Unit 1 5 Trade TheoriesS

7/28/2019 Unit 1 5 Trade TheoriesS

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INTERNATIONAL BUSINESS

MANAGEMENT

4/1/2013 a.velsamy, sona school of management 1

TRADE THEORIES


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Learning objectives

To understand and evaluate several trade

theories.

To assess the implications of trade theories on

international business.

Explain the pattern of international trade

observed in the world economy.


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# The case of US Information Technology

manufacturing.

# Countrys economy may gain if its citizens buy

certain products from other country -

international trade allows a country to specializein manufacturing and export of products that

can be produced most efficiently, while

importing products that can be produced moreefficiently in other countries.


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The pattern of international trade

Ghana exports cocoa, Brazil exports coffee, Saudi

arabia exports oil, china exports crawfish

But why does japan export automobiles, consumer

electronics. Why swiss export chemicals,

pharmaceuticals, jewelry and watches.

Intervention of govt. policies.


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INTERNATIONAL TRADE THEORIES

Mercantilism 16th & 17th century simultaneously to encourage export, discourage

imports ( Zero sum game)

1776, Theory of Absolute advantage by Adam smiths explained unrestricted free trade

is beneficial to country

Theory of comparative advantage by 19th century economist David Ricardo, - through

his book Principles of Political economy in 1817

Eli Heckscher (1919) & Bertil ohlin(1933) , - HeckscherOhlin theory

1966, Product life-cycle theory by Raymond Vermon

1970, New trade theory by Paul Krugman of the Massachusetts institute of technology

Economies of Scale, First-Mover advantages

1990, Theory of national competitive advantage by Michael Porter of HBS

1953, The Leontief paradox


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Mercantilism: mid-16th century

A nations wealth depends on accumulatedtreasure

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.


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Mercantilism-(zero-sum game)

David Hume in 1752 pointed out that:

Increased exports leads to inflation and higherprices

Increased imports lead to lower prices

Result: Country A sells less because of highprices and Country B sells more because of

lower prices In the long run, no one can keep a trade

surplus


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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.


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The Theory of Absolute Advantage

Rice

Cocoa

G

0 5 10 15 20

5

10

1

5

20

A

BK

G

K


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The Theory of Absolute Advantage and the

Gains from Trade

Production and Consumption without Trade (equal resource for both crops

S. Korea 2.5 10.0

Total production 20 20

S. Korea 6.0 14.0

Resources Required to Produce 1 Ton of Cocoa and RiceCocoa Rice

Ghana 10 20S. Korea 40 10

Ghana 10.0 5.0

Total production 12.5 15.0Production with Specialization

Ghana 20 0S. Korea 0 20

Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean RiceGhana 14.0 6.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 4.0 1.0

S. Korea 3.5 4.0


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Theory of Comparative Advantage

David Ricardo: Principles of Political Economy

(1817).

Should trade even if country is more efficient

in the production than its trading partner.


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The Theory of Comparative Advantage

3.75 7.5

2.5

0 5 10 15 20

5

10

15

20

Coc

oa

Rice

G

C

A

K

KB

G


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Comparative Advantage and the Gains from Trade

S. Korea 40 20

S. Korea 2.5 5.0

S. Korea 0.0 10.0

S. Korea 4 6

Resources Required to Produce 1 Ton of Cocoa and Rice

Ghana 10 13.33

Production and Consumption without Trade

Ghana 10.0 7.5

Total production 12.5 12.5Production with Specialization

Ghana 15 3.75

Total production 15 13.75Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice

Ghana 11 7.75

Increase in Consumption as a Result of Specialization and Trade

Ghana 1.0 0.25

S. Korea 1.5 1.0

Cocoa Rice


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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 moreresources (diminishing returns to specialization).

Different goods use resources in different proportions.

Dynamic effects and economic growth :

However:

Free trade might increase a countrys stock of resources (aslabor and capital arrives from abroad), and

Increase the efficiency of resource utilization.


