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International trade theories


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International trade theories

  1. 1. T.J. Joseph International Trade Theories
  2. 2. Introduction • Fundamental questions in International Trade – Why does international trade take place? – What determines which country should export a particular good and which country should import it? – Who gains from such trade?
  3. 3. Why do Nations Trade? (i) Nations are different - Unequal distribution of natural resources - Difference in Technology - Cost Advantages: Cost of production for the same product differs among different locations Better explained by the Theories of Absolute Advantage and Comparative Advantage - Different Preferences: Americans prefer Basmati rice grown in India (taste differences) Due to different income levels (ii) To achieve economies of scale in production - The New Trade Theory Supplyconditions(production possibilities) Demand conditions
  4. 4. Why study trade theory? • Talks about benefits of international trade – theories show why countries should trade for products/ services even when they can produce them domestically (Classical theories) • Talks about patterns of international trade – theories show why countries specialize the way they do (Factor endowment theories) • Talks about the role of intervention – theories help articulate the role of government policy (tariffs, quotas, etc.)
  5. 5. “International trade theories has long held that …..some trade is better than no trade, and more trade is better than less trade, and free trade is better than restricted trade…” Free trade is a situation where a government does not influence international trade through quotas and tariffs “…. Free trade is considered to be fair trade, because what is free must be fair…” !!!!
  6. 6. An overview of trade theory • Early thinking: Theory of Mercantilism • Adam Smith: The theory of absolute advantage, 1776 • Ricardo: The theory of comparative advantage, 1817 • Heckscher-Ohlin theory: 20th century • “New” trade theory based on economies of scale • Product Life Cycle theory • Porter’s Competitive Advantage Theory
  7. 7. Theory of Mercantilism • A trade theory prevailed during 16th to 19th centuries • The wealth of a nation is measured based on its accumulated wealth in terms of gold and silver • Nations should accumulate wealth by encouraging exports and discouraging imports • Theory of mercantilism aims at creating trade surplus and in turn accumulate nation’s wealth
  8. 8. Absolute Advantage Theory • Adam Smith, ‘An Enquiry into the Nature and Causes of the Wealth of Nations’, 1776 • There is international benefit from trade – Everyone better off without making anyone worse off • When one country can produce a unit of good with less cost than another country, the first country has an absolute (cost) advantage in producing that good • Cost is considered based on number of labour units used
  9. 9. Absolute Advantage Theory Assumptions: • Two countries (A&B), both producing two products (x&y) • Labour is the only factor of production and its productivity remains the same • Perfect mobility of labour between the sectors within a country • No mobility of labour between the countries • Assumes perfect competition – No transportation cost – No restrictions on the movement of goods between the countries (free trade)
  10. 10. Theory of Absolute Advantage • Assume, two countries, country A and country B producing only two commodities, x and y • Suppose, A can produce x cheaper than B, and B can produce y cheaper than A • Means, A has an absolute advantage in the production of x and B in the production of y • Thus, A will be better off concentrating on the production of x and B on the production of y • A will export x to B, and B will export y to A
  11. 11. Theory of Absolute Advantage • Both countries will gain from the trade – Results in specialization – Increases productivity • But what happens if A has absolute advantage in the production of both x and y? • i.e., if A can produce x cheaper than B and it can produce y much cheaper than B • Should A produce both x and y and B nothing?
