International Trade Theory Chapter 4 International Trade Theory

International Trade Theory Chapter 4

International Trade Theory

• Overview

• Mercantilism

• Absolute Advantage

• Comparative Advantage

• Heckscher-Olin Theory

• Product Life Cycle Theory

• New Trade Theory

• Porter’s Diamond

The Impact of Trade Policies

• Ghana

• 1970

• GNP/capita
• $250

• 1992

• GNP/per capita
• $450
• GNP Growth/year
• 1.5%

• Shift from productive uses (cocoa) to unproductive uses (subsistence agriculture).

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 are easy to understand (Saudi Arabia/oil or Mexico/labor intensive goods). Others are not so easy to understand (Japan and cars).

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 exports through subsidies.
• Minimize imports through tariffs and quotas.

• Flaw: “Zero-sum game”.

David Hume - 1752

• Increased exports leads to inflation and higher prices.

• Increased imports lead to lower prices.

• Result: Country A sells less because of high prices and Country B sells more because of lower prices.

• In the long run, no one can keep a trade surplus.

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.

• Trade between countries is, therefore, beneficial.

• Assumes there is an absolute advantage balance among nations.

• Ghana/cocoa.

The Theory of Absolute Advantage

The Theory of Absolute Advantage and the Gains from Trade

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.

The Theory of Comparative Advantage

Comparative Advantage and the Gains from Trade

Simple Extensions of the Ricardian Model

• Diminishing returns:

• More a country produces, at some point, will require more resources.

• However:

• Free trade can increase a country’s production resources, and
• Increase the efficiency of resource utilization.

Ghana’s PPF under Diminishing Returns

The Influence of Free Trade on the PPF

Is the Mercantilist Theory Still Valid?

• A qualified Yes.

• Equate political power with economic power and economic power with a trade surplus.

• Japan

Heckscher (1919)-Olin (1933) Theory

• 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.

Heckscher vs Ricardo

• Economists prefer Heckscher on theoretical grounds but is a relatively poor predictor of trade patterns.

• Ricardo’s Comparative Advantage Theory, regarded as too limited for predicting trade patterns, actually predicts them with greater accuracy.

• In the end, differences in productivity may be the key to determining trade patterns.

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.

International Product Trade Cycle Model

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.

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

• Economies of scale may preclude new entrants.

• Role of the government.

Founded 1915 by William Boeing

• Founded 1915 by William Boeing

• Largest commercial airplane manufacturer.

• 9,000 commercial jetliners in service.

• Established 1967

• Western Europe buying 25% of aircraft ,but selling only 10%.

• France, Germany, Great Britain

• To date: 3,203 orders - 1,890 deliveries.

Airbus vs Boeing

Porter’s Diamond (Harvard Business School, 1990)

• The Competitive Advantage of Nations.

• Looked at 100 industries in 10 nations.

• Thought existing theories didn’t go far enough.

• Question: “Why does a nation achieve international success in a particular industry?”

Determinants of National Competitive Advantage

• Factor endowments:nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry.

• Firm strategy, structure and rivalry:the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.

• Demand conditions:the nature of home demand for the industry’s product or service.

• Related and supporting industries:the presence or absence in a nation of supplier industries or related industries that are nationally competitive.

Porter’s Diamond Determinants of National Competitive Advantage

The Diamond

• Success occurs where these attributes exist.

• More/greater the attribute, the higher chance of success.

• The diamond is mutually reinforcing.

Factor Endowments

• Taken from Heckscher-Olin

• Basic factors:

• natural resources,
• climate,
• location.

• Advanced factors:

• communications,
• skilled labor,
• technology.

Advanced Factor Endowments

• More likely to lead to competitive advantage.

• Are the result of investment by people, companies, government.

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 company’s competitiveness.

Evaluating Porter’s Theory

• If Porter is right, country exports should reflect the presence of the four ‘diamond’ components. Countries will import goods from industries where some or all the components are missing.

• Too soon to tell.

Determinants of National Competitive Advantage

Porter’s diamond, but...

• ‘Double Diamond’ - look to attributes of both countries.

• Professor Alan Rugman, University of Toronto

• Home country may ‘sound’ good, but

• Company can rely on the host country.
• Neighboring countries can too.
• Canada and the U.S.

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.