UNIVERSITY OF SOUTHERN MINDANAO

International Trade Theory

Prepared by: R. Panaguiton

Business Administration Department
College of Business, Development Economics, and Management
 Chapter Objectives
1. Understand why nations trade with each other.
2. Summarize the different theories explaining trade flows
between nations.
3. Recognize why many economists believe that unrestricted
free trade between nations will raise the economic welfare of
countries that participate in a free trade system.
4. Explain the arguments of those who maintain that government
can play a proactive role in promoting national competitive
advantage in certain industries.
5. Understand the important implications that international trade
theory holds for business practice.
Insert Running Title 2
 Why Is Free Trade Beneficial?
•Free trade - a situation where 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
•Trade theory shows why it is beneficial for a country to
engage in international trade even for products it is able
to produce for itself
 Why Is Free Trade Beneficial?

•International trade allows a country

•to specialize in the manufacture and export of
products and services that it can produce efficiently
•import products and services that can be produced
more efficiently in other countries
•limits on imports may be beneficial to producers, but
not beneficial for consumers
 Why Do Certain
Patterns of Trade Exist?
•Some patterns of trade are fairly easy to explain
• it is obvious why Saudi Arabia exports oil, Ghana
exports cocoa, and Brazil exports coffee
•But, why does Switzerland export chemicals,
pharmaceuticals, watches, and jewelry?
•Why does Japan export automobiles, consumer
electronics, and machine tools?
 What Role Does
Government Have In Trade?
•The mercantilist philosophy makes a crude case for
government involvement in promoting exports and
limiting imports
•Smith, Ricardo, and Heckscher-Ohlin promote
unrestricted free trade
•New trade theory and Porter’s theory of national
competitive advantage justify limited and selective
government intervention to support the development of
certain export-oriented industries
 What Is Mercantilism?

•Mercantilism (mid-16th century) suggests that it is in a

country’s best interest to maintain a trade surplus -to
export more than it imports
•advocates government intervention to achieve a
surplus in the balance of trade
•Mercantilism views trade as a zero-sum game - one in
which a gain by one country results in a loss by another
 What Is Smith’s Theory
Of Absolute Advantage?
•Adam Smith (1776) argued that a country has an
absolute advantage in the production of a product when
it is more efficient than any other country in producing it
•countries should specialize in the production of goods
for which they have an absolute advantage and then
trade these goods for goods produced by other
countries
 How Does The Theory
Of Absolute Advantage Work?

•Assume that two countries, Ghana and South Korea,

both have 200 units of resources that could either be
used to produce rice or cocoa
•In Ghana, it takes 10 units of resources to produce one
ton of cocoa and 20 units of resources to produce one
ton of rice
•Ghana could produce 20 tons of cocoa and no rice, 10
tons of rice and no cocoa, or some combination of rice
and cocoa between the two extremes
 How Does The Theory
Of Absolute Advantage Work?
•In South Korea it takes 40 units of resources to produce
one ton of cocoa and 10 resources to produce one ton
of rice
•South Korea could produce 5 tons of cocoa and no
rice, 20 tons of rice and no cocoa, or some
combination in between
 How Does The Theory
Of Absolute Advantage Work?
•Without trade
•Ghana would produce 10 tons of cocoa and 5 tons of
rice
•South Korea would produce 10 tons of rice and 2.5
tons of cocoa
•With specialization and trade
•Ghana would produce 20 tons of cocoa
•South Korea would produce 20 tons of rice
•Ghana could trade 6 tons of cocoa to South Korea for
6 tons of rice
 How Does The Theory
Of Absolute Advantage Work?
•After trade
•Ghana would have 14 tons of cocoa left, and 6 tons of
rice
•South Korea would have 14 tons of rice left and 6 tons
of cocoa
•If each country specializes in the production of the good
in which it has an absolute advantage and trades for the
other, both countries gain
•trade is a positive sum game
How Does The Theory
Of Absolute Advantage Work?
Absolute Advantage and the Gains from Trade
 What Is Ricardo’s Theory
Of Comparative Advantage?

•David Ricardo asked what happens when one country

has an absolute advantage in the production of all
goods
•The theory of comparative advantage (1817) - countries
should specialize in the production of those goods they
produce most efficiently and buy goods that they
produce less efficiently from other countries
•even if this means buying goods from other countries
that they could produce more efficiently at home
 How Does The Theory Of Comparative
Advantage Work?

•Assume Ghana is more efficient in the production of

both cocoa and rice
•In Ghana, it takes 10 resources to produce one ton of
cocoa, and 13 1/3 resources to produce one ton of rice
•So, Ghana could produce 20 tons of cocoa and no rice,
15 tons of rice and no cocoa, or some combination of
the two
 How Does The Theory Of Comparative
Advantage Work?

