1. International Trade Theory
Chapter 5
International
Trade Theory
Chapter 5: International Trade Theory

2. Introduction International trade theory
explains why it is beneficial for countries to engage in international trade
helps countries formulate their economic policy
explains the pattern of international trade in the world economy
You already know that countries trade with each other, but do you know why they trade? U.S. manufacturers know how to make clothing, in fact, much of clothing worn by Americans used to be made in the U.S. Now, however, the U.S. buys a lot of its textiles from places like Honduras and Guatemala. Why does Ford assemble cars made for the American market in Mexico, while BMW and Nissan manufacture cars for Americans in the U.S.?
These are questions that economists have tried to answer for many years, and in this chapter we’ll look at patterns of trade and explore some of the theories that have been used to explain those patterns.

3. An Overview of Trade Theory
Question: What is free trade?
Answer:
Free trade refers to 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
First though, let’s answer the question of what we mean by free trade. Free trade refers to 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. In other words, goods and services are allowed to cross borders without any restrictions.

4. An Overview of Trade Theory
Question: How has international trade theory evolved?
Answer:
Mercantilism (16th and 17th centuries) encouraged exports and discouraged imports
Adam Smith (1776) promoted unrestricted free trade
David Ricardo (19th century) built on Smith ideas
Eli Heckscher and Bertil Ohlin (20th century ) refined Ricardo’s work
We’ll begin our discussion with a look at mercantilism, a 16th and 17th century philosophy that encouraged countries increase exports and limit imports. Then, we’ll go on to the theories advocated by Adam Smith and David Ricardo who promoted the notion of free trade, or a situation where government allows market forces to work, and doesn’t intervene with quotas or duties to influence what citizens can buy from other countries, or sell to other countries. Their work was later extended by Eli Heckscher and Bertil Ohlin.

5. The Benefits of Trade Answer:
Question: Why is it beneficial for countries to engage in free trade?
Answer:
International trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, and import products that can be produced more efficiently in other countries
it is beneficial for a country to engage in international trade even for products it is able to produce for itself
The main point that Smith, Ricardo, and Heckscher-Ohlin made is that it’s beneficial for countries to trade with each other, even when they could be self-sufficient. So, they try to answer the question that we asked above—why should the U.S. buy textiles from other countries when it could produce them itself? As we’ll explain, Smith, Ricardo, and Heckscher-Ohlin showed that if countries specialized in the production and export of products that they produced most efficiently, they could trade for products that could be produced more efficiently in other countries. You might also recall from the Opening Case that free trade and globalization have helped Bangladesh thrive.

6. The Pattern of International Trade
International trade theory helps explain trade patterns
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?
You might think that some of these trade patterns are easy to explain, and you’d be right! We know why Saudi Arabia exports oil for example, the country is endowed with tremendous natural resources! But, why does Japan export cars and consumer electronics? Why does Switzerland export pharmaceuticals and watches? These trade patterns are more difficult to explain!

7. Trade Theory and Government Policy
While the theories all suggest that trade is beneficial, they lack agreement in their recommendations for government policy
Mercantilism makes a case for government involvement in promoting exports and limiting imports
Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade
New trade theory and Porter justify limited and selective government intervention to support the development of certain export-oriented industries
So, while all of the theories were trying to explain trade, they differed in how they viewed the role of government. Mercantilism suggested that government should be involved in helping to promote exports and limit imports, while Smith, Ricardo, and Heckscher-Ohlin argued that government should stay out of trade and market forces should influence how countries trade.
Krugman and Porter fall somewhere between these positions. They argue that the government should intervene in the markets in a limited way that helps support the development of certain export-oriented industries.

