Trade and investment theories

Question 1

Why do countries trade?

Answer 1

Trade enables countries to use their national resources more efficiently through specialisation

Question 2

Classical theory:

Comparative advantage principle - David Ricardo - 1817

Answer 2

• Beneficial for 2 countries to trade as long as one is relatively more efficient at producing goods & services needed by the other. What matters is not the absolute cost of production but rather the relative efficiency with which a country can produce the product
• Lowest opportunity cost determines who has the comparative advantage relative to the other country
• Makes sense because the market price is lower than their opportunity cost
• Stems from ideas of natural resources of each country but CA can be created or acquired by investments e.g. Japan investing in the consumer electronics industry - acquired more knowledge and skills to create an advantage

Question 3

International product life cycle theory - Raymond Vernon - 1966

Answer 3

Each product goes through 3 stages of evolution: introduction, maturity and standardisation

• Intro stage: a new product is introduced in an advanced economy, because they have substantial capital and R&D resources which are advantages for inventing new goods - a temporary monopoly is created in the inventing country
• Maturity stage: products inventors mass produce it, and seek to export to other advanced economies BUT foreign firms will produce alternative versions, ending the inventor’s monopoly - competition intensifies and lower-income countries start to want the product - inventors have small profit margin
• Standardisation: knowledge about how to make product is widespread, manufacturing straightforward, cheaper inputs and lower cost labour in lower-income countries - product exported to world
• BUT vernon assumed product diffusion process happened slowly enough to generate temporary advantages - this is not the case as the IPLC demonstrates national advantages don’t last forever and the cycle is becoming much shorter as emerging markets adopt trends much quicker

Question 4

Limitations of early trade theories

Answer 4

• Fail to account for complexities in contemporary trade
• Traded products are not just commodities anymore such as wheat etc, today many products are characterised by strong branding and differentiated features
• Large scale production in certain industries may bring about scale economies that help offset weak national comparative advantage
• Many services can not be traded like they used to be able and must be internationalised by FDI thus classical theories have limited applicability to international commerce in services

Question 5

Contemporary theory:

Competitive advantage theory - michael porter - 1990

Answer 5

• The collective competitive advantages of the nation’s firms derives from distinctive assets or competencies which are difficult to imitate
  the relationship is reciprocal i.e. the CA of the nation will drive the development of new firms with these same CA e.g. Britain in the drug industry e.g. GSK
• Born out of innovation - the more innovative firms in a nation, the stronger the firm’s competitive advantage
• The most important point this theory raises is that CA does not derive entirely from the store of natural resources but from the development of advantages