CHAPTER 5
INTERNATIONAL TRADE THEORY
LEARNING OBJECTIVES:
5.1 Describe the benefits, volume and patterns of international trade.
5.2 Explain how mercantilism worked and identify its inherent flaws.
5.3 Detail the theories of absolute advantage and comparative advantage.
5.4 Summarize the factor proportions theory of trade.
5.5 Explain the international product life cycle theory.
5.6 Outline the new trade theory and the first mover advantage.
5.7 Describe the national competitive advantage theory and the Porter Diamond.
CHAPTER OUTLINE:
Benefits, Volume, and Patterns of International Trade
Benefits of International Trade
Volume of International Trade
International Trade Patterns
Trade Interdependence
Trade Dependence
Mercantilism
How Mercantilism Worked
Trade Surpluses
Government Intervention
Colonialism
Flaws of Mercantilism
Theories of Absolute and Comparative Advantage
Absolute Advantage
Case: Riceland and Tealand
Gains from Specialization and Trade
Comparative Advantage
Gains from Specialization and Trade
Assumptions and Limitations
Factor Proportions Theory
Labor Versus Land and Capital Equipment
Evidence on Factor Proportions Theory: The Leontief Paradox
International Product Life Cycle
Stages of the Product Life Cycle
Limitations of the Theory
New Trade Theory
First-Mover Advantage
National Competitive Advantage
Factor Conditions
Copyright © 2019 Pearson Education, Inc.
Advanced Factors
Demand Conditions
Related and Supporting Industries
Firm Strategy, Structure, and Rivalry
Government and Chance
Bottom Line for Business
Globalization and Trade
Supporting Free Trade
A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 5.
These slides and the lecture outline below form a completely integrated package that simplifies the
teaching of this chapter’s material.
Lecture Outline
This chapter explores international trade in goods and services, examining its benefits, volume,
and patterns. It also explores the main theories of why nations trade.
I. BENEFITS, VOLUME, AND PATTERNS OF INTERNATIONAL TRADE
International trade is the purchase, sale, or exchange of goods and services across national
borders. One way to measure the importance of trade is to examine the volume of an economy’s
trade relative to total output (see Map 5.1).
A. Benefits of International Trade
Creates new entrepreneurial opportunities, expands the choice of goods and services,
and creates jobs. The U.S. Department of Commerce estimates that for every $1 billion
increase in exports, 22,800 U.S. jobs are created.
B. Volume of International Trade
World merchandise exports are worth more than $16.5 trillion and service exports are
valued at more than $4.8 trillion (see Table 5.1). Trade in merchandise is around 9.1
percent of total trade; services account for 22 percent of total trade.
C. International Trade Patterns
Trade volume and world output provide insight into the international trade environment
but do not disclose trading partners.
1. Trade Interdependence
Trade between most nations is characterized by a degree of interdependency.
Companies in developed nations trade a great deal with companies in other
developed nations. The level of interdependency between pairs of countries often
reflects the amount of trade that occurs between a company’s subsidiaries in the
two nations. Emerging markets that share borders with developed countries are
often dependent on their wealthier neighbors. Complete independence was
considered desirable from the sixteenth through eighteenth centuries, but is not
desirable today.
2. Trade Dependence
II. Mercantilism
Nations should accumulate financial wealth, usually in the form of gold, by encouraging
exports and discouraging imports. Other measures of a nation’s well-being, such as living
standards or human development, are irrelevant. It was practiced from around 1500 to the late
1700s by European nations, including Britain, France, the Netherlands, Portugal, and Spain.
A. How Mercantilism Worked
Trade was to benefit mother countries; colonies (in Africa, Asia, and North, South, and
Central America) were exploitable resources.
1. Trade surpluses
Nations increased wealth through a trade surplus—when the value of a nation’s
exports exceeds the value of imports. Trade deficits were to be avoided at all
costs.
2. Government intervention
Governments intervened in international trade to maintain a trade surplus. They
banned certain imports, imposed tariffs or quotas, and subsidized home-based
industries to expand exports. Removal of gold and silver from the nation was
outlawed.
3. Colonialism
Mercantilist nations acquired colonies as sources of inexpensive raw materials
and markets for higher-priced finished goods. Trade among mercantilist nations
and their colonies expanded wealth and created armies and navies to control
colonial empires and protect shipping.
B. Flaws of Mercantilism
The main problem with mercantilism is that it viewed international trade as a zero-sum
game—a nation benefits only at the expense of other nations. But if all nations barricade
their markets from imports and push their exports onto others, international trade would
be severely restricted. Also, it kept colonial markets poor: they received little money for
raw materials but were charged high prices for finished goods.
