Chapter # 2: International Trade Policy and Trade Institutions
v International trade allows countries to specialize in those areas of economic activity to which their
resources and skills are best suited.
o It is also an indispensable source of tax revenue for government treasuries.
o Tax revenues could be used to support social programs such as education and health care
also infrastructure development.
v Mercantilism: A nations wealth is measured by its stock of precious metals.
o Dominant economic philosophy that drove national approaches to international trade
and wealth accumulation.
o Zero-sum game: for one party to win the other must lose.
o Mercantilists viewed economic system as consisting of three components:
o Balance of trade: is the difference between a countrys exports and imports.
o Exports were subsidized while imports were subject to high tariffs and quotas two
policy measures which restrict international trade.
v Absolute Advantage: a country should specialize in the production of what it could produce more
efficiently than its prospective trading patterns, and trade with those countries for all other products it
wished to consume.
o Labour theory of value: commodities should be valued in terms of amount of labour
embodied in their production.
o Counties should specialize in those products requiring the fewest units of labour; they
should produce products in which they have an absolute advantage.
v Comparative Advantage: argument that it was possible for a country to gain from international trade
even when it did not possess an absolute advantage.
o Comparative advantage would exist provided there was a difference in the relative
labour requirements for the production of a particular product.
v Heckscher-Ohlin Model: a country will export the products that use most intensely its most abundant
factor of production. It will import those products which use most intensely its least abundant factor of
o Different products have different factor intensities, which mean that they require
relatively more capital or more labour to manufacture.
1. Ex: production of steel requires relatively more capital than the production of
cloths (labour intensive product).
2. Clothing is likely to be cheaper in a country such as India with its abundance of
labour than in Canada where labour is relatively less abundant.
3. These differences in country endowments and factor intensities result in price
differences that drive counties to trade with each other.
v The Product Cycle Theory: developed to account for failure of the Hechscher-Ohlin model to explain
international trade patterns. o Assumes that an advanced country such as Canada would produce products which
catered to high-income countries and which were relatively labour saving and capital
o The life cycle of a product is divided into three stages:
1. First stage: The product is produced only in Canada new and innovative
product, firms producing the product are assumed to want to market it in
Canada where demand is strongest and consumer response can be adequately
2. Second (maturity stage): Export to other advanced countries ex: Canada to
USA & Europe.
Adopt mass production and exploit economies of scale.
3. Third (Standardized product stage): manufacture of product shifts to
Products are now well known
Widespread consumer acceptance.
Driven by low labour costs.
v The Linder Theory: explains trade patterns by examining consumer demand.
o Tastes and preferences of consumers would be function of income levels.
o Countries should be expected to trade most intensely with countries with similar levels of
per capita income and less intensely with countries with dissimilar levels of per capita
o Country similarity theory
v Krugman`s Model of International Trade (New trade Theory): international trade has the effect of
increasing incomes, expanding overall output, and increasing the range of products available to
o Non-monopolistic competition: firms produce differentiated products, and consumer
brand loyalty is possible. As two countries enter an international trading relationship,
the size of the overall market expands, allowing firms in each country to increase
production and exploit economies of scale.
v The Diamond of National Advantage: on the concept of comparative advantage by postulating that a
county`s competitive advantage in international markets is driven by four factors:
1. Factor conditions-skilled labour force, energy, and natural resources.
2. Demand conditions existence of domestic knowledgeable and sophisticated
consumers who can drive product innovation and quality standards.
3. Supporting industries providing professional services
4. Firm strategy, structure, and rivalry drive productive efficiency and
competitiveness among domestic companies, making them stronger
participants in international markets.
o Ownership advantages: ownership of foreign production facilities conveys an advantage
on firms over competitors who do not own such facilities.
o Location advantages: ability to shift production, sales, and profits to low-tax jurisdictions. o Internalization Advantages: licensing agreements, allowing another firm to use its
intellectual property for a fee. Allows internalization of management skills, technology,
and capital assets.
v Transactions Cost Analysis: transaction costs are classified as being search costs (eg. Costs associated with
funding suitable input suppliers, agents, and distributers).
o Firms seek to minimize transaction costs in order to expand their markets globally.
o Contracting costs: cost associated with negotiating and drawing up contracts between
the firm and its suppliers and market intermediaries.
o Monitoring costs: costs of monitoring contractual agreements.
o Enforcement costs: costs associated with enforcing contractual agreements.
v Non-tariff barriers: Voluntary agreements to restrain trade and bilateral or multilateral special trade
agreements such as the Multifibre Agreement, which restricts trade in textiles and apparel.
v Doha round: developing country round focuses on agriculture a sector of critical importance in
o Safeguard measures for developing countries to protect their markets from importing
surges and declining commodity prices.
v UNCTAD: United Nations Conference on Trade and Development.
v ITC: International Trade Centers
v Infant industry agreement: protection of newly independent countries from direct competition in order
to survive and prosper.
v Employment Agreement: protection of domestic industry from the standpoint of maintaining
employment levels in key sectors.
v National Security Agreement: restrict international trade and investment that could be a risk on national
v Protectionism: measures adapted by national governments to unduly restrict trade and foreign
o Government use various policy measures to restrict trade and investment flows and
protect domestic industries: tariffs, quotas, voluntary trade restrictions, and quality
v Tariffs: tax imposed by a domestic government on an internationally traded product.
v Export tariff: on product being exported from a country.
v Import tariff: on a product being imported into a country.
v Ad valorem tariff: tariffs generate revenues for the domestic government that levies them and may be
assessed as a percentage of market value of the imported product.
v Specific tariff: specific dollar amount on each unit of the product that enters, leaves, or is transshipped
through the country.
v Transit tariff: product that is being transshipped from one country to another.
v Compound tariff: have both ad valorem and specific components. v Quota: quantitative restriction on the volume of a product that can be imported into a country over a
specified time period. Form of non-tariff barrier (NTB) used on countries to restrict free trade and
protect domestic industries.
v Absolute quota: place a strict limit on the volume of imports coming into a country.