International Business

1International BusinessInternational Trade TheoryLecture 72OverviewIntroductionAn Overview of Trade TheoryThe benefits of tradeThe pattern of international tradeTrade theory and government policyMercantilismAbsolute Advantage3OverviewComparative AdvantageQualifications and assumptionsExtension of the Ricardian ModelHeckscher-Ohlin TheoryThe Leontiff Paradox4OverviewThe Product Life-Cycle TheoryEvaluating the PLC theoryNew Trade TheoryIncreasing product variety and reducing costsEconomies of scale, first mover advantages, and the pattern of tradeImplications of new trade theory5OverviewNational Competitive Advantage: Porters DiamondFactor endowmentsDemand conditionsRelated and supporting industriesFirm strategy, structure, and rivalry6OverviewEvaluating Porters TheoryImplications for ManagersLocationFirstmover advantagesGovernment policy7IntroductionRefer to the industry of roses of Ecuador; this product is considered as the Rolls Royce of rosesThey have huge heads and unusually vibrant colours, including 10 different redsThe industry started some 30 years ago and has been expanding rapidly sinceEcuador is now the worlds fourth largest producer of roses; it is the nations fifth largest export; $240m in sales annually8IntroductionThe Ecuadorian rose industry is a striking example of the benefits of free trade and globalizationLow barriers to trade have allowed Ecuador to exploit its comparative advantage in the growing of roses and thus help the country to emerge as a major exporter of rosesEconomic growth and personal incomes have been bolstered by the emerging rose industry9IntroductionHelped consumers in foreign markets to access affordable high-quality roses from EcuadorWho are the losers?In the world of international trade, there are always winners and losersThe benefits to the winners outweigh the costs borne by the losers, resulting in a net gain to society10IntroductionIn the long run, free trade stimulates economic growth and raises living standards across the boardInternational trade theory has shaped the economic policy of many nations in the past 50 yearsIt has been the driver in the formation of WTO and other regional trade blocs; examples?The 1990s saw a global move toward greater free trade; why?11IntroductionIt is therefore important to understand what what these theories are and why they have been so successful in shaping the economic policy of so many nations and the competitive environment in which international business compete12IntroductionThe aims:Review the theories that explain why it is beneficial for a country to engage in international tradeExplain the pattern of international trade that we observe in the world economy; patterns of exports and imports of goods and services among countries13An Overview of Trade TheoryTheories noted as far as 16th and 17th centuriesMercantilismCountries should simultaneously encourage exports and discourage importsOld and discredited doctrine; its echoes still remain in modern political debate and in the trade policies of many countries14An Overview of Trade TheoryAbsolute advantageAdam Smiths theory; dates back to 1776Explains why unrestricted free trade is beneficial to a countryFree 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 country15An Overview of Trade TheoryThe invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exportsA laissez-faire stance toward trade is in the best interests of a countryBuilding on Smiths work are two additional theories16An Overview of Trade TheoryComparative advantageTheory advanced by the 19th century economist David RicardoThis theory is the intellectual basis of the modern argument for unrestricted free tradeIn the 20th century, Ricardos work was refined by two Swedish economistsTheory known as Heckscher-Ohlin theory17The benefits of tradeThe theories can identify with a certain degree of precision the specific benefits of international tradeCommon sense suggests that international trade is beneficialExample of Iceland? explain18The benefits of tradeGoing beyond the common sense notion, why is it beneficial for a country to engage in international trade, even for products it is able to produce for itselfIssue of US consumers buying home-made products; nationalistic sentiments; help save jobs from foreign competition19The benefits of tradeThe different theories tell us that a countrys economy may gain if its citizens buy certain products from other nations that could be produced at home; explain?Example of US specializing in the production of certain goods and importing other products20The benefits of tradeThe economic argument is often difficult for segments of a countrys population to accept; explain with examplesFuture threatened by importsLimit the imports,through quotas, tariffsMay benefit particular groups, but hurts the economy as a wholeLimits on imports are often in the interests of domestic producers, but not domestic consumers21The pattern of international tradeThe theories of Smith, Ricardo, and Hechscher-Ohlin help to explain the pattern of international trade that we observe in the world economyThe different aspects to be taken into considerationClimate and natural resources; examples?22The pattern of international tradeHowever, much of the observed pattern of international trade is difficult to explainWhy Japan exports automobiles, consumer electronics, and machine tools?David Ricardos theory of comparative advantage offers an explanation in terms of international differences in labour productivity23The pattern of international tradeThe more sophisticated Heckscher-Ohlin theory emphasizes the interplay between the the proportions in which the factors of production are available in different countries and the proportions in which they are needed for producing particular goods; assumption rests on the fact that countries have varying endowments of the various factors of production24The pattern of international tradeOne early response to the failure of the Heckscher-Ohlin theory to explain the observed pattern of international trade was the product life-cycle theory; proposed by Raymond VernonEarly in the life cycle, most new products are produced in and exported from the country in which they are developed; what happens next, when the product is widely accepted internationally?25The pattern of international tradeSimilarly, during the 1980s, new theory has been developed; new trade theory developed by Paul KrugmanIt stresses that in some cases, countries specialise in the production and export of particular products not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of firms; examples?26The pattern of international tradeIn such industries, firms that enter the market first are able to build a competitive advantage that is subsequently difficult to challengeThus, the observed pattern of trade between nations may be due in part to the ability of firms within a given nation to capture first-mover advantages; examples? 