International Trade Theory

1. International Trade Theory 5-1

2. Chapter Objectives • Explain trade theories • Discuss how global efficiency can be increased through free trade • Introduce prescriptions for altering trade patterns • Explore how business decisions influence international trade 5-2

3. International Trade • The purchase, sale, or exchange of goods and services across national borders. • International Trade: • Provides a country’s people with a greater choice of goods and services • Important engine for job creation • Trade in goods and services is one means by which countries are linked economically

4. World’s Top Merchandise Exporters US - USD693blln (10.7%) Germany – USD613.1 blln (9.5%) Japan – USD416.7 (6.5%) World’s Top Service exporters US – USD272.6 blln (17.4%) UK – USD123.1 blln (7.8%) Germany – USD99.6% (6.3%) Volume of International Trade

5. Degree of Dependence • Independence—complete economic independence • Country has no reliance on other countries for goods, services, or technologies • Price of independence is having to do without goods that cannot be produced domestically • Hinders country’s ability to borrow and adapt existing technologies • Interdependence— trade based on mutual need • Neither trading partner is likely to cut off supplies or markets for fear of retaliation • Governments may be pressured to sustain trade • Dependence—developing countries rely heavily on: • The sale of one commodity for export earnings • 25 % of emerging countries sell one commodity • One country as supplier or customer • Industrialized countries

6. General Types of Trade Theories • Descriptive: the natural order of trade • Laissez-faire conditions • Which products, how much, and with whom a country will trade in the absence of restrictions • Prescriptive: questions whether governments should interfere with the free movement of goods and services • Both types of theories • provide insights about markets for exports and potentially successful export products • help companies determine where to locate production facilities 5-3

7. Trade Theory Timeline NCA C A NTT A A IPLCT FPT M 1800 1900 1500 1600 1700 2000

8. Mercantilism • Initial trade theory that formed the foundation of economic thought from 1500 – 1800 • Based on concept that a nations wealth is measured by its holding of treasure (gold) • Nations should accumulate financial wealth by encouraging exports and discouraging imports. • Favorable balance of trade: country is exporting more than it is importing • Unfavorable balance of trade: country is importing more than it is exporting, i.e. a trade deficit 5-4

9. Nations often imposed restrictions on imports since they did not want “their” treasure moving to another country to pay for the imports • Intended to benefit colonial powers • colonies supplied commodities to the mother country • mother country tried to run trade surpluses with their own colonies Mercantilism faded after 1800

10. Mercantilism-Zero-Sum Game • In 1752, David Hume pointed out that: • Increased exports lead to inflation and higher prices • Increased imports lead to lower prices • Result: Country A sells less because of high prices and Country B sells more because of lower prices • In the long run, no one can keep a trade surplus

11. Neomercantilism Current term to describe the approach of countries that try to run favorable balances of trade to achieve some social or political gains 5-5

12. Theory of Absolute Advantage • Adam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more of a product with the same amount of input than another country can vary • A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient • Trade between countries is, therefore, beneficial • Assumes there is an absolute balance among nations • Example: Ghana/cocoa

13. Absolute Advantage • Absolute advantage holds that different countries produce some goods more efficiently than other countries • A nation with an absolute advantage can produce greater output of a good or service than other nations using the same amount of, or fewer, resources. • Thus, global efficiency can be increased through international free trade 5-6

14. Country Specialization • Under the concept of absolute advantage countries could increase efficiency because: • Labor could become more skilled by repeating the same tasks • Labor would not lose time in switching from the production of one kind of product to another • Long production runs would provide incentives for the development of more effective working methods 5-7

15. Natural Advantage • Countries have inherent advantages • Climate • Natural resources • Labor forces • Two countries that have opposite natural advantages should favor trade with one another 5-8

16. Acquired Advantage • Most contemporary trade is manufactured goods and services rather than agricultural goods or natural resources • Countries with an acquired advantage produce manufactured goods and services competitively • Product technology- Danish Silver tableware • Process technology – Japanese steel 5-9

17. Absolute Trade Advantage Figure 5.2 5-10

18. Theory of Comparative Advantage • David Ricardo (Principles of Political Economy, 1817): • Extends free trade argument • Efficiency of resource utilization leads to more productivity • Should import even if country is more efficient in the product’s production than country from which it is buying • Look to see how much more efficient • If only comparatively efficient, than import • Makes better use of resources • Trade is a positive-sum game

19. Comparative Advantage • There are still global gains to be made if a country specializes in products it produces more efficiently than other products • Regardless of whether other countries can produce those same products even more efficiently • A country has a comparative advantage when it is unable to produce a good more efficiently than other nations, but produces the good more efficiently than it does any other good. 5-11

20. Comparative Advantage Figure 5.3 5-12

21. Basic Assumptions • Full employment • Economic efficiency is sought • Division of gains • Two countries/two commodities • Transportation costs • Mobility • Statics and dynamics • Services • Country size/variety of resources 5-13

22. Heckscher (1919)-Olin (1933) Theory • Export goods that intensively use factor endowments which are locally abundant • Corollary: import goods made from locally scarce factors • Note: Factor endowments can be impacted by government policy - minimum wage • Patterns of trade are determined by differences in factor endowments - not productivity

