International Trade & Factor Mobility Theory

Trade Theories
 Trade theory helps managers and government policymakers focus on three critical
questions:

 What products should be imported and exported,

 how much should be traded, and

 with whom should they trade?

 While descriptive (free trade) theories suggest a laissez-faire treatment of trade,

prescriptive (interventionist) theories suggest that governments should influence trade
patterns. Trade in goods and services and the movement of production factors links
countries internationally.

Theory of Mercantilism
 The concept of mercantilism (a zero-sum game) served as the foundation of economic
thought for nearly three hundred years (1500–1800).
 It purports that a country’s wealth is measured by its holdings of treasure (usually gold).
 To amass a surplus (a favorable balance of trade), a country must export more than it
imports and then collect gold and other forms of wealth from countries that run a deficit
(an unfavorable balance of trade).
 Every inch of a country's soil be utilized for agriculture, mining or manufacturing.
 All raw materials found in a country be used in domestic manufacture, since finished goods
have a higher value than raw materials.
 A large, working population be encouraged.
 All export of gold and silver be prohibited and all domestic money be kept in circulation.
 All imports of foreign goods be discouraged as much as possible.
 Where certain imports are indispensable, they be obtained at first hand, in exchange for
other domestic goods instead of gold and silver.
 As much as possible, imports be confined to raw materials that can be finished [in the home
country].
 Opportunity is constantly sought for selling a country's surplus manufactures to foreigners,
so far as necessary, for gold and silver.
 No importation be allowed if such goods are sufficiently and suitably supplied at home.

Theory of Neomercantilism
 Neomercantilism represents the more recent strategy of countries that use protectionist
trade policies in an attempt to run favorable balances of trade and/or accomplish particular
social or political objectives.
 Neomercantilism is a term used to describe a policy regime which encourages exports,
discourages imports, controls capital movement and centralizes currency decisions in the
hands of a central government.
 The objective of neo-mercantilist policies is to increase the level of foreign reserves held by
the government, allowing more effective monetary policy and fiscal policy.
 The East India Company is one of the best examples of the collaboration of state and
merchants in exploiting market opportunities.
 The benefits that occurred as a result were:
1. It slowly encouraged the evolution of regional into nation states;
2. A commercial class emerged which, in return for paying taxes, received state
protection in the form of monopolies and tariffs;
3. Once colonies were established, managing the transport of private goods and the
volume of trade enriched the imperialist states and provided both significant
employments for the general population and opportunities for upward class mobility
for the more enterprising individuals.

Theory of Absolute Advantage

 In 1776 Adam Smith asserted that the wealth of a nation consisted of the goods and
services available to its citizens. His theory of absolute advantage holds that a country can
maximize its own economic well being by specializing in the production of those goods and
services that it can produce more efficiently than any other nation and enhance global
efficiency through its participation in (unrestricted) free trade. Smith reasoned that:
 Workers become more skilled by repeating the same tasks;
  Workers do not lose time in switching from the production of one kind of product to
another; and
 Long production runs provide greater incentives for the development of more effective
working methods.
 Smith also asserted that country-specific advantages can either be natural or acquired.
 Natural Advantage. A country may have a natural advantage in the production of
particular products because of given climatic conditions, access to particular
resources, the availability of labor, etc. Variations in natural advantages among
countries help to explain where particular products can be produced most
efficiently.
 Acquired Advantage. An acquired advantage represents a distinct advantage in
skills, technology, and/or capital assets that yields differentiated product offerings
and/or cost-competitive homogeneous products. Technology, in particular, has
created new products, displaced old products, and altered trading-partner
relationships.
 Assumptions:
1. Market forces, not government controls, should determine the direction, volume,
and composition of international trade.
2. Under free (unregulated) trade each nation should specialize in producing those
goods it could produce most efficiently.
3. Nation capable of producing more of a good with the same input than another
nation.
4. An absolute advantage—either natural or acquired.
5. Some goods exported to pay for imports of goods that could be produced more
efficiently elsewhere.
6. Assumes perfect competition and no transportation costs in a world of two
countries and two products.
7. Each nation has two input units it can use to produce either rice or automobiles.
8. Each country uses one unit of input to produce each product.
9. With the same quantity of input units — the total output is greater.
  Example of Absolute Advantage:

