International Economic TheoriesDocument Transcript
INTERNATIONAL ECONOMIC THEORIES
AND APPLICATION IN INTERNATIONAL
1 An overview of international
3 Theory of Absolute
4 Theory of Comparative
5 Competitive Theory -
7 Product Life Cycle Theory
8 New Trade Theory
An overview of international trade theory
International trade is exchange of capital, goods, and services across
international borders or territories. In most countries, it represents a
significant share of gross domestic product (GDP). While international trade
has been present throughout much of history, its economic, social, and
political importance has been on the rise in recent centuries.
Industrialization, advanced transportation, globalization, multinational
corporations, and outsourcing are all having a major impact on the
international trade system. Increasing international trade is crucial to the
continuance of globalization. International trade is a major source of
economic revenue for any nation that is considered a world power. Without
international trade, nations would be limited to the goods and services
produced within their own borders.
International trade is in principle not different from domestic trade as the
motivation and the behaviour of parties involved in a trade does not change
fundamentally depending on whether trade is across a border or not. The
main difference is that international trade is typically more costly than
domestic trade. The reason is that a border typically imposes additional costs
such as tariffs, time costs due to border delays and costs associated with
country differences such as language, the legal system or a different culture.
International trade uses a variety of currencies, the most important of
which are held as foreign reserves by governments and central banks. Here
the percentage of global cumulative reserves held for each currency between
1995 and 2005 are shown: the US dollar is the most sought-after currency,
with the Euro in strong demand as well.
Another difference between domestic and international trade is that factors
of production such as capital and labour are typically more mobile within a
country than across countries. Thus international trade is mostly restricted to
trade in goods and services, and only to a lesser extent to trade in capital,
labour or other factors of production. Then trade in good and services can
serve as a substitute for trade in factors of production. Instead of importing
the factor of production a country can import goods that make intensive use
of the factor of production and are thus embodying the respective factor. An
example is the import of labour-intensive goods by the United States from
China. Instead of importing Chinese labour the United States is importing
goods from China that were produced with Chinese labour. International
trade is also a branch of economics, which, together with international
finance, forms the larger branch of international economics.
Free trade is a type of trade policy that permits trading partners’ mutual
gains from trade as a function of the law of comparative advantage. Under a
free trade policy, prices are a reflection of true supply and demand, and are
the sole determinant of resource allocation. Free trade differs from other
forms of trade policy where the allocation of goods and services amongst
trading countries are determined by artificial prices that do not reflect the
true nature of supply and demand. These artificial prices are the result of
protectionist trade policies, whereby governments intervene in the market
through price adjustments and supply restrictions. Such government
interventions generally increase the cost of goods and services to both
consumers and producers. Interventions include subsidies, taxes and tariffs,
non-tariff barriers, such as regulatory legislation and quotas, and even inter-
government managed trade agreements such as the North American Free
Trade Agreement (NAFTA) and Central America Free Trade Agreement
(CAFTA) (contrary to their formal titles.)- Any governmental market
intervention resulting in artificial prices that do not reflect the principles of
supply and demand. Most states conduct trade polices that are to a lesser or
greater degree protectionist. One ubiquitous protectionist policy employed by
states comes in the form agricultural subsidies whereby countries attempt to
protect their agricultural industries from outside competition by creating
artificial low prices for their agricultural goods.
Why do nations trade what they do? Is trade a good thing? The theory of
International trade provides answers. The answers are both convincing and
elegant, hence the vast majority of economists agree about the desirability of
liberal trade. But the argument is also subtle and often misunderstood or
distorted. Thus a large proportion of the general population tends to oppose
liberal trade from confusion. This essay will attempt to convey why the
answers convince most economists and why their liberal trade position is so
often misunderstood. The essay’s focus is theory, but theory convinces when
it succeeds in fitting the data. Thus passing reference will be made to
empirical findings, a sensibility much more thoroughly developed in the
graduate textbook of Feenstra (2003).
“Buy low, sell high” logic leads economists to comparative advantage
theory. Comparative advantage means the comparison of relative price
differences between nations to explain the pattern of trade. For example,
compare the relative price of wheat in terms of cheese at home to the same
relative price in the foreign economy in a hypothetical equilibrium with no
trade (autarky) or with restricted trade. The country with the lower relative
price of wheat is said to have a comparative advantage in wheat while the
other country has, symmetrically, a comparative advantage in cheese. Buy
low, sell high logic predicts that a country will export the good in which it
has a comparative advantage.
Notice that the focus on relative prices tends to cancel out forces
(exchange rate manipulations, environmental or labor standards) which cause
national differences in levels of nontraded factor (or goods) prices. Note also
that by this reasoning a country must have a comparative advantage in some
good. Prices of nontraded factors of production adjust in general equilibrium
so that each country ends up in the trade equilibrium with a competitive or
absolute cost advantage in the good in which it has a comparative advantage.
Partial equilibrium thinking takes factor prices as given and does not impose
the external budget constraint that requires exports to pay for imports. Partial
equilibrium reasoning leads to misunderstandings explored below as the case
of many goods, the prediction is that a country will on average export goods
which are relatively cheap in the absence of trade and import goods which
are relatively expensive in the absence of trade. The prediction is about
correlation. Bernhofen and Brown (2005) show that Japan’s opening to
trade in the 1850’s reveals data consistent with the prediction.
