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
Advanced Factors
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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
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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
2. Government intervention
Governments intervened in international trade to maintain a trade
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
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In a world of two countries (Riceland and Tealand) with two
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).
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
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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
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.
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
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
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2. A first-mover advantage is the economic and strategic advantage
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
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
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
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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.
Quick Study Questions
Quick Study 1
1. Q: List several benefits of international trade?
2. Q: World merchandise exports are valued at how many times the value of
worldwide service exports?
3. Q: What portion of total world merchandise trade is accounted for by two way
trade between high income economies?
A: Trade among the world’s high-income economies accounts for roughly 60
4. Q: What term often describes the nature of trade between a developing nation and
a neighboring wealthy one?
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A: This pattern resembles the theory of comparative advantage in that a product’s
components are made in the country that can produce them at a high level of
productivity.
Quick Study 6
1. Q: What is the main thrust of new trade theory?
A: The new trade theory argues that: (1) there are gains to be had from
2. Q: The economic and strategic advantage gained by being the first company to
enter an industry is called what?
Quick Study 7
1. Q: The national competitive advantage theory states that a nation’s
competitiveness in an industry depends on the capacity of the industry to do
what?
A: National competitive advantage theory states that a nation’s competitiveness in
2. Q: The four main components of the Porter diamond are: (1) factor conditions,
(2) demand conditions, (3) firm strategy, structure, and rivalry, and what else?
A: The Porter diamond consists of four elements that form the basis of
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specifications. However, the United States and its backers said that the amended
policy was no better than the old one. The U.S. government notified U.S.
importers that they are liable for hefty tariffs on $520 million worth of European
luxury goods in retaliation for European barriers on banana imports. Washington
said $520 million is the sum that U.S. companies such as Chiquita and Dole lost
because of the EU banana quota system. The tariffs affected a range of EU goods,
from Belgian biscuits and Scottish cashmere sweaters to Italian cheese and
Spanish leather goods.
The British Trade Minister Brian Wilson called the U.S. action
“potentially catastrophic” for the British cashmere industry concentrated in
Scotland. The French Foreign Ministry also called on the United States to halt
what Paris considered an illegal action by Washington. “We strongly deplore that
the U.S. has once again acted unilaterally,” the ministry said in a statement. “We
are asking them to show good faith and to reconsider this unacceptable decision.”
The World Trade Organization ruled in April 1999 that the European Union’s
banana import program violated international trade law and would have to
change. Caribbean leaders reacted to the ruling with anger and concern, saying it
posed a dire threat to tiny island nations that rely on bananas for their foreign
exchange. The Caribbean accounts for 10 percent of the world’s banana trade.
Much of the remaining 90 percent is dominated by Latin America’s so-called
“dollar banana” producers. Finally, other issues that could be discussed are job
creation, setting an international trade precedent, political strategy, and the
environment.
Teaming Up
Debate Project. Two groups of four students each will debate the advantages and
disadvantages of completely free international trade. After the first student from each
side has spoken, the second student will question the opponent’s arguments, looking for
holes and inconsistencies. The third student will attempt to answer these arguments. A
fourth student will present a summary of each side’s arguments. Finally, the class will
vote on which team has offered the more compelling argument.
A: Students should be sure to support their arguments with aspects of the theories
Practicing International Management Case
First in Asia and the World
5-16. Q: As the first to set up an international air express business in 1969, DHL had
the first-mover advantage over other companies. Is being a first mover as
advantageous for a service company such as DHL, as it is for a manufacturing
company such as Boeing? Explain.
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A: In theory, the principle of first-mover advantage is the same for a service firm
5-17. Q: What elements are necessary for a service company to achieve global success?
A: Key to a service company’s success in markets abroad is the people that
5-18. Q: Instead of relying on local agents, DHL prides itself on having its own staff of
more than 300,000 people across the globe. What are the merits and drawbacks
of this international staffing approach?
5-19. Q: What do you think are the dangers, if any, of being a first mover?
A: DHL largely overreached in its expansion throughout the United States. It
underestimated its competition and faced a global recession after launching its