Introduction International Trade Theory

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Learning Outcomes:

• Acquaint yourself with various theories propounded byvarious experts in the field of international trade sharingtheir views and experiences by way of theories.

• Theories also help people in the trade to implement them inpractical scenario and finding ways and solutions to day today problems faced in working.

Case Study

The Gains From Trade Ghana And South KoreaLiving standards in Ghana and South Korea were roughlycomparable in 1970. Ghana’s 1970 gross national product(GNP) per head was $250, and South Korea’s was $260. By1998 the situation had changed dramatically. South Korea had aGNP per head of $8,600 and boasted the world’s 12th largesteconomy. Ghana’s GNP per capita in 1998 was only $390, whileits economy ranked 96 in the world. These differences ineconomic circumstances were due to vastly different economicgrowth rates since 1970. Between 1968 and 1998, the averageannual growth rate in Ghana’s GNP was less than 1.5 percent.In South Korea achieved a rate of more than 8 percent -annuallybetween 1968 and 1998.While no simple explanation addresses the difference growthrates between Ghana and South Korea, part of the answer maybe found in the countries’ attitudes to ward- international trade.A now classic study by the World suggests that whereas theSouth Korean government implemented policies that encour-aged companies engage in international trade, the actions of theGhanaian- government. Discouraged domestic producers frombecoming involved in international trade. As a conse-quence, in1980 trade accounted for 18. Percent of Ghana’s GNP by valuecompared to 74 percent of South’s GNP.In1957, Ghana became the first of Great Britain’s West Africancolonies to gain independence. Its first president, KwameNkrumah, influenced the rest of the continent with his theoriesof pan-African socialism. For Ghana this meant the impositionof high tariffs on many imports, an import substitution policyaimed at fostering Ghana self- sufficiency in certain manufac-tured goods, and the adop-tion of policies that discouragedGhana’s enterprises from engaging in exports. The results werean unmitigated disaster that transformed one of Africa’s mostprosperous is into one of the worlds poorest.As an illustration of how Ghana’s antitrade policies destroyedthe Ghanaian economy, consider the Ghanaian, government’sinvolvement in the cocoa trade. A combination- of favorableclimate, good soils, and ready access -to the world shippingroutes has given Ghana an absolute advantage in cocoaproduction. Quite simply, it is one of the best places in theWorld to grow cocoa. As a conse-quence, Ghana was the world’slargest producer and ex-porter of cocoa in 1957. Then thegovernment of the newly independent nation created a state-

LESSON 2INTRODUCTION INTERNATIONAL TRADE THEORY

controlled co-coa marketing board. The board was given theauthority to fix prices for cocoa and was designated the solebuyer of all cocoa grown in Ghana. The board held down theprices that it paid farmers for cocoa, while selling the co-coa thatit bought from them on the world market at world prices.Thus, it might buy cocoa from farmers at 25 cents. A poundand sell it on the world market for the world price of 50 cents apound. In effect, the board was taxing exports by payingfarmers considerably less for their cocoa than it was worth onthe world market and money was used to fund the governmentpolicy of nationalization and industrialization.One result of the cocoa policy was that between 1963 and 1979the price paid by the cocoa marketing board to Ghana’s farmersincreased by a factor of 6, while the price of consumer goods inGhana increased by factor of 22, and while the price of cocoa inneighboring countries in-creased by a factor of 22,and while theprice of cocoa in neighboring countries in creased by a factor of36! In real terms, the Ghanaian farm-ers were paid less every yearfor their cocoa by the cocoa marketing board, while the worldprice increased signifi-cantly. Ghana’s farmers responded byswitching to the production of subsistence foodstuffs thatcould be sold within Ghana, and the country’s production andexports of cocoa plummeted by more than one-third in sevenyears. At the same time, the Ghanaian government’s attempt tobuild an industrial base through state-run enterprises was acomplete failure. The resulting drop in Ghana’s export earningsplunged the country into recession, led to a de-cline in itsforeign currency reserves, and severely limited its ability to payfor necessary imports.In essence, what happened in Ghana is that the inward orientedtrade policy of the Ghanaian government resulted in a shift ofthat country’s resources away from the profitable activity ofgrowing cocoa-where it had an ab-solute advantage in the worldeconomy and toward growing subsistence foods and manufac-turing, where it had no advantage. This inefficient use of thecountry’s resources severely damaged the Ghanaian economyand held back the country’s economic developmentIn contrast, consider the trade policy adopted by the SouthKorean government. The World Bank has characterized thetrade policy of South Korea as “strongly outward oriented.”Unlike in Ghana, the policies of the South Korean governmentemphasize low import barriers on manufactured goods (butnot on agricultural goods) and incen-tives to encourage SouthKorean firms to export. Beginning in the late 1950s, the South -Korean government progressively reduced import tariffs froman average of 60 percent -of the price of an imported good toless than 20 percent in the mid-1980s. On most nonagriculturalgoods, import tariffs were reduced to zero. In addition, thenumber of -imported goods subjected to quotas was reducedfrom more than 90 percent in the late 19505 to zero by the early1980s. Over the same period, South Korea progressively

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reduced the subsidies given to South Korean exporters from anaverage of 80 percent of their sales price in the late 1950s to anaverage of less than 20 percent of their sales price in 1965 anddown to zero in 1984. Put another way, with the exception ofthe agricultural sector (where a strong farm lobby maintainedimport controls), South Korea moved progressively toward afree trade stance.South Korea’s outward-looking orientation has been rewardedby a dramatic transformation of its economy. Initially, SouthKorea’s resources shifted from agriculture to the manufactureof labor-intensive goods, especially textiles, clothing, andfootwear. An abundant supply of cheap but well-educatedlabor helped form the basis of South Korea’s comparativeadvantage in labor-intensive manufacturing. More recently, aslabor costs have risen, the growth areas in the economy havebeen in the more capita-in--tensive manufacturing sectors,especially motor vehicles, semiconductors, consumer electronics,and advanced materials. As a result of these developments,South Korea has gone through some dramatic changes. In thelate 1950s, 77 percent of the country’s employment was in theagricultural sector; today the figure is less than 20percent.Overthe same period the percentage of its GNP accounted for bymanufacturing in-creased from less than 10 percent to morethan 30 percent, while the overall GNP grew at an annual rate ofmore than 9 percent.Sources: “Poor Man’s Burden: A survey of the third World,“The economist, September 23, 1989;World Bank, WorldDevelopment report, 2000(Oxford: Oxford university press,2000s,) Table 1;J. Whalee, “international Trade, Distortions, andLong-Run Economic Growth, “International Monetary FundStaff Papers 40, no. 2 (June 1993), p. 299.

IntroductionThe opening case illustrates the gains that come from interna-tional trade. For a long time the economic policies of theeconomic policies of the Ghanaian government discouragedtrade with other nations. The result was a shift in Ghana’sresources away from productive uses (grow-ing cocoa) andtoward unproductive uses (subsistence agriculture). Theeconomic policies of the South Korean government encouragedtrade with other nations. ‘The result was a shift in SouthKorea’s resources away from uses where it had no compara-tiveadvantage in the world economy (agriculture) and toward moreproductive uses (labor-intensive manufacturing). As a directresult of their policies toward interna-tional trade, Ghana’seconomy declined while South Korea’s grew. This chapter hastwo goals that are related to the story of Ghana and SouthKorea. The first is to review a number of theories that explainwhy it is beneficial for a country to engage in international trade.The second goal is to explain the pattern of in-ternational tradethat we observe in the world economy. With regard to thepattern of trade, we will be primarily concerned with explainingthe pattern of exports and im-ports of products betweencountries. We will not be concerned with the pattern of for-eigndirect investment between countries.

An Overview of Trade TheoryWe open this chapter with a discussion of mercantilism.Propagated in the 16th and 17th centuries, mercantilism

advocated that countries should simultaneously encourageexports and discourage imports. Although mercantilism is anold and largely discredited doctrine, its echoes remain in modempolitical debate and in the trade policies of many countries.Next we will look at Adam Smith’s theory of absolute advan-tage. Proposed in 1776, Smith’s theory was the first to explainwhy unrestricted free trade is beneficial to a country. Free traderefers to a situation where a government does not attempt toinfluence through quotas or duties what its citizens can buyfrom another country, or what they can produce and sell toanother country. Smith argued that the invisible hand of themarket mechanism, rather than government policy, shoulddeter- mine what a country imports and what it exports. Hisarguments imply that such laissez-faire stance toward trade wasin the best interests of a country. Building on sumit’s work aretwo additional theories that we shall review. One is the theoryof comparative advantage, advanced by the 19th centuryEnglish economist David Ricardo. This theory is the intellectualbasis of the modem argument for unrestricted free trade. In the20th century two Swedish economists, Eli Heckscher and BertilOhlin whose theory is known as the Heckscher-Ohlin theory,refined Ricardo’s work.

The Benefits of tradeThe great strength of the theories of Smith, Ricardo, andHeckscher-Ohlin is that they identify with precision the specificbenefits of international trade. Common sense suggests thatsome international trade is beneficial. For example, nobodywould suggest that Iceland should grow its own oranges.Iceland can benefit from trade by exchang-ing some of theproducts that it can produce at a low cost (fish) for someproducts that it cannot produce at all (oranges). Thus, byengaging in international trade, Icelanders are able to addoranges to their diet of fish.The theories of Smith, Ricardo, and Heckscher-Ohlin gobeyond this commonsense notion, however, to show why it isbeneficial for a country to engage in international trade even forproducts it is able to produce for itself. This is a difficult conceptfor people to grasp. For example, many people in the UnitedStates believe that American consumers should buy productsproduced in the-United States by American companies when-ever possible to help save American jobs from foreigncompetition. Such thinking apparently underlay a 1997 decisionby the International Trade Commission to protect the Louisi-ana crawfish industry from inexpensive Chinese imports (seethe companying Country Focus).The same kind of nationalistic sentiments can be observed inmany other countries. However, the theories of Smith, Ricardo,and Heckscher-Ohlin tell us that a country’s. Economy may gainif its citizens buy certain products from other nations that couldbe produced at home. The gains arise because internationaltrade allows a country to spe-cialize in the manufacture andexport of products that can be produced most efficiently in thatcountry, while importing products that can be produced moreefficiently in other countries. So it may make sense for theUnited States to specialize in the production and export ofcommercial jet aircraft, since the efficient production of com-mercial jet aircraft requires resources that are abundant in theUnited States, such as a highly skilled labor force and cutting-


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Tedge technological know-how. On the other hand, it may makesense for the United States to import textiles from India sincethe efficient production of textiles requires a relatively cheaplabor force-and cheap lab-or is not abundant in the UnitedStates.Of course, this economic argument is often difficult forsegments of a country’s pop-ulation to accept. With their futurethreatened by imports, American textile companies and theiremployees have tried hard to persuade the U.S. government tolimit the importation of textiles by demanding quotas andtariffs. Similarly, as the Country Fo-cus illustrates, with theirfuture threatened by imports, the Louisiana crawfish indus-trysucceeded in persuading the government to limit imports ofcrawfish from China. Although such import controls maybenefit particular groups, such as American tex-tile businessesand their employees or Louisiana crawfish farmers, the theoriesof Smith, Ricardo, and Heckscher-Ohlin suggest that theeconomy as a whole is hurt by this kind of action. Limits onimports are often in the interests of domestic producers, butnot domestic consumers.

