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Chapter 4 International Trade Theory
-trade patterns in the World
1. Explain key trade theories.
2. Evaluate the rationale for government policies to
control trade.
3. Evaluate the effects of governments and pressure
groups on trade policies.
4. Compare and contrast the various approaches to trade
control.5. International Factor Movements
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1. An Overview Of Trade Theory
International free trade allows a country to specialize in themanufacture and export of products that can be produced mostefficiently in that country, and import products that can beproduced more efficiently in other countries .
Questions should be focused are:
what products should we import and export?
How much should we trade?
With whom should we trade?
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Theories of International Trade
1500 1600 1700 1800 1900 2000
Year
Mercantilism Absolute Advantage
Comparative Advantage
Factor Proportions Theory
International Product Life Cycle
New Trade Theory
Global Competitive Advantage
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1.1MERCANTILISM
Mercantilism, which emerged in England in the mid-16thcentury, asserted that it is in a countrys best interest tomaintain a trade surplus, to export more than it imports.
Mercantilism advocated government intervention toachieve a surplus in the balance of trade, many political viewstoday have the goal of boosting exports while limitingimports by seeking only selective liberalization of trade;
It viewed trade as a zero-sum game, one in which a gain by
one country results in a loss by another.
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1.2 Classical Trade Theory
The Theory of Absolute Advantage
The ability of a country to produce a productwith fewer inputs than another country. Hence,different countries produce some goods more
efficiently than other countries Thus, global efficiency can be increased
through international free trade
The Theory of Comparative Advantage
The notion that although a country may
produce both products more cheaply thananother country, it is relatively better atproducing one product than the other
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ABSOLUTE ADVANTAGE
In 1776, Adam Smith attacked the mercantilist assumption that trade is azero-sum game and argued that countries differ in their ability to producegoods efficiently, and that a country has an absolute advantage in theproduction of a product when it is more efficient than any other country inproducing it. According to Smith, countries should specialize in theproduction of goods for which they have an absolute advantage and then
trade these goods for the goods produced by other countries.Through specialization, countries could increase their efficiency because ofthree reasons:
Labor could become more skilled by repeating the same tasks;
Labor would not lose time in switching from the production of one kind
of product to another; Long production runs would provide incentives for the development ofmore effective working methods.
But in what products should a country specialize? Smith believed the
marketplace would make the determination, he thought that a countrys
advantage would be either natural or acquired.
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Absolute Trade Advantage
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COMPARATIVE ADVANTAGE
In 1817, David Ricardo took Adam Smiths theory one step further byexploring what might happen when one country has an absolute advantage inthe production of all goods. According to Ricardos theory ofcomparativeadvantage, it makes sense for a country to specialize in the production ofthose goods that it produces most efficiently and to buy the goods that itproduces less efficiently from other countries.
Heckscher and Ohlin argued that comparative advantage arises from
differences in national factor endowments. Countries will export goods
that make intensive use of those factors that are locally abundant, while
importing goods that make intensive use of factors that are locally scarce
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Absolute/Comparative Advantage are
Theories of Specialization
Possible invalid assumptions of these theories
Full employment may be compromised
Economic efficiency objective may not be fully held (culture, etc.) Unequal division of gains may put off some countries
Transportation costs can drive down an advantage
Mobility of factors is not always the case, especially HR
Dynamics of technological innovation, etc. change the landscape quickly
and give advantage
Adam SmithDivision of Labor
Industrial societies increase output using same labor-hours as pre-industrial society
David RicardoComparative Advantage
Countries with no obvious reason for trade can specialize inproduction, and trade for products they do not produce
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The Leontief Paradox
A country that is relatively labor abundant (capital abundant) should specializein the production and export of that product which is relatively labor intensive(capital intensive).
In 1953, Wassily Leontief postulated that since the U.S. was relativelyabundant in capital compared to other nations, the U.S. would be an exporter ofcapital intensive goods and an importer of labor-intensive goods.
However, he found that U.S. exports were less capital intensive than U.S.imports
Since this result was at variance with the predictions of the theory, it hasbecome known as the Leontief Paradox
Theories explaining trade patterns
How much does a country trade?
What types of products does a country trade?
With whom do countries trade?
