Theories of International Trade

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 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

Evolution of Trade Theories Mercantilism Absolute advantage (Classical) Comparative advantage Factor Proportions Trade International Product Cycle New Trade Theory National competitive advantage

Mercantilism

Absolute advantage (Classical)

Comparative advantage

Factor Proportions Trade

International Product Cycle

New Trade Theory

National competitive advantage

Mercantilism: mid-16th century A nation’s wealth depends on accumulated treasure Gold and silver are the currency of trade Theory says you should have a trade surplus. Maximize export through subsidies. Minimize imports through tariffs and quotas Flaw: restrictions, impaired growth

A nation’s wealth depends on accumulated treasure

Gold and silver are the currency of trade

Theory says you should have a trade surplus.

Maximize export through subsidies.

Minimize imports through tariffs and quotas

Flaw: restrictions, impaired growth

Defining mercantilism … … trade theory holding that nations should accumulate financial wealth, usually in the form of gold ( forget things like living standards or human development ) by encouraging exports and discouraging imports

… trade theory holding that nations should accumulate financial wealth, usually in the form of gold ( forget things like living standards or human development ) by encouraging exports and discouraging imports

Theory of absolute advantage Adam Smith: Wealth of Nations ( 1776) argued: Capability of one country to produce more of a product with the same amount of input than another country 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

Adam Smith: Wealth of Nations ( 1776) argued:

Capability of one country to produce more of a product with the same amount of input than another country

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

Theory of absolute advantage … destroys the mercantilist idea since there are gains to be had by both countries party to an exchange … questions the objective of national governments to acquire wealth through restrictive trade policies … measures a nation’s wealth by the living standards of its people

… destroys the mercantilist idea since there are gains to be had by both countries party to an exchange

… questions the objective of national governments to acquire wealth through restrictive trade policies

… measures a nation’s wealth by the living standards of its people

Theory of absolute advantage PPF – Production Possibility Frontier

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

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

Theory of comparative advantage

Comparative advantage and the gains from trade

Comparative advantage: Bollywood

Assumptions and limitations Driven only by maximization of production and consumption Only 2 countries engaged in production and consumption of just 2 goods? What about the transportation costs? Only resource – labour (that too, non-transferable) No consideration for ‘learning theory’

Driven only by maximization of production and consumption

Only 2 countries engaged in production and consumption of just 2 goods?

What about the transportation costs?

Only resource – labour (that too, non-transferable)

No consideration for ‘learning theory’

Factor proportions theory 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 Remember, focus on relative advantage, not absolute advantage

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

Remember, focus on relative advantage, not absolute advantage

Factor proportions theory … trade theory holding that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply Example: Australia – lot of land and a small population (relative to its size) So what should it export and import?

… trade theory holding that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply

Example:

Australia – lot of land and a small population (relative to its size)

So what should it export and import?

Factor Proportions Trade Theory Considers Two Factors of Production Labor Capital

Labor

Capital

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 )

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 )

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

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

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!

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!

Product life-cycle Theory R.Vernon (1966) … trade theory holding that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its lifecycle 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

… trade theory holding that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its lifecycle

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

Product life cycle theory Fig 4.5

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

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

New trade theory In industries with high fixed costs: Specialization increases output, and the ability to enhance economies of scale increases Learning effects are high. These are cost savings that come from ‘learning by doing’

In industries with high fixed costs:

Specialization increases output, and the ability to enhance economies of scale increases

Learning effects are high. These are cost savings that come from ‘learning by doing’

New trade theory - applications Typically, requires industries with high, fixed costs World demand will support few competitors Competitors may emerge because of “ First-mover advantage” Economies of scale may preclude new entrants Role of the government becomes significant Some argue that it generates government intervention and strategic trade policy

Typically, requires industries with high, fixed costs

World demand will support few competitors

Competitors may emerge because of “ First-mover advantage”

Economies of scale may preclude new entrants

Role of the government becomes significant

Some argue that it generates government intervention and strategic trade policy

Theory of national competitive advantage The theory attempts to analyze the reasons for a nations success in a particular industry Porter studied 100 industries in 10 nations postulated determinants of competitive advantage of a nation based on four major attributes Factor endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry

The theory attempts to analyze the reasons for a nations success in a particular industry

Porter studied 100 industries in 10 nations

postulated determinants of competitive advantage of a nation based on four major attributes

Factor endowments

Demand conditions

Related and supporting industries

Firm strategy, structure and rivalry

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

Success occurs where these attributes exist.

More/greater the attribute, the higher chance of success

The diamond is mutually reinforcing

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

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

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

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

Advanced factor endowments Advanced factors: Are the result of investment by people, companies, government and are more likely to lead to competitive advantage If a country has no basic factors, it must invest in advanced factors

Advanced factors: Are the result of investment by people, companies, government and are more likely to lead to competitive advantage

If a country has no basic factors, it must invest in advanced factors

Advanced factor endowments communications skilled labor research Technology education

communications

skilled labor

research

Technology

education

Demand conditions Demand: creates capabilities creates sophisticated and demanding consumers Demand impacts quality and innovation

Demand:

creates capabilities

creates sophisticated and demanding consumers

Demand impacts quality and innovation

Related and supporting industries Creates clusters of supporting industries that are internationally competitive Must also meet requirements of other parts of the Diamond

Creates clusters of supporting industries that are internationally competitive

Must also meet requirements of other parts of the Diamond

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

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

Determinants of Competitive Advantage in nations Fig 4.8 Government Company Strategy, Structure, and Rivalry Demand Conditions Related and Supporting Industries Factor Conditions Chance Two external factors that influence the four determinants.

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

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

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

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

India in the global competitiveness report