[ InternationaL and business trade ]

International Trade theory - |Reviewer|Semi-Finals

INTRODUCTION  We have assumed away differences in the prices

 The growth of the Indian pharmaceutical of resources in different countries.
industry is an example of the benefits of free  We have assumed that resources can move
trades and globalization. freely from the production of one good to
 The economic arguments surrounding the another within a country.
benefits and costs of free trade in goods and  We have assumed constant return to scale, that
services are not abstract academic ones. is, that specialization bt Ghana or South Korea
has no effect on the amount of resources
 OVERVIEW OF TRADE THEORY required to produce one ton of Cocoa or rice.
 We have assumed that each country has a fixed
THE BENEFITS OF TRADE stock of resources and that free trade does not
 The great strength of the theories of Smith, change efficiency with which a country uses its
Ricardo, and Heckscher -Ohlin is that they resources.
identify with precision the specific benefits of  We have assumed away that the effects of trade
international trade. on income distribution within a country.
 Their theories go beyond this common sense
notion to show why it is beneficial for a country EXTENSIONS OF THE RICARDIAN MODEL
to engage in international trade even for
products it is able to produce for itself.  IMMOBILE RESOURCES
 However, their theories tell us that a country's  Resources do not always shift quite so easily
economy may gain if its citizens buy certain from producing one good to another. A
products from other nations that could be certain amount of friction is involved.
produced at home.  While the theory predicts that the benefits
of free trade outweigh the costs by a
THE PATTERN OF INTERNATIONAL TRADE significant margin, this is of cold comfort to
 The theories of Smith, Ricardo, and Heckscher- those who bear the costs.
Ohlin help to explain the pattern of international  DIMINISHING RETURNS
trade that we observe in the world economy.  It is more realistic to assume diminishing returns
Some aspects of the pattern are easy to to specialization.
understand. However, much of the observed 1. Not all resources are of the same
pattern of international trade is more difficult to quality.
understand. 2. Different goods use resources in
different proportions
 THE GAINS FROM TRADE  Diminishing returns to specialization occurs
when more units of resources are required to
 POTENTIAL WORLD PRODUCTION IS GREATER produce each additional unit.
WITH UNRESTRICTED FREE TRADE THAN IT IS  DYNAMIC EFFECT AND ECONOMIC GROWTH
WITH RESTRICTED TRADE  Opening an economy to trade is likely to
generate dynamic gains of two sort:
QUALIFICATIONS AND ASSUMPTIONS  Free trade might increase a country's stock of
 We have assumed a simple world which there resources as increased supplies of labor and
are only two countries and two goods. capital from abroad become available for use
 We have assumed away transportation costs within the country.
between countries.  Free trade might also increase the efficiency
with which a country uses its resources.

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International Trade theory - |Reviewer|Semi-Finals

 Wassily Leontief, a winner of the Nobel Prize in

THE SAMUELSON’S CRITIQUE economics, published a study which many of
 Paul Samuelson's critique looks at what happens these tests have raised questions about the
when a rich country enters into a free trade validity of the Heckscher-Ohlin theory. Using the
agreement with a poor country that rapidly Heckscher-Ohlin theory. Thus, the result was at
improves its productivity after the introduction variance with the predictions of the theory, it
of a free trade regime. has become known as the Leontief paradox.

 "FREE TRADE MAY TURN OUT PROGMATICALLY THE LEONTIEF PARADOX

TO BE STILL BEST FOR EACH REGION IN  No one is quite sure why we observe the
COMPARISON TO LOBBYIST-INDUCED TARIFFS Leontief paradox. One possible explanation is
AND QUOTAS WHICH INVOLVE BOTH A that the United States has a special advantage in
PERVERSION OF DEMOCRACY AND NON-SUBTLE producing new products or goods made with
DEADWEIGHT DISTORTION LOSSES." innovative technologies. Some empirical studies
tend to confirm this. Still, tests of the Heckscher-
HECKSCHER-OHLIN THEORY Ohlin theory using data for a large number of
countries tend to confirm the existence of the
 ELI HECKSCHER Leontief paradox.
 BERTIL OHLIN  The new research shows that once differences
in technology across countries are controlled
 Swedish economists Eli Heckscher (in 1919) and for, countries do indeed export those goods that
Bertil Ohlin (in 1933) put forward a different make intensive use of factors that are locally
explanation of comparative advantage. They abundant, while importing goods that make
argued that comparative advantage arises from intensive use of factors that are locally scarce. In
differences in national factor endowments. other words, once the impact of differences of
 By factor endowments they meant the extent to technology on productivity is controlled for, the
which a country is endowed with such resources Heckscher-Ohlin theory seems to gain predictive
as land, labor, and capital. power

