Chapter Three

International Trade
 International Trade Theory

An Overview of Trade Theory

What Is International Trade?
Trade is the concept of exchanging goods and

services between two people or entities.

International trade theories are simply different

theories to explain international trade

International Trade Theory
International trade is then the concept of this
exchange between people or entities in two
different countries
there is a great deal of theory, policy, and business

strategy that constitutes international trade

What Are the Different International Trade
Theories?
International Trade Theory
(1) Classical or Country Based Theories
It is the main historical theories which are from the
perspective of a country, or country-based.
(A) Mercantilism
(B) Absolute Advantage
(C) Comparative Advantage
(D) Heckscher-Ohlin Theory (Factor
Proportions Theory)
(A) Mercantilism
Mercantilism (mid-16th century) suggests that it is in
a countrys best interest to maintain a trade surplus
-to export more than it imports
This theory stated that a countrys wealth was
determined by the amount of its gold and silver
holdings.
In its simplest sense, mercantilists believed that a
country should increase its holdings of gold and silver
by promoting exports and discouraging imports.
Mercantilism
The objective of each country was to have a trade
surplus and to avoid a trade deficit
Although mercantilism is one of the oldest trade
theories, it remains part of modern thinking.
Countries such as Japan, China, Singapore, Taiwan,
and even Germany still favor exports and
discourage imports through a form of neo-
mercantilism in which the countries promote a
combination of protectionist policies and restrictions
and domestic-industry subsidies.
Mercantilism
Nearly every country, at one point or another, has
implemented some form of protectionist policy to
guard key industries in its economy
While export-oriented companies usually support
protectionist policies that favor their industries or
firms, other companies and consumers are hurt by
protectionism

Mercantilism

Taxpayers pay for government subsidies of select

exports in the form of higher taxes.
Import restrictions lead to higher prices for
consumers, who pay more for foreign-made goods
or services
Thus, mercantilisms protectionist policies only benefit
select industries, at the expense of both consumers
and other companies, within and outside of the
industry
Mercantilism
In general, Mercantilism views trade as a zero-sum
game - one in which a gain by one country results in
a loss by another
(B) Absolute Advantage
In 1776, Adam Smith offered a new trade theory
called absolute advantage, which focused on the
ability of a country to produce a good more
efficiently than another nation.
In other word, Adam Smith (1776) argued that a
country has an absolute advantage in the
production of a product when it is more efficient
than any other country in producing it
Absolute Advantage
Smith reasoned that trade between countries
shouldnt be regulated or restricted by government
policy or intervention.
He stated that trade should flow naturally
according to market forces
countries should specialize in the production of goods
for which they have an absolute advantage and then
trade these goods for goods produced by other
countries
Absolute Advantage
How Does The Theory Of Absolute Advantage
Work?
Assume that two countries, Ghana and South Korea,
both have 200 units of resources that could either be
used to produce rice or cocoa
In Ghana, it takes 10 units of resources to produce
one ton of cocoa and 20 units of resources to produce
one ton of rice
Ghana could produce 20 tons of cocoa and no rice, 10 tons
of rice and no cocoa, or some combination of rice and
cocoa between the two extremes
Absolute Advantage
In South Korea it takes 40 units of resources to
produce one ton of cocoa and 10 resources to
produce one ton of rice
South Korea could produce 5 tons of cocoa and no rice,
20 tons of rice and no cocoa, or some combination in
between
Without trade
Ghana would produce 10 tons of cocoa and 5 tons of
rice
South Korea would produce 10 tons of rice and 2.5
tons of cocoa
Absolute Advantage
With specialization and trade
Ghana would produce 20 tons of cocoa
South Korea would produce 20 tons of rice
Ghana could trade 6 tons of cocoa to South Korea for
6 tons of rice
After trade
Ghana would have 14 tons of cocoa left, and 6 tons of
rice
South Korea would have 14 tons of rice left and 6 tons
of cocoa
Absolute Advantage
If each country specializes in the production of the
good in which it has an absolute advantage and
trades for the other, both countries gain
trade is a positive sum game
(C) Comparative Advantage
David Ricardo asked what happens when one
country has an absolute advantage in the
production of all goods
The theory of comparative advantage (1817) -
countries should specialize in the production of
those goods they produce most efficiently and
buy goods that they produce less efficiently from
other countries
Comparative Advantage
Comparative advantage occurs when a country
cannot produce a product more efficiently than the
other country;
however, it can produce that product better and
more efficiently than it does other goods.
This implies that Comparative advantage focuses on
the relative productivity differences, whereas
absolute advantage looks at the absolute
productivity.
Comparative Advantage
How Does The Theory Of Comparative Advantage
Work?
Assume Ghana is more efficient in the production of
both cocoa and rice
In Ghana, it takes 10 resources to produce one ton
of cocoa, and 13 1/3 resources to produce one ton
of rice
So, Ghana could produce 20 tons of cocoa and no
rice, 15 tons of rice and no cocoa, or some
combination of the two
Comparative Advantage
In South Korea, it takes 40 resources to produce one
ton of cocoa and 20 resources to produce one ton
of rice
So, South Korea could produce 5 tons of cocoa and
no rice, 10 tons of rice and no cocoa, or some
combination of the two
Comparative Advantage
With trade
Ghana could export 4 tons of cocoa to South Korea in
exchange for 4 tons of rice
Ghana will still have 11 tons of cocoa, and 4
additional tons of rice
South Korea still has 6 tons of rice and 4 tons of cocoa
if each country specializes in the production of the
good in which it has a comparative advantage and
trades for the other, both countries gain
Comparative Advantage
Comparative advantage theory provides a strong
rationale for encouraging free trade
totaloutput is higher
both countries benefit

