Compare different theories of international trade

International trade is defined as trade between two or more partners from different countries (an exporter and an importer), that is, international trade occurs when a firm exports goods and/or services to consumers in another country. In olden days, there used to be extensive trade between Romans and the Indians. The Arabian nomads carried out long distance trading activities with the help of camels. They traded silk and spices in Far East.

The first theory of international trade emerged in England in the mid-16th century. Referred to as mercantilism, it advocated that countries should simultaneously encourage exports and discourage imports. Hence, imports were limited by tariffs and quotas, while exports were subsidized. At that time, gold and silver were the currency of trade between countries; a country could earn gold and silver by exporting goods whereas importing goods in an outflow of gold and silver to those countries. The main tenet of mercantilism was that it was in a country’s best interests to maintain a trade surplus so as to accumulate gold and silver and, consequently, increase its national wealth and prestige.

The classical economist David Hume pointed out an inconsistency in the mercantilist doctrine in 1752. According to Hume, in the long run no country could sustain a surplus on the balance of trade and so accumulate gold and silver as the mercantilists had envisaged. Although mercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the trade policies if many countries. Mercantilism was that it viewed trade as a zero-sum game.

Proposed in 1776, Adam Smith’s theory attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently and therefore should specialize in the production of goods for which they have an absolute advantage and then trade these for goods produced by other countries. A country is said to be more productive than another country, if it can produce more output (goods) for a given quantity of input, such as labour or energy inputs. Smith’s theory was the first to explain why unrestricted free trade is beneficial to a country and argued that the invisible hand of the market mechanism, rather than government policy should determine what a country imports and what it exports.

Building on Smith’s work are two additional theories. One is the theory of comparative advantage, advanced by the 19th century English economist David Ricardo. According to this theory, a country should produce and export those goods and services for which it is relatively more productive than are other countries and import those goods and services for which other countries are relatively more productive than it is (Mahoney, Trigg, Griffin, & Pustay, 1998). The differences between absolute and comparative advantage theories are subtle. Absolute advantage looks at absolute productivity differences, comparative advantage looks at relative productivity differences (Mahoney, Trigg, Griffin, & Pustay, 1998). This theory is the intellectual basis of the modern argument for unrestricted free trade.

In the 20th century, Ricardo’s work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher-Ohlin theory. They argued that comparative advantage arises from differences in national factor endowments. By factor endowments, they meant the extent to which a country is endowed with such resources as land, labor, and capital. Nations have varying factor endowments, and different factor endowments explain differences in factor costs. The more abundant a factor, the lower its cost. The Heckscher-Ohlin theory predicts that countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. Most economists prefer the Heckscher-Ohlin theory to Ricardo’s theory because it makes fewer simplifying assumptions.

Because of its influence, the theory has been subjected to many empirical tests. Using the Heckscher-Ohlin theory, Leontief postulated that since the United States was relatively abundant in capital compared to other nations, the Unites States would be an exporter of capital-intensive goods and an importer of labor-intensive goods. To his surprise, however, he found that U.S exports were less capital-intensive than U.S imports. Since this result was at variance with the predictions of the theory, it has become known as the Leontief paradox.

Raymond Vernon proposed the product life-cycle theory in the mid-1960s. A product life cycle refers to the time period between the launch of a product into the market till it is finally withdrawn. This cycle is split into four different stages. The first stage is the introduction stage where the company launches the product it has developed after thorough market research. It is an awareness creating stage and is not associated with profits! However, strict vigilance is required to ensure that the product enters the growth stage where the marketer works on increasing their product’s market share. Rapid sales and profits are characteristics of the growth stage.

The maturity stage views the most competition as different companies struggle to maintain their respective market shares. Most of the profits are made in this stage and research costs are minimum. Finally, the revenue generated from sales of the product starts dipping due to market saturation, stiff competition and latest technological developments. Special efforts are required to raise the product’s popularity in the market once again, by either reducing cost of the product, tapping new markets or withdrawing the product.

