Chapter II Theories of International Trade and

Business

I Introduction

II Trade Theories

I. Mercantilism

II Theory of Absolute Advantage

III Theory of Comparative Advantage

IV Factor Endowment Theory








I Introduction :

Why do countries trade???
Shouldnt strong country such as the United States
produce all of the computers, television sets,
automobiles, cameras, and VCRs it wants rather than
import such products from Japan???

Why do the Japanese and other countries buy wheat,
corn, chemical products,aircraft,manufacturing
goods, and informational services from the United
States???

The major reason of trade that is accepted :

countries have different natural,human and capital
resources and different ways of combining these
resources, they are not equally efficient at
producing all the goods and services.

The trade pattern is explained by different trade
theories given by different economist at different
time period.
Trade between and among countries has occurred for
many thousands of years .But it was not until the 15
th

century that people tried to explain why trade occurs
and how trade benefits both parties to exchange
II Trade Theories :

Trade theories are representation of our
understanding of How the global trade works. They
explain the connection between variables, predict how
and when those connections will exist and set controls
in relationship to when these theories apply, to what
extent and where they o not apply.

Trade theory explains why trade exists, how it
happens and where it does and doesnt occurs.

The following figure shows a time line of when the
main theories of international trade were proposed

Time :
Mercantilism
Absolute advantage
Comparative Advantage
Factor Proportions Theory
International competitive Advantage
1500 1600 1700
1800
1900
2000
PLC
I Mercantilism : David Hume ( 1752)

The first international trade theory, emerged in
England in the mid-16
th
century.

A nations wealth depends on accumulation of precious
metals like gold and silver

Thus, earning of gold and silver is the main motive for
countries to trade with each other.

Government can intervene to achieve trade surplus or
accumulate gold and silver by discouraging imports by
imposing tariffs and quotas and subsidizing exports.

Criticism : Believes in zero sum game i.e. a game in which a
gain by one country results in a loss to another .
II Theory of Absolute Advantage :

Adam Smith in 1776 in London.

Smith stated that productive efficiency differed among
different countries because of
* Diversity in the natural and acquired resources
possessed by them.
* Difference in natural advantage such as
varying climate, quality of land , availability of
minerals, water and other natural resources
* while the difference in acquired resources manifests
in different levels of technology and skills available .

A particular country should specialize in producing only those
goods that it is able to produce with greater efficiency ,
that is at lower cost; and exchange those goods with other
goods of their requirement from a country that produces
those other goods with greater efficiency or at lower cost.

III Comparative Cost Advantage Theory:
David Ricardo (1817)
One country has a comparative advatge over
another in the production of a certain commodity if
its opportunity cost of producing that commodity is
lower
A country should specialize in the production and
export of a commodity in which it possesses greatest
relative advantage.i.e. even if a country is able to produce
all its good at lower costs than another country can, trade
, 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..



Assumptions of above two theories :

1. All units of labor are homogeneous
2. Labor is perfectly mobile within the country but it is
perfectly immobile between different countries.
3. There is full employment in countries engaged in
international trade.
4. There is no transportation cost involved in foreign trade.
5. International trade is free from all government controls
like tariffs;
6. There is perfect competition both in the goods market and
factor market
7. Two countries, two commodities
8. Labor is the only factor of production

IV Factor Endowment Theory :

Swedish economist Eli Heckscher ( in 1919) and
Bertil Ohlin (in 1933)

Ricardos theory stresses that comparative
advantage arises from differences in productivity
whereas as Heckscher Ohlin argued that
comparative advantage arises from difference in
national factor endowments.



Explanation

The theory explains that different nations have
different factor endowment and different factor
endowment explain difference in factor cost. The
more abundant a factor , the lower its cost. So, the
Heckscher-Ohlin postulates that countries will
export those 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.

Assumptions : HO Theory

1. Two countries, two commodities and two factors of
production
2. There is perfect competition in the goods and factors
market
3. Full employment of resources
4. Quantity of factor endowment in two countries is
different.
5. Perfect mobility of factors within region but immobile
between different countries
6. Free and unrestricted trade between the two countries.


V Product Life Cycle (PLC)

Raymond Vernon In mid 1960s

The location of the production of certain kind of
product shifts, as they go through their life cycles.

Many products go through a cycle during which a
country starts off as an exporter,then loses its
exports markets, and then finally loses its domestic
market as well thereby becoming an importer of that
very product
A PLC consists of four stages :

I Introduction
II Growth
III Maturity
IV Decline

I Introduction Stage :

New products are developed in response to observed
need
Production occurs in domestic location
As production increases and exceeds local consumption,
exports start taking place
Price is inelastic, profits are high
II Growth Stage :

Increase in exports by innovating country
More competition
Demand grows in foreign markets
Increased demand results additional manufacturing
unit
Some foreign production

III Maturity Stage :

A decline in exports from the innovating country
Increased competitiveness of price
Production start up in emerging market


IV Decline Stage :

The country in which the innovation first began
and exported now becomes the importer.
VI National Competitive Advantage : Porters Diamond

Michael Porter (1990)

Diamond published in 1990 was based on a study of 100
firms in 10 developed nations

Porter questions why a particular country is more
competitive in a particular industry?

For example : Italy maintains competitive advantage in the
production of ceramic tiles and Switzerland possesses the
competitive advantage in watches.
Why there is a difference ?








FACTORS, which MICHAEL PORTER BELIEVED EXTENDED
BEYOND NATURAL ENDOWMENT, INCLUDE.



1. Factor conditions
2. Demand conditions
3. Relating and supporting industries
4. Firm strategy , structure and competition

Besides the four factor s, Porter gives weight age to a couple
of factors , such as government policy
.
Porters diamond framework Porters
diamond framework
Government
Chance
Structure of
Firms and
Rivalry
Related and
Supporting
Industries
Demand
Conditions
Factor
Conditions