International Trade Theory

• Adam Smith`s Theory of Absolute Advantage

• David Ricardo`s Theory of Comparative
Advantage
• Heckscher-Ohlin`s Theory of Factor Endowment
• Raymond Vernon`s Product Life Cycle Theory
• New Trade Theory based on economies of scale
• Theory of national competitive advantage:
Porter`s diamond
 International Trade Theory
Trade theory focuses on three basic questions:
• a) What products to import and export?
b) How much to trade?, and
c) With whom to trade?
• Some theories explain trade patterns that exist in the absence of
governmental interference, and some theories explain what
governmental actions should strive for in trade
• Climate and natural resource endowments explain why Brazil
exports coffee, Saudi Arabia exports oil
But
• Why Japan exports electronics and machine tools?
• Switzerland exports chemicals, watches?
 International Trade Theory
• Interplay between proportions in which the factors of production
(land, lab our, capital, technology) are available in different
countries
• Product Life Cycle Theory
• New products are produced in and exported from the country in
which they are produced
• Once product is internationally accepted, production in other
countries as a result it is exported back to original country
• Some countries specialize in the production and export of particular
products not because of differences in factors of endowments, but
in certain industries the world market can support only limited
number of firms
• Certain countries achieve competitive advantage in certain sectors
(Michael Porter)
 International Trade Theory: Mercantilism
• Gold & silver were major component of
national wealth
• Earn gold and silver by exporting goods
• Amass gold and silver to maintain national
prestige and to maintain trade surplus
• Government intervention to achieve trade
surplus
• Flaw with this theory is that it views trade as
zero sum game
Theory of Absolute Advantage
• Adam Smith in 1776 in his book “The Wealth
of Nations” argued that
• Countries differ in their ability to produce
goods efficiently
• Country has an absolute advantage in
production of a product when it is more
efficient than any other country producing it
• Countries should specialize in the
production of goods for which they have
absolute advantage then trade for goods
produced by other countries
Theory of Absolute Advantage
• Countries should never produce goods at
home that it can buy at a lower cost from
other countries
• Specializing in production of goods in
which each has absolute advantage both
countries benefit engaging in trade
Theory of Absolute Advantage
Theory of Absolute Advantage
Theory of Comparative Advantage
• Makes sense for a country
• To specialize in the production of those goods that
it produces most efficiently and to buy goods that it
produces less efficiently from other countries, even if
this means buying goods from other countries that it
could produce more efficiently itself
• Message is “ Potential world production is grater
with unrestricted free trade than it is with
restricted trade”
• Theory suggests that consumers in all nations can
consume more if there are no restrictions on trade
Theory of Comparative Advantage
Theory of Comparative Advantage
Heckscher-Ohlin`s Theory of Factor Endowment
• Put forward different explanation of comparative
advantage
• Comparative advantage arises from differences in
national factor endowments
• Factor endowments mean extent to which a country is
endowed with such resources as land, labour and
capital
• Nations have varying factor endowments and
different factor endowments explain differences in
factor costs that means more abundance a factor, the
lower its cost
Heckscher-Ohlin`s Theory of Factor Endowment
• Predicts that countries will exports those goods that
make intensive use of factors that are locally
abundant while importing goods that make intensive
use of factors that are locally scarce
• Free trade is beneficial
• Differences in factor endowments, rather than
differences in productivity determine pattern of
international trade
• USA exports agriculture products
• China exports labour intensive goods
Product Life Cycle Theory (Raymond Vernon)
• PLC theory explains the location of production
will shift internationally depending upon the
stage of life cycle of the product
• There are four basic stages of PLC
• Introduction
• Growth
• Maturity
• Decline
 Product Life Cycle Theory (Raymond Vernon)

Innovation in Exporting by
response to Evolving
the innovating
observed need product
country