Case study

Crawfish WarsOnce upon a time, Louisiana was owned by the French.Napoleon sold the territory to the United States, when ThomasJefferson was president, but many of the French stayed on,over time, their descendants developed the distinctive Cajunculture that today is cele-brated in the United States for itsunique cuisine and -music. At the heart of that cuisine can befound the venerable crawfish, as Louisianans call the crayfish.The crawfish is a fresh-water crustacean native to the bayous ofLouisiana. A central ingredient of crawfish pie, bisque, etouffee,and gumbo, the craw-fish is to Cajun Louisiana what wine is toFrance: a symbol of culinary symbol of its culture. It is also amajor industry that -generates $300 million per year in revenuesfor Louisiana crawfish farmers-or at least it did until the Chineseappeared.In the early 1990s, development of the Chinese industry wasencouraged by Louisiana importers to meet the growingdemand for crawfish. In China, the crawfish industry proved tobe attractive for entrepreneurial farmers. Chinese crawfish firststarted to appear on the Louisiana scene in 1991. Although old-time Cajuns were quick to claim that the Chinese crawfish had amarkedly inferior taste, consumers didn’t seem, to notice thedifference. More importantly perhaps, they liked the price, whichran between $2 and $3 per pound depending on the season,compared to $5 to $8 per pound for native Louisiana crawfish.With the significant price advantage, sales of Chinese importsskyrocketed - from 353,000pounds in 1992 to 5.5 millionpounds in 1996. By 1996, Louisiana state officials estimated th-at 3,000 jobs had been lost in the local indus-try mostlyminimum-wage crawfish peelers, due to markets share gainsmade by the Chinese.This was too much for the Louisiana industry to stomach. In1996, Louisiana’s Crawfish Promotion and research board fileda petition with the International trade Commission, an arm ofthe U.S. government, requesting an antidumping action. The

petition claimed that Chinese crawfish producers dumping theirproduct; selling at below cost to drive Louisiana producers outof business, the industry requested that a 200 percent to 300percent import tax be placed on Chinese crawfish. The State ofLouisiana appropriated $350,000 from state funds to supportthe action.Lawyer representing the Chinese crawfish in-dustry claimed thatlower production costs in China were the reason for the lowprices-not dumping. One Louisiana-based importer of Chinesecrawfish pointed out that 27 processing plants in Chinasupplied his company. Workers at these plants were givenhousing and other amenities and paid 15 cents per hour, or $9for a 60-hour week. The lawyers also said Chinese crawfish havebeen I good for American consumers, who have saved moneyand benefited from a steadier supply, and good for Louisianacuisine, because it is has be-come less expensive to cock. Thelawyers pointed out that the action was not in the interests ofAmer-ican consumers, since it was nothing more than anattempt by Louisiana producers to reestablish their lucrativemonopoly on the production of crawfish, a monopoly thatwould enable them to extract higher prices from consumers.However, the International Trade Commission was deaf tosuch arguments. The commission deemed that China was a“nonmarket economy” since it was not yet a member of theWorld Trade organization (something that changed in 2001).The commission then used prices in a “market econ-omy,”Spain, to establish a benchmark for a “fair market value” forcrawfish. Since Spanish crawfish sell for approximately twice theprice of Chinese crawfish and about the same price as Louisianacrawfish, the commission concluded that the Chi-nese weredumping (selling below cost of production). In August1997,the commission levied a 110 to 123 percent duty onimports of Chinese crawfish, effectively negating the priceadvantage enjoy by Chinese producers. In the interests ofprotecting American jobs, the commission sided with Louisianaproducers and against American consumers, who would nowhave to pay higher prices for crawfish. Under commissionregulations, the ruling would stay place for five years, after whichthe legitimacy of import duty must be reevaluated.

The pattern of international tradeThe theories of Smith, Ricardo, and Heckscher-Ohlin also helpto explain the pattern of international trade that we observe inthe world economy. Some aspects of the pattern are easy tounderstand. Climate and natural resource endowments explainwhy Ghana exports cocoa, Brazil exports coffee, Saudi Arabiaexports oil, and China exports crawfish. But much of theobserved pattern of international trade is more difficult toexplain. For example, why does Japan export automobiles,consumer electronics, and machine tools? Why does Switzer-land export chemicals, watches, and jewelry? David Ricardo’stheory of comparative advantage offers an explanation in termsof international differences in labor productivity. The moresophisticated Heckscher-Ohlin theory emphasizes the interplaybetween the, proportions in which the factors of production(such as land, labor, and capita) are available in differentcountries and the proportions in which they are needed forproducing particular goods. This explanation rests on the


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assumption that countries have varying endowments of mevarious factors of production. Tests of this theory, however,suggest that it is a less powerful explanation of real-world tradepatterns than once thought. -One early response to the failure of the Heckscher-Ohlin theoryto explain the ob-served pattern of international trade-was theproduct life-cycle theory. “Proposed by Ray-mond Vernon, thistheory suggests that early in their life cycle, most new productsare produced in and exported from the country in which theywere developed. As a new product becomes widely acceptedinternationally, however, production starts in other countries.As a result, the theory suggests, the product may ultimately beexported back to the country of its original innovation.In a similar vein, during the 1980s economists such as PaulKrugman of. Massa-chusetts Institute of Technology devel-oped what has come to be known as the new trade theory. Newtrade theory stresses that in some cases countries specialize in.the production and export of particular products not becauseof underlying differences in factor endowments, but because incertain industries the world market can support only a limitednumber of firms. (This is argued to be the case for the com-mercial air-craft industry.) In, such industries, firms that enterthe market first are able to build a competitive advantage that issubsequently difficult to challenge. Thus, the observed patternof trade between nations may be due in part to the ability offirms within a given nation to capture first-mover advantages.The United States dominates in, the export of commercial jetaircraft because American firms such as Boeing were first moversin .the world market. Boeing built a competitive advantage thathas subsequently been difficult for firms from countries withequally favorable factor endow-ments to challenge.In a work related to the new trade theory, Michael Porter of theHarvard Business School developed a theory, referred to, as thetheory of nation competitive advantage that attempts to explainwhy particular nations achieve international success in particularindustries. Like the new trade theorists, in addition to factorendowments, Porter points out the importance of countryfactors such as domestic demand and do-mestic rivalry inexplaining a nation’s dominance in the production and exportof particular products.

The Theory and Government PolicyAlthough all these theories agree that international trade isbeneficial to, a country, they lack agreement in their recommen-dations for government policy. Mercantilism makes a crude casefor government involvement in promoting exports andlimiting imports. The theories of Smith, Ricardo, andHeckscher-Ohlin form part of the case for unrestricted freetrade. The argument for unrestricted free trade is that bothimport controls and export incentives (such as subsidies) areself-defeating and result In wasted resources. Both the newtrade theory and Porter’s theory of national competi-tiveadvantage can be interpreted as justifying some limited govern-ment intervention to support the development of certainexport-oriented industries.

MercantilismThe first theory of international trade emerged in England inthe mid-16th century. Referred to as mercantilism, its principle

assertion was gold and silver were the mainstays of nationalwealth and essential to vigorous commerce. At that time, goldand silver were the currency of trade between countries; acountry could earn gold and silver by exporting goods. By thesame token, importing goods from other countries. The maintenet of mercantilism was that it was in a country’s to maintaina trade surplus, to export more than it imported. By doing so, acountry would accumulate gold and silver and, consequently,increase its national wealth and prestige. As the Englishmercantilist writer Thomas Mun put it in 1630.The ordinary means therefore to increase our wealth andtreasure is by foreign tread, where we must ever observe thisrule: to sell more to strangers yearly than we consume of theirsin value.Consistent with this belief, the mercantilist doctrine advocatedgovernment intervention to achieve a surplus in the balance oftrade. The mercantilists saw no virtue in a large volume of tradeper se. Rather, they recommended policies to maximize exportsand minimize imports. To achieve this, imports were limited bytariffs and quotas, while exports were subsidized.The classical economist David Hume pointed out an inherentinconsistency in the mercantilist doctrine in 1752. According toHume, if England had a balance-of-trade surplus with France(it exported more than it imported) the resulting inflow ofgold and silver would swell the domestic money supply andgenerated inflation in England. In France, however the outflowof gold and silver would have the opposite effect. France’smoney supply would contract, and its prices would fall. Thischange in relative prices between France and England wouldencourage the France to buy fewer English goods (because theywere becoming more expensive) and the English to buy moreFranch goods. The result would be deterioration in the Englishbalance of trade and an improvement in France’s trade balance,until the English surplus was elim-inated. Hence, according toHume, in the long run no country could sustain a surplus ODthe balance of trade and so accumulate gold and silver as themercantilists had envisaged.The flaw with mercantilism was that it viewed trade as a zerogame. (A zero-sum game is one in which a gain by one countryresults in a loss by another.) It was left to Adam Smith andDavid Ricardo to show the shortsightedness of this approachand to demon-strate that trade is a positive sum game, or asituation in which all countries can benefit. The mercantilistdoctrine is by no means dead. For example, Jarl Hagelstam, adirector at the Finnish Ministry of Finance, has observed that inmost trade negotiations:The approach of individual negotiating countries, bothindustrialized and developing has been to press for tradeliberalization in areas where their own comparative competitiveadvantages are. The strongest, and to resist liberalization inareas where they are less competitive and fear that importsWould replace domestic production.Hagelstam attributes this strategy by negotiating countries to aneomercantilist belief held by the politicians of many nations.This belief equates political power with economic power andeconomic power with a balance-of-trade surplus; Thus, the


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Ttrade strategy of many nations is designed to simultaneouslyboost exports and limit imports.

