sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
chap
ter th
ree
Concept PreviewAfter reading this chapter, you should be able to:
1. understand the theories that attempt to explain why certain goods are traded internationally
2. comprehend the arguments for imposing trade restrictions
3. explain the two basic kinds of import restrictions: tariff and nontariff barriers
4. state the agreements reached during the Uruguay Round
5. appreciate the relevance of the changing status of tariff and nontariff barriers to businesspeople
Economic Theories on International Trade,
Development, and Investment
Economic Theories on International Trade,
Development, and Investment
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
chap
ter th
ree
Concept Preview continued After reading this chapter, you should be able to:
6. recognize the weakness of GNP/capita as an economic indicator
7. identify the common characteristics of developing nations
8. understand the new definition of economic development which includes more than economic growth
9. understand why some governments are changing from an import substitution strategy to one of export promotion and the implications of this change for businesspeople
10. explain some of the theories of foreign direct investment
Economic Theories on International Trade,
Development, and Investment
Economic Theories on International Trade,
Development, and Investment
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-3
Economic Theories of International Trade
International trade theory Mercantilism Absolute Advantage Comparative Advantage Heckscher-Ohlin Theory of Factor Endowment
Trade restrictions Economic development International investment theories
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-4 Theory of Mercantilism
Essential to a nation’s welfare to accumulate a stock of precious metals
Viewed as the only source of wealth Mercantilists era ended in 1700’s A “favorable” trade balance still means that a
nation exports more goods and services than it imports
Modern-day economic nationalism, industrial policy based on heavy state intervention
France nationalized key industries to make the state stockholder and financier customer and marketer policy reversed in 1986
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-5
Theory of Absolute Advantage
Adam Smith claimed market forces, not government controls, should determine the direction, volume, and composition of international trade
Under free (unregulated) trade each nation should specialize in producing those goods it could produce most efficiently
Nation capable of producing more of a good with the same input than another nation
An absolute advantage—either natural or acquired Some goods exported to pay for imports of goods
that could be produced more efficiently elsewhere
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Theory of Absolute Advantage
Commodity US Japan TotalTons of Rice 3 1 4
Automobiles 2 4 6
Assumes perfect competition and no transportation costs in a world of two countries and two products
One unit of input (combination of land, labor, and capital) Each nation has two input units it can use to produce either rice
or automobiles Each country uses one unit of input to produce each product
3-6
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Commodity US Japan Total
Tons of Rice 6 0 6
Automobiles 0 8 8
Each nation produces only the product at which it is most efficient
With the same quantity of input units — the total output is greater
3-7
Theory of Absolute Advantage (each country specializes)
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Theory of Absolute AdvantageTerms of trade (ratio of international prices)
Commodity US Japan TotalTons of Rice 3 3 6
Automobiles 4 4 8
With specialization the total production is greater but to consume both products the countries must trade some of their surplus
What are the limits within which the countries are willing to trade?
Japan will trade if they can get more than 1 ton of rice they get in Japan for 4 cars
American rice growers will trade their rice for Japan automobiles for less than 1.5 cars it costs in US
1.25 tons of rice per car is equal benefit
3-8
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Theory of Absolute Advantage(gains from specialization and trade)
Commodity US JapanTons of Rice 2
Automobiles 2
Both nations gain by trading Each nation specialized in producing the product in which
it was more efficient Traded its surplus for goods it could not produce as
efficiently What is one country has an absolute advantage in the
production of both rice and automobiles? Will there still be a basis for trade?
