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International Trade Theory

What is international trade?

Exchange of raw materials and manufactured goods
(and services) across national borders

International Trade Theory

Before there was theory . . . there was trade! One of

the earliest of humankinds activities.
Trade is the buying and selling of goods and
services across national borders. Why? Because, it is
making both parties to any transaction better off.
Trade theories, in general, attempt to explain who
trades how much of what with whom, and why . . .
and at what price. But NO ONE THEORY explains all


International Trade Theory

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

Classical Trade Theories

Mercantilism (pre-16th century)
Takes an us-versus-them view of trade
Other countrys gain is our countrys loss
Free Trade theories
Absolute Advantage (Adam Smith, 1776)
Comparative Advantage (David Ricardo, 1817)
Specialization of production and free flow of goods
benefit all trading partners economies
Free Trade refined
Factor-proportions (Heckscher-Ohlin, 1919-33)
International product life cycle (Ray Vernon, 1966)


New Trade Theory

Global Strategic Rivalry

Firms gain competitive advantage trough:
intellectual property, R&D, economies of
scale and scope, experience
National Competitive Advantage
(Porter, 1990)

From the mid-16th Century till 19th Century
A nations wealth depends on its accumulated
treasure, basically Gold & Silver
Gold and silver are the currency of trade.
Export more to strangers than we import to
amass treasure, expand kingdom
Trade is win or lose; a zero-sum game.
The interest of the State is dominant


Government intervenes to achieve a surplus in
Theory says you should have a trade surplus.
Maximize exports through subsidies.
Minimize imports through tariffs and quotas.
King, exporters, domestic producers: happy
Subjects: unhappy because domestic goods stay
expensive and of limited variety
Fit quite well with an age of exploration, colonialism,
imperialism, and capitalism. (East India Companies)

David Hume - 1752

Increased exports leads to inflation and higher

Increased imports lead to lower prices.
Result: Country A sells less because of high
prices and Country B sells more because of lower
In the long run, no one can keep a trade surplus.


Free Trade Theory

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.
The pattern of International Trade displays patterns
that are easy to understand (Saudi Arabia/oil or
Bangladesh/labor intensive goods). Others are not so
easy to understand (Japan and cars).

Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).
Capability of one country to produce more of a product
with the same amount of input than another country.
A country
Should specialize in production of and export products for which it
has absolute advantage; import other products
Has absolute advantage when it is more productive than another
country in producing a particular product
Trade between countries is, therefore, beneficial.
Assumes there is an absolute advantage balance among
No longer zero sum; everybody wins!


Comparative Advantage
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 products
production than country from which it is buying.
Look to see how much more efficient. If only comparatively
efficient, than import.
Country should specialize in the production of those goods
in which it is relatively more productive... even if it has
absolute advantage in all goods it produces
Makes better use of resources
Absolute Advantage is a special case of Comparative

Factor Endowments Trade Theory

Developed by Eli Heckscher (1919)
Expanded by Bertil Ohlin (1933)
Factor Endowments Trade Theory originally
considered two factors of Production- Labor
& Capital
Other factors were added later


Factor Endowments Trade Theory

Factors of production: labor, capital, land, human
resources, technology
A country has a comparative advantage in producing
products that intensively use factors of production
(resources) it has in abundance
Export goods that intensively use factor endowments
which are locally abundant.
Corollary: import goods made from locally scarce
Patterns of trade are determined by differences in
factor endowments - not productivity.

Factor Proportions Trade Theory

A country that is relatively labor
abundant (capital abundant) should
specialize in the production and export of
that product which is relatively labor
intensive (capital intensive).



Leontief paradox
Could Factor Proportions Theory be used to explain the types
of goods the United States imported and exported?
US has relatively more abundant capital yet imports goods
more capital intensive than those it exports
The labor cost is high, but exports more labor intensive
US has special advantage on producing new products
made with innovative technologies
These may be less capital intensive, but more labor
intensive till they reach mass-production state

Product Life-Cycle Theory

(Raymond Vernon, 1966)
As products mature, both location of sales and
optimal production changes.
Affects the direction and flow of imports and
Globalization and integration of the economy makes
this theory less valid.


