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• UNIT - 2
Trade Theories: • Mercantilism, • Absolute Advantage Theory• Comparative Cost Theory• Heckseher-Ohlin Theory• Product Life Cycle Theory• The New Trait Theory• Porter’s Diamond
Learning Objectives Understand theories of international trade
Comprehend arguments of imposing trade restrictions
Explain two basic kinds of import restrictions
Appreciate the relevance of changing status of tariff and non tariff barriers
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Learning Objectives
Recognize the weaknesses of GNP/capita as economic indicator
Understand new definition of economic development
Understand why governments change from import substitution to export promotion
Explain some theories of foreign direct investment
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International Trade Theory
• Mercantilism• Economic philosophy based on belief
that • (1) a nation’s wealth depends on
accumulated treasure, usually gold, and
• (2) to increase wealth, government policies should promote exports and discourage imports
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Theory of Comparative Advantage
• Comparative Advantage• A nation having absolute disadvantages
in the production of two goods with respect to another nation has a comparative or relative advantage in the production of the good in which its absolute disadvantage is less
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Absolute Advantage
Each Country Specializes
Example
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Absolute AdvantageTerms of Trade (Ratio of International Prices)
Gains from Specialization and Trade
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Theory of Comparative Advantage
• Comparative Advantage• A nation having absolute disadvantages
in the production of two goods with respect to another nation has a comparative or relative advantage in the production of the good in which its absolute disadvantage is less
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Theory of Comparative Advantage
Example
Each Country Specializes
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Comparative AdvantageTerms of Trade – at a rate of ¾ bolt of cloth for 1 ton of soybeans
Terms of Trade – at a rate of 1 bolt of cloth for 1 ton of soybeans
Gains from Specialization and Trade
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Comparative Advantage
• Production Possibility Frontiers (figure 3.1)
Figure 3.1
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Heckscher-Ohlin Theory of Factor Endowment
• Factor Endowment • Heckscher-Ohlin theory that countries
export products requiring large amounts of their abundant production factors and import products requiring large amounts of their scarce production factors
• The theorem examines the reason for comparative cost differences in production and states that a country has comparative advantage in the production of that commodity which uses more intensively the countrys more abundant factor.
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• In Heckcher-ohlin model, factors of production are regarded as scarce or abundant in relative and not abundant terms.
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• Example: even if a country has more capital, than other countries, it could be poor in capital. A country can be regarded as richly endowed with capital only if the ratio of capital to other factors is higher when compared to other countries.
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of
I. In country A: supply of labor = 25 units
supply of capital = 20units
capital-labor ratio = 0.8
II. In country B: supply of labor = 12 units
supply of capital = 15units
capital-labor ratio = 1.25
• From this, even though country A has more capital in absolute terms, country B is more richly endowed with capital because the ratio of capital to labor in country A ( 0.8) is less than in country B ( 1.25 ).
Pattern of trade under Hechscher-Ohlin model
Capital abundant country
Capital intensive goods
Labor abundant country
The two-country-two commodity model of Heckscher and Ohlin is based on a number of explicit and implict assumptions.The assumptions are:
• Two countries, two products and two factors: The original Heckscher–Ohlin model contained two countries, and had two commodities that could be produced. Since there are two (homogeneous) factors of production this model is sometimes called the "2×2×2 model". If both countries were producing all the output they could and trading only between themselvs ( only two coutries ) there should be a balance in trade.
• Inputs and the outputs are perfectly competitive:
the factors of production, labor and capital were exchanged in markets that paid them only what they wre worth
• Production output must have constant Return to Scale
• Both of the countries in the simple HO model produced both commodities, and both technologies have constant returns to scale (CRS). (CRS production has twice the output if both capital and labor inputs are doubled, so the two production functions must be 'homogeneous of degree 1').
• Capital mobility within countries• It is further assumed that capital can shift
easily into either technology, so that the industrial mix can change without adjustment costs between the two types of production.
• For instance, if the two industries are farming and fishing it is assumed that farms can be sold to pay for the construction of fishing boats with no transaction costs.
• Both countries have identical production technology
• This assumption means that producing the same output of either commodity could be done with the same level of capital and labour in either country. Actually, it would be inefficient to actually use the same balance in either country (because of the relative availability of either input factor) but, in principle this would be possible. Another way of saying this is that the per-capita productivity is the same in both countries in the same technology with identical amounts of capital.
• Capital immobility between countries• The basic Heckscher–Ohlin model depends upon the
relative availability of capital and labor differing internationally, but if capital can be freely invested anywhere competition (for investment) will make relative abundances identical throughout the world. (Essentially, Free Trade in capital would provide a single worldwide investment pool.)
• Labour immobility between countries• Like capital, labor movements are not permitted in the
Heckscher-Ohlin world, since this would drive an equalization of relative abundances of the two production factors, just as in the case of capital immobility above. This condition is more defensible as a description of the modern world than the assumption that capital is confined to a single country.
• Commodities have the same price everywhere• The 2x2x2 model originally placed no barriers to trade,
had no tariffs, and no exchange controls . It was also free of transportation costs between the countries, or any other savings that would favour procuring a local supply.