In the 1970s, the new trade theory began to emerge when a number of economists were arguing that increasing returns to specialization might exist in some industries. If international trade results in a country specializing in the production of a certain good, and if there are economies of scale in producing that good, then as output of that good expands, unit costs will fall. In such a case, there will be increasing returns to specialization, not diminishing returns.

New trade theory also argues that if the output required to realize significant scale economies represents a substantial proportion of total world demand for that product, the world economy may be able to support only a limited number of firms producing that product. Those firms that enter the world market first may gain an advantage that may be difficult for other firms to match. Thus, a country may dominate in the exports of a particular product where scale economies are important, and where the volume of output required to gain scale economies represents a significant proportion of world output, because it is home to a firm that was an early mover in this industry.

In 1990, Michael Porter published the results of intensive research that attempted to determine why some nations succeed and others fail in international competition. This question cannot be easily answered by the Heckscher-Ohlin theory and the theory of comparative advantage only offers a partial explanation. Porter and his team looked at 100 industries in 10 nations. Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete and these attributes promote or impede the creation of competitive advantage. These attributes are:

Factor endowments―a nation’s position in factors of production such as skilled labor or the infrastructure necessary to compete in a given industry.

Demand conditions―the nature of home demand for the industry’s product or service.

Relating and supporting industries―the presence or absence of supplier industries and related industries that are internationally competitive.

Firm strategy, structure, and rivalry―the conditions governing how companies are created, organized, and managed and the nature of domestic rivalry.

Factor endowments

Demand Conditions

Related and supporting industries

Firm strategy, structure and rivalry

Porter speaks of these four attributes as constituting the diamond. He argues that firms are most likely to succeed in industries of industry segments where the diamond is most favorable. The effect of one attribute is contingent on the state of others. For example, Porter argues favorable demand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firms to respond to them.

Porter maintains that two additional variables can influence the national diamond in important ways: chance and government. Chance events, such as major innovations, can reshape industry structure and provide the opportunity for one’s nation’s firm to supplant another’s. Government, by its choice of policies, can detract from or improve national advantage. For example, regulation can alter home demand conditions.

Foreign Direct Investment (FDI) occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country. Once a firm undertakes FDI, it becomes a multinational enterprise. FDI takes on two main forms; the first is a green-field investment, which involves the establishment of a wholly new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country.

There are two structurally different types of FDI, depending on the way the MNE organizes its international business, namely horizontally or vertically. Horizontal FDI is normally associated with bilateral flows of investments between developed economies. In this case the parent company reproduces the whole process of production of goods and/or services in different countries. Vertical FDI means that the home company fragments the production process across different locations/countries according to their respective comparative advantages generating intra-firm trade. By this way, the parent company rationalizes its production and aims to reduce costs and to obtain gains in terms of efficiency. Vertical investments are mostly present in FDI flows from developed to less developed economies and normally refer to less sophisticated stages of the production process such as assembling operations. Vertical FDI may also take place between developed economies but in more sophisticated stages of the production process.

Complementarity between trade and FDI is normally found in trade models that incorporate vertical foreign investment, meaning that the MNE fragments/splits the production process across countries in order to reduce costs. In these types of models, Helpman (1984), and Grossman and Helpman (1991), differences in relative factor endowments between countries and differences in factor intensities and specialization between sectors are determinants of both trade and the formation of multinationals. They are particularly useful to explain FDI from developed countries into developing economies.

Markusen (1984) shows that complementarity between FDI and trade is still possible when countries have identical endowments, preferences and technology, and multinationalisation occurs in the context of multi-plant economies of scale. His basic idea is the existence of firm/headquarter-specific activities which are distinct from plant-specific activities. Firm-specific activities are produced centrally at the headquarters, have a public good nature and generate firm-specific fixed costs. It includes activities such as R&D, distribution, administration services, marketing. Plant-specific activities are associated with the production process and generate plant-specific fixed costs. One possible solution for the model is a multinational monopoly, in which headquarter activities concentrate in the home country and the production plant goes to the host country, originating bilateral trade-headquarter services in exchange for final goods.