Trade is a positive sum game

(D) Heckscher-Ohlin Theory (Factor
Proportions Theory)
The theories of Smith and Ricardo didnt help
countries determine which products would give a
country an advantage.
Both theories assumed that free and open markets
would lead countries and producers to determine
which goods they could produce more efficiently.
Heckscher-Ohlin Theory (Factor
Proportions Theory
Eli Heckscher (1919) and Bertil Ohlin (1933) -
comparative advantage arises from differences in
national factor endowments
Their theory is based on a countrys production
factorsland, labor, and capital, which provide the
funds for investment in plants and equipment.
Heckscher-Ohlin Theory (Factor
Proportions Theory
They determined that the cost of any factor or
resource was a function of supply and demand.
Factors that were in great supply relative to demand
would be cheaper; factors in great demand relative
to supply would be more expensive.
Heckscher-Ohlin Theory (Factor
Proportions Theory
Their theory stated that countries would produce
and export goods that required resources or factors
that were in great supply and, therefore, cheaper
production factors.
In contrast, countries would import goods that
required resources that were in short supply, but
higher demand
Heckscher-Ohlin Theory (Factor
Proportions Theory
For example, China and India are home to cheap,
large pools of labor. Hence these countries have
become the optimal locations for labor-intensive
industries like textiles and garments.
Heckscher-Ohlin Theory (Factor
Proportions Theory
Does The Heckscher-Ohlin Theory Hold?
Wassily Leontief (1953) theorized that since the U.S.
was relatively abundant in capital compared to other
nations, the U.S. would be an exporter of capital
intensive goods and an importer of labor-intensive
goods.
However, he found that U.S. exports were less capital
intensive than U.S. imports
Since this result was at variance with the predictions
of trade theory, it became known as the Leontief
Paradox
(2) Modern Firm or Company Based
Theories
By the mid-twentieth century, the theories began to
shift to explain trade from a firm, rather than a
country, perspective.
(A) Country Similarity Theory
(B) Product Life Cycle Theory
(A) Country Similarity Theory
Swedish economist Steffan Linder developed the country
similarity theory in 1961, as he tried to explain the
concept of intra industry trade.
Linders theory proposed that consumers in countries that
are in the same or similar stage of development would
have similar preferences.
In this firm-based theory, Linder suggested that
companies first produce for domestic consumption.
When they explore exporting, the companies often find
that markets that look similar to their domestic one, in
terms of customer preferences, offer the most potential
for success.
Country Similarity Theory
Linders country similarity theory then states that
most trade in manufactured goods will be between
countries with similar per capita incomes, and intra
industry trade will be common.
This theory is often most useful in understanding
trade in goods where brand names and product
reputations are important factors in the buyers
decision-making and purchasing processes
(B) Product Life Cycle Theory
The product life-cycle theory - as products mature
both the location of sales and the optimal production
location will change affecting the flow and direction
of trade
proposed by Ray Vernon in the mid-1960s
Atthis time most of the worlds new products were
developed by U.S. firms and sold first in the U.S.
Product Life Cycle Theory
According to the product life-cycle theory
the size and wealth of the U.S. market gave U.S. firms a
strong incentive to develop new products
initially, the product would be produced and sold in the U.S.

