The Learning Objectives for this chapter are To understand theories of international trade To explain how free trade improves global efficiency To identify factors affecting national trade patterns To explain why a country’s export capabilities are dynamic To understand why production factors, especially labor and capital, move internationally To explain the relationship between foreign trade and international factor mobilitys
Why do countries trade? Countries trade in order to meet certain economic objectives, but they struggle with questions on what, how much, and with whom they should trade. They need to ensure that their decisions on what to produce make sense from an efficiency standpoint, and whether there are ways to improve competitiveness. Some countries allow market forces to determine trade relations, others intervene to control the process.
This Figure shows that trade in goods and services and the movement of the production factors are the means by which countries are linked internationally.
Theories that explain trade patterns explore how much countries depend on trade, in what products, and with which countries. Some theories suggest that governments should influence trade patterns, other support a laissez-faire approach.
This Figure shows the major trade theories and their emphases. Managers can use the theories to predict and understand how government policy decisions could affect business competitiveness.
Factor mobility is also an important issue in trade because it influences a nation’s competitiveness. The three factors of production are land, labor, and capital.
Some theories including mercantilism and neomercantilism explore how governments can interfere with trade flows in order to achieve certain national objectives.
The mercantilist theory suggests that countries should try to achieve a favorable balance of trade. This theory was the basis of economic thought from 1500 to 1800. Under mercantilism, governments restricted imports and subsidized the production of goods that would otherwise not be competitive in domestic or export markets.
Countries with a neomercantilist approach seek a favorable balance of trade, but do so in order to achieve some social or political objective.
Why shouldn’t countries just be self-sufficient? According to the theories of absolute and comparative advantage, specializing in the things a country does best and trading for everything else can be beneficial.
Adam Smith’s theory of absolute advantage suggested that a nation’s wealth is based on its available goods and services rather than on gold. Therefore, if trade is unrestricted, a country can specialize in what it can produce most efficiently, and trade for everything else. Consumers benefit from free trade and specialization with lower prices and more choices. A country’s advantage in the production of a particular good may be a result of a natural advantage like climate, or an acquired advantage like technology.
This Figure illustrates the production possibilities for two countries under the conditions of absolute advantage. Notice that with free trade and specialization both countries benefit.
What happens when a country can produce all products at an absolute advantage? Well, there are still gains to be made from specialization and free trade. David Ricardo explored this issue in 1817 and discovered that gains from trade occur even in a country that has an absolute advantage in all products because the country gives up less efficient output in order to focus on more efficient output.
This Figure illustrates the production possibilities for two countries under the conditions of comparative advantage. Notice that by specializing in the production of goods in which a country has a comparative advantage and trading for goods in which a country has an absolute disadvantage both countries still gain.
While the theories of specialization – absolute advantage and comparative advantage – offer policymakers a greater understanding of free trade, they are based on a number of assumptions that may not always be valid. Specifically, the theories assume that full employment exists, that economic efficiency is the primary goal of countries, that the division of gains is acceptable to both countries, that the world is composed of only two countries and two products, that there are no transportation costs, that advantages are static, and that while resources can move freely within a country, they are immobile internationally. Keep in mind that the theories can apply to trade in services as well as trade in products and that they apply to situations in which multi-country production takes place.
Every country produces so-called nontradeable goods like haircuts. When it comes to tradeable goods though, country size can be a determining factor in the production choice. Larger countries typically have more varied climates and natural resources and are usually more self-sufficient than smaller countries. Moreover, because production and market centers in large countries are more likely to be located farther away from other countries, transportation costs are higher.
What types of products does a country trade? We can use the factor proportions theory to help answer that question. The theory suggests that factor costs are determined by a country’s relative endowments of land, labor, and capital. These costs then determine which goods can be produced most efficiently. Keep in mind though that not all production factors are equal especially when it comes to labor. Moreover, how a product is produced – with capital or labor – is important as is the size of the production run required for greatest efficiency.
