Chapter 2

Trade Theories and Economic Development

Chapter Outline

• Basis for International Trade- Production Possibility Curve- Principle of Absolute Advantage- Principle of Comparative/Relative Advantage• Exchange Ratios, Trade, and Gain• Factor Endowment Theory

Chapter Outline

• The Competitive Advantage of Nations• A Critical Evaluation of Trade Theories- The Validity of Trade Theories- Limitations and Suggested Refinements• Economic Cooperation- Levels of Economic Integration• Economic and Marketing Implications

BASIS FOR INTERNATIONAL TRADE

Whenever a buyer and a seller come together, each expects to gain something from the other. The same expectation applies to nations that trade with each other. It is virtually impossible for a country to be completely self-sufficient without incurring undue costs. Therefore, trade becomes a necessary activity, though, in some cases, trade does not always work to the advantage of the nations involved. Virtually all governments feel political pressure when they experience trade deficits. Too much emphasis is often placed on the negative effects of trade, even though it is questionable whether such perceived disadvantages are real or imaginary. The benefits of trade, in contrast, are not often stressed, nor are they well communicated to workers and consumers.

Why do nations trade? A nation trades because it expects to gain something from its trading partner. One may ask whether trade is like a zero-sum game, in the sense that one must lose so that another will gain. The answer is no, because, though one does not mind gaining benefits a someone else’s expense, no one wants to engage in a transaction that includes a high risk of loss. For trade to take place, both nations must anticipate gain from it. In other words, trade is a positive-sum game. Trade is about “mutual gain.” In order to explain how gain is derived from trade, it is necessary to examine a country’s production possibility curve. How absolute and relative advantages affect trade options is based on the trading partners’ production possibility curves.

Adam Smith may have been the first scholar to investigate formally the rationale behind foreign trade. In his book Wealth of Nations, Smith used the principle of absolute advantage as the justification for international trade. According to this principle, a country should export a commodity that can be produced at a lower cost than can other nations. Conversely, it should import a commodity that can only be produced at a higher cost than can other nations. Consider, for example, a situation in which two nations are each producing two products. Table 2.1 provides hypothetical production figures for the USA and Japan based on two products: the computer and the automobile.

Principle of absolute advantage

Basis for International Trade

• Principle of Absolute Advantage- a country should export a commodity that

can be produced at a lower cost than can other nations

- or import a commodity that can only be produced at a higher cost than can other nations

Basis for International Trade

• Principle of Comparative/Relative Advantage- a country should export either a product with

the greatest comparative advantage (or with the least comparative disadvantage)

- or import either a product for which it has the greatest comparative disadvantage (or the least comparative advantage)

Factor Endowment Theory • Factors of Production- labor- land - capital- others (technology, education, etc.)• inequality of relative prices is a function of regional factor

endowments • comparative advantage is determined by relative abundance

of such endowments

Factor endowment theory

The principles of absolute and relative advantage provide a primary basis for trade to occur, but the usefulness of these principles is limited by their assumptions. One basic assumption is that the advantage, whether absolute or relative, is determined solely by labor in terms of time and cost. Labor then determines comparative production costs and subsequent product prices for the same commodity. If labor is indeed the only factor of production or even a major determinant of product content, countries with high labor cost should be in serious trouble. An interesting fact is that Japan and Germany, in spite of their very high labor costs, have remained competitive and have performed well in trade. It thus suggests that absolute labor cost is only one of several competitive inputs that determine product value.