as demand grew in other developed countries, U.S. firms

would begin to export
demand for the new product would grow in other advanced
countries over time making it worthwhile for foreign
producers to begin producing for their home markets
Product Life Cycle Theory

U.S. firms might set up production facilities in

advanced countries with growing demand, limiting
exports from the U.S.
As the market in the U.S. and other advanced
nations matured, the product would become more
standardized, and price would be the main
competitive weapon
Product Life Cycle Theory
Producers based in advanced countries where labor
costs were lower than the United States might now
be able to export to the United States
If cost pressures were intense, developing countries
would acquire a production advantage over
advanced countries
Production became concentrated in lower-cost
foreign locations, and the U.S. became an importer
of the product
Product Life Cycle Theory
Does The Product Life Cycle Theory Hold?
The product life cycle theory accurately explains what
has happened for products like photocopiers and a
number of other high technology products developed in the
United States in the 1960s and 1970s
mature industries leave the U.S. for low cost assembly
locations
But, the globalization and integration of the world
economy has made this theory less valid today
the theory is ethnocentric
production today is dispersed globally
products today are introduced in multiple markets
simultaneously
(c) Global Strategic Rivalry or new trade
Theory

Global strategic rivalry theory emerged in the

1980s and was based on the work of economists
Paul Krugman and Kelvin Lancaster.
Their theory focused on MNCs and their efforts to
gain a competitive advantage against other global
firms in their industry.
Global Strategic Rivalry or new trade Theory

Firms will encounter global competition in their

industries and in order to prosper, they must develop
competitive advantages.
The critical ways that firms can obtain a sustainable
competitive advantage are called the barriers to
entry for that industry.
The barriers to entry refer to the obstacles a new firm may face
when trying to enter into an industry or new market.
Global Strategic Rivalry or new trade Theory

The barriers to entry that corporations may seek to

optimize include:
o research and development,
o the ownership of intellectual property rights,
o economies of scale,
o unique business processes or methods as well as
extensive experience in the industry, and
o the control of resources or favorable access to raw
materials.
Global Strategic Rivalry or new trade Theory

New trade theory suggests that the ability of firms

to gain economies of scale can have important
implications for international trade
Countries may specialize in the production and
export of particular products because in certain
industries, the world market can only support a limited
number of firms
Global Strategic Rivalry or new trade Theory

What Are The Implications Of New Trade Theory

For Nations?
Nations may benefit from trade even when they do
not differ in resource endowments or technology
a country may dominate in the export of a good simply
because it was lucky enough to have one or more firms
among the first to produce that good
Governments should consider strategic trade policies
that nurture and protect firms and industries where first
mover advantages and economies of scale are
important
(D) Porters National Competitive Advantage
Theory
Michael Porter (1990) tried to explain why a nation
achieves international success in a particular
industry
identified four attributes that promote or impede the
creation of competitive advantage
1. Factor endowments - a nations position in factors of
production necessary to compete in a given industry
can lead to competitive advantage
can be either basic (natural resources, climate, location)
or advanced (skilled labor, infrastructure, technological
know-how)
Porters National Competitive Advantage Theory

