International Trade Theory

An Overview of Trade Theory

Free Trade occurs when a government does not attempt to
influence, through quotas or duties, what its citizens can buy
from another country or what they can produce and sell to
another country.
The Benefits of Trade allow a country to specialize in the
manufacture and export of products that can be produced most
efficiently in that country.
The Pattern of International Trade displays patterns that are
easy to understand (Saudi Arabia/oil or China/crawfish).
Others are not so easy to understand (Japan and cars).
The history of Trade Theory and Government Involvement
presents a mixed case for the role of government in promoting
exports and limiting imports. Later theories appear to make a
case for limited involvement.
Mercantilism: mid-16th century
A nation’s wealth depends on accumulated treasure
Gold and silver are the currency
of trade.
Theory says you should have
a trade surplus.
Maximize exports
through subsidies.
Minimize imports through tariffs
and quotas.
Flaw: “zero-sum game”.
 David Hume - 1752

Increased exports leads to inflation and higher prices.

Increased imports lead to lower prices.
Result: Country A sells less because of high prices and
Country B sells more because of lower prices.
In the long run, no one can keep a trade surplus.
 Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

Capability of one country to produce more of a product
with the same amount of input than another country.
Produce only goods where you are most efficient, trade for
those where you are not efficient.
Trade between countries is,
therefore, beneficial.
Assumes there is an
absolute advantage balance among
nations.
Ghana/cocoa.
The Theory of Absolute Advantage
G
20
15
Cocoa

A
10

Figure 4.1
K
B
5

G’ K’

0 5 10 15 20
Rice
 The Theory of Absolute Advantage
and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 20
S. Korea 40 10
Production and Consumption without Trade
Ghana 10.0 5.0
S. Korea 2.5 10.0
Total production 12.5 15.0
Production with Specialization
Ghana 20 0
S. Korea 0 20
Total production 20 20
Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice
Ghana 14.0 6.0
S. Korea 6.0 14.0
Increase in Consumption as a Result of Specialization and Trade
Ghana 4.0 1.0
S. Korea 3.5 4.0 Table 4.1
 Theory of Comparative Advantage

David Ricardo: Principles of Political Economy (1817).

Extends free trade argument
Efficiency of resource utilization leads to more
productivity.
Should import even if country is more efficient in the
product’s production than country from which it is
buying.
Look to see how much more efficient. If only
comparatively efficient, than import.
Makes better use of resources
Trade is a positive-sum game.
The Theory of Comparative Advantage
G
20

C
15
Cocoa

A
10

K Figure 4.2
5

B
2.5 K’
G’
0 3.75 5 7.5 10 15 20
Rice
Comparative Advantage and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 13.33
S. Korea 40 20
Production and Consumption without Trade
Ghana 10.0 7.5
S. Korea 2.5 5.0
Total production 12.5 12.5
Production with Specialization
Ghana 15 3.75
S. Korea 0.0 10.0
Total production 15 13.75
Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice
Ghana 11 7.75
S. Korea 4 6
Increase in Consumption as a Result of Specialization and Trade
Ghana 1.0 0.25
S. Korea 1.5 1.0 Table 4.2
Simple Extensions of the Ricardian
Model
Immobile resources:
Resources do not always move easily from one
economic activity to another.
Diminishing returns:
More a country produces, at some point, will require
more resources (diminishing returns to specialization).
Different goods use resources in different
proportions.
However:
Free trade might increase a country’s stock of
resources (as labor and capital arrives from abroad),
and
Increase the efficiency of resource utilization.
 Ghana’s PPF under Diminishing Returns

Cocoa G

Figure 4.3
G’
0 Rice
 The Influence of Free Trade on the PPF

PPF2

PPF1
Cocoa

Figure 4.4 G’

0 Rice
A Link Between Trade and Growth
Sachs and Warner: 1970 to 1990 study
Open economy developing countries grew 4.49%/year.
Closed economy developing countries grew 0.69%/year.
Open economy developed countries grew 2.29%/year.
Closed economy developed countries grew 0.74%/year.

Frankel and Romer:

On average, a one percentage point increase in the ratio
of a country’s trade to its GDP increases income/person
by at least 0.5%. For every 10% increase in the
importance of international trade in an economy, average
income levels will rise by at least 5%.
Heckscher (1919)-Olin (1933) Theory

Factor endowments: extent to which a country is

endowed with such resources as land, labor, and capital.
Export goods that intensively use factor endowments
which are locally abundant.
Corollary: import goods made from locally scarce
factors.
Patterns of trade are determined by differences in
factor endowments - not productivity.
Remember, focus on relative advantage, not absolute
advantage.
 The Leontief Paradox, 1953

Disputes Heckscher-Olin in some instances.

