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Chapter 7 Internatioanl Business

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Chapter 7 International Business

Chapter 7 International Business

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  • {"49":"So, why are all of these theories are important to international business, and to companies? \nThere are at least three important implications for companies that come from this discussion, location implications, first-mover implications, and policy implications. Let’s talk about each one.\n","38":"So, what does all of this mean? Well, suppose we live in a world without trade. Small markets might find that they don’t have certain products available if producers can’t sell enough to achieve economies of scale, or if the products are available, prices will probably be very high. \nBut, if countries trade with each other, markets are bigger, and firms have the opportunity to sell enough to achieve scale economies. Consumers have more choice and lower prices!\n","27":"In reality, this could be the case, and it’s a lightening rod for critics of free trade. If a developed government follows a free trade policy, what happens to the textile worker? Well, perhaps the government could help retrain the textile worker, but at least in the short-term, he’s likely to feel some pain! So, keep in mind, that while free trade may be best in the long run, there may be some short-term pain involved.\nFree trade can also increase the efficiency of resource utilization. For example, if firms can sell to a bigger market, they can gain from the economies associated with large scale production. \n","16":"Now, suppose Ghana traded 6 tons of its 20 tons of cocoa to South Korea in exchange for 6 tons of South Korea’s 20 tons of rice. Are the countries better off? Was trade beneficial?\n","5":"We’ll begin our discussion with a look at mercantilism, a 16th and 17th century philosophy that encouraged countries increase exports and limit imports. Then, we’ll go on to the theories advocated by Adam Smith and David Ricardo who promoted the notion of free trade, or a situation where government allows market forces to work, and doesn’t intervene with quotas or duties to influence what citizens can buy from other countries, or sell to other countries. Their work was later extended by Eli Heckscher and Bertil Ohlin.\n","55":"Question 4: Porter’s Diamond is made up of all of the following except\nFactor endowments\nRelated and supporting industries\nFirm strategy, structure, and rivalry\nSupply conditions\nDid you pick D? I hope so!\n","44":"Porter’s second factor, demand conditions, refers to the nature of home demand for the industry’s product or service. Porter argued that sophisticated and demanding customers pressured firms to be more competitive.\n","33":"Over time, as demand for the new product grew in other advanced countries, Vernon argued that foreign producers would begin to produce the product. U.S. producers, in an effort to capitalize on foreign demand, would also begin to produce in the foreign markets. So, what’s happened to trade flows? Well, exports from the U.S. slowed down as they were replaced by foreign production. \nAs the U.S. market and the foreign markets matured, the product became more standardized, and price became more important to consumers. \n","22":"So, by specializing and trading, Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice. This will leave Ghana with 11 tons of cocoa left, and 4 more tons of rice. South Korea benefits too, it has 6 tons of rice left, and has gained 4 tons of cocoa. Again, both countries gain from trade!\n","11":"So, now that you have an overview of the various theories, let’s look at them in more depth. We’ll start with mercantilism.\nAs we said before, the mercantilist philosophy was around in the mid-16th century. The main idea of the philosophy was that the accumulation of gold and sliver were essential to the wealth, and power of a nation. So, it was in the best interests of a country to try to maximize its holdings of gold and silver by encouraging exports and discouraging imports. \nIn order to achieve this goal, the philosophy advocated intervention in the market by the government. Typically, this meant that imports were limited through tariffs and quotas, while exports were maximized through government subsidies.\nA key flaw in the philosophy however, was that it was a zero-sum game. A country could only achieve its goal of maximizing a trade surplus at the expense of another nation. In other words, if one country successfully exported more than it imported, and consequently increased its holdings of gold and silver, another country would fail to achieve a trade surplus. This other country would in fact buy more than it sold, see its gold and silver leave the country, and become a weaker nation!\nEven with these flaws, the mercantilist philosophy still persists. Countries like China and Japan have been accused of following a neo-mercantilist philosophy. Today, for example, China is under considerable fire for intervening in the market to keep its currency value low relative to the U.S. dollar making it easier to sell its products to the U.S., and making it harder for American companies to sell their products to China. We’ll talk more about how this works in later chapters, but for now, you can learn more about it in the Country Focus in your text. \n","50":"We’ll start with location implications. The theories that we’ve discussed point out that countries have particular advantages for different productive activities. Remember for example, that China’s low cost work force makes it a better place to produce textiles than the U.S. \nSo, there is a link between the theories and the decision of where to locate productive activities. Firms should disperse their productive activities to those countries where they can be produced most efficiently. As you see in the Closing Case, Logitech has capitalized on production advantages in both Taiwan and China. \n","39":"We also need to consider the effect of first mover advantages because the pattern of trade we see in the world economy may be the result of first mover advantages and economies of scale. \nCompanies that can achieve economies of scale ahead of other firms, and so have a lower cost structure, have important first mover advantages. Airbus is currently enjoying the first mover advantages associated with its super jumbo plane. Airbus has to sell at least 250 super jumbos just to break even on the project. The market over the next twenty years is expected to be just 400 to 600 planes, so it’s not worthwhile for Boeing to even get in the market. Airbus has first mover advantages based on scale economies.