INTERNATIONAL TRADE
CHAPTER 2:
INTERNATIONAL TRADE THEORIES
LEARNING OBJECTIVES
• To realize the benefits of the exchange of goods and services
for the world and the citizens of each country
• To look at classical, country-based theories (to prove the
importance of trading)
• To use the modern, firm-based theories to describe global
strategies adopted by businesses
WHAT IS INTERNATIONAL TRADE?
The exchange of goods,
services, … between residents
of two countries
WHY DO COUNTRIES NEED TO TRADE?
• Both countries benefit: A win-win situation
• Citizens of the countries benefit
HOW?
Exports: Bring in fuel (money) for the economy
SUPPLIERS
Imports: Put pressure on domestic producers
COMPETITION
PRICES
QUALITY
WHY DO WE NEED TO KNOW THE THEORIES?
For…..
• Governments designing policies for imports, exports, FDI
• For convincing politicians who are against free trade
• Companies for directing their efforts in production and sales
MERCANTILISM – 16TH CENTURY
PHILOSOPHY
A country´s wealth is measured by its holdings of gold and silver
Question: How do we increase a country´s holdings?
Answer: By having more EXPORTS and less IMPORTS
Question: How do we increase exports and reduce imports?
Answer: By subsidizing exporting industries and taxing imports
Question: But who pays for subsidies? Is the absence of competition good
for the average citizen?
Big Question: Is the Wealth of a Nation in what the King and his friends
have in their pockets?
ABSOLUTE ADVANTAGE by Adam Smith
The real wealth of a nation is not in its holdings but in the goods and
services available to its citizens - In the pockets of its citizens
Will the average citizen have more goods available (at lower prices and
better quality) if we allow countries to freely trade?
A big YES… How?
If each country specializes in the area it does better (natural advantage or
acquired – climate, raw materials, technology…) and then it exchanges
goods with goods the other country does better.
Remember, specialization will lead to:
• labour becoming more skilled and more efficient. Large-scale
production will help in the development of better methods and
lower costs.
THE PROOF FOR THE ABSOLUTE ADVANTAGE
ASSUME THAT:
• We have two countries: USA and SRI LANKA
• Both can produce Tea and Wheat
• Both have the same amount of resources: 100 units per country
• Production rates of countries:
USA - 5 resources needed to produce 1 ton of wheat
20 resources needed to produce 1 ton of tea
SRI LANKA – 10 resources needed to produce 1 ton of wheat
4 resources needed to produce 1 ton of tea
Hypothesis 1: No trading takes place and each country devotes ½ of its
resources for tea and ½ for wheat
WHEAT
TEA
USA
10
2,5
SRI LANKA
5
12,5
TOTAL
15
15
Hypothesis 2: Each country devotes all its resources (100 units) in the
production of its most efficient commodity and starts
trading
WHEAT
TEA
USA
20
0
SRI LANKA
0
25
TOTAL
20
25
Notes:
• Adam Smith had really proved that total production will be increased
when each nation concentrated all resources on its most efficient
commodity and then traded with other nations
• He also stated that if a country, as compared to another, is more efficient
in both commodities then trading should not take place. Is that so?
COMPARATIVE ADVANTAGE by D. Ricardo
• Countries will export goods they have a comparative advantage in and
import goods they do not have a comparative advantage in.
• The concept of opportunity cost is introduced here. The opportunity cost
of a good (X) is the amount of some other good (Y) that must be given
up (sacrificed, forgone) when we produce 1 unit of good (X)
• If the opportunity cost of a good (X) in country (A) is less than the
opportunity cost of good (X) in country (B), then we say that country
(A) has a comparative advantage in the production of good (X). In other
words, it sacrifices less for a particular good that what the other country
sacrifices for that good.
• Therefore, in spite of country A being more efficient in both goods
trading, should take place. Each country will have a comparative
advantage in one of its products. Both will benefit.
THE PROOF FOR COMPARATIVE ADVANTAGE
ASSUME THAT:
• We have two countries: USA and FRANCE
• Both can produce Cheese and Wine
• Productivity is measured in unit labour requirements i.e. # of hours of
labour required to produce a kilo of cheese or a bottle of wine
• Unit labour requirements
CHEESE
WINE
labour HOURS
USA
2
4
200
FRANCE
10
5
200
FINDING THE BEST SCENARIO WITH THE
OPPORTUNITY COST CONCEPT
Opportunity Cost of cheese in terms of wine - USA – ½
Opportunity Cost of wine in terms of cheese - USA – 2
Opportunity Cost of cheese in terms of wine - FRANCE – 2
Opportunity Cost of wine in terms of cheese - FRANCE – ½
• What should the USA produce? Cheese - ½ is lower than 2
• What should FRANCE produce? Wine – ½ is lower than 2
WORKING OUT DIFFERENT SCENARIOS
Scen. 1 Each country uses half of its labour in the production of cheese and the other
half in the production of wine
CHEESE
WINE
USA
50
25
FRANCE
10
20
TOTAL
60
45
Scen. 2 USA specializes in the production of wine and France in the production of cheese
CHEESE
WINE
USA
0
50
FRANCE
20
0
TOTAL
20
50
Scen. 3 USA specializes in the production of cheese and France in the production of cheese
USA
FRANCE
TOTAL
CHEESE
WINE
100
0
0
40
100
40
FACTOR ENDWONMENT THEORY
by Hecksher – Ohlin (Swedish)
Question: What determinates the low factor costs for products?
