International Trade Theoryby

Md. Nuruzzaman, Ph.D.Director (Training), NAPD

International Trade Theory

Overview Mercantilism Absolute Advantage Comparative Advantage Heckscher-Olin Theory Product Life Cycle Theory New Trade Theory Porter’s Diamond

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1st British African colony to win independence (1957).

Nkrumah espoused pan African socialism.

High tariffs. Anti-exporting policy.

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Kept lowering tariffs on manufactured goods. Created incentives to export. Reduced quotas. Reduced subsidies. 1950s: 77% of employment in agriculture.

Now 20%. Manufacturing GNP went from 10% to over

30%.3

The Impact of Trade Policies Ghana 1970

GNP/capita • $250

1992 GNP/per capita

• $450

GNP Growth/year • 1.5%

Shift from productive uses (cocoa) to unproductive uses (subsistence agriculture).

Korea 1970

GNP/per capita • $260

1992 GNP/per capita

• $6790

GNP Growth/year• 9%

Shift from non-comparative advantage uses (agriculture) to productive uses (labor-intensive manufacturing).

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An Overview of Trade Theory

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.

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.

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).

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Mercantilism: mid-16th century A nation’s wealth depends on accumulated

treasure Gold and silver are the currency

of trade. Theory says you should have

a trade surplus. Maximize exports through

subsidies. Minimize imports through tariffs

and quotas.

Flaw: “Zero-sum game”.6

David Hume - 1752

Increased exports leads to inflation and higher prices.

Increased imports lead to lower prices. Result: Country A sells less because of high

prices and Country B sells more because of lower prices.

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

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Zero–sum game In game theory and economic theory, a zero–sum game is a

mathematical representation of a situation in which a participant's gain (or loss) of utility is exactly balanced by the losses (or gains) of the utility of the other participant(s).

If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero.

Thus cutting a cake, where taking a larger piece reduces the amount of cake available for others, is a zero–sum game if all participants value each unit of cake equally (see marginal utility).

In contrast, non-zero–sum describes a situation in which the interacting parties' aggregate gains and losses are either less than or more than zero. A zero–sum game is also called a strictly competitive game while non-zero–sum games can be either competitive or non-competitive

The zero-sum property (if one gains, another loses) means that any result of a zero-sum situation is Pareto optimal (generally, any game where all strategies are Pareto optimal is called a conflict game).

Zero-sum games are a specific example of constant sum games where the sum of each outcome is always zero. Such games are distributive, not integrative; the pie cannot be enlarged by good negotiation.

Situations where participants can all gain or suffer together are referred to as non-zero–sum. Thus, a country with an excess of bananas trading with another country for their excess of apples, where both benefit from the transaction, is in a non-zero–sum situation. Other non-zero–sum games are games in which the sum of gains and losses by the players are sometimes more or less than what they began with.

Choice 1Choice 2

Choice 1 –A, A B, –B

Choice 2 C, –C –D, D

Generic zero-sum game

Theory of Absolute Advantage Adam Smith: Wealth of Nations (1776). Capability of one country to produce more of a product

with the same amount of input than another country. Produce only goods where you are most efficient, trade for

those where you are not efficient. Trade between countries is, therefore, beneficial.

Assumes there is an absolute advantage balance among nations.

Ghana/cocoa.

The Theory of Absolute Advantage

0 5 10 15 20

5

10

1

5

20

A

BK

G

K’G’

Rice

Coco

a

Figure 4.1

The Theory of Absolute Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and RiceCocoa Rice

Ghana 10 20S. Korea 40 10

Production and Consumption without TradeGhana 10.0 5.0S. Korea 2.5 10.0

Total production 12.5 15.0Production with Specialization

Ghana 20 0S. Korea 0 20

Total production 20 20Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean

RiceGhana 14.0 6.0 S. Korea 6.0 14.0

Increase in Consumption as a Result of Specialization and TradeGhana 4.0 1.0

S. Korea 3.5 4.0 Table 4.1

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 is buying.• Look to see how much more efficient. If only comparatively

efficient, than import.

Makes better use of resources Trade is a positive-sum game.

The Theory of Comparative Advantage

0 5 10 15 20

5

10

1

5

20

Coco

a

Rice

Figure 4.2

3.75

7.5

2.5

G

C

A

G’

B

K

K’

Comparative Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice

Ghana 10 13.33S. Korea 40 20

Production and Consumption without TradeGhana 10.0 7.5S. Korea 2.5 5.0

Total production 12.5 12.5Production with Specialization

Ghana 15 3.75S. Korea 0.0 10.0Total production 15 13.75Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean

RiceGhana 11 7.75 S. Korea 4 6

Increase in Consumption as a Result of Specialization and TradeGhana 1.0

0.25S. Korea 1.5 1.0

Cocoa Rice

Table 4.2

Simple Extensions of the Ricardian Model

Diminishing returns: More a country produces, at some point, will

require more resources.

However: Free trade can increase a country’s production

resources, and Increase the efficiency of resource utilization.

Ghana’s PPF under Diminishing Returns

Coco

a

Rice

G’

G

0

Figure 4.3

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The Influence of Free Trade on the PPF

Coco

a

Rice

G’

PPF2

0

Figure 4.4

PPF1

Is the Mercantilist Theory Still Valid?

