Chapter 06 – International Trade Theory
International Trade Theory
Learning Objectives
• LO6-1: Understand why nations
trade with each other.
• LO6-2: Summarize the different
theories explaining trade flows
between nations.
• LO6-3: 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.
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
6
Chapter 06 – International Trade Theory
OUTLINE OF CHAPTER 6: INTERNATIONAL TRADE THEORY
Opening Case: A Tale of Two Nations: Ghana and South Korea
Introduction
An Overview of Trade Theory
The Benefits of Trade
The Pattern of International Trade
Trade Theory and Government Policy
Mercantilism Country Focus: Is China Manipulating Its Currency in Pursuit of a Neo-
Mercantilist Policy?
Absolute Advantage
Heckscher-Ohlin Theory
The Leontief Paradox
The Product Life-Cycle Theory
Product Life-Cycle Theory in the Twenty-First Century
Focus on Managerial Implications
Location, First-Mover Advantages, and Government Policy
Chapter Summary
Critical Thinking and Discussion Questions
Chapter 06 – International Trade Theory
6-3
Closing Case: Trade Wars Are Good and Easy to Win
Appendix: International Trade and the Balance of Payments
Balance-of-Payments Accounts
Does the Current Account Deficit Matter?
Chapter 06 – International Trade Theory
CLASSROOM DISCUSSION POINT
Ask students why countries trade with each other. Write their responses on the board and
try to group the responses according to the various theories presented in the text.
OPENING CASE: A Tale of Two Nations: Ghana and South Korea
Summary
The opening case explores the contrast between South Korea and Ghana, two nations that
in 1970 were at similar levels of economic development. The countries pursued different
policies toward international trade and experienced very different outcomes as a result of
those policies. South Korea, which embraced international trade and established policies
to promote it, now has the world’s 11th largest economy with a per capita income of
$32,000. In contrast, Ghana, which initially pursued a policy that was much more
isolationist, is significantly poorer with a per capita income of just $1,786. Discussion of
the case can begin with the following questions:
QUESTION 1: How have the different approaches toward international trade by Ghana
and South Korea changed the economic future of the two countries?
ANSWER 1: In 1970, Ghana and South Korea were in similar places economically.
Ghana’s GDP per capita was $250, while GDP per capita in South Korea was about $260.
QUESTION 2: How would you describe the approach to international trade used by
Ghana following its independence from Great Britain in 1957? Has the policy been
successful? What does your response tell you about the benefits of international trade?
ANSWER 2: Following its independence from Great Britain in 1957, Ghana pursued an
inward focusing policy that discouraged both imports and exports and instead promoted
self-sufficiency. Ghana’s President, Kwame Nkrumah, imposed high tariffs on imports
Chapter 06 – International Trade Theory
opened its market to international trade, the legacy of the failed policies is reflected in
Ghana’s GDP per capita which stands below $2,000.
QUESTION 3: How would you characterize the policy followed by South Korea over
the past half century? Has the policy been successful? Explain.
ANSWER 3: In 1970, South Korea had a GDP per capita of just $260. Today, that figure
has soared to $32,000 suggesting that the policies pursued by the country over the past 50
years have been beneficial. Rather than focusing inward as Ghana did, South Korea chose
to embrace globalization, and opened its market to international trade and investment.
The country adopted policies to reduce barriers to entry, created an environment
conducive to investment in export-oriented industries, and encouraged producers to
LECTURE OUTLINE
This lecture outline follows the Power Point Presentation (PPT) provided along with this
instructor’s manual. The following provides a brief overview of each Power Point slide
along with teaching tips and additional perspectives.
Slides 6-3 ‒ 6-7 An Overview of Trade Theory
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.
Chapter 06 – International Trade Theory
goods. Yet others are not so obvious or easily explained, such as cars exported from
Japan.
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.
Slide 6-8 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.
CONNECT
Video Case
Did You Know That the Last Time the United States Imposed Tariffs on Imports of Steel It Led
to Job Losses?
Summary
This activity explores the implications of tariffs imposed by the United States on steel imported
from China. The tariffs have led to higher prices on steel.
Activity
Students are asked to watch a video on steel tariffs and then respond to questions about the video.
Chapter 06 – International Trade Theory
Slides 6-9 ‒ 6-10 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. Thus, a country has an absolute advantage in the production of a product.
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.
The Gains from Trade
Ricardo’s theory suggests that consumers in all nations can consume more if there are no
restrictions on trade.
Qualifications and Assumptions
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
Extensions of the Ricardian Model
The simple model of comparative advantage assumes constant returns to specialization.
A more likely scenario is diminishing returns to specialization where 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 highly skilled jobs, production per unit of input will decrease. (Diminishing
Chapter 06 – International Trade Theory
CONNECT
Video Case
The Rise of Bangladesh’s Textile Trade
Summary
This activity explores Bangladesh’s textile industry as it relates to the theory of comparative
advantage.
