International Trade Theories

Frank McDonald
Lecture 3

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www.bradford.ac.uk/management

Lecture Outline
• Mercantilism and trade
• Classical theories of trade – inter-
industry trade
• Modern theories of trade – intra-
industry trade
• Implications for business strategies

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 Mercantilism
• Maximise exports and minimise imports
or maximise inflows and minimise
outflows
• Mercantilism leads to accumulation of
capital if successful because Inflows <
Outflows
• Leads to inflationary pressure

Mercantilism
• Some trading partners in deficit if some
are in surplus
• Leads to decline in the ability of deficit
countries to buy goods and services
• Need to recycle surpluses to deficit
countries – China finances a
substantial part of the borrowing of
countries in the West especially the
USA
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 Mercantilism
• Can become a difficult balancing act
and can lead to trade wars and
competitive
• Long hard struggle to move towards
the idea of free trade to let markets
decide on what is traded
• A problem of macroeconomic balance –
remind yourselves of the material in the
Business Economics module
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Classical Theories of Trade

• Absolute advantage – countries concentrate
on production where they have absolutely
higher productivity
• Comparative advantage – countries
concentrate on production where they have
comparatively higher productivity
• Absolute and Comparative advantages are
the theoretical basis for free trade

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 Terms of trade
• Terms of trade – ratio of price of
exports to price of imports
• Higher price of exports the more the
terms of trade in favour of country with
higher export prices
• The terms of trade measure who gains
most from trade but free trade on
classical basis is mutually beneficial
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Inter-industry trade
• Inter-industry trade - trade across
different industries explained by theory
of absolute and comparative advantage
• Comparative advantage explained by
labour and capital intensity
• Labour rich countries have comparative
advantage in labour intensive products
vice versa for capital rich countries
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Problems with classical trade
theories
• Both classical theories assume fixed
technology and that capital and labour
do not cross frontiers
• Both cannot prove that free trade will
benefit everyone - assumes that the
surplus from free trade is used to
compensate losers
• Both cannot show why intra-industry
trade takes place
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Intra-industry trade
• Intra-industry trade results from
differences in qualities and
technologies
• Differences in transport and logistical
costs
• Economies of Scale (internal and
external)
• First & Second mover advantages
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 First & Second Mover
Advantages

AC
AC1 = first mover
C1 AC2 = second mover
C2
AC1
AC2

0 Q1 Output

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First & Second Mover

Advantages
• First movers have a cost advantage over
second movers unless second movers have
lower costs (eg AC2 < AC1) and can enter the
market at output at least equal to first mover
(ie Q1)
• Overcoming first mover advantages can be
very difficult unless second movers have
very large cost advantages or can quickly
expand output to reach cost levels of first
movers
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 Quality advantages
• If lower cost locations cannot provide
the same level of quality higher cost
locations can retain markets (eg VW
and BMW produced in Germany)
• Speed of delivery and meeting high
competency in meeting domestic
market requirements can also offset
high costs

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Other theories
• Porter’s diamond explains the national
competitive advantage of industries that
leads to international competitive
advantages (see Peng pp 125-126)
• Vernon’s product life cycle explains
evolution of trade as product matures
domestic firms begin to export then
produce abroad and finally import from
other countries (see Peng pp122-123)
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 Protection
• Case for protection – infant industry
argument (eg European Airbus case)
• Helping to adjust to decline of
industries caused by increased trade
(eg MFA for textiles)
• Anti-dumping duties to counteract
unfair trading practices

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Implications for Business

Strategies
• Mercantilist policies to promote exports and
discourage imports are often implemented –
this can lead to distortion of trade
• Firms need to be aware of protectionist
policies and there implications for trade
flows
• Membership of WTO and trade agreements
can lessen mercantilist policies

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 Implications for Business
Strategies
• Trade on the basis of absolute and
comparative advantage will largely be
influenced by amounts of capital
relative to labour.
• Absolute and comparative advantage
can change overtime by trade flows
and capital flows – see handout on
Blackboard of flying geese theory

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Implications for Business

Strategies
• Trade flows on the basis of absolute
and comparative advantage can
therefore change – China may not
always be the best place to assemble
manufactured products.
• Absolute and comparative advantage
can only explain inter-industry trade

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 Implications for Business
Strategies
• Intra-industry trade is explained by a
complex mix of market, cost, quality and
price factors.
• Intra-industry trade is driven by competitive
advantages and these can be built up and
run down
• Firms need to be aware that intra-industry
trade flows are primarily driven by how firms
interact with their host locations to develop
competitive advantages.
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