trade theories

TRADE THEORIES

Trade Theory-Global Business Management 2

PRESENTED BY

Aditya Suresh – 186

Akash Gupta – 188

Alankar Das - 190


CONTENTS

1.Mercantilism theory

2.Absolute Advantage theory

3.Comparative Advantage theory

4.Factor Endowment theory

5.Product Life Cycle theory

6.Leontief Paradox

7.Heckscher Ohlin theory

8. Porter`s Diamond theory

9.New Trade Theory


WHY DO COUNTRIES TRADE ?

1. Availability of products (natural resources, new products, etc.)

2. International price differential as a consequence of:

Productivity differential Differences in technology Differences in factor endowments

Economies of scale 3. Product differentiation and market structure


WHAT IS TRADE THEORY

Exchange of raw materials and manufactured goods (and services) across national borders


MERCANTILISM THEORY

The theory that a country’s power depended mainly on its wealth to build strong navies and purchase vital trade goods


MERCANTILISM THEORY

In 17th century group of men (merchants, bankers, government officials & philosophers) wrote essays on international trade that advocated an economic philosophy known as Mercantilism

In their view, a country becomes rich if it exports more than it imports

Surplus in trade balance will result in an inflow of precious metals; gold and silver

More precious metals means a richer and more powerful nation

Countries have to do their best to increase exports and restrict imports.


CONTD..

Since all countries cannot have surplus at the same time & because stock of metals is fixed in short run, a country gains from trade only at expense of others

Wealth of nations was measured by stock of metals they possess

In contrast, today we measure wealth of a nation by its stock of human, man-made & natural resources available for producing goods & services

Mercantilists advocated strict government control of economic activity because gain from trade comes at expense of other nations (i.e. zero-sum-game)


CONTD..

GOLD AND SILVER ARE CURRENCY FOR TRADE

THEORY SAYS YOU SHOULD HAVE A SURPLUS

MAXIMIZE EXPORT THROUGH SUBSIDIES

MINIMIZE IMPORTS THROUGH TARIFFS AND QUOTAS

ASSUMPTIONS

THERE IS A FINITE AMOUNT OF WEALTH IN

THE WORLD

A NATION CAN ONLY GROW RICH AT THE EXPENSE OF OTHER

NATIONS

A NATION SHOULD TRY TO ACHIEVE & MAINTAIN

A FAVOURABLE TRADE BALANCE ( EXPORTING

MORE THAN ITS IMPORT)Trade Theory-Global Business Management 10


LIMITATIONS

In modern economy a

nation holding gold will lose the competitive

price advantage

Mercantilism is expensive to implement because it requires complex

navigation laws that are difficult

to enforce

Overlooked other sources of country’s wealth like capital &

skilled work force

Economic regulation tends to result in

illegal activity or smuggling

ABSOLUTE ADVANTAGE THEORY

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



CONTD..

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

Efficient production

of goods leads to

potential well being of

people

Both exporting &

the importing

country gain by engaging

in trade

LIMITATIONS

Fails to explain how free trade can be advantageous to two countries when one country can produce all goods

Country not having absolute advantage can’t gain from free trade

Differences in climatic conditions & natural resources won’t lead to absolute advantage

What if the country is bad at making everything?



COMPARATIVE ADVANTAGE THEORY

David Ricardo: (1817) argued:A country should produce only goods where

it is most efficient & import those goods in which it’s less efficient

Even if a country is efficient in producing all the goods, still trade between two countries will prove beneficial

Assumes that a country does not have to be best at anything to gain from trade

Country gains in those activities which it can produce at world prices even though it may not have absolute advantage

LIMITATIONS • Ricardo's Theory was based on only two

countries & only two commodities, but international trade is among many countries with many commodities• Assumption of full employment helps theory to

explain trade on the basis of comparative advantage. Cost of production, even in terms of labour, may change as countries, at different levels of employment move towards full employment• Another serious defect is that transportation

costs are not considered in determining comparative cost differences• Ricardian theory is not applicable to developing

countries as these countries are nowhere near to full employment



FACTOR ENDOWMENT THEORY

Trade theory holding that countries produce & export those goods that require resources (factors) that are abundant (and thus cheapest) & import those goods that require resources that are in short supply

Example: Australia – lot of land and a small

population (relative to its size) So what should it export and

import?


CONTD..

1.Assumes that production function are identical for all countries

2.Assumes that there is no unemployment

4-19

TWO FACTORS OF PRODUCTION

•Labour

•Capital


LIMITATIONS

Assumes that the production functional are identical for all the countries

Assumes that there is no

unemployment

Had poor predictive

power

Considered capital as

homogeneous

Trade Theory-Global Business Management 4-21

•Trade theory holding that a country will begin by exporting its product & later undertake foreign direct investment as product moves through its lifecycle•As products mature, both location of sales optimal production changes•Affects direction & flow of imports & exports•Globalization & integration of economy makes this theory less valid

PRODUCT LIFE CYCLE THEORY ( R .VERON ( 1966))


•Increased emphasis on technology’s impact on product cost

•Explained international investment

•Limitations•Most appropriate for technology-based products•Some products not easily characterized by stages of maturity•Most relevant to products produced through mass production

PRODUCT CYCLE AND TRADE IMPLICATION


HECKSCHER OHLIN THEORY

Given by Filip Heckscher Explained link between factor

endowments & comparative advantage of nations

Country has comparative advantage in those factors which make use of abundant factor

Free trade equalizes factor prices Trade gains are greatest between

countries with greatest difference in economic structure

Eli Filip Heckscher (1879-1952)

http://en.wikipedia.org/wiki/Image:Eli_Heckscher.jpg


LIMITATIONS

1.Based on over simplified assumptions & is unrealistic

2.Gives undue importance to supply & less importance to demand


LEONTIEF PARADOX

Given by Wassily Leontief in 1973 Found out that U.S. exports were

apparently labour intensive & imports capital intensive

Findings were contradictory to predictions of Heckscher-Ohlin theorem

Stimulated enormous amount of empirical & theoretical research on subject


LIMITATIONS

1.Leontief considered only capital & labour

inputs, leaving out natural resource inputs

2.But in reality capital & natural resources are

used together in production

PORTER’S DIAMOND MODEL

Developed by Michael Porter in his book ‘The Competitive Advantage of Nations’

Explains why particular industries become competitive in particular locations

Competitiveness of one company is related to the performance of other companies

Demand, factor conditions, government policies help companies create competitive advantage



LIMITATIONS

1.In his book, Porter was optimistic about future of

Korea & less optimistic about future of Singapore

2.It was basically a home based concept & ignored

the nature of multinational activities

NEW TRADE THEORY

Collection of economic models in International trade which focuses on role of increasing returns to scale

This theory relaxed the assumption of constant returns to scale

Emphasized firm level differences in same industry of the same country

Also emphasized the growing trend of intermediate goods

Assumed that all firms are symmetrical, meaning they have the same production co-efficient



LIMITATIONS

1.Can only treat a situation when there are many firms with different production

processes

2.Assumes that all firms are symmetrical, which

may not be true in every case

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