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Theories of International Trade

Factors that drive trade and their consequences for MNEs

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Session 03

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The Ricardian Model

Specialisation on the basis of opportunity (comparative) cost advantage

If, in two countries, the ratio of exchange between two commodities isdifferent international trade will emerge

Portugal England

Opportunitycost of Wine

80/90=0.89 120/100=1.2

Opportunity

cost of Cloth

90/80=1.12 100/120=0.83

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Opportunity cost of wine in Portugal is less than that in England

Opportunity cost of cloth in England is less than that in Portugal

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The Heckscher-Ohlin-Samuelson Model

Countries will export those goods whoseproduction is relatively intensive in the factorswith which they are well endowed

A country has a comparative advantage in thegoods that make relatively intensive use of thecountrys relatively abundant factor

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Implications of the theoriesof Comparative Advantage

International trade will tend to equalise factor pricesacross countries that trade Factor price equalisationTheorem.

An increase in the endowment of one of the factors willreduce the production of goods that intensively use theother factor Rybczynski Theorem.

Free trade will increase the real income of the relativelyabundant factor and reduce that of the relatively scarcefactor Stolper-Samuelson Theorem.

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Alternative Theoriesof International Business

Scale Economies (Returns to scale)

Imperfect Competition

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Scale Economies

Internal to the firm External to the firm

National Concentration ofproduction in a large,

efficient plant

A large industrysupporting an

industrial labour forceand extensiveinfrastructure

International R&D by a multi-

national firm

Extensive division of

labour in an industrywith low barriers totrade andcommunication

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Scale Economies are a Basis for Trade

Increasing returns to scale provide a basis fortrade independent of comparative advantage

A firm possessing internal economies of scalepotentially monopolises an industry, creatingimperfect market, both domestically andinternationally.

If it produces more, lowering the cost per unit, itcan lower the market price and sell moreproducts, because it sets the market price

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The industry that possesses external economies mayproduce at lower costs than the same industry that issimilar in size in other countries.

A country can dominate world markets in a particularproduct, not because it has one massive firm producingenormous quantities, but because it has many small firmsthat interact to create a large, competitive, critical mass.

No one firm need be all that large, but all small firms intotal may create such competitive industry that firms inother countries cannot break into the industry on acompetitive basis.

When increasing returns to scale are international, tradebetween countries with similar patterns of resourceallocation will tend to be intra-industry, and tradebetween countries with different patterns of resourceallocation will tend to be inter-industry.

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Alternative Theoriesof International Business

(Cont)

Product differentiation

Externalities

Irreversible investmentsStrategic trade/Managed trade

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Free Trade Vs Protection

Free Trade

A system of commercial policy which draws no distinctionbetween domestic and foreign commodities and thus neitherimposes additional burden on the latter nor grants anyspecial favour to the former

Maximisation of output: P = Px/Py= MCx/MCy= MRT

Optimisation of consumption: P = Px/Py= MUx/MUy= MRS

Wordwide Pareto Optimality: MRS = MRT

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Forms of Protection

Tariff Barriers Ad valorem duty

Specific duty

Compound duty

Non-tariff Barriers (NTBs)

Quota, VERs

Export subsidy/tax

Import deposits/licensing

State trading monopolies

Exchange controls

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Impact of Protection onNational Welfare

Decline in the volume of trade

Protects domestic prices

Rise in domestic production Domestic consumption declines

Increase in govt. revenue

National welfare falls

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Why State Intervention?

Infant industry argument

Domestic distortions in commoditymarkets

Distortions in factor markets

Revenue

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Readings

Chapter 6, A K Sundaram and J S Black.

Exercise on comparative cost advantage.

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