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MGT520 - International Business - Lecture Handout 21

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In 1776, Adam Smith questioned the prevailing Mercantilist ideas on trade and developed the theory of Absolute Advantage. Smith reasoned that if trade were unrestricted, each country would specialize in those products in which it had a competitive advantage. Each country’s resources would shift to the efficient industries because the country could not compete in the inefficient ones. Through specialization, countries could improve their efficiency because 1) labor could become more skilled by repeating the same tasks, 2) labor would not lose time in switching among production of different products, and 3) long production runs would provide incentives for the development of more efficient working methods.

Natural Advantage:

A country may have a natural advantage in some products because of climate or other natural resources (labor, minerals, etc.).

Acquired Advantage:

In manufactured goods, countries usually have acquired an advantage in either their product or process technology.

Resource Efficiency Example:

Figure 5.2 illustrates how the United States has an absolute advantage in wheat, while Sri Lanka has an absolute advantage in tea. By the U.S. specializing in wheat production and Sri Lanka specializing in tea production, the global production of tea and wheat can be increased.


Would there still be benefits to be gained from trade if a single country were more efficient at both products (i.e., the same country had an absolute advantage in both products)? In 1817, David Ricardo examined this question and found that, yes, trade was still beneficial even when the same country was better at producing both goods.

A. An Analogous Explanation of Comparative Advantage:

Assume the best physician in town is also the best medical secretary. Should he try to do both tasks? No, if the physician wants to maximize his/her income, s/he should work as a physician and hire someone else to serve as medical secretary. The same kind of logic applies to the theory of comparative advantage.

B. Production Possibility Example:

See Figure 5.3 in the text. The illustration is altered (from Figure 5.2) to where the United States now is more efficient than Sri Lanka in both wheat production and tea production. However, the United States has a comparative advantage in wheat production (over tea production). Therefore, by concentrating on the product where it has its greatest efficiency advantage (wheat) and letting Sri Lanka produce the product (tea) in which the United States is comparatively less efficient, global output can be increased and specialization and trade can benefit both countries.


A. Full Employment:

These theories assume full employment. Let’s say that the physician above had free time on his hands (less than full employment). It might then be in his/her best interest to do the medical secretary tasks as well.

B. Economic Efficiency Objective:

In the physician example, it was assumed that profit maximization was the physician’s goal. That may not be the case. Perhaps the physician enjoyed doing administrative tasks. In the same way, countries often pursue objectives other than output efficiency.

C. Division of Gains:

While specialization does increase output, it is unclear how the gains from the additional output will be divided. Trade will benefit both countries, but it usually does not benefit both countries equally. If one country perceives a trading partner as receiving too large a share of the benefits, that country may forgo its relatively small absolute gains in order to prevent the other country from receiving large gains.

D. Two Countries, Two Commodities:

The world is comprised of multiple countries and multiple commodities. Although the assumption of two countries and two commodities is unrealistic, it does not diminish the theories’ usefulness. Economists have applied the same reasoning and demonstrated economic efficiency advantages in multiproduct and multicountry trade relationships.

E. Transport Costs:

If it costs more to transport the goods than is saved through specialization, then the advantages of trade are negated.

F. Mobility:

The theories of absolute and comparative advantage assume that resources can move domestically from the production of one good to another, and at no cost. This is often not correct. For example, a steelworker in Indiana might not move easily into a software development job in California.

G. Services:

Though the theories discussed above deal with commodities, much of the reasoning can be applied to trade in services as well since, like commodities, the production of services consumes resources.


Absolute and comparative advantage theories do not consider the impact of country size on trade patterns. This is discussed ahead.

A. Variety of Resources:

Large countries are apt to have greater variety in climate and natural resources, making them more selfsufficient than smaller countries.

B. Transport Costs:

Large countries tend to face larger transportation costs in serving their markets domestically. It may be cheaper to buy imports simply if you live near the border than to have domestically produced cheaper goods shipped from across the country.

C. Size of Economy and Production Scales:

For products that can be produced more efficiently en masse, small countries will tend to export more, while large countries may be able to achieve economies of scale simply by producing for their domestic market.


Hecksher and Ohlin helped predict the types of products in which countries would possess a comparative advantage. They predicted that countries would tend to export products that utilized factors of production which were relatively abundant in their country.