\n","28":"Now, suppose we allow for the dynamic effects that are likely to come from trade. Free trade can increase a country’s stock of resources. For example, since the early 1990s, Western companies have been investing in Eastern Europe increasing the amount of capital that’s available to use. \n","17":"The answer is yes! After trade, Ghana would still have 14 tons of cocoa left, and it would acquire 6 tons of rice. Remember, when it tried to be self sufficient it was only able to produce 10 tons of cocoa and 5 tons of rice, so with trade it’s gained 4 tons of cocoa and 1 ton of rice. \n","6":"The main point that Smith, Ricardo, and Heckscher-Ohlin made is that it’s beneficial for countries to trade with each other, even when they could be self-sufficient. So, they try to answer the question that we asked above—why should the U.S. buy textiles from other countries when it could produce them itself? As we’ll explain, Smith, Ricardo, and Heckscher-Ohlin showed that if countries specialized in the production and export of products that they produced most efficiently, they could trade for products that could be produced more efficiently in other countries. You might also recall from the Opening Case that free trade and globalization have helped Bangladesh thrive. \n","45":"The third factor, relating and supporting industries, refers to the presence or absence of supplier and related industries that are internationally competitive and contribute to other industries. According to Porter, successful industries will be grouped in clusters in countries, so if a country has world class manufacturers of semi-conductor processing equipment, it will tend to have a competitive semi-conductor industry.\n","34":"Some foreign producers with lower wage costs exported to the U.S. market during this stage. \nLater, production shifted to developing countries where wages were even lower, and the U.S. became an importer of the product. \n","23":"As you can see, Ghana has an absolute advantage in the production of both products! Why should it trade with South Korea? Ricardo argued that it’s still beneficial for Ghana to trade because it has a comparative advantage in the production of cocoa. In other words, while Ghana can produce more cocoa and more rice than South Korea, it can produce 4 times as much cocoa, and only one and a half times as much rice. Ghana is comparatively more efficient at producing cocoa!\n","12":"In 1776, Adam Smith, in his landmark book, The Wealth of Nations, challenged the mercantilist philosophy and its zero-sum approach to trade. Smith argued that free trade, or trade without government intervention, could be beneficial to countries if each country produced and exported those products in which it was most efficient, or in his words, those products in which the country had an absolute advantage. Smith argued that if countries specialized in the production of goods in which they had an absolute advantage they could then trade these goods for the goods produced by other countries. \n","1":"Welcome to Global Business Today, Seventh Edition by Charles W.L. Hill. \n","51":"New trade theory explains the importance of first mover advantages for firms. Remember that being a first mover in an industry can have important competitive implications, especially in industries where economies of scale are critical and the global industry can only support a few companies. \nYou might recall our discussion of the aerospace industry, and the importance of first mover advantages, or how Nokia used its first mover advantages to take a lead in the cell phone industry.\nFinally, consider the link between trade theory and government policy. A government’s policy on free trade has important implications on a firm’s global competitiveness. \nFirms can influence government policy decisions through lobbying. You might think about some of the industries in the U.S. like steel or agriculture that have been successful in influencing policy. Keep in mind, that while the actions of these industries may help the firms within the industry, the decisions that are made as a result of their influence are not always beneficial to the country as a whole! For example, while the steel industry was successful at getting protection from foreign competition in the early 2000s, the higher prices that resulted from the protection meant that the auto industry suffered.\nRemember, that no one theory explains all trade patterns, but taken together, they help us understand what’s happening in the world today.\n","40":"What are the implications of this? Well, new trade theory suggests that countries might benefit from trade even if they don’t differ in resource endowments or technology. The theory also suggests that a country might be dominant in the export of a good just because it was lucky enough to have companies that were among the first to produce the product. Remember our example of Airbus and its super jumbo jet!\nKeep in mind that new trade theory is at odds with the Heckscher-Ohlin theory which, remember, suggested that countries would produce and export those products which made intensive use of abundant factors of production. But, new trade theory doesn’t contradict comparative advantage theory because it actually identifies a source of comparative advantage.