Theories of Intl Trade

8/3/2019 Theories of Intl Trade

http://slidepdf.com/reader/full/theories-of-intl-trade 1/38

4/28/2012 Prof. R.Bala

International Business Management



4/28/2012 Prof. R.Bala 2

Theories of International Trade

Classical Theories of Trade

Theory of Absolute Advantage

Theory of Comparative Advantage

Heckscher-Ohlin (Factor-Proportions)Theory

Product Life cycle Theory

Newer Theories of International Trade Strategic Trade Theory

Porter’s ‘Diamond Theory’



4/28/2012 Prof. R.Bala 3

Theory of ‘Absolute’ Advantage

‘If a country could produce a good cheaperthan other countries, it had an absolute advantage in production of that good.

In order to maximize national income,countries should produce and exportsurpluses of what they have absoluteadvantage in and buy whatever else they

need from the rest of the world’.

- Adam Smith (The Wealth of Nations 1776)



4/28/2012 Prof. R.Bala 4

The Un answered Question

What if a country has absoluteadvantage in all products or evenworse, no products at all?

Absolute Advantage theory would implythat the former country need not tradewhile the latter country could not trade!

Common sense tells that there is

something untenable in the conclusiondrawn which led to ‘The Theory of Comparative Advantage’ of David Ricardo.



4/28/2012 Prof. R.Bala 5

The theory of Comparative Advantage

David Ricardo showed that both countries shouldand in fact will trade in order to increase thenational welfare as long as each has a comparativeadvantage in the production of one good over

another.

Incentives for trade would exist even when onecountry has absolute cost advantage in everythingor another country has cost advantage in nothing.

All that is needed is that a country’s ability toproduce one good relative to another good shouldbe different from another country’s relative ability toproduce the same two goods.



4/28/2012 Prof. R.Bala 6

An example of Comparative Advantage

Let us consider two countries – US & France both of which canproduce beef & wine.

• Factors of production can be costlessly transformed fromproducing beef to wine & vice versa.

• If US used all factors of production it can produce 25 bottles

of wine. Or alternatively US can produce 50 pounds of beef.• The corresponding figures for France are 150 bottles of wine

& 60 pounds of beef.

• France can produce more of both beef & wine.

• Should there be any trading at all between US & France?

• Assume that the initial ‘no trade’ production & consumptionof beef in the two countries is 40 pounds in the US and 20pounds in France.



4/28/2012 Prof. R.Bala 7

Initial (Pre Trade) Production Pattern

Beef Wine

US 40 5

France 20 100

Total 60 105



4/28/2012 Prof. R.Bala 8

Analysis of relative ability to produce

For every pound of beef that France doesnot choose to produce, it releases landthat can produce 2.5 bottles of wine

(=150/60). In other words in France eachpound of beef costs 2.5 bottles of wine.

Likewise, for every pound of beef that USdoes not choose to produce, it releases

land that can produce 0.5 bottles of wine(=25/50). In other words, in US eachpound of beef costs 0.5 bottles of wine.



4/28/2012 Prof. R.Bala 9

An assessment of trading opportunity

Let us assume that the two countries agree totrade with each other at a price between 2.5 & 0.5 bottles of wine for each pound of beef - sayone bottle of wine per pound of beef.

At this price, US has incentive to sell beef forFrench wine since for each pound of beef sold itcan get twice the amount of wine that it didbefore. (One bottle of wine instead of 0.5 bottleof wine per pound of beef foregone)

Likewise, France has incentive to sell it’s wine for

US beef, since for each bottle of wine sold it canget 2.5 times the amount of beef that it didbefore. (one pound of beef instead of 0.4 poundsof beef per bottle of wine foregone)



4/28/2012 Prof. R.Bala 10

An argument in favor of trade

Assuming neither country wants to reduce it’s production & consumption level from the pre trade level in their areas of comparative advantage, this is what is likely to happen.

US can produce 10 more pounds of beef & sell it to France inexchange for 10 bottles of wine.

