International Trade Theories
After reading this chapter, you should be able to:
- Understand the meaning of international trade
- Analyse the classical trade theories
- Compare and contrast the theory of absolute advantage and comparative advantage
- Relate the importance of the product life cycle theory with trade and product development
- Review recent trends in world trade
THE LOGITECH MOUSE
Logitech International is the world’s largest manufacturer of computer mice. Established in 1981 in Switzerland, it has headquarters in California, manufacturing is done in Taiwan, production in China, with parts being supplied from Malaysia and Philippines. Logitech is best known for its innovative cost effective products—mice, keyboards and low cost video cameras.
Logitech is the quintessential global corporation which is known for constant innovation in the highly competitive business of personal computer peripherals. Logitech’s production process is cleanly divided according to regional comparative advantage. Although its basic R&D is concentrated in Switzerland and Fremont, the global corporation’s competitive advantage is derived from its ability to reap the benefits of globally dispersed production.
Logitech shifted its production to Taiwan in the late 1980s to take advantage of the expertise of a well developed supply base for parts, a qualified work force and a rapidly growing domestic computer industry. It got space to set up in Hsinchu’s industrial park at a modest price and won customers like Apple and IBM.
In the 1990s Logitech shifted production to China to take advantage of its low cost labour force. Logitech products are assembled in its Chinese factories although the parts are often sourced from other parts of the world. Take for instance the assembly of a mouse – the chips are manufactured at a plant in Malaysia and the optical sensors sourced from US manufacturer Agilent Technologies in Philippines.
The Logitech mouse then sells at a competitive price globally.
References: Logitech History, http://www.logitech.com/lang/pdf/logitech_history_200703.pdf, How Logitech Protects Its Manufacturing Secrets in China, http://www.bloomberg.com; last accessed on 2 September 2018.
International trade is the exchange of goods and services between countries. Trade is the business of buying and selling goods or services in order to make a profit. Trade can be conducted within a country, or internationally between nations. When a country is a seller of goods or services to another country or region, such a transaction is called export, and a transaction through which goods or services are being purchased into a country or region is called import.
In the global economy all kinds of commodities can be traded, from a small quantity of a precious metal such as gold to a supertanker full of oil. Commodities for trade fall into three main categories:
- Primary products are derived from natural resources, such as tin, wood, grain, and fish, obtained from mining, forestry, agriculture, and fishing.
- Secondary products are manufactured from primary products, and include cars, computers, ships, and clothes.
- Tertiary products refer to services provided by banks, insurance companies, law firms, and other professional organizations.
INTERNATIONAL TRADE THEORIES
The growth of international trade is explained by a number of theories which attempt to explain differences in trade structure between nations and regions.
The earliest explanation of international trade was known as the mercantilist doctrine. It emerged in England in the middle of the sixteenth century and explained international trade being based on two fundamental goals of foreign economic policy.
The mercantilist doctrine, explains trade between nations to be motivated by a nation’s desire to build its gold reserves.
- The primary goal of trade was to increase the wealth of the nation by acquiring gold to be used for military conquest.
- The second goal of international trade was to maximize exports and minimize imports to have a surplus in the balance of trade. Countries used various measures to act as barriers to trade to achieve this goal.
The main drawback of the theory of mercantilism was that it did not recognize anything except gold as the measure of a country’s wealth. It ignored factors such as the quantity of its capital, the skill of its workforce and the strength of other production inputs including land and natural resources.
The theory also considers international trade to be a zero sum game, according to which for one party to benefit from trade the other party has to be a loser.
The classical approach propounded that domestic production was the prime source of a nation’s wealth and productive efficiency was considered the motivating factor behind trade. The classical approach is known for two famous theories given by economists Adam Smith and David Ricardo respectively. They are the Theory of Absolute Advantage and the Theory of Comparative Advantage.
The classical approach considered domestic production as the prime source of a nation’s wealth and productive efficiency was considered the motivating factor behind trade.
Theory of Absolute Advantage
Adam Smith introduced the theory of absolute advantage, in 1776, in his famous book An Inquiry into the Nature and Causes of the Wealth of Nations. According to him, trade between nations was based on the concept of absolute advantage. A country has an absolute advantage in the production of a product when it is able to produce it more efficiently than any other country. According to this theory, a country should export those goods and services in which it has a production advantage and import those goods and services in which it has a production disadvantage.
The theory of absolute advantage considers trade between nations to be based on the concept of absolute advantage. A country has an absolute advantage in the production of a product when it is able to produce it more efficiently than any other country.
According to Smith, a country’s absolute advantage arises from two sources:
- Natural advantages: A country may have a natural advantage in producing a product because of climatic conditions, access to certain natural resources, or availability of cheap or skilled labour force. Thus, India’s climate and land type support the production of cotton, whereas the climate and land conditions in Brazil support the production of coffee. Producing cotton in Brazil and coffee in India may be possible at a very high cost of production. It will therefore make economic sense for India to produce cotton and import coffee and for Brazil to produce coffee and import cotton.
- Acquired advantages: Most of the world trade today is in manufactured goods and services rather than agricultural goods and natural resources. Countries that produce manufactured goods and services competitively have an acquired advantage, usually in either product or process technology. Product technology gives a country’s products an identity that helps them to face global competition by being easily distinguished from those of its competitors. For example, Indian exports of brass items are distinguished for their craftsmanship and quality all over the world. The international repute is based on the Indian expertise in the craftsmanship which has been polished to perfection over centuries.
According to this theory, a nation benefits from international trade as it saves costs in importing goods that it would otherwise have to produce in the domestic market. Unlike the mercantilist doctrine which says that a nation could only gain from trade if the trading partner lost (zero-sum game), the absolute advantage theory argues that both countries would gain from an efficient allocation of national resources.
Figure 4.1 provides a simple illustration of how a country gains from free trade. Let us assume that two countries Brazil and India have the same amount of resources and these can be used to produce either cotton or coffee. If 100 units of resources are available, we further assume that it takes Brazil four units of resources to produce one tonne of coffee and 10 units of cotton. Thus, Brazil could produce 25 tonnes of coffee and no cotton, or 10 tonnes of cotton and no coffee or some combination between these two.
Similarly, we assume that India uses 20 units of resources to produce one tonne of coffee and five units of resources to produce one tonne of cotton. India could, thus, produce five tonnes of coffee and no cotton or 20 tonnes of cotton and no coffee or some combination between these two.