Absolute advantageIn his 1776 landmark book The Wealth of Nations, AdamSmith attacked the mercan-tilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability toproduce goods efficiently. In his time, the English, by virtue oftheir superior manufacturing processes, were the world’s mostefficient textile manufacturers. Due to the combination offavorable climate, good soils, and accumulated expertise, theFrench had the world’s most efficient wine industry. TheEnglish had an absolute advantage in the production oftextiles, while the French had an absolute advantage in theproduction of wine. Thus, a country has an absolute advantagein the production of a product when it is more efficient thanany other country in producing it.According to Smith, countries should specialize in the produc-tion of goods for which they have an absolute advantage andthen trade these for goods produced by other countries. InSmith’s time, this suggested that the English should specializein the production of textiles while the French should specializein the production of wine. England could get all the wine itneeded by selling its textiles to France and buy-ing wine inexchange. Similarly, France could get all the textiles it needed byselling wine to England and buying textiles in exchange. Smith’sbasic argument, therefore, is that you should never producegoods at home that you can buy at a lower cost from othercountries. Smith demonstrates that by specializing in theproduction of goods in which each has an absolute advantage,both countries benefit by engaging in trade.Consider the effects of trade between Ghana and South Korea.The production of any good (output) requires resources(inputs) such as land, labor, and capital. Assume that Ghanaand South Korea both have the same amount of resources andthat these resources can be used to produce either rice or cocoa.Assume further that 200 units of resources are available in eachcountry. Imagine that in Ghana it takes 10 resources to produceone ton of cocoa and 20 resources to produce one ton of rice.Thus, Ghana could produce 20 tons of cocoa and no rice, 10tons of rice and no cocoa, or some combination of rice and co-coa between these two extremes. The different combinationsthat Ghana could produce are represented by the line GG’ inFigure 2.1. This is referred to as Ghana’s production possibilityfrontier (PPF). Similarly, imagine that in South Korea it takes 40resources to produce one ton of cocoa and 10 resources toproduce one ton of rice. Thus, South Ko-rea could produce 5tons of cocoa and no rice, 20 tons of rice and no cocoa, or somecom-bination between these two extremes. The differentcombinations available to South Korea are represented by theline KK’ in Figure 2.1, which is South Korea’s PPF. Clearly,Ghana has an absolute advantage in the production of cocoa.(More resources are needed to produce a ton of cocoa in SouthKorea than in Ghana.) By the same token, South Ko-rea has anabsolute advantage in the production of rice.Now consider a situation in which neither country trades withany other. Each country devotes half of its resources to theproduction of rice and half to the produc-tion of cocoa. Each

country must also consume what it produces. Ghana would beable to produce 10 tons of cocoa and 5 tons of rice (point A inFigure 2.1), while South Ko-rea would be able to produce 10tons of rice and 2.5 tons of cocoa. Without trade, the com-bined production of both countries would be 12.5 tons ofcocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15tons of rice (5 tons in Ghana and 10 tons in South Korea). Ifeach country were to specialize in producing the good for whichit had an absolute advantage and then trade with the other forthe good it lacks, Ghana could produce 20 tons of cocoa, andSouth Korea could produce 20 tons of rice. Thus, by specializ-ing, the production of both goods could be increased.Production of cocoa would increase from 12.5 tons to 20 tons,while production of rice would increase from 15 tons to 20tons. The increase in production that would result fromspecialization is therefore 7.5 tons of cocoa and 5 tons of rice.Table 2.1 summarizes these figures.

20 G 15 Figure 2.1 The theory of Advantage 10 A 5 K B 2.5 K1 0 5 10 15 20 Rice

Coc

oa

Table 2.1Absolute Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of cocoa and riceCocoa Rice

Ghana 10 20South Korea 40 10

Production and Consumption without TreadCocoa Rice

Ghana 10.0 5.0South Korea 2.5 10.0Total production 12.5 15.0

Production with specializationCocoa Rice

Ghana 20 0.0South Korea 0.0 20.0Total production 20.0 20.0

Consumption After Ghana Trades 6 Tons ofCocoa for 6 Tons of South Korean Rice

Cocoa RiceGhana 14.0 6.0South Korea 6.0 14.0


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Increase in Consumption as a Resultof Specialization and Trade

Cocoa RiceGhana 4.0 1.0South Korea 3.5 4.0By engaging in trade and swapping one ton of cocoa for oneton of rice, producers in both countries could consume moreof both cocoa and rice. Imagine that Ghana and South Koreaswap cocoa and rice on a one-to-one basis; that is, the price ofone ton of cocoa is equal to the price of one ton of rice. IfGhana decided to export 6 tons of co-coa to South Korea andimport 6 tons of rice in return, its final consumption after tradewould be 14 tons of cocoa and 6 tons of rice. This is 4 tonsmore cocoa than it could have consumed before specializationand trade and 1 ton more rice. Similarly, South Korea’s finalconsumption after trade would be 6 tons of cocoa and 14 tonsof rice. This is 3.5 tons more cocoa than it could have con-sumed before specialization and trade and 4 tons more rice.Thus, as a result of specialization and trade, output of bothcocoa and rice would be increased, and consumers in bothnations would be able to consume more. Thus, we can see thattrade is a positive-sum game; it produces net gains for allinvolved.

Comparative AdvantageDavid Ricardo took Adam Smith’s theory one step further byexploring what might happen when one country has anabsolute advantage in the production of all goods. Smith’stheory of absolute advantage suggests that such a countrymight derive no ben-efits from international trade. In his 1817book Principles of Political Economy, Ricardo showed that thiswas not the case. According to Ricardo’s theory of comparativeadvantage, it makes sense for a country to specialize in theproduction of those goods that it produces most efficiently andto buy the goods that it produces less efficiently from othercountries, even if this means buying goods from othercountries that it could produce more efficiently itself. While thismay seem counterintuitive, the logic can be explained with asimple example.Assume that Ghana is more efficient in the production of bothcocoa and rice; that is Ghana has an absolute advantage in theproduction of both products. In Ghana it takes 10 resources toproduce one ton one ton of cocoa and, 13 1/3 resources toproduce one ton of rice. Thus, given its 200 units of resources,Ghana can produce 20 tons of cocoa and no rice, 15 tons of riceand no cocoa, or any combination in between on its PPF (theling GG’ in figure 2.2). In South Korea it takes 40 resources toproduce one ton of cocoa and 20 resources to produce one tonof rice. Thus South Korea can produce 5 tons of cocoa and norice, 10 tons of rice and no cocoa, or any combination on itsPPF (the link KK’ in figure 2.2). Again assume that withouttrade, each country uses half of its resources to produce rice andhalf to produce cocoa. Thus, without “trade, Ghana willproduce 10 tons of cocoa, and 7.5 tons of rice (point A inFigure 2.2), while South Ko-rea will produce 2.5 tons of cocoaand 5 tons of rice (point B in Figure2.2).

20 G C 15 Figure 2.2 The Theory of Comparative Advantage 10 A

5 B 2.5 K1 G1 0 3.75 5 7.5 10 15 20

Coc

oa

In light of Ghana’s absolute advantage in the production ofboth goods, why should it trade with South Korea? AlthoughGhana has an absolute advantage in the pro-duction of bothcocoa and rice, it has a comparative advantage only in theproduction of cocoa: Ghana can produce 4 times as much cocoaas South Korea, but only 1.5 times as much rice. Ghana iscomparatively more efficient at producing cocoa than it is atproducing rice.Without trade the combined production of cocoa will be 12.5tons (10 tons in Ghana and 2.5 in South Korea), and thecombined production of rice will also be 12.5 tons (7.5tons inGhana and 5 tons in South Korea). Without trade each countrymust consume what it produces. By engaging in trade, the twocountries can increase their combined production of rice andcocoa, and consumers in both nations can consume more ofboth goods.

The Gains from TradeImagine that Ghana exploits its comparative advantage in theproduction of cocoa to increase its output from 10 tons to 15tons. This uses up 150 units of resources, leaving the remain-ing50 units of resources to use in producing 3.75 tons of rice(point C in fig-ure 1.2). Meanwhile, South Korea specializes inthe production of rice, producing l0 tons. The combinedoutput of both cocoa and rice has now increased. Before special-ization, the combined output was 12.5 tons of cocoa and 12.5tons of rice. Now it is 15 tons of cocoa and 13.75 tons of rice(3.75 tons in Ghana and 10 tons in South Korea). The sourceof the increase in production is summarized in Table 2.2.Not only is output higher, but also both countries can nowbenefit from trade. If Ghana and South Korea swap cocoa andrice on a one-to-one basis, with both coun-tries choosing toexchange 4 tons of their export for 4 tons of the import, bothcoun-tries are able to consume more cocoa and rice than theycould before specialization and trade (see Table 2.2). Thus, ifGhana exchanges 4 tons of cocoa with South Korea for 4 tonsof rice, it is still left with 11 tons of rice, which is 1 ton morethan it had before trade. The 4 tons of rice it gets from SouthKorea in exchange for its 4 tons of cocoa, when added to the3.75 tons it now produces domestically, leaves it with a to-tal of7.75 tons of rice, which is 25 of a ton more than it had beforespecialization. Similarly, after swapping 4 tons of rice withGhana, South Korea still ends up with 6 tons office, which ismore than it had before specialization. In addition, the 4 tonsof cocoa it receives in exchange is 1.5 tons more than it pro-duced before trade. Thus, consumption of cocoa and rice canincrease in both countries as a result of specializa-tion and trade.


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TThe basic message of the theory of comparative advantage isthat potential’ world pro-duction is greater with unrestrictedfree trade than it is with restricted trade. Ricardo’s the-orysuggests that consumers in all nations can consume more ifthere are no restrictions on trade. This occurs even in countriesthat lack an absolute advantage in the pro-duction of any good.In other words, to an even greater degree than the theory of ab-solute advantage, the theory of comparative advantage suggeststhat trade is a positive-sum game in which all countries thatparticipate realize economic gains. As such, this theory pro-videsa strong rationale for encouraging free trade. So powerful isRicardo’s theory that it remains a major intellectual weapon forthose who argue for free trade.

Qualifications and AssumptionsThe conclusion that free trade Js universally beneficial is a ratherbold one to draw from such a simple model. Our simplemodel includes many unrealistic assumptions:1. We have assumed a simple world in which there are only two

countries and two goods. In the real world, there are manycountries and many goods.

Table 2.2Comparative Advantage and the Gains From Trade

Resources Required to Produce 1 Ton of Cocoa and RiceCocoa Rice

Ghana 10 13.33South Korea 40 20

Production and Consumption without TradeCocoa Rice


Production with specializationCocoa Rice


Consumption After Ghana Trades 4 Tons of Cocoafor 4 Tons of South Korean Rice

Cocoa RiceGhana 11.0 7.75South Korea - 4.0 6.0

Increase in Consumption as a Resultof Specialization and Trade

Cocoa RiceGhana 1.0 0.25South Korea 1.5 1.02. We have assumed away transportation costs between

countries.3. We have assumed away differences in the prices of resources

in different countries. We have said nothing about exchangerates, simply assuming that cocoa and rice could be swappedon a one-to-one basis.

4. We have assumed that resources can move freely from theproduction of one good to another within a country. Inreality, this is not always the case.

5. We have assumed constant returns to scale; that is, thatspecialization by Ghana or South Korea has no effect on theamount of resources required to produce one ton of cocoaor rice. In reality, both diminishing and increasing returns tospecialization exist. The amount of resources required toproduce a good might decrease or increase as a nationspecializes in production of that good.

6. We have assumed that each country has a fixed stock ofresources and that free trade does not change the efficiencywith which a country uses its resources. This staticassumption makes no allowances for the dynamic changes ina country’s stock of resources and in the efficiency with whichthe country uses its resources that might result from freetrade.

7. We have assumed away the effects of trade on incomedistribution within a country.

Given these assumptions, can the conclusion that free trade ismutually beneficial be extended to the real world of manycountries, many goods, positive transportation costs, volatileexchange rates, immobile domestic resources, nonconstantreturns to specialization, and dynamic changes? Although adetailed extension of the theory of comparative advantage isbeyond the scope of this book, economists have shown thatthe basic result derived from our simple model can be general-ized to a world composed of many countries producing manydifferent goods. Despite the shortcomings of the Ricardianmodel, research suggests that the basic proposition thatcountries will ex-port the goods that they are most efficient atproducing is borne out by the data. How-ever, once all theassumptions are dropped, the case for unrestricted free trade,while still positive, has been argued by some economistsassociated with the “new trade the-ory” to lose some of itsstrength.