• If the two countries have separate currencies, this does not affect the model in any way . Since there are no transaction costs or currency issues the law of one price applies to both commodities, and consumers in either country pay exactly the same price for either good.
• Perfect internal competition• Neither labor nor capital has the power to
affect prices or factor rates by constraining supply; a state of perfect competition exists.
Advantages of Heckscher-ohlin theory over the classical theory
• Two factors of production• Differences in factor supplies• Relative prices of factors• Relative productivities of factors• Differences in factor endowments( qlty)• Causes of differences in comparative
costs( comparative costs)
Criticism against the Heckscher–Ohlin model
• Static theory- “it only gives some characteristics of an economy at a given point in time”.- no information about the change.
• Factors not homogeneous- there is assumption only but no two countries are homogeneous.• Eg: labor both skilled and unskilled, is
of various types.
• Production techniques not homogeneous.• Eg: textiles may be produced with
handlooms which requires more labor and less capital or with highly sophisticated power looms requiring a small number of workers- the trade may not follow model.
• Tastes and demand patterns not identical
• Production techniques not homogeneous.• Eg: textiles may be produced with
handlooms which requires more labor and less capital or with highly sophisticated power looms requiring a small number of workers- the trade may not follow model.
• Tastes and demand patterns not identical
• No constant returns- but countries having rich factor endowment have high advantages of economies of scale.
• Transport costs influence trade- loading unloading of goods….
• Unrealistic assumptions of full employment and perfect competition- trade restrictions on a large scale.
• Factor prices do not determine commodity prices.
• Vague and conditional theory.
Opportunity cost theory
• OP.cost approach defines cost in terms of the value of the alternatives of other opportunities, which have to be foregone in order to achieve a particular thing.
• According to the opportunity cost theory, the basis of international trade is the differences between nations in the opportunity costs of production of commodities.
• Though it same as comparative cost theory, there is difference in measuring the cost of producing wine in terms of labor or in terms of any real cost, but in OP.cost theory, it is measured in contrast to the comparative cost approach, the cost of producing wine in terms of the amount of cloth foregone in order to produce one more unit of wine.
Opportunity cost theory
• What Does Opportunity Cost Mean?1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.
• The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% - 2%).
• The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages.
• Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).
In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise) with another option is the opportunity cost.
Advantages of opportunity cost theory
1. Takes into account the entire cost of production: it takes into account the entire cost of production and does not suffer from the weakness of labor theory of value.
2. Ease in empirical verification: only fewer difficulties in empirical verification.
3. Can accommodate trade based upon non-price competition and policy measures that restrict trade.
limitations
1. Fails to explain the determination of terms of trade.
2. Develops trade theory in barter terms rather paper standards.
3. Unable to recognize the role of capital flows
Product Life Cycle theory
• By Raymond vernon’s • The theory states that the location of
production of certain kinds of products changes as they go through their life cycle.
• There are four stages :• Introduction - domestic location a
small part of the production to the customers in foreign markets new product
• Growth – new product is in dd than competitors enter the market
• Maturity – dd begins to raise, it may be growing in some countries and declining in others
• Decline
Product Life-Cycle Theory
• As products mature, both location of sales and optimal production changes.
• Affects the direction and flow of imports and exports.
• Globalization and integration of the economy makes this theory less valid.
© McGraw Hill Companies, Inc.,2000
International Product Trade Cycle Model
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
1 3 4 5 6 7 8 9 10 11 12 13 14 15
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
High Income Countries
Medium Income Countries
Low Income Countries
Time
Stages of Production Development
New Product Standardized ProductMaturing Product
Quantity
production
consumption
2
Exports Imports
Imports
Exports
Exports
Imports
© McGraw Hill Companies, Inc.,2000
Figure 4.5
Assumption of the theory1. Stimulus to innovate a new product is provided by the
need and opportunities of the domestic market.
2. Innovating firm have no information about conditions in foreign markets whether in other advanced countries or in developing countries.
3. Innovating firms in advanced country are exposed to a very different home environment from other advanced industrialized countries.
4. The appearances of rival producer, leads to the manufacture of the product for export.
5. New products are initially developed in capital rich countries.
The New Trade Theory
• Began to be recognised in the 1970s.• Deals with the returns on specialisation where substantial
economies of scale are present.• Specialisation increases output, ability to enhance
economies of scale increase.• In some industries there are likely to be only a few
profitable firms.
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The New Trade Theory
• Thus firms with first mover advantages will develop economies of scale and create barriers to entry for other firms.like-
1. They are able to establish themselves
2. Capture a significance portion of the world market.
3. Able to achieve competitive advantage on the basis of economies of scale and learning effects
• The commercial aircraft industry is an excellent example (eg. Boeing, Airbus)
• New trade theory does NOT contradict the theory of comparative advantage, but instead identifies a source of comparative advantage
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• Founded 1915 by William Boeing• Largest commercial airplane manufacturer.• 9,000 commercial jetliners in service.
