Chapter 06 – International Trade Theory
International Trade Theory
Learning objectives
Understand why nations trade with each other.
Summarize the different theories explaining trade flows between nations.
Recognize why many economists believe that unrestricted free trade between
nations will raise the economic welfare of countries that participate in a free trade
system.
Explain the arguments of those who maintain that government can play a
proactive role in promoting national competitive advantage in certain industries.
Understand the important implications that international trade theory holds for
business practice.
This chapter presents the major theories of international trade. Scholars first began to offer
explanations for trade in the fifteenth century. Since then, various trade theories have developed,
along with efforts to refine them.
Approaches to trade range from support for free trade to managed trade, to mercantilist approaches,
to controlled trade, and even, in extremely rare cases, to no trade.
Free trade, with no government interference, is certain to hurt some domestic industries that are not
competitive globally. Workers in the U.S. textile industry, for example, may lose jobs to workers in
lower wage economies. Yet consumers in the U.S. like to purchase inexpensive, quality goods.
The opening case considers the economic implications of a new free trade agreement between China
and Australia. The closing case explores the possibility of a landmark trade agreement that is on the
negotiating table between the United States and the member nations of the European Union.
OUTLINE OF CHAPTER 6: INTERNATIONAL TRADE THEORY
Opening Case: China and Australia Enter into a Free Trade Agreement
Introduction
An Overview of Trade Theory
The Benefits of Trade
The Pattern of International Trade
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Chapter 06 – International Trade Theory
Trade Theory and Government Policy
Mercantilism
Country Focus: Is China a Neo-Mercantilist Nation?
Absolute Advantage
Comparative Advantage
The Gains from Trade
Qualifications and Assumptions
Extensions of the Ricardian Model
Country Focus: Moving U.S. White-Collar Jobs Offshore
Heckscher-Ohlin Theory
The Leontief Paradox
The Product Life-Cycle Theory
Product Life-Cycle Theory in the Twenty-First Century
New Trade Theory
Increasing Product Variety and Reducing Costs
Economies of Scale, First-Mover Advantages and the Pattern of Trade
Implications of New Trade Theory
National Competitive Advantage: Porter’s Diamond
Factor Endowments
Demand Conditions
Related and Supporting Industries
Firm Strategy, Structure, and Rivalry
Evaluating Porter’s Theory
Focus on Managerial Implications
Location
First-Mover Advantages
Government Policy
Chapter Summary
Critical Thinking and Discussion Questions
Closing Case: Creating the World’s Biggest Free Trade Zone
Appendix: International Trade and the Balance of Payments
Balance-of-Payments Accounts
Does the Current Account Deficit Matter?
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Chapter 06 – International Trade Theory
CLASSROOM DISCUSSION POINT
Ask students why countries trade with each other. Write their response on the board and
try to groups the responses according to the various theories presented in the text.
Next, ask them what would happen if countries did not trade with each other. Again,
write the responses on the board using the same format.
Finally, identify how their responses fit into the country/firm framework, and then refer
back to their responses throughout the presentation of the material in the chapter.
LECTURE OUTLINE
This lecture outline follows the Power Point Presentation (PPT) provided along with this
instructor’s manual. The PPT slides include additional notes that can be viewed by
clicking on “view,” then on “notes.” The following provides a brief overview of each
Power Point slide along with teaching tips, and additional perspectives.
Slides 6-3 and 6-4 The Benefits of Trade
Free trade refers to a situation where a government does not attempt to influence through
quotas or duties what its citizens can buy from another country or what they can produce
and sell to another country.
Smith, Ricardo, and Heckscher-Ohlin show why it is beneficial for a country to engage in
international trade even for products it is able to produce for itself.
Slide 6-5 The Patterns of Trade
International trade allows a country to specialize in the manufacture and export of
products that it can produce efficiently, and import products that can be produced more
efficiently in other countries.
Some patterns of trade are fairly easy to explain—it is obvious why Saudi Arabia exports
oil, the United States exports agricultural products, and Mexico exports labor intensive
goods. Yet others are not so obvious or easily explained, such as cars exported from
Japan.
Slide 6-6 Trade Theory and Government Policy
The various theories have differing prescriptions for government policy on trade.
Mercantilism makes a crude case for government involvement in promoting exports and
limiting imports. Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade.
