Unit 1 international trade theory

Theories
of
International
Trade

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights
International Business, 5/e
4-2
Learning Objectives
 To understand the traditional arguments
of how and why international
trade improves the welfare of all
countries


To review the history and compare the
implications of trade theory from the
original work of Adam Smith to the
contemporary theories of Michael Porter
To examine the criticisms of classical
trade theory and examine alternative
viewpoints of which business and
economic forces determine trade patterns
between countries

4-3
Evolution of Trade Theories
 Mercantilism
 Absolute advantage (Classical)
 Comparative advantage
 Factor Proportions Trade
 International Product Cycle
 New Trade Theory
 National competitive advantage

4-4
Mercantilism: mid-16th century
 A nation’s wealth depends on accumulated
treasure


Gold and silver are the currency of
trade
Theory says you should have a trade surplus.


Maximize export through subsidies.
Minimize imports through tariffs
and quotas
 Flaw: restrictions, impaired growth

4-5
Defining mercantilism …
 … trade theory holding that nations
should accumulate financial wealth,
usually in the form of gold (forget
things like living standards or
human development) by encouraging
exports and discouraging imports

4-6
Theory of absolute advantage
 Adam Smith: Wealth of Nations (1776) argued:

 Capability of one country to produce more of
a product with the same amount of input than
another country
A country should produce only goods where it
is most efficient, and trade for those goods
where it is not efficient

 mong
Trade between countries is, therefore, beneficial
Assumes there is an absolute balance a
nations

4-7


 … destroys the mercantilist idea since there
are gains to be had by both countries party to
an exchange
… questions the objective of national
governments to acquire wealth through
restrictive trade policies
… measures a nation’s wealth by the living
standards of its people

4-8
PPF – Production Possibility Frontier

4-13
Theory of comparative advantage
 David Ricardo: Principles of Political Economy (1817)



Extends free trade argument
Efficiency of resource utilization leads to more
productivity
Should import even if country is more efficient in the
product’s production than country from which it is
buying.
 Look to see how much more efficient. If only
comparatively efficient, than import.


Makes better use of resources
Trade is a positive-sum game

4-14
Theory of comparative advantage

4-15
Comparative advantage and the gains
from trade

4-17
Comparative advantage:
Bollywood

4-20
Assumptions and limitations





Driven only by maximization of production
and consumption
Only 2 countries engaged in production and
consumption of just 2 goods?
What about the transportation costs?
Only resource – labour (that too, non-
transferable)
No consideration for ‘learning theory’

4-21
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Factor proportions theory


Heckscher (1919) - Olin (1933) Theory
Export goods that intensively use factor endowments
which are locally abundant
 Corollary: import goods made from locally
scarce factors



Note: Factor endowments can be impacted by
government policy - minimum wage
Patterns of trade are determined by differences in
factor endowments - not productivity
Remember, focus on relative advantage, not absolute
advantage

4-22
McGraw-Hill/Irwin
Factor proportions theory


… trade theory holding that countries produce
and export those goods that require resources
(factors) that are abundant (and thus cheapest)
and import those goods that require resources
that are in short supply
Example:

 Australia – lot of land and a small population
(relative to its size)
So what should it export and import?

4-23
Factor Proportions Trade Theory
Considers Two Factors of Production
 Labor
 Capital
McGraw-Hill/Irwin

4-24
McGraw-Hill/Irwin
Factor Proportions Trade Theory
A country that is relatively labor
abundant (capital abundant)
should specialize in the production
and export of that product which is
relatively labor intensive (capital
intensive)

4-25
McGraw-Hill/Irwin
The Leontief Paradox
The Test:
Could Factor Proportions Theory be
used to explain the types of goods the
United States imported and exported?
The Method:
Input-output analysis

4-26
McGraw-Hill/Irwin
The Leontief Paradox
The Findings:
The U.S. exported labor-intensive
products and imported capital-intensive
products.
The Controversy:
Findings were the opposite of what was
generally believed to be true!

4-27
McGraw-Hill/Irwin
Product life-cycle Theory




R.Vernon (1966)
… trade theory holding that a company will
begin by exporting its product and later
undertake foreign direct investment as the
product moves through its lifecycle
As products mature, both location of sales and
optimal production changes
Affects the direction and flow of imports and
exports
Globalization and integration of the economy
makes this theory less valid

4-28
Product life cycle theory
Fig 4.5
McGraw-Hill/Irwin

4-29
The Product Cycle and Trade
Implications
 Increased emphasis on technology’s
impact on product cost
 Explained international investment
 Limitations
McGraw-Hill/Irwin


 Most appropriate for technology-based
products
Some products not easily characterized by
stages of maturity
Most relevant to products produced
through mass production

4-30
McGraw-Hill/Irwin
New trade theory
In industries with high fixed costs:
 Specialization increases output, and the
ability to enhance economies of scale
increases
 Learning effects are high. These are cost
savings that come from ‘learning by
doing’

4-31
McGraw-Hill/Irwin
New trade theory - applications
 Typically, requires industries with high, fixed
costs
 World demand will support few competitors
 Competitors may emerge because of “ First-
mover advantage”


Economies of scale may preclude new entrants
Role of the government becomes significant
 Some argue that it generates government
intervention and strategic trade policy

4-32
McGraw-Hill/Irwin
Theory of national competitive advantage


The theory attempts to analyze the reasons for a
nations success in a particular industry
Porter studied 100 industries in 10 nations
 postulated determinants of competitive advantage
of a nation based on four major attributes
 Factor endowments
 Demand conditions
 Related and supporting industries
 Firm strategy, structure and rivalry

4-33
Porter’s diamond

McGraw-Hill/Irwin


Success occurs where
these attributes exist.
More/greater the
attribute, the higher
chance of success
The diamond is
mutually reinforcing

4-34
McGraw-Hill/Irwin
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
Advanced factor endowments

4-35
McGraw-Hill/Irwin
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

4-36
McGraw-Hill/Irwin


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

4-37
McGraw-Hill/Irwin
 communications
 skilled labor
 research
 Technology
 education

4-38
Demand conditions
 Demand:


creates capabilities
creates sophisticated
and demanding
consumers
 Demand impacts quality
and innovation
McGraw-Hill/Irwin

4-39
McGraw-Hill/Irwin
Related and supporting industries
 Creates clusters of supporting industries that
are internationally competitive
 Must also meet requirements of other parts
of the Diamond

4-40
McGraw-Hill/Irwin
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

4-41
Determinants of Competitive Advantage
in nations
Government
Company Strategy,
Structure,
and Rivalry
Demand
Conditions
Related
and Supporting
Industries
Factor
Conditions
Chance
Two external
factors that
influence the
four
determinants.
McGraw-Hill/Irwin
Fig 4.8

4-42
McGraw-Hill/Irwin
Porter’s Theory-predictions
 Porter’s theory should predict the pattern of
international trade that we observe in the real
world
 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

4-43
McGraw-Hill/Irwin
Implications for business
 Location implications:


Disperse production activities to countries
where they can be performed most efficiently
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

4-44
McGraw-Hill/Irwin

4-45
McGraw-Hill/Irwin

4-46
India in the global competitiveness report
McGraw-Hill/Irwin

Unit 1 international trade theory

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