International business: THEORIES OF INTERNATIONAL TRADE
AN ASSIGNMENT ON
“THEORIES OF INTERNATIONAL TRADE”
Table of Contents
1, 2, 3, 4
Absolute Advantage Theory
Comparative Advantage Theory
7, 8, 9, 10
The Hackscher-Ohlin Trade Model
11, 12, 13, 14, 15, 16
17, 18, 19, 20, 21
Definition of 'Mercantilism':
The main economic system used during the sixteenth to eighteenth centuries. The main goal was to
increase a nation's wealth by imposing government regulation concerning all of the nation's commercial
interests. It was believed that national strength could be maximized by limiting imports via tariffs and
Investopedia explains 'Mercantilism'
This approach assumes the wealth of a nation depends primarily on the possession of precious metals
such as gold and silver. This type of system cannot be maintained forever, because the global economy
would become stagnant if every country wanted to export and no one wanted to import.
Some economic historians (like Peter Temin) argue that the economy of the Early Roman Empire was
a market economy and one of the most advanced agricultural economies to have existed (in terms of
productivity, urbanization and development of capital markets), comparable to the most advanced
economies of the world before the Industrial Revolution, namely the economies of 18th century England
and 17th century Netherlands. There were markets for every type of good, for land, for cargo ships;
there was even an insurance market.
Many European economists between 1500 and 1750 are today generally considered mercantilists;
however, these economists did not see themselves as contributing to a single economic ideology. The
bulk of what is commonly called "mercantilist literature" appeared in the 1620s in Great Britain. Adam
Smith, who was critical of the idea, was the first person to organize formally most of the contributions
of mercantilists into what he called "the mercantile system" in his 1776 book The Wealth of Nations.
Beyond England, Italy, France, and Spain had noted writers who had mercantilist themes in their work,
indeed the earliest examples of mercantilism are from outside of England: in Italy, Giovanni Botero
(1544-1617) and Antonio Serra (1580-?), in France, Colbert and some other precursors to the
physiocrats, in Spain, the School of Salamanca writers Francisco de Vitoria (1480 or 1483 – 1546),
Domingo de Soto (1494-1560), Martin de Azpilcueta (1491 - 1586), and Luis de Molina (1535-1600).
Mercantilism is an economic theory that the prosperity of a nation depends upon its capital, and that the
volume of the world economy and international trade is unchangeable. Government economic policy
based on these ideas is also sometimes called mercantilism,
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, especially through the use of
Mercantilism is the economic doctrine that government control of foreign trade is of paramount
importance for ensuring the military security of the country. In particular, it demands a positive balance
High tariffs, especially on manufactured goods, are an almost universal feature of mercantilist policy.
Other policies have included:
Building a network of overseas colonies;
Forbidding colonies to trade with other nations;
Monopolizing markets with staple ports;
Banning the export of gold and silver, even for payments;
Forbidding trade to be carried in foreign ships;
Promoting manufacturing with research or direct subsidies;
Maximizing the use of domestic resources;
Restricting domestic consumption with non-tariff barriers to trade.
Mercantilism contained many interlocking principles some of them as follows:
1. Precious metals, such as gold and silver, were deemed indispensable to a nation’s wealth. If a nation
did not possess mines or have access to them, precious metals should be obtained by trade. It was
believed that trade balances must be “favorable,” meaning an excess of exports over imports. Colonial
possessions should serve as markets for exports and as suppliers of raw materials to the mother country.
Manufacturing was forbidden in colonies, and all commerce between colony and mother country was
held to be a monopoly of the mother country.
2. A strong nation, according to the theory, was to have a large population, for a large population would
provide a supply of labor, a market, and soldiers. Human wants were to be minimized, especially for
imported luxury goods, for they drained off precious foreign exchange. Sumptuary laws (affecting food
and drugs) were to be passed to make sure that wants were held low.
Mercantilism as a whole cannot be considered a unified theory of economics because mercantilism has
traditionally been driven more by the political and commercial interests of the State and security
concerns than by abstract ideas. There were no mercantilist writers presenting an overarching scheme
for the ideal economy, as Adam Smith would later do for classical (laissez-faire) economics. Some
scholars thus reject the idea of mercantilism completely, arguing that it gives "a false unity to disparate
events". Mercantilists viewed the economic system as a zero-sum game, in which any gain by one party
required a loss by another. Thus, any system of policies that benefited one group would by definition
harm the other, and there was no possibility of economics being used to maximize the "commonwealth",
or common good.
Mercantilist domestic policy was more fragmented than its trade policy. The early modern era was one
of letters patent and government-imposed monopolies; some mercantilists supported these, but others
acknowledged the corruption and inefficiency of such systems. Many mercantilists also realized that
the inevitable results of quotas and price ceilings were black markets. One notion mercantilists widely
agreed upon was the need for economic oppression of the working population; laborers and farmers
were to live at the "margins of subsistence". The goal was to maximize production, with no concern for
consumption. Extra money, free time, or education for the "lower classes" was seen to inevitably lead
to vice and laziness, and would result in harm to the economy.