Comparative advantage differences between nations are explained by
exogenous differences in national characteristics. Labor differs in its
productivity internationally and different goods have different labor
requirements, so comparative labor productivity advantage was Ricardo’s
predictor of trade patterns. Ricardian trade theory is useful in its simplicity
and even rather loosely confirmed by empirical evidence. The factor
proportions theory added relative factor endowment differences to the
exogenous explanation of comparative advantage (Jones, 1987). More capital
abundant countries have higher labor productivity, but the advantage gained
relative to the less abundant countries varies with the relative capital
intensity of the good’s technology. Combining technology and endowment
differences appears to account well for actual trade patterns (Davis and
Trade theory also encompasses endogenous differences between countries.
One focus is on economies of scale. The wider market due to trade induces a
cost advantage in an industry in one of the countries. Another theory is based
on monopolistic competition, whereby the wider markets due to trade
increase product variety as buyers seek the special characteristics of foreign
brands. Differentiated products trade flows both ways within product
Trade costs also shape the pattern of trade. The economic theory of
gravity explains the complex bilateral trade patterns among countries.
Actual trade is much lower than gravity predicts in a frictionless world,
providing evidence of trade costs much larger than those due to policy or
transportation. The costs are well explained by geography and a set of
national differences. The stability of the relationships over time suggests that
these costs change slowly. There are gains from trade in all these models.
But the division of the gains will be uneven and there will be losers.
Distribution matters in two ways, between and within nations.
Internationally, with only mild qualifications, gains are shared between
nations: some trade is better than none. Each nation can act through trade
policy to take more of the gain, however, leading to destructive trade wars
with mutual losses. Within national economies, there are gains on average
but there are ordinarily losers. National institutions act to redistribute some
of the gains (U.S. Trade Adjustment Assistance) or provide temporary relief
from losses due to trade (escape clause protection), at the cost of lowering
the overall gain from trade.
The topics of this outline are developed below in more detail.
Mercantilism is an economic theory that holds that the prosperity of a
nation is dependent upon its supply of capital, and that the global volume of
international trade is "unchangeable". Economic assets or capital, are
represented by bullion (gold, silver, and trade value) held by the state, which
is best increased through a positive balance of trade with other nations
(exports minus imports). Mercantilism suggests that the ruling government
should advance these goals by playing a protectionist role in the economy;
by encouraging exports and discouraging imports, notably through the use of
tariffs and subsidies.
Mercantilism was the dominant school of thought throughout the early
modern period (from the 16th to the 18th century). Domestically, this led to
some of the first instances of significant government intervention and control
over the economy, and it was during this period that much of the modern
capitalist system was established. Internationally, mercantilism encouraged
the many European wars of the period and fuelled European imperialism.
Belief in mercantilism began to fade in the late 18th century, as the
arguments of Adam Smith and the other classical economists won out.
Today, mercantilism (as a whole) is rejected by economists, though some
elements are looked upon favourably by non-economists.
The Austrian lawyer and scholar Philipp Wilhelm von Hornick, in his
Austria Over All, If She Only Will of 1684, detailed a nine-point program of
what he deemed effective national economy, which sums up the tenets of
• That every inch of a country's soil be utilized for agriculture, mining
• That all raw materials found in a country be used in domestic
manufacture, since finished goods have a higher value than raw
• That a large, working population be encouraged.
• That all export of gold and silver be prohibited and all domestic
money be kept in circulation.
• That all imports of foreign goods be discouraged as much as possible.
• That where certain imports are indispensable they be obtained at first
hand, in exchange for other domestic goods instead of gold and
• That as much as possible, imports be confined to raw materials that
can be finished [in the home country].
• That opportunities be constantly sought for selling a country's surplus
manufactures to foreigners, so far as necessary, for gold and silver.
• That no importation be allowed if such foods are sufficiently and
suitably supplied at home.
In spite of Adam Smith's repudiation of mercantilism, it was favoured in
the United States by such prominent figures as Alexander Hamilton, Henry
Clay, Henry Charles Carey, and Abraham Lincoln and in Britain by such
figures as Thomas Malthus. When Britain passed its Corn Laws in 1815,
Malthus thought such restrictions were a good idea, but Ricardo disagreed.
Eventually Smith's view was accepted in the English-speaking world, and in
1849 the corn laws were repealed largely on "Free Market" arguments given
by Sir Robert Peel.
Adam Smith rejected the mercantilist focus on production, arguing that
consumption was the only way to grow an economy. Keynes argued that
encouraging production was just as important as consumption. Keynes also
noted that in the early modern period the focus on the bullion supplies was
reasonable. In an era before paper money, an increase for bullion was one of
the few ways to increase the money supply. Keynes and other economists of
the period also realized the balance of payments is an important concern.
Since the 1930s, all nations have closely monitored the inflow and outflow
of capital, and most economists agree that a favourable balance of trade is
desirable. Keynes also adopted the essential idea of mercantilism that
government intervention in the economy is a necessity. While Keynes'
economic theories have had a major impact, few have accepted his effort to
rehabilitate the word mercantilism. Today the word remains a pejorative
term, often used to attack various forms of protectionism. The similarities
between Keynesianism, and its successor ideas, with mercantilism have
sometimes led critics to call them neo-mercantilism. Some other systems that
do copy several mercantilist policies, such as Japan's economic system, are
also sometimes called neo-mercantilist. In an essay appearing in the 14 May
2007 issue of Newsweek, economist Robert J. Samuelson argued that China
was pursuing an essentially mercantilist trade policy that threatened to
undermine the post-World War II international economic structure.