•In South Korea, it takes 40 resources to produce one

ton of cocoa and 20 resources to produce one ton of
rice
•So, South Korea could produce 5 tons of cocoa and no
rice, 10 tons of rice and no cocoa, or some combination
of the two
 How Does The Theory Of Comparative
Advantage Work?

•With trade
•Ghana could export 4 tons of cocoa to South Korea in
exchange for 4 tons of rice
•Ghana will still have 11 tons of cocoa, and 4 additional
tons of rice
•South Korea still has 6 tons of rice and 4 tons of cocoa
•if each country specializes in the production of the
good in which it has a comparative advantage and
trades for the other, both countries gain
 How Does The Theory Of Comparative
Advantage Work?

•Comparative advantage theory provides a strong

rationale for encouraging free trade
•total output is higher
•both countries benefit
•Trade is a positive sum game
How Does The Theory Of Comparative
Advantage Work?

Comparative Advantage and the Gains from Trade

 Is Unrestricted Free Trade
Always Beneficial?
• Unrestricted free trade is beneficial, but the gains may not be as great as
the simple model of comparative advantage would suggest
• immobile resources
• diminishing returns
• dynamic effects and economic growth
• the Samuelson critique
• But, opening a country to trade could increase
• a country's stock of resources as increased supplies become available
from abroad
• the efficiency of resource utilization and so free up resources for other
uses
• economic growth
 Could A Rich Country Be
Worse Off With Free Trade?
•Paul Samuelson - the dynamic gains from trade may not
always be beneficial
•free trade may ultimately result in lower wages in the
rich country
•The ability to offshore services jobs that were
traditionally not internationally mobile may have the
effect of a mass inward migration into the United States,
where wages would then fall
•but, protectionist measures could create a more
harmful situation than free trade
 What Is The
Heckscher-Ohlin Theory?

•Eli Heckscher (1919) and Bertil Ohlin (1933) -

comparative advantage arises from differences in
national factor endowments
• the extent to which a country is endowed with
resources like land, labor, and capital
•The more abundant a factor, the lower its cost
 What Is The
Heckscher-Ohlin Theory?

•The pattern of trade is determined by factor

endowments
•Heckscher and Ohlin predict that countries will
•export goods that make intensive use of locally
abundant factors
•import goods that make intensive use of factors that
are locally scarce
 Does The Heckscher-Ohlin
Theory Hold?

•Wassily Leontief (1953) theorized that since the U.S.

was relatively abundant in capital compared to other
nations, the U.S. would be an exporter of capital
intensive goods and an importer of labor-intensive
goods.
•However, he found that U.S. exports were less capital
intensive than U.S. imports
•Since this result was at variance with the predictions of
trade theory, it became known as the Leontief Paradox
 What Is The
Product Life Cycle Theory?

•The product life-cycle theory - as products mature both

the location of sales and the optimal production location
will change affecting the flow and direction of trade
•proposed by Ray Vernon in the mid-1960s
•At this time most of the world’s new products were
developed by U.S. firms and sold first in the U.S.
 What Is The
Product Life Cycle Theory?
• According to the product life-cycle theory
• the size and wealth of the U.S. market gave U.S. firms a
strong incentive to develop new products
• initially, the product would be produced and sold in the U.S.
• as demand grew in other developed countries, U.S. firms
would begin to export
• demand for the new product would grow in other advanced
countries over time making it worthwhile for foreign producers
to begin producing for their home markets
 What Is The
Product Life Cycle Theory?
•U.S. firms might set up production facilities in advanced
countries with growing demand, limiting exports from the
U.S.
•As the market in the U.S. and other advanced nations
matured, the product would become more standardized,
and price would be the main competitive weapon
 What Is The
Product Life Cycle Theory?
•Producers based in advanced countries where labor
costs were lower than the United States might now be
able to export to the United States
•If cost pressures were intense, developing countries
would acquire a production advantage over advanced
countries
•Production became concentrated in lower-cost foreign
locations, and the U.S. became an importer of the
product
What Is The
Product Life Cycle Theory?
The Product Life Cycle Theory
 Does The Product Life
Cycle Theory Hold?

•The product life cycle theory accurately explains what

has happened for products like photocopiers and a
number of other high technology products developed in
the United States in the 1960s and 1970s
•mature industries leave the U.S. for low cost assembly
locations
 Does The Product Life
Cycle Theory Hold?