  12. 12. Theory of Absolute Advantage Limitations • Explains the causes of trade only when both the countries enjoy absolute advantage in the production of at least one product • Assumes that transportation costs are either non- existent or insignificant, which may not always hold good • Assumes that prices are comparable across countries, implying stability of exchange rate • Perfect mobility of labour between sectors – labour may be mobile but to an extent
  13. 13. Comparative Advantage Theory • David Ricardo, ‘The Principles of Political Economy & Taxation’, 1817. • Nations can still gain from trade even without an absolute advantage. • Facilitator – Difference in opportunity cost • A country has a Comparative Advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country compared to other countries
  14. 14. The Comparative Advantage Theory  Even if countries do not have an absolute advantage, they can gain from trade by allocating resources based on their comparative advantage and trade with each other Assumptions:  Mostly same as that of absolute advantage theory
  15. 15. Comparative Advantage - Illustration • Labour requirements (opportunity cost in the bracket) • The relative price of one PC is 2 textiles in India (6/3), while it is ½ textiles in the US • Hence, PC is relatively cheaper in the US • In the case of relative price of textiles, the reverse is the case • US specializes in PCs • India Specializes in Textiles India US Textiles 3 (1/2) 2 (2) PCs 6 (2) 1 (1/2)
  16. 16. Gains from Trade In Autarky (No Trade) • Suppose labour employed (in million) • Consequent output (in million) India US Textiles 90 40 PCs 60 60 Total Labour 150 100 India US World Textiles 30 20 50 PCs 10 60 70 GNP 40 80 120
  17. 17. Gains from Trade With Trade • Labour employed (in million) • Consequent output (in million) India US Textiles 150 0 PCs 0 100 Total Labour 150 100 India US World Textiles 50 0 50 PCs 0 100 100 GNP 50 100 150
  18. 18. Terms of Trade • 1 PC for 1 Textile (1:1) • 1 PC for 2 Textiles (1:2) • 2 PCs for 1 Textile (2:1) India US World Textiles 30 20 50 PCs 20 80 100 GNP 50 100 150 India US World Textiles 30 20 50 PCs 10 90 100 GNP 40 110 150 India US World Textiles 30 20 50 PCs 40 60 100 GNP 70 80 150
  19. 19. Terms of Trade • Gains from trade depends on the terms of trade • The ratio of export prices to import prices is referred to as terms of trade • i.e., it represents how many units of one product is exchanged for one unit of the other product between the two countries • The terms of trade (number of textiles in terms of PCs) will lie between ½ and 2
  20. 20. Relative Wages under Recardian Model • Labour requirements (opportunity cost in the bracket) • US specializes in PCs • India Specializes in Textiles India US Textiles 3 (1/2) 2 (2) PCs 6 (2) 1 (1/2)
  21. 21. • Wages (wages = marginal product of labour) – In India wages = 1/3 units of textiles – In the US wages = 1/1 = 1 unit of PC • If price of Textiles = price of PC, say $12; – Labour in India gets 12/3 = $4 as wages – Labour in the US gets 12/1 = $12 as wages • Relative Wage of a country’s worker is the amount they are paid compared with the amount that workers in another country are paid per hour. – Relative wage in the US = 12/4 = $3 – Relative wage in India = 4/12 = $0.33
  22. 22. • The US is 6 times as productive as India in PCs but only 1.5 times as productive in textiles, and end up with a wage rate 3 times as high as India’s • It is because the relative wage is between the relative productivities that each country ends up with a cost advantage in one good. • Because of lower wage rate, India has a cost advantage in textiles, though it has lower productivity. • The US has a cost advantage in PCs despite its higher wage rate, because higher wage rate is more than offset by its higher productivity.
  23. 23. Ricardian Model – An Overview • Illustrates the potential benefits from trade • Trade leads to international specialization • With labour as the only factor, it moves from relatively less efficient industries to relatively more efficient industries Gains from Trade (a) International trade brings in efficiency in production and consumption, and (b) It provides a market for goods and services
  24. 24. Limitations (Implicit Assumptions) • Assumption of Perfect Competition • Productivity of labour constant for both products and in both countries, implying constant returns to scale • Labour is perfectly mobile between sectors but immobile between countries • No technological innovation in any of the economies • The above discussion on trade assumes that there is no restrictions on trade • But in real life trade restrictions in the form of tariff and non- tariff barriers, quantitative restrictions, etc exist • Thus, there is a deviation from the expected and actual gain from trade
  25. 25. The Heckscher – Ohlin Model Cause of trade – International differences in labour productivity – Ricardian view – Differences in countries resources – H-O model. • Developed by Eli Heckscher and Bertil Ohlin • Also called Factor-proportions Theory – because it discusses: – The proportions in which different factors of production are available in different countries, and – The proportion in which they are used in producing different goods
  26. 26. • Assumptions – Two factors of production – capital & labour – Two countries (India and Japan), differ in factor abundance/ endowments – Two commodities – Steel and Cloth – Steel is more capital intensive and Cloth is more labour intensive in both countries – Both goods uses both factors and the relative factor intensities are the same for each good in the two countries.
