International Business

International Trade Theory

Lecture 7

Overview
Introduction
An Overview of Trade Theory
The benefits of trade
The pattern of international trade
Trade theory and government policy

Mercantilism
Absolute Advantage
2

Overview
Comparative Advantage
Qualifications and assumptions
Extension of the Ricardian Model

Heckscher-Ohlin Theory
The Leontiff Paradox

Overview
The Product Life-Cycle Theory
Evaluating the PLC theory

New Trade Theory

Increasing product variety and reducing costs
Economies of scale, first mover advantages,
and the pattern of trade
Implications of new trade theory
4

Overview
National Competitive Advantage: Porters
Diamond
Factor endowments
Demand conditions
Related and supporting industries
Firm strategy, structure, and rivalry

Overview
Evaluating Porters Theory
Implications for Managers
Location
Firstmover advantages
Government policy

Introduction
Refer to the industry of roses of Ecuador; this
product is considered as the Rolls Royce of roses
They have huge heads and unusually vibrant colours,
including 10 different reds
The industry started some 30 years ago and has been
expanding rapidly since
Ecuador is now the worlds fourth largest producer of
roses; it is the nations fifth largest export; $240m in
sales annually
7

Introduction
The Ecuadorian rose industry is a striking
example of the benefits of free trade and
globalization
Low barriers to trade have allowed Ecuador to
exploit its comparative advantage in the
growing of roses and thus help the country to
emerge as a major exporter of roses
Economic growth and personal incomes have
been bolstered by the emerging rose industry
8

Introduction
Helped consumers in foreign markets to access
affordable high-quality roses from Ecuador
Who are the losers?

In the world of international trade, there are

always winners and losers
The benefits to the winners outweigh the
costs borne by the losers, resulting in a net
gain to society
9

Introduction
In the long run, free trade stimulates economic
growth and raises living standards across the
board
International trade theory has shaped the economic
policy of many nations in the past 50 years
It has been the driver in the formation of WTO
and other regional trade blocs; examples?
The 1990s saw a global move toward greater free
trade; why?
10

Introduction
It is therefore important to understand what
what these theories are and why they have
been so successful in shaping the economic
policy of so many nations and the
competitive
environment
in
which
international business compete

11

Introduction
The aims:
Review the theories that explain why it is
beneficial for a country to engage in
international trade
Explain the pattern of international trade
that we observe in the world economy;
patterns of exports and imports of goods
and services among countries
12

An Overview of Trade Theory

Theories noted as far as 16th and 17th
centuries
Mercantilism
Countries should simultaneously encourage
exports and discourage imports
Old and discredited doctrine; its echoes still
remain in modern political debate and in the
trade policies of many countries
13

An Overview of Trade Theory

Absolute advantage
Adam Smiths theory; dates back to 1776
Explains why unrestricted free trade is
beneficial to a country
Free trade refers to a situation where 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
14

An Overview of Trade Theory

The invisible hand of the market mechanism,
rather than government policy, should
determine what a country imports and what it
exports
A laissez-faire stance toward trade is in the best
interests of a country

Building on Smiths
additional theories

work

are

15

two

An Overview of Trade Theory

Comparative advantage
Theory advanced by the 19th century economist
David Ricardo
This theory is the intellectual basis of the
modern argument for unrestricted free trade

In the 20th century, Ricardos work was

refined by two Swedish economists
Theory known as Heckscher-Ohlin theory
16

The benefits of trade

The theories can identify with a certain
degree of precision the specific benefits of
international trade
Common sense suggests that international
trade is beneficial
Example of Iceland? explain

17

The benefits of trade

Going beyond the common sense notion,
why is it beneficial for a country to engage
in international trade, even for products it is
able to produce for itself
Issue of US consumers buying home-made
products; nationalistic sentiments; help save
jobs from foreign competition
18

The benefits of trade

The different theories tell us that a countrys
economy may gain if its citizens buy certain
products from other nations that could be
produced at home; explain?
Example of US specializing in the
production of certain goods and importing
other products
19

The benefits of trade

The economic argument is often difficult for
segments of a countrys population to accept;
explain with examples
Future threatened by imports
Limit the imports,through quotas, tariffs
May benefit particular groups, but hurts the economy as
a whole

