Module 5 in International Business and Trade

Title: International Trade Theory

Content/discussion

People around the world are accustomed to purchasing goods and services produced in other
countries. In fact, many consumers get their first taste of another country’s culture through
merchandise purchased from that country. Chanel perfume evokes the romanticism of France. The
fine artwork on Imari porcelain conveys the Japanese attention to detail and quality, and
American Eagle Jeans portray the casual lifestyle of people in the United States.

In this lesson, we explore international trade in goods and services. We begin by examining the
benefits, volume, and patterns of international trade.

BENEFITS

International trade provides people with a greater choice of goods and services. For example,
because Finland has a cool climate, it cannot be expected to grow cotton. But it can sell paper and
other products made from lumber (which it has in abundance) to the United States. Finland can
then use the proceeds from the sale of products derived from lumber to buy U.S. grown cotton.
Thus, people in Finland get cotton they otherwise would not have. Likewise, although the United
States has vast forests, the wood-based products from Finland might be of a certain quality that fills
a gap in the U.S. marketplace.

VOLUME

Most of world merchandise trade is composed of trade in manufactured goods. The dominance of
manufactured goods in the trade of merchandise has persisted over time and will likely continue to
do so. The reason is its growth is much faster than trade in the two other classifications of
merchandise – mining and agricultural products. Although the importance of trade in services is
growing for many nations, it tends to be relatively more important for the world’s richest countries.

PATTERNS

Exploring the volume of international trade and world output provides useful insights into the
international trade environment, but it does not tell us who trades with whom. It does not reveal
whether trade occurs primarily between the world’s richest nations or whether there is significant
trade activity involving poorer nations. Customs agencies in most countries record the destination
of exports, the source of imports, and the physical quantities and values of goods crossing their
borders. Customs data reflects overall trade patterns among nations, but this type of data is
sometimes misleading. For example, governments sometimes deliberately distort the reporting of
trade in military equipment or other sensitive goods. In other cases, extensive trade in unofficial
(underground) economies can distort the real picture of trade between nations.
MERCANTILISM

The trade theory that nations should accumulate financial wealth, usually in the form of gold, by
encouraging exports and discouraging imports is called mercantilism. It states that other
measures of a nation’s well-being, such as living standards or human development, are irrelevant.
The practice of mercantilism rested on three essential pillars: trade surpluses, government
intervention, and colonialism.

TRADE SURPLUSES

Nations believed they could increase their wealth by maintaining a trade surplus – the condition
that results when the value of a nation’s exports is greater than the value of its imports. In
mercantilism, a trade surplus means that a country takes in more gold on the sale of its exports
than it pays out for its imports. A trade deficit is the opposite condition – one that results when the
value of a country’s imports is greater than the value of its exports.

GOVERNMENT INTERVENTION

Governments actively intervened in international trade in order to maintain a trade surplus.

According to mercantilism, the accumulation of wealth depends on increasing a nation’s trade
surplus, not necessarily expanding its total value or volume of trade. The governments of
mercantilist nation did this by either banning certain imports or imposing various restrictions on
them, such as tariffs or quotas. At the same time, the nations subsidized industries based in the
home country in order to expand exports.

COLONIALISM

Mercantilist nations acquired territories (colonies) around the world to serve as sources of
inexpensive raw materials and as markets for higher-priced finished goods. These colonies were
the source of essential raw materials, including tea, sugar, tobacco, rubber and cotton. These
resources would be shipped to the mercantilist nation, where they were incorporated into finished
goods such as clothing, cigars, and other products. These finished goods would then be sold to
colonies. Trade between mercantilist countries and their colonies were a huge source of profits for
the mercantilist powers. The colonies received low prices for basic raw materials but paid higher
prices for finished goods.

INTERNATIONAL PRODUCT LIFE CYCLE

The international product life cycle theory follows the path of a good through its life cycle (from
new to maturing to standardized product) in order to determine where it will be produced.

In stage 1, the new product stage, the high purchasing power and demand of buyers in an
industrialized country drive a company to design and introduce a new product concept. Because
the exact level of demand in the domestic market is highly uncertain at this point, the company
keeps its production volume low and based in the home country. Keeping production where initial
research and development occurred and staying in contact with customers allow the company to
monitor buyer preferences and to modify the product as needed. Although initially there is no
export buyer, exports do begin to pick up late in the new product stage.

In stage 2, the maturing product stage, the domestic market and markets abroad become fully
aware of the existence of the product and its benefits. Demand rises and is sustained over a fairly
lengthy period of time. As exports begin to account for an increasingly greater share of total
product sales, the innovating company introduces production facilities in the countries with the
highest demand. Near the end of the maturity stage, the product begins generating sales in
developing nations, and perhaps some manufacturing presence is established there.

In stage 3, the standardized product stage, competition from other companies selling similar
products pressures companies to lower prices in order to maintain sales level. As the market
becomes more price sensitive, the company begins searching aggressively for low-cost production
bases in developing nations to supply a growing worldwide market. Furthermore, as most
production now takes place outside the innovating country, demand in the innovating country is
supplied with imports from developing countries and other industrialized nations.

THEORIES OF ABSOLUTE ADVANTAGE

The ability of a nation to produce a good more efficiently than any other nation is called an
absolute advantage. In other words, a nation with an absolute advantage can produce a greater
output of a good or service than other nations using the same amount of, or fewer resources.

