International Trade Theory
5-1
Chapter Objectives
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Explain trade theories
Discuss how global efficiency can be
increased through free trade
Introduce prescriptions for altering
trade patterns
Explore how business decisions
influence international trade
5-2
International Trade

The purchase, sale, or
exchange of goods and
services across national
borders.

International Trade:
• Provides a country’s people with a
greater choice of goods and services
• Important engine for job creation

Trade in goods and services is one
means by which countries are linked
economically
Volume of International Trade
World’s Top Merchandise
Exporters
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US - USD693blln
(10.7%)
Germany – USD613.1
blln (9.5%)
Japan – USD416.7
(6.5%)
World’s Top Service
exporters
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US – USD272.6 blln
(17.4%)
UK – USD123.1 blln
(7.8%)
Germany – USD99.6%
(6.3%)
Degree of Dependence
Independence—complete economic independence
• Country has no reliance on other countries for goods,
services, or technologies
• Price of independence is having to do without goods
that cannot be produced domestically
• Hinders country’s ability to borrow and adapt existing
technologies
Interdependence— trade based on mutual need
• Neither trading partner is likely to cut off supplies or
markets for fear of retaliation
• Governments may be pressured to sustain trade
Dependence—developing countries rely heavily on:
• The sale of one commodity for export earnings
– 25 % of emerging countries sell one commodity
• One country as supplier or customer
• Industrialized countries
General Types of Trade Theories
Descriptive: the natural order of trade
• Laissez-faire conditions
• Which products, how much, and with whom a
country will trade in the absence of restrictions
 Prescriptive: questions whether governments
should interfere with the free movement of goods
and services
• Both types of theories
– provide insights about markets for exports and
potentially successful export products
– help companies determine where to locate
production facilities
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5-3
Trade Theory Timeline
NCA
CA
NTT
AA
IPLCT
FPT
M
1500
1600
1700
1800
1900
2000
Mercantilism
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Initial trade theory that formed the
foundation of economic thought from 1500
– 1800
Based on concept that a nations wealth is
measured by its holding of treasure (gold)
Nations should accumulate financial
wealth by encouraging exports and
discouraging imports.
Favorable balance of trade: country is
exporting more than it is importing
Unfavorable balance of trade: country is
importing more than it is exporting, i.e. a
trade deficit
5-4

Nations often imposed restrictions on
imports since they did not want “their”
treasure moving to another country to pay
for the imports
• Intended to benefit colonial powers
– colonies supplied commodities to the
mother country
– mother country tried to run trade
surpluses with their own colonies
Mercantilism faded after 1800
Mercantilism-Zero-Sum Game
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In 1752, David Hume pointed out
that:
• Increased exports lead to inflation and higher
prices
• Increased imports lead to lower prices
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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
Neomercantilism
Current term to describe the
approach of countries that try to run
favorable balances of trade to
achieve some social or political gains
5-5
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
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Trade between countries is, therefore,
beneficial
Assumes there is an absolute balance
among nations
• Example: Ghana/cocoa
Absolute Advantage
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Absolute advantage holds that different
countries produce some goods more
efficiently than other countries
A nation with an absolute advantage can
produce greater output of a good or
service than other nations using the
same amount of, or fewer, resources.
Thus, global efficiency can be increased
through international free trade
5-6
Country Specialization
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Under the concept of absolute
advantage countries could
increase efficiency because:
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Labor could become more skilled by
repeating the same tasks
Labor would not lose time in switching
from the production of one kind of
product to another
Long production runs would provide
incentives for the development of
more effective working methods
5-7
Natural Advantage
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Countries have inherent advantages
• Climate
• Natural resources
• Labor forces
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Two countries that have opposite
natural advantages should favor
trade with one another
5-8
Acquired Advantage

