International Trade & Investment – Comprehensive Study Notes

Early Trade Theory – Mercantilism

• Historical context
  • Dominant in Europe during 16th–17th centuries, bridging feudalism → early liberalism.
  • Coined ex-post by Adam Smith as a “loose system of economic ideas.”
• Core principles
  • Bullionism: national wealth measured by stock of gold & silver ("specie").
  • Positive Balance of Trade (BOT): \text{Exports} > \text{Imports} believed to inject specie into the kingdom.
  • Zero-sum worldview: one nation’s gain ≈ another’s loss.
  • Labor theory of value: commodity price ∝ labor hours embedded.
  • Assumed under-employment ⇒ more money supply ↑ output & jobs, not prices.
• Policy toolkit
  • Export subsidies; import duties/quotas; outright prohibitions.
  • Colonial expansion → captive markets + cheap raw materials.
  • Protectionism & “beggar-thy-neighbour” strategies.
• Leading proponents
  • Jean-Baptiste Colbert (France) – “favourable balance of trade.”
  • Thomas Mun – “means to enrich a kingdom”; blueprint for England.
  • Gerard Malynes, Charles Davenant, et al.
• Ethical & practical implications
  • Fostered colonial exploitation and international rivalry.
  • Criticised for ignoring consumer welfare and mutual gains.

Early Trade Theory – Price Specie Flow Mechanism (PSFM)

• Architect: David Hume (mid-18th c.).
• Objective: refute mercantilist claim of limitless specie accumulation.
• The mechanism
  • Trade surplus ⇒ inflow of gold/silver ⇒ money supply ↑.
  • Via Quantity Theory of Money $MV = PY$ (with $V, Y$ fixed), higher $M$ ⇒ higher $P$ (inflation).
  • Domestic prices ↑ & wages ↑ ⇒ exports ↓, imports ↑ ⇒ surplus erodes until $X = M$.
  • Mirror process for a deficit country (deflation restores competitiveness).
• Key assumptions
  1. Full employment.
  2. Homogeneous goods & perfect competition.
  3. No capital flows; gold standard.
  4. Flexible exchange rates or automatic gold movements.
• Significance
  • Introduced self-correcting balance-of-payments logic.
  • Shifted focus from output effects of money to price effects.

Comparative Snapshot – Mercantilism vs PSFM

• Mercantilism: $\uparrow M$ → $\uparrow Y,\uparrow N$ (output & jobs).
• PSFM: $\uparrow M$ → $\uparrow P$ → lost competitiveness; automatic re-equilibration.

Classical Trade Theory – Absolute Advantage (Adam Smith, 1776)

• Framework & assumptions
  • 2 countries, 2 commodities, homogeneous labour, constant opportunity cost, zero transport cost, free trade, full employment.
  • Labour mobile domestically, immobile internationally.
• Rule
  • Each nation exports the good it produces with fewer labour hours (higher productivity) and imports the other.
  • Trade is a positive-sum game.
• Example recap (Chairs vs Tables)
  • Country A: 10 workers → 40 chairs or 20 tables.
  • Country B: 10 workers → 20 chairs or 40 tables.
  • Specialisation (A→chairs, B→tables) & 1:1 barter raises world output by 10 chairs + 10 tables; each country gains 5 chairs + 5 tables.
• Limitations
  • Cannot explain trade if one nation is more efficient in both goods.
  • Ignores multi-good, multi-factor reality, technological change, policy barriers, transport cost, variable opportunity cost.

Classical Trade Theory – Comparative Advantage (David Ricardo, 1817)

• Essence
  • Even if a country is absolutely less efficient in both goods, trade is beneficial if it specialises where its absolute disadvantage is smallest (lowest relative opportunity cost).
• Standard assumptions (extends Smith’s set)
  • Constant costs → linear PPF; no transport costs; no tech change; labour theory of value; free trade; two countries/goods; full employment.
• Opportunity Cost logic
  • France: $1\,\text{cloth} = 2\,\text{wine}$; USA: $1\,\text{cloth} = 1\,\text{wine}$.
  • USA has comparative advantage in cloth (lower cost); France in wine.
• Illustrative results (100 labour-hour maximum)
  • Self-sufficiency: 2 750 total units.
  • Specialisation: world output ↑ to 3 000 units (USA cloth 2 000, France wine 1 000).
  • Trade at 1 cloth : 1 wine delivers consumption bundles superior to autarky (France gains 250 cloth; USA gains 500 cloth, etc.).
• Connections & advances
  • Haberler reframed in opportunity-cost terms; Samuelson formalised mathematically.
• Weaknesses
  • Distribution of gains across social classes ignored.
  • Assumes identical technologies & excludes factor endowments, scale economies, transport costs, etc.

