International Trade
Theory
Learning Objectives
LO 6-1 Understand why nations trade with each other.
LO 6-2 Summarize the different theories explaining trade flows between nations.
LO 6-3 Recognize why many economists believe that unrestricted free trade
between nations will raise the economic welfare of countries that participate in a
free trade system.
LO 6-4 Explain the arguments of those who maintain that government can play a
proactive role in promoting national competitive advantage in certain industries.
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LO 6-5 Understand the important implications that international trade theory
holds for management practice.
An Overview of Trade Theory 1 of 4
Free trade
▪ 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 country
▫ Adam Smith’s theory of absolute advantage
▫ The invisible hand of the market
▪ David Ricardo’s theory of comparative advantage
▪ Heckscher-Ohlin theory
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An Overview of Trade Theory 2 of 4
Learning Objective 6-1 Understand why nations trade with each other.
The Benefits of Trade
● Some international trade is beneficial even for products a country can produce for
itself
○ Allows specialization
● Limits on imports are often in the interests of domestic producers but not domestic
consumers
An Overview of Trade Theory 3 of 4
“ The Pattern of International Trade
● Some patterns of trade are fairly easy to
understand, but not all
● Ricardo’s theory of comparative advantage
○ Differences in labor productivity
● Heckscher-Ohlin theory
○ Factors of production
○ Vernon product life-cycle theory
● Krugman’s new trade theory
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Competitive Advantage
Switzerland has long had a national competitive advantage in the
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manufacture of watches.
An Overview of Trade Theory 4 of 4
▪ Trade Theory and Government Policy
▫ Mercantilism
▫ Government involvement in promoting exports and
limiting imports
▫ Smith, Ricardo, and Heckscher-Ohlin
▫ Argument for unrestricted free trade
▫ New trade theory and Porter
▫ Strategic trade policy
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Mercantilism
Learning Objective 6-2 Summarize the different theories explaining trade flows
between nations.
Mercantilism (mid-16th century)
▪ It is in a country’s best interest to maintain a trade surplus—to
export more than it imports
▪ Advocates government intervention to achieve a surplus in the
balance of trade
▪ Mercantilism views trade as a zero-sum game—one in which a
gain by one country results in a loss by another
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Absolute Advantage
Adam Smith (1776) The Wealth of Nations
▪ Absolute advantage
▫ Countries should specialize in the production of
goods for which they have an absolute
advantage and then trade these goods for goods
produced by other countries
▫ Both countries benefit from specialization and
trade
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Figure 6.1 The theory of
absolute advantage
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Comparative
David Ricardo (1817) Principles of Political Economy
Advantage 1 of 8
● A country should specialize in the production of
those goods that it produces most efficiently
and buy the goods that it produces less
efficiently from other countries, even if it can
produce those goods more efficiently itself
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Comparative Advantage 2 of 8
The Gains from Trade
● Potential world production is greater with unrestricted
free trade than it is with restricted trade.
● The theory of comparative advantage suggests that
trade is a positive-sum game in which all countries that
participate realize economic gains.
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Ethics and International Business 9 of 9
Learning Objective 6-3 Recognize why many economists believe that unrestricted free
trade between nations will raise the economic welfare of countries that participate in a
free trade system.
Qualifications and Assumptions
● Simple world with 2 countries and 2 goods
● No transportation costs
● No differences in price of resources
● Resources can move freely
● Constant returns to scale
● Each country has a fixed stock of resources and free trade does
not change the efficiency with which a country uses its
resources 13
● No effects of trade on income distribution within a country
Comparative Advantage 4 of 8
Extensions of the Ricardian Model
● Immobile resources
○ Resources do not always move easily from one
economic activity to another
○ Political opposition to the adoption of a free trade
regime typically comes from those whose jobs are
most at risk
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Comparative Advantage 5 of 8
Extensions of the Ricardian Model continued
● Diminishing returns
○ Constant returns to specialization
○ Diminishing returns to specialization
■ All resources are not the same quality
■ Different goods use resources in
different proportions
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Comparative Advantage 6 of 8
Extensions of the Ricardian Model continued
▪ Dynamic Effects and Economic Growth
▫ Trade can result in dynamic changes
▫ Free trade might increase a country’s stock of
resources as increased supplies of labor and capital
from abroad become available for use within the
country.
