2. I. International Trade and Investment Theories
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1500 1600 1700 1800 1900 2000
Mercantilism
Absolute Advantage
Comparative Advantage
Factor Proportion Theory
International Product Life Cycle
New Trade Theory
National Competitive Advantage
3. Volume of International Trade
13%
10%
8%
5%
5%
4%
4%4%3%
3%
41%
World’s Top Exporters
United states
Germany
Japan
France
United Kingdom
Italy
Canada
Netherlands
Hongkong
China
All others
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4. 12/18/2018 Kartikeya Singh,SMS Varanasi 4
WHAT INDIA OWNS
■ Bicycles: 44.8%
■ Car/jeep/van: 4.7%
■ Computer/laptop: 9.5%
■ Computer/laptop with internet: 3.1%
■ Computer/laptop without internet: 6.3%
■ Radio/transistor: 19.9%
■ Scooter/motorcycle/ moped: 21%
■ Telephone/mobile phone: 63.2%
■ Both telephone and mobile phone: 6%
■ Landline only: 4%
■ Mobile only: 53.2%
■ TV: 47.2%
■ TV, computer/laptop, telephone/mobile phone, scooter/car: 4.6%
■ None of the specified assets available: 17.8%
5. II. Mercantilism
• Mercantilism is the first trade theory and it emerged in
England in the mid-16th Century.
• During 17th century, gold and silver were the currency of
trade between countries.
• A country could earn gold and silver by exporting goods.
• Importing goods would be responsible for the outflow of
silver and gold.
• Mercantilist doctrine advocates state intervention to
achieve surplus in the balance of trade.
• To achieve surplus, government is expected to
discourage imports by imposing tariffs and quotas and
subsidizing exports.
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6. III. Absolute Cost theory – Adam Smith
Trade is between two
countries
Only two commodities are
traded
Free trade exists between the
countries
The only element of cost of
production is labour.
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7. III. Absolute Cost theory – Adam Smith
• Trade between two
countries would be
mutually beneficial if one
country could produce
one commodity at an
absolute advantage(over
the other country) and the
other country could, in
turn produce another
commodity at an absolute
advantage over the first.
USA UK
No. of Unit
of Wheat
Per unit of
Labour
10 4
No. of Unit
of Cloth per
unit Labour
3 7
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8. III. Absolute Cost theory – Adam Smith
• Limitations:
• If there is one country that does not have
an absolute advantage in the production
of any product, will there still be benefit to
trade, and will trade even occur?
• The answer may be found in the
extension of absolute advantage, the
theory of comparative advantage.
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9. IV. Comparative Cost theory –
Ricardian Theory
• The comparative cost theory was first systematically
formulated by the English economist David Recardo in
the “Principles of Political Economy and Taxation”
Published in 1817.
• It Says - If trade is left free, each country, in the long
run, tends to specialise in the production and export of
those commodities in which they have the comparative
advantage in real cost, and import of those
commodities which have disadvantage to produce it at
home in terms of real cost.
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10. IV. Comparative Cost theory – Ricardian
Theory
Assumptions:
• Labour is the only element of cost of production
• Goods are exchanged against one another according
to the relative amounts of labour embodied in them
• Labour is perfectly mobile within the country,
• Labour is homogeneous.
• Production is subject to the law of constant returns.
• International trade is free from all barriers.
• There is no transport cost.
• There is perfect competition.
• There are only two countries and two commodities.
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11. IV. Comparative Cost theory –
Ricardian Theory
Country No. of units
of labour per
unit of cloth
No. of units
of labour per
unit wine
Exchange
ratio
between
wine and
cloth
Exchange
ratio of cloth
with Rice
England 100 120 1 wine = 1.2
cloth
1 Cloth = .88
Wine
Portugal 90 80 1 wine = 0.88
cloth
1 Cloth = 1.12
Wine
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12. IV. Comparative Cost theory – Ricardian Theory
Evaluation of Theory.
• Labour is certainly not the only element of cost.
• The demand and supply conditions play a very
important role in the determination of the price at which
commodities are exchanged.
• Differences in wages may alter the ratio
• Mobility and homogeneity of labour is also incorrect.
• Ricardo tacitly assumed constant costs, but constant
cost is rare case.
• It is highly impractical to assume that international trade
is free and does not involve cost of transport.