Heckscher–Ohlin Factor-Proportions Theory

• Proposition (H-O Theorem)
  • A country exports goods that intensively use its relatively abundant (and cheap) factor and imports goods intensive in its scarce factor.
• Mechanism
  • Comparative advantage arises from relative factor endowments, not productivity alone.
  • E.g., labor-rich India exports textiles; capital-rich Germany exports machinery.
• Assumptions (11)
  1. 2 countries, 2 goods (X labor-intensive, Y capital-intensive), 2 factors (L, K).
  2. Identical technology.
  3. Constant returns to scale; incomplete specialisation.
  4. Identical, homothetic tastes.
  5. Perfect competition; factor mobility domestically but not internationally.
  6. No trade barriers or transport costs; balanced trade; full employment.
• Limitations
  • Ignores tech gaps, economies of scale, policy effects, capital/labour mobility in modern globalisation.
• Why still relevant
  • Explains broad North–South trade patterns (developing = labor-intensive exports; developed = capital-intensive exports).

Modern / Firm-Based Trade Theories

Economies of Scale & Intra-Industry Trade

• Increasing returns: output ↑ > input ↑ because of specialisation & division of labour.
• Imperfect competition → product differentiation.
• Steffan Linder’s Country Similarity Theory (1961): similar-income nations trade differentiated goods within same industry.

Technological Gap & Product Cycle Models

• Posner (1961): innovator enjoys temporary export monopoly until imitation erodes gap.
• Vernon (1966) Product Cycle
  1. Introduction – skill-intensive production at home.
  2. Growth – standardisation, outward FDI.
  3. Maturity – low-cost countries take over; original innovator may import.

Global Strategic Rivalry Theory (Krugman & Lancaster, 1980s)

• Focus on multinational corporations (MNCs) striving for sustainable advantage.
• Barriers to entry include: R&D, intellectual-property ownership, scale economies, proprietary processes, industry experience, resource control.

Porter’s National Competitive Advantage (Diamond Model, 1990)

• Four systemic determinants
  1. Firm strategy, structure & rivalry – domestic competition breeds global strength.
  2. Factor conditions – basic (natural resources) vs advanced (skills, tech, infrastructure).
  3. Demand conditions – sophisticated home buyers push innovation.
  4. Related & supporting industries – clusters enhance productivity (e.g., Silicon Valley).
• Two external variables
  • Government – catalyst, challenger (anti-trust, education, infrastructure, demand stimulation).
  • Chance – exogenous shocks (wars, breakthroughs) altering competitiveness landscape.

Comparative Tables, Formulas & Key Numeric References

• Quantity Theory of Money: $MV = PY$.
• Opportunity cost example (Italy/Japan Cars vs Computers)
  • Italy: OC of 1 car = $\tfrac{3}{6} = 0.5$ computer; OC of 1 computer = 2 cars.
  • Japan: OC of 1 car = 1 computer; OC of 1 computer = 1 car.
  • Comparative advantage → Italy in cars, Japan in computers.
• Wheat–Cloth exercises (U.S./U.K.) illustrate gains from trade at exchange rate $6W = 6C$, production shifts, and consumption gains (e.g., total output rising from 39 units autarky → 48 units with trade).

Ethical, Philosophical & Real-World Implications

• Mercantilism’s zero-sum lens fostered colonialism and conflict; modern theory emphasises mutual gains (positive-sum) but raises distributional concerns (who gains within nations?).
• Technology-cycle & strategic theories highlight dynamic rents, intellectual-property ethics, and role of multinational power.
• Factor-endowment & scale-economy perspectives inform debates on offshoring, labour standards, and development policy.

Conceptual Connections & Revision Cues

• Smith → specialisation rhetoric; Ricardo → relative costs; Heckscher-Ohlin → resource abundance; Modern theories → scale, technology, strategy.
• Self-correction (Hume) contrasts with state intervention (Mercantilists) and strategic trade policies (Porter, Krugman).
• Remember: Absolute ≠ Comparative; Comparative ≠ Factor-proportions; Factor-proportions ≠ Technology-gap – each layer refines understanding of WHY nations trade.