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International Economic Theories


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International Economic Theories

  1. 1. INTERNATIONAL ECONOMIC THEORIES AND APPLICATION IN INTERNATIONAL Index No. Topic 1 An overview of international trade theory 2 Mercantilism 3 Theory of Absolute Advantage 4 Theory of Comparative Advantage 5 Competitive Theory - Porter’s Diamond 7 Product Life Cycle Theory 8 New Trade Theory
  2. 2. An overview of international trade theory International trade is exchange of capital, goods, and services across international borders or territories. In most countries, it represents a significant share of gross domestic product (GDP). While international trade has been present throughout much of history, its economic, social, and political importance has been on the rise in recent centuries. Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Increasing international trade is crucial to the continuance of globalization. International trade is a major source of economic revenue for any nation that is considered a world power. Without international trade, nations would be limited to the goods and services produced within their own borders. International trade is in principle not different from domestic trade as the motivation and the behaviour of parties involved in a trade does not change fundamentally depending on whether trade is across a border or not. The main difference is that international trade is typically more costly than domestic trade. The reason is that a border typically imposes additional costs such as tariffs, time costs due to border delays and costs associated with country differences such as language, the legal system or a different culture. International trade uses a variety of currencies, the most important of which are held as foreign reserves by governments and central banks. Here the percentage of global cumulative reserves held for each currency between 1995 and 2005 are shown: the US dollar is the most sought-after currency, with the Euro in strong demand as well. Another difference between domestic and international trade is that factors of production such as capital and labour are typically more mobile within a country than across countries. Thus international trade is mostly restricted to
  3. 3. trade in goods and services, and only to a lesser extent to trade in capital, labour or other factors of production. Then trade in good and services can serve as a substitute for trade in factors of production. Instead of importing the factor of production a country can import goods that make intensive use of the factor of production and are thus embodying the respective factor. An example is the import of labour-intensive goods by the United States from China. Instead of importing Chinese labour the United States is importing goods from China that were produced with Chinese labour. International trade is also a branch of economics, which, together with international finance, forms the larger branch of international economics. Free trade is a type of trade policy that permits trading partners’ mutual gains from trade as a function of the law of comparative advantage. Under a free trade policy, prices are a reflection of true supply and demand, and are the sole determinant of resource allocation. Free trade differs from other forms of trade policy where the allocation of goods and services amongst trading countries are determined by artificial prices that do not reflect the true nature of supply and demand. These artificial prices are the result of protectionist trade policies, whereby governments intervene in the market through price adjustments and supply restrictions. Such government interventions generally increase the cost of goods and services to both consumers and producers. Interventions include subsidies, taxes and tariffs, non-tariff barriers, such as regulatory legislation and quotas, and even inter- government managed trade agreements such as the North American Free Trade Agreement (NAFTA) and Central America Free Trade Agreement (CAFTA) (contrary to their formal titles.)- Any governmental market intervention resulting in artificial prices that do not reflect the principles of supply and demand. Most states conduct trade polices that are to a lesser or greater degree protectionist. One ubiquitous protectionist policy employed by states comes in the form agricultural subsidies whereby countries attempt to protect their agricultural industries from outside competition by creating artificial low prices for their agricultural goods. Why do nations trade what they do? Is trade a good thing? The theory of International trade provides answers. The answers are both convincing and elegant, hence the vast majority of economists agree about the desirability of liberal trade. But the argument is also subtle and often misunderstood or distorted. Thus a large proportion of the general population tends to oppose liberal trade from confusion. This essay will attempt to convey why the answers convince most economists and why their liberal trade position is so often misunderstood. The essay’s focus is theory, but theory convinces when it succeeds in fitting the data. Thus passing reference will be made to
  4. 4. empirical findings, a sensibility much more thoroughly developed in the graduate textbook of Feenstra (2003). “Buy low, sell high” logic leads economists to comparative advantage theory. Comparative advantage means the comparison of relative price differences between nations to explain the pattern of trade. For example, compare the relative price of wheat in terms of cheese at home to the same relative price in the foreign economy in a hypothetical equilibrium with no trade (autarky) or with restricted trade. The country with the lower relative price of wheat is said to have a comparative advantage in wheat while the other country has, symmetrically, a comparative advantage in cheese. Buy low, sell high logic predicts that a country will export the good in which it has a comparative advantage. Notice that the focus on relative prices tends to cancel out forces (exchange rate manipulations, environmental or labor standards) which cause national differences in levels of nontraded factor (or goods) prices. Note also that by this reasoning a country must have a comparative advantage in some good. Prices of nontraded factors of production adjust in general equilibrium so that each country ends up in the trade equilibrium with a competitive or absolute cost advantage in the good in which it has a comparative advantage. Partial equilibrium thinking takes factor prices as given and does not impose the external budget constraint that requires exports to pay for imports. Partial equilibrium reasoning leads to misunderstandings explored below as the case of many goods, the prediction is that a country will on average export goods which are relatively cheap in the absence of trade and import goods which are relatively expensive in the absence of trade. The prediction is about correlation. Bernhofen and Brown (2005) show that Japan’s opening to trade in the 1850’s reveals data consistent with the prediction. Comparative advantage differences between nations are explained by exogenous differences in national characteristics. Labor differs in its productivity internationally and different goods have different labor requirements, so comparative labor productivity advantage was Ricardo’s predictor of trade patterns. Ricardian trade theory is useful in its simplicity and even rather loosely confirmed by empirical evidence. The factor proportions theory added relative factor endowment differences to the exogenous explanation of comparative advantage (Jones, 1987). More capital abundant countries have higher labor productivity, but the advantage gained relative to the less abundant countries varies with the relative capital intensity of the good’s technology. Combining technology and endowment differences appears to account well for actual trade patterns (Davis and Weinstein, 2002).
