Int Business Chap4. Du

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Chapter 4:

International Trade Theory


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Theories of International Trade

1. Mercantilism: The theory was introduced in mid-16th century in

England. The main tenet of the theory was that itwas in a countrys best interests to maintain a

trade surplus by means of exporting more andimporting less. By doing so, a country wouldaccumulate gold and silver and, consequently,increase its national wealth and prestige. One ofthe implication of the theory is beggar-thy-neighbor policy. Adam Smith and all theClassical economists were critical about thetheory.


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Limitations of Mercantilism:

State England France

State 1 X>M: Trade Surplus X


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Theories of International Trade

2. Opportunity Cost theory: Adam Smith (1776): Absolute Advantage

Theory

David Ricardo (1881) : ComparativeAdvantage Theory

Hecksher (1919)-Ohlin (1933) : Factor

Endowment Theory


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2. Opportunity Cost theory (Contd.)

Assumptions: (i) 2-coutry-2-commodity model. (ii) Increasing cost.

Before Trade Bangladesh USA

Production Possibility Curve (PPC) ab ed

Consumption=Production C1 C2

a

b

e

d

I

C

IC1

C1

C2

Industrial Goods

Agricultural goods


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Industrial Goods

Agricultural Goods

I

M

N

IC2IC1

a

b

e

d

T

T

After Trade Bangladesh USAProduction PB PU

Consumption I I

Export Agricultural Goods: PBM Industrial Goods: PUN

Import Industrial Goods: IM Agricultural Goods: IN

PB

PU


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Gains from Trade of Bangladesh: Point I belongs to IC2. Before tradeconsumption was at C1 which belongs to IC1. Since IC2 is higher thanIC1 so there is a gain from trade on the part of Bangladesh.

Gains from Trade of USA: Point I belongs to IC2. Before tradeconsumption of USA was at C2 which belongs to IC1. Since IC2 is higher

than IC1 so there is a gain from trade on the part of USA. Balanced Balance of Trade: Notice that since there are only 2 countries

under consideration so the export of Bangladesh is just equal to theimport of USA. Similarly, the import of Bangladesh is just equal to theexport of USA.

Conclusion: The theory focuses on the gain from international trade. Thetheory proved that the earlier view of trade being a zero-sum game is nottrue as both countries of trade can be benefited from trade. A countrywould be gaining from international trade as long as it achieves a higherindifference curve. The theory also focuses on the determination ofterms of trade (i.e., global price line). More importantly, the theory guidesevery country to take advantage of specialization in certain line of

production.


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Limitations of Opportunity cost theory

The assumption of balanced balance of trade is notalways most desirable.

The assumption of perfect mobility of factors of

production within the country is not true. The assumption of perfect immobility of factors across

countries is not true

The assumption of constant technology is invalid. This istruer for manufactured commodities than agricultural

commodities. In consequence, developing countriescontinuously face deterioration in its terms of trade anddeveloped countries continuously face advantages interms of trade.


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The Leontief Paradox

Challanging the Hechscher-Ohlin (opportunity cost)theory, Wassily Leontief observed that US exportswere less capital intensive than US imports although

US has abundance in capital and scarcity in labor.One possible explanation is that US has a specialadvantage in producing new products or goods madewith innovative technologies. Thus, US may beexporting goods that heavily use skilled labor, andinnovative entrepreneurship, such as computersoftware, while importing heavy manufacturingproducts that use large amounts of capital.


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Political implication of the trade theory:Prebisch-Singer Hypothesis

As early as in 1950s Prebisch and Singer studied the terms of trade (definedas the export price divided by import price) of developing countries andobserved that there was a secular decline in the terms of trade of developingcountries due to the fact of low income and price elasticity of demand foragricultural goods. They argued that the decline would continue in future, aswell, which is evidential that between 1977 and 1997 the terms of trade of

developing countries declined by 60%. Due to the decline in terms of tradethere is a continuous flow of purchasing power from developing countries todeveloped countries. Moreover, the developed country policy of agriculturalsubsidy restricted the import to hinder the export growth of developingcountries. Thus, the apparently innocent trade theory has the seriousimplication of making the developed countries more rich and developing

countries marginalized.