\nSo, governments might use this information to implement strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important. \n","29":"However, one of the leading economists of the twentieth century, Paul Samuelson, argued that dynamic gains from trade can sometimes lead to negative outcomes. \nWhen Samuelson looked at what happened when a rich country like the U.S. entered into a free trade agreement with a poor country like China that achieved rapid gains after entering into the agreement, Samuelson found that the rich country might actually lose! In our example, the losses would occur because real wage rates in the U.S. would fall as a result of the free trade agreement and the cheaper prices it meant on imported products. \nSamuelson is particularly concerned with the trend to offshore service jobs that have traditionally not been mobile. He believes the effect of this trend will be similar to a mass inward migration to the U.S. You can learn more about this trend in the Country Focus in your text. \nDespite concerns like those of Samuelson, studies show that there is a link between trade and economic growth. Specifically, countries that adopt a more open stance toward international trade tend to have higher growth rates than those that close their economies to trade.\n","18":"Trade would also benefit South Korea. By trading, South Korea would have 14 tons of rice left, and it would acquire 6 tons of cocoa. Again, recall that without trade, South Korea could only produce 10 tons of rice, and 2 and a half tons of cocoa. So, South Korea has gained 3 and a half tons of cocoa, and 4 tons of rice. \nBoth countries gained from trade.\n","7":"You might think that some of these trade patterns are easy to explain, and you’d be right! We know why Saudi Arabia exports oil for example, the country is endowed with tremendous natural resources! But, why does Japan export cars and consumer electronics? Why does Switzerland export pharmaceuticals and watches? These trade patterns are more difficult to explain! \n","46":"Finally, the fourth factor, firm strategy, structure, and rivalry, refers to the conditions in the nation that govern how companies are created, organized, and managed, and the nature of domestic rivalry. \n","35":"So, we see that over the life cycle of the product, there’s a shift from exports from the U.S., to production in foreign developed countries, to production in developing countries, and exports from the developing countries to the U.S.\n","24":"Why should it trade with South Korea? Ricardo argued that it’s still beneficial for Ghana to trade because it has a comparative advantage in the production of cocoa. In other words, while Ghana can produce more cocoa and more rice than South Korea, it can produce 4 times as much cocoa, and only one and a half times as much rice. Ghana is comparatively more efficient at producing cocoa! With trade both countries gain.\n","13":"Let’s look at an example of what Smith meant. \nAssume that two countries, Ghana and South Korea, both have 200 units of resources that they could use either to produce rice or to produce cocoa. \nNow, suppose that in Ghana, it takes 10 units of resources to produce one ton of cocoa, and 20 units of resources to produce one ton of rice. What could Ghana produce? \nWell, Ghana could use all of its resources to produce 20 tons of cocoa, or it could put all of its resources into the production of 10 tons of rice. Or, Ghana could produce some combination of rice and cocoa. \n","2":"Chapter 5: International Trade Theory \n","52":"Now, let’s see how well you understand the material in this chapter. I’ll ask you a few questions. See if you can get them right. Ready?\nQuestion 1: Which theory did not suggest that there could be gains from specialization and trade?\nmercantilism\nabsolute advantage\ncomparative advantage\nHeckscher-Ohlin theory\nIf you picked A, you’re right!\n","41":"Which country do you think of when you think of success in the auto industry? How about the pharmaceutical industry? If you’re like most people, you probably answered Japan to the first question, and Switzerland to the second. You might be wondering why some countries become associated with success in a particular industry. This question intrigued Michael Porter, too, who in 1990, believing that the theories at the time still left gaps in our understanding of trade patterns, tried to explain why a country might achieve international success in a particular industry. \nPorter identified four factors that he argued promoted or impeded the creation of competitive advantage in an industry. Together, he called these factors the diamond of competitive advantage. Porter also suggested that two additional variables – chance and government – could impact industry success rates. \n","30":"Now, let’s move on to look at another theory of trade. Eli Heckscher and Bertil Ohlin extended Ricardo’s work by suggesting that a country’s comparative advantage is a result of differences in national factor endowments. \nHeckscher and Ohlin argued that countries will export goods that make intensive use of factors of production like land, labor, and capital that are locally abundant. At the same time, countries will import goods that make intensive use of factors that are locally scarce. So, a country like China with abundant low-cost labor will produce and export products that are labor intensive like textiles, while the U.S., which lacks abundant low cost labor, imports textiles from China. \nNote that this theory explains trade patterns using differences in factor endowments, while Ricardo explains trade patterns using differences in productivity.