Simple Extensions of the Ricardian ModelLet us explore the effect of relaxing three of the assumptionsidentified above in the simple comparative advantage model.Below we relax the assumption that resources move freely fromthe production of one good to another within a country, theassumption of constant returns to specialization, and theassumption that trade does not change a country’s stock ofresources or the efficiency with which those resources areutilized.

Immobile ResourcesIn our simple comparative model of Ghana and South Korea,we assumed that producers (farmers) could easily convert landfrom the production of cocoa to rice, and vice versa. While thisassumption may hold for some agricultural products, resourcesdo not always shift quite so easily from producing one good toanother. A certain amount of friction is involved. For example,embracing a free trade regime for an ad-vanced economy such asthe United States often implies that the country will produceless of some labor-intensive goods, such as textiles, and moreof some knowledge-in-tensive goods, such as computer


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software or biotechnology products. Although the country as awhole will gain from such a shift, textile producers will lose. Atextile worker in South Carolina is probably not qualified towrite software for Microsoft. Thus, the shift to free trade maymean that she becomes unemployed or has to accept anotherless attractive job, such as working at a fast-food restaurant, Foran example of how the shift toward free trade can impact anindividual enterprise and its employ-ees, look at the Manage-ment Focus profiling how the outdoor equipment cooperativeREI is adjusting its own production activities to deal with amove toward greater free trade in textiles in the U.S. economy.Resources do not always move easily from one economic activityto another. The process creates friction and human sufferingtoo. While the’ theory predicts that the benefits of free tradeoutweigh the costs by a significant margin, this is of coldcomfort to those who bear the costs. Accordingly, politicalopposition to the adoption of a free trade regime typicallycomes from those whose jobs are most at risk. In the UnitedStates, for example, textile workers and their unions have longopposed the move to-ward free trade precisely because thisgroup has much to lose from free trade Govern-ments oftenease the transition toward-free trade by helping to retrain thosewho lose their jobs as a result. The pain caused by the move-ment toward a free trade regime is a short-term phenomenon,while the gains from trade once the transition has been madeare both significant and enduring.

Diminishing ReturnsThe simple comparative advantage model developed aboveassumes constant returns to specialization. By constant returnsto specialization we mean the units of resources. Required toproduce a good (cocoa or rice) are assumed to remain constantno matter where one is on a country’s production possibilityfrontier (PPF). Thus, we assumed that it always took Ghana 10units of resources to produce one ton of cocoa. However, it ismore realistic to assume diminishing returns to specialization.Diminishing re-turns to specialization occurs when more unitsof resources are required to produce each additional unit. While10 units of resources may be sufficient to increase Ghana’soutput of cocoa from12 tons to 13 tons, 11 units of resourcesmay be needed to increase output from13 to 14 tons, 12 unitsof resources to increase output from 14 tons to 15 tons, and soon. Diminishing returns implies a convex PPF for Ghana (seefigure 2.3), rather than the straight line depicted in Figure 2.2.

Case study

Free Trade and REIRecreational Equipment Inc. (REI) is a buyer’s cooperative thathas grown into one of the major suppliers of outdoorequipment in the United States and has a rapidly growinginternational business. Started in Seattle in 1938 by LloydAnderson, the company provided high-quality climbing gear ata low price to members ‘of the cooperative, For its first 37 years,REI operated a single store in Seattle, but in 1975 the coopera-tive started opening stores in other cities. Today REI hasbecome a $621 million with 60 stores worldwide, 6,600employees revenue growth of 8 to 10 percent annually, and agoal of opening up three to five retail outlets per year. Despitethe growth, REI is still organized as a cooperative with 1.7

million active members. All members receive a dividend check atthe end of each year that amounts to, about 10 percent of valueof their purchases during the year (one does not have to be amember to shop at REI). REI also has one of the fastestgrowing, and most profitable, Internet sites in the retailindustry, which registered revenues of $412 million in 1999, up300 percent from a year earlier.To supply some of its own product need, REI has twosubsidiaries. One of these, Thaw, has been supplying REI witha range of gear, include tents, backpack, sleeping bags, andclothing, for 33 years. In recent years, Thaw has concentrated onproducing clothing items made out of fleece for REI’s stores.Unfortunately for thaw’s 200 employees, the economics ofmananufacturing garments in the United States have beenchang-ing for several years. Following passage of the NorthAmerican Free Trade Agreement (NAFTA) in 1993,all tariffs ontrade in textile garments between the United states and Mexicowere dropped (a tariff is a tax on imports). In the followingyears, an increasing number of textile operations shut down inthe United States and moved to Mexico, attracted by lower laborcosts. Wage rates for textile workers in Mexico run about $5' to$10 a day, compared to $8 to $10 an hour at Thaw’s opera-tion.For a labor-intensive operation such as garment production,these wage differentials are significant.Given these economics, in mid-2000 REI announced it wouldbe closing its Thaw subsidiary and sourcing its fleece productsfrom Mexico, by shifting its production to Mexico, REI expectsto reduce the cost of its fleece items by 20 percent. That meanslower prices for REI’s members and other customers andbigger profits for REI, which translates into larger dividendchecks, for REI’s members. It also means that its employees atthe thaw will be out of a job. To assist its former employees atThaw, REI has added funds to federal money to assist with jobretraining, unemployment benefits, and health insurance,The events at Thaw are being repeated across the country. Since1993, about 450,000 jobs have been lost in the U.S. garmentindustry as production has moved to low wage countries suchas Mexico, for-mer textile workers, most of whom are lowskilled, have found it difficult to find alternative full-time em-ployment. The department of Labor estimates that between1995and 1997, 58 percent of unemployed textile workers failedto find full-time jobs, while for the 42 percent that did, theiraverage wage dropped by some 20 percent. As painful as thishas been for textile workers, the American consumer has gainedfrom lower prices, and American companies in many otherindustries have seen their sales to Mexico boom as trade barriershave come down. Thus, while a strong case can be made thatNAFTA has benefited the majority of American and Mexicansalike, it has inflicted pain on some groups, such as U.S. textileworkers, and forces some companies, such as REI, to makedifficult managerial decisions.Sources: R. 1. Nelson, “REI’s Globalization,” Seattle Times,May 14, 2000, pp. D1, D2, and E Chabrow, “REI Gets HeadStart in Clicks and Mortar Race, “ Information Week, May 1,2000.


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G Figure 2.3 Ghana’s PPF under Diminishing Returns

Cocoa

G1 0 Rice

It is more realistic to assume diminishing returns for tworeasons. First, not all resources are of the same quality. As acountry tries to increase its output of a certain good, it isincreasingly likely to draw on more marginal resources whoseproductivity is not as great as those initially employed. Theresult is that it requires evermore resources to produce an equalincrease in output. For example, some land is more productivethan other land. As Ghana tries to expand its output of cocoa,it might have to utilize increasingly marginal land that is lessfertile than the land it originally used. As yields per acre decline,Ghana must use more land to produce one ton of cocoa.A second reason for diminishing returns is that different goodsuse resources in dif-ferent proportions. For example, imaginethat growing cocoa uses more land and lass labor than growingrice, and that Ghana tries to transfer resources from riceproduction to cocoa production. The rice industry will releaseproportionately too much labor and too little land for efficientcocoa production. To absorb the additional resources of laborand land, the cocoa industry will have to shift toward morelabor-intensive methods of production. The effect is that theefficiency with which the cocoa industry uses labor will decline,and returns will diminish.Diminishing returns show that it is not feasible for a country tospecialize to the degree suggested by the simple Ricardianmodel outlined earlier. Diminishing returns to specializationsuggest that the gain from specialization likely to be exhaustedbefore specialization is complete. In reality, most countries donot specialize, but instead produce a range of goods. However,the theory predicts that it is worthwhile to specialize until thatpoint where the resulting gains from trade are out weighed bydiminishing returns. Thus, the basic conclusion that unre-stricted free trade is beneficial still holds, although because ofdiminishing returns, the gains may not be as great as suggestedin the constant returns case.

Dynamic Effects and Economic GrowthOur simple comparative advantage model assumed that tradedoes not change a country’s stock of resources or the efficiencywith which it utilizes those resources. This static assumptionmakes no allowances for the dynamic changes that might resultform trade. If we relax this assumption, it becomes apparentthat opening an economy to trade is likely to generate dynamicgains of two-sorts. First, free trade might increase a country’sstock of resources as increased supplies of labor and capitalfrom abroad be-come available for use within the country. Thisis occurring now in Eastern Europe, where many Westernbusinesses are investing large amounts of capital in the formerCommunist countries.

PPF2 Figure 2.4 The Influence of free PPF1 Trade on the PPF

Cocoa

0 Rice

Second, free trade might also increase the efficiency with which acountry uses its resources. Gains in the efficiency of resourceutilization could arise from a number of factors. For example,economies of large-scale production might become available astrade expands the size of the total market available to domesticfirms. Trade might make better technology from abroadavailable to domestic firms; better technology can increase laborproductivity or the productivity of land. (The so-called greenrevolution had this effect on agricultural outputs in developingcountries.) Also, opening an economy to foreign competitionmight stimulate domestic- producers to look for ways toincrease their efficiency. Again, this phenomenon is arguablyoccurring in the once-protected markets of Eastern Europe,where many former state monopolies are increasing theefficiency of their operations to survive in the competitiveworld market.Dynamic gains in both the stock of a country’s resources andthe efficiency with which resources are utilized will cause acountry’s PPF to-shift outward. This is illustrated in Figure 2.4,where the shift from BPF1 to PPF2 results from the dynamicgains that arise from free trade. As a consequence of thisoutward shift, the country in Figure 2.4 can produce more ofboth goods than it did before introduction of free trade. Thetheory suggests that opening an economy to free trade not onlyresults in static gains of the type discussed earlier, but alsoresults in dynamic gains that stimulate eco-nomic growth. Ifthis is so, the case for free trade becomes stronger.

Evidence for the link between Trade and GrowthMany economic studies have looked at the relationship betweentrade and economic growth. In general, these studies suggestthat, as predicted by the theory, countries that adopt a moreopen stance toward international trade enjoy higher growthrates than se that close their economies to trade. Jeffrey Sachsand Andrew Warner created a measure of how “open” tointernational trade an economy was and then looked at therelationship between “openness” and economic growth for asample of more than 100 countries for the years 1970 to 1990.Among other findings, they reported:We find a strong association between openness and growth,both within the group of developing and the group ofdeveloped countries. Within the group of developing countries,the open economies grew at 4.49 percent per year, and the closedeconomies grew at 0.69 percent per year. Within the group ofdeveloped economies, the open economies grew at 2.29 percentper year, and the dosed economies grew at 0.74 percent per year.The message of this study seems clear: Adopt an openeconomy and embrace free trade, and over time your nation will


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be rewarded with higher economic growth rates. Higher growthwill raise income levels and living standards. This last point hasre-cently been confirmed by a study that looked at the relation-ship between trade and growth in incomes. The study,undertaken by Jeffrey Frankel and David Romer, found that onaverage, a one percentage point increase in the ratio of acountry’s trade to its gross domestic product increases incomeper person by at least one-half percent. For every 10 percentincrease in the importance of international trade in an economy,av-erage income levels will rise by at least 5 percent. Despite theshort-term adjustment costs associated with adopting a freetrade regime, trade would seem to produce greater economicgrowth and higher living standards in the long run, just as thetheory of Ri-cardo would lead us to expect.

