International

Business
Fourth Edition
CHAPTER 4

International Trade Theory

 4-3

Chapter Focus

Explain why it is beneficial for a country to engage

in international trade.

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 4-4

Chapter Focus

Explain why it is beneficial for a country to engage

in international trade.
Explain the pattern of international trade
observed in the world economy.

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 4-5

1st British African colony to win independence (1957).

Nkrumah espoused pan African socialism.
High tariffs.
Anti export (trade) policy.

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 4-6

Kept lowering tariffs on manufactured goods.

Created incentives to export (trade).
Reduced quotas.
Reduced subsidies.
1950s: 77% of employment in agriculture. Now 20%.
Manufacturing GNP went from 10% to over 30%.

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 4-6

The Impact of Trade Policies

Ghana Korea
1970 1970
GNP/capita GNP/per capita
$250 $260
1992
1992
GNP/per capita
GNP/per capita
$6790
$450
GNP Growth/year
GNP Growth/year
9%
1.5%
Shift from non-comparative
Shift from productive uses advantage uses (agriculture) to
(cocoa) to unproductive uses productive uses (labor-intensive
(subsistence agriculture). manufacturing).

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 4-7

An Overview of Trade Theory

Free Trade occurs when 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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 4-7

An Overview of Trade Theory

Free Trade occurs when 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.

The Benefits of Trade allow a country to

specialize in the manufacture and export of
products that can be produced most efficiently in
that country.

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 4-7

An Overview of Trade Theory

Free Trade occurs when 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.
The Benefits of Trade allow a country to specialize in the manufacture and export of
products that can be produced most efficiently in that country.

The Pattern of International Trade displays

patterns that are easy to understand (Saudi
Arabia/oil or China/crawfish). Others are not so
easy to understand (Japan and cars).

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 4-7

An Overview of Trade Theory

Free Trade occurs when 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.
The Benefits of Trade allow a country to specialize in the manufacture and export of
products that can be produced most efficiently in that country.
The Pattern of International Trade displays patterns that are easy to understand
(Saudi Arabia/oil or China/crawfish). Others are not so easy to understand (Japan and
cars).

The history of Trade Theory and Government

Involvement presents a mixed case for the role of
government in promoting exports and limiting
imports. Later theories appear to make a case for
limited involvement.

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 4-8

Mercantilism: mid-16th century

A nations wealth depends on accumulated treasure

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 4-8

Mercantilism: mid-16th century

A nations wealth depends on accumulated treasure
Gold and silver are the currency
of trade.

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 4-8

Mercantilism: mid-16th century

A nations wealth depends on accumulated treasure
Gold and silver are the currency
of trade.
Theory says you should have
a trade surplus.

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 4-8

Mercantilism: mid-16th century

A nations wealth depends on accumulated treasure
Gold and silver are the currency
of trade.
Theory says you should have
a trade surplus.
Maximize exports
through subsidies.
Minimize imports through tariffs
and quotas.

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 4-8

Mercantilism: mid-16th century

A nations wealth depends on accumulated treasure
Gold and silver are the currency
of trade.
Theory says you should have
a trade surplus.
Maximize exports
through subsidies.
Minimize imports through tariffs
and quotas.
Flaw: zero-sum game.

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 4-10

Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

Capability of one country to produce more of a

product with the same amount of input than
another country.

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 4-10

Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

Capability of one country to produce more of a

product with the same amount of input than
another country.
Produce only goods where you are most efficient,
trade for those where you are not efficient.

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 4-10

Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

Capability of one country to produce more of a

product with the same amount of input than
another country.
Produce only goods where you are most efficient,
trade for those where you are not efficient.
Assumes there is an
absolute advantage balance among nations, e.g.,
Ghana/cocoa.

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 4-20

The Theory of Absolute Advantage

G
20
15
Cocoa

A
10

Figure 4.1
K
B
5

G K

0 5 10 15 20
Rice
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 4-21

The Theory of Absolute Advantage

and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 20
S. Korea 40 10
Production and Consumption without Trade
Ghana 10.0 5.0
S. Korea 2.5 10.0
Total production 12.5 15.0
Production with Specialization
Ghana 20 0
S. Korea 0 20
Total production 20 20
Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice
Ghana 14.0 6.0
S. Korea 6.0 14.0
Increase in Consumption as a Result of Specialization and Trade
Ghana 4.0 1.0
S. Korea 3.5 4.0 Table 4.1
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 4-13
Theory of Comparative Advantage
David Ricardo: Principles of Political Economy (1817).

