chapter 3 theories of international trade and investment

Chapter 3

Theories of International Trade and Investment

Ch 3: Theories of International Trade and Investment

This Chapter explains theoretically the patterns of global trade and investment seen in Ch 2. It answers to questions like: why nations trade, who trades with whom and what?

Two parts in this Chapter:A. Theories of International TradeB. Theories of Foreign Direct

Investment

A. International Trade Theory International Trade Theory tries to

answer the question: “why nations trade?” Who trades with whom and what commodities?

It also addresses important issues of direction, composition, and volume of goods traded.

The most influential theory of international trade until late 18th century was Mercantilism.

1. Mercantilism

An economic philosophy evolved in Europe between 16th & 18th centuries, as a kind of post-factum rationalisation of colonialism and imperialism.

Although ended in the late 1700s, some people still believe in its arguments:

=> exports are “good” because they bring in precious metals and create jobs , but

1. Mercantilism contd…

=>Imports are “bad” because they drain out precious metals and transfer jobs to other nations,

So governments should encourage exports and discourage imports.

This view in essence sees trade as a zero-sum activity – one party gains only at the cost of another.


But were zero-sum transactions viable? Can a nation increase its exports if other nations do not liberalize imports?

Implicit justification of international exploitation, colonialism, more precisely.

Colonial expansion beginning 15th century was an application of the Mercantilist philosophy.


In another sense, this philosophy was also a recipe of government intervention in economic activities including international economic relations.

With the enunciation of Adam Smith’s free market economy and liberal trade theory, this philosophy lost its appeal.

Is this philosophy still practiced


anywhere? Japan is often termed as “fortress

of mercantilism” because of their protectionism.

They try to maintain a cheap yen in order to capture attractive export markets while reducing the threat of imports.

China is possibly another example.

2. Adam Smith’s Free Market Philosophy

Adam Smith, a British economist, was incensed by the Mercantilist philosophy that expanding exports but curtailing imports were the way of becoming rich.

He was also very critical of government intervention and control over trade and economic activities.

He published his seminal work “An Inquiry into the Nature and Causes of

2. Adam Smith’s Free Market Philosophy

the Wealth of Nations” in 1776. He advocated for laissez-faire or free

market economy where the invisible hand of demand and supply, rather than government intervention, would determine economic activities.

He advocated for liberal trade as a means of increased global production, consumption and welfare.

His trade theory: Theory of Absolute Advantage

3. Theory of Absolute Advantage

According to Adam Smith, a nation will have absolute advantage in a product if it can produce same output as another nation with lesser inputs or more output with same inputs.

Therefore, the nation should specialize in the product in which it has absolute advantage and export it, while it should import the product in which it does not have absolute advantage.

3. Theory of Absolute Advantage: an example We consider two countries, two

products which can be produced with two units of inputs by each with perfect competition and no transportation costs.

Before trade:Commodity USA China Total

Tons of Soybeans

3 1 4

Bolts of Cloth

2 4 6

3. Theory of Absolute Advantage: an example So in USA either 3 tons of soybeans

or 2 bolts of cloth can be produced with 1 unit of input.

In China only 1 ton of soybeans can be produced or 4 bolts of cloth with 1 unit of input.

Therefore, USA has an absolute advantage in soybean production while China has an absolute advantage in cloth production.

3. Theory of Absolute Advantage: an example Each country specializes in producing

the good that it has more advantage in.

Total production of both goods is greater than pre-specialization stage. This leaves surplus with each. Commodity USA China Total

Tons of soybeans

6 0 6

Bolts of cloth

0 8 8

3. Theory of Absolute Advantage: example In order to consume both products, the two

countries exchange their surplus in trade. What is the rationalization of trade? What

would be the terms of trade or the exchange rate?

Chinese producers of cloth domestically exchange 1 ton soybean for 4 bolts of cloth. Hence, they would trade cloth for soybeans if they get more than 1 ton of soybeans for 4 bolts of cloth.

The US soybean growers trade soybeans for Chinese cloth if they get a bolt of cloth for less than 1.5 tons of soybeans.

3. Theory of Absolute Advantage: an example That means, the

Chinese cloth producers would be prepared to accept a price which is more than .25 ton of soybean for a bolt of cloth. This is their floor price below which they will not go.

On the other hand, US soybean producers have a domestic exchange rate of 1.5 ton soybean for 1 bolt of cloth. So, their limit of international exchange is anything less than 1.5 ton soybean.

3. Theory of Absolute Advantage: an example So, actual price,

which Adam Smith did not suggest in his theory, will be in the range .25 to 1.5 ton soybean for 1 bolt cloth.

We may suggest a mid-point, say 1.33 ton soybean

for 1 bolt cloth. Evidently both

nations gain from trading, as may be seen in the table in next slide.

3. Theory of Absolute Advantage: an example

USA consumes 2 bolts more of cloth than pre-trade situation and China consumes 2 tons more soybean.

These are their respective gains.

