International Trade Theories

Prof Vishwa Ballabh

International Trade

Mercantilism

Absolute and Comparative Advantages

Heckscher and Ohlin and Theories of
strategic Trade
Competitive Advantage

Mercantilism
An economic philosophy based on the belief that a
nations wealth depends on the accumulated treasure,
usually gold. To increase wealth, government policies
should promote export and discourage imports.
Nation should regulate its domestic and international
affairs so as to promote its interests.
Solution lies in strong foreign trade and country should
achieve favorable balance of payment.
Gold and silver earn would help increase income,
employment and consumptions.
Tariffs, quota and other commercial policies were
proposed by mercantilists to achieve favorable balance
of payment.

Criticism
Favorable balance of payment is short term
phenomenon and over time price rise would eliminate
advantages due to favorable balance of payment.
It was also static view and assumed world pie (total
output) would remain constant and therefore gains from
trade comes at the expense of trading partner.
International trade permits nation to take advantages of
specialization and division of labor which increases the
general level of output with in the nation and thus raises
world output.

Absolute advantage

The capability of one nation to produce more of a good with same

amount of input than another country.

The costs differences govern movement of goods among nation.

International trade and specialization would be beneficial when one

nation has an absolute advantage in one good and the other nation
has an absolute advantage in other.

Weakness what if some country does not have absolute advantage

in production of any good? Is trade still desirable ?

Comparative advantages
A nation having absolute disadvantage in
the production two goods with respect to
an other nation has a comparative or
relative advantage in the production of the
good in which its absolute disadvantage is
less.
How does it work.

TABLE 1

The Production Opportunities of

the USA and the Brazil

Minutes Needed to Make 1

Ounce of:

Amount of Meat or Potatoes

Produced in 8 Hours

Meat

Potatoes

Meat

Potatoes

USA

60 min/oz

15 min/oz

8 oz

32 oz

Brazil

20 min/oz

10min/oz

24 oz

48 oz

FIGURE 1
(a) The USAs Production Possibilities Frontier

The Production
Possibilities
Frontier

If there is no trade the

USA chooses this
production and
consumption

Panel (a) shows

the combinations of
meat and potatoes
that the USA can
produce.

16

32

Potatoes (ounces)

(b) The BRAZILs Production Possibilities Frontier

Meat (ounces)

24
Panel (b) Shows
the combinations
of meat and
potatoes that the
Brazil can
produce. Both
production
possibilities
frontiers are
derived from Table
1 and the
assumption that
the USA and
Brazil each work 8
hours a day

If there is no trade, the

Brazil chooses this
production and
consumption.

12

24

48
Potatoes (ounces)

FIGURE 2
(a) The USAs Production and Consumption

Meat (ounces)

USAs
consumption
with trade

USAs
production
and
consumption
without trade

A*

5
4

USAs
Production
with trade

32
16

17

Potatoes (ounces)

How Trade
Expands the Set
of Consumption
Opportunities
The proposed
trade between
the USA and the
Brazil offers each
of them a
combination of
meat and
potatoes that
would be
impossible in the
absence of trade.
In panel (a), the
USA gets to
consume at point
A* rather than
point B. Trade
allows each to
consume more
meat and more
potatoes

(b) The Brazil s Production and Consumption

Meat (ounces)
24

Brazils
Production with
trade

18

Brazils
consumption
with trade

13

B*
Brazils
production and
consumption
without trade

B
12

12

24

27

27
Potatoes (ounces)

TABLE 2

The Gains from Trade: A Summary

USA
Meat

Potatoes

Brazil
Meat

Potatoes

Without Trade:
Production and
Consumption

4 oz

16 oz

12 oz

24 oz

Production

0 oz

32 oz

18 oz

12 oz

Trade

Gets 5 oz

Gives 15
oz

Give 5 oz

Gets 15
oz

Consumption

5 oz

17 oz

13 oz

27 oz

+ 1 oz

+1 oz

+ 1 oz

+3 oz

With Trade:

Gains from Trade:

Increase in Consumption

TABLE 3
The Opportunity Cost of Meat and Potatoes

Opportunity Cost of:

1 ounce of Meat

1 Ounce of Potatoes

USA

4 oz potatoes

oz meat

Brazil

2 oz potatoes

oz meat

The Equilibrium without International Trade

When an economy cannot trade in world markets, the price adjusts to balance domestic supply and
demand. This figure shows consumer and producer surplus in an equilibrium without international
trade for the steel market in the imaginary country of Isoland.
FIGURE 3
Price of
Steel
Domestic
supply

Consumer
surplus
Equilibrium
Price
Producer
surplus
Domestic
demand

0
Equilibrium
quantity

Quantity of
Steel

International Trade in an Exporting Country

Once trade is allowed, the domestic price rises to equal the world price. The supply curve shows the quantity of
steel produced domestically, and the demand curve shows the quantity consumed domestically. Exports from
Isoland equal the difference between the domestic quantity supplied and the domestic quantity demanded at the
world price.

FIGURE 4

Price of
Steel
Domestic
supply
Price after
trade

World
price

Price before
trade

Domestic
demand

Exports
0
Domestic
quantity
demanded

Domestic
quantity
supplied

Quantity of Steel

FIGURE 5

How Free Trade Affects Welfare in an Exporting Country

When the domestic price rises to equal the world price, sellers are better off (producer surplus rises from C to B + C+ D),
and buyers are worse off (consumer surplus falls from A + B + A). Total surplus rises by an amount equal to area D,
indicating that trade raises the economic well- being of the country as a whole.

Before Trade

After Trade

Change

Consumer Surplus

A+B

-B

Producer Surplus

B+C+D

+(B+D)

A+B+C

A+B+C+D

+D

Total Surplus

The area D shows the increase in total surplus and represent the gains from
Trade.

Price of
Steel

Exports
A

Price after
trade
Price
before
trade

Domestic
supply
World
price

C
Domestic
demand

Quantity of Steel

International Trade in an Importing Country

FIGURE 6

Once trade is allowed, the domestic price falls to equal the world price. The supply curve shows the
amount produced domestically, and the demand curve shows the amount consumed domestically.
Imports equal the difference between quantity demanded and the domestic quantity supplied at the world
price.
Price of
Steel
Domestic
supply
Price
before
trade
World
price

Price
after
trade

Imports
0

Domestic
demand
Quantity of
Steel

How Free Trade Affects Welfare in an Importing Country

FIGURE 7

When the domestic price falls to equal the world price, buyers are better off (consumer surplus rises
from A to A + B + D), and sellers are worse off (producer surplus falls from B + C to C). Total surplus
rises by an amount equal to area D, indicating that trade raises the economic well- being of the
country as a whole.
Before Trade

After Trade

Change

Consumer Surplus

A+B+D

+(B+D)

Producer Surplus

B+C

-B

A+ B + C

A+ B + C + D

+D

Total Surplus

The area D shows the increase in total surplus and represent the gains from Trade

Price of
Steel

Domestic
supply

Price before
trade

A
B

Price after
trade

World
price

D
Imports

Domestic
demand
Quantity of Steel

FIGURE 8
Price of
Steel
Domestic
supply

Equilibrium
without trade

Price
with tariff

B
C

Price
without
tariff

World
price

Imports with
tariff

s
2

Domestic
demand
D

Q Q

Imports without tariff

Quantity of
Steel

The Effects of a Tariff

A tariff reduces the quantity of imports and moves a market closer to the equilibrium that would exist without trade. Total
surplus falls by an amount equal to area D + F. These two triangles represent the deadweight loss from the tariff

Before Trade

After
Trade

Change

Consumer Surplus

A+B +C +D+ E+F

A+B

- ( C + D + E + F)

Producer Surplus

C+G

+C

None

+E

A+ B + C + D + E + F +
G

A+ B + C
+D

- (D+ F)

Government Revenue
Total Surplus

The area D + F shows the Fall in total surplus and represents the deadweight loss of the tariff.