III. THEORIES OF ABSOLUTE AND COMPARATIVE ADVANTAGE
A. Absolute Advantage
Absolute advantage is the ability of a nation to produce a good more efficiently than any
other nation (produce a greater output using the same, or fewer, resources). Adam Smith
reasoned that international trade should not be burdened by tariffs and quotas, but
should flow according to market forces. A country should produce the goods in which it
holds an absolute advantage and trade with others to obtain the goods it needs but does
not produce efficiently.
1. Case: Riceland and Tealand
In a world of two countries (Riceland and Tealand) with two products (rice and
tea) where transport costs nothing, each produces and consumes its own rice and
tea. In Riceland, 1 resource unit produces a ton of rice, but 5 units are needed to
produce a ton of tea. In Tealand, 6 resource units produce a ton of rice, but 3
units are needed to produce a ton of tea. Thus, Riceland has an absolute
advantage in rice production and Tealand has an absolute advantage in tea
production.
2. Gains from specialization and trade
i. Although each country now specializes and world output
increases, both countries face a problem: Riceland consumes only its rice
and Tealand consumes only its tea. The problem can be resolved through
trade.
ii. Although Tealand does not gain as much as Riceland, it gets more
rice than it would without trade. Actual gains depend on the total
resources of each country and the demand for each good in each country
(Figure 5.2).
iii. The theory of absolute advantage destroys the mercantilist idea
that international trade is a zero-sum game. Because both countries gain,
international trade is a positive-sum game.
iv. The theory argues against restrictive trade policies and for nations
to instead open their doors to trade so their people obtain more goods
more cheaply in order to raise living standards.
B. Comparative Advantage
Comparative advantage is the inability of a nation to produce a good more efficiently
than other nations, but an ability to produce that good more efficiently than it does any
other goods. Thus, trade is still beneficial even if one country is less efficient in the
production of two goods, as long as it is less inefficient in the production of one of the
goods.
1. Gains from Specialization and Trade
a. Suppose that Riceland now holds absolute advantages in the production
of both rice and tea. In Riceland, 1 resource unit produces a ton of rice
but 2 are needed to produce a ton of tea. In Tealand, 6 resource units still
produce a ton of rice, and 3 units are still needed to produce a ton of tea.
Thus, Riceland has absolute advantages in producing both goods.
b. Although Tealand has absolute disadvantages in rice and tea, it has a
comparative advantage in tea; Tealand produces tea more efficiently than
it produces rice.
c. By specializing and trading, Tealand gets double the rice than if it
produced the rice itself, and Riceland gets twice as much tea than if it
produced the tea itself (Figure 5.3).
2. Assumptions and Limitations
a. Assumes countries are only driven by the maximization of production
and consumption. Governments get involved in trade for many reasons
(e.g., concerns for workers or consumers).
b. Assumes only two countries engaged in the production and consumption
of two goods. In reality, more than 180 countries and countless products
are produced, traded, and consumed.
c. Assumes no transportation costs. In reality, transportation costs are a
major expense of international trade.
d. Assumes labor is the only resource for production and is mobile within
each nation but cannot be transferred. Other resources are clearly needed
in production and labor is becoming more mobile.
e. Assumes specialization does not result in efficiency gains. In fact,
specialization results in increased knowledge of a task and future
improvements.
IV. FACTOR PROPORTIONS THEORY
Factor proportions theory (also known as Heckscher–Ohlin theory) states that countries
produce and export goods that require resources (factors) that are abundant and import goods
that require resources in short supply. Thus, the theory focuses on the productivity of the
production process.
A. Labor versus Land and Capital Equipment
1. Factor proportions theory breaks resources into two categories: (1) labor and (2)
land and capital equipment. It predicts that a country will specialize in products
that require labor if labor cost is low relative to land and capital costs, and vice
versa.
2. Factor proportions theory is conceptually appealing (e.g., Australia has much
land and a small population; its exports consist of products that require much
land whereas imports consist of manufactured and consumer goods).
B. Evidence on Factor Proportions Theory: The Leontief Paradox
1. Theory not supported by studies that examine trade flows.
2. Wassily Leontief tested whether the United States, which uses an abundance of
capital equipment, exports goods requiring capital-intensive production, and
imports goods requiring labor-intensive production. He found U.S. exports
require more labor-intensive production than its imports; called the Leontief
Paradox.
3. One explanation is that factor proportions theory considers a country’s
production factors to be homogeneous—particularly labor. But labor skills vary
greatly within a country.
