Trade Theories

THEORIES OF

INTERNATIONAL TRADE

AIM OF THEORIES

• The aim of the trade theories is to understand or answer the following questions that become quite apparent in international trade

Why do countries trade? Do countries trade or do firms trade? Do the elements that create competitiveness of firms,

industries or countries arise from inherent endowments of the country or do they change with time and circumstances?

Once these elements are identified, can they be exploited, manipulated or managed by firms or governments to benefit the traders?

EVOLUTION OF TRADE THEORIESThe Theory of Absolute

Advantage Adam Smith

The Theory of Competitive Advantage David Ricardo

The Theory of Factor Proportions Eli Heckscher & Bertil Ohlin

The Leontief ParadoxWassily Leontief

Product Cycle TheoryRaymond Vernon

Overlapping Product Range Theory

Staffan Linder

Imperfect Markets and Trade Theory

Paul Krugman

The Competitive Advantage of Nations

Michael Porter

Classical Trade Theory

THEORY OF ABSOLUTE ADVANTAGE

• Theorized in the year 1776 by Adam Smith

• “Each country should specialize in the production and export of those goods which it produces most efficiently, i.e, with the lowest number of labor-hours”

• Speaks of two main areas: “absolute advantage” and “division of labor”

• Production needs labor - the primary element of value in society

• Some countries due to the skills of their workers or quality of natural resources can produce the same product in lesser man-hours leading to efficiency called “absolute advantage”

THEORY OF ABSOLUTE ADVANTAGE

• Prior to the Industrial Revolution, a worker performed all stages of a production process limiting output

• The Industrial Revolution led to separation of the production process into different stages, each performed by one individual thus leading to “division of labor”

• This led to increase in the production of workers and industry

• This further led to division of labor and specialized product across countries

• Each country, specializing in products where it possessed “absolute advantage”, produced more and exchanged the excess for products that were cheaper than those produced at home

THEORY OF COMPARATIVE ADVANTAGE

• Theorized in the year 1819 by David Ricardo

• “Even if one country was most efficient in the production of two products, it must be relatively more efficient in the production of one good. It should, therefore, specialize in the production and export of that good in exchange for the importation of the other good, leading to comparative advantage”


• This takes the theory of absolute advantage one step further

• Comparative advantage is about giving up production of one product where it does not have comparative advantage.

• This leads to trade between countries of products where they have or do not have comparative advantage

Country Wheat ClothEngland 2 man-hours 4man-hoursIndia 4 man-hours 2 man-hours


• When the total man-hours available for production within a country are devoted to the full production of the product, an idea can be obtained of the “production possibilities frontiers” of each country

• This helps to understand the amount of trade-off of producing one product over another

• When costs or prices are allocated to these trade-offs, it indicates the opportunity costs, which is the value of a factor of production in it’s next best use

GAINS FROM INTERNATIONAL TRADE

• Without trade, a country consumes what it produces

• Once comparative advantage has been identified, focus should shift to production of the good it produces best

• This could lead to production exceeding consumption creating surplus which can be traded internationally

• This could also allow the country to consume more than was earlier possible leading to welfare of society

• A country can also achieve consumption levels beyond what it can produce by itself

FACTOR PROPORTIONS TRADE THEORY

• Created by Eli Heckscher and Bertil Ohlin

• “A country that is relatively labor-abundant/capital-abundant should specialize in the production and export of only that product which is relatively labor-intensive/capital-intensive”

• Considers two factors of production - labor & capital – and technology would decide the way they combine to produce a good. Different goods require different proportions of the two factors of production.

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Factor Proportions Trade Theory

Considers Two Factors of Production

• Labor

• Capital


• These factor intensities or proportions are relative and depend on the basis of what product “X” relative to product “Y”

• e.g leather goods v/s computer memory chips

• Factor intensities depend on the state of technology used, assuming that the same level of technology is used across countries

• Hence, does not believe that differences in the efficiency of production create differentiation in cost of production and thereby, international trade


• While assuming that labor and capital are immobile and cannot move across borders, this theory believes that if there is no difference in technology or productivity, it is the price of the factors that determine the cost differences

• These prices are dependent on the endowments of labor and capital that the country possesses.