Mercantilism developed at a time when the European economy was in transition. Isolated feudal estates
were being replaced by centralized nation-states as the focus of power. Technological changes in
shipping and the growth of urban centers led to a rapid increase in international trade. Mercantilism
focused on how this trade could best aid the states. Another important change was the introduction of
double-entry bookkeeping and modern accounting.
Prior to mercantilism, the most important economic work done in Europe was by the medieval
scholastic theorists. They focused mainly on microeconomics and local exchanges between individuals.
This period saw the adoption of Niccolò Machiavelli's realpolitik and the primacy of the raison d'état
in international relations. The mercantilist idea that all trade was a zero sum game, in which each side
was trying to best the other in a ruthless competition, was integrated into the works of Thomas Hobbes.
Note that non-zero sum games such as prisoner's dilemma can also be consistent with a mercantilist
view. In prisoner's dilemma, players are rewarded for defecting against their opponents. More modern
views of economic co-operation amidst ruthless competition can be seen in the folk theorem of game
Adam Smith and David Hume are considered to be the founding fathers of anti-mercantilist thought. A
number of scholars found important flaws with mercantilism long before Adam Smith developed an
ideology that could fully replace it. Critics like Dudley North, John Locke, and David Hume
undermined much of mercantilism.
Failure to understand other theory: Mercantilists failed to understand the notions of absolute advantage
and comparative advantage (although this idea was only fully fleshed out in 1817 by David Ricardo)
and the benefits of trade. In modern economic theory, trade is not a zero-sum game of cutthroat
competition, because both sides can benefit (rather, it is an iterated prisoner's dilemma). By imposing
mercantilist import restrictions and tariffs instead, both nations ended up poorer.
Impossibility to maintain trade balance: David Hume famously noted the impossibility of the
mercantilists' goal of a constant positive balance of trade. As bullion flowed into one country, the supply
would increase and the value of bullion in that state would steadily decline relative to other goods.
Eventually it would no longer be cost-effective to export goods from the high-price country to the lowprice country, and the balance of trade would reverse itself. Mercantilists fundamentally misunderstood
this, long arguing that an increase in the money supply simply meant that everyone gets richer.
Importance on bullion: The importance placed on bullion was also a central target, even if many
mercantilists had themselves begun to de-emphasize the importance of gold and silver. Adam Smith
noted that at the core of the mercantile system was the "popular folly of confusing wealth with money,"
bullion was just the same as any other commodity, and there was no reason to give it special treatment.
Rent seeking critique: The critique that mercantilism was a form of rent-seeking has also seen criticism,
as scholars such Jacob Viner in the 1930s point out that merchant mercantilists such as Mun understood
that they would not gain by higher prices for English wares abroad.
In the English-speaking world, Adam Smith's utter repudiation of mercantilism was accepted,
eventually, as public policy in the British Empire and in the United States. Initially it was rejected 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.
In the 20th century, most economists on both sides of the Atlantic have come to accept that in some
areas mercantilism had been correct. Most prominently, the economist John Maynard Keynes explicitly
supported some of the tenets of mercantilism. Adam Smith had rejected focusing on the money supply,
arguing that goods, population, and institutions were the real causes of prosperity. These views later
became the basis of monetarism, whose proponents actually reject much of Keynesian monetary theory,
and has developed as one of the most important modern schools of economics.
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.
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 that the balance of payments is an
important concern, and since the 1930s, all nations have closely monitored the inflow and outflow of
capital, and most economists agree that a favorable balance of trade is desirable. Keynes also adopted
the essential idea of mercantilism that government intervention in the economy is a necessity. 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
One area Smith was reversed on well before Keynes was that of 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.
Absolute Advantage Theory
In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm,
or country) to produce more of a good or service than competitors, using the same amount of resources.
Adam Smith first described the principle of absolute advantage in the context of international trade,
using labor as the only input.
Definition of 'Absolute Advantage'
The ability of a country, individual, company or region to produce a good or service at a lower cost per
unit than the cost at which any other entity produces that good or service.
Investopedia explains 'Absolute Advantage'
Entities with absolute advantages can produce something using a smaller number of inputs than another
party producing the same product. As such, absolute advantage can reduce costs and boost profits.