▫ Free trade might also increase the efficiency with
which a country uses its resources.
▫ Dynamic gains in both the stock of a country’s resources and
the efficiency with which resources are utilized will cause a
country’s PPF to shift outward. 16
Figure 6.4 The influence of free trade on the PPF
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Comparative Advantage 7 of 8
Extensions of the Ricardian Model continued
▪ Trade, Jobs and Wages: The Samuelson Critique
▫ What happens when a rich country (U.S.) enters into a free
trade agreement with a poor country (China) that rapidly
improves its productivity after the introduction of a free
trade regime?
▪ Lower prices may not make up for lower wages in the U.S.
▪ Historically, free trade has benefited wealthy countries.
▪ Protectionist measures may be harmful.
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Extensions of the Ricardian Model continued
● Evidence for the link between trade and growth
○ Countries that adopt a more open stance toward
international trade enjoy higher growth rates than
those that close their economies to trade.
Comparative Advantage 8 of 8 19
Heckscher-Ohlin Theory 1 of 2
Learning Objective 6-2 Summarize the different theories explaining trade flows between
nations.
Factor endowments
▪ Comparative advantage arises from differences in national factor
endowments.
▪ Countries will export those goods that make intensive use of
factors that are locally abundant.
▪ Countries will also import goods that make intensive use of
factors that are locally scarce.
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Heckscher-Ohlin Theory 2 of 2
The Leontief Paradox
▪ Raised questions about the validity of the Heckscher-Ohlin
theory
▪ Found that U.S. exports were less capital intensive than U.S.
imports.
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The Product Life-Cycle Theory 1 of 2
Raymond Vernon proposed this in 1960s
▪ Most new products were developed and first sold
▪ in the U.S.
▪ The wealth and size of the U.S. market gave U.S.
▪ firms a strong incentive to develop new consumer
▪ products.
▪ The high cost of U.S. labor gave U.S. firms an
▪ incentive to develop cost-saving process
▪ innovations.
▪ Over time demand grows in other countries, and
▪ price becomes competitive. 22
The Product Life-Cycle Theory 2 of 2
Product Life-Cycle Theory in the Twenty-First
Century
▪ Historically, an accurate theory
▪ Now seems ethnocentric and increasingly dated
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New Trade Theory 1 of 4
Economies of scale
▪ Major source of cost reductions
▪ The ability of firms to gain economies of scale can have
important implications for international trade.
1. Trade can increase the variety of goods available to consumers
and decrease the average cost of those goods.
2. In those industries in which the output required to attain
economies of scale represents a significant proportion of total
world demand, the global market may be able to support only a
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small number of enterprises.
New Trade Theory 2 of 4
Learning Objective 6-3 Recognize why many economists believe that unrestricted free
trade between nations will raise the economic welfare of countries that participate in a
free trade system.
Increasing Product Variety and Reducing Costs
▪ World without trade
▫ The variety of goods that a country can produce and the
scale of production are limited by the size of the market.
▪ World with trade
▪ Individual national markets are combined into a larger world
market.
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▪ Each nation can increase the variety of goods available to its
consumers and lower the costs of those goods.
New Trade Theory 3 of 4
Economies of Scale, First-Mover Advantages, and
the Pattern of Trade
▪ First-mover advantages
▫ Can gain a scale-based cost advantage that later
entrants find almost impossible to match
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New Trade Theory 4 of 4
Implications of New Trade Theory
● Nations may benefit from trade even when they do not
differ in resource endowments or technology.
● A country may predominate in the export of a good
simply because it was lucky enough to have one or
more firms among the first to produce that good.
