Theory of International Trade

Why Trade?

Countries benefit from foreign tradeThey can import resources they lack at homeHigher standards of living and greater satisfactionThey can import goods for which they are a relativelyinefficient producerSpecialization often results in increased output andeconomies of scaleContributes to global interdependence

Concepts of TradeMutual Gains From TradeWhen trade is voluntary:Both sides must expect to gain from it, otherwise they would not tradeScarcity and ChoiceWants exceed resourcesChoices are necessitated by scarcity

Theory of Mercantilism

Theory Of MercantilismThe first theory of international trade called Mercantilism in England, in mid-16th century.Gold and silver were the currency of tradeCountrys interests was to maintain a trade surplus, to export more than it importedBy doing so, a country would accumulate gold and silver and, consequently, increase its national wealth and prestigeby an English mercantilist writer Thomas Mun in 1630.

Demerits:Problems with this theory is that it excludes the fact that in some cases it is good to importIf the import is completely refused, the population will have to do without certain consumer items

Theory of Absolute Advantage

Theory of Absolute AdvantageProposed by Adam Smith in 1776 in his book The Wealth of NationsHe was a Scottish Classical EconomistSome of his great books are The theory of Moral Sentiments and The Wealth of Nations

Contd

He said, A country has an absolute advantage in the production of a product more efficiently than any other country

He said, Countries should specialize in the production of goods for which they have absolute advantage and then trade these for goods produced by other countries.

ContdSmiths basic argument that a country should never produce goods that can buy at a lower cost from other countries Examples:England should specialize in the production of textiles and French in wine and then trade theseGhana and South Korea doing trade of cocoa and rice

DemeritsSmiths theory can not explain if there should be trade when a country has absolute advantage on all goods over other countryIn this case, a country might derive no benefits from international trade

Comparative Cost Theory

Comparative Cost TheoryIt is attributed to David Ricardo an English political economist in 1817 in his book Principles of Political Economy and TaxationHe was also a member of Parliament, Businessman, Financier and Speculator

Contd.Some countries have the advantage of producing some goods at a lower cost compared to other countries.The countries in the long run should specialize in the business in which they enjoy comparatively low cost advantage and export the product while it will import other goods in which other countries have comparatively low cost advantage, if free trade is allowed

e.g. Japan in producing electronics and India in textile

The Theory of Comparative Advantage3.757.52.5G

Contd

Example

CountryWheatCost Per Unit In Man HrsWineCost Per Unit In Man Hrs

England1530Portugal1015

The basic message of this theoryPotential world production is greater with unrestricted free trade than it is with restrictedConsumers in all nations can consume more if there are no restrictions on tradeTrade is a positive sum game in which all countries that participate realize economic gains.

Assumptions of this theoryThe only element of the cost of production is labourThere are no trade barriersTrade is free from cost of transportation

CriticismAn advanced nation may gain an advantage by shifting labour and resources to more profitable goods such as microchips and away from less profitable goods like potato chips. Thus there is a chance that the advanced nation may buy all the potato chips it wants as it has more wealth for microchipsAdvanced industrial countries may keep undeveloped countries on agriculture instead of developing their own manufactures (which would have made them competition for the industrialized nations)

Hecksher-Ohlin Theory

Hecksher-Ohlin TheorySwedish economists-Eli Heckscher(1919) & Bertil Ohlin(1933)Ohlin-student of HecksherEki HeckscherBertil Ohlin

PostulatesH-O Theory is based upon two postulates:The factor endowments are different in different countries.E.g. Land-Argentina & AustraliaLabour- INDIA & ChinaCapital-U.S.A & U.K.Different commodities require for their production different proportions of the factors of production.

ContdThey gave a different explanation of comparative advantageThey argued that comparative advantage arises from differences in national factor endowments (land, labor, capital)Different factor endowments among countries explain differences in factor costs.The more abundant a factor, the lower its costExport those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are scarce.

Assumptions It is based on the neo-classical theory which considers land ,labour and capital as the factors of production.Factor endowments vary in quantity but are homogenous qualitatively.Resources are fully employed in the trading countries.The production are fully employed in the trading countries.Technologies are same across countries.