Should trade even if country is more efficient in the

production than its trading partner.

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 4-23

The Theory of Comparative Advantage

G
20

C
15
Cocoa

A
10

K Figure 4.2
5

B
2.5 K
G
0 3.75 5 7.5 10 15 20
Rice
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 4-24

Comparative Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 13.33
S. Korea 40 20
Production and Consumption without Trade
Ghana 10.0 7.5
S. Korea 2.5 5.0
Total production 12.5 12.5
Production with Specialization
Ghana 15 3.75
S. Korea 0.0 10.0
Total production 15 13.75
Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice
Ghana 11 7.75
S. Korea 4 6
Increase in Consumption as a Result of Specialization and Trade
Ghana 1.0 0.25
S. Korea 1.5 1.0 Table 4.2

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 4-16

Extensions of the Ricardian Model

Immobile resources:
Resources do not always move easily from one
economic activity to another.
Diminishing returns:
More a country produces, at some point, will require
more resources (diminishing returns to specialization).
Different goods use resources in different
proportions.
However:
Free trade might increase a countrys stock of
resources (as labor and capital arrives from abroad),
and
Increase the efficiency of resource utilization.

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 4-26

Ghanas PPF under Diminishing Returns

Cocoa G

Figure 4.3
G
0 Rice

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 4-27

The Influence of Free Trade on the PPF

PPF2

PPF1
Cocoa

Figure 4.4
G

0 Rice

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 4-28

A Link Between Trade and Growth

Sachs and Warner: 1970 to 1990 study
Open economy developing countries grew 4.49%/year.
Closed economy developing countries grew 0.69%/year.
Open economy developed countries grew 2.29%/year.
Closed economy developed countries grew 0.74%/year.

Frankel and Romer:

On average, a one percentage point increase in the ratio
of a countrys trade to its GDP increases income/person
by at least 0.5%. For every 10% increase in the
importance of international trade in an economy, average
income levels will rise by at least 5%.

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 4-20

Heckscher (1919)-Olin (1933) Theory

Labor is not the only Factor of production. We

need to account for land, capital, and
technology.

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 4-20

Heckscher (1919)-Olin (1933) Theory

Factor endowments: extent to which a country

is endowed with such resources as land, labor,
and capital.

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 4-20

Heckscher (1919)-Olin (1933) Theory

Export goods that intensively use factor

endowments which are locally abundant.

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 4-20

Heckscher (1919)-Olin (1933) Theory

Export goods that intensively use factor

endowments which are locally abundant.
Corollary: import goods made from
locally scarce factors.

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 4-20

Heckscher (1919)-Olin (1933) Theory

Patterns of trade are determined by

differences in factor endowments - not
productivity.
Remember, focus on relative advantage, not
absolute advantage.

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 4-21

The Leontief Paradox, 1953

Disputes Heckscher-Olin in some instances.

Factor endowments can be impacted by
government policy - minimum wage.
US tends to export labor-intensive products, but
is regarded as a capital intensive country.

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 4-23

Product Life-Cycle Theory

(Raymond Vernon, 1966)
Article in the Quarterly Journal of Economics.
As products mature, both location of sales and optimal
production changes.
Affects the direction and flow of imports and exports.
Globalization and integration of the economy makes this
theory less valid.

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 4-24
The Product Life-Cycle Theory
160
140
United States production
120
100
80
60
40
Exports Imports consumption
20
0

160
140
120
100
Other Advanced Countries Exports
80
60
40
20
0 Imports
160
140
120 Developing Countries
100
80
60 Exports
40
20
0 Imports

New Product Maturing Product Standardized Product Figure 4.5

Stages of Production Development

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 4-25

The New Trade Theory

Began to be recognized in the 1970s.
Deals with the returns on specialization where
substantial economies of scale are present.
Specialization increases output, ability to enhance
economies of scale increase.
In addition to economies of scale, learning effects also
exist.
Learning effects are cost savings that come from
learning by doing.