Theory of Comparative Advantage

 In 1817 David Ricardo reasoned that there would still be gains from trade if a country
specialized in the production of those things it can produce most efficiently, even if other
countries can produce those same things even more efficiently.
 Put another way, Ricardo’s theory of comparative advantage holds that a country can
maximize its own economic well-being by specializing in the production of those goods and
services it can produce relatively efficiently and enhance global efficiency through its
participation in (unrestricted) free trade.
 An Analogous Explanation. Would it make sense for the best physician in town, who also
happens to be the most talented medical secretary, to handle all of the administrative
duties of an office? No. The physician can maximize both output and income by working as
a physician and employing a less skilled secretary. In the same manner, a country will gain if
it concentrates its resources on the production of the goods and services it can produce
most efficiently.
 Production Possibility Example. A country can simultaneously have a comparative
advantage and an absolute advantage in the production of a given product. Assume that
the United States is more efficient than Costa Rica in the production of both wheat and tea;
however, the U.S. has a comparative ad-vantage in wheat production. By concentrating on
the production of the product in which it has the greater advantage (wheat) and allowing
Costa Rica to produce the product in which the United States is comparatively less efficient
(coffee), global output can be increased, and specialization and trade will benefit both
countries

 Assumptions:
1. Full Employment
The theories of absolute and comparative advantage both assume that resources are fully
employed.
2. Economic Efficiency
Often, countries also pursue objectives other than output efficiency. They may avoid
overspecialization because of the vulnerability created by changes in technology and by price
fluctuations or because they do not trust foreign countries to always supply them with essential
goods.
3. Division of Gains
Many people are concerned with relative as well as absolute economic gains. If they perceive
that a trading partner is gaining too large a share of benefits, they may prefer to forgo absolute
gains for themselves so as to prevent others from gaining a relative economic advantage.
4. Transport Costs
If it costs more to transport the goods than is saved through specialization, the advantages of
trade are negated.
5. Static's and Dynamics
The relative conditions that give countries production advantages and disadvantages change.
For example, the resources needed to produce coffee or wheat in either Costa Rica or the
United States could change because of advancements in and acceptance of genetically modified
crops. In fact, most trade today is due to acquired advantage; thus, technical dynamics cause
countries to gain or lose both absolutely and relatively.
6. Services
The theories of absolute and comparative advantage deal with products rather than services.
However, with a growing portion of world trade made up of services, the theories apply
because resources must also go into service production (eg, education, shipping services).
 7. Production Networks
Both theories deal with trading one product for another. Increasingly, however, portions of a
product may be made in different countries. A company might conduct R&D in Country A,
secure components in Countries B and C, assemble final products in Country D, manage
finances in Country E, and carry out call-center services in Country F.
8. Mobility
For example, steelworkers might not move easily into software development jobs because of
different skill needs. Even if they do, they may be less productive than before.

Trade Pattern Theories

Trade Pattern Theories answers 3 questions:

1. How Much Does a Country Trade?

A. Theory of Country Size

 The theory of country size holds that large countries tend to export a smaller portion of
their output and import a smaller portion of their consumption.
 Large countries are more apt to have varied climates and a greater assortment of natural
resources than smaller economies, thus making the large countries more self-sufficient.
 Further, given the same types of terrain and modes of transportation, the greater the
distance, the higher the associated transport costs.
 Thus, firms in large countries often face higher transportation costs in terms of sourcing
inputs from and delivering output to distant foreign markets than do their closer foreign
competitors
Bigger countries differ in several ways from smaller countries. They
 Tend to export a smaller portion of output and import a smaller part of
consumption.
 Have higher transport costs for foreign trade.

