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GLOBAL BUSINESS ENVIRONMENT

ASSIGNMENTON

THEORIES OF INTERNATIONAL BUSINESS(trade)

SUBMITED BY:ANJALI AGGARWAL

PGDM-IBFIB1104


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INTERNATIONAL TRADE THEORIES

International business began with international trade operations, facilitated by the laissez faire in

the world economy. It improved the well-being of many nations, and the imposition of trade

barriers reduced the gains from trade, giving rise to the search for alternate avenues to

exporting. The latter resulted in the establishment of subsidiaries in foreign countries through

FDI. In this context, it is pertinent to understand the determinants of and the effects of

international trade and FDI on the trading partners, international operations of multinationals

and the economies of the home and host countries. Several theories have been formulated,

from time to time, which form the bases of international trade and FDI.

THEORY OF MERCANTILISM

During the sixteenth to the three-fourths of the eighteenth centuries, the world trade was being

conducted according to the doctrine of mercantilism. It comprised many modern features like

belief in nationalism and the welfare of the nation alone, planning and regulation of economic

activities for achieving the national goals, curbing imports and promoting exports.

The mercantilists believed that the power of a nation lied in its wealth, which grew by acquiring

gold from abroad. This was considered possible by increasing exports and impeding imports.

Such reasoning gathered support on the ground that gold could finance military expeditions and

wars, and the exports would create employment in the economy. Mercantilists failed to realize

that simultaneous export promotion and import regulation are not possible in all countries, and

the mere possession of gold does not enhance the welfare of a people. Keeping the resources

in the form of gold reduces the production of goods and services and, thereby, lowers welfare.

The concentration in the production of goods for domestic consumption by using resources in a

less efficient manner would also mean lower production and smaller gains from international

trade.

The theory of mercantilism was rejected by Adam Smith and Ricardo by stressing the

importance of individuals, and pointing out that their welfare was the welfare of the nation. They

believed in liberalism and enlightenment, and treated the wealth of the nation in terms of the

"the sum of enjoyments" of the individuals in society. Any activity, which would increase the


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consumption of the people, was to be considered with favor. Their trade doctrines were based

upon the principles of free trade and the specialization in the production of those goods where

resources were most suitable.

Theory of Absolute Cost AdvantageThe theory of absolute cost advantage was propounded by Adam Smith (1776), arguing that the

countries gain from trading, if they specialize according to their production advantages.

EXAMPLE:

LABOUR COST OF PRODUCTION ( IN HOURS)

1 unit of good A 1 unit of good B

Country I 10 20

Country II 20 10

This table shows that, in the absence of trade, both the goods are produced in both thecountries, because of their demand in the domestic markets. The cost of production is

determined by the amount of labour required in the production of the respective goods. The

greater the amount of labour, the higher will be the cost of production, and the commodity willhave a larger value in exchange. The pre-trade exchange ratio in country I would be 2A=1B and

in country II IA=2B.

If trade takes place between these two countries then they will specialise in terms of absolute

advantage and gain from trading with each other. Country I enjoys absolute cost advantage in

the production of good A and country II in good B. One unit of good A may be produced in

country I with 10 hours of labour, whereas it costs 20 hours of labour in country II. The

production of the unit of good B costs 20 hours of labour in country I and 10 hours of labour in

country II. After trade, the international exchange ratio would lie somewhere between the pre-

trade exchange ratio of the two countries. If it is nearer to country I domestic exchange ratio

then trade would be more beneficial to country II and vice versa. Assuming the international

exchange ratio is established IA=IB, then both the trading partners would be able to save 10

hours of labour, which may be used either for the production of other goods and services or may

be enjoyed by the workers as leisure, which improves their welfare in either way. The terms of


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trade between the trading partners would depend upon their economic strength and the

bargaining power.

Theory of Comparative Cost Advantage

Ricardo (1817), though adhering to the absolute cost advantage doctrine of Adam Smith,

pointed out that cost advantage to both the trade partners was not a necessary condition for

trade to occur. It would still be beneficial to both the trading countries even if one country can

produce all the goods with less labour cost than the other country. According to Ricardo, so long

as the other country is not equally less productive in all lines of production, measurable in terms

of opportunity cost of each commodity in the two countries, it will still be mutually gainfull for

them if they enter into trade.

