International

Trade Theory

Introduction
International Trade
Theory
explains why it is beneficial
for countries to engage in
international trade
helps countries formulate
their economic policy
explains the pattern of
international trade in the
world economy

An Overview of Trade
Theory
Question: How has international trade
theory evolved?
Answer:
Mercantilism (16th and 17th centuries)
encouraged exports and discouraged imports
Adam Smith (1776) promoted unrestricted
free trade
David Ricardo (19th century) built on Smith
ideas
Eli Heckscher and Bertil Ohlin (20th century)
refined Ricardos work

Why is Free Trade

Beneficial?
Free trade - a situation where 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

Trade theory - shows why it is beneficial

for a country to engage in international
trade even for products it is able to
produce for itself
International trade allows a country
to specialize in the manufacture and export of
products that it can produce efficiently
import products that can be produced more
efficiently in other countries
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Why do Certain
Patterns of Trade Exist?
Some patterns of trade are fairly
easy to explain:
it is obvious why Saudi Arabia exports
oil, Ghana exports cocoa, and Brazil
exports coffee

But, why does Switzerland

export chemicals,
pharmaceuticals, watches, and
jewelry?
Why does Japan export
automobiles, consumer
electronics, and machine tools?
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The Pattern of
International Trade
Ricardos theory of comparative
advantage - existing trade patterns are
related to differences in labor productivity
Heckscher and Ohlin - explain trade
through the interplay between the
proportions in which the factors of
production are available in different
countries and the proportions in which
they are need for producing particular
goods

Ray Vernon - trade patterns could

be explained by looking at a
products life cycle

The Pattern of
International Trade
Paul Krugman - developed new
trade theory - the world market
can only support a limited number
of firms in some industries
trade will skew toward those
countries that have firms that
were able to capture first
mover advantages
Michael Porter - focused on the
importance of country factors to
explain a nations dominance in
the production and export of
certain products

Trade Theory and

Government Policy
The mercantilist philosophy makes a
crude case for government involvement
in promoting exports and limiting
imports
Smith, Ricardo, and Heckscher-Ohlin
promote unrestricted free trade
New trade theory and Porters theory of
national competitive advantage justify
limited and selective government
intervention to support the development
of certain export-oriented industries
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Mercantilism

Mercantilism suggests that it is

in a countrys best interest to
maintain a trade surplus -to
export more than it imports
advocates government intervention to
achieve a surplus in the balance of
trade
Mercantilism views trade as a zerosum game - one in which a gain by
one country results in a loss by another

Mercantilism is problematic and

not economically valid, yet many
political views today have the goal
of boosting exports while limiting
imports by seeking only selective
liberalization of trade.
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What is Smiths Theory

of Absolute Advantage?
Smith (1776) - countries differ in
their ability to produce goods
efficiently.
Adam Smith argued that a country
has an absolute advantage in the
production of a product when it is
more efficient than any other country
in producing it
countries should specialize in the
production of goods for which they have
an absolute advantage and then trade
these goods for the goods produced by
other countries
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How does the Theory

of Absolute Advantage
Work?

Assume that two countries, Ghana and South

Korea, both have 200 units of resources that could
either be used to produce rice or cocoa
In Ghana, it takes 10 units of resources to produce
one ton of cocoa and 20 units of resources to
produce one ton of rice

Ghana could produce 20 tons of cocoa and no rice, 10 tons

of rice and no cocoa, or some combination of rice and
cocoa between the two extremes

In South Korea it takes 40 units of resources to

produce one ton of cocoa and 10 resources to
produce one ton of rice

South Korea could produce 5 tons of cocoa and no rice, 20

tons of rice and no cocoa, or some combination in between

Ghana has an absolute advantage in the production of

cocoa
South Korea has an absolute advantage in the
production of rice
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How does the Theory

of Absolute Advantage
Work?
Without trade
Ghana would produce 10 tons of cocoa and 5 tons of rice
South Korea would produce 10 tons of rice and 2.5 tons of
cocoa

With specialization and trade

Ghana would produce 20 tons of cocoa
South Korea would produce 20 tons of rice
Ghana could trade 6 tons of cocoa to South Korea for 6 tons of
rice

After trade
Ghana would have 14 tons of cocoa left, and 6 tons of rice
South Korea would have 14 tons of rice left and 6 tons of cocoa

If each country specializes in the production of the

good in which it has an absolute advantage and trades
for the other, both countries gain
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Absolute Advantage
Figure 5.1: The Theory of Absolute
Advantage

Absolute Advantage
Table 5.1: Absolute Advantage and the Gains from Trade

Ghana in
Africa

South Korea in
Asia

Ricardos Theory
of Comparative Advantage
David Ricardo asked what might happen when
one country has an absolute advantage in the
production of all goods
Ricardos theory of comparative advantage
suggests that countries should specialize in
the production of those goods they produce
most efficiently and buy goods that they
produce less efficiently from other countries,
even if this means buying goods from other
countries that they could produce more
efficiently at home.
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How Does the Theory of

Comparative Advantage
Work?

