International Business

Trade Theories

Prof. C . K . Sreedharan

Brief Background

• Foreign trade is as old as history.• International trade is so old, that no one can

say when it began.• Ancient world trade existed in Mesopotamia

and Rome.• In fact the ancient Roman empire became

powerful due to international trade.

• The Europeans initially developed the ship building industry and invented navigational system.

• Navigators like Christopher Columbus, Marco Polo and Vasco Da Gama planned voyages to Asia in general and to India in particular, which at that time was known for its wealth and prosperity all over the world.

• Modern trade can be traced back to 14 th. Century when Spain, Portugal, France, England etc. created trade routes.

• The Europeans soon realized that the quickest way to earn wealth was to first start trading with Asian countries and then to colonize them. India was a perfect example of colonization by Briton.

Reasons for foreign trade

• The natural resources of the world are unevenly distributed.

• One country possess product “X” in surplus and lacks in respect of product “Y”. In another country the reverse may be true.

• Example:• Concentration of resources such as oil in the

middle east.• Abundant availability of diamond in South

Africa.• Hence uneven distribution of resources make

foreign trade inevitable and desirable.

Trade Theories

• Hence it is a fact that foreign trade between countries existed for thousands of years.

• But it was not until the 15 th. Century that people tried to explain why trade occurs and how trade benefits the countries.

• Trade theories try to explain why trade between countries take place.

• These theories are getting modified and new theories are being developed.

• The well known international trade theories are given below:S.No

Trade Theory Period

1234

567

Theory of MercantalismTheory of Absolute AdvantageTheory of Comparative AdvantageFactor Endowments or Heckscher- Ohlin TheoryProduct Life Cycle TheoryNew Trade TheoryMichael Porter’s Diamond model( National competitive advantage)

15-16 Century177618171933

196019801990

Theory of Mercantalism

• It is the first international trade theory which emerged in England in the mid-16 th. Century.

• The main feature of this theory is that gold and silver are important for creating national wealth and for commerce.

• During that time, gold and silver were the currency of trade between countries.

• A country could earn gold and silver by exporting goods.

• Similarly importing goods from other countries would result in the outflow of gold and silver to other countries.

• According to this theory, earning of gold and silver is the main motive for trade.

• This theory advocated that countries should simultaneously encourage exports and discourage imports.

• This theory was of the notion that exports was per say good because they earn a country gold, while imports were per say bad because they resulted in the outgo of gold. ( In olden days gold was the currency normally used for trade).

• A country should strive to reduce its dependence on imports by producing as much as it could itself.

• In practical terms, it suggested that the govt. policy should seek to reduce imports by imposing duties on imports.

• At the same time, every effort should be made to boost exports by whatever means.

• Hence the main tenet of Mercantalism theory was that it was in the countries best interest to maintain a trade surplus- by exporting more than the import.

• Criticisms:• If one country succeeds in achieving a large

export surplus it can do so only if other countries run a trade deficit.

• If all the countries follow such a policy, the result will be disastrous.

• Either one country will succeed at the expense of the rest or all will fail.

• But all countries should benefit through international trade.

• But in reality the mercantile doctrine is still being followed by many countries.

• Governments of all countries today are intervening in their foreign trade by imposing tariff and non tariff barriers on imports and offering incentives to exports.

• This theory is no longer relevant in the present day of Globalization.

• However, other theories which were propagated later provide a more useful explanation of why nations trade with each other.

Theory of Absolute Advantage

• This theory was profounded by Adam Smith – who is called as Father of Modern Day Economics.

• In his book “ The Wealth of Nations”- published in the year 1776 Smith argued that countries differ in their ability to produce goods efficiently.

• The theory states that a country is supposed to have an absolute advantage in the production of an item when it is more efficient than others.

• Each country should specialize in the production of the product in which it has an absolute advantage and trade these goods.

• Procure its needs of other products in which it has disadvantage through trade.

• In his time, the English, by virtue of their superior manufacturing processes, were the world’s most efficient textile manufacturers.

• Due to the combination of favourable climate, good soil and accumulated expertise, the French had the world’s most efficient wine industry.

• As per Adam Smith, English should specialize in the production of textiles while French should specialize in wine.

• England could get all the wine it needed by selling its textiles to France and buying wine in exchange.

• Similarly, France could get all the textiles it needed by selling wine to England and buying textile in exchange.

• This way both countries stand to gain by trade.

• Absolute advantage may come due to the factors of climate, quality of land , natural resources or expertise of labour, technology and entrepreneurship.

• Example: The example given below explains the theory better.

• In the following example the efficiency of two countries is measured in terms of the labour hours required to produce one unit of each product.

Country Oil oil Shoes

Spain 2 4

Italy 4 2

• From the above, it can be seen that Spain has an absolute advantage in the production of olive oil (it takes only 2 hours to produce one unit) , where as Italy has absolute advantage to produce shoes ( it takes only 2 hours to produce one unit).

