IMS02

17/01/2016
International Marketing Strategy

Post Graduate Diploma in Management
Trade Theories and

Economic Development
Trade Institutions and
Trade Policy
These Lecture Slides summarize the key points covered in the

respective chapters in your recommended text; these slides do
NOT substitute, at all, the required reading of the assigned
chapter from the text. These slides also may contain additional
supplementary material extracted from other texts and sources
outside your text book.
Lecturer: Adrian Mifsud
MBA (IUKB), BM Dip, MIM
Trade Theories and Economic

Development
17/01/2016
Chapter Outline
Basis for International Trade
- Production Possibility Curve
- Principle of Absolute Advantage
- Principle of Comparative/Relative Advantage
Exchange Ratios, Trade, and Gain
Factor Endowment Theory
Chapter Outline
The Competitive Advantage of Nations
A Critical Evaluation of Trade Theories
- The Validity of Trade Theories
- Limitations and Suggested Refinements
Economic Cooperation
- Levels of Economic Integration
Economic and Marketing Implications
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Whenever a buyer and a seller come together, each

expects to gain something from the other.
The same expectation applies to nations that trade
with each other.
It is virtually impossible for a country to be
completely self-sufficient without incurring undue
costs.
Therefore, trade becomes a necessary activity,
though, in some cases, trade does not always work
to the advantage of the nations involved.
Virtually all governments feel political pressure when

they experience trade deficits.
Too much emphasis is often placed on the negative
effects of trade, even though it is questionable
whether such perceived disadvantages are real or
imaginary.
The benefits of trade, in contrast, are not often
stressed, nor are they well communicated to workers
and consumers.
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One may ask whether trade is like a zero-sum game,

in the sense that one must lose so that another will
gain.
The answer is no,because,though one does not
mind gaining benefits at someone elses expense,
no one wants to engage in a transaction that
includes a high risk of loss.
For trade to take place, both nations must anticipate
gain from it.In other words, trade is a positive-sum
game. Trade is about mutual gain.

Production possibility curve
Without trade, a nation would have to produce all commodities

by itself in order to satisfy all its needs.
Figure 2.1 shows a hypothetical example of a country with a
decision concerning the production of two products: computers
and automobiles.
Figure 2.1Production possibility

curve: constant opportunity cost
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Production possibility curve
Because each country has a unique set of resources,

each country possesses its own unique production
possibility curve.
This curve, when analyzed, provides an explanation of
the logic behind international trade.
Regardless of whether the opportunity cost is constant or
variable, a country must determine the proper mix of any
two products and must decide whether it wants to
specialize in one of the two.
Specialization will likely occur if specialization allows the
country to improve its prosperity by trading with another
nation.
Principle of Absolute Advantage
Adam Smith may have been the first scholar to

investigate formally the rationale behind foreign
trade.
In his book Wealth of Nations, Smith used the
principle of absolute advantage as the justification
for international trade.
According to this principle, a country should export a
commodity that can be produced at a lower cost than
can other nations. Conversely, it should import a
commodity that can only be produced at a higher
cost than can other nations.
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Product
USA
Japan
Case 1
Computer
Automobile
20
10
10
20
Case 2
Computer
Automobile
20
30
10
20
Case 3
Computer
Automobile
20
40
10
20
Table 2.1Possible physical output
Table 2.1 provides hypothetical production figures for the USA and
Japan based on two products: the computer and the automobile.
Case 1 shows that, given certain resources and

labour, the USA can produce twenty computers or
ten automobiles or some combination of both.
Japan is able to produce only half as many
computers.
Therefore, the USA has an absolute advantage in
computers.
But the situation is reversed for automobiles, an..d
therefore Japan has an absolute advantage in
automobiles.
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Based on Table 2.1, it should be apparent

why trade should take place between the two
countries.
The USA has an absolute advantage for
computers but an absolute disadvantage for
automobiles.
For Japan, the absolute advantage exists for
automobiles and an absolute disadvantage
for computers.
If each country specializes in the product for