  5. 5. Trade theory also encompasses endogenous differences between countries. One focus is on economies of scale. The wider market due to trade induces a cost advantage in an industry in one of the countries. Another theory is based on monopolistic competition, whereby the wider markets due to trade increase product variety as buyers seek the special characteristics of foreign brands. Differentiated products trade flows both ways within product categories. Trade costs also shape the pattern of trade. The economic theory of gravity explains the complex bilateral trade patterns among countries. Actual trade is much lower than gravity predicts in a frictionless world, providing evidence of trade costs much larger than those due to policy or transportation. The costs are well explained by geography and a set of national differences. The stability of the relationships over time suggests that these costs change slowly. There are gains from trade in all these models. But the division of the gains will be uneven and there will be losers. Distribution matters in two ways, between and within nations. Internationally, with only mild qualifications, gains are shared between nations: some trade is better than none. Each nation can act through trade policy to take more of the gain, however, leading to destructive trade wars with mutual losses. Within national economies, there are gains on average but there are ordinarily losers. National institutions act to redistribute some of the gains (U.S. Trade Adjustment Assistance) or provide temporary relief from losses due to trade (escape clause protection), at the cost of lowering the overall gain from trade. The topics of this outline are developed below in more detail. MERCANTILISM Mercantilism is an economic theory that holds that the prosperity of a nation is dependent upon its supply of capital, and that the global volume of international trade is "unchangeable". Economic assets or capital, are represented by bullion (gold, silver, and trade value) held by the state, which is best increased through a positive balance of trade with other nations (exports minus imports). Mercantilism suggests that the ruling government
  6. 6. should advance these goals by playing a protectionist role in the economy; by encouraging exports and discouraging imports, notably through the use of tariffs and subsidies. Mercantilism was the dominant school of thought throughout the early modern period (from the 16th to the 18th century). Domestically, this led to some of the first instances of significant government intervention and control over the economy, and it was during this period that much of the modern capitalist system was established. Internationally, mercantilism encouraged the many European wars of the period and fuelled European imperialism. Belief in mercantilism began to fade in the late 18th century, as the arguments of Adam Smith and the other classical economists won out. Today, mercantilism (as a whole) is rejected by economists, though some elements are looked upon favourably by non-economists. The Austrian lawyer and scholar Philipp Wilhelm von Hornick, in his Austria Over All, If She Only Will of 1684, detailed a nine-point program of what he deemed effective national economy, which sums up the tenets of mercantilism comprehensively:- • That every inch of a country's soil be utilized for agriculture, mining or manufacturing. • That all raw materials found in a country be used in domestic manufacture, since finished goods have a higher value than raw materials. • That a large, working population be encouraged. • That all export of gold and silver be prohibited and all domestic money be kept in circulation. • That all imports of foreign goods be discouraged as much as possible. • That where certain imports are indispensable they be obtained at first hand, in exchange for other domestic goods instead of gold and silver. • That as much as possible, imports be confined to raw materials that can be finished [in the home country]. • That opportunities be constantly sought for selling a country's surplus manufactures to foreigners, so far as necessary, for gold and silver. • That no importation be allowed if such foods are sufficiently and suitably supplied at home. In spite of Adam Smith's repudiation of mercantilism, it was favoured in the United States by such prominent figures as Alexander Hamilton, Henry Clay, Henry Charles Carey, and Abraham Lincoln and in Britain by such
  7. 7. figures as Thomas Malthus. When Britain passed its Corn Laws in 1815, Malthus thought such restrictions were a good idea, but Ricardo disagreed. Eventually Smith's view was accepted in the English-speaking world, and in 1849 the corn laws were repealed largely on "Free Market" arguments given by Sir Robert Peel. Adam Smith rejected the mercantilist focus on production, arguing that consumption was the only way to grow an economy. Keynes argued that encouraging production was just as important as consumption. Keynes also noted that in the early modern period the focus on the bullion supplies was reasonable. In an era before paper money, an increase for bullion was one of the few ways to increase the money supply. Keynes and other economists of the period also realized the balance of payments is an important concern. Since the 1930s, all nations have closely monitored the inflow and outflow of capital, and most economists agree that a favourable balance of trade is desirable. Keynes also adopted the essential idea of mercantilism that government intervention in the economy is a necessity. While Keynes' economic theories have had a major impact, few have accepted his effort to rehabilitate the word mercantilism. Today the word remains a pejorative term, often used to attack various forms of protectionism. The similarities between Keynesianism, and its successor ideas, with mercantilism have sometimes led critics to call them neo-mercantilism. Some other systems that do copy several mercantilist policies, such as Japan's economic system, are also sometimes called neo-mercantilist. In an essay appearing in the 14 May 2007 issue of Newsweek, economist Robert J. Samuelson argued that China was pursuing an essentially mercantilist trade policy that threatened to undermine the post-World War II international economic structure. The Austrian School of economics, always an opponent of mercantilism, describes it this way: “ Mercantilism, which reached its height in the Europe of the seventeenth and eighteenth centuries, was a system of statism which employed economic fallacy to build up a structure of imperial state power, as well as special subsidy and monopolistic privilege to individuals or groups favoured by the state. Thus, mercantilism held exports should be encouraged by the government and imports discouraged. ”
