International Trade TheoryInternational Trade Theory

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Chapter ObjectivesChapter Objectives

Explain trade theoriesExplain trade theories Discuss how global efficiency can be Discuss how global efficiency can be

increased through free tradeincreased through free trade Introduce prescriptions for altering Introduce prescriptions for altering

trade patternstrade patterns Explore how business decisions Explore how business decisions

influence international tradeinfluence international trade

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International TradeInternational Trade

The purchase, sale, or The purchase, sale, or exchange of goods and exchange of goods and services across national services across national borders.borders.

International TradeInternational Trade::• Provides a country’s people with a greater Provides a country’s people with a greater

choice of goods and serviceschoice of goods and services

• Important engine for job creationImportant engine for job creation

Trade in goods and services is one means by which countries are linked economically

Volume of International TradeVolume of International Trade

World’s Top Merchandise World’s Top Merchandise ExportersExporters

US - USD693blln US - USD693blln (10.7%)(10.7%)

Germany – USD613.1 Germany – USD613.1 blln (9.5%)blln (9.5%)

Japan – USD416.7 Japan – USD416.7 (6.5%)(6.5%)

World’s Top Service World’s Top Service exportersexporters

US – USD272.6 blln US – USD272.6 blln (17.4%)(17.4%)

UK – USD123.1 blln UK – USD123.1 blln (7.8%)(7.8%)

Germany – USD99.6% Germany – USD99.6% (6.3%)(6.3%)

Degree of DependenceIndependence—complete economic independence

• Country has no reliance on other countries for goods, services, or technologies

• Price of independence is having to do without goods that cannot be produced domestically

• Hinders country’s ability to borrow and adapt existing technologies

Interdependence— trade based on mutual need• Neither trading partner is likely to cut off supplies or

markets for fear of retaliation• Governments may be pressured to sustain trade

Dependence—developing countries rely heavily on:• The sale of one commodity for export earnings

– 25 % of emerging countries sell one commodity• One country as supplier or customer• Industrialized countries

General Types of Trade TheoriesGeneral Types of Trade Theories

Descriptive: the natural order of tradeDescriptive: the natural order of trade• Laissez-faire conditionsLaissez-faire conditions• Which products, how much, and with whom a Which products, how much, and with whom a

country will trade in the absence of restrictionscountry will trade in the absence of restrictions Prescriptive: questions whether governments Prescriptive: questions whether governments

should interfere with the free movement of goods should interfere with the free movement of goods and servicesand services

• Both types of theories – provide insights about markets for exports and

potentially successful export products– help companies determine where to locate

production facilities

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Trade Theory TimelineTrade Theory Timeline

1500 1600 20001700 1800 1900

M

A A

C A

FPT

IPLCT

NTT

NCA

MercantilismMercantilism Initial trade theory that formed the Initial trade theory that formed the

foundation of economic thought from 1500 foundation of economic thought from 1500 – 1800– 1800

Based on concept that a nations wealth is Based on concept that a nations wealth is measured by its holding of treasure (gold)measured by its holding of treasure (gold)

Nations should accumulate financial Nations should accumulate financial wealth by encouraging exports and wealth by encouraging exports and discouraging imports.discouraging imports.

Favorable balance of trade: country is Favorable balance of trade: country is exporting more than it is importingexporting more than it is importing

Unfavorable balance of trade: country is Unfavorable balance of trade: country is importing more than it is exporting, i.e. a importing more than it is exporting, i.e. a trade deficittrade deficit

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Nations often imposed restrictions on Nations often imposed restrictions on imports since they did not want “their” imports since they did not want “their” treasure moving to another country to pay treasure moving to another country to pay for the importsfor the imports

• Intended to benefit colonial powersIntended to benefit colonial powers– colonies supplied commodities to the colonies supplied commodities to the

mother countrymother country– mother country tried to run trade mother country tried to run trade

surpluses with their own coloniessurpluses with their own colonies

Mercantilism faded after 1800

Mercantilism-Zero-Sum GameMercantilism-Zero-Sum Game

In 1752, David Hume pointed out that:In 1752, David Hume pointed out that:• Increased exports lead to inflation and higher Increased exports lead to inflation and higher

pricesprices• Increased imports lead to lower pricesIncreased imports lead to lower prices

Result: Country A sells less because of Result: Country A sells less because of high prices and Country B sells more high prices and Country B sells more because of lower pricesbecause of lower prices