Limits on imports are often in the interests of

domestic producers, but not domestic consumers
20

The pattern of international trade

The theories of Smith, Ricardo, and
Hechscher-Ohlin help to explain the pattern
of international trade that we observe in the
world economy
The different aspects to be taken into
consideration
Climate and natural resources; examples?
21

The pattern of international trade

However, much of the observed pattern of
international trade is difficult to explain
Why Japan exports automobiles, consumer
electronics, and machine tools?
David Ricardos theory of comparative
advantage offers an explanation in terms of
international
differences
in
labour
productivity
22

The pattern of international trade

The more sophisticated Heckscher-Ohlin
theory emphasizes the interplay between the
the proportions in which the factors of
production are available in different
countries and the proportions in which they
are needed for producing particular goods;
assumption rests on the fact that countries
have varying endowments of the various
factors of production
23

The pattern of international trade

One early response to the failure of the HeckscherOhlin theory to explain the observed pattern of
international trade was the product life-cycle
theory; proposed by Raymond Vernon
Early in the life cycle, most new products are
produced in and exported from the country in
which they are developed; what happens next,
when the product is widely accepted
internationally?
24

The pattern of international trade

Similarly, during the 1980s, new theory has been
developed; new trade theory developed by Paul
Krugman
It stresses that in some cases, countries specialise
in the production and export of particular products
not because of underlying differences in factor
endowments, but because in certain industries the
world market can support only a limited number
of firms; examples?
25

The pattern of international trade

In such industries, firms that enter the
market first are able to build a competitive
advantage that is subsequently difficult to
challenge
Thus, the observed pattern of trade between
nations may be due in part to the ability of
firms within a given nation to capture firstmover advantages; examples?
26

The pattern of international trade

In a work related to the new trade theory,
Michael Porter, developed a theory referred
to as the theory of national competitive
advantage
This attempts to explain why particular
nations achieve international success in
particular industries
27

The pattern of international trade

In addition to factor endowments, Porter
points out the importance of country factors
such as domestic demand and domestic
rivalry in explaining a nations dominance
in the production and export of particular
products

28

Trade theory and government policy

Although all these theories agree that
international trade is beneficial to a country,
they
lack
agreement
in
their
recommendations for government policy
Mercantilism: crude case for government
involvement in promoting exports and
limiting imports
29

Trade theory and government policy

The theories of Smith, Ricardo, and HeckscherOhlin form part of the case for unrestricted free
trade; both import controls and export incentives
are self-defeating and result in wasted resources
Both the new trade theory and Porters theory of
national competitive advantage can be interpreted
as justifying some limited government
intervention to support the development of certain
export-oriented industries
30

Mercantilism
The first theory of international trade; it
emerged in England in the mid-16th century
The principal assertion of mercantilism was
that gold and silver were the mainstays of
national wealth and essential to vigorous
commerce

31

Mercantilism
The main tenet
It was in a countrys best interests to
maintain a trade surplus, to export more
than it imported; by doing so, a country
would accumulate gold and silver and,
increase its national wealth, prestige, and
power
English mercantilist writer: Thomas Mun
32

Mercantilism
Consistent with this belief, the doctrine advocated
government intervention to achieve a surplus in
the balance of trade; no virtue in large volume of
trade; rather policies to maximise exports and
minimise imports; how?
The classical economist David Hume pointed out
an inherent inconsistency in this mercantilist
doctrine in 1752; example of UK and France
balance of surplus; explain?
33

Mercantilism
The flaw with this theory was that it viewed
trade as a zero-sum game; gain by one
country results in a loss by another
Subsequent theories showed the shortsightedness of this approach and
demonstrated that trade is a positive-sum
game, or a situation in which all countries
can benefit
34

Mercantilism
Unfortunately, the mercantilist doctrine is
by no means dead
Neo-mercantilists equate political power
with economic power and economic power
with a balance-of-trade surplus
Examples?

