1. International Finance

2. Introduction
• It is the branch of economics which deals with the
dynamics of:
– International Trade
– Exchange rate
– Foreign Investment
– Global financial system
• It is a branch of International Economics
• It is concerned with understanding all the procedures,
techniques & tools related to helping firm in accessing
global markets for short/long term funds

3. • International trade
– Applies microeconomic models to understand
the emergence and significance of international
trade
• Why? – Theories international trade – Their
practical application
• Different types of trade policy – free, restricted, etc.
• How composition of international trade changes
due to changes in economic conditions, etc.

4. What is International Trade??
• International trade is a cross border trade
• It refers to exchange of capital, goods, services, and
across international borders or territories
• Without international trade, nations would be limited to
the goods and services produced within their own borde
rs
• Each country has scarce resources / specific skills –
better to produce some, rather than all – to optimize
the utilization

5. International Trade Theories

6. Absolute Advantage theory
• Adam Smith – trade b/w two nations is based on
absolute advantage
• When one nation is more efficient (has absolute
advantage) than another in production of A, but
• Less efficient (has absolute disadvantage) in
production of B
• Both nations can gain by each specializing in
production of good of its absolute advantage
• Numerical example – next slide

7. 3-1
• Assume - Total resources for each X & Y = 200 Mhrs
– X requires 10 Mhrs for 1 unit of rice & 20 Mhrs for 1 unit of wheat
– Y requires 40 Mhrs for 1 unit of rice & 10 Mhrs for 1 unit of wheat
Country Rice Wheat Before Trade
Absolute Advantage
X 10 5
X – Rice
Y 2.5 10
Y - Wheat
Total 12.5 15
Production with Consumption after Gain from
specialization trade of 6 units specialization and
each trade
Country Rice Wheat Rice Wheat Rice Wheat
X 20 0 14 6 4 1
Y 0 20 6 14 3.5 4
Total 20 20 20 20 7.5 5

8. Comparative Advantage theory
• Ricardo – even if one nation is less efficient
(has absolute disadvantage) in both A & B than
other nation
• Still it is beneficial for trade

9. Example - Comparative Advantage
• Total resources for each X & Y = 200 Mhrs
• Country X requires10 Mhrs for 1 unit of rice and 13.33 Mhrs
for 1 unit of wheat
• Country requires 40 Mhrs for 1 unit of rice and 20 Mhrs for 1
unit of wheat
Country Rice Wheat
X 10 7.5
Y 2.5 5
Total 12.5 12.5
• Absolute Advantage – X in both products
• Comparative Advantage – Y in wheat

10. Example – Gains from trade
Production Production Consumption Gain from
without with after trade of specialization
specialization specialization 4 units each and trade
Country Rice Wheat Rice Wheat Rice Wheat Rice Wheat
X 10 7.5 15 3.75 11 7.75 1 0.25
Y 2.5 5 0 10 4 6 1.5 1
Total 12.5 12.5 15 13.75 15 13.75 2.5 1.25

11. Heckscher-ohlin Theory / Factor
Endowment Theory - Assumptions:
• 2 countries, 2 goods and 2 Factor of production (FOP)
i.e. L, K
• Two factors are available in fixed amounts in each of
the two countries; they are fully mobile b/w industries
within each country; but immobile b/w countries
• Two countries are alike in every respect except for
their endowments of two factors
• For each of the two goods, required technology is
available

12. Heckscher-ohlin Theory / Factor
Endowment Theory
• A country is labor-abundant if it has a higher ration of
labor to other factors than does the rest of the world
• A product is labor-intensive if labor costs are a greater
share of its value than the are of the value of other
products.
• A country has comparative advantage in the good that is
relatively intensive in the country’s relatively abundant
factor
• Export – commodity intensive in its relatively abundant &
cheap factor of production (FOP)
• Import – commodity intensive in its relatively scarce &
expensive factor of production (FOP)

13. Empirical Test of H-O Model
(Leontief Paradox)
• Wassily W. Leontief made an attempt to test the
Heckscher-Ohlin theory empirically.
• In 1954, Leontief found that the U.S. (the most
capital-abundant country in the world) exported labor-
intensive commodities and
• imported capital-intensive commodities, in contradiction
with Heckscher-Ohlin theory ("H-O theory").
• This contradiction is called as Leontief Paradox
• Leontief's paradox undermined the validity of the
Heckscher-Ohlin theorem (H-O) theory

14. Arguments to support HO Model
• Some economists argue that the U.S. has an advantage
in highly skilled labor more so than capital.
• This can be seen as viewing "capital" more broadly, to
include human capital.
• Using this definition, the exports of the U.S. are very
(human) capital-intensive, and not particularly
intensive in (unskilled) labor.

15. Overlapping product Ranges Theory
• The type, complexity and diversity of
product demands of a country increase as
country's income increases.
• International trade patterns would
follow this principle
• So that countries of similar income per
capita levels will trade most intensively
having overlapping product demands
• According to Linder - nations with similar
demands would develop similar industries.
• These nations would then trade with each

16. Overlapping product Ranges Theory
• For instance, both the U.S. and Germany are developed
countries with a significant demand for cars, so both
have large automotive industries (overlapping
product demands)
• Rather than one country dominating the industry with a
comparative advantage - both countries trade different
brands of cars between them.

17. Product Life Cycle Theory
• The product life-cycle theory looks at the potential export
possibilities of a product in five discrete stages in its life-
cycle

18. • Stage 1: Introduction
– A new product is manufactured in the innovating country
and sold primarily in that domestic market
– Any overseas sales are generated through exports to other
markets
– At this stage the innovating company has little competition
in markets abroad.
• Stage 2: Expansion
– Sales increase, but so does competition as other firms
enter the arena
– At this point, the firm begins some production abroad, to
serve foreign markets and to counter the competition

19. • Stage 3: Maturity
– Exports from the home country decrease, because of
increased production in overseas locations.
– Price has become a critical determinant of
competitiveness, so minimising costs becomes an
important objective.
– Production may shift to less developed countries to
take advantage of lower labour costs
– At this point, domestic production may cease and the
product is imported by the home market.

20. • Stage 4: Sales decline
– This occurs because competitors have achieved economies of
scale equal to those of the innovator.
• Stage 5: Demise
– The innovator may cease production and leave the declining
market to imitators
– Product's popularity has also ceased and consumers seek other
products.
• This theory holds - for products such as consumer durables,
synthetic fabrics and electronic equipment;
• Products which have a long time-span from innovation to eventual
peak consumer demand.