DR.M.KARUNANITHI M.B.A., M.PHIL., S.E.T., PH.D., M.COM.
INTERNATIONAL BUSINESS
UNIT- II
Introduction of Trade theories— Mercantilism — Absolute Advantage — Comparative Advantage — Heckscher-
Ohlin Theory — The New Trade Theory — Porter's Diamond Competitive Advantage Theory.
Introduction of Trade theories:
From ages to civilizations; world history is essentially a story of wars and trade. Major
wars were primarily fought mainly for economic reasons rather than conflict of political; cultural
or social ideas. For examples; Britons set up their colonies world over for trade; U. S. invaded
Iraq and Libya mainly for economic reasons. Africa was colonized for trade and commerce so
was the story of Latin America. Historians, World over, generally believe that most of wars were
fought for trade-related reasons. Theories of international trade and its applications help us
understand the motives and reasons behind such wars explaining trade pattern and the benefits
that flow from trade. An understanding of international trade theory helps us as investors or
consumers, buyers or sellers, companies and governments to determine how to act for their own
benefit within the global trading system.
Theories of International Trade
International trade theories are the base for a person, firm, and nation to understand how
international trades or businesses are. They help to understand how the international market is,
what factors hinder companies from success, and how a company will make its share in the
international market.
Behavior and motivation of buyers are the significant factors to consider in domestic
business and knowledge of basic causes and nature of business is more emphasized in
international business or trade. For this, it is necessary to gain a clear knowledge of international
business or trade theories.
Mercantilism Theory
Mercantilism can be considered the oldest theory of international trade. Mercantilism
promoted international business or trades. It was systematically developed in the 15th century by
an Italian Economist, Antonio Serra, and lasted nearly 300 years. Mercantilism talks about a
nation should increase its exports and reduce imports as far as possible.
During the mercantilism period, gold, silver, and other precious metal were the only
means of exchange of trade between nations. A nation was considered strong which has enough
of these precious metals.
DR.M.KARUNANITHI M.B.A., M.PHIL., S.E.T., PH.D., M.COM.,
It assumed increasing exports would earn more silver and gold and a nation’s economy
will be stronger and importing means an outflow of precious metals means weakening the nation.
Thus, the main theme of the mercantilist theorists is to promote exports and reduce
imports by means of different restrictions such as barriers, quotas, etc. and it is a state-controlled
theory.
It aims to protect a nation’s wealth from the outflow to other nations by different
restricting means which is also called protectionism. It also assumes a zero-sum game which
means if two nations participate in international trade one should face a loss equal to benefit of
the next nation and vice versa.
Absolute Cost Advantage Theory
Adam Smith, the father of economics propounded the absolute cost advantage theory by
addressing the weakness of mercantilism theory. He introduced the concept of free trade policy
which was totally ignored by mercantilism.
Absolute cost advantage refers to the advantage a nation gets from producing products
more efficiently with the same input than other nations.
It suggests a nation should specialize its production in the product in which it gets
absolute cost advantage and ignore in which it gets absolute disadvantage. The specialized
products should be exported to another nation and products having the absolute disadvantage of
the home country should be imported from another nation, as such the international trade
occurred.
Smith also ignores the zero-sum game of mercantilism – rather he assumes a positive-
sum game which means if two countries participate in international both can be benefited. And,
here government plays the role of facilitator.
Comparative Cost Advantage Theory:
By criticizing Adam Smith’s absolute cost advantage theory David Ricardo introduced
the comparative cost advantage theory. He argued that absolute advantage is not necessary rather
a nation should focus on where it gets comparatively more advantage.
Ricardo suggests there can be no trade if two nations’ absolute cost advantage is equal. It
suggests a nation should specialize its production on the product in which it gets comparatively
more advantage or in case of disadvantage, should choose the product having fewer
disadvantages.
DR.M.KARUNANITHI M.B.A., M.PHIL., S.E.T., PH.D., M.COM.,
Ricardo suggests while producing the costs should be checked carefully and compared
and then the product asking comparatively less cost should be produced.