The Austrian School of economics, always an opponent of mercantilism,
describes it this way:
“ Mercantilism, which reached its height in the Europe of the
seventeenth and eighteenth centuries, was a system of statism which
employed economic fallacy to build up a structure of imperial state
power, as well as special subsidy and monopolistic privilege to
individuals or groups favoured by the state. Thus, mercantilism held
exports should be encouraged by the government and imports
One area Smith was reversed on well before Keynes was in the use of data.
Mercantilists, who were generally merchants or government officials,
gathered vast amounts of trade data and used it considerably in their research
and writing. William Petty, a strong mercantilist, is generally credited with
being the first to use empirical analysis to study the economy. Smith rejected
this, arguing that deductive reasoning from base principles was the proper
method to discover economic truths. Today, many schools of economics
accept that both methods are important, the Austrian School being a notable
In specific instances, protectionist mercantilist policies also had an important
and positive impact on the state that enacted them. Adam Smith himself, for
instance, praised the Navigation Acts as they greatly expanded the British
merchant fleet, and played a central role in turning Britain into the naval and
economic superpower that it was for several centuries. Some economists thus
feel that protecting infant industries, while causing short term harm, can be
beneficial in the long term.
Nonetheless, The Wealth of Nations had a profound impact on the end of the
mercantilist era and the later adoption of free market policy. By 1860,
England removed the last vestiges of the mercantile era. Industrial
regulations, monopolies and tariffs were withdrawn
ABSOLUTE ADVANTAGE THEORY
In economics, Absolute advantage refers to the ability of a particular person
or a country to produce a particular good with fewer resources than another
person or country. Absolute advantage is the ability to produce more of a
given product using a given amount of resources. It can be contrasted with
the concept of comparative advantage which refers to the ability to produce a
particular good at a lower opportunity cost.
The idea of absolute advantage is generally attributed to Adam Smith, while
"the principle of comparative advantage", is generally attributed to David
Ricardo in his 1817 Principles of Political Economy and Taxation. While
there are possible gains from trade with absolute advantage, comparative
advantage extends the range of possible mutually beneficial exchanges. In
other words it is not necessary to have an absolute advantage to gain from
trade, only a comparative advantage.
• Producing a good with fewer inputs (capital, labor, land, raw materials, etc.) per
unit of output than other countries
• If input prices are the same in two countries, the country with an absolute
advantage in a good will have a lower unit cost of production for that good
• A country should produce and export products in which it has an absolute
• A country should import products in which it has an disadvantage
The two concepts have applications outside international trade, though this is
where they are most commonly used. Suppose that two castaways on a
desert island gather both fruit and grain, which they then share equally
between them. Suppose that Castaway A can gather more fruit per hour than
Castaway B, and therefore has an absolute advantage in this good.
Nonetheless, it may well make sense for A to leave some fruit-gathering to B.
This is because it is possible that B gathers fruit slightly slower than A, but
gathers grain extremely slowly. One needs to look at comparative advantage
rather than absolute advantage, to discover how A and B can each best
allocate their effort. If A's initial advantage over B in grain-gathering is
greater than his or her advantage in fruit-gathering, then fruit-effort should
be transferred from A to B, to the point where A's comparative advantages in
the two goods are equal. Thus it may be rational for fruit to flow from B to
A, despite A's absolute advantage.
Examples of Absolute Advantage
Country A can produce one widget using one unit of labour.
Country B can produce one widget using two units of labour.
Country A has an absolute advantage over Country B in producing widgets.
Country A has 100 units of labour. It uses 20 to produce 80 units of
Parachutes, and 80 to produce 20 units of Barbie dolls. Country B has 100
units of labour. It uses 40 to produce 100 units of Barbie dolls, and 60 to
produce 20 units of Parachutes.
If the countries maximized their potential, Country A could produce 400
units of Parachutes, and country B could produce 250 units of Barbie dolls.
Through trade, the two countries would achieve a more efficient allocation of
resources and increase their prosperity.
A country has an absolute advantage over another in producing a good, if it
can produce that good using fewer resources than another country. For
example if one unit of labour in Scotland can produce 80 units of wool or 20
units of wine; while in Spain one unit of labour makes 50 units of wool or 75
units of wine, then Scotland has an absolute advantage in producing wool
and Spain has an absolute advantage in producing wine. Scotland can get
more wine with its labour by specializing in wool and trading the wool for
Spanish wine, while Spain can benefit by trading wine for wool.’ The
benefits to nations from trading are the same as to individuals: trade permits
specialization, which allows resources to be used more productively...
You and your friends decided to help with fundraising for a local charity
group by printing t-shirts and making birdhouses.
• Scenario 1: One of your friends, Gina, can print 5 t-shirts or build 3
birdhouses an hour. Your other friend, Mike, can print 3 t-shirts an
hour or build 2 birdhouses an hour. Because your friend Gina is more
productive at printing t-shirts and building birdhouses compared to
Mike, she has an absolute advantage in both printing t-shirts and
• Scenario 2: Suppose Gina wasn't as agile with the hammer and could
only make 1 birdhouse an hour, but she took a sewing class and could
print 10 t-shirts an hour. Mike on the other hand takes woodworking
and so he can build 5 birdhouses an hour, but he doesn't know the
first thing about making t-shirts so he can only print 2 t-shirts an
hour. While Gina would have the absolute advantage in printing
shirts, Mike would have an absolute advantage in building
COMPARITIVE ADVANTAGE THEORY
In economics, comparative advantage refers to the ability of a person or a
country to produce a particular good at a lower opportunity cost than another
person or country. It is the ability to produce a product most efficiently given
all the other products that could be produced.  It can be contrasted with
absolute advantage which refers to the ability of a person or a country to
produce a particular good at a lower absolute cost than another.
