Part Three

Theories and Institutions: Trade and Investment


Chapter 5

International Trade Theory





!                   Explain trade theories.

!                   Discuss how to increase global efficiency through free trade.

!                   Introduce prescriptions for altering trade patterns.

!                   Explore how business decisions influence international trade.



Chapter Overview


Foreign trade is an age-old phenomenon. Chapter 5 examines many of the descriptive and prescriptive theories associated with this process. Beginning with Mercantilism, the chapter presents the concepts of absolute and comparative advantage, factor proportions theory and country size and country similarity theories. It also discusses the international product life cycle and Porters determinants of national competitive advantage. The chapter concludes with a discussion of the strategic reasons firms participate in the international trade process.



Chapter Outline


OPENING CASE: Sri Lankan Trade [See Map 5.1]

This case describes the pivotal role of international trade in the development of the Sri Lankan economy. An island nation of nearly 20 million people, the countrys trade activities date back to the middle of the third century. During the colonial period, the Portuguese sought Ceylonese spices, and then the British developed tea, rubber and coconut plantations. Since receiving its independence from the UK in 1948, Sri Lanka has looked to international trade to help solve such interrelated problems as its shortage of foreign exchange, its overdependence on exports of tea and on the British market and the insufficient growth of output and employment. Specifically, Sri Lanka has been guided by four different trade policies: a liberal approach of noninterference in trade from 1948-1960, a policy of import substitution from 1960-1977, the combination of strategic trade policy guided by import substitution from 1977-1988 and the implementation of strategic trade policy combined with an openness to imports from 1988 to the present. The move to establish strategic export industries has accomplished many of Sri Lankas objectives; manufacturing now accounts for 70 percent of its exports, and tea is increasingly being exported in value-added forms.


Teaching Tip: Carefully review the PowerPoint slides for Chapter 5. For additional visual summaries of key chapter points, also review:

·         Table 5.2—International Changes during a Product’s Life Cycle

·         Figure 5.5—Determinants of Global Competitive Advantage in the text.


I.                   INTRODUCTION

Foreign trade (importing and exporting activities) is one means by which countries are linked economically. Two general types of trade theories pertain to international business. Descriptive theories deal with the natural order of trade; they examine and explain patterns of trade under laissez-faire conditions. Prescriptive theories deal with the question of whether governments should seek to alter the amount, composition and/or direction of trade.



The concept of mercantilism (a zero-sum game) was popular from about 1500-1800; it purports that a countrys wealth is measured by its holdings of treasure (usually gold). To amass a surplus (a favorable balance of trade) a country must export more than it imports and then collect gold (and other forms of wealth) from countries that run a deficit (an unfavorable balance of trade). Neomercantilism represents the more recent policy of countries that try to run a favorable balance of trade in order to achieve some particular national objective via protectionism.



In 1776 Adam Smith claimed the wealth of a nation consisted of the goods and services available to its citizens. His theory of absolute advantage holds that a country can maximize its own economic well being by specializing in the production of those goods it can produce more efficiently than any other nation and enhance global efficiency through its participation in (unrestricted) free trade.

A.                Natural Advantage

A country may have a natural advantage in the production of particular products because of given climatic conditions, access to certain natural resources, the availability of needed labor forces, etc.

B.                 Acquired Advantage

An acquired advantage represents a distinct advantage in skills, technology and/or capital assets, thus yielding differentiated product offerings and/or cost-competitive homogeneous products.

C.                Resource Efficiency Example [See Figure 5.2]

Real income depends on the output of goods as compared to the resources used to produce them. The production possibilities curve shows that by specializing and trading, two countries can have more than they would without trade, thus optimizing global efficiency.



In 1817 David Ricardo reasoned there would still be gains from trade if a country specialized in the production of those things it can produce most efficiently, even if other countries can produce those things even more efficiently. Put another way, Ricardo’s theory of comparative advantage holds that a country can maximize its own economic well-being by specializing in the production of those goods it can produce relatively efficiently and enhance global efficiency through its participation in (unrestricted) free trade.

A.                An Analogous Explanation of Comparative Advantage

Would it make sense for the best physician in town, who also happens to be the most talented medical secretary, to handle all of the administrative duties of an office? No. The physician can maximize both output and income by working as a physician and employing a secretary. In the same manner, a country will gain if it concentrates its resources on the production of those products it can produce most efficiently.