Since absolute advantage is determined by a simple comparison of labor productivities, it is possible
for a party to have no absolute advantage in anything; in that case, according to the theory of absolute
advantage, no trade will occur with the other party. It can be contrasted with the concept of
comparative advantage which refers to the ability to produce a particular good at a lower opportunity
Origin of the theory
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 in which he countered mercantilist
ideas. Smith argued that it was impossible for all nations to become rich simultaneously by following
mercantilism because the export of one nation is another nation’s import and instead stated that all
nations would gain simultaneously if they practiced free trade and specialized in accordance with their
Features of this theory:
A country that has an absolute advantage produces greater output of a good or service than other
countries using the same amount of resources. Smith stated that tariffs and quotas should not restrict
international trade; it should be allowed to flow according to market forces. Contrary to mercantilism
Smith argued that a country should concentrate on production of goods in which it holds an absolute
advantage. No country would then need to produce all the goods it consumed. The theory of absolute
advantage destroys the mercantilist idea that international trade is a zero-sum game. According to the
absolute advantage theory, international trade is a positive-sum game, because there are gains for both
countries to an exchange.
The theory that trade occurs when one country, individual, company, or region is absolutely more
productive than another entity in the production of a good. A person, company or country has an
absolute advantage if its output per unit of input of all goods and services produced is higher than that
of another entity producing that good or service.
Problems of Absolute Advantage:
There is a potential problem with absolute advantage. If there is one country that does not have an
absolute advantage in the production of any product, will there still be benefit to trade, and will trade
even occur? The answer may be found in the extension of absolute advantage, the theory of comparative
The principle was described by Adam Smith in the context of international trade. Now I am describing
some of them below
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 labor in India can
produce 80 units of wool or 20 units of wine; while in Spain one unit of labor makes 50 units
of wool or 75 units of wine, then India has an absolute advantage in producing wool and Spain
has an absolute advantage in producing wine. India can get more wine with its labor by
specializing in wool and trading the wool for Spanish wine, while Spain can benefit by trading
wine for wool. (Adam Smith, Wealth of Nations, Book IV, Ch.2.) The benefits to nations from
trading are the same as to individuals: trade permits specialization, which allows resources to
be used more productively
Comparative Advantage Theory
Definition of 'Comparative Advantage'
The ability of a firm or individual to produce goods and/or services at a lower opportunity cost than
other firms or individuals. A comparative advantage gives a company the ability to sell goods and
services at a lower price than its competitors and realize stronger sales margins.
Investopedia explains 'Comparative Advantage'
Having a comparative advantage - or disadvantage - can shape a company's entire focus. For example,
if a cruise company found that it had a comparative advantage over a similar company, due ito its closer
proximity to a port, it might encourage the latter to focus on other, more productive, aspects of countrys.
Origins of the theory
The idea of comparative advantage has been first mentioned in Adam Smith's Book The Wealth of
Nations: "If a foreign country can supply us with a commodity cheaper than we ourselves can make it,
better buy it of them with some part of the produce of our own industry, employed in a way in which
we have some advantage." But the law of comparative advantages has been formulated by David
Ricardo who investigated in detail advantages and alternative or relative opportunity in his 1817 book
On the Principles of Political Economy and Taxation in an example involving England and Portugal.
Ricardo's Theory of Comparative Advantage
David Ricardo stated a theory that other things being equal a country tends to specialize in and exports
those commodities in the production of which it has maximum comparative cost advantage or minimum
comparative disadvantage. Similarly the country's imports will be of goods having relatively less
comparative cost advantage or greater disadvantage.
1. Ricardo's Assumptions:Ricardo explains his theory with the help of following assumptions:1. There are two countries and two commodities.
2. There is a perfect competition both in commodity and factor market.
3. Cost of production is expressed in terms of labor i.e. value of a commodity is measured in
terms of labor hours/days required to produce it. Commodities are also exchanged on the
basis of labor content of each good.
4. Labor is the only factor of production other than natural resources.
5. Labor is homogeneous i.e. identical in efficiency, in a particular country.
6. Labor is perfectly mobile within a country but perfectly immobile between countries.
7. There is free trade i.e. the movement of goods between countries is not hindered by any
8. Production is subject to constant returns to scale.
9. There is no technological change.
10. Trade between two countries takes place on barter system.
11. Full employment exists in both countries.
12. Perfect occupational mobility of factors of production - resources used in one industry can
be switched into another without any loss of efficiency
13. Perfect occupational mobility of factors of production - resources used in one industry can
be switched into another without any loss of efficiency
Constant returns to scale (i.e. doubling the inputs in each country leads to a doubling of
No externalities arising from production and/or consumption
Transportation costs are ignored
If businesses exploit increasing returns to scale (i.e. economies of scale) when they
specialize, the potential gains from trade are much greater. The idea that specialization
should lead to increasing returns is associated with economists such as Paul Romer and Paul
2. Ricardo's Example:On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by taking
an example of England and Portugal as two countries & Wine and Cloth as two commodities.
As pointed out in the assumptions, the cost is measured in terms of labor hour. The principle of
comparative advantage expressed in labor hours by the following table.
