Chapter Five
International Trade Theory
5-3
Overview of 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
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Trade Theory-Overview
• The Pattern of International Trade displays patterns
that are easy to understand (Saudi Arabia/oil or
China/crawfish).
- Others are not so easy to understand (Japan and
cars)
• The history of Trade Theory and government
involvement presents a mixed case for the role of
government in promoting exports and limiting imports
• Later theories appear to make a case for limited
involvement
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Mercantilism: Mid-16th Century
• A nation’s wealth depends on accumulated treasure
- Gold and silver are the currency of trade
• Theory says you should have a trade surplus
- Maximize export through subsidies
- Minimize imports through tariffs and quotas
• Flaw: “zero-sum game”
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Mercantilism-Zero-Sum Game
• In 1752, David Hume pointed out that:
- Increased exports lead 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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Theory of Absolute Advantage
• Adam Smith argued (Wealth of Nations, 1776):
Capability of one country to produce more of a product
with the same amount of input than another country
can vary
- A country should produce only goods where it is most
efficient, and trade for those goods where it is not efficient
• Trade between countries is, therefore, beneficial
• Assumes there is an absolute balance among
nations
- Example: Ghana/cocoa
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Theory of Absolute Advantage
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Absolute Advantage and the
Gains From Trade
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Theory of
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
product’s production than country from which it is buying
- Look to see how much more efficient
• If only comparatively efficient, than import
• Makes better use of resources
• Trade is a positive-sum game
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Theory of
Comparative Advantage
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Comparative Advantage and the
Gains From Trade
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Simple Extensions of the
Ricardian Model
• Immobile resources:
- Resources do not always move easily from one
economic activity to another
• Diminishing returns:
- Diminishing returns to specialization suggests that
after some point, the more units of a good the country
produces, the greater the additional resources
required to produce an additional item
- Different goods use resources in different proportions
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Simple Extensions of the
Ricardian Model
• Free trade (open economies):
- Free trade might increase a country’s stock of
resources (as labor and capital arrives from abroad)
- Increase the efficiency of resource utilization
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PPF Under Diminishing Returns
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Influence of Free Trade on PPF
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Heckscher (1919)-Olin (1933) Theory
• Export goods that intensively use factor endowments
which are locally abundant
- Corollary: import goods made from locally scarce factors
•
Note: Factor endowments can be impacted by government
policy - minimum wage
• Patterns of trade are determined by differences in
factor endowments - not productivity
• Remember, focus on relative advantage, not absolute
advantage
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Product Life-Cycle
Theory - R. Vernon (1966)
• 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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Product life cycle theory
Fig 4.5
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New Trade Theory
In industries with high fixed costs:
- Specialization increases output, and the ability to enhance
economies of scale increases
- Learning effects are high.
• These are cost savings that come from “learning by doing”
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New Trade Theory-Applications
• Typically, requires industries with high, fixed costs
- World demand will support few competitors
• Competitors may emerge because of “ First-mover
advantage”
- Economies of scale may preclude new entrants
- Role of the government becomes significant
• Some argue that it generates government intervention
and strategic trade policy
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Theory of National
Competitive Advantage
• The theory attempts to analyze the reasons for a
nation’s success in a particular industry
• Porter studied 100 industries in 10 nations
- Postulated determinants of competitive advantage of a
nation were based on four major attributes
•
•
•
•
Factor endowments
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry
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Porter’s Diamond
• Success occurs where these attributes exist
• More/greater the attribute, the higher chance of
success
• The diamond is mutually reinforcing
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Porter’s Diamond
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Factor Endowments
• Factor endowments: A nation’s position in factors
of production such as skilled labor or infrastructure
necessary to compete in a given industry
- Basic factor endowments
- Advanced factor endowments
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Basic Factor Endowments
• Basic factors: Factors present in a country
- Natural resources
- Climate
- Geographic location
- Demographics
• While basic factors can provide an initial advantage
they must be supported by advanced factors to
maintain success
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Advanced Factor Endowments
• Advanced factors: The result of investment by
people, companies, and government are more likely to
lead to competitive advantage
- If a country has no basic factors, it must invest in advanced
factors
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Advanced Factor Endowments
• Communications
• Skilled labor
• Research
• Technology
• Education
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Demand Conditions
• Demand:
- creates capabilities
- creates sophisticated and
demanding consumers
• Demand impacts quality and
innovation
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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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Firm Strategy, Structure
and Rivalry
• Long term corporate vision is a determinant of success
• Management ‘ideology’ and structure of the firm can
either help or hurt you
• Presence of domestic rivalry improves a company’s
competitiveness
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Porter’s Theory-Predictions
• Porter’s theory should predict the pattern of
international trade that we observe in the real world
• Countries should be exporting products from those
industries where all four components of the diamond
are favorable, while importing in those areas where the
components are not favorable
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Implications for Business
• Location implications:
- Disperse production activities to countries where they can
be performed most efficiently
• First-mover implications:
- Invest substantial financial resources in building a firstmover, or early-mover advantage
• Policy implications:
- Promoting free trade is in the best interests of the home
country, not always in the best interests of the firm, even
though many firms promote open markets
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Looking Ahead to Chapter 6
• The Political Economy of International Trade
-
Instruments of Trade Policy
The Case for Government Intervention
The Revised Case for Free Trade
Development of the World Trading System
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