Theories of International Trade

Learning Objectives

To understand the traditional arguments of how and why international trade improves the welfare of all countries To review the history and compare the implications of trade theory from the original work of Adam Smith to the contemporary theories of Michael Porter To examine the criticisms of classical trade theory and examine alternative viewpoints of which business and economic forces determine trade patterns between countries

Evolution of Trade Theories

Mercantilism Absolute advantage (Classical) Comparative advantage Factor Proportions Trade International Product Cycle New Trade Theory National competitive advantage

Mercantilism: mid-16th century

A nations wealth depends on accumulated treasure

Gold and silver are the currency of trade Maximize export through subsidies. Minimize imports through tariffs and quotas

Theory says you should have a trade surplus.

Flaw: restrictions, impaired growth

Defining mercantilism

trade theory holding that nations should accumulate financial wealth, usually in the form of gold (forget things like living standards or human development) by encouraging exports and discouraging imports

4-6

Criticism

Its a zero sum game gain by one country and loss of another.. Gold and silver are no longer exist as standard for measuring the wealth..

Theory of absolute advantage

Adam Smith: Wealth of Nations (1776) argued: Capability of one country to produce more of a product with the same amount of input than another country A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient Trade between countries is, therefore, beneficial Assumes there is an absolute balance among nations

Theory of absolute advantage

destroys the mercantilist idea since there are gains to be had by both countries party to an exchange questions the objective of national governments to acquire wealth through restrictive trade policies measures a nations wealth by the living standards of its people

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 products 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

Comparative advantage and the gains from trade

Assumptions and limitations

Driven only by maximization of production and consumption Only 2 countries engaged in production and consumption of just 2 goods? What about the transportation costs? Only resource labour (that too, nontransferable) No consideration for learning theory

Factor proportions theory

Heckscher (1919) - Olin (1933) Theory Export goods that intensively use factor endowments which are locally abundant Corollary: import goods made from locally scarce factors

Note: Factor endowments can be impacted by government policy - minimum wage

Patterns of trade are determined by differences in factor endowments - not productivity Remember, focus on relative advantage, not absolute advantage

Factor proportions theory

trade theory holding that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply Example:

Australia lot of land and a small population (relative to its size) So what should it export and import?

Factor Proportions Trade Theory Considers Two Factors of Production

Labor

Capital

Factor Proportions Trade Theory

A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive)

The Leontief Paradox

The Test:
Could Factor Proportions Theory be used to explain the types of goods the United States imported and exported?

The Method:
Input-output analysis

The Leontief Paradox

The Findings:
The U.S. exported labor-intensive products and imported capital-intensive products.

The Controversy:
Findings were the opposite of what was generally believed to be true!

Product life-cycle Theory

R.Vernon (1966)

trade theory holding that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its lifecycle 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

Product life cycle theory

Fig 4.5

The Product Cycle and Trade Implications Increased emphasis on technologys impact on product cost Explained international investment Limitations

Most appropriate for technology-based products Some products not easily characterized by stages of maturity Most relevant to products produced through mass production

New trade theory

In industries with high fixed costs:

Specialization increases output, and the ability to enhance economies of scale increases Learning effects are high. These are cost savings that come from learning by doing

New trade theory - applications

Typically, requires industries with high, fixed costs

World demand will support few competitors

Competitors may emerge because of Firstmover 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

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

postulated determinants of competitive advantage of a nation based on four major attributes

Factor

endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry

Porters diamond

Success occurs where these attributes exist. More/greater the attribute, the higher chance of success The diamond is mutually reinforcing

Factor endowments

Factor endowments:- A nations position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry Basic factor endowments Advanced factor endowments

Basic factor endowments

Basic factors: Factors present in a country

Natural resources Climate Geographic location Demographics

While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success

Advanced factor endowments

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

Advanced factor endowments

communications skilled labor research Technology education

Demand conditions

Demand: creates capabilities creates sophisticated and demanding consumers Demand impacts quality and innovation

Related and supporting industries

Creates clusters of supporting industries that are internationally competitive Must also meet requirements of other parts of the Diamond

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 a companys competitiveness

Determinants of Competitive Advantage in nations

Fig 4.8

Chance
Company Strategy, Structure, and Rivalry

Two external factors that influence the four determinants.

Factor Conditions Related and Supporting Industries

Demand Conditions

Government

Porters Theory-predictions

Porters theory should predict the pattern of international trade that we observe in the real world
Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable

Implications for business

Location implications:

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

First-mover implications:

Invest substantial financial resources in building a first-mover, or early-mover advantage

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

Policy implications:

India in the global competitiveness report