Chapter 6 International Trade Theory

MGT 372 LectureBy: Ms. Adina Malik

Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country

An Overview Of Trade Theory

Smith, Ricardo and Heckscher-Ohlin show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself

International trade allows a country:to specialize in the manufacture and export of products that it can produce efficientlyimport products that can be produced more efficiently in other countries

The Benefits Of Trade

Some patterns of trade are fairly easy to explain - it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee. But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Japan export automobiles, consumer electronics, and machine tools?

The Patterns Of International Trade

Why does Ford assemble cars made for the American market in Mexico, while BMW and Nissan manufacture cars for Americans in the U.S.? Now, the U.S. buys a lot of its textiles from places like Honduras and Guatemala; and of course, Bangladesh too !!

The Patterns Of International Trade

1. Mercantilism2. Absolute Advantage3. Comparative Advantage4. Heckscher-Ohlin Theory5. The Leontiff Paradox6. Product Life Cycle Theory7. Porter’s Diamond Theory

Trade Theories

Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -- to export more than it importsCountries conducted trade in exchange of gold and silver in the mid 16th century in England. A country could earn gold and silver by exporting, thereby increasing their gold and silver reserve-an increase in national wealth, prestige and power.The contrary takes place when a country imports.So, this theory advocated government intervention to achieve a surplus in the balance of trade.

Mercantilism

The policy was to maximize exports and minimize imports-imports were limited by tariffs & quotas, while exports were subsidized.This theory is however criticized because trade surplus increase money supply in a country. An increase in money supply raises the demand and consequently the price of goods. The result of this is inflation. It views trade as a zero-sum game, one in which a gain by one country results in a loss by another, rather than a positive-sum game, a situation where all countries in trade can benefit.

Mercantilism

Adam Smith was against mercantilism. He argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing itAccording to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries. A country should never produce goods at home that it can buy at a lower cost from other countries=> specialization in the production of goods in which it has absolute advantage.

Absolute Advantage

Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa.

Absolute Advantage

Resources required to produce 1 (one) ton of cocoa and rice

Country Cocoa Rice

Ghana 10 20

South Korea 40 10

David Ricardo extended Adam Smith’s Theory by exploring what might happen when one country has absolute advantage in production of all goods. He extended the free trade argument and proved that trade is a positive-sum game. Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home

Comparative Advantage

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Assume:Ghana is more efficient in the production of both cocoa and rice.In Ghana, it takes 10 resources to produce one tone of cocoa, and 13 1/3 resources to produce one ton of riceSo, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two

In South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of riceSo, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two

Comparative Advantage

Ghana has an absolute advantage in the production of both goods, then why should it trade with South Korea? Ghana has an absolute advantage in the production of both goods, but it has a comparative advantage only in the production of cocoa. Ghana can produce 4 times as much as cocoa as South Korea, but only 1.5 times as much rice.

Comparative Advantage

If each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain.Potential world production is greater with unrestricted free trade than it is with restricted trade.Comparative advantage theory provides a strong rationale for encouraging free trade.The theory therefore suggests that trade is a positive-sum game (to an even greater degree than that suggested by the theory of absolute advantage).

Comparative Advantage

Ricardo’s theory suggests that comparative advantage arises from differences in productivity Eli Heckscher and Bertil Ohlin argued that comparative advantage arises from differences in national factor endowments – the extent to which a country is endowed with resources like land, labor, and capitalThe Heckscher-Ohlin theory predicts that countries will export goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce

Heckscher-Ohlin Theory

Factor endowments determines cost of operation there

EG: China in textile, footwear; USA in high tech product, Australia in agro and dairy products.