Portugal requires less hours of labor for both wine and cloth. One unit of wine in Portugal is produced
with the help of 80 labor hours as above 120 labor hours required in England. In the case of cloth too,
Portugal requires less labor hours than England. From this it could be argued that there is no need for
trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that
Portugal stands to gain by specializing in the commodity in which it has a greater comparative
advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.
Effects on the economy
Conditions that maximize comparative advantage do not automatically resolve trade deficits. In fact,
many real world examples where comparative advantage is attainable may 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.
The theory of comparative advantage, and the corollary that nations should specialize, is criticized on
pragmatic grounds within the import substitution industrialization theory of development economics,
on empirical grounds by the Singer–Prebisch thesis which states that terms of trade between primary
producers and manufactured goods deteriorate over time, and on theoretical grounds of infant industry
and Keynesian economics. In older economic terms, comparative advantage has been opposed by
mercantilism and economic nationalism.
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Free mobility of capital in a globalize world
Ricardo explicitly bases his argument on an assumed immobility of capital:" ... if capital freely flowed
towards those countries where it could be most profitably employed, there could be no difference in the
rate of profit, and no other difference in the real or labor price of commodities, than the additional
quantity of labor required to convey them to the various markets where they were to be sold."
Economist Ha-Joon Chang criticized the comparative advantage principle, contending that it may have
helped developed countries maintain relatively advanced technology and industry compared to
developing countries. In his book Kicking Away the Ladder, Chang argued that all major developed
countries, including the United States and United Kingdom, used interventionist, protectionist economic
policies in order to get rich and then tried to forbid other countries from doing the same.
Assumption rather than discovery
Philosopher and Professor of Evolutionary Psychology Bruce Charlton has argued that comparative
advantage is a metaphysical assumption, rather than a discovery. In addition to falsifiable nature of the
principle, he notes that the principle relies on several assumptions that are not necessarily operative.
Comparative advantage and international trade
Comparative advantage exists when a country has a margin of superiority in the production of a
good or service i.e. where the opportunity cost of production is lower.
Ricardo's theory of comparative advantage was further developed by Heckscher, Ohlin and
Samuelson who argued that countries have different factor endowments of labor, land and capital
inputs. Countries will specialize in and export those products which use intensively the factors of
production which they are most endowed.
Worked example of comparative advantage
Consider the data in the following table:
To identify which country should specialize in a particular product we need to analyses the internal
opportunity cost for each country. For example, were the UK to shift more resources into higher
output of personal computers, the opportunity cost of each extra PC is four CD players. For Japan the
same decision has an opportunity cost of two CD players. Therefore, Japan has a comparative
advantage in PCs.
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Determinants of 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: If an economy can improve the
quality of its labor 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 .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 advantage.
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 trade agreements.
Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales
Interpreting the Theory of Comparative Advantage
A better way to state the results is as follows. The Ricardian model shows that if we want to maximize
total output in the world then,
First, fully employ all resources worldwide;
Second, allocate those resources within countries to each country's comparative advantage
Third, allow the countries to trade freely thereafter.
The good in which a comparative advantage is held is the good that the country produces most
efficiently. Therefore, if given a choice between producing two goods (or services), a country will make
the most efficient use of its resources by producing the good with the lowest opportunity cost, the good
for which it holds the comparative advantage. The country can trade with other countries to get the
goods it did not produce.
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The Heckscher-Ohlin Trade Model
The Heckscher-Ohlin (HO hereafter) model was first conceived by two Swedish economists, Eli
Heckscher (1919) and Bertil Ohlin. Rudimentary concepts were further developed and added later by
Paul Samuelson and Ronald Jones among others. There are four major components of the HO model:
1. Factor Price Equalization Theorem,
2. Stolper-Samuelson Theorem,
3. Rybczynski Theorem, and
4. Heckscher-Ohlin Trade Theorem.
Heckscher–Ohlin theorem is one of the four critical theorems of the Heckscher–Ohlin model. It states
that a country will export goods that use its abundant factors intensively, and import goods that use its
scarce factors intensively. In the two-factor case, it states: "A capital-abundant country will export the
capital-intensive good, while the labor-abundant country will export the labor-intensive good."
The critical assumption of the Heckscher–Ohlin model is that the two countries are identical, except for
the difference in resource endowments.
Initially, when the countries are not trading:
The price of capital-intensive good in capital-abundant country will be bid down relative to
the price of the good in the other country,
The price of labor-intensive good in labor-abundant country will be bid down relative to the
price of the good in the other country.
Features of the model
The Heckscher–Ohlin model (H–O model) is a general equilibrium mathematical model of
international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm School of Economics.
