Lecture 5
International Trade Theory
Outline
A.
B.
Overview of Free Trade Theory International Trade Theories
Mercantilism Absolute Advantage Comparative Advantage Heckscher-Ohlin Theory Product life-cycle Theory New Trade Theory Porters Diamond
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A. Overview of Free Trade Theory
Free Trade
A government does not attempt to impose quotas or duties to influence:
what its citizens can buy from another country what they can produce and sell to another country
The Benefits of Trade allow a country to:
specialize in the manufacture and export of products that can be produced most efficiently in that country import products that can be produced more efficiently in other countries
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A. Overview of Free Trade Theory
A Shift to Free Trade
While majority of the society gain, some individuals and industries lose (e.g. high unemployment)
Trade occurs when overall gains outweigh the losses
Examples:
Hollowing Out the U.S. Knowledge-Based Industry
Global Business Today: P.162-164 Global Business Today: P.178
Free Trade and REI
B. International Trade Theories
Early theories are used to explain why unrestricted free trade is beneficial to a country
Example: Theory of mercantilism, absolute advantage, comparative advantage and Heckscher-Ohlin Theory
Later theories appear to make a case for some limited government involvement to support certain export-oriented industries
Example: Product Life Cycle Theory, New Trade Theory and Porters Diamond
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Mercantilism
A nations wealth depends on accumulated treasure. Gold and silver can be used for the currency of trade A countrys best interest is to maintain a trade surplus
Export > Import Maximize export through subsidies Minimize imports through tariffs and quotas A surplus in the balance of trade
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Mercantilism
Characteristics of Mercantilism
Trade monopolies arose Smuggling flourished Colonial empires were established
Mercantilism
The Flaw of Mercantilism
Trade is a zero-sum game (A gain by one country results in a loss by another)
Example: Trade surplus in Country A money supply in Country A inflation in Country A demand in Country A demand in Country B no trade surplus in Country A
No one can keep a trade surplus in the long run
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Absolute Advantage
Capability of one country to produce more of a product using the same amount of input A country should produce only goods where it is more efficient at production, and trade for those goods which are relatively not efficiently produced.
Trade between countries is, therefore, beneficial
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Absolute Advantage and the Gain from Trade
Resources required to produce 1 ton of cocoa and rice Cocoa
Ghana South Korea 10 40 Production and consumption without trade Cocoa Rice 20 10 Rice
Ghana South Korea Total production
10.0 2.5 12.5
Production with specialization Cocoa
5.0 10.0 15.0
Rice 0.0 20.0 20.0
Ghana South Korea Total production
20.0 0.0 20.0
Consumption after Ghana trades 6 tons of cocoa for 6 tons of South Korean rice Cocoa Rice Ghana South Korea 14.0 6.0 6.0 14.0 Rice 1.0 4.0
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Increase in consumption as a result of specialization and trade Cocoa
Ghana South Korea 4.0 3.5
Comparative Advantage
If Country A can produce good X at a lower opportunity cost than Country B, Country A has a comparative advantage in the production of good X.
The opportunity cost of good X production ~ the amount of good Y that must be given up in order to produce one more units of good X
Trade is a positive-sum game 2 countries can get benefits from trade
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Better use of resources (productivity)
Comparative Advantage and the Gain from Trade
Resources required to produce 1 ton of cocoa and rice Cocoa
Ghana South Korea 10 40 Production and consumption without trade Cocoa Rice 13.33 20 Rice
Ghana South Korea Total production
10.0 2.5 12.5
Production with specialization Cocoa
7.5 5.0 12.5
Rice 3.75 10.0 13.75
Ghana South Korea Total production
15.0 0.0 15.0
Consumption after Ghana trades 4 tons of cocoa for 4 tons of South Korean rice Cocoa Rice Ghana South Korea 11.0 4.0 7.75 6.0 Rice 0.25 1.0
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Increase in consumption as a result of specialization and trade Cocoa
Ghana South Korea 1.0 1.5
Comparative Advantage
There are many assumptions under the principle of comparative advantage:
2 countries; 2 goods No transportation costs between countries No differences in the prices of resources in different countries No effects of trade on income distribution within a country Resources can move freely from the production of one good to another within a country Constant returns to scale for production Fixed stock of resources and level of efficiency
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Limitations of Absolute Advantage and Comparative Advantage
Absolute Advantage: What if a country has absolute advantage in both products? Or no absolute advantage at all? Comparative Advantage (certain assumptions are violated): Resources do not always move easily from one economic activity to another. Free trade might increase a countrys stock of resources. Free trade might increase efficiency at which a country uses its resources. (e.g. enjoying non-constant returns to scale)
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Heckscher-Ohlin Theory
A country exports goods that intensively use factor endowments which are locally abundant and imports goods made from locally scarce factors The patterns of trade are determined by differences in factor endowments - not by productivity Focus on relative advantage, not absolute advantage
Examples: China, Mexico and Vietnams relative abundance of low-cost labor
Important implication
2 countries with identical tastes can still have a basis for trade if
factor endowments of the countries differ
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Limitation of Heckscher-Ohlin Theory
Leontief, in 1953 postulated Leontief Paradox to test the variance of actual trade flow with the predictions of Heckscher-Ohlin theory
The U.S. was relatively abundant in capital compared to other nations The U.S. would be an exporter of capital-intensive goods and an importer of labor-intensive goods However, U.S. exports were actually less capital intensive than U.S. imports http://c3po.cochise.cc.az.us/pratt/Internecon/leont.htm
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Product life-cycle Theory
When products mature, both location of sales and optimal production change affects the direction and flow of imports and exports The life of a product can be divided into 3 stages: new product, mature product and standard product. Example: Development of Photocopiers Global Business Today: P.180-182
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Product life-cycle Theory
Example: Country A produces a new product: Demand grows in Country A and demand in Country B is limited to high-income group
Country A exports to Country B
Demand for Country B increases: Country Bs producers start to produce for their home markets Country A also sets up production facilities in Country B
Production in Country B limits the potential for exports from Country A.