Commodity United States China

Tons of soybeans 2

Bolts of cloth 2

4. Theory of Comparative Advantage

An improved version of Advantage Theory was stated by David Ricardo, another British scholar in 1817. It came to be known as Theory of Comparative Advantage.

And the ground for the theory was created by a major limitation of the Theory of Absolute Advantage.

4. Theory of Comparative Advantage The limitation is that Adam Smith’s

theory will be valid only if there is a pair of countries each of which has absolute advantage in one commodity.

But this is a rare combination. In real life, one of the states may have absolute advantage in both the commodities while another country may have absolute disadvantage in both. Will trade still be beneficial for both? Adam Smith has no answer but Ricardo said, yes.


Commodity United States China Total

Tons of soybeans

4 5 9

Bolts of cloth

2 5 7

• Suppose before specialization the scenario is as follows:

• China has absolute advantage in producing both goods and USA has absolute disadvantage in both.

• Apparently, there may not be trade, according to Theory of Absolute Advantage. But Ricardo makes deeper analysis of respective positions and argues that


Commodity United States China Total

Tons of soybeans

8 0 8

Bolts of cloth

0 10 10

• USA has disadvantage in both products but the degree of disadvantage is less in soybeen than in cloth.

• We may turn around the logic and say: USA has a relative less disadvantage and hence, comparative advantage in producing soybeans:

4. Theory of Comparative Advantage We may also say, although China has

absolute advantage in both, its advantage is comparatively less in soybean. Hence, it has comparative disadvantage in the product.

This is the essence of Ricardo’s Comparative Advantage Theory.

Therefore, beneficial trade is possible between USA and China. Results of specialization may be seen in table in previous slide.


The terms of trade will be between 1 ton of soybeans for 1 bolt of cloth for China.

½ bolt of cloth for 1 ton of soybeans for USA.

According to the Theory of Comparative Advantage, the range of advantageous trade for both economies lie between the pre-trade price ratios.

4. Theory of Comparative Advantage Suppose an exchange rate of ½ bolt

of cloth for 1 ton of soybeans is fixed. Then the final result is:


Tons of soybeans

4 5

Bolts of cloth 3 6

4. Theory of Comparative Advantage Gains from specialization & trade are

as follows:


Tons of soybeans

Bolts of cloth 1 1

5. Heckscher-Ohlin Theory of Factor Endowment Both Adam Smith and Ricardo’s theories

suffer from limitations. Two Swedish economists in 1919 and 1933

came out with a better explanation of international trade in terms of factors of production. It came to be known as Heckscher-Ohlin Factor Endowment Theory.

The model essentially says that countries will export products that use their abundant & cheap factors of production and import products that use the countries' scarce factors.

5. Heckscher-Ohlin Theory of Factor Endowment Australia, having large amount of land, exports

land-intensive products such as grain & cattle. Bangladesh, on the other hand, exports labor-

intensive goods due to the fact that it has relatively large populations.

The essence of this theory is difference in factor endowment. Based on this, there can be trade between developed-developing, developed-developed and developing-developing, if there is difference in factor endowments.

Trade is not possible between countries with same factor endowment, e.g. labor-intensive vs labor intensive.

5. Heckscher-Ohlin Theory of Factor Endowment

This model assumes factor prices depend only on the factor endowment.

This assumption is not true as factor prices are not set in a perfect market.

As a result factor prices do not fully reflect factor supply.

5. Heckscher-Ohlin Theory of Factor Endowment

In addition, the assumption of universal availability of a given technology is not very correct.

There is always a lag between the introduction of a new production method and its application.

6. Leontieff Paradox A study by Wassily Leontief in 1953

found that USA, even after being a capital-intensive country exported relatively labor-intensive products and imported capital intensive products.

This contradicts the result of Heckscher-Ohlin theory. That is why it is known as Leontief Paradox with reference to Heckscher-Ohlin Theory.

A group of Harvard economists later empirically examined the trading behavior of US economy and found out that US has been exporting high value labor intensive

6. Leontief Paradox items produced

by highly skilled labor and importing capital intensive items produced by developing countries with mature technology and unskilled labor.

What is the significance of Leontief Paradox?

Actually, Leontief Paradox was a very dynamic theory which could explain economic transformation, upscaling of labor and role of technology.

It could explain why certain industry or

6. Leontief Paradox technology becomes

obsolete in one country and adopted in another country.

Thus, Leontief Paradox had higher explanatory power compared to many other contemporary theories of trade.

How would one differentiate between H-O theory and L.P.?

H-O does not focus on specific direction of trade but L.P. does: trade between developed and developing countries;

H-O deals with trade in all types of products but L.P only manufactured items.

6. Leontief Paradox

H-O does not talk about calibration of factors of production but L.P. does – skilled vs unskilled labor, latest vs mature technology.

7. The Linder Theory of Overlapping Demand Swedish economist Stefan Linder’s

demand-oriented theory states that income per capita level determines a country’s demand as customers’ tastes are strongly affected by income levels.

This is a demand side theory unlike other theories of trade we have covered.

