International Business

UNIT-2-1
 THEORIES OF
INTERNATIONAL TRADE
 Learning Objectives

 To discuss the implications of trade theories on

international business
 To explain various theories of international trade
 To examine gains from trade under various trade
theories
 To explain the theoretical framework for
shifting patterns of production and trade
 Implications of Trade Theories

Trade theories provides the conceptual

base for international trade and shifts in
trade patterns.
They also facilitate in understanding the
basic reasons behind the evolution of a
country as a supply base or market for
specific products.
 Theory of Mercantilism
The theory attributes and measures the
wealth of a nation by the size of its
accumulated treasures.

It aims at accumulating financial wealth in

terms of gold by encouraging exports and
discouraging imports.
 Export maximization and import restriction
 Acquisition of precious metals
 European colonial powers primarily engaged in
international trade for the benefit of their respective
parent countries
 East India company entered into India to take the
advantage of its rich resources of spices, cotton , finest
muslin cloth etc
 Other European Countries –such as Germany , France,
Portugal, Spain, Italy and the East Asian nation Japan
also actively set up colonies to exploit the natural
human resources
 Always focused on trade surplus
 The colonies served as cheap source of primary
commodities /raw materials both for direct
consumption and further production
LIMITATIONS OF THE THEORY
 International trade becomes a zero sum game

 Favorable balance of trade is possible in the short run

but not in the long run nor relevant to the present
days
 Theory of Absolute Advantage

It may be defined as ability of a nation to produce the goods

more efficiently and cost effectively than any other country

Each country should specialize in producing those goods that it

can produce more efficiently, instead of producing all products.

Thus, a country should use increased production to export and

acquire more goods by way of imports which in turn would
improve living standards of its people.
 ABSOLUTE ADVANTAGE

UNITS UK INDIA
REQUIRED TO
PRODUCE
1 Tonne of Tea 10 5

1 Tonne of Rice 4 10
 Gains of Specialization and Trade under
Absolute Advantage (in Tonnes)
 
BEFORE TRADE AFTER TRADE

UK INDIA TOTAL UK INDIA TOTAL

TEA 5 10 15 0 20 20

RICE 12.5 5 17.5 25 0 25

         
32.3 45
 Theory of Comparative Advantage

CA may be defined as the inability of a nation to produce a good more

efficiently than other nations, but its ability to produce that good more
efficiently compared to the other good.

Thus, the country may be at an absolute disadvantage with respect to

both the commodities but the absolute disadvantage is lower in one
commodity than another.

Therefore, a country should specialize in the production and export of

a commodity in which the absolute disadvantage is less than that of
another commodity or in other words, the country has got a
comparative advantage in terms of more production efficiency.
Comparative Advantage-An Illustration

Units required to
produce UK INDIA  
one Tonne of
TEA 10 5  
RICE 5 4  
 Production=units Allocated/Units Required To
Produce One Tonne
PRODUCTION WITH TRADE- PRODUCTION WITH TRADE-
Tonn PRODUCTION WITHOUT
75:25 (Increase in Rice 90:10 (Increase in Tea
es TRADE- 50:50
production) production)

  UK INDIA TOTAL UK INDIA TOTAL UK INDIA TOTAL

0 75/5=15 15 0 90/5=18 18
TEA 50/10=5 50/5=10 15

100/5=20 25/4=6.25 26.25 100/5=20 10/4=2.5 22.5

RICE 50/5=10 50/4=12.5 22.5

      37.5     41.25     40.25

 Revealed Comparative Advantage
It is measured by a country’s share of world exports of a commodity
divided by its share in total exports.

RCAij = (Xij/Xwj)/(Xi / Xw)

Where
Xij = ith country’ export of commodity j
Xw = world exports of commodity j
Xi = total exports of country i
Xw = total world exports
 Factor Endowment
(Hecksher-Ohlin) Theory

A nation will export the goods whose

production requires intensive use of the
nation’s relatively abundant and cheap
factors
The country has to import the goods
whose production requires intensive use of
its scarce and expensive factors.
 The Leontief Paradox

Wassily Leontief carried out an empirical test of the

Heckscher-Ohlin Model in 1951 and found that the
US exported more labour-intensive commodities and
imported more capital intensive products which was
contrary to the results of Heckscher-Ohlin Model of
factor endowment.
 Country Similarity Theory

Trade occurs between nations that have similar

characteristics, such as economic, geographic,
cultural, etc.
However, in case of manufactured goods, cost was
determined by similarity in product demands
across countries rather than by relative production
costs or factor endowments
 The New Trade Theory

The theory elucidates that international trade

enables a firm to increase its output due to
specialization by providing larger markets, resulting
into enhancing its efficiency.

It helps explain the trade patterns when markets are

not perfectly competitive or when economies of
scale are achieved by production of specific
products.
International Product Life Cycle Theory

The theory explains the variations and

reasons for change in production and
consumption pattern among various
markets over a time period.
Stage 3: Maturity
It results in standard products
Large scale production and economies
Low unit cost of production
Shift manufacturing to developing economies
Stage 4: Decline
 It results in location of manufacturing facilities
in developing countries
 Original innovative country becomes net
importer
Stages of International Product Life Cycle
The IPLC has four distinct identifiable stages that influences
demand structure, production, marketing strategy, and
international competition as follows:
Stage 1: Introduction of new product
Firms innovate new products based on needs and
problems in the domestic market
Stage 2: Growth
It results in attracting competitors
Increased exports
Further innovation
Shift manufacturing to foreign countries
 Theory of Competitive Advantage
According to the theory, a firm’s home country
environment is the main source of competencies and
innovations often referred to as the DIAMOND MODE,
it focuses upon the four determinants:

 Factor (Input) Conditions

 Firm Strategy and Rivalry
 Demand Conditions
 Related and Supporting Industries