Chapter 06 – International Trade Theory
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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 explores the phenomenal growth of
India’s pharmaceutical industry over the past decade.
The growth of the industry came after India made an
agreement with the World Trade Organization to
comply with intellectual property rights. Today, many
Western pharmaceutical companies are outsourcing
their manufacturing to the country.
The closing case explores Bangladesh’s thriving textile
industry. Thanks to the country’s low wage rates,
investments in textile technology, and strong supporting
industry, Bangladesh has been able to increase its
exports of textiles even during the recent global
recession.
6
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OUTLINE OF CHAPTER 6: INTERNATIONAL TRADE THEORY
Opening Case: The Rise of India’s Drug Industry
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 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
Evaluating the Product Life-Cycle Theory
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
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Management Focus: The Rise (and Fall) of Finland’s Nokia
Implications for Managers
Location
First-Mover Advantages
Government Policy
Chapter Summary
Critical Thinking and Discussion Questions
Closing Case: The Rise of Bangladesh’s Textile Trade
Appendix: International Trade and the Balance of Payments
Balance of Payments Accounts
Does the Current Account Deficit Matter?
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.
OPENING CASE: The Rise of India’s Drug Industry
The opening case explores the phenomenal growth of India’s pharmaceutical industry.
Over the past decade, pharmaceutical exports from India have exploded going from just
$1 billion in 2000 to almost $10 billion in 2010. Much of this growth can be attributed to
the decision by many Western firms to outsource their manufacturing to the country.
India, with its relatively low cost labor, large pool of English speaking scientists and
workers, and knowledge of U.S. and European drug regulations is an attractive
manufacturing location for Western firms. Discussion of the case can revolve around the
following questions:
1. Discuss how India’s 2005 agreement with the World Trade Organization helped shape
the global pharmaceutical industry. What benefits has growth of the industry brought to
the country? How has it benefitted Western consumers?
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2. Using Porter’s Diamond of Competitive Advantage, discuss India’s competitive
advantage in pharmaceuticals. What factors contribute to the country’s competitive
advantage in the production of pharmaceutical products? What are the implications of
India’s competitive advantage for workers in the United States?
3. Reflect on the restrictions that limited Indian firms from exporting to developed
nations prior to 2005. In your opinion, were these restrictions fair? Who were they
designed to protect?
Teaching Tip: For more information on the growth of the pharmaceutical industry in
India, go to
{http://www.businessweek.com/globalbiz/content/may2009/gb20090520_181591.htm}
and {http://www.businessweek.com/magazine/welcome-to-india-the-land-of-the-drug-
reps-09082011.html}.
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 6-3-6-4 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.
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
limiting imports. Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade.
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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.
Slides 6-8-6-13 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 Britain were to specialize in textile production and Spain in wine production, Smith
argued that both Britain and Spain could consume more textiles and wine than if each
only produced for their own consumption. Thus, trade is a positive sum game.
Slides 6-14-6-19 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
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
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
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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.
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 6-22-6-23 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.
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 6-25-6-31 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.
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Slide 6-32-6-34 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.
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 6-35 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 6-36-6-39 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.
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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 order to reap the eventual rewards.
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Slides 6-42-6-45 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.
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 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 tells 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
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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,
the theory suggests that opening a country to free trade stimulates economic growth,
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?
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: Re-read the Country Focus feature, Is China a 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) With a trade surplus of $260 billion in 2008, and foreign exchange reserves of nearly
$2 trillion, China has been criticized as following a neo-mercantilist policy. For years,
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. Some
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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 to other countries?
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
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:
factor endowments, demand conditions, related and supporting industries, and firm
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
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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
CLOSING CASE: The Rise of Bangladesh’s Textile Trade
The closing case discusses Bangladesh’s competitive advantage in the production of
textile products. Bangladesh, a very poor country, has been able to grow even during the
most recent global recession thanks to its strong textile industry. Bangladesh, with its
low wages, large investments in textile technology, and strong network of supporting
industries, is now one of the world’s lowest cost producers of textiles. The country has
been able to capitalize on these advantages to increase its exports of textiles to $10.7
billion up from $9.3 billion in 2009. Discussion of the case can revolve around the
following questions:
QUESTION 1: Why was the shift to a free trade regime in the textile industry good for
Bangladesh?
ANSWER 1: Until 2005, Bangladesh’s opportunities in the developed nations were
governed by a quota system. However, when the quota system was replaced with free
QUESTION 2: Who benefits when retailers in the United States source textiles from low
wage countries such as Bangladesh? Who might lose? Do the gains outweigh the losses?
ANSWER 2: During the 2008-2009 global recession, Wal-Mart and other retailers
increased their purchases from Bangladesh to take advantage of the country’s low cost
garments. Bangladesh’s low cost, but highly productive workforce and strong supporting
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QUESTION 3: What international trade theory, or theories, best explain the rise of
Bangladesh as a textile exporting powerhouse?
ANSWER 3: The move of Bangladesh to become a dominant player in the global textile
industry in the last decade is a direct result of the country’s relatively low wage rates,
QUESTION 4: How secure is Bangladesh’s textile industry from foreign competition?
What factors could ultimately lead to a decline?
ANSWER 4: At the moment, Bangladesh is attractive to importers not only because of its
low cost garments, but also because it offers a chance for diversification. Importers,
worried that relying on China as a sole source of goods could be too risky, see
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: Late Economist Samuelson Bridged Math, Money
Run Time: 10:06
Abstract: This video explores the lasting contributions of Nobel Prize-winning
economist, Paul Samuelson to the field of economics.