• Therefore, a country that is relatively labor-abundant should specialize in the production of relatively labor-intensive goods and should export those labor-intensive goods in exchange for capital-intensive goods.

• And vice versa


• Assumptions:– Assumes that two countries, two products and two factors

of production called as 2x2x2 assumption– Markets for the inputs and the output are perfectly

competitive where labor and capital were exchanged in markets that paid them only what they were worth

– Trade of output was competitive so that one country had no market over the other

– Increasing production of a product leads to diminishing returns. Thus, increased specialization would require more inputs per unit of output

– Both countries use identical technology, producing each product in the same way. This confirms that the only way a good can be produced cheaper in one country than another only if either the labor or capital is cheaper

THE LEONTIEF PARADOX• Wassily Leontief tested the factor proportions theory in 1950

• Tried to explain whether the factor proportions theory could be used to understand the type of gods exported by the USA

• Devised a method to determine the relative amounts of labor and capital in a good and called it “input-output analysis”

• A technique that breaks up a good into values and quantities of labor, capital and other factors employed in the manufacture of goods

THE LEONTIEF PARADOX• Hypothesized that US exports should be more capital

intensive than US imports

• However, he found that the products that the US exported were more labor-intensive than the products imported by the US

This is called as the “Leontief Paradox”

• It was found that Leontief did not analyze the labor and capital components of the imports but analyzed the labor and capital contents of the domestic equivalents of these imports

• Others then debated the need to distinguish different types of labor and capital, differentiating labor into skilled and unskilled labor and similarly for capital

OVERLAPPING PRODUCT RANGES THEORY

• “The type, complexity and diversity of product demands of a country increase as the country’s income increases. International trade patterns would follow this principle so that countries with similar per-capita income levels will trade more intensely having overlapping product demands”

• This theory focuses not on the production or supply side but on the preferences of the consumers – the demand side

• Linder accepted that in natural resource based industries, trade was determined by relative costs of production and factor endowments.


• However, he believed trade in manufactured goods was dictated not by cost concerns but by the similarity in product demand across countries

• Theory based on 2 principles:– As per capita income rises, the complexity and quality level

of products demanded by the population also rises. The total range of product sophistication demanded by a country’s residents is dependent on its level of income

– Entrepreneurs that produce the needs of society are more knowledgeable about their domestic markets than the international markets and hence cannot serve a foreign market due to lack of experience


• “International trade in manufactured goods is influenced by a similarity of demands. The countries seeing the most intensive trade are those with similar per-capita incomes and possess a greater likelihood of overlapping product demands”

• The overlapping ranges of product sophistication represent products that entrepreneurs know well from their home markets and can therefore potentially export and compete with in international markets

• e.g: US and Canada v/s US and Mexico

• The overlapping product ranges are today known as “market segments”

PRODUCT CYCLE THEORY

• Theory created by Raymond Vernon in 1966

• “The country that possesses comparative advantage in the production and export of an individual product changes over time as the technology of manufacturing the product matures”

• Vernon focused on the product, the country and technology of manufacture and not the factor proportions


• While using the assumptions of the factor proportion theory, Vernon added 2 technology based premises– Technical innovations leading to new and profitable

products require large quantities of capital and highly skilled labor, which are predominantly available in highly industrialized, capital-intensive countries

– These technical innovations of both product and methods of manufacture, go through 3 stages of maturation as the product becomes more commercialized.

As the manufacturing process becomes more standardized and low-skill labor intensive, the comparative advantage in production and exports shifts across countries

Product Cycle TheoryIs supply-side and demand-side in orientation.

Three stages:1. New Product - Highly skilled labor and large capital investment, flexible, high cost of production.

2. Maturing Product - Standardized process, decline in flexibility and highly skilled labor, sales and competition increases.

3. Standardized Product - Product produced by country with cheapest unskilled labor, low profitability, fierce competition, end of product cycle.

Important to match the product by its maturity stage to location of production to maintain competitiveness.