which it has an absolute advantage, each
can use its resources more effectively while
improving consumer welfare at the same
time.
Since the USA would use fewer resources in
making computers, it should produce this
product for its own consumption as well as
for export to Japan.
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Based on this same rationale, the USA

should import automobiles from Japan rather
than manufacture them itself.
For Japan, of course, automobiles would be
exported and computers imported.
This can also be applied for trades: as for a
doctor is absolutely better than a mechanic in
performing surgery, whereas the mechanic is
absolutely superior in repairing cars.
a country should export a commodity that

can be produced at a lower cost than can
other nations
or import a commodity that can only be

produced at a higher cost than can other
nations
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Principle of Comparative/Relative Advantage
One problem with the principle of absolute

advantage is that it fails to explain whether
trade will take place if one nation has
absolute advantage for all products under
consideration.
Case 2 of Table 2.1 shows this situation.

Product
USA
Japan
Case 1
Computer
Automobile
20
10
10
20
Case 2
Computer
Automobile
20
30
10
20
Case 3
Computer
Automobile
20
40
10
20
Table 2.1 provides hypothetical production figures for the USA and
Japan based on two products: the computer and the automobile.
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In Case 2, the USA has absolute advantage

for both products, resulting in absolute
disadvantage for Japan for both.
The efficiency of the USA enables it to
produce more of both products at lower cost.
At first glance, it may appear that the USA
has nothing to gain from trading with Japan.
British economist David Ricardo, perhaps the

first economist to fully appreciate relative
costs as a basis for trade, argues that
absolute production costs are irrelevant.
More meaningful are relative production
costs, which determine what trade should
take place and what items to export or
import.
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According to Ricardos principle of relative (or

comparative) advantage, one country may be
better than another country in producing
many products but should produce only what
it produces best.
Essentially, it should concentrate on either a
product with the greatest comparative
advantage or a product with the least
comparative disadvantage.
Conversely, it should import either a product

for which it has the greatest comparative
disadvantage or one for which it has the least
comparative advantage.
The advantage ratio for computers is 2:1
(i.e., 20:10) in favour of the USA.
Also in favour of the USA, but to a lesser
extent, is the ratio for automobiles, 1.5:1 (i.e.,
30:20).
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These two ratios indicate that the USA

possesses a 100% advantage over Japan for
computers but only a 50% advantage for
automobiles.
The USA has a greater relative advantage for
the computer product and should specialize
in producing the computer product.
For Japan, having the least comparative
disadvantage in automobiles,it should make
and export automobiles to the USA.
These two ratios indicate that the USA

possesses a 100% advantage over Japan for
computers but only a 50% advantage for
automobiles.
The USA has a greater relative advantage for
the computer product and should specialize
in producing the computer product.
For Japan, having the least comparative
disadvantage in automobiles,it should make
and export automobiles to the USA.
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It should be pointed out that comparative

advantage is not a static concept.
John Maynard Keynes, an influential English
economist, opposed Indias industrialization
efforts in 1911 based on his assumption of
Indias static comparative advantage in
agriculture!
Alexander Hamilton endorsed the doctrine of

dynamic comparative advantage as a basis of
international trade.
This doctrine explains why Taiwan and Indias
Bangalore have now become high technology
centres!
It also explains why or how the United Kingdom, lost
the lead to the USA in 1900 in the steel industry.
Andrew Carnegies mills among others were able to
produce twice as much steel as Great Britain three
decades later.
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Principle of Comparative/Relative
Advantage
- a country should export either a product with
the greatest comparative advantage (or with
the least comparative disadvantage)
- or import either a product for which it has the
greatest comparative disadvantage (or the
least comparative advantage)

Exchange Ratios, Trade and Gain
Although an analysis of relative advantage

can indicate what a country should export
and import, that analysis cannot explain
exactly how a country will gain from trading
with a partner.
In order to determine the extent of trading
gain, an examination of the domestic
exchange ratio is required.
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Theoretically, trade should equalize the

previously unequal domestic exchange ratios
and bring about a new ratio, known as the world
market exchange ratio, or terms of trade.
This ratio will lie between the limits established
by the pre-trade domestic exchange ratios.
Such benefits derived from trade do not imply
that trade must always take place and that all
nations will always gain from trade.