Product Cycle Theory:

Vernons Premises

Technical innovations leading to new and

profitable products require large quantities of
capital and skilled labor

The product and the methods for manufacture

go through three stages of maturation


International Product Trade Cycle Model

High Income Countries production

Exports Imports consumption

u 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

a Medium Income Countries Exports

t Imports
y 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Low Income Countries

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Time
New Product Maturing Product Standardized Product

Stages of Production Development


The Product Cycle and Trade Implications

Increased emphasis on technologys impact on
product cost
Explained international investment
Most appropriate for technology-based products
Some products not easily characterized by stages of
Most relevant to products produced through mass


Classic Theory Conclusion

Free Trade expands the world pie for goods/services
Theory Limitations:
Simple world (two countries, two products)
no transportation costs
no price differences in resources
resources immobile across countries
constant returns to scale
each country has a fixed stock of resources and no efficiency
gains in resource use from trade
full employment


The New Trade Theory

Began to be recognized in the 1970s.
Deals with the returns on specialization
where substantial economies of scale are
Specialization increases output, ability to
enhance economies of scale increase.

Application of the New Trade Theory

Typically, requires industries with high, fixed
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.


First-Mover Advantage
Economies of scale may preclude new
Role of the government.

Boeing & Airbus

Porters Diamond (1990)

The Competitive Advantage of Nations.
Looked at 100 industries in 10 nations.
existing theories didnt go far enough.
Question: Why does a nation achieve
international success in a particular industry?


Determinants of National Competitive

Factor endowments: nations 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 industrys product or service.
Firm strategy, structure and rivalry: the conditions in
the nation governing how companies are created,
organized, and managed and the nature of domestic rivalry.
Related and supporting industries: the presence or
absence in a nation of supplier industries or related
industries that are nationally competitive.

Porters Diamond


The Diamond
Success occurs where these attributes exist.
More/greater the attribute, the higher chance
of success.
The diamond is mutually reinforcing.

Factor Endowments
Factors of production: the inputs necessary to
compete in any industry
Basic factors-natural, capital and labor resources
(Heckscher-Olin)- are largely inherited
Advanced factors -supportive infrastructure,
technology & communication systems and an
educated workforce
Advanced factors lead to competitive advantage- created as a
result of investment by people, companies, government.
Generalized factorscan be used in a number of different industries
Specialized factorstailored for use in specific industries
Selective disadvantages may lead to advantages
in factors of production under certain conditions


Demand conditions
Characterized by the nature and size of buyers
needs in the home market for the industrys
goods or services
Size of the market segment can lead to scale-
efficient facilities
Efficiency can lead to domination of the industry
in other countries
Demanding consumers may lead to efficient
Value system


Related and supporting industries

Creates clusters of supporting industries that are
internationally competitive.
supporting services, facilities, suppliers and so on
Support in design
Support in distribution
Related industries as suppliers and buyers
Supplying industries in the home base has several
advantages in downstream industries
Efficient, early, rapid, and sometimes preferential access to the
most cost-effective inputs
Ongoing coordination
Innovation and upgrading
A competitive domestic supplier industry is better than
relying on well-qualified foreign suppliers


Firm strategy, structure, and rivalry

One country differs from another with regard to
managerial systems and philosophies and with regard to
capital markets
Institutional environments that allow firms to take a long-
term view contribute positively to competitiveness
Presence of a large number of competing firms or rivals in
the domestic industry
Competition among firms is necessary for allocative efficiency in a
market system, but domestic rivalry contributes to dynamic,
technological efficiency


Porter Diamond Interactions

Most important Interactionsall related to rivalry
Domestic rivalsparticularly when clustered in a
geographic regioncontribute to the creation of factors
Especially specialized, advanced factors
A group of domestic rivals contribute to the presence of
specialized and sophisticated suppliers
Rivalry among domestic firms producing differentiated
products enlarges home demand and makes it more

Reinert/Windows on the World Economy,



Spatial Clusters in the World

Flexibility and home base concepts converge in spatial
Interlinked firms/activities that exist in the same local and regional
setting (in terms of economic, social, cultural and institutional factors)
AKA clusters, networks, centers of excellence, and industrial districts
Much productive knowledge cannot be codified into explicit
Rather, communicated via a highly social process of face-to-face
interaction over a relatively long period of time
Consequently, innovation and learning is a spatially-located, social and
collective process among a group of firms


Spatial Clusters in the World


Why do spatial clusters contribute to the

productivity of firms?
Concentrated communication made possible by a
cluster increases learning and innovation
Contributes to the dynamic, technological efficiency of
firms in the cluster
Trust increases over time which facilitates
contracting and exchange among firms
Common business culture develops which reduces



International Business
International business consists of all
commercial transactionsincluding sales,
investments, and transportationthat take
place between two or more countries-to
satisfy the profit motives of individuals,
companies, and organizations

Why studying International Business is important ?

Most companies are either international or compete

with international companies
Modes of operations may differ from those used
The best way of conducting business may differ by
An understanding helps you make better career
An understanding helps you decide what
government policies to support