International Trade Theories

Free trade
A Government does not attempt to influence trade through quotas or duties, what its citizens can buy from another country, or what they can produce and sell to another country

Theories
      

Mercantilism Absolute advantage Theory Comparative cost advantage theory Factor proportion/ Hecksher-Ohlin theory HecksherThe new Product life cycle theory The New trade theory Competitive advantage theory/Porters Diamond model

Mercantilism


Mercantilism is a 16th Century doctrine Governments job is to create policy that promotes heavy exportation, collection of revenue, and industrial development internally.

Mercantilism


A country should maintain a trade surplus, to export more than import. It is a zero sum game- A gain by one gamecountry results in a loss for another. Gold and silver were the currencies of trade.

Mercantilism


In Practice, it serves to make Practice, the State the stockholder, financier, customer, marketer, collector, and enforcer of contracts with other nations. Colonial relationship resulted from mercantilism.

Absolute Advantage Theory



Given by Adam Smith, in the book Wealth of Nations Countries should specialize in the production of goods for which they have absolute advantage, and trade these for goods produced by other countries.

Absolute Advantage


Countries should specialize in producing what they are best atatthings they have an absolute advantage. Incentive to trade is based on each country having an absolute advantage in a product. In reality-this is unrealistic and quite realityuncommon to happen this way.

G 20 C O C O A

15 A 10 K 5 B K

0 0 5 RICE 10

G 15 20

Resources required to produce 1 ton of Cocoa and Rice Cocoa 10 40 Rice 20 10

Ghana South Korea

Production and consumption without trade Cocoa 10 2.5 12.5 Production with specialization Cocoa 20 0 20 Rice 0 20 20 Rice 5 10 15.0

Ghana South Korea Total production

Ghana South Korea Total Production

Comparative advantage


Ricardo indicated that nations that are comparatively more efficient at production will make those goods even though they may not have an absolute advantage. It is this Comparative Advantage that explains and predicts trade of goods where absolute advantages may not exist.

Comparative advantage


Ricardo indicated that nations will produce and trade goods where they have a Comparative Advantage even though more than one nation holds Absolute Advantage in production. It is the nation that is comparatively better in production that will trade.

Comparative advantage


The implication for Ricardo is that human skill, productivity, capital, or government policy can intervene and make a nation an exporter of goods. Examples can be where governments promote comparative advantage through subsidies, resources and development, or direct funding

Comparative advantage


Smith said trade was explained through Absolute Advantage; Ricardo Advantage; said it was Comparative Advantage; Advantage; HeckscherHeckscher-Ohlin indicates it is supply of factors that predicts, explains, and controls trade. Every producer has to have a supply base. Sources of supply coming from locally abundant Factor Endowments lower supply costs and make for cheaper production and more likely export.

Comparative Advantage Theory

It makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.

G 20 C O C O A

C 15

A 10 K 5 B 0 0 5 K 10 RICE G 15 20

Resources required to produce 1 ton of Cocoa and Rice Cocoa 10 40 Rice 13.33 20

Ghana South Korea

Production and consumption without trade Cocoa 10 2.5 12.5 Production with specialization Cocoa 15 0 15 Rice 3.75 10 13.75 Rice 7.5 5 12.5

Ghana South Korea Total production

Ghana South Korea Total Production

Assumptions of comparative advantage theory

     

Only two countries in the world No transportation costs No tariffs between countries Constant returns to scale Fixed stock of resources Effects of trade on income distribution of a country are ignored.

HeckscherHeckscher-ohlin Theory
Comparative advantage arises due to differences in national factor endowments, like land, labor and capitol. Countries will export those goods that make intensive use of locally abundant factors, different factor endowments explain the differences in factor costs. The more abundant a factor, the lower its cost

The Leontief Paradox



Wassily Leontief empirically tested the Heckscher-ohlin Theory, these Heckschertests question the validity of HeckscherHeckscher-ohlin Theory Leontief postulated USA has abundant capital, compared to other nations, so US would be an exporter of capital-intensive goods and an capitalimporter of labor-intensive goods labor-

Issues with Heckscher-ohlin Theory Heckscher

Ohlin assumed also that technology for production was universally available, which it isnt. HeckscherHeckscher-Ohlin also assumes that products can be either capital or labor intensive, not both. HeckscherHeckscher-Ohlin also ignore transportation and logistical costs to and from a factory

Leontief Paradox


Surprise finding- US exports were findingless capital intensive than US imports. Possible explanation could be US has advantage in producing innovative technology( software) based products which may be less capital intensive than mature products (Heavy machinery)

Leontief Propositions to overcome Issues in H-O Theory H1.

2.

3.

4.

There are differences in tastes and preferences that contradict market and factor influences. These are called demand biases. biases. There are trade barriers that government imposes that influence production. There are natural resources in abundance or not. There are factor intensity reversely that occur over time.

Product Life Cycle theory

The PLC Theory

The product life cycle model was given by Raymond Vernon Vernons PLC model asserts that product innovation and initial use occurs first in higher income countries and then diffuses to middle and lower income countries as technology and skills gaps overcome and consumer preferences switch to the newer products.

Trends in PLC
1.

2.

3.

4.

The export performance of the mature innovating country is better than others. Technology is better in the mature countries as products diffuse production tends to move from technologytechnology-intensive to labor-intensive. laborCountries that were innovators can fall from that place. Trade may increase in later stages of product maturity as costs and prices decline and production economies rise.

Competitive Advantage of Nations

Micheal E Porter

Firm strategy, structure & rivalry chance

Factor conditions

Demand conditions

Related & supporting industries

government

Introduction to the New Trade Theory

Up to now, trade theory has been dependent on national advantage, production efficiency, factor endowments, government agendas, country or industry maturity, or overlapping demand similarity. These theories have a few commonalities: 1. They depend on national differences to explain, predict, and control trade. 2. They assume government is either involved, or not involved at all. 3. They dont consider firm level strategy, structure or economy. 4. The newer trade theories do that.

New Trade Theory-contd TheoryAccording to New Trade Theory, which is Theory, actually a set of papers by various scholars, trade is predicted by the increasing returns that firms can earn by trading intentionally. In New Trade Theory: 1. There is increasing return in Economy of Scale.( learning effect) 2. First mover advantage

New Trade theory-contd theory3. Intra-Industry trade is best Intraexplained by increasing returns. 4. Externalities like government policy, political relations, national history, consumption differences, accident, and luck all predict variance in trade

Conclusion
Remember, Remember, no theory thoroughly explains all trade, predicts it all accurately, and establishes limits on where trade does or does not occur. Every theory has advantages though, and it may be better to consider theories in combination rather than independently. independently.

Implications for Business

The implications of trade theories for Business are 1. Location implications 2. First mover Implications 3. Policy Implications