• As per the theory, Spain should export olive oil and import shoes. Likewise, Italy should export shoes to Spain and import oil from it.

Theory of Comparative Advantage

• Trade based on Absolute advantage is easy to understand.

• But what happens when one country can produce all the products with an absolute advantage?. Can trade take place?. Can trade be mutually advantageous to the trading partners?

• In this context, the theory of Comparative Advantage propagated by David Ricardo becomes meaningful.

• In his book “ Principles of political Economy” (1817), Ricardo argued that it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce itself efficiently.

• The theory states that relative rather than absolute cost difference should be basis for export.

• As per this theory a country should specialize in the production of those goods that it produces more efficiently than other countries.

Example

• One ton of

• Cloth Wheat

• France 30 hrs 40 hrs

• Germany 10 hrs 20 hrs

• From the above data, it can be seen that Germany has an Absolute Advantage in the production of both cloth and wheat. It can produce both in lesser hours than France.

• Based on this data, one may conclude that Germany should produce both cloth and wheat it needs and not trade with France at all.

• However this solution is not optimal.

• Let us analyze the situation.

• Germany can produce three times as much cloth as France(30/10), but only two times as much wheat(40/20).

• Hence Germany is comparatively more efficient in producing cloth than wheat.

• Germany should devote all its resources to producing cloth and import all the wheat it needs from France.

• France should specialize in producing wheat and import all its cloth from Germany.

• Each country benefits by specializing in the product in which it has a comparative or relative advantage, and then obtain the other product through trade.

Assumptions and Limitations

• The two theories- Absolute and Comparative Advantage- are based on several assumptions that limit their real-world application.

1. It is assumed that countries are driven only by the maximization of production and consumption. This not true. Governments of most countries are guided by other considerations when they are trading with other countries.

2. The theories assume that there are only two countries engaged in the production and consumption of just two goods. This is also is not the case.There are currently more than 200 countries and a countless nuber of transactions take place worldwide.

3. It is assumed that that there are no transportation costs involved for exporting goods from one country to another.

- In reality transportation costs are major expenses in international trade.

- If transportation costs outweigh the benefits trade will not occur at all.

4. The two theories consider that labour is the only factor of production that helps convert raw materials into finished products.

- At the time when the theories were propounded, production processes were highly labour intensive and wage cost was the major element in the total cost of production.

• It was also assumed that labour was immobile.

• The scenario is different now.

• The Silicon Valley is largely staffed by Indians.

Factor Endowments or Hecksher-Ohlin Theory

• Also known as factor proportion theory.• Swedish economists Hecksher and Ohlin had

put forward a different explanation of comparative advantage.

• According to this theory, the comparative advantage of a country arises from differences in national factor endowments.

• Factors of endowment mean the extent to which a country is endowed with resources like land, labour and capital.

• Different nations have different factor endowments, and different factor endowments result in different factor costs.

• The theory says that countries will export those goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce.

• In other words the theory states that a country with abundant capital will export capital-intensive goods, while the labour abundant countries will export labour-intensive products.

• Despite its commonsense appeal, this theory is not validated by research.

• The subsequent researches conducted concluded that capital-abundant country cannot export capital-intensive goods.

• It has been observed that despite the US having abundant capital, its exports were labour-intensive and imports capital intensive.

Product life cycle theory

• This theory is developed by Raymond Vernon of Harvard Business School which considers the influence of MNC’s in the world trade.

• This theory (is also called as International Product Life Cycle Theory) says that a company starts by exporting its products, moves to a foreign country through FDI and eventually exports back to the home country thereby the initial exports eventually becoming its import.

• Product Life Cycle Theory

1New productdevelopment

2Sales in owncountry

3Limited export to Other countries 4

Regular exports fromParent country

Production inForeign country

5

6 Reverse export

• Stage 1-2: The firm introduces an innovative product in response to a felt need in the domestic market.This is sold mainly in domestic market.

• Stage 2-3: The product reaches growth stage and the firm starts exporting.

• Stage 4-5: Demand for the product grows in foreign market and the firm sets up manufacturing facility in the foreign country.

• Stage-6: Cost of production increases in the home country and also competition in the home country increases. The firm starts importing the product.

Example

• The photocopier was developed in 1960s by Xerox in the US and initially sold in US.

• Later Xerox exported photocopiers to Japan and to advanced countries in Europe.

• As demand started to grow in these countries, Xerox entered into JV in Japan with Fuji-Xerox and in UK with Rank- Xerox and started production there.

• Once Xerox’s patent expired, other foreign competitors like Canon in Japan and Olivetti in Italy stared to produce the photocopiers.

• As a consequence exports from the US declined and users in US started to buy photocopiers from lower cost foreign sources, particularly from Japan.

• As a consequence US stared to import photocopiers from Japan.

• Limitations:

• As like othe trade theories this theory offers only partial explanation for foreign trade.

