INTERNATIONALIZATION

1
TRADE THEORIES
2 INTERNATIONAL TRADE THEORIES

TWO GROUPS
Classical or country-based theories
Modern or firm-based theory
3 International Trade Theories

 Classical or country-based theories

The founders of the various theories of the classical country-based approach were mainly
concerned with the fact that the priority should be in increasing the wealth of one’s own
nation. They were mainly of the view that the focus should be on economic growth on a
priority basis.
 Mercantilism
 Absolute Advantage
 Comparative Advantage
 Heckscher-Ohlin theory (Factor Proportions theory)
4 Mercantilism

Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop
an economic theory. This theory stated that a country’s wealth was determined by the amount
of its gold and silver holdings. In it’s simplest sense, mercantilists believed that a country
should increase its holdings of gold and silver by promoting exports and discouraging imports.
In other words, if people in other countries buy more from you (exports) than they sell to you
(imports), then they have to pay you the difference in gold and silver. The objective of each
country was to have a trade surplus, or a situation where the value of exports are greater than
the value of imports, and to avoid a trade deficit.
5 Absolute Advantage

 Adam Smith(1776), An Inquiry into the Nature and Causes of the Wealth of Nations Recent
versions have been edited by scholars and economists. Smith offered a new trade theory called
absolute advantage, which focused on the ability of a country to produce a good more efficiently
than another nation.
 Smith reasoned that trade between countries shouldn’t be regulated or restricted by government
policy or intervention. He stated that trade should flow naturally according to market forces. In a
hypothetical two-country world, if Country A could produce a good cheaper or faster (or both)
than Country B, then Country A had the advantage and could focus on specializing on producing
that good. Similarly, if Country B was better at producing another good, it could focus on
specialization as well. By specialization, countries would generate efficiencies, because their
labor force would become more skilled by doing the same tasks. Production would also become
more efficient, because there would be an incentive to create faster and better production
methods to increase the specialization.
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 Smith’s theory reasoned that with increased efficiencies, people in both countries would
benefit and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t
be judged by how much gold and silver it had but rather by the living standards of its
people.
7 Comparative Advantage

 The challenge to the absolute advantage theory was that some countries may be better at
producing both goods and, therefore, have an advantage in many areas. In contrast, another
country may not have any useful absolute advantages. To answer this challenge, David
Ricardo (1817), an English economist, introduced the theory of comparative advantage.
Ricardo reasoned that even if Country A had the absolute advantage in the production of
both products, specialization and trade could still occur between two countries. 
Comparative advantage occurs when a country cannot produce a product more efficiently
than the other country; however, it can produce that product better and more efficiently
than it does other goods. The difference between these two theories is subtle. Comparative
advantage focuses on the relative productivity differences, whereas absolute advantage
looks at the absolute productivity.
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 Let’s look at a simplified hypothetical example to illustrate the subtle difference between these
principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal services. It
turns out that Miranda can also type faster than the administrative assistants in her office, who
are paid $40 per hour. Even though Miranda clearly has the absolute advantage in both skill sets,
should she do both jobs? No. For every hour Miranda decides to type instead of do legal work,
she would be giving up $460 in income. Her productivity and income will be highest if she
specializes in the higher-paid legal services and hires the most qualified administrative assistant,
who can type fast, although a little slower than Miranda. By having both Miranda and her
assistant concentrate on their respective tasks, their overall productivity as a team is higher. This
is comparative advantage. A person or a country will specialize in doing what they do relatively
better. In reality, the world economy is more complex and consists of more than two countries
and products. Barriers to trade may exist, and goods must be transported, stored, and distributed.
However, this simplistic example demonstrates the basis of the comparative advantage theory
9 Heckscher-Ohlin Theory (Factor Proportions
Theory):
 The theories of Smith and Ricardo didn’t help countries determine which products would give a
country an advantage. Both theories assumed that free and open markets would lead countries
and producers to determine which goods they could produce more efficiently. In the early
(1919), two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on
how a country could gain comparative advantage by producing products that utilized factors that
were in abundance in the country. Their theory is based on a country’s production factors—land,
labor, and capital, which provide the funds for investment in plants and equipment. They
determined that the cost of any factor or resource was a function of supply and demand. Factors
that were in great supply relative to demand would be cheaper; factors in great demand relative
to supply would be more expensive. Their theory, also called the factor proportions theory,
stated that countries would produce and export goods that required resources or factors that were
in great supply and, therefore, cheaper production factors. In contrast, countries would import
goods that required resources that were in short supply, but higher demand.
10 CLASSICAL THEORIES LIMITATIONS

 Simple world (two countries, two products)

 no transportation costs
 no price differences in resources
 resources immobile across countries
 constant returns to scale
 each country has a fixed stock of resources and no efficiency gains in resource use
from trade
 full employment
11 Modern or firm-based theory

 Country similarity theory

 Product life cycle theory
 Global strategic rivalry theory
 Porter’s national competitive advantage theory
12 Country Similarity Theory:

  Swedish economist Steffan Linder developed the country similarity theory in 1961, as
he tried to explain the concept of in train industry trade. Linder’s theory proposed that
consumers in countries that are in the same or similar stage of development would have
similar preferences. In this firm-based theory, Linder suggested that companies first
produce for domestic consumption. When they explore exporting, the companies often find
that markets that look similar to their domestic one, in terms of customer preferences, offer
the most potential for success. Linder’s country similarity theory then states that most trade
in manufactured goods will be between countries with similar per capita incomes, and in
train industry trade will be common. This theory is often most useful in understanding
trade in goods where brand names and product reputations are important factors in the
buyers’ decision-making and purchasing processes.
13 Product life cycle theory

