Chapter Two
three
International
Trade Theory
and Applications
Learning Concepts – Chapter 2
1. Understand the purpose of International
Trade Theory as explanation, prediction and
control of trade phenomena.
2. Know theories that explain trade flows, like
mercantilism, absolute advantage, comparative,
advantage, Heckscher-Ohlin, product life cycle,
income-preference similarity, and new trade
theory.
Copyright, John Wiley and Sons, Inc.
Chapter Two
three
International
Trade Theory
and Applications
Learning Concepts – Chapter 2 (cont)
3. Understand how theory is created and know
that further trade theory development is needed
that explains flows in human resources, capital,
information, and technological resources.
4. Comprehend that international trade has
grown dramatically in the goods, services,
commodities, and information sectors.
Copyright, John Wiley and Sons, Inc.
Chapter Two
three
International
Trade Theory
and Applications
Learning Concepts – Chapter 2 (cont)
5. Know that international trade is difficult to
pressure and precisely explain in simplistic
models.
6. Explain tariff and non-tariff barriers to trade
and how they work.
Copyright, John Wiley and Sons, Inc.
The purpose of Trade Theory
Theories are representations of our understanding of
“how the world works”. They explain the
connection between variables, predict how and
when those connections will exist, and set
controls in relationship to when these theories
apply, to what extent, and where they do not apply.
All good theories should do these things.
Copyright, John Wiley and Sons, Inc.
The purpose of Trade Theory
Trade theory explains why trade exists, how it
happens, and where it does and not occur. When
you see trade theory, you want to ask some
questions: (1) does theory x apply to something?
(2) can I think of an example? (3) can I identify
where it doesn’t work?
Copyright, John Wiley and Sons, Inc.
Trade Theory - Mercantilism
 Mercantilism is a 16th Century doctrine stating that
a nation should export more goods that it imports.
 Government’s job is to create policy that promotes
heavy exportation, collection of revenue, and
industrial development internally.
 In Practice, it serves to make the State the
stockholder, financier, customer, marketer, collector,
and enforcer of contracts with other nations. Colonial
relationship resulted from mercantilism.
Copyright, John Wiley and Sons, Inc.
Trade Theory - Absolute
Advantage
 Under Mercantilism State policies predicted where
trade would occur. In 1776, Adam Smith indicated
that was better predicted and explained by market
forces rather than government desires.
 Laissez-Faire policy where government has no
influence should promote trade better, according to
Smith.
 Nations could specialize in producing and
exporting goods where they have a natural or
acquired Absolute Advantage and import those
goods they don’t produce as well.
 Nations will export to pay for goods they import.
Copyright, John Wiley and Sons, Inc.
Trade Theory - Comparative
Advantage
 Adam Smith said that nations should specialize in
those goods where they have an Absolute
Advantage – they should import everything else.
 David Ricardo indicated in 1817 there may be a
better explanation since few States actually
specialize like that.
 Ricardo indicated that nations that are
comparatively more efficient at production will make
those goods even though they may not have an
absolute advantage.
 It is this Comparative Advantage that explains and
predicts trade of goods where absolute advantages
may not exist.
Copyright, John Wiley and Sons, Inc.
Trade Theory - Smith & Ricardo
 Ricardo indicated that nations will produce and
trade goods where they have a Comparative
Advantage even though more than one nation holds
Absolute Advantage in production. It is the nation
that is comparatively better in production that will
trade.
 The implication for Ricardo is that human skill,
productivity, capital, or government policy can
intervene and make a nation an exporter of goods.
 Examples can be where governments promote
comparative advantage through subsidies, resources
and development, or direct funding.
Copyright, John Wiley and Sons, Inc.
Trade Theory - Heckscher-Ohlin
 Smith said trade was explained through Absolute
Advantage; Ricardo said it was Comparative
Advantage; Heckscher-Ohlin indicates it is supply of
factors that predicts, explains, and controls trade.
 Every producer has to have a supply base. Sources
of supply coming from locally abundant Factor
Endowments lower supply costs and make for
cheaper production and more likely export.
Copyright, John Wiley and Sons, Inc.
Heckscher-Ohlin Problems
 Heckscher-Ohlin says that cheaper supply from
locally plentiful sources predicts where trade will
occur.
 This may not be true. Locally abundant supply may
not be the cheapest. There are market faces, like
supply and demand, at work. There is also
government policy or speculation that serves to
throw off a “perfect” market.
 An example is government imposed minimum wage
that raises the cost of an abundant factor – labor.
Copyright, John Wiley and Sons, Inc.
Heckscher-Ohlin Problems
 Ohlin assumed also that technology for production
was universally available, which it isn’t.
 Heckscher-Ohlin also assumes that products can
be either capital or labor intensive, not both.
 Heckscher-Ohlin also ignore transportation and
logistical costs to and from a factory.
Copyright, John Wiley and Sons, Inc.
Trade Theory - Leontief
 Leontief challenges Heckscher-Ohlin on a number
of grounds. First, Leontief observes that the U.S (a
capital intensive nation) exports labor-intensive
goods.
 Second, the U.S also exports technically
sophisticated goods that require skilled labor.
 Third the U.S imports capital intensive goods made
with unskilled labor.
 If Heckscher-Ohlin is correct, how could these
things exist?
Copyright, John Wiley and Sons, Inc.
Trade Theory - Leontief
To overcome the contradictions in Heckscher-Ohlin,
Leontief proposed the followings:
1. There are differences in tastes and preferences that
contradict market and factor influences. These are
called demand biases.
