Chap005 (2)

International Business 8e

By Charles W.L. Hill

Chapter 5

International Trade Theory

Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Introduction

Two goals of the chapter:

To review a number of theories that explain why it is beneficial for a country to engage in international trade (IT)?

To explain the pattern of “IT” that we observe in the world economy.

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Introduction

Mercantilism – propagated in the 16th & 17th centuries---countries should encourage exports & discourage imports.

Theory of Absolute Advantage – Adam Smith was the first to explain why unrestricted free trade is beneficial to a country. Smith argued that the invisible hand of the market mechanism, rather than the govt. policy should determine what a country imports & what it exports.

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Introduction

Theory of Comparative Advantage – advanced by the 19th century by David Ricardo.

Heckscher-Ohlin Theory ( H-O) – in the 20th century Ricardo’s work was refined by two Swedish economists.

The strength of above mentioned theories is that they identify the specific benefits of “IT”.

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Why Is Free Trade Beneficial?Free trade - a situation where a government does

not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country

Trade theory shows why it is beneficial for a country to engage in international trade even for products it is able to produce for itself

International trade allows a countryto specialize in the manufacture and export of products

that it can produce efficientlyimport products that can be produced more efficiently

in other countries

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Why Is Free Trade Beneficial?

Import controls, in the form of quotas & tariffs, may benefit particular business groups & their employees but the economy as a whole is hurt by this kind of action.

Limits on imports are often in the interests of domestic producers, but not domestic consumers.

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Why Do Certain Patterns Of Trade Exist?

Some patterns of trade are fairly easy to explain: climate & natural resource endowments

explains why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee

But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry?

Why does Japan export automobiles, consumer electronics, and machine tools?

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What Role Does Government Have In Trade?

The mercantilist philosophy makes a crude case for government involvement in promoting exports and limiting imports

Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade

New trade theory and Porter’s theory of national competitive advantage justify limited and selective government intervention to support the development of certain export-oriented industries.

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What Is Mercantilism?

Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -to export more than it importsadvocates government intervention to achieve

a surplus in the balance of trade

Mercantilism views trade as a zero-sum game - one in which a gain by one country results in a loss by another

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What Is Smith’s Theory Of Absolute Advantage?

Adam Smith argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing itcountries should specialize in the production of

goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries

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How Does The Theory Of Absolute Advantage Work?

Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa

In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice

and no cocoa, or some combination of rice and cocoa between the two extremes

In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice South Korea could produce 5 tons of cocoa and no rice, 20 tons of

rice and no cocoa, or some combination in between

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Without trade Ghana would produce 10 tons of cocoa and 5 tons of rice South Korea would produce 10 tons of rice and 2.5 tons of cocoa

With specialization and trade Ghana would produce 20 tons of cocoa South Korea would produce 20 tons of rice Ghana could trade 6 tons of cocoa to South Korea for 6 tons of

rice After trade

Ghana would have 14 tons of cocoa left, and 6 tons of rice South Korea would have 14 tons of rice left and 6 tons of cocoa

If each country specializes in the production of the good in which it has an absolute advantage and trades for the other, both countries gain

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Absolute Advantage and the Gains from Trade

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What Is Ricardo’s Theory Of Comparative Advantage?

David Ricardo asked what might happen when one country has an absolute advantage in the production of all goods

Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home

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How Does The Theory Of Comparative Advantage Work?Assume

Ghana is more efficient in the production of both cocoa and rice

in Ghana, it takes 10 resources to produce one ton of cocoa, and 13 1/3 resources to produce one ton of rice

So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two

in South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice

so, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two

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How Does The Theory Of Comparative Advantage Work?With trade

Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice

Ghana will still have 11 tons of cocoa, and 4 additional tons of rice

South Korea still has 6 tons of rice and 4 tons of cocoa if each country specializes in the production of the good

in which it has a comparative advantage and trades for the other, both countries gain

Comparative advantage theory provides a strong rationale for encouraging free trade

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How Does The Theory Of Comparative Advantage Work?

Comparative Advantage and the Gains from Trade

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Gains from Trade – Qualifications & Assumptions

The conclusion that free trade is universally beneficial is, indeed, based on many unrealistic assumptions:

1) A simple world in which there are only two countries & two goods. Whereas, in the real world there are many countries & many goods.

2) No transportation cost between/among countries.