Comparative advantage explains how trade can create value for both parties
even when one can produce all goods with fewer resources than the other.
The net benefits of such an outcome are called gains from trade.
Origins of the theory
Comparative advantage was first described by Robert Torrens in 1815 in an
essay on the Corn Laws. He concluded it was England's advantage to trade
with Poland in return for grain, even though it might be possible to produce
that grain more cheaply in England than Poland.
However the term is usually attributed to David Ricardo who explained it in
his 1817 book On the Principles of Political Economy and Taxation in an
example involving England and Portugal. In Portugal it is possible to
produce both wine and cloth with less labour than it would take to produce
the same quantities in England. However the relative costs of producing
those two goods are different in the two countries. In England it is very hard
to produce wine, and only moderately difficult to produce cloth. In Portugal
both are easy to produce. Therefore while it is cheaper to produce cloth in
Portugal than England, it is cheaper still for Portugal to produce excess wine,
and trade that for English cloth. Conversely England benefits from this trade
because its cost for producing cloth has not changed but it can now get wine
at a lower price, closer to the cost of cloth. The conclusion drawn is that each
country can gain by specializing in the good that it has comparative
advantage in and trading that good for the other.
Assumption underlying comparative
1. No transportation cost
2. Common opportunity cost and no economies of scale
3. Homogeneous goods
4. No trade barriers
5. Perfect mobility of resources
The following hypothetical examples explain the reasoning behind the
theory. In Example 2 all assumptions are italicized for easy reference, and
some are explained at the end of the example.
Comparative advantage then the young man will specialize in tasks at which
he is most productive, while the older man will concentrate on tasks where
his productivity is only a little less than that of a young man. Such an
arrangement will increase total production for a given amount of labour
supplied by both men and it will make both of them richer.
Suppose there are two countries of equal size, Northland and Southland
that both produce and consume two goods, Food and Clothes. The
productive capacities and efficiencies of the countries are such that if both
countries devoted all their resources to Food production, output would be as
• Northland: 100 tonnes
• Southland: 400 tonnes
If all the resources of the countries were allocated to the production of
clothes, output would be:
• Northland: 100 tonnes
• Southland: 200 tonnes
Assuming each has constant opportunity costs of production between the
two products and both economies have full employment at all times. All
factors of production are mobile within the countries between clothing and
food industries, but are immobile between the countries. The price
mechanism must be working to provide perfect competition.
Southland has an absolute advantage over Northland in the production of
Food and Clothing. There seems to be no mutual benefit in trade between the
economies, as Southland is more efficient at producing both products. The
opportunity costs shows otherwise. Northland's opportunity cost of
producing one tonne of Food is one tonne of Clothes and vice versa.
Southland's opportunity cost of one tonne of Food is 0.5 tonne of Clothes.
The opportunity cost of one tonne of Clothes is 2 tonnes of Food. Southland
has a comparative advantage in food production, because of its lower
opportunity cost of production with respect to Northland. Northland has a
comparative advantage over Southland in the production of clothes, the
opportunity cost of which is higher in Southland with respect to Food than in
To show these different opportunity costs lead to mutual benefit if the
countries specialize production and trade, consider the countries produce and
consume only domestically. The volumes are:
Production and consumption before trade
Northland 50 50
Southland 200 100
TOTAL 250 150
This example includes no formulation of the preferences of consumers in the
two economies which would allow the determination of the international
exchange rate of Clothes and Food. Given the production capabilities of each
country, in order for trade to be worthwhile Northland requires a price of at
least one tonne of Food in exchange for one tonne of Clothes; and Southland
requires at least one tonne of Clothes for two tonnes of Food. The exchange
price will be somewhere between the two. The remainder of the example
works with an international trading price of one tonne of Food for 2/3 tonne
If both specialize in the goods in which they have comparative advantage,
their outputs will be:
Production after trade
Northland 0 100
Southland 300 50
TOTAL 300 150
World production of food increased. Clothing production remained the same.
Using the exchange rate of one tonne of Food for 2/3 tonne of Clothes,
Northland and Southland are able to trade to yield the following level of
Consumption after trade
Northland 75 50
Southland 225 100
World total 300 150
Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both
benefited, and now consume at points outside their production possibility
Assumptions in Example 2
• Two countries, two goods - the theory is no different for larger
numbers of countries and goods, but the principles are clearer and the
argument easier to follow in this simpler case.
• Equal size economies - again, this is a simplification to produce a
• Full employment - if one or other of the economies has less than full
employment of factors of production, then this excess capacity must
usually be used up before the comparative advantage reasoning can
• Constant opportunity costs - a more realistic treatment of
opportunity costs the reasoning is broadly the same, but
specialization of production can only be taken to the point at which
the opportunity costs in the two countries become equal. This does
not invalidate the principles of comparative advantage, but it does
limit the magnitude of the benefit.
• Perfect mobility of factors of production within countries - this is
necessary to allow production to be switched without cost. In real
economies this cost will be incurred: capital will be tied up in plant
(sewing machines are not sowing machines) and labour will need to
be retrained and relocated. This is why it is sometimes argued that
'nascent industries' should be protected from fully liberalised
During the period in which a high cost of entry into the market
(capital equipment, training) is being paid for.
