International Trade Theories & FDI

Mercantilism:

Mercantilism is an economic theory, considered to be a form of economic nationalism that

holds that the prosperity of a nation is dependent upon its supply of capital, and that the global
volume of international trade is "unchangeable". Economic assets (or capital) are represented by
bullion (gold, silver, and trade value) held by the state, which is best increased through a positive
balance of trade with other nations (exports minus imports).

Absolute Advantage:

Principle of absolute advantage refers to the ability of a party (an individual, or firm, or
country) to produce more of a good or service than competitors, using the same amount of
resources. Countries should produce those goods in which they have absolute advantage.

Comparative Advantage:

The law of comparative advantage refers to the ability of a party (an individual, a firm, or a
country) to produce a particular good or service at a lower opportunity cost than another party. It
is the ability to produce a product most efficiently given all the other products that could be
produced. “Abilities are compared and if other countries are efficient in production of some
goods you should not produce that rather switch to other product.” Assume that no difference in
currency value and factor of production are movable.

Heckscher-Ohlin Theorem:

The Heckscher–Ohlin theorem says "A capital-abundant country will export the capital-
intensive good, while the labor-abundant country will export the labor-intensive good."

Product Life-Cycle Theory:

The product life-cycle theory suggests early in a product’s life-cycle all the parts and labor
associated with that product come from the area in which it was invented. After the product
becomes adopted and used in the world markets, production gradually moves away from the
point of origin. In some situations, the product becomes an item that is imported by its original
country of invention.

New Trade Theory:

New Trade Theory (NTT) is a collection of economic models in international trade which
focuses on the role of increasing economies of scale and network effects (words of mouth).
Michael Porter Diamond Model:

The Diamond model of Michael Porter for the Competitive Advantage of Nations offers a
model that can help understand the competitive position of a nation in global competition. This
model can also be used for other major geographic regions.

These interlinked advanced factors for Competitive Advantage for countries or regions in
Porters Diamond framework are:

1. Firm Strategy, Structure and Rivalry

The world is dominated by dynamic conditions, and it is direct competition that impels firms to
work for increases in productivity and innovation

2. Demand Conditions
The more demanding the customers in an economy, the greater the pressure facing firms to
constantly improve their competitiveness via innovative products, through high quality, etc)

3. Related Supporting Industries

Spatial proximity of upstream or downstream industries facilitates the exchange of information
and promotes a continuous exchange of ideas and innovations

4. Factor Conditions
Contrary to conventional wisdom, Porter argues that the "key" factors of production (or
specialized factors) are created, not inherited. Specialized factors of production are skilled
labor, capital and infrastructure.

Factor Endowment:
It is commonly understood as the amount of land, labor, capital, and entrepreneurship that a
country possesses and can exploit for manufacturing.

Instruments of Trade Policy:

1) Tariffs

2) Subsidies

3) Import Quotas & voluntary export restraints

4) Local content requirement

5) Administrative policies

6) Anti-dumping policies
 Foreign Direct Investment

Foreign Direct Investment (FDI) refers to long term participation by country A into country B.
It usually involves participation in management, joint-venture, transfer of technology and "know-
how". There are two types of FDI: inward foreign direct investment and outward foreign direct
investment, resulting in a net FDI inflow.

Types of FDI:

Horizontal FDI is FDI in the same industry abroad as that in which a firm operates at home.

Vertical FDI is FDI in associated industries in the chain of vertical integration.

Factors for FDI:

1) Transportation Cost

2) Market Imperfection

3) Strategic Behavior

4) Product Life Cycle

5) Location Advantage

Radical View: MNEs are coming to just extract the profits from the host country and they won’t
return anything. Keep the developing or under-developed countries as they are.

Free Market View: MNEs should produce in other countries to balance the production.

Pragmatic Nationalism: There are some benefits & cost for both counties.