Answer: Differences in countries endowments of labour relative to
endowments of land or capital
i.e. If labour were abundant in relation to land and capital then labour
costs would be low or
If labour were scarce in relation to land and capital then labour costs would
be high
Note: A country is considered abundant in a product after we take a look at
its ratio (comparison of one factor to the other) and then relate it to the
other country´s ratio.
Example for Factors Endowments Theory
labour
LAND
GREECE
5 MILLIONS
2,5 MIL. ACRES
FRANCE
20 MILLIONS
20 MIL. ACRES
Ratio of Land/labour for Greece – 2,5/5 = ½ and for…
France – 20/20 =1
Therefore, France is land abundant
Ratio of Labour/Land for Greece – 5/2,5 = 2 and for…
France – 20/20 =1
Therefore, Greece is labour abundant
LEONTIEF´S PARADOX
(Trying to proof the validity of Factors Endowment Theory)
• He studied USA imports and exports
• Findings: Successful American companies were exporting
goods which had a higher labour intensity
USA imports were more capital intensive
• USA is considered a capital intensive country and the
findings of Leontief show the opposite
• H – O theory assumes erroneously that production factors
are homogeneous
• But are labour skills (training, education) the same from
country to country?
COUNTRY SIMILARITY THEORY
by Steffan Linder
• Country-based theories are good in explaining trade of
primary/undifferentiated goods (commodities) between
countries
• They are good in explaining inter-industry trade
(differentiated goods produced by different industries)
• However, they cannot explain intra-industry trade
(differentiated goods produced by the same industry)
Explanation of intra-industry trade by Linder
When consumers in two countries have similar levels of per
capita income, then differentiated goods will be available in
both countries
Consumers will then make their decision based on brand
names and different features of the product
Note: The focus in explaining intra-industry is on demand (consumer)
and not on supply (factor endowment)
INTERNATIONAL PRODUCT LIFE CYCLE THEORY
by Raymond Vernon
As the stage in a product´s life cycle changes, so will the production
location. Moves in exports and imports are also observed.
The International Product Life Cycle consists of three stages:
Growth or New: Innovated in advanced large countries with R&D and
large population. Inelastic price and heavy marketing. Some exports seen.
Focus strategy.
Maturity: Competitors appear. Price becomes elastic. Production
increases. Technology advances. Exports increase. Differentiation
strategies seen.
Standardized: Technology known. Competition on price. Low cost
locations sought. Innovating country becomes a net importer.
Porter´s National Competitive Advantage
(The Diamond)
The interaction of four country-specific and firm-specific elements
determines whether a firm will be successful in international trade.
Factor Conditions
Firm, Strategy, Structure
and Rivalry
Demand Conditions
Related and
Supporting Industries
Explanation of Porter´s Elements
Factor Conditions
Labour, land, and capital plus educational level of labour.
Training, investment in R&D, and innovation can further
enhance the above factors (government support)
Demand Conditions
A large pool of sophisticated consumers is needed for innovation
to take place
Related and Supporting Industries
A large number of suppliers (competition) is needed for lower
prices and better quality of suppliers
Firm Strategy, Structure and Rivalry
Competition is needed domestically. The right products which
can also be sold abroad (strategy). A flexible structure for
servicing markets abroad (Right government policies)
Criticism/limitation of Absolute Theory
• Flow: Assumes erroneously that countries cannot benefit from trading in
cases where a country has absolute advantage in both or all products.
• Does not explain what determines the products for which a country will
have an absolute advantage (Factor Endowment does that)
• Does not explain intra-industry trade
• It is too simplistic. Assumes perfect information and perfect markets.
Criticism/limitation of Comparative Advantage
The limitations seen for Absolute
Advantage hold true for Comparative
Advantage also.
However, Comparative Advantage has
corrected the flaw of Absolute
Advantage
Criticism/limitation of Factor Endowment
• Does not explain intra-industry trade
• It is also a poor predictor of world trade moves (Leontief)
• Factors like education of labour, technology, management
and marketing know-how are not considered.
Criticism/limitation of Country Similarity
• Not really a theory of international trade but only a sound
explanation of why companies engage in intra-industry trade
Criticism/limitation
of International Product Life Cycle
Does not stand for all products:
• Some products do not go through all stages (obsolescence)
• Cost is a little concern for luxury products
• MNEs might sometimes produce, innovate and test both
home and abroad, at the same time
Criticism/limitation
of Porter´s Diamond
• Theory was not tested empirically
• Does not provide specific action
• Some firms in some countries decide not to enter other
markets in spite of conditions being there. E.g. Swiss
companies – not involved in the computer industry