• Immobility of factors of production between countries - why are
there different rates of productivity? The modern version of
comparative advantage (developed in the early twentieth century by
the Swedish economists Eli Heckscher and Bertil Ohlin) attributes
these differences to differences in nations' factor endowments. A
nation will have comparative advantage in producing the good that
uses intensively the factor it produces abundantly. For example:
suppose the US has a relative abundance of capital and India has a
relative abundance of labour.
Further those cars are capital intensive to produce, while cloth is labour
intensive. Then the US will have a comparative advantage in making
cars, and India will have a comparative advantage in making cloth. If
there is international factor mobility this can change nations' relative
factor abundance. The principle of comparative advantage still applies,
but who has the advantage in what can change.
• Negligible Transport Cost - Cost is not a cause of concern when
countries decided to trade. It is ignored and not factored in.
• Assume that half the resources are used to produce each good in
each country. This takes place before specialization
• Perfect competition - this is a standard assumption that allows
perfectly efficient allocation of productive resources in an idealized
The economist Paul Samuelson provided another well known example in his
Economics. Suppose that in a particular city the best lawyer happens also to
be the best secretary, that is he would be the most productive lawyer and he
would also be the best secretary in town. However, if this lawyer focused on
the task of being an attorney and instead of pursuing both occupations at
once, employed a secretary, both the output of the lawyer and the secretary
Flaw in theory
The flaw in the theory, as demonstrated by this example, can be shown by
the fact that the individual chose to be a lawyer and not a secretary. He could
have chosen to be a secretary, employed by a less talented lawyer, but he did
not choose this latter option. This is because being a lawyer is more
profitable than being a secretary. Extending this to the global economy, there
are advanced and highly profitable products and primitive and less profitable
ones. Countries that produce the primitive and less profitable product are
impoverished and lack global power. Thus no country wants to produce the
less profitable product, and so they engage in a trade war as they compete to
produce the most profitable products. For example, the competition between
Europe's Airbus and America's Boeing over the profitable passenger jet
Flaw in Argument - Many countries may want to produce the less profitable
product, as it may increase employment levels. It takes time to go from
subsistence farming to producing commercial jets and producing cheaper
goods is a rung on the ladder of prosperity. No country would want to
produce the less profitable product only if there was no demand for such
product or the profit was not economically feasible, even with cheaper
Effects on the economy
Conditions that maximize comparative advantage do not automatically
resolve trade deficits. In fact, in many real world examples where
comparative advantage is attainable may in fact require a trade deficit. For
example, the amount of goods produced can be maximized, yet it may
involve a net transfer of wealth from one country to the other, often because
economic agents have widely different rates of saving.
As the markets change over time, the ratio of goods produced by one country
versus another variously changes while maintaining the benefits of
comparative advantage. This can cause national currencies to accumulate
into bank deposits in foreign countries where a separate currency is used.
Macroeconomic monetary policy is often adapted to address the depletion of
a nation's currency from domestic hands by the issuance of more money,
leading to a wide range of historical successes and failures. These effects of
comparative advantage in particular are an underlying influence leading to
imbalances that epitomize some of the recent financial crises. The Global
financial crisis of 2008–2009 is no exception.
What determines comparative advantage?
Comparative advantage is a dynamic concept. It can and does change over
time. Some businesses find they have enjoyed a comparative advantage in
one product for several years only to face increasing competition as rival
producers from other countries enter their markets.
For a country, the following factors are important in determining the relative
costs of production:
• The quantity and quality of factors of production available (e.g.
the size and efficiency of the available labour force and the
productivity of the existing stock of capital inputs). If an economy
can improve the quality of its labour force and increase the stock of
capital available it can expand the productive potential in industries
in which it has an advantage.
• Investment in research & development (important in industries
where patents give some firms significant market advantage) - for
more information on this have a look at this page
• Movements in the exchange rate. An appreciation of the exchange
rate can cause exports from a country to increase in price. This makes
them less competitive in international markets.
• Long-term rates of inflation compared to other countries. For
example if average inflation in Country X is 4% whilst in Country B
it is 8% over a number of years, the goods and services produced by
Country X will become relatively more expensive over time. This
worsens their competitiveness and causes a switch in comparative
• Import controls such as tariffs and quotas that can be used to
create an artificial comparative advantage for a country's domestic
producers- although most countries agree to abide by international
• Non-price competitiveness of producers (e.g. product design,
reliability, quality of after-sales support)
COMPETITIVE ADVANTAGE THEORY
Competitive advantage is a position a firm occupies against its competitors.
According to Michael Porter, the three methods for creating a sustainable
competitive advantage are through cost leadership, differentiation or focus.
Cost advantage occurs when a firm delivers the same services as its
competitors but at a lower cost. Differentiation advantage occurs when a firm
delivers greater services for the same price of its competitors. They are
collectively known as positional advantages because they denote the firm's
position in its industry as a leader in either superior services or cost.
Many forms of competitive advantage cannot be sustained indefinitely
because the promise of economic rents invites competitors to duplicate the
competitive advantage held by any one firm.
A firm possesses a sustainable competitive advantage when its value-
creating processes and position have not been able to be duplicated or
imitated by other firms,. Sustainable competitive advantage results,
according to the resource-based view theory in the creation of above-normal
(or supranormal) rents in the long run.
