This is the summary consisting of the midterm material for the course International Business offered at the University of Amsterdam.
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Chapter 6: International Trade Theory
Mercantilism advocated that countries should simultaneously encourage exports and discourage
imports. It is an old doctrine but it remains in modern political debate and in the trade policy of
many countries. The main tenet of mercantilism was that it was in a country’s best interests to
maintain a trade surplus so a country would accumulate gold and silver and, consequently,
increase its national wealth, prestige and power.
The aw with mercantilism was that it viewed trade as a zero-sum game; one in which a gain by
one country results in a loss by another. David Hume pointed out that mercantilism would
eventually result in a deterioration of the country’s balance of trade. According to Hume, in the
long run, no country could sustain a surplus on the balance of trade and so accumulate gold and
silver as the mercantilists had envisaged.
Free trade refers to a situation in which a government does not attempt to in uence through
quotas or duties what its citizens can buy from another country or what they can produce and sell
to another country. Adam Smith argued that the invisible hand of the market mechanism, rather
than government policy, should determine what a country imports and what it exports. A country
has an absolute advantage in the production of a product when it is more e cient than any other
country at producing it. Smith argues that countries should specialise in the production of goods
for which they have an absolute advantage and then trade these goods for those produced by
other countries. Smith’s basic argument, therefore, is that a country should never produce goods
at home that it can buy at a lower cost from other countries. By specialising, the production of all
goods in the world would increase (all products would be produced at the lowest cost). Trade is a
positive-sum game; it produces net gains for all involved.
Production possibility frontier (PPF) -> the di erent combinations of products a country can
produce.
David Ricardo’s theory of comparative advantage explains what might happen when one
country has an absolute advantage in the production of all goods. Smith’s theory of absolute
advantage suggests that such a country might derive no bene ts from international trade.
However, Ricardo showed that this was not the case. According to Ricardo, it makes sense for a
country to specialise in the production of those goods that it produces most e ciently
(comparative advantage) and to buy goods that it produces less e ciently from other countries,
even if this means buying goods from other countries that it could produce more e ciently itself.
The basic message of the theory of comparative advantage is that potential world production is
greater with unrestricted free trade than it is with restricted trade. Ricardo’s theory suggests that
consumers in all nations can consume more if there are no restrictions on trade. This occurs even
in countries that lack an absolute advantage in the production of any good.
The Ricardian model is simple and based on many assumptions. Three are relaxed as follows:
- Immobile resources
We assume countries can easily convert the production of products, however, resources
do not always shift quite so easily from producing one good to another. For instance, free
trade would mean for wealthy nations that production will shift from labour-intensive
goods to more of some knowledge-intensive goods. Although the country as a whole will
gain from this shift, production workers will lose. The fact is: resources do not always
move easily from one economic activity to another. The process creates ction and human
su ering.
- Diminishing returns
In the simple model, we assumed constant returns to specialisation, meaning the units
of resources required to produce a goods remain constant no matter where one is on a
country’s production possibility frontier (PPD). However, it is more realistic to assume
diminishing returns to specialisation which occurs when more units of resources are
required to produce each additional unit. This implies a convex PPF rather than a straight
line. It is more realistic to assume diminishing returns for two reasons:
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, 1. Not all resources are of the same quality. As countries try to increase output of a
certain good, it is likely they will use more marginal resources with lower productivity.
2. Di erent goods use resources in di erent proportions.
The theory predicts that it is worthwhile to specialise until that point where the resulting
gains from trade are outweighed by diminishing returns. Thus, the basic conclusion that
unrestricted free trade is bene cial still holds, although the gains may not be as great as
initially suggested.
- Dynamic e ects and economic growth
We assumed that trade does not change a county’s stock of resources or the e ciency
with which it utilises those resources. However, it becomes apparent that trade is likely to
generate dynamic gains of two sorts.
1. Free trade might increase a country’s stock of resources as increased supplies of labor
and capital from abroad become available for use within the country.
2. Free trade might increase the e ciency with which a country uses its resources.
The dynamic gains in both the stock of a country’s resources and the e ciency with which
resources are utilised will cause a country’s PPF to shift outward. As a consequence of
this outward shift, the country can produce more of both goods than it did before
introduction of free trade.
In a recent and widely discussed analysis, Paul Samuelson argued that contrary to the standard
interpretation, in certain circumstances the theory of comparative advantage predicts that a rich
country might actually be worse o by switching to a free trade regime with a poor nation.
Many economic studies have looked at the relationship between trade and economic growth. In
general, these studies suggest that as predicted by the standard theory of comparative
advantage, countries that adopt a more open stance toward international trade enjoy higher
growth rates than those that close their economies to trade. The message seems clear: Adopt an
open economy and embrace free trade, and your nation will be rewarded with higher economic
growth rates.
Ricardo’s theory stresses that comparative advantage arises from di erences in labour
productivity. Heckscher and Ohlin have argued that comparative advantage arises from
di erences in national factor endowments; the extent to which a country is endowed with such
resources as land, labour and capital. Nations have varying factor endowments which explains
di erences in factor costs (the more abundant a factor, the lower its cost). The Heckscher–Ohlin
theory predicts that countries will export those goods that make intensive use of factors that are
locally abundant while importing goods that make intensive use of factors that are locally scarce.
Most economists prefer the Heckscher-Ohlin theory to Ricardo’s because it makes fewer
simplifying assumptions. However, Leontief has looked into this theory further. He argued that
because the US is relatively abundant in capital compared to other nations, it would be an
exporter of capital-intensive goods and an importer of labour-intensive goods. However, he found
that US exports were less capital intensive than US imports. Because this result is at odds with
the Heckscher-Ohlin theory, it has become known as the Leontief paradox.
In trying to explain the observed pattern of international trade, Vernon came up with the product
life-cycle theory. This theory suggest that early in their life cycle, most new products are
produced in and exported from the country in which they are developed. As the product become
widely accepted, production starts in other countries. The theory suggests that the product may
ultimately be exported back to the country of its original innovation due to price becoming the
main competitive weapon. Thus, the cycle of global production initially switches from the United
States to other advanced nations and then from those nations to developing countries.
Paul Krugman developed the new trade theory which stresses that in some cases, countries
specialise in the production and export of particular products not because of underlying
di erences in factor endowments but because in certain industries the world market can support
only a limited number of rms. In such industries, rms that enter the market rst are able to build
a competitive advantage that is subsequently di cult to challenge. The theory is based on two
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