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

NeomercantilismNeomercantilism

Current term to describe the Current term to describe the approach of countries that try to run approach of countries that try to run favorable balances of trade to favorable balances of trade to achieve some social or political gainsachieve some social or political gains

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Theory of Absolute AdvantageTheory of Absolute Advantage

Adam Smith argued (Adam Smith argued (Wealth of NationsWealth of Nations, , 1776): 1776): Capability of one country to produce Capability of one country to produce more of a product with the same amount of more of a product with the same amount of input than another country can varyinput than another country can vary• A country should produce only goods where it is A country should produce only goods where it is

mostmost efficient, and trade for those goods where it is efficient, and trade for those goods where it is not efficientnot efficient

Trade between countries is, therefore, Trade between countries is, therefore, beneficial beneficial

Assumes there is an absolute balance Assumes there is an absolute balance among nationsamong nations• Example: Ghana/cocoaExample: Ghana/cocoa

Absolute AdvantageAbsolute Advantage

Absolute advantage holds that different Absolute advantage holds that different countries produce some goods more countries produce some goods more efficiently than other countriesefficiently than other countries

A nation with an absolute advantage can A nation with an absolute advantage can produce greater output of a good or produce greater output of a good or service than other nations using the service than other nations using the same amount of, or fewer, resources.same amount of, or fewer, resources.

Thus, global efficiency can be increased Thus, global efficiency can be increased through international free tradethrough international free trade

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Country SpecializationCountry Specialization

Under the concept of absolute Under the concept of absolute advantage countries could advantage countries could increase efficiency because:increase efficiency because:

Labor could become more skilled by Labor could become more skilled by repeating the same tasksrepeating the same tasks

Labor would not lose time in switching Labor would not lose time in switching from the production of one kind of from the production of one kind of product to anotherproduct to another

Long production runs would provide Long production runs would provide incentives for the development of incentives for the development of more effective working methodsmore effective working methods

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Natural AdvantageNatural Advantage

Countries have inherent advantagesCountries have inherent advantages• Climate Climate • Natural resourcesNatural resources• Labor forcesLabor forces

Two countries that have opposite Two countries that have opposite natural advantages should favor natural advantages should favor trade with one anothertrade with one another

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Acquired AdvantageAcquired Advantage

Most contemporary trade is manufactured Most contemporary trade is manufactured goods and services rather than agricultural goods and services rather than agricultural goods or natural resourcesgoods or natural resources

Countries with an acquired advantage Countries with an acquired advantage produce manufactured goods and services produce manufactured goods and services competitivelycompetitively• Product technology- Danish Silver tablewareProduct technology- Danish Silver tableware• Process technology – Japanese steelProcess technology – Japanese steel

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Absolute Trade AdvantageAbsolute Trade Advantage

Figure 5.25-10

Theory of Theory of Comparative AdvantageComparative Advantage

David Ricardo (David Ricardo (Principles of Political Economy,Principles of Political Economy, 1817):1817):• Extends free trade argumentExtends free trade argument• Efficiency of resource utilization leads to more Efficiency of resource utilization leads to more

productivityproductivity• Should import even if country is more efficient in the Should import even if country is more efficient in the

product’s production than country from which it is buyingproduct’s production than country from which it is buying• Look to see how much more efficient Look to see how much more efficient

If only comparatively efficient, than importIf only comparatively efficient, than import Makes better use of resourcesMakes better use of resources Trade is a positive-sum gameTrade is a positive-sum game

Comparative AdvantageComparative Advantage

There are still global gains to be made if a There are still global gains to be made if a country specializes in products it produces country specializes in products it produces more efficiently than other productsmore efficiently than other products

Regardless of whether other countries can Regardless of whether other countries can produce those same products even more produce those same products even more efficientlyefficiently

A country has a A country has a comparative advantagecomparative advantage when it is unable to produce a good more when it is unable to produce a good more efficiently than other nations, but efficiently than other nations, but produces the good more efficiently than it produces the good more efficiently than it does any other good.does any other good.