MERITS OF H.O THEORY OVER CLASSICAL THEORYH-O model takes these factors-land, labour & capitalas against the one factor (labour) of the classical model.It is cast within the framework of the general equilibrium theory of value.

ContdIt is more realistic because it is based on the relative prices of factors which in turn influences the relative prices of the goods, while Ricardian theory considers the relative price of goods only.Considers differences in relative productivity of labor and capital as a basis of international trade.

CriticismsTheory explains trade being due to differences in factor proportions between countries. This implies that no trade will take place between countries endowed with similar factor endowmentsTheory ignores factors such as-transport cost, economies of scale, etc.Wijanholds-price of commodity not determined by factors of productionS.Linder(Swedish economist)-It is not applicable to manufactured goods, where the costs largely depend upon technology, management, scale of production, etc.

ContdAssumption that dont hold good in a dynamic worldfixed factor endowmentsTechnologyJ.H.Williams-contends the assumption of immobility of factors between countriesTheory is not supported by empirical evidence

The Leontief Paradox

The Leontief ParadoxWassily.W.Leontief (1906-1999)20th century Russian born U.S. Economist.Ph.D in Berlin.Father of input output analysis. -Winner of Nobel Prize in economics in 1973.

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What was tested?Heckscher-Ohlin theory states that each country exports the commodity which uses its abundant factor intensively.The first serious attempt to test the theory was made by Professor Wassily W. Leontief in 1954.

ResultLeontief reached a conclusion that the USthe most capital abundant country in the world exported labor-intensive commodities and imported capital- intensive commodities.This result has come to be known as the Leontief Paradox.

How the test was performed?Leontief used the 1947 input-output table of the US economy.200 groups of industries was aggregated into 50 sectors.Computed the labour & capital requirements.This was done for 1 million dollars worth of exports and import replacements.

Contd

US exports were labour intensive.US imports were capital intensive

Leontief's Second Test

Leontief was criticized on statistical grounds-Swerling complained that 1947 was not a typical year: the postwar disorganization of production overseas was not corrected by that time. In 1956 Leontief repeated the test for US imports and exports which prevailed in 1951.He aggregated industries into 192 industries.He found US imports were still 6% more capital-intensive.

Trade Patterns of Other CountriesCapital-intensiveLabour-intensive

S.NoCountryExportsImports1Japan(Tatemoto and Ichimura, 1959)2Canada(Wahl, 1961)-3East Germany (Stolper and Roskamp,1961)-4India(Bharawaj,1962)-

CriticismsMethodology- It was basically concerned with export industries and competitive import replacements rather than actual imports.He did not measure or compare factor endowments of America with those of other trading nations.

Hecksher-Ohlin theory was defended by some other economists(R.Jones and Hoffmeyer) Very high domestic demand of capital intensive goods.Difference in characteristics of labour across countries. Example: US tends to specialize in technology intensive products that require more highly educated labour.He did not deal adequately with natural resource component of goods.

ConclusionOhlins theory is irrefutable because it cannot be put to perfect empirical test on account of its unrealistic and restrictive assumptions.When we consider the impact of technology on productivity is not taken into consideration,the Heckcher-Ohlin theory gains predictive power.

Product Life Cycle Theory

PLC TheoryProposed by: Raymond Vernon in mid-1960sRaymond Vernon was part of the team that overlooked the Marshall plan, the US investment plan to rejuvenate Western European economies after the Second World War. He played a central role in the post-world war development of the IMF and GATT organisations. He became a professor at Harvard Business School from 1959 to 1981 and continued his career at the John F. Kennedy School of Government.

