Topic 4

International Trade

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Learning Objectives

LO 4-1 Understand the benefits derived from free exchange of

goods and services.
LO 4-2 Recognize why economists believe that unrestricted free
trade between nations raises the economic welfare of
countries.
LO 4-3 Analyze the theories that explain different aspects of
gains from trade and the prevalent patterns of trade.
LO 4-4 Examine the implications of different trade theories on
the role of government in trade policy.
LO 4-5 Understand the important implications that international
trade theory holds for management practice.
 Gains from Trade: Exchange between
Individuals
 When individuals in a society exchange
goods and services (i.e. freely trade) with
each other the gains are apparent.
 imagine if we try to be self-reliant in everything!
 Benefit from free trade for individuals in a
society:
 can specialize in doing what they are most efficient
in
 exchange products or services from others that they
are more efficient in.
 increase their welfare by expanding their consumption
of goods and services compared to no trade.

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 Is there anything special about
“International” Trade?
▪ If the gains for individuals exchanging
goods & services with people within
societies is obvious, won’t the ability to
exchange goods & services with more
people in other countries be even more
beneficial?

▪ Focus: Trade and Prosperity

Gains from Trade: Exchange between
Countries
 Benefit from trade for countries
 countries trading with each other in reality implies that
people in one country trade with people in another.
 => same rationale for gains for trade as before
 countries can specialize in the manufacture and export
of those products and services that they are most
efficient in.
 import products and services that they are not efficient in
 Trade leads to a “positive-sum outcome”
 mutual gains from trade for all participants due to
increased range of consumption choices for people in
each nation with trade relative to no trade.
 Focus:Trade, specialization and division of
labor
Pattern of International Trade
 Why does
 Saudi Arabia export oil and import wheat, cars, coffee?
 Brazil export coffee, iron ore, sugar and import machinery?
 Thailand export rice and import oil?
 Bangladesh export textiles and import cars, appliances, ?
 China export shoes, toys, appliances, computers, electronics ...?
 Why does
 Switzerland export pharmaceuticals and watches?
 Germany export railway equipment, machine tools and
cars?
 Japan, Germany, S. Korea, China both import and export cars?
 US which invented TV’s, computers, copying machines import
them now?
Putting it into Practice

Why does the

United States
import TVs when
it could make
them at home?
Evolution of Trade Theories: What
Determines Specialization?
 False Theory of Trade
 Mercantilism - protectionism
 Incomplete Theory of Trade
 Absolute Advantage – Adam Smith
 Free Trade Theories
 Comparative Advantage - efficiency gains through
lower costs.
 Ricardo’s Theory - Climate/Geography/Natural Resources
 Heckscher-Ohlin Theory - Factor Proportion
 New or Strategic Trade Theory - Increasing returns
(economies of scale) from division of labor and/or knowledge
 Competitive advantage – efficiency through location,
social and institutional factors (Porter’s Diamond)
 Pattern of Trade
 Product Life-Cycle Hypothesis Model – Vernon
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 Mercantilism
 Mercantilism (1500-1750)
 A nation’s wealth depends on accumulated “specie”
 gold and silver – trading currency during that period
 In order to increase wealth a country should
maintain a trade surplus (export > import)
 Exports meant accumulation in the stock of gold or
silver, while imports meant reduction
 Views trade as a “zero-sum game” (one in which
a gain for country results in a loss for another)
 => advocated government intervention to achieve a
surplus in the balance of trade favoring exports and
restricting imports.
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Flaws of Mercantilism
 Erroneous conception of wealth
 In the mercantilist system production and not consumption is seen
as the ultimate objective of commerce, hence interest of the
consumer is sacrificed to that of the producer.
 Mercantilist trade surpluses are unsustainable and self-
limiting
Trade surplus in Country A → money supply ↑ in Country A
→ inflation in Country A →↓demand for goods from Country A &
↑ demand for good from Country B → offsets trade surplus in Country A

In a fully employed economy, a trade

surplus cannot be sustained in the long run
 Consequently, what did the mercantilism driven
European economies do, 16th century onwards, towards
sustaining their trade surpluses?
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Absolute Advantage Theory
 Adam Smith (1776), through his absolute
advantage theory of trade, correctly refuted the
mercantilist notion of trade as a zero-sum game.
 a country has an absolute advantage in the
production of a product when it is more efficient
than other countries in producing it.
 According to absolute advantage theory, countries
had absolute advantage in the productivity of
different goods due to climate, geography and
natural resources.
 Consequently, absolute advantage theory argues
that countries should specialize in producing and
exporting goods they have an absolute advantage
in and import those goods they lack an absolute
advantage in from other countries.
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Severe Limitation of Absolute Advantage
Theory
Assume two countries Ghana and South Korea, each
producing two goods, cocoa and rice. Each country’s
productivity in the two goods is given by:
Labor Hours required to produce 1unit (ton) of cocoa and rice
Cocoa Rice
Ghana 12 15
South Korea 40 20

