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Chapter
4
International Trade
Theory
4-2
Case- The hollowing out of the U.S. based
economy
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Economic assumption: free trade produces gains
for all participating countries
Recently, US economy indicate a movement of
knowledge based jobs to developing economies.
Economists believe that:
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only routine skill jobs go overseas. Most managerial
and , marketing and R &D jobs retained in the
country.
Lower price of services means consumer can
consume more for less
Economic growth overseas will benefit the U.S.
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Trade theory-overview
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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
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Trade theory-overview
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The Pattern of International Trade displays
patterns that are easy to understand (Saudi
Arabia/oil or China/crawfish). Others are not so
easy to understand (Japan and cars)
The history of Trade Theory and government
involvement presents a mixed case for the role of
government in promoting exports and limiting
imports
Later theories appear to make a case for limited
involvement
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Mercantilism: mid-16th century
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A nation’s wealth depends on accumulated
treasure
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Theory says you should have a trade surplus.
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Gold and silver are the currency of
trade
Maximize export through subsidies.
Minimize imports through tariffs
and quotas
Flaw: “zero-sum game”
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Mercantilism-zero-sum game
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David Hume in 1752 pointed out that:
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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
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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 can vary
 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
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Example: Ghana/cocoa
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Theory of absolute advantage
Fig 4.1
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Absolute advantage and the gains from
trade
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Theory of comparative advantage
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David Ricardo: Principles of Political Economy
(1817).
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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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Theory of comparative advantage
Fig 4.2
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Comparative advantage and the gains
from trade
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Simple extensions of the Ricardian
model
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Immobile resources:
 Resources do not always move easily from one
economic activity to another
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Diminishing returns:
 Diminishing returns to specialization suggests
that after some point, the more units of a good
the country produces, the greater the additional
resources required to produce an additional item
 Different goods use resources in different
proportions
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Simple extensions of the Ricardian
model
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Free trade (open economies):
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Free trade might increase a country’s stock of
resources (as labor and capital arrives from
abroad)
Increase the efficiency of resource utilization
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PPF under diminishing returns
Fig 4.3
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Influence of free trade on PPF
Fig 4.4
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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
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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
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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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Product life cycle theory
Fig 4.5
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New trade theory
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In industries with high fixed costs:
Specialization increases output, and the ability
to enhance economies of scale increases
learning effects are high. These are cost
savings that come from “learning by doing”
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New trade theory-applications
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Typically, requires industries with high, fixed
costs
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Competitors may emerge because of “ Firstmover advantage”
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World demand will support few competitors
Economies of scale may preclude new entrants
Role of the government becomes significant
Some argue that it generates government
intervention and strategic trade policy
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Theory of national competitive
advantage
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The theory attempts to analyze the reasons for
a nations success in a particular industry
Porter studied 100 industries in 10 nations
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postulated determinants of competitive
advantage of a nation were based on four major
attributes
 Factor
endowments
 Demand conditions
 Related and supporting industries
 Firm strategy, structure and rivalry
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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
Fig 4.6
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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
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Basic factor endowments
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Basic factors: Factors present in a country
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Natural resources
Climate
Geographic location
Demographics
While basic factors can provide an initial
advantage they must be supported by
advanced factors to maintain success
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Advanced factor endowments
Advanced factors: Are the result of investment
by people, companies, government and are more
likely to lead to competitive advantage
 If a country has no basic factors,
it must invest in
advanced factors
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Advanced factor endowments
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communications
skilled labor
research
Technology
education
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Demand conditions
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Demand:
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creates capabilities
 creates sophisticated
and demanding
consumers
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Demand impacts quality
and innovation
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Related and supporting industries
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Creates clusters of supporting industries that
are internationally competitive
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Must also meet requirements of other parts
of the Diamond
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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
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Determinants of Competitive Advantage
in nations
Fig 4.8
Chance
Company Strategy,
Structure,
and Rivalry
Two external
factors that
influence the
four
determinants.
Factor
Conditions
Government
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Demand
Conditions
Related
and Supporting
Industries
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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
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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
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Implications for business
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Location implications:
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First-mover implications:
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Disperse production activities to countries
where they can be performed most efficiently
Invest substantial financial resources in building
a first-mover, or early-mover advantage
Policy implications:
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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
McGraw-Hill/Irwin
International Business, 5/e
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