This indicates that Brazil has an absolute advantage in producing coffee, whereas India has an absolute advantage in producing cotton. Therefore, Brazil should specialize in the production of coffee and India should specialize in the production of cotton. According to Adam Smith, in a situation such as this, both countries benefit from specialization and trade. World production would increase if both countries specialized in the production of the goods in which they have an absolute advantage and then traded to obtain the other goods in which they have an absolute disadvantage.
Figure 4.1 Production Possibilities with Absolute Advantage
What happens if the two countries do not trade with each other? Each country would then devote half the available resources for the production of coffee and half for the production of cotton. Brazil would then produce 12.5 tonnes of coffee and five tonnes of cotton and India would produce 10 tonnes of cotton and 2.5 tonnes of coffee as depicted in Table 4.1. Without trade, the combined production of both countries would be 15 tonnes of coffee (12.5 + 2.5) and 15 tonnes of cotton (5 + 10).
This can be explained with the help of Figure 4.1. Points A and B are measures of the output of Brazil and India when they do not trade with each other. If each country produced only that commodity in which it has an absolute advantage, Brazil would produce 25 tonnes of coffee and India would produce 20 tonnes of cotton as depicted in Table 4.2. Total global production as a result of trade would be 45 tonnes of output as against 30 tonnes of output in the absence of trade. We can, thus, see that there is a net benefit of 15 tonnes of output to the world economy as a result of trade.
A drawback of this theory is that it does not offer an explanation for a situation in which a nation may have an advantage in producing both commodities. The theory of comparative advantage offers an explanation for such a situation.
Theory of Comparative Advantage
The theory of comparative advantage, explains trade between nations in a situation where one country is more efficient in the production of both tradable commodities. It was given by David Ricardo, who stated that both countries would continue to gain from trade even if one is more efficient in the production of both goods. Ricardo explained his theory using the concept of comparative advantage.
Table 4.1 World Output with Trade
Table 4.2 World Output with Trade
The theory of comparative advantage explains trade between nation to be the outcome of possessing a relative advantage in the production of a commodity. A country has a comparative advantage in producing a product if the opportunity cost for producing it is lower at home than in a foreign country.
This is illustrated in Figure 4.2. Continuing with the example given in the preceding section, let us assume that India is more efficient in the production of both coffee and cotton. Brazil requires 10 units of resources to produce one tonne of coffee and 10 units to produce a tonne of cotton, whereas it takes India only five units of resources to produce a tonne of coffee and four units to produce a tonne of cotton. Assuming further that there is no trade between these countries, each will use half its resources for the production of coffee and half for the production of cotton. Thus, without trade, Brazil will produce five tonnes of coffee and five tonnes of cotton (Point A in Figure 4.2), while India will produce 10 tonnes of coffee and 12.5 tonnes of cotton (Point B in Figure 4.2) as depicted in Table 4.3. In the absence of trade, total world output will be 32.5 tonnes, out of which 10 tonnes is contributed by Brazil and 22.5 tonnes from India. The combined production of coffee will be 15 tonnes (5 + 10) and of cotton will be 17.5 tonnes (5 + 12.5).
Hence, India has an advantage in the production of both coffee and cotton and produces more of both commodities as compared to Brazil. However, it has a comparative advantage in the production of cotton, since it produces 2.5 times more cotton than Brazil, while it produces only twice as much coffee as Brazil.
Figure 4.2 Production Possibilities with Comparative Advantage
Table 4.3 India’s Comparative Advantage Without Trade
To understand the benefits from trade in such a situation, we use the concept of opportunity cost. The opportunity cost of producing a commodity X is the amount of other goods, which have to be given up in order to be able to produce one unit of X. A country has a comparative advantage in producing a product if the opportunity cost for producing it is lower at home than in a foreign country. Thus, the lower the opportunity cost, the higher is the comparative advantage. Table 4.4 shows the opportunity costs for producing coffee and cotton in Brazil and India, based on the information given in Figure 4.2.
Table 4.4 shows that Brazil has a lower opportunity cost in producing coffee, while India has a lower opportunity cost in producing cotton. Thus, Brazil has a comparative advantage in the production of coffee and India has a comparative advantage in the production of cotton. Therefore, as indicated by Table 4.5, if the two countries trade with each other, Brazil will export coffee and import cotton. India, on the other hand, will export cotton and import coffee. With trade, India produces 25 units of coffee and Brazil produces 10 units of cotton, with a total output of 35 units.
As long as the opportunity costs for the same commodities differ between countries, open trade will result in gains for each country through specialization in producing a commodity (or commodities) in which a country has comparative advantage viz-à-viz its trading partner(s).
Table 4.4 Opportunity Costs of Coffee and Cotton
Table 4.5 World Output with Trade Between India and Brazil
- The explanation is based only on labour as a factor of production. In the real world, all other factors of production are equally important.
- The theory assumes that a country has a fixed stock of resources.
- The theory does not consider differences in transportation cost.
- Classical economists also assumed that resources are mobile in the domestic market but they are immobile internationally. However, labour may be immobile within the domestic economy also especially if the job is highly technical. In the modern context, outsourcing has made labour mobile internationally, since the skill in an offshore employee is used across geographical boundaries.
The earliest explanations of international trade came from the mercantilist doctrine and the classical trade theory. These theories explain trade as a source of wealth generation for national economies.
Factor Proportions Theory
The factor proportions theory also called the Heckscher–Ohlin (H–O) theorem was developed by Swedish economists, Eli Heckscher in 1919 and Bertil Ohlin in 1933. It explains international trade in terms of national factor endowments and the comparative advantage of nations. The theory explains that a country’s exports are based on the differences in the endowment of labour and capital. According to the theory, the cost of production of a country depends upon its factor endowments of labour and capital, in other words, the total cost of production depends on whether an economy is labour-intensive or capital-intensive. This in turn explains its basic trade pattern and behaviour.
The Heckscher–Ohlin (H–O) theorem or factor proportions theory explains international trade as a link between national factor endowments and the comparative advantage of nations.
The basic assumptions of this theory are:
- Countries have different availability of factors of production, that is, they are differently endowed in terms of labour and capital. This makes them either capital-intensive or labour-intensive in terms of production.
