International Trade Theory What is international trade?

• International Trade Theory

International Trade Theory

• What is international trade?

• Exchange of raw materials and manufactured goods (and services) across national borders

• Classical trade theories:

• explain national economy conditions--country advantages--that enable such exchange to happen

• New trade theories:

• explain links among natural country advantages, government action, and industry characteristics that enable such exchange to happen

• Implications for International Business

Classical Trade Theories

• Mercantilism (pre-16th century)

• Takes an us-versus-them view of trade
• Other country’s gain is our country’s loss

• Free Trade theories

• Absolute Advantage (Adam Smith, 1776)
• Comparative Advantage (David Ricardo, 1817)
• Specialization of production and free flow of goods benefit all trading partners’ economies

• Free Trade refined

• Factor-proportions (Heckscher-Ohlin, 1919)
• International product life cycle (Ray Vernon, 1966)

The New Trade Theory

• As output expands with specialization, an industry’s ability to realize economies of scale increases and unit costs decrease

• Because of scale economies, world demand supports only a few firms in such industries (e.g., commercial aircraft, automobiles)

• Countries that had an early entrant to such an industry have an advantage:

• Fist-mover advantage
• Barrier to entry

New Trade Theory

• Global Strategic Rivalry

• Firms gain competitive advantage trough: intellectual property, R&D, economies of scale and scope, experience

• National Competitive Advantage (Porter, 1990)

Mercantilism/Neomercantilism

• Prevailed in 1500 - 1800

• Export more to “strangers” than we import to amass treasure, expand kingdom
• Zero-sum vs positive-sum game view of trade

• Government intervenes to achieve a surplus in exports

• King, exporters, domestic producers: happy
• Subjects: unhappy because domestic goods stay expensive and of limited variety

• Today neo-mercantilists = protectionists: some segments of society shielded short term

Absolute Advantage

• Adam Smith: The Wealth of Nations, 1776

• Mercantilism weakens country in long run; enriches only a few

• A country

• Should specialize in production of and export products for which it has absolute advantage; import other products
• Has absolute advantage when it is more productive than another country in producing a particular product

Comparative Advantage

• David Ricardo: Principles of Political Economy, 1817

• Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces

• Absolute Advantage is a special case of Comparative Advantage

Heckscher (1919)-Ohlin (1933)

• Differences in factor endowments not on differences in productivity determine patterns of trade

• Absolute amounts of factor endowments matter

• Leontief paradox:

• US has relatively more abundant capital yet imports goods more capital intensive than those it exports
• Explanation(?):
• US has special advantage on producing new products made with innovative technologies
• These may be less capital intensive till they reach mass-production state

Theory of Relative Factor Endowments (Heckscher-Ohlin)

• Factor endowments vary among countries

• Products differ according to the types of factors that they need as inputs

• A country has a comparative advantage in producing products that intensively use factors of production (resources) it has in abundance

• Factors of production: labor, capital, land, human resources, technology

International Product Life-Cycle (Vernon)

• Most new products conceived / produced in the US in 20th century

• US firms kept production close to their market initially

• Aid decisions; minimize risk of new product introductions
• Demand not based on price; low product cost not an issue

• Limited initial demand in other advanced countries initially

• Exports more attractive than overseas production

• When demand increases in advanced countries, production follows

• With demand expansion in secondary markets

• Product becomes standardized
• production moves to low production cost areas
• Product now imported to US and to advanced countries

Classic Theory Conclusion

• Free Trade expands the world “pie” for goods/services

• Theory Limitations:

• Simple world (two countries, two products)

• no transportation costs

• no price differences in resources

• resources immobile across countries

• constant returns to scale

• each country has a fixed stock of resources and no efficiency gains in resource use from trade

• full employment

New Trade Theories

• Increasing returns of specialization due to economies of scale (unit costs of production decrease)

• First mover advantages (economies of scale such that barrier to entry crated for second or third company)

• Luck... first mover may be simply lucky.

• Government intervention: strategic trade policy

National Competitive Advantage (Porter, 1990)

• Factor endowments

• land, labor, capital, workforce, infrastructure (some factors can be created...)

• Demand conditions

• large, sophisticated domestic consumer base: offers an innovation friendly environment and a testing ground

• Related and supporting industries

• local suppliers cluster around producers and add to innovation

• Firm strategy, structure, rivalry

• competition good, national governments can create conditions which facilitate and nurture such conditions

Porter’s Diamond

“So What” for business?

• First mover implications

• Location Implications

• Foreign Investment Decisions

• Government Policy implications