This Figure shows the changing composition of world trade. Most new products are developed in industrialized countries.
With whom do countries trade? Well, developed countries largely trade with other developed countries. Companies create new products in response to market conditions in their home market, and then look for markets that are close to home and most similar to what they’re accustomed to.
How do countries develop, maintain, and lose their competitive advantages? The international product life cycle theory, or PLC, offers one explanation. According to the PLC, companies manufacture products initially in the country where they were developed and researched – typically a developed country. Later, production shifts to foreign locations, and in the later stages of the product’s life, to developing economies. The theory is based on four stages: introduction, growth, maturity, and decline.
This Figure provides more details on exactly what occurs at each stage in a product’s life cycle. Keep in mind that while the theory holds for many products, it does not explain all products. In fact, today, many products are introduced at home and abroad simultaneously. Moreover, because costs drive production decisions, the initial production location may or may not be in the home country.
Another theory that helps explain why some countries have developed and sustained different competitive advantages is the diamond of national advantage theory. According to this theory, four conditions must be favorable for an industry: demand conditions, factor conditions, related and supporting industries, and firm strategy, structure, and rivalry.
This Figure provides more details on each factor that makes up the diamond of national advantage. Keep in mind though, that the existence of all four factors does not guarantee that an industry will develop, nor is it necessary given globalization. For example, today, because capital and managers are internationally mobile, it may not be necessary to depend on domestic factor conditions. Similarly, thanks to freer trade and advances in transportation, local related and supporting are not as important.
The mobility of capital, technology, and people affects trade and relative competitive positions. The factor mobility theory helps explain why production factors move, and what that means for transforming factor endowments, as well as the impact of international factor mobility on world trade.
The mobility of capital and population plays a role in a country’s factor endowments. For some countries, the movement of people can be significant. In Luxembourg for example, foreign- born people make up some 20 percent of the total population, but in Japan, account for just 2 percent. Outward migration can have a negative impact on a country if it involves the departure of educated people, but if these people then send remittances back home, it can have a positive effect. Finally, keep in mind that the movement of capital and labor is intertwined – think for example, about skilled foreign workers.
What is the relationship between trade and factor mobility? In general, if free trade is coupled with the free moving factors of production, the most efficient resource allocation should occur. The most abundant factors should move to areas of scarcity.
This Figure illustrates the substitutability of trade and factor movements under different scenarios.
When companies invest abroad they often stimulate exports from their home country through sales of components, equipment, and complimentary products.
Will the trend toward the freer movement of trade and production factors continue?
We don’t know what the future will hold, but these four interrelated factors could cause product trade to become relatively less significant in the future.
Enu international competition 120812
Go Global !Global Economic Environment :International Competition By Stephen Ong Edinburgh Napier University Business School email@example.com Visiting Professor, College of Management, Shenzhen University 12 August 2012
Agenda1. International trade theories2. Competitive advantage of nations3. Porter’s Diamond
Learning Objectives To discuss the underlying factors which contribute to competitive success in international markets. To analyse the basis for national competitive advantages in establishing specific globally competitive industries.