It builds on David Ricardo's theory of comparative advantage by predicting patterns of commerce and
production based on the factor endowments of a trading region. The model essentially says that
countries will export products that use their abundant and cheap factor(s) of production and import
products that use the countries' scarce factor(s).
Theoretical development of the model
The Ricardian model of comparative advantage has trade ultimately motivated by differences in labor
productivity using different technologies. Heckscher and Ohlin didn't require production technology to
vary between countries, so (in the interests of simplicity) the H-O model has identical production
technology everywhere. Ricardo considered a single factor of production (labor) and would not have
been able to produce comparative advantage without technological differences between countries. The
H-O model removed technology variations but introduced variable capital endowments, recreating
endogenously the inter-country variation of labor productivity that Ricardo had imposed exogenously.
The model has been extended since the 1930s by many economist.Notable contributions came from
Paul Samuelson, Ronald Jones, and Jaroslav Vanek, so that variations of the model are sometimes called
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the Heckscher-Ohlin-Samuelson model or the Heckscher-Ohlin-Vanek model in the neo-classical
Assumptions of the theory
Heckscher-Ohlin's theory explains the modern approach to international trade on the basis of following
There are two countries involved.
Each country has two factors (labor and capital).
Each country produce two commodities or goods (labor intensive and capital intensive).
There is perfect competition in both commodity and factor markets.
All production functions are homogeneous of the first degree i.e. production function is subject
to constant returns to scale.
Factors are freely mobile within a country but immobile between countries.
Two countries differ in factor supply.
Each commodity differs in factor intensity.
The production function remains the same in different countries for the same commodity. For
e.g. If commodity A requires more capital in one country then same is the case in other country.
There is full employment of resources in both countries and demand are identical in both
Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.
The 2×2×2 model
The original H-O model assumed that the only difference between countries was the relative abundances
of labor and capital. The original Heckscher–Ohlin model contained two countries, and had two
commodities that could be produced. Since there are two (homogeneous) factors of production this
model is sometimes called the "2×2×2 model".
The model has variable factor proportions between countries: Highly developed countries have a
comparatively high ratio of capital to labor in relation to developing countries. This makes the
developed country capital-abundant relative to the developing nation, and the developing nation laborabundant in relation to the developed country.
The original, 2x2x2 model was derived with restrictive assumptions. These assumptions
and developments are listed here.
Both countries have identical production technology
This assumption means that producing the same output of either commodity could be done with the
same level of capital and labor in either country. Another way of saying this is that the per-capita
productivity is the same in both countries in the same technology with identical amounts of capital.
Countries have natural advantages in the production of various commodities in relation to one another,
so this is an 'unrealistic' simplification designed to highlight the effect of variable factors. Ohlin said
that the HO-model was a long run model, and that the conditions of industrial production are
"everywhere the same" in the long run.
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Production output must have constant Return to Scale
Both of the countries in the simple HO model produced both commodities, and both technologies have
constant returns to scale (CRS). (CRS production has twice the output if both capital and labor inputs
are doubled, so the two production functions must be 'homogeneous of degree 1').
These conditions are required to produce a mathematical equilibrium. With increasing returns to scale
it would likely be more efficient for countries to specialize, but specialization is not possible with the
The technologies used to produce the two commodities differ
The CRS production functions must differ to make trade worthwhile in this model. For instance if the
functions are Cobb-Douglas technologies the parameters applied to the inputs must vary. An example
Where A is the output in arable production, F is the output in fish production, and K, L are capital and
labor in both cases.
In this example, the marginal return to an extra unit of capital is higher in the fishing industry, assuming
units of F(ish) and A(rable) output have equal value. The more capital-abundant country may gain by
developing its fishing fleet at the expense of its arable farms. Conversely, the workers available in the
relatively labor-abundant country can be employed relatively more efficiently in arable farming.
Labor mobility within countries
Within countries, capital and labor can be reinvested and re-employed to produce different outputs. Like
the comparative advantage argument of Ricardo, this is assumed to happen costless.
Capital immobility between countries
The basic Heckscher–Ohlin model depends upon the relative availability of capital and labor differing
internationally, but if capital can be freely invested anywhere competition (for investment) will make
relative abundances identical throughout the world.
Differences in labor abundance would not produce a difference in relative factor abundance (in relation
to mobile capital) because the labor/capital ratio would be identical everywhere.
As capital controls are reduced, the modern world has begun to look a lot less like the world modelled
by Heckscher and Ohlin. It has been argued that capital mobility undermines the case for Free Trade
itself, see: Capital mobility and comparative advantage Free trade critique. Capital is mobile when:
There are limited exchange controls
Foreign Direct Investment (FDI) is permitted between countries, or foreigners are permitted to
invest in the commercial operations of a country through a stock or corporate bond market
Labor immobility between countries
Like capital, labor movements are not permitted in the Heckscher-Ohlin world, since this would drive
an equalization of relative abundances of the two production factors.This condition is more defensible
as a description of the modern world than the assumption that capital is confined to a single country.