  8. 8. One area Smith was reversed on well before Keynes was in the use of data. Mercantilists, who were generally merchants or government officials, gathered vast amounts of trade data and used it considerably in their research and writing. William Petty, a strong mercantilist, is generally credited with being the first to use empirical analysis to study the economy. Smith rejected this, arguing that deductive reasoning from base principles was the proper method to discover economic truths. Today, many schools of economics accept that both methods are important, the Austrian School being a notable exception. In specific instances, protectionist mercantilist policies also had an important and positive impact on the state that enacted them. Adam Smith himself, for instance, praised the Navigation Acts as they greatly expanded the British merchant fleet, and played a central role in turning Britain into the naval and economic superpower that it was for several centuries. Some economists thus feel that protecting infant industries, while causing short term harm, can be beneficial in the long term. Nonetheless, The Wealth of Nations had a profound impact on the end of the mercantilist era and the later adoption of free market policy. By 1860, England removed the last vestiges of the mercantile era. Industrial regulations, monopolies and tariffs were withdrawn ABSOLUTE ADVANTAGE THEORY In economics, Absolute advantage refers to the ability of a particular person or a country to produce a particular good with fewer resources than another person or country. Absolute advantage is the ability to produce more of a given product using a given amount of resources. It can be contrasted with the concept of comparative advantage which refers to the ability to produce a particular good at a lower opportunity cost. The idea of absolute advantage is generally attributed to Adam Smith, while "the principle of comparative advantage", is generally attributed to David Ricardo in his 1817 Principles of Political Economy and Taxation. While there are possible gains from trade with absolute advantage, comparative advantage extends the range of possible mutually beneficial exchanges. In
  9. 9. other words it is not necessary to have an absolute advantage to gain from trade, only a comparative advantage. • Producing a good with fewer inputs (capital, labor, land, raw materials, etc.) per unit of output than other countries • If input prices are the same in two countries, the country with an absolute advantage in a good will have a lower unit cost of production for that good • A country should produce and export products in which it has an absolute advantage • A country should import products in which it has an disadvantage The two concepts have applications outside international trade, though this is where they are most commonly used. Suppose that two castaways on a desert island gather both fruit and grain, which they then share equally between them. Suppose that Castaway A can gather more fruit per hour than Castaway B, and therefore has an absolute advantage in this good. Nonetheless, it may well make sense for A to leave some fruit-gathering to B. This is because it is possible that B gathers fruit slightly slower than A, but gathers grain extremely slowly. One needs to look at comparative advantage rather than absolute advantage, to discover how A and B can each best allocate their effort. If A's initial advantage over B in grain-gathering is greater than his or her advantage in fruit-gathering, then fruit-effort should be transferred from A to B, to the point where A's comparative advantages in the two goods are equal. Thus it may be rational for fruit to flow from B to A, despite A's absolute advantage. Examples of Absolute Advantage Example 1 Country A can produce one widget using one unit of labour. Country B can produce one widget using two units of labour. Country A has an absolute advantage over Country B in producing widgets. Example 2
  10. 10. Country A has 100 units of labour. It uses 20 to produce 80 units of Parachutes, and 80 to produce 20 units of Barbie dolls. Country B has 100 units of labour. It uses 40 to produce 100 units of Barbie dolls, and 60 to produce 20 units of Parachutes. If the countries maximized their potential, Country A could produce 400 units of Parachutes, and country B could produce 250 units of Barbie dolls. Through trade, the two countries would achieve a more efficient allocation of resources and increase their prosperity. A country has an absolute advantage over another in producing a good, if it can produce that good using fewer resources than another country. For example if one unit of labour in Scotland can produce 80 units of wool or 20 units of wine; while in Spain one unit of labour makes 50 units of wool or 75 units of wine, then Scotland has an absolute advantage in producing wool and Spain has an absolute advantage in producing wine. Scotland can get more wine with its labour by specializing in wool and trading the wool for Spanish wine, while Spain can benefit by trading wine for wool.’ The benefits to nations from trading are the same as to individuals: trade permits specialization, which allows resources to be used more productively... Example 3 You and your friends decided to help with fundraising for a local charity group by printing t-shirts and making birdhouses. • Scenario 1: One of your friends, Gina, can print 5 t-shirts or build 3 birdhouses an hour. Your other friend, Mike, can print 3 t-shirts an hour or build 2 birdhouses an hour. Because your friend Gina is more productive at printing t-shirts and building birdhouses compared to Mike, she has an absolute advantage in both printing t-shirts and building birdhouses. • Scenario 2: Suppose Gina wasn't as agile with the hammer and could only make 1 birdhouse an hour, but she took a sewing class and could print 10 t-shirts an hour. Mike on the other hand takes woodworking and so he can build 5 birdhouses an hour, but he doesn't know the first thing about making t-shirts so he can only print 2 t-shirts an hour. While Gina would have the absolute advantage in printing shirts, Mike would have an absolute advantage in building birdhouses.