Analysis of competitive advantage is the subject of numerous theories of
strategy, including the five forces model pioneered by Michael Porter of the
Harvard Business School.
The primary factors of competitive advantage are innovation, reputation and
Porter's Strategic Theory
The context within which SIS theory emerged was the competitive strategy
framework put forward by Porter (1980, 1985), which was based on
industrial organisation economics. For developments along that path, see
Kaufmann 1966, Kantrow 1980, Pyburn 1981, Parsons 1983, EDP Analyzer
1984a, 1984b, McFarlan 1984, Benjamin et al 1984, Wiseman & Macmillan
1984, Ives & Learmonth 1984, Cash & Konsynski 1985, Porter & Millar
1985, Keen 1986, King 1986). Strategic information systems theory will then
be shown to be concerned with the use of information technology to support
or sharpen an enterprise's competitive strategy.
Competitive strategy is an enterprise's plan for achieving sustainable
competitive advantage over, or reducing the edge of, its adversaries. In
Porter's view, the performance of individual corporations is determined by
the extent to which they cope with, and manipulate, the five key 'forces'
which make up the industry structure:
• the bargaining power of suppliers;
• the bargaining power of buyer;
• the threat of new entrants;
• the threat of substitute products; and
• rivalry among existing firms.
There are two basic strategic stances that enterprises can adopt:
• low cost; and
• Product differentiation.
In the long run, firms succeed relative to their competitors if they possess
sustainable competitive advantage in either of these two, subject to reaching
some threshold of adequacy in the other. Somogyi & Galliers (1987)
provide examples of applications of information technology which are
consistent with these two strategic stances, mapped against the particular
enterprise activities to which they contribute.
Another important consideration in positioning is 'competitive scope', or the
breadth of the enterprise's target markets within its industry, i.e. the range of
product varieties it offers, the distribution channels it employs, the types of
buyers it serves, the geographic areas in which it sells, and the array of
related industries in which it competes.
Under Porter's framework, enterprises have four generic strategies available
to them whereby they can attain above-average performance. They are:
• cost leadership;
• cost focus; and
• Focused differentiation.
According to Porter, competitive advantage grows out of the way an
enterprise organises and performs discrete activities. The operations of any
enterprise can be divided into a series of activities such as salespeople
making sales calls, service technicians performing repairs, scientists in the
laboratory designing products or processes, and treasurers raising capital.
By performing these activities, enterprises create value for their customers.
The ultimate value an enterprise creates is measured by the amount
customers are willing to pay for its product or services. A firm is profitable if
this value exceeds the collective cost of performing all of the required
activities. To gain competitive advantage over its rivals, a firm must either
provide comparable value to the customer, but perform activities more
efficiently than its competitors (lower cost), or perform activities in a unique
way that creates greater buyer value and commands a premium price
Porter’s Four Generic Strategies (Porters1980)
Many differentiation bases exist, classified into four major groups (Borden
1964, quoted in Wiseman 1988):
• product (quality, features, options, style, brand name, packaging,
sizes, services, warranties, returns);
• price (list, discounts, allowances, payment period, credit terms);
• place (channels, coverage, locations, inventory, transport); and
• Promotion (advertising, personal selling, sales promotion, publicity).
Porter studied 100 industries in 10 nations
• postulated determinants of competitive advantage of a nation based on
four major attributes
• Factor endowments:- A nation’s position in factors of production such
as skilled labor or infrastructure necessary to compete in a given industry
1. Basic factor endowments
Basic factors: Factors present in a country
• Natural resources
• Geographic location
While basic factors can provide an initial advantage they must be
supported by advanced factors to maintain success
2. Advanced factor endowments
Advanced factors: Are the result of investment by people, companies,
government and are more likely to lead to competitive advantage. If a
country has no basic factors, it must invest in advanced factors
• Skilled labor
3. Demand conditions
• Creates capabilities
• Creates sophisticated and demanding
• consumers Demand impacts quality and innovation
4. Related and supporting industries
• Creates clusters of supporting industries that are internationally
• Must also meet requirements of other parts of the Country
5. Firm strategy, structure and rivalry
• Long term corporate vision is a determinant of success
• Management ‘ideology’ and structure of the firm can either
help or hurt you
• Presence of domestic rivalry improves a company’s
The product life-cycle theory is an economic theory that was developed by
Raymond Vernon in response to the failure of the Heckscher-Ohlin model to
explain the observed pattern of international trade. The theory suggests that
early in a product's life-cycle all the parts and labor associated with that
product come from the area in which it was invented. After the product
becomes adopted and used in the world markets, production gradually moves
away from the point of origin. In some situations, the product becomes an
item that is imported by its original country of invention. A commonly
used example of this is the invention, growth and production of the personal
computer with respect to the United States.
The model applies to labor-saving and capital using products that (at least at
first) cater to high-income groups.
3 stages: New product stage: The product is produced and consumed in the
US. No trade takes place. Maturing product stage: mass-production
techniques are developed and foreign demand (in developed countries)
expands. At this stage the US exports the product to other developed
countries. Standardized product stage: Production moves to developing
countries, which then export the product to developed countries.
The model demonstrates dynamic comparative advantage. The country that
has the comparative advantage in the production of the product changes from
the innovating (developed) country to the developing countries.
There are four stages in a product's life cycle:
The location of production depends on the stage of the cycle.