- The production function is an input–output function showing the relationship between output and its inputs in terms of capital and labour. Each commodity has its own specific production function but the production function is identical everywhere in the world. This essentially implies that the same quality of labour and capital input will produce the same output of a given commodity everywhere in the world.
- It also assumes that technology is constant across the world. Therefore, technological differences have no role to play in a country’s trade.
- Another assumption of the theory is that demand for factors of production is identical across the world; therefore, the cost of production is determined by its supply. It is the differences in the relative supply of a factor of production that lead to a difference in its price. Thus, the cost of production of a commodity is determined by whether production in the economy is labour-intensive or capital-intensive.
According to the factor proportions theory, the comparative advantage of nations is a result of differences in its basic economic structure. A country’s efficiency in production depends on its cost of production, which in turn depends on the availability of its factors of production. A country has a lower cost of production through the use of its abundant factor as compared to its scarce factor of production. This implies that if an economy has more labour in comparison to land and capital, its production costs would be lower if it uses labour-intensive technology as compared to the use of capital-intensive methods of production.
These relative-factor costs would lead countries to choose the production and export of those products which use its abundant, and, therefore, cheaper factors of production and import those products which it can domestically produce at a higher cost. Thus, the comparative advantage of a country arises out of differences in the structure of its economy.
For example, the US has abundant capital in comparison to labour. Hence, it exports capital-intensive commodities such as motor vehicles, whose production requires a greater use of capital than other products, and imports labour-intensive commodities, such as clothing.
The implications of the H–O theorem for world trade are as follows:
- Trade as well as trade gains should be greatest between countries with the greatest differences in economic structure.
- Trade would result in countries specializing, producing and exporting goods that are based on their economic structure and distinctly different from their imports.
- Trade policy should take the form of trade restrictions rather than trade stimulation.
- Countries should export goods that make intensive use of their relatively abundant factors.
The Leontief paradox, developed by Wassily Leontief in 1953, is a contradiction of the H–O theorem. According to the H–O theorem, a country exports those goods which make intensive use of its abundant factor and imports those goods which make intensive use of its scarce factor. As per the H–O theorem, the US trade structure should have capital-intensive exports and labour-intensive imports. Leontief tested this using input-output tables covering 200 industries and 1,947 trade figures, and found that US exports were labour-intensive and its imports capital-intensive. Since this result contradicted the predictions of the H–O theorem, these findings came to be known as the Leontief paradox.
The Leontief paradox contradicted the findings of the H–O theorem by testing trade patterns of the US economy.
The Leontief study led to further empirical research, which has shown many paradoxical results, and it challenges to the general applicability of the factor-endowments theorem in other countries, such as Germany, India, Canada, and Japan.
Some of the issues raised by the Leontief paradox were:
- Demand bias for capital-intensive goods: The US domestic demand for capital-intensive goods is so strong that it reverses the US comparative cost advantage in the production and export of such goods.
- Existence of trade barriers: The US labour-intensive imports were reduced by trade barriers (for example, tariffs and quotas) imposed to protect and save American jobs.
- Importance of natural resources: Leontief considered only capital and labour inputs, leaving out natural resources inputs. Since natural resources and capital are often used together in production, a country that imports capital-intensive goods may be actually importing natural resource-intensive goods. For example, the US imports crude oil, which is capital-intensive.
- Factor-intensity reversals: A factor-intensity reversal occurs when the relative prices of labour and capital change over time, which changes the relative mix of capital and labour in the production process of a commodity from being capital-intensive to labour-intensive or vice versa.
Linder’s Income-preference Similarity Theory
Staffan B. Linder’s income-preference similarity theory is based on actual patterns of world trade which contradict the H–O theorem. It has been observed that since 1970, three-fourths of total world exports originate in the developed world with increasing trade volumes between countries of the developed world. This contradicts the H–O theorem, according to which trade should originate among nations which have different factor endowments. This means that trade should take place largely between developed countries producing manufactured goods and developing countries producing primary products (natural resource commodities such as oil and petroleum) using labour-intensive technology.
According to the Linder’s income-preference similarity theory, trade potential between nations depends on similarity of demand preferences for different goods.
According to Linder differences in factor endowments can explain trade in natural resource-intensive products, but not in manufactured goods. According to him, a country’s manufactured exports are mainly determined by internal demand. International trade in manufactured goods takes place largely among developed nations because there is a strong domestic demand for these goods and a country will only export those goods which it manufactures at home.
Linder also explained that trade intensity between nations can be explained by similarities in demand for manufactured goods between nations. The more similar the demand preference for manufactured goods in two countries, the more intensive is the potential trade between them. If two countries have the same or similar demand structures, then their consumers and investors will demand the same goods with similar degrees of quality and sophistication. This is known as preference similarity. This similarity boosts trade between the two industrialized countries.
The theory of factor proportions, the Leontif paradox and Linder’s income–preference similarity theory are explanations of international trade based on differences in endowments of two factors of production—labour and capital.
According to Linder, the most important determinant of demand was average per capita income. Countries with high per capita income will demand high-quality ‘luxury’ consumer goods (for example, motor vehicles) and sophisticated capital goods (for example, telecommunications equipment and machinery), while low per capita income countries will demand low quality, ‘necessity’ consumer goods (for example, bicycles) and less sophisticated capital goods (for example, food processing machinery).
As a result, a rich country that has a comparative advantage in the production of high-quality, advanced manufactured goods will find big export markets in other affluent countries, where people demand such products. Similarly, manufactured exports of the poorer countries will find their best markets in other poor countries with similar demand structures.
Linder also stated that the effect of per capita income levels on trade in manufactured goods is affected by entrepreneurial ignorance, cultural and political differences, transportation costs, and obstacles such as tariff barriers.
Product Life Cycle Theory
The product life cycle model, given by Raymond Vernon in the mid-1960s, focused on knowledge as an independent variable in the decision of a firm to trade or invest.
Using the same basic tools and assumptions as the factor proportions theory, Vernon added two technology-based assumptions to the existing theory:
- Technical innovations leading to new and profitable products require large quantities of capital and highly skilled labour. These factors of production are predominantly available in highly industrialized capital-intensive industries.
- The same technical innovations, both the product itself and more importantly the methods for its manufacture, go through three stages towards maturity as the product becomes increasingly commercialized.