© McGraw Hill Companies, Inc.,2000
• Established 1967• Western Europe buying 25% of aircraft ,but selling
only 10%.• France, Germany, Great Britain • To date: 3,203 orders - 1,890 deliveries.
© McGraw Hill Companies, Inc.,2000
• Boeing and Airbus:• Boeing spent nearly 5 billion US dollar to develop
Boeing 777 jet liner. if Boeing manufactures a large output then this fixed cost will get spread, and fixed cost per unit will be small. On the other hand, if it manufactures only a limited number then unit fixed cost will be high. In aerospace industry, as the output of accumulated airframes doubled, its cost declined by 20%. Thus Boeing and Airbus were able to enter earlier they were able to capture most of the market share. Organizations from other nations like Japan, instead of directly entering into the industry, sub-contractors with primary manufacturers.
Implications from the application of the New Trade Theory
• Typically, requires industries with high, fixed costs.
• World demand will support few competitors.• Competitors may emerge because “they got there
first”• first-mover advantage.
• Some argue that it generates government intervention and strategic trade policy (e.g. the need to nurture and protect “first movers”)
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National Competitive Advantage:Porter’s Diamond(Harvard Business School, 1990)
• Looked at 100 industries in 10 nations.• Thought existing theories didn’t go far enough.
• Results contained in The Competitive Advantage of Nations.• Question: “Why does a nation achieve international success in
a particular industry?” (e.g. Switzerland in Watches and Pharmaceuticals; Finland in Mobile Phones)
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Figure 3.3 Variable Impacting Competitive Advantage: Porter’s Diamond
Determinants or components of National Competitive Advantage
• Factor endowments: nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry.
• Firm strategy, structure and rivalry: the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.
• Demand conditions : the nature of home demand for the industry’s product or service.
• Related and supporting industries : the presence or absence in a nation of supplier industries or related industries that are nationally competitive.
Porter’s Competitive Advantage of Nations
Demand Conditions Nature of domestic demand.
If customers are demanding, firms will produce high-quality and innovative products gaining competitive advantage
Factor Conditions• Level and consumption of
factors of production• Lack of natural endowments
has caused nations to invest in the creation of advanced factors
Related and supporting industries Suppliers and
industry support services tend to form a cluster in a given location
Firm Strategy, Structure, Rivalry Extent of domestic
competition, The existence of
barriers to entry The firm’s
management style and organization.
Factor Endowments• Taken from Heckscher-Olin• Basic factors:
• natural resources,• climate,• location.
• Advanced factors:• communications,• skilled labor,• technology.
Advanced Factor Endowments
• More likely to lead to competitive advantage.• Are the result of investment by people,
companies, government.
Demand Conditions• Demand creates the capabilities.• Look for sophisticated and demanding
consumers.• impacts quality and innovation.
Relationship of Basic to Advanced Factors
• Basic can provide an initial advantage.• Must be supported by advanced factors to maintain
success.• No basics, then must invest in advanced factors.
Firm Strategy, Structure and Rivalry
• Management ‘ideology’ can either help or hurt you.• Presence of domestic rivalry improves a company’s
competitiveness.
The Diamond
• Success occurs where these attributes exist.• More/greater the attribute, the higher chance of
success.• The four attributes, government policy and chance work as
a reinforcing system.• Nokia is a good example of a firm which has built its
competitive advantage as a result of factors in Porter’s diamond.
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Determinants of National Competitive Advantage
Company Strategy,Structure,
and Rivalry
DemandConditions
Relatedand Supporting
Industries
FactorConditions
Government
Source: Michael Porter, The Competitive Advantage of Nations
Chance
© McGraw Hill Companies, Inc.,2000
Two external factors that influence the four determinants.
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• Role of chance:
1. New invention
2. Political decisions by foreign governments.
3. Wars
4. Significant shifts in world financial markets or exchange rates.
5. Surges in world or regional demand, and
6. Major technological breakthroughs
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• Role of governments:
1. Subsidies
2. Education policies
3. The regulation or deregulation of capital markets
4. The purchase of goods and services
5. Tax-laws and
6. Anti-trust regulation.
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Limitation of the porters diamond theory
1. Observations of foreign or foreign plus domestic, rather than just domestic, demand conditions have spurred much of the recent growth in Asian exports as . Japanese companies as fujitech target their sales almost entirely to foreign markets.
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2. Companies and countries are not dependent entirely on domestic factor conditions. For example, capital and managers are now internationally mobile.
3. If related and supporting industries are not available locally, materials and components are now more easily brought in from abroad because of advancements in transportation and the relaxation of import restrictions.
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4. Companies react not only to domestic rivals but also to foreign-based rivals they compete with at home and abroad.
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Evaluating Porter’s Theory
• If Porter is right, his model is expected to predict the pattern of international trade in the real world:• a country’s exports should reflect the presence of
the four ‘diamond’ components. • Countries will import in those areas where the
components are not favorable.• This theory is too new. Requires independent empirical
testing.
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Conclusion
• The theories of international trade is important to an individual business firm primarily because they can help the firm to decide to locate its various production activities. Firms involved in IT can do exert a strong influence on government policy toward trade. By govt., business firms can promote free trade or trade restrictions.
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