UNIT-II: Theories of International Trade, Trading Environment of International Trade - Free Trade Vs
Protection- Tariff and Non-tariff Barriers –Trade Blocks.
(Refer Michael R. Czinkota, Iikka A. Ronkainen & Michael H. Moffett., International Business, Cengage Learning,
Theories of International Trade
The Theories of Trade
• To understand the traditional arguments of how and why international trade improves
the welfare of all countries
• To explore the similarities and distinctions between international trade and international investment
Evolution of Trade Theory
• The Age of Mercantilism (pg no. 150)
• Classical Trade Theory (pg no. 151-153)
• Factor Proportions Trade Theory
• International Investment and Product Cycle Theory
• The New Trade Theory: Strategic Trade
• Mixed exchange through trade with accumulation of wealth
• Conducted under authority of government
• Demise of mercantilism inevitable
Classical Trade Theory
• The Theory of Absolute Advantage
– The ability of a country to produce a product with fewer inputs than another country
• The Theory of Comparative Advantage
– The notion that although a country may produce both products more cheaply than another
country, it is relatively better at producing one product than the other
Classical Trade Theory Contributions (pg no. 159)
• Adam Smith—Division of Labor
– Industrial societies increase output using same labor-hours as pre-industrial society
• David Ricardo—Comparative Advantage
– Countries with no obvious reason for trade can specialize in production, and trade for
products they do not produce
• Gains From Trade
– A nation can achieve consumption levels beyond what it could produce by itself
Factor Proportions Trade Theory
• Developed by Eli Heckscher
• Expanded by Bertil Ohlin
Factor Proportions Trade Theory
Considers Two Factors of Production (pg no. 159-160)
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).
Product Cycle Theory (pg no. 163)
• Raymond Vernon
• Focus on the product, not its factor proportions
• Two technology-based premises
Product Cycle Theory: (pg no. 163)
• Technical innovations leading to new and profitable products require large quantities of capital and
• The product and the methods for manufacture go through three stages of maturation
Stages of the Product Cycle (pg no. 164)
• The New Product
• The Maturing Product
• The Standardized Product
The Product Cycle and Trade Implications (pg no. 165)
• Increased emphasis on technology’s impact on product cost
• Explained international investment
– Most appropriate for technology-based products
– Some products not easily characterized by stages of maturity
– Most relevant to products produced through mass production
The New Trade Theory:
Two New Contributions
• Paul Krugman-How trade is altered when markets are not perfectly competitive
• Michael Porter-Examined competitiveness of industries on a global basis
Strategic Trade (pg no. 167)
Krugman’s Economics of Scale:
• Internal Economies of Scale (pg no. 168)
• External Economies of Scale (pg no. 169)
Strategic Trade (pg no. 169-171)
• Government can play a beneficial role when markets are not purely competitive
• Theory expands to government’s role in international trade
• Four circumstances exist that involve imperfect competition in which strategic trade may apply
• The Four Circumstances Involving Imperfect Competition:
• 3. Repetition
Barriers to Trade (pg no. 82-86)
Why do countries produce goods and services that could be more cheaply purchased from other countries?
• To encourage local production
• To help local firms export
• To protect local jobs
• Protect infant industries
• Reduce dependency
• Encourage local and foreign direct investment
• Reduce balance of payment problems
• Reduce or avoid dumping
Commonly used barriers
• Price based barriers- Ad valorem
• Quantity limits-quotas- embargo
• International price fixing- cartel
• Financial limits- exchange control
• Foreign investment controls-minority stakes, limiting profits etc
Tariff barriers affect prices; nontariff barriers may affect either price or quantity directly.
A tariff (sometimes called duty) is the most common type of trade control and is a tax that
governments levy on an official boundary.
Tariffs also serve as a source of government revenue.
• Export tariff
If the tariff collected by the exporting country are called Export tariff
• Import tariff
If the tariff collected by importing country, it is an import tariff.
• Transit tariff
If the tariff collected by a country through which the goods have passed, it is an transit tariff.
• Specific duty
A government may asses a tariff on a per-unit basis, in which case it is applying specific duty.
• Ad valorem duty
It may access a tariff as a percentage of the value of the item, in which case it is an ad valorem duty
• Compound duty
If it accesses both a specific duty & an ad valorem duty on the same product, the combination is a
• Dumping – i.e., selling goods overseas, or both. Dumping ranges from predatory to unintentional.
Predatory dumping is the tactic of a foreign firm that intentionally sells at a loss in another country to
increase market share at the expense of domestic producers. This amounts to an international price
Unintentional dumping is the result of time lags between the date of sales transactions, shipment &
Non – tariff barriers- rules , regulations and bureaucratic
The quota is the most common type of quantitative imports or export restriction.
An import quota prohibits or limits the quantity of a product that can be imported in a year.
Quota raise prices just as tariffs do but, being defined in physical terms, they directly affect the
amount of imports by putting an absolute ceiling on supply.
Quota generate revenues for those companies that are able to obtain a portion of the intentionally
limited supply of the product that they can then sell to local customers.
• Buy national restrictions
Another form of quantitative trade control is “Buy local” legislation or “buy national” restrictions.
Government purchases are a large part of total expenditures in many countries; typically
governments favor domestic products.
Sometimes governments specify a domestic content restriction- i.e., a certain percentage of
products must be of local origin. Sometimes they favor domestic producers by establishing price
• Customs valuation
It is difficult for customs officials to determine if invoice prices are honest
- They may arbitrarily increase value
- Valuation procedures have been developed.
• Technical barriers
• Restriction on services
• Counter trade
It is a sale that encompasses more than an exchange of goods, services or idea for money.
In International Market, Counter trade Transactions "are those transactions that have as a basic
characteristic - linkage, legal or otherwise between exports & imports of goods or services in
addition to or in places of Financial settlements”
• A trade bloc is a type of intergovernmental agreement, often part of a regional intergovernmental
organization, where regional barriers to trade (tariffs and non-tariff barriers) are reduced or eliminated
among the participating states.
• One of the first economic blocs was the German Customs Union (Zollverein) initiated in 1834, formed
on the basis of the German Confederation and subsequently German Empire from 1871.
• Surges of trade bloc formation were seen in the 1960s and 1970s, as well as in the 1990s after the
collapse of Communism.
• By 1997, more than 50% of all world commerce was conducted under the auspices of regional trade
• Economist Jeffrey J. Scott of the Peterson Institute for International Economics notes that members of
successful trade blocs usually share four common traits: similar levels of per capita GNP, geographic
proximity, similar or compatible trading regimes, and political commitment to regional organization.
• Advocates of worldwide free trade are generally opposed to trading blocs, which, they argue,
encourage regional as opposed to global free trade.
• Scholars and economists continue to debate whether regional trade blocs are leading to a more
fragmented world economy or encouraging the extension of the existing global multilateral trading
• Trade blocs can be stand-alone agreements between several states (such as NAFTA) or part of a
regional organization (such as the European Union).
• Depending on the level of economic integration, trade blocs can fall into different categories, such as:
 preferential trading areas, free trade areas, customs unions, common markets and economic and