The theory explains trade between nations for technology-intensive products using a four-stage model. It used the example of US exports of manufactured goods to explain the basic theory. The model assumed that there are two kinds of nations in a trading relationship—the innovator and the imitator.
The product life cycle model focuses on four stages in the life of a product to explain trade between nations.
The innovator nation develops its initial exports as a result of its product innovation ability. Over a period of time this ability to innovate gets reduced due to technological diffusion and lower costs of production abroad which enable an imitating nation to produce the same commodity at a lower cost but using similar technology.
The life cycle model includes the following four stages:
- Introduction: The domestic market (the US in this case) has an export monopoly in a new product.
- Growth: Foreign production of this product begins.
- Maturity: Foreign production of this product becomes competitive in export markets.
- Decline: The exporter (the US) now becomes an importer of this no longer new product.
The theory stated that a technology-intensive new product is first produced in the domestic market because of the benefits of being close to customers and suppliers. This gives the nation an advantage over other competitors, and gives it an export monopoly. As the product design and production gets standardized, producers in other countries also begin to manufacture the product and the initial export monopoly of the nation declines. This is followed by the displacement of the original exporter as imitators begin to take over. Finally, foreign producers achieve sufficient competitive strength arising out of economies of scale and lower labour costs to export to the former exporting market.
On the other hand, an imitating country starts to import the new product from the innovating country at different times. If this imitating country is a high-income, advanced country (for example, Germany), it begins to import around the same time that the innovator (US) begins exporting. If, however, it is a low-income, developing country (for example, Mexico), then imports will begin some time after the US begins its exports to the world economy.
Local production begins at a time when the local market grows to a sufficient size and cost conditions favour production against imports. If the imitating country is an advanced country, this coincides with the stage when US exports begin to show a decline, but if it is a developing country, this stage comes a bit later. Finally, when production begins to exceed consumption, the imitating country begins to export, and may export first to third countries and later to the innovating country.
Vernon’s theory also suggests that the product-cycle model of international trade is associated with the life cycle stage of the product itself. As the product moves through its life cycle, the life cycle of international trade also changes. The new-product stage in the product life cycle is associated with the first production of the product in the innovating country and the early portion of the export monopoly stage. During this stage, production functions are unstable and rapidly changing techniques are used in production. No economy of scale is reached. This phase is also characterized by a small number of firms and no close substitute products. The growth-product stage is associated with the later portion of the export monopoly and the start of foreign production. During this stage, mass-production methods are used to exploit expanding markets, and, therefore, high returns are achieved from economy of scale and market growth. Finally, the mature-product stage is associated with the third and fourth stages of the product-cycle model of international trade. This last stage is characterized by production of standardized products with stable techniques and intense price competition.
The product life cycle theory helps to explain changes in production and trade in new product lines. It is generally true that the US has been the principal innovator and production has spread rapidly to other countries that have been technically competent (for example, Germany) and to those which have had a comparative advantage in terms of cheap labour (for example, Mexico). It is also useful to remember that since the development of the model in the 1960s, the share of the US in global gross domestic product (GDP) declined substantially, with other countries, such as Germany and Japan emerging as strong innovators.
The product life cycle theory offers accurate explanations of several global products. A classic example of this is photocopiers, which were developed in the early 1960s by Xerox in the US and exported to other parts of the world, including Japan. It expanded through joint ventures to meet increasing demand and set up production facilities in countries like Japan and England. With the expiry of original patents, foreign competitors such as Canon in Japan and Oliveti in Italy entered the global market as low-cost competitors causing a decline in US exports. Production has subsequently shifted to other low-cost locations such as Thailand and Singapore, and the US, Japan and the United Kingdom are now importers of the product.
A basic drawback of the theory is its original ethnocentric orientation, and assumption of the US as the country of origin for most products. In subsequent years, products such as video game consoles have been developed in Japan, and wireless phones in Europe. Recent editions of laptops, digital cameras and compact disks have seen a simultaneous introduction in different parts of the world. As the global value chain gets more and more dispersed, the predictive power of Vernon’s theory keeps losing more value.
The New Trade Theory
The new trade theory refers to a series of papers by A. Dixit and V. Norman, K. Lancaster, Paul Krugman, E. Helpman, and W. Ethier, which propound the idea that trade between countries is based on increasing returns, product differentiation, and first mover advantage.
New trade theory explains trade between countries as based on increasing returns, product differentiation, and first mover advantage.
Economies of Scale
The theory argues that economies of scale lead to increasing returns leading to specialization in many industries. Economies of scale refer to a reduction in the manufacturing cost per unit as a result of increased production quantity during a given time period. This is the result of using larger and more efficient equipment, financial economies on the bulk purchase of goods, and the allocation of fixed costs such as administrative overheads and R&D over a larger output. Production costs also decline because of the learning curve, which refers to the improvement in productive efficiency arising out of increased production, leading to reduction in costs.
Paul Krugman combined the concepts of economies of scale with the use of differentiated products to explain the pattern of intra-industry trade. According to this explanation, economies of scale determine the geographical concentration of the production of goods. He also explained that the concept of product differentiation was associated with resource constraints and imperfect competition between firms. Product differentiation, in turn, creates a product identity that is responsible for brand loyalty and helps the firm attain a monopoly. Thus, firms in the same industry but from different countries produce differentiated products, which become the basis of intra-industry trade creating a larger market for goods and allowing better utilization of internal economies of scale. The theory is along the same lines as Linder’s income-preference similarity theory and finds empirical support in industries such as automobiles, speciality chemicals and wine, and explains the high proportion of intra-industry trade in overall international trade.
First Mover Advantage
This explanation of trade emphasizes the economic and strategic benefits to a firm from being an early entrant in the market. These benefits arise in the form of market share from reduced costs and improved technical expertise; benefits which are not available to the late entrant. The theory emphasizes that for products which have significant economies of scale and represent a substantial volume of world trade, the first movers in an industry get a low-cost advantage that later entrants are unable to match. Various studies have proved that first movers have become industry leaders.
Michael Porter of the Harvard Business School proposed the theory of national competitive advantage to explain what enabled a nation to compete in the international arena. Considered an extension of Adam Smith’s theory of absolute advantage, Porter explained national competitiveness in terms of having four attributes—factor endowments, demand conditions, related and supporting industries, and firm strategy, structure and rivalry. They are together known as ‘Porter’s Diamond’. He considered the emergence of countries such as Switzerland in precision instruments and pharmaceuticals, Japan in automobiles, and Germany and the US in chemicals to be the result of these attributes.