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Most contemporary trade is manufactured
goods and services rather than agricultural
goods or natural resources
Countries with an acquired advantage
produce manufactured goods and services
competitively
• Product technology- Danish Silver tableware
• Process technology – Japanese steel
5-9
Absolute Trade Advantage
Figure 5.2
5-10
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
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If only comparatively efficient, than import
Makes better use of resources
Trade is a positive-sum game
Comparative Advantage
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There are still global gains to be made if a
country specializes in products it produces
more efficiently than other products
Regardless of whether other countries can
produce those same products even more
efficiently
A country has a comparative advantage
when it is unable to produce a good more
efficiently than other nations, but
produces the good more efficiently than it
does any other good.
5-11
Comparative Advantage
Figure 5.3
5-12
Basic Assumptions
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Full employment
Economic efficiency is sought
Division of gains
Two countries/two commodities
Transportation costs
Mobility
Statics and dynamics
Services
Country size/variety of resources
5-13
Heckscher (1919)-Olin (1933)
Theory
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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
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Patterns of trade are determined by
differences in factor endowments not productivity
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Countries produce and export goods
that require resources (factors) that
are abundant and import goods that
require resources in short supply.
• Land-labor relationship
• Labor-capital relationship
• Technological complexities
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Leontief Paradox
5-14
Product Life-Cycle
Theory - R. Vernon (1966)
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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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Introduction
Growth
Maturity
Decline
Production Location
Market Location
Competitive Factors
Production Technology
5-16
Product Life Cycle Theory of Trade (PLC)
Raymond Vernon—the production location for many
products moves from one country to another
depending on the stage in the product’s life cycle
Stage 1: Introduction
• Innovation, production, and sales in same country
– new products developed in response to nearby
observed need and markets for them
– early production occurs in domestic location
• Location and importance of technology
– most new technology that results in new
products and production methods originates in
industrial countries
• Exports and labor
– export small part of production
– production process likely to be labor intensive
– capital machinery for large-scale production
develops later in industrialized countries
Stage 2: Growth
• Increases in exports by the innovating country
• More competition
• Increased capital intensity
– growing sales offer incentives to companies to
develop process technology
• Some foreign production
Stage 3: Maturity
• Decline in exports from the innovating country
• More product standardization
• More capital intensity
• Increased competitiveness of price
• Production start-ups in emerging countries
Stage 4: Decline
• Production increased in emerging economies
• Innovating country becoming net importer
Verification and limitations of plc theory
• High transportation costs limit export opportunities,
regardless of the life cycle stage
• Shifts in production site do not change for many
types of products
– innovating country maintains its export ability
throughout the life cycle
» products with very short life cycles
» luxury products for which cost is not a
concern for the consumer
» products used to promote differentiation
strategy
» products requiring specialized technical labor
to evolve
• MNEs increasingly introduce new products at home
and abroad simultaneously
Country-Similarity Theory
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Economic similarity of industrial countries
• Most of the world’s trade occurs among
countries that have similar characteristics
• country similarity theory—once a
company has developed a new product
to serve needs in a local market, it will
turn to markets it sees as most similar
to those at home
• Similarity in location, culture, political and
economics interest
• most trade takes place among industrial
countries because:
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growing importance of acquired advantage
as opposed to natural advantage
markets in industrial countries can support
products and their variations
importance of industrial markets due to
their size
incomes are high and people buy more
• Few emerging countries trade with each
other
Similarity of location
• Distances among countries accounts for many world
trade relationships
• Methods to overcome distance disadvantages are
difficult to maintain
Cultural similarity
• Importers and exporters find it easier to do business in
a country perceived as being similar
• Historic colonial relationships explain much of
international trade
Similarity of political and economic interests
• Political relationships and economic agreements among
countries may discourage or encourage trade between
them or their companies
• Military conflicts disrupt trade patterns
• Political animosity may interfere with trading channels
New Trade Theory
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There are gains to be made from
specialization and increasing EOS
The companies first to the market
can create barriers to entry
• First-mover advantage
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Government may play a role in
assisting its home companies.
Strategic Trade Policy
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Governmental role and influence in
affecting the acquired advantage of
production within their borders
Alter conditions for industries in
general
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change conditions that affect factor
proportions, efficiency, and innovation
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Target conditions for a specific
industry
• typically results in no more than small
payoffs
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hard to identify and target appropriate
industries
too many countries identify the same
industry, leading to excessive competition
relative conditions change, causing relative
capabilities to change as well
• have been a few notable government
successes in targeting a specific
industry
Theory of National
Competitive Advantage
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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
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Factor endowments
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry
Porter’s Diamond
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Success occurs where these
attributes exist
More/greater the attribute, the
higher chance of success
The diamond is mutually
reinforcing
Porter’s Diamond
Factor Endowments
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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
Basic Factor Endowments
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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
Advanced Factor Endowments
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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
Advanced Factor
Endowments
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Communications
Skilled labor
Research
Technology
Education
Demand Conditions
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Demand:
• creates capabilities
• creates sophisticated and
demanding consumers
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Demand impacts
quality and
innovation
Related and Supporting
Industries
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Creates clusters of supporting
industries that are internationally
competitive
Must also meet requirements of
other parts of the Diamond
Firm Strategy, Structure
and Rivalry
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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
Porter’s Theory-Predictions
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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
Implications for Business
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Location implications:
• Disperse production activities to countries
where they can be performed most efficiently
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First-mover implications:
• Invest substantial financial resources in
building a first-mover, or early-mover
advantage
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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