International Business

Oded Shenkar and Yadong Luo Chapter 2

International Trade Theory and Application

Chapter 2: International Trade Theory and Application

Do You Know?
What are the major theories of international trade? How do governments limit trade with other countries, and what are their reasons for doing so? How do different technological levels define a countrys trade relationships? Why do countries with similar levels of technology trade more than countries with disparate technology levels?
Chapter 2: International Trade Theory and Application

International Trade Theories

International trade is the exchange of goods and services across borders. Export structures vary across countries. A number of international trade theories can explain these different structures.

Chapter 2: International Trade Theory and Application

The Mercantilist Doctrine

Mercantilism is a 16th Century doctrine stating that a nation should export more goods that it imports. Governments job is to create policy that promotes heavy exportation, collection of revenue, and industrial development internally. In practice, it serves to make the State the stockholder, financier, customer, marketer, collector, and enforcer of contracts with other nations.
Chapter 2: International Trade Theory and Application

Absolute Advantage Theory

In 1776, Adam Smith proposed that market forces rather than government desires were a better predictor of trade. Laissez-Faire policy where government has no influence should promote trade better. Nations will export to pay for goods they import.
Chapter 2: International Trade Theory and Application

Absolute Advantage Theory

Nations could specialize in producing and exporting goods where they have a natural or acquired Absolute Advantage and import those goods they dont produce as well.
Exhibit 2-1: Labor hours required to product one unit of a good.

Chapter 2: International Trade Theory and Application

Comparative Advantage Theory

David Ricardo indicated in 1817 there may be a better explanation since few States actually specialize like that. Ricardo indicated that nations that are comparatively more efficient at production will make those goods even though they may not have an absolute advantage. Comparative Advantage explains and predicts trade of goods where absolute advantages may not exist.
Chapter 2: International Trade Theory and Application

Comparative Advantage Theory

Opportunity Cost the amount of other goods which have to be given up to product one unit of a good. Exhibit 2-2: Labor hours required to produce one unit of a good.

Exhibit 2-3: Opportunity costs for producing wine and cloth.

Chapter 2: International Trade Theory and Application

Comparative Advantage Theory

Comparative Advantage must be explained by:
Comparative Production Cost depends on the commoditys production process. Production Factors such as labor, land, capital, and natural resources.

Chapter 2: International Trade Theory and Application

Heckscher-Ohlin Theorem
Countries export goods that make intensive use of the countrys abundant factor. Countries import goods that make intensive use of the countrys scarce factor. Differences in comparative advantage are attributed to differences in the structure of the economy.
Chapter 2: International Trade Theory and Application

Heckscher-Ohlin Theorem
Assumptions:
Countries vary in the availability of various factors of production. The Production Function is identical anywhere in the world.
The amount of output produced by using any given amount of capital and labor.

Technology is constant in all trading countries. Conditions of demand for production factors are the same in all countries.
Chapter 2: International Trade Theory and Application

Heckscher-Ohlin Theorem
Implications
Trade should be greatest between countries with the greatest differences in economic structure. Trade should cause countries to specialize more. Trade policy should take the form of trade restrictions. Countries should export goods that make use of the abundant factors.
Chapter 2: International Trade Theory and Application

Heckscher-Ohlin Theorem
Implications
Free trade should equalize factor prices between countries with similar relative factor endowments. Factor prices should be nearly equal between countries with more liberal mutual trade. International investment should be stimulated by difference in factor endowments.
Chapter 2: International Trade Theory and Application

The Leontief Paradox

Leontief challenges Heckscher-Ohlin on a number of grounds.
The U.S (a capital intensive nation) exports laborintensive goods. The U.S also exports technically sophisticated goods that require skilled labor. The U.S imports capital intensive goods made with unskilled labor.

Exhibit 2-4: Capital position in U.S. exports and imports

Chapter 2: International Trade Theory and Application

The Leontief Paradox

Stimulated a search for explanations.
Demand bias for capital-investment goods. Existence of trade barriers. Importance of natural resources Prevalence of factor-intensity reversals.

Chapter 2: International Trade Theory and Application

Human Skills and Technology-Based View

Keesing indicated that trade direction and flow is predicted by gaps in human skills and technology. Nations with higher levels of humans skills and technology will produce and export goods to nations with lower levels.

