Theories of international trade explained.

1. Theories of International Trade
Abhinav|Chhavi|Kartika|Sakshi|Triparna

2. Mercantilism
• Mercantilism was the primary
economic system of trade used from
the 16th to 18th century.
Mercantilist theorists believed that
the amount of wealth in the world
was static. Thus, European nations
took several strides to ensure their
nations accumulated as much of this
wealth as possible.
• The goal was to increase a nation's
wealth by imposing government
regulation that oversaw all of the
nation's commercial interests. It was
believed national strength could be
maximized by
limiting imports via tariffs and
maximizing exports.

3. Jean-Baptiste Colbert: The
Champion of Mercantilism
• French Secretary of State Jean-Baptiste Colbert (1619-1683)
was one of the most influential proponents of mercantilism .
• He was also a devout monarchist and wanted an economic
strategy to protect the French crown from a rising Dutch
mercantile class.
• Colbert increased the size of the French navy on the premise
that his country would have to take control of trade routes to
increase its wealth.
• Even though his practices were ultimately unsuccessful, his
ideas became hugely popular until the theory of free market
economics was popularized.

4. • Mercantilism was popularized in Europe during the 1500s.
• Mercantilism replaced the older, feudal economic system in
Western Europe, leading to one of the first occurrences of
political oversight and control over an economy.
• At the time, England, the center of the British Empire, was
small and contained relatively few natural resources. Thus, to
grow England’s wealth, England introduced fiscal
policies, including the Sugar Act and Navigation Acts, to
move colonists away from foreign products and create another
incentive for buying British goods.
• The resulting favorable balance of trade was thought to
increase national wealth.

5. Affect of Mercantilism on British
Colonies
• Controlled production and trade
• The expansion of the slave trade
• Inflation and taxation
• American Revolution

6. Criticism of Mercantilism Theory
• Mercantilism is a philosophy of a zero sum game – where
people benefit at the expense of others. It is not a philosophy
for increasing global growth and reducing global problems.
Also, increasing other peoples wealth can lead to selfish
benefits, e.g. growth of other countries, increases markets for
our exports. Trying to impoverish other countries will harm
our own growth and prosperity.
• Mercantilism which stresses government regulation and
monopoly tends to lead to inefficiency and corruption.
• Mercantilism justified Empire building and the poverty of
colonies to enrich the Empire country.

7. • Economist Adam Smith, who is widely considered the father
of modern economics, argued in his seminal book "The Wealth
of Nations" that free trade enables businesses to specialize in
the production of the goods that they manufacture most
efficiently.
• Specialized production leads to economies of scale which, in
turn, lead to higher productivity and economic growth. In a
free trade system, businesses have incentives to be innovative.
By creating more useful products, better production and
distribution systems, and more efficient operations, businesses
can grow and prosper.

8. Justification for Mercantilism
• Tariffs in response to domestic subsidies
• Protection against dumping
• Infant industry argument
• Today, mercantilism is considered an outdated philosophy.
However, barriers to trade still exist to protect locally
entrenched industries.
• For example, the United States adopted a protectionist trade
policy toward Japan in the post-war period and negotiated
voluntary export restrictions with the Japanese government,
which limited the quantity of Japanese exports to the United
States.

9. Adam Smith is recognised
as the founder of modern
economics and as one of
the first and most famous
thinkers who argued in
favour of free trade and he
developed the theory of
absolute advantage in 1776.
Theory Of Absolute Advantage

10. • Export those goods and services for which a
country is more productive than other countries.
• Import those goods and services for which other
countries are more productive that it is.
• Country should concentrate on production of
goods in which it holds an absolute advantage.
• Measures nations wealth by the standard of
living of its people.
Absolute Advantage

11. The main concept of absolute advantage is
generally attributed to ADAM SMITH for his
1776 publication An inquiry into the nature
and causes of the wealth of nations on which
he countered mercantilist ideas.
Origin Of Theory

12. • Party X can produce 10 widgets per hour with 5
employees.
• Party Y can produce 20 widgets per hour with 5
employees.
• Assuming that the employees of both parties are
paid equally, Party Y has an absolute advantage
over Party X in producing widgets per hour because
Party Y is producing twice as many as party X with
same number of employees.
Example of Absolute Theory

