International Trade Theory
Chapter 4
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International Trade Theory
Overview
Mercantilism
Absolute Advantage
Comparative Advantage
Heckscher-Olin Theory
Product Life Cycle Theory
New Trade Theory
Porter’s Diamond
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1st British African colony to win
independence (1957).
Nkrumah espoused pan African
socialism.
High tariffs.
Anti-exporting policy.
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Kept lowering tariffs on manufactured goods.
Created incentives to export.
Reduced quotas.
Reduced subsidies.
1950s: 77% of employment in agriculture.
Now 20%.
Manufacturing GNP went from 10% to over
30%.
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The Impact of Trade Policies
Ghana
1970
GNP/capita
• $250
1992
GNP/per capita
• $450
GNP Growth/year
• 1.5%
 Shift from productive uses
(cocoa) to unproductive uses
(subsistence agriculture).
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Korea
1970
GNP/per capita
• $260
1992
GNP/per capita
• $6790
GNP Growth/year
• 9%
 Shift from non-comparative
advantage uses (agriculture)
to productive uses (laborintensive manufacturing).
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An 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.
The Pattern of International Trade displays patterns
that are are easy to understand (Saudi Arabia/oil or
Mexico/labor intensive goods). Others are not so easy
to understand (Japan and cars).
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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 exports through
subsidies.
Minimize imports through tariffs
and quotas.
Flaw: “Zero-sum game”.
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David Hume - 1752
Increased exports leads 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: Wealth of Nations (1776).
Capability of one country to produce more of a product
with the same amount of input than another country.
Produce only goods where you are most efficient, trade for
those where you are not efficient.
Trade between countries is, therefore, beneficial.
Assumes there is an absolute advantage
balance among nations.
Ghana/cocoa.
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20
10
A
Figure 4.1
K
5
Cocoa
15
The Theory of Absolute
Advantage
G
0
B
5
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G’
10
Rice
15
K’
20
4-9
The Theory of Absolute Advantage and
the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Ghana
S. Korea
Cocoa
10
40
Rice
20
10
Production and Consumption without Trade
Ghana
S. Korea
Total production
10.0
2.5
12.5
5.0
10.0
15.0
Ghana
S. Korea
Total production
20
0
20
0
20
20
Ghana
S. Korea
14.0
6.0
6.0
14.0
Production with Specialization
Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice
Increase in Consumption as a Result of Specialization and Trade
Ghana
S. Korea
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4.0
3.5
1.0
4.0
Table 4.1
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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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20
The Theory of Comparative
G
Advantage
Cocoa
15
C
5
10
A
Figure 4.2
K
B
2.5
0
3.75
5
7.5
K’
10
Rice
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G’
15
20
4-12
Comparative Advantage and the Gains
from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Ghana
S. Korea
Cocoa
10
40
Rice
13.33
20
Production and Consumption without Trade
Ghana
10.0
S. Korea
2.5
Total production 12.5
7.5
5.0
12.5
Ghana
S. Korea
Total production
15
0.0
15
3.75
10.0
13.75
Ghana
S. Korea
11
4
Production with Specialization
Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice
7.75
6
Increase in Consumption as a Result of Specialization and Trade
Ghana
S. Korea
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1.0
1.5
0.25
1.0
Table 4.2
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Simple Extensions of the
Ricardian Model
Diminishing returns:
More a country produces, at some point, will
require more resources.
However:
Free trade can increase a country’s production
resources, and
Increase the efficiency of resource utilization.
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Ghana’s PPF under Diminishing
Returns
Cocoa
G
Figure 4.3
G’
0
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Rice
4-15
The Influence of Free Trade on
the PPF
Cocoa
PPF2
PPF1
G’
Figure 4.4
0
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Rice
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Is the Mercantilist Theory Still
Valid?
A qualified Yes.
Equate political power with economic
power and economic power with a trade
surplus.
Japan
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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.
Patterns of trade are determined by differences in
factor endowments - not productivity.
Remember, focus on relative advantage, not
absolute advantage.
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The Leontief Paradox, 1953
Disputes Heckscher-Olin in some instances.
Factor endowments can be impacted by
government policy - minimum wage.
US tends to export labor-intensive products,
but is regarded as a capital intensive country.
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Heckscher vs Ricardo
Economists prefer Heckscher on theoretical
grounds but is a relatively poor predictor of
trade patterns.
