chapter 2 theories of intl trade

8/12/2019 Chapter 2 Theories of Intl Trade

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Chapter II Theories of International Trade andBusiness

I Introduction

II Trade Theories

I. Mercantilism

II Theory of Absolute Advantage

III Theory of Comparative Advantage

IV Factor Endowment Theory


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I Introduction:

Why do countries trade???

Shouldnt strong country such as the United Statesproduce 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,manufacturinggoods, and informational services from the UnitedStates???


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The major reason of trade that is accepted :

countries have different natural,human and capitalresources and different ways of combining theseresources, they are not equally efficient at

producing all the goods and services.

The trade pattern is explained by different tradetheories given by different economist at different

time period.

Trade between and among countries has occurred formany thousands of years .But it was not until the 15thcentury that people tried to explain why trade occurs

and how trade benefits both parties to exchange


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II Trade Theories :

Trade theories are representation of our

understanding of How the global trade works. Theyexplain the connection between variables, predict howand when those connections will exist and set controlsin relationship to when these theories apply, to whatextent and where they o not apply.

Trade theory explains why trade exists, how it

happens and where it does and doesnt occurs.


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The following figure shows a time line of when themain 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


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I Mercantilism : David Hume ( 1752)

The first international trade theory, emerged in

England in the mid-16thcentury.

A nations wealth depends on accumulation of preciousmetals like gold and silver

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

Government can intervene to achieve trade surplus oraccumulate gold and silver by discouraging imports byimposing tariffs and quotas and subsidizing exports.

Criticism : Believes in zero sum game i.e. a game in which aain b one countr results in a loss to another .


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II Theory of Absolute Advantage :

Adam Smith in 1776 in London.

Smith stated that productive efficiency differed amongdifferent countries because of

* Diversity in the natural and acquired resourcespossessed by them.

* Difference in natural advantage such asvarying climate, quality of land , availability ofminerals, water and other natural resources

* while the difference in acquired resources manifests

in different levels of technology and skills available .


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A particular country should specialize in producing only thosegoods 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 producesthose other goods with greater efficiency or at lower cost.


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III Comparative Cost Advantage Theory:

David Ricardo (1817)

One country has a comparative advatge overanother in the production of a certain commodity ifits opportunity cost of producing that commodity islower

A country should specialize in the production andexport of a commodity in which it possesses greatestrelative 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 theproduction of those goods that it produces mostefficiently and to buy the goods that it produces less

efficiently from other countries..


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Assumptions of above two theories :

1. All units of labor are homogeneous

2. Labor is perfectly mobile within the country but it isperfectly immobile between different countries.

3. There is full employment in countries engaged ininternational trade.

4. There is no transportation cost involved in foreign trade.5. International trade is free from all government controlslike tariffs;

6. There is perfect competition both in the goods market andfactor market

7. Two countries, two commodities8. Labor is the only factor of production


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IV Factor Endowment Theory :

Swedish economist Eli Heckscher ( in 1919) andBertil Ohlin (in 1933)

Ricardos theory stresses that comparative

advantage arises from differences in productivitywhereas as Heckscher Ohlin argued thatcomparative advantage arises from difference innational factor endowments.


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Explanation

The theory explains that different nations havedifferent factor endowment and different factorendowment explain difference in factor cost. The

more abundant a factor , the lower its cost. So, theHeckscher-Ohlin postulates that countries willexport those goods that make intensive use ofthose factors that are locally abundant, while

importing goods that make intensive use of factorsthat are locally scarce.


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Assumptions : HO Theory

1. Two countries, two commodities and two factors of

production2. There is perfect competition in the goods and factorsmarket

3. Full employment of resources4. Quantity of factor endowment in two countries is

different.5. Perfect mobility of factors within region but immobile

between different countries6. Free and unrestricted trade between the two countries.


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V Product Life Cycle (PLC)

Raymond Vernon In mid 1960s

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

Many products go through a cycle during which acountry starts off as an exporter,then loses itsexports markets, and then finally loses its domestic

market as well thereby becoming an importer of thatvery product


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A PLC consists of four stages :

I Introduction

II GrowthIII MaturityIV Decline

I Introduction Stage :

New products are developed in response to observedneed

Production occurs in domestic location

As production increases and exceeds local consumption,exports start taking place

Price is inelastic, profits are high


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II Growth Stage :

Increase in exports by innovating country

More competitionDemand grows in foreign marketsIncreased demand results additional manufacturing

unit

Some foreign production

II Maturity Stage :

A decline in exports from the innovating countryIncreased competitiveness of priceProduction start up in emerging market


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l d d


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VI National Competitive Advantage : Porters Diamond

Michael Porter (1990)

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

Porter questions why a particular country is more

competitive in a particular industry?

For example : Italy maintains competitive advantage in theproduction of ceramic tiles and Switzerland possesses the

competitive advantage in watches.Why there is a difference ?


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FACTORS, which MICHAEL PORTER BELIEVED EXTENDED

BEYOND NATURAL ENDOWMENT, INCLUDE.

1. Factor conditions2. Demand conditions3. Relating and supporting industries

. Firm strategy , structure and competition

Besides the four factor s, Porter gives weight age to a coupleof factors , such as government policy


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.Porters diamond framework Porters

diamond framework

Government

Chance

Structure of

Firms and

Rivalry

Related and

Supporting

Industries

Demand

Conditions

Factor

Conditions

chapter 2 theories of intl trade

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