This is the stage where a product is conceptualized and first brought to
market. The goal of any new product introduction is to meet consumer's
needs with a quality product at the lowest possible cost in order to return the
highest level of profit. The introduction of a new product can be broken
down into five distinct parts:
• Idea validation, which is when a company studies a market, looks for
areas where needs are not being met by current products, and tries to
think of new products that could meet that need. The company's
marketing department is responsible for identifying market
opportunities and defining who will buy the product, what the
primary benefits of the product will be, and how the product will be
• Conceptual design occurs when an idea has been approved and
begins to take shape. The company has studied available materials,
technology, and manufacturing capability and determined that the
new product can be created. Once that is done, more thorough
specifications are developed, including price and style. Marketing is
responsible for minimum and maximum sales estimates, competition
review, and market share estimates.
• Specification and design is when the product is nearing release. Final
design questions are answered and final product specs are determined
so that a prototype can be created.
• Prototype and testing occurs when the first version of a product is
created and tested by engineers and by customers. A pilot production
run might be made to ensure that engineering decisions made earlier
in the process were correct, and to establish quality control. The
marketing department is extremely important at this point. It is
responsible for developing packaging for the product, conducting the
consumer tests through focus groups and other feedback methods,
and tracking customer responses to the product.
• Manufacturing ramp-up is the final stage of new product
introduction. This is also known as commercialization. This is when
the product goes into full production for release to the market. Final
checks are made on product reliability and variability.
In the introduction phase, sales may be slow as the company builds
awareness of its product among potential customers. Advertising is crucial at
this stage, so the marketing budget is often substantial. The type of
advertising depends on the product. If the product is intended to reach a mass
audience, than an advertising campaign built around one theme may be in
order. If a product is specialized, or if a company's resources are limited,
than smaller advertising campaigns can be used that target very specific
audiences. As a product matures, the advertising budget associated with it
will most likely shrink since audiences are already aware of the product.
Author Philip Kotler has found that marketing departments can choose from
four strategies at the commercialization stage. The first is known as "rapid
skimming." The rapid refers to the speed with which the company recovers
its development costs on the product—the strategy calls for the new product
to be launched at a high price and high promotion level. High prices mean
high initial profits (provided the product is purchased at acceptable levels of
course), and high promotion means high market recognition. This works best
when the new product is unknown in the marketplace.
The opposite method, "slow skimming," entails releasing the product at high
price but with low promotion level. Again, the high price is designed to
recover costs quickly, while the low promotion level keeps new costs down.
This works best in a market that is made up of few major players or products
—the small market means everyone already knows about the product when it
The other two strategies involve low prices. The first is known as rapid
penetration and involves low price combined with high promotion. This
works best in large markets where competition is strong and consumers are
price-conscious. The second is called slow penetration, and involves low
price and low promotion. This would work in markets where price was an
issue but the market was well-defined.
Besides the above marketing techniques, sales promotion is another
important consideration when the product is in the introductory phase.
According to Kotler and Armstrong in Principles of Marketing, "Sales
promotion consists of short-term incentives to encourage purchase or sales of
a product or service. Whereas advertising offers reasons to buy a product or
service, sales promotion offers reason to buy now." Promotions can include
free samples, rebates, and coupons.
The growth phase occurs when a product has survived its introduction and is
beginning to be noticed in the marketplace. At this stage, a company can
decide if it wants to go for increased market share or increased profitability.
This is the boom time for any product. Production increases, leading to lower
unit costs. Sales momentum builds as advertising campaigns target mass
media audiences instead of specialized markets (if the product merits this).
Competition grows as awareness of the product builds. Minor changes are
made as more feedback is gathered or as new markets are targeted. The goal
for any company is to stay in this phase as long as possible.
It is possible that the product will not succeed at this stage and move
immediately past decline and straight to cancellation. That is a call the
marketing staff has to make. It needs to evaluate just what costs the company
can bear and what the product's chances for survival are. Tough choices need
to be made—sticking with a losing product can be disastrous.
If the product is doing well and killing it is out of the question, then the
marketing department has other responsibilities. Instead of just building
awareness of the product, the goal is to build brand loyalty by adding first-
time buyers and retaining repeat buyers. Sales, discounts, and advertising all
play an important role in that process. For products that are well-established
and further along in the growth phase, marketing options include creating
variations of the initial product that appeal to additional audiences.
At the maturity stage, sales growth has started to slow and is approaching the
point where the inevitable decline will begin. Defending market share
becomes the chief concern, as marketing staffs have to spend more and more
on promotion to entice customers to buy the product. Additionally, more
competitors have stepped forward to challenge the product at this stage,
some of which may offer a higher quality version of the product at a lower
price. This can touch off price wars, and lower prices mean lower profits,
which will cause some companies to drop out of the market for that product
altogether. The maturity stage is usually the longest of the four life cycle
stages, and it is not uncommon for a product to be in the mature stage for
A savvy company will seek to lower unit costs as much as possible at the
maturity stage so that profits can be maximized. The money earned from the
mature products should then be used in research and development to come
up with new product ideas to replace the maturing products. Operations
should be streamlined, cost efficiencies sought, and hard decisions made.
From a marketing standpoint, experts argue that the right promotion can
make more of an impact at this stage than at any other. One popular theory
postulates that there are two primary marketing strategies to utilize at this
stage—offensive and defensive. Defensive strategies consist of special sales,
promotions, cosmetic product changes, and other means of shoring up
market share. It can also mean quite literally defending the quality and
integrity of your product versus your competition. Marketing offensively
means looking beyond current markets and attempting to gain brand new
buyers. Relaunching the product is one option. Other offensive tactics
include changing the price of a product (either higher or lower) to appeal to
an entirely new audience or finding new applications for a product.