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 4-26

Application of the New Trade Theory

Typically, requires industries with high, fixed

costs.
World demand will support few competitors.
Competitors may emerge because they got
there first.
First-mover advantage.
Some argue that it generates government
intervention and strategic trade policy.

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 4-27

First-Mover Advantage
Economies of scale may preclude new entrants.
Role of the government.

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 4-28

Porters Diamond
(Harvard Business School, 1990)

The Competitive Advantage of Nations.

Looked at 100 industries in 10 nations.
Thought existing theories didnt go far enough.
Question: Why does a nation achieve international
success in a particular industry?

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 4-41

Determinants of National
Competitive Advantage
Factor endowments:nations position in factors of
production such as skilled labor or infrastructure
necessary to compete in a given industry.

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 4-42

Determinants of National
Competitive Advantage
Factor endowments:nations position in factors of
production such as skilled labor or infrastructure
necessary to compete in a given industry.
Demand conditions:the nature of home demand for the
industrys product or service.

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 4-43

Determinants of National
Competitive Advantage
Factor endowments:nations position in factors of
production such as skilled labor or infrastructure
necessary to compete in a given industry.
Demand conditions:the nature of home demand for the
industrys product or service.
Related and supporting industries:the presence or
absence in a nation of supplier industries or related
industries that are nationally competitive.

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 4-44

Determinants of National
Competitive Advantage
Factor endowments:nations position in factors of
production such as skilled labor or infrastructure necessary
to compete in a given industry.
Demand conditions:the nature of home demand for the
industrys product or service.
Related and supporting industries:the presence or absence
in a nation of supplier industries or related industries that
are nationally competitive.
Firm strategy, structure and rivalry:the conditions in
the nation governing how companies are created,
organized, and managed and the nature of domestic
rivalry.

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 4-30

Porters Diamond
Determinants of National Competitive Advantage

Firm Strategy,
Structure and
Rivalry

Factor Endowments Demand Conditions

Related and
Supporting
Figure 4.6
Industries

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 4-31

The Diamond

Success occurs where these attributes exist.

More/greater the attribute, the higher chance of
success.
The diamond is mutually reinforcing.

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 4-32
Determinants of
National Competitive Advantage

Chance
Company Strategy,
Structure,
and Rivalry

Two external
factors that Factor Demand
influence the Conditions Conditions
four
determinants.
Related
and Supporting
Industries
Government

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 4-33

Factor Endowments
Taken from Heckscher-Olin
Basic factors:
natural resources
climate
location
demographics
Advanced factors:
communications
skilled labor
research
technology

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 4-34

Advanced Factor Endowments

More likely to lead to competitive

advantage.
Are the result of investment by people,
companies, government.

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 4-35

Relationship of Basic to Advanced

Factors

Basic can provide an initial advantage.

Must be supported by advanced factors to
maintain success.
No basics, then must invest in advanced factors.

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 4-36

Demand Conditions
Demand creates the capabilities.
Look for sophisticated and demanding
consumers.
impacts quality and innovation.

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 4-37

Related and Supporting Industries

Creates clusters of supporting industries that are

internationally competitive.
Must also meet requirements of other parts of the
Diamond.

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 4-38

Firm Strategy, Structure and

Rivalry
Management ideology can either help or hurt you.
Presence of domestic rivalry improves a companys
competitiveness.

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 4-39

Evaluating Porters Theory

If Porter is right, we would expect his model to

predict the pattern of international trade that we
observe in the real world. Countries should be
exporting products from those industries where all
four components of the diamond are favorable, while
importing in those areas where the components are
not favorable.
Too soon to tell.

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 4-55

Implications for Business

Location implications:makes sense to disperse
production activities to countries where they can be
performed most efficiently.
First-mover implications:It pays to invest substantial
financial resources in building a first-mover, or early-
mover, advantage.
Policy implications:promoting free trade is generally in
the best interests of the home-country, although not
always in the best interests of the firm. Even though,
many firms promote open markets.

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