Likewise, France can produce 16 pounds of beef & 110 bottlesof wine & after consuming 100 bottles, sell the remaining 10bottles to US, in exchange for 10 pounds of beef. In effect,France can have 16+10 = 26 pounds of beef as against pretrade position of 20 pounds.

In the process both US & France stand to gain. US is richer by5 bottles of wine and France by 6 pounds of beef.

Clearly trade makes both the countries better off compared topre trade equilibrium. A clear Win – Win situation to both.



4/28/2012 Prof. R.Bala 11

Post trade Consumption Pattern

Beef Wine

FromDomestic

Production

FromImport

Total From

Domestic

Production

Import Total

US 40 0 40 0 10 10

France 16 10 26 100 0 100Total 56 10 66 100 10 110

Pre tradeConsumption

60 105



4/28/2012 Prof. R.Bala 12

Differential relative advantage, the key

factor

Despite the fact that France could overall producemore beef, The US had a relative advantage inproduction of beef. For each bottle of wine thatwas given up, US could produce1/0.5= 2 pounds

of beef, while France could produceonly1/2.5=0.4 pounds of beef.

The reverse is true in the case of relativeadvantage for wine production

It makes strong business sense for France to

focus more on wine production & import beef .The vice versa is true of US. This then is therationale of Ricardo’s theory of comparativeadvantage.



4/28/2012 Prof. R.Bala 13

Intuition behind the concept of

comparative advantage

Assume you are the CEO of your own company.

You have acquired considerable skill in typing & infact you are the fastest typist in your company.

Your available time is finite and you have the option

to do your own typing or hire a typist. But you canearn more by running the company rather thantyping.

How would you prefer to spend your time?

Would you hire a typist even if he is slower than youin typing.

If your answer to the questions is ‘Running thecompany’ & ‘Yes’, you have grasped Ricardo’s theory.



4/28/2012 Prof. R.Bala 14

Heckscher-Ohlin Theory (Factor-

Proportions Theory)

Both Adam Smith & Ricardo models are based only on onefactor of production

Heckscher – Ohlin addressed a situation where more thanone factor of production was involved

Basic tenet is that trade is profitable only when countriestake advantage of their different factor endowments.

Even if two countries are equally endowed, opportunitiesfor mutually profitable trade still exist due to differences infactor prices and differences in demand patterns in the two

countries. Difference in demand patterns may be a result of different income distributions or differences in tastebetween the two countries



4/28/2012 Prof. R.Bala 15

Factor – Proportions Theory

Comparative advantage arises from differences in nationalfactor endowments.

What is meant by factor endowments is the extent to whicha country is endowed with resources like land, labor andcapital

The more abundant a factor the lower the cost of thatfactor.

H-O Theory says that countries will export those goodswhich makes intensive use of those factors which areabundant and import goods which makes intensive use of

those resources which are locally scarce. International trade is determined by differences in factor

endowments rather than differences in productivity.



4/28/2012 Prof. R.Bala 16

The Leontief Paradox

Using H-O theory, Leontief postulated thatsince US was relatively abundant in capitalcompared to other nations US should be

an exporter of capital intensive goods andan importer of labor intensive goods. Butto his surprise, he observed that USexports were less capital intensive than

US imports . Since the result was atvariance with the theory, it has becomeknown as Leontief paradox.



4/28/2012 Prof. R.Bala 17

Explanation for Leontief’s Paradox

A key assumption in H-O theory is Technology isthe same across nations, which is not really thecase.

Difference in technology leads to difference in

productivity which in turn drives internationaltrade patterns.

Japan’s success in exporting automobiles in1970s was based not just on the relativeabundance of capital, but also on it’s

development of innovative manufacturingtechnology that enabled it to achieve higherproductivity in automobile production than othercountries which also had abundant capital.



4/28/2012 Prof. R.Bala 18

Explanation for Leontief’s Paradox

A recent empirical work suggests that thisexplanation is in fact correct.

The new research shows that once theTechnology across counties is factored in ,countries do indeed export goods that makeintensive use of factors which are locallyabundant, while importing goods that makeintensive use of factors that are locally scarce.

In other words, once the difference in Technology& their impact on productivity are factored in H-Otheory still holds good.