Examples

 Most large countries (such as Brazil, China, India, the United States, and Russia) import
much less of their consumption needs and export much less of their production output
than do small nations (such as Uruguay, Belgium, and Taiwan).
 Assume that the normal maximum distance for transporting a given product is 100 miles
because prices rise too much at greater distances. Although almost any location in tiny
Belgium is within 100 miles of a foreign country, the same isn’t true for its two largest
 neighbors, France and Germany. Thus, Belgium’s dependence on trade as a percentage
of its production and consumption is greater than the comparable figures in either
France or Germany, a fact that can be partially explained by the distance factor due to
country size.
B. Size of the Economy
 While land area helps explain the relative dependence on trade, countries’ economic
size helps explain differences in the absolute amount of trade. Nine of the world’s top
10 exporters in 2012 were developed countries, and the only exception was China,
which is the world’s second largest economy. Similarly, developed countries account for
well over half of the world’s exports.
 Example: Although United States’ dependence on either imports or exports is
comparatively low, it is the world’s largest trader (imports + exports).

2. What Types of Products Does a Country Trade?

According to the factor proportions theory, factors in relative abundance are cheaper than
factors in relative scarcity.

 People and Land Factor-proportions theory appears logical In countries that have many
people relative to the amount of land, such as Hong Kong and the Netherlands, land price is
very high because it’s in such demand. Neither Hong Kong nor the Netherlands excels in the
production of goods requiring large amounts of land, such as wool or wheat.
 Manufacturing Locations – In Hong Kong, clothing production occurs in multistory factories
where workers share minimal space, but it does not compete in the production of
automobiles, which requires much more space per worker.
 Capital, Labor Rates, and Specialization - In countries where little capital is available for
investment and the amount of investment per worker is low, managers might expect to find
cheap labor rates and export competitiveness in products that need large amounts of labor
relative to capital. Such as Bangladesh.
 Process Technology – The optimum location for production depends on comparing the cost
in each locale based on the type of production that minimizes costs there. Example: Rice
harvesting in Indonesia, where many manual laborers are employed, versus Italy, where
mechanized methods require few workers.
 Product Technology - Manufacturing competitiveness depends largely on technology to
develop new products and processes. Most new products originate in developed countries.

3. With Whom Do Countries Trade?

Country Similarity Theory:

 The country-similarity theory states that when a firm develops a new product in response to
observed conditions in its home market, it is likely to turn to those foreign markets that are
most similar to its domestic market when commencing its initial international expansion
activities.
 So much trade takes place among industrialized countries because of the growing
importance of acquired advantages, i.e., skills and technology.
 In addition, markets in most industrialized countries are large enough to support new
product introductions and the subsequent variants across the product life cycle.
 At the same time, trade in differentiated products occurs because over time firms in
different countries develop product variants for particular market segments.
 Cultural similarity also facilitates trade. In particular, a common language and a common
religion represent two major facilitators of the international trade and investment process.
 Historical and political relationships, as well as economic agreements, may encourage or
discourage trade with particular countries.

The Product Life Cycle Theory

 The product life-cycle theory is an economic theory that was developed by Raymond
Vernon in response to the failure of the Heckscher-Ohlin model to explain the observed
pattern of international trade. The theory suggests that early in a product's life-cycle all the
parts and labor associated with that product come from the area in which it was invented.
After the product becomes adopted and used in the world markets, production gradually
moves away from the point of origin. In some situations, the product becomes an item that
is imported by its original country of invention.
 There are five stages in a product's life cycle:
1. Introduction
2. Growths
3. Maturity
4. Saturation
5. Decline

Stage 1: Introduction: New products are introduced to meet local (i.e., national) needs, and
new products are first exported to similar countries, countries with similar needs, preferences,
and incomes. If we also presume similar evolutionary patterns for all countries, then products
are introduced in the most advanced nations. (E.g., the IBM PCs were produced in the US and
spread quickly throughout the industrialized countries.)