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1.3 Factor Proportions Trade
Theory
Developed by Eli Heckscher
Expanded by Bertil Ohlin
Labor
Capital
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Factor Proportions Land-labor relationship
Labor-capital relationship
Technological complexities
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1.4 THE PRODUCT LIFE CYCLE THEORY
In the mid-1960s, Raymond Vernon proposed the product life-cycle theory that suggested that as products mature both thelocation of sales and the optimal production location will changeaffecting the flow and direction of trade.
According to the PLF theory of trade, the production location
moves from one country to another depending on the stage in theproducts life cycle.
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Life cycle stage
Maturity ischaracterized by
A decline in exportsfrom innovating countryMore productstandardizationMore capital intensityIncreased
competitiveness of priceProduction start-ups inemerging economies
Growth ischaracterized
byIncrease inexports byinnovatingcountryMorecompetitionIncreasedcapital intensitySome foreignproduction
Introductionstage is
marked byInnovation inresponse toobserved needExporting bythe innovativecountry evolvingproductcharacteristics
Decline is
characterized byA concentrationof production indevelopingcountriesAn innovatingcountry becoming
a net importer
Life cycle stage
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Limitations of PLC Theory
Products with extremely short PLCs
Luxury products where cost may be of little concern
Businesses with products that follow a differentiation strategy
Products that require specialized technical labor for subsequentproduct generations
Global start-ups
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1.5 The New Trade Theory:Strategic Trade
Two New Contributions ofStrategic Trade
Paul Krugman-How trade is altered when markets are not perfectly
competitive
Michael Porter-Examined competitiveness of industries on a global
basis
New trade theory suggests that because ofeconomies of scale (unit costreductions associated with a large scale of output) and increasing returns to
specialization, in some industries there are likely to be only a few profitablefirms
Firms with first mover advantages (the economic and strategicadvantages that accrue to many entrants into an industry) will developeconomies of scale and create barriers to entry for other firms
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Strategic Trade
Government can play a beneficial role when markets are not
purely competitive Theory expands to governments role in international trade
Four circumstances exist that involve imperfect competition inwhich strategic trade may apply
Porters Diamond of National Advantage
Innovation is what drives and sustains competitiveness
Four components of competition
Factor Conditions
Demand Conditions Related and Supporting Industries
Firm Strategy, Structure, and Rivalry
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National Competitive Advantage: PortersDiamond
Porters 1990 study tried to explain why a nation achieves
international success in a particular industry and identified
four attributes that promote or impede the creation of
competitive advantage:
Factor Endowments
A nation's position in factors of production can lead to
competitive advantage
These factors can be either basic (natural resources, climate,
location) or advanced (skilled labor, infrastructure,
technological know-how)
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Demand Conditions
The nature of home demand for the industrys product orservice influences the development of capabilities
Sophisticated and demanding customers pressure firms to becompetitive
Relating and Supporting Industries
The presence supplier industries and related industries that areinternationally competitive can spill over and contribute to otherindustries
Successful industries tend to be grouped in clusters incountries - having world class manufacturers of semi-conductorprocessing equipment can lead to (and be a result of having) acompetitive semi-conductor industry
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Porters Diamond of competitive
Porters Diamond of competitive advantage is shown in
following figure
Government policy can affectdemand through product standards,influence rivalry through regulationand antitrust laws, and impact the
availability of highly educatedworkers and advanced transportationinfrastructure
.
The four attributes, governmentpolicy, and chance work as a
reinforcing system, complementingeach other and in combinationcreating the conditions appropriate forcompetitive advantage
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2 Movements in Factors of Production
Movements in factors of production include labor migration
the transfer of financial assets through internationalborrowing and lending
transactions of multinational corporations involving directownership of foreign firms
Like movements of goods and services (trade), movements of factors of
production are politically sensitive and are often restricted.
Restrictions on immigration
Restrictions on financial asset flows (less common today in Europe
and U.S.)
Restrictions on the activities of multinational corporations
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2.1 Labor migration To show the effects of labor migration
(mobility), lets build a simple model with
only one composite good called output. Suppose that there are only two important
factors of production: land and labor.
On a fixed parcel of land, the productivity ofworkers eventually diminishes as eachworks more hours and as more workersproduce on that fixed parcel of land.
Fig. 1 The Marginal Product of Labor
The marginalproductivity of laboreventually decreases.
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International Labor Mobility(cont.)
Workers in the domestic country have an incentive to move tothe foreign country until the purchasing power of wagesbetween the countries are equal.
Emigration from the domestic country raises real wages ofthe remaining workers there.
It increases the supply of labor services and decreases thereal wage in the foreign country.
