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 Trade

B. 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.
1. Mercantilism contd…

 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.
1. Mercantilism contd…

 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
1. Mercantilism contd…

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
 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 3 1 4
Soybeans
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 6 0 6
soybeans
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  On the other hand,
Chinese cloth US soybean
producers would be producers have a
prepared to accept a domestic exchange
price which is more rate of 1.5 ton
than .25 ton of soybean for 1 bolt of
soybean for a bolt of cloth. So, their limit
cloth. This is their of international
floor price below exchange is
which they will not anything less than
go. 1.5 ton soybean.
3. Theory of Absolute
Advantage: an example
 So, actual price, for 1 bolt cloth.
which Adam Smith  Evidently both
did not suggest in
his theory, will be in nations gain from
the range .25 to 1.5 trading, as may
ton soybean for 1 be seen in the
bolt cloth. table in next
 We may suggest a slide.
mid-point, say 1.33
ton soybean
 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.
 4. Theory of Comparative
Advantage
• Suppose before specialization the scenario is as
follows:
Commodity United States China Total

Tons of 4 5 9
soybeans
Bolts of cloth 2 5 7

• 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
 4. Theory of Comparative
Advantage

• 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:
Commodity United States China Total
Tons of 8 0 8
soybeans
Bolts of cloth 0 10 10
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.
4. Theory of Comparative
Advantage
 The terms of  According to the
trade will be Theory of
between 1 ton of Comparative
soybeans for 1 Advantage, the
bolt of cloth for range of
China. advantageous
trade for both
 ½ bolt of cloth economies lie
for 1 ton of between the pre-
soybeans for USA. 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:

Commodity United States China

Tons of soybeans 4 5

Bolts of cloth 3 6
 4. Theory of Comparative
Advantage
 Gains from specialization & trade are as
follows:

Commodity United States China

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  What is the
highly skilled labor significance of
and importing Leontief Paradox?
capital intensive  Actually, Leontief
items produced by Paradox was a very
developing countries dynamic theory which
could explain economic
with mature
transformation,
technology and upscaling of labor and
unskilled labor. role of technology.
 It could explain why
certain industry or
6. Leontief Paradox
 technology becomes  How would one
obsolete in one country differentiate between
and adopted in another H-O theory and L.P.?
country.  H-O does not focus on
 Thus, Leontief Paradox specific direction of
had higher explanatory trade but L.P. does:
power compared to trade between
many other developed and
contemporary theories developing countries;
of trade.  H-O deals with trade in
all types of products but
L.P only manufactured
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 exports
2. Foreign production begins
3. Foreign competition in export markets
4. 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
9. National Competitive
Advantage from Regional Clusters
 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:
9. National Competitive
Advantage from Regional Clusters
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
9. National Competitive
Advantage from Regional Clusters
 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:
9. National Competitive
Advantage from Regional Clusters

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.
8. Dunning’s Eclectic Theory of
International Production
 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
8. Dunning’s Eclectic Theory of
International Production
− 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.