Substitution between FDI and trade is found in models that assume horizontal investments, meaning that the MNE produces the same goods and services in different countries. This is the most common type of FDI and refers to bilateral investments between developed economies. Some trade models assume similarity between countries .in size, endowments and technology .plus economies of scale at the firm and plant-levels incorporating an endogenous formation of multiplant multinationals. This is the case of models by Hortsman and Markusen (1992), Brainard (1993) and Markusen and Venables (1998) and they admit alternative solutions depending, on one hand, on the relative size of the firm and plant scale economies, and on the other on trade costs .trans- port costs plus barriers to trade and investment. In other words, the equilibrium – exporting or investing – depends on the trade-off between proximity to the market which reduces trade costs and the concentration of production which allows for a better exploitation of economies of scale. High transport costs and plant-scale economies favour horizontal FDI that may be associated with distinct equilibriums.

On the other hand, Markusen and Venables (1998, 2000), Egger and Pfaffermayer (2002) explore another avenue, i.e., they research the convergence hypothesis to demonstrate that FDI and trade are substitutes. Starting with the assumption of asymmetry between countries they demonstrate that the convergence in terms of size, endowments and income increases the activities of MNEs. As multinational enterprises displace national enterprises the volume of trade decreases, meaning that FDI substitutes trade. Finally, trade models by Markusen (1997, 2000) and Carr et al. (2001) admit both vertical and horizontal FDI and consequently find solutions that admit both complementarity as well as substitution between FDI and trade.

The international business literature typically looks at FDI and trade as alternative modes of entry in foreign markets. The internalization theory, developed by Buckley and Casson (1976), says that a firm will enter a foreign market through FDI when alternative entry modes, namely exports, have associated higher transaction costs. Dunning (1979) uses the OLI paradigm to explain that a firm may choose FDI instead of exports when it possesses ownership advantages, when the foreign market has location advantages – access to a big domestic market or production resources – and when there are advantages of internalizing market access operations. In this case, FDI and trade can be substitutes, as well as complementary, depending on which of those advantages was determinant for the investment decision.

The particular question on whether FDI and trade are substitutes or complementary has produced some empirical research without a definite result. Despite the strong theoretical foundations for a substitute relation between FDI and trade this result has been found in few empirical studies – Frank and Freeman (1978), Cushman (1988) and Blonigen (2001) – while complementarity has been the most common result.

Most empirical research on this topic has looked for how changes in FDI correlate to changes in trade and vice versa. In other words, they have questioned whether systematic changes in FDI are related to systematic changes in trade, in particular if trade and FDI are substitutes (negative correlation) or complementary (positive correlation). These studies have not questioned or studied the direction of causality between FDI and trade and this seems to be a general limitation. As we will see contrasting results are associated with the diversity of interactions that exist between FDI and trade, but also, with different perspectives of analysis: country, industry and firm among others.

At the country level, as suggested by Fontagné (1999), the links between trade and FDI can be seen from three different perspectives: the investing or home country, the recipient or host country and third countries. For the investing country FDI can be a substitute for trade to the extent that exports are replaced by local sales by the affiliates in foreign markets. On the other hand, FDI may also be complementary to trade to the extent that induces intra-firm trade in intermediate and final goods (e.g. headquarter services). In the former case investing abroad will have a negative impact on production, employment and trade balance in the home country, while in the latter case will have a positive impact.

In the case of the host country the argument is symmetrical to that of the investor and therefore inward FDI may have a complementary or substitute relation with trade. Again the effects on domestic production, employment and the balance of trade (current account) can be diverse. Third economies may also affect, and be affected by, the relationship between FDI and trade, to the extent that foreign affiliates in these countries develop new trade relations with the affiliates in the host country and vice-versa.