New trade theory and Porter’s theory of national competitive advantage justify limited
and selective government intervention to support the development of certain
export-oriented industries.
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Chapter 06 – International Trade Theory
Slide 6-7 Mercantilism
Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus—
to export more than it imports, and advocates government intervention to achieve a
surplus in the balance of trade.
It views trade as a zero-sum game—one in which a gain by one country results in a loss
by another.
Another Perspective: An interesting perspective of how the mercantilist philosophy may
be a hindrance to trade negotiations between the United States and the European Union
can be found at
{http://www.cato.org/blog/no-time-mercantilist-posturing-transatlantic-trade-talks}.
Slides 6-8 through 6-13 Absolute Advantage
Adam Smith argued that countries differed in their ability to produce goods efficiently,
and should specialize in the production of the goods they can produce the most
efficiently.
If Ghana were to specialize in cocoa production and South Korea in rice production,
Smith argued that both Ghana and South Korea could consume more cocoa and rice than
if each only produced for their own consumption. Thus, trade is a positive sum game.
Slides 6-14 through 6-19 Comparative Advantage
David Ricardo asked what might happen when one country has an absolute advantage in
the production of both goods. Ricardo’s theory of comparative advantage suggests that
countries should specialize in the production of those goods they produce most efficiently
and buy goods that they produce less efficiently from other countries, even if this means
buying goods from other countries that they could produce more efficiently at home.
The simple example of comparative advantage presented in the text makes a number of
assumptions: only two countries and two goods; zero transportation costs; similar prices
and values; resources are mobile between goods within countries, but not across
countries; constant returns to scale; fixed stocks of resources; and no effects on income
distribution within countries. While these are all unrealistic, the general proposition that
countries will produce and export those goods that they are the most efficient at
producing has been shown to be quite valid.
Slide 6-20 Is Unrestricted Free Trade Always Beneficial? Extensions of the Ricardian
Model
Diminishing returns to specialization suggest that after some point, the more of a good
that a country produces, the greater will be the units of resources required to produce
each additional item. If crops are grown on increasingly less fertile land, mining is done
on less productive ore, or less skilled personnel need to be hired to perform high skilled
jobs, production per unit of input will decrease. (Diminishing returns implies a PPF
which is convex.) In reality, countries do not specialize entirely, but produce a range of
goods. It is worthwhile to specialize up until that point where the resulting gains from
trade are offset by diminishing returns.
Opening an economy to trade is likely to generate dynamic gains of two types. First,
trade might increase a country’s stock of resources as increased supplies become available
from abroad. Secondly, free trade might increase the efficiency of resource utilization,
and free up resources for other uses.
Another Perspective: An overview of the ideas and philosophies of David Ricardo, from
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Chapter 06 – International Trade Theory
which his theory of comparative advantage emerged, is available at
{http://www.econlib.org/library/Enc/bios/Ricardo.html}. Students might also consult
{http://www.newschool.edu/nssr/het/profiles/ricardo.htm}.
Slide 6-21 The Samuelson Critique
Samuelson argues that in some cases, the dynamic gains from trade may not be so
beneficial. He argues that the ability to off-shore services jobs that were traditionally not
internationally mobile may have the effect of a mass inward migration into the United
States, where wages fall.
Slides 6-22 and 6-23 Heckscher-Olin Theory
The Heckscher-Ohlin theory predicts that countries will export those goods that make
intensive use of factors of production which are locally abundant, while importing goods
that make intensive use of factors that are locally scarce. It focuses on differences in
relative factor endowments rather than differences in relative productivity.
Another Perspective: A more complete description of the Heckscher-Ohlin theory is
available at {http://www.newschool.edu/nssr/het/profiles/heckscher.htm}.
Slide 6-24 The Leontief Paradox
Using the Heckscher-Ohlin theory, Leontief, in 1953 postulated that since the United
States was relatively abundant in capital compared to other nations, the United States
would be an exporter of capital intensive goods and an importer of labor-intensive goods.
To his surprise, however, he found that U.S. exports were less capital intensive than U.S.
imports. Since this result was at variance with the predictions of the theory, it has
become known as the Leontief Paradox.
Another Perspective: A more extensive description of the Leontief Paradox is available at
{http://www.newschool.edu/nssr/het/profiles/leontief.htm}.