● Luck, entrepreneurship, and innovation give a firm
first-mover advantages.
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National Competitive Advantage: Porter’s
Diamond 1 of 6
Learning Objective 6-2 Summarize the different theories explaining trade flows
between nations.
Porter
▪ Why does a nation achieve international success in a particular industry?
▪ Four broad attributes of a nation shape the environment in which local firms
compete
1. Factor endowments
2. Demand conditions
3. Related and supporting industries
4. Firm strategy, structure, and rivalry
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Figure 6.5 The determinants of national
competitive advantage: Porter’s diamond
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National Competitive Advantage: Porter’s
Diamond 2 of 6
Porter continued
● The diamond
○ Firms are most likely to succeed in industries or industry
segments where the diamond is most favorable
○ A mutually reinforcing system
○ Two additional variables can influence the national diamond
1. Chance
2. Government
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National Competitive Advantage: Porter’s
Diamond 3 of 6
Factor Endowments
▪ Basic factors
▫ Natural resources, climate, location, demographics
▪ Advanced factors
▫ Communication infrastructure, sophisticated and skilled
labor, research facilities, and technological know-how
▫ Advanced factors are a product of investment by individuals,
companies, and governments
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National Competitive Advantage: Porter’s
Diamond 4 of 6
Demand Conditions
▪ Firms gain competitive advantage if their domestic consumers
are sophisticated and demanding
Related and Supporting Industries
▪ The benefits of investments in advanced factors of production
by related and supporting industries can spill over into an
industry, thereby helping it achieve a strong competitive
position internationally
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National Competitive Advantage: Porter’s
Diamond 5 of 6
Firm Strategy, Structure, and Rivalry
● Different nations are characterized by different
management ideologies, which may or may not help them
build national competitive advantage
● There is a strong association between vigorous domestic
rivalry and the creation and persistence of competitive
advantage in an industry
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Learning Objective 6-4 Explain the arguments of those who maintain that
government can play a proactive role in promoting national competitive advantage in
certain industries.
Evaluating Porter’s Theory
● Government policy can influence supporting and related
industries through regulation and influence firm rivalry
through such devices as capital market regulation, tax policy,
and antitrust laws.
● Porter’s theory has not been subjected to detailed empirical
testing.
National Competitive Advantage: Porter’s Diamond 34
6 of 6
Focus on Managerial Implications
Learning Objective 6-5 Understand the important implications that international trade
theory holds for business practice.
Location, First-Mover Advantages, and Government
Policy
● Location: from a profit perspective, firms should disperse
production to countries where they can be performed most
efficiently.
● First-mover advantages: it pays to invest substantial financial
resources in trying to build an early advantage.
● Government policy: according to Porter, government should
invest in education, infrastructure, and basic research
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Appendix of
Image Long
Descriptions
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Appendix 1 Figure 6.1 The theory of absolute
advantage
Ghana would be able to produce 10 tons of cocoa and 5 tons of rice (point A in Figure 6.1),
while South Korea would be able to produce 10 tons of rice and 2.5 tons of cocoa (point B in
Figure 6.1). Without trade, the combined production of both countries would be 12.5 tons of
cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons in Ghana and
10 tons in South Korea). If each country were to specialize in producing the good for which it
had an absolute advantage and then trade with the other for the good it lacks, Ghana could
produce 20 tons of cocoa, and South Korea could produce 20 tons of rice. Thus, by
specializing, the production of both goods could be increased. Production of cocoa would
increase from 12.5 tons to 20 tons, while production of rice would increase from 15 tons to
20 tons. The increase in production that would result from specialization is therefore 7.5
tons of cocoa and 5 tons of rice.
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Appendix 2 Figure 6.5 The determinants of
national competitive advantage: Porter’s diamond.
Porter’s four broad attributes are: factor
endowments; demand conditions; related and
supporting industries; and firm strategy, structure,
and rivalry. Each impacts the others.
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