International Trade Theories An international trade theory can be seen as a measure to address problems in a country with a weak macro

economy, high unemployment and inflation. International commitment to a free market economy will bring prosperity to the world economic system. Since 1970, the time of Adam Smith, economists have shown that free trade is efficient and leads to economic welfare. Mercantilism This trade theory suggested that a government can improve economic well being of the country by increasing exports and reducing imports, but turned out to be a flaw strategy. Absolute Advantage A country has an absolute advantage over it trading partners if it is able to produce more of a good or service with the same amount of resources or the same amount of a good or service with fewer resources. Comparative Advantage A country has a comparative advantage in the production of a good or service that it produces at a lower opportunity cost than its trading partners. Some countries have an absolute advantage in the production of many goods relative to their trading partners. Some have an absolute disadvantage. They are inefficient in producing anything, relative to their trading partners. The theory of comparative costs argues that, put simply, it is better for a country that is inefficient at producing a good or service to specialize in the production of that good it is least inefficient at, compared with producing other goods. Factor Endowment Theory - Hecksher Ohlin theory powerfully supplements the theory of comparative advantage by bringing consideration to the endowment and cost of factors of production. The Heckscher Ohlin theorem states that countries which are rich in labor will export labor intensive goods and countries which are rich in capital will export capital intensive goods. The theory states that countries like China with big labor force will focus on labor intensive goods, and Sweden with more capital will focus on producing goods that are capital intensive. The production of goods and services requires capital and workers. Some goods require more capital - technical equipment and machinery - and are called capital intensive. Examples of these goods are cars, computers, and cell phones. Other goods require less equipment to produce and rely mostly on the efforts of the workers. These goods are called labor intensive. Examples of these goods are shoes and textile products such as jeans.

Heckscher-Ohlin's theory explains the modern approach to international trade on the basis of following assumptions: 1. There are two countries involved. 2. Each country has two factors (labor and capital). 3. Each country produce two commodities or goods (labor intensive and capital intensive). 4. There is perfect competition in both commodity and factor markets. 5. All production functions are homogeneous of the first degree i.e. production function is subject to constant returns to scale. 6. Factors are freely mobile within a country but immobile between countries. 7. Two countries differ in factor supply. 8. Each commodity differs in factor intensity. 9. The production function remains the same in different countries for the same commodity. For e.g. If commodity A requires more capital in one country then same is the case in other country. 10. There is full employment of resources in both countries and demand are identical in both countries. 11. Trade is free i.e. there are no trade restrictions in the form of tariffs or nontariff barriers. 12. There are no transportation costs. Given these assumption, Ohlin's thesis contends that a country export goods which use relatively a greater proportion of its abundant and cheap factor. While same country imports goods whose production requires the intensive use of the nation's relatively scarce and expensive factor. Example: Imagine two countries that each produces both jeans and cell phones. Although both countries use the same production technologies, one has a lot of capital but a limited number of workers, while the other country has little capital but lots of workers. The country that has a lot of capital but few workers can produce many cell phones but few pairs of jeans because cell phones are capital intensive and jeans are labor intensive. The country with many workers but little capital, on the other hand, can produce many pairs of jeans but few cell phones. According to the Heckscher-Ohlin theory, trade makes it possible for each country to specialize. Each country exports the product the country is most suited to produce in exchange for products it is less suited to produce. The

country that has a lot of capital specializes in the production of cell phones, whereas the country that has more labor specializes in the production of jeans.

In this case, neither country has specialized in producing more of one of the two particular products - both countries produce about the same number of jeans and cell phones.

Country A - having more capital than labor - has specialized in producing more cell phones. Country B - having more labor than capital - has specialized in producing more jeans. In this case, trade may benefit both countries involved. Overlapping Demand Theory: Stefan Linder (1961) presented overlapping demand theory by focusing demand driven aspects of manufacturing products in international trade. According Linders theory, in each country industries produce goods designed to please the taste of the domestic consumers. However not every consumer is alike and some prefer alternative products, with

slightly different characteristics. International trade provides means to obtain these goods. Thus, the international trade is that consumers benefit of widely variety of goods. Further Linder explains relationship between similar standards of living and factor endowments in countries. Since the theory describes consumer preferences of both potential exports and imports countries, it is known as Similarity of Preferences Theory. This theory suggests that intra-industry trade takes place between the countries with similar levels of development. According this theory, the companies that develop new products for the domestic market, export the products to those countries that are at similar level of development after meeting the needs of the domestic market. According to Linder, the similarities in consumer preferences in the countries that are at the same economic development provide the scope for intra-industry trade among countries. example India and China However mostly developing countries do not trade between themselves as the surplus of most of these countries would be raw materials and agricultural products and their requirements would be technology and high technology-oriented products. example, Vietnam and Ethiopia. Basis for trade among countries 1) Similarity of location 2) Cultural similarity 3) Similarity of political and economic interests SIMILARITY OF LOCATION Countries prefer to export to the neighboring countries in order to have the advantages of less transportation cost. For example, Finland is a major exporter to Russia due to less transportation costs. CUTLURAL SIMILARITIES

Countries prefer to export to those countries having similar culture. For example, exports and imports among European countries, between USA and Canada ,among the Asian countries, and among the Islamic countries. SIMILARITY OF POLITICAL AND ECONOMIC INTERESTS Similar political interests close political relations and economic interests enable the countries to enter into agreements for exports and imports. Countries prefer to trade with their politically friendly countries. For example, India used to export to the former USSR. The feud of the USA with Cuba resulted in the USA importing of sugar from Mexico by abandoning sugar import from Cuba

References:
http://scribd.com http://www.eco.uc3m.es/~desmet/internationaltrade/slides/eng_HO.pdf http://www.econ.rochester.edu/people/jones/Palgrave_Jones_on_Heckscher_Ohlin.pdf http://www.slideshare.net/ampotzki/savedfiles?s_title=chapter-3-theories-of-internationaltrade&user_login=Shelly38 http://www.slideshare.net/ampotzki/savedfiles?s_title=factor-endowments-and-effect-ontrade&user_login=RChengeta http://www.slideshare.net/ampotzki/savedfiles?s_title=heckscher-ohlin-modelpresentation&user_login=zeddem http://www2.econ.iastate.edu/classes/econ355/choi/ho.htm

Mariano Marcos State University College of Business, Economics and Accountancy Batac City, Ilocos Norte

INTERNATIONAL TRADE THEORIES: FACTOR ENDOWMENT THEORY AND THEORY OF OVERLAPPING DEMAND

By: Queenie Ray Y. Gallardo Jessah Lavinah Balbas Rochelle Ann Quaoit Ericah Jean Tagalicud

Ms. Carmela R. Guillermo Instructor