• The New Product:

– Innovation requires highly skilled labor and large amount of capital for R&D

– Product is designed and normally manufactured near the parent firm

– The product is non-standardized– The production process requires a high degree of flexibility– Costs of production are quite high– Innovator is a monopoly and hence gets high profit margins– Price elasticity is low and high income users buy the

product irrespective of the high cost


• The Maturing Product:

– Since production expands, the process becomes more standardized

– Due to standardization, the need for highly skilled labor declines– The innovating country increases exports – Competitors develop, putting pressure on prices and profit

margins– The innovating firm has to decide on ways to maintain market

share– The challenge now is to decide whether to accept losing market

share or to invest abroad and maintain market share by exploiting factor production costs


• The Standardized Product:– The product is completely standardized in manufacture– The country of production becomes the one with the

cheapest unskilled labor– Competition is fierce and profit margins are low– The country manufacturing the product at this stage has

benefits of net trade surplus

• Hence, as knowledge and the technology continually change, the country of the product’s comparative advantage also changes.

PRODUCT CYCLE THEORY• Contributions of the theory:

– Speaks of the increasing emphasis of technology on product costs– Explains international investment– Recognizes the mobility of capital across countries– Shifted focus from the country to the product– Matches product by it’s maturity stage with it’s location of

production

• Limitations:– Most appropriate for technology base products– Does not take into account products that are resource based or

services– Relevant to products that eventually end up in mass production

and hence cheap labor forces

THE IMPERFECT MARKETS TRADE THEORY

• Floated by Paul Krugman in the 1990s

• Trade is altered when markets are not perfectly competitive or when production of specific products possess economies of scale. Explains changing trade pattern, including intra-industry trade, based on the imperfection of both – factor markets and product markets.

• Focuses on 2 types of economies of scale:– Internal economies of scale– External economies of scale


• Internal Economies of Scale:

– When the cost per unit of output depends on the size of the firm, the larger the firm the greater the scale benefits and lower the cost per unit

– A firm with internal economies of scale can monopolize an industry creating an imperfect market, both domestically and internationally

– With lower cost per unit, it lowers market price and sell more since it sets market prices

– For a firm to expand to enjoy its economies of scale, it has to take away resources from other domestic industries

– The country then has a narrower range of products in which it specializes, providing an opportunity to other countries to specialize in the products abandoned called “abandoned product ranges”

– Then using comparative advantage, countries again search and exploit these situations


• This theory also explains the concept of “Intra-industry trade”

• Intra-industry trade: When a country exports and imports the same product

• Measured with the Grubel-Lloyd Index:

Intra Industry Trade Index (i) = 1 – (X-M)

(X+M)

• The closer the index value to 1, the higher the intra industry trade in the product category

• The closer the index value to O, the more one-way the trade between countries exists

• Currently comprises about 25% of global trade


• External Economies of Scale:

– When the cost per unit depends on the size of the industry and not the size of the firm, the industry of that country may produce at lower costs than the same industry smaller in size in another country.

– A country can dominate in world markets in a particular product, not because it has one massive firm producing huge quantities, but because it has many small firms together creating a competitive, critical mass

– External economies of scale may not lead to imperfect markets but may result in an industry retaining dominance in its field in world markets

– This provides an explanation as to why tall industries do not always move to the country with lowest cost of energy, resources or labor

THE COMPETITIVE ADVANTAGE OF NATIONS

THEORY• Floated by Michael Porter explaining sustenance of

critical mass for a firm or nation

• “A nation’s competitiveness depends on the capacity of its industry to innovate and upgrade. Companies gain competitive advantage because of pressure and challenge. Companies benefit from having strong domestic rivals, aggressive home-based suppliers and demanding local customers.”

• Competitive advantage is created and sustained through a highly localized process. Innovation is what drives and sustains competitiveness.


THEORYFirm Strategy, Structure and

Rivalry

PORTER’s DIAMOND OF NATIONAL ADVANTAGE

Factor Conditions

Demand Conditions

Related and Supporting Industries


THEORY• Factor conditions:

– The appropriateness of the nation’s factors of production to compete successfully in a specific industry

– Though important, these factors are not the only source of competitiveness.