Activity
Students are asked to watch a video on Bangladesh’s textile industry and then respond to
questions about the video.
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 6-20 ‒ 6-21 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.
Chapter 06 – International Trade Theory
6-9
Product Life-Cycle in the Twenty-First Century
Globalization weakens this theory.
Slides 6-24 ‒ 6-27 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.
Economies of Scale, First-Mover Advantages, and the Pattern of Trade
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.
Implications of New Trade Theory
New trade theory suggests that nations may benefit from trade even when they do not
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.
CONNECT
Case Analysis
New Trade Theory and Aircraft Production
Chapter 06 – International Trade Theory
Class Discussion
Discuss new trade theory and the role of government in helping an industry like the aircraft
industry to be successful. How has government policy shaped other industries?
Slides 6-28 ‒ 6-34 National Competitive Advantage: Porter’s Diamond
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
Factor endowments are the nation’s relative position in factors of production. They are
divided into basic and advanced.
Related and Supporting Industries
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.
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.
CONNECT
Click and Drag
Applying Porter’s Model
Summary
This activity focuses on Michael Porter’s Theory of Competitive Advantage. Porter theorized that
the four attributes of his model may promote or impede the creation of competitive advantage.
Chapter 06 – International Trade Theory
CONNECT
Click and Drag
Trade Theories: A Historical Approach
Summary
This activity focuses on the evolution of trade theory beginning with the early mercantilist
approach to modern day new trade theory and Porter’s Diamond of Competitive Advantage.
Activity
Students are asked to match the various trade theories to a timeline.
Slide 6-35 Focus on Managerial Implications
Location, First-Mover Advantages, and Government Policy
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.
Chapter 06 – International Trade Theory
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.
Balance-of-Payments Accounts
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.
CONNECT
Click and Drag
The Balance of Payment (BOP) Explained
Summary
This activity focuses on the balance of payments. Understanding the different accounts in the
balance of payments and the transactions related to those accounts provides insight to potential
policy decisions by the government.
Activity
Students are asked to match various transactions to the correct balance of payment account.
Chapter 06 – International Trade Theory
CRITICAL THINKING AND DISCUSSION QUESTIONS
QUESTION 1: Mercantilism is a bankrupt theory that has no place in the modern world.
Discuss.
ANSWER 1: In its purest sense, mercantilism is a bankrupt theory that has no place in the
modern world. The principal tenet of mercantilism is that a country should maintain a
trade surplus, even if that means that imports are limited by government intervention.
This policy is bankrupt for at least two reasons. First, it is inconsistent with the general
notion of globalization, which is becoming more and more prevalent in the world. A
QUESTION 2: Is free trade fair? Discuss.
ANSWER 2: This question will probably generate a fair amount of discussion. Trade
theory suggests that specialization and free trade benefits all countries. However, a case
can be made in some situations for imposing trade barriers. For example, if a developing
QUESTION 3: Unions in developed nations often oppose imports from low-wage
countries and advocate trade barriers to protect jobs from what they often characterize as
“unfair” import competition. Is such competition “unfair”? Do you think that this
argument is in the best interests of (a) the unions, (b) the people they represent, and/or (c)
the country as a whole?
ANSWER 3: The theory of comparative advantage suggests that a country should
specialize in producing those goods that it can produce most efficiently, while buying
goods that it can produce relatively less efficiently from other countries. Furthermore, the
theory suggests that opening a country to free trade stimulates economic growth, which
Chapter 06 – International Trade Theory
QUESTION 4: What are the potential costs of adopting a free trade regime? Do you
think governments should do anything to reduce these costs? Why?
ANSWER 4: Students will probably be divided on this question, and a lively debate
should ensue. For example, students should recognize that by adopting a free trade
regime, jobs will be lost in some industries; however, they may not agree on exactly what
QUESTION 5: Reread the Country Focus “Is China Manipulating Its Currency in
Pursuit of a Neo-Mercantilist Policy?”
a. Do you think China is pursuing an economic policy that can be characterized as neo-
mercantilist?
b. What should the United States, and other countries, do about this?
ANSWER 5:
a. Many students will probably agree that in the past, the allegations that China was
pursuing a neo-mercantilist policy seemed to ring true. Countries pursuing a neo-
mercantilist policy focus on achieving high trade surpluses while at the same time
b. Students will probably suggest that the United States and other countries continue to
put pressure on China to open its markets to imports or risk retaliatory measures. With
QUESTION 6: Reread the Country Focus “Moving U.S. White-Collar Jobs Offshore.”
a. Who benefits from the outsourcing of skilled white-collar jobs to developing nations?
Who are the losers?
b. Will developed nations like the United States suffer from the loss of high-skilled and
high-paying jobs?