2. Demand conditions - the nature of home demand

for the industrys product or service
influences the development of capabilities
sophisticated and demanding customers pressure firms to
be competitive
3. Relating and supporting industries - the presence or
absence of supplier industries and related
industries that are internationally competitive
can spill over and contribute to other industries
successful industries tend to be grouped in clusters in
countries
Porters National Competitive Advantage Theory

4. Firm strategy, structure, and rivalry - the conditions

governing how companies are created, organized,
and managed, and the nature of domestic rivalry
different management ideologies affect the development
of national competitive advantage
vigorous domestic rivalry creates pressures to innovate, to
improve quality, to reduce costs, and to invest in
upgrading advanced features
Determinants of National Competitive Advantage:
Porters Diamond
Porters National Competitive Advantage Theory

What Are The Implications Of Trade Theory For

Managers?
1. Location implications - a firm should disperse its various
productive activities to those countries where they can be
performed most efficiently
firms that do not may be at a competitive disadvantage
2. First-mover implications - a first-mover advantage can help
a firm dominate global trade in that product
3. Policy implications - firms should work to encourage
governmental policies that support free trade
want policies that have a favorable impact on each
component of the diamond
Which Trade Theory Is Dominant
Today?
While they have helped economists, governments,
and businesses better understand international
trade and how to promote, regulate, and manage it,
these theories are occasionally contradicted by
real-world events
Which Trade Theory Is Dominant
Today?
As a result, its not clear that any one theory is dominant
around the world. This section has sought to highlight the
basics of international trade theory to enable you to
understand the realities that face global businesses.
In practice, governments and companies use a
combination of these theories to both interpret trends
and develop strategy.
Just as these theories have evolved over the past five
hundred years, they will continue to change and adapt as
new factors impact international trade.
The Political Economy of International
Trade
Introduction
Free trade refers to a situation where a govt does
not attempt to restrict what its citizens can buy from
another country or what they can sell to another
country
While many nations are nominally committed to free
trade, they tend to intervene in international trade
to protect the interests of politically important
groups
Instruments of Trade Policy

There are seven main instruments of trade policy

1. Tariffs
2. Subsidies
3. Import quotas and Voluntary export restraints
4. Local content requirements
5. Administrative policies
6. Antidumping policies
Tariffs
A tariff - a tax levied on imports that effectively
raises the cost of imported products relative to
domestic products
Specific tariffs are levied as a fixed charge for each
unit of a good imported
Ad valorem tariffs are levied as a proportion of the
value of the imported good
Why Tariffs?
Tariffs
increase government revenues
provide protection to domestic producers against
foreign competitors by increasing the cost of imported
foreign goods
force consumers to pay more for certain imports

So, tariffs are unambiguously pro-producer and

anti-consumer, and tariffs reduce the overall
efficiency of the world economy
Subsidies
A subsidy - a government payment to a domestic
producer
Subsidies help domestic producers
compete against low-cost foreign imports
gain export markets

Consumers typically absorb the costs of subsidies

Import Quotas and Voluntary Export
Restraints
An import quota - a direct restriction on the quantity
of some good that may be imported into a country
Tariff rate quotas - a hybrid of a quota and a
tariff where a lower tariff is applied to imports
within the quota than to those over the quota
Voluntary export restraints - quotas on trade
imposed by the exporting country, typically at the
request of the importing countrys government
A quota rent - the extra profit that producers make
when supply is artificially limited by an import
quota
Local Content Requirements
A local content requirement demands that some
specific fraction of a good be produced
domestically
can be in physical terms or in value terms
Local content requirements benefit domestic
producers and jobs, but consumers face higher
prices
Administrative policies
Administrative trade polices - bureaucratic rules
that are designed to make it difficult for imports to
enter a country
These polices hurt consumers by denying access to
possibly superior foreign products
Antidumping polices
Dumping - selling goods in a foreign market below
their cost of production, or selling goods in a
foreign market at below their fair market value
a way for firms to unload excess production in foreign
markets
may be predatory behavior, with producers using
substantial profits from their home markets to subsidize
prices in a foreign market with a view to driving
indigenous competitors out of that market, and later
raising prices and earning substantial profits
Antidumping polices
Antidumping polices - designed to punish foreign
firms that engage in dumping
the goal is to protect domestic producers from unfair
foreign competition
firms that believe a foreign firm is dumping can file
a complaint with the government
ifthe complaint has merit, antidumping duties, also
known as countervailing duties may be imposed
The Case for Government Intervention

