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International Trade Theory
Learning objectives
• Understand why nations
trade with each other.
• 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
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
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OUTLINE OF CHAPTER 6: INTERNATIONAL TRADE THEORY
Opening Case: Creating the World’s Biggest Free Trade Zone
Introduction
An Overview of Trade Theory
The Benefits of Trade
Country Focus: Is China a Neo-Mercantilist Nation?
Absolute Advantage
Comparative Advantage
The Gains from Trade
Heckscher-Ohlin Theory
The Leontief Paradox
The Product Life-Cycle Theory
Product Life-Cycle Theory in the 21st Century
New Trade Theory
Increasing Product Variety and Reducing Costs
National Competitive Advantage: Porter’s Diamond
Factor Endowments
Focus on Managerial Implications
Location
Government Policy
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Chapter Summary
Critical Thinking and Discussion Questions
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.
OPENING CASE: Creating the World’s Biggest Free Trade Zone
The opening case explores the possible positive economic outcomes of a free trade
agreement between the United States and the European Union (EU), which President
Obama committed to in his 2013 State of the Union address. Such an agreement could
1. Discuss how a free trade agreement between the United States and the EU countries
3. A new free trade agreement between the two sides could eliminate or reduce many
non-tariff barriers to international trade. Provide some examples of how this would work
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and how doing away with these trade barriers will help both sides accelerate economic
recovery.
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 fiview,” then on finotes.” 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
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.
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
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.
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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 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
Slide 6-20 Is Free Trade 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
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.
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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
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.
Slides 6-25 through 6-31 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 6-32 through 6-34 New Trade Theory
New trade theory suggests that because of economies of scale and increasing returns to
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.
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industry) and economies of scale.
Slide 6-35 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.
Slides 6-36 through 6-39 Theory of National Competitive Advantage
Michael Porter hypothesizes that a nation’s competitiveness depends on the capacity of
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.
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
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.
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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.
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.
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.
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 principle tenant of mercantilism is that a country should maintain a
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QUESTION 2: Is free trade fair? Discuss.
ANSWER 2: This question will probably generate a fair amount of discussion. Trade
theory tells suggests that specialization and free trade benefits all countries. However, a
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
fiunfair” import competition. Is such competition fiunfair”? 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,
QUESTION 4: What are the potential costs of adopting a free trade regime? Do you think
governments should do anything to reduce these costs? What?
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ANSWER 4: Students will probably be divided on this question, and a lively debate
should ensue. For example, certainly, students will probably recognize that by adopting a
QUESTION 5: Reread the Country Focus feature, Is China a Neo-Mercantilist Nation?
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. Previously, with a trade surplus of $295 billion in 2011, and foreign exchange reserves
of nearly $2 trillion, China had been criticized as following a neo-mercantilist policy.
For years, China’s exports grew faster than its imports, and some critics suggest that
QUESTION 6: Reread the Country Focus on moving white-collar jobs offshore.
a. Who benefits from the outsourcing of skilled white-collar jobs to developing nations?
Who are the losers?
b. Will developing nations like the United States suffer from the loss of high-skilled and
high-paying jobs?
c. 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: 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 should be the
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QUESTION 7: 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 7: 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
attributes promote or impede the creation of competitive advantage. These attributes are:
QUESTION 8: 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 8: This is a difficult question. Certainly, most students will recognize that
these countries are in dire straights and need assistance from richer countries. Most
Chapter 06 – International Trade Theory
CLOSING CASE: The Rise of India’s Drug Industry
The closing case explores the phenomenal growth of India’s pharmaceutical industry.
Over the past 15 years, pharmaceutical exports from India have exploded, going from just
$1 billion in 2000 to almost $14 billion in 2012. Much of this growth can be attributed to
the decision by many Western firms to outsource their manufacturing to the country, as
QUESTION 1: How might (a) U.S. pharmaceutical companies and (b) U.S. consumers
benefit from the rise of the Indian pharmaceutical industry?
ANSWER 1: For U.S. pharmaceutical companies, the obvious attraction of India as a
drug manufacturing center is lower costs, which will enable them to protect their earnings
QUESTION 2: Who might have lost out as a result of the recent rise of the Indian
pharmaceutical industry?
ANSWER 2: Offset against the economic benefit of lower pharmaceutical pricing in the
QUESTION 3: Do the benefits from trade with the Indian pharmaceutical sector
outweigh the losses?
ANSWER 3: Students’ answers might vary. No one can argue that out-of-pocket
expenses for U.S. consumers could be reduced dramatically by manufacturing
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QUESTION 4: What international trade theory (or theories) best explains the rise of
India as a major exporter of pharmaceuticals?