There is supply side constraint as well. Supply curve of developing countriesis inelastic due to institutional rigidities". According to Cobweb theoremcurrent demand of agricultural product reflects in the supply of the next yearthat hardly matches the current demand. Thus, even if demand increases

the suppliers of agricultural product can not take advantages of that.


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Agricultural Subsidies of

Developed Countries Developing country producers of agricultural product face

Intense competitions from developed countries due to hugeagricultural subsidy. Per farmer subsidy $19,000 both in Europe(43% of value) and USA (22% of value), $21,000 in Japan (62%

of value), $8,000 in Canada (18% of the value of gross farmreceipts). Such subsidies are currently running $20 billionannually. UN observed that it affects developing countriesexport worth $50 billion which is equivalent to the annual foreignaid flow of developed countries to developing countries.

Realizing the problem, some of the developing countries have

recently started to concentrate in the export of manufacturedgoods rather than agricultural goods. However, United Nationsobserved in 2001 that such exports of LDCs face more importrestrictions of developed countries for what LDCs lose as muchas 2% of their GNP worth $100 billion annually.


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3. Product LifeCycle Theory

Reymond Vernon introduced this theory in the mid-1960s. The theory tellsus how the location of production and consumption of different productschange during the life-cycle of the product. The products include mass-produced automobiles, televisions, instant cameras, photocopiers,personal computers, and semi-conductor chips. Vernon observed that formost of the 20-th century a very large proportion of the worlds newproducts had been developed by US firms and sold first in the US market

due to the wealth and size of the US market. Due to high labor cost inUSA, the technology of production of these products was capital intensivetechnology. During the early cycle of product life these product wereexported to other countries for limited number of consumers. Later cycleexperienced production in other countries as well with almost similar kindof technology. In the matured cycle of product life developing countries

took part in the production to export it back to developed countries. Thus,although USA introduced the product and during the initial cycle USA wasan exporter of the product, but overtime other developed countries whowere initially the importers of the product, starts exporting to USA. Later,when the product becomes standardized product, developing countriestakes part in export as well.


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3. Criticism and implications of ProductLifeCycle Theory

The theory suffers from the US biasness as the founder Vernon overfocused the US contribution in the introduction of most modernproducts. Products are now global products like the contribution ofIndian designers and Japanese technology can not be denied in thedevelopment of computers.

The theory concludes that developing countries are the ultimatebeneficiaries as manufacturers and exporters of the products. This isnot true. Producers of developed countries identify the potentials ofdeveloping countries much earlier than the local entrepreneurs ofdeveloping countries, and captures the overseas production. Thus, it

is the IBM of USA that holds the production of Argentine and Mexicanproduction of the mainframe production. In addition to profitrepatriation, huge money goes back home in the form of royalty,patent and trademark. The WTO efforts of making TRIPS operationalsafeguards the interest of developed country producers in this regard.


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4. The New Trade Theory

During 1970s most economists argued that the increasing cost ordecreasing return assumption of traditional trade theories isquestionable. Due to the economies of scale and learning effectsthere should be increasing return or decreasing costs for higherlevel of output. For example, the Boeing spent $5 billion to develop

its Boeing 777 jetliner. If the variable cost of production for labor,equipment and parts equal $80 million per aircraft, then selling 100units would make a cost of $130 million per aircraft and selling 500would make a cost of $ 90 million. Thus, average cost fallssignificantly with increased volume of production. If learning effect istaken under consideration then variable cost further goes down to

further reduce the average cost. Learning effect is more effective incost reduction of complex manufacturing product than easy process.Taking both under consideration the Boeing can make $70 millionper unit for 500 units of production compared to $130 million per unitfor 500 units of production.