Stage 2: Growth: A copy product is produced elsewhere and introduced in the home country
(and elsewhere) to capture growth in the home market. This moves production to other
countries, usually on the basis of cost of production. (E.g., the clones of the early IBM PCs were
not produced in the US.) The Period till the Maturity Stage is known as the Saturation Period.

Stage 3: Maturity: The industry contracts and concentrates—the lowest cost producer wins
here. (E.g., the many clones of the PC are made almost entirely in lowest cost locations.)

Stage 4: Saturation: This is a period of stability. The sales of the product reach the peak and
there is no further possibility to increase it.

Stage 5: Decline: Poor countries constitute the only markets for the product. Therefore almost
all declining products are produced in developing countries. (E.g., PCs are a very poor example
here, mainly because there is weak demand for computers in developing countries. A better
example is textiles.)

 Types of products abound for which production locations usually do not shift. Such
exceptions include the following:

1. Products with high transport costs that may have to be produced close to the market, thus
never becoming significant exports.
2. Products that, because of very rapid innovation, have extremely short life cycles, making it
impossible to reduce costs by moving production from one country to another. Some
fashion items fit this category.
3. Luxury products for which cost is of little concern to the consumer. In fact, production in a
developing country may cause consumers to perceive the product as less luxurious.
4. Products for which a company can use a differentiation strategy, perhaps through
advertising, to maintain consumer demand without competing on the basis of price.
5. Products that require specialized technical personnel to be located near production so as to
move the products into their next generation of models. This seems to explain the long-
term U.S. dominance of medical equipment production and German dominance in rotary
printing presses.

Porter Diamond Theory

The approach looks at clusters of industries, where the competitiveness of one company is
related to the performance of other companies and other factors tied together in the value-
added chain, in customer-client relation, or in local or regional contexts. The Porter analysis was
made in two steps.
 First, clusters of successful industries have been mapped in 10 important trading nations.
 In the second, the history of competition in particular industries is examined to clarify the
dynamic process by which competitive advantage was created.
 According to the diamond of national competitive advantage theory, companies’
development and maintenance of internationally competitive products depends on
favorable
1. Demand conditions.
2. Factor conditions.
3. Related and supporting industries.
4. Firm strategy, structure, and rivalry.
Demand conditions in the home market can help companies create a competitive advantage,
when sophisticated home market buyers pressure firms to innovate faster and to create more
advanced products than those of competitors. Or new products (or industries) usually arise
from companies’ observation of need or demand, which has traditionally been in their home
country, where they start up production
This was the case for the Italian ceramic tile industry after World War II: In a postwar housing
boom, consumers wanted cool floors (which tile would provide) because of the hot Italian
climate.
Factor conditions are human resources, physical resources, knowledge resources, capital
resources and infrastructure. Specialized resources are often specific for an industry and
important for its competitiveness. Specific resources can be created to compensate for factor
disadvantages.
Wood was expensive, and most production factors (skilled labor, capital, technology, and
equipment) were available within Italy on favorable terms.
Related and supporting industries can produce inputs which are important for innovation and
internationalization. These industries provide cost-effective inputs, but they also participate in
the upgrading process, thus stimulating other companies in the chain to innovate.
Firm strategy, structure and rivalry constitute the fourth determinant of competitiveness. The
way in which companies are created, set goals and are managed is important for success. But
the presence of intense rivalry in the home base is also important; it creates pressure to
innovate in order to upgrade competitiveness.
Barriers to market entry were low in the tile industry (some companies started up with only
three employees), and hundreds of companies-initiated production. Rivalry became intense as
companies tried to serve increasingly sophisticated Italian consumers. These circumstances
forced breakthroughs in both product and process technologies, which gave the Italian
producers advantages over foreign firms and enabled them to gain the largest global share of
tile exports.
Government can influence each of the above four determinants of competitiveness.[2] Clearly
government can influence the supply conditions of key production factors, demand conditions
in the home market, and competition between firms. Government interventions can occur at
local, regional, national or supranational level.
Chance events are occurrences that are outside of control of a firm. They are important
because they create discontinuities in which some gain competitive positions.