Heckscher-Ohlin Theory

Srilankan Tea

Chinese Textile Australian Meat and Dairy

Wassily Leontief theorized that since 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, he found that U.S. exports were less capital intensive than U.S. importsSince this result was at variance with the predictions of the theory, it became known as the Leontief Paradox

The Leontief Paradox

The product life-cycle theory, proposed by Raymond Vernon, suggested that as products mature both the location of sales and the optimal production location will change affecting the flow and direction of tradeVernon argued that the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new productsVernon argued that initially, the product would be produced and sold in the U.S., later, as demand grew in other developed countries, U.S. firms would begin to export Over time, demand for the new product would grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets

The Product Life Cycle Theory

U.S. firms might also set up production facilities in those advanced countries where demand was growing limiting the exports from the U.S. As the market in the U.S. and other advanced nations matured, the product would become more standardized, and price the main competitive weaponProducers based in advanced countries where labor costs were lower than the United States might now be able to export to the U.S.If cost pressures became intense, developing countries would begin to acquire a production advantage over advanced countries

The Product Life Cycle Theory

The United States switched from being an exporter of the product to an importer of the product as production becomes more concentrated in lower-cost foreign locations

Product Life Cycle Theory

Product Life-Cycle Theory

Net exporter

Net importer

New product (Brands Like IBM, Apple)

Phase IAll production in

USUS exports to

advanced countries like

Europe, Japan

Phase IIProduction started in

other advanced nations

US exports mostly to

LDCs

Phase IIIOther

advanced nations

export to LDCs

US exports to LDCs

displaced

Phase IVEurope exports

to US

Phase VProduction shifted to developing countries

like India, China,Malaysia through investment and

alliances and then exported.

Time

Figure 4.1: The product life cycle Source: Wells (1972), as cited by Dicken (2003), p.203.

Introduction

Growth Early Maturity

Late Maturity

Decline

The product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the US in the 1960s and 1970sBut, the increasing globalization and integration of the world economy has made this theory less valid in today's world

The Product Life Cycle Theory

Michael Porter tried to explain why a nation achieves international success in a particular industry and identified four attributes that promote or impede the creation of competitive advantage:Factor endowments (skilled labor, infrastructure)Demand conditions (the nature of home demand)Relating and supporting industries (the presence or absence of supplier industries and related industries that are internationally competitive)Firm strategy, structure, and rivalry (how companies are created, organized and managed & the nature of domestic rivalry)

National Competitive Advantage: Porter’s Diamond

National Competitive Advantage: Porters Diamond by Michael Porter in 1990

Factor endowments refer to a nation’s position in factors of production necessary to compete in a given industry=> competitive advantageThese factors can be either basic (natural resources, climate, location, demographics) or advanced (sophisticated & skilled labor, research facilities, communication infrastructure, technological know-how) Advanced factors are a product of investment by individuals, companies & governments.

Factor Endowments

Demand conditions refer to the nature of home demand for the industry’s product or service that influences the development of capabilitiesSophisticated and demanding customers pressure firms to be competitive, by creating pressures for innovation and qualityE.g. Japanese camera industry; wireless telephone equipment industry of Scandinavia and Sweden

Demand Conditions

The presence of supplier industries and related industries that are internationally competitive can spill over and contribute to other industries E.g. Until the mid-1980s, the technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in personal computers and several other technically advanced electronic products. E.g. Adoption of the automobile took off in the USA after the construction of a national system of highways and gas stations.

Relating And Supporting Industries

The conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalry impacts firm competitivenessDifferent management ideologies affect the development of national competitive advantage. E.g. predominance of engineers in top management at German and Japanese firms-improvement in manufacturing processes and product designE.g. predominance of finance people in top management at the US firms-overemphasis on maximizing short term financial returnVigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features

Firm Strategy, Structure, And Rivalry

Government policy can:affect demand through product standardsinfluence rivalry through regulation and antitrust lawsimpact the availability of highly educated workers and advanced transportation infrastructure. The four attributes, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage

Evaluating Porter’s Theory

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 and some lose.

E.g. This chance may arise from any new agreement, opening of a new market. Like, Multi-Fiber Agreement of WTO created huge chance for the ready-made garments industry of the developing nations.

E.g. unexpected oil price rises, wars, political unrest, etc.

Evaluating Porter’s Theory