Chapter Two Copyright, John Wiley and Sons, Inc. Chapter Two three Learning Concepts – Chapter 2 1. Understand the purpose of International Trade Theory

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Copyright, John Wiley and Sons, Inc.

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Learning Concepts – Chapter 2

1. Understand the purpose of International Trade Theory as explanation, prediction and control of trade phenomena.

2. Know theories that explain trade flows, like mercantilism, absolute advantage, comparative, advantage, Heckscher-Ohlin, product life cycle, income-preference similarity, and new trade theory.

International Trade Theory

and Applications


and Applications

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Learning Concepts – Chapter 2 (cont)

3. Understand how theory is created and know that further trade theory development is needed that explains flows in human resources, capital, information, and technological resources.

4. Comprehend that international trade has grown dramatically in the goods, services, commodities, and information sectors.


and Applications


and Applications

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Learning Concepts – Chapter 2 (cont)

5. Know that international trade is difficult to pressure and precisely explain in simplistic models.

6. Explain tariff and non-tariff barriers to trade and how they work.


and Applications


and Applications

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The purpose of Trade Theory

Theories are representations of our understanding of “how the world works”. They explain the connection between variables, predict how and when those connections will exist, and set controls in relationship to when these theories apply, to what extent, and where they do not apply. All good theories should do these things.

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The purpose of Trade Theory

Trade theory explains why trade exists, how it happens, and where it does and not occur. When you see trade theory, you want to ask some questions: (1) does theory x apply to something? (2) can I think of an example? (3) can I identify where it doesn’t work?

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Trade Theory - Mercantilism

Mercantilism is a 16th Century doctrine stating that a nation should export more goods that it imports.

Government’s job is to create policy that promotes heavy exportation, collection of revenue, and industrial development internally.

In Practice, it serves to make the State the stockholder, financier, customer, marketer, collector, and enforcer of contracts with other nations. Colonial relationship resulted from mercantilism.

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Trade Theory - Absolute Advantage

Under Mercantilism State policies predicted where trade would occur. In 1776, Adam Smith indicated that was better predicted and explained by market forces rather than government desires.

Laissez-Faire policy where government has no influence should promote trade better, according to Smith.

Nations could specialize in producing and exporting goods where they have a natural or acquired Absolute Advantage and import those goods they don’t produce as well.

Nations will export to pay for goods they import.

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Trade Theory - Comparative Advantage

Adam Smith said that nations should specialize in those goods where they have an Absolute Advantage – they should import everything else.

David Ricardo indicated in 1817 there may be a better explanation since few States actually specialize like that.

Ricardo indicated that nations that are comparatively more efficient at production will make those goods even though they may not have an absolute advantage.

It is this Comparative Advantage that explains and predicts trade of goods where absolute advantages may not exist.

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Trade Theory - Smith & Ricardo

Ricardo indicated that nations will produce and trade goods where they have a Comparative Advantage even though more than one nation holds Absolute Advantage in production. It is the nation that is comparatively better in production that will trade.

The implication for Ricardo is that human skill, productivity, capital, or government policy can intervene and make a nation an exporter of goods.

Examples can be where governments promote comparative advantage through subsidies, resources and development, or direct funding.

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Trade Theory - Heckscher-Ohlin

Smith said trade was explained through Absolute Advantage; Ricardo said it was Comparative Advantage; Heckscher-Ohlin indicates it is supply of factors that predicts, explains, and controls trade.

Every producer has to have a supply base. Sources of supply coming from locally abundant Factor Endowments lower supply costs and make for cheaper production and more likely export.

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Heckscher-Ohlin Problems

Heckscher-Ohlin says that cheaper supply from locally plentiful sources predicts where trade will occur.

This may not be true. Locally abundant supply may not be the cheapest. There are market faces, like supply and demand, at work. There is also government policy or speculation that serves to throw off a “perfect” market.

An example is government imposed minimum wage that raises the cost of an abundant factor – labor.

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Heckscher-Ohlin Problems

Ohlin assumed also that technology for production was universally available, which it isn’t.

Heckscher-Ohlin also assumes that products can be either capital or labor intensive, not both.

Heckscher-Ohlin also ignore transportation and logistical costs to and from a factory.

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Trade Theory - Leontief

Leontief challenges Heckscher-Ohlin on a number of grounds. First, Leontief observes that the U.S (a capital intensive nation) exports labor-intensive goods.

Second, the U.S also exports technically sophisticated goods that require skilled labor.

Third the U.S imports capital intensive goods made with unskilled labor.

If Heckscher-Ohlin is correct, how could these things exist?