Laissez-Faire vs. Intervention Trade theory helps answer What products should we import and export? How much should we trade? With whom should we trade? Laissez-faire approach Free trade theories – absolute advantage and comparative advantage Intervention approach Mercantilism and neomercantilism
Laissez-Faire vs. Intervention International Operations and Economic Connections
Theories of Trade PatternsTheories explore country size factor proportions country similarityTheories explore trade competitiveness Product life cycle Diamond of national advantage
Trade Theories and Business What Major Trade Theories Do and Don’t Discuss: A Checklist
Factor Mobility TheoryA country’s competitiveness depends on quality and quantity of production factors Land Labour Capital
Interventionist TheoriesTheories that support government intervention in the flow of trade Mercantilism Neomercantilism
Mercantilism Mercantilism countries should export more than they import Maintain a favourable balance of trade trade surplus Avoid an unfavourable balance of trade trade deficit
Neomercantilism Neomercantilism run an export surplus to achieve social or political objectives
Free Trade TheoriesTwo theories that support free trade Absolute advantage theory Comparative advantage theoryMarket forces should determine trade specialization
Theory of Absolute Advantage Theory of absolute advantage different countries produce some goods more efficiently than others Free trade brings Specialization natural advantage acquired advantage product technology process technology Greater efficiency Higher global output
Theory of Absolute Advantage Production Possibilities under Conditions of Absolute Advantage
Theory of Comparative Advantage Theory of comparative advantage free trade can increase global output even if one country has an absolute advantage in the production of all products Consider comparative advantage absolute disadvantage
Theory of Comparative Advantage Production Possibilities under Conditions of Comparative Advantage
Theories of Specialization:Assumptions and Limitations Theories of specialization make assumptions that may not be valid full employment economic efficiency division of gains two countries, two commodities transport costs statics and dynamics services production networks mobility
How Much Does A Country Trade?Theory of country size large countries depend less on trade than small countriesLarge countries usually export a smaller portion of output and import a smaller part of consumption have higher transportation costs for foreign trade
What Does A Country Trade?Factor proportions theory factors in relative abundance are cheaper than factors that are relatively scarceBut production factors are not homogenous labourProcess technology capital versus labour
What Does A Country Trade? Worldwide Trade by Major Sectors
Choosing Trading Partners Country similarity theory most trade occurs among developed countries share similar market characteristics produce and consume much more than developing countries Trading partners are affected by Cultural similarity Political relations between countries Distance
Product Life-Cycle Theory Raymond Vernon 1966 Optimal location in the world to produce a product changes as the market for the product matures Growth in demand and production in advanced nations shifts to developing nations Developed nations over time shifts from being an exporter to an importer Globalization and integration of the world economy makes this theory less relevant
Product Life Cycle TheoryThe product life cycle theory the production location of certain manufactured products shifts as they go through their life cycleFour stages 1.Introduction 2.Growth 3.Maturity 4.Decline
Product Life Cycle Theory Life Cycle of the International Product
New Trade Theory Emerged in the 1970’s when economists questioned the assumption of diminishing returns to specialization When substantial economies of scale are present, the returns on specialization will result in increased productivity and lower unit costs ability to enhance economies of scale increases Trade is mutually beneficial because it allows for the: specialization of production realization of scale economies and “learning effects” greater variety of goods produced decrease in the average costs of goods
Economies of Scale and First Mover Advantage Industries with high fixed costs require a substantial proportion of the world demand to spread fixed costs over a large volume and to utilize specialized assets World market may only support a few competitorsFirst Mover Advantage economic and strategic advantages to early entrants ability to capture economies of scale and low cost structure scale-based cost advantage can create entry barriers
Implications of New Trade Theory Nations may benefit from trade even when they do not differ in resource endowments or technology A nation may predominate in the export of a good simply because it has one or more firms among the first to produce that good which creates entry barriers Those economies of scale that result from first mover advantage translate into a comparative advantage Some argue that it justifies government intervention and strategic trade policy
Theory of National Competitive Advantage Michael Porter 1990 Attempts to analyze the reasons for a nation’s competitive advantage in a particular industry Studied 100 industries in 10 nations Identified four major attributes promote or impede the competitive advantage of a nation
