International Trade

Theories
JENNY F. ALPE, LPT
Theories
Classical or Country-Based Modern and Firm - Based
Trade Theories Theories (20th century)
(main historical theories)
Mercantilism Country Similarity

Absolute advantage Product Life cycle

Comparative Advantage Global strategic rivalry

Heckscher-Ohlin Porter’s National Competitive

advantage
Classical or Country-Based
Trade Theories
Mercantilism
• stated that a country’s wealth
was determined by the
amount of its gold and silver
holdings. In it’s simplest sense,
mercantilists believed that a
country should increase its
holdings of gold and silver by
promoting exports and
discouraging imports.
Mercantilism
• Countries objectives is to have
a trade surplus, or a situation
where the value of exports are
greater than the value of
imports, and to avoid a trade
deficit, or a situation where the
value of imports is greater than
the value of exports.
• Protectionism - nations
promoted exports was to impose
restrictions on imports
Absolute Advantage
• It is a theory offered by Adam Smith in 1776.
• focused on the ability of a country to produce
a good more efficiently than another nation.
Smith reasoned that trade between countries
shouldn’t be regulated or restricted by
government policy or intervention.
• if Country A could produce a good cheaper or
faster (or both) than Country B, then Country
A had the advantage and could focus on
specializing on producing that good.
Similarly, if Country B was better at
producing another good, it could focus on
specialization as well.
Absolute Advantage
• Smith’s theory reasoned that with increased efficiencies, people
in both countries would benefit and trade should be encouraged.
His theory stated that a nation’s wealth shouldn’t be judged by
how much gold and silver it had but rather by the living
standards of its people.
Comparative Advantage
• By David Ricardo in 1817. Ricardo reasoned
that even if Country A had the absolute
advantage in the production
of both products, specialization and trade
could still occur between two countries.
• occurs when a country cannot produce a
product more efficiently than the other
country; however, it can produce that
product better and more efficiently than it
does other goods.
• focuses on the relative productivity
differences
Heckscher-Ohlin Theory (Factor
Proportions Theory)
• By Swedish economists, Eli Heckscher and
Bertil Ohlin, 1900s.
• focused their attention on how a country
could gain comparative advantage by
producing products that utilized factors that
were in abundance in the country. Their
theory is based on a country’s production
factors—land, labor, and capital, which
provide the funds for investment in plants
and equipment. They determined that the
cost of any factor or resource was a function
of supply and demand.
Factor proportions theory
• They determined that the cost of any factor or resource
was a function of supply and demand. Factors that
were in great supply relative to demand would be
cheaper; factors in great demand relative to supply
would be more expensive.
• stated that countries would produce and export goods
that required resources or factors that were in great
supply and, therefore, cheaper production factors. In
contrast, countries would import goods that required
resources that were in short supply, but higher
demand.
• For example, China and India are home to cheap, large
pools of labor. Hence these countries have become the
optimal locations for labor-intensive industries like
textiles and garments.
Leontief Paradox
• In the early 1950s, Russian-born American
economist Wassily W. Leontief studied the
US economy closely and noted that the United
States was abundant in capital and, therefore,
should export more capital-intensive goods.