B.                 Production Possibility Example [See Figure 5.3]

A country can simultaneously have a comparative advantage and an absolute disadvantage in the production of a given product. Assume that the United States is more efficient than Sri Lanka in the production of both wheat and tea. However, the United States has a comparative advantage in wheat production. By concentrating on the product in which it has the greater advantage (wheat) and letting Sri Lanka produce the product in which the U.S. is comparatively less efficient (tea), global output can be increased, and specialization and trade can benefit both countries.



The theories of absolute and comparative advantage are based upon the economic gains from specialization, i.e., concentration on the production of a limited number of products. Each holds that specialization will maximize output and that subsequent trade will maximize consumer welfare. However, both theories make certain assumptions that may not always be valid.

A.        Full Employment

Both theories assume that resources are fully employed. When countries have many un- or under-employed resources, they may seek to restrict imports in order to employ their own available workers and other assets.

B.        Economic Efficiency Objective

Countries often pursue objectives other than economic efficiency. For example, they may intentionally avoid overspecialization because of the vulnerability created by potential changes in technology and price fluctuations.

C.                Division of Gains

Although specialization does maximize output, it is unclear how those gains will be divided. If one country perceives a trading partner as receiving too large a share of the benefits, it may choose to forego its relatively small gains in order to prevent the other country from receiving large gains.

D.                Two Countries, Two Commodities

The world is comprised of multiple countries and multiple commodities. Nonetheless, the theories are still useful; economists have applied the same reasoning and demonstrated the economic efficiency advantages in multi-product and multi-country production and trade relationships.

E.                 Mobility

Neither the assumption that resources can move domestically from the production of one good to another and at no cost, nor the assumption that resources cannot move internationally, is entirely valid. Nonetheless, domestic mobility is greater than the international mobility of resources. Clearly, the movement of resources such as labor and capital is an alternative to trade.

F.         Statics and Dynamics

Although the theories of absolute and comparative advantage consider gains at a given time (a static view), the relative conditions that surround a countrys advantage or disadvantage are dynamic (constantly changing). Thus one cannot assume future advantages will remain constant.

E.                 Services

Although the theories of absolute and comparative advantage were developed from the perspective of trade in commodities, much of the same reasoning can be applied to trade in services.



The theory of country size holds that large countries are more apt to have varied climates and natural resources, and therefore will generally be more nearly self-sufficient than small countries. Research based on country size helps explain the country-by-country differences regarding how much and what products will be traded through specialization that are not dealt with by the theories of absolute and comparative advantage.

A.                Variety of Resources

Large countries are more apt to have varied climates and a greater assortment of natural resources than smaller countries, thus making the large countries more self-sufficient.

B.        Transport Costs

Given the same types of terrain and modes of transportation, the greater the distance, the higher transport costs will be. Thus certain firms in large countries may face higher transportation costs in terms of serving their distant national markets than do their closer foreign competitors.

C.        The Size of the Economy and Production Scales

Countries with large economies and high per capita incomes are more likely to produce goods that use technologies requiring long production runs. These countries develop industries to serve their large domestic markets, which in turn tend to also be competitive in export markets. On the other hand, given its capacity the technologically intensive company from a small nation may have a compelling need to sell abroad. In turn, this need would pull resources from other industries within the firms domestic market, thereby causing more national specialization than in a larger nation.



The Heckscher-Ohlin theory of factor endowment is useful in extending the concept of comparative advantage by bringing into consideration a nation’s endowment and cost of factors of production. The theory holds that a country will tend to export products that utilize factors of production relatively abundant in that nation.

A.                Land-Labor Relationship

In countries with many people relative to the size of the available land, labor would be relatively (comparatively) cheap; thus those countries should concentrate on producing and exporting labor-intensive goods.

B.        Labor-Capital Relationship

In countries where little capital is available for investment and where the amount of investment per worker is low, then low labor rates would also be expected. Again, those countries should concentrate on producing and exporting labor-intensive goods. (The fact that labor skills tend to vary across countries has led to international task specialization with respect to national production activities.)

C.        Technological Complexities

Factor proportions analysis becomes complicated when the same product can be produced by different methods, such as with different mixes of labor and capital. Managers must consider the cost in each locale, based on the type of production that will minimize costs there.



Vernons international product life cycle (PLC) describes how the location of production and trade activities shifts as a product moves through its life cycle.

A.        Changes through the Cycle

A great majority of the new technology that results in new products and production methods originates in industrial countries.

1.                  Introduction. Innovation, production and sales occur in the domestic (innovating) country. Because the product is not yet standardized, the production process tends to be relatively labor intensive, and innovative customers tend to accept relatively high introductory prices.

2.                  Growth. As demand grows, competitors enter the market. Foreign demand, competition, exports and often direct investment activities also begin to accelerate.

