Chapter of International Business

1. Fourth Edition
MBA(1ST
) Management Studies
Section C
International Business
Provided By : Mr.Md.Mahmudul Hasan
Fouji
Jagannath University

2. CHAPTER 4
International Trade Theory

3. 1st British African colony to win independence (1957).
Nkrumah (Osagyefo Kwame Nkrumah) espoused pan
African socialism.
High tariffs.
Anti export (trade) policy.

4. Kept lowering tariffs on manufactured goods.
Created incentives to export (trade).
Reduced quotas.
Reduced subsidies.
1950s: 77% of employment in agriculture. Now 20%.
Manufacturing GNP went from 10% to over 30%.

5. The Impact of Trade Policies
• Ghana
• 1970
– GNP/capita
• $250
• 1992
– GNP/per capita
• $450
– GNP Growth/year
• 1.5%
• Shift from productive uses
(cocoa) to unproductive
uses
• Korea
• 1970
– GNP/per capita
• $260
• 1992
– GNP/per capita
• $6790
– GNP Growth/year
• 9%
• Shift from non-comparative
advantage uses (agriculture)
to productive uses (labor-
intensive manufacturing).
4-6
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6. An Overview of Trade Theory
• Free Trade occurs when 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.
4-7
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7. An Overview of Trade Theory
• Free Trade occurs when 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.
• The Benefits of Trade allow a country to
specialize in the manufacture and export
of products that can be produced most
efficiently in that country.
4-7
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8. An Overview of Trade Theory
• Free Trade occurs when 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.
• The Benefits of Trade allow a country to specialize in the
manufacture and export of products that can be produced most
efficiently in that country.
• The Pattern of International Trade
displays patterns that are easy to
understand (Saudi Arabia/oil or
China/crawfish). Others are not so
easy to understand (Japan and cars).
4-7
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9. An Overview of Trade Theory
• Free Trade occurs when 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.
• The Benefits of Trade allow a country to specialize in the manufacture and
export of products that can be produced most efficiently in that country.
• The Pattern of International Trade displays patterns that are easy to
understand (Saudi Arabia/oil or China/crawfish). Others are not so easy to
understand (Japan and cars).
• The history of Trade Theory and
Government Involvement presents a
mixed case for the role of government in
promoting exports and limiting imports.
Later theories appear to make a case for
limited involvement.
4-7
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10. Mercantilism: mid-16th century
• A nation’s wealth depends on accumulated
treasure
4-8
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11. Mercantilism: mid-16th century
• A nation’s wealth depends on accumulated
treasure
• Gold and silver are the currency
of trade.
4-8
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12. 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.
4-8
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13. 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 exports
through subsidies.
– Minimize imports through tariffs
and quotas.
4-8
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14. 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 exports
through subsidies.
– Minimize imports through tariffs
and quotas.
• Flaw: “zero-sum game”.
4-8
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15. Theory of Absolute Advantage
Adam Smith: Wealth of Nations (1776).
• Capability of one country to produce
more of a product with the same amount
of input than another country.
4-10
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16. Theory of Absolute Advantage
Adam Smith: Wealth of Nations (1776).
• Capability of one country to produce
more of a product with the same amount
of input than another country.
• Produce only goods where you are most
efficient, trade for those where you are
not efficient.
4-10
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17. Theory of Absolute Advantage
Adam Smith: Wealth of Nations (1776).
• Capability of one country to produce
more of a product with the same amount
of input than another country.
• Produce only goods where you are most
efficient, trade for those where you are
not efficient.
• Assumes there is an
absolute advantage
balance among nations, e.g.,
4-10
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18. The Theory of Absolute
Advantage
Rice
Cocoa
Figure 4.1
G’
0 5 10 15 20
5101520
A
B
K
G
K’

19. The Theory of Absolute Advantage
and the Gains from Trade
Production and Consumption without Trade
S. Korea 2.5 10.0
Total production 20 20
S. Korea 6.0 14.0
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 20
S. Korea 40 10
Ghana 10.0 5.0
Total production 12.5 15.0
Production with Specialization
Ghana 20 0
S. Korea 0 20
Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice
Ghana 14.0 6.0
Increase in Consumption as a Result of Specialization and Trade
Ghana 4.0 1.0
S. Korea 3.5 4.0 Table 4.1

