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New
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China
Australia
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PORTERS DIAMOND
3-1
Evolution of Trade Theory
The Age of Mercantilism
Classical Trade Theory
Absolute cost advantage
theory
Comparative cost theory
Factor Proportions Trade
Theory
Modern firm based theory
Life cycle theory
The New Trade Theory
Theory of national
competitive advantage
Mercantilism
Mid 16th century
Policy: increase national wealth by
increasing gold and silver
It is a countrys best interests to
maintain a trade surplus by exporting
more and importing less.
Trade is viewed as a zero sum game.
1. Why should countries
trade?
More national wealth/prestige (0-sum
game)
Mercantilism (16th c)
More consumption (positive-sum
game)
Efficient use of resources for production:
Adam Smith (18th c)-absolute
advantage
David Ricardo (19th c)-comparative
advantage
Relative abundance of resources:
Mercantilism: Zero-Sum Game
David Hume 1752
Increased exports leads to inflation and
higher prices(England)
Increased imports lead to lower
prices(France)
Resulting in
Country A selling less because of high prices
Country B selling more because of lower prices
In the long run, no one can keep a trade
surplus
Patterns of International
Trade
Some patterns are easy to
understand
Natural resources (Saudi Arabia/oil)
Climate (Brazil/ coffee)
Others are not so easy to understand
Japan and cars
Switzerland and watches
Absolute Cost Advantage
Theory
Adam smith in 1776 in his book The Wealth
of Nations
THEOREM
Others things being equal a country tend to
produce and export those goods in which it
has absolute advantage and import those
goods in which it has absolute disadvantage.
Assumption
s
Two countries, and two
commodities.
Labour is only one factor of
production.
Labour is homogeneous
but it differs in productivity
in different countries.
Labour is perfectly mobile
within the country but
immobile internationally.
No cost of production.
Perfect competition.
Free trade
Absolute Advantage Example
Ghana :Cocoa
South Korea : Rice
Suppose the only production factor is labor
Each country has 200 labors as endowment
Absolute advantage example(200
labour/resources)
Resources
required to produce 1 ton of cocoa and rice
Ghana
S .Korea
cocoa
10 Lab
40 lab
rice
20Lab
10lab
Ghana can produce 20 tons of cocoa or no rice or 10 tons of rice or
no cocoa .
[Link] can produce 5 tons of cocoa or no rice or 20 tons of rice
and no cocoa .
Production and consumption without trade (denotes half
resources of labour)
Ghana
10
5
S .Korea
2.5
10
Total
12.5
15.0
Production with specialization
Ghana
20
S .Korea
0
0
20
Absolute advantage - example
Consumption after Ghana trades 6 tons of cocoa for
6 tons of rice from Korea
cocoa
rice
Ghana
14
6
Korea
6
14
Increase in consumption as a result of specialization
and trade
Ghana
Korea
cocoa
4.0
3.5
rice
1.0
4.0
Absolute Advantages
Flaw
What happens to trade if one country has an
absolute advantage in both products?
No trade would occur
DAVID RICARDO in 1817 in his book
Principles of Political Economy and
Taxation
Differences between Comparative
and Absolute Advantage
Absolute versus relative productivity
differences
Comparative advantage incorporates the
concept of opportunity cost
Value of what is given up to get the good
A relative price is the pri ce of a commodity such as a good or
service in terms of another; i.e., the ratio of two prices .
Comparative advantage
In economics the law of comparative advantage refers to the
ability of a party (an individual, a firm, or a country) to
produce a particular good or service at a lower opportunity cost
than another party. It is the ability to produce a product with
the highest relative efficiency given all the other products that
could be produced.
It can be contrasted with absolute advantage which refers to
the ability of a party to produce a particular good at a lower
absolute cost than another.
Comparative advantage explains how trade can create value for
both parties even when one can produce all goods with fewer
resources than the other. The net benefits of such an outcome
are called gains from trade.
THEOREM
Others things being equal, a country
tends to specialize and export those
commodities in the production of which
it has a maximum comparative cost
advantage and import those goods in
which it has comparative cost
disadvantage.
ASSUMPTIONS OF THE THEORY
Two countries, and two commodities.
Labour is only one factor of production.
Labour is homogeneous but it differs in
productivity in different countries.
Labour is perfectly mobile within the
country but immobile internationally.
No cost of production.
Perfect competition.
Free trade.
COST COMPARISIONS
LABOUR COST OF PRODUCTION (IN HOURS)
1 UNIT OF WINE
1 UNIT OF
CLOTH
PORTUGAL
90hrs
ENGLAND
100hrs
80 hrs
120 hrs
Portugal has absolute advantage in production of cloth
and wine but comparative advantage in production of
wine
England has absolute disadvantage in production of
cloth and wine but comparative advantage in
production of cloth.
Gains from trade
LABOUR COST OF PRODUCTION (IN HOURS)
1 UNIT OF WINE
1 UNIT OF
CLOTH
PORTUGAL
ENGLAND
80
120
PORTUGAL HAS CLOTH EXPENSIVE THAN WINE
1 UNIT OF WINE= 0.89 UNITS OF CLOTH
ENGLAND HAS WINE EXPENSIVE THAN CLOTH
1 UNIT OF WINE=1.2 UNITS OF CLOTH
(If England could import 1unit of wine at a
Price less than 1.2 units of cloth it can gain
from trade. If Portugal could import more
than 0.89 unit of cloth for 1 unit of wine it
would also gain)
90
100
CONCLUSION
England will export cloth and import wine
from Portugal and can save 20 hours of labour.
Portugal will export wine and import cloth
from England and can save 10 hours of labour.
CRITICISM OF THE THEORY
Non labour cost has not been included.
Assumes homogeneous labour.
Static theory.
One sided theory.
Ignores transportation cost.
Factor Endowment theory
Eli Heckscher (1919) and BertinOhlin(1933)
Nations export products that use inputs which are relatively
abundant (cheap) at home, and import products which need
inputs which are relatively scarce (expensive) at home.
Factor abundance means the extent to which the country is
endowed with such resources like land, labour, capital.
Factor Proportions Trade
Theory
Considers Two Factors of
Production
Labor
Capital
EXAMPLES
India has been a substantial exporter of agricultural
products due to large land.
China excels in production of labour extensive
manufacturing industries like textiles, cloth due to low
labour cost.
Ranbaxy ,HCL outsource from china due to cheap
labour.
Leontief Paradox
Wassily leontief in 1953, conducted a test to
predict the validity of Heckcsher Ohlin
theory.
Using the factor endowment theory, since
UNITED STATES is rich in capital compared to
other countries the U.S would be an exporter
of capital intensive goods and an importer of
labour intensive goods, but he found that
U.S exports were less capital intensive than
U.S imports. This result came to be known
as leontief paradox in international trade.
The Leontief Paradox
The Findings:
The U.S. exported laborintensive products and
imported capital-intensive
products.
The Controversy:
Findings were the opposite of
what was generally believed to
Factor Endowment theory
Factor
endowment theory is thus justified on
theoretical grounds. It is poor predictor of real world
trade patterns.
The theory is limited in its scope. Possible cause
given by Leontief was that U.S has special
advantage in producing new products made with
innovative technology.
The best solution is to return to the comparative cost
theory which predicts that trade patterns are largely
driven by international differences in productivity.
Difference in technology may lead to differences in
productivity which in turn drives international trade
patterns.
IMPLICATIONS FOR BUSINESS
Shows why it is beneficial to engage in
international trade even for products it is able
to producer for itself.
Pattern of international trade.
International differences in labour productivity
Countries having various factors endowments.
Difference in technology brings differences in
productivity.
