The document discusses several theories of international trade, including: 1. Mercantilism held that a nation's wealth depends on accumulating gold and silver, and that governments should promote exports and discourage imports to achieve a trade surplus. 2. Comparative advantage theory proposed by Ricardo states that countries should specialize and trade for goods they are relatively less efficient in producing to increase total global output. Even if less efficient overall, a country benefits from importing goods where its disadvantage is lower. 3. Heckscher-Ohlin theory proposes that patterns of trade are determined by differences in factor endowments (e.g. land, labor, capital), with countries exporting goods intensive in their locally abundant factors

1. INTERNATIONAL
BUSINESS
TOPIC 4

2. INTERNATIONAL
TRADE THEORY

3. Chapter Focus
• Review several trade theories that explain why it
is beneficial for a country to engage in
international trade.
• Explain the pattern of international trade
observed in the world economy.

4. Mercantilism: Mid-16th century
• A nation’s wealth depends on accumulated treasure
• Gold and silver are the currency of trade (and
measure of wealth).
 A country that has no gold must import it
• To increase wealth, countries must have trade
surplus
• Therefore government policies should promote
exports and discourage imports
 Importation of gold depends on exports of
goods
 Importation of other goods tightly controlled
• Flaw: “zero-sum game”
 if country advances economically, another loses
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5. The 7 Instruments of Trade Policy
Antidumping
Duties
Local
Content
Requirements
Tariffs
Voluntary
Exports
Restraints
Subsidies
Administrative
Policies
Import
Quotas

6. Tariffs
Tariffs
Specific
Fixed charge
per unit
Ad Valorem
Charge is
a proportion of the
goods value
 Oldest form of protection.
 Good for the Government.
 Good for producers.
 Leads to inefficiency.
 Bad for consumers.

7. Subsidies
Government
payment to a
domestic producer
Cash Grants
Tax Breaks
Low Interest
Loans
Government
Equity
Participation

8. Subsidies
Agriculture
1.Keeps inefficient
farmers in business.
2.Encourages production
of subsidized products.
3.Produce products grown
more cheaply elsewhere.
4.Reduces agriculture
trade.
Helps domestic
producers to
compete internationally.
Paid by taxing
individuals

9. Import Quotas and Voluntary Export
Restraints
Direct restriction
on the quantity of a
good that can
be imported into
a country.
Import Quotas
Quota on trade imposed
by the exporting
country at the request
of the importing
country’s government.
VERs
Helps
producers
Quota
rent

10. Local Content Requirements
A specific
fraction of a
good must be
domestically
produced.
A specific
fraction of a
good must be
domestically
produced.
Physical
amount
Value
Widely used
by developing
countries to
develop their
manufacturing
base.
Used by developed
countries to
protect local jobs
and industry from
foreign competition.

11. Administrative Policies
• Bureaucratic rules designed to make it difficult for imports to enter
a country.
• Japanese ‘masters’ in imposing rules.
• Tulip bulbs.
• Federal Express.

12. Antidumping Policies
• Selling goods into a foreign market below
production costs, or
• Selling below “fair market value”.
• Used to unload excess production.
• Or, predatory pricing.
• Antidumping policies are used to punish
foreign firms.
• Protect local industry from “unfair” practices.
• Impose “countervailing” duties.

13. Political Arguments for Intervention
Further
Foreign Policy
Objectives
Protect
Industry
and Jobs.
National
Security
Retaliation
Protect
Consumers
Protect
Human
Rights

14. Economic Arguments for Intervention
Infant
Industry
Strategic
Trade
Policy
 Infant industry is the oldest economic
argument for government intervention,
dating to 1792 and Alexander Hamilton.
 Protect developing country’s new industry
from developed countries better
established industries. Recognized by
GATT.
 Strategic trade policy can help a
firm gain ‘first mover’ advantages
or overcome barriers created by a
different (foreign) first mover.

15. Revised Case for Free Trade
Paul Krugman, MIT economist, argues that strategic
trade policies can lead to trade wars. The best way to
handle disputes is to work to establish rules that minimize
trade-distorting subsidies - a function of the World
Trade Organization.
He also argues that government intervention usually favors
special interest groups that distort the subsidy to their
own ends.
Therefore, “a blanket policy of free trade, with exceptions
granted only under extreme pressure … may be the best
policy that the country is likely to get.”