• By taking a two-country-two-commodity model, Ricardo
has over simplified the situation.
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13. V.Opportunity Cost - Theory
• The concept of opportunity cost was first
developed in 1914 by Friedrich Von Wieser in
his book “Theries der gesellschaftlichen
Wirtschaft”.
• Opportunity is the cost of any activity measured
in terms of of the value of the best alternative
that is not chosen(that is foregone).
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14. V.Opportunity Cost – Theory
Assumption
• Here there is only one factor of production, that is
labour
• Labour is homogeneous
• Labour is perfectly mobile within the country and
immobile outside the country
• Free trade exists between the countries
• There is full employment in the participating
countries.
• Cost of production is measured in terms of factors
of production involved.
• The countries are free from transportation cost
• The countries are free from government interference
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16. VI Factor endowment theory – Heckscher
Ohlin Theory
• Bertil Ohlin and Eli Heckscher have given an extension to
comparative cost theory given by David Ricardo.
• He has drawn his ideas from Heckscher’s General
Equilibrium Analysis. Hence it is known as Heckscher Ohlin
theory.
• According to Bertil Ohlin, trade arises due to the differences
in the relative prices of different goods in different
countries.
• The difference in commodity price is due to the difference
in factor prices(i.e. Costs).
• Factor prices differ because endowments (i.e. capital and
labor) differ in countries. Hence, trade occurs because
different country have different factor endowment
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17. VI Factor endowment theory – Heckscher
Ohlin Theory
• Assumptions:
• There is perfect competition in both the factor and product
markets in the participating countries
• The factors of production are perfectly mobile within the
country but immobile outside the country.
• The quality of factors of production is identical in both the
countries
• Both the countries have fully employed the factors of
production of production
• There exists free trade.
• Proportion of Endowment varies between the countries.
• Same input mix is used in the country.
• Law of constant return
• Factor supplies in both the country is fixed.
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18. VI Factor endowment theory –
Heckscher Ohlin Theory
• Causes of comparative cost difference in the
international trade :
– Different endowments of factors of production for
different countries.
– The factors of production used in producing different
commodities require them to be used with different
degrees of intensity.
• The country will export products that use their
abundant and cheap factors of production and
import products that use the countries scarce
factors.
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19. VI Factor endowment theory – Heckscher
Ohlin Theory
Particulars/Countries India Bangladesh
Supply of Labour 50 24
Supply of Capital 40 30
Capital/Labour 0.8 1.25
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Figures in units
20. VI Factor endowment theory – Heckscher
Ohlin Theory
It concludes that:
• The basis of internal trade is the difference in
commodity prices in the two countries.
• Differences in the commodity prices are due
to cost differences which are the results of
differences in factor endowments in two
countries.
• A capital reach Country specializes in capital
intensive goods and exports them. While a
labour abundant country specializes in labour
intensive goods and exports them.
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21. VI Factor endowment theory – Heckscher
Ohlin Theory
• Limitations.
– Static nature.
– Capital as Endowment.
– Identical production function.
– No Unemployment.
– No perfect competition.
– Unrealistic Assumptions.
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22. VII Complimentary trade theories – Stopler –
Samuelson theorem
• Paul Samuelson and Wolfgarg Stopler
empirically obtained that “An increase in the
relative price of labour intensive product will
increase the wage rate relative to both
commodity prices and reduce the rent
relative to both commodity prices.”
• When the wage rent ratio improves on account
of an increase in relative price of industrial
product, laborers tend to gain more.
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23. VII Complimentary trade theories – Stopler –
Samuelson theorem
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B’ BO
A
A’
Labour
Capital
24. VII Complimentary trade theories – Stopler –
Samuelson theorem
• The Stopler-Samuelson theorem implies that an
increase in any product price due to trade
produces a proportionally greater increase in the
price of factor used intensively to that good and
a fall in the price of the factor used less
intensively.
• The income gain is shared in a greater
proportion by the abundant factor.
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25. VIII. International Product life Cycles
1. Introduction 2. Growth 3. Maturity 4. Decline
Producti
on
Location
•
Ininnovating(us
ually industrial)
country
• In
innovating
and other
industrial
countries
• Multiple
countries
Mainly in
developing
countries
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Kartikeya Singh,SMS Varanasi 25
Vernon 1966
26. VIII. International Product life Cycles
1. Introduction 2. Growth 3. Maturity 4. Decline
Market
Location
• Mainly in innovating
country, with some
exports
• Mainly in
industrial
countries
• Shift in export
markets as
foreign
production
replaces
exports in some
markets
• Growth in
Developing
countries
• Some
decrease in
industrial
countries
• Mainly in
developing
countries.