A country may have high labor cost on an absolute basis; yet this cost can be relatively low if productivity is high. Countries with low wages tend to have low productivity. Any subsequent productivity gains usually result in higher wages and currency appreciation. Furthermore, the price of a product is not necessarily determined by the amount of labor it embodies, regardless of whether or not the efficiency of labor is an issue. Since product price is not determined by labor efficiency alone, other factors of production must be taken into consideration, including land and capital

Together, all of these production factors contribute significantly to the creation of value within a particular product. One reason for the importance of identifying other factors of production is that different commodities require different factor inputs and that no country is well endowed in all production factors. The varying proportion of these factors embodied in various goods has a great deal of impact on what a country should produce. Corn, for instance, is best produced where there is an abundance of land (relative to labor and capital), even though corn can be grown in most places in the world. Oil refining, in contrast, requires relatively more capital and relatively less labor and land because of expensive equipment and specialized personnel. In clothing production the most important input factor is that the economy is labor-intensive. The varying factor inputs and proportions for different commodities, together with the uneven distribution of such factors of production in different regions of the world, are the basis of the Heckscher–Ohlin theory of factor endowment.

This theory holds that the inequality of relative prices is a function of regional factor endowments and that comparative advantage is determined by the relative abundance of such endowments. According to Ohlin, there is a mutual interdependence among production factors, factor movements, income, prices, and trade. A change in one affects the rest. Prices of factors and subsequent product prices in each region depend on supply and demand, which in turn are affected by the desires of consumers, income levels, quantity of various factors, and physical conditions of production. Since countries have different factor endowments, a country would have a relative advantage in a commodity that embodies in some degree that country’s comparatively abundant factors. A country should thus export that commodity which is relatively plentiful (i.e., in comparison to other commodities) within the relatively abundant factor (i.e., in comparison to other countries). This exported item may then be exchanged for goods that would use large quantities of the country’s scarce factors if domestically produced.

Michael PorterThe Competitive Advantage of Nations

• Determinants of International Competitiveness

- factor conditions- demand conditions- related and supporting industries- firm strategy, structure, and rivalry- chance- government

These four determinants interact and form the “diamond” which provides the context in which a nation’s firms are born and compete. A nation is competitive when it has specialized assets and skills necessary for competitive advantage in an industry. Firms gain competitive advantage in industries when their home base offers better ongoing information into product and process needs. They gain competitive advantage when owners, managers, and employees support intense commitment and sustained investment. In the end, nations succeed in particular industries because their dynamic home environment stimulates firms to upgrade and widen their advantages over time. Therefore, the effect of one determinant is determined by the state of the others: the advantages in one determinant can enhance the advantages in others.

ECONOMIC COOPERATIONGiven inherent constraints in any system, conditions

for the best policy rarely exist. A policy maker must then turn to the second-best policy. This practice applies to international trade as well. Worldwide free trade is ideal, but cannot be attained. The theory of second best suggests that the optimum policy is to have economic cooperation on a smaller scale. In an attempt to reduce trade barriers and improve trade, many countries within the same geographic area often join together to establish various forms of economic cooperation. Levels of economic integration Trade theorists have identified five levels of economic cooperation. They are: free trade area, customs union, common market, economic and monetary union, and political union.

Free trade areaIn a free trade area, the countries involved eliminate duties among

themselves, while maintaining separately their own tariffs against outsiders. Free trade areas include the NAFTA (North American Free Trade Agreement), the EFTA (European Free Trade Association), and the now defunct LAFTA (Latin- American Free Trade Association).The purpose of a free trade area is to facilitate trade among member nations. The problem with this kind of arrangement is the lack of coordination of tariffs against the nonmembers, enabling nonmembers to direct their exported products to enter the free trade area at the point of lowest external tariffs. The first free trade agreement signed by the USA was with Israel in 1985, and the US–Israel Free Trade Area Agreement eliminates all customs duties and most nontariff barriers between the two countries. More recently, the USA has entered into free trade agreements with Singapore and Chile, while Mexico has done the same with the EU. Singapore has also concluded trade deals with Australia and Japan. It should be apparent that countries forming a free trade area do not need to share joint boundaries.

Customs unionA customs union is an extension of the free trade area in

the sense that member countries must also agree on a common schedule of identical tariff rates. In effect, the objective of the customs union is to harmonize trade regulations and to establish common barriers against outsiders. Uniform tariffs and a common commercial policy against nonmembers are necessary to prevent them from taking advantage of the situation by shipping goods initially to a member country that has the lowest joint boundaries. The world’s oldest customs union is the Benelux Customs Union. A more recent example is the one formed between Turkey and the European Union; this took effect in 1996.