Product
USA
Japan
Case 1
Computer
Automobile
20
10
10
20
Case 2
Computer
Automobile
20
30
10
20
Case 3
Computer
Automobile
20
40
10
20
Case 3 of Table 2.1, the USA now makes forty automobiles

where the exchange ratio in both products is 2:1.
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Not only does the USA have absolute advantage for

both products, but it also has the same domestic
exchange ratio as that of Japan.
This situation is graphically expressed by two
parallel production possibility curves (Figure 2.2).
Figure 2.2Absolute advantage without

relative advantage (identical
domestic exchange ratios)

Under these circumstances, trade probably

will not occur for two principal reasons
USA is 100% better than Japan for each product,

the relative advantage for the USA is identical for
both products.
Since both countries have the identical domestic
exchange ratio, there is no incentive or gain from
trading for either party.
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Whether in the USA or in Japan, one unit of

computer will fetch two automobiles.
When such other costs as paperwork and
transportation are taken into account, it
becomes too expensive to export a product
from one country to another.
Thus international trade is a function of the
varying domestic exchange ratios, and these
ratios cause variations in comparative costs
or prices.
The principles of absolute and relative

advantage provide a primary basis for trade
to occur.
One basic assumption is that the advantage,
whether absolute or relative, is determined
solely by labour in terms of time and cost.
Labour then determines comparative
production costs and subsequent product
prices for the same commodity.
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It is misleading to analyse labour costs

without also considering the quality of that
labour.
A country may have high labour cost on an
absolute basis; yet this cost can be relatively
low if productivity is high.
Any subsequent productivity gains usually
result in higher wages and currency
appreciation.
Since product price is not determined by

labour efficiency alone, other factors of
production must be taken into consideration,
including land and capital.
Together, all contribute significantly to the
creation of value within a particular product.
Different commodities require different factor
inputs and that no country is well endowed in
all production factors.
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Different commodities require different factor

inputs and that no country is well endowed in
all production factors.
The varying proportion of these factors
embodied in various goods has a great deal
of impact on what a country should produce.
Corn needs land, Oil exploraton needs capital and clothing

needs a labour-intensive market.
The HeckscherOhlin theory of factor

endowment holds that the inequality of
relative prices is a function of regional factor
endowments and that comparative
advantage is determined by the relative
abundance of such endowments.
According to Ohlin, there is a mutual

interdependence among production factors, factor
movements, income, prices, and trade a change
in one affects the rest.
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Since countries have different factor

endowments, a country would have a relative
advantage in a commodity that embodies in
some degree that countrys comparatively
abundant factors.
A country should thus export that commodity
which is relatively plentiful (i.e., in
comparison to other commodities) within the
relatively abundant factor (i.e., in comparison
to other countries).
This exported item may then be exchanged

for goods that would use large quantities of
the countrys scarce factors if domestically
produced.
A country that is relatively abundant in labour but

relatively scarce in capital is likely to have:
a comparative advantage in the production of labourintensive goods

deficiencies in the relatively less labour and land
because of expensive equipment and specialized
personnel.
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Factors of Production
labour
land
capital
others (technology, education, etc.)
inequality of relative prices is a function of regional
factor endowments
comparative advantage is determined by relative
abundance of such endowments
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Michael Porter
Michael Porters book, The Competitive

Advantage of Nations, has received a great
deal of interest all over the world.
Based on his analysis of over a hundred
case studies of industries in ten leading
developed nations, Porter has identified four
major determinants of international
competitiveness:
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Michael Porter
(1) factor conditions,