8. Mercantilism
Mercantilism (mid-16th century) - it is in a country’s best interest to maintain a trade surplus - to export more than it imports
it advocated government intervention to achieve a surplus in the balance of trade
it viewed trade as a zero-sum game (one in which a gain by one country results in a loss by another)
Mercantilism is problematic and not economically valid, yet many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade
So, now that you have an overview of the various theories, let’s look at them in more depth. We’ll start with mercantilism.
As we said before, the mercantilist philosophy was around in the mid-16th century. The main idea of the philosophy was that the accumulation of gold and sliver were essential to the wealth, and power of a nation. So, it was in the best interests of a country to try to maximize its holdings of gold and silver by encouraging exports and discouraging imports.
In order to achieve this goal, the philosophy advocated intervention in the market by the government. Typically, this meant that imports were limited through tariffs and quotas, while exports were maximized through government subsidies.
A key flaw in the philosophy however, was that it was a zero-sum game. A country could only achieve its goal of maximizing a trade surplus at the expense of another nation. In other words, if one country successfully exported more than it imported, and consequently increased its holdings of gold and silver, another country would fail to achieve a trade surplus. This other country would in fact buy more than it sold, see its gold and silver leave the country, and become a weaker nation!
Even with these flaws, the mercantilist philosophy still persists. Countries like China and Japan have been accused of following a neo-mercantilist philosophy. Today, for example, China is under considerable fire for intervening in the market to keep its currency value low relative to the U.S. dollar making it easier to sell its products to the U.S., and making it harder for American companies to sell their products to China. We’ll talk more about how this works in later chapters, but for now, you can learn more about it in the Country Focus in your text.

9. Absolute Advantage
Smith (1776) - countries differ in their ability to produce goods efficiently
A country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it
According to Smith
trade is not a zero-sum game
countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries
In 1776, Adam Smith, in his landmark book, The Wealth of Nations, challenged the mercantilist philosophy and its zero-sum approach to trade. Smith argued that free trade, or trade without government intervention, could be beneficial to countries if each country produced and exported those products in which it was most efficient, or in his words, those products in which the country had an absolute advantage. Smith argued that if countries specialized in the production of goods in which they had an absolute advantage they could then trade these goods for the goods produced by other countries.

10. Absolute Advantage
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
So, 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
Let’s look at an example of what Smith meant.
Assume that two countries, Ghana and South Korea, both have 200 units of resources that they could use either to produce rice or to produce cocoa.
Now, suppose that 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. What could Ghana produce?
Well, Ghana could use all of its resources to produce 20 tons of cocoa, or it could put all of its resources into the production of 10 tons of rice. Or, Ghana could produce some combination of rice and cocoa.

11. Absolute Advantage
In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice
So, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between
Ghana has an absolute advantage in the production of cocoa
South Korea has an absolute advantage in the production of rice
What about South Korea? Suppose in South Korea that it takes 40 units of resources to produce one ton of cocoa, and 10 units of resources to produce one ton of rice.
South Korea’s production options then are to devote all of its resources to producing 5 tons of cocoa, or all of its resources to producing 20 tons of rice, or to share its resources and produce some combination of rice and cocoa.
Based on this information, we would say that Ghana has an absolute advantage in the production of cocoa—it is more efficient at producing cocoa than South Korea. Remember, more resources are needed to produce a ton of cocoa in South Korea than in Ghana. You’ve probably guessed that South Korea then has an absolute advantage in the production of rice.

12. Absolute Advantage 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
If each country specializes in the product in which it has an absolute advantage and trades for the other product
Ghana would produce 20 tons of cocoa
South Korea would produce 20 tons of rice
So, we’ve got these two countries that could be self-sufficient and produce their own rice and cocoa. Let’s suppose that they choose to do so, and that Ghana uses its resources to produce 10 tons of cocoa and 5 tons of rice. South Korea might use its resources to produce 10 tons of rice and 2 and half tons of cocoa. So, both countries have the option of consuming both products.
Now, let’s think about Adam Smith’s ideas of specializing in what you do best and trading for other products. Would this help Ghana and South Korea?
Well, if Ghana specializes in producing cocoa, it would devote all of its resources to cocoa production and produce 20 tons of cocoa. South Korea’s absolute advantage was in the production of rice, so it would devote all of its resources to produce 20 tons of rice.

13. Absolute Advantage Suppose
Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice
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
Both countries gained from trade
Now, suppose Ghana traded 6 tons of its 20 tons of cocoa to South Korea in exchange for 6 tons of South Korea’s 20 tons of rice. Are the countries better off? Was trade beneficial?