Slides 6-25 through 6-30 The Product Life Cycle
Raymond Vernon suggested that as products mature, both the location of sales and the
optimal production location will change, affecting the direction and flow of imports and
exports. Globalization weakens this theory.
Slides 6-31 through 6-33 New Trade Theory
New trade theory suggests that because of economies of scale and increasing returns to
specialization, in some industries there are likely to be only a few profitable firms. Firms
with first mover advantages will develop economies of scale and create barriers to entry
for other firms.
New trade theory does not contradict the theory of comparative advantage, but instead
identifies a source of comparative advantage.
A nation may be able to specialize in producing a narrower range of products than it
would in the absence of trade, yet by buying goods that it does not make from other
countries, each nation can simultaneously increase the variety of goods available to its
consumers and lower the costs of those goods.
The pattern of trade we observe in the world economy may be the result of first-mover
advantages (economic and strategic advantages that accrue to early entrants into an
industry) and economies of scale.
Slide 6-34 Think Like a Manager: First-Mover Advantages
Slide 6-35 Implications of New Trade Theory
New trade theory suggests that nations may benefit from trade even when they do not
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Chapter 06 – International Trade Theory
differ in resource endowments or technology.
The theory also suggests that a country may predominate in the export of a good simply
because it was lucky enough to have one or more firms among the first to produce that
good.
Slides 6-36 through 6-39 Theory of National Competitive Advantage
Michael Porter hypothesizes that a nation’s competitiveness depends on the capacity of
its industry to innovate and upgrade. Porter’s study tried to explain why a nation achieves
international success in a particular industry. This study found four broad attributes that
promote or impede the creation of competitive advantage: factor endowments, demand
conditions, relating and supporting industries, and firm strategy, structure, and rivalry.
These attributes form Porter’s diamond.
Factor endowments are the nation’s relative position in factors of production. They are
divided into basic and advanced.
Demand conditions refer to the nature of home demand for the product or service, and
influences the development of production capabilities. Sophisticated and demanding
customers pressure firms to be competitive.
Related and supporting industries refer to the presence in a nation of supplier industries
and related industries that are internationally competitive, and can spill over and
contribute to other industries.
Firm strategy, structure and rivalry refer to the conditions in the nation governing how
companies are created, organized, and managed, and how the nature of domestic rivalry
impacts firms’ competitiveness.
Firms that face strong domestic competition will be better able to face competitors from
other firms.
Slide 6-40 Evaluating Porter’s Theory
In addition to these four main attributes, government policies and chance can impact any
of the four. Government policy can affect demand through product standards, influence
rivalry through regulation and antitrust laws, and impact the availability of highly
educated workers and advanced transportation infrastructure.
Slide 6-41 Implications for Managers
There are at least three main implications of the material discussed in this chapter for
international businesses: location implications, first-mover implications, and policy
implications.
From a profit perspective, it makes sense for a firm to disperse its various productive
activities to those countries where, according to the theory of international trade, they can
be performed most efficiently.
Being a first mover can have important competitive implications, especially if there are
economies of scale and the global industry will only support a few competitors. Firms
need to be prepared to undertake huge investments and suffer losses for several years in
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Chapter 06 – International Trade Theory
order to reap the eventual rewards.
Being a first mover can have important competitive implications, especially if there are
economies of scale and the global industry will only support a few competitors.
Firms need to be prepared to undertake huge investments and suffer losses for several
years in order to reap the eventual rewards.
One of the most important implications for businesses is that they should work to
encourage governmental policies that support free trade.
If a business is able to get its goods from the best sources worldwide, and compete in the
sale of products into the most competitive markets, it has a good chance to survive and
prosper. If such openness is restricted, a business’s long-term survival will be in greater
question.
Another Perspective: For information about foreign governments and their approaches to
international trade, visit the Electronic Embassy at {http://www.embassy.org/}. This site
provides links to all of the foreign embassies located in Washington D.C.
Slides 6-42 through 6-45 Balance of Payments
The balance-of-payments accounts keep track of the payments to foreigners for imports
of goods and services, and receipts from foreigners for goods and services exported to
them.
There are three main accounts: the current account, the capital account, and the
financial account.
In the United States, the current account deficit has been growing because of its imports
of physical products, but the country runs a current account surplus in trade in services.
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