• Some
developing
country exports.
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27. VIII. International Product life Cycles
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1. Introductio
n
2. Growth 3. Maturity 4. Decline
Competitive
factors
• Near Monopoly
position.
•Sales based on
uniqueness rather
than price
• Evolving product
characteristics
• Fast growing
demand
• Number of
competitors
increases
• Some
competitors
begin price
cutting
• Product
becoming more
standardised
• Overall
stabilized
demand
• Number of
competitors
decreases
• Price is very
important,
especially in
developing
countries
• Overall
declining
demand
• Price is key
weapon
• Number of
producers
continues to
decline
28. VIII. International Product life Cycles
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1. Introductio
n
2. Growth 3. Maturity 4. Decline
Production
Technology
• Short production
runs
• Evolving methods
o coincide with
product evolution
• High labour input
and labour skills
relative to capital
input
• Capital input
increases
• Methods more
standardized
• Long
production runs
using high
capital inputs
• Highly
standardized
• Less labour
skill needed
• Unskilled
labour on
mechanized
long production
runs
29. VIII. International Product life Cycles
Limitations:-
• Because of rapid innovation, product life
cycle is short
• Luxury products does not follow any pattern
• Products that require specialized technical
labour to evolve their next generation.
• Products use advertising to sustain in the
market does not follow the trend.
• Production in home as well as abroad takes
place at the same time.
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30. IX. Market Imperfections theory
• (Stephen Hymer, 1976 & Charles P.
Kindleberger, 1969 & Richard E. Caves,
1971)
• Market imperfection can be defined as
anything that interferes with trade.
• Two dimensions of imperfections.
– Imperfections cause a change in holding the
market portfolio.
– Imperfections cause a deviation from firms
preferred risk level.
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31. IX. Market Imperfections
theory
• According to Hymer, market imperfections are
structural,
• Arises from structural deviations from perfect
competition in the final product market.
• Arise Due to
– exclusive and permanent control of proprietary
technology,
– privileged access to inputs,
– scale of economies,
– control of distribution systems,
– and product differentiation but in their absence
markets are perfectly efficient.
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32. XI Internationalization Theory
• According to the internationalization theory
the reason why production is done by only
one company instead of many in various
locations is that it is more profitable to
produce with one company.
• Internalization occurs only when firms
perceive the benefits to exceed the costs.
• Internalization: Political and Commercial
Risk – Cost Increases.
– When cost are high a firm may license or
outsourse production.
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33. XI Internationalization Theory
• Internalization theory focuses on
imperfections in intermediate product
markets
• Two main kinds of intermediate
product are distinguished:
– knowledge flows linking research and
development (R&D) to production,
– and flows of components and raw
materials from an upstream production
facility to a downstream one.
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34. FDI - Foreign Direct Investment
• Why is FDI increasing?
• Why do firms choose FDI over exporting or
licensing to enter a foreign market?
• Why are certain locations attractive for FDI?
• How does political ideology influence
government policy over FDI?
• From a host or source country perspective,
what are FDI’s costs and benefits?
• How can governments restrict/encourage
FDI?
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35. FDI - Foreign Direct Investment
• Foreign direct investment (FDI) happens when a
firm invests directly in facilities in a foreign
country
• A firm that engages in FDI becomes a
multinational enterprise (MNE)
– Multinational = “more than one country”
• Factors which influence FDI are related to
factors that stimulate trade across national
borders
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36. FDI - Foreign Direct Investment
• Involves ownership of entity abroad for
– production
– Marketing/service
– R&D
– Raw materials or other resource access
• Parent has direct managerial control
– The degree of direct managerial control depends on
the extent of ownership of the foreign entity and on
other contractual terms of the FDI.
– No managerial involvement = portfolio
investment.
