2. 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
3. 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.)
4. “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…” !!!!
5. An overview of trade theory
• Adam Smith: The theory of absolute advantage, 1776
• Ricardo: The theory of comparative advantage, 1817
• Heckscher-Ohlin theory: 20th century
• Leontief Paradox: 1954
• Bretton Woods System : 1944
7. Learning objective :-
Differentiate between Absolute Advantage and
Comparative Advantage theory
In economics, the principle of absolute advantage refers to the ability of a party (an
individual, or firm, or country) to produce more number of a good product or service
than competitors, using the same amount of resources.
Terms
The theory of comparative advantage is an economic theory about the
potential gains from trade for individuals, firms, or nations that arise from
differences in their factor endowments or technological progress. In an economic
model, an agent has a comparative advantage over another in producing a
particular good if he can produce that good at a lower relative opportunity cost i.e.
at a lower relative marginal cost prior to trade
8. The existence of a comparative
advantage allows both parties to
benefit from trading, because each
party will receive a good at
a price that is lower than
its opportunity cost of producing
that good.
9. Absolute advantage compares the productivity of different
producers or economies. The producer that requires a smaller
quantity inputs to produce a good is said to have an absolute
advantage in producing that good.
The accompanying figure shows the amount of output Country A
and Country B can produce in a given period of time . Country A
uses less time than Country B to make either food or clothing.
Country A makes 6 units of food while Country B makes one unit,
and Country A makes three units of clothing while Country B
makes two. In other words, Country A has an absolute advantage
in making both food and clothing
10. Absolute Advantage :-
Comparative advantage refers to the ability of a party
to produce a particular good or service at a lower
opportunity cost than another. Even if one country
has an absolute advantage in producing all goods,
different countries could still have different
comparative advantages. If one country has a
comparative advantage over another, both parties can
benefit from trading because each party will receive a
good at a price that is lower than its own opportunity
cost of producing that good. Comparative advantage
drives countries to specialize in the production of the
goods for which they have the lowest opportunity
cost, which leads to increased productivity.
11. For example, consider again Country A and Country B in .
The opportunity cost of producing 1 unit of clothing is 2
units of food in Country A, but only 0.5 units of food in
Country B. Since the opportunity cost of producing clothing
is lower in Country B than in Country A, Country B has a
comparative advantage in clothing.
Thus, even though Country A has an absolute advantage in
both food and clothes, it will specialize in food while
Country B specializes clothing. The countries will then trade,
and each will gain.
13. 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
14. • 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.
15. • 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.
17. 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.
18. 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.
19. 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
H-O Theory: Summary
21. Wassily Leontief received a Nobel prize in 1973 for his
contribution to the input output analysis. Three of his
students, Paul Samuelson, Robert Solow and Vernon Smith
are also recipients. The Heckscher Ohlin theory states that
each country exports the commodity which uses its abundant
factor
intensively. The HO theory was generally accepted on the
basis of casual empiricism. Moreover, there wasn't any
technique to test the HO theory until the input output
analysis was invented. The first serious attempt to test the
theory was made by Professor Wassily W. Leontief in 1954.
The first
Empirical
Test of the
HO
theory
Result: Leontief reached a paradoxical conclusion that
the US—the most capital abundant country in
the
world by any criterion—exported labor intensive
commodities and imported capital intensive
commodities. This result has come to be known
as the Leontief Paradox.
[para = contrary to, doxa = opinion]
22. Criticism- At first, Leontief was criticized on statistical grounds.
Swerling (1953)- complained that 1947 was not a typical
year: the postwar disorganization of production overseas
was not corrected by that time.
Leontief's
Second
Test-
In 1956 Leontief repeated the test for US imports and
exports which prevailed in 1951. In his second study,
Leontief aggregated industries into 192 industries. He
found that US imports were still more capital
intensive
than US exports. US imports were 6% more capital
intensive. (The transition of the US
economy from a wartime to peace time economy was
not complete until the 1960s)
23. Baldwin's
Third
Test-
More recently, Professor Robert Baldwin (1971)
used the 1962 US trade data and found that US
imports were 27% more capital intensive than
US exports. The paradox continued. [There
were some computational problems in this
study.]
Afterwards, there were no new empirical
studies on US trade.
24. JAPAN
East
Germany
• Tatemoto and Ichimura (1959) studied Japan's trade
pattern and discovered another paradox. Japan was a labor
abundant country, but exported capital intensive goods
and
imported labor intensive goods. Japan's overall trade
pattern was inconsistent with HO.
• Stolper and Roskamp (1961) applied Leontief's method
to
the trade pattern of East Germany. East Germany's
exports
were capital intensive. About 3/4 of EG's trade was with
the
communist bloc, and EG was capital abundant relative to
its
trading partners. Thus, the EG case was consistent with
Trade Patterns of Other Countries
25. Wahl (1961) studied Canada's trade pattern.
Canadian exports were capital intensive. Most
of Canadian trade was with the US. The result
was inconsistent with HO.
CANADA
INDIA
Bharadwaj (1962) studied India's trade
pattern. India's exports were labor
intensive. Consistent with HO theory.
However, Indian trade with the US was
not. Indian exports to the US were capital
intensive.
26. 1. Leontief: US was more efficient
Leontief himself suggested an explanation for his own paradox.
He argued that US workers may be more efficient than foreign
workers. Perhaps U.S. workers were three times as effective as
foreign workers. Note that this increased effectiveness of the
American workers was not due to a higher capital labor ratio,
because we assume that countries have identical technologies
and hence identical Capital labor ratios. It means that the
average American worker is three times as effective as he would
be in the foreign country.
Given the same K/L ratio, Leontief attributed the superior
efficiency of American labor to superior economic organization
and economic incentives in the U.S. However, Leontief found
very few believers among economists.
Explanations for the LP
27. 2. Factor Intensity Reversal
If a commodity is produced by a labor intensive process in the
labor rich country and also by the capital intensive process in
the capital rich country, then factor intensities are reversed in
the production of that commodity.
Example: agriculture is labor intensive in India but
Capital intensive in US.
If the US imports agricultural products, then an LP occurs in
the US, because a capital abundant country is importing the
capital intensive product.
If the US exports agricultural products, then an LP occurs in
India, because a labor abundant country, India, is importing
the labor intensive good.
28. William Travis (1964) argued that tariff may have been
responsible for the LP. However, tariffs tend to reduce trade
volume, but not reverse commodity trade pattern. In other
words, an import tariff cannot induce a country to export
goods that intensively use its scarce factor. It would only
reduce the volume of goods which it would export in the
absence of a tariff.
Baldwin (1971) showed that this indeed was the case.
Without tariff, the capital labor ratio of imports would have
fallen by 5%, which is not sufficient to resolve the LP.
Remark- Tariffs and transport costs tend to reduce the
volume of trade, but not reverse the pattern
of trade.
3. Tariffs and Transport Costs
29. A capital abundant country need not export the capital
intensive good if her tastes are strongly biased toward Capital
intensive goods. Thus, LP can be explained if the US had a
strong consumption bias toward the capital intensive goods.
Stefan ValavanisVail (1954)
Example
of
demand
bias-
Switzerland leads the world in per capita annual chocolate
consumption, 22.5 pounds per person! (Swiss Chocolate).
Per capita consumption of chocolates is less than 5 pounds
in the United States. Per capita consumption of seafood in
Japan is 60 kg per year while that of the US was about 15
pounds in 2001. Thus, the Japanese people consumes 10
times as much seafood as Americans per person. When
commodities are narrowly classified, there exists a
considerable difference in tastes and consumption patterns
between trading countries.
4. Demand Bias
30. Human capital has not been taken into account in evaluating
LP. The idea is simple. Human capital is created by education.
Education, like investment in physical capital, requires time
and uses up resources. Leontief did not include the value of
human capital in his calculations. But he argued that US
exports were skilled Labor intensive than US imports.
5. Human Capital
These analyses show that presence of human
capital can play an important role in determining
trade patterns between countries. However,
available empirical evidence is not very conclusive
either way.
Evaluation-
32. It provides a sophisticated tool for analyzing
competitiveness with all its implications. The essence of
his argument is that ‘The home nation influences the
ability of its firms to succeed in particular
industries.’ Michael Porter considers that these four
attributes shape the environment :
Factor conditions/ Factor endowments
Demand Conditions
Related and supporting industries
Firm strategy, structure and rivalry
Porter speaks of these above attributes as constituting the
diamond.
The industry is the arena in which the competitive
advantage is won or lost.
33. Michael E.Porter’s Diamond Model
Firm Strategy,
Structure and Rivalry
Demand Conditions
Related And Supporting
Industries
Factor
Cond itions
34. Being the inputs which effect the competition in any
industry
comprises a no.of categories such as human resources,
capital resources, physical resources, infrastructure
resources.
Depending upon the degree of investment required for the
possession of a particular factor, factor’s of production are
divided into two groups:
BASIC FACTORS : They require the modest, private and
social investment. They include natural resources, climate ,
location, semi-skilled labour.
ADVANCED FACTORS : These comprises of the highly
educated personnel, research facilities. These factors require
the large and sustained investments for their development.
Factor conditions
35. There is another division which accounts for the
establishment of the competitive advantage most.
These are as follows :
Generalized factors: The meaning comes from
their name as they could be deployed in a wide
range of industries.
Specialized factors : They are characterised by
narrow field of application due to the higher
degree of the customization to the needs of a
particular industry.
Contd...
36. Demand Conditions
Porter emphasises that role home demand plays in
upgrading competitive advantage. Firms are typically most
sensitive to the needs of their closests customers. This
means that, regardless of the state of the other determinats
in the daimond, competitively in an industry it is
impossible to achieve unless demand conditions allow for a
successful realisation of firm’s products. The sources of
this are being divided into the 3 broad attributes:
Home demand cpomposition
Demand side and pattern of growth
Internalization of domestic demand
37. Related and supporting
industries
The third attribute is the related and supporting industries.
Important benefit of home based suppliers is expressed in
the process of innovation and upgrading. Supplier help firms
to perceive new methods and opportunities to apply new
technology.
Related industries are those in which the firms can share in
the value chain. Another way by which related industries
could influence competitiveness is by means of pulling
through the demand for complementary products and
services.
38. Firm Strategy, Structure and
Rivalry
The fourth broad attribute of national competitive advantage
in porters model is the strategy structure and rivalry of firms
within a nation.
This is reflective of company goals and individual goals as
well as national prestige and national priority. Domestic
rivalry not only creates pressure to innovate but to innovate
in ways that upgrade the competitive advantages of a nation
firms.
Their pressure lowers the significance of advantages
created through the little effort and investment.
39. Porters considerers the two additional variables which are not
as important as the determinants but are significnat in
shaping the direction of the influence.
These two are Chance and Government.
Chance : These are developments beyond the control of
firms such as pure investors etc.
Government : It is important to extent to which its
policies can influence the entire system
of determinants either in the direcion of
undermining or enhancing competitive
advantage.
Contd...
40. Conclusion
He contents that the degree to which a nation is likely to achieve
international success in a certain industry is a function of the
combined impact of the four attributes. He argues that the
presence of all the four factor components is usually required for
this diamond to boost its competitive advantage .
42. Before World War I, nearly all of the world economy
was on the gold standard
A government would define a unit of its currency as
worth a particular amount of gold, ready to sell/buy any
amount of gold at that time
The currency was convertible
could be converted into gold freely
The currency’s price in terms of gold was its parity
44. The Bretton woods system was born in 1944 in Bretton
Woods, New Hampshire , endorsed by the 730
delegates of 44 countries.
Goal:
To establish a postwar international monetary
system of convertible currencies, fixed exchange
rates and free trade.
BUT
With 2 rival plans !!
45. Keynes’ plan centred on the idea that a new international
financial institution, the International Clearing Union,
would be created whose role was much like that of a central
bank.
