UMAIR FAROOQ MUGHAL

INTERNATIONAL TRADE THEORY

BY UMAIR FAROOQ MUGHALM-COM FROM PU

E-mail & Mobile no umair_farooq123@yahoo.com

+92 331 3366205

Working as a Teacher & Banker in MCB Bank. Currently Teach International business & finance, Interpersonal skill, I to B, MBF, Economics, Computer, EOP, BCRW, Audit and B-Law in The house of accounting and New Stars College.

‘’Tell me and I forget, Teach me and I may remember, involve me

and I learn’’

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Learning Objectives

After studying this Slide, you should be able to:What is International Trade TheoryInternational Trade Theory DefinitionsInternational Trade Theories [Why do Nations

Trade]MercantilismTheory of Absolute AdvantageTheory of Comparative AdvantageHeckscher-Ohlin TheoryThe Product Life Cycle Theory

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What is International Trade Theory

Introduction:International trade is the exchange of goods and

services between countries. International trade allows a country to specialize in the manufacture and export of products and services that it can produce efficiently and import products and services that can be produced more efficiently in other countries. International trade theories are simply different theories to explain international trade. Countries trade with each other when they do not have the resources, or capacity to satisfy their own needs and wants.This presentation explains number of trade theories which means why trade is beneficial for a country.

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What is International Trade Theory

Definitions:

‘’The exchange of capital, goods, and services across international borders is called international trade.’’

‘’The exchange of goods and services along international borders is called international trade.’’

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International Trade Theories (Why do Nations Trade?)

Mercantilism Theory of Absolute Advantage Theory of Comparative Advantage Heckscher-Ohlin Theory The Product Life Cycle Theory

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Mercantilism (mid-16th century)

Definition ‘’Mercantilism trade theory holding that nations should accumulate

financial wealth, usually in the form of gold (forget things like living standards or human development) by encouraging exports and discouraging imports.’’

‘’Government of a country increase their export as compare to import to maintain trade surplus is called Mercantilism trade theory.’’

Theory says you should have a trade surplus.› Maximize export through subsidies.› Minimize imports through tariffs and quotas.› Mercantilism views trade as a zero-sum game - one in which a

gain by one country results in a loss by another

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Theory of Absolute Advantage

Definition:

‘’Theory of Absolute Advantage contain that countries produce only those goods in which it is more efficient & trade those goods in which it is less efficient.’’

In 1776, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game and argued that countries differ in their ability to produce goods efficiently, and that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it.

According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries.

  In the theory of international trade, a country or firm has an absolute advantage if it can produce

a product (good or service) more efficiently (cheaply) than others.

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Theory of Absolute Advantage Example

An example:

Assume:

Assume that two countries, Japan & China, both have 200 labour hours units of resources that could either be used to produce LED & TAB

Lower labour-hours per unit of production mean lower production costs and higher productivity of labour.

Only these two countries in the world.

Only two products TAB & LED

Trade 6 by 6

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Theory of Absolute Advantage Example

Labour Hours Required to Produce 1 Unit of LED & TAB

  LED TAB

Japan 10 20

China 20 10

Explanation: Japan need 10 labour hours to produce 1 unit LED & 20

labour hours to produce 1 TAB.

China need 20 labour hours to produce 1 unit LED & 10 labour hours to produce 1 TAB.

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Theory of Absolute Advantage Example

Production & Consumption Without Trade  LED TAB

Japan 10 5

China 5 10

Total Production 15 15

Explanation: If Japan uses 100 labour hours to produce LED then he

produces 10 units of LED & he uses remaining 100 labour hours to produce TAB then he produces 5 units of TAB.

If China uses 100 labour hours to produce LED then he produces 5 units of LED & he uses remaining 100 labour hours to produce TAB then he produces 10 units of TAB.

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Theory of Absolute Advantage Example

Production with Specialization  LED TAB

Japan 20 0

China 0 20

Total Production 20 20

Explanation: According to specialization if Japan uses all resources for

production of LED he produces 20 units of LED & no TAB.

China with its specialization in TAB produces 20 units TAB by using 200 labour hours.

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Theory of Absolute Advantage Example

Consumption After Japan Trades 6 Units of LED for 6 Units of China TAB

  LED TABJapan 14 6

China 6 14

Explanation: This schedule shows that consumption after trade of 6

units of Japan LED in return of 6 units of China TAB.

