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Lecture 2

Theory of International Trade

Session Outline

• Definition • Why do Nations Trade?• Barriers to trade• Non-tariff barriers to trade• Other economic developments.

Definition

• International trade: the branch of economics concerned with the exchange of goods and services with foreign countries.

• Higher rate of profit (Absolute advantages, taxes, concessions and incentives

• Expansion of production capacities• Competition (pull and push effects)• Wider market• Political stability• Technology• High cost of transportation

Difference between Domestic and IB

Why do Nations Trade?• Mercantilism;• Theory of Absolute

Advantage;• Theory of Comparative

advantage;• Factor Endowment Theory;• International Product Cycle

Theory;• Other Considerations.

Mercantilism

• A trade theory which holds that a government can improve the well-being of the country by encouraging exports and stifling imports.

• Cf.) Neo mercantilism: without the reliance on precious metal (gold).

Theory of Absolute Advantage

• A trade theory which holds that by specializing in the production of goods, which they can produce more efficiently than any others, nations can increase their economic well-being.

• An example, Assume:– labour is the only cost of production;– lower labour-hours per unit of production means lower

production costs and higher productivity of labour.

• North has an absolute advantage in the production of cloth.

• South has an absolute advantage in the production of grain.

• It follows that:– If North produces cloth and South produces grain,

and an exchange ratio can be arranged, both the countries will benefit from trade.

Analysis

Theory of Comparative Advantage

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

• An example, Assume:– labour is the only cost of production;– lower labour-hours per unit of production

means lower production costs and higher productivity of labour.

• North has an absolute advantage in the production of both cloth and grain but the relative costs differ (i.e. gains from trade).

• North has comparative advantage in Cloth (South in grain) because it is relatively better at producing them.

• It follows that:– Under the circumstance presented in the above

example, both countries can benefit from trade.

Analysis

Factor Endowment Theory• Also known as the Heckscher-Ohlin theory• It extends the concept of comparative

advantage by bringing into consideration resources and their cost of factors of production

• Helps to explain why – nations with relatively large labour forces will

concentrate on producing labour-intensive goods,– whereas, countries with relatively more capital

than labour will specialize in capital-intensive goods.

Weaknesses of Factor Endowment Theory

• Some countries have minimum wage laws that result in high prices for relatively abundant labour

• The Leontief paradox: countries like the United States actually export relatively more labour-intensive goods and import capital-intensive goods

• No single theory can explain the role of economic factors in trade theory.

International Product Life Cycle Theory (IPLC)

• A theory of the stages of production for a product with new “know-how”:

• It is first produced by the parent firm, • Then by its foreign subsidiaries and • Finally anywhere in the world where costs

are the lowest; • It helps to explain why a product that begins

as a nation’s export often ends up as an import.

Other Considerations

• Government regulation

• Monetary currency valuation

• Consumer Tastes

Reasons for Barriers to Trade• Protect local jobs by shielding home-country business

from foreign competition.• Encourage local production to replace imports.• Protect infant industries that are just getting started.• Reduce reliance on foreign suppliers.• Encourage local and foreign direct investment.• Reduce balance of payments problems.• Promote export activity.• Prevent foreign firms from dumping, that is, selling

goods below cost in order to achieve market share.• Promote political objectives such as refusing to trade

with countries that practice apartheid or deny civil liberties to their citizens.

Commonly Used Barriers to Trade

• Price-based barriers – Tariffs: a tax on goods shipped internationally

• Quantity limits – Quotas: a quantity limit on imported goods– Embargos: a quota set to zero

• International price fixing – A cartel: a group of firms that collectively agree to fix

prices or quantities sold in an effort to control price• Non-tariff barriers• Financial limits

– Exchange controls: controls that restrict the flow of currency

• Foreign investment controls – Limits on FDI – Limits on transfer or remittance of funds

Types of Tariffs

• Import and export tariffs: a tax levied on imports or exports of a country.

• Transit tariff: a tax levied on goods passing through the country.

• Specific duty: a tariff based on the number of items being imported.

• Ad valorem duty: a tariff based on a percentage of the value of imported goods.

• Compound duty: a tariff consisting of both a specific and ad valorem duty.

Impacts of a tariff

Reasons for Tariffs

• To retaliate against dumping: the selling of goods at a price below cost or below that in the home country.

• To protect local industry.• To raise revenue. • To reduce foreign expenditures by citizens in

order to improve the country’s balance of payments.

Non-Tariff Barriers to Trade

• Quotas• “Buy national” restrictions• Customs valuation• Technical barriers• Antidumping legislation, subsidies and

countervailing duties• Agricultural product regulations and subsidies• Export restraints.

Common non-tariff barriers to trade

Other Economic Developments

• Countertrade: barter trade in which the exporting firm receives payments in products from the importing country.

• Trade in Services: as high-income countries move toward a service economy, trade in services has grown.

• Free Trade zones: a designated area where importers can defer payment of customs duty while further processing of products takes place (as a foreign trade zone).

Growing importance of IB• Current trends are towards increasing globalisation and

interdependence of firms, markets and countries• Intense competition at global level• Exchange rate developments- shift from –ve to +ve growth• Global capital flows to and from all regions• Differences in Price and Cost• Restructuring the economy to integrate with global economy• Increased importance of Corporate Social Responsibility• Liberal trade policies and procedures• Revolution in communication and transportation

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Seminar Question

• Domestic versus international trade• Discuss benefits and weaknesses of

the Theory of Comparative Advantage