\n","19":"You may be thinking that Smith’s ideas are great if you’ve got two countries where one is clearly better at producing one product and the other is clearly more efficient at producing the other product. But what happens if one country has an absolute advantage in the production of all products? Is trade still beneficial? \nIn 1817, David Ricardo tried to answer these questions with his theory of comparative advantage. He argued that at it still makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself. \n","8":"We can use the work of Smith, Ricardo, and Heckscher-Ohlin to explain the trade patterns that we see in the world today. Ray Vernon also answered some of these questions with his product life cycle theory that followed the production of a product over time. \n","47":"So, did Porter achieve his goal of increasing our understanding of trade patterns? \nPorter argued that a nation’s success in an industry is a function of the combined impact of the four points on his diamond. He also suggested that government could play a role. For example, government imposed subsidies could affect factor endowments, or by imposing local product standards, a government could change demand conditions. Rivalry among firms could be influenced by antitrust laws, and so on. \n","36":"You may be thinking that this theory doesn’t really seem valid anymore, and you’d be right! While the product life cycle was useful for explaining trade patterns for products like photocopiers that were developed in the 1960s and 1970s, today, given the effects of globalization and the integration of the world economy, the theory doesn’t hold up well. \nToday, you can think of many products that were designed and introduced outside the U.S., like videogame consoles that were initially introduced in Japan, or Europe’s wireless phones. In addition, many products are introduced simultaneously in the U.S., Japan, and Europe. Production of these new products is often globally dispersed from the start.\n","25":"Keep in mind that the examples that we’ve looked at are rather simplistic. We assumed that there were only two countries and two products, that there were no transportation costs, that prices and values in the two countries were similar, that resources were mobile between goods within the same country, but not across borders, that returns to scale were constant, that there was a fixed stock of resources, and that there were no effects on income distribution within countries.\nEven so, the theory of comparative advantage with its focus on specialization and free trade provides a strong rationale for trade. With free trade, both countries can be better off! \n","14":"What about South Korea? Suppose in South Korea that it takes 40 units of resources to produce one ton of cocoa, and 10 units of resources to produce one ton of rice. \nSouth Korea’s production options then are to devote all of its resources to producing 5 tons of cocoa, or all of its resources to producing 20 tons of rice, or to share its resources and produce some combination of rice and cocoa. \nBased on this information, we would say that Ghana has an absolute advantage in the production of cocoa—it is more efficient at producing cocoa than South Korea. Remember, more resources are needed to produce a ton of cocoa in South Korea than in Ghana. You’ve probably guessed that South Korea then has an absolute advantage in the production of rice.\n","3":"You already know that countries trade with each other, but do you know why they trade? U.S. manufacturers know how to make clothing, in fact, much of clothing worn by Americans used to be made in the U.S. Now, however, the U.S. buys a lot of its textiles from places like Honduras and Guatemala. Why does Ford assemble cars made for the American market in Mexico, while BMW and Nissan manufacture cars for Americans in the U.S.? \nThese are questions that economists have tried to answer for many years, and in this chapter we’ll look at patterns of trade and explore some of the theories that have been used to explain those patterns. \n","53":"Question 2: Which theory viewed trade as a zero sum game?\nmercantilism\nabsolute advantage\ncomparative advantage\nHeckscher-Ohlin theory\nIf you picked A, you’re correct!\n","42":"As we said before, Porter grouped these factors into a diamond and argued that firms are most likely to succeed in industries where the diamond is favorable. \n","31":"In 1953, Wassily Leontief tested the Heckscher-Ohlin theory. Leontief suggested that since the U.S. was relatively abundant in capital compared to other countries, the U.S. should export capital intensive goods, and import labor intensive goods. \nIf you think Leontief was right with his hypothesis, you’re wrong! Leontief, contrary to what common sense would tell us, actually found that U.S. exports were less capital intensive than U.S. imports. His findings have come to be known as the Leontief Paradox. \n","20":"Let’s explain what we mean by this. Going back to our example of Ghana and South Korea, suppose that Ghana is more efficient at producing both cocoa and rice. \nSuppose that in Ghana it takes 10 resources to produce one ton of cocoa, and 13 and one third resources to produce one ton of rice. Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two. \n","9":"Paul Krugman also attempted to answer these questions with his so called, new trade theory. He argued that in some industries, the world market can only support a few firms, and that the firms that are able to build a competitive position early, will be difficult to challenge. Think of the large commercial aircraft industry for example. How many companies can you think of? Probably just two—Boeing and Airbus Industries. Michael Porter extended Krugman’s work with his theory of national competitive advantage. Porter argued that a county’s ability to be successful in certain industries depends not only on factor endowments, but also on domestic demand and domestic rivalry. \n","48":"So, if his arguments are correct, his model ought to predict the patterns of trade we see in the real world. Unfortunately, at this time, his theory hasn’t been well tested. While it seems to make sense, without empirical testing, we really don’t know. Remember that the Heckscher Ohlin theory made sense, until Leontief decided to test it, that is!