International Trade

Theory
 Key Issues

• Why do nations trade with each-other?

• How do different theories explain trade flows?
• How does free trade raise the economic welfare
of all participating nations? Any disagreements?
• Can government actively influence a country’s
competitive advantage?
• Why is an understanding of trade theory
important for managers?
Slide
4-1

International Trade Theory

• What is international trade?
– Exchange of raw materials and manufactured goods
(and services) across national borders
• Classical trade theories:
– explain national economy conditions--country
advantages--that enable such exchange to happen
• New trade theories:
– explain links among natural country advantages,
government action, and industry characteristics that
enable such exchange to happen
Slide
4-2

Classical Country-Based Theories

• Mercantilism (pre-16th century)
– Takes an us-versus-them view of trade; other
country’s gain is our country’s loss
– Neo-mercantilism views persist today
• Free Trade supporting theories
– Show that specialization of production and free
flow of goods grow all trading partners’ economies
– Absolute Advantage (Adam Smith, 1776)
– Comparative Advantage (David Ricardo, 1817)
• Free Trade refined
– Factor-proportions (Heckscher-Ohlin, 1919)
– International product life cycle (Ray Vernon, 1966)
Slide
4-3

The New Trade Theory

• In many industries, as output expands with
specialization, the ability to realize economies of
scale increases and unit costs should decrease
• Because of such scale economies, world demand
supports only a few firms in such industries (e.g.,
commercial aircraft, automobiles)
• Countries that had an early entrant to such an
industry have an advantage in such an industry:
– Fist-mover advantage
– Barrier to entry
Slide
4-4

New Trade Theory

• Global Strategic Rivalry
– Firms gain competitive advantage trough:
intellectual property, R&D, economies of scale and
scope, experience
• National Competitive Advantage (Porter, 1990)
Slide
4-5
Mercantilism/Neomercantilism
• Prevailed from 1500 to 1800
– Export more to “strangers” than we import to amass treasure,
expand kingdom
– Maximize exports and minimize imports: no advantage in
increased trade
• Government intervenes to achieve a surplus in exports
– King, exporters, domestic producers: happy
– Subjects: unhappy because domestic goods stay expensive and of
limited variety
• Today neo-mercantilists=protectionists: some segments of
society shielded short term
• Zero-sum vs positive-sum game view of trade
Slide
4-6
Absolute Advantage
• Adam Smith: The Wealth of Nations, 1776
• Mercantilism weakens a country in the long run and
enriches only a few segments
• A country should specialize in and export products
for which it has absolute advantage; import others
• A country has absolute advantage when it is more
productive than another country in producing a
particular product
Slide
4-7

Comparative Advantage
• David Ricardo: Principals of Political Economy, 1817
• Country should specialize in the production of those goods
in which it is relatively more productive... even if it has
absolute advantage in all goods it produces
• Absolute advantage is really a special case of comparative
advantage
Slide 4-8

Heckscher (1919)-Ohlin (1933) Theory

• The pattern of international trade depends on
differences in factor endowments not on
differences in productivity
• Absolute amounts of factor endowments matter
• Leontief paradox:
– US has relatively more abundant capital yet imports
goods more capital intensive than those it exports
– Explanation(?):
• US has special advantage on producing new products made
with innovative technologies
• These may be less capital intensive till they reach mass-
production state
Slide
4-9

Theory of Relative Factor Endowments

(Heckscher-Ohlin)

• Factor endowments vary among countries

• Products differ according to the types of factors
that they need as inputs
• A country has a comparative advantage in
producing products that intensively use factors of
production (resources) it has in abundance
• Factors of production: labor, capital, land, human
resources, technology
Slide
4-10

International Product Life-Cycle (Vernon)

• Most new products initially conceived and produced in the
US in 20th century
• US firms kept production close to the market
• Aid decisions; minimize risk of new product introductions
• Demand not based on price yet; low production cost not an
issue
• Limited initial demand in other advanced countries
• Exports more attractive than production there initially
• With demand increase in advanced countries
• Production follows there.
• With demand expansion elsewhere
• Product becomes standardized
• production moves to low production cost areas
• Product now imported to US and to advanced countries
Slide 4-11

Classic Theory Limitations

• Fundamentally: Free Trade expands the world “pie” for
goods/services
Theory Limitations
• Simple world (two countries, two products)
• no transportation costs
• no price differences in resources
• resources immobile across countries
• constant returns to scale
• each country has a fixed stock of resources and no
efficiency gains in resource use from trade
• full employment
Slide
4-12

New Trade Theories

• Increasing returns of specialization due to
economies of scale (unit costs of prod.
decrease)
• First mover advantages (economies of scale
such that barrier to entry crated for second or
third company)
• Luck... first mover may be simply lucky.
• Government intervention: strategic trade policy
Slide
4-13

National Competitive Advantage

(Porter, 1990)

• Factor endowments
• land, labor, capital, workforce, infrastructure
(some factors can be created...)
• Demand conditions
• large, sophisticated domestic consumer base: offers an
innovation friendly environment and a testing ground
• Related and supporting industries
• local suppliers cluster around producers and add to innovation
• Firm strategy, structure, rivalry
• competition good, national governments can create conditions
which facilitate and nurture such conditions
Slide
4-14

“So What” for business?

• First mover implications
– invest to be first, particularly in global industries or in
markets which can support a few firms
• Location Implication
– if countries have comparative advantages MNEs want
to locate appropriate activities in those countries…
• Foreign Investment Decisions
• Government Policy implications
– companies generate imports and exports. Thus can
influence government decisions on trade policy...