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Fig. 5-2: Causes and Effects ofInternational Labor Mobility
Labor migration between thedomestic country and theforeign country is also predictedto increase the value of worldoutput.
The value of foreign output
rises by the area under itsMPL* curve from OL1 toOL2
The value of domesticoutput falls by the areaunder its MPL curve fromOL2
toOL1
The value of world output
is maximized when themarginal productivity oflabor is the same acrosscountries.
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International Labor Mobility(cont.)
The Heckscher-Ohlin model predicts that trade in goods is an alternative to factormobility.
Services from factors of production are embodied in goods, so that the
value of goods reflects the value or productivity of the factors of production
that produced them. But equalization of factor prices with labor mobility does
not really occur for reasons that are similar to the reasons given in theHeckscher-Ohlin model:
The model assumes that trading countries produce the same goods, butcountries may produce different goods so that marginal productivities of laborare not comparable.
The model assumes that trading countries have the same technology, butdifferent technologies could affect the productivities of factors and thereforethe wages and income paid to these factors.
Barriers to immigration and emigration and transportation costs may prevent
the purchasing power of wages from equalizing. Barriers to movements forother factors of production, like land and capital, are also important.
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2.2 International Borrowing andLending
International capital mobility refers to mobility of financial assets, orcapital, across countries. Financial capital is a source of funds used to build physical capital
(ex., factories and equipment). International capital mobility can be interpreted as intertemporal
trade: trade of goods consumed today by borrowers in return for goods
consumed in the future by lenders. For any economy, there is a trade-off (opportunity cost) between consuming
today and saving for the future: resources can either be consumed or saved. To save and invest more today typically means that economies need to
consume less today. We represent this concept by drawing a special kind of production possibility
frontier, an intertemporal production possibility frontier.
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International Borrowing andLending (cont.)
Suppose that the domestic country has a comparative advantage in(bias towards) current consumption, while the foreign country has acomparative advantage (bias towards) future consumption.
In the absence of international borrowing and lending, the relative price
of current consumption should be lower in the domestic country. But what is the relative price of current consumption?
The price of borrowing 1 unit of output/income to consume today is theoutput/income that needs to be repaid in the future:
principal + interest = 1+r, where ris the interest rate
The price of current consumption relative to future consumption is 1/(1+r)
The opportunity cost of consuming 1 unit of output/ income today is theoutput/income that could be earned by saving it:
principal + interest = 1+r, where ris the interest rate
The opportunity cost of current consumption relative to future
consumption is 1/(1+r)
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3. FOCUS ON MANAGERIAL
IMPLICATIONS
The conditions in the nation governing how companies are created,organized, and managed, and the nature of domestic rivalry impacts firmcompetitiveness
There are at least three main implications for international businesses:
location implications, first-mover implications, and policy implications.
Location
One way in which the material discussed in this chapter matters to aninternational business is the link between the theories and a firmsdecision about where to locate its productive activities
