International trade theories aim to explain why trade occurs between countries. Classical theories focused on country advantages like absolute advantage and comparative advantage. New theories examine how natural advantages, government policies, and industry characteristics enable trade. Porter's diamond of national advantage analyzes how factor conditions, demand conditions, related/supporting industries, and firm strategy/rivalry determine a country's competitive advantage.

1. INTERNATIONAL BUSINESS
UNIT-3

2. International Trade Theory
• What is international trade?
– Exchange of raw materials and manufactured goods
(and services) across national borders
• Classical trade theories:
– explain national economy conditions--country
advantages--that enable such exchange to happen
• New trade theories:
– explain links among natural country advantages,
government action, and industry characteristics that
enable such exchange to happen

3. Classical Country-Based
Theories
MERCANTILISM (PRE-16TH CENTURY)
– Takes an us-versus-them view of trade; other
country’s gain is our country’s loss
– Neo-mercantilism views persist today
FREE TRADE SUPPORTING THEORIES
– Show that specialization of production and free
flow of goods grow all trading partners’ economies
– Absolute Advantage (Adam Smith, 1776)
– Comparative Advantage (David Ricardo, 1817)
FREE TRADE REFINED
– Factor-proportions (Heckscher-Ohlin, 1919)
– International product life cycle (Ray Vernon, 1966)

4. Mercantilism
• Prevailed from 1500 to 1800
– Export more to “strangers” than we import to amass treasure,
expand kingdom
– Maximize exports and minimize imports: no advantage in
increased trade
• Government intervenes to achieve a surplus in exports
– King, exporters, domestic producers: happy
– Subjects: unhappy because domestic goods stay expensive
and of limited variety
• Today neo-mercantilists=protectionists: some segments of
society shielded short term
• Zero-sum vs positive-sum game view of trade

5. THEORY OF ABSOLUTE
ADVANTAGE
• Adam Smith: Wealth of Nations (1776)
argued:
–Capability of one country to produce
more of a product with the same amount
of input than another country
–A country should produce only goods
where it is most efficient, and trade for
those goods where it is not efficient
• Trade between countries is, therefore,
beneficial

6. • Assumes there is an absolute balance
among nations
• questions the objective of national
governments to acquire wealth through
restrictive trade policies
• measures a nation’s wealth by the living
standards of its people
THEORY OF ABSOLUTE
ADVANTAGE

7. Video
https://www.youtube.com/watch?
v=Vvfzaq72wd0

8. • Party A can produce 5 widgets per hour with 3
employees.
• Party B can produce 10 widgets per hour with 3
employees.
• Assuming that the employees of both parties
are paid equally, Party B has an absolute
advantage over Party A in producing widgets
per hour. This is because Party B can produce
twice as many widgets as Party A can with the
same number of employees.
PARTY B HAS THE COMPETITIVE ADVANTAGE
EXAMPLE:

9. 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.

10. • David Ricardo: Principles of Political Economy
(1817)
– Extends free trade argument
– Efficiency of resource utilization leads to more
productivity
– Should import even if country is more efficient in the
product’s production than country from which it is
buying.
– Look to see how much more efficient. If only
comparatively efficient, than import.
• Makes better use of resources
• Trade is a positive-sum game
COMPARATIVE DIFFERENCE IN
COST

11. • Driven only by maximization of production
and consumption
• Only 2 countries engaged in production and
consumption of just 2 goods?
• What about the transportation costs?
• Only resource – labour (that too, non-
transferable)
• No consideration for ‘learning theory’
Assumptions And Limitations

12. Ricardo's Classic Example
Trade costs, particularly transportation, reduce and may eliminate the
benefits from trade, including comparative advantage.
Paul Krugman gives the following example.

13. Hecksher –Ohlin Theory Video
https://www.youtube.com/watch?
v=hN9y_PmiPvE

14. Heckscher-Ohlin Theory
The pattern of international trade depends on differences in
factor endowments not on differences in productivity
• Absolute amounts of factor endowments matter
• Leontief paradox:
– US has relatively more abundant capital yet imports
goods more capital intensive than those it exports
– Explanation:
• US has special advantage on producing new products made
with innovative technologies
• These may be less capital intensive till they reach mass-
production state

15. Theory of Relative Factor
Endowments (Heckscher-Ohlin)
• Factor endowments vary among countries
• Products differ according to the types of factors
that they need as inputs
• A country has a comparative advantage in
producing products that intensively use factors of
production (resources) it has in abundance
• Factors of production: labor, capital, land, human
resources, technology.

16. Michael Porter's Theory of Competitive
Advantage
• Michael Porter's Theory of Competitive
Advantage of Nations against the Theory
of Competitive advantage sought to
examine the issue of why some nation's
business firms succeeded high in
international/global competition.