3-9
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Theory of Comparative Advantage
Ricardo 1817 Even though a nation holds an absolute
advantage in the production of two goods The two countries can still trade with
advantages The less efficient nation is not equally less
efficient in the production of both goods
3-10
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Theory of Comparative Advantage
Commodity US Japan Total
Tons of Rice 6 3 9
Automobiles 5 4 9
Compared to the US, Japan is less inefficient in automaking Japan has a relative or comparative advantage
3-11
Theory of Comparative Advantage(each country specializes)
Commodity US Japan Total
Tons of Rice 12 0 12
Automobiles 0 8 8
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Theory of Comparative Advantage (terms of trade)
Commodity US Japan
Tons of Rice 8 4
Automobiles 4 4 Terms of trade will be somewhere between 1 ton of rice for 5/6ths of
an auto that American rice growers must pay in the US Terms of trade will be 1 1/3 automobiles Japanese automakers must
pay for 1 ton of Japanese rice
3-12
Commodity US Japan
Tons of Rice 6 4
Automobiles 6 4 This left the US with some surplus rice and one less automobile than
before Japan has more rice and the same quantity of automobiles American rice growers should be able to trade 2 tons of surplus rice for 2
automobiles elsewhere
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Theory of Comparative Advantage (gains from specialization and trade)
Commodity US Japan
Tons of Rice 1
Automobiles 1
3-13
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-14
Heckscher-Ohlin Theory of Factor Endowment
International and interregional differences in production costs occur because of differences in the supply of production factors
Goods that require a large amount of the abundant (thus less costly) factor will have lower production costs
Enables them to be sold for less in international markets
Prices only depend on the factor endowment this is not true-factor prices are not set in a perfect market legislated minimum wages
I
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-15
Heckscher-Ohlin Theory of Factor Endowment
Ohlin assumed a given technology was universally available
Superior technology often permits a nation to produce at lower costs
Assumed a given product was either labor- or capital-intensive
Heckscher-Ohlin ignored transportation costs
II
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-16
Leontief Paradox (1953) The U.S., one of the most capital-intensive countries of the
world, exports labor-intensive products. The U.S. exports technology-intensive products produced
by highly skilled labor requiring a large capital investment to educate and train.
The U.S. imports goods made with mature technology requiring capital-intensive mass production processes operated by unskilled labor.
Economists Assumptions differences in taste (preferences) are neglected marketers cannot ignore because of ‘taste’ products flow in a direction completely
contrary to international trade theory
Heckscher-Ohlin Theory of Factor Endowment III
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
International Trade Theory-Money
Price per Unit
Commodity United States Japan
Total cost of land, labor, and capital to produce the daily output of rice or automobiles is $10,000 in the US and 2.5 million yen in Japan.
To determine if it is more advantageous to buy locally or import traders need an exchange rate to determine prices in their own currencies.
yen/automillion.6254
yenmillion 2.5 o$5,000/aut2
$10,000 sAutomobile
yen/tonmillion2.51
yenmillion 2.5 $3,330/ton3
$10,000 rice, of Tons
3-17
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
International Trade Theory-Money (exchange rate)
Price per Unit (dollars)Commodity United States Japan
Ton of Rice $3,330 $10,000
Automobiles 5,000 2,500
Price per Unit (yen) Commodity United States Japan
Ton of Rice 0.83 million yen 2.5 million yen
Automobiles 1.25 million yen 0.625 million yen
3-18
Influence of exchange rate Currency devaluation
lower its prices in terms of other currencies
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-19
Some Newer Explanations for the Direction of Trade
Economies of scale and the experience curve most industries benefit from economies of scale as a firm produces more products it learns ways to
improve production
First mover theory firms that enter the market first will soon dominate it
Linder theory of overlapping demand another explanation is needed to explain trade in
manufactured goods tastes are strongly affected by income levels—
therefore a nation’s per capita level determines the kinds of goods they will demand
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-20 Porter’s Competitive Advantage of Nations
