This document provides an overview of international trade theory. It defines international trade and outlines several theories for why nations trade, including mercantilism, absolute advantage, comparative advantage, and factor endowment theory. It also discusses the international product life cycle theory and how trade barriers can impact trade between nations. The document contrasts the theories of absolute and comparative advantage using examples and analyzes different considerations in international trade such as government regulation and consumer tastes.

1. INTERNATIONAL
TRADE THEORY
Presented By,
Ravish Kumar-64
Ranjan Kumar-171
Ankit Semwal-125

2. OBJECTIVES
Define the term international trade and discuss the role of
mercantilism in modern international trade.
Contrast the theories of absolute advantage and comparative
advantage.
Relate the importance of international product life cycle
theory to the study of international economics.

3. INTRODUCTION
International trade: the branch of economics concerned
with the exchange of goods and services with foreign
countries.
We will focus on:
International trade theory

4. WHY DO NATIONS TRADE?
Trade theories:
Mercantilism;
theory of absolute advantage;
theory of comparative advantage;
factor endowment theory;
international product cycle theory;
other considerations.

5. Trade theory-overview
Free Trade occurs when a government does not attempt to
influence, through quotas or duties, what its citizens can buy
from another country or what they can produce and sell to
another country
The Benefits of Trade allow a country to specialize in the
manufacture and export of products that can be produced
most efficiently in that country

6. MERCANTILISM MID- 16TH CENTURY
A trade theory which holds that a government can improve
the well-being of the country by encouraging exports
and stifling imports.
Cf.) Neo mercantilism: without the reliance on precious
metal (gold).

7. CONTD..
A nation’s wealth depends on accumulated “treasure”
Gold and silver are the currency of trade
Mercantilists sought what we now call ‘development’
They argued their countries should run a trade surplus
Maximize export through subsidies
Minimize imports through tariffs and quotas
Flaw: “zero-sum game”
Mercantilists neglected to see
the benefits of trade

8. But there was a flaw in
the mercantilists’ argument
They assumed that trade was a zero-sum game
As England, France, and the Netherlands competed with each
other, many thought
only about advantage for their country

9. THEORY OF ABSOLUTE ADVANTAGE
A trade theory which holds that by specializing in the
production of goods, which they can produce more
efficiently than any others, nations can increase their
economic well-being.
An example
Assume:
labour is the only cost of production;
lower labour-hours per unit of production means lower
production costs and higher productivity of labour.

10. Theory of absolute advantage
(Continued)
North has an absolute advantage in the production of cloth.
South has an absolute advantage in the production of grain.
It follows that:
If North produces cloth and South produces grain, and an exchange ratio
can be arranged, both the countries will benefit from trade.

11. THEORY OF COMPARATIVE ADVANTAGE
A trade theory which holds that nations should produce
those goods for which they have the greatest relative
advantage.
An example
Assume:
labour is the only cost of production;
lower labour-hours per unit of production means lower
production costs and higher productivity of labour.

12. Theory of comparative advantage
(Continued)
North has an absolute advantage in the production of both cloth and grain but the relative
costs differ (i.e. gains from trade).
In North, one unit of cloth costs 50/100 hours of grain.
In South, one unit of cloth costs 100/100 hours of grain.
It follows that:
If North can import more than a half unit of grain for one unit of cloth, it will gain from
trade.
If South can import one unit of cloth for less than one unit of grain, it will also gain from
trade.
Under the circumstance presented in the above example, both countries can benefit from
trade.

13. FACTOR ENDOWMENT THEORY
Also known as the Heckscher-Ohlin theory,
It extends the concept of comparative advantage by bringing into
consideration the endowment and cost of factors of
production and helps to explain why nations with relatively
large labour forces will concentrate on producing labourintensive goods, whereas, countries with relatively more capital
than labour will specialize in capital-intensive goods.
Weaknesses of factor endowment theory:
Some countries have minimum wage laws that result in high
prices for relatively abundant labour.
The Leontief paradox: countries like the United States actually
export relatively more labour-intensive goods and import
capital-intensive goods.
No single theory can explain the role of economic factors in trade theory.