(2) demand conditions,
(3) related and supporting industries, and
(4) firm strategy, structure, and rivalry.
These four determinants interact and form

the diamond which provides the context in
which a nations firms are born and compete.
Michael Porter
A nation is competitive when it has

specialized assets and skills necessary for
competitive advantage in an industry.
Firms gain competitive advantage in
industries when their home base offers better
ongoing information into product and process
needs.
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Michael Porter
They gain competitive advantage when

owners, managers, and employees support
intense commitment and sustained
investment.
In the end, nations succeed in particular
industries because their dynamic home
environment stimulates firms to upgrade and
widen their advantages over time.
Michael Porter
Therefore, the effect of one determinant is

determined by the state of the others: the
advantages in one determinant can enhance
the advantages in others.
Porters theory also includes two additional
variables: chance and government.
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Michael Porter
Chance events are developments outside

the control of firms, and they include pure
inventions, breakthroughs in basic
technologies, wars, external political
developments, and major shifts in market
demand.
Government at all levels, on the other hand,
can improve or detract from a countrys
national advantage.
Michael Porter
Regulations and investment policies can

affect domestic rivalry and home demand
conditions.
The diamond promotes the clustering of
a nations competitive industries.
The countrys successful industries are
usually linked through vertical
(buyer/supplier) or horizontal (common
customers, technology) relationships.
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Michael Porter
Porter does offer a number of explanations or

qualifications.
A countrys national competitive advantage in
a particular industry may be eroded when
conditions in the national diamond no longer
support investment and innovation to match
the industrys evolving structure.
Some important reasons for the loss of
advantage are:
Michael Porter
deterioration of factor conditions,

local needs not compatible with global
demand,
loss of home buyers sophistication,
technological change,
firms adjustment inflexibility, and
reduction in domestic rivalry.
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Michael Porter
Yet by advocating clustering, the theory also

looks static in the sense that it implies that
newcomers (nations) will have difficulties in
gaining competitive advantage in a new area.
Figure 2.4 shows the world competitiveness
scoreboard for nations for 2007 and 2015.
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Michael Porter
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Michael Porter
Determinants of International
Competitiveness
- factor conditions
- demand conditions
- related and supporting industries
- firm strategy, structure, and rivalry
- chance
- government
A Critical Evaluation of Trade

Theories - Validity of Trade Theories
Several studies have investigated the validity

of the classical trade theories.
The evidence collected by MacDougall
shortly after World War II showed that
comparative cost was useful in explaining
trade patterns.
Other studies using different data and time
periods have yielded results similar to
MacDougalls.
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The studies conducted by Leontief revealed

that the USA actually exports labourintensive goods and imports capital-intensive
products.
These paradoxical findings are now called
the Leontief Paradox.
Thus, the findings are ambiguous, indicating
that, in its simplest form, the Heckscher
Ohlin theory is not supported by the
evidence.

In theory, the more different two countries are

different, the more they stand to gain by
trading with each other.
There is no reason why a country should
want to trade with another that is a mirror
image of itself.
However, a look at world trade casts some
doubt on the validity of classical trade
theories.
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Developed countries trade more among

themselves than with developing countries.
There is a tendency for corporations in
developed countries to prefer to form directinvestment ties in the other more stable,
developed countries while avoiding heavy
investment in the fast-growing developing
world.

The trade pattern shown is surprising

theoretically, because advanced economies
have similar climate and factor proportions
and thus should not trade with one another
since there are no comparative advantages.
Apparently, other variables in addition to
factor endowment play a significant role in
determining trade volume and practices
because considerable trade does occur
between developed nations.
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Theories - Limitations and suggested refinements
Trade theories provide logical explanations about

why nations trade with one another, but limited by
their underlying assumptions.
Most of the worlds trade rules are based on a
traditional model that assumes that
(1) trade is bilateral,

(2) trade involves products originating primarily in the
exporting country,
(3) the exporting country has a comparative advantage, and
(4) competition focuses primarily on the importing countrys
market.

However, todays realities are quite different.
Trade is a multilateral process.

Trade is often based on products assembled from
components that are produced in various
countries.
It is not easy to determine a countrys
comparative advantage.
Competition usually extends beyond the importing
country to include the exporting country and third
countries.
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One limitation of classical trade theories is

that the factors of production are assumed to
remain constant for each country because of
the assumed immobility of such resources
between countries.
On the other hand, outsourcing and foreign
direct investment are a means to gain or use
foreign land.