ANSWER 4: There are several trade theories demonstrated by India’s rise as a major
INTEGRATING iGLOBES
There are several iGLOBE video clips that can be integrated with the material presented
in this chapter. In particular, you might consider the following:
Title: How Many Manufacturing Jobs Can U.S. Realistically Maintain?
Run Time: 9:32
Abstract: This video explores the decline and now upward trend of manufacturing in the
Key Concepts: globalization, global economy, global production, trade theory, rationale
for foreign direct investment, trade policy, strategic trade policy, impact of the
multinational on the host country
Notes: One topic that is sure to generate considerable discussion in the upcoming U.S.
presidential elections is the status of U.S. manufacturing. Manufacturing has long been
an important part of the U.S. economy, providing jobs and the economic growth that
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being offset by higher productivity rates among U.S. workers, making China a less
attractive manufacturing destination. As a result, companies are rethinking their global
production strategies, and some are finding that after considering the additional risk
associated with offshore production, dealing with foreign labor laws, and managing
complex global supply chains, manufacturing in the United States can actually make
more sense.
Discussion Questions and Answers:
1. Reflect on the changes in U.S. manufacturing over the last half century. Why did the
United States lose so many jobs? What impact did that job loss have on the U.S.
economy and on the economies of countries like China and Mexico that have been the
recipients of outsourced U.S. jobs?
Answer: Over the last 50 years, the United States has seen its manufacturing sector
diminish enormously. Indeed, despite still being the world’s largest manufacturing
economy, job losses continue – some 700,000 just since 2000. Most students will
2. Using Porter’s Diamond of Competitive Advantage, explain U.S. manufacturing today,
and how it could change in the next five to ten years. Consider the role of government in
the success of the sector and the future competitiveness of a nation.
Answer: Michael Porter has suggested that four attributes shape the competitive
environment in a country and the ability of firms to compete. The four attributes are
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3. Why are companies like Wham-O returning to the United States to manufacture their
products? Discuss the implications of this trend for countries like China that depend on
Western manufacturing investments.
Answer: The recent announcement by Wham-O, maker of Frisbee, that it is bringing its
manufacturing back to the United States may have caught some people by surprise.
4. What is an innovation economy? How does it differ from a traditional manufacturing
economy?
Answer: Martin Schmidt, professor at the Massachusetts Institute of Technology,
suggests that the United States is becoming an innovation economy. In an innovation
economy, labor cost is less important as manufacturing becomes a capital-intensive
INTEGRATING VIDEOS
There are also several longer video clips that can be integrated with the material
presented in this chapter. In particular, you might consider the following from
International Business DVD Volume 6:
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Title: Young Indian Mogul
Learning Objectives
The purpose of this video is to help you:
❖ Explore the extreme contrasts in standards of living that exist within modern day
India and identify the challenges facing India as it attempts to capitalize on its
economic success, and at the same time help the vast number of people still living at
a subsistence level.
Key Words
❖ Levels of economic development
Synopsis
Modern day India is an example of great contrasts. At one extreme are people like Suhas
Gopinath, CEO of a firm that is worth at least $100 million. At the other end of the
spectrum are a vast number of people surviving on less than a dollar per day. Suhas
Gopinath is part of the country’s growing middle and upper class. Suhas Gopinath
started his global software company, Globals Inc., at the age of 14 with little more than a
However, the success of individuals like Suhas Gopinath can present a misleading picture
of India and its potential role in the global economy. Just 1,000 miles away in the
nation’s capital, Delhi, thousands of Indians are living in the midst of a giant slum
subsisting on whatever they can find. Life in the slum is very difficult. One man about
the same age as Suhas Gopinath lives with his entire family in a single room that is little
more than a shack. Flies are everywhere and malnutrition is evident. People sift through
the mounds of garbage everyday looking for things they can sell. If the man is successful
at finding salable items, he can make 2,000 rupees per month which is about $40.
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Discussion Questions
1. Discuss the vast contrasts in living standards that exist in India. What challenges do
these differences present to the Indian government?
2. How would you characterize the investment climate in India?
3. In your opinion do Indian companies like Globals Inc that are so successful have a
social responsibility to help the nation’s poor? Do foreign companies doing business in
India have any such responsibility? Why might it be in their best interest to display good
corporate citizenship?
INCORPORATING globalEDGE™ EXERCISES
Exercise 1
The WTO’s 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
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Answers to Exercise Questions
Exercise 1
Search Phrase: fiInternational Trade Statistics”
Exercise 2
The information requested is related to Australia’s registered wine suppliers. After
provides a basic list for comparison. As this is a government resource, the source is found
under the globalEDGE category fiResearch: Government Resources”. Be sure to click on
the Resource Desk link to search this area of the globalEDGE website.
Search Phrase: fiAustralian Suppliers”
Resource Name: Australia: Australian Suppliers Directory