27The pattern of international tradeIn a work related to the new trade theory, Michael Porter, developed a theory referred to as the theory of national competitive advantageThis attempts to explain why particular nations achieve international success in particular industries28The pattern of international tradeIn addition to factor endowments, Porter points out the importance of country factors such as domestic demand and domestic rivalry in explaining a nations dominance in the production and export of particular products29Trade theory and government policyAlthough all these theories agree that international trade is beneficial to a country, they lack agreement in their recommendations for government policyMercantilism: crude case for government involvement in promoting exports and limiting imports30Trade theory and government policyThe theories of Smith, Ricardo, and Heckscher-Ohlin form part of the case for unrestricted free trade; both import controls and export incentives are self-defeating and result in wasted resourcesBoth the new trade theory and Porters theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain export-oriented industries31MercantilismThe first theory of international trade; it emerged in England in the mid-16th centuryThe principal assertion of mercantilism was that gold and silver were the mainstays of national wealth and essential to vigorous commerce32MercantilismThe main tenetIt was in a countrys best interests to maintain a trade surplus, to export more than it imported; by doing so, a country would accumulate gold and silver and, increase its national wealth, prestige, and powerEnglish mercantilist writer: Thomas Mun33MercantilismConsistent with this belief, the doctrine advocated government intervention to achieve a surplus in the balance of trade; no virtue in large volume of trade; rather policies to maximise exports and minimise imports; how?The classical economist David Hume pointed out an inherent inconsistency in this mercantilist doctrine in 1752; example of UK and France balance of surplus; explain?34MercantilismThe flaw with this theory was that it viewed trade as a zero-sum game; gain by one country results in a loss by anotherSubsequent theories showed the short-sightedness of this approach and demonstrated that trade is a positive-sum game, or a situation in which all countries can benefit35MercantilismUnfortunately, the mercantilist doctrine is by no means deadNeo-mercantilists equate political power with economic power and economic power with a balance-of-trade surplusExamples?36Absolute AdvantageA country has an absolute advantage in the production of a product when it is more efficient than any other country in producing itAdam Smith attacked the mercantilist assumption that trade is a zero-sum game; landmark book of Adam Smith in 1776; The Wealth of Nations37Absolute AdvantageCountries differ in their ability to produce goods efficiently; examples?According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these for goods produced by other countriesExample of Ghana and Korea in the production of cocoa and rice38Absolute AdvantageResources required to produce 1 ton of cocoa and riceProduction and consumption without tradeProduction with specializationConsumption after tradeIncrease in consumption as a result of specialization and trade39Absolute AdvantageAs a result of specialization and trade, output of different products would increase, and consumers in various nations would be able to consume moreTrade is thus a positive sum game; it produces net gains for all involved40Comparative AdvantageWhat happens when one country has an absolute advantage in the production of all goods?David Ricardo took Smiths theory one step further to study the aboveSmiths theory of absolute advantage suggests that a country may not benefit from international trade; in his book Principles of Political Economy, Ricardo showed this was not the case41Comparative AdvantageAccording to Ricardos theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods it produces less efficiently from other countries; even if this means buying goods from other countries that it could produce more efficiently itself42Comparative AdvantageExample of Ghana and Korea in the production of cocoa and rice; with Ghana having an absolute advantage in both products; explain?The basic message of the theory of comparative advantage is that potential world production is greater with unrestricted free trade than it is with restricted trade; consumers in all nations can consume more if there are no restrictions on tradeThis occurs in countries that lack an absolute advantage in the production of any good43Comparative AdvantageThe theory of comparative advantage suggests that trade is a positive-sum game in which all countries that participate realize economic gains; this theory provides a strong rationale for free trade44Comparative AdvantageQualifications and assumptionsThe conclusion that free trade is universally beneficial is a rather bold; assumptions made:Assume a simple world in which there are only two countries and two goodsTransportation costs?45Comparative AdvantageDifferences in the prices of resources in different countries; exchange rates?Resources can move freely from the production of one good to anotherAssume constant returns to scale; there may may be diminishing or increasing returns to specialization46Comparative AdvantageAssume that each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resourcesAssume away the effects of trade on income distribution within a country47Comparative AdvantageGiven these assumptions, can the conclusion that free trade is mutually beneficial be extended to the real world of many countries, many goods, positive transportation costs, volatile exchange rates, immobile domestic resources, non-constant returns to specialization, and dynamic changes?48Comparative AdvantageEconomists have shown that the basic result from the simple model can be generalized to a world of many countries producing many different goodsHowever, some economists associated with the new trade theory, argue that the case, for unrestricted free trade, while still positive, loses some of its strength49Comparative AdvantageExtensions of the Ricardian ModelWe may still consider the effect of relaxing three of the assumptions identified