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Comparative AdvantageComparative Advantage

Figure 5.35-12

Basic Assumptions Basic Assumptions

Full employmentFull employment Economic efficiency is soughtEconomic efficiency is sought Division of gainsDivision of gains Two countries/two commoditiesTwo countries/two commodities Transportation costsTransportation costs MobilityMobility Statics and dynamicsStatics and dynamics ServicesServices Country size/variety of resourcesCountry size/variety of resources

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Heckscher (1919)-Olin (1933) Heckscher (1919)-Olin (1933) TheoryTheory

Export goods that intensively use factor Export goods that intensively use factor endowments which are locally abundantendowments which are locally abundant• Corollary: import goods made from locally scarce Corollary: import goods made from locally scarce

factorsfactors Note: Factor endowments can be impacted by government Note: Factor endowments can be impacted by government

policy - minimum wagepolicy - minimum wage

Patterns of trade are determined by Patterns of trade are determined by differences in factor endowments - differences in factor endowments - not productivitynot productivity

Countries produce and export goods Countries produce and export goods that require resources (factors) that that require resources (factors) that are abundant and import goods that are abundant and import goods that require resources in short supply.require resources in short supply.

• Land-labor relationshipLand-labor relationship• Labor-capital relationshipLabor-capital relationship• Technological complexitiesTechnological complexities

Leontief ParadoxLeontief Paradox

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Product Life-Cycle Product Life-Cycle Theory - R. Vernon (1966)Theory - R. Vernon (1966)

As products mature, both location of As products mature, both location of sales and optimal production sales and optimal production changeschanges

Affects the direction and flow of Affects the direction and flow of imports and exportsimports and exports

Globalization and integration of the Globalization and integration of the economy makes this theory less valideconomy makes this theory less valid

IntroductionIntroduction GrowthGrowth MaturityMaturity DeclineDecline

Production LocationProduction Location

Market LocationMarket Location

Competitive FactorsCompetitive Factors

Production TechnologyProduction Technology

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Product Life Cycle Theory of Trade (PLC)Raymond Vernon—the production location for many

products moves from one country to another depending on the stage in the product’s life cycle

Stage 1: Introduction• Innovation, production, and sales in same country

– new products developed in response to nearby observed need and markets for them

– early production occurs in domestic location• Location and importance of technology

– most new technology that results in new products and production methods originates in industrial countries

• Exports and labor– export small part of production– production process likely to be labor intensive– capital machinery for large-scale production

develops later in industrialized countries

Stage 2: Growth• Increases in exports by the innovating country• More competition• Increased capital intensity

– growing sales offer incentives to companies to develop process technology

• Some foreign productionStage 3: Maturity

• Decline in exports from the innovating country• More product standardization• More capital intensity• Increased competitiveness of price• Production start-ups in emerging countries

Stage 4: Decline• Production increased in emerging economies• Innovating country becoming net importer

Verification and limitations of plc theoryVerification and limitations of plc theory

• High transportation costs limit export opportunities, regardless of the life cycle stage

• Shifts in production site do not change for many types of products

– innovating country maintains its export ability throughout the life cycle

» products with very short life cycles» luxury products for which cost is not a

concern for the consumer» products used to promote differentiation

strategy» products requiring specialized technical

labor to evolve• MNEs increasingly introduce new products at home

and abroad simultaneously

Country-Similarity Theory

Economic similarity of industrial countries• Most of the world’s trade occurs among

countries that have similar characteristics

• country similarity theory—once a company has developed a new product to serve needs in a local market, it will turn to markets it sees as most similar to those at home

• Similarity in location, culture, political and economics interest

• most trade takes place among industrial countries because:

growing importance of acquired advantage as opposed to natural advantage

markets in industrial countries can support products and their variations

importance of industrial markets due to their size

incomes are high and people buy more

• Few emerging countries trade with each other

Similarity of location• Distances among countries accounts for many world

trade relationships• Methods to overcome distance disadvantages are

difficult to maintainCultural similarity

• Importers and exporters find it easier to do business in a country perceived as being similar

• Historic colonial relationships explain much of international trade

Similarity of political and economic interests• Political relationships and economic agreements

among countries may discourage or encourage trade between them or their companies

• Military conflicts disrupt trade patterns• Political animosity may interfere with trading channels

New Trade TheoryNew Trade Theory

There are gains to be made from There are gains to be made from specialization and increasing EOSspecialization and increasing EOS

The companies first to the market The companies first to the market can create barriers to entrycan create barriers to entry• First-mover advantageFirst-mover advantage

Government may play a role in Government may play a role in assisting its home companies.assisting its home companies.