20. Theory of Comparative Advantage
David Ricardo: Principles of Political Economy
(1817).
– Should trade even if country is more efficient in
the production than its trading partner.
4-13
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21. Theory of Comparative
Advantage
•Assume Ghana is more efficient in production of both cocoa and
rice.
Scenario 1:
•In Ghana it takes 10 resources to produce 1 ton of cocoa and 13 1/3
resources to produce 1 ton of rice.
•Thus with 200 resources Ghana can produce 20 tons (200/10)of
cocoa and no rice. Or 15 tons of rice(200/13.33) and no cocoa or any
combination of the two.
•In South Korea it takes 40 resources to produce 1 ton of cocoa and
20 resources to produce 1 ton of rice.
•Thus , with 200 resources Korea can produce 5(200/40) tons of
cocoa and no rice or 10 tons of rice and no cocoa or any combination
of the two on its PPF.

22. The Theory of Comparative
Advantage
Figure 4.2
3.75 7.5
2.5
0 5 10 15 20
5101520
Cocoa
Rice
G
C
A
K
K’
B
G’

23. Theory of Comparative
Advantage
Scenario 2:
If both the countries use half of the resources to produce cocoa
and half of the resources to produce rice:
•Thus with 100 resources for each of the products, Ghana can
produce 10 tons (100/10)of cocoa and 7.5 tons(100/13.33) of rice.
•In the same way with 100 resources Korea would produce 2.5
tons(100/40) of cocoa and 5 tons(100/20) of rice.
•So without trade the total production would be 12.5(10+2.5) tons
of cocoa and 12.5(7.5+5) tons of rice.

24. The Theory of Comparative
Advantage (Specialization)
3.75 7.5
2.5
0 5 10 15 20
5101520
Cocoa
Rice
G
A(100 resources for each
(10 cocoa & 7.5 rice))
K
K’
G’
A’ (100 resources for each, 2.5 cocoa
and 5 rice)

25. Theory of Comparative
Advantage
Scenario 3: International Trade takes Place:
Cocoa to Rice Ratio in Ghana: 10: 7.5 or 4:3 or 1: 0.75
Cocoa to Rice ratio in Korea: 2.5:5 or 1:2
Cocoa is cheaper in Ghana. So Ghana can sell 1 unit of cocoa to
Korea and get 2 units of Rice whereas she can only get 0.75 units
of rice in exchange of giving up 1 unit of cocoa production in her
own country.
So, Ghana would export cocoa and import rice.

26. Theory of Comparative
Advantage
On the other hand,
Rice to cocoa Ratio in korea:5:2.5 or 1:0.5
Rice to cocoa Ratio in Ghana:7.5:10 or 1: 1.33
Rice is cheaper in Korea because Korea can sell 1 unit of Rice to
Ghana and get 1.33 units of cocoa whereas she can only get 0.5
units of cocoa by sacrificing the same amount of rice in her own
country.
SO Comparative Advantage comes into effect

27. Comparative Advantage and the Gains from
Trade
S. Korea 40 20
S. Korea 2.5 5.0
S. Korea 0.0 10.0
S. Korea 4 6
Resources Required to Produce 1 Ton of Cocoa and Rice
Ghana 10 13.33
Production and Consumption without Trade
Ghana 10.0 7.5
Total production 12.5 12.5
Production with Specialization
Ghana 15 3.75
Total production 15 13.75
Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice
Ghana 11 7.75
Increase in Consumption as a Result of Specialization and Trade
Ghana 1.0 0.25
S. Korea 1.5 1.0
Cocoa Rice
Table 4.2

28. The Theory of Comparative
Advantage
Figure 4.2
3.75 7.5
2.5
0 5 10 15 20
5101520
Cocoa
Rice
G
C
A
K
K’
B
G’

29. The Basic Message of the Theory of
Comparative Advantage
•Potential world Production is higher
greater with unrestricted free trade than
it is with restricted trade.
•Trade is a positive-sum game where all
countries that participate realize
economic gains.