  11. 11. COMPARITIVE ADVANTAGE THEORY In economics, comparative advantage refers to the ability of a person or a country to produce a particular good at a lower opportunity cost than another person or country. It is the ability to produce a product most efficiently given all the other products that could be produced. [1] It can be contrasted with absolute advantage which refers to the ability of a person or a country to produce a particular good at a lower absolute cost than another. Comparative advantage explains how trade can create value for both parties even when one can produce all goods with fewer resources than the other. The net benefits of such an outcome are called gains from trade. Origins of the theory Comparative advantage was first described by Robert Torrens in 1815 in an essay on the Corn Laws. He concluded it was England's advantage to trade with Poland in return for grain, even though it might be possible to produce that grain more cheaply in England than Poland. However the term is usually attributed to David Ricardo who explained it in his 1817 book On the Principles of Political Economy and Taxation in an example involving England and Portugal. In Portugal it is possible to produce both wine and cloth with less labour than it would take to produce the same quantities in England. However the relative costs of producing those two goods are different in the two countries. In England it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. Conversely England benefits from this trade because its cost for producing cloth has not changed but it can now get wine
  12. 12. at a lower price, closer to the cost of cloth. The conclusion drawn is that each country can gain by specializing in the good that it has comparative advantage in and trading that good for the other. Assumption underlying comparative 1. No transportation cost 2. Common opportunity cost and no economies of scale 3. Homogeneous goods 4. No trade barriers 5. Perfect mobility of resources Examples The following hypothetical examples explain the reasoning behind the theory. In Example 2 all assumptions are italicized for easy reference, and some are explained at the end of the example. Example 1 Comparative advantage then the young man will specialize in tasks at which he is most productive, while the older man will concentrate on tasks where his productivity is only a little less than that of a young man. Such an arrangement will increase total production for a given amount of labour supplied by both men and it will make both of them richer. Example 2 Suppose there are two countries of equal size, Northland and Southland that both produce and consume two goods, Food and Clothes. The productive capacities and efficiencies of the countries are such that if both countries devoted all their resources to Food production, output would be as follows: • Northland: 100 tonnes • Southland: 400 tonnes
  13. 13. If all the resources of the countries were allocated to the production of clothes, output would be: • Northland: 100 tonnes • Southland: 200 tonnes Assuming each has constant opportunity costs of production between the two products and both economies have full employment at all times. All factors of production are mobile within the countries between clothing and food industries, but are immobile between the countries. The price mechanism must be working to provide perfect competition. Southland has an absolute advantage over Northland in the production of Food and Clothing. There seems to be no mutual benefit in trade between the economies, as Southland is more efficient at producing both products. The opportunity costs shows otherwise. Northland's opportunity cost of producing one tonne of Food is one tonne of Clothes and vice versa. Southland's opportunity cost of one tonne of Food is 0.5 tonne of Clothes. The opportunity cost of one tonne of Clothes is 2 tonnes of Food. Southland has a comparative advantage in food production, because of its lower opportunity cost of production with respect to Northland. Northland has a comparative advantage over Southland in the production of clothes, the opportunity cost of which is higher in Southland with respect to Food than in Northland. To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade, consider the countries produce and consume only domestically. The volumes are: Production and consumption before trade Food Clothes Northland 50 50
  14. 14. Southland 200 100 TOTAL 250 150 This example includes no formulation of the preferences of consumers in the two economies which would allow the determination of the international exchange rate of Clothes and Food. Given the production capabilities of each country, in order for trade to be worthwhile Northland requires a price of at least one tonne of Food in exchange for one tonne of Clothes; and Southland requires at least one tonne of Clothes for two tonnes of Food. The exchange price will be somewhere between the two. The remainder of the example works with an international trading price of one tonne of Food for 2/3 tonne of Clothes. If both specialize in the goods in which they have comparative advantage, their outputs will be: Production after trade Food Clothes Northland 0 100 Southland 300 50 TOTAL 300 150
  15. 15. World production of food increased. Clothing production remained the same. Using the exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland are able to trade to yield the following level of consumption: Consumption after trade Food Clothes Northland 75 50 Southland 225 100 World total 300 150 Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now consume at points outside their production possibility frontiers. Assumptions in Example 2 • Two countries, two goods - the theory is no different for larger numbers of countries and goods, but the principles are clearer and the argument easier to follow in this simpler case. • Equal size economies - again, this is a simplification to produce a clearer example. • Full employment - if one or other of the economies has less than full employment of factors of production, then this excess capacity must usually be used up before the comparative advantage reasoning can be applied.
