International Trade Theories PDF

INTERNATIONAL TRADE THEORIES UNIT-2 LESSONS INCLUDED: ▪Lesson 1: Classical International Trade Theories ▪Lesson 2: Critical Evaluation on Classical International Trade Theories ▪Lesson 3: Modern Theories of International Trade ▪Lesson 4: Critical Evaluation of Modern International Trade Theories ...

INTERNATIONAL TRADE THEORIES UNIT-2 LESSONS INCLUDED: ▪Lesson 1: Classical International Trade Theories ▪Lesson 2: Critical Evaluation on Classical International Trade Theories ▪Lesson 3: Modern Theories of International Trade ▪Lesson 4: Critical Evaluation of Modern International Trade Theories Objectives/Competencies: On completion of this unit, the student is expected to be able to do the following: 1. To realize the benefits of the exchange of goods and services for the world and the citizens of each country. 2. To look at classical, country-based theories (to prove the importance of trading). 3.To use the modern, firm-based theories. 4.To describe global strategies adopted by businesses. Introduction: International trade is the exchange of goods and services between countries. It has been an important part of the global economy for centuries. Classical international trade theories were developed in the 18th and 19th centuries to explain the benefits of trade and to understand how countries should specialize in the production of goods and services. WHAT IS INTERNATIONAL TRADE? International trade theories are simply different theories to explain international trade. Trade is the concept of exchanging goods and services between two people or entities. International trade is then the concept of this exchange between people or entities in two different countries. People or entities trade because they believe that they benefit from the exchange. They may need or want the goods or services. While at the surface, this many sound very simple, there is a great deal of theory, policy, and business strategy that constitutes  WHY DO COUNTRIES NEED TO TRADE? Both countries benefit: A win-win situation Citizens of the countries benefit HOW? Exports: Bring in fuel (money) for the economy Imports: Put pressure on domestic producers COMPETITION PRICES QUALITY WHY DO WE NEED TO KNOW THE THEORIES? Governments designing policies for imports, exports, FDI For convincing politicians who are against free trade Companies for directing their efforts in production and sales MERCANTILISM - 16TH CENTURY PHILOSOPHY A country´s wealth is measured by its holdings of gold and silver Question: How do we increase a country´s holdings? Answer: By having more EXPORTS and less IMPORTS Question: How do we increase exports and reduce imports? Answer: By subsidizing exporting industries and taxing imports Question: But who pays for subsidies? Is the absence of competition good for the average citizen? Big Question: Is the Wealth of a Nation in what the MERCANTILISM - 16TH CENTURY PHILOSOPHY The mercantilist theory was one of the first theories to explain international trade. It argued that countries should export more than they import in order to accumulate wealth. This theory was based on the idea that gold and silver were the only true measures of a country's wealth. Mercantilists believed that countries should use trade to acquire these precious metals. Theory of Absolute Advantage Adam Smith was the first economist to investigate formally the rationale behind foreign trade. In his book, Wealth of Nations, Smith used the principle of absolute advantage as the justification for international trade. According to this principle, a country should export a commodity that can be used at a lower cost than other nations can. On the contrary, it should import commodity that can only be produced at a higher cost than other nations can. Theory of Absolute Advantage Example: Consider a situation in which two nations are each producing two products, the following table provides hypothetical production figures for the United States and Japan based on two products – the computer and automobile. The United States can produce 20 computers or 10 automobiles or some combination of both. In contrast, Japan is able to produce only half as many computers (Japan produces 10 for every 20 computers that United States produces). The disparity might be the result of better skills by American workers in making this product. Therefore, the United States has an absolute advantage in computers. But the situation is reversed for automobiles because the United States makes 10 cars for every 20 units manufactured in Japan. In this instance, Japan has an absolute advantage. Theory of Comparative Advantage The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas. In contrast, another country may not have any useful absolute advantages. To answer this challenge, David Ricardo, an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned that even if Country A had the absolute advantage in the production of both products, specialization and trade could still occur between two countries. Theory of Comparative Advantage The comparative advantage theory was also developed by Adam Smith. This theory argued that countries should specialize in the production of goods in which they have a comparative advantage. A comparative advantage exists when a country can produce a good at a lower opportunity cost than any other country. The opportunity cost of producing a good is the value of the next best