35

Absolute Advantage
A country has an absolute advantage in the
production of a product when it is more
efficient than any other country in
producing it
Adam Smith attacked the mercantilist
assumption that trade is a zero-sum game;
landmark book of Adam Smith in 1776;
The Wealth of Nations
36

Absolute Advantage
Countries differ in their ability to produce goods
efficiently; examples?
According to Smith, countries should specialize in
the production of goods for which they have an
absolute advantage and then trade these for goods
produced by other countries
Example of Ghana and Korea in the production of
cocoa and rice
37

Absolute Advantage
Resources required to produce 1 ton of
cocoa and rice
Production and consumption without trade
Production with specialization
Consumption after trade
Increase in consumption as a result of
specialization and trade
38

Absolute Advantage
As a result of specialization and trade,
output of different products would increase,
and consumers in various nations would be
able to consume more
Trade is thus a positive sum game; it
produces net gains for all involved

39

Comparative Advantage
What happens when one country has an absolute
advantage in the production of all goods?
David Ricardo took Smiths theory one step
further to study the above
Smiths theory of absolute advantage suggests that
a country may not benefit from international trade;
in his book Principles of Political Economy,
Ricardo showed this was not the case
40

Comparative Advantage
According to Ricardos theory of
comparative advantage, it makes sense for a
country to specialize in the production of
those goods that it produces most efficiently
and to buy the goods it produces less
efficiently from other countries; even if this
means buying goods from other countries
that it could produce more efficiently itself
41

Comparative Advantage
Example of Ghana and Korea in the production of
cocoa and rice; with Ghana having an absolute
advantage in both products; explain?
The basic message of the theory of comparative
advantage is that potential world production is
greater with unrestricted free trade than it is with
restricted trade; consumers in all nations can
consume more if there are no restrictions on trade
This occurs in countries that lack an absolute
advantage in the production of any good
42

Comparative Advantage
The theory of comparative advantage
suggests that trade is a positive-sum game
in which all countries that participate
realize economic gains; this theory provides
a strong rationale for free trade

43

Comparative Advantage
Qualifications and assumptions
The conclusion that free trade is universally
beneficial is a rather bold; assumptions
made:
Assume a simple world in which there are
only two countries and two goods
Transportation costs?
44

Comparative Advantage
Differences in the prices of resources in
different countries; exchange rates?
Resources can move freely from the
production of one good to another
Assume constant returns to scale; there may
may be diminishing or increasing returns to
specialization
45

Comparative Advantage
Assume that each country has a fixed stock
of resources and that free trade does not
change the efficiency with which a country
uses its resources
Assume away the effects of trade on income
distribution within a country

46

Comparative Advantage
Given these assumptions, can the
conclusion that free trade is mutually
beneficial be extended to the real world of
many countries, many goods, positive
transportation costs, volatile exchange rates,
immobile domestic resources, non-constant
returns to specialization, and dynamic
changes?
47

Comparative Advantage
Economists have shown that the basic result
from the simple model can be generalized
to a world of many countries producing
many different goods
However, some economists associated with
the new trade theory, argue that the case, for
unrestricted free trade, while still positive,
loses some of its strength
48

Comparative Advantage
Extensions of the Ricardian Model
We may still consider the effect of relaxing three
of the assumptions identified in the simple model
Resources move freely from the production of one good
to another
Constant returns to scale
Trade does not change a countrys stock of resources or
the efficiency with which the resources are utilized

Explain the effects?

49

Heckscher-Ohlin Theory
Eli Heckscher and Bertil Ohlin put forward a
different explanation of comparative advantage
It arises from differences in national factor
endowments
By factor endowments, they meant the extent to
which a country is endowed with such resources
as land, labour, and capital
Impact on costs?
50

Heckscher-Ohlin Theory
The Heckscher-Ohlin theory attempts to
explain the pattern of international trade
that we observe in the world economy
The theory predicts that countries will
export those goods that make extensive use
of factors that are locally abundant, while
importing goods that make intensive use of
factors that are locally scarce
51

Heckscher-Ohlin Theory
Like Ricardos theory, the Heckscher-Ohlin
theory argues that free trade is beneficial
Unlike Ricardos theory, however, the
Heckscher-Ohlin theory argues that the
pattern of international trade is determined
by differences in factor endowments, rather
than differences in productivity
52

Heckscher-Ohlin Theory
Examples: US and China?
It is relative not absolute, endowments that
are important

53

The Leontief Paradox

The Heckscher-Ohlin theory has been one
of the most influential theoretical ideas in
international economics
Because of its influence, the theory has
been subjected to many empirical tests;
famous study by Wassily Leontief in 1953

54

The Leontief Paradox

Using the Heckscher-Ohlin theory, Leontief
postulated that since US was relatively
abundant in capital compared to other
nations, the US would be an exporter of
capital-intensive goods, and an importer of
labour-intensive goods; however, US
exports were less capital intensive than US
imports; hence the Leontief paradox
55

The Product Life-Cycle Theory

Raymond Vernon initially proposed this theory in
the mid 1960s
A very large proportion of the worlds new
products had been developed by US firms and
sold first in the US market; examples?
Products could still be produced at low-cost sites
and exported back into the US market; then, why
initially produced in the US itself?
56

The Product Life-Cycle Theory

What about the initial demand in the US market
and in other developed markets?
High income groups in advanced countries

Over time, what happens?

