The Theory of Trade and Investment

Prepared for class discussion

By
Prof. S.Suryanarayanan
 Learning Objectives
 Understand why nations trade with each other.
 Summarize the different theories explaining trade flows between
nations.
 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.
 Explain the arguments of those who maintain that government
can play a proactive role in promoting national competitive advantage
in certain industries.
 Understand the important implications that international trade
theory holds for management practice.
 Why and how trade and investment occurs across borders?

 Why do countries trade?

 Do countries trade or do firms trade?
 Do the elements that give rise to the competitiveness of a firm, an
industry or a country as a whole, arise from some inherent endowment
of the country itself or do they change with time and circumstance?
 Once identified, can these sources of competitiveness be manipulated
or managed by firms or governments to the benefit of the traders?
 Evolution of trade:
 Collapse of feudal society; autarky, a society that did not trade; self
sufficiency
 Emergence of mercantilism; benefits of trade, colonial possessions,
colonialism, British East India company,
 Mercantilism: Political and economic policy in the seventeenth and
eighteenth centuries aimed at increasing nation’s wealth and power by
encouraging the export of goods in return for gold.

 Benefits of Industrial Revolution, fall of mercantilism.

The Evolution of Trade Theory
The Theory of Absolute Advantage
Adam Smith, 1776

The Theory of Comparative

Advantage
David Ricardo, 1819
The Theory of Factor Proportions
Eli Heckscher and Bertil Ohlin, early 20th
Century

Overlapping Product Ranges

The Leontief Paradox
Theory
Wassily Leontief, 1950
Staffan Burenstam Linder, 1960s
Imperfect Markets/Strategic
Product Cycle Theory
Trade
Raymond Vernon, 1966
Paul Krugman, 1980s
The Competitive Advantage of
Chapter 3
Nations
Michael Porter, 1990s
5 Czinkota: International Business, 8e
 An Overview of Trade Theory

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
 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
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
 Evolution of trade theory
 Theory of Absolute advantage by Adam smith
 Each country should specialize in the production and export of that good which it
produces most efficiently-that is, with the fewest labor hours.

 Absolute advantage: The ability to produce a good or service more efficiently than it
can be produced elsewhere.
 Division of labor: The premise of modern industrial production where each stage in the
production of a good is performed by one individual separately, rather than one
individual being responsible for the entire production of the good.
 Theory of comparative advantage by David Ricardo
 Even if one country was most efficient in the production of two products. It must be
relatively more efficient in the production of one good. It should then specialize in the
production and export of that good in exchange for the importation of the other good.
 Comparative advantage: The ability to produce a good or service more cheaply,
relative to other goods and services than is possible in other countries.

 Example:
 Ghana and South Korea have 200 units of resources
 Ghana produces 1 tonne of Cocoa with 10 units of resources and 1 tonne of rice with 20
units of resources
 South Korea takes 40 units of resources to produce I tonne of Cocoa and 10 units of
resoureces for 1 tonne of rice
 Production possibility frontier:
A theoretical method of representing the total productive capabilities of a nation used in the formulation of classical and
modern trade theory.

Basis: 200 units of Cocoa, tons Rice, tons

resources
Ghana 20 0
10 5
0 10
South korea 5 0
2.5 10
0 20
 Gains from international trade

Resources reqd.to produce 1 Cocoa Rice

ton of
Ghana 10 20
South korea 40 10
Production and consumption
without trade

Ghana 10 5
South korea 2.5 10
Total 12.5 15
Production with
specialization
Ghana 20 0
South korea 0 20
Total production 20 20
Consumption after Ghana tons of cocoa with 6 tons of Korean rice
trades 6 south
Ghana 14 (4) 6 (1)
South korea 6 (3.5) 14 (4)
Figures in bracket shows Consumption as a result of
increase in specialization and trade.
 Is Unrestricted Free Trade Always Beneficial?
 Unrestricted free trade is beneficial, but the gains may not be as great
as the simple model of comparative advantage would suggest
 immobile resources
 diminishing returns
 dynamic effects and economic growth
 the Samuelson critique
 But, opening a country to trade could increase
 a country's stock of resources as increased supplies become
available from abroad
 the efficiency of resource utilization and so free up resources for
other uses
 economic growth
Could A Rich Country Be Worse Off With Free Trade?
 Paul Samuelson - the dynamic gains from trade may not always be
beneficial
 Free trade may ultimately result in lower wages in the rich country
 The ability to offshore services jobs that were traditionally not
internationally mobile may have the effect of a mass inward migration
into the United States, where wages would then fall
 But, protectionist measures could create a more harmful situation
than free trade
 Factor Endowment
(Hecksher-Ohlin) Theory
 A nation will export the goods whose production requires intensive use of the nation’s
relatively abundant and cheap factors and import the goods whose production requires
intensive use of its scarce and expensive factors.
 Factor intensity in production
 Factors of production-all inputs into the production process including capital, labour, land
and technology.
 Factor intensity—the proportion of capital input to labour input used in the production of
good.
 The countries endowment determines the relative costs of labour and capital as
compared with other countries.
 The Leontief paradox
 Wassily Leontief carried out an empirical test of the Heckscher-Ohlin Model in 1951 and
found that the US exported more labour-intensive commodities and imported more
capital intensive products which was contrary to the results of Heckscher-Ohlin Model of
factor endowment.

