Theories of International Trade and Investment, Notes, MBS 3rd Sem

Unit 2 - Theories of International Trade and   Investment

Ø They are the two sides of a same coin

Ø International trade and investment both are the essential parts of the modern economic system across the globe.

Ø  Transaction involving international trade and investment are probably the most dynamic and dominating components of international business activities and they have tremendous impact in overall socio- economic scenarios globally.

Ø  Both are closely related to each other since trade derives the forms of investment in market and sets a volume of capital injection to expand business activities through mobilization technology, innovative ideas and human resources.

Ø Velocity of international trade forces to make a big dose of capital investment between countries in the global market due to which countries in world economy are involving in trade to meet the growing demand of people and their preferences.

Ø   In fact, international trade between countries takes place because the people of different countries have different needs and preferences and the countries are endowed with different resources.

Ø Comparative advantages is the prime part of trade to be happened between countries in global market.

In the global trade, there are a variety of trade theories which describe the need of doing international trade. Trade theories initially provide the basic criteria and major doctrines related to trade to be conducted between the countries. Here are some doctrines regarding global trade which make trade possible among countries with their respective objectives.

International Trade theories by nature 

A)    Interventionist doctrine: It is also known as conventional doctrine. It has two trade philosophies

i)                   Mercantilism: It is the idea and policy which dominated the economic scene of England and parts of Europe between the close of the 16^th century and the middle of the 18^th century. Mercantilism emphasizes on three aspects: Trade, treasure and power. It is the doctrine which advocated the principle of balance of trade which requires the creation of surplus of exports over imports. Mercantilists favored to stimulate export and discourage imports. Commercial measures suggested by Mercantilists were: a) Restriction on import of manufactured goods b) Encouragement to the export of manufactured goods c) Restriction on industries which interfered with other industries.

ii)                 Laissez- faire Policy: It is the policy designed by classical economist Adam Smith known as father of economics. It is the doctrine which favors the minimum role of government in economic activities and trade. According to this policy, the government is the best which governs least.

B)    Theories related to free trade : Under it there are two theories of international trade namely

i)                   Absolute Advantage Theory: It was developed by Adam Smith a classical economist who focused on absolute difference in cost due to which trade between countries take place. The idea of this theory is that every country should specialize in the production of that commodity which it can produce more cheaply than others and exchange it for the commodities which cost less in another countries. This highlights division of labor at the international level requires the existence of absolute differences in costs.

With the help of table it can discuss.

Country	Goods-X	Goods-Y
A	10	5
B	5	10

The table reveals that country A can produce 10X or 5Y with one unit of labor and country B can produce 5X or 10Y with one unit of labor. In this case, country A has an absolute advantage in the production of X and country B has an absolute advantage in the production of Y.

 

ii)                 Comparative Cost Advantage or Difference in Cost Theory: This doctrine was developed by David Ricardo. According to him, it is not absolute but the comparative differences in cost that determines trade relations between two countries. Production costs differ in countries because of geographical deviation, division of labor and specialization in production. In this way, each country specializes in the production of that commodity in which its comparative cost of production is the least. With the help of following fig, we can discuss it.

Country	Wine	Cloth
England	120	100
Portugal	80	90

The table shows that the production of a unit of wine in England requires 120 men for a year, while a unit of cloth requires 100 men for the same period. On the other hand the production of the same quantities of wine and cloth in Portugal requires 80 and 90 men respectively. Thus England uses more labor than Portugal in producing both wine and cloth. In other words, the Portuguese labor is more efficient than the England labor in producing both goods. So Portugal possesses an absolute advantage in both wine and cloth but Portugal would benefit more by producing wine and exporting it to England because it possesses greater comparative advantage in it.

C)    Factor Endowment theory: This theory was developed by Eli Heckscher and Bertil Ohlin. The central idea of this theory is that the main cause of trade between regions is the difference in prices of commodities based on relative factor endowments and factor prices. Some countries have much capital and some countries have much labor. The theory now says that countries that are rich in capital will export capital- intensive goods and the countries that have much labor will export labor –intensive goods.

This theory is based on some assumptions

1.     It is a two –by –two-by two model.

2.     There is perfect competition in commodity and factor market

3.     There is full employment of resources

4.     There is no change in technology

5.     There is free trade between two countries.

D)   International product life cycle theory: Prof Raymond Vernon explained this theory in 1966. The theory is based on the experience of US economy. According this theory as the product reaches the stage of maturity and decline, production will shift to foreign locations especially to emerging economies where unskilled, inexpensive labor can be made efficient for standardized production process. In any given market, products pass through four distinct phases of life cycle in the international market. Introduction, the growth, the maturity and the declining and death. Hence a product reaching at maturity and decline phase in one country, market may be introduced afresh in another country markets.

E)     The theory of National competitive Advantage: Porter’s Diamond:  This theory highlights about how the countries in the global market are capable and efficient in a particular product in their domestic market. Porter tried to solve the puzzle   by identifying of national competitive advantage. As per this theory there are four attributes that always shape the environment in which local firms compete. These attributes known as Porter’s Diamond are

1.     Factor Endowment

2.     Demand condition

3.     Related and Supporting Industries

4.     Firm strategy, Structure and rivalry