Factor endowments can be impacted by

government policy - minimum wage.

US tends to export labor-intensive products, but

is regarded as a capital intensive country.
 Heckscher vs Ricardo
Economists prefer Heckscher on theoretical
basis but is a relatively poor predictor of
trade patterns.

Ricardo’s Comparative Advantage Theory, is

too limited for predicting trade patterns,
actually predicts them with greater accuracy.

In the end, differences in productivity may be

the key to determining trade patterns.
 Product Life-Cycle Theory
(Raymond Vernon, 1966)

Article in the Quarterly Journal of Economics.

As products mature, both location of sales and

optimal production changes.

Affects the direction and flow of imports and

exports.

Globalization and integration of the economy

makes this theory less valid.
 The Product Life-Cycle Theory
160
140
United States production
120
100
80
60 Exports Imports consumption
40
20
0

160
140
120
Other Advanced Countries
100
80
Exports
60
40
20
0 Imports
160
140
120 Developing Countries
100
80
60 Exports
40
20
0 Imports

New Product Maturing Product Standardized Product Figure 4.5

Stages of Production Development
 The New Trade Theory
Began to be recognized in the 1970s.

Deals with the returns on specialization where substantial

economies of scale are present.
Specialization increases output, ability to enhance economies
of scale increase.

In addition to economies of scale, learning effects also

exist.
Learning effects are cost savings that come from “learning by
doing”.
Application of the New Trade Theory

Typically, requires industries with high, fixed

costs.
World demand will support few competitors.
Competitors may emerge because “they got
there first”.
First-mover advantage.
Some argue that it generates government
intervention and strategic trade policy.
 First-Mover Advantage

Economies of scale may prevent new

entrants.

Role of the government.

 Porter’s Diamond
(Harvard Business School, 1990)

The Competitive Advantage of Nations.

Looked at 100 industries in 10 nations.

Thought existing theories didn’t go far

enough.

Question: “Why does a nation achieve

international success in a particular industry?”
 Determinants of National
Competitive Advantage
Factor endowments: nation’s position in factors of
production such as skilled labor or infrastructure necessary
to compete in a given industry.
Demand conditions: the nature of home demand for the
industry’s product or service.
Related and supporting industries: the existence or absence
of supplier industries or related industries that are
nationally competitive.
Firm strategy, structure and competition: the conditions of
how companies are created, organized, and managed and the
nature of domestic competition.
 Porter’s Diamond
Determinants of National Competitive Advantage

Firm Strategy,
Structure and
Rivalry

Factor Endowments Demand Conditions

Related and
Supporting
Figure 4.6
Industries
 The Diamond

Success occurs where these features exist.

More/greater the feature, the higher chance of
success.

The diamond is mutually reinforcing.

 Determinants of
National Competitive Advantage

Chance
Company Strategy,
Structure,
and Rivalry

Two external
factors that Factor Demand
influence the Conditions Conditions
four
determinants.
Related
and Supporting
Industries
Government
 Factor Endowments
Taken from Heckscher-Olin
Basic factors:
natural resources
climate
location
demographics
Advanced factors:
communications
skilled labor
research
technology
 Advanced Factor Endowments
More likely to lead to competitive advantage.
Are the result of investment by people,
companies, government.

Relationship of Basic to Advanced

Factors
Basic can provide an initial advantage.
Must be supported by advanced factors to
maintain success.
No basics, then must invest in advanced factors.
 Demand Conditions
Demand creates the capabilities.
Look for sophisticated and demanding consumers.
impacts quality and innovation.

Related and Supporting Industries

Creates clusters of supporting industries that are
internationally competitive.
Must also meet requirements of other parts of the Diamond.

Firm Strategy, Structure and Rivalry

Management ‘ideology’ can either help or hurt you.
Presence of domestic rivalry improves a company’s
competitiveness.
 Evaluating Porter’s Theory

If Porter is right, we would expect his model

to predict the pattern of international trade
that we observe in the real world. Countries
should be exporting products from those
industries where all four components of the
diamond are favorable, while importing in
those areas where the components are not
favorable.
Too soon to tell.
 Implications for Business
Location implications:makes sense to disperse
production activities to countries where they
can be performed most efficiently.
First-mover implications:It pays to invest
substantial financial resources in building a
first-mover, or early-mover, advantage.
Policy implications:promoting free trade is
generally in the best interests of the home-
country, although not always in the best
interests of the firm. Even though, many
firms promote open markets.