1 unit of good A 1 unit of good B

Country I 80 90

Country II 120 100

country I enjoys absolute cost advantage in the production of {both the goods A and B as

compared to their production in country II. But country I has comparative cost advantage in

good A and country II in good B. We take the help of the concept of opportunity cost in order to

know the relative comparative advantage in the production of the goods in the two

countries me opportunity cost to produce one unit of good A is the amount of good B which has

to be sacrificed for producing the additional unit of good A. the opportunity cost of one unit of A

in country I is 0.89 unit of good B and in country II it is 1.2 unit of good B. On the other hand, the

opportunity cost of one unit of good B in country I is 1.125 units of good A and 0.83 unit of good

A, in country II. The opportunity cost of the two goods are different in both the countries and as

long as this is the case, they will have comparative advantage in the production of either,good A

or good B, and will gain from trade regardless of the fact that one of the trade partners may be

possessing absolute cost advantage in both lines of production. Thus, country I has

comparative advantage in good A as the opportunity cost of its production is lower in this

country as compared to its opportunity cost in country II which has comparative advantage in

the production of good B on the same reasoning.


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The gains from trade in terms of Ricardo's doctrine may be understood by distinguishing the

terms of trade under `autarky' (i.e., haying no trade with the outside world because of the closed

economy) and in terms of trade with the outside world. The domestic exchange ratio is

determined by internal cost of production. In Table 2.2, the exchange ratio before trade in

country I should be 1A-0.898 and in country II 1A=l. 1B. If the international exchange ratio

prevails between 0.89 and 1.2, the international trade would be gainful to both the countries.

Assuming it settles at 1A=1B then country I gains 10 hours of labour and country II gains an

equivalent of 20 hours of labour.

Both the absolute advantage and comparative advantage theories failed to realise that the

welfare of society does not depend only on the gains from the international trade but depends

upon the way the gains are distributed. The individual gains under the theories are not

guaranteed unless the government adopts an appropriate redistribution policy. There have to be

certain incentives for the producers also in order to keep them engaged in the exportable

production. These theories have also been criticized on the ground that labour is not the only

input determining the cost of production.

Heckseher-Ohlin Trade Model

Adam Smith and Ricardo's trade models considered labour as the only factor input and the

differences in the labour productivity determining the trade. Eli Heckscher (1919) and Bertin

Ohlin (1933) developed the international trade theory (H.O. Trade Model) with two factor inputs,

labour and capital, pointing out that different countries have been bestowed with different factor

endowments, and the differences in factor endowments cause trade between the trading

partners. The theory is based on the assumption that there are impediments to trade, and that

there is perfect competition in both the product and factor markets. Further, the theory is based

on the comparative advantage in terms of the relative factor prices. A country specialising in the

production of the goods which require its abundant factor can export them. Thus, if a country is

rich in capital, it will produce capital intensive products and export them in exchange for the

labour intensive products. On the other hand, another country, rich in labour, will produce labour

intensive goods and export them. It will import capital intensive goods.

In the H.O. trade theory, the factor abundance has two meanings the factor abundance in terms

of the factor prices, and the, factor abundance in terms of the physical amount of the factors.

Assume there are two countries: I and II, then the richness of the country in terms of factor


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prices means relatively low price of the factors of production. Country I is rich in capital as

compared to country II, if Pic/P

ig < P2c/P2c. Pic is the price of capital in country I and P

iL is the

price of labour in country I, and P2c is the price of capital in country II and P2L

is the price of

labour in country II. The second definition of the factor abundance compares the overall physical

amount of labour and capital. Country I is capital rich, if the ratio of capital to labour in this

country is larger. C1/L

I> C

2/L

2, where C

1and L

1are the total amount of capital and labour in

country I, and C2

L2

are the total amount of capital and labour in country II, respectively. The

H.O. trade theory holds good, if the factor abundance is defined in terms of factor prices,

because of the incorporation of the demand factor in it. The importance of this theory, which has

the effect of determining the trade patterns and the gains from trade,

this illustrates the pre-trade and after-trade production and consumption in the two countries.

Country I--capital rich, is measured along the Y axis and country II-labour abundant, is

measured along the X axis. There are two goods. A and B. Good A is capital intensive and good

B is labour intensive. Before trade country I is producing and consuming at G and country II at

H. The II, II1

community indifference curve in the two countries is tangent to their production

possibility curves AB and A1

B1

at G and H, respectively. In the domestic market of country I,

good A is cheaper and good B is expensive. In country II, it is good B which has lower price,

good A being costly.