\nHowever, to get an idea of how the theory can explain success in an industry, think about Nokia. You might own a Nokia cell phone, but you might not know that Nokia is a Finnish company, and that it’s a leading player in the global cell phone industry. You’re probably wondering how a company from a small, European country came to be so successful. Well, in the case of Nokia, all the points on Porter’s diamond were favorable. You can learn more about Nokia in the Management Focus in your text. \n","37":"Now, let’s move on to new trade theory. This theory, which was developed in the 1970s, argued that because of the unit cost reductions that are associated with a large scale of output, some industries can support only a few firms. We call the cost reductions economies of scale. \nAchieving economies of scale can be very important to firms. Microsoft for example, is able to spread the costs of developing new versions of Windows over millions of PCs. However, in some industries, in order to achieve economies of scale, firms have to have a major share of the world’s market. For example, the costs of developing new aircraft are so high, that firms have to hold a significant share of the world market in order to gain economies of scale. Remember, that there are only two makers of large commercial aircraft in the world!\nThe theory also looks at the role of first mover advantages, or the economic and strategic advantages achieved by some firms. Firms that achieve first mover advantages will develop economies of scale, and create barriers to entry for other firms. In 2007, for example, American law firm, McDermott Will & Emery teamed up with a Chinese law company to provide legal assistance to both Western firms doing business in China, and Chinese firms doing business in the West. The venture is the first of its kind, and McDermott is hoping that by being in the market ahead of the curve and signing on customers, it will gain an advantage over other companies that get into the market later. \n","26":"But, what happens if we relax some of these assumptions? Suppose we say that resources are not mobile, that a country can’t simply decide to produce cocoa instead of rice. Or, that you couldn’t simply ask a textile worker to go write software programs for Microsoft? \n","15":"So, we’ve got these two countries that could be self-sufficient and produce their own rice and cocoa. Let’s suppose that they choose to do so, and that Ghana uses its resources to produce 10 tons of cocoa and 5 tons of rice. South Korea might use its resources to produce 10 tons of rice and 2 and half tons of cocoa. So, both countries have the option of consuming both products. \nNow, let’s think about Adam Smith’s ideas of specializing in what you do best and trading for other products. Would this help Ghana and South Korea?\nWell, if Ghana specializes in producing cocoa, it would devote all of its resources to cocoa production and produce 20 tons of cocoa. South Korea’s absolute advantage was in the production of rice, so it would devote all of its resources to produce 20 tons of rice. \n","4":"First though, let’s answer the question of what we mean by free trade. Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country. In other words, goods and services are allowed to cross borders without any restrictions.\n","54":"Question 3: Economies of scale and first mover advantages are central to which theory of trade?\nPorter’s diamond of competitive advantage\nNew trade theory\nVernon’s product life cycle\nComparative advantage\nThe correct answer is B. Did you get it right?\n","43":"The first factor, called factor endowments, refers to a country’s position in the factors of production that can lead to a competitive advantage. So, here Porter included things like the skilled labor or infrastructure that were important to achieving a competitive advantage in a particular industry.\n","32":"Do you know why some products that used to be made at home are now made in other countries, especially less developed ones? The answer to this question may lie in where the product is in its life cycle. \nThe product life cycle theory which was developed in the mid-1960s by Ray Vernon who suggested that as products mature, both the sales location, and the optimal production location will change, and of course, as these change, so will the flow and direction of trade. In other words, products move through different stages over their life, and as they do, where they are produced and sold change, too. Let’s look at this process more carefully. \nVernon observed, at the time, that most of the world’s new products were developed by American firms and sold initially in the U.S. He attributed this to the wealth and size of the U.S. market. Vernon argued that rather than producing these new products in other countries, manufacturers preferred to produce them locally to be closer to the market, and to the firm’s decision making. \nVernon suggested that while demand was growing in the U.S., there would be only limited demand by high-income consumers in other advanced countries. Therefore, there would be little incentive for firms in the foreign countries to produce the product, and the other developed markets would be served by exports from the U.S. \n","21":"Now, suppose that in South Korea it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice. \nSouth Korea could use all of its resources to produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two. \n","10":"So, while all of the theories were trying to explain trade, they differed in how they viewed the role of government. Mercantilism suggested that government should be involved in helping to promote exports and limit imports, while Smith, Ricardo, and Heckscher-Ohlin argued that government should stay out of trade and market forces should influence how countries trade. \nKrugman and Porter fall somewhere between these positions. They argue that the government should intervene in the markets in a limited way that helps support the development of certain export-oriented industries. \n"}

