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International Trade Theory Chapter 4

International Trade Theory Overview Mercantilism Absolute Advantage Comparative Advantage Heckscher-Olin Theory Product Life Cycle Theory New Trade Theory Porter’s Diamond

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An 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.

The Pattern of International Trade displays patterns that are are easy to understand (Saudi Arabia/oil or Mexico/labor intensive goods). Others are not so easy to understand (Japan and cars).

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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 exports through

subsidies. Minimize imports through tariffs

and quotas.

Flaw: “Zero-sum game”.© McGraw Hill Companies, Inc.,2000 4-6

David Hume - 1752

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.

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Theory of Absolute Advantage Adam Smith: Wealth of Nations (1776). Capability of one country to produce more of a product

with the same amount of input than another country. Produce only goods where you are most efficient, trade for

those where you are not efficient. Trade between countries is, therefore, beneficial.

Assumes there is an absolute advantage balance among nations.

Ghana/cocoa.

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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.

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Simple Extensions of the Ricardian Model

Diminishing returns: More a country produces, at some point, will

require more resources.

However: Free trade can increase a country’s production

resources, and Increase the efficiency of resource utilization.

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Is the Mercantilist Theory Still Valid?

A qualified Yes. Equate political power with economic

power and economic power with a trade surplus.

Japan

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Heckscher (1919)-Olin (1933) Theory

Export goods that intensively use factor endowments which are locally abundant. Corollary: import goods made from locally scarce

factors. Patterns of trade are determined by differences in

factor endowments - not productivity. Remember, focus on relative advantage, not

absolute advantage.

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The Leontief Paradox, 1953

Disputes Heckscher-Olin in some instances. Factor endowments can be impacted by

government policy - minimum wage. US tends to export labor-intensive products,

but is regarded as a capital intensive country.

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Heckscher vs Ricardo Economists prefer Heckscher on theoretical

grounds but is a relatively poor predictor of trade patterns.

Ricardo’s Comparative Advantage Theory, regarded as too limited for predicting trade patterns, actually predicts them with greater accuracy.

In the end, differences in productivity may be the key to determining trade patterns.

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Product Life-Cycle Theory(Raymond Vernon, 1966)

Article in the Quarterly Journal of Economics. 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.

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The New Trade Theory

Began to be recognized in the 1970s. Deals with the returns on specialization

where substantial economies of scale are present. Specialization increases output, ability to

enhance economies of scale increase.

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First-Mover Advantage

Economies of scale may preclude new entrants.

Role of the government.

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Porter’s Diamond(Harvard Business School, 1990)

The Competitive Advantage of Nations. Looked at 100 industries in 10 nations.

Thought existing theories didn’t go far enough.

Question: “Why does a nation achieve international success in a particular industry?”

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Implications for Business

Location implications:makes sense to disperse production activities to countries where they can be performed most efficiently.

First-mover implications:It pays to invest substantial financial resources in building a first-mover, or early-mover, advantage.

Policy implications:promoting free trade is generally in the best interests of the home-country, although not always in the best interests of the firm. Even though, many firms promote open markets.

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