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Theories
of
International
Trade
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Learning Objectives To understand the traditional arguments
of how and why international trade improves the welfare of all countries
To review the history and compare the implications of trade theory from the original work of Adam Smith to the contemporary theories of Michael Porter
To examine the criticisms of classical trade theory and examine alternative viewpoints of which business and economic forces determine trade patterns between countries
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Evolution of Trade Theories
Mercantilism Absolute advantage (Classical) Comparative advantage Factor Proportions Trade International Product Cycle New Trade Theory National competitive advantage
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Mercantilism: mid-16th century
A nation’s wealth depends on accumulated treasure Gold and silver are the currency of
trade Theory says you should have a trade surplus.
Maximize export through subsidies. Minimize imports through tariffs
and quotas Flaw: restrictions, impaired growth
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Defining mercantilism …
… trade theory holding that nations should accumulate financial wealth, usually in the form of gold (forget things like living standards or human development) by encouraging exports and discouraging imports
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Theory of absolute advantage
Adam Smith: Wealth of Nations (1776) argued: Capability of one country to produce more of
a product with the same amount of input than another country
A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient
Trade between countries is, therefore, beneficial Assumes there is an absolute balance among
nations
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Theory of absolute advantage
… destroys the mercantilist idea since there are gains to be had by both countries party to an exchange
… questions the objective of national governments to acquire wealth through restrictive trade policies
… measures a nation’s wealth by the living standards of its people
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Theory of absolute advantage
PPF – Production Possibility Frontier
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Theory of comparative advantage
David Ricardo: Principles of Political Economy (1817) Extends free trade argument Efficiency of resource utilization leads to more
productivity Should import even if country is more efficient in the
product’s production than country from which it is buying.
Look to see how much more efficient. If only comparatively efficient, than import.
Makes better use of resources Trade is a positive-sum game
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Theory of comparative advantage
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Comparative advantage and the gains from trade
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Comparative advantage: Bollywood
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Assumptions and limitations
Driven only by maximization of production and consumption
Only 2 countries engaged in production and consumption of just 2 goods?
What about the transportation costs? Only resource – labour (that too, non-
transferable) No consideration for ‘learning theory’
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Factor proportions theory
Heckscher (1919) - Olin (1933) Theory Export goods that intensively use factor endowments
which are locally abundant Corollary: import goods made from locally
scarce factors Note: Factor endowments can be impacted by
government policy - minimum wage Patterns of trade are determined by differences in
factor endowments - not productivity Remember, focus on relative advantage, not absolute
advantage
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Factor proportions theory
… trade theory holding that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply
Example: Australia – lot of land and a small population
(relative to its size) So what should it export and import?
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Factor Proportions Trade TheoryConsiders Two Factors of Production
Labor
Capital
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Factor Proportions Trade Theory
A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive)
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The Leontief Paradox
The Test: Could Factor Proportions Theory be used
to explain the types of goods the United States imported and exported?
The Method:Input-output analysis
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The Leontief Paradox
The Findings:The U.S. exported labor-intensive products and imported capital-intensive products.
The Controversy:Findings were the opposite of what was generally believed to be true!
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Product life-cycle TheoryR.Vernon (1966)
… trade theory holding that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its lifecycle
As products mature, both location of sales and optimal production changes
Affects the direction and flow of imports and exports
Globalization and integration of the economy makes this theory less valid
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Product life cycle theory
Fig 4.5
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The Product Cycle and Trade Implications
Increased emphasis on technology’s impact on product cost
Explained international investment Limitations
Most appropriate for technology-based products
Some products not easily characterized by stages of maturity
Most relevant to products produced through mass production
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New trade theory
In industries with high fixed costs: Specialization increases output, and the
ability to enhance economies of scale increases
Learning effects are high. These are cost savings that come from ‘learning by doing’
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New trade theory - applications
Typically, requires industries with high, fixed costs World demand will support few competitors
Competitors may emerge because of “ First-mover advantage” Economies of scale may preclude new entrants Role of the government becomes significant
Some argue that it generates government intervention and strategic trade policy
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Theory of national competitive advantage
The theory attempts to analyze the reasons for a nations success in a particular industry
Porter studied 100 industries in 10 nations postulated determinants of competitive advantage
of a nation based on four major attributes Factor endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry
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Porter’s diamond
Success occurs where these attributes exist.
More/greater the attribute, the higher chance of success
The diamond is mutually reinforcing
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Factor endowments
Factor endowments:- A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry
Basic factor endowments Advanced factor endowments
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Basic factor endowments
Basic factors: Factors present in a country Natural resources Climate Geographic location Demographics
While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success
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Advanced factor endowments
Advanced factors: Are the result of investment by people, companies, government and are more likely to lead to competitive advantage
If a country has no basic factors, it must invest in advanced factors
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Advanced factor endowments
communications skilled labor research Technology education
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Demand conditions
Demand: creates capabilities creates sophisticated
and demanding consumers
Demand impacts quality and innovation
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Related and supporting industries
Creates clusters of supporting industries that are internationally competitive
Must also meet requirements of other parts of the Diamond
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Firm Strategy, Structure and Rivalry
Long term corporate vision is a determinant of success
Management ‘ideology’ and structure of the firm can either help or hurt you
Presence of domestic rivalry improves a company’s competitiveness
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Determinants of Competitive Advantage in nations
GovernmentGovernment
Company Strategy,Structure,
and Rivalry
DemandConditions
Relatedand Supporting
Industries
FactorConditions
ChanceChance
Two external factors that influence the four determinants.
Fig 4.8
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Porter’s Theory-predictions
Porter’s theory should predict the pattern of international trade that we observe in the real world
Countries should be exporting products from
those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable
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Implications for business
Location implications: Disperse production activities to countries
where they can be performed most efficiently First-mover implications:
Invest substantial financial resources in building a first-mover, or early-mover advantage
Policy implications: Promoting free trade is in the best interests of the
home-country, not always in the best interests of the firm, even though, many firms promote open markets
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India in the global competitiveness report