THEORIES OF COMPARATIVE ADVANTAGE

A country has a comparative advantage when it is unable to produce a good more efficiently than
other nations but produces the good more efficiently than it does any other goods. In other words,
trade is still beneficial even if one country is less efficient in the production of two goods, as long as
it is less inefficient in the production of one of the goods.

NEW TRADE THEORY AND THE FIRST-MOVER ADVANTAGE

The new trade theory argues that, as specialization and output increase, companies realize
economies of scale that push the unit costs of production lower. This forces potential new entrants
to an industry to produce a similar level of output if they want to be competitive in their pricing.
The economies of scale in production help a firm to gain a first-mover advantage – the economic
and strategic advantage gained by being the first company to enter an industry.

FACTOR PROPORTIONS THEORY

The factor proportions theory states that countries produce and export goods that require
resources (factors) that are abundant, and import goods that require resources that are in short
supply. Factor proportions theory predicts that a country will specialize in products that require
labor if its cost is low relative to the cost of land and capital, and vice versa. The apparent paradox
between predictions of the theory and actual trade flows is called the Leontief Paradox.
NATIONAL COMPETITIVE ADVANTAGE THEORY AND THE PORTER DIAMOND

National competitive advantage theory states that a nation’s competitiveness in an industry (and
therefore, trade flows) depends on the capacity of the industry to innovate and upgrade. The
porter diamond identifies four elements that form the basis of national competitiveness: (1) factor
conditions (basic and advanced), (2) demand conditions, (3) related and supporting industries, and
(4) firm strategy, structure, and rivalry. The actions of governments and the occurrence of chance
events can also affect the competitiveness of a nation’s companies.

REVIEW ITEMS

ENUMERATION:

International business trade

• Benefits
• Volume
• Patterns

Two other classifications of merchandise

• Mining
• Agricultural products

The practice of mercantilism rested on 3 essential pillars

• Trade surpluses
• Government intervention
• Colonialism

Mercantilism banning certain imports or imposing various restrictions

• Tariffs or quotas

Sources of inexpensive raw materials

• Tea
• Sugar
• Tobacco
• Rubber
• Cotton

Finished goods

• Clothing
• Cigars
• Other products
International product life cycle theory

• The new product stage

• The maturing product stage
• The standardized product stage

The porter diamond identifies 4 elements

• Factor conditions (basic and advanced)

• Demand conditions
• Related and supporting industries
• Firm strategy, structure, and rivalry

another country’s culture through merchandise purchased

• Chanel perfume evokes the romanticism of France.

• The fine artwork on Imari porcelain conveys the Japanese
• American Eagle Jeans portray the casual lifestyle of people in the United States

IDENTIFICATION

Benefits - International trade provides people with a greater choice of goods and services.

Volume - Most of world merchandise trade is composed of trade in manufactured goods.

Patterns - Exploring the volume of international trade and world output provides useful insights
into the international trade environment, but it does not tell us who trades with whom.

Mercantilism - The trade theory that nations should accumulate financial wealth, usually in the
form of gold, by encouraging exports and discouraging imports.

Trade Surplus - the condition that results when the value of a nation’s exports is greater than the
value of its imports. Nations believed they could increase their wealth by maintaining a trade
surplus.

Colonialism - Mercantilist nations acquired territories (colonies) around the world to serve as
sources of inexpensive raw materials and as markets for higher-priced finished goods.

Government Intervention - actively intervened in international trade in order to maintain a trade

surplus.

International Product Life Cycle - follows the path of a good through its life cycle (from new to
maturing to standardized product) in order to determine where it will be produced.

New product stage - the high purchasing power and demand of buyers in an industrialized country
drive a company to design and introduce a new product concept.
Maturing product stage - the domestic market and markets abroad become fully aware of the
existence of the product and its benefits.

Standardized Product Stage - competition from other companies selling similar products
pressures companies to lower prices in order to maintain sales level.

Absolute Advantage - The ability of a nation to produce a good more efficiently than any other
nation is called an absolute advantage.

Comparative Advantage - unable to produce a good more efficiently than other nations but
produces the good more efficiently than it does any other goods. Trade is still beneficial even if one
country is less efficient in the production of two goods, as long as it is less inefficient in the
production of one of the goods.

New Trade Theory – as specialization and output increase, companies realize economies of scale
that push the unit costs of production lower.

First-mover advantage - the economic and strategic advantage gained by being the first company
to enter an industry.

Factor Proportions Theory - states that countries produce and export goods that require
resources (factors) that are abundant, and import goods that require resources that are in short
supply. Predicts that a country will specialize in products that require labor if its cost is low relative
to the cost of land and capital, and vice versa

Leontief Paradox - The apparent paradox between predictions of the theory and actual trade
flows.

National Competitive Advantage Theory - a nation’s competitiveness in an industry (and

therefore, trade flows) depends on the capacity of the industry to innovate and upgrade.

Customs agencies - in most countries record the destination of exports, the source of imports, and
the physical quantities and values of goods crossing their borders.

Customs data - reflects overall trade patterns among nations, but this type of data is sometimes
misleading.

Trade deficit - is the opposite condition. One that results when the value of a country’s imports is
greater than the value of its exports.