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4. Chapter. International Trade Theory. Economic assumption: free trade produces gains for all participating countries Recently, US economy indicate a movement of knowledge based jobs to developing economies. Economists believe that :

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International Trade Theory

case the hollowing out of the u s based economy
Economic assumption: free trade produces gains for all participating countries

Recently, US economy indicate a movement of knowledge based jobs to developing economies.

Economists believe that:

only routine skill jobs go overseas. Most managerial and , marketing and R &D jobs retained in the country.

Lower price of services means consumer can consume more for less

Economic growth overseas will benefit the U.S.

Case- The hollowing out of the U.S. based economy
trade theory overview
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

Trade theory-overview
trade theory overview1
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
David Hume in 1752 pointed out that:

Increased exports leads 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: Wealth of Nations (1776) argued:
    • 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 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
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
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)
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 nations 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
Porter’s diamond
  • Success occurs where these attributes exist.
  • More/greater the attribute, the higher chance of success
  • The diamond is mutually reinforcing

Fig 4.6

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: Are the result of investment by people, companies, governmentand 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
determinants of competitive advantage in nations


Company Strategy,


and Rivalry

Two external factors that influence the four determinants.






and Supporting



Determinants of Competitive Advantage in nations

Fig 4.8

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