 Early innovation, production, and

sales generally occur in domestic
location
i. To use excess capacity
ii. Quick feedback
iii. Save transportation
Product Life Cycle Stages: Introduction contd..
Location and importance of innovation
 Early manufacturing and sales occur in industrial
countries as 95% of world technology sources
from industrial countries
 Industrial countries have advantage of highly
skilled human resources, high economy which
enable them to invest in R&D
 Innovation is the main source of companies’
competitive strength
 Continuous innovation is required to shield oneself
from imitations
 Innovations/ improvements maybe in the output or
the process (product or manufacturing/ marketing
process)
 LDCs (least developed countries) cannot afford
R&D and hence may lack competitiveness
 Product Life Cycle Stages: Introduction contd..
Exports and labor
 Even during this stage, some exports may
take place in similar market segments
 The high-scale production process takes
sometime to streamline
 Production will not be standardized at this
stage, hence it is more labor-intensive to
allow rapid changes as dictated by market
feedback
 Product Life Cycle Stages: Growth
- Increase in exports by the innovating country
- To address increase in foreign demand (of similar nature)
- Increase in exports by the innovating country
- To address increase in foreign demand (of similar nature)
- More competition
- Competition enforces more
variations so need for labor
intensive production may still arise
- Increased capital intensity
- Rapid growth in sales encourages
standardization and development of
process technology
- Some foreign Companies expand to
foreign production; establish and
specialize in foreign market
Product Life Cycle Stages: Maturity
Maturity stage is characterized by
 Decline in exports by the innovating country
 Decrease in demand in some countries and increase
in some, but overall demand falls
 More product standardization
 More capital intensity
 Increased price
competition
 Production startups
in LDCs
 Encouraged use of
unskilled labor in LDCs
Product Life Cycle Stages: Decline

Decline stage is
characterized by
 Concentration of
production in LDCs
 Innovating country
becoming net importer
 Product Life Cycle Stages
Introduction Growth Maturity Decline
Production - In innovating (usually -In innovating and & other - Multiple countries - Mainly in developing
Location industrial country) industrial countries countries

Market - Mainly in innovating - Mainly in industrial countries -Growth in developing -Mainly in developing
Location country with some -Shift in exports markets as countries countries
exports foreign production replaces -Some decrease in -Some developing
exports in some markets industrial countries country exports
Competitive - Near monopoly - Fast growing demand - Overall stabilized -Overall declining
Factors - Sales based on - Number of competitor demand demand
uniqueness rather than increases -Number of competitor - Price is key weapon
price -Some competitors begin price decreases -Number of producers
cutting - Price is very continue to decline
-Product becoming more important, especially in
standardized developing countries

Production - Short production runs - Capital input increases -Long production runs - Unskilled labour on
Technology -Evolving methods to - Methods more standardized using high capital mechanized long
coincide with product inputs production runs
evolution - Highly standardized
-High labour input & -Less labour skill
labour skills relative to needed
capital output
Product Life Cycle Stages: Verification and
Limitations
Reasons for which PLC theory may not hold true
• Shorter life cycle of products requires rapid
innovations, hence no incentive for cost reduction
by changing location, like electronics and
computing goods
• For price inelastic goods-luxury, cost reduction is of
less priority
• In case of very high international transportation
costs involved, no incentive for exports
• Products for which price as a differentiating factor
is of less importance
• Products requiring longer term commitment from
the innovators
 New Trade Theory
• Economies of scale are unit costs reduction
associated with a large scale of output
• International trade results in a country
specializing in the production of a certain goods if
there exists economies of scale in producing that
good
• Economies of scale: the variety of goods that
a country can produce and the scale of production
are limited by the size of market
 New Trade Theory
• Domestic market may not be big enough to achieve
economies of scale for certain products and
accordingly these products may not be produced,
limiting variety of products available to consumers
• New Trade Theory argument
“ If economies of scale represents a substantial
proportion of total world demand for the product,
the world market may be able to support only a
limited number of firms based in limited number of
countries producing that product”
 Example of Aerospace (Big Aircraft Jet Sector)
•Boeing: $ 5 billion to develop Boeing 777
If it makes 100 aircrafts
- then fixed cost would be $ 50 million per unit
- variable cost (labour, parts, equipments) $ 80 million per unit

If it makes 500 aircrafts $ 130 million

-then fixed cost would be $ 10 million per unit
- variable cost (labour, parts, equipments) $ 80 million per unit
$ 90 million
- $ 40 million is saved with increased production
Example of Aerospace (Big Aircraft Jet Sector) cont’ d
Learning Curve Effect:
In aerospace industry each time accumulated output of airframes
was doubled, unit cost declined by 80% of previous level i.e.
- 4th airframe cost 80% of 2nd
- 8th airframe cost 80% of 4th
- 16th airframe cost 80% of 8th
So 100th aircraft variable cost might be $ 80 million
So 500th aircraft variable cost might be $ 60 million
So with learning curve effect + economies of scale
- 100 aircrafts = (50+80) = 130 million per unit
- 500 aircrafts = (10+60) = 70 million per unit
Example of Aerospace (Big Aircraft Jet Sector) cont’ d
List Price is $ 120 million

• Market demand projected is 1500 from time period of 1997 to

2008

• If Boeing makes 500 then only 3 companies can operate in the

sector
 New Trade Theory
• Nations may benefit from trade even when they do
not differ in resource endowments or technology
(Trade allows nations to specialize in the production
of certain products, attaining scale of economies &
lowering the cost) - (First Mover Advantage)
• New trade theory varies with factor endowment
theory that suggest that a country will predominate
in the export of a product when it is particularly well
endowed with these factors used intensively in its
manufacture
Theory of national competitive advantage:
Porter`s Diamond Model

