International Business

MMS Sem III

International Trade Theories

An Overview Of Trade Theory

Mercantilism
Encourage exports

Free Trade
Unrestricted Free Trade

Comparative Advantage

Heckscher-Ohlin Theory

An Overview of Trade Theory

Free Trade occurs when 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. 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. The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish). Others are not so easy to understand (Japan and cars). The history of Trade Theory and Government Involvement presents a mixed case for the role of government in promoting exports and limiting imports. Later theories appear to make a case for limited involvement.

 Explain why it is beneficial for a country to engage in international trade. Explain the pattern of international trade observed in the world economy.

Mercantilism: mid-16th century

A nations wealth depends on accumulated treasure Gold and silver are the currency of trade. Theory says you should have a trade surplus. Maximize exports through subsidies. Minimize imports through tariffs and quotas.

Theory of Absolute Advantage Adam Smith: Wealth of Nations (1776).

Capability of one country to produce more of a product with the same amount of input than another country. Produce only goods where you are most efficient, trade for those where you are not efficient. Assumes there is an absolute advantage balance among nations, e.g., Ghana/cocoa.

1st British African colony to win independence (1957). Nkrumah espoused pan African socialism. High tariffs. Anti export (trade) policy.

Kept lowering tariffs on manufactured goods. Created incentives to export (trade). Reduced quotas. Reduced subsidies. 1950s: 77% of employment in agriculture. Now 20%. Manufacturing GNP went from 10% to over 30%.

The Theory of Absolute Advantage

G 20

Cocoa

15

10

K 5

B G K 15 20

10

Rice

The Theory of Absolute Advantage and the Assume 200 units Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Ricece

Ghana Ghana S Ghana Korea

Cocoa to Produce Rice Resources Required 1 Ton of Cocoa and Rice

Production and Consumption without Trade

10.0

5.0

10

10 40 20

20 10 5.0 10.0 15.0 0 20 20

Each country devotes half resource

Ghana Korea Total production Ghana Ghana 20 Korea Total production

10.0 2.5 12.5 20 0 0 20

Production with Specialization Production with Specialization

Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice

Increase in Consumption as a Result of Specialization and Trade

Ghana S. S. Korea Korea

14.0 206.0

6.0 14.0
1.0 4.0

Ghana Korea

4.0 3.5

Theory of Comparative Advantage David Ricardo: Principles of Political Economy (1817).

It makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries even if this means buying goods from other countries that it could produce more efficiently itself.

The Theory of Comparative Advantage

G 20

Cocoa

15

A
10 5 K B K 10
G

2.5

15

20

Rice

Comparative Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice
Ghana has absolute advantage

Cocoa

Rice

Ghana S. Korea Ghana S. Korea Total production Ghana S. Korea Total production Ghana S. Korea

10 40 10.0 2.5 12.5 15 0.0 15 11 4

13.33 20 7.5 5.0 12.5

Production and Consumption without Trade

Ghana Comparative advantage is in Cocoa

Production with Specialization

3.75 10.0 13.75 7.75 6

Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice

Increase in Consumption as a Result of Specialization and Trade

Ghana S. Korea

1.0 1.5

0.25 1.0

Extensions of the Ricardian Model

Immobile resources: Resources do not always move easily from one economic activity to another. Diminishing returns: More a country produces, at some point, will require more resources (diminishing returns to specialization). Different goods use resources in different proportions. However: Free trade might increase a countrys stock of resources (as labor and capital arrives from abroad), and Increase the efficiency of resource utilization.

Ghanas PPF under Diminishing Returns

Cocoa

G 0

Rice

The Influence of Free Trade on the PPF

PPF2 PPF1

Cocoa

G
0

Rice

A Link Between Trade and Growth

Sachs and Warner: 1970 to 1990 study Open economy developing countries grew 4.49%/year. Closed economy developing countries grew 0.69%/year. Open economy developed countries grew 2.29%/year. Closed economy developed countries grew 0.74%/year.
Frankel and Romer: On average, a one percentage point increase in the ratio of a countrys trade to its GDP increases income/person by at least 0.5%. For every 10% increase in the importance of international trade in an economy, average income levels will rise by at least 5%.

Heckscher (1919)-Olin (1933) Theory

Labor is not the only Factor of production. We need to account for land, capital, and technology. Factor endowments: extent to which a country is endowed with such resources as land, labor, and capital. Export goods that intensively use factor endowments which are locally abundant.

Corollary: import goods made from locally scarce factors.

Patterns of trade are determined by differences in factor endowments - not productivity. Remember, focus on relative advantage, not absolute advantage.

The Leontief Paradox, 1953

Disputes Heckscher-Olin in some instances. Factor endowments can be impacted by government policy - minimum wage. US tends to export labor-intensive products, but is regarded as a capital intensive country

Product Life-Cycle Theory (Raymond Vernon, 1966)

Article in the Quarterly Journal of Economics. 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.

The New Trade Theory

Began to be recognized in the 1970s. Deals with the returns on specialization where substantial economies of scale are present.
Specialization increases output, ability to enhance economies of scale increase.

In addition to economies of scale, learning effects also exist.

Learning effects are cost savings that come from learning by doing.

Application of the New Trade Theory

Typically, requires industries with high, fixed costs. World demand will support few competitors. Competitors may emerge because they got there first.
First-mover advantage.

Some argue that it generates government intervention and strategic trade policy.

First-Mover Advantage
The economic and strategic advantages that accrue to early entrants into an industry. Economies of scale may preclude new entrants. Role of the government.

Porters Diamond
(Harvard Business School, 1990)
The Competitive Advantage of Nations. Looked at 100 industries in 10 nations.

Thought existing theories didnt go far enough. Question: Why does a nation achieve international success in a particular industry?

Determinants of National Competitive Advantage

Factor endowments:nations position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry. Demand conditions:the nature of home demand for the industrys product or service. Related and supporting industries:the presence or absence in a nation of supplier industries or related industries that are nationally competitive. Firm strategy, structure and rivalry: the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.

 The Diamond
Success occurs where these attributes exist.
More/greater the attribute, the higher chance of success.

The diamond is mutually reinforcing.

Porters Diamond
Determinants of National Competitive Advantage
Firm Strategy, Structure and Rivalry

Factor Endowments

Demand Conditions

Related and Supporting Industries

Determinants of National Competitive Advantage

Chance
Company Strategy, Structure, and Rivalry

Two external factors that influence the four determinants.

Factor Conditions

Demand Conditions

Related and Supporting Industries

Government

Factor Endowments
Taken from Heckscher-Olin Basic factors:

natural resources climate location demographics

Advanced factors:

communications skilled labor research technology

Relationship of Basic to Advanced Factors

Basic can provide an initial advantage. Must be supported by advanced factors to maintain success. No basics, then must invest in advanced factors.

Demand Conditions
Demand creates the capabilities. Look for sophisticated and demanding consumers. impacts quality and innovation.

Related and Supporting Industries

Creates clusters of supporting industries that are internationally competitive. Must also meet requirements of other parts of the Diamond.

Firm Strategy, Structure and Rivalry

Management ideology can either help or hurt you. Presence of domestic rivalry improves a companys competitiveness.

Evaluating Porters Theory

If Porter is right, we would expect his model to 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. Too soon to tell.

Implications for Business

Location implications:makes sense to disperse production activities to countries where they can be performed most efficiently. First-mover implications:It pays to invest substantial financial resources in building a first-mover, or early-mover, advantage. Policy implications:promoting free trade is generally in the best interests of the home-country, although not always in the best interests of the firm. Even though, many firms promote open markets.