Michael Porter explained national competitiveness in terms of four attributes known as ‘Porter’s Diamond’.
The concept of factor endowments, introduced for the first time in the H–O Theorem refer to a nation’s factors of production such as skilled labour and capital. However, Porter proposed a hierarchy among them and distinguished between basic factors such as natural resources, climate, location and demographics, and advanced factors such as skilled labour, communication technology and research facilities.
According to him, advanced factors have a significant role to play in the national competitive advantage and are the result of the efforts of individuals, companies, and governments. The theory explains that basic factors provide a nation with an initial advantage, which is reinforced by the advanced factors. Lack of natural endowments makes nations invest in the creation of advanced factors in order to have the ability to compete globally. For instance, various Caribbean nations have upgraded their communication systems to attract banking and other services into the economy. Japan’s investment in the creation of engineers is likewise responsible for the success of its manufacturing sector.
Competitiveness is not only a function of the size of the demand but also its nature. For instance, if domestic demand is sophisticated, it forces the firm to produce high-quality products through innovative production practices. Japanese cameras are considered the best worldwide because of the demand for sophisticated products by the Japanese consumer. Similarly, Nokia’s global leadership in mobile telephony is the outcome of the domestic demand in Finland.
Related and Supporting Industries
Competitive advantage is strengthened through the presence of efficient backward and forward linkages. A firm’s suppliers and other related industries lead to spillover effects that translate into global competitiveness. For instance, Switzerland’s success in pharmaceuticals is linked to its prior knowledge and leadership in the technologically-related dye industry. Similarly, the leadership of the US in personal computers and other electronically advanced products is based on its technological leadership in the semi-conductor industry. The emergence of the software industry in the Indian context is the result of its English-speaking qualified labour force located in the golden triangle—the cities of Hyderabad, Chennai and Bangalore—developed with support from the large number of engineering colleges, government assistance in infrastructure, and other facilities creating networks of learning. According to Porter, the existence of related and supporting industries leads to their getting grouped into clusters of related industries. He identified the German textile and apparel cluster as an example where high-quality wool, cotton, synthetic fibres, sewing machine needles, and a wide variety of textile machinery are all grouped together. Such clusters are valuable sources of knowledge, which benefits everyone in the cluster through movements of employees between firms and for professional meetings and conferences.
Firm Strategy, Structure and Rivalry
This refers to the extent of domestic competition, barriers to entry, and the firm’s management style and organization. The existence of heavy competition in the domestic market forces a firm to develop its skills to be internationally competitive. Market structure also affects a firm’s competitive response. The oligopolistic automobile sector has seen intense competition among auto majors Toyota, Honda, Nissan and Mitsubishi to improve performance through better and superior products. Management styles and beliefs also play a role in building competitive advantage. Porter noted that the emphasis of German and Japanese firms on improving manufacturing processes and product design is the result of a predominance of engineers in their top management teams. In contrast to this, US firms are usually led by people from finance, and hence, they lack attention to manufacturing details.
The technological gap and the product life cycle theories explain trade in manufactured goods by a skilled labour force assisted by technological advancements.
According to Porter, the degree of a nation’s success is a function of the combined impact of all these factors. Along with these, the government has a role to play through policies on subsidies, education and capital markets, which have an impact on domestic demand and on supporting and related industries.
It is difficult to comment on the predictive capability of Porter’s theory since it has not been subjected to too much empirical testing. Just like other theories, it offers a partial explanation and complements them.
None of the theories discussed in this chapter individually explain the entire range of motives for international trade between nations, but collectively provide invaluable insights about international trade.
The comparative advantage theory, is a powerful explanation of international trade in natural resource products, such as bananas. The factor proportions theory given by the H–O theorem is the most acceptable explanation of the pattern of trade in labour-intensive products. Extending the factor proportions theory by including skilled labour and technologies, the H–O theorem explains current trade patterns between developed and developing countries. Trade between Europe and Southeast Asia is an example of this. Major exports from Europe are technology-intensive products, including power generation equipment, petroleum processing machinery, medical equipment, and transportation equipment, whereas exports from Southeast Asia are mostly labour or skilled labour-intensive products, such as garments, furniture, shoes, rubber products, arts and crafts, and standardized electric and electronics products.
Meanwhile, the technological gap (human skills and technology-based views) and the product life cycle theories emerge as powerful explanations of trade in ‘new’ products, that is, manufactures made by a skilled workforce using different technologies. These skills and technologies are the key factors responsible for improving a country’s terms of trade, which is the major concern of both developed and developing countries today. Terms of trade is the relative price of exports, that is, the unit price of exports divided by the unit price of imports, which improves if the country exports more goods that are associated with advanced human skills and technologies. Although the product life cycle model is less applicable today than when it was first propounded, it still explains key patterns in the evolution of international trade as every new product goes through a series of stages in the global marketplace.
The Leontief paradox and Linder’s income-preference similarity theory are perfect explanations for trade in sophisticated manufacturing products, and trade between regions with similar income levels and consumption preferences. These theories view market demand (income levels and demand structure) as important parameters of international trade. Indeed, international trade today is driven not only by national differences in factor endowments but also by national differences in market demand. Intra-regional trade still accounts for a high proportion of world trade because of similarities in income levels and demand structures, as well as efficiencies arising from reduced uncertainty and transaction costs. The limitation of these theories is that they did not explain how trade activities would take place between two nations sharing similar income levels but with different consumption preferences. Due to this weakness, they seem unable to explain the increasing trade between developed countries and newly industrialized nations (for example, Singapore, South Korea, Taiwan, and Hong Kong) or emerging markets (for example, China, Brazil, India, Russia, and Mexico). These countries are not in the same region, nor do they share similar consumption preferences with the Western world. Increasing incomes and elevated purchasing power seem to be the key driver of this trade phenomenon.
The basic contribution of the new trade theory is that it helps to understand intra-industry and intra-firm trade. The theory brings firms into the picture as the link between national factor endowments, firm behaviour, and firm incentives in explaining international trade. This link is important because firms rather than countries conduct international trade and investment. The efficiency of international trade is maximized if both differences in national factor endowments and the advantages of economies of scale of firms are combined and realized simultaneously. Since the TNC’s role in international trade and investment is highly visible, the new trade theory has attracted more attention in recent years. The limitation of this theory, however, is that it overlooks other incentives beyond increasing returns from economies of scale.
