Classical theories of International Trade

International Trade Theory
What is international trade?
Exchange of raw materials and manufactured goods (and services) across national borders
Classical trade theories:
explain national economy conditions--country advantages--that enable such exchange to happen
New trade theories:
explain links among natural country advantages, government action, and industry characteristics that enable such exchange to happen
Implications for International Business

Classical Trade Theories
Mercantilism (pre-16th century)
Takes an us-versus-them view of trade
Other country’s gain is our country’s loss
Free Trade theories
Absolute Advantage (Adam Smith, 1776)
Comparative Advantage (David Ricardo, 1817)
Specialization of production and free flow of goods benefit all trading partners’ economies
Free Trade refined
Factor-proportions (Heckscher-Ohlin, 1919)
International product life cycle (Ray Vernon, 1966)

The New Trade Theory
As output expands with specialization, an industry’s ability to realize economies of scale increases and unit costs decrease
Because of scale economies, world demand supports only a few firms in such industries (e.g., commercial aircraft, automobiles)
Countries that had an early entrant to such an industry have an advantage:
Fist-mover advantage
Barrier to entry

New Trade Theory
Global Strategic Rivalry
Firms gain competitive advantage trough: intellectual property, R&D, economies of scale and scope, experience
National Competitive Advantage (Porter, 1990)

Mercantilism/Neomercantilism
Prevailed in 1500 - 1800
Export more to “strangers” than we import to amass treasure, expand kingdom
Zero-sum vs positive-sum game view of trade
Government intervenes to achieve a surplus in exports
King, exporters, domestic producers: happy
Subjects: unhappy because domestic goods stay expensive and of limited variety
Today neo-mercantilists = protectionists: some segments of society shielded short term

Absolute Advantage
Adam Smith: The Wealth of Nations, 1776
Mercantilism weakens country in long run; enriches only a few
A country
Should specialize in production of and export products for which it has absolute advantage; import other products
Has absolute advantage when it is more productive than another country in producing a particular product
Rice
Cocoa
G
G'
K
K'
G: Ghana
K: S. Korea

Comparative Advantage
David Ricardo: Principles of Political Economy, 1817
Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces
Absolute Advantage is a special case of
Comparative Advantage
Rice
Cocoa
G
K
K'
G'
G: Ghana
K: S. Korea

Heckscher (1919)-Ohlin (1933)
Differences in factor endowments not on differences in productivity determine patterns of trade
Absolute amounts of factor endowments matter
Leontief paradox:
US has relatively more abundant capital yet imports goods more capital intensive than those it exports
Explanation(?):
US has special advantage on producing new products made with innovative technologies
These may be less capital intensive till they reach mass-production state

Theory of Relative Factor Endowments (Heckscher-Ohlin)
Factor endowments vary among countries
Products differ according to the types of factors that they need as inputs
A country has a comparative advantage in producing products that intensively use factors of production (resources) it has in abundance
Factors of production: labor, capital, land, human resources, technology

International Product Life-Cycle (Vernon)
Most new products conceived / produced in the US in 20th century
US firms kept production close to their market initially
Aid decisions; minimize risk of new product introductions
Demand not based on price; low product cost not an issue
Limited initial demand in other advanced countries initially
Exports more attractive than overseas production
When demand increases in advanced countries, production follows
With demand expansion in secondary markets
Product becomes standardized
production moves to low production cost areas
Product now imported to US and to advanced countries

Classic Theory Conclusion
Free Trade expands the world “pie” for goods/services
Theory Limitations:
Simple world (two countries, two products)
no transportation costs
no price differences in resources
resources immobile across countries
constant returns to scale
each country has a fixed stock of resources and no efficiency gains in resource use from trade
full employment

New Trade Theories
Increasing returns of specialization due to economies of scale (unit costs of production decrease)
First mover advantages (economies of scale such that barrier to entry crated for second or third company)
Luck... first mover may be simply lucky.
Government intervention: strategic trade policy

National Competitive Advantage (Porter, 1990)
Factor endowments
land, labor, capital, workforce, infrastructure
(some factors can be created...)
Demand conditions
large, sophisticated domestic consumer base: offers an innovation friendly environment and a testing ground
Related and supporting industries
local suppliers cluster around producers and add to innovation
Firm strategy, structure, rivalry
competition good, national governments can create conditions which facilitate and nurture such conditions

Porter’s Diamond