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37. FDI - Foreign Direct Investment
• FDI forms
– Purchase of existing assets
• Quick entry, local market know-how, local financing may be
possible, eliminate competitor, buying problems
– New investment
• No local entity exists or is available for sale, local financial
incentives may encourage, no inherited problems, long lead
time to generation of sales or other desired outcome
– Participation in an international joint-venture
• Shared ownership with local and/or other non-local partner
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39. FDI - Foreign Direct Investment
• FDI over exporting
– High transportation costs, trade barriers
• FDI over licensing or franchising
– Need to retain strategic control
– Need to protect technological know-how
– Capabilities not suitable for
licensing/franchising
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40. FDI - Foreign Direct Investment
• Follow main competitors
– Oligopolistic industries
– Interdependence of the few major competitors forces
immediate strategic responses
• International product life-cycle (Vernon,)
• Eclectic paradigm of FDI (John Dunning)
– Combines ownership specific, location specific, and
internalization specific advantages that drive FDI
choice over a decision to enter through licensing or
exports
– OLO, ownership, Location and Internationalisation
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41. XIII. Eclectic Paradigm of FDI (Dunning)-
OLI Model
• Ownership advantage: creates a monopolistic advantage
which can be used to prevail in markets abroad.
– Unique ownership advantage protected through ownership
– e.g., Brand, technology, economies of scale, management know-
how
• Location advantage: the FDI destination local market must
offer factors (land, capital, know-how, cost/quality of labor,
economies of scale) such that it is advantageous for the firm
to locate its investment there (link to trade theory)
• Internalization advantage: transaction costs of an arms-
length relationship --licensing, exports-- higher than managing
the activity within the MNE’s boundaries
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42. XIII. Eclectic Paradigm of FDI (Dunning)-
OLI Model
• John Dunning eclectic paradigm
• If a company wants to service a local or
foreign market from a foreign localization,
it must have access to firm specific
advantages or be able to acquire these at
lower cost
• This is what we have called ownership
specific advantages or O - advantages
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43. XIII. Eclectic Paradigm of FDI (Dunning)-
OLI Model
• Some firms have a firm specific capital
known as knowledge capital: Human
capital (managers), patents, technologies,
brand, reputation…
• This capital can be replicated in different
countries without losing its value, and
easily transferred within the firm without
high transaction costs
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44. XIII. Eclectic Paradigm of FDI (Dunning)-
OLI Model
• Given that ownership specific advantages
are present, it must be in the best interest
for the firm to use these itself, rather than
sell them or license them to other firms
• These are Internalization or I-advantages,
and can arise because a hierarchy is a
more efficient way of organizing
transactions than a market
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45. XV. Instruments of Trade Policy- Tariffs
Objective
• To understand trade policy and its
instruments; and
• To understand the welfare effects of various
trade policy instruments on consumers’,
producers’ and governments’ welfare in both
the applying country (the home country) and
its trading partners (foreign countries).
47. XV. Instruments of Trade Policy- Tariffs -
Trade Policy
• What is trade policy?
– A set of rules and regulations applied to
trade.
• Objectives of trade policy?
48. XV. Instruments of Trade Policy- Tariffs - Common
Instruments
• 1. Tariff – a levy on imports and exports.
– Specific tariff
– Ad valorem tariff
• 2. Subsidies
– Import subsidies.
– Export subsidies.
49. XV. Instruments of Trade Policy- Tariffs
• Specific tariffs
– Fixed charge for each unit of goods imported
(often based on height, number, length,
volume or other unit of measurement).
– Often levied on foodstuffs and raw materials
• E.g. Rs.1 per kill of apple etc …
• Ad valorem tariff – levy as percentage of
value (instead of quantity, weight etc.)
50. XV. Instruments of Trade Policy- Tariffs -
Why tariff?
• A tariff could be levied for one or all of the
following purposes:
– To protect domestic producers from foreign
competition (i.e. protective tariff). In extreme cases a
tariff could be so high that it effectively prohibits
imports (i.e. prohibitive tariff).
– To raise Revenue for government (i.e. revenue
tariffs).
– For environmental and health purposes, i.e. to
discourage the consumption of goods that are harmful
for environment (i.e. green tariff; a.k.a. eco-tariff)
and/or health (e.g. tariffs on cigarettes and liquors).