Heckscher-Ohlin TheoryRicardo’s theory stresses that comparative advantage arises fromdifferences in pro-ductivity. Thus, whether Ghana is mareefficient than South Korea. In the production of cocoa dependson how productively it uses its resources. Ricardo stressedLabor pro-ductivity and argued that differences in laborproductivity between nations underlie the notion of compara-tive advantage. Swedish economists Eli Heckscher (in 1919) andBertil Ohlin (in 1933) put forward a different explanation ofcomparative ad-vantage. They argued that comparative advan-tage arises from differences in national factor endowments. Byfactor endowments they meant the extent to which a coun-try isendowed with such resources as land, labor, and capital Nationshave varying factor endowments, and different factor endow-ments explain differences in factor costs. The more abundant afactor, the lower its cost. The Heckscher-Ohlin theory predictsthat countries will export those goods that make intensive useof factors that are locally abundant, while importing goods thatmake intensive use of factors that are locally scarce. Thus, theHeckscher-Ohlin theory attempts to explain the pattern ofinternational trade that we observe in the world economy. LikeRicardo’s theory the Heckscher-Ohlin theory argues that freetrade is beneficial. Unlike Ricardo’s the-ory, however, theHeckscher-Ohlin theory argues that the pattern of internationaltrade is determined by differences in factor endowments, ratherthan differences in productivity.The Heckscher-Ohlin theory also has commonsense appeal. Forexample, the ‘United States has long been a substantial exporterof agricultural goods, reflecting in part its unusual abundanceof arable land. In contrast, China excels in the export of goodsproduced in labor-intensive manufacturing industries, such astextiles and footwear. This reflects China’s relative abundance oflow-cost labor. The United States, which lacks abundant low-cost labor, has been a primary importer of these goods. Notethat it is relative, not absolute, endowments that are important;a coun-try may have larger absolute amounts of land and laborthan another country, but be relatively abundant in one ofthem.

The Leontief ParadoxThe Heckscher-Ohlin theory has been one of the mostinfluential theoretical ideas in international economics. Mosteconomists prefer the Heckscher-Ohlin theory to Ri-cardo’stheory because it makes fewer simplifying assumptions. Because

of its influence, the theory has been subjected to many empiricaltests. Beginning with a famous study published in 1953 byWassily Leontief (winner of the Nobel Prize in economics in1973), many of these tests have raised questions about thevalidity of the Heckscher- Ohlin theory. 15 Using the Heckscher-Ohlin theory, Leontief postulated that since the united Stateswas relatively abundant in capital compared to other nations,the united States would be an exporter of capital-intensivegoods and an importer of labor-intensive goods. To hissurprise, however, ‘he found that U.S. exports were less capitalintensive than U.S. imports. Since this result was at variancewith the predictions of the theory, it has become known as theLeontief paradox.No one is quite sure why we observe the Leontief paradox.One possible explanation is that the United States has a specialadvantage in producing new products or goods made withinnovative technologies. Such products may be less capitalintensive than products whose technology has had time tomature and become suitable for mass production. Thus, theUnited States may be exporting goods that heavily use skilledlabor and innovative entrepreneurship, such as computersoftware, while importing heavy manufacturing products thatuse large amounts of capital. Some more recent empiricalstudies tend to confirm this. Recent tests of the Heckscher-Ohlin theory using data for a large number of countries tend toconfirm the existence of the Leontief paradox.This leaves economists with a difficult dilemma. They prefer theHeckscher-Ohlin theory on theoretical grounds, but it is arelatively poor predictor of real-world international tradepatterns. On the other hand, the theory they regard as being toolim-ited, Ricardo’s theory of comparative advantage, actuallypredicts trade patterns with greater accuracy. The best solution tothis dilemma may be to return to the Ricardian idea that tradepatterns are largely driven by international differences inproductivity. Thus, one might argue that the United Statesexports commercial aircraft and imports automobiles notbecause its factor endowments are especially suited to aircraftmanu-facture and not suited to automobile manufacture, butbecause the United States is more efficient at producing aircraftthan automobiles. A key assumption in the Heckscher-Ohlintheory is that technologies are .the same across countries. Thismay not to be the case, and differences in technology may leadto differences in productivity, which in turn, drives internationaltrade patterns. Thus, Japan’s success in exporting automobilesin the 1970s and 1980s was based not just on the relativeabundance of capital, but also on its development of innova-tive manufacturing technology that enabled it to achieve higherproductivity levels in automobile production than othercountries that that also had abundant capital.

The Product Life-Cycle TheoryRaymond Vernon initially proposed the product life-cycle theoryin the mid-1960s.19 Vernon’s theory was based on the observa-tion that for most of the 20th century a very large proportionof the world’s new products had been developed by U.S. firmsand sold first in the U.S. market (e.g.mass-produced automo-biles, televisions, instant cameras, photocopiers, personalcomputers, and semiconductor chips). To explain this, Vernon


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Targued that the wealth and size of the U.S market gave U.S.firms a strong incentive to develop new consumer products. Inaddition, the high cost of U.S. labor gave U.S. firms an incentiveto develop cost-saving process innovations. -Just because a new product is developed by a U.S. firm and firstsold in the U.S. market, it does not follow that the productmust be produced in the United States. It could be producedabroad at some low-cost location and then exported back intothe United States. However, Vernon argued that most newproducts were initially products were initially produced- inAmerica. Apparently, the pioneering firms believed it was betterto keep production facilities close the market and to the firm’scenter of decision making, given the uncertainty and risksinherent in introducing new products. Also, the demand formost new products tends to be based on nonprice factors.Consequently, firms can charge relatively high prices for newproducts, which obviate the need to look for low cost produc-tion sites in other countries. .Vernon went on to argue that early in the life cycle of a typicalnew product, demand is starting to grow rapidly in the UnitedStates, demand in other advance countries is limited to high-income groups. The limited initial demand in other advancedcountries does not make it worthwhile for firms in thosecountries to start producing the new product, but it doesnecessitate some exports from the United States to thosecountries.Over time, demand for the new product starts to grow in otheradvanced countries (e.g., Great Britain, France, Germany, andJapan). As it does, it becomes worthwhile for foreign producersto begin producing for their home markets. In addition,U.S.firms might set up production facilities in those advancedcountries where demand is growing. Consequently, productionwithin other advanced countries begins to limit the potential forexports from the United States.As the market in the United States and other advanced nationsmatures, the product becomes more standardized, and pricebecomes the main competitive weapon. As this occurs, costconsiderations start to playa greater role in the competitiveprocess. Producers based in advanced countries where laborcosts are lower than in the United States (e.g., Italy, Spain) mightnow be able to export to the United States.If cost pressures become intense, the process might, not stopthere. The cycle by which the United States lost its advantage toother advanced countries might be repeated once more, asdeveloping countries (e.g., Thailand) begin to acquire a produc-tion advantage over advanced countries. Thus, the locus ofglobal production initially switches from the United States toother advanced nations and then from those nations todeveloping countries.The consequence of these trends for the pattern of world tradeis that is over time the United States switches, from being anexporter of the Product to an importer of product as produc-tion becomes concentrated in lower-cost foreign locations.Figure 2.5 shows the growth of production and consumptionover time in the United States, other advanced countries, anddeveloping countries.

Evaluating the Product Life-Cycle TheoryHistorically, the product life-cycle theory is an accurate explana-tion of international trade patterns. Consider photocopiers; theproduct was first developed in the early 1960s by Xerox in theUnited States and sold initially to U.S. users. Originally Xeroxexported photocopiers from the United States, primarily toJapan and the advanced countries of Western Europe. Asdemand began to grow in those countries, Xerox entered intojoint ventures to set up production in Japan (Fuji- Xerox) andGreat Britain (Rank. Xerox). In addition, once Xerox’s patentson the photocopier process expired, other foreign competitorsbegan to enter the market (e.g., Canon in Japan, Olivetti inItaly). As a consequence, exports from the United Statesdeclined, and U.S. users be-gan to buy some of their photo-copiers from lower-cost foreign sources, particularly Japan. Morerecently, Japanese companies have found that manufacturingcosts are too high in their own country, so they have begun toswitch production to developing countries such as Singaporeand Thailand. As a result, initially, the United States and nowseveral other advanced countries (e.g., Japan and Great Britain)have switched from being exporters of photocopiers to beingimporters. This evolution in the pattern of international tradein photocopiers is consistent with the predictions of the prod-uct life cycle theory ‘that mature industries tend to go out of theUnited States and into low- cost assembly locations.However, the product life-cycle theory is not without weak-nesses. Viewed from an Asian or European perspective,Vernon’s argument that most new products are developed andintroduced in the United States seems ethnocentric. Although itmay be true that during U.S. global dominance (from 1945 to1975), most new products were produced in the United States,there have always been important exceptions. These exceptionsappear to have become more common in recent years. Manynew products now introduce in Japan (e.g., videogame con-soles). With the increased globalization European perspective,Vernon’s argument that most new products are developed andintroduced in the United States seems ethnocentric. Although itmay be true that during U.S. global dominance (from 1945 to1975), most new products were produced in the United States,there have always been important exceptions. These exceptionsappear to have become more common in recent years. Manynew products now introduce in Japan (e.g., videogame con-soles). With the increased globalization and integration of agrowing num-ber of new products (e.g., laptop computers,compact disks, and digital cameras) are now introducedsimultaneously in the United States, Japan, and the advancedEuro-pean nations. This may be accompanied by globallydispersed production, with par-ticular components of a newproduct being produced in those locations around the globewhere the mix of factor costs and skills is most favorable (aspredicted by the the-ory of comparative advantage).Consider laptop computers, which were introduced simulta-neously in a number of major national markets by Toshiba.Although various components for Toshiba laptop computersaremanufactured in Japan (e.g., display screens, memory chips),other com-ponents are manufactured in, Singapore and Taiwan


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and still others (e.g., hard drives and microprocessors) aremanufactured in the United States. All the components areshipped to Singapore for final assembly, and the completedproduct is then shipped-to the major world markets (theUnited States, Western Europe, and Japan). The pattern oftrade associated with this new product is both different fromand more complex than the pattern predicted by

Figure 2.5The product Life-Cycle Theory

Vernon’s model. Trying to explain this pattern using theproduct life-cycle theory would be very difficult. The theory ofcomparative advantage might better explain why certaincomponents are produced in certain locations and why the finalproduct is assembled in Singapore. Although Vernon’s theorymay be useful for explaining the pattern of international tradeduring the brief period of American global dominance,’ itsrelevance in the modern world is limited.

The New Trade TheoryThe new trade theory began to emerge in the 1970s when anumber of economists were questioning the assumption ofdiminishing returns to specialization used in interna-tionaltrade theory (see Figure 2.3). They argued that increasing returnsto special-ization might exist in some industries. Economies ofscale represent one particularly important source of increasingreturns. Economies of scale are unit cost reductions as-sociatedwith a large scale of output. If international trade results in acountry special-izing in the production of a certain good, and ifthere are economies of scale- in producing that good, then asoutput of that good expands, unit costs will fall. In such a case,there will be increasing returns to specialization, not diminish-ing returns! Put differently, as a country produces more of the

good, due to the realization of economies of scale, productivitywill increase and unit costs will fall.New trade theory also argues that if the output required torealize significant scale economies represents a substantialproportion of total world demand for that product1 the worldmarket may be able to support only a limited number of firmsbased in a lim-ited number of countries producing thatproduct. Those firms that enter the world market first may gainan advantage that may be difficult for other firms to match.Thus, a country may dominate in the export of a particularproduct where scale economies are important, and where thevolume of output required to gain scale economies rep-resentsa significant proportion of world output, because it is home toa firm that was an early mover in this industry.