Chance
Firm Strategy,
Structure &
Rivalry

Factor Demand
Endowments Conditions

Related &
Supporting Government
Industries
Porter`s Diamond Model: Factor Endowments
• Nations factors of production such as skilled labour
or the infrastructure necessary to compete in given
industry
• Similarity with Ohlin`s theory
• Analyse the factors of production
• Basic factor: natural resources, climate, location,
demographics
• Advanced factors (products of investment by individuals,
companies& government) : communication,
infrastructure & skilled labour, research facilities,
technological know- how
Porter`s Diamond Model: Demand Conditions
• Nature of home demand for the industry`s product or
service
• Role of home demand plays in upgrading
competitive advantage
• Characteristics of home demand are particularly
important in shaping the attributes of domestically
made products and in creating pressures for
innovation and quality
• Firms gain competitive advantage if their domestic
consumers are sophisticated and demanding
Porter`s Diamond Model: Related & Supporting
Industries
• Presence and absence of supplier industries and
related industries that are internationally competitive
• Presence of suppliers or related industries that are
internationally competitive
• Strength in fabricated steel products (balls, bearings)
has imparted strengths in Swedish`s specialty in steel
industry
• Technological advancement in semi conductor of U.S. in
mid 1980s have good impact in U.S. success in PCs
Porter`s Diamond Model: Firm Strategy,
Structure & Rivalry
• Conditions governing how companies are created,
organised and managed and the nature of domestic
rivalry
• Different nations characterised by different management
ideologies, which either help then or do not help them to
build national competitive advantage
• Strong association between vigorous domestic rivalry
and the creation and persistence of competitive
advantage in an industry
Porter`s Diamond Model: Firm Strategy,
Structure & Rivalry
• Vigorous domestic rivalry induces firms to look for ways to
improve efficiency which makes then better international
competitors
• Domestic rivalry creates pressures to innovate, improve in quality,
reduce costs, invest in upgrading advanced factors
Besides these other two factors are:
•Chance Events: Such as major innovations can reshape industry
structure & provide opportunity for one nation`s firm to supplant
another
• Government: government by its choice of policies, can detract
from or improve national advantage
Source: Handmade paper in Nepal; Banjara GB; GTZ/PSP-RUFIN 2007
Michael Porter’s Diamond Model to identify ruling constraints in
the honey sub sector
Total Average
Factor conditions
Forage 93 3.7
Human Resource availability and skill 74 3.0
Knowledge base and research capability 59 2.4
Capital availability 56 2.2
Infrastructure 60 2.4
Total Average 2.7

Demand conditions
Size of domestic market 90 3.6
Sophistication of buyers 63 2.52
Differentiation among producers 67 2.68
Growth rate of domestic demand 87 3.48
Total Average 3.1
Supporting industries
Product development according to buyer specification 67 2.68

Services: Marketing / Market Research / Advertising 54 2.16

Training 80 3.2
Research and Development 58 2.32
Bottles and other equipment supplies 59 2.36
Producers Association 73 2.92
Promotional institution 59 2.36
Total Average 2.6

Firm Structure
Monopoly or oligopoly in the local market 69 2.76
Backward linkages 67 2.68
Domestic Rivalry 65 2.6
Barriers to entry 85 3.4

Abundance of micro beekeepers / suppliers of raw honey87 3.48

Total Average 3.0

5: Highly favourable, 4: Favourable, 3: Neutral, 2: Unfavourable, 1: Highly unfavourable

Source: Report on “Exploring Competitiveness” Workshop on Honey Sub-sector; Shrestha S. GTZ/PSP-RUFIN 2005
Implications for IB
Location
• From profit perspective, it makes sense for a firm to
disperse its productive activities to those countries
where according to the theory of international trade,
can be performed efficiently
• Result is global web of productive activities, with
different activities being performed in different
locations around the globe
First Mover Advantage
• Firms establish first mover advantage with regard to
the production of particular new product may
subsequently dominate global trade in that product
Implications for IB
First Mover Advantage
• True in industries where the global market can profitably
support only limited number of forms e.g. aerospace & also
early commitments also seem to be important in less
concentrated industries such as cellular phones
Government Policy
• Business can exert strong influence on government trade
policy, lobbying to promote free trade or trade restrictions
• In 1991 IBM & Apple protested strongly against intention
of U.S. government to place tariff on Japanese imports of
LCD screens
• Restrictions on import of steel are result of direct pressure
by U.S. firms on government