Unit 2: International Trade Theories
Mercantilism Theory (Oldest Trade Theory)
Mercantilism says that a country becomes rich and powerful by exporting more and importing less. The goal is to accumulate gold and wealth.
Key Points
- Exports = Good; Imports = Bad
- Government should support exports and reduce imports by using tariffs (taxes) and quotas
- More exports bring more money (gold) into the country
Criticism
- It ignores the fact that both countries can benefit from trade
- Focus on gold, not on improving people's living standards
Absolute Cost Advantage Theory (Adam Smith)
A country should export goods it can produce more efficiently (at lower cost) and import goods that other countries produce more efficiently.
Key Idea
Trade is beneficial when one country has an absolute advantage (can produce more output with fewer resources).
Example
- India can produce rice cheaper than Japan
- Japan can produce cars cheaper than India
Result
Both countries gain from trade by focusing on what they do best.
Comparative Cost Advantage Theory (David Ricardo)
Even if a country has no absolute advantage, it should still trade based on comparative advantage – the good it can produce at a lower opportunity cost.
Key Idea
Trade benefits both countries if each produces and exports goods where it has comparative advantage.
Example
- India can produce 1 unit of rice in 10 hours and 1 unit of cloth in 20 hours
- Japan can produce 1 unit of rice in 5 hours and 1 unit of cloth in 5 hours
- → Japan has absolute advantage in both, but
- India has comparative advantage in rice (lower opportunity cost)
- → India should export rice, Japan should export cloth
Result
Trade allows both to specialize and benefit.
Factor Endowment Theory (Heckscher-Ohlin Theory)
Countries should export goods made from resources they have in abundance and import goods made from scarce resources.
Key Idea
Trade is based on differences in factors of production like land, labor, and capital.
Example
- India has lots of cheap labor → exports labor-intensive goods (textiles, handicrafts)
- USA has more capital → exports capital-intensive goods (machinery, tech)
Result
Each country benefits by using its natural advantages efficiently.
International Product Life Cycle Theory (Raymond Vernon)
Trade patterns change over time based on the life cycle of a product – from new product to maturity to decline.
Stages and Trade Behavior
| Stage | Description | Trade Impact |
|---|---|---|
| 1. Introduction | Product invented and first sold in home country | Exports are low; mainly domestic sales |
| 2. Growth | Demand rises; product exported to developed countries | Exports increase |
| 3. Maturity | Product is standardized; production shifts to developing countries | Home country may now import |
| 4. Decline | Product demand falls; low-cost countries export | Developed countries import cheap versions |
Summary Table
| Theory | Key Idea | Main Focus |
|---|---|---|
| Mercantilism | Export more, import less to become rich | National wealth (gold) |
| Absolute Advantage | Export goods produced cheapest and best | Efficiency |
| Comparative Advantage | Export goods with lowest opportunity cost | Specialization |
| Factor Endowment | Export goods using abundant resources | Resource advantage |
| Product Life Cycle | Trade changes as product matures and moves to low-cost nations | Product stage over time |
In short, These trade theories help us understand why countries trade, what they trade, and how trade patterns evolve. Businesses and governments can make better trade decisions using these theories.
International Investment Theories
These theories explain why companies invest in foreign countries (called Foreign Direct Investment or FDI) and how they benefit from it.
Theory of Capital Movements (Classical Theory)
This theory says that capital (money) moves from countries with low returns to countries with high returns.
Key Idea
Investors want higher profits, so they invest in countries where interest rates or returns are higher.
Example: If interest rates in India are higher than in the USA, investors from the USA may invest in India.
Assumptions
- Free movement of capital
- No government restrictions
- Equal risk in both countries
Limitation
It ignores non-financial reasons like market access, labor cost, and political stability.
Market Imperfections Theory
This theory says companies invest abroad because markets are not perfect – there are barriers like taxes, tariffs, transport costs, and government rules.
Key Idea
Companies do FDI to avoid these barriers and get closer to customers.
Example: A car company may set up a plant in India to avoid import duties and serve local customers directly.
Key Imperfections
- Trade barriers
- Transportation costs
- Legal and regulatory differences
- Monopoly or brand power
Conclusion: FDI helps companies bypass barriers and control foreign markets better.
Internationalization Theory
This theory says firms invest abroad to keep control over their operations, instead of giving rights to others (like through licensing or franchising).