Factor Mobility Theory

Factor mobility concerns the free movement of factors of production, such as labor and capital,
across national borders.

Why Factors Move

CAPITAL

 While capital is the most internationally mobile factor, short-term capital is the most mobile
of all. Capital is primarily transferred because of differences in expected returns, although
firms may also respond to government incentives.
 Companies and private individuals primarily transfer capital because of differences in
expected return (accounting for risk). They find information on interest-rate differences
readily available, and they can transfer capital by wire instantaneously at a low cost.
 Political and economic conditions affect investors’ perceptions of risk and where they prefer
to put their capital.
 Companies invest abroad for the long term to tap markets, improve quality, and lower
operating costs.
 Governments give foreign aid and loans. Not-for-profit organizations donate money abroad
to relieve worrisome economic and social conditions.
 Individuals remit funds to help their families and friends in foreign countries.
PEOPLE

 Some might immigrate to another country, become citizens, and plan to reside there for the
rest of their lives. MNEs may assign some to work abroad for periods ranging from a few
days to several years (usually to a place where they also transfer capital), while some
countries allow workers to enter on temporary work permits, usually for short periods. For
instance, most workers in the United Arab Emirates are there on temporary work permits.
 Economic Motives - People work in another country largely for economic reasons.
 Political Motives - For example, because of persecution or war dangers, in which case they
are known as refugees and usually become part of the labor pool where they live.
 It may be difficult to distinguish between economic and political motives associated with
international labor mobility, because poor economic conditions often accompany repressive
and/or uncertain political conditions.

Effects of Factor Movement

 Although capital and labor are in fact different production factors, they are intertwined.
Further, neither international capital nor population movements are new occurrences.
 Immigrants bring human capital, thus adding to the base of a country’s skills and enabling
competition in new areas.
 Inflows of capital to those same countries can be used to develop infrastructure and natural
and other acquired advantages, thus enabling increased participation in the international
trade arena.
 Countries lose potentially productive resources when educated people leave, a situation
known as brain drain, but they may in turn gain from the remittances that citizens who are
working abroad send home. Developing countries have lost people with substantial work
skills. However, many of these people are now sending remittances back
 The emigrants learn abroad, transfer ideas back home, use remitted capital to start
businesses with family members or on their own, and export to companies with which they
had connections abroad.
 Countries receiving productive human resources also incur costs by providing social services
and acculturating people to a new language and society.

The Relationship of Trade and Factor Mobility

Factor movement is an alternative to trade that may or may not be a more efficient allocation
of resources.

Substitution
When factor proportions vary widely among countries, pressures exist for the most abundant
factors to move to countries with greater scarcity. Thus, in countries where labor is relatively
abundant compared to capital, workers tend to be poorly paid; many will attempt to go to
countries that enjoy full employment and offer higher wages.

Likewise, capital tends to move away from countries where it is abundant to those where it is
relatively scarce. However, the inability to gain sufficient access to foreign production factors
may stimulate efficient methods of domestic substitution, such as the development of
alternatives for traditional production methods.

Example: Russia has a low population density and the most unfarmed arable land of any
country. Next door is China with the highest population and little available unfarmed land.
About 400 thousand Chinese are now working on Russian farms, and much of the output is
shipped to China.

Complementarity

Factor mobility via foreign direct investment may in fact stimulate foreign trade because of the
need for equipment, components, and/or complementary products in the destination country.

Alternatively, trade may be restricted by local content laws, or when foreign direct investment
leads to import substitution.

Factor mobility through foreign investment often stimulates trade because of

 The need for components.

 The parent company’s ability to sell complementary products.
 The need for equipment for subsidiaries.

Example: Coca-Cola’s exports of concentrate to its bottling facilities abroad.