  27. 27. • Based on these postulates, the H-O model predicts that the capital surplus country specializes in the production and export of capital-intensive goods and the labour surplus country specializes in the production and export of labour-intensive goods.
  28. 28. Consider two countries : Country A (Japan) Country B (India) Capital abundant Labour abundant High C/L ratio Low C/L ratio Low relative cost of capital (r/w) High relative cost of capital (r/w) Produces capital-intensive product, Steel Produces labour-intensive product, Cloth Low relative price of Steel (PS/PC) High relative price of Steel (PS/PC) Exports Steel and imports Cloths Exports Cloth and import Steel
  29. 29. The H-O Theorem Countries tend to export goods whose production is intensive in factors with which they are abundantly endowed. Gains from Trade Trade leads to convergence of relative prices, which in turn has strong effect on the relative earnings of the factors of production.
  30. 30. H-O Theory: Summary • Provides a different explanation of comparative advantage • Comparative advantage arises from difference in national factor endowments • Difference in factor endowments explains the differences in factor costs (prices) • The more abundant a factor, the lower its cost • This theory assumes that technologies are the same across countries
  31. 31. H-O Theory: Summary • H-O theory has more commonsense appeal – Example: the US has long been a substantial exporter of agricultural goods, reflecting in part its unusual abundance of arable land – China exports labour-intensive manufactured goods reflecting China’s relative abundance of low-cost labour – The US, which lacks abundance labour imports these goods from China Note: it is relative, not absolute, endowments that are important
  32. 32. The Leontief Paradox • H-O theory, one of the most influential theoretical ideas in international economics • Makes few simplifying assumptions than Ricardo’s theory • H-O theory has been subject to many empirical tests and most raised questions about its validity • Most famous is by Wassily Leontief in 1953 for the US
  33. 33. The Leontief Paradox • Since US was relatively abundant in capital compared to other nations, the US would be an exporter of capital-intensive goods and an importer of labour intensive goods • However, Leontief found that US exports were less capital intensive than US imports • This has become known as Leontief paradox
  34. 34. The Leontief Paradox Why it is so? 1. US has a special advantage in producing new and innovative products Such products may be less capital intensive and heavily use skilled labour and innovative entrepreneurship Ex: Computer software 2. May be due to the assumption of uniform technology across countries
  35. 35. The Leontief Paradox • Differences in technology may lead to differences in productivity, which in turn drives international trade patterns • New research shows that once differences in technology across countries are controlled for, countries do indeed exports goods that make intensive use of factors that are locally abundant • That is, the H-O model has predictive power once the impact of differences of technology on productivity is controlled for
  36. 36. References 1. Chapters 5, ‘International Business’ by Charles W. Hill and Arun K. Jain, Tata McGraw Hill publication. 2. Chapter 2, ‘International Business’ by Oded Shenkar and Yadong Luo, Wiley publication.
