Unit II, III, & IV – International Trade Theory

Day and Date:

Unit Highlights… Introduction Mercantilism Trade based on absolute advantage Trade based on Comparative advantage and

concept of Opportunity Cost Heckscher Ohlin Theory Technological gap theories Product life cycle theory Theories of economies of scale Linder’s hypothesis

Text book reference chapters…

International Economics by Dominick Salvatore – Chapter 2

International Economics by Francis Cherunilam – Chapter 6

Let us recapitulate…

International trade theory helps us assimilate,

• Why nations trade?• What are gains from trade?• What is the pattern of trade?

Mercantilism: Origin…

Essays and pamphlets written by merchants, bankers, government officials, and philosophers in the 17th and 18th centuries in England, Spain, France, Portugal, and Netherlands.

Mercantilism: Basic tenets

Maintain EXPORT SURPLUS (i.e., Export>Imports)

Export Surplus = inflow of bullion More bullion --»»»» More global power

Since all nations cannot simultaneously have export surplus, one nation’s gain implied another’s loss – ECONOMIC NATIONALISM

The dilemma…

If a nation lost in trade why would it trade???

Trade based on absolute advantage - Adam Smith

A nation can gain by SPECIALIZING in the production of a commodity of its ABSOLUTE ADVANTAGE and exchanging it with another nation for a commodity of its ABSOLUTE DISADVANTAGE.

Trade based on absolute advantage…basic postulates

Free trade

Laissez-faire

However, protection extended to industry crucial for national defense.

Trade based on absolute advantage – Benefits…

Efficient utilization of world resources

Maximum world welfare

The dilemma…

Trade restrictions for national welfare???

Trade based on Comparative advantage – David Ricardo

If two countries want to benefit from specialization and free trade, country 1 should specialize and trade the commodity in which it is MOST BEST at producing, while country 2 should specialize and trade the commodity in which it is LEAST WORSE at producing.

What is comparative advantage?

The ability of a country to produce a commodity at lower cost, relative to other commodities, compared to another country.

Comparative advantage and Opportunity Cost…Gottfried Haberler

Cost of something in terms of opportunity foregone.

Opportunity cost to a country of producing a unit more of a good, such as for export or to replace an import, is the quantity of some other good that could have been produced instead.

The dilemma…simplistic assumptions

Two nations; two commodities Free trade Perfect mobility of resources No transportation costs No technological advancement Constant costs of production

Heckscher Ohlin Theory…basic postulate

Countries trade because they differ with respect to the availability of the factors of production.

Capital-abundant country will export the capital-intensive good, while the labor-abundant country will export the labor-intensive good.

The dilemma…

All international trade happens because of resource advantage? Do the trends reflect that???

Technological gap theories

International Trade is governed by relative technological sophistication of nations.

Competitive trade advantage is a function of ability to innovate

Product life cycle theory…Raymond Vernon

There are four stages in a product’s life cycle –introduction, growth, maturity and decline

Early in a product's life-cycle resources are acquired domestically. Once it becomes adopted in the world markets, production gradually moves away from the point of origin.

In some situations, the product becomes an import item for the country of invention.

Theory of economies of scale

Production at a larger scale (more output) can be achieved at a lower cost (i.e. with economies or savings).

When production within an industry has this characteristic, specialization and trade can result in improvements in world productive efficiency and welfare benefits that accrue to all trading countries.

Linder’s hypothesis…Staffan Burenstam Linder

The more similar are the demand structures of countries the more they will trade with one another.

International trade will still occur between two countries having identical preferences and factor endowments.

To conclude…

Markets have been going global, and everyone knows it. Theoretical reasons include,

Differences in Technology Differences in resource endowments Differences in demand Economies of Scale

You should now know…

Why nations trade?

What are the theoretical foundations of international trade?