International Trade

Theory

Lecture-3
Ravikesh Srivastava
 Trade ?
 Primary intensive- Agriculture, mines
 Technology intensive- PCs
 Knowledge intensive- Software
 Capital intensive- Construction
machinery & equipments
 Combination of all intensive- Telecom
products, pharmaceuticals, airplanes,
automobiles
The Importance of Trade Theory
Trade theory helps managers and govern-
ment policymakers focus on three critical
questions:
 What products should be imported and exported?
 How much should be traded?
 With whom should they trade?

While descriptive theories suggest a laissez-faire

treatment of trade, prescriptive theories suggest that
governments should influence trade patterns.
 Trade and Investment Policies
 import substitution: a policy of developing
domestic industries to manufacture goods
and provide services that would otherwise
be imported
 strategic trade policy: the identification
and development of targeted domestic
industries in order to improve their
competitiveness at home and abroad
 Trade Theory
 The Mercantilist Doctrine
 Absolute Advantage Theory
 Comparative Advantage Theory
 Heckscher-Ohlin Theorem
 The Leontief Paradox
 The Product Life-Cycle Theory
 The New Trade Theory
 The Mercantilist Doctrine
 First or Pre-classical theory of Trade
 Demonstrated by David Hume in 1752
 Focus on Two Goals:
 Increase the wealth of Nation by acquiring
precious metals eg. Gold
 To extract Trade Gains with max Export and Min
Import
 Overlooked other sources of a country’s
wealth accumulation as capital, skill of work force,
land and other natural resources.
 Free Trade Theories:
Absolute & Comparative Advantage
• The theories of absolute and comparative advantage
demonstrate how economic growth can occur via
specialization and trade.
• Free trade (a positive-sum game) implies speciali-
zation and requires that nations neither artificially
limit imports nor artificially promote exports.
• The invisible hand of the market determines
which competitors survive, as customers buy
those products that best serve their needs.
Nations specialize in the production of certain products, some
of which may be exported; export earnings can in turn be used
to pay for imported goods and services.
 Absolute Advantage Theory
 In 1776, Adam Smith introduced doctrine of
Laissez-faire to IT.
 Focus on “Freedom of enterprise and freedom of
commerce”
 Individual countries to specialize in goods they
were best suited to produce because of natural
advantage
 Stated that a nation’s import should consist of
goods made more efficiently abroad while exports
should consist of goods made more efficiently at
home.
Absolute Advantage Theory
Country Wheat ( 1 unit) Coffee ( 1 Unit)
USA 2 8

Colombia 10 2
 Comparative Advantage Theory

 In 1817, David Ricardo introduced book on the

Principles of Political Economy and Taxation.
 Focus on comparative advantage of a nation in
producing a good relative to other nation.
 Based on opportunity cost theory
 A country has a comparative advantage in
producing a good if the opportunity cost for
producing the good is lower than in other country.
Comparative Advantage Theory

Country Wine ( 1 gallon) cloth ( 1 yard)

England 120 100

Portugal 80 90
Comparative Advantage Theory

Country Opportunity cost Opportunity

for Wine cost for Cloth
England 120/100=1.2 100/120=0.83

Portugal 80/90=0.89 90/80=1.13

 Theory of Comparative Advantage

Comparative advantage [David Ricardo, 1817]:

A country can (i) maximize its own economic well-
being by specializing in the production of those
goods and services it can produce relatively
efficiently and (ii) enhance global efficiency via
its participation in free trade.
Ricardo also reasoned that:
• a country can simultaneously have an absolute
and a comparative advantage in the production
of a given product
• by concentrating on the production of the product
in which it has the greater advantage, a country
can further enhance both global output and its
own economic well-being
 Assumptions and Limitations
of the Free Trade Theories
The theories of absolute and comparative advantage both
make assumptions that may not be entirely valid.
 Full employment of resources

 Exclusive pursuit of economic efficiency objectives

 Equitable division of gains from specialization

 Only two countries and two commodities

 Exclusion of transport costs

 A static rather than a dynamic view

 Exclusion of services

 Unrestricted factor mobility

 Heckscher-Ohlin Theorem
 In 1933, heckscher & Ohlin explained link between
national factor endowments & comparative
advantage on nations.
 A country would export commodities whose
production is intensive in its relatively abundant
factor.
 Theorem assumes constant in input, technology,
demand for factor of production with difference in
relative supply will lead to differences in the
relative price between two countries.
 Implication of H-O Theorem
 Trade as well as trade gains should be greatest
between countries with the greatest differences in
economic structure.
 Trade should cause countries to specialize more in
producing and exporting goods that are distinctly
different from their imports.
 Countries should export goods that make intensive
use of their relatively abundant factors.
 Factor prices should be nearly equal between
countries with more liberal mutual trade.
 International investment should be stimulated by
differences in factor endowments.
 The Leontief Paradox
 Demand bias for capital-intensive goods.
 Existence of trade barriers
 Importance of natural resources
 Prevalence of factor-intensity reversals
 The Product Life-Cycle Model
 Proposed by Raymond Vernon in 1960s.
 Focus on imitation-gap approach.
 As product cycle develops, the cost advantage will
change accordingly and a comparative advantage
in innovative capacity may be offset by a cost
disadvantage.
 International Product Life-
Cycle (Vernon)
 Limited initial demand in other advanced
countries initially
 Exports more attractive than overseas production
 When demand increases in advanced countries,
production follows
 With demand expansion in secondary markets
 Product becomes standardized
 production moves to low production cost areas
 Product now imported to US and to advanced
countries
 Product Life Cycle (PLC) phases

The optimal location for the production of certain

types of goods and services shifts over time as
they pass through the stages of: (i) introduction,
(ii) growth, (iii) maturity, and (iv) decline.
Exceptions to the typical pattern of the PLC would include:
• products that have very short life cycles
• luxury goods and services
• products that require specialized labor
• products that are differentiated from competitive
offerings
• products for which transportation costs are relatively high
During the decline stage, a product is often imported by the country
where it was initially developed; however, the importing firm may or
may not be the innovating firm.
 Product Life Cycle Characteristics

Stage Intro. Growth Maturity Decline

PRODUCTION Innovating Innovating Ind’l + Developing
LOCATION(S) country + other ind’l developing countries

MARKET Innovating Industrial Industrial + Developing

LOCATIONS + other ind’l countries developing countries

COMPETITIVE Uniqueness Rising comp. Price compe- Declining

FACTORS & demand tition demand

PRODUCTION Short prod’n Capital input Economies Rationali-

TECHNNOLOGY runs increases of scale zation
 The New Trade Theory
 As output expands with specialization, an
industry’s ability to realize economies of scale
increases and unit costs decrease
 Because of 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:
 Fist-mover advantage
 Barrier to entry
 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)
 New Trade Theories
 Increasing returns of specialization due to
economies of scale (unit costs of production
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