Strategic Trade Policy

Governmental role and influence in Governmental role and influence in affecting the acquired advantage of affecting the acquired advantage of production within their bordersproduction within their borders

Alter conditions for industries in Alter conditions for industries in generalgeneral

change conditions that affect factor proportions, efficiency, and innovation

Target conditions for a specific Target conditions for a specific industryindustry• typically results in no more than small

payoffs hard to identify and target appropriate

industries too many countries identify the same

industry, leading to excessive competition relative conditions change, causing relative

capabilities to change as well

• have been a few notable government successes in targeting a specific industry

Theory of National Theory of National Competitive AdvantageCompetitive Advantage

The theory attempts to analyze the reasons The theory attempts to analyze the reasons for a nation’s success in a particular for a nation’s success in a particular industryindustry

Porter studied 100 industries in 10 nationsPorter studied 100 industries in 10 nations• Postulated determinants of competitive Postulated determinants of competitive

advantage of a nation were based on four advantage of a nation were based on four major attributesmajor attributes

Factor endowmentsFactor endowments Demand conditionsDemand conditions Related and supporting industriesRelated and supporting industries Firm strategy, structure and rivalryFirm strategy, structure and rivalry

Porter’s DiamondPorter’s Diamond

Success occurs where these Success occurs where these attributes existattributes exist

More/greater the attribute, the More/greater the attribute, the higher chance of successhigher chance of success

The diamond is mutually The diamond is mutually reinforcingreinforcing

Porter’s DiamondPorter’s Diamond

Factor EndowmentsFactor Endowments

Factor endowments:Factor endowments: A nation’s A nation’s position in factors of production such as position in factors of production such as skilled labor or infrastructure necessary to skilled labor or infrastructure necessary to compete in a given industrycompete in a given industry• Basic factor endowmentsBasic factor endowments• Advanced factor endowmentsAdvanced factor endowments

Basic Factor EndowmentsBasic Factor Endowments

Basic factors:Basic factors: Factors present in a Factors present in a countrycountry• Natural resourcesNatural resources• ClimateClimate• Geographic locationGeographic location

• DemographicsDemographics While basic factors can provide an initial While basic factors can provide an initial

advantage they must be supported by advantage they must be supported by advanced factors to maintain successadvanced factors to maintain success

Advanced Factor EndowmentsAdvanced Factor Endowments

Advanced factors:Advanced factors: The result of The result of investment by people, companies, investment by people, companies, and government are more likely to and government are more likely to lead to competitive advantage lead to competitive advantage • If a country has no basic factors, it must invest in If a country has no basic factors, it must invest in

advanced factorsadvanced factors

Advanced Factor Advanced Factor EndowmentsEndowments

CommunicationsCommunications Skilled laborSkilled labor ResearchResearch TechnologyTechnology EducationEducation

Demand ConditionsDemand Conditions

Demand:Demand:• creates capabilities creates capabilities • creates sophisticated and creates sophisticated and

demanding consumersdemanding consumers

Demand impacts Demand impacts quality and quality and innovationinnovation

Related and Supporting Related and Supporting IndustriesIndustries

Creates clusters of supporting Creates clusters of supporting industries that are internationally industries that are internationally competitivecompetitive

Must also meet requirements of Must also meet requirements of other parts of the Diamondother parts of the Diamond

Firm Strategy, Structure Firm Strategy, Structure and Rivalryand Rivalry

Long term corporate vision is a Long term corporate vision is a determinant of successdeterminant of success

Management ‘ideology’ and structure Management ‘ideology’ and structure of the firm can either help or hurt of the firm can either help or hurt youyou

Presence of domestic rivalry Presence of domestic rivalry improves a company’s improves a company’s competitivenesscompetitiveness

Porter’s Theory-PredictionsPorter’s Theory-Predictions

Porter’s theory should predict the pattern Porter’s theory should predict the pattern of international trade that we observe in of international trade that we observe in the real worldthe real world

Countries should be exporting products Countries should be exporting products

from those industries where all four from those industries where all four components of the diamond are favorable, components of the diamond are favorable, while importing in those areas where the while importing in those areas where the components are not favorablecomponents are not favorable

Implications for BusinessImplications for Business Location implications:Location implications:

• Disperse production activities to countries Disperse production activities to countries where they can be performed most efficientlywhere they can be performed most efficiently

First-mover implications:First-mover implications:• Invest substantial financial resources in building Invest substantial financial resources in building

a first-mover, or early-mover advantagea first-mover, or early-mover advantage Policy implications:Policy implications:

• Promoting free trade is in the best interests of Promoting free trade is in the best interests of the home country, not always in the best the home country, not always in the best interests of the firm, even though many firms interests of the firm, even though many firms promote open marketspromote open markets