In the overseas market, the price is given by the P2P

2international price line. Now, the countries

move to the points J and K tangent to the international price line, and country I is producing


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more of good A and country II more of good B. By exchanging goods of their specialisation

under free trade, they reach to the I2I1

2indifference curve at point E and enjoy gains from the

international trade as E lies on the higher indifference curve.

As in the case of the classical trade model, the H.O. trade theory also cannot guarantee

the.

(desired) income distribution among different classes in the country. In country I, the returns

to capital are higher and, in country II, the returns to labour are higher because of the greater

demand for producing respective goods for the world market.

The basic trade models are based upon certain assumptions, such as no transportation cost

and free flow of information to all the producers and consumers. They do not take into account

the effect's of trade on the world prices. These trade theories are static, and ignore the effects of

technological progress on the growth of the world economy. These are the real issues and needto be incorporated in a modified version of the classical and neo-classical theories.

If a nation has monopoly in certain products, it may influence the world price. It may enhance its

gains by "optimum tariffs'', which seek to maximise the welfare of the country. Trade may

complicate the growth process. It may affect the employment and may even reduce the welfare

of the country. This may occur in the case of immeserising growth (when benefits from the

higher output are neutralised by the unfavourable terms of trade). The country ends up with

lower real income after growth because the gains arising from higher output are wiped out by

the deteriorating terms of trade. It may, however, by noted that the modified version of the basic

theory does not alter the conclusion that a country produces and exports the commodity in

which it has comparative advantages, and uses the abundant factor in its production. Trade

benefits the nation, but the distribution of gains may be skewed. Adjustment to trade is not

costless but the short-term cost to adjustment should be weighted against the long-term gains

from trade.

The Leontief Paradox

There was a setback to the proponents of the H.O. trade theory in the early 1950's, when

Leontief tested his hypothesis that capital rich countries export capital intensive goods and

import labour intensive goods and vice versa with the help of the input-output data of the United

State's economy. His results refuted the H.O. contention. It was a shocking news for the

economists that the U.S. being a capital rich country should be exporting labour intensive goods

and importing capital intensive goods. Several, explanations were looked into for resolving the


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Leontief paradox. The key factors identified in support of the Leontief paradox were: U.S.

protective trade policy, import of natural resources and the investment in human capital.

William P. Travis examined the Leontief theory in terms of the U.S. tariff policy. When Leontief

tested his hypothesis, the U.S. was importing more of such items as crude oil, paper pulp,

primary.copper, lead, metallic ores and newsprint, which are capital intensive. Thus, according

to Travis, the U.S. protective trade policy was responsible for Leontiefs findings.

The U.S. imports of natural resources like minerals and forest products and the exports of farm

products further support the Leontief presentation. Investment in human capital raises the

productivity of labour. That is why the exports of the U.S. consisted of labour intensive products

and its imports were of capital intensive nature.

Product Life-Cycle ApproachThe product life-cycle approach is associated with the work of Raymond Vernon. Published in

1966, it deals with the evolution of the U.S. multinationals and foreign direct investment

patterns. In Vernon's model, three stages are followed in the introduction and establishment of

new products in the domestic and foreign markets, with emphasis on innovation and oligopoly

power as being the first basis for export and later for the FDI.

The first stage in the sequential development of the product is the new product stage which

emerges in the home country following innovations as a result of intense R&D activities by the

company. The product is introduced in the overseas market through export, and the innovating

firm earns excessive profits both from domestic sales and exports abroad because of its

monopoly position.

The second stage is, characterised by the mature product stage, when the demand in the

foreign countries expands and the host country firms begin to produce competing products. The

home country enterprise is induced to invest abroad for taking advantage of its technology and

increasing demand for the product. As the company specific advantages of the firms controlling

the technology are much higher than the local firms, the production in the host country would becheaper. It stimulates foreign investment in subsidiaries.

In the third stage, the product becomes standardized, arid competition grows in, the world

market. The MNEs invest even in the LDCs, where the cost of production is lower. The host

country, otherwise, has to import these products from abroad because its own production cost is

more. The foreign investment may take the form of licensing arrangements also.


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The initial analysis of the product life cycle approach gives a good account of the nature of the

expansion of the U.S. companies after World War H. The theory was modified by Vernon in

1971 and 1977 in the light of the oligopoly threat arising from global innovative activities. He

identified the first stage as the emerging oligopoly, the second stage as the mature oligopoly

and the third stage as the senescent oligopoly, referring to the state of production when the

standardized product is entirely produced abroad. The home country, where the product was

initially innovated, imports all of the goods that it needs.

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