A. Land-Labor Relationship:

In countries with a lot of labor relative to the amount of land, labor (abundant) would be relatively cheaper than land (scarce). The country would then concentrate on the production of labor-intensive goods, since it could produce those goods more cheaply than could a country where labor was relatively scarce (and therefore more expensive

B. Labor-Capital Relationship:

In countries where there is little capital (scarce) available for investment and where the amount of investment per worker is low, one would expect labor rates to be low and export competitiveness to occur in goods requiring large amounts of labor relative to capital.

C. Technological Complexities:

The factor-proportions analysis becomes more complicated when the same product can be produced by different methods, such as with labor or capital. In the final analysis, managers must compare the cost in each locale based on the type of production that will minimize costs there.


Ray Vernon’s theory tries to explain why the production and consumption locations of goods change in predictable patterns over time.

Stage 1: Introduction:

New products tend to be produced in and consumed in high-income industrial countries.

  • Innovation, production, and sales in same country: New products tend to be developed near the market for these products. This domestic production ensures rapid feedback from the market.
  • Location and importance of technology: Industrialized countries tend to be the location preferences for R&D investment. Consequently, technological innovations tend to occur in industrialized countries.
  • Exports and labor: In stage one, production tends to be more labor-intensive. Process technology has not been automated and product technology is still in flux.

Stage 2: Growth:

As demand grows, the producer may be led to establish foreign production facilities in order to tap additional markets. Competitors in other developed countries might also begin production.

Stage 3: Maturity:

Worldwide demand begins to level off. Because markets and technologies are widespread, the innovating country no longer has a production advantage. There are incentives to move plants to emerging markets where unskilled, inexpensive labor is sufficient for standardized production processes.

Stage 4: Decline:

By this time, market and cost factors have led to almost all production occurring in emerging markets. Replacement units tend to now be exported from LDCs to the country where the innovation was first developed.

Verification and Limitations of the PLC Theory:

There are a number of exceptions to the PLC theory, such as products with very short life cycles, luxury products, products that require highly skilled labor, and products that never take on commodity-like characteristics.


A. Economic Similarity of Industrial Countries:

Most of the world’s trade occurs among countries that have similar characteristics (e.g., developed countries with other developed countries). Similar markets will have demand for similar products.

B. Similarity of Location:

Countries that are near each other will trade more than countries that are distant from each other. Transportation costs are only one of several facts explaining these patterns.

C. Cultural Similarity:

Having a similar language and religion tends to facilitate trade among countries.

D. Similarity of Political and Economic Interests:

Cuba and the United States, which have very dissimilar political and economic interests, don’t trade. Countries that see eye-to-eye politically and economically tend to have stronger trade relationships than those who do not.


No country is entirely independent from or entirely dependent on other countries. Rather, countries can be place on a continuum between those two extremes.

A. Independence:

In this instance, a country would have no reliance on other countries for any goods, service, or technologies. Of course, such a country would have to go without any goods they could not produce themselves. Certain indigenous tribes cut off from the rest of the world would serve as examples of extreme independence.

B. Interdependence:

In this instance, countries develop trade relationships based on mutual need. France and Germany, for example, have highly interdependent economies. Each depends about equally on the other as a trading partner, and so neither is likely to cut off supplies or markets for fear of retaliation.

C. Dependence:

Many developing countries have decried their dependence because they rely so heavily on the sale of one primary commodity and/or on one country as a customer and supplier. This dependence often has grown out of a colonial relationship. Roughly one-fourth of emerging economies depend on one country for more than half of their export earnings.


If an acquired advantage can give a country a competitive advantage in trade, it is natural that governments would be interested in developing acquired advantages in their country. How can governments help create successful industries within their borders? Two approaches are: 1) alter conditions that will affect industry in general; and 2) alter conditions that will affect a targeted industry.

Implications for Business:

  1. Most of the theories discussed have implications for the location of production activities. Firms will attempt to locate different activities in the location that is optimal for the production of that good, component, or service.
  2. Being a first mover can have important competitive implications, especially if there are economies of scale and the global industry will only support a few competitors. Firms need to be prepared to undertake huge investments and suffer losses for several years in order to reap the eventual rewards.
  3. Governmental policies with respect to free trade or protecting domestic industries can significantly impact global competitiveness. The opening case showed how Ghana's policies negatively impacted the global success of its cocoa business. While new trade theory may suggest that governments subsidize specific industries, Porter's theory focuses how policies can influence the attributes of the diamond.
  4. One of the most important implications for business is that they should work to encourage governmental policies that support free trade. If a business is able to get its goods from the best sources worldwide, and compete in the sale of products into the most competitive markets, it has a good chance to survive and prosper. If such openness is restricted, a business’s long-term survival will be in greater question.

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