International Trade Theories

Theories
of
International
Trade
4-2
Learning Objectives
To understand the traditional arguments

of how and why international trade
improves the welfare of all countries
To review the history and compare the
implications of trade theory from the
original work of Adam Smith to the
contemporary theories of Michael Porter
To examine the criticisms of classical trade
theory and examine alternative viewpoints
of which business and economic forces
determine trade patterns between countries
McGraw-Hill/Irwin
International Business, 5/e
2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
4-3
Evolution of Trade Theories
Mercantilism
Absolute advantage (Classical)
Comparative advantage
Factor Proportions Trade
International Product Cycle
New Trade Theory
National competitive advantage
McGraw-Hill/Irwin
4-4
Mercantilism: mid-16th century
A nations wealth depends on accumulated

treasure
Theory says you should have a trade surplus.
Gold and silver are the currency of

trade
Maximize export through subsidies.
Minimize imports through tariffs
and quotas
Flaw: restrictions, impaired growth
McGraw-Hill/Irwin
4-5
Defining mercantilism
trade theory holding that nations

should accumulate financial wealth,
usually in the form of gold (forget
things like living standards or
human development) by encouraging
exports and discouraging imports
McGraw-Hill/Irwin
Adam smith (Absolute Advantage)
McGraw-Hill/Irwin
4-7
Theory of absolute advantage
Adam Smith: Wealth of Nations (1776) argued:

Capability of one country to produce more of
a product with the same amount of input than
another country
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
McGraw-Hill/Irwin
4-8
destroys the mercantilist idea since there

are gains to be had by both countries party to
an exchange
questions the objective of national
governments to acquire wealth through
restrictive trade policies
measures a nations wealth by the living
standards of its people
McGraw-Hill/Irwin
4-9

PPF Production Possibility Frontier
McGraw-Hill/Irwin
4-10
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4-11
McGraw-Hill/Irwin
4-12
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4-13
McGraw-Hill/Irwin
Theory of comparative advantage
law of comparative advantage refers to the

ability of a country to produce a particular
good or service at a lower opportunity cost
than another party.
McGraw-Hill/Irwin
4-15
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
products 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
McGraw-Hill/Irwin
4-16
McGraw-Hill/Irwin
4-17
Comparative advantage and the gains

from trade
McGraw-Hill/Irwin
4-18
McGraw-Hill/Irwin
4-19
Comparative advantage:
Bollywood
McGraw-Hill/Irwin
4-20
McGraw-Hill/Irwin
4-21
McGraw-Hill/Irwin
4-22
Assumptions and limitations
Driven only by maximization of production

and consumption
Only 2 countries engaged in production and
consumption of just 2 goods?
What about the transportation costs?
Only resource labour (that too, nontransferable)
No consideration for learning theory
McGraw-Hill/Irwin
Haberlers Opportunity Cost

Theory
Opportunity Cost theory was propounded by Prof. Haberler,
According to Haberler goods are not produced by the
labor only. Production of goods uses various combinations
of factors of production (land, labor, capital).
Each country exports goods which it produces at lower
opportunity cost and imports those with higher
opportunity costs.
Thus, this theory provides the basis for international business
in terms of exporting a particular product rather than other
products.
McGraw-Hill/Irwin
Following are some assumptions of this theory

There are only two nationas.
There are only two commodities.
There are only two factors of productions such as
labour & capital.
There is perfect competition in both the factors and
commodity market.
Supply of each factor is fixed.
There is full employment in each country
There is no change in technology.
There is factor immobility of factors of productions
between countries but they are fully mobile within
countries.
There is free and unrestricted trade between countries.
McGraw-Hill/Irwin
Haberler's theory of trade base on opportunity

cost is represented by production possibility curves.
A production possibility curve represents the
production frontiers (of generally two goods) that
can be reached by using all the available factors of
production. In simple words, the production
possibility curve shows the various combinations of
two goods that can be produced given the 'factor
endowments of a country-factor endowments
include all the factors of production available to a
country. In this sense, Haberler deviates from the
Classical assumption of only one factor and
introduces, in his model, all the factors of
production
McGraw-Hill/Irwin
Heckscher-Ohlin theory
History of Bertil ohlin:Between 1944 and