3.                  Maturity. Global demand begins to peak, production processes are relatively standardized and global price competition forces production site relocation to lower cost developing countries.

4.                  Decline. Market factors and cost pressures dictate that almost all production occur in developing countries. The product is then imported by the country where it was initially developed.

B.                 Verification and Limitations of the PLC Theory

Exceptions to the typical pattern of the international product life cycle would include: products that have very short life cycles, luxury goods, products that require specialized labor, products that can be differentiated and products for which transportation costs are relatively high.


Previously examined theories would lead one to conclude that the greater the dissimilarity among countries, the greater the potential for trade. However, the country similarity theory states that when a firm develops a new product in response to observed conditions in the home market, it is likely to turn to those foreign markets that are most similar to its domestic market when commencing its initial international expansion activities.

A.                The Economic Similarity of Industrial Countries

So much trade takes place among industrialized countries because of the growing importance of acquired advantage (skills and technology). In addition, markets in most industrialized countries are large enough to support new product introductions and their subsequent variants across the life cycle.

B.                 The Similarity of Location

Countries that are near to each other enjoy relatively lower transportation costs than those that are more distant. While the disadvantages of distance may be overcome through innovative technology and marketing methods, such gains are difficult to maintain in the long run.

C.                Cultural Similarity

Cultural similarity as expressed through language and religion is a major facilitator of the international trade and investment process.

D.                The Similarity of Political and Economic Interests

Countries that agree politically and are economically similar are likely to encourage trade among themselves. In some circumstances at least, they may also discourage trade among countries with whom they disagree.


X.                DEGREE OF DEPENDENCE

Theories of independence, interdependence and dependence help explain world trade patterns and countries trade policies. Realistically, countries are located along a continuum between the two extremes.

A.                Independence

Under conditions of independence, a country would not rely on other countries for any goods, services, or technologies.

B.                 Interdependence

One way a country can limit its vulnerability to foreign changes is through interdependence, i.e., the development of trade relationships on the basis of mutual need. Each country depends about equally on the other as a trading partner, so neither is likely to cut off supplies or markets for fear of retaliation from the partner nation.

C.                Dependence

Many developing countries are dependent (rely on) on the sale of one primary commodity, or on one country as a primary customer and/or supplier. In addition, emerging economies largely depend on production processes that compete on the basis of low-wage inputs.



Governments have long debated their roles in affecting the acquired advantage of production within their borders. From the standpoint of national competitiveness, the issue revolves around the development of successful industries. The two basic approaches to strategic trade policy are (a) alter conditions that will affect industry in general or (b) alter conditions that will affect a targeted industry.



Regardless of the advantages a country may gain by trading, international trade will not ordinarily occur unless companies within that country have competitive advantages and perceive that international opportunities are greater than domestic ones.

A.        The Porter Diamond

In addition to the four determinants of national competitive advantage that are set forth in the Porter diamond, the roles of chance and government are also critical. Usually all four determinants need to be favorable if a given national industry is going to attain global competitiveness.

1.                  Demand Conditions. The nature and size of demand in the home market lead to the establishment of production facilities to meet that demand.

2.                  Factor Conditions. Resource availability (inputs, labor, capital and technology) contributes to the competitiveness of both firms and nations that compete in particular industries.

3.                  Related and Supporting Industries. The local presence of internationally competitive suppliers and other related industries contributes to both the cost effectiveness and strategic competitiveness of firms.

4.                  Firm Strategy, Structure and Rivalry. The creation and persistence of national competitive advantage requires leading-edge product and process technologies and business strategies.

B.        Points and Limitations of the Porter Diamond

The existence of the four favorable conditions often represents a necessary but not a sufficient condition for the development of a particular national industry. Even when abundant, resources are ultimately limited, thus firms must make choices regarding their pursuit of existing opportunities. Further, given the ability of firms to gain market information and production inputs from abroad, the absence of any of the four conditions within a country may be overcome by their existence internationally.



International trade occurs because of the completion of mutually satisfactory transactions between or among importers and exporters.

A.                Strategic Advantages of Exports

The strategic advantages of exports include the utilization of excess capacity (that in turn leads to improved economies of scale and cost competitiveness), the potential profitability due to the nature of demand and government policies found in foreign markets, as well as overall business risk minimization.

B.                 Strategic Advantages of Imports

The strategic advantages of imports include lower-cost, higher-quality products, product line differentiation and expansion opportunities and overall business risk minimization.