13. This theory was a step forward in explaining the need
for countries to specialize in certain products and
engage in international trade to increase their
productivity. This theory was not helpful to those
countries who did not have an absolute advantage in
certain goods.
CRITICISM

14. David Ricardo’s theory of
Comparative advantage
 David Ricardo came up with the law of
comparative advantage in 1817.
It is a theory about political gains from trade
of companies, countries and people that arise on
account of differences in factor endowments or
technological progress.
He demonstrated that if two countries capable
of producing two commodities engage in
the free market, then each country will increase
its overall consumption by exporting the good
for which it has a comparative advantage while
importing the other good, provided that there
exist differences in labor productivity between
both countries.
David Ricardo (1772-1823)

15. Assumptions
Free tradeThere is no transport cost
Labour is homogenous
Cost of production is expressed in terms of labour
Production is subject to constant returns to scale
There are two countries and two commodities
Perfect competition exits
Labour is perfectly mobile
No technological changeFull employment exits

16. Example
Poorland’s cost of producing wine is higher than Richland’s in
terms of hours of labour and is lower in terms of bread.
Poorland has a comparative advantage in producing wine.
Richland has a comparative advantage in producing bread.

17. If they exchange wine and bread one for one, Poorland can
specialize in producing wine and trading some of it to Richland,
and Richland can specialize in producing bread.
By shifting ten hours of labours out of producing bread, Poorland
gives up the one loaf that this labour could have produced, the
reallocated labour produces two bottles of wine, which will trade
for two loaves of bread. Trade nets Poorland one additional loaf
of bread.
By shifting three hours out of producing wine, Richland cuts wine
production by one bottle but increases bread production by three
loaves. It trades two of these loaves for Poorland’s two bottles of
wine. Richland has one more bottle of wine than it had before,
and an extra loaf of bread

18. CRITICISM
Restrictive model- only two countries and two
commodities
Labour theory of value
Full employment
Ignore transport cost
Demand is ignored
No free trade
Complete specialization
Not applicable to developing countries

19. Heckscher-Ohlin Theorem of
International Trade

20. Ohlin states that trade results on
account of the different relative
price of different goods in different
countries. The relative price
commodity difference is the result
of relative costs and factor price
differences in different countries.
Differences in factor prices are
due to differences in factor
endowments in different
countries. It, thus, boils down to
the fact that trade occurs because
different countries have different
factor endowments. Ohlin’s
theory is, therefore, also described
as the factor endowment theory or
the factor proportions analysis.
The Heckscher-Ohlin theorem is: countries which are rich in
labour will export labour intensive goods and countries
which have plenty of capital will export capital-intensive
products.

21. Ohlin’s theory is usually expounded in terms of a two-factor
model with labour and capital as the two factors of
endowments. The gist of the theory is: what determine trade are
differences in factor endowments. Some countries have plenty
of capital; others have an abundance of labour.

22. Ohlin’s Simple Model:
Ohlin makes the following assumptions of a simplified
static model to the analysis:
1. There are two countries A and B.
2. There are two factors, labour and capital.
3. There are two goods; X and Y of which X is labour-intensive and Y is
capital-intensive.
4. Country A is labour-abundant country В is capital-rich.
5. There is perfect competition in both the commodity and factor markets.
6. All production functions are homogeneous of the first degree. Hence
there are constant returns to the scale.
7. There are no transport costs or other impediments to trade.
8. Demand conditions are identical in both the countries.

23. The Price Criterion of Relative
Factor Abundance:
According to the price criterion, a country having capital relatively cheap
and labour relatively dear is regarded as relatively capital-abundant,
irrespective of its ratio of total quantities of capital to labour in comparison
with the other country. In symbolic terms, when:
(PK/PL) A < (PK/PL) B
Country A is relatively capital-abundant. (Here P stands for factor price
and К for capital, L for labour, A and В for the two respective countries.)
Ohlin’s theorem may be verified diagrammatically in Fig. 1.