FIGURE 9
Price of
Steel

Domestic
supply
Domestic
supply +
Import supply

Equilibrium
without trade
Quota
A
Isolandian
price with
quota

E
D

Price
without
quota

Equilibrium
with quota

= world

Word
price

Imports
with quota

price

s
2

Domestic
demand

Q
Imports without
quota

D
2

Quantity
of Steel

The Effect of an Import Quota

An Import quota, like a tariff, reduces the quantity of imports and moves a market closer to the equilibrium that
would exist without trade. Total surplus falls by an amount equal to area D + F. These two triangles represents
the deadweight loss from the quota . In addition, the import quota transfers E + E to whoever holds the import
licenses.

Before Quota

After Quota

Change

Consumer Surplus

A + B + C + D + E + E + F

A+ B

- ( C + D + E + E + F)

Producer Surplus

C+G

+C

License- Holder
Surplus

None

E + E

+(E + E)

A + B + C + D + E + E + F + G

A + B + C + E + E + G

- (D+ F)

Total Surplus

The area D + F shows the fall in total surplus and represents the deadweight loss of the quota.

COMPARATIVE ADVANTAGE IN THE

HECKSCHER OHLIN TRADE
MODEL
WHAT DETERMINES TRADE IS DIFFERENCES IN
FACTOR ENDOWMENTS.
COUNTRIES THAT ARE RICH IN CAPITAL WILL
EXPORT CAPITAL-INTENSIVE GOODS.
COUNTRIES THAT HAVE MUCH LABOUR WILL
EXPORT LABOUR-INTENSIVE GOODS.

FACTOR ABUNDANCE DEFINED

BY FACTOR PRICES
IF P1C/P1L<P2C/P2L
WHERE PiC = PRICE OF CAPITAL IN COUNTRY i
PiL = PRICE OF LABOUR IN COUNTRY I
THEN COUNTRY 1 IS ABUNDANT IN CAPITAL AND
COUNTRY 2 IS ABUNDANT IN LABOUR
COUNTRY 1 WILL EXPORT CAPITAL-INTENSIVE
GOOD AND COUNTRY 2 WILL EXPORT THE
LABOUR-INTENSIVE GOOD.

FACTOR ABUNDANCE DEFINED

IN PHYSICAL TERMS

IF C1/L1>C2/L2
WHERE Ci = AMOUNT OF CAPITAL IN COUNTRY i
Li = AMOUNT OF LABOUR IN COUNTRY i
COUNTRY 1 IS RICH IN CAPITAL AND COUNTRY 2 IS RICH IN LABOUR.

COUNTRY 1 WILL PRODUCE CAPITAL-INTENSIVE GOOD AND COUNTRY 2

WILL PRODUCE LABOUR-INTENSIVE GOOD.

COUNTRY 1 MAY/MAY NOT EXPORT CAPITAL-INTENSIVE GOOD AND

COUNTRY 2 MAY/MAY NOT EXPORT LABOUR-INTENSIVE GOOD.

DEMAND FACTOR IN THE DOMESTIC COUNTRY WILL DETERMINE THE

ACTUAL OUTCOME

COMMODITY AND FACTOR

PRICES UNDER TRADE

IF THERE ARE NO IMPEDIMENTS TO TRADE COMMODITY

PRICES WILL BE THE SAME IN BOTH THE COUNTRIES WHICH
ARE TRADING WITH EACH OTHER.

IF FACTORS ARE FULLY MOBILE INTERNATIONALLY THEN

FACTOR PRICES WILL BE THE SAME IN ALL THE COUNTRIES.

IN CASE OF FACTOR IMMOBILITY WITHIN COUNTRIES TRADE

IN GOODS CAN BE VIEWED AS A SUBSTITUTION FOR
FACTOR MOBILITY WHICH IN TERN ENSURES COMPLETE
FACTOR-PRICE EQUALISATION.