This occurs when the product peaks in the maturity stage and then begins a
downward slide in sales. Eventually, revenues will drop to the point where it
is no longer economically feasible to continue making the product.
Investment is minimized. The product can simply be discontinued, or it can
be sold to another company. A third option that combines those elements is
also sometimes seen as viable, but comes to fruition only rarely. Under this
scenario, the product is discontinued and stock is allowed to dwindle to zero,
but the company sells the rights to supporting the product to another
company, which then becomes responsible for servicing and maintaining the
Problems With the Product Life Cycle Theory
While the product life cycle theory is widely accepted, it does have critics
who say that the theory has so many exceptions and so few rules that it is
meaningless. Among the holes in the theory that these critics highlight:
• There is no set amount of time that a product must stay in any stage;
each product is different and moves through the stages at different
times. Also, the four stages are not the same time period in length,
which is often overlooked.
• There is no real proof that all products must die. Some products have
been seen to go from maturity back to a period of rapid growth
thanks to some improvement or re-design. Some argue that by saying
in advance that a product must reach the end of life stage, it becomes
a self-fulfilling prophecy that companies subscribe to. Critics say that
some businesses interpret the first downturn in sales to mean that a
product has reached decline and should be killed, thus terminating
some still-viable products prematurely.
• The theory can lead to an over-emphasis on new product releases at
the expense of mature products, when in fact the greater profits could
possibly be derived from the mature product if a little work was done
on revamping the product.
• The theory emphasizes individual products instead of taking larger
brands into account.
• The theory does not adequately account for product redesign and/or
NEW TRADE THEORY
New Trade Theory's development
The theory was initially associated with Paul Krugman in the early 1970s;
Krugman claims that he heard about monopolistic competition from Robert
Solow. Looking back in 1996 Krugman wrote that International economics a
generation earlier had completely ignored returns to scale. "The idea that
trade might reflect an overlay of increasing-returns specialization on
comparative advantage was not there at all: instead, the ruling idea was that
increasing returns would simply alter the pattern of comparative advantage."
In 1976, however, MIT-trained economist Victor Norman had worked out
the central elements of what came to be known as the Helpman-Krugman
theory. He wrote it up (by hand) and showed it to the great monopolistic
competition innovator, Avinash Dixit, and they both agreed it wasn't very
significant. Indeed Norman never had the paper typed, much less published.
Norman's formal stake in the race comes from the final chapters of the
famous Dixit-Norman book (Theory of International Trade : A Dual, General
Equilibrium Approach, ISBN 0-521-29969-1).
James Brander, a PhD student at Stanford at the time, was undertaking
similarly innovative work using models from industrial organisation theory
-- cross-hauling -- to explain two way trade in similar products
New Trade Theory (NTT) is the economic critique of international free
trade from the perspective of increasing returns to scale and the network
effect. Some economists have asked whether it might be effective for a
nation to shelter infant industries until they had grown to a sufficient size
large enough to compete internationally.
New Trade theorists challenge the assumption of diminishing returns to
scale, and some argue that using protectionist measures to build up a huge
industrial base in certain industries will then allow those sectors to dominate
the world market (via a Network effect).
They wondered whether free trade would have prevented the development of
the Japanese auto industries in the 1950s, when quotas and regulations
prevented import competition. Japanese companies were encouraged to
import foreign production technology but were required to produce 90
percent of parts domestically within five years. It is said that the short-term
hardship of Japanese consumers (who were unable to buy the superior
vehicles produced by the world market) was more than compensated for by
the long-term benefits to producers, who gained time to out-compete their
Less quantitative forms of this "infant industry" argument against totally free
trade have been advanced by trade theorists since at least 1848 (see: History
of free trade.)
New Trade Theory is based, ultimately, on four innovations that have in
recent years modified the reigning neoclassical economics:
1. An appreciation of market imperfections.
2. The new industrial economics of strategic behavior.
3. New Growth Theory, a fresh approach to the question of economic
4. A changing appreciation of the political context.
The Theory's impact
Although there was nothing particularly 'new' about the idea of protecting
'infant industries' (an idea offered in theory since the 18th century, and in
trade policy since the 1880s) what was new in "New Trade Theory" was the
rigor of the mathematical economics used to model the increasing returns to
scale, and especially the use of the network effect to argue that the formation
of important industries was path dependent in a way which industrial
planning and judicious tariffs might control.
The model they developed was highly technical, and predicted the
possibilities of national specialization-by-industry observed in the industrial
world (movies in Hollywood, watches in Switzerland, etc). The story of
path-dependent industrial concentrations sometimes leads to monopolistic
The econometric evidence for NTT was mixed, and again, highly technical.
Due to the time-scales required and the particular nature of production in
each 'monopolizable' sector, statistical judgments have been hard to make. In
many ways, there is too limited a dataset to produce a reliable test of the
hypothesis which doesn't require arbitrary judgements from the researchers.
Japan is cited as evidence of the benefits of "intelligent" protectionism, but
critics of NTT have argued that the empirical support post-war Japan offers
for beneficial protectionism is unusual, and that the NTT argument is based
on a selective sample of historical cases. Although many examples (like
Japanese cars) can be cited where a 'protected' industry subsequently grew to
world status, regressions on the outcomes of such "industrial policies"
(including the failures) have been less conclusive
4.Marketing – Philip Kotler