14. Comparative Advantage
Ricardo’s theory of comparative advantage - a country should specialize in the production of those goods that it produces most efficiently and buy the goods that it produces less efficiently from other countries
You may be thinking that Smith’s ideas are great if you’ve got two countries where one is clearly better at producing one product and the other is clearly more efficient at producing the other product. But what happens if one country has an absolute advantage in the production of all products? Is trade still beneficial?
In 1817, David Ricardo tried to answer these questions with his theory of comparative advantage. He argued that at it still makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.

15. The Gains from Trade
The theory of comparative advantage - trade is a positive sum gain in which all gain
potential world production is greater with unrestricted free trade than it is with restricted trade
provides a strong rationale for encouraging free trade
Why should it trade with South Korea? Ricardo argued that it’s still beneficial for Ghana to trade because it has a comparative advantage in the production of cocoa. In other words, while Ghana can produce more cocoa and more rice than South Korea, it can produce 4 times as much cocoa, and only one and a half times as much rice. Ghana is comparatively more efficient at producing cocoa! With trade both countries gain.

16. Extensions of the Ricardian Model
The Link between Trade and Growth
Countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade
higher growth rates raise income levels and living standards
However, one of the leading economists of the twentieth century, Paul Samuelson, argued that dynamic gains from trade can sometimes lead to negative outcomes.
When Samuelson looked at what happened when a rich country like the U.S. entered into a free trade agreement with a poor country like China that achieved rapid gains after entering into the agreement, Samuelson found that the rich country might actually lose! In our example, the losses would occur because real wage rates in the U.S. would fall as a result of the free trade agreement and the cheaper prices it meant on imported products.
Samuelson is particularly concerned with the trend to offshore service jobs that have traditionally not been mobile. He believes the effect of this trend will be similar to a mass inward migration to the U.S. You can learn more about this trend in the Country Focus in your text.
Despite concerns like those of Samuelson, studies show that there is a link between trade and economic growth. Specifically, countries that adopt a more open stance toward international trade tend to have higher growth rates than those that close their economies to trade.

17. Heckscher-Ohlin Theory
Heckscher and Ohlin - comparative advantage arises from differences in national factor endowments (the extent to which a country is endowed with resources such as land, labor, and capital)
the more abundant a factor, the lower its cost
countries will export goods that make intensive use of those factors that are locally abundant, and import goods that make intensive use of factors that are locally scarce
Now, let’s move on to look at another theory of trade. Eli Heckscher and Bertil Ohlin extended Ricardo’s work by suggesting that a country’s comparative advantage is a result of differences in national factor endowments.
Heckscher and Ohlin argued that countries will export goods that make intensive use of factors of production like land, labor, and capital that are locally abundant. At the same time, countries will import goods that make intensive use of factors that are locally scarce. So, a country like China with abundant low-cost labor will produce and export products that are labor intensive like textiles, while the U.S., which lacks abundant low cost labor, imports textiles from China.
Note that this theory explains trade patterns using differences in factor endowments, while Ricardo explains trade patterns using differences in productivity.

18. The Leontief Paradox
Leontief (1953) - since the U.S. was relatively abundant in capital, it would be an exporter of capital intensive goods and an importer of labor-intensive goods
Leontief found however, that U.S. exports were less capital intensive than U.S. imports
Possible explanations for these findings include
that the U.S. has a special advantage in producing products made with innovative technologies that are less capital intensive
differences in technology lead to differences in productivity which then drives trade patterns
In 1953, Wassily Leontief tested the Heckscher-Ohlin theory. Leontief suggested that since the U.S. was relatively abundant in capital compared to other countries, the U.S. should export capital intensive goods, and import labor intensive goods.
If you think Leontief was right with his hypothesis, you’re wrong! Leontief, contrary to what common sense would tell us, actually found that U.S. exports were less capital intensive than U.S. imports. His findings have come to be known as the Leontief Paradox.