At country level studies by Grubert and Mutti (1991), Blomstrom and Kokko (1994), Eaton and Tamura (1994), Brenton et al. (1999), Clausing (2000), and Hejazi and Safarian (2001) have found that FDI and trade are complementary. Several studies use the gravity model with success, Grubert and Mutti (1991) research how FDI relates to exports and imports for the United States, using trade flows with 33 counties in 1982. The study finds complementarity between FDI and both imports and exports on a bilateral basis. However the authors suggest that a clear cut conclusion needs a multilateral study. Clausing (2000) uses a panel data approach and studies the interaction between outward FDI and exports in the United States in her relation with 29 countries; and he also studies the relationship between inward FDI into the US and American imports. He uses gravity equations to find complementarity between trade and FDI.

At the micro-level a different perspective is possible with firm-level studies, as this is better suited for an effective understanding of FDI and trade relationships. However, this approach faces severe data limitations and studies are limited to the few countries that have comprehensive firm data bases with investments decisions.

One of the issues that have received considerable attention is the effect of exchange rate risk on the volume of trade. It has been argued that higher volatility of exchange rates leads to a decrease in international trade transactions. This is because most trade contracts are not for immediate delivery of goods; and since they are denominated in terms of the currency of either the importer or the exporter, unanticipated fluctuations in the exchange rate affect realized profits and hence the volume of trade. It is implicitly assumed that forward exchange markets that can help traders eliminate this type of variations in profits either are not available (as it is true for the majority of currencies because most are not fully convertible, thereby impairing forward markets) or for some reason they are not utilized to fully hedge exchange risk present in trade transactions.

The empirical evidence, regarding the effect of exchange rate risk on trade, has at best been inconclusive. The large majority of the empirical studies are unable to establish a systematically significant link between exchange rate variability and the volume of international trade whether on an aggregate or on a bilateral basis. Abrams (1980), Akhtar and Hilton (1984), Cushman [4; 5; 6] and Kenan and Rodrik [12] find some significant negative effects of exchange volatility on exports. However, Bailey, Tavlas, and Uhlan [3], Hooper and Kohlhagen[ 10] and an International Monetary Fund Study [11] do not find any supporting evidence for the depressing effect of exchange rate volatility on international trade. It is also interesting to note that, in many of these studies, a significant positive effect of exchange rate volatility on the volume of trade is found for some cases. However, the positive effect, believed to be at odds with the theory was either ignored or dismissed as a perverse result, since “as far as volumes are concerned, theoretical considerations are unambiguous in suggesting that increased uncertainty should reduce the level of trade” [11, 18]. However, whether an increase in the volatility of the exchange rate – increases or decreases investment (trade), will in general depend on the risk aversion parameter of the model. The existing work on the effects of exchange rate uncertainty on trade has employed, as recognized by Hooper and Kohlhagen [10] a restrictive version of portfolio choice which leads to an unambiguously negative relation.

Scholars such as Bhagwati (1988) have noted that an increase in GDP generally leads to a corresponding expansion of trade, unless the pattern of growth-induced supply and corresponding demand creates an anti-trade bias. Neoclassical trade theory typically stresses the causality that runs from home-factor endowments and productivity to the supply of exports. In the case of Austria, Kunst and Marin (1989) find empirical evidence of growth-driven exports. The product life cycle hypothesis developed by Vernon (1966) also has attracted considerable attention among international trade theorists in recent years. Segerstrom, Anant, and Dinopoulos (1990), for example, use the product life cycle hypothesis as a basis for analysing North-South trade in which research and development races between firms determines the rate of product innovation in the North.

The most interesting economic scenarios suggest a two-way causal relationship between growth and trade. According to Bhagwati (1988), increased trade (for whatever reason) produces more income (increased GDP), and more income facilitates more trade – the result being a ‘virtuous circle.’ This type of feedback has also been noted by Grossman and Helpman (1991) in their models of North-South trade.

Whether trade cause GDP gains or losses, whether GDP trade cause exports, or whether a two-way causal relationship exists between trade and GDP can, in the end, be decided only empirically.

Foreign Direct Investment – Trends in Mauritius

International Trade – Trends in Mauritius