Theory of International Trade

Why Trade?

Countries benefit from foreign trade

• They can import resources they lack at home
• Higher standards of living and greater satisfaction
• They can import goods for which they are a relatively
inefficient producer
• Specialization often results in increased output and
economies of scale
• Contributes to global interdependence
 Concepts of Trade

Mutual Gains From Trade Scarcity and Choice

• When trade is voluntary: • Wants exceed resources
– Both sides must expect to – Choices are necessitated
gain from it, otherwise they by scarcity
would not trade
Theory of Mercantilism
 Theory Of Mercantilism

• The first theory of international trade called

Mercantilism in England, in mid-16th century.
• Gold and silver were the currency of trade
• Country’s interests was to maintain a trade
surplus, to export more than it imported
• By doing so, a country would accumulate gold
and silver and, consequently, increase its
national wealth and prestige—by an English
mercantilist writer Thomas Mun in 1630.
 Demerits:

• Problems with this theory is that it excludes the

fact that in some cases it is good to import
• If the import is completely refused, the population
will have to do without certain consumer items
Theory of Absolute Advantage
 Theory of Absolute Advantage

• Proposed by Adam Smith

in 1776 in his book ‘The
Wealth of Nations’
• He was a Scottish
Classical Economist
• Some of his great books
are ‘The theory of Moral
Sentiments’ and
‘The Wealth of Nations’
 Cont’d…

• He said, ‘ A country has an absolute advantage in

the production of a product more efficiently than
any other country

• He said, ‘Countries should specialize in the

production of goods for which they have absolute
advantage and then trade these for goods
produced by other countries.
 Cont’d…

• Smith’s basic argument that a country should

never produce goods that can buy at a lower cost
from other countries
Examples:
• England should specialize in the production of
textiles and French in wine and then trade these
• Ghana and South Korea doing trade of cocoa
and rice
 Demerits

• Smith’s theory can not explain if there should be

trade when a country has absolute advantage on
all goods over other country
• In this case, a country might derive no benefits
from international trade
Comparative Cost Theory
 Comparative Cost Theory

• It is attributed to David
Ricardo an English
political economist in
1817 in his book
‘Principles of Political
Economy and Taxation’
• He was also a member
of Parliament,
Businessman,
Financier and
Speculator
 Cont’d….

• Some countries have the advantage of

producing some goods at a lower cost
compared to other countries.
 The countries in the long run should specialize

in the business in which they enjoy

comparatively low cost advantage and export
the product while it will import other goods in
which other countries have comparatively low
cost advantage, if free trade is allowed

e.g. Japan in producing electronics and India in

textile
 The Theory of Comparative Advantage

G
20

C
15
Cocoa

A
10

K
5

B
2.5 K’
G’
0 3.75 5 7.5 10 15 20
Rice
Cont’d…
 Example

Wheat Wine
Country Cost Per Unit In Man Hrs Cost Per Unit In Man Hrs

England 15 30

Portugal 10 15
 The basic message of this theory

• Potential world production is greater with

unrestricted free trade than it is with restricted
• Consumers in all nations can consume more if
there are no restrictions on trade
• Trade is a positive sum game in which all
countries that participate realize economic gains.
 Assumptions of this theory

• The only element of the cost of production is

labour
• There are no trade barriers
• Trade is free from cost of transportation
 Criticism

• An advanced nation may gain an advantage by

shifting labour and resources to more profitable
goods such as microchips and away from less
profitable goods like potato chips. Thus there is a
chance that the advanced nation may buy all the
potato chips it wants as it has more wealth for
microchips
• Advanced industrial countries may keep
undeveloped countries on agriculture instead of
developing their own manufactures (which would
have made them competition for the industrialized
nations)
Hecksher-Ohlin Theory
 Hecksher-Ohlin Theory

• Swedish economists-Eli Heckscher(1919) & Bertil

Ohlin(1933)
• Ohlin-student of Hecksher

Eki Heckscher Bertil Ohlin

 Postulates

H-O Theory is based upon two postulates:

2.The factor endowments are different in different
countries.
– E.g. Land-Argentina & Australia
– Labour- INDIA & China
– Capital-U.S.A & U.K.
3.Different commodities require for their production
different proportions of the factors of production.
 Cont’d…

• They gave a different explanation of comparative

advantage
• They argued that comparative advantage arises from
differences in national factor endowments (land, labor,
capital)
• Different factor endowments among countries explain
differences in factor costs.
• The more abundant a factor, the lower its cost
• Export those goods that make intensive use of factors
that are locally abundant, while importing goods that
make intensive use of factors that are scarce.
 Assumptions

• It is based on the neo-classical theory which considers

land ,labour and capital as the factors of production.
• Factor endowments vary in quantity but are homogenous
qualitatively.
• Resources are fully employed in the trading countries.
• The production are fully employed in the trading countries.
• Technologies are same across countries.
 MERITS OF H.O THEORY OVER
CLASSICAL THEORY

