Module Overview Theory of Mercantilism Absolute Advantage Theory Comparative Advantage Theory Hecksher-Ohlin Theory The new product life cycle theory The new Trade Theory Porter’s Diamond Model Implications for International Business
Introduction International trade theory explains why it is beneficial for countries to engage in international trade helps countries formulate their economic policy explains the pattern of international trade in the world economy
An Overview of Trade Theory Question: What is free trade?• Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country
Mercantilism A nation’s wealth depends on ‘build up wealth’ of Gold and silver as they were the currency of trade in that age. Mercantilism (mid-16th century England) asserted that it is in a country’s best interest to maintain a trade surplus, to export more than it imports Maximize export through subsidies Minimize imports through tariffs and quotas it advocated government intervention to achieve a surplus in the balance of trade it viewed trade as a zero-sum game (one in which a gain by one country results in a loss by another) Stayed from 1500-1800, and trade strategy of many nations were boost exports and limit import.
Limitation of Mercantilism: Zero-Sum GameIn 1752, David Hume pointed out that: • Increased exports lead to inflation and higher prices • Increased imports lead to lower prices Result: Country A sells less because of high prices and Country B sells more because of lower pricesIn the long run, no one can keep a trade surplusMercantilism is problematic and not economically valid, yet many political views today have the goal of boosting exports while limiting imports
Theory of Absolute Advantage Adam Smith 1723-1790In 1776, Adam Smith in his book The Wealth Of Nations argued:q Countries differ in their ability to produce goods efficiently.q A country has an “absolute advantage” when it is the most efficient in producing a particular product. (Countries should specialize in producing products for which they have an absolute advantage, and trade these goods for those produced more efficiently by other countries.)q Such trade will be beneficial to both countries. Thus it is a “positive- sum game”
Absolute Advantage: An Example 20 Ghana and South Korea can each produce and consume G cocoa and rice. Each country has 200 units of resources q Ghana (G) has the resources to produce any 15 combination of cocoa and/or rice that lies on its Production Possibility Frontier (PPF). q South Korea (K) has the resources to 10 produce these combinations of cocoa and/orCocoa A rice. q Without trade, each country devotes half of K its resources to each product (points A and 5 » B B). 2.5 G’ K’ 0 5 10 15 20 Rice
Absolute Advantage: An Example of Gains from Trade Cocoa Rice Ghana 10 20Resources Required to Produce 1Ton of Cocoa and Rice. S. Korea 40 10Production and Consumption Ghana 10.0 5.0without Trade. S. Korea 2.5 10.0 Total Production 12.5 15.0 Ghana 20.0 0.0Production with Specialization S. Korea 0.0 20.0 Total Production 20.0 20.0Consumption After Ghana Trades 6 Ghana 14.0 6.0Tons of Cocoa for 6 Tons of S. S. Korea 6.0 14.0Korean RiceIncrease in Consumption as a result Ghana 4.0 1.0of Specialization and Trade S. Korea 3.5 4.0
David Ricardo andTheory of Comparative Advantage In 1817, David Ricardo in his book The Principles of Political Economy extended Smith’s free trade argument: A country should specialize in the production of goods that it produces more efficiently in comparison to other goods — even if the country doesn’t hold an absolute advantage for that good. The country should import the goods it produces less efficiently, even if it can produce that good all by itself. Due to increased efficiency (better use of limited resources), potential world production is greater with unrestricted free trade. Comparative Advantage maximize countries combined output Therefore, free trade is universally beneficial (a positive-sum game) even when nations do not have an absolute advantage.
The Theory of Comparative Advantage Ghana and South Korea can each produce and consume cocoa and rice. q Ghana (G) produces both cocoa and rice, with a 20 G comparative advantage in cocoa. q South Korea (K) is more efficient in producing rice than cocoa — a comparative advantage in C 15 rice. q Ghana is more efficient than S. Korea in theCocoa production of both cocoa and rice — an A absolute advantage in both products.10 q Without trade, each country would devote half of its resources to each product (points A and K B). 5 q With trade, and specialization in cocoa, Ghana B 2.5 can produce at point C. K G’ ’ 0 3.75 7.5 0 5 10 15 20 Rice
Comparative Advantage: An Example of Gains from Trade Cocoa RiceResources Required to Produce 1 Ghana 10 13.3Ton of Cocoa and Rice. S. Korea 40 20Production and Consumption Ghana 10.0 7.5without Trade (points A and B). S. Korea 2.5 5.0 Total Production 12.5 12.5 Ghana 15.0 3.75Production with Specialization S. Korea 0.0 10.0(points C and K’) Total 15.0 13.75Consumption After Ghana Trades 4 Production Ghana 11.0 7.75Tons of Cocoa for 4 Tons of S.Korean Rice S. Korea 4.0 6.0Increase in Consumption as a result Ghana 1.0 0.25of Specialization and Trade S. Korea 1.5 1.0
Absolute Advantage VersusComparative Advantage ComparativeAbsolute advantage advantage Adam Smiths Absolute But Comparative advantage Advantage can gain by can gain in production of production of one good more than one good A country enjoys an absolute A country enjoys a advantage over another comparative advantage country in the production of in the production of a a product if it uses fewer resources to produce that good if that good can be product than the other produced at a lower cost country does. in terms of other goods.
