This document provides an overview of key concepts in international finance and international trade theories. It discusses that international finance deals with international trade, exchange rates, foreign investment, and the global financial system. It then explains several theories of international trade, including absolute advantage theory, comparative advantage theory, Heckscher-Ohlin theory, overlapping product ranges theory, and product life cycle theory. Each theory aims to explain patterns of international specialization and trade between countries.

1. International Finance

2. Introduction
• It is the branch of economics which deals with the
dynamics of:
– International Trade
– Exchange rate
– Foreign Investment
– Global financial system
• It is a branch of International Economics
• It is concerned with understanding all the procedures,
techniques & tools related to helping firm in accessing
global markets for short/long term funds

3. • International trade
– Applies microeconomic models to understand
the emergence and significance of international
trade
• Why? – Theories international trade – Their
practical application
• Different types of trade policy – free, restricted, etc.
• How composition of international trade changes
due to changes in economic conditions, etc.

4. • International trade is a cross border trade
• It refers to exchange of capital, goods, services, and
across international borders or territories
• Without international trade, nations would be limited to
the goods and services produced within their own borde
rs
• Each country has scarce resources / specific skills –
better to produce some, rather than all – to optimize
the utilization
What is International Trade??

5. International Trade Theories

6. Absolute Advantage theory
• Adam Smith – trade b/w two nations is based on
absolute advantage
• When one nation is more efficient (has absolute
advantage) than another in production of A, but
• Less efficient (has absolute disadvantage) in
production of B
• Both nations can gain by each specializing in
production of good of its absolute advantage
• Numerical example – next slide

7. 3-1• Assume - Total resources for each X & Y = 200 Mhrs
– X requires 10 Mhrs for 1 unit of rice & 20 Mhrs for 1 unit of wheat
– Y requires 40 Mhrs for 1 unit of rice & 10 Mhrs for 1 unit of wheat
Country Rice Wheat Before Trade
Absolute Advantage
X – Rice
Y - Wheat
X 10 5
Y 2.5 10
Total 12.5 15
Production with
specialization
Consumption after
trade of 6 units
each
Gain from
specialization and
trade
Country Rice Wheat Rice Wheat Rice Wheat
X 20 0 14 6 4 1
Y 0 20 6 14 3.5 4
Total 20 20 20 20 7.5 5

8. Comparative Advantage theory
• Ricardo – even if one nation is less efficient
(has absolute disadvantage) in both A & B than
other nation
• Still it is beneficial for trade

9. Example - Comparative Advantage
• Absolute Advantage – X in both products
• Comparative Advantage – Y in wheat
Country Rice Wheat
X 10 7.5
Y 2.5 5
Total 12.5 12.5
• Total resources for each X & Y = 200 Mhrs
• Country X requires10 Mhrs for 1 unit of rice and 13.33 Mhrs
for 1 unit of wheat
• Country requires 40 Mhrs for 1 unit of rice and 20 Mhrs for 1
unit of wheat

10. Example – Gains from trade
Production
without
specialization
Production
with
specialization
Consumption
after trade of
4 units each
Gain from
specialization
and trade
Country Rice Wheat Rice Wheat Rice Wheat Rice Wheat
X 10 7.5 15 3.75 11 7.75 1 0.25
Y 2.5 5 0 10 4 6 1.5 1
Total 12.5 12.5 15 13.75 15 13.75 2.5 1.25

11. Heckscher-ohlin Theory / Factor
Endowment Theory - Assumptions:
• 2 countries, 2 goods and 2 Factor of production (FOP)
i.e. L, K
• Two factors are available in fixed amounts in each of
the two countries; they are fully mobile b/w industries
within each country; but immobile b/w countries
• Two countries are alike in every respect except for
their endowments of two factors
• For each of the two goods, required technology is
available

12. Heckscher-ohlin Theory / Factor
Endowment Theory
• A country is labor-abundant if it has a higher ration of
labor to other factors than does the rest of the world
• A product is labor-intensive if labor costs are a greater
share of its value than the are of the value of other
products.
• A country has comparative advantage in the good that is
relatively intensive in the country’s relatively abundant
factor
• Export – commodity intensive in its relatively abundant &
cheap factor of production (FOP)
• Import – commodity intensive in its relatively scarce &
expensive factor of production (FOP)

13. Empirical Test of H-O Model
(Leontief Paradox)
• Wassily W. Leontief made an attempt to test the
Heckscher-Ohlin theory empirically.
• In 1954, Leontief found that the U.S. (the most capital-
abundant country in the world) exported labor-intensive
commodities and
• imported capital-intensive commodities, in contradiction
with Heckscher-Ohlin theory ("H-O theory").
• This contradiction is called as Leontief Paradox
• Leontief's paradox undermined the validity of the
Heckscher-Ohlin theorem (H-O) theory

14. Arguments to support HO Model
• Some economists argue that the U.S. has an advantage
in highly skilled labor more so than capital.
• This can be seen as viewing "capital" more broadly, to
include human capital.
• Using this definition, the exports of the U.S. are very
(human) capital-intensive, and not particularly
intensive in (unskilled) labor.

15. Overlapping product Ranges Theory
• The type, complexity and diversity of product demands of
a country increase as country's income increases.
• International trade patterns would follow this principle
• So that countries of similar income per capita levels will
trade most intensively having overlapping product
demands
• According to Linder - nations with similar demands would
develop similar industries.
• These nations would then trade with each other in similar
but differentiated goods.

16. Overlapping product Ranges Theory
• For instance, both the U.S. and Germany are developed
countries with a significant demand for cars, so both
have large automotive industries (overlapping product
demands)
• Rather than one country dominating the industry with a
comparative advantage - both countries trade different
brands of cars between them.

17. Product Life Cycle Theory
• The product life-cycle theory looks at the potential export
possibilities of a product in five discrete stages in its life-
cycle

18. • Stage 1: Introduction
– A new product is manufactured in the innovating country
and sold primarily in that domestic market
– Any overseas sales are generated through exports to other
markets
– At this stage the innovating company has little competition
in markets abroad.
• Stage 2: Expansion
– Sales increase, but so does competition as other firms
enter the arena
– At this point, the firm begins some production abroad, to
serve foreign markets and to counter the competition

19. • Stage 3: Maturity
– Exports from the home country decrease, because of
increased production in overseas locations.
– Price has become a critical determinant of
competitiveness, so minimising costs becomes an
important objective.
– Production may shift to less developed countries to
take advantage of lower labour costs
– At this point, domestic production may cease and the
product is imported by the home market.

20. • Stage 4: Sales decline
– This occurs because competitors have achieved economies of
scale equal to those of the innovator.
• Stage 5: Demise
– The innovator may cease production and leave the declining
market to imitators
– Product's popularity has also ceased and consumers seek other
products.
• This theory holds - for products such as consumer durables,
synthetic fabrics and electronic equipment;
• Products which have a long time-span from innovation to eventual
peak consumer demand.