Chapter 4 Intl Trade Theory

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Chapter

InternationalTrade Theory

4



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International Business, 5/e© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Case - The hollowing out of the U.S.

based economy Economic assumption: free trade produces gains for all

participating countries (trade is a win-win game)

Recently, US economy indicates a movement of knowledge based jobs to developing economies.

Economists believe that:

Only routine skill jobs go overseas. Most managerial and

marketing and R&D jobs are retained within the country USA). Lower price of services means consumer can consume more

for less (consumer savings)

Economic growth overseas will benefit the U.S.



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Trade Theory An overview

Free Trade is said to have occurred when a government/

independent customs territory does not attempt to

influence, through quotas or duties, what its citizens canbuy from another country or what they can produce and sell

to another country (comparative advantage).

The Benefits of Trade allow a country to specialize in the

manufacturing and export of products that can be producedmost efficiently in that country.



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Trade Theory An overview

The Pattern of International Trade displays ascenario that is easy to understand (e.g. Saudi

Arabia/oil or Pakistan/cotton). Others are not so

easy to understand (e.g. Japan and cars) The history of Trade Theory and government

involvement presents a mixed case for the roleof government in promoting exports and

limiting imports (mercantilism/beggar thyneighbor)

Later theories appear to make a case for limitedinvolvement (trade liberalization)



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Mercantilism: mid-16th century

A nation¶s wealth depends on accumulated treasure

Gold and silver used to serve as a currency for

payments in international trade

Theory says you should have a trade surplus.

Maximize export through subsidies.

Minimize imports through imposition of tariffs

and quotas

Flaw in the above approach: ³zero-sum game´



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Mercantilism-zero-sum game

David Hume in 1752 pointed out that:

Increased exports leads to inflation and higher prices

Increased imports lead to lower prices Result: Country µA¶ sells less because of high

prices and Country µB¶ sells more because of lower

prices

In the long run, no one can keep a trade surplus



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Theory of absolute advantage

Fig 4.1



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Absolute advantage and the gains

from trade



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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 isbuying/importing.

Look to see how much more efficient. If onlycomparatively efficient than import.

Makes better use of resources

Trade is a positive-sum game (everyone gains)



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Theory of comparative advantage

Fig 4.2



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Comparative advantage and gains from trade



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Qualifications & Assumptions

The simple model of free trade proposed by classical

economists makes certain unrealistic assumptions to simplify

complex real world phenomenon: -

World comprises two countries, two goods & one factor of production

i.e. labour;

There is no transportation costs and no trade barriers;

T here are no price difference for resources in two countries;

Resources are freely within country but not between the countries;

There are constant return to scale;

Countries have fixed quantity and quality of production resources;

Tastes are similar and preferences of people are represented by

indifference curves.

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Simple extensions of the Ricardian

model Immobile resources:

Resources do not always move easily from oneeconomic activity to another

Diminishing returns:

Diminishing returns to specialization suggests that after some point, the more units of a good the

country produces, the greater the additionalresources required to produce an additional item

Different goods use resources in different proportions



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Simple extensions of the Ricardian

model

Free trade (open economies):

Free trade might increase a countrys stockof resources (as labor and capital arrivesfrom abroad)

Increase the efficiency of resourceutilization



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PPF under diminishing returns

Fig 4.3



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Influence of free trade on PPF

Fig 4.4



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Heckscher (1919)-Ohlin (1933) Theory

Export goods that intensively use factorendowments which are locally abundant

Corollary: import goods made from locallyscarce factors Note: Factor endowments can be influenced by

government policy - minimum wage/rentals

Patterns of trade are determined by differences

in factor endowments - not productivity Remember, this model focuses on relative

advantage, not absolute advantage



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Product life-cycle Theory - R. Vernon,(1966)

As products mature, both location of sales and

optimal production changes

Affects the direction and flow of the imports andexports

Globalization and integration of the world

economy, however, makes this theory less valid



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Product life cycle theory

Fig 4.5



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New trade theory

In industries with high fixed costs:

Specialization increases output, and theability to enhance economies of scaleincreases

Learning effects are high. These are cost savings that come from learning bydoing transfer of technology.



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New trade theory-applications

Typically, requires industries with high, fixedcosts

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



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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

he postulated determinants of competitiveadvantage of a nation were based on fourmajor attributes

Factor endowments

Demand conditionsRelated and supporting industries

Firm strategy, structure and rivalry



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© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Porters diamond

Success occurs where these attributes exist.

More/greater the attribute, the higher chance of success

The diamond is mutually reinforcing

Fig 4.6





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Factor endowments

Factor endowments:- A nations positionin factors of production such as skilled

labor, capital or infrastructure necessaryto compete in a given industry. FactorEndowments are of two types:

Basic factor endowments Advanced factor endowments





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Basic factor endowments

Basic factors: Factors present in a country

Natural resources

Climate Geographic location

Demographics

While basic factors can provide an initialadvantage they must be supported byadvanced factors to maintain success





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Advanced factor endowments

Advanced factors: Are the result of investment by people, companies,

government and are more likely to lead tocompetitive advantage

If a country has no basic factors,

it must invest in the advanced factors i.e.high technical skills, education and HRD andmanagement etc.





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Advanced factor endowments

Communications

Skilled labor

Research

Technology Education





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Demand conditions

Demand:

creates capabilities

createssophisticated anddemandingconsumers

Demand impacts qualityand innovation





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Related & supporting industries

Creates clusters of supporting industriesthat are internationally competitive

Must also meet requirements of otherparts of the Poters Diamond





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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 acompanys competitiveness





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Determinants of Competitive

Advantage in nations

GovernmentGovernment

Company Strategy,Structure,and Rivalry

DemandConditions

Relatedand Supporting

Industries

FactorConditions

ChanceChance

Two externalfactors thatinfluence thefourdeterminants.

Fig 4.8





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Porters Theory-predictions

Porters theory should predict the patternof international trade that we observe inthe real world

Countries should be exporting productsfrom those industries where all four

components of the diamond arefavorable, while importing in those areaswhere the components are not favorable





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Implications for business

Location implications:

Disperse production activities to countries wherethey 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 thehome-country, not always in the best interests of the firm, even though, many firms promote openmarkets

Chapter 4 Intl Trade Theory

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