Chapter 6 International trade
International trade Objectives Introduction International trade theory Barriers to trade Non-tariff barriers to trade Other economic developments.
Objectives Define the term international trade and discuss the role of mercantilism in modern international trade. Contrast the theories of absolute advantage and comparative advantage. Relate the importance of international product life cycle theory to the study of international economics. Explain some of the most commonly used barriers to trade and other economic developments that affect international economics. Discuss some of the reasons for the tensions between the theory of free trade and the widespread practice of national trade barriers.
Introduction International trade: the branch of economics concerned with the exchange of goods and services with foreign countries. We will focus on: International trade theory Barriers to trade.
Why do nations trade? Trade theories: Mercantilism; theory of absolute advantage; theory of comparative advantage; factor endowment theory; international product cycle theory; other considerations.
Mercantilism A trade theory which holds that a government can improve the well-being of the country by encouraging exports and stifling imports. Cf.) Neo mercantilism: without the reliance on precious metal (gold).
Theory of absolute advantage A trade theory which holds that by specializing in the production of goods, which they can produce more efficiently than any others, nations can increase their economic well-being. An example Assume: labour is the only cost of production; lower labour-hours per unit of production means lower production costs and higher productivity of labour.
North has an absolute advantage in the production of cloth. South has an absolute advantage in the production of grain. It follows that: If North produces cloth and South produces grain, and an exchange ratio can be arranged, both the countries will benefit from trade. Theory of absolute advantage (Continued)
Theory of comparative advantage A trade theory which holds that nations should produce those goods for which they have the greatest relative advantage. An example Assume: labour is the only cost of production; lower labour-hours per unit of production means lower production costs and higher productivity of labour.
North has an absolute advantage in the production of both cloth and grain but the relative costs differ (i.e. gains from trade). In North, one unit of cloth costs 50/100 hours of grain. In South, one unit of cloth costs 100/100 hours of grain. It follows that: If North can import more than a half unit of grain for one unit of cloth, it will gain from trade. If South can import one unit of cloth for less than one unit of grain, it will also gain from trade. Under the circumstance presented in the above example, both countries can benefit from trade. Theory of comparative advantage (Continued)
Factor endowment theory Also known as theHeckscher-Ohlin theory, It extends the concept of comparative advantage by bringing into consideration the endowment and cost of factors of production and helps to explain why nations with relatively large labour forces will concentrate on producing labour-intensive goods, whereas, countries with relatively more capital than labour will specialize in capital-intensive goods. Weaknesses of factor endowment theory: Some countries have minimum wage laws that result in high prices for relatively abundant labour. The Leontief paradox: countries like the United States actually export relatively more labour-intensive goods and import capital-intensive goods. No single theory can explain the role of economic factors in trade theory.
International product life cycle theory (IPLC) A theory of the stages of production for a product with new “know-how”: it is first produced by the parent firm, then by its foreign subsidiaries and finally anywhere in the world where costs are the lowest; it helps to explain why a product that begins as a nation’s export often ends up as an import.
Figure 6.1The international product life cycleSource: Raymond Vernon and Louis T. Wells, Jr., The Manager in the International Economy (Englewood Cliffs, NJ: Prentice Hall, 1991), p. 85
Other considerations Government regulation Monetary currency valuation Consumer tastes
Reasons for barriers to trade Protect local jobs by shielding home-country business from foreign competition. Encourage local production to replace imports. Protect infant industries that are just getting started. Reduce reliance on foreign suppliers. Encourage local and foreign direct investment. Reduce balance of payments problems. Promote export activity. Prevent foreign firms from dumping, that is, selling goods below cost in order to achieve market share. Promote political objectives such as refusing to trade with countries that practice apartheid or deny civil liberties to their citizens.
Commonly used barriers to trade Price-based barriers Tariffs: a tax on goods shipped internationally Quantity limits Quotas: a quantity limit on imported goods Embargos: a quota set to zero International price fixing A cartel: a group of firms that collectively agree to fix prices or quantities sold in an effort to control price Non-tariff barriers Financial limits Exchange controls: controls that restrict the flow of currency Foreign investment controls Limits on FDI Limits on transfer or remittance of funds
Types of tariffs Import and export tariffs: a tax levied on imports or exports of a country. Transit tariff: a tax levied on goods passing through the country. Specific duty: a tariff based on the number of items being imported. Ad valorem duty: a tariff based on a percentage of the value of imported goods. Compound duty: a tariff consisting of both a specific and ad valorem duty.
Reasons for tariffs To retaliate against dumping: the selling of goods at a price below cost or below that in the home country. To protect local industry. To raise revenue. To reduce foreign expenditures by citizens in order to improve the country’s balance of payments.
Non-tariff barriers to trade Quotas “Buy national” restrictions Customs valuation Technical barriers Antidumping legislation, subsidies and countervailing duties Agricultural product regulations and subsidies Export restraints.
Other economic developments Countertrade: barter trade in which the exporting firm receives payments in products from the importing country. Trade in services: as high-income countries move toward a service economy, trade in services has grown. Free trade zones: a designated area where importers can defer payment of customs duty while further processing of products takes place (as a foreign trade zone).
Table 6.3Overview of the US balance of current account, 2006, preliminary Source: Adapted from BEA, Survey of Current Business, June 2007, Table 2 International transactions