1. Theories of International Trade
Unit II

2. Trade theories 2 extremes: Mercantilism v/s Free Trade Or
Interventionist v/s Laissez faire
Interventionist theories
Free Trade theories
Competitive Advantage theory
Mercantilism
Absolute advantage
Product Life Cycle (PLC) Theory
Neomercantilism
Comparative advantage
Porter Diamond
Theory
H-O Theory

3. Mercantilism
Best way of becoming rich is by exporting more than importing..
Difference settled in gold..
Trade theory that says: ‘country’s wealth is measured by its treasure holding’, usually gold
Thus:
X more, M less
Gold empowers Govt., which empowers the army and national institutions..
Time 1500 – 1750 cen.
Outcome: accumulation of gold by colonial powers
Unrest: American revolution (1775–1783).. And many more..

4. EXPLORER COUNTRY YEAR[in order] GEOGRAPHIC AREA EXPLORED
Columbus Italian sponsored by Spain Sailed westward to find route to India and China, found the New World America…
Amerigo Vespucci Italy 1498 Sailed South America's coast - later maps called it "America"
Vasco Da Gama: Portugal 1498 Sailed around the tip of Africa: cape of good hope.. and reached the Indies.. India..

5. Neomercantilism
Mercantilism justifies favorable trade to pile up gold..
Neomercantilism: Approach to have favorable BoT for social or political advantage
Social advantage: to have full employment of resources in order to have surplus production to send abroad..
Political advantage: to give aid and grant to other countries..

6. Free Trade Theories Absolute advantage: Adam Smith, 1776
Comparative advantage: David Ricardo, 1817
Factor-proportions: Heckscher-Ohlin, 1919

7. Absolute Advantage Adam Smith: The Wealth of Nations, 1776
Mercantilism weakens country in long run; enriches only a few
A country
Should specialize in production and export of products in which it has absolute advantage; import other products
Has absolute advantage when it is more productive than another country in producing a particular product
Comodity US UK
Wheat (kg/labor) 6 1
Cloth (mts/labor) 2

8. Production Possibility Curve
A curve that shows
Total output (of 2 commodities) that can be produced
By a country using all its resources…
So theory of absolute advantage shows world’s production increases due to international trade..

9. Comparative Advantage
David Ricardo: Principles of Political Economy, 1817
Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces
Absolute Advantage is a special case of Comparative Advantage
Commodity US UK
Comparative disadvantage
Comparative adv US
Wheat 6 1
1/6
6/1=6 more adv
Cloth 3 2
2/3
3/2=1.5

10. Classic Theory Conclusion
Free Trade expands the world “pie” for goods/services
Theory Limitations:
Simple world (two countries, two products)
no transportation costs
no price differences in resources
resources immobile across countries
constant returns to scale
full employment
Real world: many countries and many goods
Transportation costs may decline with specialization
Prices in different countries can be (are) effected by exchange rates. Wheat and Tea are not necessarily a one-to-one swap
resources can move from country to country: labor (Mexico to US), capital
(constant returns to scale: specialization does not effect the amount of resources required to produce one ton of wheat or tea) both diminishing and increasing returns to specialization exist
assumed fixed stock of resources in each country. Trade can change the efficiency with which the resources are used and the stock of resources may change too (more people, more natural resources, more efficient use due to technology)
Full employment implies use of resources at full efficiency...

11. Theory of Relative Factor Endowments (Heckscher-Ohlin): Modern Theory
Factor endowments vary among countries
Products differ according to the types of factors they need as inputs
A country has a comparative advantage in producing products that intensively use factors of production it has in abundance and which is thus cheap..
Factors of production: labor, capital

12. Heckscher--Ohlin (1919)
Differences in factor endowments and not differences in productivity determine patterns of trade
Theory: ‘H-O postulates that each nation will export commodity intensive in its relatively abundant and cheap labor and vice-versa’.

13. Important determinants
Factor endowments: commodity: high in K/L , L/K
Factor prices: low in r/w and w/r
US and UK PPF pre trade
Post trade
International trade continues until relative and absolute factor prices are equalized.. HOW???