2. There are trade barriers that government imposes
that influence production.
3. There are natural resources in abundance or not.
4. There are factor intensity reversely that occur over
time.
Copyright, John Wiley and Sons, Inc.
Trade Theory - Human Skills &
Technology
Up to now, trade has been explained as occurring from
Absolute Advantage, Comparative Advantage, from
factor endowments or moderated by taste, biases or
policy.
Keesing had another idea. He indicated that trade
direction and flow is predicted by gaps in human
skills and technology.
Copyright, John Wiley and Sons, Inc.
Trade Theory - Human Skills &
Technology
According to Keesing, nations with higher levels of
humans skills and technology will produce and
export goods to nations with lower levels.
 Human Skills are predicted by level of development
in the scientific, technical, managerial, and skilled
labor sectors.
 Technology level is predicted by capital-intensive
technology development, and also the imitation lag
that exists as technology innovations diffuse to
developing areas.
Copyright, John Wiley and Sons, Inc.
Trade Theory - Product Life
Cycle
The product life cycle model by Raymond Vernon is
closely related to the Keesing model.
Vernon’s PLC model asserts that product innovation
and initial use occurs first in higher income countries
and then diffuses to middle and lower income
countries as technology and skills gaps overcome
and consumer preferences switch to the newer
products.
Copyright, John Wiley and Sons, Inc.
Trade Theory - Product Life
Cycle
Several trends emerge in PLC:
1. The export performance of the mature innovating
country is better than others.
2. Technology is better in the mature countries – as
products diffuse production tends to move from
technology-intensive to labor-intensive.
3. Countries that were innovators can fall from that
place.
4. Trade may increase in later stages of product
maturity as costs and prices decline and production
economies rise.
Copyright, John Wiley and Sons, Inc.
Trade Theory - IncomePreference Similarity
Developed countries trade more than les
developed countries – this is the assumption.
Trade should take place between developed nations
producing manufactured products and less
developed nations producing primary products (e.g.
natural resources) and labor-intensive goods.
According to Linder, the range of production is
determined by internal demand. Countries with
similar internal demand conditions should therefore
trade. This is called Preference Similarity.
Copyright, John Wiley and Sons, Inc.
Old Trade Theory - New Trade
Theory
Up to now, trade theory has been dependent on
national advantage, production efficiency, factor
endowments, government agendas, country or
industry maturity, or overlapping demand similarity.
These theories have a few commonalities:
1. They depend on national differences to explain,
predict, and control trade.
2. They assume government is either involved, or not
involved at all.
3. They don’t consider firm level strategy, structure or
economy.
4. The newer trade theories do that.
Copyright, John Wiley and Sons, Inc.
Trade Theory - New Trade
Theory
According to New Trade Theory, which is actually a
set of papers by various scholars, trade is predicted
by the increasing returns that firms can earn by
trading intentionally. In New Trade Theory:
1. There is increasing return in Economy of Scale.
2. Intra-Industry trade is best explained by increasing
returns.
3. Externalities like government policy, political
relations, national history, consumption differences,
accident, and luck all predict variance in trade.
Copyright, John Wiley and Sons, Inc.
Theory Assessment
Remember, no theory thoroughly explains all trade,
predicts it all accurately, and establishes limits on
where trade does or does not occur. Every theory
has advantages though, and it may be better to
consider theory in combination rather in
independently.
Copyright, John Wiley and Sons, Inc.
Theory Assessment (cont)
1. Traditional trade theory uses national differences to
explain trade.
2. Factor endowment and skills or technology also
predict trade.
3. Overlapping demand and income preferences
predict motives.
4. Increased returns on investment also predicts trade.
Copyright, John Wiley and Sons, Inc.
International Trade Patterns
The overall trend is trade in favor of big growth. As the
following slides show. In sum, though,
1. Trade in manufactured goods, mined products, and
agricultural products is up very substantially over the
past 50 years.
2. World trade is up across all regions with the
developing world increasing trade development
fastest.
3. Services trade is up exponentially.
Copyright, John Wiley and Sons, Inc.
Trade Measurement
Trade measurement is generally a difficult exercise
since nations do not use similar indexed systems. It
is important to realize that different trade data is
collected for different purposes and that
aggregations may be biased. The general trend
though is – “Trade is up”.
Each country collects and reports trade data-major
sources of reliable data can be found from the U.S
Department of Commerce, the World Trade
Organization, Shippers Export Declarations, and the
World Bank. The CIA Factbook also offers some
trade data.
Copyright, John Wiley and Sons, Inc.
Barriers to Trade
There are various arguments for erecting trade barriers
- among them 1. National Defense.
2. Infant Industries.
3. Protecting domestic jobs.
4. Preventing dumping.
Copyright, John Wiley and Sons, Inc.
Instruments of Trade
“Protection”
 Tariffs – A tax on incoming goods.
Ad valorem tariff.
2. Specific tariff.
3. Compound tariff.
 Variable levy.
 Lowered duty for local input.
1.
Copyright, John Wiley and Sons, Inc.
Instruments of Trade
“Protection”
 Non-Tariffs barriers.
1.
2.
3.
4.
5.
6.
Quota – number of goods.
Tariff quota – the aggregate tariff amount
collected.
Direct government participation.
Customs or administrative procedures.
Safety, content or other standards.
Corrupt practices.
Copyright, John Wiley and Sons, Inc.