Chapter 2: International Trade Theory and Application

Human Skills and Technology-Based View

Human Skills are predicted by
Level of development in the scientific, technical, managerial, and skilled labor sectors.

Technology level is predicted by:

capital-intensive technology development imitation lag that exists as technology innovations diffuse to developing areas.
Chapter 2: International Trade Theory and Application

The Product Life-Cycle Model

Product innovation and initial use occurs first in higher income countries Diffuses to middle and lower income countries as technology and skills gaps overcome and consumer preferences switch to the newer products.
Chapter 2: International Trade Theory and Application

The Product Life-Cycle Model

Several trends emerge in PLC:
The export performance of the mature innovating country is better than others. Technology is better in the mature countries as products diffuse production tends to move from technology-intensive to labor-intensive. Countries that were innovators can fall from that place. Trade may increase in later stages of product maturity as costs and prices decline and production economies rise.

Chapter 2: International Trade Theory and Application

The Product Life-Cycle Model

Exhibit 2-5: Product cycle model of international trade innovating country

Chapter 2: International Trade Theory and Application

The Product Life-Cycle Model

Exhibit 2-6: Product cycle model of international trade imitating country

Chapter 2: International Trade Theory and Application

Linders Income-Preference Similarity Theory

Developed countries trade more than less developed countries (assumption) Trade should take place between developed nations producing manufactured products and less developed nations producing primary products (e.g. natural resources) and labor-intensive goods. According to Linder, the range of production is determined by internal demand. Countries with similar internal demand conditions should therefore trade. This is called Preference Similarity.
Chapter 2: International Trade Theory and Application

The New Trade Theory

Countries do not specialize and trade solely to take advantages of differences. They also trade because of increasing returns. Because of economies of scale, there are increasing returns to specialization. Economies of scale reduction of manufacturing cost per unit as a result of increased production quantity during a given period.

Chapter 2: International Trade Theory and Application

The New Trade Theory

Inter-industry trade determined by Heckscher-Ohlin. Intra-industry trade driven by increasing returns resulting from specialization within the industry. Externality when the actions of one agent directly affect the environment of another.

Chapter 2: International Trade Theory and Application

Theory Assessment
These theories provide insights in international trade. No theorem can fully explain the range of motives for international trade.

Chapter 2: International Trade Theory and Application

International Trade Volume and Growth

International trade continues to grow briskly
In 2000, global merchandise exports reached $6.2 trillion
Increase of 12.5% over 1999

Global exports of commercial services reached $1.4 trillion

Increase of 6% over 1999

Significant change in in the share of various world regions.

Chapter 2: International Trade Theory and Application

International Trade Volume and Growth

Exhibit 2-7: World merchandise trade by major product group, 1950 - 2000

Chapter 2: International Trade Theory and Application

International Trade Volume and Growth

Exhibit 2-8: World merchandise trade by region and selected economy

Chapter 2: International Trade Theory and Application

International Trade Volume and Growth

Exhibit 2-8: World merchandise trade by region and selected economy (cont)

Chapter 2: International Trade Theory and Application

Service Trade
The import and export of:
Financial services Information services Education and training Travel and tourism Healthcare Consulting and advisory services

Accounts for about one quarter of global trade, but rapidly growing.
Chapter 2: International Trade Theory and Application

Service Trade
Exhibit 2-9: Trade in commercial services of the U.S.

Chapter 2: International Trade Theory and Application

Trade Measurement
Trade measurement is generally a difficult exercise since nations do not use similar indexed systems. Different trade data is collected for different purposes and aggregations may be biased. Major sources of reliable data
U.S Department of Commerce World Trade Organization Shippers Export Declarations World Bank

Chapter 2: International Trade Theory and Application

Major Exporters and Importers

In merchandise trade, top exporters and importers are developed countries.
Exhibit 2-10a: Top 10 leading exporters and importers in world merchandise trade, 2000

Chapter 2: International Trade Theory and Application

Major Exporters and Importers

In commercial services, top exporters and importers are developed countries.
Exhibit 2-10b: Top 10 leading exporters and importers in world trade in commercial services, 2000

Chapter 2: International Trade Theory and Application

U.S. Trade Partners

Canada is the largest trade partner Followed by the EU, Mexico, and Japan
Developed economies

Canada and Mexico benefit from proximity and NAFTA membership.

