THEORIES OF INTERNATIONAL TRADE

Unit II

Trade theories

2 extremes: Mercantilism v/s Free Trade Or Interventionist v/s Laissez faire

Interventionist theories

Free Trade theories

Competitive Advantage theory

Mercantilism Absolute advantage

Product Life Cycle (PLC) Theory

Neomercantilism

Comparative advantage

Porter Diamond Theory

H-O Theory

Mercantilism

Best way of becoming rich is by exporting more than importing..

Difference settled in gold.. Trade theory that says: ‘country’s wealth is

measured by its treasure holding’, usually gold Thus:

X more, M less Gold empowers Govt., which empowers the

army and national institutions.. Time 1500 – 1750 cen. Outcome: accumulation of gold by colonial

powers Unrest: American revolution (1775–1783).. And

many more..

EXPLORER COUNTRY YEAR[in order] GEOGRAPHIC AREA EXPLORED

Columbus Italian sponsored by Spain 1492 Sailed westward to find route to India and China, found the New World America…

Amerigo Vespucci Italy 1498 Sailed South America's coast - later maps called it "America"

Vasco Da Gama: Portugal 1498 Sailed around the tip of Africa: cape of good hope.. and reached the Indies.. India..

Neomercantilism

Mercantilism justifies favorable trade to pile up gold..

Neomercantilism: Approach to have favorable BoT for social or political advantage

Social advantage: to have full employment of resources in order to have surplus production to send abroad..

Political advantage: to give aid and grant to other countries..

Free Trade Theories

Absolute advantage: Adam Smith, 1776 Comparative advantage: David Ricardo,

1817 Factor-proportions: Heckscher-Ohlin,

1919

Absolute Advantage

Adam Smith: The Wealth of Nations, 1776 Mercantilism weakens country in long run;

enriches only a few A country

Should specialize in production and export of products in which it has absolute advantage; import other products

Has absolute advantage when it is more productive than another country in producing a particular product

Comodity US UK

Wheat (kg/labor)

6 1

Cloth (mts/labor)

1 2

Production Possibility Curve

A curve that shows Total output (of 2 commodities) that can

be produced By a country using all its resources…

So theory of absolute advantage shows world’s production increases due to international trade..

Comparative Advantage

David Ricardo: Principles of Political Economy, 1817

Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces

Absolute Advantage is a special case of Comparative AdvantageCommodity US UK Comparative

disadvantageComparative adv US

Wheat 6 1 1/6 6/1=6 more adv

Cloth 3 2 2/3 3/2=1.5

Classic Theory Conclusion

Free Trade expands the world “pie” for goods/services

Theory Limitations: Simple world (two countries, two products) no transportation costs no price differences in resources resources immobile across countries constant returns to scale full employment

Theory of Relative Factor Endowments (Heckscher-Ohlin): Modern Theory

Factor endowments vary among countries

Products differ according to the types of factors they need as inputs

A country has a comparative advantage in producing products that intensively use factors of production it has in abundance and which is thus cheap..

Factors of production: labor, capital

Heckscher--Ohlin (1919)

Differences in factor endowments and not differences in productivity determine patterns of trade

Theory: ‘H-O postulates that each nation will export commodity intensive in its relatively abundant and cheap labor and vice-versa’.

Important determinants

Factor endowments: commodity: high in K/L , L/K

Factor prices: low in r/w and w/r

US and UK PPF pre trade Post trade

International trade continues until relative and absolute factor prices are equalized.. HOW???

Factor Price equalization theorem

Trade leads to equalization of relative and absolute factor prices between nations…

K-abundant nation: high K/L and low r/w ratio

L-abundant nation: high L/K and low w/r ratio..

Labor intensive and capital intensive commodity..

Empirical Test

Leontief paradox: US has relatively more abundant capital yet

imports goods more capital intensive than those it exports.. 1947.. Ms30% more k-intensive than Xs..

Explanation(?): US has special advantage on producing new

products made with innovative technologies These may be less capital intensive till they

reach mass-production state

Factor Intensity Reversal Test (FIR)

Situation where a commodity is L-intensive in labor intensive country and k-intensive in K abundant country…

International Product Life-Cycle :Vernon, 1966

Most new products conceived / produced in the US in 20th century

US firms kept production close to their market initially

Limited initial demand in other advanced countries initially

When demand increases in advanced countries, production follows

With demand expansion in secondary markets Product becomes standardized production moves to low production cost areas Product now imported to US and to advanced

countries

Vernon Product Life-Cycle Model

Introduction: Requires highly skilled labor

Growth: to advanced countries, home country sales increase

Maturity: Requires standardized production, unskilled labor

Decline: in production in home country and increased production in low skilled developing countries. Home country produces new products..

5-20

What Is Porter’s Diamond Of Competitive Advantage?

Michael Porter tried to explain why a nation achieves international success in a particular industry

He identified four attributes that promote or impede the creation of competitive advantage

1. Factor endowments - a nation’s position in factors of production necessary to compete in a given industry

can lead to competitive advantage can be either basic (natural resources, climate, location) or

advanced (skilled labor, infrastructure, technological know-how)

2. Demand conditions - the nature of home demand for the industry’s product or service

influences the development of capabilities sophisticated and demanding customers pressure firms to

be competitive

5-21

What Is Porter’s Diamond Of Competitive Advantage?

3. Relating and supporting industries - the presence or absence of supplier industries and related industries that are internationally competitive

can spill over and contribute to other industries successful industries tend to be grouped in clusters in

countries

4. Firm strategy, structure, and rivalry - the conditions governing how companies are created, organized, and managed, and the nature of domestic rivalry

different management ideologies affect the development of national competitive advantage

vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features

5-22

What Is Porter’s Diamond Of Competitive Advantage?

Determinants of National Competitive Advantage: Porter’s Diamond

Summary

Mercantilism Free trade theory Competitive theory

A market to think about: Computers Hardware only!!!!