• Capital intensive production requires more

equipment and machinery to produce goods;
therefore, require a larger financial investment.
• Labor intensive refers to production that requires
a higher labor input to carry out production
activities in comparison to the amount of capital
required.
Leontief Paradox
• the United States was importing more capital-
intensive goods. According to the factor
proportions theory, the United States should
have been importing labor-intensive goods, but
instead it was actually exporting them. His
analysis became known as the Leontief
Paradox because it was the reverse of what was
expected by the factor proportions theory. In
subsequent years, economists have noted
historically at that point in time, labor in the
United States was both available in steady
supply and more productive than in many other
countries; hence it made sense to export labor-
intensive goods.
Modern or Firm-Based
Trade Theories
Modern or Firm-Based Trade Theories
• firm-based theories emerged after World War II and was
developed in large part by business school professors, not
economists.
• intraindustry trade - refers to trade between two countries of
goods produced in the same industry. For example, Japan
exports Toyota vehicles to Germany and imports Mercedes-Benz
automobiles from Germany.
• firm-based theories incorporate other product and service
factors, including brand and customer loyalty, technology, and
quality, into the understanding of trade flows.
Country Similarity Theory
• Swedish economist Steffan Linder
developed in 1961, as he tried to explain
the concept of intraindustry trade.
• proposed that consumers in countries
that are in the same or similar stage of
development would have similar
preferences.
Country Similarity Theory
• Linder suggested that companies first
produce for domestic consumption. When
they explore exporting, the companies
often find that markets that look similar
to their domestic one, in terms of
customer preferences, offer the most
potential for success.
• This theory is often most useful in
understanding trade in goods where
brand names and product reputations are
important factors in the buyers’ decision-
making and purchasing processes.
Product Life Cycle Theory
• Raymond Vernon, a Harvard Business
School professor, developed in 1960s.
• The theory, originating in the field of
marketing, stated that a product life
cycle has three distinct stages:
(1) new product
(2) maturing product
(3) standardized product.
Product Life Cycle Theory
• The theory assumed that production of the
new product will occur completely in the
home country of its innovation.
• It has also been used to describe how the new Maturing
personal computer (PC) went through its product product
product cycle. The PC was a new product in
the 1970s and developed into a mature
product during the 1980s and 1990s. Today,
the PC is in the standardized product stage, Standardized
and the majority of manufacturing and product
production process is done in low-cost
countries in Asia and Mexico.
Global Strategic Rivalry Theory
• emerged in the 1980s and was based on the
work of economists Paul Krugman and Kelvin
Lancaster.
• Firms will encounter global competition in
their industries and in order to prosper, they
must develop competitive advantages. The
critical ways that firms can obtain a
sustainable competitive advantage are called
the barriers to entry for that industry.
• barriers to entry refer to the obstacles a new
firm may face when trying to enter into an industry
or new market.
The barriers to entry that corporations
may seek to optimize include:
• research and development,
• the ownership of intellectual property rights,
• economies of scale,
• unique business processes or methods as well as extensive
experience in the industry, and
• the control of resources or favorable access to raw materials.
Porter’s National Competitive Advantage
Theory
• Michael Porter of Harvard Business School
developed a new model to explain national
competitive advantage in 1990.
• states that a nation’s competitiveness in an
industry depends on the capacity of the
industry to innovate and upgrade. His
theory focused on explaining why some
nations are more competitive in certain
industries.
The four determinants in Porter’s Theory
• local market resources and
capabilities
• local market demand
conditions,
• local suppliers and
complementary industries
• local firm characteristics.
Local market resources and
capabilities (factor conditions)
• Porter recognized the value of the factor proportions theory,
which considers a nation’s resources (e.g., natural resources and
available labor) as key factors in determining what products a
country will import or export. Porter added to these basic
factors a new list of advanced factors, which he defined as
skilled labor, investments in education, technology, and
infrastructure. He perceived these advanced factors as providing
a country with a sustainable competitive advantage.
Local market demand conditions
• Porter believed that a sophisticated home market is critical to
ensuring ongoing innovation, thereby creating a sustainable
competitive advantage. Companies whose domestic markets are
sophisticated, trendsetting, and demanding forces continuous
innovation and the development of new products and
technologies.
Local suppliers and complementary
industries
• To remain competitive, large global firms benefit from having
strong, efficient supporting and related industries to provide the
inputs required by the industry. Certain industries cluster
geographically, which provides efficiencies and productivity.
Local firm characteristics
• include firm strategy, industry structure, and industry rivalry. Local
strategy affects a firm’s competitiveness. A healthy level of rivalry
between local firms will spur innovation and competitiveness.

In addition to the four determinants of the diamond, Porter also noted

that government and chance play a part in the national
competitiveness of industries. Governments can, by their actions and
policies, increase the competitiveness of firms and occasionally entire
industries.
Any Questions?