The Aerospace ExampleThe commercial aerospace industry, which is currently domi-nated by just two firms, Boe-ing and Airbus (although there areseveral niche players), is a good example of this the-ory.Economies of scale in this industry come from the ability tospread fixed costs over a large out put. The fixed costs ofdeveloping a new commercial jet airliner are astro-nomical.Boeing spent an estimated $5 billion to develop its Boeing 777jetliner. A ma-jor source of scale economies is the ability tospread these fixed costs over a large output.If Boeing only makes 100 of the Boeing 777, its fixed costs willamount to $50 million per unit (i.e., $5 billion divided by 100).If the variable costs such as labor, equipment, and parts equal$80 million per aircraft, the total cost-of each aircraft would be$130 million (i.e., $80 million in per unit variable costs plus $50million in per unit fixed costs). If Boeing makes 500 of theseaircraft, the fixed costs fall to $10 million per unit (i.e., $5billiondivided by 500), bringing the total cost of each aircraft to just$9J million (i.e., 80 million plus $10 million). The economiesof scale here are significant, with average unit costs falling by $40million as output expands from 100 units to 500 units.In addition to economies of scale, learning effects also exist inthis industry. These too may result in increasing returns tospecialization. Learning effects are cost savings that come fromlearning by doing labor, for example, learns by repetition howbest to carry out a task. Labor productivity increases over timeand variable unit costs fall as individuals learn the most efficientway to perform a particular task. Learning effects tend to bemore significant when a technologically complex task is repeatedbecause there is more to learn. Thus, learning effects will bemore significant in an assembly process involving 1,000complex steps than in an assembly process involving 100 sim-ple steps-and assembling a commercial jetliner involves morecomplex steps than perhaps any other product. Learning effectswere first documented in the aerospace in-dustry where it wasfound that each time accumulated output of airframes wasdoubled, unit costs declined to 80 percent of their previouslevel. Thus, the fourth airframe typically cost only 80 percent ofthe second airframe to produce, the eighth airframe only 80percent of the fourth, the 16th only 80 percent of the eighth,and so on. This observation implies that the $80 million in perunit variable costs required to build a 777 will decline over timeas Output expands, primarily because of gains in labor pro-


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Tductivity. Thus, while variable costs per unit might be $80million by the time 100\air-craft have been ‘manufactured, bythe time 500 aircraft have been manufactured, they may havefallen to $60 million per unit.Combine learning effects with our earlier calculation of thedecline in unit fixed costs, and our analysis suggests that asoutput of 777s expands from 100 to 500 units, unit costs willfall from $130 million ($80 million variable costs and $50million fixed costs per unit), to $70 million ($60 millionvariable costs plus $10 million fixed costs per unit). Obviously,increasing returns to specialization are very important in this in-dustry. Just how important they are can be appreciated by thefact that the list price for a new Boeing 777 is about $120million. Thus, if Boeing sells only 100 aircraft it will not makeany money on this product. If it sells 500 aircraft, due to scaleeconomies and learning effects it will make acceptable profits.World demand is large enough to support only a limitednumber of aircraft producers at high output levels. Forecastssuggest that the global market for long-range air-craft with aseating capacity of about 300, such as the 777, will be about1,500 aircraft between 1997 and 2008. If we assume that Boeinghas to sell about 500 aircraft to make a decent return on itsinvestment, this suggests that the world market is large enoughto support only three producers profitably!

ImplicationsNew trade theory has important implications. The theorysuggests that a country may predominate in the export of agood simply because it was lucky enough to have one or morefirms among the first to produce that good. Underpinning thisargument is the notion of first, mover advantages, which arethe economic and strategic advantages that accrue to earlyentrants into an industry. Because they are able to gain econo-mies of scale and learning effects, the early entrants in anindustry may get a lock on the world market that discouragessubsequent entry. First movers’ ability to benefit from increas-ing returns creates a barrier to entry: In the commercial aircraftindustry, for example, the fact that Boeing and Airbus arealready in the industry and have the benefits of economies ofscale and learning effects discourages new entry and reen-forcesthe dominance1bf America and Europe in the trade ofcommercial jet aircraft. This dominance is further reenforcedbecause global demand may not be sufficient to profitablysupport another producer in the industry. So although Japanesefirms might be able to compete in the market, they have decidednot to enter the industry but to ally themselves as majorsubcontractors with primary producers (e.g., Mitsubishi HeavyIndustries is a major subcontractor for Boeing on the 767 and777 programs).New trade theory is at variance with the Heckscher-Ohlin theory,which suggests that a country will predominate in the export ofa product-when it is particularly well endowed with thosefactors used intensively in its manufacture. New trade theoristsargue that the United States leads in exports of commercial jetaircraft not because it is better endowed with the factors ofproduction required to manufacture aircraft, but because one ofthe first movers in the industry, Boeing, was a U.S. firm. Thenew trade theory is not at variance with the theory of compara-

tive advantage. Economies of scale and learning effects bothincrease the efficiency of resource utilization, and hence in-creaseproductivity. Thus, the new trade theory identifies an importantsource of com-parative advantage.It is perhaps too early to say how useful this theory is inexplaining trade patterns. The theory is so new that littlesupporting empirical work has been done. Consistent with thetheory, however; a study by Harvard business historian AlfredChandler suggests the ex-istence of first-mover advantages is animportant factor in explaining the dominance of firms fromcertain nations in certain Industries. The number of firms isvery limited in many global industries, including the chemicalindustry, the heavy construction equipment industry, the heavytruck industry, the tire industry, the consumer electron-icsindustry, the jet engine industry, and the computer softwareindustry.Perhaps the most contentious implication of the new tradetheory is the argument that it generates for governmentintervention and strategic trade policy. New trade theorists stressthe role of luck, entrepreneurship, and innovation in giving afirm first mover advantages. According to this argument, thereason Boeing was the first mover in commercial jet aircraftmanufacture-rather than firms like Great Britain’s De--Havillandand Hawker Siddely, or Holland’s Fokker, all of which couldhave been -was that Boeing was both lucky and innovative. Oneway Boeing was lucky is that De-Havilland shot itself in thefoot when its Comet jet airliner, introduced two years earlierthan Boeing’s first jet airliner, the 7,07, was found to be full ofserious technological flaws. Had De-Havilland not made someserious technological mistakes! Great Britain might now be theworld’s leading exporter of commercial jet aircraft! Boeing’sinnovativeness was demonstrated by its independent develop-ment of the technologi-cal know-how required to build acommercial jet airliner. Several new trade theorists have pointedout, however, that Boeing’s R&D was largely paid for by theU.S. gov-ernment; the 707 was a spin off from a government-funded military program. Herein lies a rationale for governmentintervention. By the sophisticated and judicious use ofsubsidies, could a government increase the chances of itsdomestic firms becoming first movers in newly emergingindustries, as the U .S. government apparently did with Boe-ing? If this is possible, and the new trade theory suggests itmight be, then we have an economic rationale for a proactivetrade policy that is at variance with the free trade prescriptions ofthe trade theories we have reviewed so far.

Nation Competitive Advantage: Pointer’s DiamondIn 1990, Michael porter of the Harvard Business Schoolpublished the results of intensive research effort that attemptedto determine why some nations succeed and others fail ininternational competition. Porter and his team looked at 100industries in 10 nations.


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Figure 2.6 Determinants of National Competitive Advantage: Poter’s Diamond

Firm Strategy Structure, and Rivalry

Factor Endowments

Demand Conditions

Related and Supporting Industries

The book that contains the results of this work, The Competi-tive Advantage of nation, has made an important contributionto thinking about trade. Like the work of the new tradetheorists, Porter’s work was driven by a belief that existingtheories of international trade told only part of the story. ForPorter, the essen-tial task was to explain why a nation achievesinternational success in a particular industry. Why does Japan doso well in the automobile industry? Why does Switzerland excelin the production and export of precision instruments andpharmaceuticals? Why do Germany and the United States do sowell in the chemical industry? These questions cannot beanswered easily by the Heckscher-Ohlin theory, and the theoryof comparative advantage offers only a partial explanation. Thetheory of comparative advantage would say that Switzerlandexcels in the production and export of precision instrumentsbecause it uses its resources very productively in these industries.Although this may be correct, this does not explain whySwitzerland is more productive in this industry than GreatBritain, Germany, or Spain. Porter tries to solve this puzzle.Porter theorizes that four broad attributes of a nation shape theenvironment in which local firms compete and these attributespromote or impede the creation of competitive advantage (seeFigure 2.6). These attributes are• Factor endowments-a nation’s position in factors of

production such as skilled labor or the infrastructurenecessary to compete in a given industry.

• Demand conditions—the nature of home demand for theindustry’s product or service.

• Relating and supporting industries—the presence or absenceof supplier industries and related industries that areinternationally competitive.

• Firm strategy, structure, and rivalry—the conditionsgoverning how companies areCreated, organized, and managed and the nature of domesticrivalry.

Porter speaks of these four attributes as constituting thediamond. He argues that firms are most likely to succeed inindustries or industry segments where the diamond is mostfavorable. He also argues that the diamond is a mutuallyreinforcing system. The effect of one attribute is contingent onthe state of others. For example, Porter argues favorabledemand conditions will not result in competitive advantageunless the state of rivalry is sufficient to cause firms to respondto them.

Porter maintains that two additional variables can influence thenational diamond in important ways: chance and government.Chance events, such as major innovations, can reshape industrystructure and provide the opportunity for one nation’s firms tosupplant another’s. Government, by its choice of policies, candetract from or improve national advantage. For example,regulation can alter home demand conditions, an-titrust policiescan influence the intensity of rivalry within an industry, andgovernment investments in education can change factorendowments.

Factor EndowmentsFactor endowments lie at the center of the Heckscher-Ohlintheory. While Porter does not propose anything radically new,he does analyze the characteristics of factors of production. Herecognizes hierarchies among factors, distinguishing betweenbasic factors (e.g., natural resources, climate, location, anddemographics) and advanced factors (e.g., communicationinfrastructure, sophisticated and skilled labor, research, facilities,and technological know-how). He argues that advanced factorsare the most significant for competitive advantage. Unlike thenaturally endowed basic factors, advanced factors are a productof investment by individuals, companies, and govern-ments.Thus, government investments in basic and higher education,by improving the general skill and knowledge level of thepopulation and by stimulating advanced research at highereducation institutions, can upgrade a nation’s advanced factors.The relationship between advanced and basic factors is complex.Basic factors can provide an initial advantage that is subse-quently reinforced and extended by investment in advancedfactors. Conversely, disadvantages in basic factors can createpressures to in-vest in advanced factors. An obvious exampleof this phenomenon is Japan, a country that lacks arable landand mineral deposits and yet through investment has built asubstantial endowment of advanced factors. Porter notes thatJapan’s large pool of engineers (reflecting a much highernumber of engineering graduates per capita than almost anyother nation) has been vital to Japan’s success in many manufac-turing industries.

