Adam Smith theory of international trade

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Adam Smith theory of international trade

  1. 1. International Trade Theory Chapter 4
  2. 2. International Trade Theory <ul><li>Overview </li></ul><ul><li>Mercantilism </li></ul><ul><li>Absolute Advantage </li></ul><ul><li>Comparative Advantage </li></ul><ul><li>Heckscher-Olin Theory </li></ul><ul><li>Product Life Cycle Theory </li></ul><ul><li>New Trade Theory </li></ul><ul><li>Porter’s Diamond </li></ul>© McGraw Hill Companies, Inc.,2000 4-1
  3. 3. An Overview of Trade Theory <ul><li>Free Trade occurs when 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. </li></ul><ul><li>The Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country. </li></ul><ul><li>The Pattern of International Trade displays patterns that are are easy to understand (Saudi Arabia/oil or Mexico/labor intensive goods). Others are not so easy to understand (Japan and cars). </li></ul>© McGraw Hill Companies, Inc.,2000 4-5
  4. 4. Mercantilism: mid-16 th century <ul><li>A nation’s wealth depends on accumulated treasure </li></ul><ul><li>Gold and silver are the currency of trade. </li></ul><ul><li>Theory says you should have a trade surplus. </li></ul><ul><ul><li>Maximize exports through subsidies. </li></ul></ul><ul><ul><li>Minimize imports through tariffs and quotas. </li></ul></ul><ul><li>Flaw: “Zero-sum game”. </li></ul>© McGraw Hill Companies, Inc.,2000 4-6
  5. 5. David Hume - 1752 <ul><li>Increased exports leads to inflation and higher prices. </li></ul><ul><li>Increased imports lead to lower prices. </li></ul><ul><li>Result: Country A sells less because of high prices and Country B sells more because of lower prices. </li></ul><ul><li>In the long run, no one can keep a trade surplus. </li></ul>© McGraw Hill Companies, Inc.,2000 4-7
  6. 6. Theory of Absolute Advantage <ul><li>Adam Smith: Wealth of Nations ( 1776). </li></ul><ul><li>Capability of one country to produce more of a product with the same amount of input than another country. </li></ul><ul><li>Produce only goods where you are most efficient, trade for those where you are not efficient. </li></ul><ul><ul><li>Trade between countries is, therefore, beneficial. </li></ul></ul><ul><li>Assumes there is an absolute advantage balance among nations. </li></ul><ul><li>Ghana/cocoa. </li></ul>© McGraw Hill Companies, Inc.,2000 4-8
  7. 7. Theory of Comparative Advantage <ul><li>David Ricardo: Principles of Political Economy ( 1817). </li></ul><ul><ul><li>Extends free trade argument </li></ul></ul><ul><ul><li>Efficiency of resource utilization leads to more productivity. </li></ul></ul><ul><ul><li>Should import even if country is more efficient in the product’s production than country from which it is buying. </li></ul></ul><ul><ul><ul><li>Look to see how much more efficient. If only comparatively efficient, than import. </li></ul></ul></ul><ul><li>Makes better use of resources </li></ul><ul><li>Trade is a positive-sum game. </li></ul>© McGraw Hill Companies, Inc.,2000 4-11
  8. 8. Simple Extensions of the Ricardian Model <ul><li>Diminishing returns: </li></ul><ul><ul><li>More a country produces, at some point, will require more resources. </li></ul></ul><ul><li>However: </li></ul><ul><ul><li>Free trade can increase a country’s production resources, and </li></ul></ul><ul><ul><li>Increase the efficiency of resource utilization. </li></ul></ul>© McGraw Hill Companies, Inc.,2000 4-14
  9. 9. Is the Mercantilist Theory Still Valid? <ul><li>A qualified Yes. </li></ul><ul><li>Equate political power with economic power and economic power with a trade surplus. </li></ul><ul><li>Japan </li></ul>© McGraw Hill Companies, Inc.,2000 4-17
  10. 10. Heckscher (1919)-Olin (1933) Theory <ul><li>Export goods that intensively use factor endowments which are locally abundant. </li></ul><ul><ul><li>Corollary: import goods made from locally scarce factors. </li></ul></ul><ul><li>Patterns of trade are determined by differences in factor endowments - not productivity. </li></ul><ul><li>Remember, focus on relative advantage, not absolute advantage. </li></ul>© McGraw Hill Companies, Inc.,2000 4-18
  11. 11. The Leontief Paradox, 1953 <ul><li>Disputes Heckscher-Olin in some instances. </li></ul><ul><li>Factor endowments can be impacted by government policy - minimum wage. </li></ul><ul><li>US tends to export labor-intensive products, but is regarded as a capital intensive country. </li></ul>© McGraw Hill Companies, Inc.,2000 4-19
  12. 12. Heckscher vs Ricardo <ul><li>Economists prefer Heckscher on theoretical grounds but is a relatively poor predictor of trade patterns. </li></ul><ul><li>Ricardo’s Comparative Advantage Theory, regarded as too limited for predicting trade patterns, actually predicts them with greater accuracy. </li></ul><ul><li>In the end, differences in productivity may be the key to determining trade patterns. </li></ul>© McGraw Hill Companies, Inc.,2000 4-20
  13. 13. Product Life-Cycle Theory ( Raymond Vernon, 1966 ) <ul><li>Article in the Quarterly Journal of Economics. </li></ul><ul><li>As products mature, both location of sales and optimal production changes. </li></ul><ul><li>Affects the direction and flow of imports and exports. </li></ul><ul><li>Globalization and integration of the economy makes this theory less valid. </li></ul>© McGraw Hill Companies, Inc.,2000 4-21
  14. 14. The New Trade Theory <ul><li>Began to be recognized in the 1970s. </li></ul><ul><li>Deals with the returns on specialization where substantial economies of scale are present. </li></ul><ul><ul><li>Specialization increases output, ability to enhance economies of scale increase. </li></ul></ul>© McGraw Hill Companies, Inc.,2000 4-23
  15. 15. First-Mover Advantage <ul><li>Economies of scale may preclude new entrants. </li></ul><ul><li>Role of the government. </li></ul>© McGraw Hill Companies, Inc.,2000 4-25
  16. 16. Porter’s Diamond ( Harvard Business School, 1990) <ul><li>The Competitive Advantage of Nations. </li></ul><ul><li>Looked at 100 industries in 10 nations. </li></ul><ul><ul><li>Thought existing theories didn’t go far enough. </li></ul></ul><ul><li>Question: “Why does a nation achieve international success in a particular industry?” </li></ul>© McGraw Hill Companies, Inc.,2000 4-29
  17. 17. Implications for Business <ul><li>Location implications: makes sense to disperse production activities to countries where they can be performed most efficiently. </li></ul><ul><li>First-mover implications: It pays to invest substantial financial resources in building a first-mover, or early-mover, advantage. </li></ul><ul><li>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. Even though, many firms promote open markets. </li></ul>4-42

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