It makes sense for a firm to disperse its various productive activities tothose countries where they can be performed most efficiently
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First Mover AdvantagesBeing a first mover can have important competitive implications,
especially if there are economies of scale and the global industry willonly support a few competitors
Government policies with respect to free trade or protecting domesticindustries can significantly impact global competitiveness
Businesses should work to encourage governmental policies thatsupport free trade
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4. A test for international trade theory
Destination WorldNorth
America
South andCentral
AmericaEurope
CIS AfricaMiddleEast
Asia
Origin
World 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0North America 13.0 37.5 28.3 5.5 3.1 7.3 9.7 9.6
South and Central
America 3.8 6.2 27.2 1.8 1.7 3.7 1.9 2.6
Europe 41.0 17.6 16.6 69.7 46.4 40.5 30.5 12.5
Commonwealth of
Independent States
(CIS) 4.5 1.3 1.7 6.0 26.1 2.3 4.0 2.0
Africa 3.5 4.5 3.2 3.2 0.3 11.7 2.3 2.9
Middle East 6.5 4.3 1.2 1.9 1.4 8.0 19.8 14.6
Asia 27.7 28.6 21.9 11.9 21.0 26.5 31.8 55.9
Shares of regional trade flows in world merchandise exports, 2008 (Percentage)
World merchandise exports by region and
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World merchandise exports by region andselected economy (Billion dollars andpercentage)
1948 1953 1963 1973 1983 1993 2003 2008
Value
World 59 84 157 579 1838 3676 7377 15717
Share
World 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0United States 21.7 18.8 14.9 12.3 11.2 12.6 9.8 8.2
South and Central America 11.3 9.7 6.4 4.3 4.4 3.0 3.0 3.8
Brazil 2.0 1.8 0.9 1.1 1.2 1.0 1.0 1.3
Europe 35.1 39.4 47.8 50.9 43.5 45.4 45.9 41.0
Commonwealth of Independent States
(CIS) b - - - - - - 2.6 4.5
Asia 14.0 13.4 12.5 14.9 19.1 26.1 26.2 27.7
China 0.9 1.2 1.3 1.0 1.2 2.5 5.9 9.1
Japan 0.4 1.5 3.5 6.4 8.0 9.9 6.4 5.0
India 2.2 1.3 1.0 0.5 0.5 0.6 0.8 1.1
Six East Asian traders 3.4 3.0 2.4 3.4 5.8 9.7 9.6 9.0
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Leading exporters and importers in world
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Leading exporters and importers in worldmerchandise trade, 2008 (Billion dollars andpercentage)
Rank Importers Value Share
Annual
percentag
e change
1 United
States
2169.5 13.2 7
2 Germany 1203.8 7.3 14
3 China 1132.5 6.9 18
4 Japan 762.6 4.6 23
5 France 705.6 4.3 14
6 United
Kingdom
632.0 3.8 1
7Netherlands
573.2 3.5 16
8 Italy 554.9 3.4 8
9 Belgium 469.5 2.9 14
10 Korea,
Republic of
435.3 2.7 22
Rank Exporters Value Share
Annual
percentag
e change
1 Germany 1461.9 9.1 11
2 China 1428.3 8.9 17
3 United States 1287.4 8.0 124 Japan 782.0 4.9 9
5 Netherlands 633.0 3.9 15
6 France 605.4 3.8 10
7 Italy 538.0 3.3 8
8 Belgium 475.6 3.0 10
9
Russian
Federatio
n 471.6 2.9 33
10
United
Kingdom 458.6 2.9 4
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Exports in commercial services of selectedeconomies by origin and destination, 2007
Value Share Annual percentage change
07 07 04-07 06 07World 1586629 100.0 14 13 21
European Union (27) 918349 57.9 14 13 20
United States 186557 11.8 10 11 14
Japan 26376 1.7 5 -4 14
Russian Federation 25930 1.6 32 20 43
China 24001 1.5 30 9 45
Singapore 15491 1.0 19 24 19
Australia 14617 0.9 19 10 28
India 12754 0.8 42 38 45
Hong Kong, China 11218 0.7 9 -15 28
Korea, Republic of 9804 0.6 13 16 16
Brazil 8693 0.5 24 15 33
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Leading importers in world trade in commercialservices (excluding intra-EU (27) trade), 2008
Rank Importers Value Share
Annual percentage
change
1 Extra-EU (27) imports 620.7 23.9 13
2 United States 367.9 14.2 8
3 Japan 167.4 6.4 13
4 China 158.0 6.1 22
5 Korea, Republic of 91.8 3.5 12
6 Canada 86.6 3.3 6
7 India 83.6 3.2 18
8 Singapore 78.9 3.0 6
9 Russian Federation 74.6 2.9 29
