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International Trade Theory

1. explains why it is beneficial for countries to engage in international trade
2. helps countries formulate their economic policy
3. explains the pattern of international trade in the world economy

Free Trade

the absence of government barriers to the free flow of goods and services between countries

Why is it beneficial for countries to engage in free trade?

1. International trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, and import products that can be produced more efficiently in other countries
a. it is beneficial for a country to engage in international trade even for products it is able to produce for itself
2. While trade theories all suggest that trade is beneficial, they lack agreement in their recommendations for government policy


economic philosophy advocating that countries should encourage exports and discourage imports
a. advocates government intervention to achieve a surplus in the balance of trade

Zero-Sum Game (Mercantilism)

a gain by one country results in a loss by another

Mercantilism is problematic and economically invalid, yet...

many political views today embrace mercantilist policies

Adam Smith (1776)

countries differ in their ability to produce goods efficiently

A country has a(n) ______ in the production of a product when it is more efficient than any other country in producing it

absolute advantage

According to Adam Smith's theory of Absolute Advantage:

1. trade is not a zero-sum game
2. countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries

Ricardo's (1817) Theory of Comparative Advantage

a country should specialize in the production of those goods that it produces most efficiently and buy the goods that it produces less efficiently from other countries even if this means buying goods from other countries that it could produce more efficiently itself.
trade is a positive sum game in which all gain.

Does Ricardo's Theory of Comparative Advantage provide a strong rationale for encouraging free trade?

Yes, because potential world production is greater with unrestricted free trade than it is with restricted trade

Heckscher-Ohlin Theory

comparative advantage arises from differences in national factor endowments. Thus, countries will export goods that make intensive use of those factors that are locally abundant, and import goods that make intensive use of factors that are locally scarce.

Factor Endowments

the extent to which a country is endowed with resources such as land, labor, and capital

Leontief (1953)

since the U.S. was relatively abundant in capital, it would be an exporter of capital intensive goods and an importer of labor-intensive goods

Leontief Paradox

found that U.S. exports were actually less capital intensive than U.S. imports

Vernon's (mid 1960's) Product Life-Cycle Theory

as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade.

New trade theory (1970s) suggests (two points):

1. Because of economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods
2. In those industries when the output required to attain economies of scale represents a significant proportion of total world demand, the global market may only be able to support a small number of firms

2 implications of new trade theory:

1. nations may benefit from trade even when they do not differ in resource endowments or technology
2. a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good (first movers)

the 4 attributes of Porter's diamond (1990) are:

1. Factor endowments
2. Demand conditions
3. Related and supporting industries
4. Firm strategy, structure, and rivalry
4a. Chance
4b. Government

If correct, Porter's diamond should:

predict the pattern of international trade in the real world:
a. Countries should export products from industries where the diamond is favorable
b. Countries should import products from areas where the diamond is not favorable

3 main implications of international trade theory for international businesses:

1. Location implications
2. First-mover implications
3. Policy implications

New-Trade Theory

theory that sometimes countries specialize in the production and export of a particular product not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of firms

Drawback of the product life cycle theory

While the theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the US in the 1960s and 1970s, the increasing globalization and integration of the world economy has made this theory less valid in today's world

______ provides an economic rationale for a proactive trade policy that is at variance with other free trade theories

new trade theory

Constant Returns to Specialization

the units of resources required to produce a good are assumed to remain constant no matter where one is on a country's production possibility frontier

Economies of Scale

unit costs are reduced as production output is increased, up to a certain point

First-Mover Advantages

advantages accruing to the first firms to enter a market

________ identified four attributes to attempt to explain how a nation achieves success in a particular industry

Porter's Diamond

Demand Conditions (porter's diamond)

the nature of home demand for an industry's product or service

Relating and Supporting Industries (porter's diamond)

the presence or absence of supplier industries and related related industries that are internationally competitive

Firm strategy, structure, and rivalry (porters diamond)

the conditions governing how companies are created, organized, and managed and the nature of domestic rivalry

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