17. The theory of competitive advantage probes into three major aspects of trade
phenomenon:
i. Why does a nation succeed international in a particular industry?
ii. What influence does a nation carry on competition in specific
industries and their segments?
iii. Why do a nation's firms choose particular strategies of business?
Porter's analysis begins with following premises:
1. The nature of competition and the sources of competitive advantage
differentials in the industries.
2. Successful global enterprises draw competitive advantages through
their value chain of worldwide network.
3. Innovation is the pillion of gaining/sustaining competitive advantage.
4. Pioneering and aggressive competitors in exploiting new
market/technology are most successful.
• Porter undertook intensive research of 100 industries in ten countries. On
the basis of empirical investigation, Porter identified for attributes of nation
which determine (promote, impede) its competitive advantage referred to as
Porter's Diamond.

19. The Porter's Diamond narrates for
major attributes
 Factor Conditions
• A country's factor endowments or supply of factors of production such
as human resources, physical resources, knowledge resources,
location, capital resources and infrastructure play a significant role in
determining its national competitive advantage. Besides basic factors
(e.g., natural resources, climate, etc.,) advanced factors (e.g., skilled
labour, communications infrastructure, technology) are the crucial
determinants of the capabilities and competitiveness of a nation.
• Advanced factors are declined by the efforts of the individuals, firms,
institution and government in a country.
• Japan's success may largely be attributed to its advanced factors
creation rather than basic factors arability. A nation can overcome its
deficiency or comparative disadvantage of basic factors endowment by
focussing on creation of advanced factors to improve its competitive
advantage.

20.  Demand Conditions
• The demand conditions in home market is important in stimulating domestic
firms to undertake innovation and improve quality of products. When
domestic buyers are sophisticated, a pressure in the market is created for
the domestic firms to meet high standards of quality demanded.
• For example, Japanese knowledge buyers have induced the Japanese
camera manufacturers to produce innovative models first in the home
market and then for the exports. Similarly, local customers in Sweden have
stimulated Ericsson to invest in cellular phone equipment industry much
before the rising global demand.
A nations demand conditions, thus, refer to:
i. The nature of home buyers needs - their sophistication and fastidiousness
ii. The size and pattern of growth of home market
iii. The timing of development of demands relative to buyer in foreign markets
iv. The knowledge presence of domestic buyers in foreign markets and their
preferences.
v. The timing of market saturation and challenges at home market provide a
strong reason to acquire global competitive position to a business firm.

21.  Suppliers and Related Industries
• National advantage in an industry is also conditioned by the
preserve of vigorous home-based suppliers of cost-effective and
quality inputs or related supporting industries. For example, the US
success in several electronic goods including personal computers is
attributed to the growth of semiconductor industry in the country.
Same is the case with Malaysia to some extent.
• Likewise, Sweden steel industry has contributed much to the
success of Sweden's output in ball bearings and cutting tools.
• Successful industrial growth in the exporting country may emerge
on quantum of the growing clusters of related/supervising industries.
German textile and approach sector is a chronic case in this regard
- (textile machinery, sewing machine needles, textile clothes forming
the cluster of textile exporting industry of the country). Ongoing
coordination and just-in-time strategy is easy when such clusteral
industrial growth occurs in a nation.

22.  Firm Strategy, Structure and Rivalry
• Different nations have different management attitudes, ideologies
and approaches which either strengthen or weaken their
comparative advantage. Will and motivation to go international are
based on the firm, management strategies and organisational
structure.
• Most firms in Japan and Germany, for instance are found to be
controlled by the top management teams which placed more
emphasis on improvement of the product designs and process. On
the other hand, US firms management is governed by the people
with finance backgrounds who mainly focussed on maximising
short-term financial return on investment.
• Consequence is that the US has lost its competitive advantage in
the automobile and such other manufacturing goods whereas Japan
has built up its strength in this sector.
• Domestic rivalry in the market also provides an impetus to the
creation and sustaining of competitive advantage in an industry. Our
domestic rivalry situation calls for innovation, product improvement,
enhancing efficiency and cost effectiveness in the business. A
computing firm's goal in such a situation is to set the business
strategy to capture larger market share and go global.

23. • Porter argued that government policy and actions as well as chance
events are the secondary auxiliary variables in creating competitive
and effective advantage of a nation.
• Effective positive industrial and trade policy of an open economy
would encourage local firms to compete abroad.
• Restrictive and protective policies weakened the firm's abilities to
compete in global markets.
• Some times chance events may become the cause of success.
• In short, all the attributes mentioned in Porter's Diamond have
combined effects in determining a nation's competitive advantage.
• The government can play a positive role in shaping the Diamond to
enhance the national competitive advantage in chosen industries.
• Indeed, Porter's theory gives an important message to the policy
market that it is the business firms who compete and not nations.
• Therefore, the government policies and actions should be directed
to the creation of favourable environment and provide a framework
that cause to encourage business community firms to improve,
innovate and be dynamic in achieving the competitive advantage.
• The government of a developing nation should design positive
policies in this regard, based on a long-term planning horizon, not
on short-term economic fluctuations.