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Key Concepts: economic theory and the role of the government, trade theory,
globalization
Special Note: The iGLOBE Nobel Prize Winning Milton Friedman Dies at Age 94
(December 2006) can be used in conjunction with this iGLOBE.
Notes: Paul Samuelson, arguably one of the most influential economists in the world,
died recently at the age of 94. Samuelson, who, in the 1970s, won the United States’ first
Nobel Prize in economics, was a professor at the Massachusetts Institute of Technology
(MIT) for 69 years. He is credited with changing the way people think about economics,
and making the discipline more accessible to the average person. Samuelson supported
the ideas of John Maynard Keynes that government should play a central role in the
economy. However, Samuelson’s theories, which were initially dubbed New Economics,
were based on a mathematical understanding of the way in which economies work.
According to David Wash, an economist journalist, Samuelson’s approach to economics
changed the way economists talked to each other, and indeed how they described the
economy. Samuelson’s emphasis on math allowed for the measurement and
manipulation of economic indicators in a way that had not been used before.
Warsh claims that Samuelson, along with John Maynard Keynes, Milton Friedman, and
Kenneth Arrow, represent 20th century thinking on economics. Samuelson’s position that
government and regulation are important in how economies are run had significant
impact on policymakers. As principal adviser to President John F. Kennedy, Samuelson
played a key role in economic thinking and policymaking during a critical time in U.S.
history. Samuelson’s role as an advisor to policymakers continued through much of his
lifetime.
Samuelson’s legacy in economics is likely to be lasting. Samuelson continued to be
active in the field of economics even late in life, and is revered by colleagues. While
Samuelson published numerous papers in technical journals, his two books, Foundations
of Economic Analysis (1947) and Economics: An Introductory Analysis (1948) are
perhaps his biggest contributions to the field. More than half a century after they were
published, the two books remain the foundation for much of current theory on economics
and influence the contents of most technical journals on the subject. Furthermore, many
individuals in key advisory positions in the United States government today are products
of MIT, and therefore, are well-schooled in Samuelson’s beliefs.
Discussion Questions:
1. Who was Paul Samuelson? Why was he so important to the field of economics?
Discuss his basic philosophies. What was Samuelson’s perspective on the role of
government in the economy?
2. Paul Samuelson advocated government intervention in the marketplace. How did his
philosophy differ from other economic greats like Milton Friedman? How did
Samuelson view free trade?
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3. Reflect on the recent global economic crisis. How has the work of Paul Samuelson
influenced the policies of governments as they respond to the challenges they are
currently facing?
4. Paul Samuelson continued to be actively involved in economic thinking even in his
90s. Comment on his legacy. Why will his approach to economic thinking continue?
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:
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.
❖ Discuss how foreign companies might view the investment climate in India.
❖ Consider the social responsibility of successful individuals and companies toward
those who are less fortunate.
❖ Recognize the potential impact of companies from emerging markets like India on
the global market place.
Key Words
❖ Levels of economic development
❖ Social responsibility
❖ Globalization
❖ Global competition and strategy
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
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started his global software company, Globals Inc., at the age of 14 with little more than a
simple home computer and big ideas. Six years later, he is an incredible success story.
His company operates in eleven countries including the United States supplying software
solutions to hundreds of companies. Suhas Gopinath, who claims that he was inspired by
Bill Gates, is now a role model for other young Indians hoping to cash in on the
technology boom that is sweeping the country. Despite being offered $100 million by a
Houston-based venture capital firm for just 35 percent of his business, Suhas Gopinath
leads a relatively modest lifestyle living with his parents in Bangalore, a city that has
greatly benefitted from the technology boom, and continuing his education at a nearby
college.
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.
Astonishingly, this makes the man better off than 300 million other Indians who live on
less than $1 a day.
Today, India is grappling with the challenges of how to capitalize on the opportunities
presented by globalization, while at the same time deal with the extreme poverty that is
so prevalent throughout the country. The country must find ways to encourage people
like Suhas Gopinath to achieve their dreams, and facilitate their success yet still ensure
that the people living in the slums of Delhi are not left behind. Attracting more foreign
investment and promoting social and economic responsibility may be the key to meeting
these challenges.
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?
4. Discuss the implications of the growth of companies from emerging markets on the
global market place. What does this trend mean for competitors from developed
countries? What does this trend suggest about the global market place in the future?
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INCORPORATING globalEDGE™ EXERCISES
Use the globalEDGE™ site {http://globalEDGE.msu.edu/} to complete the following
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
country, region, and main product or service categories. Using the most recent statistics
available, identify the top five countries that lead in the export and import of
merchandise, respectively.
Exercise 2
Food in an integral part of understanding different countries, cultures, and lifestyles. In
fact, your company is interested in importing Australian wine to the United States.
However, you must first identify which Australian suppliers can provide specific types of
wine for your burgeoning dinner cruise business. After searching the supplier directory,
use specific criteria to compare the profiles of companies supplying both red and white.
Decide which supplier is best for your company. Be sure to justify your conclusion.
Answers to Exercise Questions
Exercise 1
The report can be accessed by searching the term fiInternational Trade Statistics” at
http://globaledge.msu.edu/ResourceDesk/. The WTO: International Trade Statistics
comes up as the second source in this search. As this is a published report that primarily
Exercise 2
The information requested is related to Australia’s registered wine suppliers. After
searching the term fiAustralian suppliers” at http://globaledge.msu.edu/ResourceDesk/,
the Australian Suppliers Directory is the only source returned. Once at the webpage, a
search for suppliers with the search fired AND wine” as well as fiwhite AND wine”
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