 Input-output analysis: a method for estimating market activities and potential that
measures the factors inflows into production and resultant outflow of products.

 Assumption– technologies are same in all countries.

 Country Similarity Theory

 Trade occurs between nations that have similar characteristics, such as

economic, geographic, cultural, etc. However, in case of manufactured
goods, cost was determined by similarity in product demands across
countries rather than by relative production costs or factor endowments
 Product cycle theory
 The theory explains the variations and reasons for change in production and consumption
pattern among various markets over a time period.
 The PLC has four distinct identifiable stages that influences demand structure, production,
marketing strategy, and international competition as follows:
Stage 1: Introduction
Stage 2: Growth
Stage 3: Maturity
Stage 4: Decline

 Location of production moves from industrialised to lower cost developing nations.

 The New Trade Theory
 Economies of scale and imperfect competition
 The theory elucidates that international trade enables a firm to increase its output due to
specialization by providing larger markets, resulting into enhancing its efficiency. It helps
explain the trade patterns when markets are not perfectly competitive or when
economies of scale are achieved by production of specific products.

 Abandoned product range-the outcome of a firm narrowing its range of products to

obtain economies of scale which provides opportunities for other firms to enter the
markets for the abandoned products.
 Intra industry trade-the simultaneous export and import of the same good by a country.
It is of interest due to the traditional theory that a country will either export or import a
good but not to do both at the same time.
 Product differentiation- the effort to build unique differences or improvements into
products.
 Strategic trade in imperfect competition; circumstances are:
1. Price—monopolistic, government interference-
2. Cost—scale economies
3. Repetition– learning by doing
4. Externalities– government subsidizes, promotes externalities like education, training
 Theory of Competitive Advantage

 According to the theory, a firm’s home country environment is the main source of
competencies and innovations often referred to as the diamond mode, it focuses
upon the four determinants:
 Factor (Input) Conditions
 Firm Strategy and Rivalry
 Demand Conditions
 Related and Supporting Industries
 1. Factor Conditions (Contrary to conventional wisdom, Porter argues that the "key"
factors of production (or specialized factors) are created, not inherited. Specialized
factors of production are skilled labor, capital and infrastructure. "Non-key" factors or
general use factors , such as unskilled labor and raw materials, can be obtained by
any company and, hence, do not generate sustained competitive advantage.
However, specialized factors involve heavy, sustained investment. They are more
difficult to duplicate. This leads to a competitive advantage, because if other firms
cannot easily duplicate these factors, they are valuable).
 2.Firm Strategy, Structure and Rivalry (The world is dominated by
dynamic conditions, and it is direct competition that impels firms to work
for increases in productivity and innovation)
 3. Demand Conditions (The more demanding the customers in an
economy, the greater the pressure facing firms to constantly improve
their competitiveness via innovative products,through high quality, etc)
 4. Related Supporting Industries (Spatial proximity of upstream or
downstream industries facilitates the exchange of information and
promotes a continuous exchange of ideas and innovations)
What Are The Implications Of Trade theory For Managers?
 Or why do managers understand International Trade Theory?
1. Location implications - a firm should disperse its various productive activities to
those countries where they can be performed most efficiently
 firms that do not may be at a competitive disadvantage
2. First-mover implications - a first-mover advantage can help a firm dominate
global trade in that product
3. Policy implications - firms should work to encourage governmental policies that
support free trade
 want policies that have a favorable impact on each component of the
diamond
 Is ‘ mercantilism’ a zero sum game?
 Mercantilism views trade as a zero-sum game—one in which a gain by
one country results in a loss by another
 Does ‘ theory of absolute advantage’ suggest trade positive?
 If each country specializes in the production of the good in which it has
an absolute advantage and trades for the other, both countries gain
 trade is a positive sum game
 Is free trade encouraged by ‘ theory of comparative advantage’ a
positive sum game?
 Comparative advantage theory provides a strong rationale for
encouraging free trade
 total output is higher
 both countries benefit
 Trade is a positive sum game
 An Overview of Trade Theory
 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