International Trade Theory (Ch-4) Chapter Outline 1.Introduction 2.Various trade theories  Mercantilism  Theory of Absolute Advantage  Theory of Comparative Advantage  Assumptions of Free Trade  The product Life Cycle Theory  New Trade Theory  National Competitive Advantage: Porter’s Diamond

Mercantilism The first theory of international trade emerged in England in the mid-16 th century referred to as mercantilism. Its Principle assertion was that Gold & Silver were the mainstays of national wealth & essential to vigorous commerce. At that time gold & silver were the currency of trade between countries. The main tenet of mercantilism was that it was in a country’s best interests to maintain a trade surplus: to export more than it imported.

Absolute Advantage Adam Smith argued that countries differ in their ability to produce goods efficiently. He suggested that countries should specialize in the production of goods for which they have an absolute advantage & then trade these goods for the goods of other countries, who enjoy absolute advantage in the production of those goods. Smith’s basic argument is that you should never produce goods at home that you can buy at a lower cost from other countries.

The theory of Comparative Advantage David Ricardo argued that a particular country should specialized in the production of those goods that it produces most efficiently & to buy the goods that it produces less efficiently from other countries. Ricardo's theory stresses that comparative advantage arises from differences in productivity.

Assumptions of Free Trade  We have assumed a simple world in which there are only two countries and two goods. In the real world, there are many countries & many goods.  We have assumed away transportation costs between countries.  We have assumed away differences in the prices of resources in different countries.  We have assumed that while resources can move freely from the production of one good to another within a country, they are not free to move internationally. In reality resources are somewhat Internationally mobile such as capital, labor.

Cont.  We have assumed constant returns to scale. That means, the amount of resources required to produce a good might decrease or increase as a nation specializes in production of that good.  We have assumed away the effects of trade on income distribution within a country.

The Product Life Cycle Theory Raymond Vernon established this theory. US firms Advanced countries Developing countries

Heckscher-Ohlin Theory He argued that the comparative advantage arises from differences in national factor endowment such as, land, labor & capital. The theory predicts that countries will export those goods that make intensive use of factors that are locally abundant. While importing goods that make intensive use of factors that are locally scarce. Endowments that are important; a country may have larger absolute amounts of land, labor & capital etc than another country but be relatively abundant in one of them.

National Competitive Advantage: Porter’s Diamond Firm strategy,Structure & Rivalry Demand condition Related & supporting Industries Factor endowments

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