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Trade Theory - Leontief

To overcome the contradictions in Heckscher-Ohlin, Leontief proposed the followings:

1. There are differences in tastes and preferences that contradict market and factor influences. These are called demand biases.

2. There are trade barriers that government imposes that influence production.

3. There are natural resources in abundance or not.

4. There are factor intensity reversely that occur over time.

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Trade Theory - Human Skills & Technology

Up to now, trade has been explained as occurring from Absolute Advantage, Comparative Advantage, from factor endowments or moderated by taste, biases or policy.

Keesing had another idea. He indicated that trade direction and flow is predicted by gaps in human skills and technology.

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Trade Theory - Human Skills & Technology

According to Keesing, nations with higher levels of humans skills and technology will produce and export goods to nations with lower levels.

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

Technology level is predicted by capital-intensive technology development, and also the imitation lag that exists as technology innovations diffuse to developing areas.

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Trade Theory - Product Life Cycle

The product life cycle model by Raymond Vernon is closely related to the Keesing model.

Vernon’s PLC model asserts that product innovation and initial use occurs first in higher income countries and then diffuses to middle and lower income countries as technology and skills gaps overcome and consumer preferences switch to the newer products.

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Trade Theory - Product Life Cycle

Several trends emerge in PLC:

1. The export performance of the mature innovating country is better than others.

2. Technology is better in the mature countries – as products diffuse production tends to move from technology-intensive to labor-intensive.

3. Countries that were innovators can fall from that place.

4. Trade may increase in later stages of product maturity as costs and prices decline and production economies rise.

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Trade Theory - Income-Preference Similarity

Developed countries trade more than les developed countries – this is the assumption. Trade should take place between developed nations producing manufactured products and less developed nations producing primary products (e.g. natural resources) and labor-intensive goods.

According to Linder, the range of production is determined by internal demand. Countries with similar internal demand conditions should therefore trade. This is called Preference Similarity.

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Old Trade Theory - New Trade Theory

Up to now, trade theory has been dependent on national advantage, production efficiency, factor endowments, government agendas, country or industry maturity, or overlapping demand similarity. These theories have a few commonalities:

1. They depend on national differences to explain, predict, and control trade.

2. They assume government is either involved, or not involved at all.

3. They don’t consider firm level strategy, structure or economy.

4. The newer trade theories do that.

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Trade Theory - New Trade Theory

According to New Trade Theory, which is actually a set of papers by various scholars, trade is predicted by the increasing returns that firms can earn by trading intentionally. In New Trade Theory:

1. There is increasing return in Economy of Scale.

2. Intra-Industry trade is best explained by increasing returns.

3. Externalities like government policy, political relations, national history, consumption differences, accident, and luck all predict variance in trade.

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Theory Assessment

Remember, no theory thoroughly explains all trade, predicts it all accurately, and establishes limits on where trade does or does not occur. Every theory has advantages though, and it may be better to consider theory in combination rather in independently.

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Theory Assessment (cont)

1. Traditional trade theory uses national differences to explain trade.

2. Factor endowment and skills or technology also predict trade.

3. Overlapping demand and income preferences predict motives.

4. Increased returns on investment also predicts trade.

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International Trade Patterns

The overall trend is trade in favor of big growth. As the following slides show. In sum, though,

1. Trade in manufactured goods, mined products, and agricultural products is up very substantially over the past 50 years.

2. World trade is up across all regions with the developing world increasing trade development fastest.

3. Services trade is up exponentially.

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Trade Measurement

Trade measurement is generally a difficult exercise since nations do not use similar indexed systems. It is important to realize that different trade data is collected for different purposes and that aggregations may be biased. The general trend though is – “Trade is up”.

Each country collects and reports trade data-major sources of reliable data can be found from the U.S Department of Commerce, the World Trade Organization, Shippers Export Declarations, and the World Bank. The CIA Factbook also offers some trade data.

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Barriers to Trade

There are various arguments for erecting trade barriers - among them -

1. National Defense.

2. Infant Industries.

3. Protecting domestic jobs.

4. Preventing dumping.

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Instruments of Trade “Protection”

Tariffs – A tax on incoming goods.

1. Ad valorem tariff.

2. Specific tariff.

3. Compound tariff. Variable levy. Lowered duty for local input.

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Instruments of Trade “Protection”

Non-Tariffs barriers.

1. Quota – number of goods.

2. Tariff quota – the aggregate tariff amount collected.

3. Direct government participation.

4. Customs or administrative procedures.

5. Safety, content or other standards.

6. Corrupt practices.

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Chapter Two Copyright, John Wiley and Sons, Inc. Chapter Two three Learning Concepts – Chapter 2 1. Understand the purpose of International Trade Theory