Demand conditions nature of the domestic demand
Factor conditions level and composition of factors of production
Related and supporting industries suppliers and support services
Firm strategy, structure and rivalry the extent of domestic competition, barriers to entry,
and firms’ management style and organization
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Arguments for Trade Restrictions
National defense certain industries need protection
from imports because they are vital to national defense
Infant industries in the long run these firms will have a
comparative advantage but these firms need protection from imports until labor i trained
eventually protection will not be needed
Protect domestic jobs projectionists argue that low foreign
hourly wages will produce cheap goods and flood local market
wage costs are not all the costs of production
Scientific tariff or fair competition want to eliminate “unfair”
advantage that a foreign competitor might have due to superior technology, low raw material costs, lower taxes or lower labor costs
“equalize” the process for fair competition
Retaliation industry that has exports with
import restrictions placed by another country want retaliation with similar restrictions
3-21
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Trade Restrictions
Dumping—sell a product abroad… for less than the cost of production the price in the home market the price to third countries
New types of dumping—unfair competition caused by… social dumping--firms in developing nations that have
lower labor costs and poorer working conditions environmental dumping--a country’s lax environmental
standards financial services dumping--a nation’s low
requirements for bank capital/asset ratios cultural dumping--cultural barriers aiding local firms
3-22
I
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-23
IITrade Restrictions
Subsidies A government makes to firms either to encourage
exports or to protect it from imports Cash payments Government participation in ownership Low-cost loans to foreign buyers and exporters Preferential tax treatment
Countervailing duties offset the effects of a subsidy
Other arguments for trade restrictions permit diversification of the domestic economy improve the balance of trade
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Number of countervailing Duty (CD) and Antidumping (AD) Measures in Force by GATT Members
Measures & Country 1990 1991 1992 1993CD measures
United States 94 87 93 122
European Union (12) — 1 — 2
Canada 31 30 29 29
Australia 1 5 12 12
Brazil — 1 13 13
Chile — 2 4 0
New Zealand — — — 1
AD measures United States 201 216 267 304
European Union (12) 137 144 159 150
Canada 78 69 73 85
Australia 24 30 44 76
Brazil 6 19 23 28
Other 12 19 33 38Note: — = not available.
Source: A. Chapman and Po-Ye Lee, “Canadian and International Use of Anti-Dumping and Countervailing Measures,” Research Branch, Canadian International Trade Tribunal, July 1995, p. 14.
3-24
Table 3.1
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-25
IIITrade Restrictions
Tariffs Ad Valorum-a percentage of the invoice value Specific-fixed sum of money charged for a physical unit Compound—combination of ad valorum and specific
Official prices price used by customs when actual invoice price is lower
Variable levy Lower duty for more local input Non-tariff barriers
Quantitative quotas-numerical limit for a specific type of good tariff-rate quotas
Non Quantitative direct government participation in trade customs and other administrative procedures standards
Costs of barriers to trade
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Tariff barriers Nontariff BarriersImport duties QuantitativeAd valorem Quotas Specific Tariff-rate quotas Compound Global
Variable levies DiscriminatoryOfficial prices Voluntary export restrictions
Orderly marketing arrangementsNonquantitative
Direct government participation in tradeSubsidyBuy domesticallyImport licensesManipulation of exchange ratesLocal content requirementsCustoms and other administrative proceduresTariff classifications
Documentation requirementsProduct valuation standardsHealth, safety, and product qualityPackaging and labelingProduct testing methods
Kinds of Import Restrictions3-26
Table 3.2
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-27
Economic Development
Levels of economic development—World Bank low income ($750 or less) lower middle income ($766-$3,035) upper middle income ($3,036-$9,385) high income ($9,385 or more)
GNP/capita as an economic indicator underground economy currency conversion Purchasing Power Parity
number of units of a currency required to buy the same amounts of goods and services in the domestic market as one dollar would buy in the U.S.