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Commodities have the same price everywhere
The 2x2x2 model originally placed no barriers to trade, had no tariffs, and no exchange controls. It was
also free of transportation costs between the countries, or any other savings that would favor procuring
a local supply.
If the two countries have separate currencies, this does not affect the model in any way (Purchasing
Power Parity applies).
Perfect internal competition
Neither labor nor capital has the power to affect prices or factor rates by constraining supply; a state of
perfect competition exists.
Econometric testing of H–O model theorems
Heckscher and Ohlin considered the Factor-Price Equalization theorem an econometric success.
Modern econometric estimates have shown the model to perform poorly, however, and adjustments
have been suggested, most importantly the assumption that technology is not the same everywhere.
Criticism against the Heckscher–Ohlin model
Although H-O model is normally thought to be basic for international trade theory, there are many
points of criticism against the model.
Poor predictive power
The original Heckscher–Ohlin model and extended model such as the Vanek model performs poorly,
as it is shown in the section "Econometric testing of H-O model theorem. Even when the HOV formula
fits well, it does not mean that Heckscher–Ohlin theory is valid. Indeed, Heckscher–Ohlin theory claims
that the state of factor endowments of each country determines the production of each country.
Factor equalization theorem
The factor equalization theorem (FET) applies only for most advanced countries. Heckscher–Ohlin
theory is badly adapted to the analyze South-North trade problems. The assumptions of HO are
unrealistic with respect to North-South trade. Income differences between North and South is the
concern that third world cares most. The factor price equalization theorem has not shown a sign of
realization, even for a long time lag of a half century.
Identical production function
The standard Heckscher–Ohlin model assumes that the production functions are identical for all
countries concerned. This means that all countries are in the same level of production and have the same
technology which is highly unrealistic. The standard Heckscher–Ohlin model ignores all these vital
factors when one wants to consider development of less developed countries in the international
context. Even between developed countries, technology differs from industry to industry and firm to
Capital as endowment
In the modern production system, machines and apparatuses play an important role. What is named
capital is nothing other than these machines and apparatuses, together with materials and intermediate
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products. Capital is the most important of factors, or one should say as important as labor. By the help
of machines and apparatuses’ quantity is not changed at once. But the capital is not an endowment given
by the nature. It is composed of goods manufactured in the production and often imported from foreign
countries. In this sense, capital is internationally mobile. The concept of capital as natural endowment
distorts the real role of capital.
Capital goods take different forms. It may take the form of a machine-tool such as lathe, the form of a
transfer-machine, which you can see under the belt-conveyors. Despite these facts, capital in the
Hechscher–Ohlin Model is assumed as homogeneous and transferable to any form if necessary. This
assumption is not only far from the reality, but also it includes logical flaw.
In the Heckscher–Ohlin model, the rate of profit is determined according to how abundant capital is.
Before the profit rate is determined, the amount of capital is not measured. This logical difficulty was
the subject of academic controversy which took place many years ago. In fact, this is sometimes named
Cambridge Capital Controversies. Heckscher–Ohlin theorists ignore all these stories without providing
any explanation how capital is measured theoretically.
Unemployment is the vital question in any trade conflict. Heckscher–Ohlin theory excludes
unemployment by the very formulation of the model, in which all factors (including labor) are employed
in the production.
No room for firms
Standard Heckscher–Ohlin theory assumes the same production function for all countries. This implies
that all firms are identical. The theoretical consequence is that there is no room for firms in the HO
Besides the usual assumptions of two countries, two commodities, no transport cost, etc. Ohlin's theory
also assumes no qualitative difference in factors of production, identical production function, constant
return to scale, etc. All these assumptions makes the theory unrealistic one.
Ohlin's theory is not free from constrains. His theory includes only two commodities, two countries and
two factors. Thus it is a restrictive one.
According to Ohlin's theory, supply plays a significant role than demand in determining factor prices.
But if demand forces are more significant, a capital abundant country will export labor intensive good
as the price of capital will be high due to high demand for capital.
Static in Nature
Like Ricardian Theory the H-O Model is also static in nature. The theory is based on a given state of
economy and with a given production function and does not accept any change.
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According to Wijnholds, it is not the factor prices that determine the costs and commodity prices but it
is commodity prices that determine the factor prices.
Consumers' Demand ignored
Ohlin forgot an important fact that commodity prices are also influenced by the consumers' demand.
According to Haberler, Ohlin's theory is based on partial equilibrium. It fails to give a complete,
comprehensive and general equilibrium analysis.