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Theory of Absolute Advantage Example

Increase in Consumption as a Result of Specialization & Trade

  LED TABJapan 4 (14 -10) 1 (6 - 5)

China 1 (6 – 5) 4 (14 – 10) Explanation: This schedule shows that increase in consumption as a result

of specialization. Japan produces 20 units of LED with specialization & he need only 10 units after trade 6 Units of LED, 4 units remaining it is an Absolute Advantage.

This schedule shows that increase in consumption as a result of specialization. China produces 20 units of TAB with specialization & he needs only 10 units after trade 6 Units of TAB, 4 units remaining it is an Absolute Advantage.

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Theory of Absolute

Advantage Example

LED

5

10

15

20

TAB5 10 15 20

Y-axis

X-axis

J

J

C

C

A

B

PPF – Production possibility Frontier.

Explanation:

This diagram show that if Japan use all its labour hours to produce LED then he produce 20 units of LED & if he use all labour hours to produce TAB then he produce 10 TAB. 

If China uses all its labour hours to produce LED then he produces 10 units of LED & if he use all labour hours to produce TAB then he produce 20 TAB. The different combinations that Japan could produce are represented by the line JJ’. This is referred to as Japan Production Possibility Frontier (PPF).

I draw this curve on x-axis & y-axis. At 5 & 10 curve is join that is show the two countries production & consumption that is show from A & B. The different combinations that China could produce are represented by the line CC’. This is referred to as China Production Possibility Frontier (PPF). 

Clearly Japan has an absolute advantage in LED because he produces 20 LED by using 200 labour hours & China has an absolute advantage in TAB because he produce 20 TAB using 200 labour hours as compare to Japan.

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Theory of Comparative Advantage

Definition:

‘’A person or country who produce a good on lower opportunity or labour cost that is called comparative advantage’’

The theory of comparative advantage (1817) – David Ricardo asked what happens when one country has an absolute advantage in the production of all goods.

A trade theory which holds that nations should produce those goods for which they have the greatest relative advantage.

The theory of comparative advantage (1817) - countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries.

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Theory of Comparative Advantage Example

An example:

Assume:

Assume that two countries, Japan & China, both have 200 labour hours units of resources that could either be used to produce LED & TAB

Lower labour-hours per unit of production mean lower production costs and higher productivity of labour.

Only these two countries in the world.

Only two products TAB & LED

Trade 4 by 4

Japan have comparative advantage in both goods.

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Theory of Comparative Advantage Example

Labour Hours Required to Produce 1 Unit of LED & TAB

  LED TAB

Japan 10 15

China 40 20

Explanation: Japan need 10 labour hours to produce 1 unit LED & 15

labour hours to produce 1 TAB.

China need 40 labour hours to produce 1 unit LED & 20 labour hours to produce 1 TAB.

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Theory of Comparative Advantage Example

Production & Consumption Without Trade  LED TAB

Japan 10 6.67

China 2.5 5

Total Production 12.50 11.67

Explanation: If Japan uses 100 labour hours to produce LED then he

produces 10 units of LED & he uses remaining 100 labour hours to produce TAB then he produces 6.67 units of TAB.

If China uses 100 labour hours to produce LED then he produces 2.5 units of LED & he uses remaining 100 labour hours to produce TAB then he produces 5 units of TAB.

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Theory of Comparative Advantage Example

Production with Specialization  LED TAB

Japan 15 3.33

China 0 10

Total Production 15 13.33

Explanation: According to specialization if Japan uses 150 labour hours

to produce LED then he produces 15 units of LED & if he use remaining 50 labour hours to produce TAB then he produce 3.33 units of TAB.

China with its specialization in TAB produces 10 units TAB by using 200 labour hours. Because he need 20 labour hours to produce 1 unit of TAB.

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Theory of Comparative Advantage Example

Consumption After Japan Trades 4 Units of LED for 4 Units of China TAB

  LED TABJapan 11 7.33

China 4 6

Explanation: This schedule shows that consumption after trade of 4

units of Japan LED in return of 4 units of China TAB.

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Theory of Comparative Advantage Example

Increase in Consumption as a Result of Specialization & Trade

  LED TABJapan 1 (11 -10) 0.66 (7.33 – 6.67)

China 1.5 (4 – 2.5) 1 (5 – 4) Explanation:

This schedule shows that increase in consumption as a result of specialization or comparative advantage. Japan produces 15 units of LED & 3.33 units of TAB with specialization & he need only 10 units of LED after trade 4 Units of LED and 6.67 units of TAB after receiving 4 units of TAB, 1 units of LED and 0.66 (7.33 – 6.67) unit of TAB remaining it is an Comparative Advantage.