•But, the globalization and integration of the world

economy has made this theory less valid today
•the theory is ethnocentric
•production today is dispersed globally
•products today are introduced in multiple markets
simultaneously
 What Is New Trade Theory?
• New trade theory suggests that the ability of firms to
gain economies of scale (unit cost reductions
associated with a large scale of output) can have
important implications for international trade
• Countries may specialize in the production and export
of particular products because in certain industries, the
world market can only support a limited number of
firms
• new trade theory emerged in the 1980s
• Paul Krugman won the Nobel prize for his work in
2008
 What Is New Trade Theory?

1. Through its impact on economies of scale, trade can increase

the variety of goods available to consumers and decrease the
average cost of those goods
• without trade, nations might not be able to produce those
products where economies of scale are important
• with trade, markets are large enough to support the
production necessary to achieve economies of scale
• so, trade is mutually beneficial because it allows for the
specialization of production, the realization of scale
economies, and the production of a greater variety of
products at lower prices
 What Is New Trade Theory?

2. In those industries when output required to attain

economies of scale represents a significant proportion
of total world demand, the global market may only be
able to support a small number of enterprises
• first mover advantages - the economic and strategic
advantages that accrue to early entrants into an
industry
• economies of scale
• first movers can gain a scale based cost advantage
that later entrants find difficult to match
 What Are The Implications Of
New Trade Theory For Nations?

•Nations may benefit from trade even when they do not

differ in resource endowments or technology
•a country may dominate in the export of a good simply
because it was lucky enough to have one or more
firms among the first to produce that good
•Governments should consider strategic trade policies
that nurture and protect firms and industries where first
mover advantages and economies of scale are
important
 What Is Porter’s Diamond Of
Competitive Advantage?
• Michael Porter (1990) tried to explain why a nation
achieves international success in a particular industry
• 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)
 What Is Porter’s Diamond Of
Competitive Advantage?
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
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
 What Is Porter’s Diamond Of
Competitive Advantage?

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
 What Is Porter’s Diamond Of
Competitive Advantage?
Determinants of National Competitive Advantage: Porter’s Diamond
 Does Porter’s Theory Hold?
•Government policy can
•affect demand through product standards
•influence rivalry through regulation and antitrust laws
•impact the availability of highly educated workers and
advanced transportation infrastructure.
•The four attributes, government policy, and chance work
as a reinforcing system, complementing each other and
in combination creating the conditions appropriate for
competitive advantage
•So far, Porter’s theory has not been sufficiently tested to
know how well it holds up
 What Are The Implications Of Trade Theory
For Managers?

1. Location implications - a firm should disperse its various

productive activities to those countries where they can be
performed most efficiently
• firms that do not may be at a competitive disadvantage
2. First-mover implications - a first-mover advantage can help a
firm dominate global trade in that product
3. Policy implications - firms should work to encourage
governmental policies that support free trade
• want policies that have a favorable impact on each
component of the diamond
 What Is The
Balance Of Payments?
• A country’s balance of payments accounts keep track
of the payments to and receipts from other countries
for a particular time period
• double entry bookkeeping
• sum of the current account balance, the capital
account and the financial account should be zero
 What Is The
Balance Of Payments?
• There are three main accounts
1. The current account records transactions of goods, services,
and income, receipts and payments
• current account deficit - a country imports more than it
exports
• current account surplus – a country exports more than it
imports
2. The capital account records one time changes in the stock of
assets
3. The financial account records transactions that involve the
purchase or sale of assets
• net change in U.S. assets owned abroad
• foreign owned assets in the U.S.
What Is The
Balance Of Payments?
United States Balance of Payments Accounts, 2010
 Is A Current
Account Deficit Bad?
• Question: Does current account deficit in the United States
matter?
• A current account deficit implies a net debtor
• so, a persistent deficit could limit future economic growth
• But, even though capital is flowing out of the U.S. as payments
to foreigners, much of it flows back in as investments in assets
• Yet, suppose foreigners stop buying U.S. assets and sell their
dollars for another currency
• a dollar crisis could occur
 References
[1] Geringer, M., McNett, J., Minor, M., & Ball, D. (2015). International Business -
Standalone book (1st ed.). McGraw-Hill Education.
[2] Griffin, R., & Pustay, M. (2014). International Business: A Managerial Perspective
(8th ed.). Pearson.
[3] Hill, C. (2014). International Business: Competing in the Global Marketplace (9th
ed.). McGraw-Hill Education.
[4] Hill, C., & Hult, T. G. M. (2018). International Business: Competing in the Global
Marketplace (12th ed.). McGraw-Hill Education.
[5] Hill, J. (2008). International Business: Managing Globalization. SAGE Publications,
Inc.