24. In a nutshell, we can interpret Ohlin’s theory as under:
1. Two countries A and В will involve themselves in trade, if relative
price of goods X and Y are different. To quote Ohlin, “the immediate
cause of inter-regional trade is always that goods can be bought cheaper
from outside in terms of money than they can be produced at home.”
2. Under comparative market conditions, prices are equal to average
costs. Thus, relative price differences are an account of cost differences.
3. Cost differences are taking place because of the factor price
differences in the two countries.
4. Factor prices are determined by factors’ supply and demand.
Assuming a given demand, it follows that a capital-rich country has a
cheaper or a lower capital price and a labour-abundant country has a
relatively lower labour price.
5. Ohlin states that each region has advantages in the production of
goods into which enter considerable amounts of factors abundant and
cheap in that region.
6. It follows that country A will tend to specialise in the production of
X and export its surplus. Likewise, В will specialise in Y and export it.

25. i. The basis of
internal trade is the
difference in
commodity prices
in the two
countries.
ii. Differences in
commodity prices
are due to cost
differences which
are the results of
differences in
factor endowments
in the two
countries.
iii. A capital-rich
country specialises
in labour-intensive
goods and exports
them. A labour-
abundant country
specialises in
labour-intensive
goods and exports
them.
Thus, Ohlin’s theory concludes that:

26. Limitations of Heckscher Ohlin's
H-O Theory ↓
Unrealistic
assumptions
Restrictive
One sided
theory
Static in nature
Wijnhold’s
criticism
Consumer’s
demand
ignored
Leonteif
paradox

27. Product Life-Cycle Theory
In1960′s, Raymond Vernon
introduces it
Stages : Innovation, Growth,
Maturity and Decline
Many products go through a trade
cycle
Predicting the product trade
performance

28. Phase I : Innovation
Introduction
Of The
Product
Low
Awareness
Huge
Investment
Is Made
Low Profits
Low
Competitors

29. Phase II : Growth
Demand
And Profit
Increases
Production
Cost
Decreases
Awareness
Is High
Competition
Increases
Export
Starts

30. Phase II : Maturity
Product Awareness is Maximum
Rate of Increase of Sales Decreases
Competition is Very High and Profit
Margin Decreases
Foreign Demand Grows
Export Surge Followed by a Fall in Export

31. Phase II : Decline
Product and Production Process is
Well Known
Revenue Drops and Many Products
Phase Out
Production Shifts to Developing
Countries
Imports Starts

32. Based on : Raymond Vernon, 1966. International investment and International trade in the product cycle. The
Quarterly journal of Electronics 80(2), pp. 190-207

33. Porter’s theory of competitive
advantage
• Michael Porter’s theory of
competitive advantage
contributes to understanding
the competitive advantage of
nations in international trade
and production.
• He tried to explain why a
nation achieves international
success in a particular
industry and identified four
attributes that promote or
impede the creation of
competitive advantage.

34. Factor endowments- A nation’s position in factors of production
necessary to compete in a given industry.
Can lead to competitive advantage
Can be either basic(natural resources,climate,location) or
advanced (skilled labour,infrastructure,technological know
how).
Demand conditions- The nature of home demand for the industry’s product or
service.
Influences the development of capabilities
Sophisticated and demanding customers
pressure firms to be competitive.

35. Relating and supporting industries- The presence and absence of
supplier industries that are internationally competitive.
Can spill over and contribute to other industries
Successful industries tend to be grouped in
cluster in countries.
Firm strategy, structure and rivalry- The conditions governing how
companies are created,organized,and managed, and the nature of domestic rivalry.
Different management ideologies affect the development of national
competitive advantage.
Vigorous domestic rivalry creates pressures to innovate ,to improve
quality ,to reduce cost, and to invest in upgrading advance features

36. •Government policy can
Affect demand through product standards
Influence rivalry through regulation and anti trust laws
Impact the availability of highly educated workers and advanced
transportation infrastructure.
•The four attributes, Government policy, and chance work as an
reinforcing system, complementing each other and in combination
creating the conditions appropriate for competitive advantage.

37. Thank You!