30. Extensions of the Ricardian Model
• Immobile resources:
– Resources do not always move easily from one
economic activity to another.
• Diminishing returns:
– More a country produces, at some point, will
require more resources (diminishing returns to
specialization).
– Different goods use resources in different
proportions.
• However:
– Free trade might increase a country’s stock of
resources (as labor and capital arrives from
abroad), and
– Increase the efficiency of resource utilization.
4-16
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31. Ghana’s PPF under Diminishing
Returns
Cocoa
Rice
G’
G
0
Figure 4.3

32. The Influence of Free Trade on the
PPF
Figure 4.4
Cocoa
Rice
G’
PPF2
0
PPF1

33. Heckscher (1919)-Olin (1933)
Theory
• Labor is not the only Factor of
production. We need to account for
land, capital, and technology.
• Ricardo Had highlighted Labor
Productivity. Whichever country had
more labor productivity in a particular
good’s production would be able to
export that good.
4-20
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34. Heckscher (1919)-Olin (1933)
Theory
• Factor endowments: extent to which a
country is endowed with such
resources as land, labor, and capital.
• Comparative Advantage arises out of
national factor endowments. USA
exports agricultural products because it
has huge arable land. China excels in
exporting labor-intensive manufactured
goods like textile and footwear due to
its abundance of low-cost labor.
4-20
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35. Heckscher (1919)-Olin (1933)
Theory
• Export goods that intensively use factor
endowments which are locally
abundant.
4-20
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36. Heckscher (1919)-Olin (1933)
Theory
• Export goods that intensively use factor
endowments which are locally
abundant.
• Corollary: import goods made from
locally scarce factors.
• So, the US exports agricultural
products and imports textile goods.
• Ivory cost exports Ivory, imports
automobiles.
4-20
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37. Heckscher (1919)-Olin (1933)
Theory
• Patterns of trade are determined by
differences in factor endowments - not
productivity.
• Remember, focus on relative
advantage, not absolute advantage.
e.g.Venezuela May have absolute
advantage in oil but does not have a
relative advantage over Saudi Arabia.
4-20
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38. The Leontief (Wassily Leontief)
Paradox, 1953
• Disputes Heckscher-Olin in some
instances.
• Factor endowments can be impacted by
government policy - minimum wage.
• US tends to export labor-intensive
products, but is regarded as a capital
intensive country.
4-21
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39. The Leontief Paradox?
• No answer as yet
• Maybe because the US has advantages in
innovative technologies which are less
capital intensive but rather skill based
(Computer Software)on the other hand
she may import products that require
heavy machinery and in turn large
amounts of capital.

40. Dilemma Between Ricardo and H-O
• H-O theoretically stronger but Ricardo more accurate
in predicting patterns of international trade.
• The US exports commercial aircraft and imports cars
not because it lacks the necessary factor
endowments for cars but because it is more efficient
in producing aircrafts. Same true for Japan.
• H-O assumes technology is same across countries.
• So the solution to this dilemma maybe to resort to
the Ricardian idea of productivity. Once technology
is same then H-O comes into play.