  37. 37. International Trade Theories: Product Life Cycle Theory & Competitive Advantage Theory T.J. Joseph
  38. 38. Product Cycle Theory • Introduced by Raymond Vernon in 1966 • Differs from previous trade theories • Focus on the product, not its factor proportions • Puts less emphasis on comparative cost doctrine • Increased emphasis on technology’s impact on product cost – the innovation, – the effects of scale economies • Explains international investment
  39. 39. Product Cycle Theory: Vernon’s Premises Vernon uses two technology-based propositions: – 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 different stages of maturation
  40. 40. Most manufactured products have a kind of life cycles, similarly to the human beings: New-product phase (I), Growth phase (II), Maturity phase (III), Decline phase (IV) (V) Phase I: Product is produced and consumed only in the innovating country. Phase II: Production is perfected in the innovating country and increases rapidly to accommodate rising demand at home and abroad. The innovating nation has a monopoly in both the home and export markets. Stages of the Product Cycle
  41. 41. Phase III: The product becomes more or less standardized and the innovating firm may find it profitable to license other domestic and foreign firms to manufacture the products. Thus the imitating country starts producing the product for domestic consumption Phase IV: The imitating country begins to undersell the innovating country in third markets, and production of the product in the innovating country declines Phase V: The imitating country starts underselling the innovating country in the latter's markets as well, and production of the product in the innovating country declines rapidly or collapses Production moves to low cost production locations
  42. 42. The Product Cycle Model Phase I Phase II Phase III Phase IV Phase V New Product Maturing Product Standardized Product Source: Raymond Vernon, ‘International Investment and International Trade in the Product Cycle’, Quarterly Journal of Economics (May 1966), pp.190-207
  43. 43. International Product Life-Cycle • Most new products initially conceived and produced in the US in 20th century • US firms kept production close to the market Minimize risk of new product introductions Demand not based on price yet; production cost not an issue • Limited initial demand in other advanced countries  Exports more attractive than production there initially • With demand increase in advanced countries  Production follows there. • With demand expansion elsewhere  Product becomes standardized  production moves to low production cost areas  Product now imported to US and to advanced countries
  44. 44. The Product Cycle and Trade Implications  Explains the competitive evolution of a product, shifting location of production and export to other countries  Same firm moving production locations  Changing pattern of trade is due to shifting location of production  Therefore, country of comparative advantage would change  Explains international investment – recognizing the mobility of capital (factor mobility) across countries Limitations – Most appropriate for technology-based products – Some products not easily characterized by stages of maturity
  45. 45. National Competitive Advantage (Porter, 1990) • Why does a nation achieve success internationally in a particular industry? • Why are firms based in a particular nation able to create and sustain competitive advantage against its global competitors in a particular field?
  46. 46. Overview • Introduced by Michael Porter, a famous Harvard business professor in 1990 • Conducted a comprehensive study of 100 industries in 10 nations to learn ‘what leads to success’ • Believes the standard classical theories on comparative advantage provides only a partial explanation – They do not say why these countries are more productive compared to others • A nation attains competitive advantage if its firms are competitive • And, firms become competitive through innovations • Innovation – either technical improvements to the product or to the production process
  47. 47. The Diamond of National Advantage • Four determinants of National Competitive Advantage (“Porter’s Diamond”) 1. Factor Conditions 2. Demand Conditions 3. Related and Supporting Industries 4. Firm Strategy, Structure and Rivalry
  48. 48. 1. Factor Conditions • ‘Key’ factors of production (or specialized or advanced factors like skilled labour, capital and infrastructure) are created, not inherited • They are difficult to duplicate, and create competitive advantage • ‘Non-key’ factors (basic factors) like unskilled labour can be obtained by any firm and do not generate sustained competitive advantage • Lack of resources actually helps countries to become competitive (Eg: Switzerland, Japan, Sweden)
  49. 49. 2. Demand Conditions • Sophisticated domestic market is an important element in producing competitiveness • Makes firms to sell superior products as the market demands high quality • Closeness to such consumers enables the firm to learn the needs & desires of consumers [same argument as in the first stage of Product Cycle Theory] • Helps the firm to be competitive in the global market • Example: French Wine industry
  50. 50. 3. Related and Supporting Industries • A set of strong related and supporting industries is important to the competitiveness of firms • Includes suppliers and related industries • local suppliers cluster around producers (upstream and/or downstream industries), and add to innovation • Advantages of such clustering or agglomeration: – Potential technology knowledge spillovers • Disadvantages: – Potential poaching of your employees by rival companies – Increase in competition, decreasing profit margin Ex: Detroit and Silicon Valley in U.S.
