Lesson 3: Trade Theories: BBC 1200 - International Business and Trade 2 SEM 2019-2020

LESSON 3: TRADE THEORIES
BBC 1200 – INTERNATIONAL BUSINESS AND TRADE

2ND SEM 2019-2020
TRADE THEORIES
Specialization as a Basis for Trade:

ABSOLUTE AND COMPARATIVE ADVANTAGE
Theory of Absolute Advantage
•Adam Smith
•A country is said to have an absolute advantage if the country can produce a good at a
lower cost than another.
•Fewer resources are needed to provide the same amount of goods as compared to the
other country
• This efficiency in production creates “an absolute advantage”, which allows for
beneficial trade
Using the same units of resources
Country Commodity X Commodity Y

A 10 5
B 5 10
Then both countries will gain by trading. After the opening of trade,
country A will specialize
in the production of goods X and country B will specialize in product Y

Commodity Grain from Trade
Production before trade
Country X Y X Y
A 10 5 10 -5
B 5 10 -5 10

Total production 15 15 5 5
Theory of Comparative Advantage
•David Ricardo created the theory of comparative advantage. He argued that a

country boosts its economic growth the most by focusing on the industry in which it
has the most substantial comparative advantage
•Comparative advantage is when a country produces a good or service for a lower
opportunity cost .
•The country may not be the best at producing something. But the good or service
has a low opportunity cost
In this case, country B has the absolute advantage in
producing both products, but it has a comparative
advantage in trucks because it is relatively better at
producing them. Country B is 3.5 times better at
trucks, and only 1.17 times better at cars
Factor Endowment as a Basis for Trade Theory: Hecksher-Ohlin Theory
• Swedish economists , Eli Hecksher and Bertil Ohlin

•Refinement of David Ricardo’s theory and showed that nations primarily export
goods and services that intensely use their abundant factors of production
•Attributes the comparative advantage of a nation to its factor endowments:
land ( quantity, quality, and minerals beneath it) , labor (quantity and skill),
capital and technology
•The key assumptions for the H-O theory to work are:

1)Perfect competition in the market
2)Immobility of factors of production
Porter’s “Diamond”Model of National Competitive Advantage
• A model designed to help understand the

competitive advantage that nations possess due to
certain factors available to them ,and to explain how
governments can act as catalysts to improve a
country’s position in a globally competitive economic
environment
• There are four factors that determine national
competitive advantage
1) Factor Conditions
2) Demand Conditions
3)Related and Supporting Industries
4) Firm Structure, Strategy, and Rivalry
1) Factor Conditions
• Factor conditions refer to the different types of resources that may or may not be present within a
nation. Resources include such things as human resources, capital resources, natural resources,
infrastructure, and knowledge resources.
• Two types of factor conditions: basic and advanced
• Basic factors include natural resources and unskilled labor. Advanced factors include skilled labor,
specialist knowledge, and capital, amongst others.
• Porter argues that basic factors do not generate competitive advantage as they can be obtained by
any company. Only advanced factor conditions can generate competitive advantage.
• However, The Porter Diamond suggests that countries can create new factor advantages for
themselves, such as a strong technology industry, skilled labor, with government support of a
country's economy.
2) Demand Conditions
•When domestic demand is high, the number of suppliers will also be high. With
sizeable demand , domestic competition among suppliers will intensify and will
result in lower prices as well as sophisticates, innovative new products. And this
could lead to specialization!
•Demand conditions include such factors as market size, market growth rate, and
market sophistication.
•Example: In the United States, the demand for electronics has been strong and
rapidly growing. Thus, US became a global leader for these products, which are also
in strong demand in other high-income countries
3. Related and Supporting Industries
•The success of one industry can be dependent on the success of related

industries or suppliers.
•The presence of internationally competitive suppliers within a nation can be
helpful to the companies using those suppliers. This is because it gives cost-
effective access to inputs. Alongside this, it gives early access to new products
and encourages the rapid sharing of information.
•Having lots of related industries with a nation often results in new industries.
This happens where the related industries can share resources.
• For example, car manufacturers in Germany could share access to a wind
tunnel. This use of shared resources within a nation can create a competitive
advantage, as it increases the barrier to entry.
4. Firm Strategy, Structure, and Rivalry
•The competitiveness of firms in one nation is determined by how those firms set strategy and structure
themselves.
•Competitiveness is also determined by how much competition there is between firms in the industry.
•How firms are structured and set goals will differ from nation to nation. It will be determined by a
multitude of social, political, and legal factors.
•Intense rivalry causes a drive to innovate. For example, German car manufacturers BMW, Mercedes, and
VW would not be so successful without the existence of each other. This intense rivalry drives innovation
and makes these companies successful internationally.
The model also shows that
there are two extra
determinants that can
influence any or all of the four
determinants.
1)Government
2)Chance
1) Chance
• Refers to an external shock or development that could drastically change

or hasten the course of economic development.
• Example: Innovation in information technology has increased efficiency
all over the world and has increased connectivity among citizens globally.
• In contrast some external shocks could have negative effects on
countries, for example, the Icelandic volcano eruption of 2010 disrupted
air travel in northern Europe for days. Or the catastrophic 2011 and 2018
tsunami in Japan. The global nuclear power also came under great
scrutiny because of the effect on Japan’s Fukushima nuclear power plant.
• Human-caused shocks , such as terrorist attacks could also result in
negative business effects.
2) Government
•Government institutions and policies could help or hurt competitiveness of nations since it has the
potential to affect all four determinants.
•For example, in the case of factor condition, if government policy does not support incentives for higher
education, the quality and quantity of labor force will be detrimentally affected with corresponding loss in
the nation’s global competitiveness.
•Government policy could also stifle demand through excessive taxation.
•Government policies could also stunt the growth of related and supporting industries through the
implementation of programs that divert resources to sectors in which companies do not have core
competencies
•Government policies could impact market structure or the level of competiveness in an industry.

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LESSON 3: TRADE THEORIES

BBC 1200 – INTERNATIONAL BUSINESS AND TRADE

Specialization as a Basis for Trade:

Country Commodity X Commodity Y

in the production of goods X and country B will specialize in product Y

•David Ricardo created the theory of comparative advantage. He argued that a

• Swedish economists , Eli Hecksher and Bertil Ohlin

•The key assumptions for the H-O theory to work are:

• A model designed to help understand the

•The success of one industry can be dependent on the success of related

• Refers to an external shock or development that could drastically change

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