Transcript

  • 1. Global Business Today 7e by Charles W.L. Hill McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
  • 2. Chapter 5 International Trade Theory 5-2
  • 3. Introduction International trade theory explains why it is beneficial for countries to engage in international trade helps countries formulate their economic policy explains the pattern of international trade in the world economy 5-3
  • 4. An Overview of Trade Theory Question: What is free trade? Answer:  Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country 5-4
  • 5. An Overview of Trade Theory Question: How has international trade theory evolved? Answer:  Mercantilism (16th and 17th centuries) encouraged exports and discouraged imports Adam Smith (1776) promoted unrestricted free trade David Ricardo (19th century) built on Smith ideas Eli Heckscher and Bertil Ohlin (20th century ) refined Ricardo’s work 5-5
  • 6. The Benefits of Trade Question: Why is it beneficial for countries to engage in free trade? Answer:  International trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, and import products that can be produced more efficiently in other countries it is beneficial for a country to engage in international trade even for products it is able to produce for itself 5-6
  • 7. The Pattern of International Trade  International trade theory helps explain trade patterns Some patterns of trade are fairly easy to explain - it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Japan export automobiles, consumer electronics, and machine tools? 5-7
  • 8. The Pattern of International Trade  Ricardo’s theory of comparative advantage - existing trade patterns are related to differences in labor productivity  Heckscher and Ohlin - explain trade through the interplay between the proportions in which the factors of production are available in different countries and the proportions in which they are need for producing particular goods  Ray Vernon - trade patterns could be explained by looking at a product’s life cycle 5-8
  • 9. The Pattern of International Trade  Paul Krugman developed new trade theory - the world market can only support a limited number of firms in some industries trade will skew toward those countries that have firms that were able to capture first mover advantages  Michael Porter - focused on the importance of country factors to explain a nation’s dominance in the production and export of certain products 5-9
  • 10. Trade Theory and Government Policy  While the theories all suggest that trade is beneficial, they lack agreement in their recommendations for government policy Mercantilism makes a case for government involvement in promoting exports and limiting imports Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade New trade theory and Porter justify limited and selective government intervention to support the development of certain export-oriented industries 5-10
  • 11. Mercantilism  Mercantilism (mid-16th century) - it is in a country’s best interest to maintain a trade surplus - to export more than it imports it advocated government intervention to achieve a surplus in the balance of trade it viewed trade as a zero-sum game (one in which a gain by one country results in a loss by another)  Mercantilism is problematic and not economically valid, yet many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade 5-11
  • 12. Absolute Advantage  Smith (1776) - countries differ in their ability to produce goods efficiently  A country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it  According to Smith trade is not a zero-sum game countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries 5-12
  • 13. Absolute Advantage  Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice So, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes 5-13
  • 14. Absolute Advantage In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice So, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between  Ghana has an absolute advantage in the production of cocoa  South Korea has an absolute advantage in the production of rice 5-14
  • 15. Absolute Advantage  Without trade Ghana would produce 10 tons of cocoa and 5 tons of rice South Korea would produce 10 tons of rice and 2.5 tons of cocoa  If each country specializes in the product in which it has an absolute advantage and trades for the other product Ghana would produce 20 tons of cocoa South Korea would produce 20 tons of rice 5-15
  • 16. Absolute Advantage  Suppose Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice  After trade Ghana would have 14 tons of cocoa left, and 6 tons of rice South Korea would have 14 tons of rice left and 6 tons of cocoa  Both countries gained from trade 5-16
  • 17. Absolute Advantage Figure 5.1: The Theory of Absolute Advantage 5-17
  • 18. Absolute Advantage Table 5.1: Absolute Advantage and the Gains from Trade 5-18
  • 19. Comparative Advantage  Ricardo (1817) - what happens when one country has an absolute advantage in the production of all goods  Ricardo’s theory of comparative advantage - a country should specialize in the production of those goods that it produces most efficiently and buy the goods that it produces less efficiently from other countries even if this means buying goods from other countries that it could produce more efficiently itself 5-19
  • 20. Comparative Advantage  Assume Ghana is more efficient in the production of both cocoa and rice In Ghana, it takes 10 resources to produce one tone of cocoa, and 13 1/3 resources to produce one ton of rice So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two 5-20
  • 21. Comparative Advantage In South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice So, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two  If each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries will gain 5-21