Assume:
Assume

Ghana is more efficient in the production of both

cocoa and rice
in Ghana, it takes 10 resources to produce one ton
of cocoa, and 131/3 resources to produce one ton of
rice
So, Ghana could produce 20 tons of cocoa and no
rice, 15 tons of rice and no cocoa, or some
combination of the two
in South Korea, it takes 40 resources to produce
one ton of cocoa and 20 resources to produce one
ton of rice
so, South Korea could produce 5 tons of cocoa and
no rice, 10 tons of rice and no cocoa, or some
combination of the two
If each country specializes in the production of the
good in which it has a comparative advantage and
trades for the other, both countries will gain
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How Does the Theory of

Comparative Advantage
Work?
With trade:
Ghana could export 4 tons of cocoa to South Korea
in exchange for 4 tons of rice
Ghana will still have 11 tons of cocoa, and 4
additional tons of rice
South Korea still has 6 tons of rice and 4 tons of
cocoa
if each country specializes in the production of the
good in which it has a comparative advantage and
trades for the other, both countries gain

Comparative advantage theory provides a

strong rationale for encouraging free trade
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Comparative Advantage
Figure 5.2: The Theory of Comparative Advantage

How does the Theory of

Comparative Advantage
Work?
Comparative Advantage and the Gains from Trade

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Is Unrestricted Free Trade

Always Beneficial?
Unrestricted free trade is beneficial, but the
gains may not be as great as the simple
model of comparative advantage would
suggest
immobile resources
diminishing returns
dynamic effects and economic growth

Opening a country to trade could increase

a country's stock of resources as increased
supplies become available from abroad
the efficiency of resource utilization and so free
up resources for other uses
economic growth
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Could a Rich Country be

Worse Off with Free Trade?
Paul Samuelson - the dynamic gains
from trade may not always be
beneficial
free trade may ultimately result in lower
wages in the rich country

The ability to offshore services jobs that

were traditionally not internationally
mobile may have the effect of a mass
inward migration into the United States,
where wages would then fall
But, protectionist measures could create
a more harmful situation than free
trade
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Heckscher-Ohlin Theory
Heckscher and Ohlin - comparative
advantage arises from differences in
national factor endowments (the extent to
which a country is endowed with
resources such as land, labor, and capital)
the more abundant a factor, the lower its cost
countries will export goods that make
intensive use of those factors that are locally
abundant, and import goods that make
intensive use of factors that are locally
scarce
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The Leontief Paradox

Wassily Leontief theorized that since the U.S.

was relatively abundant in capital compared to
other nations, the U.S. would be an exporter
of capital intensive goods and an importer
of labor-intensive goods.
However, he found that U.S. exports were less
capital intensive than U.S. imports
Possible explanations for these findings include
that the U.S. has a special advantage in
producing products made with innovative
technologies that are less capital intensive
differences in technology lead to differences in
productivity which then drives trade patterns

Since this result was at variance with the

predictions of trade theory, it became known as
the Leontief Paradox
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Product Life Cycle

Theory
The product life-cycle theory - (Raymond Vernon) - as products
mature both the location of sales and the optimal production
location will change affecting the flow and direction of trade.

the size and wealth of the U.S.

market gave U.S. firms a strong
incentive to develop new products
initially, the product would be
produced and sold in the U.S.
as demand grew in other
developed countries, U.S. firms
would begin to export
demand for the new product would
grow in other advanced countries
over time making it worthwhile for

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What is the
Product Life Cycle Theory?
U.S. firms might set up production facilities in
advanced countries with growing demand, limiting
exports from the U.S.
As the market in the U.S. and other advanced nations
matured, the product would become more
standardized, and price the main competitive weapon
Producers based in advanced countries where labor
costs were lower than the United States might now
be able to export to the United States
If cost pressures were intense, developing countries
would acquire a production advantage over advanced
countries
Production became concentrated in lower-cost foreign
locations, and the United States became an importer
of the product
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What is the
Product Life Cycle Theory?
The Product Life Cycle Theory