Demand ConditionsPorter emphasizes the role home demand plays in upgradingcompetitive advantage. Firms are typically most sensitive to theneeds of their closest customers. Thus, the characteristics ofhome demand are particularly important in shaping theattributes of domestically made products and in creatingpressures for innovation and quality. Porter -argues that anation’s firms gain competitive advantage if their domesticconsumers are sophisticated and demanding. Such consumerspressure local firms to meet, stan-dards of product quality andto produce innovative products. Porter notes that Japan’ssophisticated and knowledgeable buyers of cameras helpedstimulate the Japanese camera industry to improve productquality and to introduce innovative model, A similar examplecan be found in the wireless telephone equipment industry,where sophisticated and demanding local customers inScandinavia helped push Nokia of Finland and Ericsson ofSweden to invest in cellular phone technology long beforedemand for cellular phones took off in other developed


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Tnations As a result, Nokia and Ericsson, together withMotorola, today are dominant players in the global cellulartelephone equipment industry. Finland has the highestpenetration rate for mobile phones in the world with morethan 70 percent of Finns owning a wireless handset. The caseof Nokia is reviewed in more depth in the accompanyingManagement Focus.

Related and Supporting IndustriesThe third broad attribute of national advantage in an industryis the presence of suppliers or related industries that areinternationally competitive. The benefits of investments inadvanced factors of production by related and supportingindustries can spill over into an industry, thereby helping itachieve a strong competitive position internationally. Swedishstrength in fabricated steel products (e.g., ball bearings andcutting tools) has drawn on strengths in Sweden’s specialty steelindustry. Technological leadership in the US. Semiconductorindustry until the mid-1980s provided the basis for U.s. successin personal computers and several other technically advancedelectronic products. Similarly, Switzerland’s success in pharma-ceuticals is closely related to its previous international success inthe technologically related dye industry.One consequence of this process is that successful industrieswith in a country tend to be grouped into clusters of relatedindustries. This was one of the most pervasive findings ofPorter’s study. One such cluster is the German textile andapparel sector, which includes high-quality cotton, wool,synthetic fibers, sewing machine needles, and a wide range oftextile machinery. Such clusters are important, because valuableknowledge can flow between the firms within a geographiccluster, benefiting all within that cluster. Knowledge flaws occurwhen employees move between firms within a region and whennational industry associations bring employees from differentcompanies together for regular conferences or workshops.

Firm Strategy, Structure, and RivalryThe fourth broad attribute of national competitive advantage inPorter’s model is the Strategy, structure, and rivalry of firmswithin a nation. Porter makes two important points here. First,different nations are characterized by different managementideologies. Which either help them or do not help them tobuild national competitive advantage. For example, Porter notesa predominance of engineers in tap management at Germanand Japanese firms. He attributes this to these firms’ emphasison improving manufacturing processes and product design. Incontrast, Porter notes a predominance of people with financebackgrounds leading many U.S. firms. He links this to. U.S.firms’ lack of attention to improving manufacturing processesand product design, particularly during the 1970s and 80s. Healso argues that the dominance of finance has led to a corre-sponding overemphasis on maximizing short-term financialreturns. According to Porter, one consequence of these differentmanagement ideologies has been a relative loss of U.S. competi-tiveness in those engineering-based industries wheremanufacturing processes and product design issues are all-important (e.g., the automobile industry).Porter’s second point is that there is a strong associationbetween vigorous domestic rivalry and the creation and

persistence of competitive advantage in an industry. Vigorousdomestic rivalry induces firms to look for ways to improveefficiency, which makes them better international competitors.Domestic rivalry creates pressures to innovate, to improvequality, to reduce cost, and to invest in upgrading advancedfactors. All this helps to create world-class competitors. Portercites the case of Japan:Nowhere is the role of domestic rivalry mare evident than inJapan, where it is all-out warfare in which many companies failto achieve profitability. With goals that stress market share,Japanese companies engage in a continuing struggle to outdoeach other. Shares fluctuate markedly. The process is promi-nently covered in the business press. Elaborate rankingsmeasure whichCompanies are most popular with university graduates. Therate of new product and process development is breathtaking,A similar point about the stimulating effects of strongdomestic competition can be with regard to the rise of Nokiaof Finland to global preeminence in the market for cellulartelephone equipment. Far details see the Management Focus.

Evaluating Porter’s TheoryPorter contends that the degree to which a nation is likely toachieve international success in a certain industry is a function ofthe combined impact of factor endowments, domestic demandconditions, related and supporting industries, and domesticrivalry. He argues that the presence of all four components isusually required for this diamond to boost competitiveperformance (although there are exceptions). Porter alsocontends that government can influence each of the fourcomponents of the diamond.

The Rise of Finland’s NokiaThe mobile telephone equipment industry is one of the greatgrowth stories of recent years. The number of wirelesssubscribers has been expanding rapidly. By the end of 2000,there were over 550 million wireless subscribers worldwide, upfrom less than 10 million in 1990. Forecasts suggest that by2004, the number could reach 1.4 billion. Three firms currentlydominate the global market for wireless equipment (e.g.,wireless phones, base station equipment, digital switches):Motorola, Nokia, and Ericsson. Nokia leads the market inmobile telephone sales and is gaining rapidly on Motorola inthe network equipment segment.Nokia’s roots are in Finland, not normally a country that comesto mind when one talks about leading edge technologycompanies. In the 1980s, Nokia was a rambling Finnishconglomerate with activities that embraced tire manufacturing,paper production, consumer electronics, and telecommunicationequipment. By 2000 it had transformed itself into a focusedtelecommunications equipment manufacturer with a globalreach, sales of $24 billion, and earnings of $4.5 billion. Howhas this former conglomerate emerged to take a global leader-ship position in wireless telecom munication equipment? Muchof the answer lies in the history, geography, and politicaleconomy of Finland-and its Nordic neighbors.The story starts in 1981 when the Nordic nations got togetherto, create the world’s first international mobile telephone


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network. They had good reason to become pioneers; in thesparsely populated and inhospitably cold areas, it cost far toomuch to lay down a traditional wire line telephone service. Yetthe same geographic features make telecommunications all, themore valuable; people driving through the Arctic winter andowners of remote northern houses need a telephone tosummon help if things go wrong. As a result, Sweden, Norway,and Finland became the first nations to take wireless telecom-munications seri-ously. They found, for example, that while itcost up to $800 per subscriber to bring a traditional wirelineservice to remote locations in the far north, the same locationscould be linked by wireless telephones for only $500 per person.As a consequence, by 1994, 12 percent of people in Scandinaviaowned wireless phones compared with less than 6, percent inthe United States, the world’s second most developed market.This leadership has continued. In mld-2000 some 70 percent ofthe, population in Finland owned a wireless phone, comparedwith 30 percent in the United States.Either positively or negatively. Factor endowments can beaffected by subsidies, policies toward capital markets, policiestoward education, and so on. Government can shape domesticdemand through local product standards or with regulationsthat mandate or influence buyer needs. Government policy caninfluence supporting and related industries through regulationand influence firm rivalry through such devices as capital marketregulation, tax policy, and antitrust laws.If Porter is correct, we would expect his model to predict thepattern of international trade that we observe in the real world.Countries should be exporting products from those industrieswhere all four components of the diamond are favorable, Whileimporting in those areas where the. Components are notfavorable. Is he correct? We simply do not know. Porter’s theoryhas not yet been subjected to independent empirical testing.Much about the theory rings true, but the same can be said forthe new trade theory, the theory of comparative advantage, andthe Heckscher-Ohlin theory. It may be that each of thesetheories, which complement each other, explains some-thingabout the pattern of international trade.

Implication for BusinessWhy does all this matter for business? There are at least threemain implications for international businesses of the materialdiscussed in this chapter: location implications, first-moverimplications, and policy implications.Nokia, as a long-time telecommunication equipment Supplier,was well positioned to take advantage of this development.Other forces were also at work at in Finland that helped Nokiadevelop its competitive edge. Unlike virtually every otherdeveloped nation, Finland has never had a national telephonemonopoly. Instead the country’s telephone services have longbeen provided by about 50 autonomous local telephonecompanies, whose elected boards set prices) by referendum(which naturally means low prices). This army of independentand cost-conscious tele-phone service providers preventedNokia from taking anything for granted in its home count\y.With typical finish pragmatism, they were willing to buy fromthe lowest-cost supplier, whether that was Nokia, Ericsson,Motorola, or someone else. This situation contrasted sharply

with that prevailing in most developed nations until the late1980s and early 1990s; domestic telephone monopolies typicallypurchased equipment from a dominant local supplier or madeit themselves. Nokia responded to this competitive pressure bydo-ing everything possible to drive down its manufacturingcost while still staying at the leading edage of wireless technol-ogy.The consequences of these forces are clear. Nokia is now theleader in digital wireless technology, which is the wave of thefuture. Many now regard Finland as the lead market for wirelesstelephone services. If you want to see the future of wireless,you don’t go to New York or San Francisco, you go to Helsinki,where Finns use their wireless handsets not just to talk to eachother, but also to browse the Web, execute e-commercetransactions, control household heating and lighting systems,or purchase Coke from a wireless-enabled vending machine.Nokia has gained this lead because Scandinavia started switchingto digital technology five years before the rest of the world.Spurred on by its cost-conscious Finnish customers, Nokia nowhas the lowest cost structure of any cellular phone equipmentmanufac-turer in the world, making it a more profitable enter-prise than Motorola, its leading global rival. Nokia’s operatingmargins in 2000 were 20 percent, compared with 6.4 percent atMotorola.Sources: “Lessons from the Frozen North,” The Economist,October 8, .1994, pp. 76-77; G. Edmondson, “GrabbingMarkets form the giants,” Business Week. Special Issue: 21stCentury Capitalism, 1995, pp. 156; company news releases; “ AFinnish Fable,” The Economist, October 14, 2000; “To theFinland Base’ Station,” The Economist, October 9, 1999, pp.23-27; and “A Survey of Telecommunications,” The Econo-mist, October 9, 1999.