in the simple modelResources move freely from the production of one good to anotherConstant returns to scaleTrade does not change a countrys stock of resources or the efficiency with which the resources are utilizedExplain the effects?50Heckscher-Ohlin TheoryEli Heckscher and Bertil Ohlin put forward a different explanation of comparative advantageIt arises from differences in national factor endowmentsBy factor endowments, they meant the extent to which a country is endowed with such resources as land, labour, and capitalImpact on costs?51Heckscher-Ohlin TheoryThe Heckscher-Ohlin theory attempts to explain the pattern of international trade that we observe in the world economyThe theory predicts that countries will export those goods that make extensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce52Heckscher-Ohlin TheoryLike Ricardos theory, the Heckscher-Ohlin theory argues that free trade is beneficialUnlike Ricardos theory, however, the Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments, rather than differences in productivity53Heckscher-Ohlin TheoryExamples: US and China?It is relative not absolute, endowments that are important54The Leontief ParadoxThe Heckscher-Ohlin theory has been one of the most influential theoretical ideas in international economicsBecause of its influence, the theory has been subjected to many empirical tests; famous study by Wassily Leontief in 195355The Leontief ParadoxUsing the Heckscher-Ohlin theory, Leontief postulated that since US was relatively abundant in capital compared to other nations, the US would be an exporter of capital-intensive goods, and an importer of labour-intensive goods; however, US exports were less capital intensive than US imports; hence the Leontief paradox56The Product Life-Cycle TheoryRaymond Vernon initially proposed this theory in the mid 1960sA very large proportion of the worlds new products had been developed by US firms and sold first in the US market; examples?Products could still be produced at low-cost sites and exported back into the US market; then, why initially produced in the US itself?57The Product Life-Cycle TheoryWhat about the initial demand in the US market and in other developed markets?High income groups in advanced countriesOver time, what happens?Consequence of the trends for the pattern of world trade over time: switch from being an exporter to an importer of the product as production becomes concentrated in lower-cost foreign locations58Evaluating the PLC theoryHistorically, the PLC theory seems to be an accurate explanation of international trade patternsExamples: photocopiers in the USHowever, the PLC theory is not without weaknessesViewed from an Asian or European perspective, Vernons argument that most new products are developed in the US seems ethnocentric59Evaluating the PLC theoryCould be true during the US dominance period (1945 1975)Exceptions appear to have become more common in recent years; Japan, Europe?Impact of globalization and integration of the world economy? Launch of new products60New Trade TheoryThe new trade theory began to emerge in the 1970s when a number of firms pointed out that the ability of firms to attain the economies of scale might have important implications for international tradeEconomies of scale are unit cost reductions associated with a large scale of output; may also have a number of sources61New Trade TheoryAbility of large volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipmentExamples?62New Trade TheoryNew trade theory makes two important pointsThrough its impact on EoS, trade can increase the variety of goods available to consumers and decrease the average costs of those goodsIn those industries, when the output required to attain EoS represents a significant proportion of total world demand, the global market may only be able to support a small number of enterprises; examples? First movers in specific production?63National Competitive Advantage: Porters DiamondWhy a nation achieves international success in a particular industry? Why some nations succeed and others fail international competition?Japan: automobile industrySwitzerland: precision instruments, pharmaceuticalsPartial explanation by the known theories64National Competitive Advantage: Porters DiamondPorter theorizes that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantageFactor endowmentsA nations position in factors of production, such as skilled labour, infrastructure, necessary to compete in a given industry65National Competitive Advantage: Porters DiamondDemand conditionsThe nature of home demand for the industrys product or serviceRelating and supporting industriesThe presence or absence of supplier industries and related industries that are internationally competitive66National Competitive Advantage: Porters DiamondFirm strategy, structure, and rivalryThe conditions governing how companies are created, organized, and managed and the nature of domestic rivalryPorter speaks of these four attributes as constituting the diamondFirms are most likely to succeed in industries or industry segments where the diamond is most favorable67National Competitive Advantage: Porters DiamondThe diamond is a mutually reinforcing system; the effect of one attribute is contingent on the state of the others68Evaluating Porters TheoryPorter contends that the degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of the four attributes; the presence of the four components is usually required for the diamond to boost competitive performanceWho can influence each of the components?69Evaluating Porters TheoryWhat about the Government? The latter can influence positively or negativelyFactor endowments: subsidies, policies toward capital markets, educationDomestic demand: local product standards, regulations that influence buyer needsSupporting and related industries: regulation70Evaluating Porters TheoryFirm rivalry: capital market regulation, tax policy, antitrust lawsIf Porters theory is correct, we would expect his model to predict the pattern of international trade, that we observe in the real worldCountries exporting products from those industries where all four components of the diamond are favorable; is it true?One cannot say? Extent of empirical testing?71Implications for ManagersWhy does all this matter for business?The theories discussed have three main implicationsLocationFirst-moverGovernment policy72QuestionsMercantilism is a bankrupt theory that has no place in the modern world. DiscussIs free trade fair? DiscussWhat are the potential costs of adopting a free trade regime? Do you think governments should do anything to reduce these costs? Discuss