4/28/2012 Prof. R.Bala 19

The International Product Life Cycle (PLC)

Theory

The PLC Theory developed by RaymondVernon states that certain kind of productsgo through a continuum, or cycle that

consists of four stages – introduction,growth, maturity and decline – and the location of production will shiftinternationally depending on the

stage of the cycle



4/28/2012 Prof. R.Bala 20

Product Life Cycle Theory Life cycle stage

Introduction Growth Maturity Decline

Productionlocation

In innovating(usuallyindustrial)country

In innovating& otherindustrialcountries

Multiplecountries

Mainly LDCs

Marketlocation

Mainlyinnovatingcountry withsome exports

Mainly inindustrialcountries.

Shift in export

markets asforeignproductionreplacesexports insome markets

Growth inLDCs

Somedecrease in

industrialcountries

Mainly inLDCs

Some LDCexports



4/28/2012 Prof. R.Bala 21



Competitivefactors

•Near Monopolyposition

•Sales based onuniquenessrather thanprice

• Evolvingproductcharacteristics

•Fast growingdemand

•Number of competitorsincrease

•Somecompetitorsbegin pricecutting

•Productbecomingmorestandardized

• Overallstabilized

demand•Number of competitorsdecreases

•Price is veryimportantesp. in LDCs

•Overalldeclining

demand•Price is keyweapon

•Number of producerscontinues todecrease



4/28/2012 Prof. R.Bala 22



ProductionTechnology

•ShortProduction runs

•Evolvingmethods tocoincide withproductevolution

•High labor andlabor skillsrelative tocapital input

•Capital inputincreases

•Methodsmorestandardized

•Longproduction

runs usinghigh capitalinputs

•Highlystandardized

•Less laborskills needed

•Unskilledlabor on

mechanizedlongproductionruns



4/28/2012 Prof. R.Bala 23

Strategic Trade Theory

Recognizes the ground reality that in place of perfect competition postulated by classicaltheorists, competition in global markets is seento be imperfect.

Firms & Governments can act strategically toaffect trade flows and the position of nationaleconomies.

Concentration of economic power has enabled

firms & Governments to make strategic choicesto build competitive advantage in global trade atthe firm, industry & country levels



4/28/2012 Prof. R.Bala 24

Strategic Trade Theory

Recognizes that Governments & MNCs canintervene in trade in defined ways:

1. Creating barriers to entry by heavy promotionalor investment expenditure

2. Using ‘economies of scale’ to force down prices

3. ‘Dumping’ to capture volume market share bypricing below cost.

4.

Preventive strategies in innovation, design, R&Dand market penetration to deny competitiveadvantage to rivals

5. Providing Government ‘supply side’ subsidies



4/28/2012 Prof. R.Bala 25

Basic Premises of Strategic Trade

Theories

1. Increasing returns to scale provide a justification for trade for reasons other thancomparative advantage since firms will have theincentive to produce and export in order to

lower costs by attaining greater scale of economies. (e.g. Commercial AirframesIndustry)

2. Product differentiation can result in intraindustry trade since within the industry the

product can have different brand identities.(e.g. US exporting Ford Escort and importingBMW)



4/28/2012 Prof. R.Bala 26


Theories

3.Imperfect competition creates rents and tradepolicy could shift rents from the foreign countryto home country. (e.g. Imposition of quotas willincrease domestic prices and thus can create

rents for foreign producers. The home countrymay counterbalance it with subsidy to domesticproducers.

4.Externalities and spillover effects (particularly in

innovation & R&D ) may sometimes provide a justification for industry protection for reasonsother than industry infancy or national security



4/28/2012 Prof. R.Bala 27


Theories

5. Irreversible investments induce anasymmetry between entry and exit costsand can therefore lead to hysteric

responses to price or quantity shifts.(e.g. Cater pillar lost substantial marketshare in early 1980s when the US $appreciated 35% in real terms against

the Japanese yen. Yet the firm could notexit markets because the cost of reentrywould be prohibitive.



