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Learning outcomes
• By the end of this lecture students should
1. Understand different theories that explain the basis for international trade (classical, neo-classical and modern theories)
2. Explain the gains from international trade
3. Apply theories of international trade to real world situation
Introduction
• International Trade, involve exchange of goods and services between two countries
• Goods, services, labour and capital are internationally traded because there are gains
• Does trade affect growth and development?
• There is no consensus on the issue
International trade theories
• The theories explain the basis/reasons for trade and they includes
1. Mercantilist view
2. Absolute advantage theory (Adam Smith)
3. Comparative advantage theory (David Ricardo)
4. Neo-classical/standard theories of international trade (Factor endowment theory (H-O) and factor price equalisation theory
5. Economies of scale, imperfect competition
• H-O and new trade theories (intra-industry arguments)
• Product variety theory
• Technological gap theory
• Product life cycle theory
Reasons for trade
1. Differences in technology • Technology refers to resources used (labour,
capital, land) • Comparative advantage based theory due to
technological differences 2. Differences in resource endowments • Endowments can be skills abilities, natural
resources (pure exchange theory and factor proportions)
3. Differences in demand/prefer
Gains from trade
• International trade allows the following;
1. Expand market opportunities
2. Increase learning opportunities (learning by doing-effect)
3. Technological transfer (open room for imitation embodied and tacit knowledge, skills and FDI flows)
4. Allows efficient international allocation of resources
5. Create value for surplus goods (vent for surplus theory- Adam Smith’s argument)
• One of the classical theories
Gains from Trade
• There are gains from trade that arises from
1. Comparative costs advantage
• Trade gains arises because of differences in opportunity costs
• When there are differences in domestic exchange ratios between two countries meaningful trade can always take place
Gains from trade (Neo-Classical model)
Gains from trade cont.
• As long as domestic price ratio (RR) differ from world price ratio (WW) gains from trade are feasible (different slopes shows different factor-price ratios)
• Under autarky production and consumption are at C with the pre-trade price ratio RR, and community IC I0
• With trade the country production shift from C to G with specialisation in Y and consumption and J
• Under trade the community is consuming outside its production possibility curve at I1
• At world prices the country produces OX* and OY* and consumes OX and OY
Classical vs Modern theories
• Theories explain how countries trade
1. Classical theories
• These are country-based theories (perspective)
2. Modern theories
• They are firm based or company based theories
Mercantilism
• Developed in the 16th century
• Believed in the accumulation of gold and silver
• Objective is to create a trade surplus with other countries
• Sell export and import less so that you are paid more in gold and silver
• Wealth nations amass more riches from their colonies through this approach
• Today protectionism in akin to the mercantilism
Absolute Advantage
• A country can enjoy batter living standards under trade than under autarky (self-sufficient)
• The theory was advanced by Adam Smith • Assumed two countries England and Portugal • Two goods cloth and wine • Labour as a factor of production • Technology is fixed • Division of labour (specialisation) • Specialisation and trade can result in greater
standard of living than self-sufficiency
Absolute advantage
Cloth Wine
Zimbabwe
40 90
Zambia
100 20
• Under autarky • Zimbabwe takes 40
hours to produce 1 tonne of cloth
• 90 hours to produce 1 mega litre of wine
• Zambia takes 100 hours to produce the same units of cloth and
• 20 hours to produce the same unit of wine
Absolute advantage cont.
Cloth Wine
Zimbabwe 40+90 0
Zambia 0 100 +20
• Under trade the countries can specialise
• Zimbabwe can produce 3 tonnes of cloth from the 120 hours
• Zambia can produce 6 mega litres of wine from 120hours
• Through trade both countries will have more of both goods
Relative Advantage
• The theory was propounded by David Ricardo • Even if a country has absolute advantage in the
production of both goods gains from trade are still possible
• Assumptions i. Fixed factor inputs ii. Factors are mobile across sectors but not
internationally mobile iii. Assumes no transaction costs • Comparative advantage is reflected by productivity
differences
Relative Advantage cont.