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Evaluating the Product Life

Cycle Theory
The product life cycle theory accurately
explains what has happened for products like
photocopiers and a number of other high
technology products developed in the United
States in the 1960s and 1970s
But, the globalization and integration of the
world economy has made this theory less
valid today:
the theory is ethnocentric
production today is dispersed globally
products today are introduced in multiple
markets simultaneously
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New Trade Theory

New trade theory suggests that the ability of firms
to gain economies of scale (unit cost reductions
associated with a large scale of output) can have
important implications for international trade.
1.Through its impact on economies of scale, trade can
increase the variety of goods available to consumers
and decrease the average cost of those goods
without trade, nations might not be able to produce
those products where economies of scale are important
with trade, markets are large enough to support the
production necessary to achieve economies of scale
so, trade is mutually beneficial because it allows for the
specialization of production, the realization of scale
economies, and the production of a greater variety of
products at lower prices
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New Trade Theory

2. In those industries when output required to
attain economies of scale represents a
significant proportion of total world demand,
the global market may only be able to
support a small number of enterprises.
first mover advantages - the economic and
strategic advantages that accrue to early
entrants into an industry
economies of scale
first movers can gain a scale based cost
advantage that later entrants find difficult to
match
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What are the Implications of

New Trade Theory for Nations?
Nations may benefit from trade even when they
do not differ in resource endowments or
technology
a country may dominate in the export of a
good simply because it was lucky enough to
have one or more firms among the first to
produce that good
Governments should consider strategic trade
policies that nurture and protect firms and
industries where first mover advantages and
economies of scale are important
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Porters Diamond of
Competitive Advantage
Michael Porter tried to explain why a nation achieves
international success in a particular industry and identified
four attributes that promote or impede the creation of
competitive advantage:
1.Factor endowments - a nations position in factors of
production necessary to compete in a given industry
can lead to competitive advantage
can be either basic (natural resources, climate, location) or
advanced (skilled labor, infrastructure, technological know-how)

2.Demand conditions - the nature of home demand for

the industrys product or service
influences the development of capabilities
sophisticated and demanding customers pressure firms to be
competitive
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Porters Diamond of
Competitive Advantage
3. Relating and supporting industries - the
presence or absence of supplier industries and
related industries that are internationally competitive
can spill over and contribute to other industries
successful industries tend to be grouped in clusters in
countries

4. Firm strategy, structure, and rivalry - the

conditions governing how companies are created,
organized, and managed, and the nature of domestic
rivalry
different management ideologies affect the development of
national competitive advantage
vigorous domestic rivalry creates pressures to innovate, to
improve quality, to reduce costs, and to invest in upgrading
advanced features
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Porters Diamond
Determinants of National Competitive Advantage: Porters Diamond

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Does Porters Theory

Hold?
Government policy can:
affect demand through product standards
influence rivalry through regulation and antitrust
laws
impact the availability of highly educated workers
and advanced transportation infrastructure.

The four attributes, government policy, and

chance work as a reinforcing system,
complementing each other and in combination
creating the conditions appropriate for
competitive advantage
So far, Porters theory has not been sufficiently
tested to know how well it holds up
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Summary of Intl Trade

Theory
Mercantilism
Absolute Advantage -- Smith
Comparative Advantage -- Ricardo
Factor Endowments -- Heckscher & Ohlin
Leontief Paradox -- Leontief
Product Cycle -- Vernon
Economies of Scale -- Krugman &
Lancaster
Competitive Advantage -- Porter

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Summary:

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The Implications of Trade

Theory for Managers
1. Location implications - a firm
should disperse its various
productive activities to those
countries where they can be
performed most efficiently
firms that do not, may be at a
competitive disadvantage

2. First-mover implications - a
first-mover advantage can help a
firm dominate global trade in that
product
a firm can invest resources in trying to
build first-mover advantages, even if it
means losses for a few years before a
venture becomes profitable
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The Implications of Trade

Theory for Managers
3. Policy implications - firms
should work to encourage
governmental policies that
support free trade
Government policies on free
trade or protecting domestic
industries can significantly
impact global competitiveness
firms should lobby the
government to adopt policies
that have a favorable impact
on each component of the
diamond
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In Search of Mutualistic
Market

Supporting

FreeVs.
Trade
Against
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