4/28/2012 Prof. R.Bala 28

How Trade Policies affect Market

Access

Business Barriers

Tariff Non Tariff



4/28/2012 Prof. R.Bala 29

Tariff Barriers

Direction – Import Tariff, Export Tariff

Purpose - Protective, Revenue

Types - Basic, Auxiliary, Countervailing

Rates -Specific, Ad valorem, combined Production - Single stage, Value added

Distribution & cascade, Excise

Consumption



4/28/2012 Prof. R.Bala 30

Non Tariff Barriers

Type Manifestation

GovernmentParticipation inTrade

Administrative Guidance, Subsidies,Government Procurement & state trading

Customs & EntryProcedures

Product classification, Product valuation,Documentation, Licence or permit, InspectionHealth & Safety Regulations

ProductRequirements

Product standards, Packaging, Labeling & Marking, Product Testing, Product Specification

Quotas Export Quotas, Import Quotas

Financial Control Exchange control, Multiple Exchange rates,Prior import deposits, credit restrictions, Profitremittance restrictions



4/28/2012 Prof. R.Bala 31

Porter’s ‘Diamond’ Theory

FactorConditions

Firm strategy,Structure &

Rivalry

Related & SupportingIndustries

DemandConditions



4/28/2012 Prof. R.Bala 32

Basic Premises postulated by Porter

The nature of competition and the sources of competitiveadvantage differ widely among industries and even amongindustry segments.

Successful global competitors perform some activities in thevalue chain outside their home country and drawcompetitive advantages from their entire world widenetwork rather than just their home base

Firms gain and sustain competitive advantage in moderninternational competition through innovation

Firms that successfully gain competitive advantage in anindustry are those that move early and aggressively toexploit a new market or technology



4/28/2012 Prof. R.Bala 33

Attributes having a Direct impact on a

firm’s ability to compete globally

Factor conditions

Demand conditions

Related & support industries

Company strategy , structure & rivalry



4/28/2012 Prof. R.Bala 34

Factor conditions

Success of nations in particular industries is created andnot inherited

The success is not based on natural endowments such asland, labor capital etc.,

The ability to compete requires skilled labor & infrastructure A nation possessing skilled labor can turn natural resources

into competitive advantage whereas a nation with abundantnatural resource but without skilled labor is unable to turnthe natural resources into competitive advantage.

The value added concept is the integral part of theexplanation as to why a particular industry is internationallycompetitive.



4/28/2012 Prof. R.Bala 35

Demand conditions

The nature of home market demand influencesthe success of a nation’s industry in internationalmarkets.

This is dependent on the size of the home

market, the number and the level of sophistication of the consumers.

The behavior of the consumers and local retailersis of crucial importance.

If the consumers demand high quality productsand the retailers discriminate among theproducers , it would induce producers to makeproducts of international quality.



4/28/2012 Prof. R.Bala 36

Related & Support Industries

These play a major role in industry’sability to compete internationally.

An industry vying for export

competitiveness needs suppliers at homewith internationally competitive inputs.

Their absence will negatively impact onthe industry’s ability to compete

Related industries must also beinternationally competitive.



4/28/2012 Prof. R.Bala 37

Company strategy structure and rivalry

Creation & sustaining of competitive advantage isa highly localized process.

It is the differences in national economicstructures, values, cultures and institutions which

significantly impact competitive success.

It is these national circumstances and the localenvironment which determine how companies arecreated, organized and managed as well as the

nature of domestic rivalry. The home nation is pivotal to competitive

advantage & hence competitive success.



4/28/2012 Prof. R.Bala 38

Central Thesis of Porter’s Model

Competitiveness is born of intense domesticrivalry.

Advocates an active Anti- trust policy andavoidance of protection as policy prescriptions

Government cannot create competitive industriesbut only companies can create competitiveindustries.

Government’s role should be confined to creatingenvironment in which companies can gaincompetitive advantage by influencing the fourpoints on the diamond. rather than directlyinvolving itself in the process.

Date post:	07-Apr-2018
Category:	Documents
Upload:	lohi-kurmala
View:	228 times
Download:	0 times

Theories of Intl Trade

Documents