Ricardo’s Comparative Advantage Theory,
regarded as too limited for predicting trade
patterns, actually predicts them with greater
accuracy.
In the end, differences in productivity may be
the key to determining trade patterns.
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Product Life-Cycle Theory
(Raymond Vernon, 1966)
Article in the Quarterly Journal of Economics.
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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International Product Trade Cycle Model
production
High Income Countries
Exports
Q
u
a
n
t
i
t
y
1
2
3
4
Imports
5
6
7
8
9
10
Medium Income Countries
11
12
13
14
consumption
15
Exports
Imports
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Low Income Countries
Exports
Imports
1
2
3
4
New Product
5
6
7
8
9
Maturing Product
10
11
12
14
15
Standardized Product
Stages of Production Development
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13
Time
Figure 4.5
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The New Trade Theory
Began to be recognized in the 1970s.
Deals with the returns on specialization
where substantial economies of scale are
present.
Specialization increases output, ability to
enhance economies of scale increase.
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Application of the New Trade
Theory
Typically, requires industries with high, fixed
costs.
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.
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First-Mover Advantage
Economies of scale may preclude new
entrants.
Role of the government.
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Founded 1915 by William Boeing
Largest commercial airplane manufacturer.
9,000 commercial jetliners in service.
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Established 1967
Western Europe buying 25% of aircraft ,but
selling only 10%.
France, Germany, Great Britain
To date: 3,203 orders - 1,890 deliveries.
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Airbus vs Boeing
Airplane Orders
800
700
600
500
Boeing
Airbus
400
300
200
100
0
85 86 87 88 89 90 91 92 93 94 95 96 97
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Porter’s Diamond
(Harvard Business School, 1990)
The Competitive Advantage of Nations.
Looked at 100 industries in 10 nations.
Thought existing theories didn’t go far enough.
Question: “Why does a nation achieve
international success in a particular
industry?”
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Determinants of National
Competitive Advantage
Factor endowments:nation’s position in factors of production
such as skilled labor or infrastructure necessary to compete in a
given industry.
Firm strategy, structure and rivalry:the conditions in the
nation governing how companies are created, organized, and
managed and the nature of domestic rivalry.
Demand conditions:the nature of home demand for the
industry’s product or service.
Related and supporting industries:the presence or absence
in a nation of supplier industries or related industries that are
nationally competitive.
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Porter’s Diamond
Determinants of National Competitive Advantage
Firm Strategy,
Structure and
Rivalry
Factor Endowments
Figure 4.6
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Demand Conditions
Related and
Supporting
Industries
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The 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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Factor Endowments
Taken from Heckscher-Olin
Basic factors:
natural resources,
climate,
location.
Advanced factors:
communications,
skilled labor,
technology.
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Advanced Factor Endowments
More likely to lead to competitive
advantage.
Are the result of investment by
people, companies, government.
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Relationship of Basic to
Advanced Factors
Basic can provide an initial advantage.
Must be supported by advanced factors to
maintain success.
No basics, then must invest in advanced
factors.
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Demand Conditions
Demand creates the capabilities.
Look for sophisticated and
demanding consumers.
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
Management ‘ideology’ can either help or
hurt you.
Presence of domestic rivalry improves a
company’s competitiveness.
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Evaluating Porter’s Theory
If Porter is right, country exports should
reflect the presence of the four ‘diamond’
components. Countries will import goods
from industries where some or all the
components are missing.
Too soon to tell.
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Determinants of
National Competitive Advantage
Chance
Two external
factors that
influence the
four
determinants.
Company Strategy,
Structure,
and Rivalry
Factor
Conditions
Demand
Conditions
Related
and Supporting
Industries
Government
Source: Michael Porter, The Competitive Advantage of Nations
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Porter’s diamond, but...
‘Double Diamond’ - look to attributes of
both countries.
Professor Alan Rugman, University of Toronto
Home country may ‘sound’ good, but
Company can rely on the host country.
Neighboring countries can too.
Canada and the U.S.
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Implications for Business
Location implications:makes sense to disperse
production activities to countries where they can be
performed most efficiently.
First-mover implications:It pays to invest
substantial financial resources in building a firstmover, or early-mover, advantage.
Policy implications:promoting free trade is
generally in the best interests of the home-country,
although not always in the best interests of the firm.
Even though, many firms promote open markets.
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