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-28
Annual Costs to American Consumers for Import Protection
Cost per American Number of Total Cost
Product Group Job Saved Jobs Involved ($ million)Benzoid Chemicals $1,000,000 216 $ 216
Luggage 933,628 226 211
Softwood Lumber 758,678 605 459
Sugar 600,177 2,261 1,357
Polyethylene resins 590,604 298 176
Dairy Products 497,897 2,378 1,184
Frozen Con. O.J. 461,412 609 281
Ball bearings 438,356 146 64
Maritime 415,325 4,411 1,832
Ceramic tiles 400,576 347 139
Machine tools 348,349 169 59
Apparel & textiles 340,727 12,624 4,301
Source: Gary C Hufbauer and Kimberley Ann Elliott, Measuring the Cost of Protection in the United States (Washington, D.C.: Institute for International Economics, 1994), pp. 11-13.
Table 3.3
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-29
Underground Economies (percentage of GDP, 1994) Figure 3.4
26%
23%
21%
18% 18% 18%
15%14% 14% 14%
13% 13%12%
10%9%
7%6%
0%
10%
20%
30%
Italy
Spain
Belgiu
m
Sweden
Norway
Denmark
Irelan
d
Canad
a
France
German
y
Netherla
nds
Austra
lia
United K
ingdom
United S
tate
s
Japan
Austria
Switzerla
nd
Source: “Light on the Shadows,” The Economist, May 3, 1997, p. 64.
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-30
Table 3.4GNP/Capita based on UN ICP for Selected Countries in 1994
GNP/Capita in US$ GNP/Capita in US$ based
Converted at World Bank on Purchasing Power
Country Adjusted Exchange Rates Parity (PPP)
Switzerland $37,930 $25,150
Japan 34,630 21,140
Denmark 27,970 19,880
Norway 26,390 20,210
USA 25,880 25,880
Mexico 4,180 7,040
Indonesia 880 3,600
China 530 2,510
India 320 1,280
Uganda 190 1,410
Source: World Development Report 1996, Table 1, pp. 188-89.
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
Economic DevelopmentCommon Characteristics of Developing Nations
GNP/capita <$6,000 Unequal distribution of
income Technological dualism Regional dualism >80% agriculture and/or
unproductive agriculture
Disguised unemployment or underemployment
High population growth (2.5—4.0% annually)
High illiteracy High malnutrition rates and
poor health Political instability Reliance on few products for
export Difficult topography Low savings rate
3-31
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-32
Economic Development
Human-needs Approach Defines economic development as the elimination of
poverty and unemployment as well as increases in income Long and healthy life Ability to acquire knowledge Access to resources needed for a decent standard of living Elements measured by:
life expectancy adult literacy GDP/capita
Investment in human capital more than just capital accumulation is needed for growth must be investment in education of people managers can ensure capital is productive can maintain the capital equipment
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-33
Economic Development
Import substitution local production of goods to replace imports a method for developing countries to lessen their
dependence on developed countries protection granted to local industries local manufacturers feel no pressure to become
competitive in world markets domestic firms that must buy from local suppliers
cannot export due to excessive costs
sect
ion
one
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999
3-34
International Investment Theories Monopolistic Advantage Theory (Stephen Hymer)
foreign direct investment occurred largely in oligopolistic industries rather than in industries operating in near-perfect competition
Product and Factor Market Imperfections (Caves) superior knowledge permits the investing firm to produce differentiated products that consumers
would prefer to locally made goods International Product Life Cycle foreign direct investment is a natural stage in the life of a product
Follow-the-leader (Knickerbocker) when one firm, especially the leader in an oligopolistic industry, entered a market, other firms in the
industry followed (defensive strategy) Cross-investment (Graham) in certain oligopolistic industries, European firms tended to invest in the US when American firms
had gone to Europe
Internationalization extension of the market imperfection theory a firm has superior knowledge, but it may obtain a higher price for that knowledge by using it than
by selling it in the open market
Dunning’s Eclectic Theory of International Production ownership specific— the extent to which a firm has or can get tangible and intangible assets not
available to other firms internalization—in the firm’s best interests to use its ownership-specific advantages (internalize)
rather than license them to foreign owners (externalize) location-specific— the firm will profit by locating part of its production facilities overseas