19. The Product Life Cycle Theory
Vernon (mid-1960s ) proposed 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
the wealth and size of the U.S. market gave a strong incentive to U.S. firms to develop new products
In the early stages of a product’s life cycle demand may grow in the U.S., but demand in other advanced countries is limited to high-income groups
it is not worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the U.S. to those countries
Do you know why some products that used to be made at home are now made in other countries, especially less developed ones? The answer to this question may lie in where the product is in its life cycle.
The product life cycle theory which was developed in the mid-1960s by Ray Vernon who suggested that as products mature, both the sales location, and the optimal production location will change, and of course, as these change, so will the flow and direction of trade. In other words, products move through different stages over their life, and as they do, where they are produced and sold change, too. Let’s look at this process more carefully.
Vernon observed, at the time, that most of the world’s new products were developed by American firms and sold initially in the U.S. He attributed this to the wealth and size of the U.S. market. Vernon argued that rather than producing these new products in other countries, manufacturers preferred to produce them locally to be closer to the market, and to the firm’s decision making.
Vernon suggested that while demand was growing in the U.S., there would be only limited demand by high-income consumers in other advanced countries. Therefore, there would be little incentive for firms in the foreign countries to produce the product, and the other developed markets would be served by exports from the U.S.

20. The Product Life Cycle Theory
Over time, demand for the new product starts to grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets
U.S. firms might also set up production facilities in those advanced countries where demand is growing limiting the exports from the U.S.
As the market in the U.S. and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon
Over time, as demand for the new product grew in other advanced countries, Vernon argued that foreign producers would begin to produce the product. U.S. producers, in an effort to capitalize on foreign demand, would also begin to produce in the foreign markets. So, what’s happened to trade flows? Well, exports from the U.S. slowed down as they were replaced by foreign production.
As the U.S. market and the foreign markets matured, the product became more standardized, and price became more important to consumers.

21. The Product Life Cycle Theory
Producers based in advanced countries where labor costs are lower than the United States might now be able to export to the U.S.
If cost pressures become intense, developing countries begin to acquire a production advantage over advanced countries
The United States switches from being an exporter of the product to an importer of the product as production becomes more concentrated in lower-cost foreign locations
Some foreign producers with lower wage costs exported to the U.S. market during this stage.
Later, production shifted to developing countries where wages were even lower, and the U.S. became an importer of the product.

22. The Product Life Cycle Theory
Figure 5.5: The Product Life Cycle
So, we see that over the life cycle of the product, there’s a shift from exports from the U.S., to production in foreign developed countries, to production in developing countries, and exports from the developing countries to the U.S.

23. Evaluating The Product Life Cycle Theory
While 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 US in the 1960s and 1970s, the increasing globalization and integration of the world economy has made this theory less valid in today's world
today, many new products are initially introduced in Japan or Europe, or are introduced simultaneously in the U.S., Japan, and Europe
production may also be dispersed to those locations where it is most favorable
You may be thinking that this theory doesn’t really seem valid anymore, and you’d be right! While the product life cycle was useful for explaining trade patterns for products like photocopiers that were developed in the 1960s and 1970s, today, given the effects of globalization and the integration of the world economy, the theory doesn’t hold up well.
Today, you can think of many products that were designed and introduced outside the U.S., like videogame consoles that were initially introduced in Japan, or Europe’s wireless phones. In addition, many products are introduced simultaneously in the U.S., Japan, and Europe. Production of these new products is often globally dispersed from the start.

24. New Trade Theory New trade theory (1970s) suggests
Because of economies of scale (unit cost reductions associated with a large scale of output), trade can increase the variety of goods available to consumers and decrease the average cost of those goods
Now, let’s move on to new trade theory. This theory, which was developed in the 1970s, argued that because of the unit cost reductions that are associated with a large scale of output, some industries can support only a few firms. We call the cost reductions economies of scale.
Achieving economies of scale can be very important to firms. Microsoft for example, is able to spread the costs of developing new versions of Windows over millions of PCs. However, in some industries, in order to achieve economies of scale, firms have to have a major share of the world’s market. For example, the costs of developing new aircraft are so high, that firms have to hold a significant share of the world market in order to gain economies of scale. Remember, that there are only two makers of large commercial aircraft in the world!
The theory also looks at the role of first mover advantages, or the economic and strategic advantages achieved by some firms. Firms that achieve first mover advantages will develop economies of scale, and create barriers to entry for other firms. In 2007, for example, American law firm, McDermott Will & Emery teamed up with a Chinese law company to provide legal assistance to both Western firms doing business in China, and Chinese firms doing business in the West. The venture is the first of its kind, and McDermott is hoping that by being in the market ahead of the curve and signing on customers, it will gain an advantage over other companies that get into the market later.