There are two types of arguments

1. Political arguments - concerned with
protecting the interests of certain groups
within a nation (normally producers), often
at the expense of other groups (normally
consumers)
2. Economic arguments - concerned with
boosting the overall wealth of a nation (to
the benefit of all, both producers and
consumers)
Political arguments for government
intervention
Political arguments for government intervention
include
1. protecting jobs
2. protecting industries deemed important for national
security
3. retaliating to unfair foreign competition
4. protecting consumers from dangerous products
5. furthering the goals of foreign policy
6. protecting the human rights of individuals in exporting
countries
Political arguments for government
intervention
1. Protecting jobs and industries - the most common
political reason for trade restrictions
typically the result of political pressures by unions or
industries that are "threatened" by more efficient
foreign producers, and have more political clout than
the consumers who will eventually pay the costs
2. National Security - governments protect certain
industries such as aerospace or advanced
electronics because they are important for
national security
this argument is less common today than in the past
Political arguments for govt intervention

3. Retaliation - when governments take, or threaten to

take, specific actions, other countries may remove trade
barriers
can be a risky strategy
if threatened governments dont back down, tensions can
escalate and new trade barriers may be enacted
4. Protecting Consumers - protecting consumers from
unsafe products is also be an argument for restricting
imports
often involves limiting or banning the import of certain
products
Political arguments for govt intervention

. 5. Furthering Foreign Policy Objectives - trade policy

can be used to support foreign policy objectives
preferential trade terms can be granted to countries
that a government wants to build strong relations with
rogue states that do not abide by international laws or
norms can be punished
However, it might cause other countries to undermine
unilateral trade sanctions
Political arguments for govt intervention

.6. Protecting Human Rights - governments can use

trade policy to improve the human rights policies of
trading partners
unless a large number of countries choose to take such
action, however, it is unlikely to prove successful
Some critics have argued that the best way to
change the internal human rights of a country is to
engage it in international trade
Economic arguments for intervention
Economic arguments for government intervention
in international trade include
1. The infant industry argument
2. Strategic trade policy
Economic arguments for intervention
1. The infant industry argument - suggests that an
industry should be protected until it can develop and
be viable and competitive internationally
thishas been accepted as a justification for temporary
trade restrictions under the WTO
However, this argument has been criticized because
it is useless unless it makes the industry more efficient
if a country has the potential to develop a viable
competitive position, its firms should be capable of
raising necessary funds
Economic arguments for intervention
2. Strategic Trade Policy - suggests that in cases
where there may be important first mover
advantages, governments can help firms from their
countries attain these advantages
also suggests that govts can help firms overcome
barriers to entry into industries where foreign firms have
an initial advantage
The Revised Case for Free Trade
New trade theorists believe govt intervention in
international trade is justified
classic trade theorists disagree
Some new trade theorists believe that while
strategic trade theory is appealing in theory, it may
not be workable in practice they suggest a revised
case for free trade
Two situations where restrictions on trade may be
inappropriate
Retaliation
Domestic Policies
Retaliation and War
Krugman - strategic trade policies aimed at
establishing domestic firms in a dominant position in
a global industry are beggar-the-neighbor policies
that boost national income at the expense of other
countries
A country that attempts to use such policies will
probably provoke retaliation
a trade war could leave both countries worse off
Domestic Policies
Governments can be influenced by special interest
groups
a governments decision to intervene in a market may
appease a certain group, but not necessarily the
support the interests of the country as a whole
 End of Chapter Three