Consequence of the trends for the pattern of world
trade over time: switch from being an exporter to
an importer of the product as production becomes
concentrated in lower-cost foreign locations
57

Evaluating the PLC theory

Historically, the PLC theory seems to be an
accurate explanation of international trade patterns
Examples: photocopiers in the US
However, the PLC theory is not without
weaknesses
Viewed from an Asian or European perspective,
Vernons argument that most new products are
developed in the US seems ethnocentric
58

Evaluating the PLC theory

Could be true during the US dominance period
(1945 1975)

Exceptions appear to have become more

common in recent years; Japan, Europe?
Impact of globalization and integration of the
world economy? Launch of new products

59

New Trade Theory

The new trade theory began to emerge in
the 1970s when a number of firms pointed
out that the ability of firms to attain the
economies of scale might have important
implications for international trade
Economies of scale are unit cost reductions
associated with a large scale of output; may
also have a number of sources
60

New Trade Theory

Ability of large volume producers to utilize
specialized employees and equipment that
are more productive than less specialized
employees and equipment
Examples?

61

New Trade Theory

New trade theory makes two important points
Through its impact on EoS, trade can increase the
variety of goods available to consumers and
decrease the average costs of those goods
In those industries, when the output required to
attain EoS represents a significant proportion of
total world demand, the global market may only
be able to support a small number of enterprises;
examples? First movers in specific production?
62

National Competitive Advantage:

Porters Diamond
Why a nation achieves international success
in a particular industry? Why some nations
succeed and others fail international
competition?
Japan: automobile industry
Switzerland:
precision
pharmaceuticals

instruments,

Partial explanation by the known theories

63

National Competitive Advantage:

Porters Diamond
Porter theorizes that four broad attributes of
a nation shape the environment in which
local firms compete, and these attributes
promote or impede the creation of
competitive advantage
Factor endowments
A nations position in factors of production,
such as skilled labour, infrastructure, necessary
to compete in a given industry
64

National Competitive Advantage:

Porters Diamond
Demand conditions
The nature of home demand for the industrys
product or service

Relating and supporting industries

The presence or absence of supplier industries
and related industries that are internationally
competitive

65

National Competitive Advantage:

Porters Diamond
Firm strategy, structure, and rivalry
The conditions governing how companies are created,
organized, and managed and the nature of domestic
rivalry

Porter speaks of these four attributes as

constituting the diamond
Firms are most likely to succeed in industries or
industry segments where the diamond is most
favorable
66

National Competitive Advantage:

Porters Diamond
The diamond is a mutually reinforcing
system; the effect of one attribute is
contingent on the state of the others

67

Evaluating Porters Theory

Porter contends that the degree to which a
nation is likely to achieve international
success in a certain industry is a function of
the combined impact of the four attributes;
the presence of the four components is
usually required for the diamond to boost
competitive performance
Who can influence each of the components?
68

Evaluating Porters Theory

What about the Government? The latter can
influence positively or negatively
Factor endowments: subsidies, policies
toward capital markets, education
Domestic demand: local product standards,
regulations that influence buyer needs
Supporting
and
related
industries:
regulation
69

Evaluating Porters Theory

Firm rivalry: capital market regulation, tax policy,
antitrust laws
If Porters theory is correct, we would expect his
model to predict the pattern of international trade,
that we observe in the real world
Countries exporting products from those industries
where all four components of the diamond are
favorable; is it true?
One cannot say? Extent of empirical testing?
70

Implications for Managers

Why does all this matter for business?
The theories discussed have three main
implications
Location
First-mover
Government policy

71

Questions
Mercantilism is a bankrupt theory that has
no place in the modern world. Discuss
Is free trade fair? Discuss
What are the potential costs of adopting a
free trade regime? Do you think
governments should do anything to reduce
these costs? Discuss
72