The Theories of TradeThe Theories of Trade

Learning ObjectivesLearning ObjectivesTo understand the traditional To understand the traditional arguments of how and why arguments of how and why international trade improves the international trade improves the welfare of all countrieswelfare of all countries

To explore the similarities and To explore the similarities and distinctions between international distinctions between international trade and international investmenttrade and international investment

Evolution of Trade TheoryEvolution of Trade Theory

The Age of MercantilismThe Age of MercantilismClassical Trade TheoryClassical Trade TheoryFactor Proportions Trade TheoryFactor Proportions Trade TheoryInternational Investment and International Investment and Product Cycle TheoryProduct Cycle TheoryThe New Trade Theory: Strategic The New Trade Theory: Strategic TradeTrade

MercantilismMercantilism

Mixed exchange through trade Mixed exchange through trade with accumulation of wealthwith accumulation of wealth

Conducted under authority of Conducted under authority of governmentgovernment

Demise of mercantilism Demise of mercantilism inevitableinevitable

Classical Trade TheoryClassical Trade TheoryThe Theory of Absolute AdvantageThe Theory of Absolute Advantage– The ability of a country to produce a product The ability of a country to produce a product

with fewer inputs than another countrywith fewer inputs than another country

The Theory of Comparative AdvantageThe Theory of Comparative Advantage– The notion that although a country may The notion that although a country may

produce both products more cheaply than produce both products more cheaply than another country, it is relatively better at another country, it is relatively better at producing one product than the otherproducing one product than the other

Classical Trade Theory Classical Trade Theory ContributionsContributions

Adam Smith—Division of LaborAdam Smith—Division of Labor– Industrial societies increase output using Industrial societies increase output using

same labor-hours as pre-industrial societysame labor-hours as pre-industrial society

David Ricardo—Comparative David Ricardo—Comparative AdvantageAdvantage– Countries with no obvious reason for Countries with no obvious reason for

trade can specialize in production, and trade can specialize in production, and trade for products they do not producetrade for products they do not produce

Gains From TradeGains From Trade– A nation can achieve consumption levels A nation can achieve consumption levels

beyond what it could produce by itselfbeyond what it could produce by itself

Factor Proportions Trade TheoryFactor Proportions Trade Theory

Developed by Eli HeckscherDeveloped by Eli Heckscher

Expanded by Bertil OhlinExpanded by Bertil Ohlin

Factor Proportions Trade TheoryFactor Proportions Trade TheoryConsiders Two Factors of ProductionConsiders Two Factors of Production

LaborLaborCapitalCapital

Factor Proportions Trade TheoryFactor Proportions Trade Theory

A country that is relatively labor A country that is relatively labor abundant (capital abundant) abundant (capital abundant) should specialize in the should specialize in the production and export of that production and export of that product which is relatively labor product which is relatively labor intensive (capital intensive). intensive (capital intensive).

Product Cycle TheoryProduct Cycle Theory

Raymond VernonRaymond Vernon

Focus on the product, not its Focus on the product, not its factor proportionsfactor proportions

Two technology-based Two technology-based premisespremises

Product Cycle Theory:Product Cycle Theory:Vernon’s PremisesVernon’s Premises

Technical innovations leading to Technical innovations leading to new and profitable products new and profitable products require large quantities of capital require large quantities of capital and skilled laborand skilled labor

The product and the methods for The product and the methods for manufacture go through three manufacture go through three stages of maturationstages of maturation

Stages of the Product CycleStages of the Product Cycle

The New ProductThe New Product

The Maturing ProductThe Maturing Product

The Standardized ProductThe Standardized Product

The Product Cycle and Trade The Product Cycle and Trade ImplicationsImplications

Increased emphasis on technology’s Increased emphasis on technology’s impact on product costimpact on product cost

Explained international investmentExplained international investment

LimitationsLimitations– Most appropriate for technology-based Most appropriate for technology-based

productsproducts– Some products not easily characterized by Some products not easily characterized by

stages of maturitystages of maturity– Most relevant to products produced through Most relevant to products produced through

mass productionmass production

The New Trade Theory: The New Trade Theory: Strategic TradeStrategic Trade

Two New ContributionsTwo New ContributionsPaul Krugman-How trade is Paul Krugman-How trade is altered when markets are not altered when markets are not perfectly competitiveperfectly competitive

Michael Porter-Examined Michael Porter-Examined competitiveness of industries on competitiveness of industries on a global basisa global basis

Strategic TradeStrategic Trade

Krugman’s Economics of Scale:Krugman’s Economics of Scale:Internal Economies of ScaleInternal Economies of ScaleExternal Economies of ScaleExternal Economies of Scale

Strategic TradeStrategic Trade

Government can play a beneficial Government can play a beneficial role when markets are not purely role when markets are not purely competitivecompetitiveTheory expands to government’s Theory expands to government’s role in international traderole in international tradeFour circumstances exist that Four circumstances exist that involve imperfect competition in involve imperfect competition in which strategic trade may applywhich strategic trade may apply

Strategic TradeStrategic Trade

The Four Circumstances Involving The Four Circumstances Involving Imperfect Competition:Imperfect Competition:

1.Price1.Price2.Cost2.Cost

3. Repetition3. Repetition 4.Externalities4.Externalities