DEVELOPMENTS IN WORLD TRADE
International trade split into three broad groups in the first three decades after World War II. The first group consisted of the ‘old’ industrial countries which functioned as market oriented economies with increasingly liberalized trade regimes under the General Agreement on Tariffs and Trade (GATT).
The second group, comprising the Soviet Union, the rest of eastern Europe and China, consisted of centrally planned economies in which state-owned firms followed government policy in production and trading decisions. International trade played a relatively minor role in these economies, although some cooperation within the group was organized under the umbrella of the Council for Mutual Economic Assistance (CMEA). The CMEA was a 1949–1991 economic organization under the hegemony of Soviet Union comprising the countries of the Eastern Bloc along with a number of communist states elsewhere in the world.
The third group of developing countries comprised many nations that had recently gained their political independence between 1946 and 1962. Many of them opted for a mixed system in which the government played a strong interventionist role to encourage industrialization. This essentially led to a regime of import substituting policies that relied on high tariff and non-tariff barriers to protect domestic industries.
This tripartite system led to a rise in the share of industrial countries in world trade, while those of the centrally planned and developing economies decreased. The character of this tripartite trading system began to change with the emergence of the East Asian economies characterized by high per capita income growth with strong trade expansion in manufactured goods. This was simultaneously accompanied by policy re-orientation in Mexico and China in the early 1980s combined with the fall of the Berlin Wall and the dissolution of the Soviet Union a decade later.
World Trade Trends
- Global trade flows showed gradual growth up to the late 1990s. This was followed by a strong rise in the early 2000s and a sharp fall after the economic crisis in 2008.
- Trade experienced fairly strong growth from 1995 to 2001, followed by a boom from 2002 to 2008 along with rising commodity prices. The financial crisis of 2008 caused a steep fall in trade flows in 2009, followed by a strong recovery in 2010 and 2011.
- Trade flows from 1995 to 2001 saw strong growth despite various global crises. These included Mexico’s monetary crisis (1995–2001), the Asian financial crisis of 1997, and the bursting of the dotcom bubble in 2001. The last two had a negative impact on merchandise trade in 1998 and 2001.
- China’s accession to the WTO in December 2001 made a significant contribution to the growth in world trade from 2002 to 2008. Strong Chinese demand for natural resources contributed to rising prices for crude oil and other primary commodities between 2002 and 2008.
- Exports of goods showed renewed growth in 2010, with a growth rate of 14 per cent in volume. This recovery was offset by the Arab Spring episode—an increase in oil prices in 2010, as a result of political instability in oil-producing countries.
- The increased impact of debt crises and geo-political tensions in 2014, led to a slowdown in world trade over the last few years. In value terms, world merchandise trade grew at an average of about 1 per cent per annum from 2012 to 2014.1
- Global trade recorded its highest growth rate in six years in 2017, both in volume and value terms. Overall merchandise trade grew by 4.7 per cent. Merchandise exports recorded an increase of 11 per cent, valued at USD 17.73 trillion and exports in commercial services increased by 8 per cent to USD 5.2 trillion.2
- The revival of world trade in 2017 is attributed to several different factors – these include increased investment spending, which is highly correlated with trade, and higher commodity prices, which raise incomes in resource-based economies and encourage investment in the energy sector, e.g., shale oil in the US.3
Volume of Trade
International trade after World War II entered a long period of record expansion with world merchandise exports rising by more than 8 per cent per annum in real terms from 1950 to 1973. Trade growth slowed thereafter under the impact of two oil price shocks, a burst of inflation caused by monetary expansion, and inadequate macroeconomic adjustment policies. In the 1990s, trade expanded again more rapidly, partly driven by innovations in the information technology (IT) sector and partly by the emergence of the Southeast Asian economies. Despite the contraction of trade caused by the dotcom crisis (a crisis generated by IT companies due to the misplaced confidence regarding profits and the speculation resulting from it, which resulted in rapidly rising stock prices and the subsequent crash) in 2001, the average expansion of world merchandise exports continued to be high averaging 6 per cent from 2000 to 2007.
World merchandise exports were severely affected by the global financial crisis which started off in mid-2007. They grew by just 2 per cent in volume terms over the course of 20084 and contracted by 12.2 per cent in the following year,5 the steepest fall ever. The decline in trade volumes saw short-lived reversal in 2010 when exports surged by 14.5 per cent, enabling world trade to return to its pre-crisis level6 and before decelerating to a growth rate of 5 per cent and 2 per cent in 2011 and 2012, respectively.7,8
Between 1980 and 2011, the share of the developing world in exports increased from 34 per cent to 47 per cent and their share in world imports from 20 per cent to 42 per cent.9 Asia is playing an increasing role in world trade. The value of world merchandise exports rose from USD 2.03 trillion in 1980 to USD 18.40 trillion in 2012, which is equivalent to 7.1 per cent growth per year on average in current dollar terms. The increase in commercial services trade was even more, recording a growth of USD 367 billion in 1980 to USD 4.35 trillion in 2012, or 8 per cent per year. In terms of volume (i.e., accounting for changes in prices and exchange rates), world merchandise trade recorded a more than fourfold increase between 1980 and 2011,10 and increased by 2.1 per cent in 2013.
The value of merchandise trade and commercial services showed a modest growth from 2012 to 2014, but declined in 2015. A decline in world commodity prices had a significant impact on the value of global merchandise trade in 2015. It then showed a sharp increase in 2017, due to increase in merchandise trade by 4.7 per cent and an increase in commercial services by 8 per cent.11
World merchandise trade grew at 2.8 per cent in 2015 and is expected to be maintained at the same level in 2016. Asia made the highest contribution to growth in world trade, followed by Europe (59 per cent of global trade growth) and North America. It is expected that trade growth will increase to 3.6 per cent in 2017.
The share of developing economies’ exports in world trade increased from 26 per cent in 1995 to 44 per cent in 2014 while the share of developed economies’ exports decreased from 70 per cent to 52 per cent.