The product becomes mature and standardized The competition is based on price, not on product quality
Country A becomes the importer of the product as production becomes more concentrated in lower-cost Country B
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Limitations of Product life-cycle Theory
The trend of globalization and integration of the economy makes this theory less effective because:
nowadays, new products are introduced in many markets simultaneously to recoup the R and D costs many companies are operating in international markets from the beginning the exporter of the product doesnt become the importer of the product the pattern of trade associated with new products is more complex the theory does not predict when it is profitable to invest abroad
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New Trade Theory
New trade theory suggests the followings: Nations can benefit from trade even when they do not differ in resource endowments or technology. Because of economies of scale and increasing returns to specialization, there are only a few profitable firms in some industries. Firms with first mover advantages will develop economies of scale and create barriers to entry for other firms. Example: Commercial aerospace industry
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New Trade Theory
Competitors may not emerge because of firstmover advantage
Economies of scale Learning effects
avoid new entrants
Governments role becomes significant and it should consider strategic trade policies
Example: Boeings research and development was largely supported by the US government
The theory is still too fresh and there is not enough evidence to judge its accuracy.
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Porters Diamond
It attempts to analyze the reasons for a nations success in a particular industry Porter studied competitive advantage of 100 industries in 10 nations based on 4 major attributes:
Factor endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry
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Porters Diamond
Success occurs where these attributes exist The greater the attribute, the higher chance of success The diamond is mutually reinforcing
Firm strategy, structure and rivalry Factor endowments
Related and supporting industries
Demand conditions
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Components of Porters Diamond & its implications: Factor Endowments
Basic factor endowments
Natural resources, climate, location, demographics, etc
Communication infrastructure, skilled labour, research facilities, technological know-how, etc A product of investment by individuals, companies, and governments such as education
Advanced factor endowments
Advanced factors are more likely to lead to competitive advantage.
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Components of Porters Diamond & its implications: Demand Conditions
It refers to the role of domestic demand in upgrading competitive advantage Sophisticated demand pressures local firms to:
meet high standards of product quality produce innovative products Example: Japanese camera industry
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Components of Porters Diamond & its implications: Related and Supporting Industries
Investment in advanced factors of production by related and supporting industries can spill over into an industry
achieve a strong competitive position internationally
Example: Technological leadership in the US semiconductor industry until the mid-1980s provided the basis for US success in PCs
The creation of clusters of supporting industries allows the key industry to become internationally competitive
Example: German textile and apparel sector
High-quality cotton, wool, synthetic fibers and textile machinery Knowledge flows within the industry in the country, creating a competitive advantage
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Components of Porters Diamond & its implications: Structure, Strategy and Rivalry
Structure and Strategy refers to the conditions in the nation governing how the companies are created, organized and managed
Example: The predominance of engineers in top management at German and Japanese firms
Emphasize on improving manufacturing processes and product design
Domestic rivalry induces firms to look for ways to improve efficiency, which makes them become world-class competitors
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Determinants of Competitive Advantage in nations
Chance Company Strategy, Structure, and Rivalry Two external factors that influence the four determinants. Factor Conditions Related and Supporting Industries Demand Conditions
Government
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Porters Theory
Countries should be exporting products from those industries where all four components of the diamond are favorable They should be importing in those areas where the components are not favorable Examples:
The Rise of Finlands Nokia (Global Business Today: P.189) Logitech (Global Business Today: P. 194-195) Crawfish Wars (Global Business Today: P.168)
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Managerial Implications from Trade Theories
Location implications
The companies disperse production activities to countries where they can be performed most efficiently
First-mover implications
The companies must invest substantial financial resources in building a first-mover advantage before a new venture becomes profitable
Example: Japanese firms invested heavily in Liquid Crystal Display (LCDs) in 1980s
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Managerial Implications from Trade Theories
Policy implications
Businesses should work to encourage governmental policies that support free trade
Example: IBM and Apple protest against imposing tariff on Japans imports and LCDs during 1980s
It is a firms best interest to invest in upgrading advanced factors of production
Example: The companies invest in better training for their employees and increase their commitments for research and development
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Managerial Implications from Trade Theories
Policy implications
Business should urge the government to:
increase its investment in:
Education Infrastructure Basic research
adopt policies that promote strong competition within domestic markets
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