ANSWER 6:
a. Most students will recognize that developing countries benefit from the outsourcing of
skilled white-collar jobs in numerous ways including job creation, higher wages, and
Chapter 06 – International Trade Theory
training and development. Some students might also point out that because of these
b. Responses to this question will vary by student. Many students will probably suggest
that loss of high-skilled, high-paying jobs is indeed detrimental to developing nations
QUESTION 7: Is there a difference between the transference of high-paying white-collar
jobs, such as computer programming and accounting, to developing nations, and low-
paying blue-collar jobs? If so, what is the difference, and should government do anything
to stop the flow of white-collar jobs out of the country to countries like India?
ANSWER 7: This question is likely to generate a lively debate. Many students will
suggest that the outward flow of white-collar jobs is indeed a serious issue, one that
QUESTION 8: Drawing on the new trade theory and Porter’s theory of national
competitive advantage, outline the case for government policies designed to build a
national competitive advantage in biotechnology. What kind of policies would you
recommend the government adopt? Are these policies at variance with the basic free trade
philosophy?
ANSWER 8: Porter’s theory of national competitive advantage argues that four broad
attributes of a nation shape the environment in which local firms compete, and that these
Chapter 06 – International Trade Theory
strategy, structure, and rivalry. Porter goes on to argue that firms are most likely to
succeed in industries in which the diamond (which are the four attributes collectively) is
favorable. Porter adds two factors to the list of attributes described above: chance and
government policy. New trade theory addresses a separate issue. This theory argues that
due to the presence of substantial scale economies, world demand will support only a few
QUESTION 9: The world’s poorest countries are at a competitive disadvantage in every
sector of their economies. They have little to export. They have no capital; their land is of
poor quality; they often have too many people given available work opportunities; and
they are poorly educated. Free trade cannot possibly be in the interests of such nations.
Discuss.
ANSWER 9: This is a difficult question. Certainly, most students will recognize that
CLOSING CASE: “Trade Wars Are Good and Easy to Win”
Summary
The closing case explores Donald Trump’s perspective on trade and the actions he has
taken on trade while President of the United States. Trump’s isolationist views are in
stark contrast to U.S. trade policy of the past 70 years. Trump appears to be under the
impression that trade agreements are zero-sum games and further that other countries can
be bullied into making concessions to the United States. Trump has boasted that “trade
wars are good and easy to win” indicating that he intends to impose widespread tariffs as
Chapter 06 – International Trade Theory
part of his effort to make America great again. Discussion of the case can begin with the
following questions:
QUESTION 1: What economic theory of trade do Donald Trump’s views seem most
closely aligned with?
ANSWER 1: Most students will probably agree that Donald Trump’s views on trade
appear to be most closely aligned with mercantilism and the philosophy that it is in a
country’s best interests to export more than it imports. Students sharing this view will
QUESTION 2: What are the possible benefits of Donald Trump’s position on
international trade? What are the potential costs and risks of his position?
ANSWER 2: Since the end of World War II, the United States has been a strong force in
pushing the world to adopt free trade measures. Indeed, until the election of Donald
Trump, there was little dispute as to leadership role of the United States in the global
economy. Now however, there are concerns that that leadership role could be rapidly
deteriorating. Already for example, the remaining 11 countries that were part of the TPP
QUESTION 3: Do you think Trump is correct? Are trade wars good and easy to win?
What does it mean to “win” a trade war? What does it mean to “lose”?
ANSWER 3: Since winning the election, Donald Trump has moved swiftly to change
Chapter 06 – International Trade Theory
his statements that China and Mexico are taking advantage of the United States. Some
students will have direct experience with job losses related to shifts in manufacturing
locations or cheap imports. These students may support the notion that protectionist
moves are important to protect U.S. jobs. Other students, however, will probably counter
MHE INTERNATIONAL BUSINESS VIDEO LIBRARY
ongoing stream of updated video suggestions correlated by key concept and major topic.
Every new clip posted is supported by teaching notes and discussion questions. Please
feel free to leave comments in the library that you feel might be helpful to your
colleagues.
CONNECT
Geography
Summary
This activity is designed to test the student’s knowledge of geography. Questions related to
chapter material are asked, requiring students to understand the topics and the locations of the
countries involved.
Chapter 06 – International Trade Theory
INCORPORATING globalEDGE™ EXERCISES
Exercise 1
The Word Trade Organization International Trade Statistics is an annual report that
provides comprehensive, comparable, and updated statistics on trade in merchandise and
commercial services. This report allows for an assessment of world trade flows by
Exercise 2
Food is an integral part of understanding different countries, cultures, and lifestyles. You
run a chain of high-end premium restaurants in the United States, and you are looking for
to work with.
Answers to Exercises
Additional Info:
There are several ways to get a list of Top 10 exporters and importers in the world from
this website. The easiest is to access the interactive “International Trade and Market
Access Data” tool. You can get a ranking of the countries at the bottom of this tool. The
default is for exports, but there is a drop-down at the top to allow you to switch the data
for imports.
Exercise 2 Answer
Chapter 06 – International Trade Theory
Additional Info:
A supplier directory developed by the Australian Trade and Investment Commission
allows importers from around the world to search for and identify potential Australian
exporters.