  • 22. Comparative Advantage  With trade Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice Ghana will still have 11 tons of cocoa, and 4 additional tons of rice South Korea still has 6 tons of rice and 4 tons of cocoa 5-22
  • 23. Comparative Advantage Figure 5.2: The Theory of Comparative Advantage 5-23
  • 24. The Gains from Trade  The theory of comparative advantage - trade is a positive sum gain in which all gain potential world production is greater with unrestricted free trade than it is with restricted trade provides a strong rationale for encouraging free trade 5-24
  • 25. Qualifications and Assumptions  The simple example of comparative advantage assumes only two countries and two goods zero transportation costs similar prices and values resources are mobile between goods within countries, but not across countries constant returns to scale fixed stocks of resources no effects on income distribution within countries 5-25
  • 26. Extensions of the Ricardian Model  Suppose the following assumptions are relaxed 1. Resources move freely from the production of one good to another within a country 2. There are constant returns to scale 3. Trade does not change a country’s stock of resources or the efficiency with which those resources are utilized 5-26
  • 27. Extensions of the Ricardian Model 1. Immobile Resources Resources do not always move freely from one economic activity to another Governments may help retrain displaced workers 2. Diminishing Returns The simple model assumes constant returns to specialization (the units of resources required to produce a good are assumed to remain constant), but an assumption of diminishing returns is more realistic since not all resources are of the same quality and different goods use resources in different proportions 5-27
  • 28. Extensions of the Ricardian Model 3. Dynamic Effects and Economic Growth Trade might increase a country's stock of resources as increased supplies become available from abroad Free trade might increase the efficiency of resource utilization, and free up resources for other uses 5-28
  • 29. Extensions of the Ricardian Model The Samuelson Critique Paul Samuelson - dynamic gains can lead to less beneficial outcomes concerned that the ability to offshore services jobs The Link between Trade and Growth Countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade higher growth rates raise income levels and living standards 5-29
  • 30. Heckscher-Ohlin Theory  Heckscher and Ohlin - comparative advantage arises from differences in national factor endowments (the extent to which a country is endowed with resources such as land, labor, and capital) the more abundant a factor, the lower its cost countries will export goods that make intensive use of those factors that are locally abundant, and import goods that make intensive use of factors that are locally scarce 5-30
  • 31. The Leontief Paradox  Leontief (1953) - since the U.S. was relatively abundant in capital, it would be an exporter of capital intensive goods and an importer of labor-intensive goods Leontief found however, that U.S. exports were less capital intensive than U.S. imports  Possible explanations for these findings include that the U.S. has a special advantage in producing products made with innovative technologies that are less capital intensive differences in technology lead to differences in productivity which then drives trade patterns 5-31
  • 32. The Product Life Cycle Theory  Vernon (mid-1960s ) proposed the product life-cycle theory - as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade the wealth and size of the U.S. market gave a strong incentive to U.S. firms to develop new products  In the early stages of a product’s life cycle demand may grow in the U.S., but demand in other advanced countries is limited to high-income groups it is not worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the U.S. to those countries 5-32
  • 33. The Product Life Cycle Theory  Over time, demand for the new product starts to grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets U.S. firms might also set up production facilities in those advanced countries where demand is growing limiting the exports from the U.S.  As the market in the U.S. and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon 5-33
  • 34. The Product Life Cycle Theory  Producers based in advanced countries where labor costs are lower than the United States might now be able to export to the U.S.  If cost pressures become intense, developing countries begin to acquire a production advantage over advanced countries  The United States switches from being an exporter of the product to an importer of the product as production becomes more concentrated in lower-cost foreign locations 5-34
  • 35. The Product Life Cycle Theory Figure 5.5: The Product Life Cycle 5-35
  • 36. Evaluating The Product Life Cycle Theory  While the product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the US in the 1960s and 1970s, the increasing globalization and integration of the world economy has made this theory less valid in today's world today, many new products are initially introduced in Japan or Europe, or are introduced simultaneously in the U.S., Japan, and Europe production may also be dispersed to those locations where it is most favorable 5-36
  • 37. New Trade Theory New trade theory (1970s) suggests 1. Because of economies of scale (unit cost reductions associated with a large scale of output), trade can increase the variety of goods available to consumers and decrease the average cost of those goods 2. In those industries when the output required to attain economies of scale represents a significant proportion of total world demand, the global market may only be able to support a small number of firms 5-37