1967, Bertil Ohlin was the leader of the
Swedish Liberal Party, and between 1944
and 1945 he was also the Secretary of
Trade of the Swedish Government. Bertil
McGraw-Hill/Irwin
4-27
Factor proportions theory
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
McGraw-Hill/Irwin
4-28
Factor proportions theory
trade theory holding that countries produce

and export those goods that require resources
(factors) that are abundant (and thus cheapest)
and import those goods that require resources
that are in short supply
Example:
Australia lot of land and a small population

(relative to its size)
So what should it export and import?
McGraw-Hill/Irwin
4-29
Factor Proportions Trade Theory

Considers Factors of Production
Land
Labor
Capital
McGraw-Hill/Irwin
4-30
Factors Relationship
LAND LABOR
LABOR CAPITAL
TECHNOLOGICAL COMPLEXITIES
McGraw-Hill/Irwin
4-31
Factor Proportions Trade Theory
A country that is relatively labor

abundant (capital abundant)
should specialize in the production
and export of that product which is
relatively labor intensive (capital
intensive)
McGraw-Hill/Irwin
4-32
The Leontief Paradox

The Test:
Could Factor Proportions Theory be used
to explain the types of goods the United
States imported and exported?
The Method:
Input-output analysis
McGraw-Hill/Irwin
4-33
The Leontief Paradox

The Findings:
The U.S. exported labor-intensive
products and imported capital-intensive
products.
The Controversy:
Findings were the opposite of what was
generally believed to be true!
McGraw-Hill/Irwin
Foreign Direct Investment (FDI)

Theories
It was in 1960, when Hymer in his research revealed that
the orthodox theories of international trade and capital
movements are unable to explain the involvement of
multinationals in foreign countries.
Any theory of FDI must give answer to following
questions
Why companies decide to invest abroad directly?
Why companies give preference to direct investment
over exporting or licensing?
How companies compete with local firms in an
unknown environment?
How companies select countries for direct investment?
McGraw-Hill/Irwin
Theories of FDI can broadly be classified in four

categories
Market Imperfections Approach
International Product Life Cycle
Transaction Cost Approach
Eclectic Paradigm
McGraw-Hill/Irwin
Market Imperfection Approach

According to Hymer a multinational invest its money
overseas only when the company has certain
advantages not owned by local competitors. These
advantages may derive from skills in management,
marketing, production, finance or technology. They
may refer to preferential access to raw materials or
other inputs
Market imperfection permits the multinational to
exploit its monopolistic advantages in foreign
markets. Thus we can say that FDI is an outcome
of imperfect market.
McGraw-Hill/Irwin
Market imperfections make exporting both

restrictive and expensive.
FDI employed as a strategic tool to bypass
prohibitive restrictions
Theory of FDI based on market imperfection
suggests that foreign investment is undertaken
by those firms who enjoy some monopolistic
or oligopolistic advantage.
McGraw-Hill/Irwin
Market imperfection may be created in number of ways

Internal or external economies of scale often exists,
possibly due to privileged access to raw materials or
to final markets, possibly from increase in physical
production.
Effective differentiation may create substantial
imperfection. This differentiation may be in product,
process, marketing and organization skills.
Government policies have an impact on fiscal and
monetary matters on trade barriers.
McGraw-Hill/Irwin
International Product Life Cycle

Theory
Vernon(1966, 1977) developed a theory of FDI on the basis
of product life cycle. It is based on concept that a
product passes through different stages which are
predefined.
This theory depends on following assumptions
Production of products tries to achieve economies of
scale.
Tastes and preferences of customers are different in
different countries.
With the passage of time products undergo changes in
their production technique, marketing skills etc.
McGraw-Hill/Irwin
International Product Life Cycle has following three stages

New Product Stage
Maturing Product Stage
Standardized Product Stage
The IPLC theory has two important tenets
(a) Technology is a critical factor in creating and
developing new products.
(b) Market size and structure are important in determining
trade patterns.
McGraw-Hill/Irwin
McGraw-Hill/Irwin
McGraw-Hill/Irwin
4-43
The Product Cycle and Trade

Implications
Increased emphasis on technologys
impact on product cost
Explained international investment
Limitations
Most appropriate for technology-based

products
Some products not easily characterized by
stages of maturity
Most relevant to products produced through
mass production
McGraw-Hill/Irwin
Transaction Cost Theory

The transaction Cost Theory was conceived by
Coase (1937) and further elaborated by
McManus (1972).
This theory is based on the criticism of
neoclassical economics which arises from the
non-realization of the assumptions of perfect
competition.
McGraw-Hill/Irwin
4-45
It stipulates the conditions under which a

company will or should choose to use the
market, e.g. an agent or importer, or when it
will or should integrate the activities into the
company by, for e.g. establishing a production
subsidiary abroad.
McGraw-Hill/Irwin
The theory stipulates that

If:
Uncertainty about outcomes prevails, e.g. as to the
size/stability of demand.
Transaction i.e. buying/ selling, recur frequently,
and
The transaction require substantial transaction
specific investments in, for e.g. special production
equipments
Then:
The economic activity will be internalized, i.e.

carried out by the company itself rather than
transacted using the markets.
McGraw-Hill/Irwin
Eclectic Paradigm
This eclectic theory for Foreign Direct Investments was
developed by John Dunning. It is also one of the
contingency models. It explains the conditions under
which a company internationalizes through FDIs rather
than by exporting. Thus, it shares the same basic idea
with the Transaction Cost Theory and it is also known
as the theory which explains the growth and
development of MNCs.
According to the Eclectic Theory, for foreign direct
investment to take place three conditions are stipulated
and formulated into OLI formula.
McGraw-Hill/Irwin
OLI Formula
Ownership Advantage
Ownership advantages are proprietary rights e.g.
patent, which provide the firm with a
competitive advantage. An ownership
advantage is necessary to overcome the basic
advantages a naturalized company has on its
own market. Thus, an ownership advantage is
precondition for going international.
McGraw-Hill/Irwin
Location Advantage
Location specific advantage, i.e. advantage
derived from superior factor or demand
endowment in the foreign country. The
location specific advantage is precondition for
establishing production abroad whether by
way of a license or an investment in a
production subsidiary.
McGraw-Hill/Irwin
Internalization Advantage
Internalization advantages, i.e. advantages derived from

doing it yourself instead of using the market. In case
a market does not exist for, for e.g., the know-how
possessed by a company or the price offered is too
low compared to the companys own estimates of its
potential or, as in case of a license, the company
cannot control the use of it, then the company may
decide to establish its own production or sales
subsidiary abroad. Thus, an internalization advantage
is the precondition for investing abroad.
McGraw-Hill/Irwin
The above told three preconditions can be

arranged to form a table of conditions under
which various market entry modes will
prevail
McGraw-Hill/Irwin

International Trade Theories

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Theories

To understand the traditional arguments

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Evolution of Trade Theories

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Mercantilism: mid-16th century

A nations wealth depends on accumulated

Theory says you should have a trade surplus.

Gold and silver are the currency of

Flaw: restrictions, impaired growth

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

trade theory holding that nations

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Adam smith (Absolute Advantage)

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Theory of absolute advantage

Adam Smith: Wealth of Nations (1776) argued:

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Theory of absolute advantage

destroys the mercantilist idea since there

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Theory of absolute advantage

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Theory of comparative advantage

law of comparative advantage refers to the

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Theory of comparative advantage

David Ricardo: Principles of Political Economy (1817)

Extends free trade argument

Makes better use of resources

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Theory of comparative advantage

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Comparative advantage and the gains

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Assumptions and limitations

Driven only by maximization of production

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Haberlers Opportunity Cost

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Following are some assumptions of this theory

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Haberler's theory of trade base on opportunity

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

History of Bertil ohlin:Between 1944 and

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Factor proportions theory

Heckscher (1919) - Olin (1933) Theory

Note: Factor endowments can be impacted by

Patterns of trade are determined by differences in

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Factor proportions theory

trade theory holding that countries produce

Australia lot of land and a small population

2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Factor Proportions Trade Theory