Values, Free Global Trade and Production Standards—A Hard Trio to Mix

The debate over laissez-faire versus activist government trade policies is generally a heated one because different country values underlie differing views and government policies. The argument for free trade policy is based on the achievement of global economic efficiency, but the associated social and environmental values may differ across countries and cultures. Ethical questions center on whether (a) all countries should have similar production standards and (b) firms should be permitted to locate production activities in countries whose lower standards allow them to realize lower costs.



Companies Adjust to Changing Trade Policies and Conditions

Firms have greater opportunities to pursue global strategies and capture economies of scale by serving markets in more than one country from a single base of production if those countries have relatively few restrictions on foreign trade and investment activities. Current issues concern the future of trade relationships between industrialized and developing countries, as well as the concept of national sovereignty. At least four factors might cause merchandise trade to become relatively less significant in the future:

  • the growing tide of protectionist sentiment
  • the possibility of more efficient country-by-country production
  • increasingly flexible and efficient small-scale production methods
  • the rapid growth of services as a portion of production and consumption within the industrialized nations.




Teaching Tip: Visit for additional information and links relating to the topics presented in Chapter 5. Be sure to refer your students to the on-line study guide, as well as the Internet exercises for Chapter 5.



CLOSING CASE: The Indian Cashew Processing Industry [See Map 5.2]


1.         What trade theories help to explain where cashew tree products have been produced historically?

The primary theory that explains where cashew trees have been found historically is that of factor proportions. Originally found in Brazil, the cashew tree was introduced into other tropical countries by Portuguese traders. Vulnerable to insects in the close quarters of plantations, cashews propagate in the wild forests of India, East Africa, Indonesia, Southeast Asia and Brazil, i.e., places where the soil and climatic conditions are favorable. Because cashew fruit only keeps for 24 hours after being harvested, it is essentially bound to the place where it is grown. Cashew nuts, on the other hand, can last a year or longer if properly handled. However, processing requires manual dexterity even though wage rates are low. If the nut breaks during processing, its value decreases significantly. Because the processing methods do not require expensive machinery, nuts can be processed wherever there is a trained workforce willing to work for low wages. Given the cost dimensions of the process, both the concepts of absolute and comparative advantage apply. Once mechanical equipment was developed to replace hand processing, product variants were distinguishable on the bases of quality and flavor differences, and new competitors were present in the marketplace; it is evident that the cashew is moving across the stages of the international product life cycle.


2.                  What factors threaten Indias future competitive position in cashew nut production?

Many developing countries are able to produce and/or process nuts as cheaply as India and may, in some instances, be geographically or culturally closer to certain markets than India. In addition, Indias position in cashew nut production is threatened by continued improvements in the mechanical equipment designed to replace hand processing. All of these factors encourage new competitors to enter the market, particularly at the processing level, thus cutting off Indias access to additional supplies and diminishing its share of the market.


3.                  If you were an Indian cashew producer, what alternatives might you consider to maintain future competitiveness?

A cashew producer who competes in the high-end of the market will have a continued advantage in the sale of higher-grade nuts until such time as newer machinery solves the breakage problem. In addition, Indian cashews can be differentiated because of their distinct flavor differences, which are the result of the growing conditions and process. Therefore, given Indias leadership position with respect to cashew production and product quality, producers should work hard to establish a national brand identity and capture the country-of-origin assets associated with Indian cashews. However, Indian producers must at the same time develop a contingency plan for the eventual possibility of having to replace workers with processing machines and shifting those workers to other types of jobs. Producers should also be proactive in terms of finding new uses for products from the cashew tree.


Additional Exercises: The International Trade Process


Exercise 5.1. The concepts of absolute and comparative advantage and the international product life cycle all deal with the composition of trade, i.e., explanations as to what products are traded by given nations. Ask students to discuss the likelihood that (a) an innovating country, (b) another industrialized country and (c) a developing country would enjoy an absolute advantage, a comparative advantage, or no particular advantage as a product moves through each of the stages of the international product life cycle. Be sure students explain their reasoning.


Exercise 5.2. The factor proportions theory and the theory of country similarity both deal with patterns of trade, i.e., national trading partners. Ask students to compare and contrast the two theories, i.e., in what ways are they complementary and in what ways do they differ? Then select the home countries of various students in your class and ask the students to identify their natural and acquired advantages and then compare the various similarities of the selected countries.


Exercise 5.3. Porters diamond deals with the competitive advantages of nations. Select the home countries of various students in your class. Then lead the class in a comparative analysis of the four points of Porters diamond, plus the roles of chance and government, in each of those nations. Conclude the discussion by exploring the associated competitive advantages that may accrue to firms that operate in each of those countries.