24. Concluding Remarks
Various theories of international trade when reviewed
together provide an understanding of the complexities
involved in international business. They furnish an insight
to the business division members. They suggest at least
three major implications for international business:
i. Locational significance
ii. Importance of first-mover advantage
iii. Policy designs

25. WORLD TRADE ORGANIZATION
• The World Trade Organization (WTO) is the only global international
organization dealing with the rules of trade between nations. At its heart are
the WTO agreements, negotiated and signed by the bulk of the world’s
trading nations and ratified in their parliaments. The goal is to help producers
of goods and services, exporters, and importers conduct their business.
• The WTO can ...
• 1 ... cut living costs and raise living standards
• 2 ... settle disputes and reduce trade tensions
• 3 ... stimulate economic growth and employment
• 4 ... cut the cost of doing business internationally
• 5 ... encourage good governance
• 6 ... help countries develop
• 7 ... give the weak a stronger voice
• 8 ... support the environment and health
• 9 ... contribute to peace and stability
• 10 ... be effective without hitting the headlines

26. WTO FUNCTIONS
• While the WTO is driven by its member states, it could not function
without its Secretariat to coordinate the activities.
• The Secretariat employs over 600 staff, and its experts — lawyers,
economists, statisticians and communications experts — assist WTO
members on a daily basis to ensure, among other things, that
negotiations progress smoothly, and that the rules of international
trade are correctly applied and enforced.
• Trade negotiations
The WTO agreements cover goods, services and intellectual
property. They spell out the principles of liberalization, and the
permitted exceptions. They include individual countries’ commitments
to lower customs tariffs and other trade barriers, and to open and
keep open services markets. They set procedures for settling
disputes. These agreements are not static; they are renegotiated
from time to time and new agreements can be added to the package.
Many are now being negotiated under the Doha Development
Agenda, launched by WTO trade ministers in Doha, Qatar, in
November 2001.

27. • Implementation and monitoring
WTO agreements require governments to make their trade
policies transparent by notifying the WTO about laws in
force and measures adopted. Various WTO councils and
committees seek to ensure that these requirements are
being followed and that WTO agreements are being
properly implemented. All WTO members must undergo
periodic scrutiny of their trade policies and practices, each
review containing reports by the country concerned and
the WTO Secretariat.
• Dispute settlement
The WTO’s procedure for resolving trade quarrels under
the Dispute Settlement Understanding is vital for enforcing
the rules and therefore for ensuring that trade flows
smoothly. Countries bring disputes to the WTO if they
think their rights under the agreements are being infringed.
Judgments by specially appointed independent experts
are based on interpretations of the agreements and
individual countries’ commitments.

28. • Building trade capacity:
WTO agreements contain special provision for developing
countries, including longer time periods to implement
agreements and commitments, measures to increase their
trading opportunities, and support to help them build their
trade capacity, to handle disputes and to implement technical
standards. The WTO organizes hundreds of technical
cooperation missions to developing countries annually. It also
holds numerous courses each year in Geneva for
government officials. Aid for Trade aims to help developing
countries develop the skills and infrastructure needed to
expand their trade.
• Outreach:
The WTO maintains regular dialogue with non-governmental
organizations, parliamentarians, other international
organizations, the media and the general public on various
aspects of the WTO and the ongoing Doha negotiations, with
the aim of enhancing cooperation and increasing awareness
of WTO activities.

29. • The WTO agreements are lengthy and complex
because they are legal texts covering a wide range of
activities. But a number of simple, fundamental
principles run throughout all of these documents.
These principles are the foundation of the multilateral
trading system.
• Non-discrimination
A country should not discriminate between its trading
partners and it should not discriminate between its
own and foreign products, services or nationals.
• More open
Lowering trade barriers is one of the most obvious
ways of encouraging trade; these barriers include
customs duties (or tariffs) and measures such as
import bans or quotas that restrict quantities
selectively.

30. • Predictable and transparent
Foreign companies, investors and governments should be confident that trade barriers
should not be raised arbitrarily. With stability and predictability, investment is encouraged,
jobs are created and consumers can fully enjoy the benefits of competition — choice and
lower prices.
• More competitive
Discouraging ‘unfair’ practices, such as export subsidies and dumping products at below
cost to gain market share; the issues are complex, and the rules try to establish what is fair
or unfair, and how governments can respond, in particular by charging additional import
duties calculated to compensate for damage caused by unfair trade.
• More beneficial for less developed countries
Giving them more time to adjust, greater flexibility and special privileges; over three-
quarters of WTO members are developing countries and countries in transition to market
economies. The WTO agreements give them transition periods to adjust to the more
unfamiliar and, perhaps, difficult WTO provisions.
• Protect the environment
The WTO’s agreements permit members to take measures to protect not only the
environment but also public health, animal health and plant health. However, these
measures must be applied in the same way to both national and foreign businesses. In
other words, members must not use environmental protection measures as a means of
disguising protectionist policies.