41. Product Life-Cycle Theory
(Raymond Vernon, 1966)
• Article in the Quarterly Journal of Economics.
• 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.
4-23
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42. The Product Life-Cycle Theory
production
consumption
Figure 4.5
Exports
160
140
120
100
80
60
40
20
0
United States
Other Advanced Countries
Developing Countries
Stages of Production Development
New Product Standardized ProductMaturing Product
Imports
Imports
Exports
Exports
Imports
160
140
120
100
80
60
40
20
0
160
140
120
100
80
60
40
20
0
4-24
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43. The New Trade Theory
• Began to be recognized in the 1970s.
• Deals with the returns on specialization
where substantial economies of scale are
present.
– Specialization increases output, ability to
enhance economies of scale increase.
• In addition to economies of scale, learning
effects also exist.
– Learning effects are cost savings that come from
“learning by doing”.
4-25
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44. Application of the New Trade
Theory
• Typically, requires industries with high,
fixed costs.
• World demand will support few
competitors.
• Competitors may emerge because “they
got there first”.
• First-mover advantage.
• Some argue that it generates
government intervention and strategic
trade policy.
4-26
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45. First-Mover Advantage
• Economies of scale may preclude new
entrants.
• Role of the government.
4-27
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46. Porter’s Diamond
(Harvard Business School, 1990)
• The Competitive Advantage of Nations.
• Looked at 100 industries in 10 nations.
– Thought existing theories didn’t go far
enough.
• Question: “Why does a nation achieve
international success in a particular
industry?”
4-28
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47. Determinants of National
Competitive Advantage
• Factor endowments:nation’s position in factors
of production such as skilled labor or
infrastructure necessary to compete in a given
industry.
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48. Determinants of National
Competitive Advantage
• Factor endowments:nation’s position in factors
of production such as skilled labor or
infrastructure necessary to compete in a given
industry.
• Demand conditions:the nature of home
demand for the industry’s product or service.
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49. Determinants of National
Competitive Advantage
• Factor endowments:nation’s position in factors
of production such as skilled labor or
infrastructure necessary to compete in a given
industry.
• Demand conditions:the nature of home
demand for the industry’s product or service.
• Related and supporting industries:the presence
or absence in a nation of supplier industries or
related industries that are nationally
competitive.McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

50. Determinants of National Competitive
Advantage
• Factor endowments:nation’s position in factors of
production such as skilled labor or infrastructure
necessary to compete in a given industry.
• Demand conditions:the nature of home demand for the
industry’s product or service.
• Related and supporting industries:the presence or
absence in a nation of supplier industries or related
industries that are nationally competitive.
• Firm strategy, structure and rivalry:the conditions in the
nation governing how companies are created,
organized, and managed and the nature of domestic
rivalry.
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51. Porter’s Diamond
Determinants of National Competitive
Advantage
Factor Endowments
Firm Strategy,
Structure and
Rivalry
Demand Conditions
Related and
Supporting
IndustriesFigure 4.6
4-30
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52. The Diamond
• Success occurs where these attributes
exist.
– More/greater the attribute, the higher chance
of success.
• The diamond is mutually reinforcing.
4-31
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53. Determinants of
National Competitive Advantage
GovernmentGovernment
Company Strategy,
Structure,
and Rivalry
Demand
Conditions
Related
and Supporting
Industries
Factor
Conditions
ChanceChance
Two external
factors that
influence the
four
determinants.
4-32
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54. Factor Endowments
• Taken from Heckscher-
Olin
• Basic factors:
– natural resources
– climate
– location
– demographics
• Advanced factors:
– communications
– skilled labor
– research
– technology
4-33
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55. Advanced Factor Endowments
• More likely to lead to competitive
advantage.
• Are the result of investment by
people, companies, government.
4-34
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56. Relationship of Basic to
Advanced Factors
• Basic can provide an initial advantage.
• Must be supported by advanced factors to
maintain success.
• No basics, then must invest in advanced
factors.
4-35
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57. Demand Conditions
• Demand creates the capabilities.
• Look for sophisticated and
demanding consumers.
– impacts quality and innovation.
4-36
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58. Related and Supporting
Industries
• Creates clusters of supporting industries that
are internationally competitive.
• Must also meet requirements of other parts of
the Diamond.
4-37
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59. Firm Strategy, Structure and
Rivalry
• Management ‘ideology’ can either help or
hurt you.
• Presence of domestic rivalry improves a
company’s competitiveness.
4-38
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60. Evaluating Porter’s Theory
• If Porter is right, we would expect his
model to predict the pattern of
international trade that we observe in the
real world. Countries should be exporting
products from those industries where all
four components of the diamond are
favorable, while importing in those areas
where the components are not favorable.
• Too soon to tell.
4-39
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61. Implications for Business
• Location implications:makes sense to disperse
production activities to countries where they
can be performed most efficiently.
• First-mover implications:It pays to invest
substantial financial resources in building a
first-mover, or early-mover, advantage.
• Policy implications:promoting free trade is
generally in the best interests of the home-
country, although not always in the best
interests of the firm. Even though, many firms
promote open markets.