Demand Conditions:
• Nature of home demand for an industry’s product or service
–Influences development of capabilities
–Sophisticated and demanding customers pressure firms to be
competitive

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National Competitive Advantage: Porter’s
Diamond
Related and Supporting Industries
• Presence or absence of supplier industries and related industries that
are internationally competitive
Can spill over and contribute to other industries
Successful industries tend to be grouped in clusters in countries

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National Competitive Advantage: Porter’s
Diamond
Firm Strategy, Structure and Rivalry
• Conditions governing:
–How companies are created, organized, and managed
–Nature of domestic rivalry

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Evaluating Porter’s Theory
• Porter contends that the degree to which a nation is likely to achieve
international success in a certain industry is a function of the
combined impact of factor endowments, domestic demand
conditions, related and supporting industries and domestic rivalry.
• Presence of all four components is usually required for this diamond
to boost competitive performance.
• Porter also contends that government can influence each of the four
components of the diamond either positively or negatively.

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Evaluating Porter’s Theory
• Factor endowments can be affected by subsidies, policies towards
capital markets, policies toward education and so on.
• Government can shape domestic demand through local product
standards or with regulations that mandate or influence buyer needs.
• Government policy can influence supporting and related industries
through regulation and influence firm rivalry through such devices as
capital market regulation, tax policy and antitrust laws.

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6. Factor Mobility Theory
• Factor mobility theory of trade pattern focuses on the reasons why
production factors move, the effects that such movement has in
transforming factor endowments, and the effect of international
factor mobility(especially people) on world trade.
Why production factors move
• Capital:
• Capital especially short-term capital is the most internationally mobile
factor production factor.
• Companies and private individuals primarily transfer capital because
of differences in expected return
• People:
• People are also internationally mobile, but less so than capital.
• Of people who go abroad to work, some move permanently and some
move temporarily.
• People largely work in other countries for economic reasons.
• People also move for political reasons, eg. War dangers.
Effects of factor movements
• Factor movements alter factor endowments.
Relationship Between Trade and Factor
Mobility
• Substitution
• There are pressures for the more abundant factors to move to an area
of scarcity.
• The lowest costs occur when trade and production factors both are
mobile.
• Both finished goods and production factors are partially mobile
internationally.
• Complementarity
• Factor mobility compliments trade
• Factor mobility through foreign investment often stimulates trade
because of
The need for components.
The parent’s ability to sell complementary products.
The need for equipment for subsidiaries.
 Trade and Investment Theories

1.Interventionist 2. Free Trade 3. Trade Pattern

Theories Theories Theories

4. Product
i. Mercantilism (i)Absolute advantage and Life Cycle
ii. Neomercantilism (ii) Comparative Theory
Advantage 5. Porter
Diamond
Theory

6. Factor
Mobility
Theory
References:
• Hill, Charles W.L., Hult Thomas M. G. Rohit Mehtani (2019).
International Business: Competing in the Global Marketplace, 11/e;
New Delhi: McGraw Hill Education
• Daniels, John D and Radebaugh, Lee H et.al. (2014). International
Business: Environments and Operations, 12/e; New Delhi: Pearson
Education

Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTECH