International Trade

1. 1
International Business
Chapter 05
International Trade
Theories

2. 2
Objectives
• To explain trade theories
• To discuss how global efficiency can be increased through
free trade
• To introduce prescriptions for altering trade patterns
• To explore how business decisions influence international trade

3. 3
Companies’ International Operations Link Countries Economically
OBJECTIVES
STRATEGY
MEANS OF OPERATING
• Importing and exporting
goods and services (trade)
• Transferring production
factors, such as labor and
capital, internationally
Country B
Country A

4. 4
Introduction
Trade in goods and services is one means by which countries
are linked economically
Types of trade theories
• Descriptive—deal with natural order of trade
– examine and explain trade patterns under laissez-
faire conditions
• Prescriptive—concerned with government interference in
the free movement of goods and services
– considers governments’ affect on the amount,
composition, and direction of trade
• Both types of theories
– provide insights about markets for exports and
potentially successful export products
– help companies determine where to locate production
facilities

5. 5
Mercantilism
Foundation of economic thought from 1500—1800
• Intended to benefit colonial powers
– colonies supplied commodities to the mother country
– mother country tried to run trade surpluses with their
own colonies
• A country’s wealth determined by its holding of treasure,
usually gold
• Countries should export more than they import
– favorable balance of trade
– governments imposed restrictions on imports
– governments subsidized many products that could
not otherwise compete in domestic or export markets
• Mercantilism faded after 1800
Neo-mercantilism—attempt to achieve favorable trade balances
to achieve social or political objectives

6. 6
Absolute Advantage
Adam Smith—different countries produce some goods more
efficiently than other countries
• Free trade increases global efficiency
• Each country will specialize in products that give it a
competitive advantage
– labor becomes more skilled by repeating tasks
– no time lost switching from production of one kind to
production of another kind
– long production runs provide incentives for development
of more effective work methods
• Natural advantage—stems from climatic conditions, access
to certain natural resources, or availability of certain labor
forces
• Acquired advantage— based on technology and skill
development
– product technology
– process technology

7. 7
Production Possibilities with Absolute Advantage
ASSUMPTIONS for Sri Lanka
1. 100 units of resources available
2. 10 units to produce a ton of wheat
3. 4 units to produce a ton of tea
4. Uses half of total resources per product
when there is no foreign trade
ASSUMPTIONS for United States
1. 100 units of resources available
2. 5 units to produce a ton of wheat
3. 20 units to produce a ton of tea
4. Uses half of total resources per product
when there is no foreign trade
PRODUCTION Tea Wheat
(tons) (tons)
Without Trade:
Sri Lanka (point A) 12.5 5
U.S. (point B) 2.5 10
Total 15.0 15
With Trade:
Sri Lanka (point C) 25 0
U.S. (point D) 0 20
Total 25 20
U.S. production possibilities
10
Quantity of Wheat (tons)
0 5 15 20 25
5
10
15
20
25
Quantity
of
Tea
(tons) A
B
C
D
Sri Lankan production possibilities

8. 8
Comparative Advantage
David Ricardo—gains from trade will occur even in a country
that has absolute advantage in all products because the
country must give up less-efficient output to produce more
efficient output
Country should specialize in products it can make most
efficiently, even if other countries can make the product more
efficiently
Theory accepted by most economists
• Theory is influential in promoting policies for freer trade

9. 9
Production Possibilities with Comparative Advantage
ASSUMPTIONS for Sri Lanka
1. 100 units of resources available
2. 10 units to produce a ton of wheat
3. 10 units to produce a ton of tea
4. Uses half of total resources per product
when there is no foreign trade
PRODUCTION Tea Wheat
(tons) (tons)
Without Trade:
Sri Lanka (point A) 5 5
U.S. (point B) 10 12.5
Total 15 17.5
With Trade (increasing
tea production):
Sri Lanka (point C) 10 0
U.S. (point D) 6 17.5
Total 16 17.5
ASSUMPTIONS for United States
1. 100 units of resources available
2. 4 units to produce a ton of wheat
3. 5 units to produce a ton of tea
4. Uses half of total resources per product
when there is no foreign trade
10
Quantity of Wheat (tons)
0 5 15 20 25
5
10
15
20
25
Quantity
of
Tea
(tons)
C
D
E
U.S. production possibilities
A
B
Sri Lankan production possibilities
With Trade (increasing
wheat production):
Sri Lanka (point C) 10 0
U.S. (point E) 5 18.75
Total 15 18.75

10. 10
Assumptions and Limitations of Theories
Of Specialization
Both absolute and comparative advantage theories are based
on specialization
• Countries should trade output based on their own specialization for the
output from other countries specialization
1. Full employment: not valid assumption
2. Economic efficiency objective: countries’ goals may not be
limited to economic efficiency
3. Division of gains: if trading partner is perceived to be gaining too large a
share of benefits, other partner may forgo absolute gains to prevent
relative losses
4. Two countries, two commodities: original two-country, two
product logic applies to more complex situations
5. Transport costs: may negate advantages of trading
6. Mobility: Resources are neither as mobile nor as immobile as the theories
assume.
7. Static & Dynamic: Economic conditions/factor conditions are not static,
but dynamic.
8. Services: not only products are traded, services are also traded now

11. 11
Factor-Proportion Theory
Eli Heckscher and Bertil Ohlin—relative factor costs lead
countries to excel in the production and export of products
That used their abundant, and therefore cheaper production
Factors.
Land-labor relationship—in countries in which there are many
people relative to the amount of land, land price is very high
because it’s in demand
• Land costs and technology dictate what types of industries
choose to locate in a country
Labor-capital relationship— production factors, especially labor,
are not as homogeneous as assumed
• Labor skills vary within and among countries due to
differences in training and education
– led to international specialization by task to produce a
given product
Technological complexities—the same product can be produced
by different methods (labor or capital)

12. 12
Product Life Cycle Theory of Trade (PLC)
Raymond Vernon—the production location for many
Products moves from one country to another depending
on the stage in the product’s life cycle
Stage 1: Introduction
• Innovation, production, and sales in same country
– new products developed in response to nearby
observed need and markets for them
– early production occurs in domestic location
• Location and importance of technology
– most new technology that results in new products
and production methods originates in industrial
countries
• Exports and labor
– export small part of production
– production process likely to be labor intensive
– capital machinery for large-scale production develops
later in industrialized countries

13. 13
Product Life Cycle Theory of Trade (cont.)
Stage 2: Growth
• Increases in exports by the innovating country
• More competition
• Increased capital intensity
– growing sales offer incentives to companies to
develop process technology
• Some foreign production
Stage 3: Maturity
• Decline in exports from the innovating country
• More product standardization
• More capital intensity
• Increased competitiveness of price
• Production start-ups in emerging countries
Stage 4: Decline
• Production increased in emerging economies
• Innovating country becoming net importer

14. 14
Product Life Cycle Theory of Trade (cont.)
Verification and limitations of plc theory
• High transportation costs limit export opportunities,
regardless of the life cycle stage
• Shifts in production site do not change for many types of
products
– innovating country maintains its export ability throughout
the life cycle
» products with very short life cycles
» luxury products for which cost is not a concern for the
consumer
» products used to promote differentiation strategy
» products requiring specialized technical labor to evolve
• MNEs increasingly introduce new products at home and abroad
simultaneously

15. 15
Country-Similarity Theory
Economic similarity of industrial countries
• Most of the world’s trade occurs among countries that have
similar characteristics
– country similarity theory—once a company has developed a
new product to serve needs in a local market, it will turn to
markets it sees as most similar to those at home
- most trade takes place among industrial countries because:
» growing importance of acquired advantage as opposed to
natural advantage
» markets in industrial countries can support products and
their variations
» importance of industrial markets due to their size
» incomes are high and people buy more
• Few emerging countries trade with each other

16. 16
World Trade by Major Product Category as
Percentage of Total World Trade for Selected Years
1980 1990 1998
100
80
60
40
20
0
Percentage
53.9
27.7
14.7
3.7
70.7
14.2
12.3
2.8
62.8
7.9
8.6
20.7
Commercial services
Manufactured products
Mining products
Agricultural products

17. 17
Country-Similarity Theory (cont.)
Similarity of location
• Distances among countries accounts for many world
trade relationships
• Methods to overcome distance disadvantages are difficult
to maintain
Cultural similarity
• Importers and exporters find it easier to do business in a
country perceived as being similar
• Historic colonial relationships explain much of
international trade
Similarity of political and economic interests
• Political relationships and economic agreements among
countries may discourage or encourage trade between
them or their companies
• Military conflicts disrupt trade patterns
• Political animosity may interfere with trading channels

18. 18
Degree of Dependence
Independence: Complete economic independence
• Country has no reliance on other countries for goods,
services, or technologies
• Price of independence is having to do without goods that
cannot be produced domestically
• Hinders country’s ability to borrow and adapt existing
technologies
Interdependence: Trade based on mutual need
• Neither trading partner is likely to cut off supplies or
markets for fear of retaliation
• Governments may be pressured to sustain trade
Dependence: Developing countries rely heavily on:
• The sale of one commodity for export earnings
– 25 % of emerging countries sell one commodity
• One country as supplier or customer
• Industrialized countries

19. 19
Strategic Trade Policy
Governmental role and influence in affecting the acquired
advantage of production within their borders
• Alter conditions for industries in general
– change conditions that affect factor proportions, efficiency,
and innovation
• Target conditions for a specific industry
– typically results in no more than small payoffs
» hard to identify and target appropriate industries
» too many countries identify the same industry, leading to
excessive competition
» relative conditions change, causing relative capabilities to
change as well
– have been a few notable government successes in targeting
a specific industry

20. 20
The Porter Diamond
Indicates four important conditions for competitive
superiority
• Demand conditions—observation of need or demand
– usually in home country
– production started near the observed market
• Factor conditions— availability and terms for acquiring
them
• Related and supporting industries—existence of
infrastructure
• Firm strategy, structure, and rivalry
– influenced by other three conditions
Existence of the four favorable conditions does not guarantee
that an industry will develop in a locale
Absence of one of the four conditions from a country may not
inhibit companies from becoming globally competitive

21. 21
Determinants of Global Competitive Advantage:
The Porter Diamond
Demand
Conditions
Factor
Conditions
Related and
Supporting
Industries
Firm Strategy,
Structure, and
Rivalry

22. 22
Companies’ Role in Trade
Most trade theories based on a national perspective
• Decisions to trade are usually made by companies
Strategic advantages of exports
• Use of excess capacity—companies leverage their
competencies by using them abroad
• Cost reduction
– experience curve effect—cost reductions stemming
from increased output
• Greater profitability—may have higher profit margins in
foreign markets
• Risk spreading—counterbalance business cycles in
different countries
Strategic advantages of imports
• Procurement of supplies abroad may lower costs
• Foreign products complement existing products
• Reduces dependence on single suppliers

23. END OF THE PRESENTATION
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