EMPERICAL EVIDENCE OF HECKSCHEROHLIN THEOREM--THE LEONTIEF PARADOX:

POSSIBLE EXPLANATIONS

SKILLED LABOUR
R&D-ORIENTED INDUSTRIES
NATURAL RESOURCES INDUSTRIES
INTERNAL DEMAND
PRODUCT LIFE CYCLE
INTRA-INDUSTRY TRADE

NEW THEORIES OF INTERNATIONAL TRADE

THEORIES OF STRATEGIC
TRADE

THEORY OF COMPETITIVE
ADVANTAGE

THE ECONOMICS GAINS FROM TRADE:

THEORIES OF STRATEGIC TRADE
WHAT IS STRATEGIC TRADE?
POLICIES DESIGNED TO SECURE RENTS
1.
ONE COUNTRY HAS MARKET POWER--WHEN ONE COUNTRY
EXERCISES SIGNIFICANT MARKET POWER OVER THE SUPPLY OF A
GOOD.
IN SUCH SITUATION,

AN EXPORTING COUNTRY MAY BE ABLE TO INCREASE THE PRICE

OF ITS EXPORTS BY RESTRICTING OUTPUT.

AN IMPORTING COUNTRY MAY GAIN BACK SOME OF THE RENTS

ACCRUING TO A MONOPOLY EXPORTER BY IMPOSING A TARIFF

THE ECONOMICS GAINS FROM TRADE: THEORIES OF

STRATEGIC TRADE

Average Unit Cost

AC0

Foreign Producers Average

Costs

AC

U.S. Producers
Average Costs

Qus

Annual Production

2.
ECONOMIES OF SCALE IN PRODUCTION--IN INDUSTRIES
CHARACTORISED BY LARGE ECONOMIES OF SCALE IN PRODUCTION
THE GOVERNMENT IN A LARGE MARKET CAN PROVIDE A DOMESTIC
FIRM WITH AN ADVANTAGE OVER FOREIGN PRODUCERS BY CLOSING
THE MARKET.

THE ECONOMIC GAINS FROM TRADE:

THEORIES OF STRATEGIC TRADE
3.

LEARNING BY DOING (THE INFANT INDUSTRY

ARGUMENT )--IF THE NATION WITH THE LARGEST
CUMULATIVE PRODUCTION IN AN INDUSTRY HAS
THE LOWEST COSTS THEN COMPARATIVE
ADVANTAGE CAN BE CREATED, NOT MERELY
INHERITED.

4.

EXTERNAL ECONOMIES--INNOVATION AND

KNOWLEDGE GENERATION CREATE POSITIVE
EXTERNALITIES---------- GENERATING SOCIAL
RETURNS BEYOND THOSE CAPTURED BY THE
INNOVATING FIRM.

THE DEBET OVER STRATEGIC GOVERNMENT INTERVENTION

EUROPEANS FIRMS: AIRBUS
PRODUCE W/O SUBSIDY

DONT PRODUCE

-5

Produce w/o
Subsidy

-5

100

American
Firms: Boeing

60

Dont
Produce

EUROPEAN FIRMS: AIRBUS

Produce w/
Subsidy

Produce w/o
Subsidy

-5

Produce w/o
Subsidy

-5
American Firms:
Boeing

Dont
Produce

0
100

-5

60

Dont Produce

70

0
0

EUROPEAN FIRMS: AIRBUS

Produce w/o Subsidy

-5

Produce
w/o Subsidy

-5
American
Firms: Boeing

Produce w/
Subsidy

Produce w/subsidy

100
5

-5

0
110

5
60

Dont
Produce

5
-5

Dont Produce

70
0

CRITICS OF STRATEGIC
TRADE THEORIES

THE THEORIES ARE BASED ON ASSUMPTION THAT OTHER

COUNTRIES WILL NOT RETALIATE AGAINST THE COUNTRY
THAT INITIATES RESTRICTIVE POLICIES WHICH MAY NOT
HOLD IN THE REAL WORLD.