Cloth Wine
Zimbabwe 40 70
Zambia 100 80
• If Zimbabwe has a comparative advantage in both Cloth and Wine
• According to absolute
advantage theory trade is not possible
• However, relative comparative advantage makes trade possible
Relative advantage
Cloth Wine
Zimbabwe 120/ 40
0
Zambia 0 180/ 80
• Under autarky Zimbabwe need 110 hour to produce a unit each for both Cloth and Wine
• Zambia needs 180 to produce the same
• If each country specialise Zimbabwe can produce 2.75 units of cloth. Zambia can produce 2.25 units of wine
• The global output exceeds the autarky level
Heckscher-Ohlin (H-O) theory
• Developed by Swedish economists
• Explained trade flow in terms of factor proportions
• Applies mainstream microeconomic theory
• It is the standard international trade theory
• A country export commodities that uses a relatively abundant factor and import commodities that uses a relatively less abundant factor
PPF for country 1
• Country 1 has comparative advantage in labour intensive Good X
• The country consume at V
• It imports VS of Y and export ST of X
• Due to trade it consumes at a higher IC
PPF for Country 2
• Country 2 has comparative advantage in the capital intensive Good Y
• It consumes at J • J is at a higher
IC and outside its PPF
• It imports HJ and export GH
Heckscher-Ohlin model
• Assuming two countries 1 and 2
• Two goods Y, which is capital intensive and good X, which is labour intensive
• The countries have equal sizes
• In a two country world the trade triangles are equal GHJ=VST
H-O Proposition
• H-O factor proportion; A country have comparative advantage in the production of a good that uses relatively abundant factor
• Capital-abundant Country 2 will specialise in the production and exportation of capital-intensive Good Y while importing labour-intensive Good X
• Labour-abundant Country 1 will specialise in the production and exportation of labour-abundant Good X while importing capital-intensive Good Y
Leontieff Paradox
• The empirical relevance of the H-O theory was challenged by Leontieff (1953) using aggregate US industry data
• US exports were found to be relatively labour intensive i.e. the capital/labour ratio for exporting industries was lower than that for import-competing industries
• Results failed to conform with the general perception that US is the world’s most capital rich country.
• The results contradict the H-O proposition and this become known as the Leontief Paradox
Liontieff paradox cont.
• Similar studies were also done in other countries with paradoxical results
• Some explanation for these results was the factor intensity reversal
• Differences in taste may also explain trade patterns
Limitations of H-O theory
1. It is based on the static model of factor endowment
2. It is based on the Ricardian model of comparative advantage, which is being challenged in the modern world
3. Comparative advantage criticised for reinforcing the asymmetry distribution of gains between developed and developing countries
4. Fails to explain the current new trade patterns where international trade is no longer driven by comparative advantage alone but by imperfect competition (intra-industry trade)
Limitations cont.
• To day most of trade flows consists of goods that are coming from the same industry (intra-industry trade) as opposed to goods from different industries (inter-industry trade)
• This pattern violate the principle of comparative advantage
• There is imperfect markets, product differentiation, and product variety theories
Modern theories
• The new theories explain trade on the basis of intra-industry trade as opposed to inter-industry trade
• Reasons for intra-industry trade are explaining by different theories as according to;
1. Product life cycle theory (Vernon)
2. Technological gap theory (Posner)
3. Product variety hypothesis
4. Availability theory (Kravis)
Product Cycle theory
• By Vernon (1966), innovations, new product improvements are likely to take place in skill-abundant countries
• As the product matures comparative advantage shifts to another country
• The life cycle of products means all products will experience the course of innovation, growth, maturity and decline. – The stage of new products – The stage of mature technique – The stage of standardization
Product life cycle theory cont.
Time
Stage 1
Consumption in Inventing CountriesQuantity
Stage 2 Stage 3 Stage 4 Stage 5
T1 T2 T3 T4O
Export
Import
Import
Export
Production in Inventing Countries
Production in Imitating Countries
Consumption in Imitating Countries
Product life cycle theory cont.
• O- t1 the introduction of new products
• t1-t2 the growing period of products
• t2-t3 the maturing period of products
• t3-t4 The innovating country can manufacture the identical cheaper products than the inventing country by native cheap non-skilled labor, sell in the international market and compete with the inventing country.
• After t4 Imitation countries begin to sell products to the inventing country, and the output of the inventing country will decrease so substantially as to come to a full stop. And the life cycle of the products will finish.
Product life cycle theory cont.
• At t0 the new product is first produced
• At t1 the innovating country start to export the product
• t2 second generation producer become net exporters
Product life cycle theory cont.
• At t3 innovating country become net importer
• At t4 least developed countries become net exporters
Technological gap theory (Posner)
• The technological gap theory proves that leading technology can form comparative advantage even among the countries with close endowments and tastes.
• However, the theory does not explain the transfer of trade flow and the causes of the emergence and disappearance of technological gap.
Technological gap theory cont.
• T0-T1: demand lag; the time lag from the invention of new products in innovating countries to the acceptance of product in importing countries.
• T0-T3: imitation lag; time interval from the invention of new products in innovating countries to the time the product becomes generic production until the import is zero.
Export of Country A and B
Time
Production of Country A
Export of Country B
Imitation Lag
T1T0 T2 T3
Production of Country B
Demand Lag
Response Lag
Grasp Lag
Technological gap theory cont.
• T0-T2: the response lag; the time lag from the invention of new products to imitation of the product in importing countries.
• T2-T3: the grasp lag; from imitation to no import until the generic production can meet domestic demand and turn to export.
• T1-T3 is the trading period caused by technological gap.
Technological gap theory
• The existence of technological gap gives the innovating firm a temporary monopoly and advantage in foreign markets
• US was by that time technology leader