Assumptions for Absolute advantage andcomparative advantage The conclusion that free trade is universally beneficial is rather bold for such a simple model as previously shown. The model has many unrealistic assumptions, such as…q There are only two economies, producing two goods.q There are no transport costs.q Resource prices are identical in the two countries.q Trade does not affect income distribution within a country.q Resources can move from the production of one good to another within a country.q There are constant returns to scale.q That free trade does not change the efficiency with which a country uses its resources, or the stock of resources.
Limitations of Absolute advantage theory andcomparative advantage theory Immobile resources: Resources do not always move easily from one economic activity to another Diminishing returns: Diminishing returns to specialization suggests that after some point, the more units of a good the country produces, the greater the additional resources required to produce an additional item Different goods use resources in different proportions
Heckscher-Ohlin Theory Comparative advantage arise from differences in Productivity. Swedish economists Eli Heckscher (in 1919), and Bertil Ohlin (in 1933) had another explanation for comparative advantage. Comparative advantage did not stem from differences in productivity (as theorized by Ricardo), but from differences in national factor endowments. (the extent to which a country is gifted with resources such as land, labor, capital, human resources, capital) A country should export goods that intensively use factor endowments which are abundantly available in the country. A country should Import goods that make intensive use of factors which are scarce.
The Limitation of Heckscher-OhlinTheory: The Leontief Paradox The Leontief Paradox: In 1953 Wassily Leontief disputed the Hechscher-Ohlin theory in some instances. The US is abundant in capital relative to most other nations. So, according to Hecksher-Ohlin, the US should be an exporter of capital-intensive goods, and an importer of labor-intensive goods. Actually, in 1953, US exports were less capital-intensive than US imports. Heckscher-Ohlin is a relatively poor predictor of real-world trade patterns. Ricardo’s theory is more accurate. In the end, differences in productivity may be the key to determining trade patterns.
Product Life-Cycle Theory - Raymond. Vernon(1966) Most new products initially conceived & produced in the US in 20th century q US firms kept production close to the market vWork out the innovations of new product introductions vDemand not based on price yet so low production cost not an issue q Limited initial demand in other advanced countries vExports more attractive than production in other countries q When demand increases in advanced countries vProduce in foreign countries when demand necessitate q As developed market demand matures, new demand comes from less developed countries vProduct becomes standardized vproduction moves to low production cost areas vProduct now imported to US and to advanced countries
Product Life-Cycle Theory - R. Vernon (1966) Limitation: This theory was based upon what was occurring at that time in the US. Globalization and integration of the economy makes this theory less valid today.
The New Trade TheoryThe New Trade Theory emerged in the 1970’s. It deals with thereturns on specialization where substantial economies of scale arepresent q Output increases with increased production. q Economies of scale increase with increased output. q Unit costs of production should decrease along with economies of scale. q The world economy will profitably support only a few firms in industries with substantial economies of scale.
The first mover advantage. Early entries to an industry may gain a lock on the market as they are first to gain economies of scale; this discourages new entries — the first mover advantage. Because of economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods In those industries Where demand become more crucial, the global market may only be able to support a small number of firms Important factors to first-mover advantage are: luck entrepreneurship innovation government intervention.
Limitation of first mover advantage There may be an economic rationale for a strategic or proactive trade policy if it helps domestic firms become first movers in an industry; this is in conflict with earlier free-trade theories
National Competitive Advantage: Porter’s Diamond Michael Porter (1990), of HBS, tried to explain why a nation achieves international success in a particular industry Porter identified four attributes he calls the diamond that promote or impede the creation of competitive advantage 1. Factor endowments 2. Demand conditions 3. Related and supporting industries 4. Firm strategy, structure, and rivalry In addition, Porter identified two additional variables (chance and government) that can influence the diamond in important ways
Porter’s Diamond The conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.A nation’sposition in The nature offactors of home demandproduction, for thesuch as skilled industry’slabor or product orinfrastructure service.necessary tocompete in agivenindustry. The presence or absence in a nation of supplier industries or related industries that are nationally competitive.
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 (Natural resources, Climate, Geographic location, Demographics) Advanced factor endowments
Advanced Factor Endowments Advanced factors: The result of investment by people, companies, and government 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
Demand Conditions 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 (like suppliers or related industries)
Firm Strategy, Structureand 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
Porter’s Theory-Predictions 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: Separate production activities to countries where they can be performed most efficiently Ex: If design can performed most efficiently in France, it is where design facility should be kept. 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