THE JUSTIFICATIONS FOR INTERVENTIONS ARE

CRITICALLY DEPENDENT ON OBSCURE ASSUMPTIONS
ABOUT INDUSTRY STRUCTURE AND BEHAVIOUR

THE THEORIES ASSUME THAT HOME MARKET

PROTECTION WILL STRENGTHEN, NOT WEAKEN,
DOMESTIC FIRMS WHICH IS QUESTIONABLE

THE POLICIES SUGGESTED ARE EXTREMELY DIFFICULT TO

IMPLEMENT

COMPETITIVE ADVANTAGE
OF NATIONS
PORTER POSED THREE QUESTIONS:
WHY DOES A NATION SUCCEED
INTERNATIONALLY IN A PARTICULAR
INDUSTRY?
WHAT IS THE INFLUENCE OF THE NATION
ON COMPETITION IN SPECIFIC INDUSTRIES
AND INDUSTRY SEGMENTS?
WHY DO A NATIONS FIRMS SELECT
PARTICULAR STRATEGIES?

FOUR KEY PREMISES:

THE NATURE OF COMPETITION AND THE SOURCES OF

COMPETITIVE ADVANTAGE DIFFER WIDELY AMONG INDUSTRIES
(AND EVEN AMONG INDUSTRY SEGMENTS);

SUCCESSFUL GLOBAL COMPETITORS PERFORM SOME

ACTIVITIES IN THE VALUE CHAIN OUTSIDE THEIR HOME
COUNTRY AND DRAW COMPETITIVE ADVANTAGES FROM THEIR
ENTIRE WORLDWIDE NETWORK RATHER THAN FROM JUST
THEIR HOME BASE;

FIRMS GAIN AND SUSTAIN COMPETITIVE ADVANTAGE IN MODERN

INTERNATIONAL COMPETITION THROUGH INNOVATION;

FIRMS THAT SUCCESSFULLY GAIN COMPETITIVE ADVANTAGE IN

AN INDUSTRY ARE THOSE THAT MOVE EARLY AND
AGGRESSIVELY TO EXPLOIT A NEW MARKET OR TECHNOLOGY.

THE DETERMINANTS OF NATIONAL COMPETITIVE

ADVANTAGE
FIRM
STRATEGY,
STRUCTURE
AND RIVALRY

FACTOR
CONDITIONS

DEMAND
CONDITIONS

RELATED AND
SUPPORTING
INDUSTRIES

 FACTOR CONDITIONS
A NATIONS ENDOWNMENT OF FACTORS PLAY A MORE
COMPLEX ROLE IN DETERMINING NATIONAL COMPETITIVE
ADVANTAGE THAN GENERALLY ACKNOWLEDGED.
FACTOR ENDOWNMENT ARE DYNAMIC, AND COULD BE
UPGRADED, CREATED AND SPECIALISED.
FACTORS ARE DIVIDED INTO:
HUMAN RESOURCES
PHYSICAL RESOURCES
CLIMATIC CONDIITONS
KNOWLEDGE RESOURCES
LOCATIONS
CAPITAL RESOURCES
INFRASTRUCTURE
FACTORS
BASIC

ADVANCED

GENERALISED SPECIALISED

DEMAND CONDITIONS IN
THE HOME MARKET
ELEMENTS OF PORTERS FRAMEWORK ARE:
THE NATURE OF DOMESTIC BUYERS NEEDS
THE SIZE AND PATTERNS OF GROWTH OF
THE DOMESTIC MARKET
THE MECHANISM BY WHICH DOMESTIC
BUYERS NEEDS ARE COMMUNICATED TO
FOREIGN FIRMS

 PRESENCE OF VIGOROUS SUPPILYER AND

RELATED INDUSTRIES
STRATEGY, STRUCTURE AND RIVALRY
GOVERNMENT ACTIONS
CHANCE EVENTS
IMPLICATIONS FOR GOVERNMENT POLICY