  16. 16. • Constant opportunity costs - a more realistic treatment of opportunity costs the reasoning is broadly the same, but specialization of production can only be taken to the point at which the opportunity costs in the two countries become equal. This does not invalidate the principles of comparative advantage, but it does limit the magnitude of the benefit. • Perfect mobility of factors of production within countries - this is necessary to allow production to be switched without cost. In real economies this cost will be incurred: capital will be tied up in plant (sewing machines are not sowing machines) and labour will need to be retrained and relocated. This is why it is sometimes argued that 'nascent industries' should be protected from fully liberalised international trade During the period in which a high cost of entry into the market (capital equipment, training) is being paid for. • Immobility of factors of production between countries - why are there different rates of productivity? The modern version of comparative advantage (developed in the early twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin) attributes these differences to differences in nations' factor endowments. A nation will have comparative advantage in producing the good that uses intensively the factor it produces abundantly. For example: suppose the US has a relative abundance of capital and India has a relative abundance of labour. Further those cars are capital intensive to produce, while cloth is labour intensive. Then the US will have a comparative advantage in making cars, and India will have a comparative advantage in making cloth. If there is international factor mobility this can change nations' relative factor abundance. The principle of comparative advantage still applies, but who has the advantage in what can change. • Negligible Transport Cost - Cost is not a cause of concern when countries decided to trade. It is ignored and not factored in. • Assume that half the resources are used to produce each good in each country. This takes place before specialization
  17. 17. • Perfect competition - this is a standard assumption that allows perfectly efficient allocation of productive resources in an idealized free market. Attorney example The economist Paul Samuelson provided another well known example in his Economics. Suppose that in a particular city the best lawyer happens also to be the best secretary, that is he would be the most productive lawyer and he would also be the best secretary in town. However, if this lawyer focused on the task of being an attorney and instead of pursuing both occupations at once, employed a secretary, both the output of the lawyer and the secretary would increase. Flaw in theory The flaw in the theory, as demonstrated by this example, can be shown by the fact that the individual chose to be a lawyer and not a secretary. He could have chosen to be a secretary, employed by a less talented lawyer, but he did not choose this latter option. This is because being a lawyer is more profitable than being a secretary. Extending this to the global economy, there are advanced and highly profitable products and primitive and less profitable ones. Countries that produce the primitive and less profitable product are impoverished and lack global power. Thus no country wants to produce the less profitable product, and so they engage in a trade war as they compete to produce the most profitable products. For example, the competition between Europe's Airbus and America's Boeing over the profitable passenger jet industry. Flaw in Argument - Many countries may want to produce the less profitable product, as it may increase employment levels. It takes time to go from subsistence farming to producing commercial jets and producing cheaper goods is a rung on the ladder of prosperity. No country would want to produce the less profitable product only if there was no demand for such
  18. 18. product or the profit was not economically feasible, even with cheaper labour. Effects on the economy Conditions that maximize comparative advantage do not automatically resolve trade deficits. In fact, in many real world examples where comparative advantage is attainable may in fact require a trade deficit. For example, the amount of goods produced can be maximized, yet it may involve a net transfer of wealth from one country to the other, often because economic agents have widely different rates of saving. As the markets change over time, the ratio of goods produced by one country versus another variously changes while maintaining the benefits of comparative advantage. This can cause national currencies to accumulate into bank deposits in foreign countries where a separate currency is used. Macroeconomic monetary policy is often adapted to address the depletion of a nation's currency from domestic hands by the issuance of more money, leading to a wide range of historical successes and failures. These effects of comparative advantage in particular are an underlying influence leading to imbalances that epitomize some of the recent financial crises. The Global financial crisis of 2008–2009 is no exception. What determines comparative advantage? Comparative advantage is a dynamic concept. It can and does change over time. Some businesses find they have enjoyed a comparative advantage in one product for several years only to face increasing competition as rival producers from other countries enter their markets. For a country, the following factors are important in determining the relative costs of production:
  19. 19. • The quantity and quality of factors of production available (e.g. the size and efficiency of the available labour force and the productivity of the existing stock of capital inputs). If an economy can improve the quality of its labour force and increase the stock of capital available it can expand the productive potential in industries in which it has an advantage. • Investment in research & development (important in industries where patents give some firms significant market advantage) - for more information on this have a look at this page • Movements in the exchange rate. An appreciation of the exchange rate can cause exports from a country to increase in price. This makes them less competitive in international markets. • Long-term rates of inflation compared to other countries. For example if average inflation in Country X is 4% whilst in Country B it is 8% over a number of years, the goods and services produced by Country X will become relatively more expensive over time. This worsens their competitiveness and causes a switch in comparative advantage. • Import controls such as tariffs and quotas that can be used to create an artificial comparative advantage for a country's domestic producers- although most countries agree to abide by international trade agreements. • Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales support) COMPETITIVE ADVANTAGE THEORY Competitive advantage is a position a firm occupies against its competitors. According to Michael Porter, the three methods for creating a sustainable competitive advantage are through cost leadership, differentiation or focus. Cost advantage occurs when a firm delivers the same services as its competitors but at a lower cost. Differentiation advantage occurs when a firm
