International trade theory
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International Trade Theory. Chapter Five. Free Trade occurs when a government does not attempt to influence, through quotas or duties, what its citizens can buy from another country or what they can produce and sell to another country

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International Trade Theory

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International trade theory

International Trade Theory

Chapter Five

Overview of trade theory

Free Trade occurs when a government does not attempt to influence, through quotas or duties, what its citizens can buy from another country or what they can produce and sell to another country

The Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country

Overview of Trade Theory

Trade theory overview

The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish).

Others are not so easy to understand (Japan and cars)

The history of Trade Theory and government involvement presents a mixed case for the role of government in promoting exports and limiting imports

Later theories appear to make a case for limited involvement

Trade Theory-Overview

Mercantilism mid 16th century

Mercantilism: Mid-16th Century

  • A nation’s wealth depends on accumulated treasure

    • Gold and silver are the currency of trade

  • Theory says you should have a trade surplus

    • Maximize export through subsidies

    • Minimize importsthrough tariffs and quotas

  • Flaw: “zero-sum game”

Mercantilism zero sum game

In 1752, David Hume pointed out that:

Increased exports lead to inflation and higher prices

Increased imports lead to lower prices

Result: Country A sells less because of high prices and Country B sells more because of lower prices

In the long run, no one can keep a trade surplus

Mercantilism-Zero-Sum Game

Theory of absolute advantage

Theory of Absolute Advantage

  • Adam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more of a product with the same amount of input than another country can vary

    • A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient

  • Trade between countries is, therefore, beneficial

  • Assumes there is an absolute balance among nations

    • Example: Ghana/cocoa

Theory of absolute advantage1

Theory of Absolute Advantage

Absolute advantage and the gains from trade

Absolute Advantage and the Gains From Trade

Theory of comparative advantage

Theory of Comparative Advantage

  • David Ricardo (Principles of Political Economy, 1817):

    • Extends free trade argument

    • Efficiency of resource utilization leads to more productivity

    • Should import even if country is more efficient in the product’s production than country from which it is buying

    • Look to see how much more efficient

      • If only comparatively efficient, than import

  • Makes better use of resources

  • Trade is a positive-sum game

International trade theory

Theory of

Comparative Advantage

Comparative advantage and the gains from trade

Comparative Advantage and the Gains From Trade

Simple extensions of the ricardian model

Immobile resources:

Resources do not always move easily from one economic activity to another

Diminishing returns:

Diminishing returns to specialization suggests that after some point, the more units of a good the country produces, the greater the additional resources required to produce an additional item

Different goods use resources in different proportions

Simple Extensions of the Ricardian Model

Simple extensions of the ricardian model1

Free trade (open economies):

Free trade might increase a country’s stock of resources (as labor and capital arrives from abroad)

Increase the efficiency of resource utilization

Simple Extensions of the Ricardian Model

Ppf under diminishing returns

PPF Under Diminishing Returns

Influence of free trade on ppf

Influence of Free Trade on PPF

Heckscher 1919 olin 1933 theory

Export goods that intensively use factor endowments which are locally abundant

Corollary: import goods made from locally scarce factors

Note: Factor endowments can be impacted by government policy - minimum wage

Patterns of trade are determined by differences in factor endowments - not productivity

Remember, focus on relative advantage, notabsolute advantage

Heckscher (1919)-Olin (1933) Theory

Product life cycle theory r vernon 1966

As products mature, both location of sales and optimal production changes

Affects the direction and flow of imports and exports

Globalization and integration of the economy makes this theory less valid

Product Life-Cycle Theory - R. Vernon (1966)

Product life cycle theory

Product life cycle theory

Fig 4.5

New trade theory

In industries with high fixed costs:

Specialization increases output, and the ability to enhance economies of scale increases

Learning effects are high.

These are cost savings that come from “learning by doing”

New Trade Theory

New trade theory applications

Typically, requires industries with high, fixed costs

World demand will support few competitors

Competitors may emerge because of “ First-mover advantage”

Economies of scale may preclude new entrants

Role of the government becomes significant

Some argue that it generates government intervention and strategic trade policy

New Trade Theory-Applications

Theory of national competitive advantage

The theory attempts to analyze the reasons for a nation’s success in a particular industry

Porter studied 100 industries in 10 nations

Postulated determinants of competitive advantage of a nation were based on four major attributes

Factor endowments

Demand conditions

Related and supporting industries

Firm strategy, structure and rivalry

Theory of National Competitive Advantage

Porter s diamond

Success occurs where these attributes exist

More/greater the attribute, the higher chance of success

The diamond is mutually reinforcing

Porter’s Diamond

Porter s diamond1

Porter’s Diamond

Factor endowments

Factor endowments: A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry

Basic factor endowments

Advanced factor endowments

Factor Endowments

Basic factor endowments

Basic factors: Factors present in a country

Natural resources


Geographic location


While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success

Basic Factor Endowments

Advanced factor endowments

Advanced Factor Endowments

  • Advanced factors: The result of investment by people, companies, and government are more likely to lead to competitive advantage

    • If a country has no basic factors, it must invest in advanced factors

Advanced factor endowments1


Skilled labor




Advanced Factor Endowments

Demand conditions

Demand Conditions

  • Demand:

    • creates capabilities

    • creates sophisticated and demanding consumers

  • Demand impacts quality and innovation

Related and supporting industries

Creates clusters of supporting industries that are internationally competitive

Must also meet requirements of other parts of the Diamond

Related and Supporting Industries

Firm strategy structure and rivalry

Long term corporate vision is a determinant of success

Management ‘ideology’ and structure of the firm can either help or hurt you

Presence of domestic rivalry improves a company’s competitiveness

Firm Strategy, Structure and Rivalry

Porter s theory predictions

Porter’s theory should predict the pattern of international trade that we observe in the real world

Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable

Porter’s Theory-Predictions

Implications for business

Location implications:

Disperse production activities to countries where they can be performed most efficiently

First-mover implications:

Invest substantial financial resources in building a first-mover, or early-mover advantage

Policy implications:

Promoting free trade is in the best interests of the home country, not always in the best interests of the firm, even though many firms promote open markets

Implications for Business

Looking ahead to chapter 6

The Political Economy of International Trade

Instruments of Trade Policy

The Case for Government Intervention

The Revised Case for Free Trade

Development of the World Trading System

Looking Ahead to Chapter 6

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