Trade Theories

2. PRESENTED BY
Aditya
Suresh – 186
Akash Gupta
– 188
Alankar Das
- 190
Trade Theory-Global Business Management 2

3. CONTENTS
1.Mercantilism theory
2.Absolute Advantage theory
3.Comparative Advantage theory
4.Factor Endowment theory
5.Product Life Cycle theory
6.Leontief Paradox
7.Heckscher Ohlin theory
8. Porter`s Diamond theory
9.New Trade Theory
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4. WHY DO COUNTRIES TRADE ?
1. Availability of products (natural
resources, new products, etc.)
2. International price differential as
a consequence of:
 Productivity differential
 Differences in technology
 Differences in factor endowments
Economies of scale
3. Product differentiation and market
structure
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5. WHAT IS TRADE THEORY
Exchange of raw
materials and
manufactured goods
(and services) across
national borders
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6. MERCANTILISM THEORY
The theory that a country’s power depended mainly
on its wealth to build strong navies and purchase vital
trade goods
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7. MERCANTILISM THEORY
 In 17th century group of men (merchants,
bankers, government officials & philosophers)
wrote essays on international trade that
advocated an economic philosophy known as
Mercantilism
In their view, a country becomes rich if it exports
more than it imports
Surplus in trade balance will result in an inflow
of precious metals; gold and silver
More precious metals means a richer and more
powerful nation
Countries have to do their best to increase
exports and restrict imports.
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8. CONTD..
Since all countries cannot have surplus at the same time &
because stock of metals is fixed in short run, a country gains
from trade only at expense of others
Wealth of nations was measured by stock of metals they
possess
 In contrast, today we measure wealth of a nation by its stock
of human, man-made & natural resources available for
producing goods & services
Mercantilists advocated strict government control of
economic activity because gain from trade comes at expense
of other nations (i.e. zero-sum-game)
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9. CONTD..
GOLD AND SILVER ARE CURRENCY FOR
TRADE
THEORY SAYS YOU SHOULD HAVE A
SURPLUS
MAXIMIZE EXPORT THROUGH
SUBSIDIES
MINIMIZE IMPORTS THROUGH
TARIFFS AND QUOTAS
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10. ASSUMPTIONS
THERE IS A FINITE
AMOUNT OF WEALTH IN
THE WORLD
A NATION CAN ONLY
GROW RICH AT THE
EXPENSE OF OTHER
NATIONS
A NATION SHOULD TRY
TO ACHIEVE & MAINTAIN
A FAVOURABLE TRADE
BALANCE ( EXPORTING
MORE THAN ITS IMPORT)
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11. LIMITATIONS
In modern
economy a
nation
holding gold
will lose the
competitive
price
advantage
Mercantilism is
expensive to
implement
because it
requires
complex
navigation laws
that are
difficult to
enforce
Overlooked
other sources
of country’s
wealth like
capital &
skilled work
force
Economic
regulation
tends to
result in
illegal
activity or
smuggling
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12. ABSOLUTE ADVANTAGE
THEORY
Adam Smith: Wealth of Nations (1776)
argued:
Capability of one country to produce
more of a product with the same
amount of input than another country
A country should produce only goods
where it is most efficient, and trade for
those goods where it is not efficient
Trade between countries is, therefore,
beneficial
Assumes there is an absolute balance
among nations
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13. CONTD..
Destroys the
mercantilist
idea since
there are
gains to be
had by both
countries
party to an
exchange
Questions
the objective
of national
governments
to acquire
wealth
through
restrictive
trade
policies
Efficient
production
of goods
leads to
potential
well being of
people
Both
exporting &
the
importing
country gain
by engaging
in trade
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14. LIMITATIONS
Fails to explain how free trade can be
advantageous to two countries when one
country can produce all goods
Country not having absolute advantage
can’t gain from free trade
Differences in climatic conditions & natural
resources won’t lead to absolute advantage
What if the country is bad at making
everything?
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15. COMPARATIVE ADVANTAGE
THEORY
David Ricardo: (1817) argued:
A country should produce only goods where
it is most efficient & import those goods in
which it’s less efficient
Even if a country is efficient in producing all the
goods, still trade between two countries will
prove beneficial
Assumes that a country does not have to be
best at anything to gain from trade
Country gains in those activities which it can
produce at world prices even though it may not
have absolute advantage
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16. LIMITATIONS
• Ricardo's Theory was based on only two
countries & only two commodities, but
international trade is among many countries with
many commodities
• Assumption of full employment helps theory to
explain trade on the basis of comparative
advantage. Cost of production, even in terms of
labour, may change as countries, at different
levels of employment move towards full
employment
• Another serious defect is that transportation
costs are not considered in determining
comparative cost differences
• Ricardian theory is not applicable to developing
countries as these countries are nowhere near to
full employment
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17. FACTOR ENDOWMENT
THEORY
 Trade theory holding that countries
produce & export those goods that
require resources (factors) that are
abundant (and thus cheapest) &
import those goods that require
resources that are in short supply
 Example:
 Australia – lot of land and a small
population (relative to its size)
 So what should it export and
import?
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18. CONTD..
1.Assumes that
production function are
identical for all countries
2.Assumes that there is
no unemployment
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19. 4-19
TWO FACTORS OF PRODUCTION
•Labour
•Capital