Cosideirng the level of quality of the

production factors, each factor should not be
assumed to be homogeneous worldwide.
Some countries have relatively better-trained
personnel, better equipment, better-quality
land, and better climate.
Although a country should normally export
products, a country can substitute one
production factor for another to a certain
extent.
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The discussion so far has dealt with an

emphasis of trade theories on the supply
side, but demand is just as critical, and
demand reversal (when it occurs) may serve
to explain why the empirical evidence is
mixed.
Tastes should not be assumed to be the
same among various countries.

In some market situations, it is possible for

product quality to be too high.
Companies in developed countries, for
example, sometimes manufacture products
with too many refinements, which make the
products too costly for consumers elsewhere.
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The most serious shortcoming of classical trade

theories is that they ignore the marketing aspect of
trade.
These theories are concerned primarily with
commodities rather than with manufactured goods or
value-added products.
It is assumed that all suppliers have identical
products with similar physical attributes and quality.
This habit of assuming product homogeneity is not
likely to occur among those familiar with marketing.

A further shortcoming of classical trade

theories is that the trade patterns as
described in the theories are in reality
frequently affected by trade restrictions.
A country can create a relative advantage by
relying on outsourcing and other trade
barriers, such as tariffs and quotas.
Protectionism can thus alter the trade
patterns as described by trade theories.
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The new trade theory states that trade is

based on increasing returns to scale,
historical accidents, and government
policies.
Japans targeted industry strategy, for
example, does not adhere to free-market
principles.
Therefore, a moderate degree of protection
may promote domestic output and welfare.
Validity of Trade Theories
Leontief Paradox
Tendency for countries with similar endowments

to trade among themselves
Offshoring
Factor Mobility and Substitution
Demand
Marketing
Trade Barriers
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Levels of Economic Cooperation
Given inherent constraints in any system,

conditions for the best policy rarely exist.
A policy maker must then turn to the secondbest policy.
This practice applies to international trade as
well. Worldwide free trade is ideal, but cannot
be attained.
The theory of second best suggests that

the optimum policy is to have economic
cooperation on a smaller scale.
In an attempt to reduce trade barriers and
improve trade,many countries within the
same geographic area often join together to
establish various forms of economic
cooperation.
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Free Trade Area

Customs Union
Common Market
Economic and Political Union
Political Union
Free Trade Area
- elimination of internal duties
Customs Union
- free trade area + establishment of common
barriers
Common Market
- customs union + removal of restrictions on
movement of production factors
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Economic and Monetary Union

common market
+ harmonization of national economic
policies
+ one money
Political Union
harmonization of national political policies
Trade Institutions and

Trade Policy
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Transnational Institutions Affecting

World Trade
ITO (International Trade Organization): Proposed at Bretton
Woods Conference (1944) but was never ratified by the US
Congress.
GATT (General Agreement on Tariffs and Trade): A set of rules for
non discrimination, transparent procedures and settlement
of disputes in international trade. Agreed upon in Geneva
and adopted by 23 countries in1947.
Purpose: provide an international forum to encourage free
trade among member states
Means: 1. regulation and reduction of tariffs on traded
goods, 2. provision of a common mechanism for resolving
trade disputes
Name changed to World Trade Organization (WTO) on
January 1, 1995 (by Uruguay Round)
Transnational Institutions Affecting

World Trade
WTO is the new legal and institutional foundation for a
multilateral trading system. It currently it has 153
member countries.
Functions:
Administering WTO trade agreements
Forum for trade negotiations
Handling trade disputes (empowered with ability to
enforce rulings)
Monitoring national trade policies (countries found in
violation of WTO rules are expected to change policies
or else face sanctions)
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World Banking Group, 1944

Five major components:
- International Bank for Reconstruction and
Development (IBRD) - WB
- International Development Association (IDA) WB
- International Finance Corporation (IFC) - WBG
- Multilateral Investment Guarantee Agency
(MIGA) - WBG
- International Center for Settlement of Investment
Disputes (ICSID) - WPG
World Bank: Current areas of focus