American economist Dr. Wassily Leontief tested H-O theory under U.S.A conditions. He found out that
U.S.A exports labor intensive goods and imports capital intensive goods, but U.S.A being a capital
abundant country must export capital intensive goods and import labor intensive goods than to produce
them at home. This situation is called Leontief Paradox which negates H-O Theory.
Other Factors Neglected
Factor endowment is not the sole factor influencing commodity price and international trade. The H-O
Theory neglects other factors like technology, technique of production, natural factors, different
qualities of labor, etc., which can also influence the international trade.
The critical assumption of the Heckscher–Ohlin model is that the two countries are identical, except for
the difference in resource endowments. This also implies that the aggregate preferences are the same.
The relative abundance in capital will cause the capital-abundant country to produce the capitalintensive good cheaper than the labor-abundant country and vice versa.
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The diamond model is an economical model developed by Michael Porter in his book The Competitive
Advantage of Nations .He is recognized as an authority on company strategy and competition;
Definition of 'Porter Diamond
A model that attempts to explain the competitive advantage some nations or groups have due to certain
factors available to them. The Porter Diamond is a model that helps analyze and improve a nation's role
in a globally competitive field. It is a more proactive version of economic theories that quantify
comparative advantages for countries or regions.
Investopedia explains 'Porter Diamond'
Traditional economic theories cite land, location, natural resources, labor and population as
determinants in competitive advantage. The Diamond Model uses a more proactive approach in
considering factors such as:
-The firm strategy, structure and rivalry
-Demand conditions for products
-Related supporting industries
In the Diamond Model, the role of government is to encourage and push organizations and companies
to a more competitive level, thereby increasing performance and ultimately the total combined benefit.
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The approach looks at clusters, a number of small industries, where the competitiveness of one company
is related to the performance of other companies and other factors tied together in the value-added chain.
The Porter analysis was made in two steps. First, clusters of successful industries have been mapped in
10 important trading nations. In the second, the history of competition in particular industries is
examined to clarify the dynamic process by which competitive advantage was created.
The phenomena that are analyzed are classified into six broad factors incorporated into the Porter
diamond, which has become a key tool for the analysis of competitiveness:
The points of the diamond are described as follows
-A country creates its own important factors such as skilled resources and technological base.
-These factors are upgraded / deployed over time to meet the demand.
-Local disadvantages force innovations. New methods and hence comparative advantage.
-A more demanding local market leads to national advantage.
-A strong trend setting local market helps local firms anticipate global trends.
3. RELATED AND SUPPORTING INDUSTRIES
-Local competition creates innovations and cost effectiveness.
-This also puts pressure on local suppliers to lift their game
4. FIRM STRATEGY, STRUCTURE AND RIVALRY
-Local conditions affect firm strategy.
-Local rivalry forces firm to move beyond basic advantages.
5. THE GOVERNMENT IN THIS MODEL
-To help to create growth in industries.
- Events are occurrences that are outside of control of a firm.
- Important because they create discontinuities in which some gain competitive positions and
The Porter thesis is that these factors interact with each other to create conditions where innovation
and improved competitiveness occurs.
PORTER'S DIAMOND OF NATIONAL ADVANTAGE
PORTER argued that a nation can create new advanced factor endowments such as skilled labor, a
strong technology and knowledge base, government support, and culture. PORTER used a diamond
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shaped diagram as a basis of a framework to illustrate the determinants of national advantage. The
diamond represents the national playing field that the countries establish for their industries.
The Diamond as a System
-The effect of one point depends on the others.
- The points on the diamond constitute a system and are self-reinforcing.
- Domestic rivalry for final goods stimulates the emergence of an industry that provides
specialized intermediate goods.
- Porter emphasizes the role of chance in the model. Random events can either benefit or harm
a firm's competitive position like major technological breakthroughs or inventions, acts of war
and destruction, or dramatic shifts in exchange rates.
- One might wonder how agglomeration becomes self-reinforcing
- When there is a large industry presence in an area, it will increase the supply of specific factors
(ie: workers with industry-specific training) since they will tend to get higher returns and less
risk of losing employment.
- At the same time, upstream firms (ie: those who supply intermediate inputs) will invest in the
area. They will also wish to save on transport costs, tariffs, inter-firm communication costs,
- At the same time, downstream firms (ie: those use our industry's product as an input) will also
invest in the area. This causes additional savings of the type listed before.
Implications of the Competitive Advantage of Nations for Governments
The government plays an important role in Porter's diamond model. He says, "Governments proper role
is as a catalyst and challenger; it is to encourage – or even push – companies to raise their aspirations
and move to higher levels of competitive performance" Governments can influence all four of Porter's
determinants through a variety of actions such as:
- Subsidies to firms, either directly (money) or indirectly (through infrastructure).
- Tax codes applicable to corporation, business or property ownership.
- Educational policies that affect the skill level of workers.
- They should focus on specialized factor creation. (How can they do this?)
