1. The Theory of Trade and Investment
Chapter 5
The Theory of Trade and Investment

2. Learning Objectives
To understand the traditional arguments of how and why international trade improves the welfare of all countries
To review the history and compare the implications of trade theory from the original work of Adam Smith to the contemporary theories of Michael Porter
To examine the criticisms of classical trade theory and examine alternative viewpoints of which business and economic forces determine trade patterns between countries
To explore the similarities and distinctions between international trade and international investment

3. Evolution of Trade Theory
The Age of Mercantilism
Classical Trade Theory
Factor Proportions Trade Theory
International Investment and Product Cycle Theory
The New Trade Theory: Strategic Trade
The Theory of International Investment

4. The Age of Mercantilism
The evolution of trade into the form we see today reflects three events:
The Collapse of Feudal Society
The Emergence of the Mercantilist Philosophy
The Life Cycle of the Colonial Systems of the
European Nation-States

5. Mercantilism Mixed exchange through trade with accumulation of wealth
Conducted under authority of government
Demise of mercantilism inevitable

6. Classical Trade Theory
The Theory of Absolute Advantage
The ability of a country to produce a product with fewer inputs than another country
The Theory of Comparative Advantage
The notion that although a country may produce both products more cheaply than another country, it is relatively better at producing one product than the other

7. Classical Trade Theory Contributions
Adam Smith—Division of Labor
Industrial societies increase output using same labor-hours as pre-industrial society
David Ricardo—Comparative Advantage
Countries with no obvious reason for trade can specialize in production, and trade for products they do not produce
Gains From Trade
A nation can achieve consumption levels beyond what it could produce by itself

8. Factor Proportions Trade Theory
Developed by Eli Heckscher
Expanded by Bertil Ohlin

9. Factor Proportions Trade Theory Considers Two Factors of Production
Labor
Capital

10. Factor Proportions Trade Theory
A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive).

11. The Leontief Paradox The Test: The Method:
Could Factor Proportions Theory be used to explain the types of goods the United States imported and exported?
The Method:
Input-output analysis

12. The Leontief Paradox The Findings: The Controversy:
The U.S. exported labor-intensive products and imported capital-intensive products.
The Controversy:
Findings were the opposite of what was generally believed to be true!

13. Overlapping Product Ranges Theory: Staffan Burenstam Linder
Trade in manufactured goods dictated not by cost concerns, but by similarity in product demands across countries.
Work focused on preferences of consumer demand.
Today, termed market segments.

14. Product Cycle Theory Raymond Vernon
Focus on the product, not its factor proportions
Two technology-based premises

15. Product Cycle Theory: Vernon’s Premises
Technical innovations leading to new and profitable products require large quantities of capital and skilled labor
The product and the methods for manufacture go through three stages of maturation

16. Stages of the Product Cycle
The New Product
The Maturing Product
The Standardized Product

17. The Product Cycle and Trade Implications
Increased emphasis on technology’s impact on product cost
Explained international investment
Limitations
Most appropriate for technology-based products
Some products not easily characterized by stages of maturity
Most relevant to products produced through mass production

18. The New Trade Theory: Strategic Trade
Two New Contributions
Paul Krugman-How trade is altered when markets are not perfectly competitive
Michael Porter-Examined competitiveness of industries on a global basis

19. Internal Economies of Scale External Economies of Scale
Strategic Trade
Krugman’s Economics of Scale:
Internal Economies of Scale
External Economies of Scale

20. Strategic Trade
Government can play a beneficial role when markets are not purely competitive
Theory expands to government’s role in international trade
Four circumstances exist that involve imperfect competition in which strategic trade may apply

21. The Four Circumstances Involving Imperfect Competition:
Strategic Trade
The Four Circumstances Involving Imperfect Competition:
Price
Cost
Externalities
Repetition

22. Strategic Trade Porter’s Diamond of National Advantage
Innovation is what drives and sustains competitiveness
Four components of competition
Factor Conditions
Demand Conditions
Related and Supporting Industries
Firm Strategy, Structure, and Rivalry

23. Michael Porter’s Competitive Clusters
Critical masses of unusual competitive success in particular fields, located in one place

24. The Theory of International Investment
The movement of capital has allowed foreign direct investments across the globe

25. The Theory of International Investment
Firms as Seekers
Seeking Resources
Seeking Factor Advantages
Seeking Knowledge
Seeking Security
Seeking Markets

26. The Theory of International Investment
Firms as Exploiters of Imperfections
Imperfections in Access
Imperfections in Factor Mobility
Imperfections in Management
Firms as Internalizers
Establish their own multinational operations-internalize production
Competitive advantage due to confidentiality