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Chapter 5. The Theory of Trade and Investment. Learning Objectives. To understand the traditional arguments of how and why international trade improves the welfare of all countries

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Chapter 5

The Theory of Trade and Investment

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Learning Objectives

  • To understand the traditional arguments of how and why international trade improves the welfare of all countries

  • To review the history and compare the implications of trade theory from the original work of Adam Smith to the contemporary theories of Michael Porter

  • To examine the criticisms of classical trade theory and examine alternative viewpoints of which business and economic forces determine trade patterns between countries

  • To explore the similarities and distinctions between international trade and international investment

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Evolution of Trade Theory

  • The Age of Mercantilism

  • Classical Trade Theory

  • Factor Proportions Trade Theory

  • International Investment and Product Cycle Theory

  • The New Trade Theory: Strategic Trade

  • The Theory of International Investment

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The Age of Mercantilism

The evolution of trade into the form we see today reflects three events:

The Collapse of Feudal Society

The Emergence of the Mercantilist Philosophy

The Life Cycle of the Colonial Systems of the

European Nation-States

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  • Mixed exchange through trade with accumulation of wealth

  • Conducted under authority of government

  • Demise of mercantilism inevitable

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Classical Trade Theory

  • The Theory of Absolute Advantage

    • The ability of a country to produce a product with fewer inputs than another country

  • The Theory of Comparative Advantage

    • The notion that although a country may produce both products more cheaply than another country, it is relatively better at producing one product than the other

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Classical Trade Theory Contributions

  • Adam Smith—Division of Labor

    • Industrial societies increase output using same labor-hours as pre-industrial society

  • David Ricardo—Comparative Advantage

    • Countries with no obvious reason for trade can specialize in production, and trade for products they do not produce

  • Gains From Trade

    • A nation can achieve consumption levels beyond what it could produce by itself

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Factor Proportions Trade Theory

Developed by Eli Heckscher

Expanded by Bertil Ohlin

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Factor Proportions Trade TheoryConsiders Two Factors of Production

  • Labor

  • Capital

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Factor Proportions Trade Theory

A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive).

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The Leontief Paradox

The Test:

Could Factor Proportions Theory be used to explain the types of goods the United States imported and exported?

The Method:

Input-output analysis

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The Leontief Paradox

The Findings:

The U.S. exported labor-intensive products and imported capital-intensive products.

The Controversy:

Findings were the opposite of what was generally believed to be true!

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Overlapping Product Ranges Theory:Staffan Burenstam Linder

  • Trade in manufactured goods dictated not by cost concerns, but by similarity in product demands across countries.

  • Work focused on preferences of consumer demand.

  • Today, termed market segments.

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Product Cycle Theory

  • Raymond Vernon

  • Focus on the product, not its factor proportions

  • Two technology-based premises

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Product Cycle Theory:Vernon’s Premises

  • Technical innovations leading to new and profitable products require large quantities of capital and skilled labor

  • The product and the methods for manufacture go through three stages of maturation

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Stages of the Product Cycle

The New Product

The Maturing Product

The Standardized Product

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The Product Cycle and Trade Implications

  • Increased emphasis on technology’s impact on product cost

  • Explained international investment

  • Limitations

    • Most appropriate for technology-based products

    • Some products not easily characterized by stages of maturity

    • Most relevant to products produced through mass production

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The New Trade Theory: Strategic Trade

Two New Contributions

  • Paul Krugman-How trade is altered when markets are not perfectly competitive

  • Michael Porter-Examined competitiveness of industries on a global basis

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Strategic Trade

Krugman’s Economics of Scale:

Internal Economies of Scale

External Economies of Scale

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Strategic Trade

  • Government can play a beneficial role when markets are not purely competitive

  • Theory expands to government’s role in international trade

  • Four circumstances exist that involve imperfect competition in which strategic trade may apply

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Strategic Trade

The Four Circumstances Involving Imperfect Competition:





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Strategic Trade

Porter’s Diamond of National Advantage

  • Innovation is what drives and sustains competitiveness

  • Four components of competition

    • Factor Conditions

    • Demand Conditions

    • Related and Supporting Industries

    • Firm Strategy, Structure, and Rivalry

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Michael Porter’s Competitive Clusters

  • Critical masses of unusual competitive success in particular fields, located in one place

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The Theory of International Investment

  • The movement of capital has allowed foreign direct investments across the globe

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The Theory of International Investment

  • Firms as Seekers

    • Seeking Resources

    • Seeking Factor Advantages

    • Seeking Knowledge

    • Seeking Security

    • Seeking Markets

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The Theory of International Investment

  • Firms as Exploiters of Imperfections

    • Imperfections in Access

    • Imperfections in Factor Mobility

    • Imperfections in Management

  • Firms as Internalizers

    • Establish their own multinational operations-internalize production

    • Competitive advantage due to confidentiality