1. INTERNATIONAL TRADE THEORY
WEEK 2
INTERNATIONAL TRADE THEORY

2. Objectives To understand theories of international trade
To identify factors affecting national trade patterns
To explain why a country’s export capabilities are dynamic

3. Trade – is the voluntary exchange of goods, services, or money between one person or organization to another
Both parties must believe they will gain from the exchange

4. Why we need to study Trade Theory?
Trade theory helps managers and governmental policy makers focus on:
What products should we import and export ?
How much should we trade ?
With whom should we trade ?
Some theories explain trade patterns that exist in the absence of governmental interference.
Some theories explain what governmental actions should strive for trade.

5. Why we need to study 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

6. International Trade Theories
Interventionist trade theory
Mercantilism – 16th Century ( Thomas Mun)
Free Trade Theories
Absolute Advantage – 17th Century ( Adam Smith)
Comparative Advantage - 18th Century ( David Ricardo)
Factor-proportion theory - Hecksher-Ohlin Theory
The Statics and Dynamic of Trade
Production Life Cycle Theory
Porter’s Diamond-National Competitive Advantage

7. What the major trade theories Do and Don’t discuss

8. Interventionist trade theory (Mercantilism theory)
mid-16th century
Promote by Thomas Mun (1630)
Used by the economies from 1500 to 1800
Holding that a country’s wealth is measured by its holdings treasure usually gold and silver
Gold and silver are the currencies of trade
If foreigners by more goods from one country, the foreigners have to pay the country in gold and silver, enabling the country to increase its wealth.
Theory says country should have a trade surplus.
Should export more than import
Maximize export through subsidies.
Minimize imports through tariffs and quotas
To export more that import, government should restricted import and subsidized production.

9. Free Trade Theories (Theory of absolute advantage)
Adam Smith: Wealth of Nations (1776)
Concluded that:
Different countries produce some products more efficiently that others
A country should export goods and services for which it is more productive than other countries
A country should import goods and services for which other countries are more productive than it is
Free trade enables a country to expand goods and services by specializing in the production of goods and services.
Through specialization countries could increase their efficiency because:
Skilled labor – operate the same tasks
Reduce time - switching production
More incentive

10. Country has two advantages
Natural advantage – in producing product or services because of climate condition to natural resources, availability of labor forces (eg. Malaysia - Palm oil, rubber, Ghana – Cocoa)
Acquired advantage – have competitive in manufacturing good through process or technology. eg. product technology – produce unique products,

11. Absolute advantage and the gains from trade – how do efficiency work?
Assumes there is an absolute balance among nations. Example: Ghana/cocoa, Korea/rice
Ghana may produce:
20 ton cocoa or 10 rice. Or
10 ton cocoa and 5 ton rice
Korea may produce:
5 on cocoa or 20 ton rice Or
2.5 ton cocoa and 10 ton rice.
Total Productions: before
specialization
cocoa Rice
Ghana
Korea
Total
Total Productions: after
Ghana
Korea
Total
Assumptions:
200 resources are available in each country either to produce cocoa or rice
Ghana takes 10 resources to produce I ton cocoa & 20 resources to produce 1 tan rice.
Korea takes 40 resources to produce 1 ton cocoa & 10 resources to produce 1 ton rice.
No trade between both countries.
They consume all production.

12. Theory of absolute advantage- how do efficiency work?
Ghana has an absolute advantage of production in both cocoa and rice over Korea.
Ghana may produce:
20 ton cocoa or 10 rice. Or
10 ton cocoa and 5 ton rice
Korea may produce:
5 on cocoa or 20 ton rice Or
2.5 ton cocoa and 10 ton rice.
Total Productions: before specialization
cocoa Rice
Ghana
Korea
Total
Total Productions: after specialization
Ghana
Korea
Total

13. Free Trade Theories (Theory of comparative advantage)
David Ricardo: Principles of Political Economy (1817).
Country should produce and export those goods and services which it relatively more efficient at producing than other country.
Efficiency of resource utilization leads to more productivity.
Look to see how much more efficient. If only comparatively efficient, than import.
Makes better use of resources
Trade is a positive-sum game

14. Theory of comparative advantage
Fig 4.2

15. Comparative advantage and the gains from trade

16. Trade Pattern Theory - Heckscher & Olin Theory
The theory is based on country production factors (labor, land and capital)
Differences in countries endowments of labors compared to their endowment of lands or capital explain differences in the cost of productions factors
If surplus of labor compared to land and capital – labor cost would be low relative to land and capital costs.
Less labor – high labor cost than land and capitals

17. The Statics and Dynamic of Trade - Product life-cycle
Theory- Raymond. Vernon,(1966)
Location of production shift as they go through their life cycle
Affects the direction and flow of imports and exports
4 stages
Introduction
Growth
Maturity
Decline

18. The Diamond of National Advantage
The theory attempts to analyze the reasons for a nations success in a particular industry
Porter studied 100 industries in 10 nations
postulated determinants of competitive advantage of a nation were based on four faced of diamond
Factor conditions
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry
Success occurs where facets exist.

19. Determinants of Competitive Advantage in nations
Government
Company Strategy,
Structure,
and Rivalry
Demand
Conditions
Related
and Supporting
Industries
Factor
Chance
Two external factors that influence the four determinants.

20. Factor Condition
A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry
Basic and advanced conditions

21. Demand conditions Demand:
creates capabilities
creates sophisticated and demanding consumers
Demand impacts quality and innovation

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

23. Firm Strategy, Structure and Rivalry
Long term corporate vision is a determinant of success
Management ‘ideology’ and structure of the firm can either help or hurt you
Presence of domestic rivalry improves a company’s competitiveness

24. 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

25. 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

26. Test your understanding
Do you think international business theories are still relevant to the present condition of international business? Discuss
What is the major differences between Absolute Advantage and Comparative Advantage?
The Malaysian Government is currently promoting commercialization of agriculture based activities. In your opinion, is there any relevance theory of international business explain the rationales of the strategy adopted by the government. Discuss.