Chapter 2: International Trade Theory and Application

U.S. Trade Partners

Exhibit 2-11: Merchandise trade of the U.S. by region and economy, 2000

Chapter 2: International Trade Theory and Application

U.S. Trade Partners

Trade with Japan
Flow of foodstuff from U.S. to Japan explained by factor endowments Japan exports 10 times more vehicles to the U.S. than vice versa.
Trade barriers Currency exchange rates Rising fuel prices

Chapter 2: International Trade Theory and Application

U.S. Trade Partners

Exhibit 2-12a: U.S. Exports to Japan (Top ten commodities)

Chapter 2: International Trade Theory and Application

U.S. Trade Partners

Exhibit 2-12b: U.S. Imports from Japan (Top ten commodities)

Chapter 2: International Trade Theory and Application

Trade Balance
Balance of trade exports minus imports of goods and services The U.S. has the largest trade deficit Low as a percentage of GDP. Exhibit 2-13: Balance of Trade
Chapter 2: International Trade Theory and Application

Opposition to Free Trade

Opponents of free trade in opposition to globalization. Countries take the position that trade needs to protect the interests of their citizens. In one survey, 48% of Americans said foreign trade is bad for the U.S. Trade impacts at the micro level, as well as the macro. People with lower incomes tend to be more negatively disposed to trade.
Chapter 2: International Trade Theory and Application

The Sovereignty Argument

Moving production to the most efficient location deprives a countrys economic viability. Makes countries too dependent on other nations. Particularly relevant to national security. Threat to national culture and institutions.

Chapter 2: International Trade Theory and Application

The Lowest Common Denominator Argument

Product shifts to nations with the least protection. Potentially adverse to the environment and safety. Everyone will end up paying for the adverse effects. One of the main complaints of the antiglobalization movement.

Chapter 2: International Trade Theory and Application

Trade Reciprocity
Benefits from trade can be not only economic but also political and social. Passive reciprocity a country refuses to lower or eliminate barriers to trade until the other does the same. Active or aggressive reciprocity the threat of retaliation.

Chapter 2: International Trade Theory and Application

Types of Trade Barriers

Tariff barriers official constraints on the importation of certain goods or services.
Takes the form of a limitation or a special levy.

Non-tariff barriers indirect measures that discriminate against foreign manufacturers.

Chapter 2: International Trade Theory and Application

Tariffs
Surcharges that importer must pay above and beyond taxes leveled on domestic goods and services. Transparent and based on the value of the product or service. Optimal Tariff theory governments can capture a portion of the manufactures profit margin. Infant Industry theory a industry new to a country can be protected against established global players.
Chapter 2: International Trade Theory and Application

Tariffs
Exhibit 2-14: Average import tariff rates

Chapter 2: International Trade Theory and Application

Quotas
Quantitative limits on the importation of goods. Definitive, quantifiable protection of the domestic producers. Rule of origin administration of tariffs and quotes based on the country origin.

Chapter 2: International Trade Theory and Application

Export Controls
Limitation of the type of products that can be exported to other countries.
National security risks Dual purpose products Goods vital to domestic industry

Companies often argue that countries will get the products from a competitor.

Chapter 2: International Trade Theory and Application

Dumping and Anti-Dumping

Dumping - Selling a product at an unfairly low price. Undermines the principles of comparative advantage. WTO allows anti-dumping laws where there has been material injury to the domestic industry.

Chapter 2: International Trade Theory and Application

Non-Tariff Barriers
Administrative Barriers used to block the entry of products while arguing that no barrier exists Production Subsidies payments provided by a government to domestic companies to make them more competitive. Emergency Import Protection implemented to protect against a surge in imports Foreign Sales Corporations offshore corporations that market products and services of firms in foreign countries.
Chapter 2: International Trade Theory and Application

Non-Tariff Barriers
Embargoes the prohibition of exportation to a designated country. Boycotts the blank prohibition on importation of all or some goods from a designated country. Technical Standards requiring a company to demonstrate that their products meet the countrys domestic standards. Corruption Barriers to Service Trade
Chapter 2: International Trade Theory and Application