 This theory was propounded by Raymond Vernon, a business professor at

Harvard Business School, in the 1960s. The theory that originated in the
field of marketing proposed that a product life cycle has three stages,
namely, new product, maturing product, and standardised product. The
theory has a presumption that the production of a new product will
completely arise in the country where it was invented. This theory, up to a
good extent, helps in explaining the sudden rise and dominance of the
United States in manufacturing. This theory also explained the stages of
computers, from being in the new product stage in the 1970s and thereby
entering into their maturing stage in the 1980s and 1990s. In today’s
scenario, computers are in a standardised stage and are mostly
manufactured in low-cost countries in Asia. However, this theory has not
been able to explain the current trading pattern where products are being
invented and manufactured in almost all parts of the world.
14 Global strategic rivalry theory

Paul Krugman and Kelvin Lancaster were the founders of this theory. This theory
emerged around the 1980s. The theory majorly focused on multinational companies and
their strategies and efforts to gain a comparative advantage over other similar global firms
in their industry. This theory acknowledges the fact that firms will face global competition
and prove their superiority. They must surely develop a competitive advantage over each
other. The ways through which the firms can gain competitive advantage were termed as
barriers to entry for that particular industry. These barriers are basically the obstacles that
a firm will face globally when they enter the market. The barriers that companies and
firms may try to optimise are:
1.Mainly research and development,
2.The ownership of intellectual property rights,
3.Economies of scale,
4.Unique business processes or methods,
5.Extensive experience in the industry, and
6.The control of resources or favorable access to raw materials.
15 (Diamond Model) Michel Porter’s national
competitive advantage theory
 The theory emerged in the 1990s with the aim of explaining the concept
of national competitive advantage. The theory proposes that a nation’s
competitiveness majorly depends upon the capability and capacity of
the industry to come up with innovations and upgrades. This theory
attempted to explain the reason behind the excessive competitiveness
of some nations as compared to others. The diamond model consists of
six factors: Factor conditions/ Demand conditions/ Related and
supporting industries/Firm strategy, structure and rivalry/ Government/
Chance
 These factors interact with each other to create conditions where
innovation and improved competitiveness occurs
 Porter’s Diamond
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17 NEW TRADE THEORIES SUCCESS

 Increasing returns of specialization due to economies of scale (unit costs of production

decrease)

 First mover advantages (economies of scale such that barrier to entry crated for
second or third company)

 Government intervention: strategic trade policy

18 INTERNATIONALIZATION THEORIES

ECLECTIC PARADIGM (JOHN H. DUNNING)

The eclectic paradigm is a theory in economics and is also known as the OLI-Model. It is a further
development of the theory of internalization and published by John H. Dunning in 1993. The theory
of internalization itself is based on the transaction cost theory. This theory says that transactions are
made within an institution if the transaction costs on the free market are higher than the internal
costs. This process is called internalization. For Dunning, not only the structure of organization is
important. He added three additional factors to the theory:
Ownership advantages(trademark, production technique, entrepreneurial skills, returns to scale)
Locational advantages (existence of raw materials, low wages, special taxes or tariffs)
Internalization advantages (advantages by producing through a partnership arrangement such as
licensing or a joint venture
19 Uppsala model

The Uppsala model is a theory that explains how firms gradually intensify their activities in
foreign markets. The key features of both models are the following: firms first gain experience
from the domestic market before they move to foreign markets; firms start their foreign
operations from culturally and/or geographically close countries and move gradually to
culturally and geographically more distant countries; firms start their foreign operations by
using traditional exports and gradually move to using more intensive and demanding operation
modes (sales subsidiaries etc.) both at the company and target country level.
The Uppsala model is based on four core concepts: market commitment, market knowledge,
current activities and commitment decisions. These four concepts are then divided into state
aspects and change aspects. The two state aspects are market commitment, which is the
resources committed to foreign markets, and market knowledge, which is the knowledge about
foreign markets and operations possessed by the firm at a given time. The two change aspects
are current activities and commitment decisions
20 Monopolistic advantage theory (Stephen
Hymer 1976)
 The monopolistic advantage theory is an approach in international business which explains
why firms can compete in foreign settings against indigenous competitors.
 He effectively differentiated Foreign Direct Investment and portfolio investments by
including the notion of control of foreign firms to FDI Theory, which implies control of the
operation; whilst portfolio foreign investment confers a share of ownership but not control.
 He also dismissed the assumption that FDIs are motivated by the search of low costs in
foreign countries, by emphasizing the fact that local firms are not able to compete
effectively against foreign firms, even though they have to face foreign barriers (cultural,
political, lingual etc.) to market entry.
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 He suggested that firms invest in foreign countries in order to maximize their specific firm
advantages in imperfect markets.
 Stephen Hymer also suggested a second determinant for firms engaging in foreign
operations, removal of conflicts.
 Through FDI, a multinational can share or take complete control of foreign production,
effectively removing conflict. This will lead to the increase of market power for the
specific firm, increasing imperfections in the market as a whole.
 A final determinant for multinationals making direct investments is the distribution of risk
through diversification. By choosing different markets and production locations, the risk
inherent to foreign operations are spread and reduced.
22 Technology gap theory of trade (Michael
Posner)

 The technology gap theory describes an advantage enjoyed by the country that introduces
new goods in a market.
 As a consequence of research activity and entrepreneurship, new goods are produced and
the innovating country enjoys a monopoly until the other countries learn to produce these
goods: in the meantime they have to import them.
 Thus, international trade is created for the time necessary to imitate the new goods