  • 38. Increasing Product Variety and Reducing Costs  Without trade a small nation may not be able to support the demand necessary for producers to realize required economies of scale, and so certain products may not be produced  With trade a nation may be able to specialize in producing a narrower range of products and then buy the goods that it does not make from other countries each nation then simultaneously increases the variety of goods available to its consumers and lowers the costs of those goods 5-38
  • 39. Economies of Scale and First Mover Advantages  Firms with first mover advantages (the economic and strategic advantages that accrue to many entrants into an industry) will develop economies of scale and create barriers to entry for other firms  The pattern of trade we observe in the world economy may be the result of first mover advantages and economies of scale 5-39
  • 40. Implications of New Trade Theory  New trade theory suggests nations may benefit from trade even when they do not differ in resource endowments or technology a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good  So, new trade theory provides an economic rationale for a proactive trade policy that is at variance with other free trade theories 5-40
  • 41. Porter’s Diamond  Porter (1990) tried to explain why a nation achieves international success in a particular industry  Porter identified four attributes he calls the diamond that promote or impede the creation of competitive advantage 1. Factor endowments 2. Demand conditions 3. Related and supporting industries 4. Firm strategy, structure, and rivalry  In addition, Porter identified two additional variables (chance and government) that can influence the diamond in important ways 5-41
  • 42. Porter’s Diamond Figure 5.6: Determinants of National Competitive Advantage: Porter’s Diamond 5-42
  • 43. Factor Endowments  A nation's position in factor endowments (factors of production) can lead to competitive advantage These factors can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how)  Basic factors can provide an initial advantage that is then reinforced and extended by investment in advanced factors 5-43
  • 44. Demand Conditions  Demand conditions - the nature of home demand for an industry’s product or service influence the development of capabilities  Sophisticated and demanding customers pressure firms to be more competitive and to produce high quality, innovative products 5-44
  • 45. Related and Supporting Industries  Related and supporting industries - the presence supplier industries and related industries that are internationally competitive investing in these industries can spill over and contribute to success in other industries  Successful industries tend to be grouped in clusters in countries which then prompts knowledge flows between firms having world class manufacturers of semi-conductor processing equipment can lead to (and be a result of having) a competitive semi-conductor industry 5-45
  • 46. Firm Strategy, Structure, and Rivalry  Firm strategy, structure, and rivalry - the conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalry nations are characterized by different management ideologies which influence the ability of firms to build national competitive advantage  There is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry 5-46
  • 47. Evaluating Porter’s Theory  Porter - the four attributes of the diamond together with government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage  Government policy can affect demand through product standards influence rivalry through regulation and antitrust laws impact the availability of highly educated workers and advanced transportation infrastructure 5-47
  • 48. Evaluating Porter’s Theory Question: Is Porter right? Answer:  If Porter is correct, his model should predict the pattern of international trade in the real world  Countries should export products from industries where the diamond is favorable  Countries should import products from areas where the diamond is not favorable  So, far there has been little empirical testing of the theory 5-48
  • 49. Implications for Managers Question: What are the implications of international trade theory for international businesses? Answer:  There are at least three main implications for international businesses 1. Location implications 2. First-mover implications 3. Policy implications 5-49
  • 50. Location  Different countries have advantages in different productive activities differences influence a firm’s decision about where to locate productive activities a firm should disperse its productive activities to those countries where they can be performed most efficiently 5-50
  • 51. First-Mover Advantages and Government Policy  Firms that establish a first-mover advantage in the production of a new product may later dominate global trade in that product a firm can invest resources in trying to build firstmover advantages, even if it means losses for a few years before a venture becomes profitable  Government policies on free trade or protecting domestic industries can significantly impact global competitiveness businesses should encourage free trade policies 5-51
  • 52. Classroom Performance System Which theory did not suggest that there could be gains from specialization and trade? a) Mercantilism b) Absolute advantage c) Comparative advantage d) Heckscher-Ohlin theory 5-52
  • 53. Classroom Performance System Which theory viewed trade as a zero sum game? a)Mercantilism b)Absolute advantage c)Comparative advantage d)Heckscher-Ohlin theory 5-53
  • 54. Classroom Performance System Economies of scale and first mover advantages are central to which theory of trade a) Porter’s diamond of competitive advantage b) New trade theory c) Vernon’s product life cycle d) Comparative advantage 5-54
  • 55. Classroom Performance System Porter’s Diamond is made up of all of the following except a) Factor endowments b) Related and supporting industries c) Firm strategy, structure, and rivalry d) Supply conditions 5-55