INTERNATIONAL

TRADE THEORY

Presented By,Ravish Kumar-64

Ranjan Kumar-171Ankit Semwal-125

OBJECTIVES

Define the term international trade and discuss the role of mercantilism in modern

international trade.Contrast the theories of absolute advantage

and comparative advantage.Relate the importance of international product life cycle theory to the study of

international economics.

INTRODUCTION

International trade: the branch of economics concerned with the exchange of goods and services with foreign countries.

We will focus on:International trade theory

WHY DO NATIONS TRADE?

Trade theories:Mercantilism;

theory of absolute advantage;theory of comparative advantage;

factor endowment theory;international product cycle theory;

other considerations.

Trade theory-overview

Free Trade occurs when 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 countryThe Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country

MERCANTILISM MID- 16TH CENTURY

A trade theory which holds that a government can improve the well-being of the country

by encouraging exports and stifling imports.

Cf.) Neo mercantilism: without the reliance on precious metal (gold).

A nation’s wealth depends on accumulated “treasure”Gold and silver are the currency of trade

Mercantilists sought what we now call ‘development’

They argued their countries should run a trade surplus Maximize export through subsidiesMinimize imports through tariffs and quotas

Flaw: “zero-sum game”Mercantilists neglected to see the benefits of trade

CONTD..

But there was a flaw in But there was a flaw in the mercantilists’ argumentthe mercantilists’ argument

They assumed that trade was a zero-sum game As England, France, and the Netherlands competed with each other, many thought only about advantage for their country

THEORY OF ABSOLUTE ADVANTAGE

A trade theory which holds that by specializing in the production of goods, which they can produce more efficiently than any others, nations can increase their economic well-

being.An exampleAssume:

labour is the only cost of production;lower labour-hours per unit of production means

lower production costs and higher productivity of labour.

North has an absolute advantage in the production of cloth.South has an absolute advantage in the production of grain.

It follows that:If North produces cloth and South produces grain, and an

exchange ratio can be arranged, both the countries will benefit from trade.

Theory of absolute advantage (Continued)

THEORY OF COMPARATIVE ADVANTAGE

A trade theory which holds that nations should produce those goods for which they

have the greatest relative advantage. An exampleAssume:

labour is the only cost of production;

lower labour-hours per unit of production means lower production costs and higher

productivity of labour.

North has an absolute advantage in the production of both cloth and grain but the relative costs differ (i.e. gains from trade).

In North, one unit of cloth costs 50/100 hours of grain.In South, one unit of cloth costs 100/100 hours of grain.

It follows that:If North can import more than a half unit of grain for one unit of cloth,

it will gain from trade.If South can import one unit of cloth for less than one unit of grain, it

will also gain from trade.Under the circumstance presented in the above example, both countries

can benefit from trade.

Theory of comparative advantage (Continued)

FACTOR ENDOWMENT THEORY

Also known as the Heckscher-Ohlin theory, It extends the concept of comparative advantage by

bringing into consideration the endowment and cost of factors of production and helps to explain

why nations with relatively large labour forces will concentrate on producing labour-intensive goods,

whereas, countries with relatively more capital than labour will specialize in capital-intensive

goods.

Weaknesses of factor endowment theory:Some countries have minimum wage laws that result

in high prices for relatively abundant labour.The Leontief paradox: countries like the United

States actually export relatively more labour-intensive goods and import capital-intensive

goods.

No single theory can explain the role of economic factors in trade theory.

INTERNATIONAL PRODUCT LIFE CYCLE THEORY (IPLC)

A theory of the stages of production for a product with new “know-how”: it is first produced by the parent firm, then by its

foreign subsidiaries and finally anywhere in the world where costs are the lowest; it

helps to explain why a product that begins as a nation’s export often ends up as an import.

The international product life cycleSource: Raymond Vernon and Louis T. Wells, Jr., The Manager in the International Economy (Englewood Cliffs, NJ: Prentice Hall, 1991), p. 85

THE RICARDIAN MODELImmobile resources:

Resources do not always move easily from one economic activity to another

Diminishing returns:Diminishing returns to specialization suggests that after some point, the more units of a good the country produces, the greater the additional resources required to produce an additional itemDifferent goods use resources in different proportions

Free trade (open economies):Free trade might increase a country’s stock of resources (as labor and capital arrives from abroad)Increase the efficiency of resource utilization

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NEW TRADE THEORY-APPLICATIONS

Typically, requires industries with high, fixed costs

World demand will support few competitors

Competitors may emerge because of “ First-mover advantage”

Economies of scale may preclude new entrants

Role of the government becomes significantSome argue that it generates government intervention and

strategic trade policy

Commonly used barriers to trade

Price-based barriers Tariffs: a tax on goods shipped internationally

Quantity limits Quotas: a quantity limit on imported goods Embargos: a quota set to zero

International price fixing A cartel: a group of firms that collectively agree to fix prices or

quantities sold in an effort to control price

Non-tariff barriers Financial limits Exchange controls: controls that restrict the flow of currency

Foreign investment controls Limits on FDI Limits on transfer or remittance of funds

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THEORY OF NATIONAL COMPETITIVE ADVANTAGE

The theory attempts to analyze the reasons for a nations success in a particular industry

Porter studied 100 industries in 10 nations

postulated determinants of competitive advantage of a nation were based on four major

attributes

Factor endowments

Demand conditions

Related and supporting industries

Firm strategy, structure and rivalry

OTHER CONSIDERATIONS

Government regulation

Monetary currency valuation

Consumer tastes

A Link Between Trade and Growth

Sachs and Warner: 1970 to 1990 study

Open economy developing countries grew 4.49%/year.Closed economy developing countries grew 0.69%/year.Open economy developed countries grew 2.29%/year.Closed economy developed countries grew 0.74%/year.

Frankel and Romer:

On average, a one percentage point increase in the ratio of a country’s trade to its GDP increases income/person by at least 0.5%. For every 10% increase in the importance of international trade in an economy, average income levels will rise by at least 5%.

Barriers to trade

Reasons for barriers to trade

Protect local jobs by shielding home-country business from foreign competition.

Encourage local production to replace imports. Protect infant industries that are just getting started. Reduce reliance on foreign suppliers. Encourage local and foreign direct investment. Reduce balance of payments problems. Promote export activity. Prevent foreign firms from dumping, that is, selling goods

below cost in order to achieve market share. Promote political objectives such as refusing to trade with

countries that practice apartheid or deny civil liberties to their citizens.

Heckscher (1919)-Ohlin (1933) Theory

 A country will export goods that use its abundant factors intensively, and import goods that use its scarce factors intensively.

It states "A capital-abundant country will export the capital-intensive good, while the labor-abundant country will export the labor-intensive good”.

 The two countries are identical, except for the difference in resource endowments.

The relative abundance in capital will cause the capital-abundant country to produce the capital-intensive good cheaper than the labor-abundant country and vice versa.

The Leontief Paradox

Disputes Heckscher-Olin in some instances. The country with the world's highest capital-per

worker has a lower capital/labor ratio in exports than in imports.

Factor endowments can be impacted by government policy - minimum wage.

US tends to export labor-intensive products, but is regarded as a capital intensive country.

Diamond Model

Michael Porter The approach looks at clusters, a number of small

industries, where the competitiveness of one company is related to the performance of other companies and other factors tied together in the value-added chain, in customer-client relation, or in a local or regional contexts.

 The Porter analysis was made in two steps. 1) Clusters of successful industries have been mapped in 10 important trading nations. 2) The history of competition in particular industries is examined to clarify the dynamic process by which competitive advantage was created.