Developing country exports grew at 3.3 per cent in 2015, higher than the export growth of 2.6 per cent recorded in developed countries. Imports to the developed countries grew at 4.5 per cent while developing countries saw a stagnation in import growth at 0.2 per cent. South America recorded the weakest import growth of any region in 2015 as a severe recession in Brazil led to a decrease in demand.12
Composition of World Trade
There has been a long-term shift in the composition of world merchandise trade, with the share of manufactured goods rising dramatically, against a decline in agricultural products and non-fuel minerals. The prominent role played by the industrial economies in world merchandise exports up to the 1990s was closely linked to their very large share in exports of manufactured goods. Manufactures accounted for just 40 per cent of trade in 1900, but this rose to 70 per cent in 1990 and to 75 per cent in 2000 before falling back to 64 per cent in 2012. In contrast to manufactures, agricultural products saw their share in world trade fall steadily. The share of agricultural products (including processed food) declined from more than 40 per cent in 1950 to 12 per cent in 1990, and finally to 9.2 per cent in 2012. Fuels accounted for 18.8 per cent of world merchandise trade in 2012, registering a growth rate of 5 per cent from the previous year. Over the years, the domination of developed countries in world exports of manufactured goods has been greatly diluted, first in labour-intensive goods, such as textiles and clothing, and, subsequently, in electronic products and capital-intensive goods, such as automotive products.
The manufacturing sector continued to be the major contributor to world trade in 2017, with 70 per cent contribution to total exports coming from this sector. The industries making the largest contributions were—chemicals, office and telecom equipment and automotives. The Republic of Korea recorded the highest increase in exports of chemicals in the manufacturing sector. China was the top exporter of office and telecom equipment and the European Union had the top position for the export of automotives. India recorded the highest growth in the exports of iron and steel.
The increased trade growth in 2017, however, was mainly driven by an increase in exports of fuels and mining products, which increased from 13 per cent in 2015 to 15 per cent in 2017. The top six exporters of agricultural products in 2017 were the European Union, the US, Brazil, China, Canada and Indonesia. Indonesia recorded the largest increase in exports of agricultural products.
Direction of World Trade
The most dynamic traders of the global economy in the 1950–1973 period were the west European countries and Japan. Post–World War II reconstruction and the Korean War provided a major stimulus to Japanese and European exports in the early 1950s. European integration kept up the pace of intra-European trade. The US remained Japan’s largest export market throughout that period, but there was rapid movement of Japanese export to western Europe and to the Asian newly industrialized economies (NIEs).
The six NIEs followed an outward-oriented trade policy and succeeded in sharply increasing their merchandise exports from the early 1960s, leading to a growth in their share of world exports from 2.4 per cent to 9.7 per cent in two decades. Starting out as textile exporters, these economies later diversified into exports of consumer electronics and IT products. The dominant share of the US in world trade in the early 1950s went down in subsequent decades.
During the 1970s and 1980s, the share of regions in world merchandise exports varied, largely due to the fluctuations of commodity prices and exchange rates. The oil-exporting developing countries (especially those in the Middle East) increased their share between 1973 and 1983 but lost almost all their gains when oil prices fell later.
In the 1990s, Japan’s share in world exports started to shrink significantly owing to the competitive pressure exerted by the NIEs and China. The stimulus provided by the creation of the North American Free Trade Agreement (NAFTA) in 1994 was not sufficient to reverse the downward trend in the share of Canada and the US in global trade. Similarly, the European integration process which continued to deepen and expand to cover the central European countries and the Baltic States could not halt the relative decline of European exports.
The reduced share of the industrial countries can be attributed first to the rise of China, the recovery of the Commonwealth of Independent States (CIS) and in more recent years to the boom in commodity markets. Increased competition from China in the world trade of manufactured goods was concentrated initially on the textiles trade and other labour-intensive goods, such as footwear and toys, but expanded quickly into consumer electronics and IT goods. More recently, China’s biggest gains in market share were in iron and steel products. China more than tripled its share in world exports between 1990 and 2007. In 2013, China surpassed the US as the world trade leader with its combined exports and imports reaching USD 4.16 trillion, 10 per cent of world trade. This leaves no doubt that China, the world’s second-biggest economy, is now the world’s biggest trading nation on an annual basis.
Asia, Europe and North America have been the main contributors to merchandise trade between 2005 and 2015, and accounted for 88 per cent of the total in that period. The share of developing economies in merchandise exports increased from 33 per cent in 2005 to 42 per cent in 2015. Merchandise trade between developing economies has increased from 41 per cent to 52 per cent of their global trade in the last ten years. Developing economies had a 42 per cent share in world merchandise trade in 2015.
Merchandise exports grew by 3.5 per cent in developed economies and by 5.7 per cent in developing and emerging economies in 2017, an increase of 1.1 per cent and 2.3 per cent compared to 2016. Resource exporting regions such as Africa and the Middle East recorded stronger export growth than import growth, while industrialized regions such as North America, Europe and Asia had import growth that was as strong as or stronger than export growth.
Asia recorded the highest growth of 6.7 per cent for exports and an increase of 9.6 per cent in imports. They were followed by North America and South and Central America. Trade in Europe expanded at a moderate pace of 3.5 per cent for exports and 2.7 per cent for imports. Export in Africa, the Middle East and the Commonwealth of Independent States, grew at a steady rate of 2.3 per cent, driven by the stable demand for oil and other natural resources. China retained its position as the world’s largest exporter and the US as the world’s largest importer.
Trade in Services
Trade in services currently accounts for a significant proportion of global trade and has a rapidly growing share. Service trade encompasses the import and export of financial services, information services, the provision of education and training, travel and tourism, health care, consulting and advisory services, and so on. Due to their advantage in services, developed countries tend to push much more aggressively for a removal of barriers to trade in services.
Trade in commercial services has grown in line with trade in goods for the last 20 years. Although services trade grew faster than goods trade in the 1980s and 1990s, the rate of increase in services slowed in the 2000s to the point where its average rate fell below that of goods. Further more, services trade has been much less volatile than trade in goods since the global financial crisis of 2008–09. Commercial services accounted for roughly 19 per cent of total world trade in world goods and commercial services in 2012. Global exports of services increased by 5 per cent in 2014.
International trade in commercial services has been less volatile than merchandise trade in the last 20 years, clearly indicating that the service sector is less affected by global macroeconomic upheaval.