25. Increasing Product Variety and Reducing Costs
Without trade
a small nation may not be able to support the demand necessary for producers to realize required economies of scale, and so certain products may not be produced
With trade
a nation may be able to specialize in producing a narrower range of products and then buy the goods that it does not make from other countries
each nation then simultaneously increases the variety of goods available to its consumers and lowers the costs of those goods
So, what does all of this mean? Well, suppose we live in a world without trade. Small markets might find that they don’t have certain products available if producers can’t sell enough to achieve economies of scale, or if the products are available, prices will probably be very high.
But, if countries trade with each other, markets are bigger, and firms have the opportunity to sell enough to achieve scale economies. Consumers have more choice and lower prices!

26. Economies of Scale and First Mover Advantages
Firms with first mover advantages (the economic and strategic advantages that accrue to many entrants into an industry) will develop economies of scale and create barriers to entry for other firms
We also need to consider the effect of first mover advantages because the pattern of trade we see in the world economy may be the result of first mover advantages and economies of scale.
Companies that can achieve economies of scale ahead of other firms, and so have a lower cost structure, have important first mover advantages. Airbus is currently enjoying the first mover advantages associated with its super jumbo plane. Airbus has to sell at least 250 super jumbos just to break even on the project. The market over the next twenty years is expected to be just 400 to 600 planes, so it’s not worthwhile for Boeing to even get in the market. Airbus has first mover advantages based on scale economies.

27. Implications of New Trade Theory
New trade theory suggests
a country may predominate 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
What are the implications of this? Well, new trade theory suggests that countries might benefit from trade even if they don’t differ in resource endowments or technology. The theory also suggests that a country might be dominant in the export of a good just because it was lucky enough to have companies that were among the first to produce the product. Remember our example of Airbus and its super jumbo jet!
Keep in mind that new trade theory is at odds with the Heckscher-Ohlin theory which, remember, suggested that countries would produce and export those products which made intensive use of abundant factors of production. But, new trade theory doesn’t contradict comparative advantage theory because it actually identifies a source of comparative advantage.
So, governments might use this information to implement strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important.

28. Implications for Managers
Question: What are the implications of international trade theory for international businesses?
Answer:
There are at least three main implications for international businesses
Location implications
First-mover implications
Policy implications
So, why are all of these theories are important to international business, and to companies?
There are at least three important implications for companies that come from this discussion, location implications, first-mover implications, and policy implications. Let’s talk about each one.

29. Location
Different countries have advantages in different productive activities
differences influence a firm’s decision about where to locate productive activities
a firm should disperse its productive activities to those countries where they can be performed most efficiently
We’ll start with location implications. The theories that we’ve discussed point out that countries have particular advantages for different productive activities. Remember for example, that China’s low cost work force makes it a better place to produce textiles than the U.S.
So, there is a link between the theories and the decision of where to locate productive activities. Firms should disperse their productive activities to those countries where they can be produced most efficiently. As you see in the Closing Case, Logitech has capitalized on production advantages in both Taiwan and China.

30. First-Mover Advantages and Government Policy
Firms that establish a first-mover advantage in the production of a new product may later dominate global trade in that product
a firm can invest resources in trying to build first-mover advantages, even if it means losses for a few years before a venture becomes profitable
Government policies on free trade or protecting domestic industries can significantly impact global competitiveness
businesses should encourage free trade policies
New trade theory explains the importance of first mover advantages for firms. Remember that being a first mover in an industry can have important competitive implications, especially in industries where economies of scale are critical and the global industry can only support a few companies.
You might recall our discussion of the aerospace industry, and the importance of first mover advantages, or how Nokia used its first mover advantages to take a lead in the cell phone industry.
Finally, consider the link between trade theory and government policy. A government’s policy on free trade has important implications on a firm’s global competitiveness.
Firms can influence government policy decisions through lobbying. You might think about some of the industries in the U.S. like steel or agriculture that have been successful in influencing policy. Keep in mind, that while the actions of these industries may help the firms within the industry, the decisions that are made as a result of their influence are not always beneficial to the country as a whole! For example, while the steel industry was successful at getting protection from foreign competition in the early 2000s, the higher prices that resulted from the protection meant that the auto industry suffered.
Remember, that no one theory explains all trade patterns, but taken together, they help us understand what’s happening in the world today.