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4. Implication of new trade theory:

There is an important implication of the new trade theory. The worldmarket is too small for too many large firms with significant largevolume of production. The first mover takes the advantage so muchthat subsequent entrant finds it difficult to compete against the firstmovers. Thus Japan made a complementary role to Boeing and

Airbus rather than competing with them. To facilitate the potential

first mover, the respective government should come forward byextending different kinds of fiscal incentives and subsidies initially.This would increase the competitiveness of the respective firms andshift the marginal cost curve downward. The firm would be qualifiedto be the first mover. Once being the first mover, the firm wouldgenerate abnormal profit, the profit would be repatriated home

contributing to (i) increased purchasing power of the country, (ii)increased donation for social welfare and (iii) increased taxcompensating the subsidies allowed earlier. Thus the country wouldbe far more benefited than the subsidies issued earlier.


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FSC: Tax Break on Export

Introduction: Foreign Sales Corporation (FSC) introduced in USA in1971 as an income tax break for US exporters. Sales should bechanneled through shell companies, known as foreign salescorporation which are registered in offshore tax heaven like Bermuda.

Beneficiaries: 6,000 US companies saved $3.5 b of income taxes in

1998. Boeing saved $130 million, General Electric saved $150m. In 1998, European Union filed complaint with WTO claiming that FSC

is an illegal export subsidy that was in clear violation of WTO rules.

US arguments: EU follows similar tax wavers on export (that EU claims

commodity tax rather than income tax). There was a Gentlemans agreement that the entity would not attack each other,which was broken.

Internal matters of USA outside the jurisdiction of trade policy.


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FSC: Tax Break on Export (Contd..)

WTO arbitration in 2000 agreed with EU that the tax break wasillegal, and suggested USA to revise the tax code.

In retaliation USA not only retained the tax break but alsoexpanded the coverage costing the treasury $25 b tocompensate the EU rebate of VAT on export.

EU threatened USA to introduce punitive tariffs worth $4 billionon US export to the EU. This indicated an introduction of thebiggest trade war of the world.

In 2000, USA replaced it with a new system that offered up to $6billion a year in tax breaks to large exporters such as Boeingand Microsoft.

EU filed a brief with WTO seeking permission for $4 billiontariffs, and WTO finally gave the permission in 2002.

Current status: EU did not impose the sanction, and USAindicated it would change the offending law.


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5. National Competitive Advantage:

Porters Diamond

Firms Strategy,

structure, and Rivalry

FactorEndowments

DemandConditions

Related and SupportingIndustries


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Porters Diamond (Contd.) Factor Endowments: Both basic factors (like natural resources,

climate, location, and demographics) and advanced factors (likecommunication infrastructure, sophisticated and skilled labor,research facilities, and technological know-how) play role.

Example: Investment in education is the key to the outstandingsuccess of South Korea which had the same per capita incomelike India during 60s. Japans investment in engineers results inmanufacturing sector development.

Related and supporting industries: The benefits ofinvestment in advanced factors of production by related and

supporting industry can spill over into industry giving competitiveadvantage internationally. Technological leadership in the USsemiconductor industry until mid1980s provided the basis of USsuccess in personal computers. Switzerlands success inpharmaceuticals is the spill over effect of its previous success inthe technologically related dye industry


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Porters Diamond (Contd.) Demand Condition: Home demand play in upgrading

competitive advantage. Example: Japans sophisticated andknowledgeable buyers of camera contributed to theimprovement of product quality of international standard.

Firm strategy, structure and rivalry: Different nations arecharacterized by different management ideologies, whichshapes the building of national competitiveness. Porters notesthe predominance of engineers in top management in Germanand Japan firms contributed to the improvement of

manufacturing and designing. In contrast, US concentration offinance people in top management failed to contribute to productinnovation. Second point is the domestic rivalry that contributesto competitiveness as well. (Nokia in Finland: Case study)

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