  51. 51. 4. Firm Strategy, Structure and Rivalry • Strategy Investment plans, use of labour force – all depends on the country’s capital market and labour market i.e., conditions in the home market • Structure Management styles But, there is no single managerial, ownership or operational strategy universally appropriate • Rivalry Intense competition spurs innovation Example: Japanese automobile and electronics industries
  52. 52. Determinants of National Competitive Advantage: Porter’s Diamond Firm strategy, structure, and rivalry Demand conditions Factor endowments Related and supporting industries Note: Governments can influence all four
  53. 53. “So What” for business? • First mover implications – invest to be first, particularly in global industries or in markets which can support a few firms • Location of production is a key variable • Government Policy implications – Govt. plays an important role in Porter’s diamond model. Govt. can influence through: • Subsidies to firms, either directly or indirectly • Taxes applicable to corporations, business, etc. • Educational policies affecting labour skills • Enforcement of standards
  54. 54. “Including factor conditions as a cost component, demand conditions as a motivator of firm actions, and competitiveness – all combine to include the elements of classical, factor proportions, product cycle, and imperfect competition theories in a pragmatic approach to the challenges that the global markets of the 21st century present to the firms of today” Cyinkota, et al. (2003)
  55. 55. References • ‘International investment and international trade in the product cycle’, Raymond Vernon, Quarterly Journal of Economics, 1966, (pp.190-207) • ‘The Competitive Advantage of Nations’, Michael E. Porter, Harvard Business Review, March-April, 1990. • ‘Porter’s Competitive Advantage of Nations: An Assessment’, Robert M. Grant, Strategic Management Journal, Vol.12, pp.535-548 (1991) • ‘International Business’, Charles W L Hill and Arun Kumar Jain, Tata McGraw-Hill: New Delhi. • ‘International Business’, Michael R. Czinkota, Ilkka A. Ronkainen, Michael H. Moffett, (pp. 129-133)
  56. 56. References 1. Chapters 5, ‘International Business’ by Charles W. Hill and Arun K. Jain, Tata McGraw Hill publication. 2. Chapter 2, ‘International Business’ by Oded Shenkar and Yadong Luo, Wiley publication.
  57. 57. The New Trade Theory Economies of Scale, Imperfect Competition and International Trade T.J. Joseph
  58. 58. Base of International Trade Theories – Why countries trade? Reasons for Trade Classical Theories New Trade Theory Differences in Resource availability or Resource Productivity Economies of Scale Comparative advantage assuming Perfect Competition Imperfect Competition (monopolistic competition or oligopoly market structure) Constant/Diminishing Returns to Scale Increasing Returns to Scale
  59. 59. The New Trade Theory • Emerged in the 1970s by a number of economists • Countries do not necessarily specialize and trade solely to take advantage of their differences in resource endowments or technology • They also trade because of increasing returns that makes specialization advantageous in some industries • New trade theorists introduce industrial organization view into trade theory and include real-life imperfect competition in international trade • Argue that because of economies of scale, there are increasing returns to specialization in many industries
  60. 60. Economies of Scale and International Trade: The New Trade Theory Definitions: • Economies of Scale: Reduction of average cost as a result of increasing the output • Increasing Returns: a unit increase in inputs results in more than one unit increase in output • Economies of scale is an important source of increasing returns to specialization • New Trade Theory supports the Comparative Advantage theory by identifying economies of scale as an important source of comparative advantage
  61. 61. The New Trade Theory • Domestic market may not be big enough to realize economies of scale for certain products Ex: the aerospace industry dominated by Boeing and Airbus How do they achieve economies of scale? • First-mover Advantage: New Trade Theory suggests that 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 • First mover’s ability to benefit from increasing returns creates a barrier to entry Ex: Microsoft operating systems, Apple’s iPod, Google, etc.