This theory infers that international trade in manufactured goods will be greater between nations with similar income per capita levels.

7. The Linder Theory of Overlapping Demand This theory explains why trade is

concentrated among the developed countries. They have higher purchasing power and producers will cater to the demands for the high value products – manufactured or primary.

According to this theory, intra-industry trade occurs due to product differentiation. This theory explains why certain items will be imported by a country even if that country itself produced that – because of product differentiation

8. International Product Life Cycle (IPLC) Hypothesized by Raymond Vernon in

1960s this concept “views a product a product as going through a full life cycle from internationalization stage to standardization”.

In other words, a products undergoes transformation from domestic product through exports to imports of the same country.

The successive stages of a product’s life cycle is illustrated in the figure on the next slide:

8. International Product Life Cycle (IPLC)

Figure 3.2 – page 79

8. International Product Life Cycle (IPLC) The theory explains why a product

that begins as a country’s export eventually becomes its import.

The steps are as follows:1. The country exports2. Foreign production begins3. Foreign competition in export markets4. Import competition in the country

8. IPLC Theory

Can you show how the theory combines Linder Theory and Leontief Paradox?

9. National Competitive Advantage from Regional Clusters

National competitiveness involves a country’s “relative ability to design, produce, distribute, or service products within an international trading context while earning increasing returns of its resources”.

Alfred Marshall suggested that firms cluster on a geographic basis because of:

− Advantages of a common labor force− Gains from the development of specialized local

suppliers− Sharing of technological information &

enhancement of innovation rate


Michael Porter’s “Diamond Model ” adds on to Marshall’s work.

It claims that four kinds of variables affect a local firm’s ability to utilize the country’s resources to gain a competitive advantage.

The types of variables are discussed in the next slide:


1. Demand conditions – nature as well as size

2. Factor conditions – level & composition production factors

3. Related and supporting industries – suppliers & industry support services

4. Firm strategy, structure, and rivalry – the extent of domestic competition, the existence of barriers to entry, and the firms’ management style & organization


Furthermore Porter claims that competitiveness could also be affected by government and chance.

He argues that the above-mentioned factors are fundamentally interrelated, as illustrated in the following diagram:


Variables affecting competitive advantage: Porter’s Diamond

(figure 3.3 – page 84)

B. International Investment Theories

Classical investment theory postulated that flow of international capital resulted from differences in interest rates.

However contemporary international investment theory has been extended considerably.

1. Monopolistic Advantage Theory Originating from Stephen Hymer’s 1960

dissertation, this theory suggests that “foreign direct investment is made by firms on oligopolistic industries possessing technical and other advantages over indigenous firms”.

The advantages must be economies of scale, superior technology, or superior knowledge in marketing, management, or finance.

2. Financial Factors

According to Aliber imperfections in the foreign exchange markets are responsible for foreign investment.

Portfolio theory postulates that international operations diversify risk and thus maximize the expected return on investment.

3. International Product Life Cycle (IPLC)

In addition to what was discussed earlier, the IPLC also explains that foreign direct investment is a natural stage of a product’s life.

A company is often forced to invest in production facilities abroad in order to avoid losing a market that it serves by exporting.

4. Follow the Leader This defensive follow-the-leader theory

developed by Knickerbocker proposes that when one firm, the leader in an oligopolistic industry, enters a market, other firms follow suit.

The “following” firms believe that the leading firm knows something they do not, and that the initiator will achieve some advantage of risk diversification that they will not have unless they also enter the market.

5. Cross Investment This concept suggests that

oligopolistic firms invest in each other’s home countries as a defense measure.

Multinationals invest in foreign countries also because of:

− Following the customer− Seeking knowledge− Benefiting from political & economic

stabilization of the host country

6. Internalization Theory

Being an extension of the market imperfection theory, this theory purports that a firm having a superior knowledge may use the knowledge itself rather than selling it in the open market.

This investment in foreign subsidiaries will allow the firm to gain a higher return on its investments.

7. Dynamic Capabilities

This perspective puts forward the idea that achieving success in international FDI requires not only ownership of unique knowledge or resources, but also the ability to dynamically create & exploit these capabilities for quality and/or quantity-based deployment.

8. Dunning’s Eclectic Theory of International Production

This is currently the most widely cited and accepted theory of FDI.

Dunning developed this idea that attempts to provide an overall framework for explaining why firms choose to engage in FDI.


To engage in FDI a firm needs to have three kinds of advantages:

− Ownership specific – the three basic types of tangible & intangible ownership-specific advantages include nowledge/technology, economies of scale/scope, and monopolistic advantages


− Location specific – existence of raw materials, low wages, special taxes or tariffs)

− Internalization – advantages by own production rather than producing through a partnership arrangement such as licensing or a joint venture

Taken together, this theory is known as ‘OLI’ theory of FDI

Summary of International Investment Theories

Empirical tests support one aspect of all these theories – a major part of FDI is made by large, research-intensive oligopolistic firms.

All these theories also suggest that it is profitable for companies to invest overseas.

chapter 3 theories of international trade and investment

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