A qualified Yes. Equate political power with economic

power and economic power with a trade surplus.

Japan

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Heckscher (1919)-Olin (1933) Theory

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

factors. Patterns of trade are determined by differences in

factor endowments - not productivity. Remember, focus on relative advantage, not

absolute advantage.

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The Leontief Paradox, 1953

Disputes Heckscher-Olin in some instances. Factor endowments can be impacted by

government policy - minimum wage. US tends to export labor-intensive products,

but is regarded as a capital intensive country.

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Heckscher vs Ricardo Economists prefer Heckscher on theoretical

grounds but is a relatively poor predictor of trade patterns.

Ricardo’s Comparative Advantage Theory, regarded as too limited for predicting trade patterns, actually predicts them with greater accuracy.

In the end, differences in productivity may be the key to determining trade patterns.

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Product Life-Cycle Theory(Raymond Vernon, 1966)

Article in the Quarterly Journal of Economics. As products mature, both location of sales and

optimal production changes. Affects the direction and flow of imports and

exports. Globalization and integration of the economy makes

this theory less valid.

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International Product Trade Cycle Model

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1 3 4 5 6 7 8 9 10 11 12 13 14 15

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

High Income Countries

Medium Income Countries

Low Income Countries

Time

Stages of Production Development

New Product Standardized ProductMaturing Product

Quantity

production

consumption

2

Exports Imports

Imports

Exports

Exports

Imports

Figure 4.5

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The New Trade Theory

Began to be recognized in the 1970s. Deals with the returns on specialization

where substantial economies of scale are present. Specialization increases output, ability to

enhance economies of scale increase.

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Application of the New Trade Theory

Typically, requires industries with high, fixed costs.

World demand will support few competitors. Competitors may emerge because “they got

there first”. first-mover advantage.

Some argue that it generates government intervention and strategic trade policy.

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First-Mover Advantage

Economies of scale may preclude new entrants.

Role of the government.

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Founded 1915 by William Boeing Largest commercial airplane manufacturer. 9,000 commercial jetliners in service.

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Established 1967 Western Europe buying 25% of aircraft ,but

selling only 10%. France, Germany, Great Britain To date: 3,203 orders - 1,890 deliveries.

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Airbus vs Boeing

0

100

200

300

400

500

600

700

800

85 86 87 88 89 90 91 92 93 94 95 96 97

BoeingAirbus

Airplane Orders

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Porter’s Diamond(Harvard Business School, 1990)

The Competitive Advantage of Nations. Looked at 100 industries in 10 nations.

Thought existing theories didn’t go far enough.

Question: “Why does a nation achieve international success in a particular industry?”

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Determinants of National Competitive Advantage

Factor endowments:nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry.

Firm strategy, structure and rivalry:the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.

Demand conditions:the nature of home demand for the industry’s product or service.

Related and supporting industries:the presence or absence in a nation of supplier industries or related industries that are nationally competitive.

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Porter’s DiamondDeterminants of National Competitive Advantage

Factor Endowments

Firm Strategy,Structure and

Rivalry

Demand Conditions

Related and Supporting IndustriesFigure 4.6

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The Diamond

Success occurs where these attributes exist. More/greater the attribute, the higher chance of

success.

The diamond is mutually reinforcing.

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Factor Endowments

Taken from Heckscher-Olin Basic factors:

natural resources, climate, location.

Advanced factors: communications, skilled labor, technology.

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Advanced Factor Endowments

More likely to lead to competitive advantage.

Are the result of investment by people, companies, government.

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Relationship of Basic to Advanced Factors

Basic can provide an initial advantage. Must be supported by advanced factors to

maintain success. No basics, then must invest in advanced

factors.

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Demand Conditions Demand creates the capabilities. Look for sophisticated and

demanding consumers. impacts quality and

innovation.

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Related and Supporting Industries

Creates clusters of supporting industries that are internationally competitive.

Must also meet requirements of other parts of the Diamond.

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Firm Strategy, Structure and Rivalry

Management ‘ideology’ can either help or hurt you.

Presence of domestic rivalry improves a company’s competitiveness.

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Evaluating Porter’s Theory

If Porter is right, country exports should reflect the presence of the four ‘diamond’ components. Countries will import goods from industries where some or all the components are missing.

Too soon to tell.

World Trade

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Determinants of National Competitive Advantage

Company Strategy,Structure,

and Rivalry

DemandConditions

Relatedand Supporting

Industries

FactorConditions

GovernmentGovernmentSource: Michael Porter, The Competitive Advantage of Nations

ChanceChance

Two external factors that influence the four determinants.

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Porter’s diamond, but...

‘Double Diamond’ - look to attributes of both countries. Professor Alan Rugman, University of Toronto

Home country may ‘sound’ good, but Company can rely on the host country. Neighboring countries can too. Canada and the U.S.

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Implications for Business

Location implications:makes sense to disperse production activities to countries where they can be performed most efficiently.

First-mover implications:It pays to invest substantial financial resources in building a first-mover, or early-mover, advantage.

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.

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