V. INTERNATIONAL PRODUCT LIFE CYCLE
The international product life cycle theory states that a company will begin exporting its
product and later undertake foreign direct investment as the product moves through its life cycle
(a country’s export eventually becomes its import).
A. Stages of the Product Life Cycle
1. In the new product stage, stage 1, high purchasing power and demand of buyers
spur a company to design and introduce a new product concept (Figure 5.4).
Although initially there is virtually no export market, exports increase late in the
new product stage.
2. In the maturing product stage, stage 2, the domestic market and markets abroad
become fully aware of the existence of the product and its benefits. Demand rises
and is sustained over a fairly lengthy period of time. Near the end of the maturity
stage, the product generates sales in developing nations, and manufacturing is
established there.
3 In the standardized product stage, stage 3, competition from other companies
selling similar products pressures companies to lower prices in order to maintain
sales levels. An aggressive search for low-cost production bases abroad begins
and the home market may begin importing.
B. Limitations of the Theory
1. The United States is no longer the sole innovator of products in the world; new
products spring up everywhere as the research and development activities
globalize.
2. Companies today design new products and make product modifications at a very
quick pace.
3. Companies introduce products in many markets simultaneously to recoup a
product’s research and development costs before sales decline.
4. The theory is challenged by the fact that more companies are operating in
international markets from their inception. The Internet has made this easier
particularly for small and midsize companies. Also, small companies are more
often teaming up with companies in other markets to develop new products or
production technologies.
5. Yet the theory retains explanatory power when applied to technology-based
products that are eventually mass-produced.
VI. NEW TRADE THEORY
New trade theory argues: (1) there are gains to be made from specialization and increasing
economies of scale; (2) companies first to market can create barriers to entry; and (3)
government may play a role in assisting its home-based companies. It emphasizes productivity
rather than resources.
A. First-Mover Advantage
1. As specialization and output increase, companies realize economies of scale, and
unit production costs decline. Then companies expand, lower prices, and force
competitors to produce at a similar level of output to be competitive.
2. A first-mover advantage is the economic and strategic advantage gained by
being the first company to enter an industry. It creates a barrier to entry for
potential rivals and may allow a country to dominate in a product.
3. Some make a case for government assistance; by working together to target new
industries, a government and its home-based companies can be the first mover in
an industry.
VII. NATIONAL COMPETITIVE ADVANTAGE
National competitive advantage theory states that a nation’s competitiveness in an industry
depends on the capacity of the industry to innovate and upgrade. This theory attempts to explain
why some nations are more competitive in certain industries. The Porter diamond (the basis of
national competitiveness) consists of: (1) factor conditions; (2) demand conditions; (3) related
and supporting industries; and (4) firm strategy, structure, and rivalry.
A. Factor Conditions
Porter acknowledges the importance of basic factors (such as labor, natural resources,
climate, and surface features) in what a country produces and exports, but adds the
significance of advanced factors.
1. Advanced factors include skill levels of the workforce and quality of the
technological infrastructure. Account for the sustained competitive advantage
that a country enjoys in a product.
B. Demand Conditions
1. Sophisticated buyers in the home market are important to national competitive
advantage in a product area. A sophisticated domestic market drives companies
to modify existing products to include new design features and develop new
products and technologies.
C. Related and Supporting Industries
1. Companies in internationally competitive industries do not exist in isolation.
Supporting industries provide inputs, forming clusters of related activities in the
same region that reinforce productivity and competitiveness.
2. Exporting clusters are those that export products or make investments to
compete outside the local area and can lead to long-term prosperity.
D. Firm Strategy, Structure, and Rivalry
a. Strategic decisions of firms have lasting effects on future competitiveness, but
equally important is industry structure and rivalry among companies.
b. The more intense the struggle to survive among domestic companies, the greater
is their competitiveness. This heightened competitiveness helps them to compete
against imports and against companies that might develop a production presence
in the home market.
E. Government and Chance
a. Government policies toward industry and export and import regulations can hurt
or help competitiveness.
b. Chance events also can influence national competitiveness; they can help
competitiveness or threaten it.
c. Porter’s theory holds promise but has just begun to be subjected to research
using actual data on each of the factors involved and national competitiveness.
VIII. BOTTOM LINE FOR BUSINESS
This chapter explores the benefits of international trade and its volume and pattern in the world
today. Trade can free a nation’s entrepreneurial spirit and bring economic development. As the
value and volume of trade continues to expand worldwide, new theories will likely emerge to
explain why countries trade and why they have advantages in producing certain products.