51. XV. Instruments of Trade Policy- Tariffs –
Effects of tariffs
Tariffs lead to:
•Higher cost of importing goods
•Higher price of imported goods
•Lower demand for imported goods
Case 1: Effects in the tariff imposing country
52. XV. Instruments of Trade Policy-
Tariffs - Effects of tariff
• Lower demand for the good in the tariff imposing country
• Negligible effect on global prices for the good
• Negligible effect on aggregate demand for the
exporting country
Case 2: For the country whose exported goods face the
tariff and that the tariff imposing country accounts for a
negligible share of total demand for the good:
• Negligible effect on production and supply of the good
• Negligible effect on global trade of the good
53. XV. Instruments of Trade Policy- Tariffs -
Effects of tariff
•Lower demand for the good in the tariff imposing country
•Lower export (international) prices for the good
• Lower aggregate demand for the good
Case 3: For the country whose exported goods face the tariff and that
the tariff imposing country accounts for a significant share of total
demand for the good:
•Excess supply of the good
•Lower production of the good
•Lower global trade of the good
54. XV. Instruments of Trade Policy- Tariffs - How much
protection does a tariff offer?
• The actual protection that a tariff provides is
measured by a concept called effective rate of
protection.
• An analysis of effective rate of protection provided to
an industry takes into account the effects of tariffs on
inputs as well as on outputs.
• How do we calculate the effective rate of protection?
Let’s see this example:
55. XV. Instruments of Trade Policy- Costs and
benefits of tariffs
• Tariffs are the simplest trade policies
• Tariffs increase the price of imported goods, as a result:
– consumers pay higher (negative effect on their welfare)
– producers gain from higher prices.
– Government earns tariff revenue
• By artificially inflating prices of imported goods, tariffs
encourage the substitution of lower price (efficient) imports
by higher price (less efficient) domestic products. Hence,
there is a loss of efficiency.
• But of course, to get the full picture one needs to look at
the dynamic effect of tariffs (encouraging domestic
industries etc (the so called infant industry argument).
56. XV. Instruments of Trade Policy-
Subsidy
• Export subsidy:
– A payment for a firm or individual that exports
goods abroad.
– It can be fixed (fixed payment per unit) or ad
valorem (proportional to value of export).
– Exports subsidies encourage exporters to
export more. From the individual exporter’s
point of view, subsidies increase his/her export
revenue.
• Well known examples: U.S. subsidy on cotton
• The European Common Agriculture Policy (CAP)
57. XV. Instruments of Trade Policy- Benefits
and costs of subsidy
• Subsidized exporters benefit.
• Foreign consumers benefit from low
prices.
• Foreign producers suffer from low prices.
• Creates production distortion.
• Creates consumption distortion.
• Creates “terms of trade” loss for the
subsidizing country.
58. XV. Instruments of Trade Policy- Other
instruments of trade policy:
• Import Quotas
– Restriction on quantity of imports
– Often enforced through import license
– Have the same effect as tariffs on domestic
prices (hence production and consumption
distortions)
59. XV. Instruments of Trade Policy- Other
instruments … Cont’d.
• Voluntary export restraints
– Is a quota imposed on the side of the exporting
(instead of importing) country.
– Often imposed by the request of the importing
country - it thus is not truly voluntary.
– Exporting countries agree to it so as to not risk
other worse forms of trade barriers such as
import quotas or higher tariffs.
– It is discriminatory in its effect
60. XV. Instruments of Trade Policy- Other
instruments … Cont’d
• Local Content Requirements
– Requirement that some specific fraction of
a good must be produced domestically
– Provides protection to local parts
producers such as automobile parts etc.
– Was widely used as part of industrial policy
61. XV. Instruments of Trade Policy- Other
instruments … Cont’d
• Export credit schemes
– Could take several forms. Two main forms
are:
• Export loan - government institutions extend
export credits directly, often in association with
private financing.
• Export loan subsidy - Subsidized loan given to
the foreign buyer by the exporting countries’
government operating indirectly to extend
preferential refinancing and interest subsidies
to private lenders.
62. XVI. Dumping
• Dumping is said to have taken place when an exporter sells a
product to any country at a price less than the price prevailing
in its domestic market.
LEGAL FRAMEWORK :
• Based on Article VI of GATT 1994
• Customs Tariff Act, 1975 - Sec 9A, 9B (as amended in1995)
• Anti-Dumping Rules [Customs Tariff (Identification,
Assessment and Collection of Anti Dumping Duty on Dumped
Articles and for Determination of Injury) Rules, 1995].
• Investigations and Recommendations by Designated
Authority, Ministry of Commerce.
• Imposition and Collection by Ministry of Finance.
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