Chapter No.

International Trade Theories

Theories
Mercantilism Absolute Advantage Comparative advantage Heckscher-Ohlin Theory New Trade Theory

MERCANTILISM

MERCANTILISM

MERCANTILISM
Mercantilism was the first theory of international trade that emerged in England in 16th Century Mercantilism is economic nationalism for the purpose of building a wealthy and powerful state. Adam Smith defined the term mercantile system to describe the system of political economy that sought to enrich the country by restraining imports and encouraging exports.

 Since gold and silver were viewed as valuable and a sign of wealth, mercantilism suggested that countries should design policies that led to an increase in their holdings of gold and silver. The central idea of mercantilism was that countries should run a balance of trade surplus and have export of greater value than imports. The mercantile system served the interests of merchants and producers such as the British East India Company, whose activities were protected or encouraged by the state.

MERCANTILISTS
Most of the European economists who wrote between 1500 and 1750 are today generally considered mercantilists; this term was initially used solely by critics. Thomas Mun (15711641) as a major creator of the mercantile system, especially with his work published as Treasure by Foreign Trade (1664) Perhaps the last major mercantilist work was James Stuart's Principles of Political Economy published in 1767 Others include Italy's Giovanni Botero (15441617) and Antonio Serra ; France's, Jean Bodin and other

Criticism
Adam Smith criticize this idea in his book The Wealth of Nations. Smith made a number of important criticisms of mercantilist doctrine. First, he demonstrated that trade, when freely initiated, benefits both parties. Second, he argued that specialization in production allows for economies of scale, which improves efficiency and growth. Finally, Smith argued that the collusive relationship between government and industry was harmful to the general population.

Criticism from Hume

Second criticism came from Hume in 1752. Hume demonstrated how a persistent trade surplus would begin to affect money supplies, and in long run close the trade surplus. Example: According to Hume if England has balance of trade surplus with France, the resulting inflow of Gold and Silver in England would increase the domestic money supply and generate inflation in England. While inflation would be lower in France, and French goods would be more competitive. French consumers would be discouraged to buy English goods because they would become too expensive.

Absolute Advantage

ABSOLUTE ADVANTAGE
Adam Smith was the main critic of the Mercantilism. Smith put four specific reasons why a country could gain from trade:
Mutual gains from voluntary exchange of goods Increased competition The division of Labour Better use of Resources

Main Idea of Absolute Advantage

According to Smith countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries. For Example in Smiths time England was the worlds most efficient textile producer. At the same time, France had the worlds most efficient wine industry. England had Absolute advantage in production of textiles, while the French has an absolute Advantage in production of wine. So Smith says that England should concentrate on Textile and England could get all the wine it need by selling its textile to France and buying wine in Exchange.

One more Examples

To simplify the example we will use units of resource input instead of money. The following Hypothetical examples compare the output resulting from the use of 100 Units of resources.
Output possibilities from 100 Units of Resources

Criticism
Would it still be advantageous to trade where one nation is more efficient than another in production of both products?

COMPARATIVE ADVANTAGE

Main Idea of theory

In 1817 the theory was presented by David Ricardo. Theory demonstrates that if a country specializes in the products in which it has the greatest comparative advantage relative to other nations and trades those products for goods in which it has the greatest comparative disadvantage, the countrys total availability of goods will be enlarged. In other words emphasizing comparative rather than absolute advantages the theory shows that every country has a basis for trade and that specialization and trade are more efficient than policies of national self-sufficiency.

Example
Production Possibilities from 100 Units of Resources

Opportunity Cost:
Opportunity cost of any product is what has to be sacrificed in order to obtain it.

One Example
To produce 200 Tonnes of cheese in Australia from 100 units of resources will cost 160 bolts of cloth. In other words, Australia would have to forego 1.25 Tonnes of cheese for every bolt of cloth produced. Alternatively, the opportunity cost of producing 1 Tonnes of cheese is 0.8 bolt of cloth.

Opportunity Cost and Comparative Advantage Opportunity Cost Production 1 Tonne of Cheese Australia 0.8 bolts of cloth UK 1.5 bolts of Cloth

1 bolt of Cloth

1.25 Tonnes of Cheese

0.67 Tonnes of Cheese

Heckscher-Ohlin Theory (Factor Endowments)

HO Theory
Ricardos theory of comparative advantage simply assumes that different countries have different opportunity costs, but it makes no attempt to explain the reasons for these differences. Eli Heckscheer, the noted Swedish economist developed the core idea in of HO theory in 1919.

Core Idea of Theory

HO theory predicts hat countries export the products that use their abundant factors intensively(and import the products using their scarce factors intensively). It is generally agreed that variations in comparative costs exist because there is an uneven distribution in both quality and quantity of factors of production (E.g. land, labour, capital) between countries.

A country's share of factors of production is referred to as its factor endowment. Most countries possess some factors in greater abundance than others. Like Australia's major exports are agricultural products and minerals because of its unusual abundance of cropland and mineral deposits. While Iceland and Norway have strong fish exports due to coastal waters climates conducive to good fish.

Limitations of the Theory

Difficulty in moving resources, especially the labour force, into the desired industries Fluctuations in demand, or the collapse of a market in a countrys product, in a situation of international recession or unfair (Subsidized) competition Artificial limitations (Import restrictions) placed on a product by overseas countries Other Political restraints.

National competitive Advantage: Porters Diamond

NCAS :Porters Diamond

NCA is the most recent trade theory . Michael Porter in 1990 published the results of intensive research effort that attempted to determine why some nations succeed and others fail international competition. Porter and his team looked at 100 industry clusters in ten countries. E.g. food additives and furniture in Denmark, Cutlery and printing presses in Germany, Ceramic tiles in Italy, Airconditioning machinery in Japan etc.

 The main task of the study was to find answers to various questions such as: Why is a small country like Switzerland more innovative and productive in chemicals and pharmaceuticals compared to bigger countries like the UK or Spain. This study found four broad attributes. Lets have a look at these attributes

Four Attributes of NCA

Factor Endowments Demand Conditions Related and Supporting Industries Firm Strategy, Structure and Rivalry

Factor Endowment
According to Porter a nations position in factors of production such as skilled labour or infrastructure necessary to compete in a given industry can be critical . These factors can be either basic (natural resources, climate, location) or advanced (Skilled labour, infrastructure, technological know-how) While either can be important , advanced factors are more likely to lead to competitive advantage. Like japan which lacks the Basic Factors but invest in advanced factors such as technology.

Demand conditions
The nature of home demand for the industries product or service influences the development of capabilities. Sophisticated and demanding customers pressure firms to be competitive. Such as Nokia of Finland, where sophisticated and demanding customers in Finland helped push Nokia to invest in research and development in mobile phone technology long before competitors in other industrial nations.

Related and Supporting Industries

The presence in a nation of supplier industries and related industries that are internationally competitive can spill over and contribute to other industries. Switzerland's success in the dye industry has been the basis for the expansion of its pharmaceutical industry.

Firm Strategy, Structure, and Rivalry

According to Porter, the conditions in the nation governing how companies are created, organized and managed and the nature of domestic rivalry impacts firms competitiveness. One observation is that nations have different management ideologies.. Porter notes the predominance of engineers on the top management teams of German and Japanese firms, while US firms tend to have in top management teams finance experts. This has contributed to a technological advance in Germany and japan compared to the US during the 1970 and 1980

 Firms that face strong competition at home will be better able to face competitors from other nations. Japan is again noted as a positive example on this account