16. David Hume - 1752
• Criticized Mercantilism:
Increased exports leads to inflation and higher prices.
Increased imports lead to lower prices.
Result: Country A sells less because of high prices and Country B
sells more because of lower prices.
In the long run, no one can keep a trade surplus.
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17. Theory of Absolute Advantage
• Advocated by Adam Smith in Wealth of
Nations (1776).
• Market forces, not government controls,
determine the direction, volume and
composition of international trade
• Basis: Capability of one country to produce
more of a product with the same amount of
input than another country.
• A country will export goods in which it has an
absolute advantage over other countries
• the proceeds from exports will allow the
country to import other goods
• So countries should produce only goods
where they are most efficient, trade for those
where they are not efficient.
• Trade between countries is, therefore,
beneficial.
• Assumes there is an absolute advantage
balance among nations.
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18. Absolute Advantage
To have an absolute advantage a country must
be able to produce:
1) a larger amount of a good or service for the
same amount of inputs as can another country
2) the same amount of a good or service using
fewer inputs than can another country
• In classic economics a “unit of input” is
measured in: land, labor, capital

19. Absolute Advantage: Example
Assumptions:
• We consider two countries: USA and China that produce only
soybeans and cloth
• Each has two “units of input” and uses one to produce tons of
soybeans and the other bolts of cloth
• The U.S. has an absolute advantage producing soybeans
• China has an absolute advantage producing cloth

20. Absolute Advantage Example
• A “unit of input” is made of: land, labor, capital
• If each specializes, the total tons of soybeans
and bolts of cloth available to the world
increases
• Soybeans from 4 to 6; cloth from 6 to 8

21. Theory of Comparative Advantage
• Advocated by David Ricardo in 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.
• A nation may have absolute disadvantages in the production of two goods with
respect to another nation
• Yet this nation has a comparative advantage or relative advantage in the
production of the good in which its absolute disadvantage is lower
• By specializing in the production of the good in which the country has lower
comparative disadvantage, and importing other goods, the total goods available
will increase
• Makes better use of resources
• Trade is a positive-sum game.
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22. Simple Extensions of the Ricardian Model
• Immobile resources:
• Resources do not always move easily from one economic
activity to another.
• Diminishing returns:
• More a country produces, at some point, will require more
resources (diminishing returns to specialization).
• Different goods use resources in different proportions.
• However:
• Free trade might increase a country’s stock of resources (as
labor and capital arrives from abroad), and
• Increase the efficiency of resource utilization.
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23. Theory of Comparative Advantage:
Example
• Each has two “units of input” and uses one to produce tons of
soybeans and the other bolts of cloth
• The quantities have changed from the prior example
• China has the absolute advantage producing both soybeans and bolts
of cloth
• The U.S. does a better job producing soybeans, it has a a comparative
advantage or lower comparative disadvantage in soybeans

24. Theory of Comparative Advantage: Example
• The U.S. specializes in soybeans and China in cloth
• There are one fewer tons of soybeans three more bolts
of cloth
• If the U.S. exports four tons of soybeans to China for 3
bolts of cloth the U.S. consumer has more cloth
• China is left with two surplus bolts of cloth; it can trade
one with another country for more soybeans and be left
with more cloth for its citizens

25. A Link Between Trade and Growth
Sachs and Warner: 1970 to 1990 study
Open economy developing countries grew 4.49%/year.
Closed economy developing countries grew 0.69%/year.
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%.

26. Heckscher (1919)-Ohlin (1933) Theory
• Focus on factor endowments: i.e. extent to which a
country is endowed with land, labor, and capital.
• Suggests: Export goods that intensively use factor
endowments which are locally abundant and import
goods made from locally scarce factors.
• Patterns of trade are determined by differences in
factor endowments - not productivity.
• Remember, focus on relative advantage, not absolute
advantage.
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27. Heckscher-Ohlin Theory of Factor
Endowments
• Reasons for countries to export products requiring large amounts of their abundant production
factors:
• Lower cost to produce; more attractive abroad
• Imported products have low relative cost as producing locally would require large
amounts of the importing country’s scarce production factors
• Does not consider
• Government influence on factor prices - no perfect market
• Transportation costs
• Differences in tastes
• Differences in climates
• Population diversity and income levels