The ICU would issue an international currency called the
Bancor and its value would be fixed in terms of gold.
Countries would then set par values in terms of Bancor and
create accounts with the ICU which would be used to settle
trade.
46. The American plan foresaw a world free of trade
restrictions and of currencies that were pegged, all
overseen by an international institution that had
significant veto power over parity changes.
For this reason the White Memorandum focused on
creating another institution known as the United Nations
Stabilisation Fund.
Each nation would contribute a quota of their domestic
currency and gold to the UNSF and would fix the value of
their currency in terms of unitas,
47. Features from both the memorandum were taken and this
led to the creation of Bretton woods system.
This was accompanied by the creation of international
institutions, including the International Bank for
Reconstruction and Development( presently known as
WORLD BANK )and the International Monetary Fund
(IMF).
IMF was entrusted with the supervision of the new
international monetary system and with granting loans to
deal with balance of payments difficulties,whereas the
WORLD BANK specialised in granting loans for the
reconstruction of Europe and for development purposes.
48. To establish stable exchange rates;
To eliminate exchange controls;
To bring about convertibility of currencies and to
supervise orderly maintenance of exchange rates.
49. The first problem encountered was the question of
choosing the appropriate exchange rate regime, i.e.
Whether a fixed exchange rate system or a floating rate
system or any other variant of either of these two or a
combination of both.
The experts gathered at Bretton Woods finally chose the
fixed exchange rate system with some flexibility also called
adjustable peg or adjustable par values.
Second problem: was to have an institution with both
authority and resources to facilitate and ensure the smooth
working of the fixed exchange rate system. To achieve this,
the INTERNATIONAL MONETARY FUND(IMF) was set up
in1946.
50. Fixed but adjustable peg was chosen. Therefore, the
dollar was pegged to gold at the fixed rate of USD
35/ounce and the United States was prepared to
buy/sell unlimited amount of gold at this price.
Other countries were required to declare the rates of
their currencies in terms of gold/dollar and to defend
the declared rates in the forex market by buying and
selling dollars, exchange rate could only vary within
the INTERVENTION POINTS, initially fixed at +/- 1%.
52. The BW suffered from a no. of problems that led to its
eventual demise.
FIRST PROBLEM: countries which are IMF members
are required to declare parity rates of their currencies
in terms of gold/ dollar.
SECOND PROBLEM: to ensure flexibility, par values
are allowed to fluctuate but only within a margin of
not exceeding 1% on either side of the parity rate. In
December, 1971, this margin was increased to 2.25% .
53. THIRD PROBLEM: whenever the fluctuations in the exchange
rate exceed permitted margins, the countries are obliged to
intervene in the exchange market to keep the fluctuations within
the permitted band.
FOURTH PROBLEM: to keep the fluctuations in the exchange
rates within limits, central banks of member countries have to
maintain adequate foreign exchange reserves, and if the reserves
are found inadequate, members countries are eligible to borrow
foreign currencies temporarily.
LAST, if the foreign exchange difficulties persist over long
periods, the situation is described as “fundamental
disequilibrium”, and in this situation if borrowings exceeds in
amount and duration corrective measures are taken by the
countries concerned.
54. BW System worked very well during 1946-71. and
proved beneficial to the growth of the economics
particularly in the western world.
Problems started developing from 1964 and led finally
to the collapse of the system in 1971.
55. 3 main problems that led to collapse:
(1) adjustment (2) liquidity (3) confidence
The entry of US in Vietnam War.
The huge military spending for purchase of material and supplies for war led to
inflation in the US; and this in turn affected the competitiveness of US exports.
While Germany and japan were resisting revaluation of their currencies.
1962, france began to exchange dollars for gold despite the objection of the
united states.
French action led other countries to worry about whether sufficient gold would
remain for them after the French had finished selling dollars.
Feeling the pressure, the united states, on 15th august 1971, responded to a
record USD30 billion trade deficit by making the dollar inconvertible into gold,
led to the collapse of BWS !!