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Theories of International
Trade and International
Investment
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Objectives
Through this chapter, the student will be exposed to:

• International trade in general and its importance


• Mercantilism
• Adam Smith and the theory of absolute advantage
• David Ricardo and the theory of comparative advantage
• The Heckscher–Ohlin (H-O, factor proportions) model
• Raymond Vernon and the product life cycle theory of trade
• Contemporary trade theories
• Porter’s diamond.

Opening Case
Cyprus and Trade
Throughout its history, Cyprus, an island in the eastern Mediterranean Sea,
has been heavily involved in trade. Cyprus traded with the Phoenicians, the
Venetians, the Arabs, the Assyrians, the Romans, and the Greeks. It is a
country with approximately 800,000 inhabitants, with the majority being
Greek-Cypriots and a minority Turkish-Cypriots, Armenians, and Maronites
(a sect of the Catholic Church that originated in Lebanon).

65

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66 International Business
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From the Neolithic period to the middle Bronze Age, ca. 7500–1600 bc,
we know of the first Cypriots who inhabited the island and were involved
in the trade of pottery and copper. By ca. 1700 bc, there was a mass export
of pottery to Syria and Palestine. During the late Bronze Age, ca. 1600–
1050 bc, the island emerged as a commercial center, with trade exchanges
intensifying with Egypt and the Levant, especially with the emporium of
Ugarit on the north Syrian coast. Cypriot pottery, apart from copper, now
enjoyed a wide circulation overseas. Commercial enterprise encouraged the
growth of large mercantile cities on the east and southeast coasts of the
island.
From 1250 bc onward, Cyprus became embroiled in the general collapse
of Bronze Age civilizations in the eastern Mediterranean. Peaceful commerce
was interrupted by piracy; among Mycenaean visitors, the merchant was
replaced by the soldier of fortune.
The Iron Age, ca. 1050–300 bc, around 8th Century, was a time of
Buy this file fromrecovery and of rapidly widening horizons for trade with Cyprus. Contact
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with the Aegean was restored, and eastward trade flourished once again.
During the Hellenistic and the Roman period, ca. 300 bc–ad 330, Cyprus
continued to trade mainly with Egypt and the other provinces under the
Roman Empire.
Under the Greco-Roman period, 50 bc–ad 395, and the Byzantine period,
395–1191, Cyprus expanded its trade activities, especially with regard to
pottery, copper, and bronze products in most of Europe, North Africa,
and the Middle East all the way to Persia (what is known as Iran today)
and India.
There were a number of rulers in Cyprus since 1184, ranging from the
Lusignan Dynasty (1192–1489) to the Venetian Occupation (1489–1571),
to the Turkish Occupation, as an Ottoman province (1571–1878). Then,
Cyprus came under the British Administration from 1878 to 1960, when it
gained its independence from the British Crown. During all these periods,
Cyprus was heavily involved in trade, mainly with the native lands of its
rulers and the other lands they had occupied.
In 1960, the newly formed government of Cyprus inherited an economy
that exhibited most of the symptoms of underdevelopment. The productive
base of the country was inadequate and economic activity was dependent
on unstable factors; agriculture was the dominant sector in economic activ-
ity and accounted for 16 percent of the gross domestic product (GDP) and
45 percent of gainful employment; manufacturing activity was essentially
restricted to the processing of locally produced agricultural raw materi-
als; tourism had not yet taken off; exports had the characteristic structure
of underdeveloped countries, with primary commodities such as minerals
(53 percent of the total) and agricultural products (32 percent of the total)
dominating; hidden unemployment and underemployment were widespread

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Theories of International Trade and International Investment 67

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and mass emigration was taking place; financial capital was flowing out of
the country, a clear indication of the existing uncertainty.
The Government of Cyprus through a number of five-year plans started
working on the recovery of the economy, and the years between indepen-
dence in 1960 and the Turkish Invasion in 1974 were characterized by
sustained growth, accompanied by conditions of external and internal eco-
nomic stability. The GDP grew at an average annual rate of about 7 percent
in real terms. Agricultural production doubled, while industrial production
and exports of goods and services more than trebled. Tourism became the
single largest foreign exchange earner. Fixed capital formation increased
from 18 percent of GDP in 1961 to 28.5 percent in 1973. Exports from
1960 to 1973 were worth 1 billion US dollars and the main exports were
agricultural products, wine, and citrus to the United Kingdom, Germany,
Greece, the Scandinavian countries, and clothing and shoes to the Middle
East. Total imports for the same period were twice the amount of exports.
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Imports were in terms of heavy machinery and equipment, vehicles, elec-
tric appliances, and other raw materials, from the United Kingdom, other
European countries, and the United States.
In 1974, the rapid and sustained economic development was utterly dis-
rupted by the Turkish Invasion and the occupation of about one third of
the territory of the country by the Turkish army. Under this situation, the
Government of Cyprus adopted a short-term campaign of providing relief to
the 200,000 refugees displaced by the Turkish Army, and from a medium-
and long-term perspective, it was considered essential to arrest the economic
slide and lay the foundations for economic recovery and the creation of
new employment opportunities. Both objectives necessitated the adoption
of expansionary fiscal and monetary policies and the promotion of labor-
intensive projects.
The progress of the economy is indicated by the impressive rate of growth,
which over the period 1975–1981 averaged 10 percent per annum in real
terms. This emanated primarily from the foreign demand for goods and ser-
vices, which grew on average by 15 percent in constant prices. The impressive
growth performance was based on a number of exogenous and endogenous
factors. Exogenous factors, such as the booming Arab markets, the Lebanese
crisis of 1975, favorable weather, and high international market prices for
some of the major Cyprus agricultural products, provided the impetus that
lifted the economy. An additional element was foreign aid, which helped
bridge the financing gap. Internally, the aggressive and expansionary fiscal
and monetary policies, the entrepreneurial ability, which exploited the aris-
ing export opportunities, the acceptance by trade unions of a substantial cut
in wage levels, and the diligence and work ethic of the people formed the
front that led the economy to the path of recovery.

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