1. International Trade Theory

2. 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

3. Trade Theory-Overview
The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish).
Others are not so easy to understand (Japan and cars)
The history of Trade Theory and government involvement presents a mixed case for the role of government in promoting exports and limiting imports
Later theories appear to make a case for limited involvement

4. 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 export through subsidies
Minimize imports through tariffs and quotas
Flaw: “zero-sum game”

5. Mercantilism-Zero-Sum Game
In 1752, David Hume pointed out that:
Increased exports lead 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

6. Theory of Absolute Advantage
Adam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more of a product with the same amount of input than another country can vary
A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient
Trade between countries is, therefore, beneficial
Assumes there is an absolute balance among nations
Example: Ghana/cocoa

7. Theory of Absolute Advantage
Figure 5.1, p. 170

8. Absolute Advantage and the Gains From Trade
Table 5.1, p. 171

9. 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

10. Comparative Advantage
Theory of
Comparative Advantage
Figure 5.2, p. 173

11. Comparative Advantage and the Gains From Trade
Table 5.2, p. 173

12. Simple Extensions of the Ricardian Model
Immobile resources:
Resources do not always move easily from one economic activity to another
Diminishing returns:
Diminishing returns to specialization suggests that after some point, the more units of a good the country produces, the greater the additional resources required to produce an additional item
Different goods use resources in different proportions

13. Simple Extensions of the Ricardian Model
Free trade (open economies):
Free trade might increase a country’s stock of resources (as labor and capital arrives from abroad)
Increase the efficiency of resource utilization

14. PPF Under Diminishing Returns
Figure 5.3, p. 176

15. Influence of Free Trade on PPF
Fig. 5.4, p. 177

16. Heckscher (1919)-Olin (1933) Theory
Export goods that intensively use factor endowments which are locally abundant
Corollary: import goods made from locally scarce factors
Note: Factor endowments can be impacted by government policy - minimum wage
Patterns of trade are determined by differences in factor endowments - not productivity
Remember, focus on relative advantage, not absolute advantage

17. Product Life-Cycle Theory - R. Vernon (1966)
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

18. Product life cycle theory
Fig 4.5
Figure 5.5, p. 183

19. New Trade Theory In industries with high fixed costs:
Specialization increases output, and the ability to enhance economies of scale increases
Learning effects are high.
These are cost savings that come from “learning by doing”

20. New Trade Theory-Applications
Typically, requires industries with high, fixed costs
World demand will support few competitors
Competitors may emerge because of “ First-mover advantage”
Economies of scale may preclude new entrants
Role of the government becomes significant
Some argue that it generates government intervention and strategic trade policy

21. Theory of National Competitive Advantage
The theory attempts to analyze the reasons for a nation’s success in a particular industry
Porter studied 100 industries in 10 nations
Postulated determinants of competitive advantage of a nation were based on four major attributes
Factor endowments
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry

22. Porter’s Diamond Success occurs where these attributes exist
More/greater the attribute, the higher chance of success
The diamond is mutually reinforcing

23. Porter’s Diamond
Figure 5.6, p. 188

24. Factor Endowments
Factor endowments: A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry
Basic factor endowments
Advanced factor endowments

25. Basic Factor Endowments
Basic factors: Factors present in a country
Natural resources
Climate
Geographic location
Demographics
While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success

26. Advanced Factor Endowments
Advanced factors: The result of investment by people, companies, and government are more likely to lead to competitive advantage
If a country has no basic factors, it must invest in advanced factors

27. Advanced Factor Endowments
Communications
Skilled labor
Research
Technology
Education

28. Related and Supporting Industries
Creates clusters of supporting industries that are internationally competitive
Must also meet requirements of other parts of the Diamond

29. Porter’s Theory-Predictions
Porter’s theory should predict the pattern of international trade that we observe in the real world
Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable

30. Implications for Business
Location implications:
Disperse production activities to countries where they can be performed most efficiently
First-mover implications:
Invest substantial financial resources in building a first-mover, or early-mover advantage
Policy implications:
Promoting free trade is in the best interests of the home country, not always in the best interests of the firm, even though many firms promote open markets

31. Looking Ahead to Chapter 6
The Political Economy of International Trade
Instruments of Trade Policy
The Case for Government Intervention
The Revised Case for Free Trade
Development of the World Trading System