• H-O model takes these factors-land, labour &

capital–as against the one factor (labour) of the
classical model.
• It is cast within the framework of the general
equilibrium theory of value.
 Cont’d…

• It is more realistic because it is based on the

relative prices of factors which in turn
influences the relative prices of the goods,
while Ricardian theory considers the relative
price of goods only.
• Considers differences in relative productivity
of labor and capital as a basis of
international trade.
 Criticisms

• Theory explains trade being due to differences in factor

proportions between countries. This implies that no trade
will take place between countries endowed with similar
factor endowments
• Theory ignores factors such as-transport cost, economies
of scale, etc.
• Wijanholds-price of commodity not determined by factors
of production
• S.Linder(Swedish economist)-It is not applicable to
manufactured goods, where the costs largely depend
upon technology, management, scale of production, etc.
 Cont’d…

• Assumption that don’t hold good in a dynamic

world
– fixed factor endowments
– Technology
• J.H.Williams-contends the assumption of
immobility of factors between countries
• Theory is not supported by empirical evidence
The Leontief Paradox
 The Leontief Paradox

• Wassily.W.Leontief (1906- -
1999)
• 20th century Russian born
U.S. Economist.
• Ph.D in Berlin.
• Father of input output
analysis. -
• Winner of Nobel Prize in
economics in
1973.
 What was tested?

• Heckscher-Ohlin theory states that each country

exports the commodity which uses its abundant
factor intensively.
• The first serious attempt to test the theory was
made by Professor Wassily W. Leontief in 1954.
 Result

• Leontief reached a conclusion that the US—the

most capital abundant country in the world
exported labor-intensive commodities and
imported capital- intensive commodities.
• This result has come to be known as the Leontief
Paradox.
 How the test was performed?

• Leontief used the 1947 input-output table of the

US economy.
• 200 groups of industries was aggregated into 50
sectors.
• Computed the labour & capital requirements.
• This was done for 1 million dollars worth of
exports and import replacements.
 Cont’d…

• US exports were labour intensive.

• US imports were capital intensive
 Leontief's Second Test

• Leontief was criticized on statistical grounds-

Swerling complained that 1947 was not a typical
year: the postwar disorganization of production
overseas was not corrected by that time.
• In 1956 Leontief repeated the test for US imports and
exports which prevailed in 1951.
• He aggregated industries into 192 industries.
• He found US imports were still 6% more capital-
intensive.
Trade Patterns of Other Countries

S.No Country Exports Imports

Japan(Tatemoto
1 and Ichimura,
1959)
Canada(Wahl,
2 1961)
-
East Germany
3 (Stolper and
-
Roskamp,1961)
India(Bharawaj,
4 1962)
-

Capital-intensive

Labour-intensive
 Criticisms
• Methodology-
It was basically concerned with export industries
and competitive import replacements rather than
actual imports.
• He did not measure or compare factor
endowments of America with those of other
trading nations.
 Hecksher-Ohlin theory was defended by some
other economists(R.Jones and Hoffmeyer)

• Very high domestic demand of capital intensive

goods.
• Difference in characteristics of labour across
countries.
Example: US tends to specialize in technology
intensive products that require more highly educated
labour.
• He did not deal adequately with natural resource
component of goods.
 Conclusion

• Ohlin’s theory is irrefutable because it cannot be

put to perfect empirical test on account of its
unrealistic and restrictive assumptions.
• When we consider the impact of technology on
productivity is not taken into consideration,the
Heckcher-Ohlin theory gains predictive power.
Product Life Cycle Theory
 PLC Theory

• Proposed by: Raymond Vernon in

mid-1960s
• Raymond Vernon was part of the
team that overlooked the Marshall
plan, the US investment plan to
rejuvenate Western European
economies after the Second World
War.
• He played a central role in the post-
world war development of the IMF
and GATT organisations.
• He became a professor at Harvard
Business School from 1959 to 1981
and continued his career at the John
F. Kennedy School of Government.
 Cont’d…

About the theory:

• Based on the observation that new products
had been developed by U.S firms and sold first
in U.S market
• Two fundamental principles-
1. Technology
2. Market size and structure
 Cont’d...

Overview:
• It was a trade theory beyond Ricardo’s theory
• It is an internationalization process
• Products advanced in technology are produced &
sold in the home market
• Bypasses the trade barriers
• In the end the innovator becomes the importer of
the product
• It is produced by lesser developed countries or, if
the innovator has developed an MNC there
 Cont’d…

• Three stages:
1. New-product stage New-product stage

2. Maturing-product stage
3. Standardized-product
stage

Maturing-product stage Standardized-product stage

 Cont’d…

1. New-Product Stage:
• Conditions for success:
– Availability of sufficient scientists and engineers
– Higher per capita income
• Flexibility in production
• Demand is relatively price inelastic
• Product features given more priority than price
• Close contact with the market
• Few players in the domestic market as
competitors
 Cont’d…

• How to meet increase in demand?