3) No differences in the prices of resources in different countries. Nothing is mentioned about exchange rates & simply assumed that cocoa & rice could be swapped on a one-to-one basis.

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4) That resources can move freely from the production of one good to another within a country. In reality, this is not always the case.

5) Assumed constant return to scale i.e., that specialization by Ghana or South Korea has no effect on the amount of resources required to produce one ton of cocoa or rice. In reality, both diminishing & increasing returns to specialization exist. The amount of resources required to produce a good might decrease or increase as a nation specializes in production of that good.

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6) Assumed that each country has a fixed stock of resources & that free trade does not change the efficiency with which a country uses its resources. This static assumption makes no allowances for the dynamic changes in a country’s stock of resources & in the efficiency with which the country uses its resources that might result from free trade.

7) Assumed no effects of trade on income distribution within a country.

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Given these assumptions, can the conclusion that free trade is mutually beneficial be extended to the real world of many countries, many goods, positive transportation costs, volatile exchange rates, immobile domestic resources, non-constant returns to specialization, & dynamic changes?

Other economists have shown that the basic results derived from the previous simple model can be generalized to a world composed of many countries producing many different goods.

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Is Unrestricted Free Trade Always Beneficial?

Unrestricted free trade is beneficial, but the gains may not be as great as the simple model of comparative advantage would suggestimmobile resourcesdiminishing returnsdynamic effects and economic growth

Opening a country to trade could increasea country's stock of resources as increased supplies

become available from abroadthe efficiency of resource utilization and so free up

resources for other uses economic growth

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Simple Extensions of the Ricardian -Model

Let’s explore the effect of relaxing three of the assumptions identified above in the simple “Comparative Advantage Model” i.e.,

Immobile Resources - embracing a free-trade regime for an advanced economy such as US often implies that the country will produce less of some labor-intensive goods, such as textile, and more of some knowledge intensive goods, such as computer software or biotechnology products. Although the country as a whole will gain from such a shift, however textile producers will lose.

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Simple Extension of the Ricardian -Model

Resources do not always move easily from one economic activity to another.

The process creates friction & human suffering too.

Accordingly, political opposition to the adoption of a free trade regime typically comes from those whose jobs are most at risk.

Govt. often eases the transition toward free trade by retaining those who lose their job as a result.

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Diminishing Returns – the simple model of Comparative Advantage assumes constant returns to specialization.

By constant returns to specialization means the units of resources required to produce a good ( cocoa or rice) are assumed to remain constant no matter where one in on a country’s production possibility frontier (PPF).

Diminishing Returns to Specialization – occurs when more units of resources are required to produce each additional unit.

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It is more realistic to assume diminishing returns for the two reasons:

First – not all the resources are of the same quality. For example, some land is more productive than the other land. Thus as a country tries to increase its output of a certain good, it is increasingly likely to draw on more marginal resources whose productivity is not as great as those initially employed.

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Second – reason for diminishing returns is that different goods use resources in different proportions.

Diminishing returns show that it is not feasible for a country to specialize to the degree suggested by the simple Ricardian model.

Diminishing returns to specialization suggest that the gains from specialization are likely to be exhausted before specialization is complete.

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Dynamic Effects and Economic GrowthSimple comparative advantage model

assumed that trade does not change country’s stock of resources or the efficiency with which it utilizes those resources.

This static assumption makes no allowances for the dynamic changes that might result from trade.

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If we relax this assumption, it becomes apparent that opening an economy to trade is likely to generate dynamic gains of two sorts:

First – free trade might increase a country’s stock of resources as increased supplies of labor & capital from abroad become available for use within the country. This is occurring now in Eastern Europe, where many Western businesses are investing large amounts of capital in the former communist countries.

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Second – free trade might also increase the efficiency with which a country uses its resources.

Gains in the efficiency of resource utilization could arise from a number of factors, e.g.,:

Economies of large-scale production might become available as trade expands the size of total market available to domestic firms.

Trade might make better technology from abroad available to domestic firms.; better technology can increase labor productivity or the productivity of land. Also, opening an economy to foreign competition might stimulate domestic producers to increase their efficiency.

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Thus the dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized will cause a country’s PPF ( production possibility frontier) to shift outward.

As a consequence of this outward shift, the country can produce more both goods than it did before introduction of free trade.