This schedule shows that increase in consumption as a result of specialization. China produces 10 units of TAB with specialization & he needs only 5 units after trade 4 Units of TAB, 1 unit remaining it is an Absolute Advantage.

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Theory of Comparative Advantage Example

LED

5

10

15

20

TAB5 10 15 2013.333.33 6.67

2.5

J

J

C

C

A

C

B

Y-axis

X-axis

PPF – Production possibility Frontier.

Explanation:

This diagram show that if Japan use all its labour hours to produce LED then he produce 20 units of LED & if he use all labour hours to produce TAB then he produce 13.33 TAB. The different combinations that Japan could produce are represented by the line JJ’. This is referred to as Japan Production Possibility Frontier (PPF).

If China uses all its labour hours to produce LED then he produces 5 units of LED & if he use all labour hours to produce TAB then he produce 10 TAB. The different combinations that China could produce are represented by the line CC’. This is referred to as China Production Possibility Frontier (PPF).

I draw this curve on x-axis & y-axis. At 2.5, 10 & 15 curve is join that is show the two countries production & consumption that is show from A, B & C.

Clearly Japan has a comparative advantage in LED & TAB because he produces 15 LED by using 150 labour hours & 3.33 TAB by using 50 labour hours. In both products Japan use minimum labour hours as compare to China.

China has an absolute advantage in TAB because he produce 10 TAB using 200 labour hours as compare to Japan.

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Heckscher-Ohlin Theory Eli Heckscher (1919) and Bertil Ohlin (1933) ‘’Comparative advantage arises from differences in national factor

endowments.’’

The extent (degree) to which a country is endowed with resources like land, labor, and capital

The more abundant (rich) a factor, the lower its cost Summarize the different theories explaining trade flows between nations.

Basic factors: › Natural resources› Climate› Geographic location› Demographics

While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success.

Advanced factors: › The result of investment by people, companies, and government are more likely to

lead to competitive advantage. If a country has no basic factors, it must invest in advanced factors.

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The Product Life-Cycle Theory

The Product Life Cycle-Theory is an economic theory that was developed by Raymond Vernon.

The product life cycle explain How trade patterns change overtime.

1960’s, Raymond Vernon attempts to explain global trade patterns. First, new products are introduced in the United States. Then, as demand grows in the U.S it also appears in other developed nations, to which the U.S. exports.

Then other developed nations begin to produce the product as well thus causing U.S. companies to set up production in those countries as well and limiting exports from the U.S. Then it all happens again, but this time production comes online in developed nations. Ultimately the U.S. becomes an importer of the product that was initially introduced within its borders.

Weakness – Not all new products are created in the United States. Many come from

other countries first such as video game consoles from Japan, New wireless phones from Europe, etc. Several new products are introduced in several developed countries simultaneously.

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The International Product Life Cycle

Introduction & Growth Stages.

MNC Manufactures product in Developed Countries; Export to Developing Countries SALE

S

Time

Early Maturity:

MNC Moves Production to Developing Country; Begins Importing to Home Country

Late Maturity:

Developing Country Competitor Exports Product To MNC Home Country; Competes with MNC Imports

Decline

Developing Country Markets Remain Viable Target Markets For MNC; MNC Home Country Market is Diminishing

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The Product Life-Cycle Theory

The theory suggests that early in a products life-cycle all the parts and labor associated with that Product come from the area which it was invented.

After the product becomes adopted and used in the world markets, production gradually moves away from the point of origin.

In some situations, the product becomes an item that is important by its original country of invention.

Product Life-Cycle

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Expo

rt

Export

Import

DOLLARS

U.SExport

Foreign Production

Foreign competition in export market

Import Competition in

U.S. market

TIME

Domestic sales

U.S Production

Stage 1: Introduction Stage 2: Growth Stage 3: Maturity Stage 4: Decline

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Stage 1: Introduction

New products are introduced to meet local (i.e., national) needs, and new products are first exported to similar countries, countries with similar needs, preferences, and incomes.

E.g. the IBM PCs were produced in the US and spread quickly throughout the industrialized countries.

Stage 2: Growth

Increase in sale of new product attracts competitors.

Increase of demand in advanced countries; exports increase

Further innovation in product, cost reduction, market process takes place

Shift manufacturing to foreign countries

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Stage 3: Maturity

World wide production Export decline.

Large scale of Production.

Low cost production shift manufacturing to developing countries.

Technology become standard.

Stage 4: Decline

Goods produce in developing countries and thus advanced countries shift their demand to further new products to developing country.

Original innovator become importer.