Published on March 20, 2014
Theories of International Trade By:-Ajay Ritesh Ashok
4-2 Evolution of Trade Theories Mercantilism Theory Absolute advantage Theory Comparative advantage Theory Factor Proportions Theory International Product Cycle New Trade Theory
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 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
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
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
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
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’
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.
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.
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.
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.
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
4-15 The Product Cycle Theory International Product Life cycle comprises of following stages:- 1.Introduction 2.Growth 3.Maturity 4.Decline
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
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
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
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
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’
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
4-23 India in the global competitiveness report
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