  62. 62. Economies of Scale and Market Structure How international trade take place? • When there is economies of scale, large firms have cost advantage over small ones and lead to imperfectly competitive market structure (ACLarge < ACSmall) • Each country specializes in producing a restricted range of goods taking advantage of economies of scale • Helps them to produce these goods more efficiently than if tried to produce everything by itself • Specialized economies trade with each other, making possible to consume the full range of goods (variety of consumption)
  63. 63. Theory of Imperfect Competition Characteristics • A few major producers • Differentiated products • Firm is a ‘price setter’ not ‘price taker’ • Firms can sell more only by reducing their prices (downward slopping demand curve)
  64. 64. Monopolistic Competition and Trade • In autarky, variety of goods and scale of production are constrained by size of the market • Trade increases market size • Each country specializes in a narrower range of products • Trade offers mutual gain when countries do not differ in resources or technologies • Trade makes available variety of goods to the consumers of each country
  65. 65. Economies of Scale and Comparative Advantage What will be the pattern of trade that results from the economies of scale? • Two countries – Japan and India • Japan capital abundant • Two products – Steel and Rice • Suppose Steel is a monopolistic competitive sector (each firm’s product is differentiated from others) • Japan will be still the net exporter of Steel and importer of Rice
  66. 66. Intra and Inter Industry Trade • Suppose, Steel producers in India produces product different from that of Japan’s Steel producers • Some Japan consumers prefer Indian varieties • So, Japan import as well as export within Steel sector • Trade in monopolistic competition model consists of two parts:- – Intra-industry trade – two-way trade within a sector – Inter-industry trade – trade between two sectors
  67. 67. Pattern of Trade – Inter-industry trade: (Steel for Rice) reflects comparative advantage or H-O Theorem – Intra-industry trade (Steel for Steel) depends on economies of scale creating increasing returns due to specialization within the industry – The pattern of intra-industry trade is unpredictable – The relative importance of intra-industry and inter- industry trade depends on how similar countries are
  68. 68. China exports textiles to India, but also imports textiles which can be produced only using the skills in India. Is it comparative advantage or advantage due to economies of scale?
  69. 69. Why Intra-industry trade matters? • About ¼ of world trade consists of intra-industry trade • Countries are becoming increasingly similar in their level of technology and availability of capital and skilled labour • Allows countries to benefit from larger markets • More prevalent between countries that are similar in relative factor supplies (capital-labour ratios), skill levels and so on.
  70. 70. Dumping • An important consequence of imperfect competition on international trade • Firms do not necessarily charge the same price for goods that are exported and those that are sold to domestic buyers – known as price discrimination • Dumping – the most common form of price discrimination in international trade • A pricing practice in which a firm charges a lower price for exported goods than for the same goods sold domestically • Major reason: differences in the responsiveness (elasticity) of sales to price in the export and domestic markets
  71. 71. New Trade Theory: Summary • Suggests that nations may benefit from trade even when they do not differ in resource endowments or technology • Assumes economies of scale due to increasing returns • Trade helps nations to specialize in products in which they have economies of scale • In autarky, size of the market limits the variety of goods that a country can produce and the scale of production
  72. 72. New Trade Theory: Summary • By trade, each nation may able to specialize in producing a narrower range of products than in autarky • Yet they can increase the variety of goods for consumption at a lower cost • Thus, trade offers mutual gain when countries do not differ in their resource endowments or technology
  73. 73. New Trade Theory: Summary • Also argue that if world market offers economies of scale with substantial proportion of world market, then only limited number of firms based in a limited number of countries will produce those products • First-mover Advantage: The firm which enter first may gain an advantage • A country may dominate in the export of particular product where economies of scale exist because it is the home for first mover firm
  74. 74. References 1. Chapters 5, ‘International Business’ by Charles W. Hill and Arun K. Jain, Tata McGraw Hill publication. 2. Chapter 2, ‘International Business’ by Oded Shenkar and Yadong Luo, Wiley publication.