23. Countries produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply. • Land-labor relationship • Labor-capital relationship • Technological complexities • Leontief Paradox 5-14

24. Product Life-Cycle Theory - R. Vernon (1966) • As products mature, both location of sales and optimal production changes • Affects the direction and flow of imports and exports • Globalization and integration of the economy makes this theory less valid

25. Introduction Growth Maturity Decline Production Location Market Location Competitive Factors Production Technology 5-16

27. Product Life Cycle Theory of Trade (PLC) • Raymond Vernon—the production location for many products moves from one country to another depending on the stage in the product’s life cycle • Stage 1: Introduction • Innovation, production, and sales in same country • new products developed in response to nearby observed need and markets for them • early production occurs in domestic location • Location and importance of technology • most new technology that results in new products and production methods originates in industrial countries • Exports and labor • export small part of production • production process likely to be labor intensive • capital machinery for large-scale production develops later in industrialized countries

28. Stage 2: Growth • Increases in exports by the innovating country • More competition • Increased capital intensity • growing sales offer incentives to companies to develop process technology • Some foreign production • Stage 3: Maturity • Decline in exports from the innovating country • More product standardization • More capital intensity • Increased competitiveness of price • Production start-ups in emerging countries • Stage 4: Decline • Production increased in emerging economies • Innovating country becoming net importer

29. Verification and limitations of plc theory • High transportation costs limit export opportunities, regardless of the life cycle stage • Shifts in production site do not change for many types of products • innovating country maintains its export ability throughout the life cycle • products with very short life cycles • luxury products for which cost is not a concern for the consumer • products used to promote differentiation strategy • products requiring specialized technical labor to evolve • MNEs increasingly introduce new products at home and abroad simultaneously

30. Country-Similarity Theory • Economic similarity of industrial countries • Most of the world’s trade occurs among countries that have similar characteristics • country similarity theory—once a company has developed a new product to serve needs in a local market, it will turn to markets it sees as most similar to those at home • Similarity in location, culture, political and economics interest

31. most trade takes place among industrial countries because: • growing importance of acquired advantage as opposed to natural advantage • markets in industrial countries can support products and their variations • importance of industrial markets due to their size • incomes are high and people buy more • Few emerging countries trade with each other

32. Similarity of location • Distances among countries accounts for many world trade relationships • Methods to overcome distance disadvantages are difficult to maintain • Cultural similarity • Importers and exporters find it easier to do business in a country perceived as being similar • Historic colonial relationships explain much of international trade • Similarity of political and economic interests • Political relationships and economic agreements among countries may discourage or encourage trade between them or their companies • Military conflicts disrupt trade patterns • Political animosity may interfere with trading channels

33. New Trade Theory • There are gains to be made from specialization and increasing EOS • The companies first to the market can create barriers to entry • First-mover advantage • Government may play a role in assisting its home companies.

34. Strategic Trade Policy • Governmental role and influence in affecting the acquired advantage of production within their borders • Alter conditions for industries in general • change conditions that affect factor proportions, efficiency, and innovation

35. Target conditions for a specific industry • typically results in no more than small payoffs • hard to identify and target appropriate industries • too many countries identify the same industry, leading to excessive competition • relative conditions change, causing relative capabilities to change as well • have been a few notable government successes in targeting a specific industry

36. Theory of National Competitive Advantage • The theory attempts to analyze the reasons for a nation’s success in a particular industry • Porter studied 100 industries in 10 nations • Postulated determinants of competitive advantage of a nation were based on four major attributes • Factor endowments • Demand conditions • Related and supporting industries • Firm strategy, structure and rivalry

37. Porter’s Diamond • Success occurs where these attributes exist • More/greater the attribute, the higher chance of success • The diamond is mutually reinforcing

38. Porter’s Diamond

39. Factor Endowments • Factor endowments: A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry • Basic factor endowments • Advanced factor endowments

40. Basic Factor Endowments • Basic factors: Factors present in a country • Natural resources • Climate • Geographic location • Demographics • While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success

41. Advanced Factor Endowments • Advanced factors: The result of investment by people, companies, and government are more likely to lead to competitive advantage • If a country has no basic factors, it must invest in advanced factors

42. Advanced Factor Endowments • Communications • Skilled labor • Research • Technology • Education

43. Demand Conditions • Demand: • creates capabilities • creates sophisticated and demanding consumers • Demand impacts quality and innovation

44. Related and Supporting Industries • Creates clusters of supporting industries that are internationally competitive • Must also meet requirements of other parts of the Diamond

45. Firm Strategy, Structure and Rivalry • Long term corporate vision is a determinant of success • Management ‘ideology’ and structure of the firm can either help or hurt you • Presence of domestic rivalry improves a company’s competitiveness

46. Porter’s Theory-Predictions • Porter’s theory should predict the pattern of international trade that we observe in the real world • Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable

47. Implications for Business • Location implications: • Disperse production activities to countries where they can be performed most efficiently • First-mover implications: • Invest substantial financial resources in building a first-mover, or early-mover advantage • Policy implications: • Promoting free trade is in the best interests of the home country, not always in the best interests of the firm, even though many firms promote open markets