  20. 20. delivers greater services for the same price of its competitors. They are collectively known as positional advantages because they denote the firm's position in its industry as a leader in either superior services or cost. Many forms of competitive advantage cannot be sustained indefinitely because the promise of economic rents invites competitors to duplicate the competitive advantage held by any one firm. A firm possesses a sustainable competitive advantage when its value- creating processes and position have not been able to be duplicated or imitated by other firms,. Sustainable competitive advantage results, according to the resource-based view theory in the creation of above-normal (or supranormal) rents in the long run. Analysis of competitive advantage is the subject of numerous theories of strategy, including the five forces model pioneered by Michael Porter of the Harvard Business School. The primary factors of competitive advantage are innovation, reputation and relationships. Porter's Strategic Theory The context within which SIS theory emerged was the competitive strategy framework put forward by Porter (1980, 1985), which was based on industrial organisation economics. For developments along that path, see Kaufmann 1966, Kantrow 1980, Pyburn 1981, Parsons 1983, EDP Analyzer 1984a, 1984b, McFarlan 1984, Benjamin et al 1984, Wiseman & Macmillan 1984, Ives & Learmonth 1984, Cash & Konsynski 1985, Porter & Millar 1985, Keen 1986, King 1986). Strategic information systems theory will then be shown to be concerned with the use of information technology to support or sharpen an enterprise's competitive strategy. Competitive strategy is an enterprise's plan for achieving sustainable competitive advantage over, or reducing the edge of, its adversaries. In Porter's view, the performance of individual corporations is determined by the extent to which they cope with, and manipulate, the five key 'forces' which make up the industry structure:
  21. 21. • the bargaining power of suppliers; • the bargaining power of buyer; • the threat of new entrants; • the threat of substitute products; and • rivalry among existing firms. There are two basic strategic stances that enterprises can adopt: • low cost; and • Product differentiation. In the long run, firms succeed relative to their competitors if they possess sustainable competitive advantage in either of these two, subject to reaching some threshold of adequacy in the other. Somogyi & Galliers (1987) provide examples of applications of information technology which are consistent with these two strategic stances, mapped against the particular enterprise activities to which they contribute. Another important consideration in positioning is 'competitive scope', or the breadth of the enterprise's target markets within its industry, i.e. the range of product varieties it offers, the distribution channels it employs, the types of buyers it serves, the geographic areas in which it sells, and the array of related industries in which it competes. Under Porter's framework, enterprises have four generic strategies available to them whereby they can attain above-average performance. They are: • cost leadership; • differentiation; • cost focus; and • Focused differentiation. According to Porter, competitive advantage grows out of the way an enterprise organises and performs discrete activities. The operations of any enterprise can be divided into a series of activities such as salespeople making sales calls, service technicians performing repairs, scientists in the laboratory designing products or processes, and treasurers raising capital.
  22. 22. By performing these activities, enterprises create value for their customers. The ultimate value an enterprise creates is measured by the amount customers are willing to pay for its product or services. A firm is profitable if this value exceeds the collective cost of performing all of the required activities. To gain competitive advantage over its rivals, a firm must either provide comparable value to the customer, but perform activities more efficiently than its competitors (lower cost), or perform activities in a unique way that creates greater buyer value and commands a premium price (differentiation). Porter’s Four Generic Strategies (Porters1980) Many differentiation bases exist, classified into four major groups (Borden 1964, quoted in Wiseman 1988): • product (quality, features, options, style, brand name, packaging, sizes, services, warranties, returns); • price (list, discounts, allowances, payment period, credit terms); • place (channels, coverage, locations, inventory, transport); and • Promotion (advertising, personal selling, sales promotion, publicity).
  23. 23. Porter’s diamond Porter studied 100 industries in 10 nations • postulated determinants of competitive advantage of a nation based on four major attributes • Factor endowments:- A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry 1. 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 2. 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 • Communications • Skilled labor • Research • Technology • Education
  24. 24. 3. Demand conditions Demand • Creates capabilities • Creates sophisticated and demanding • consumers Demand impacts quality and innovation 4. Related and supporting industries • Creates clusters of supporting industries that are internationally competitive • Must also meet requirements of other parts of the Country 5. 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. PCL THEORY The product life-cycle theory is an economic theory that was developed by Raymond Vernon in response to the failure of the Heckscher-Ohlin model to explain the observed pattern of international trade. The theory suggests that early in a product's life-cycle all the parts and labor associated with that product come from the area in which it was invented. After the product becomes adopted and used in the world markets, production gradually moves away from the point of origin. In some situations, the product becomes an
  25. 25. item that is imported by its original country of invention.[1] A commonly used example of this is the invention, growth and production of the personal computer with respect to the United States. The model applies to labor-saving and capital using products that (at least at first) cater to high-income groups. 3 stages: New product stage: The product is produced and consumed in the US. No trade takes place. Maturing product stage: mass-production techniques are developed and foreign demand (in developed countries) expands. At this stage the US exports the product to other developed countries. Standardized product stage: Production moves to developing countries, which then export the product to developed countries. The model demonstrates dynamic comparative advantage. The country that has the comparative advantage in the production of the product changes from the innovating (developed) country to the developing countries. Product life-cycle There are four stages in a product's life cycle: • introduction • growth • maturity • decline The location of production depends on the stage of the cycle. Introduction This is the stage where a product is conceptualized and first brought to market. The goal of any new product introduction is to meet consumer's needs with a quality product at the lowest possible cost in order to return the highest level of profit. The introduction of a new product can be broken down into five distinct parts:
  26. 26. • Idea validation, which is when a company studies a market, looks for areas where needs are not being met by current products, and tries to think of new products that could meet that need. The company's marketing department is responsible for identifying market opportunities and defining who will buy the product, what the primary benefits of the product will be, and how the product will be used. • Conceptual design occurs when an idea has been approved and begins to take shape. The company has studied available materials, technology, and manufacturing capability and determined that the new product can be created. Once that is done, more thorough specifications are developed, including price and style. Marketing is responsible for minimum and maximum sales estimates, competition review, and market share estimates. • Specification and design is when the product is nearing release. Final design questions are answered and final product specs are determined so that a prototype can be created. • Prototype and testing occurs when the first version of a product is created and tested by engineers and by customers. A pilot production run might be made to ensure that engineering decisions made earlier in the process were correct, and to establish quality control. The marketing department is extremely important at this point. It is responsible for developing packaging for the product, conducting the consumer tests through focus groups and other feedback methods, and tracking customer responses to the product. • Manufacturing ramp-up is the final stage of new product introduction. This is also known as commercialization. This is when the product goes into full production for release to the market. Final checks are made on product reliability and variability. In the introduction phase, sales may be slow as the company builds awareness of its product among potential customers. Advertising is crucial at this stage, so the marketing budget is often substantial. The type of advertising depends on the product. If the product is intended to reach a mass audience, than an advertising campaign built around one theme may be in order. If a product is specialized, or if a company's resources are limited, than smaller advertising campaigns can be used that target very specific audiences. As a product matures, the advertising budget associated with it will most likely shrink since audiences are already aware of the product. Author Philip Kotler has found that marketing departments can choose from four strategies at the commercialization stage. The first is known as "rapid