• Vernon’s observation is related to US only, innovations can take place not only in capital rich countries but also in other developing countries with large domestic market.

New Trade Theory

• This theory emerged in 1980’s.

• The theory states the following:

1. There are gains from specialization and economies of scale. Specialization improve the ways of performing tasks. Experience curve for example, shall help in reducing the amount of resources needed to produce one unit of output over time.

2. The first movers into any market can create entry barriers to others, and

3. Governments may have a role to play in assisting its home based firms.

* This theory emphasizes productivity rather than a country’s resources, it is in line with the theory of comparative advantage but at odds with the factor endowments model.

• According to this theory, a company increases its output because of specialization which in turn increases efficiency.

• As the output increases, the fixed cost of production gets spread over a large number of units of output.

• The fixed cost per unit of output falls enabling the company to fix a competitive price for its products.

• The firm is now in a position to force potential competitors to produce at the same level and fix identical prices.

• Hence, the first entrant gains “First Mover Advantage” – the economic and strategic advantage gained by being the first entrant into an industry.

• The first mover advantage can create a formidable barrier to entry for potential rivals.

• Limitations:

• The new trade theory is a very recent theory and enough evidence is not available to judge its relevance and applicability.

• The main theme of the theory-first mover advantage- may not always be true.

• A late mover into a market can also gain competitive advantage.

Late mover advantage ( A case )

• Though a late mover, Toyota, the Japanese auto major wants to dispel the notion that the first mover enjoys an edge over the rivals who arrive late into a market.

• Toyota entered the Indian market through the JV route, the partner being the Bangalore based Kirlosker Electric Co., known as Toyota Kirloskar Motor (TKM) , in the year 1998 at Bidadi, near Bangalore.

• To start with, TKM released its maiden offer-Qualis. Qualis virtually had no competition.

• Telco’s Sumo was not a multi-utility vehicle like Qualis, it was a mini-truck converted into a rugged all-purpose van.

• Toyata proved that it could offer better quality than its competitor.

• Backed by a carefully thought out advertising campaign that communicated Toyata’s formidable global reputation, Qualis overtook Tata Sumo within two years of launch.

Michael Porter’s diamond theory.

• As seen earlier classical trade theories described earlier fail to explain adequately why foreign trade takes place.

• Michael Porter, Professor of Harvard, studied 100 companies in 10 developed countries to learn how a firm can become competitive.

• According to Porter, a company which enjoys competitive advantage is in a stronger position to trade with other countries.

• Porter says firm’s competitive advantage stems from the following factors:

1. Factor conditions and endowments2. Firm’s strategy and rivalry3. Demand conditions4. Related and supporting industries and5. Government’s role.

Porter’s Diamond ModelGovernment’s Role

Factor conditions &Endowments

Firm’s strategy &Rivalry.

Demand conditionsRelated & SupportingIndustries.

• Factor conditions and endowments:• Factor conditions include land, labour, natural

resources, capital and infrastructure.• These factors will give initial competitive

advantage to a nation.• Porter says sustained competitive advantage

comes from advanced factors like skilled labour, capital and infrastructure.

• Specialized factors are difficult to duplicate and a firm that possesses these factors enjoys competitive advantage because others can not easily replicate them.

• Porter also argues that lack of resources often actually help countries to become competitive.

• Abundance generates waste and scarcity generates an innovative mind set. Such countries are forced to innovate.

• Example: Drip irrigation system by Israel.

• Demand conditions:• A sophisticated and demanding domestic market is

an important requirement to achieve international competitiveness.

• The firms that have demanding domestic consumers are likely to sell superior products because the market demands high quality.

• Example: The French consume excellent quality wine. These consumers force their wine industries to produce excellent quality wine.

• Related and supporting industries:

• Related and supporting industries enhance the competitive advantage of a firm through close working relationships, joint research, sharing of knowledge and experience. This includes presence of suppliers also.

• Example: Automobile hub around Chennai and Pune.

• Firm’s strategy and rivalry:

• Intense competition spur innovation resulting in improved efficiency.

• Rivalry induces firms to look for ways to improve efficiency.

• Government role:• Government can influence all four of Porter’s

determinants through subsidies and favourable tax rates.

• India’s case is typical. Till 191, Indian firms were protected from competition and remained almost morbid. The scenario changed after 1991.

• Limitations of Porter’s theory:

1. Porter developed his research based on case studies and these tend to apply only to developed countries.

2. Porter’s model does not adequately address the role of MNC’s.

Usefulness of trade theories

• All the trade theories try to explain the importance of international trade.

• They also try to identify the factors which are responsible for promoting trade.

• Trade theories also influence the governments to understand the importance of free trade and may make them to remove trade restrictions and promote free trade.

• For an international manager , whose company is willing to set up a subsidiary in a foreign location, knowledge about the trade theories is useful.

• In order to prepare a project report and defend the proposals when doubts are raised by the overseas officials, international managers need to understand the trade theories.