Key Idea: Firms do FDI to reduce risks, protect secrets (like technology or brand), and control quality.
Example: A pharma company sets up its own plant in another country to protect its drug formula, rather than licensing it to a local firm.
Why Companies Prefer FDI:
- Maintain control over production and quality
- Protect intellectual property (like patents)
- Reduce cost of coordination and delays
- Increase profit margins
Location-Specific Advantage Theory
This theory says companies invest in countries that offer special advantages or benefits.
Key Idea
Firms choose a location because it offers low cost, skilled labor, natural resources, market size, or favorable policies.
Example
- China offers cheap labor → companies set up factories
- Middle East has oil → energy companies invest there
Factors Affecting Location Advantage
- Natural resources (oil, minerals, etc.)
- Labor cost and skill level
- Infrastructure (transport, power, etc.)
- Tax benefits and government incentives
- Proximity to big markets
Conclusion: Firms invest where they can reduce costs or increase market access.
Summary Table
| Theory | Key Idea |
|---|---|
| Capital Movements Theory | Money flows to countries with higher returns or interest rates. |
| Market Imperfections Theory | FDI helps avoid barriers like tariffs, transport cost, regulations. |
| Internationalization Theory | FDI gives full control over operations, brand, and technology. |
| Location-Specific Advantage | Invest where resources or market benefits exist. |
Conclusion
These theories explain why companies do FDI rather than just export or license. The main reasons are to earn more profit, control operations, avoid risks, and benefit from local advantage
Eclectic Theory (OLI Framework by John Dunning)
Eclectic Theory explains why firms choose Foreign Direct Investment (FDI) over other modes like exporting or licensing. It combines three advantages called OLI:
| Component | Meaning |
|---|---|
| O – Ownership Advantage | Firm has unique assets (brand, technology, skills) not available to others. |
| L – Location Advantage | Foreign country offers special benefits (cheap labor, big market, resources). |
| I – Internalization Advantage | Firm wants to control operations instead of sharing with others. |
Free Trade
Free trade means buying and selling across borders without government restrictions, such as tariffs or quotas.
Advantages of Free Trade
| Advantage | Explanation |
|---|---|
| Lower Prices | More competition leads to cheaper goods for consumers. |
| More Choices | Consumers get variety of products from other countries. |
| Efficient Resource Use | Countries specialize in what they do best (comparative advantage). |
| Economic Growth | More trade leads to investment, jobs, and higher GDP. |
| Technology Transfer | Foreign companies bring new skills and technology. |
Disadvantages of Free Trade
| Disadvantage | Explanation |
|---|---|
| Local Industries Hurt | Domestic firms may lose to foreign competition. |
| Job Losses | Jobs may shift to cheaper countries. |
| Dependency | Countries may depend too much on imports. |
| Exploitation Risk | Poor countries may face unfair trade practices. |
| Trade Imbalance | One country may import more than export, leading to deficits. |
Forms of Protectionism (To Protect Local Economy)
Governments use protection measures to restrict imports and protect domestic industries.
(a) Tariffs
Tax on imported goods to make them more expensive than local goods.
Example: India may put a tariff on Chinese toys to protect Indian toy makers.
(b) Subsidies
Financial support given to local producers to reduce their costs and compete with imports.
Example: Government gives subsidy to farmers to support agricultural exports.
(c) Import Quotas
Limits the quantity of goods that can be imported.
Example: Only 1 lakh foreign cars can be imported in a year.
(d) Voluntary Export Restraints (VERs)
Exporting country agrees to limit exports to avoid stricter restrictions.
Example: Japan voluntarily limits car exports to the USA.
(e) Administrative Policy
Using strict rules and procedures (like safety, labeling) to slow down imports.
Example: Complex customs checks delay foreign goods.
(f) Anti-dumping Policy
“Dumping” = selling goods below cost to kill competition.
Anti-dumping rules stop this by imposing extra duties on such imports.
Example: If Chinese steel is dumped in India, India imposes anti-dumping duty.
Conclusion
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Eclectic Theory (OLI) explains why firms invest abroad.
-
Free Trade helps global growth and efficiency, but may harm local jobs and industries.
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Protection measures like tariffs, subsidies, and quotas help protect the domestic economy, but reduce global trade benefits.