International Trade Theories

Theories of International Trade

Learning Objectives
To understand the traditional arguments of how and why international trade improves the welfare of all countries
To review the history and compare the implications of trade theory from the original work of Adam Smith to the contemporary theories of Michael Porter
To examine the criticisms of classical trade theory and examine alternative viewpoints of which business and economic forces determine trade patterns between countries

Evolution of Trade Theories
Mercantilism
Absolute advantage (Classical)
Comparative advantage
Factor Proportions Trade
International Product Cycle
New Trade Theory
National competitive advantage

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 export through subsidies.
Minimize imports through tariffs and quotas
Flaw: restrictions, impaired growth

Defining mercantilism …
… trade theory holding that nations should accumulate financial wealth, usually in the form of gold ( forget things like living standards or human development ) by encouraging exports and discouraging imports

Theory of absolute advantage
Adam Smith: Wealth of Nations ( 1776) argued:
Capability of one country to produce more of a product with the same amount of input than another country
A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient
Trade between countries is, therefore, beneficial
Assumes there is an absolute balance among nations

Theory of absolute advantage
… destroys the mercantilist idea since there are gains to be had by both countries party to an exchange
… questions the objective of national governments to acquire wealth through restrictive trade policies
… measures a nation’s wealth by the living standards of its people

Theory of absolute advantage PPF – Production Possibility Frontier

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

Theory of comparative advantage

Comparative advantage and the gains from trade

Comparative advantage: Bollywood

Assumptions and limitations
Driven only by maximization of production and consumption
Only 2 countries engaged in production and consumption of just 2 goods?
What about the transportation costs?
Only resource – labour (that too, non-transferable)
No consideration for ‘learning theory’

Factor proportions theory
Heckscher (1919) - Olin (1933) Theory
Export goods that intensively use factor endowments which are locally abundant
Corollary: import goods made from locally scarce factors
Note: Factor endowments can be impacted by government policy - minimum wage
Patterns of trade are determined by differences in factor endowments - not productivity
Remember, focus on relative advantage, not absolute advantage

Factor proportions theory
… trade theory holding that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply
Example:
Australia – lot of land and a small population (relative to its size)
So what should it export and import?

Factor Proportions Trade Theory Considers Two Factors of Production
Labor
Capital

Factor Proportions Trade Theory
A country that is relatively labor abundant ( capital abundant ) should specialize in the production and export of that product which is relatively labor intensive ( capital intensive )

The Leontief Paradox
The Test:
Could Factor Proportions Theory be used to explain the types of goods the United States imported and exported?
The Method:
Input-output analysis

The Leontief Paradox
The Findings:
The U.S. exported labor-intensive products and imported capital-intensive products.
The Controversy:
Findings were the opposite of what was generally believed to be true!

Product life-cycle Theory R.Vernon (1966)
… trade theory holding that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its lifecycle
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

Product life cycle theory Fig 4.5

The Product Cycle and Trade Implications
Increased emphasis on technology’s impact on product cost
Explained international investment
Limitations
Most appropriate for technology-based products
Some products not easily characterized by stages of maturity
Most relevant to products produced through mass production

New trade theory
In industries with high fixed costs:
Specialization increases output, and the ability to enhance economies of scale increases
Learning effects are high. These are cost savings that come from ‘learning by doing’

New trade theory - applications
Typically, requires industries with high, fixed costs
World demand will support few competitors
Competitors may emerge because of “ First-mover advantage”
Economies of scale may preclude new entrants
Role of the government becomes significant
Some argue that it generates government intervention and strategic trade policy

Theory of national competitive advantage
The theory attempts to analyze the reasons for a nations success in a particular industry
Porter studied 100 industries in 10 nations
postulated determinants of competitive advantage of a nation based on four major attributes
Factor endowments
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry

Porter’s diamond
Success occurs where these attributes exist.
More/greater the attribute, the higher chance of success
The diamond is mutually reinforcing

Factor endowments
Factor endowments:- A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry
Basic factor endowments
Advanced factor endowments

Basic factor endowments
Basic factors: Factors present in a country
Natural resources
Climate
Geographic location
Demographics
While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success

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

communications
skilled labor
research
Technology
education

Demand conditions
Demand:
creates capabilities
creates sophisticated and demanding consumers
Demand 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
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 competitiveness

Determinants of Competitive Advantage in nations Fig 4.8 Government Company Strategy, Structure, and Rivalry Demand Conditions Related and Supporting Industries Factor Conditions Chance Two external factors that influence the four determinants.

Porter’s Theory-predictions
Porter’s theory should 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

Implications for business
Location implications :
Disperse production activities to countries where they can be performed most efficiently
First-mover implications:
Invest substantial financial resources in building a first-mover, or early-mover advantage
Policy implications:
Promoting free trade is in the best interests of the home-country, not always in the best interests of the firm, even though, many firms promote open markets

India in the global competitiveness report

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International Trade Theories

by shanmugapriya on Nov 17, 2008

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