14. INTERNATIONAL PRODUCT LIFE
CYCLE THEORY (IPLC)
A theory of the stages of production for a product with
new “know-how”: it is first produced by the parent firm,
then by its foreign subsidiaries and finally anywhere in
the world where costs are the lowest; it helps to explain
why a product that begins as a nation’s export often ends
up as an import.

15. The international product life cycle
Source: Raymond Vernon and Louis T. Wells, Jr., The Manager in the International Economy (Englewood Cliffs, NJ: Prentice Hall, 1991), p. 85

16. THE RICARDIAN MODEL
Immobile resources:
Resources do not always move easily from one economic
activity to another
Diminishing returns:
Diminishing returns to specialization suggests that after
some point, the more units of a good the country
produces, the greater the additional resources required to
produce an additional item
Different goods use resources in different proportions
Free trade (open economies):
Free trade might increase a country’s stock of resources
(as labor and capital arrives from abroad)
Increase the efficiency of resource utilization

17. 4-17
NEW TRADE THEORYAPPLICATIONS
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

18. Commonly used barriers to trade
 Price-based barriers
 Tariffs: a tax on goods shipped internationally
 Quantity limits
 Quotas: a quantity limit on imported goods
 Embargos: a quota set to zero
 International price fixing

A cartel: a group of firms that collectively agree to fix prices or
quantities sold in an effort to control price
 Non-tariff barriers
 Financial limits

Exchange controls: controls that restrict the flow of currency
 Foreign investment controls
 Limits on FDI
 Limits on transfer or remittance of funds

19. 4-19
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
were based on four major attributes
Factor endowments
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry

20. OTHER CONSIDERATIONS
Government regulation
Monetary currency valuation
Consumer tastes

21. A Link Between Trade
Open economy developing countries
and Growth
grew 4.49%/year.
Closed economy developing countries grew
Sachs and Warner: 1970 to 0.69%/year.
1990 study
Open economy developed countries grew
2.29%/year.
Closed economy developed countries grew
0.74%/year.
Frankel and Romer:
On average, a one percentage point
increase in the ratio of a country’s trade to
its GDP increases income/person by at
least 0.5%. For every 10% increase in the
importance of international trade in an
economy, average income levels will rise
by at least 5%.

22. Barriers to trade

23. Reasons for barriers to trade
 Protect local jobs by shielding home-country business from
foreign competition.
 Encourage local production to replace imports.
 Protect infant industries that are just getting started.
 Reduce reliance on foreign suppliers.
 Encourage local and foreign direct investment.
 Reduce balance of payments problems.
 Promote export activity.
 Prevent foreign firms from dumping, that is, selling goods
below cost in order to achieve market share.
 Promote political objectives such as refusing to trade with
countries that practice apartheid or deny civil liberties to their
citizens.

24. Heckscher (1919)-Ohlin (1933) Theory
 A country will export goods that use its abundant
factors intensively, and import goods that use its
scarce factors intensively.
 It states "A capital-abundant country will export
the capital-intensive good, while the laborabundant country will export the labor-intensive
good”.
 The two countries are identical, except for the
difference in resource endowments.
 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.

25. The Leontief Paradox
 Disputes Heckscher-Olin in some instances.
 The country with the world's highest capital-per
worker has a lower capital/labor ratio in exports than
in imports.
 Factor endowments can be impacted by government
policy - minimum wage.
 US tends to export labor-intensive products, but is
regarded as a capital intensive country.

26. Diamond Model
 Michael Porter
 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, in customerclient relation, or in a local or regional contexts.
 The Porter analysis was made in two steps.
1) Clusters of successful industries have been
mapped in 10 important trading nations.
2) The history of competition in particular
industries is examined to clarify the dynamic
process by which competitive advantage was
created.