  27. 27. skimming." The rapid refers to the speed with which the company recovers its development costs on the product—the strategy calls for the new product to be launched at a high price and high promotion level. High prices mean high initial profits (provided the product is purchased at acceptable levels of course), and high promotion means high market recognition. This works best when the new product is unknown in the marketplace. The opposite method, "slow skimming," entails releasing the product at high price but with low promotion level. Again, the high price is designed to recover costs quickly, while the low promotion level keeps new costs down. This works best in a market that is made up of few major players or products —the small market means everyone already knows about the product when it is released. The other two strategies involve low prices. The first is known as rapid penetration and involves low price combined with high promotion. This works best in large markets where competition is strong and consumers are price-conscious. The second is called slow penetration, and involves low price and low promotion. This would work in markets where price was an issue but the market was well-defined. Besides the above marketing techniques, sales promotion is another important consideration when the product is in the introductory phase. According to Kotler and Armstrong in Principles of Marketing, "Sales promotion consists of short-term incentives to encourage purchase or sales of a product or service. Whereas advertising offers reasons to buy a product or service, sales promotion offers reason to buy now." Promotions can include free samples, rebates, and coupons. Growth The growth phase occurs when a product has survived its introduction and is beginning to be noticed in the marketplace. At this stage, a company can decide if it wants to go for increased market share or increased profitability. This is the boom time for any product. Production increases, leading to lower unit costs. Sales momentum builds as advertising campaigns target mass media audiences instead of specialized markets (if the product merits this). Competition grows as awareness of the product builds. Minor changes are made as more feedback is gathered or as new markets are targeted. The goal for any company is to stay in this phase as long as possible.
  28. 28. It is possible that the product will not succeed at this stage and move immediately past decline and straight to cancellation. That is a call the marketing staff has to make. It needs to evaluate just what costs the company can bear and what the product's chances for survival are. Tough choices need to be made—sticking with a losing product can be disastrous. If the product is doing well and killing it is out of the question, then the marketing department has other responsibilities. Instead of just building awareness of the product, the goal is to build brand loyalty by adding first- time buyers and retaining repeat buyers. Sales, discounts, and advertising all play an important role in that process. For products that are well-established and further along in the growth phase, marketing options include creating variations of the initial product that appeal to additional audiences. Maturity At the maturity stage, sales growth has started to slow and is approaching the point where the inevitable decline will begin. Defending market share becomes the chief concern, as marketing staffs have to spend more and more on promotion to entice customers to buy the product. Additionally, more competitors have stepped forward to challenge the product at this stage, some of which may offer a higher quality version of the product at a lower price. This can touch off price wars, and lower prices mean lower profits, which will cause some companies to drop out of the market for that product altogether. The maturity stage is usually the longest of the four life cycle stages, and it is not uncommon for a product to be in the mature stage for several decades. A savvy company will seek to lower unit costs as much as possible at the maturity stage so that profits can be maximized. The money earned from the mature products should then be used in research and development to come up with new product ideas to replace the maturing products. Operations should be streamlined, cost efficiencies sought, and hard decisions made. From a marketing standpoint, experts argue that the right promotion can make more of an impact at this stage than at any other. One popular theory postulates that there are two primary marketing strategies to utilize at this stage—offensive and defensive. Defensive strategies consist of special sales, promotions, cosmetic product changes, and other means of shoring up market share. It can also mean quite literally defending the quality and integrity of your product versus your competition. Marketing offensively means looking beyond current markets and attempting to gain brand new
  29. 29. buyers. Relaunching the product is one option. Other offensive tactics include changing the price of a product (either higher or lower) to appeal to an entirely new audience or finding new applications for a product. Decline This occurs when the product peaks in the maturity stage and then begins a downward slide in sales. Eventually, revenues will drop to the point where it is no longer economically feasible to continue making the product. Investment is minimized. The product can simply be discontinued, or it can be sold to another company. A third option that combines those elements is also sometimes seen as viable, but comes to fruition only rarely. Under this scenario, the product is discontinued and stock is allowed to dwindle to zero, but the company sells the rights to supporting the product to another company, which then becomes responsible for servicing and maintaining the product. Problems With the Product Life Cycle Theory While the product life cycle theory is widely accepted, it does have critics who say that the theory has so many exceptions and so few rules that it is meaningless. Among the holes in the theory that these critics highlight: • There is no set amount of time that a product must stay in any stage; each product is different and moves through the stages at different times. Also, the four stages are not the same time period in length, which is often overlooked. • There is no real proof that all products must die. Some products have been seen to go from maturity back to a period of rapid growth thanks to some improvement or re-design. Some argue that by saying in advance that a product must reach the end of life stage, it becomes a self-fulfilling prophecy that companies subscribe to. Critics say that some businesses interpret the first downturn in sales to mean that a product has reached decline and should be killed, thus terminating some still-viable products prematurely. • The theory can lead to an over-emphasis on new product releases at the expense of mature products, when in fact the greater profits could possibly be derived from the mature product if a little work was done on revamping the product.
