2. 4-2
Evolution of Trade Theories
Mercantilism Theory
Absolute advantage Theory
Comparative advantage Theory
Factor Proportions Theory
International Product Cycle
New Trade Theory
3. 4-3
Mercantilism: mid-16th century
A nation’s wealth depends on accumulated
treasure
Gold and silver are the currency of
trade
Theory says you should have a trade surplus.
Maximize export through subsidies.
Minimize imports through tariffs
and quotas
Flaw: restrictions, impaired growth
4. 4-4
Defining mercantilism …
… trade theory holding that nations
should accumulate financial wealth,
usually in the form of gold (forget
things like living standards or
human development) by encouraging
exports and discouraging imports
5. 4-5
Theory of absolute advantage
Adam Smith: Wealth of Nations (1776) argued:
Capability of one country to produce more of
a product with the same amount of input than
another country
A country should produce only goods where it
is most efficient, and trade for those goods
where it is not efficient
Trade between countries is, therefore, beneficial
Assumes there is an absolute balance among
nations
6. 4-6
Theory of absolute advantage
… destroys the mercantilist idea since there
are gains to be had by both countries party to
an exchange
… questions the objective of national
governments to acquire wealth through
restrictive trade policies
… measures a nation’s wealth by the living
standards of its people
8. 4-8
Theory of comparative advantage
David Ricardo: Principles of Political Economy (1817)
Extends free trade argument
Efficiency of resource utilization leads to more
productivity
Should import even if country is more efficient in the
product’s production than country from which it is
buying.
Look to see how much more efficient. If only
comparatively efficient, than import.
Makes better use of resources
Trade is a positive-sum game
9. 4-9
Assumptions and limitations
Driven only by maximization of production
and consumption
Only 2 countries engaged in production and
consumption of just 2 goods?
What about the transportation costs?
Only resource – labour (that too, non-
transferable)
No consideration for ‘learning theory’
10. 4-10
Factor proportions theory
Heckscher (1919) - Olin (1933) Theory
• The observation made by Heckscher and Ohlin
include:-
1. Factor endowments vary among countries. For e.g.
USA is rich in capital resources, India is rich in
labour, Saudi Arabia is rich in oil resources.
2. According to these economists, if labour is available
in abundance in relation to land and capital, in a
country, the price of labour would be low, and the
price of land and capital would be high in that
country.
11. 4-11
Factor proportions theory
3. These relative factor costs would lead
countries to produce the products at low costs.
4. Countries have comparative advantage based
on the factors endowed and in turn the price
of the factors. Countries acquire comparative
advantage in those products for which the
factors endowed by the country concerned are
used as inputs. For e.g. India and China have
comparative advantage in labour-intensive
industry like textile and tobacco.
12. 4-12
Factor proportions theory
Therefore, countries export those goods in which they
have comparative advantage due to factors endowed.
Countries participate in international trade by
exporting those products which they can produce at low
cost consequent upon abundance of factors and import the
other products which they can produce comparatively at
high cost.
13. Factor proportions theory
All
4-13
this means that the theory holds good if a
capital abundant country has a distinct preference
for the labour intensive goods and a labour
abundant country has a distinct preference for
capital intensive goods. If it not so, the theory may
not hold good.
14. 4-14
Product life-cycle Theory
R.Vernon (1966)
… trade theory holding that a company will
begin by exporting its product and later
undertake foreign direct investment as the
product moves through its lifecycle
As products mature, both location of sales and
optimal production changes
Affects the direction and flow of imports and
exports
Globalization and integration of the economy
makes this theory less valid
15. 4-15
The Product Cycle Theory
International Product Life cycle comprises
of following stages:-
1.Introduction
2.Growth
3.Maturity
4.Decline
16. 1.INTRODUCTION STAGE
New products are introduced to meet local
(i.e., national) needs, and new products are
first exported to similar countries, countries
with similar needs, preferences, and
incomes.
If we also presume similar evolutionary
patterns for all countries, then products are
introduced in the most advanced nations.
(E.g., the IBM PCs were produced in the
US and spread quickly throughout the
industrialized countries.)
4-16
17. 2.GROWTH
A copy product is produced elsewhere and introduced in
the home country (and elsewhere) to capture growth in the
home market.
This moves production to other countries, usually on the
basis of cost of production. (E.g., the clones of the early
IBM PCs were not produced in the US.)
• Growth results in
a. Attracting competition
b. Increased exports
c. Further innovation
d. Shift manufacturing to foreign countries.
4-17
18. 3.MATURITY
Worldwide production increases during this stage
along with the demand for the product resulting in
decline in exports.
The increased competition results in increased
product standardization and cost reduction.
The producers start gaining the economies of scale
reducing the cost of production per unit.
At this stage, technology becomes standard
4-18
19. 4.DECLINE
Markets for the product at this stage
concentrate in less developed countries as
the customers in advanced countries shift
their demand to further new products.
Thus most of the production plants at this
stage locate in developing countries and
exports decline considerably at this stage
4-19
20. 4-20
New trade theory
In industries with high fixed costs:
Specialization increases output, and the
ability to enhance economies of scale
increases
Learning effects are high. These are cost
savings that come from ‘learning by
doing’
21. 4-21
New trade theory - applications
Typically, requires industries with high, fixed
costs
World demand will support few competitors
Competitors may emerge because of “ First-
mover advantage”
Economies of scale may preclude new entrants
Role of the government becomes significant
Some argue that it generates government
intervention and strategic trade policy
