1

Chapter 5

The Theory of Trade and Investment

2

Learning ObjectivesTo understand the traditional arguments of how and why international trade improves the welfare of all countriesTo review the history and compare the implications of trade theory from the original work of Adam Smith to the contemporary theories of Michael PorterTo examine the criticisms of classical trade theory and examine alternative viewpoints of which business and economic forces determine trade patterns between countriesTo explore the similarities and distinctions between international trade and international investment

3

Evolution of Trade TheoryThe Age of MercantilismClassical Trade TheoryFactor Proportions Trade TheoryInternational Investment and Product Cycle TheoryThe New Trade Theory: Strategic TradeThe Theory of International Investment

4

The Age of Mercantilism

The evolution of trade into the form we see today reflects

three events:The Collapse of Feudal Society

The Emergence of the Mercantilist Philosophy

The Life Cycle of the Colonial Systems of theEuropean Nation-States

5

Mercantilism

Mixed exchange through trade with accumulation of wealthConducted under authority of governmentDemise of mercantilism inevitable

6

Classical Trade TheoryThe Theory of Absolute Advantage

The ability of a country to produce a product with fewer inputs than another country

The Theory of Comparative Advantage

The notion that although a country may produce both products more cheaply than another country, it is relatively better at producing one product than the other

7

Classical Trade Theory Contributions

Adam Smith—Division of LaborIndustrial societies increase output using same labor-hours as pre-industrial society

David Ricardo—Comparative Advantage

Countries with no obvious reason for trade can specialize in production, and trade for products they do not produce

Gains From TradeA nation can achieve consumption levels beyond what it could produce by itself

8

Factor Proportions Trade Theory

Developed by Eli HeckscherDeveloped by Eli Heckscher

Expanded by Bertil OhlinExpanded by Bertil Ohlin

9

Factor Proportions Trade TheoryConsiders Two Factors of Production

Labor

Capital

10

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).

11

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

12

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!

13

Overlapping Product Ranges Theory:Staffan Burenstam Linder

Trade in manufactured goods dictated not by cost concerns, but by similarity in product demands across countries.

Work focused on preferences of consumer demand.

Today, termed market segments.

14

Product Cycle Theory

Raymond Vernon

Focus on the product, not its factor proportions

Two technology-based premises

15

Product Cycle Theory:Vernon’s Premises

Technical innovations leading to new and profitable products require large quantities of capital and skilled labor

The product and the methods for manufacture go through three stages of maturation

16

Stages of the Product Cycle

The New Product

The Maturing Product

The Standardized Product

17

The Product Cycle and Trade Implications

Increased emphasis on technology’s impact on product cost

Explained international investment

LimitationsMost appropriate for technology-based productsSome products not easily characterized by stages of maturityMost relevant to products produced through mass production

18

The New Trade Theory: Strategic Trade

Two New ContributionsPaul Krugman-How trade is altered when markets are not perfectly competitive

Michael Porter-Examined competitiveness of industries on a global basis

19

Strategic Trade

Krugman’s Economics of Scale:

Internal Economies of ScaleInternal Economies of Scale

External Economies of ScaleExternal Economies of Scale

20

Strategic Trade

Government can play a beneficial role when markets are not purely competitiveTheory expands to government’s role in international tradeFour circumstances exist that involve imperfect competition in which strategic trade may apply

21

Strategic Trade

The Four Circumstances Involving Imperfect Competition:

PricePrice CostCost

RepetitionRepetition ExternalitiesExternalities

22

Strategic TradePorter’s Diamond of National AdvantageInnovation is what drives and sustains competitivenessFour components of competition

Factor ConditionsDemand ConditionsRelated and Supporting IndustriesFirm Strategy, Structure, and Rivalry

23

Michael Porter’s Competitive Clusters

Critical masses of unusual competitive success in particular fields, located in one place

24

The Theory of International Investment

The movement of capital has allowed foreign direct investments across the globe

25

The Theory of International Investment

Firms as Seekers Seeking ResourcesSeeking Factor AdvantagesSeeking KnowledgeSeeking SecuritySeeking Markets

26

The Theory of International Investment

Firms as Exploiters of ImperfectionsImperfections in AccessImperfections in Factor MobilityImperfections in Management

Firms as InternalizersEstablish their own multinational operations-internalize productionCompetitive advantage due to confidentiality