alternative that could be produced with the same resources. Smith argued that trade would benefit all countries involved because each country would be able to produce more goods than it could produce on its own, even if they did not have an absolute Heckscher-Ohlin Theory (Factor Proportions Theory) In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a country could gain comparative advantage by producing products that utilized factors that were in abundance in the country. Their theory is based on a country’s production factors—land, labor, and capital, which provide the funds for investment in plants and equipment. Their theory, also called the factor proportions theory, stated that countries would produce and export goods that required resources or factors that were in great supply and, therefore, cheaper production factors. In contrast, countries would import goods that required resources that were in short supply, but higher demand. Implications of Classical Trade Theories The classical trade theories have had a significant impact on our understanding of international trade. They have helped us to understand the benefits of trade, the importance of specialization, and the role of comparative advantage. These theories have also been used to develop trade policies and to analyze the effects of trade on different countries. Criticisms for classical international trade theories 1. The theories assume that nations trade, when in reality trade between nations is initiated and conducted by individuals or individual firms within those nations. 2. Traditional theory also assumes perfect competition and perfect information among trading partners. 3. They are limited in looking at either the transfer of goods or of direct investments. No theories explain the comprehensive dynamic flow of trade in goods, services and financial flows. 4. They do not recognize the importance of technology and expertise in the areas of marketing and management. Lesson 2: Critical Evaluation of Classical International Trade Theories Introduction While the classical theories of international trade have provided a valuable foundation for understanding international economic relations, they are not without their limitations. This lesson will delve into some of the criticisms leveled against these theories.  1. Assumptions and Simplifications Full Employment: Classical theories assume full employment, a condition that may not always be met in reality. Unemployment can distort trade patterns and challenge the predictions of these theories. Perfect Competition: The assumption of perfect competition, where there are numerous small firms with no market power, may not accurately reflect the real world, especially in industries with significant economies of scale or barriers to entry. Fixed Factor Endowments: Classical theories often assume fixed factor endowments (labor, land, capital). However, factor endowments can change over time due to technological advancements, education, and investment.  2. Neglect of Other Factors Transportation Costs: Classical theories often neglect the role of transportation costs, which can significantly impact the profitability of international trade. Protectionism: The classical theories assume a world without protectionist measures such as tariffs and quotas. In reality, these policies can distort trade patterns and reduce the benefits of free trade. Economies of Scale: The classical theories do not fully account for economies of scale, which can give larger firms a competitive advantage and influence trade patterns. 3. The Stolper-Samuelson Theorem This theorem predicts that free trade will benefit the owners of abundant factors of production and harm the owners of scarce factors. While this may be true in the long run, in the short run, there can be adjustment costs and distributional effects. 4. The Leontief Paradox The Leontief Paradox, which found that the United States, a capital-abundant country, was exporting labor-intensive goods, challenged the predictions of the Heckscher-Ohlin theory. This paradox has led to further research and refinements of the theory. Lesson 3: Modern Theories of International Trade Introduction Modern theories of international trade have emerged in response to the limitations and criticisms of the classical theories. These theories seek to provide a more comprehensive and accurate understanding of international trade in today's globalized economy. The New Trade Theory The New Trade Theory emphasizes the role of economies of scale and product differentiation in international trade. This theory suggests that trade can be beneficial even when countries have similar factor endowments. Economies of scale allow firms to reduce their costs of production as they increase their output, leading to a concentration of production in certain industries within countries. Product differentiation allows firms to compete based on the unique features of their products, leading to a greater variety of goods and services available to consumers. The Specific Factors Model The Specific Factors Model focuses on the impact of international trade on specific factors of production. This theory suggests that trade can have different effects on different groups of workers depending on their skills and the industries in which they work. Workers in sectors that benefit from trade are likely to experience gains in wages and employment, while workers in sectors that are harmed by trade may experience losses. The Gravity Model The Gravity Model is a simple model that predicts the volume of trade between two countries based on their economic size and their geographical distance. This model has been found to be remarkably accurate in explaining the patterns of international trade. The Krugman Model The Krugman Model is a model of intra-industry trade, which is the trade of similar goods between countries. This model suggests that intra-industry trade can be beneficial because it allows firms to exploit economies of scale and product differentiation.  