  30. 30. • The theory emphasizes individual products instead of taking larger brands into account. • The theory does not adequately account for product redesign and/or reinvention NEW TRADE THEORY New Trade Theory's development The theory was initially associated with Paul Krugman in the early 1970s; Krugman claims that he heard about monopolistic competition from Robert Solow. Looking back in 1996 Krugman wrote that International economics a generation earlier had completely ignored returns to scale. "The idea that trade might reflect an overlay of increasing-returns specialization on comparative advantage was not there at all: instead, the ruling idea was that increasing returns would simply alter the pattern of comparative advantage." In 1976, however, MIT-trained economist Victor Norman had worked out the central elements of what came to be known as the Helpman-Krugman theory. He wrote it up (by hand) and showed it to the great monopolistic competition innovator, Avinash Dixit, and they both agreed it wasn't very significant. Indeed Norman never had the paper typed, much less published. Norman's formal stake in the race comes from the final chapters of the famous Dixit-Norman book (Theory of International Trade : A Dual, General Equilibrium Approach, ISBN 0-521-29969-1). James Brander, a PhD student at Stanford at the time, was undertaking similarly innovative work using models from industrial organisation theory -- cross-hauling -- to explain two way trade in similar products New Trade Theory (NTT) is the economic critique of international free trade from the perspective of increasing returns to scale and the network effect. Some economists have asked whether it might be effective for a
  31. 31. nation to shelter infant industries until they had grown to a sufficient size large enough to compete internationally. New Trade theorists challenge the assumption of diminishing returns to scale, and some argue that using protectionist measures to build up a huge industrial base in certain industries will then allow those sectors to dominate the world market (via a Network effect). They wondered whether free trade would have prevented the development of the Japanese auto industries in the 1950s, when quotas and regulations prevented import competition. Japanese companies were encouraged to import foreign production technology but were required to produce 90 percent of parts domestically within five years. It is said that the short-term hardship of Japanese consumers (who were unable to buy the superior vehicles produced by the world market) was more than compensated for by the long-term benefits to producers, who gained time to out-compete their international rivals1. Less quantitative forms of this "infant industry" argument against totally free trade have been advanced by trade theorists since at least 1848 (see: History of free trade.) New Trade Theory is based, ultimately, on four innovations that have in recent years modified the reigning neoclassical economics: 1. An appreciation of market imperfections. 2. The new industrial economics of strategic behavior. 3. New Growth Theory, a fresh approach to the question of economic growth. 4. A changing appreciation of the political context. The Theory's impact Although there was nothing particularly 'new' about the idea of protecting 'infant industries' (an idea offered in theory since the 18th century, and in trade policy since the 1880s) what was new in "New Trade Theory" was the rigor of the mathematical economics used to model the increasing returns to
  32. 32. scale, and especially the use of the network effect to argue that the formation of important industries was path dependent in a way which industrial planning and judicious tariffs might control. The model they developed was highly technical, and predicted the possibilities of national specialization-by-industry observed in the industrial world (movies in Hollywood, watches in Switzerland, etc). The story of path-dependent industrial concentrations sometimes leads to monopolistic competition. Econometric testing The econometric evidence for NTT was mixed, and again, highly technical. Due to the time-scales required and the particular nature of production in each 'monopolizable' sector, statistical judgments have been hard to make. In many ways, there is too limited a dataset to produce a reliable test of the hypothesis which doesn't require arbitrary judgements from the researchers. Japan is cited as evidence of the benefits of "intelligent" protectionism, but critics of NTT have argued that the empirical support post-war Japan offers for beneficial protectionism is unusual, and that the NTT argument is based on a selective sample of historical cases. Although many examples (like Japanese cars) can be cited where a 'protected' industry subsequently grew to world status, regressions on the outcomes of such "industrial policies" (including the failures) have been less conclusive
  33. 33. Bibliography 1.Wikipedia 3.Google search 4.Marketing – Philip Kotler
  34. 34. THANK YOU