International Trade Theories

Introduction to International Business - 2

Mercantilism (16th-18th century)

Definition: a nation’s wealth depends on its gold and silver reserves, increased through a trade surplus (exports > imports)

Methods: governments promote exports and restrict imports using tariffs, quotas, subsidies and colonial monopolies

Key idea: trade is a zero-sum game - one country’s gain is another’s loss

Examples: Trump’s tariffs in the US-China trade war; China’s export-led economic strategy

Criticisms: can trigger retaliation and damage international relations; ignores how trade can benefit both countries

Absolute advantage - Adam Smith (1776)

Definition: a country has an absolute advantage if it produces a good using fewer resources per unit than another country

Theory: countries should specialise in goods they produce more efficiently, export them and import goods that other countries produce more efficiently

Key argument: Smith supported free trade and opposed mercantilist protectionism, as specialisation increases total output and benefits both countries

Trade explained: helps explain inter-industry trade

Comparative advantage

Definition: a country has a comparative advantage if it produces a good at a lower opportunitiy cost than another country, even if it is more efficient at producing everything

Theory: countries should specialise in goods with the lowest opportunity cost and trade, allowing both to benefit from specialisation and free trade

Criticisms:

• Workers: offshoring can cause job losses and lower wages

• Developing countries: may not benefit equally from trade

• Dependency: importing countries can become reliant on exporting countries

Critisicms of Absolute and Comparative advantage

Diminishing returns: over-specialisation can reduce additional gains from trade as productivity gains decline

Environmental costs: the theories overlook environmental damage that is not reflected in production costs

• e.g. intensive farming in Spain can contribute to resource depletion, soil degradation and desertification

KEY TAKEAWAY: trade can increase efficiency, but its gains may be limited by diminishing degradation and desertification

Heckscher-Ohlin (H-O) Theory of Factor Endowments

Assumption: all countries have the same technology

Theory: comparative advantage comes from differences in factor endowments (land, labour and capital)

Mechanism: abundant factors are relatively cheap, making goods that use them intensively cheaper to produce

Trade pattern: countries export goods using their abundant factors intensively and import goods using their scarce factors intensively

Example: Canada exports timber, benefiting from its abundant forest resources - the theory also helps explain North-South trade between higher and lower-income countries

The Leotief Paradox (Challenges H-O)

• HO says that capital-abundant USA should export capital-intensive goods

  • Leontief found that US exports were less-capital intensive than the good it imported, which contradicts the theory

Vernon’s product life cycle theory

New product: Invented and produced in the innovating, high-income country, close to its market

Maturing product: demand grows and production becomes standardised, so manufacturing begins shifting abroad

Standardised product: production moves to the lower-cost countries; the original innovating country may become and importer

KEY TAKEAWAY: comparative advantage changes over time as products mature and production moves to lower-cost countries

New trade theory - Paul Krugman

Purpose: explains why similarly developed countries trade similar products within the same industry

Key idea: firms operate under imperfect competition and benefit from economies of scale - producing more lowers average costs

Benefits of trade:

• Larger markets: exports increase sales, allowing firms to produce at scale, reducing costs and prices

• Greater variety: consumers access differentiated products from firms in different countries

Government intervention: governments may support domestic industries to help firms achieve economies of scale and compete internationally

Critisisms:

• Large MNCs may dominate markets and disadvantage smaller firms

  • MNCs may exploit differences between countries, harming local workers or communities

Porter’s national diamond theory

Purpose: explains why firms from certain industries become internationally competitve in particular industries

Core idea: four features of a county’s home environment interact to create competitve advantage

4 elements of Porter’s national diamond

1. Factor conditions: availability and quality of production factors, such as labour, capital, infrastructure and skills - includes basic and advanced factors

2. Demand conditions: nature of domestic demand - sophisticated, demanding customers encourage firms to innovate and improve quality

   1. Firm strategy, structure and rivalry: how firms are created, organised and managed, and the intensity of domestic competition - strong rivalry encourages efficiency and innovation

3. Related and supporting industries: presence of competitive suppliers and connected industries, which can share knowledge, resources and expertise

Additional influences:

• government: policies and intervention can strengthen or weaken the diamond e.g. through education, infrastructure or regulation

• chance: unforeseen events, such as technological breakthroughs or geopolitical shocks, can alter competitiveness

Implications of Porter’s for international trade

• countries tend to export products from industries where their diamond is the strongest

• competitive advantage is created and developed over time, rather than simply inherited through natural resources or factor endowments

• strong domestic rivalry and demanding customers push firms to upgrade

• related industries often cluster geographically, so exports may be concentrated in connected industries

KEY TAKEAWAY: a country becomes competitve when its domestic conditions help firms innovate, improve and succeed internationally