Human Capital Approach Theory This theory, which is also sometimes known as Skills Theory of International Trade, has been advocated by a number of economists, especially Becker, Kennen and Kessing. Whereas the Factor Proportions Theory considers labor as a homogenous factor, however, it is not so in the real world. In fact, for export of manufactured goods, the skill level of labor is very important determinant. Labor can be basically divided into skilled and unskilled labor.  Identical Preferences Theory This theory is based on the role of demand as an explanatory variable used by Linder. A domestic industry can flourish and reach commercially optimal level of production if the domestic demand is large enough. It is also found that countries at similar levels of economic development have similar demand characteristics. It is, therefore, postulated that trade opportunities are more among counties at similar stage of development with similar demand structure. Example: USA and Japan are highly industrialized; both have similar demand characteristics viz. computers, software, air- conditioners, internet, fashion garments etc. Strategic Trade Theory With the dramatic growth in trade in the last few decades, and the growth in the role of MNEs in international trade, there has been a resurgence of interest in taking a fresh look at theories of international trade. In the last two decades, a new set of models has come into being, using the perspectives of game theory and theories of industrial organization. While there is no one primary model, this broad collection of theories and ideas has come to be known as “strategic trade theories”. Modern Investment Theory Other theories explain investing overseas by firms, as a response to the availability of opportunities not shared by their competitors, that is, to take advantage of imperfections in markets and only enter foreign spheres of production when their comparative advantages outweigh the costs of going overseas. These advantages may be production, brand awareness, product identification, economies of scale, or access to favorable capital markets. These firms may make horizontal investments, producing the same goods abroad as they do at home, or they make vertical investments, in order to take advantage of sources of supplies or inputs. International Product Life Cycle Theory The international product life cycle theory has been found to hold primarily for such products as consumer durables, synthetic fabrics, and electronic equipment, that is, those products that have long lives in terms of the time span from innovation to eventual high consumer demand. The theory does not hold for products with a rapid time span of innovation, development, and undesirability. Lesson 4: Critical Evaluation of Modern International Trade Theories Introduction While the modern theories of international trade have provided valuable insights, they are not without their limitations. This lesson will explore some of the criticisms leveled against these theories. 1. Assumptions and Simplifications Perfect Competition: Many of these theories assume perfect competition, which may not accurately reflect the real world, especially in industries with significant economies of scale or barriers to entry. Homogenous Goods: Some theories assume that goods are homogenous, but in reality, products are often differentiated, which can influence trade patterns. Static Analysis: Many of these theories are static, meaning they do not consider the dynamic nature of the international economy, such as changes in technology, tastes, or government policies. 2. Neglect of Other Factors Environmental Impacts: Modern theories often neglect the environmental impacts of international trade, such as resource depletion and pollution. Labor Standards: The impact of international trade on labor standards, including wages and working conditions, is often overlooked. National Security: The role of international trade in ensuring national security, such as access to critical resources, is not always considered. 3. The Role of Government Modern theories often emphasize the role of markets in determining trade patterns. However, governments can play a significant role in shaping trade through policies such as tariffs, quotas, and subsidies. The impact of government policies on trade can be difficult to measure and may not be fully captured by these theories. 4. The Distribution of Gains from Trade While international trade can lead to overall economic gains, the distribution of these gains can be uneven. Some countries and industries may benefit more than others, leading to concerns about inequality. The impact of trade on income inequality is a complex issue that requires further research. Critical Evaluation of International Trade Theories A. The Validity B. Limitations The End…