The computer and information services showed highest growth in the services sector between 1995–2014. The sector recorded average annual growth of 18 per cent. In 2014, world exports of computer and information services were estimated at USD 302 billion.13
Trade in transport services has been the backbone of growth in merchandise trade between 1995 to 2014. From the early 2000s, expanding merchandise trade and international air passenger traffic have been responsible for significant growth in the transport sector. The computer and information services showed highest growth in the services sector between 1995–2014, recording an average annual growth of 18 per cent.
Transport and finance were also the two sectors most affected by the global economic crisis. World transport exports fell by 22 per cent, reflecting a weakened demand for freight transport following the sharp decline of merchandise trade. Transport exports dropped by 28 per cent in Asia, 21 per cent in Europe and 18 per cent in North America.
The global transport sector showed signs of recovery in 2010, recording growth of 16 per cent. However, world exports did not exceed pre-crisis levels until 2013, when it touched a level of USD 906 billion.
World exports of transport services made a major recovery in 2017, boosted by an increase in merchandise trade flows. World exports reached USD 931.5 billion, which was an increase of 9 per cent over the previous year. Europe, which accounted for almost half of global transport exports in 2017, showed an increase in transport revenues of 11 per cent. The increase was seen across world regions with a growth of 12 per cent in the Commonwealth of Independent States. Transport services in the Middle East grew at around 12 per cent in 2017, due to its dynamic air transport sector.
The airline industry saw phenomenal growth as international air freight volumes expanded globally by 9.9 per cent. Africa recorded the best performance with a growth of 25 per cent, which is more than double the world average, boosted by an increase in direct routes between Asia and Africa in response to higher demand. Africa also posted a record growth in international tourism revenue.
Growth in other commercial services was led by Intellectual property (IP) services with the sector recording an increase of 8 per cent to USD 2,854.6 billion. Trade in IP-related services was mostly between developed countries.14
Digital trade is a new category of trade in electronic transactions. The use of new technologies has led to the emergence of electronic transactions in goods and services which have had a significant impact on domestic and international trade.
Global e-commerce transactions were valued at USD 27.7 trillion in 2016, as compared to USD 19.3 trillion in 2012. The largest segment in e-commerce is the Business-to-business (B2B) segment, which is six times larger than business-to-consumer (B2C) e-commerce. The B2B segment had 86.3 per cent of total global market share valued at USD 23.9 trillion in 2016. The B2C segment had a share of 13.7 per cent, valued at USD 3.8 trillion in 2016.15
Digital trade transactions are categorized into three groups: ‘digitally ordered’ trade, ‘platform-enabled’ trade and ‘digital delivery’ trade.
‘Digitally ordered’ trade is ‘the cross-border sale or purchase of goods and services, conducted over computer networks by methods specifically designed for purpose of receiving or placing orders’. Delivery of the product can be digital or physical and the transaction may be directly organized between a buyer and seller or through platform-enabled trade. E-commerce can be seen as commercial transactions that are digitally-ordered and either digitally or physically delivered.
‘Platform-enabled’ trade refers to trade facilitated by online platforms such as Amazon or Uber. It links buyers and sellers trading through an intermediary who may be either inside or outside the territory of both the purchaser and/or seller. These platforms may be classified as a wholesaler/ retailer or it could be classified in terms of the nature of business activity it is engaged in (hotel, food products, transportation).
‘Digital delivery’ trade refers to services provided through cross-border transmission, and are known as ICT-enabled services. These services are recognized as Mode 1 supply of services under GATS.
- International trade is the exchange of goods and services across borders. A number of theories help to explain why nations trade with each other. Some of these include the theory of comparative advantage, the theory of absolute advantage, the factor proportions theory, the Leontief paradox and the international product life cycle theory. All of them propound the case for free trade.
- The classical approach has two basic variants—the theory of absolute advantage and the theory of comparative advantage.
- The theory of absolute advantage suggests that individual countries should specialize in the exports of goods they are best suited to produce because of natural and acquired advantages.
- The theory of comparative advantage believes that a country’s comparative advantage is dependent on differences in comparative production cost, which further depends on the commodity’s production process, and on the prices of production factors linked to the availability of those factors.
- The factor proportions theory states that differences in a country’s factor endowments are the basis of trade. This proposition was disputed by the Leontief paradox in a study of trade in the US.
- The product life cycle theory links trade with developments in a product’s life span encompassing four stages, namely, introduction, maturity, growth, and decline.
- Contemporary thinking on trade emphasizes the role of economies of scale as the determinant of trade and strategic thinkers promote the judicious use of subsidies to enable firms to become first movers in emerging industries.
- Important aspects that have to be taken into account while reviewing trends in world trade are volume, composition, direction, and trade in services. Trade in services has emerged as an important aspect of international trade especially for countries of the developing world.
- International trade
- Absolute advantage
- Comparative advantage
- Production factor
- Factor endowment
- Factor proportions theory
- Product life cycle model
- Economies of scale
- Product differentiation
- National competitiveness
- Compare the theory of absolute advantage with the theory of comparative advantage, and comment on their relevance in the present era of modern trade.
- How does the factor proportions theory explains trade between nations? How does the Leontief paradox modify its explanation?
- Explain the importance of the product life cycle theory in explaining trade between nations.
- Analyse the product life cycle theory of international trade in detail. What criticisms are levelled against it? (10)
[B.Com (Hons.), 2010]
- What are the main differences between the factor proportions and product life cycle theories of international trade? (8)
[B.Com (Hons.), 2011]
- Explain Porter’s theory of national competitive advantage as a theory of international trade. (7)
[B.Com (Hons.), 2009, 2014]
- Discuss the salient features of world trade and discuss recent trends in world trade. (8)
[B.Com (Hons.), 2015]
- What is Free Trade? Give arguments in its favour. (7)
- Briefly describe the trends in India’s foreign trade. (8)
[B.Com (Hons.), 2016]
- Explain New Trade Theory of International Trade. What is the role of economies of scale and first mover advantage? (8)
[B.Com (Hons.), 2017]
- Analyse the trends in India’s foreign trade since 2000. (15)
[B.Com (Hons.), 2018]
- Do you agree that India’s trade trends have significantly changed in the 21st century? Briefly explain the changes. (8)
[B.Com (Hons.), 2017]
- Explain the Product Life Cycle theory of International Trade. (7)
[B.Com (Hons.), 2016, B.Com 2018]