14. Factor Price equalization theorem
Trade leads to equalization of relative and absolute factor prices between nations…
K-abundant nation: high K/L and low r/w ratio
L-abundant nation: high L/K and low w/r ratio..
Labor intensive and capital intensive commodity..

15. Empirical Test Leontief paradox:
US has relatively more abundant capital yet imports goods more capital intensive than those it exports Ms30% more k-intensive than Xs..
Explanation(?):
US has special advantage on producing new products made with innovative technologies
These may be less capital intensive till they reach mass-production state

16. Factor Intensity Reversal Test (FIR)
Situation where a commodity is L-intensive in labor intensive country and k-intensive in K abundant country…

17. International Product Life-Cycle :Vernon, 1966
Most new products conceived / produced in the US in 20th century
US firms kept production close to their market initially
Limited initial demand in other advanced countries initially
When demand increases in advanced countries, production follows
With demand expansion in secondary markets
Product becomes standardized
production moves to low production cost areas
Product now imported to US and to advanced countries

18. Vernon Product Life-Cycle Model
Introduction: Requires highly skilled labor
Growth: to advanced countries, home country sales increase
Maturity: Requires standardized production, unskilled labor
Decline: in production in home country and increased production in low skilled developing countries. Home country produces new products..

20. What Is Porter’s Diamond Of Competitive Advantage?
Michael Porter tried to explain why a nation achieves international success in a particular industry
He identified four attributes that promote or impede the creation of competitive advantage
Factor endowments - a nation’s position in factors of production necessary to compete in a given industry
can lead to competitive advantage
can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how)
Demand conditions - the nature of home demand for the industry’s product or service
influences the development of capabilities
sophisticated and demanding customers pressure firms to be competitive
Have you ever wondered why some countries have certain industries that seem to be superior to those of other countries? Why for example, is Japan so strong in the global auto industry? Why does Switzerland dominate the pharmaceutical industry?
These are questions that intrigued Michael Porter, who in 1990, believing that the theories at the time still left gaps in our understanding of trade patterns, tried to explain why a country might achieve international success in a particular industry.
Porter identified four factors that he argued promoted or impeded the creation of competitive advantage in an industry.
Together, he called these factors the diamond of competitive advantage.
The first factor, called factor endowments, refers to a country’s position in the factors of production that can lead to a competitive advantage.
Here Porter included things like the skilled labor or infrastructure that were important to achieving a competitive advantage in a particular industry.
Demand conditions, the second factor, refers to the nature of home demand for the industry’s product or service.
Porter argued that sophisticated and demanding customers pressured firms to be more competitive.

21. What Is Porter’s Diamond Of Competitive Advantage?
Relating and supporting industries - the presence or absence of supplier industries and related industries that are internationally competitive
can spill over and contribute to other industries
successful industries tend to be grouped in clusters in countries
Firm strategy, structure, and rivalry - the conditions governing how companies are created, organized, and managed, and the nature of domestic rivalry
different management ideologies affect the development of national competitive advantage
vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features
The third factor, relating and supporting industries, refers to the presence or absence of supplier and related industries that are internationally competitive and contribute to other industries.
According to Porter, successful industries will be grouped in clusters in countries, so if a country has world class manufacturers of semi-conductor processing equipment, it will tend to have a competitive semi-conductor industry.
Finally, the fourth factor, firm strategy, structure, and rivalry, refers to the conditions in the nation that govern how companies are created, organized, and managed, and the nature of domestic rivalry.
Porter suggest that when domestic rivalry is strong, there’s greater pressure to innovate, improve quality, reduce costs, and invest in advanced product features.

22. What Is Porter’s Diamond Of Competitive Advantage?
Determinants of National Competitive Advantage: Porter’s Diamond
This Figure shows the four factors that comprise Michael Porter’s Diamond of Competitive Advantage.

23. Summary Mercantilism Free trade theory Competitive theory
A market to think about: Computers Hardware only!!!!