Location ImplicationsUnderlying most of the theories we have discussed is thenotion that different countries have particular advantages indifferent productive activities. Thus, from a profit perspective, itmakes sense for a firm to disperse its productive activities tothose countries where, according to the theory of internationaltrade, they can be formed most efficiently. If design can beperformed most efficiently in France, that is where designfacilities should be located; if the manufacture of basic compo-nents can be performed most efficiently in Singapore, that iswhere they should be manufactured; and if final assembly canbe performed most efficiently in China, that is where finalassembly should be performed. The result is a global web ofproductive-13ctivities, with different activities being performedin different locations around the globe depending on consider-ations of comparative advantage, factor endowments, and thelike. If the firm does not do this, it may find itself at acompetitive disadvantage relative to firms that do.Consider the production of a laptop computer, a process withfour major stages: (1) basic research and development of theproduct design, (2) manufac-ture of standard electroniccomponents (e.g., memory chips), (3) manufacture of advancedcomponents (e.g., flat-top color display screens and micropro-cessors), and (4) final assembly. Basic R&D requires a pool ofhighly skilled and educated workers with good backgrounds in


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Tmicroelectronics. The two countries with a comparativeadvantage in basic microelectronics R&D and design are Japanand the United States; so most producers of laptop computerslocate their R&D facilities in one, or both, of these countries.(Apple, IBM, Motorola, Texas Instruments, Toshiba, and Sonyall have major R&D facilities in both Japan and the UnitedStates.).The manufacture of standard electronic components is a capital-intensive process requiring semiskilled labor, and cost pressuresare intense. The best locations for such activities today are placessuch as Singapore, Taiwan, Malaysia, and South Korea. Thesecountries have pools of relatively skilled, low-cost lobor. Thus,many producers of laptop computers have standard compo-nents, such as memory chips, produced at these locations.The manufacture of advanced components such as micropro-cessors and display screens is a capital-intensive process requiringskilled labor. Because cost pressures are not so intense at thisstage, these components can be-and are- -manufactured incountries with high labor costs that also have pools of highlyskilled labor (primarily Japan and the United States).Finally, assembly is a relatively labor-intensive process requiringonly low-skilled labor, and cost pressures are intense. As aresult, final assembly may be carried out in a country such asMexico, which has an abundance of low-cost, low-skilled labor.A laptop computer produced by a U.S. manufacturer may bedesigned in California, have its, standard components producedin Taiwan and Singapore, its advanced components produced inJapan and the United States, its final assembly in Mexico, and besold in the United States or elsewhere in the world. By dispers-ing production activities to different locations around the globe,the U.S. manufacturer is taking advantage of the differencesbetween countries identified by the various theories of interna-tional trade.

First Mover ImplicationsAccording to the new trade theory, firms that establish a first-mover advantage with regard to-the production of a particularnew product may subsequently dominate global trade in thatproduct. This is particularly true in industries where the globalmarket can profitably support only a limited number of firms,such as the aerospace market, but early commitments also seemto be important in less concentrated industries such as themarket for cellular telephone equipment (see the ManagementFocus on Nokia), For the individual firm, the clear message isthat it pays to invest substantial financial resources in trying tobuild a first-mover, or early-mover, advantage, even if thatmeans several years of substantial losses before a new venturebecomes profitable.

Policy ImplicationsThe theories of international trade also matter to internationalbusinesses be-cause firms are major players on the internationaltrade scene. Business firms -produce exports, and businessfirms import the products of other countries. Because of theirpivotal role in international trade, businesses can export astrong influence on government trade policy, lobbying topromote free trade or trade restrictions. The theories ofinternational trade claim that promoting free trade is generally in

the best interests of a country, although it may not always be inthe -best interest of an individual firm. Many firms recognizethat and lobby for open markets.For example, when the U.S. government announced in 1991 itsintention to place a tariff on Japanese imports of liquid crystaldisplay (LCD) screens, IBM and Apple Computer protestedstrongly. Both IBM and Apple pointed Out that -(1) Japan wasthe lowest-cost source of LCD screens, (2) they used thesescreens in their own laptop computers, and (3) the proposedtariff, by increasing the cost of LCD screens, would increase thecost of laptop computers produced by IBM and Apple, thusmaking them less competitive in the world market. In otherwords, the tariff, designed to protect U.S. firms, would be self-defeating. In response to these pressures, the U.S, governmentreversed its posture.Unlike IBM and Apple, however, businesses do not alwayslobby for free tread. In the United States, for example, restric-tions on imports of automobiles, machine tools, textiles, andsteel are the result of direct pressure by U.S. firms on thegovernment. In some cases, the government responded bygetting for eign companies to agree to “voluntary” restrictionson their imports, using the implicit threat of more comprehen-sive formal trade barriers to get them to adhere to theseagreements. In other cases, the government used what are called“antidumping” actions to justify tariffs on Imports from othernations.As predicted by international trade theory, many of theseagreements have been self-defeating, such as the voluntaryrestriction on machine tool imports agreed to in1985. Due tolimited import competition from more efficient foreignsuppliers, the prices of machine tools in the United States roseto higher levels than would have prevailed under free trade.Because machine tools are used throughout the manufacturingindustry, the result was to increase the costs ofU.S.manufacturing in general, creating a corresponding loss inworld market competitiveness. Shielded from internationalcompetition by import barriers, the U.S. machine tool industryhad no incentive to increase its efficiency. Consequently, it lostmany of its export markets to more efficient foreign competi-tors. As a consequence of this misguided action, the U.S.machine tool industry shrunk during the period when theagreement was in force. For anyone schooled in internationaltrade theory, this was not surprising.Finally Porter’s theory of national competitive advantage alsocontains policy implications. Porter’s theory suggests that it is inthe best interest of business for a firm to invest in upgradingadvanced factors of production; for example, to invest in bettertraining for its employees and to increase its commitment toresearch and development. It is also in the best interests ofbusiness to lobby the government to adopt policies that have afavorable impact on each component of the national diamond.Thus, according to Porter, businesses should urge governmentto increase investment in education, infrastructure, and basicresearch (Science all these enhance advanced factors) and toadopt policies that promote strong competition withindomestic markets (since this makes firms stronger internationalcompetitors, according to Porter’s findings).


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Case Study

The Rise of the Indian Software IndustryAs a relatively poor country, India is not nor-mally thought offas a nation capable of building a major presence in a high-technology industry, such as computer software. In little over adecade, however, the Indian software industry has astoundedits skeptics and emerged from ob-scurity to become an impor-tant force in the global software industry. Be-tween 1991-1992and 1999-2000, sales of Indian software companies grew at acompound rate in excess of 60 percent annually. In 1991-1992,the industry had sales totaling $388 million. By 2000 they werearound $6c billion. By the late 1990s, more than 900 softwarecompanies in India em-ployed 200,000 software engineers, thethird largest concentration of such talent in the world.

Much of this growth was powered by exports. In 1985, Indiansoftware exports were worth less than $10 mil-lion. Theysurged to $1.8 billion in 1997 and hit a record $4 billion in 2000.The future looks very bright. Powered by continued export-ledgrowth, India’s National Asso-ciation of Software and ServiceCompanies projects that total software revenues generated byIndian companies will hit $28 billion by 2004-2005 and $87billion by 2007-2008. As a testament to this growth, manyforeign software companies are now investing heavily in Indiansoftware development operations including Microsoft, IBM,Oracle, and Computer Associates, the four largest U.S.-basedsoftware houses. Equally significantly, two out-of every fiveglobal companies now source their soft-ware services fromIndia.Most of the current growth of the Indian software industry hasbeen based on contract or project-based work for foreign clients.Many Indian companies, for example, maintain applications fortheir clients, convert code, or migrate software from oneplatform to another. Increasingly, Indian companies are alsoinvolved in important development projects for foreign clients.For example, TCS, India’s largest software company, has analliance with Ernst & Young under which TCS will develop andmaintain customized software for Ernst & Young’s globalclients. TCS also has a development alliance with Mi-crosoftunder which the company developed a paperless National ShareDepositary system for the Indian stock market based onMicrosoft’s Windows NT operating system and SQL Serverdatabase technology. Indian compa-nies are also movingaggressively into e-commerce projects. From almost zero in1997, e-commerce or e-business projects now account for about10 percent of all software development and service work inIndia and are - projected to reach 20 percent within two years.The Indian software industry- has emerged despite a poorinformation technology infrastructure. The in-stalled base ofpersonal computers in India stood at just 3 million in 1999,

and this in a nation of nearly 1 billion people. With just 22telephone lines per 1,000 people, India has one of the lowestpenetration rates for fixed telephone lines in Asia, if not theworld. Internet connections numbered less than 100,000 in1998, compared to 60 million in the United States. But sales ofpersonal computers are starting to take off, and the rapidgrowth of mobile telephones in India’s main cities is to someextent compensating for the lack of fixed telephone lines.In explaining the success of their industry, India’s softwareentrepreneurs point to a number of factors. Al-though thegeneral level of education in India is low, In-dia’s importantmiddle class is highly educated and its top educational institu-tions are world class. Also, India- has always emphasizedengineering. Another great plus from an international perceptiveis that English is the working language throughout much ofmiddle-class In--dia-a remnant from the days of the British raja.Then there is the wage rate. American software engineers areincreasingly scarce, and the basic salary has been driven up to oneof the highest for any occupational group in the country, withentry-level programmers earning $70,000 per year. An entry-levelprogrammer in India, in contrast, starts at around $5,000 peryear, which is very low by international standards but high byIndian stan-dards. Salaries for programmers are rising rapidly inIndia, but so is productivity. In 1992, productivity was around$21,000 per software engineer. By 1997, the fig-ure had risen to$45,000. As a consequence of these fac-tors, by 2000 work donein India for -U.S. software companies amounted to $25 to $35an hour, compared to $75 to $100 per hour for softwaredevelopment done in the United States.Another factor helping India is that satellite commu-nicationshave removed distance as an obstacle to doing business forforeign clients. Because software is nothing more than a streamof zeros and ones, it can be trans-ported at the speed of lightand negligible cost to any point in the world. In a world ofinstant communication, India’s geographical position betweenEurope and the United States has given it a time zone advan-tage. Indian companies have been able to exploit the rapidlyexpand-ing international market for outsourced-softwareservices, including the expanding market for remote mainte-nance. Indian engineers can fix software bugs, up-gradesystems, or process data overnight while their users in Westerncompanies are asleep.To maintain their competitive position, Indian soft-warecompanies are now investing heavily in training and leading-edge programming skills. They have also been enthusiasticadopters of international quality stan-dards, particularly ISO9000 certification. Indian com-panies are also starting to makeforays into the application and shrink-wrapped softwarebusiness, pri-marily with applications aimed at the domesticmarket. It may only be a matter of time, however, beforeIndian companies start to compete head to head with compa-nies such as Microsoft, Oracle, PeopleSoft, and SAP in theapplications business.Sources: P. Taylor, “Poised for Global Growth,” FinancialTimes: India’s Software Industry, December), 1997, pp. 1,8;P.Taylor, “An Industry on the Up and Up,” Financial Times;India’s Software Industry December 3, 1997, p. 3; Krishna


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TGuha, “Strategic Alliances with Global Partners,” FinancialTimes: India’s Software Industry, December 3, 1997, p. 6;“Indian SW Industry to Touch $13 Billion in 2001-02,”-Computers Today, December’ 15,2000, pp. 14-17; and UnitedNations, Human Development Report, (New York: OxfordUniversity Press, 2000), and Table 12.

Case Discussion Questions

1. To what extent does the theory of comparative advantageexplain the rise of the Indian software industry?

2. To what extent does the Heckscher-Ohlin theory explain therise of the Indian software industry?

3. Use Michael Porter’s diamond to analyze the rise of theIndian software industry. Does this analysis help explainthe rise of this industry?

4. Which of the above theories-comparative advan-tage,Heckscher-Ohlin, or Porter’s—gives the best explanation ofthe-rise of the Indian software indus-try? Why?

Activity (Questions): -

Q1) Discuss the theory of Absolute Advantage in detail andcompare it with theory of comparative advantage?

Q2) What is Heckscher-Ohlin theory, describe?Q3) Write a detailed note on product life cycle theory of

international trade?Q4) Discuss in detail about Michael porter ‘s theory of

international trade?