-
Sustainable growth and development.
Clean technologies.
Addressing higher commodity prices.
Agricultural assistance for combating inflation in food.
Liberalization of world trade.
Greater participation of rising economic powers and
developing nations in the banks governance.
Reconstruction of war-torn countries.
Assists fledging economies to participate in modern
economic trade.
Resolving debt problems of developing nations.
Bringing market economy to former Eastern bloc nations.
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Trade Positions
International trade positions have changed

substantially when measured in terms of world
market share.
The U. S share of total world export has declined
precipitously since 1950s.
Another important development is the rise of China,
India and Brazils trade positions.
The impact of international trade and marketing on
individuals is highlighted when trade is scrutinized
from a per-capita perspective.
Trade Positions (contd.)
Factors behind the decline in U.S. international

competitiveness:
Attitude of the American policy makers.
Ignoring domestic firms in an attempt to
boost the development of foreign economies
Perception amongst US manufacturers about
international marketing being risky and
complicated.
Lack of global interest
Inadequacy of information.
Unfamiliarity with international market
conditions.
Complicated trade regulations.
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The Impact of Trade and

Investment
The effect of trade Importance of Exports:

Create a trade balance by reducing trade
deficits.
Affect the currency values and fiscal and
monetary policies of the government.
Shape public perception about
competitiveness.
Determine the affordable levels of imports for
a country.
Help achieve economies of scale.

Investment
The effect of trade Importance of imports:

Firms are exposed to new competition.
Gives rise to new marketing approaches,
better processes or better products and
services.
Competitive pressures keep quality high and
price low.
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Investment
The effect of international investment

Almost one in seven U.S. manufacturing
employees works for a foreign affiliate.
To some extent, foreign direct investments
substitute for trade activities.
Even though theory suggests open
investment policy, some uneasiness exists
about the rapid growth of such investment.

Investment
Restriction on investments may

Permit more domestic control over
industries.
Deny access to foreign capital and often
innovation.
Tightening up credit markets higher
interest rates, and a decrease in
willingness to adapt to changing world
market conditions
44

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17/01/2016

International Marketing Strategy

Trade Theories and

These Lecture Slides summarize the key points covered in the

Lecturer: Adrian Mifsud

MBA (IUKB), BM Dip, MIM

Trade Theories and Economic

Basis for International Trade

Whenever a buyer and a seller come together, each

Basis for International Trade

Virtually all governments feel political pressure when

Basis for International Trade

One may ask whether trade is like a zero-sum game,

Basis for International Trade

Without trade, a nation would have to produce all commodities

Figure 2.1Production possibility

Basis for International Trade

Because each country has a unique set of resources,

Basis for International Trade

Principle of Absolute Advantage

Adam Smith may have been the first scholar to

Basis for International Trade

Principle of Absolute Advantage

Table 2.1Possible physical output

Basis for International Trade

Principle of Absolute Advantage

Case 1 shows that, given certain resources and

Basis for International Trade

Principle of Absolute Advantage

Based on Table 2.1, it should be apparent

Basis for International Trade

Principle of Absolute Advantage

If each country specializes in the product for

Basis for International Trade

Principle of Absolute Advantage

Based on this same rationale, the USA

Basis for International Trade

Principle of Absolute Advantage

a country should export a commodity that

or import a commodity that can only be

Basis for International Trade

Principle of Comparative/Relative Advantage

One problem with the principle of absolute

Basis for International Trade

Principle of Comparative/Relative Advantage

Table 2.1Possible physical output

Basis for International Trade

Principle of Comparative/Relative Advantage

In Case 2, the USA has absolute advantage

Basis for International Trade

Principle of Comparative/Relative Advantage

British economist David Ricardo, perhaps the

Basis for International Trade

Principle of Comparative/Relative Advantage

According to Ricardos principle of relative (or

Basis for International Trade

Principle of Comparative/Relative Advantage

Conversely, it should import either a product

Basis for International Trade

Principle of Comparative/Relative Advantage

These two ratios indicate that the USA

Basis for International Trade

Principle of Comparative/Relative Advantage

These two ratios indicate that the USA