20. LIMITATIONS
Assumes that
the production
functional are
identical for all
the countries
Assumes that
there is no
unemployment
Had poor
predictive
power
Considered
capital as
homogeneous
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21. 4-21
•Trade theory holding that a country will
begin by exporting its product & later
undertake foreign direct investment as
product moves through its lifecycle
•As products mature, both location of
sales optimal production changes
•Affects direction & flow of imports &
exports
•Globalization & integration of economy
makes this theory less valid
PRODUCT LIFE CYCLE THEORY
( R .VERON ( 1966))
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22. 4-22 Trade Theory-Global Business Management

23. 4-23
•Increased emphasis on technology’s
impact on product cost
•Explained international investment
•Limitations
•Most appropriate for technology-based
products
•Some products not easily characterized by
stages of maturity
•Most relevant to products produced
through mass production
PRODUCT CYCLE AND
TRADE IMPLICATION
Trade Theory-Global Business Management

24. HECKSCHER OHLIN THEORY
 Given by Filip Heckscher
 Explained link between factor
endowments & comparative
advantage of nations
 Country has comparative advantage in
those factors which make use of
abundant factor
 Free trade equalizes factor prices
 Trade gains are greatest between
countries with greatest difference in
economic structure
Eli Filip Heckscher
(1879-1952)
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25. LIMITATIONS
1.Based on over simplified
assumptions & is
unrealistic
2.Gives undue importance
to supply & less
importance to demand
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26. LEONTIEF PARADOX
 Given by Wassily Leontief in 1973
 Found out that U.S. exports were
apparently labour intensive & imports
capital intensive
 Findings were contradictory to
predictions of Heckscher-Ohlin
theorem
 Stimulated enormous amount of
empirical & theoretical research on
subject
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27. LIMITATIONS
1.Leontief considered
only capital & labour
inputs, leaving out
natural resource inputs
2.But in reality capital
& natural resources
are used together in
production
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28. PORTER’S DIAMOND
MODEL
 Developed by Michael Porter in his
book ‘The Competitive Advantage of
Nations’
 Explains why particular industries
become competitive in particular
locations
 Competitiveness of one company is
related to the performance of other
companies
 Demand, factor conditions,
government policies help companies
create competitive advantageTrade Theory-Global Business Management 28

29. LIMITATIONS
1.In his book, Porter was
optimistic about future of
Korea & less optimistic
about future of Singapore
2.It was basically a home
based concept & ignored
the nature of
multinational activities
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30. NEW TRADE THEORY
 Collection of economic models in
International trade which focuses on role of
increasing returns to scale
 This theory relaxed the assumption of
constant returns to scale
 Emphasized firm level differences in same
industry of the same country
 Also emphasized the growing trend of
intermediate goods
 Assumed that all firms are symmetrical,
meaning they have the same production
co-efficient
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31. Trade Theory-Global Business Management 31

32. LIMITATIONS
1.Can only treat a situation
when there are many firms
with different production
processes
2.Assumes that all firms
are symmetrical, which
may not be true in every
case
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33. Trade Theory-Global Business Management 33