 Ghana has an absolute advantage in production of BOTH

Cocoa and Rice!
 So what should Ghana & S. Korea specialize in?
 Limitation of absolute advantage theory: No rationale for
specialization and trade if a country is more efficient than
another in production of all goods and service.
 Is that really true?
Comparative Advantage Theory
 Ricardo (1817) demonstrated that absolute
advantage theory is erroneous, since what matters
for trade is comparative advantage and not
absolute advantage.
 Comparative advantage – A country has a
comparative advantage in a good or service if it can
produce it at a lower opportunity cost than another
country.
 Note: opportunity cost of good X is the amount of good Y that
must be given up in order to produce one more unit of good X.
 Illustration?
 Comparative advantage theory - a country should
specialize in producing goods or services that it has a
comparative advantage in and buy goods or services that
other countries have comparative advantage in.
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 Comparative Advantage
 If country A can produce good X at a lower
opportunity cost than country B, then country A has
a comparative advantage in the production of good X.
 => opportunity cost of good X is the amount of good Y that must be
given up in order to produce one more unit of good X.
 According to comparative advantage theory, efficiency
dictates that a country specializes in producing goods that
it has a comparative advantage in and buy goods that
other countries have comparative advantage in.
 => it might be beneficial for countries to import goods
that they could produce more efficiently themselves, i.e.
have absolute advantage in.
 Focus:Tragedy of Tasmania, Comparative Advantage
and Trade
Comparative Advantage Theory:
Numerical Illustration
Take the previous example again of two countries Ghana and South Korea,
each producing two goods, cocoa and rice.
Labor Hours required to produce 1unit (ton) of cocoa and rice
Cocoa Rice
Ghana 12 15
South Korea 40 20

Opportunity Cost of producing 1unit (ton) of cocoa and rice

Cocoa Rice
Ghana OC =12/15 = 0.8 units OC =15/12 = 1.25
of rice units of cocoa
South Korea OC = 40/20 = 2 units OC = 20/40 = 0.5
of rice units of cocoa

 Ghana has a Comparative Advantage in production of cocoa - specialize

in producing cocoa.
 South Korea has a Comparative Advantage in production of rice -
specialize in producing rice.
Discussion Question: Terms of Trade
Labor Hours required to produce 1unit (ton) of cocoa and rice
Cocoa Rice
Ghana 12 15

