THEORY OF

INTERNATIONAL TRADE
AND INVESTMENT

CHAPTER 2

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 THEORY OF INTERNATIONAL TRADE
AND INVESTMENT

• An overview of Trade Theory

•Mercantilism
•Absolute Advantage
•Comparative Advantage
• Heckscher-Ohlin Theory
• International Product Life Cycle Theory
• National Competitive Advantage: Porter’s Diamond
• Theories of Foreign Investment
• Implications for Business

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 1. An Overview of Trade Theory
- Free trade refers to a situation where a
government does not attempt to influence
through quotas or duties what its citizens
can buy from another country or what they
can produce and sell to another country.
- Adam Smith’s theory of absolute
advantage, proposed in 1776, was the first to
explain why unrestricted free trade is
beneficial to a country.

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- Adam Smith argued that the invisible hand of
the market mechanism, rather than government
policy, should determine what a country imports
and what it exports.
- The great strength of the theories of Smith,
Ricardo, and Heckscher-Ohlin is that they identify
the specific benefits of international trade.
- It is important to note that there is a very
extensive international trade literature regarding
these theories and that there is no absolute
agreement as to which is the most valid.

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 2. Mercantilism
- The first theory of international trade emerged in England
in the mid 16th century.
- An economic philosophy based on the belief that a
nation’s wealth depends on accumulated treasure,
usually gold.
- At that time, gold and silver were the currency of trade
between countries; a country could earn gold and silver by
exporting goods.
- Its principle assertion was that it is in a country’s best
interest to maintain a trade surplus, to export more than it
imports.
Consistent with this belief, the mercantilist doctrine
advocated government intervention to achieve a surplus
in the balance of trade.
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• Limitations in Mercantilism:
1. The flaw was that it viewed trade as a zero-
sum game (in which a gain by one country results
in a lost by another).
2. It was left to Adam Smith and David Ricardo to
show the short-sightedness of this approach
and to demonstrate that trade is a positive-
sum game (that being a situation in which all
countries can benefit, even if some benefit more
than others).

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• 3. Theory of Absolute Advantage
- this theory was developed by Adam Smith in 1776
- Smith argued that if countries specialize in the production
of goods that they can produce more efficiently than any
other country, and import those goods and services
which are produced more efficiently by other
countries, then all countries will gain increased
economic benefits.
- Thus a country has an absolute advantage in the
production of a product when it is more efficient than
any other country in producing it.

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• Simple, hypothetical, numerical example to
demonstrate the theory of absolute advantage:

• Table 1 shows the output of two goods per hour of

labour input for two countries, Australia and Japan.

• Assume for the purposes of simplicity that these are the

only two countries in the world and that they produce only
two goods, computer chips and wine, using only one
factor of production, labour.

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• Table 1 A Case of Absolute Advantage When Each
• Nation is More Efficient in the Production of
• one Good

• Nation Output per Labor Hour

• Computer Chips Wine
(bottles)
• Australia 10 8
• Japan 15 4

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• Note: 1. Australia has an absolute advantage in the
production of bottles of wine (8 bottles/hour as
compared with Japan - 4 bottles/hour)
• 2. Japan has an absolute advantage in the production
of computer chips (15 chips/hour as compared with
Australia - 10 chips/hour).
 Analysis:
• Australia, for example, trades 8 bottles of wine for
15 computer chips (Australia took only 1 hour to
produce the 8 bottles).
• It would have taken Australia 1.5 hours of labour to
produce 15 computer chips (but this was gained for
only 1 hour of labour time - so a savings of 0.5 hours of
labour time for Australia)
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• Implications:
1. Both countries have gained by allocating their scarce labor to
produce goods in which they are more productive than the
other.
2. Both can consume more goods than they could have done if
there was no international trade between them.

• Limitations in Absolute Advantage Theory:

• This theory suggests that where one country has an
absolute advantage in both products, then no trade would
occur.
• Note: This is where David Ricardo’s theory of
comparative advantage provides the answer

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• 4. Theory of Comparative Advantage
• - Ricardo took Smith’s theory one step further by
exploring what might happen when one country has an
absolute advantage in the production of all goods.

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• Hypothetical example to illustrate The Theory of
Comparative Advantage

• Table 2 A Case of Comparative Advantage when

• Australia has an Absolute Advantage
in the production of both goods

• Nation Output per Labor Hour

• Computer Chips Wine
(bottles)
• Australia 20 10
• Japan 15 4

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• Assumptions:
1. Australia develops methods that increase the number of
computer chips produced per hour to 20 per hour.
2. Wine production has also increased from 8 to 10 bottles
per hour.
3. Australia has an absolute advantage over Japan in both
wine and computer chip production.
4. Australia is 2.5 times better than Japan in wine production,
though only 1.3 times better in computer chips production.
5. The theory of absolute advantage indicates that no trade
should take place because Australia is more productive
for both goods.

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• Note: The theory of comparative advantage says no,
there is still an advantage to both countries from
continuing to trade.

• In Australia 1 bottle of wine will sell for two computer

chips.
• In Japan 1 bottle of wine will sell for 3.75 computer
chips.

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• Implications for trade:
• For example, if both the countries trade and if
Japan offers to trade 3 computer chips for 1
bottle of Australia’s wine.

• Then Australia will be better off, for it has gained

three computer chips for 1 bottle of wine, rather
than 2 it gained if there was no trade.
• Similarly, Japan is better off, for it has gained 1
bottle of wine for only 3 computer chips, rather
than the 3.75 it would pay if there was no trade.

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• Conclusion:
• 1. Australia and Japan are both better off
even though Australia has an absolute
advantage in both computer chips and wine
production.
• 2. The theory of comparative advantage
predicts that this will occur and that
international trade will benefit both countries.

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• 5. Heckscher-Ohlin Theory
- Developed by Swedish economists Eli Heckscher (in 1919)
and Bertil Ohlin (in 1933)
- Heckscher-Ohlin Theory extends the Theory of
Comparative Advantage by arguing that comparative
advantage arises from differences in national factor
endowments.
- The theory predicts that a country will have comparative
advantage in producing goods that use intensively the
resources (factors) that are most abundant in that country.
- Import goods that make intensive use of factors that are
locally scarce.

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• Implications of Heckscher-Ohlin Theory:
• Examples:
• 1. Australia has comparative advantage in
producing and exporting wheat because it has
plentiful supply of land.
• 2. China has a comparative advantage in the
production and export of clothing, in part
because it has plentiful supply of relatively cheap
labour.
• Conclusion: Unlike Ricardo’s theory, however, the
Heckscher-Ohlin theory argues that the pattern of
international trade is determined by differences in
factor endowments, rather than differences in
productivity.

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• The Leontief Paradox - named after Wassily Leontief
(1953)

- Using the Heckscher-Ohlin theory, Leontief postulated

that since U.S. was relatively abundant in capital
intensive goods compared to other nations, the U.S.
would be an exporter of capital intensive goods and
importer of labour intensive goods.
• - To his surprise, however, he found that U.S. exports were
less capital intensive than imports.
• Conclusion: Since this result was at variance with the
predictions of the theory, it has become known as the
Leontief Paradox.

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• 6. International Product Life Cycle Theory
- Developed by Raymond Vernon in 1966.
- Vernon and Wells (1968) elaborated its managerial
implications and became one of the leading explanations
of international trade patterns.
- In the 1960’s and 1970’s, this new approach to
international trade appeared most promising in aiding
business executives because it was closely related to the
product life concept in marketing.
- The theory claims that products go through a trade
cycle, during which the U.S. is initially an exporter, then
loses its export markets and may finally become an
importer

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• 6. International Product Life Cycle Theory
- Developed by Raymond Vernon in 1966.
- Vernon and Wells (1968) elaborated its managerial
implications and became one of the leading explanations
of international trade patterns.
- In the 1960’s and 1970’s, this new approach to
international trade appeared most promising in aiding
business executives because it was closely related to the
product life concept in marketing.
- The theory claims that products go through a trade
cycle, during which the U.S. is initially an exporter, then
loses its export markets and may finally become an
importer

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- ‘United States’ is used in the explanation because this
theory was built on the trade patterns of US
manufactured products.
- Thus the international product life cycle theory relates
trade and direct investment as sequential stages that
follow the life cycle of an innovative product.

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 • The international product life cycle theory
is based on the following:
a) - Early in the life cycle of a typical product,
while demand is starting to grow in the U.S.,
demand in other advanced countries is limited
to high income groups.
- The limited initial demand in other advanced
countries does not make it worthwhile for firms
in those countries to start producing the new
product, but it does necessitate some exports
from U.S. to those countries.

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- Over time, however, demand for the new
product starts to grow in other advanced
countries.
- As it does, it becomes worthwhile for foreign
producers to begin producing for their home
markets.
- In addition, U.S. firms might set up production
facilities in those advanced countries where
demand is growing.
- Consequently, production within other
advanced countries begins to limit the potential
for exports from the U.S.

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b) - As the market in the U.S. and other advanced countries
matures, the product becomes more standardized, and
price becomes the main competitive weapon.
- One result is that producers based in advanced
countries where labor costs are lower than the U.S.
might now be able to export to the U.S.

c) - If cost pressures become intense, the process might

not stop there.
- The cycle by which the U.S lost its advantage to other
advanced countries might be repeated once more as
developing countries begin to acquire a production
advantage over advanced countries.

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d) - The consequences of these trends for the
pattern of world trade is that the United States
switches from being an exporter of the product
to an importer of the product as production
becomes more concentrated in lower-cost
foreign locations.

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• Limitations of the IPLC theory:
• It is most appropriate for technology-based products -
these are the products that are most likely to experience
the changes in production process as they grow and
mature.
• Other products either resource-based (eg, minerals and
commodities) or services are not so easily characterized
by stages of maturity.
• IPLC theory is most relevant to products that eventually
fall victim to mass production and cheap labour force.

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• The assumption that most new products are
developed and introduced in the U.S. is not valid
anymore - production may be located wherever costs
and other factors are advantageous.
• Lastly, the IPLC theory fails to recognize that many
new products are launched simultaneously in
numerous markets.
• In short, although the IPLC theory may be useful for
explaining the pattern of international trade during the
brief period of American global dominance, its
relevance in the modern world is limited.

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 An Overview of the previous trade theories
- The focus of early trade theory was on the country or
nation and its inherent, natural or endowment
characteristics that may give rise to increasing
competitiveness.
- As trade theory evolved, it shifted its focus to the industry
and product level.
- These theories ignored the national competitiveness
question.
- Recently, many have turned their attention to the
question of how countries, governments, and even private
industry can alter the conditions within a country to aid the
competitiveness of its firms.
- The leader in this area of research has been Michael Porter (1990) of
Harvard Business School.

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 7. National Competitive Advantage:
• Porter’s Diamond

• Porter states:
1. National prosperity is created, not inherited - it does
not grow out of a country’s natural endowments, its
labor pool, its interest rates, or its currency values, as
classical economics insists.
2. A nation’s competitiveness depends on the
capacity of its industry to innovate and
upgrade.

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3. Companies gain advantage against the world’s best
competitors because of pressure and challenge.
4. They benefit from having strong domestic rivals,
aggressive home-based suppliers, and demanding local
customers.

• Porter’s thesis is that four major dimensions of a

nation shape the environment in which local firms
compete, and these dimensions promote or impede
the creation of competitive advantage.

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 These four major dimensions which is known
as “Porter’s Diamond” are:

1. Factor endowments (conditions)

2. Demand conditions
3. Related and supporting industries
4. Firm strategy, structure, and rivalry

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• 1.Factor Conditions:
• A nation’s position in factors of production such as skilled
labor or the infrastructure necessary to compete in a given
industry.
- Porter distinguishes 2 types of factors:
1. Basic factors (eg. natural resources, climate, location,
and demographics)
2. Advanced factors (eg. communications infrastructure,
sophisticated and skilled labour, research facilities, and
technological know-how)
- He argues that advanced factors are the most important
for competitive advantage.
- Advanced factors are a product of investment by
individuals, companies, and governments.

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• 2.Demand conditions: The nature of home
demand for the industry’s product or service
- Porter emphasizes the role home demand plays in
providing the impetus for upgrading competitive
advantage.
- Firms that can survive and flourish in highly
competitive and demanding local markets are much
more likely to gain the competitive edge.
- A nation’s firms gain competitive advantage if their
domestic consumers are sophisticated and
demanding.
- Sophisticated and demanding consumers pressure
local firms to meet high standards of product quality
and to produce innovative products.

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• 3.Related and Supporting Industries: The
presence or absence in a nation of supplier industries
and related industries that are internationally
competitive.

- A firm that is operating within a mass of related firms

and industries gains and maintains advantages
through close working relationships, proximity to
suppliers, and timeliness of product and information
flows.
- The constant and close interaction is successful if it
occurs not only in terms of physical proximity but also
through willingness of firms to work at it.

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• 4.Firm Strategy, Structure, and Rivalry: The
conditions in the nation governing how companies are
created, organized, and managed and the nature of
domestic rivalry.
- Different nations are characterized by different
“management ideologies” which either help them or do
not help them to build competitive advantage.
- No one managerial, ownership, or operational strategy is
universally appropriate.
- Vigorous domestic rivalry induces firms to look for ways
to improve efficiency, which in turn makes them better
international competitors.

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• Implications:

1. Porter’s argument is that the degree to which a

nation is likely to achieve international success
in a certain industry is a function of the
combined impact of the four components
(Porter’s Diamond)
2. Including factor conditions as a cost component,
demand conditions as a motivator of firm
actions, and competitiveness all combine to
include a pragmatic approach to the challenges
that the global markets of the twenty-first century
present to the firms of today.
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 8. Theories of Foreign Investment
- No one theory explains the many characteristics of
the foreign direct investment(FDI) process.

• Internalization Theory
- The concept of internalization is a useful explanation
of why firms pursue opportunities abroad through FDI,
rather than exporting, licensing or franchising.
- Internalization theory relies on transaction cost
economics.
- Transaction costs, defined as the transfer of goods
and services in a market, may be prone to high cost.

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 - The cost of entering a contract, eg. the costs of
negotiating, monitoring and enforcing a contract may
be higher than setting up and operating your own
subsidiary.
- If the potential cost of undertaking such transfers
through markets exceeds the costs of undertaking
them within the firm - then there exists good reasons
why a firm would internalize production through FDI.

• Dunning’s Eclectic Theory

- Dunning has synthesized various theories or
explanations of why firms invest internationally, into
one “eclectic theory”

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• In Dunning’s theory, FDI will take place when the
following three conditions are satisfied:

• A. Ownership advantages:
The firms competitive advantage such as proprietary
technology, economies of scale, management skills,
goodwill, etc. which are specific to the firm.
• B. Location advantages:
The costs, risk, political and regulatory conditions,
tariffs, taxes and transportation costs, etc. make
production in a foreign location more profitable than
production at home.

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• C. Internalization advantages:
• The benefits from operating and controlling the
business activity outweigh the advantages of
operating through a local distributor, licensee, or other
supply arrangement, that is, the transaction costs are
lower through FDI.

• Implications:
1. The approach is useful in that it focuses attention on
not only supply and demand conditions, but also other
key factors in the decision on whether or not to
undertake FDI.
2. It does represent well the complex interactive
relationship between MNC’s and FDI.

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 9. Implications for Business
• Location implications - An international business
concerns the link between the theories of international
trade and a firm’s decision about where to locate its
various productive activities.
- Underlying most of the theories is the notion that
different countries have particular advantages in
different productive activities.
- Thus, from a profit perspective, it makes sense for a
firm to disperse its various productive activities to
those countries where, according to the theory of
international trade, they can be performed most
efficiently.

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• First-Mover implications: The trade theory
suggests the importance to firms of building and
exploiting first-mover advantages.
• Policy implications: The theories of international
trade also matter to international business because
business firms are major players on the
international trade scene.
- Because of their pivotal role in international trade,
business firms can and do exert a strong influence
on government trade policy making.

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International Business and the
Roman Empire

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 International Business and the Roman
Empire
• Pax Romana, or Roman Peace ensured that
merchants were able to travel safely and rapidly.
• Common coinage simplified business transactions.
• Rome developed a systematic law, central market
locations, and an effective communication system;
all of which enabled international business to
flourish in the Roman Empire.
• The growth of the Roman Empire occurred mainly
through the linkages of business

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 International Business and the Roman
Empire (cont.)
• The decline of the Roman Empire can be
attributed in part to:
– infighting and increasing decadence
– the Pax Romana being no longer enforced
– the decline of use and acceptance of the
common coinage
– declining levels of communication
• As a result, former Roman allies cooperated with
invaders.

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 United States: A Global Leader
• The United States has developed a world
leadership position due to:
 its use of market-based transactions in the
Western world
 a broad flow of ideas, goods, and services across
national borders
 an encouragement of international
communication and transportation
 Pax Americana, an American sponsored and
enforced peace

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 The Smoot-Hawley Act
• The 1930’s, the U.S. passed the Smoot-Hawley
Act, which raised import duties to reduce the
volume of goods coming into the U.S.

• The act was passed in the hope that it would

restore domestic employment.
• The result was a worldwide depression and the
collapse of the world financial system.

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 Expansion of International Trade
• In the past 30 years, the volume of international
trade has expanded from $200 billion to over $7.5
trillion.

• The sales of foreign affiliates of multinational

corporations are now twice as high as global
exports.

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 Recent Changes in International Business

• Total world trade declined dramatically after

2000, but is again on the rise.

• The rate of globalization is accelerating.

• Regionalization is taking place, resulting in

trading blocs.

• The participation of countries in world trade is

shifting.

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 The Composition of Trade
• Between the 1960’s and the 1990’s the
importance of manufactured goods increased
while the role of primary commodities (i.e.
rubber or mining) had decreased.
• More recently, there has been a shift of
manufacturing to countries with emerging
economies.
• There has been an increase in the area of
services trade in recent years.

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