– Exports
– Foreign production
 Cont’d…

2. Maturing-Product Stage:
• Transition from New-Product Stage-
– Price competition
– Technology is diffusing
• Price elastic demand for the product
• Standardization of production process
• Change in company strategy away from focus
on production toward market protection.
• Product differentiation
 Cont’d…

• Market growth slows

• Toward the end of this stage, foreign production
may even be exported to the home country
 Cont’d…

3. Standardized-Product Stage:
• Technology becomes widely available
• Price competition
• Production shifted to less developed countries
• Offshore assembly
• Strategy to combat price competition-Product
differentiation
• Principal markets gets saturated
• Innovator’s original advantage gets eroded
International Product Life Cycle
The Product Life-Cycle Theory
160
140
United States production
120
100
80
60 Exports Imports consumption
40
20
0

160
140
120
100 Other Advanced Countries Exports
80
60
40
20
0 Imports
160
140
120 Developing Countries
100
80
60 Exports
40
20
0 Imports

New Product Maturing Product Standardized Product

Stages of Production Development

 PLC Theory-Examples
U.S Photocopiers-Xerox(1960)

Japan & Western Exported to advanced

Europe countries
Growth in demand
Joint venture-production
Fuji-Xerox(Japan)
Rank-Xerox(Great Britan)
Expiry of Xerox’s patent
Entry of competitors
Canon(Japan)
Olivetti(Italy)

Import from low-cost foreign

U.S
sources (developing countries)
 Cont’d…

• Pocket calculator
1961 1970s 1975

Sunlock
Comptometer Corp. Competitors-HP, Texas Standardized-
Instruments product stage
$1000
$240 $10/$15
 Cont’d…

Polaroid Land camera

1948 1976 1987 1992

Introduced by Late New- 47% sales-foreign

Competition from product/early operations(18 countries)
Polaroid Corp. Kodak Maturity stage
Price competition

• The New-Product stage lasted approximately for 30 years.

Cont’d…

Finland’s Nokia
• Finland
– sparsely populated
– Extremely cold climatic
condition
• How it developed
competitive edge?
 Cont’d…

German Cars:
• Germany is the leader in production of cars.
• It produces cars like VW, Mercedes – Benz,
BMW, Formula one cars etc
• It sells its products in the home market
• It exports to the advanced countries like USA,
UK, France, etc & even in Asia
• It has not yet reached the third stage
 PLC Theory-Merits

• Helps organizations going for international

expansion
• New product development in a country does not
occur by chance
• The model is best applied to consumer oriented
physical products like electronic items
 PLC Theory-Demerits

• Duration of each stage is not known

• Doesn’t explicitly state to make the choice
between-export and foreign plant
• It doesn’t explain which country’s firms are most
likely to produce in any given market or which
firms will move first.
• Vaguely defines ‘product’
 Cont’d…

Other Demerits:
• Its main assumption was that the diffusion of new
technology occurs slowly. By the late 1970’s he
recognized that this assumption was no longer valid
• It assumed integrated firms producing in one nation,
then exporting and building facilities abroad. But now
the business landscape has become more
interrelated
• He emphasized the product level and not the
consumer side
• Foreign markets are composed of not only one set of
income earners but multiple income segment
Conclusion
 Implications-Location

• Global web of productive

activities
• Factors considered
– Comparative advantage Design Manufacture
(France) (Singapore)
– Factor endowments
• Gives competitive
advantage

Assembly
(China)
 Cont’d…

Example: Laptop production

• Stages involved
Japan & US
1. R&D R&D
2. Manufacture-std. electronic
comp.
 capital-intensive Mexico
 Semi-skilled labour
 Intense cost pressure Std.
3. Manufacture-advanced Assembly Laptop electronic
comp.
comp.
 capital-intensive
 Skilled labour Singapore,
 Less cost pressure Taiwan,
4. Assembly Advanced Malaysia,
 Low-skilled labour Japan & US comp.
South Korea
 Intense cost pressure
 Cont’d…

• By dispersing production activities to different

locations around the globe, the U.S manufacturer
is taking advantage of the differences between
countries identified by the various theories of
international trade.
 Implications-Govt. Policy

• The theories of international trade claim that

promoting free trade is generally in the best
interests of a country
• US Govt.-placed tariff on Japanese imports of
LCD screens(1991)
– Protested by IBM and Apple Computer
– It was later reversed
• In contrast, US Govt. was forced by US firms to
place restrictions on imports of steel
 India-Exports & Imports

• Video
Thank You!