10 Thailand 46.3 1.8 21
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Leading exporters in world trade in commercialservices (excluding intra-EU (27) trade), 2008
Rank Exporters Value Share
Annual percentage
change
1 Extra-EU (27) exports 743.2 26.9 11
2 United States 521.4 18.8 103 China 146.4 5.3 20
4 Japan 146.4 5.3 15
5 India 102.6 3.7 17
6 Hong Kong, China 92.3 3.3 9
7 Singapore 82.9 3.0 3
8 Switzerland 75.2 2.7 16
9 Korea, Republic of 74.1 2.7 20
10 Canada 64.8 2.3 2
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Exports of the United States by origin and
destination, 2008
Destination Value Share
Annual percentage
change
2008 2000 2008 2007 2008
World 1287.4 100.0 100.0 12 12
North America 413.2 37.0 32.1 6 7Asia 329.4 27.6 25.6 11 8
Europe 311.1 23.6 24.2 16 14
South and Central
America 135.0 7.5 10.5 21 28
Middle East 55.0 2.4 4.3 21 22
Africa 28.8 1.4 2.2 28 20
CIS 13.8 0.4 1.1 49 32
European Union (27) 271.8 21.6 21.1 15 11
Canada 260.9 22.6 20.3 8 5
Mexico 151.2 14.3 11.7 2 11
China 69.7 2.1 5.4 17 11Ja an 65.1 8.4 5.1 5 7
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Imports of the United States by origin anddestination, 2008
Origin Value Share Annual percentage change
2008 2000 2008 2007 2008
World 2169.5 100.0 100.0 5 7
Asia 762.4 37.8 35.1 5 1
North America 559.0 29.4 25.8 5 5
Europe 409.6 20.3 18.9 6 4
South and Central America 167.4 6.2 7.7 1 18
Africa 117.3 2.3 5.4 14 23
Middle East 115.3 3.2 5.3 8 44
CIS 38.5 0.8 1.8 5 45European Union (27) 377.9 18.7 17.4 7 4
China 356.6 8.5 16.4 11 5
Canada 339.1 18.5 15.6 3 7
Mexico 218.6 10.9 10.1 6 3
Japan 143.6 12.0 6.6 -2 -4
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Exports and imports of China:2004-2008
Items 2008 2007 2006 2005 2004
The value of
Exports and
imports(1000
us$)
2,561,600,00
0.00
2,173,726,01
7.00
1,760,396,00
0.00
1,421,910,00
0.00
1,154,550,00
0.00
The value of
Exports (1000
us$)
1,428,500,00
0.00
1,217,775,75
6.01
968,935,601.
01
761,953,000.
00
593,326,000.
00
The value of
imports(1000
us$)
1,133,100,000.00
955,950,261.33
791,460,867.85
659,953,000.00
561,229,000.00
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Main indicators of China (units%)
Indicator 1978 1980 1990 2000 2005 2006 2007
Population 22.3 22.1 21.6 20.8 20.2 20.1 20.0
Gross Domestic Product 1.75 1.72 1.62 3.75 4.98 5.47 6.04
Foreign Trade Total 0.79 0.93 1.65 3.60 6.66 7.18 7.73
Exports 0.76 0.89 1.80 3.86 7.27 8.00 8.76
Imports 0.82 0.96 1.50 3.35 6.08 6.37 6.73
Foreign Direct Investment 0.11 1.68 2.91 7.55 5.15 4.56
Rice, Paddy 36.35 36.00 36.95 31.69 28.81 28.59 28.70
Wheat 12.13 12.54 16.58 17.00 15.55 17.46 18.10
Maize14.24 15.81 20.11 17.92 19.49 20.82 19.36
Soybeans 10.09 9.83 10.15 9.55 7.63 6.97 7.22
Source: FAO Database; UNSD Database; World Bank Database; IMF
The share of high technology to
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The share of high technology toexports
Country or Area 1990 2000 2003 2004 2005 2006
World 15.9 23.0 21.0 20.9 20.9 20.5High Income 17.2 24.1 21.5 21.5 21.7 20.6
Middle Income 19.5 20.1 19.4 19.0 20.4
Low Income 3.9 3.9
China 18.6 27.1 29.8 30.6 30.3
Hong Kong, China 23.3 12.7 14.3 15.6 11.3India 2.4 5.0 4.8 4.9 4.8
Indonesia 1.2 16.2 14.5 16.1 16.3 13.2
Japan 23.8 28.3 24.1 23.7 22.5 21.6
Korea, Rep. 17.8 34.8 32.1 32.8 32.3 32.0
Malaysia 38.2
59.5
58.9
55.6
54.7
53.8
Pakistan 0.1 0.4 1.3 1.1 1.4 1.4
Philippines 72.6 73.6 72.6 70.7 67.6
Singapore 39.7 62.6 56.3 56.6 56.6 57.8
Thailand 20.7 33.3 30.2 28.1 26.6 27.3
Viet Nam 11.0
5.6
4.5
5.3
United States 33.0 33.5 30.7 30.2 29.9 30.1
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Exchange Rate in 2009
Item 01 02 03 04 05 06 07 08 09
10.20 10.03 10.22 10.22 10.58 10.60 10.61 10.69 10.82Yuan per SDR
( End ofPeriod )
6.84 6.84 6.84 6.82 6.83 6.83 6.83 6.83 6.83Yuan per USDollar
( End ofPeriod )
Yuan per US
Dollar
( Period
Average )6.84 6.84 6.83 6.83 6.82 6.83 6.83 6.83 6.83
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