- They should enforce tough standards.
Criticisms about the Diamond Model
Although Porter theory is renowned, it has a number of critics
Outward vs inbound FDI:
Porter argues that only outward-FDI is valuable in creating competitive advantage, and inbound-FDI
does not increase domestic competition significantly because the domestic firms lack the capability to
defend their own markets and face a process of market-share erosion and decline. However, there seems
to be little empirical evidence to support that claim.
Differences between study and performance:
In his famous book, The Competitive Advantage of Nations, Porter studied eight developed countries
and two newly industrialized countries (NICs). The latter two are Korea and Singapore. Porter is quite
optimistic about the future of the Korean economy. He argues that Korea may well reach true advanced
status in the next decade. In contrast, Porter is less optimistic about Singapore. In his view, Singapore
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will remain a factor-driven economy which reflects an early stage of economic development. Since the
publication of Porter's work, however, Singapore has been more successful than Korea. This difference
in performance raises important questions regarding the validity of Porter's diamond model of a nation's
Home base concept
While the variables of Porter's diamond model are useful terms of reference when analyzing a nation's
competitiveness, a weakness of Porter's work is his exclusive focus on the 'home base' concept. In the
case of Canada, Porter did not adequately consider the nature of multinational activities. In the case of
New Zealand, the Porter model could not explain the success of export-dependent and resource-based
industries. Therefore, applications of Porter's home-based diamond require careful consideration and
Single home based diamond approach
In Porter's single home-based diamond approach, a firm's capabilities to tap into the location advantages
of other nations are viewed as very limited. The double diamond model, developed by Rugman and
D'Cruz,suggests that managers build upon both domestic and foreign diamonds to become globally
competitive in terms of survival, profitability, and growth. While the Rugman and D'Cruz North
American diamond framework fits well for Canada and New Zealand, it does not carry over to all other
small nations, including Korea and Singapore.
Double diamond model
Porter raises the basic question of international competitiveness: "Why do some nations succeed and
others fail in international competition?
This model cleverly integrates the important variables determining a nation's competitiveness into one
model. However, substantial ambiguity remains regarding the signs of relationships and the predictive
power of the 'model' because Porter fails to incorporate the effects of multinational activities. Therefore,
Porter's original diamond model has been extended to the generalized double diamond model whereby
multinational activity is formally incorporated.
A nation's competitiveness depends partly upon the domestic diamond and partly upon the 'international'
diamond relevant to its firms. The size of the global diamond is fixed within a foreseeable period,
domestic diamond varies according to the country size and its competitiveness. The difference between
the international diamond and the domestic diamond thus represents international or multinational
activities. The multinational activities include both outbound and inbound foreign direct investment
Differences between two:
Theoretically, two methodological differences between Porter and this new model are important. First,
sustainable value added in a specific country may result from both domestically owned and foreign
owned firms. Porter, however, does not incorporate foreign activities into his model as he makes a
distinction between geographic scope of competition and the geographic locus of competitive
Second, sustainability may require a geographic configuration spanning many countries, whereby
firm specific and location advantages present in several nations may complement each other. Porter's
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global firm is just an exporter and his methodology does not take into account the organizational
complexities of true global operations by multinational.
The Importance of Porter's Diamond in Business
Government policies can influence the components of the diamond model. For example, some
economists suggest that lower income taxes stimulate consumer demand, which leads to higher sales
and profits. Countries that invest in education have a skilled workforce, which helps companies engage
in research and development. The presence of supporting industries in close proximity to manufacturing
companies can reduce input costs and increase profits. Supporting industries include raw materials
suppliers and component manufacturers. A competitive industry structure is also important.
An international business theory must look at the distribution of gains from international business
activities between the firms involved and the Governments in each country and between (or among)
relevant Governments.' When Governments are satisfied with the gains generated by an international
business activity in open markets, they impose no barriers and, hence, no theory of international
business is necessary; firms will then undertake cross-national activities for reasons explained by noninternational theories, such as comparative advantage or internalization theory. When Governments
wish to redistribute the costs and benefits of international business activities, they impose policies which
firms must take into account in their decision-making-and this action/reaction environment is the
subject that IB theory must explain. Since there are no Governments that permit fully open markets, the
world of international business is one requiring differential explanation. IB theory needs to re-focus its
analysis on the relationships between international firms and Governments. Instead of competitive
strategy among firms, it should analyze bargaining strategy between firms and Governments.
Under these conditions, IB theory becomes an explanation of bilateral (and sometimes multilateral)
negotiation over appropriability as between INCs and Governments in a game of the distribution of
wealth and power. We are back to a consideration of the goals of mercantilism in the pursuit of relative
wealth and power among nations through the TNC/ INC. In a mercantilist world such as ours, we need
a mercantilist theory of international business.
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World Wide Web:
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