ContdAbout the theory:Based on the observation that new products had been developed by U.S firms and sold first in U.S marketTwo fundamental principles-TechnologyMarket size and structure

Contd...Overview:It was a trade theory beyond Ricardos theoryIt is an internationalization processProducts advanced in technology are produced & sold in the home marketBypasses the trade barriersIn the end the innovator becomes the importer of the productIt is produced by lesser developed countries or, if the innovator has developed an MNC there

ContdThree stages:New-product stageMaturing-product stageStandardized-product stage

Contd1. New-Product Stage:Conditions for success:Availability of sufficient scientists and engineersHigher per capita incomeFlexibility in productionDemand is relatively price inelasticProduct features given more priority than priceClose contact with the marketFew players in the domestic market as competitors

ContdHow to meet increase in demand?ExportsForeign production

Contd2. Maturing-Product Stage:Transition from New-Product Stage-Price competitionTechnology is diffusingPrice elastic demand for the productStandardization of production processChange in company strategy away from focus on production toward market protection.Product differentiation

ContdMarket growth slowsToward the end of this stage, foreign production may even be exported to the home country

Contd3. Standardized-Product Stage:Technology becomes widely availablePrice competitionProduction shifted to less developed countriesOffshore assemblyStrategy to combat price competition-Product differentiationPrincipal markets gets saturatedInnovators original advantage gets eroded

International Product Life Cycle

The Product Life-Cycle TheoryExports

PLC Theory-ExamplesPhotocopiers-Xerox(1960)U.SExported to advanced countriesJapan & Western EuropeGrowth in demandJoint venture-productionFuji-Xerox(Japan)Rank-Xerox(Great Britan)Entry of competitorsCanon(Japan)Olivetti(Italy)Expiry of Xeroxs patentImport from low-cost foreign sources (developing countries)U.S

ContdPocket calculator1961Sunlock Comptometer Corp.$10001970sCompetitors-HP, Texas Instruments$240Standardized-product stage$10/$151975

ContdPolaroid Land camera

The New-Product stage lasted approximately for 30 years.

1948Introduced by Polaroid Corp.1976Competition from Kodak1987Late New-product/early Maturity stage47% sales-foreign operations(18 countries)Price competition1992

ContdFinlands NokiaFinlandsparsely populatedExtremely cold climatic conditionHow it developed competitive edge?

ContdGerman Cars:Germany is the leader in production of cars.It produces cars like VW, Mercedes Benz, BMW, Formula one cars etcIt sells its products in the home marketIt exports to the advanced countries like USA, UK, France, etc & even in AsiaIt has not yet reached the third stage

PLC Theory-MeritsHelps organizations going for international expansionNew product development in a country does not occur by chanceThe model is best applied to consumer oriented physical products like electronic items

PLC Theory-DemeritsDuration of each stage is not knownDoesnt explicitly state to make the choice between-export and foreign plantIt doesnt explain which countrys firms are most likely to produce in any given market or which firms will move first.Vaguely defines product

ContdOther Demerits:Its main assumption was that the diffusion of new technology occurs slowly. By the late 1970s he recognized that this assumption was no longer valid It assumed integrated firms producing in one nation, then exporting and building facilities abroad. But now the business landscape has become more interrelatedHe emphasized the product level and not the consumer sideForeign markets are composed of not only one set of income earners but multiple income segment

Conclusion

Implications-LocationGlobal web of productive activitiesFactors consideredComparative advantageFactor endowmentsGives competitive advantage

ContdExample: Laptop productionStages involvedR&DManufacture-std. electronic comp.capital-intensiveSemi-skilled labourIntense cost pressureManufacture-advanced comp.capital-intensiveSkilled labourLess cost pressureAssemblyLow-skilled labourIntense cost pressure

Japan & USSingapore,Taiwan,Malaysia,South KoreaJapan & US

ContdBy dispersing production activities to different locations around the globe, the U.S manufacturer is taking advantage of the differences between countries identified by the various theories of international trade.

Implications-Govt. PolicyThe theories of international trade claim that promoting free trade is generally in the best interests of a countryUS Govt.-placed tariff on Japanese imports of LCD screens(1991)Protested by IBM and Apple ComputerIt was later reversedIn contrast, US Govt. was forced by US firms to place restrictions on imports of steel

India-Exports & ImportsVideo

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*The evolution in the pattern of international trade in photocopiers is consistent with the predictions of the PLC theory that mature industries tend to go out of the US and into low-cost assembly locations.*Finland never had a national telephone monopoly.Std. electronic comp-memory chipsAdvanced comp-microprocessor, flat-top color display screensStd.elec. Comp:semi-skilled labour,cost pressures are intenseAdv. Comp-