Porter’s Diamond of NationalAdvantageThe diamond of national advantage Four conditions are important for gaining and maintaining competitive superiority 1. Demand conditions 2. Factor conditions 3. Related and supporting industries 4. Firm strategy, structure, and rivalry
Porter’s Diamond of NationalAdvantage The Diamond of National Competitive Advantage
Porter’s Diamond Success occurs where the diamond is most favorable Diamond is mutually reinforcing and interdependent Chance and government can influence the national diamond Fig 4.6 32
Determinants of National Competitive Advantage1. Factor endowments nation’s position in factors of production (skilled labor or infrastructure) necessary to compete in a given industry1. Demand conditions nature of home demand for industry’s product/service1. Related and supporting industries presence or absence in a nation of supplier industries or related industries that are nationally competitive1. Firm strategy, structure and rivalry conditions in the nation governing how companies are created, organized, and managed nature of domestic rivalry
Relationship of Basic to Advanced Factors Basic factors can provide an initial advantage Basic factors must be supported by advanced factors to maintain competitive advantage If weak basic factors, the government must invest to upgrade advanced factors Advanced factors are more likely to lead to competitive advantage Advanced factors are the result of investment by 35 people, companies, government
2. Demand Conditions Demand creates: competitive capabilities sophisticated and demanding consumers Demand impacts quality and innovation
3. Related and Supporting Industries Creates clusters of supporting industries that are internationally competitive Must also meet requirements of other parts of the Porter’s Diamond
4. Firm Strategy, Structure and Rivalry Management ‘ideology’ and structure of the firm can either help or hurt the firm Presence of domestic rivalry and strong competitors improves a company’s competitiveness
Evaluating Porter’s Theory If Porter is right: his model should predict the actual pattern of international trade in the world countries should be exporting products from those industries where all four components of the diamond are favourable Countries should be importing goods from those industries where the components are not favourable Too soon to tell
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 generally in the best interests of the home-country, although not always in the best interests of the firm
Why Production Factors Move Factor mobility theory focuses on why production factors move, the effects of that movement on transforming factor endowments, and the impact of international factor mobility on world trade Capital and labour move internationally to gain more income flee adverse political situations
Effects of Factor Movements Factor movements alter factor endowments Factor movements can be substantial for some countries, and insignificant for others The movement of labour and capital are intertwined Pros and cons of outward and inward migration Brain drain Remittances
Trade and Factor MobilityThere are pressures for the most abundant factors to move to areas of scarcityThe lowest costs occur when trade and production factors are both mobile
Trade and Factor Mobility Unrestricted Trade, Factor Mobility, and the Cost of Tomatoes
Trade and Factor MobilityFactor mobility through foreign investment often stimulates trade because of the need for components the parent’s ability to sell complimentary products the need for equipment for subsidiaries
In What Direction Will TradeWinds Blow? Issues to consider 1. Displacement of jobs as developed countries shift production to more rapidly developing countries 2. Relationships among land, labour, and capital will continue to evolve 3. Continued trend toward a more finely tuned specialization of production among countries
In What Direction Will TradeWinds Blow? Monitor As economies grow, efficiencies of multiple production locations also grow because they can all gain sufficient economies of scale Small-scale production methods may enable countries to produce many goods efficiently for their own consumption Output from 3D printers Services are growing more rapidly than products as a portion of production and consumption within developed countries
Conclusion“Made in one or more of the following countries: …. The exact country of origin is unknown” Integrated Circuit label
Casestudy : TESCO1. Read and prepare the Casestudy on TESCO (Johnson, Whittington & Scholes (2011)) for discussion and presentation next week.2. Identify and evaluate the challenges facing TESCO’s global expansion by conducting External Environment, Industry, Competitor analysis, SWOT and Porter’s Diamond analysis of overseas locations.
Core Reading Juleff, L, Chalmers, A.. and Harte, P. (2008) Business Economics in a Global Environment, Napier University Edinburgh Daniels, J.D., Radebaugh, L.H. and Sullivan, D.P. (2012) International Business: Environments and Operations. 14th edition, Pearson
Next Week’s Discussion:Comparative advantage of nations► Reading “Can the US bring jobs back from China?” Businessweek 30 June 2008 DISCUSSIONDiscuss the different national competitive advantages of the USA, China and Germany in manufacturing capabilities.