Common marketA common market is a higher and more complex level of economic

integration than either a free trade area or a customs union. In a common market, countries remove all customs and other restrictions on the movement of the factors of production (such as services, raw materials, labor, and capital) among the members of the common market. As a result, business laws and labor laws are standardized to ensure undistorted competition. For an outsider, the point of entry is no longer dictated by member countries’ tariff rates since those rates are uniform across countries within the common market. The point of entry is now determined by the members’ nontariff barriers. The outsider’s strategy should be to enter a member country that has the least nontariff restrictions, because goods can be shipped freely once inside the common market. In 1993, the EU and the EFTA formed the world’s largest and most lucrative common market – the European Economic Area. The European Economic Area eliminates nontariff barriers between the EFTA and EU countries to create a free flow of goods, services, capital, and people in a market of more than 400 million people.

Economic and monetary union

Cooperation among countries increases even more with an economic and monetary union (EMU). Some authorities prefer to distinguish a monetary union from an economic union. In essence, monetary union means one money (i.e., a single currency). Economic and Monetary Union in the European Community that defines monetary union as having three basic characteristics: total and irreversible convertibility of currencies; complete freedom of capital movements in fully integrated financial markets; and irrevocably fixed exchange rates with no fluctuation margins between member currencies, leading ultimately to a single currency. The economic advantages of a single currency include the elimination of currency risk and lower transaction costs. One European Commission study found that European businesses were spending $12.8 billion (0.4 percent of the EU’s GDP) a year on currency conversions.

The European Commission’s One Market, One Money report defines an economic union as a single market for goods, services, capital, and labor, complemented by common policies and coordination in several economic and structural areas. An economic union provides a number of benefits. In terms of efficiency and economic growth, the transaction costs associated with converting one currency into another are eliminated, and the elimination of foreign exchange risk should improve trade and capital mobility. In addition, stronger competition policies should promote efficiency gains. In terms of inflation, the implementation of an economic union is a demonstration of a credible commitment to stable prices. The EU is unique in the sense that it is the first time that advanced economies have agreed to cooperate economically at such a grand scale. Naturally, with the fall of the Berlin wall in 1989, countries emerging from communism coveted EU memberships, while the EU leaders were stalling them.

Political union

A political union is the ultimate type of regional cooperation because it involves the integration of both economic and political policies. With France and Germany leading the way, the EU has been moving toward social, political, and economic integration. The EU’s goal is to form a political union similar to the fifty states of the USA. The EU’s debate over political union involves issues such as having common defense and foreign policies, strengthening the role of the EU Parliament, and adopting an EU-wide social policy. It is doubtful that pure forms of economic integration and political union can ever become reality. Even if they did, they would not last long because different countries eventually have different goals and inflation rates. More important is that no country would be willing to surrender its sovereignty for economic reasons.

The EU, despite great strides, has been plagued by infighting among member states with conflicting national interests. EC Commission adopted the Social Charter in 1989 to establish workers’ basic rights and to equalize EU social regulations (e.g., a minimum wage, labor participation in management decisions, and paid holidays for education purposes). Member countries accused of social dumping must subject their products to sanctions. European socialists believe that the Social Charter is necessary to prevent countries with the lowest social benefits from gaining a comparative advantage. The EU will be the first group of industrial nations to deal with: (1) how to redefine national sovereignty in light of new economic alliances; (2) how to combine various national priorities with a single decision-making process; and (3) how to deregulate separate economies to induce competition among national monopolies

Economic Cooperation

• Free Trade Area- elimination of internal duties• Customs Union- free trade area + establishment of common

barriers• Common Market- customs union + removal of restrictions on

movement of production factors

Economic Cooperation

• Economic and Monetary Union- common market - + harmonization of national economic policies- + one money• Political Union- harmonization of national political policies