Thus the theory suggests that opening an economy to free trade not only results in static gains , but also results in dynamic gains that stimulate economic growth.

If this is so, the case for free trade becomes stronger.

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What Is The Heckscher-Ohlin Theory?

Ricardo’s theory stresses that comparative advantages arises from differences in the productivity.

Thus, whether Ghana is more efficient than South Korea in the production of cocoa depends on how productively it uses its resources.

Ricardo stressed labor productivity & argued that differences in labor productivity b/w nations underline the notion of comparative advantage.

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What Is The Heckscher-Ohlin (H-O) Theory?

Swedish Economists “H-O” put forward a different explanation of comparative advantage.

They argued that comparative advantage arises from differences in “national factor endowments”.

By factor endowments they meant the extent to which a country is endowed with such resources as land, labor, and capital.

H-O theory, predicts that countries will export goods that make intensive use of those factors that are locally abundant, and import goods that make intensive use of factors that are locally scarce.

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Heckscher-Ohlin (H-O) Theory

Nations have varying factor endowments, & different factor endowments explain differences in factor costs.

The more abundant a factor, the lower its cost.Thus H-O theory attempts to explain the pattern of

international trade that we observe in the world economy.

Unlike Ricardo’s theory, H-O theory argues that the pattern of international trade is determined by differences in factor endowments, rather than differences in productivity.

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Does The Heckscher-Ohlin Theory Hold?

Wassily Leontief theorized that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods.

However, he found that U.S. exports were less capital intensive than U.S. imports

Since this result was at variance with the predictions of trade theory, it became known as the Leontief Paradox

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Leontief ParadoxNo one is quite sure why we observe Leontief

paradox.This leaves economists with a difficult dilemma.

They prefer the H-O theory on theoretical grounds, but it is relatively poor predictor of real-world international trade patterns.

On the other hand, the theory they regarded as being too limited, Ricardo’s theory of “comparative advantage”, actually predicts trade patterns with greater accuracy.

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Leontief ParadoxThe best solution to this dilemma may be to return

to the Ricardian’s idea that trade patterns are largely driven by international differences in productivity.

Thus, one might argue that US exports commercial aircrafts & imports cars not because its factor endowments are especially suited to aircraft manufacturing & not suited to car manufacture, but because US is more efficient at producing aircraft than cars.

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What Is The Product Life Cycle Theory?

The product life-cycle theory - (Raymond Vernon) - as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade the size and wealth of the U.S. market gave U.S. firms a strong

incentive to develop new products initially, the product would be produced and sold in the U.S. as demand grew in other developed countries, U.S. firms would

begin to export demand for the new product would grow in other advanced

countries over time making it worthwhile for foreign producers to begin producing for their home markets

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U.S. firms might set up production facilities in advanced countries with growing demand, limiting exports from the U.S.

As the market in the U.S. and other advanced nations matured, the product would become more standardized, and price the main competitive weapon

Producers based in advanced countries where labor costs were lower than the United States might now be able to export to the United States

If cost pressures were intense, developing countries would acquire a production advantage over advanced countries

Production became concentrated in lower-cost foreign locations, and the United States became an importer of the product

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The Product Life Cycle Theory

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Does The Product Life Cycle Theory Hold?

The product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the United States in the 1960s and 1970s

But, the globalization and integration of the world economy has made this theory less valid todaythe theory is ethnocentricproduction today is dispersed globallyproducts today are introduced in multiple markets

simultaneously

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What Is New Trade Theory? New trade theory suggests that the ability of firms to

gain economies of scale (unit cost reductions associated with a large scale of output) can have important implications for international trade

1. Through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods without trade, nations might not be able to produce those

products where economies of scale are important with trade, markets are large enough to support the production

necessary to achieve economies of scale so, trade is mutually beneficial because it allows for the

specialization of production, the realization of scale economies, and the production of a greater variety of products at lower prices

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What Is New Trade Theory?

2. In those industries when output required to attain economies of scale represents a significant proportion of total world demand, the global market may only be able to support a small number of enterprises

first mover advantages - the economic and strategic advantages that accrue to early entrants into an industry

economies of scale first movers can gain a scale based cost advantage

that later entrants find difficult to match

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What Are The Implications Of New Trade Theory For Nations?