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Ghanas PPF under Diminishing Returns

Cocoa

Rice

G

G

0

Figure 4.3


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The Influence of Free Trade on the PPF

Figure 4.4

Cocoa

Rice

G

PPF2

0

PPF1


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THE SAMUELSON CRITIQUE

Rich country, US enter into free trade agreement with a poor

country, China rapidly improves its productivity dynamicgain for China Samuelson model suggests that the lower

prices that US consumers pay for goods imported from

china, may not be enough to produce a net gain for the US

economy

Samuelson is concerned about the ability to send offshore

service jobs that traditionally were not internationally mobile,

such as software debugging, call center jobs, accounting

jobs and even medical diagnosis of MRI scans.

Samuelson concedes that free trade has historically

benefitted rich countries introducing protectionist measure

will harm US


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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%.


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Heckscher (1919)-Olin (1933) Theory

Patterns of trade are determined by differences in factor

endowments - not productivity.

Remember, focus on relative advantage, notabsoluteadvantage.

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.)


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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.


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Product Life-Cycle Theory

(Raymond Vernon, 1966)

Article in the Quarterly Journal of Economics.

As products mature, both location of sales and optimalproduction changes.

Affects the direction and flow of imports and exports.

Globalization and integration of the economy makes this

theory less valid.


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The International Product Life Cycle:

Innovating Firms Country


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The International Product Life Cycle: Other

Industrialized Countries


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The International Product Life Cycle: Less

Developed Countries


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The Product Life-Cycle Theory

production

consumptionExports

160140120100

806040200

United States

Other Advanced Countries

Developing Countries

Stages of Production Development

New Product Standardized ProductMaturing Product

Imports

Imports

Exports

Exports

Imports

16014012010080

6040200

16014012010080

6040200


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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.


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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.


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First-Mover Advantage

Economies of scale may preclude new

entrants.

Role of the government.


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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?


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Determinants of National Competitive

Advantage

Factor endowments: nations position in factors ofproduction such as skilled labor or infrastructure necessaryto compete in a given industry.

Demand conditions: the nature of home demand for theindustrys product or service.

Related and supporting industries: the presence or absencein 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.

P t Di d


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Porters DiamondDeterminants of National Competitive Advantage

CHANCE

GOVERNMENT


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The Diamond

Success occurs where these attributes exist.

More/greater the attribute, the higher chance ofsuccess.

The diamond is mutually reinforcing.


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Factor Endowments

Taken from Heckscher-Olin Basic factors:

natural resources

climate

location

demographics

Advanced factors:

communications skilled labor

research

technology


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Advanced Factor Endowments

More likely to lead to competitiveadvantage.

Are the result of investment by

people, companies, government.


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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 advancedfactors.


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Demand Conditions

Demand creates the capabilities.

Look for sophisticated and

demanding consumers. impacts quality and innovation.


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Related and Supporting Industries

Creates clusters of supporting industries that are

internationally competitive.

Must also meet requirements of other parts of the

Diamond.


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Firm Strategy, Structure and Rivalry

Management ideology can either help or hurtyou.

Presence of domestic rivalry improves a

companys competitiveness.


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Evaluating Porters Theory

If Porter is right, we would expect his model topredict 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 arefavorable, while importing in those areas where

the components are not favorable.

Too soon to tell.


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Implications for Business Location implications: makes sense to disperse

production activities to countries where they can be

performed most efficiently.

First-mover implications: Itpays to invest substantial

financial resources in building a first-mover, orearly-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.


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Theories of

International TradeCountry-Based Theories Country is unit of analysis

Emerged prior to WWII

Developed by economists

Explain interindustry trade Include

Mercantilism

Absolute advantage

Comparative advantage

Relative factorendowments

Firm-Based Theories

Firm is unit of analysis

Emerged after WWII

Developed by business school

professors Explain intraindustry trade

Include

Country similarity theory

Product life cycle

Global strategic rivalry National competitive

advantage


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Unit 1 5 Trade TheoriesS

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