Heckscher-Ohlin Theory: THE PRODUCT LIFE-CYCLE THEORY

- Argues that the pattern of International trade is  RAYMOND VERNON
determined by differences in factor
endowments, rather than differences in  Raymond Vernon initially proposed the product
productivity. life-cycle theory in the mid-1960s.29 Vernon's
theory was based on the observation that for
Ricardo’s Theory most of the twentieth century a very large
- Stresses that comparative advantage arises from proportion of the world's new products had
differences in productivity been developed by U.S. firms and sold first in
the U.S. market. Thus, the wealth and size of the
U.S. market gave U.S. firms a strong incentive to
BOTH: Free trade is beneficial. develop new consumer products.
 Vernon went on to argue that early in the life
cycle of a typical new product, while demand is
starting to grow rapidly in the United States,
WASSILY LEONTIEF demand in other advanced countries is limited

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to high-income groups. As the market in the  Major source of cost reductions in many
United States and other advanced nations industries.
matures, the product hecomes more
standardized, and price becomes the main Two important points of new trade theory:
competitive weapon. As this occurs, cost
considerations start to play a greater role in the  First, through its impact on economies of scale,
competitive process. trade can increase the variety of goods available
 The consequence of these trends for the pattern to consumers and decrease the average cost of
of world trade is that over time the United those goods.
States switches from heing an exporter of the
product to an importer of the product as  Second, in those industries when the output
production becomes concentrated in lower-cost required to
foreign locations.
NATIONAL COMPETITIVE ADVANTAGE
EVALUATING THE PRODUCT LIFE-CYCLE THEORY
 Historically, the product life-cycle theory seems PORTER’S DIAMOND
to be an accurate explanation of international  It’s a model for determining a country’s or
trade patterns. group’s competitive edge in a specific industry.
 This evolution in the pattern of international  The Porter Diamond model is a strategic
trade in photocopiers is consistent with the economic model that tries to explain why one
predictions of the product life-cycle theory that nation-state is more successful in a given
mature industries tend to go out of the United industry than another.
States and into low-cost assembly locations.
 However, the product: life-cycle theory is not Porter uses the model to try to address the following
without weaknesses. Viewed from an Asian or questions:
European perspective, Vernon's argument that
most new products are developed and What causes one country to become the most
introduced in the United States seems competitive in a certain industry? Porter refers to this as
ethnocentric and increasingly dated. “becoming the home base” in his model.

NEW TRADE THEORY Why does Switzerland excel in the production and export
 The new trade theory began to emerge in the of precisions instruments?
1970s when a number of economists pointed
out that the ability of firms to attain economies What allows enterprises from a single country or region
of scale might have important implications for to maintain a competitive advantage in a certain
international trade. industry?

Four board attributes:

Economies of scale
1. Factor Endowment
 Are unit cost reductions associated with a large  A nation’s position in factors of production such
scale of output. as skilled labor or the infrastructure necessary
 Have a number of sources. to compete in a given industry.

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International Trade theory - |Reviewer|Semi-Finals

2. Demand Conditions IMPLICATIONS FOR MANAGER

 The nature of home demand for the industry’s
product or service. Location implications
 a firm should disperse its various productive
3. Relating and supporting industries activities to those countries where they can be
 The presence or absence of supplier industries performed most efficiently
and related industries that ate internationally
competitive.  Firms that do not may be at a competitive
disadvantage
4. Firm Strategy, structure and rivalry
 The conditions governing how companies are First-mover implications
created, organised, and managed and the  a first-mover advantage can help a firm
nature of domestic rivalry. dominate global trade in that product

MICHAEL EUGENE PORTER Policy implications

 He is a leading authority on competitive strategy  firms should work to encourage governmental
and the competitiveness and economic policies that support free trade
development of nations, states, and regions. want policies that have a favorable impact on each
 Porter wrote "The Competitive Advantage of component of the diamond
Nations" in 1990.
 He proposed the "diamond" framework.

PORTER’S DIAMOND MODEL

 Factor Conditions
 Demand Conditions
 Relating and supporting industries
 Firm Strategy, structure and rivalry

Government
 by its choice of policies, can detract from or
improve national advantage.

Chance
 events such as major innovations, can reshape
industry structure and provide the opportunity
for one’s nation firm to supplant another’s.

TWO IMPORTANT POINTS

 Different nations ate characterised by different
management ideologies.
 There’s a strong association between vigorous
domestic rivalry and the creation and
persistence of competitive advantage in an
industry.

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