South Korea 40 20

 Consider the country specializing in cocoa. What is the MAXIMUM

amount of cocoa this country is willing to GIVE the other country
in return for receiving ONE unit of rice?
 Consider the country specializing in rice. What is the MINIMUM
amount of cocoa this country is willing to RECEIVE from the other
country in return for giving ONE unit of rice?
 What are the levels of cocoa that can be traded for ONE unit of
rice that is acceptable to both countries?
Main Limitation of Ricardian Comparative
Advantage Theory
 Assumption of (i) labor being the single factor of
production and (ii) constant opportunity costs of
production for a good implies that:
 within any country, all individuals possess the same
productive factor (labor) and every individual is identical
in terms of their productivity.
 Therefore, gains accruing from trade for a country
gets equally distributed amongst all individuals
within the country.
 Consequently, Ricardian comparative advantage
theory implies that there is NO impact of trade on
income distribution within countries.
 However, it’s clearly observable empirically that trade has
impact on income distribution within countries.
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Comparative Advantage: Heckscher-Ohlin
(H-O)Theory
 H-O theory postulates that even if countries do not
differ in their overall level of technology of production,
they can still enjoy comparative advantage over each
other in different sectors due to the following reasons:
 Countries do differ in their factors of production, i.e. the
extent to which a country is endowed with resources
such as land, skilled/unskilled labor, capital etc.
 Goods and services do differ by the factor intensities of
production, e.g. whether the production of a good uses a
more labor intensive or a more capital intensive process.
 Some factors of production are NOT mobile between
countries (i.e. cannot move freely), e.g. land is
completely immobile, labour is relatively immobile.
 H-O theory argues that in such circumstances
comparative advantage arises from differences in
national factor endowments (i.e. resource availability).
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Implications of Heckscher-Ohlin Theory
 According to H-O theory,
 countries have a comparative advantage and hence, should
specialize in and export goods & services that make
intensive use of those factors that are locally abundant and
import goods that make intensive use of factors that are
locally scarce.
 Consequently, H-O theory has major implications on
how trade affects income distribution, e.g. between
workers and capital owners or high-skilled and low-
skilled workers in a country.
 with trade the labor abundant country will see an increase
in wages, but a relative fall in the return to capital while
the capital abundant country will experience the opposite
pattern of change.
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Shortcomings of Ricardian and H-O
Comparative Advantage Theories
 Comparative Advantage theories (both Ricardo
and Heckscher-Ohlin) are unable to explain two
important empirical observations in the pattern
of trade:
 North-North Trade: Significant portion of trade is
between countries with similar technology and
factor proportions, hence similar productivity in
all sectors (developed economies).
 E.g. trade between US and Canada, UK and Germany etc.
 Intra-Industry Trade: Most of the trade occurring
between developed economies are within the
same industries.
 E.g, automobiles between Germany and US, cell phones
between Korea and Japan etc.
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New or Strategic Trade Theory
 New trade theory argues that with trade
comparative advantage can be created in those
sectors of the economy that satisfy the following
assumptions:
1) Production is characterized by
 Increasing returns to scale leading to economies of scale
2) Market structure is characterized by
 Monopolistic competition, i.e. different firms in the same industry
produce a slightly different good
3) Consumer tastes is characterized by
 Preference for variety, i.e. consumers prefer a larger range of
choices for products and services
 Examples:
 Automobiles, Computers, Smartphones, Domestic
appliances (white goods) etc.
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 New Trade Theory: Rationale for Trade
 In sectors with economies of scale, there exists a trade-off
between variety and cost.
 Preference for more variety of goods and services will tend to
increase prices for products/ services which have economies of
scale.
 => without trade, nations (especially small ones) may not have the
domestic market to realize sufficient economies of scale, thereby
unable to support existence of certain (high fixed cost) sectors.
 But with trade, firms can produce for larger global markets,
thereby better utilizing economies of scale to produce at a
lower cost, thereby creating a comparative advantage.
 => with trade a nation by generating comparative advantage
through specialization in certain products can generate exports
and import other products, resulting in better overall scale
economies.
 Focus: Specialization and Market Size
 Trade is welfare enhancing => trade between countries will
simultaneously increase the variety of good/services available
to consumers and lower the cost of those goods/services.
Implications of New Trade Theory: First Mover
Advantage (FMA)
 With trade, firms have access to bigger markets and the
resultant economies of scale generates comparative
advantage.
 Additionally if such firms are “first movers,” i.e. new
entrants into a market, then they will enjoy a cost
advantage due to economies of scale from initial market
capture, thereby creating barriers to entry for other
firms.

Barriers to
First Mover
entry for
Advantage
competitors

 However, consumers demand for “variety” creates space

for competitors.
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Implications of New Trade Theory: Strategic
Trade Policy
 According to new trade theory, a country may
have a comparative advantage in particular
sector, simply because it had one or more firms,
by luck or design, that were among the first to
produce that good.
 Such a potential for creating comparative
advantage through being a “first mover”
provides an economic rationale for a strategic
trade policy by the government.
 In sectors where the output required to attain
economies of scale represents a significant
proportion of demand, governments could
consider trade and investment policies in order to
create first mover advantages for its firms.
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Competitive Advantage Theory: Porter’s
Diamond
 Porter’s Diamond analysis is based on national
“competitive advantage.”
 Porter identified 4 major attributes that promote
or impede the creation of competitive advantage:
 Factor endowments
 Demand conditions
 Related and supporting industries
 Firm strategy, structure and rivalry
 In addition, Porter identified two additional external factors
that significantly influences the above attributes:
 Chance
 Government
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Porter’s Diamond
Greater the attribute
Success occurs where The diamond is mutually
higher the chance of
these attributes exist reinforcing
success

Chance
Company Strategy,
Structure,
and Rivalry
Two external
factors that
influence the Factor Demand
four Endowments Conditions
determinants
Related
and Supporting
Government Industries

