International Trade Theories

1. Theory of Absolute Advantages
• Adam Smith
• Focused on ability of a country to produce good more efficiently than other
Nations
• Specialization
• Proved wrong the belief that trade was a zero sum game
Assumption of the theory
1. Trade is between two countries
2. Only two commodities are traded
3. Free trade exist between the countries
4. The only element of cost of production is labor

2. Example
RESOURCES NECESSARY TO PRODUCE ONE UNIT
COUNTRY CLOTH WINE
England 80 100
Portugal 120 90
RESOURCES TO COMMIT AFTER THE SPECIALIZATION
COUNTRY CLOTH WINE
England 80+100 0
Portugal 0 90+120

3. Theory of comparative
advantages(DAVID RICARDO-1817)
• Focuses on relative productivity differences
• Less opportunity cost
• Country should specialize in those goods that have comparative advantage in.
• No restriction on trade
Assumptions
1. only two countries and two goods
2. zero transportation costs
3. similar prices and values
4.No restriction over trade
5. Constant returns to scale
6. Fixed stock of resources
7. Free trade does not affect production efficiency

4. Example
Cost per unit in man Hours
COUNTRY WHEAT WHINE
ENGLAND 15 30
PORTUGAL 10 15

5. Difference
• Absolute advantage
The ability of a country to produce particular good more
efficiently and gain absolute advantage on that
• Comparative advantage
The ability of a party to produce a particular good or service at a
lower marginal and opportunity cost over another.

6. Theory of Country Size
• Comes under Trade pattern theories
• How much does a country trade
• Trade depends on country size
• Transportation cost
• Distance create indirect cost of tying up inventory for a longer
period.

7. Factor proportions theory
• Eli Heckscher and his student Bertil Ohlin, in the 1920s
• What does a country Trade
• The standard H-O model begins by expanding the number of factors of production from
one to two.
FACTORS OF PRODUCTION
Labor Capital
• Capital labor ratio(country produces two goods)
• Capital Intensive(Steel)
• Labor intensive(clothing)

8. • Capital abundant(high capital over labor) and Labor abundant(High
labor over capital)
• The H-O model assumes that the only differences between countries
are these variations in the relative endowments of factors of
production. It is ultimately shown that
(1) trade will occur,
(2) trade will be nationally advantageous, and
(3) trade will have characterisable effects on prices, wages, and rents
when the nations differ in their relative factor endowments and when
different industries use factors in different proportions.

9. Main Theorems in H-O model
1.The Heckscher-Ohlin Theorem
capital abundant and labor abundant countries
price of finished goods
advantages of having international trade
A country that is capital abundant is one that is well endowed with capital relative to the other country.
This gives the country a propensity for producing the good that uses relatively more capital in the
production process—that is, the capital-intensive good. As a result, if these two countries were not
trading initially—that is, they were in autarky—the price of the capital-intensive good in the capital-
abundant country would be bid down (due to its extra supply) relative to the price of the good in the other
country. Similarly, in the country that is labor abundant, the price of the labor-intensive good would be
bid down relative to the price of that good in the capital-abundant country.

10. 2.Stolper-Samuelson theorem
• . describes the relationship between changes in output prices (or prices of
goods) and changes in factor prices such as wages and rents .
• capital intensive good and labor intensive good
• The theorem states that if the price of the capital-intensive good rises (for
whatever reason), then the price of capital—the factor used intensively in
that industry—will rise, while the wage rate paid to labor will fall. Thus, if
the price of steel were to rise and if steel were capital intensive, the rental
rate on capital would rise, while the wage rate would fall. Similarly, if the
price of the labor-intensive good were to rise, then the wage rate would rise,
while the rental rate would fall.

11. Country similarity theory
• Concept of intra-industry theory.
• Choosing Trade partners.
• Countries which are similar stage of development will have similar
preference.
• Firm based(Customer preferences in different countries)
• 1st firm will market in domestic countries ,if success occur then it will
go for same outside market.
• most useful in understanding trade in goods where brand names and
product reputations are important factors in the buyers’ decision-
making and purchasing processes.

12. Product Life cycle theory
1. Introductory
2. Growth
3. Matured
4. Decline
• Companies will manufacture products first in the countries in which
they were researched and developed, almost always developed
countries
• Over the product’s life cycle, production will shift to foreign
locations, especially as the product reaches the stage of maturity and
decline

14. Global Strategic Rivalry Theory
• emerged in the 1980s and was based on the work of economists Paul Krugman and Kelvin
Lancaster.
• theory focused on MNCs and their efforts to gain a competitive advantage against other
global firms in their industry
Ways which firm can hold competitive advantages
1. Differentiation
2. Quality
3. Owning intellectual property right
4. Strategic Alliance
5. Achieving economy of scale
6. Investing R&D

15. National competitive advantage theory
( Michael porter)
• NCA is basically an evaluation of how competitively a nation
participates in international markets.
• National competitive of an industry will depend upon the
capacity of an industry to innovate and upgrade