chapter

International
Trade Theories
.

Introduction

Chapter focuses on:

- Discussion of theories that explain why it is beneficial
for a country to engage in international trade
- Explanation of the pattern of international trade that we
observe in the world economy

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Learning Objectives
Understand why nations trade with each other
Summarize the different theories explaining trade flows
between nations
Recognize why many economists believe that unrestricted free
trade between nations will raise the economic welfare of
countries that participate in a free trade system
Explain the arguments of those who maintain that government
can play a proactive role in promoting national competitive
advantage in certain industries
Understand the important implications that international trade
theory holds for business practice
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What is Free Trade?

Free trade refers to 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

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Mercantilism
Emerged in England in the mid-16th century
Asserted that it is in a countrys best interest to maintain
a trade surplus (and advocated government intervention
to achieve a surplus in the balance of trade)
Viewed trade as a zero-sum game
Is problematic as an economic philosophy, yet many
political views today have the goal of boosting exports
while limiting imports
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Absolute Advantage
Proposed by Adam Smith in 1776 as a counterargument on the mercantilist assumption that trade is a
zero-sum game
Smith argued that countries
- Differ in their ability to produce goods efficiently
- Can have an absolute advantage in the production of a
product when they are more efficient than other
countries in producing it

Countries should specialize in the production of goods

for which they have an absolute advantage and then
trade these goods with other countries
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Comparative Advantage
Developed by David Ricardo in 1817

Took Adam Smiths theory a step further by exploring

what might happen when one country has an absolute
advantage in the production of all goods
His theory demonstrated that a country can have a
comparative advantage by specializing in the
production of the goods that it produces most
efficiently (among the products they produce) and
buying the goods that it produces less efficiently from
other countries
Opportunity costs
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Evaluating Ricardos
Comparative Advantage
Views trade as a positive sum in which all gain free trade
expands the world pie for goods/services, but
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
- No effects on income distribution within countries
- Full employment
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Heckscher-Ohlin Theory:
Factor Endowments
Heckscher and Ohlin argued that comparative
advantage arises from differences in national factor
endowments
Theory predicts that countries will export goods that
make intensive use of those factors that are locally
abundant, while importing goods that make intensive
use of factors that are locally scarce
Leontief Paradox

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Product Life-Cycle Theory

Proposed by Raymond Vernon in the mid-60s based
on observations of then trade and investment patterns
Product initially manufactured in the U.S., then exported to
other industrialized countries
As markets grow, U.S. companies set up plants close to their
markets in industrialized countries
As markets mature, product becomes more standardized; costs
are an issueproduction is shifted to developing countries
U.S. switches from being an exporter to being an importer of
the product
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Evaluating Vernons
Product Life-Cycle Theory
Product life cycle theory accurately explains what has
happened for products such as photocopiers and a
number of other high technology products developed in
the US in the 1960s and 1970s
Increasing globalization and integration of the world
economy has made this theory less valid in today's
world

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New Trade Theory

New trade theory suggests that because of economies

of scale and increasing returns to specialization, some

industries are likely to have only a few profitable firms
Firms with first mover advantages will develop

economies of scale and create barriers to entry for other

firms

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Implications of New Trade Theory

New trade theory suggests that nations may benefit

from trade even when they do not differ in resource

endowments or technology, and that a country may
predominate 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: specialization; scale
economies
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:
National Competitive Advantage
Based on Porters 1990 study on why a country achieves
international success in a particular industry
According to Porter, four attributes promote or impede the
creation of competitive advantage:
-

Factor endowments
Demand conditions
Related and supporting industries
Firm strategy, structure, and rivalry

These four interconnected attributes constitute the diamond

Two additional variables can influence the national diamond:
- Chance
- Government

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Evaluating Porters Theory

Government policy can affect demand through product
standards, influence rivalry through regulation and antitrust laws,
and impact the availability of highly educated workers and
advanced transportation infrastructure
Criticisms of Porters Diamond include:
- Theory has not be empirically tested
- U.S.-centric doesnt explain the diamond of other countries
- Ambiguity with the use of terms (e.g., equating competitiveness
with productivity as well as with market share)

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Theories in practice
Location implications
- It makes sense for a firm to disperse its various productive
activities to those countries where they can be performed most
efficiently

First-mover implications
- Being a first mover can have important competitive implications,
especially if there are economies of scale and the global industry
will only support a few competitors

Government policy implications

- Government policies with respect to free trade or protecting
domestic industries can significantly impact global
competitiveness
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