28. The Leontief
Paradox, 1953
• Disputes Heckscher-
Olin in some
instances.
• Factor endowments
can be impacted by
government policy –
e.g. minimum wage.
• US tends to export
labor-intensive
products, but is
regarded as a capital
intensive country.
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29. Heckscher vs Ricardo
• Economists prefer Heckscher on theoretical
grounds but is a relatively poor predictor of
trade patterns.
• Ricardo’s Comparative Advantage Theory,
regarded as too limited for predicting trade
patterns, actually predicts them with greater
accuracy.
• In the end, differences in productivity may be
the key to determining trade patterns.
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30. International Product Life-Cycle Theory
(Raymond Vernon, 1966)
• Article in the Quarterly Journal of
Economics.
• As products mature, both location of
sales and optimal production changes.
• Affects the direction and flow of imports
and exports.
• Globalization and integration of the
economy makes this theory less valid.
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31. 31
The Product Life-Cycle Theory

32. The New Trade Theory
• Began to be recognized in the 1970s.
• Deals with the returns on specialization
where substantial economies of scale are
present.
• Economies of scale: as a plant gets larger,
output increases, per unit production cost
decreases
• Specialization increases output, ability to
enhance economies of scale increase.
• In addition to economies of scale, learning
effects also exist.
• Learning effects are cost savings that come
from “learning by doing”.
• as firms produce more products, they learn
ways to improve production efficiency
further reducing costs
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33. Application of the New Trade Theory
• Typically, requires industries with high, fixed
costs.
• World demand will support few competitors.
• Competitors may emerge because “they got
there first”.
• First-mover advantage.
• Some argue that it generates government
intervention and strategic trade policy.
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34. First-Mover Advantage
• Economies of scale may preclude new
entrants.
• Role of the government is critical in assisting
local industry to be the first mover.
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35. Porter’s Diamond
(Harvard Business School, 1990)
• The Competitive Advantage of
Nations.
• Looked at 100 industries in 10
nations.
• Thought existing theories
didn’t go far enough.
• Question: “Why does a nation
achieve international success in a
particular industry?”
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36. Variables Impacting Competitive
Advantage: Porter’s Diamond
Source: Adapted from Ball et. al. (2010)

37. Determinants of National Competitive
Advantage
• Factor endowments: nation’s position in factors of production such as
skilled labor or infrastructure necessary to compete in a given industry.
• Demand conditions: the nature of home demand for the industry’s
product or service.
• Related and supporting industries: the presence or absence in a nation
of supplier industries or related industries that are nationally
competitive.
• Firm strategy, structure and rivalry: the conditions in the nation
governing how companies are created, organized, and managed and
the nature of domestic rivalry.
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38. The Diamond
• Success occurs where the attributes exist.
• More/greater the attribute, the higher chance of
success.
• The diamond is mutually reinforcing.
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39. Factor Endowments
• Taken from Heckscher-Olin
• Basic factors:
• natural resources
• climate
• location
• demographics
• Advanced factors:
• communications
• skilled labor
• research
• technology
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40. Advanced Factor Endowments
• More likely to lead to competitive
advantage.
• Are the result of investment by people,
companies, government.
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41. Relationship of Basic to
Advanced Factors
• Basic can provide an initial advantage.
• Must be supported by advanced factors to
maintain success.
• No basics, then must invest in advanced factors.
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42. Demand Conditions
• Demand creates the capabilities.
• Look for sophisticated and demanding
consumers.
• impacts quality and innovation.
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43. Related and Supporting Industries
• Creates clusters of supporting industries that are
internationally competitive.
• Must also meet requirements of other parts of
the Diamond.
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44. Firm Strategy, Structure and Rivalry
• Management ‘ideology’ can either help or hurt
you.
• Presence of domestic rivalry improves a
company’s competitiveness.
4-38
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45. Implications for Business
• Location implications: makes sense to disperse
production activities to countries where they can be
performed most efficiently.
• First-mover implications: It pays to invest substantial
financial resources in building a first-mover, or early-
mover, advantage.
• Policy implications: promoting free trade is generally in
the best interests of the home-country, although not
always in the best interests of the firm. Even though,
many firms promote open markets.