Other principles of comparative advantage are the same as the absolute advantage such as
free trade, a positive-sum game, no government intervention, etc.
Heckscher-Ohlin’s Factor Endowment Theory (H-O Model):
Eli Heckscher and Bertil Ohlin propounded the theory of factor endowment and further
explained Ricardo’s comparative cost advantage theory.
Here, factor endowment refers to the richness or easy availability of basic production
factors like land, labor, and capital to a nation. H-O model suggests that a nation should
specialize its production in products which it has an abundance of production factors.
This theory assumes factors relative to abundance are cheaper and factors relative to
scarcity are expensive to a nation.
According to this theory, if India, China, Nepal, etc. are rich in labor factors then they
should produce labor-intensive products. And, USA, Japan, etc. are rich in the capital they
should produce capital-intensive products. In this way, capital-rich countries should import
labor-intensive products, and labor-rich countries import capital-intensive products as such
international trade takes place.
While understanding the H-O model, it is necessary to understand the Leontief Paradox –
which means just the opposite of the principle of the H-O model i.e. capital-rich countries
exporting labor-intensive products and vice versa.
International Product Life Cycle (IPLC) Theory:
The IPLC theory is created by Reymond Vernon in 1966. He explained how a new
product of a nation gets domestic and international attention and starts exporting and at the end
of IPLCs the last stage how the domestic nation starts importing the same product.
Raymond explains when a country produces new products it begins to export to foreign
markets, as such, foreign nations find it cheaper to produce the same product in their home. And,
where originally the new product is originated, their people find it cheaper and beneficial to use
foreign same products over their domestic country.
DR.M.KARUNANITHI M.B.A., M.PHIL., S.E.T., PH.D., M.COM.,
And, originated country’s product sales decline, and the country is liable to import
products from foreign countries to satisfy its people’s needs.
Raymond mentioned four stages in which an international product walks,
Introduction Stage – The new or innovative product is introduced. Mainly labor-
intensive. Sales or export grows at the turtle’s speed.
Growth Stage – Exports increase. The competition takes place. Capital intensive means
are assumed.
Maturity Stage – Exports reach the top and remain constant. Intense competition.
Availability of substitute products. Exports start to decline.
Decline Stage – Exports of new products from the home country rapidly decline. The
nation has three options whether to exit the product, import, or enter into a totally new
market.
National Competitive Advantage Theory: Porter’s Diamond:
Michael Porter 1990, introduced the national competitive advantage theory which
explains why a nation succeeds in international competition.
He wanted to address what makes a firm achieve a competitive advantage in a nation or a
nation in a particular industry.
With research in 100 industries in 10 countries, he identified four factors that help a firm
to gain a national competitive advantage which he introduced as Porter’s Diamond. And, after
achieving it such factors also strengthen the exporting capacity of the firm.
The Porter’s Diamond is shortly mentioned below:
Demand Conditions – Stronger the demand of a domestic market the more high-quality
products would be produced and exporting may be attained.
Factor Endowments – A nation having better production factors would do better in the
international market.
Related and Supporting Industries – E.g. schools are the supporting institutions for
universities.
Firm Structure, Strategy, and Rivalry – The better the firm’s strategy and structure the
better the firm will win against rivalries.
DR.M.KARUNANITHI M.B.A., M.PHIL., S.E.T., PH.D., M.COM.,
New Trade Theory (NTT):
New trade theory (NTT) is developed by Paul Krugman in late 1970. In this theory,
Krugman introduces the concept of economies of scale and first-mover advantage which are the
essential factors for success in the international market.
Economies of scale refer to minimizing the per-unit cost and first-mover advantage
means realizing the benefits of new entry into the new market.
He explained, there is always not necessary to have factor endowments or structures to
have international trade it may occur without it but having economies of scale. When a nation
specializes in a particular product, gains economies of scale, become stronger in it, and start
exporting, international trade occurs.