– More important is the ability of the nation to continually create, upgrade and deploy its factors of production


THEORY• Demand Conditions:

– The degree of health and competition the firm must face from its original home market

– Firms that can survive and flourish in highly competitive and demanding local markets are more likely ot gain a competitive edge

– It is the character (demanding customers) of the market and not its size, hat promotes the continual competitiveness of the firm


THEORY• Related and Supporting Industries:

– The competitiveness of all related industries and suppliers to the firm

– A firm operating within a mass of related firms and industries gains and maintains advantages through close working relationships, proximity to suppliers and timeliness of product and information flows

– The constant and close interaction is successful when it occurs not only in terms of physical proximity but also through the firms willingness to work at it


THEORY• Firm Strategy, Structure and Rivalry:

– The conditions of the home nation that either hinder or aid in the firm’s creation and sustaining of international competitiveness

– No one managerial or operational strategy is universally appropriate

– It needs to be understood in context of the fitness and flexibility of what works for an industry in a certain nation at a specific time

THE THEORY OF INTERNATIONAL INVESTMENTS• It is a firm (not a country) and a buyer (not a country)

that are the subjects of trade whether domestic or international

• A firm attempts to access a market and its buyers

• The firm wants to utilize its competitive advantage for growth and profit and can reach this goal through international investments.

• Some other reasons might be:– Sales into a country are difficult due to high import tariffs– Need for natural resources that are available in the host country– Competition pushing for higher efficiency and lower costs of

production would lead a firm to go to a country where factors of production are cheaper

THE FOREIGN DIRECT INVESTMENT DECISION SEQUENCE

Firma and it’s Competitive Advantage

Change Competitive Advantage

Exploit Competitive Advantage Abroad

Produce at home (export)

Produce Abroad

Licensing Management

Contract

Control Assets Abroad

Joint VentureWholly Owned

Affiliate

Greenfield Investment

Acquire Foreign Enterprise

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THE THEORY OF INTERNATIONAL INVESTMENTS

Firms as Seekers:

– Seeking Resources :- Copper in Chile, Diamonds in Africa, Petroleum in the Middle East, Linseed oils from Indonesia

– Seeking Factor Advantages :- Resources could be accompanied by lower cost labor and other advantages inherent in the country of production

– Seeking Knowledge :- Acquire companies for their technical or competitive skills. Companies could also relocate around centers of industrial enterprise , Silicon Valley, Shoe manufacturing, etc

– Seeking Security :- Firms move internationally seeking political stability or security. NAFTA has helped Mexico in increasing trade with US and Canada

– Seeking Markets :- A great motivation for MNCs is the ability to gain and maintain access to newer markets.

THE THEORY OF INTERNATIONAL INVESTMENTSFirms as Exploiters of Imperfections:

• Most of the policies of governments create imperfections covering the entire range of supply and demand, trade policy, tax policies, incentives, restrictions, etc

– Imperfections in Access :- “Import Substitution Policies” which restrict imports of competitive products to allow smaller domestic firms to survive and prosper. MNCs have set up smaller firms in these countries.

– Imperfection in Factor Mobility :- Restriction by governments on the mobility of factors of production – low cost labor or capital. MNCs have exploited this through FDIs combining mobility of capital with immobility of low-cost labor

– Imperfections in Management :- Cost advantage, economies of scale, product differentiation, managerial or marketing technique and knowledge. MNCs have set up businesses using local management

THE THEORY OF INTERNATIONAL INVESTMENTS

Firms as Internalizers:

– MNCs normally focus on non-transferable sources of competitive advantage which is proprietary information possessed by the firm and its people

– Advantages center around their knowledge to produce a good r provide a service

– By establishing own multinational operations and by internalizing the production process, the firm ensures the information core to its competitiveness is kept confidential

– Management contracts or licensing agreements do not allow effective transmission of knowledge or are a threat to the loss of knowledge that leads to competitive advantage for the firm

Documents

Trade Theories