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Porter’s Diamond: Factor Endowments
and Demand Conditions
 Factor Endowments
 can be either basic (natural resources, climate, location,
demographics etc. ) or advanced (communication
infrastructure, skilled labor, research facilities, technological
know-how etc.)
 Basic factors can provide an initial advantage that is
extended by investment in advanced factors.
 Demand Conditions
 the social and institutional factors that determine the nature
of home demand for an industry’s product or service
 influencing the development of capabilities
 Illustration: sophisticated and demanding customers
pressure firms to produce high quality innovative products
 Example: Japanese camera industry
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Components of Porter’s Diamond:
Related and Supporting Industries
 Related and Supporting Industries
 The presence of supplier industries and related industries
that are internationally competitive
 These industries can have a spillover effect and contribute
to success in other industries
 Example: Early leadership of US semiconductor
industry provided the basis for US success in PCs
 Successful industries tend to be grouped in clusters in
countries which then prompts knowledge flows between firms.
 Example: Silicon Valley and the dominance of US in
information technology

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Components of Porter’s Diamond: Firm
Structure, Strategy and Rivalry
 Firm strategy, structure,
 Social and institutional factors governing the differences in
management ideologies that shape the nature of the
companies that are created and how they are organized and
managed in a society
 Example: The predominance of engineers in top management
at German and Japanese firms and the resultant emphasis on
improving manufacturing processes and product design.
 and rivalry
 the social and institutional factors in the nation governing
the nature of domestic rivalry between firms
 strong association between vigorous domestic rivalry and
the creation and persistence of competitive advantage in an
industry
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Product Life-Cycle Theory
 When products mature, both location of sales and
of optimal production changes, which affects the
direction and flow of imports and exports.
 The life of a product can be divided into 3 stages:
1. New product
2. Mature product
3. Standard product
 Example: Development of mass produced
automobiles, televisions, photocopiers, personal
computers in the US
 For most of the 20th century, the wealth and size of the
U.S. market gave a strong incentive to U.S. firms to
develop new products.
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 Product Life-Cycle: Illustration
New product appears in USA (new R&D). High demand in USA, but
demand in China is limited as only high-income group can afford product.
❑ Also, due to “Imitation Lag” (learning period to acquire technology) the
good cannot be produced immediately at lower cost by Chinese
producers.
❑ Implication: USA exports the product to China
❑ Once demand in China increases, US producers set up production
facilities there either directly or through joint ventures (Mature
product).
❑ But, production in USA limits potential Chinese exports
❑ Ultimately, the imitation of technology becomes possible and the mature
product becomes standardized => The competition is based on price, not
on product quality (Standard Product).
❑ USA becomes the importer of the product as production
becomes more concentrated in lower-cost China.
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Pattern of International Trade: Summary
 Comparative Advantage
 Ricardo
 Trade patterns reflect differences in labor productivity.
 Heckscher and Ohlin
 Trade reflects the interplay between factor endowments in
different countries and the factor intensities of producing
particular goods.
 New Trade Theory
 The world market can only support a limited number of firms in
some industries, therefore trade will skew towards those countries
that have firms that were able to capture first mover advantages.
 Product Life-Cycle
 Trade patterns reflect a product’s life cycle
 Porter’s Diamond
 Country specific attributes explain a nation’s dominance in the
production and export of certain products.
Trade Theories and Government Policy:
Summary
 Comparative advantage (both Ricardo and
Heckscher-Ohlin) & Smith’s Absolute advantage (just
a special case of Ricardian comparative advantage)
allow no role for government policy in trade.
 Comparative advantage (New trade theory) makes a
case for strategic intervention by government to
support the development of certain industries, those
that are characterized by significant economies of
scale and the limited size of the world market.
 Porter’s Diamond justifies limited and selective
government intervention to support the
development of certain globally competitive
industries.
Managerial Implications from Trade Theories
 Location implications
 The companies disperse production activities to countries
where they can be performed most efficiently based on
comparative and competitive advantages.
 First-mover implications
 The companies must invest substantial financial resources in
building a first-mover advantage before a new venture becomes
profitable
 E.g., Japanese firms investment in Liquid Crystal Display (LCDs) in 1980s
 Policy implications
 Businesses should work to encourage governmental policies
that support free trade
 E.g., IBM and Apple protested against imposing tariff on Japan’s imports of
LCDs during 1980s
 Business should urge the government to increase investment in
advanced factors, like education and infrastructure.
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Summary
In this topic we have
✓ Understood why nations trade with each other.
✓ Identified the different theories determining the rationale
for specialization and trade flows between nations.
✓ Recognized why unrestricted free trade between nations
will raise the economic welfare of countries that
participate in a free trade system.
✓ Examined the role of trade theories towards the
formulation of economic policies regarding trade.
✓ Understood the important implications that international
trade theory holds for business practice.