Nations may benefit from trade even when they do not differ in resource endowments or technologya country may dominate in the export of a good simply

because it was lucky enough to have one or more firms among the first to produce that good

Governments should consider strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important

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What Is Porter’s Diamond Of Competitive Advantage?

Michael Porter tried to explain why a nation achieves international success in a particular industry and identified four attributes that promote or impede the creation of competitive advantage

1. Factor endowments - a nation’s position in factors of production necessary to compete in a given industry

can lead to competitive advantage can be either basic (natural resources, climate, location) or

advanced (skilled labor, infrastructure, technological know-how) 2. Demand conditions - the nature of home demand for

the industry’s product or service influences the development of capabilities sophisticated and demanding customers pressure firms to be

competitive

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3. Relating and supporting industries - the presence or absence of supplier industries and related industries that are internationally competitive

can spill over and contribute to other industries successful industries tend to be grouped in clusters in countries

4. Firm strategy, structure, and rivalry - the conditions governing how companies are created, organized, and managed, and the nature of domestic rivalry

different management ideologies affect the development of national competitive advantage

vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features

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Determinants of National Competitive Advantage: Porter’s Diamond

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Does Porter’s Theory Hold?Government policy can

affect demand through product standardsinfluence rivalry through regulation and antitrust lawsimpact the availability of highly educated workers and

advanced transportation infrastructure. The four attributes, government policy, and

chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage

So far, Porter’s theory has not been sufficiently tested to know how well it holds up

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What Are The Implications Of Trade Theory For Managers?

1. Location implications - a firm should disperse its various productive activities to those countries where they can be performed most efficiently

firms that do not, may be at a competitive disadvantage

2. First-mover implications - a first-mover advantage can help a firm dominate global trade in that product

3. Policy implications - firms should work to encourage governmental policies that support free trade

firms should lobby the government to adopt policies that have a favorable impact on each component of the diamond

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What Is The Balance Of Payments?

A country’s balance of payments accounts keep track of the payments to and receipts from other countries for a particular time period

Balance of payments accounting uses double entry bookkeeping so, the sum of the current account balance, the capital account and the

financial account should always add up to zero There are three main accounts1. The current account records transactions that pertain to goods,

services, and income, receipts and payments current account deficit - a country imports more than it exports current account surplus – a country exports more than it imports

2. The capital account records one time changes in the stock of assets3. The financial account records transactions that involve the

purchase or sale of assets net change in U.S. assets owned abroad foreign owned assets in the United States

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What Is The Balance Of Payments?

United States Balance of Payments Accounts, 2007

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Is A Current Account Deficit Bad?

Does current account deficit in the United States matter?

a current account deficit implies a net debtorso, a persistent deficit could limit future economic

growthBut, even though capital is flowing out of the

United States as payments to foreigners, much of it flows back in as investments in assets

Yet, suppose foreigners stop buying U.S. assets and sell their dollars for another currency

A dollar crisis could occur

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END

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Could A Rich Country Be Worse Off With Free Trade?

Paul Samuelson - the dynamic gains from trade may not always be beneficialfree trade may ultimately result in lower wages in the

rich country

The ability to offshore services jobs that were traditionally not internationally mobile may have the effect of a mass inward migration into the United States, where wages would then fall

But, protectionist measures could create a more harmful situation than free trade

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Review Question

All of the following theories advocated free

trade except

a) Mercantilism

b) Comparative Advantage

c) Absolute Advantage

d) Heckscher-Ohlin

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Review Question

Which theory suggested that comparative advantage

arises from differences in national factor

endowments?

a) mercantilism

b) absolute advantage

c) Heckscher-Ohlin

d) comparative advantage

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Review Question

Which theory suggests that as productsmature the optimal production location willchange?

a) Mercantilism b) Comparative Advantage c) Absolute Advantage d) Product life-cycle

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Review Question

Economies of scale and first moveradvantages are important to which tradetheory?

a) Mercantilismb) Product life cyclec) New trade theoryd) Comparative advantage

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Review Question

Porter’s diamond of competitive advantage

includes all of the following except

a) Factor endowments

b) Demand conditions

c) First-mover advantages

d) Firm strategy, structure, and rivalry

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Review Question

_________ refer to the nature of home demand for the industry’s product or service.

a) Demand conditions

b) Factor endowments

c) Firm strategy, structure, and rivalry

d) Related and supporting industries

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Chap005 (2)