International Business 8e By Charles W.L. Hill Welcome to International Business, Eighth Edition, by Charles W.L. Hill.

International Trade Theory Chapter 5 International Trade Theory Chapter 5: International Trade Theory McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Why Is Free Trade Beneficial? Free trade - 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 country. (Benefits of trade: Iceland strategy) Trade theory shows why it is beneficial for a country to engage in international trade even for products it is able to produce for itself (US: buying of American products only) International trade allows a country to specialize in the manufacture and export of products that it can produce efficiently (US to produce commercial jet aircraft… Why?) import products that can be produced more efficiently in other countries (US to import textiles from Mexico… Why?) Have you ever wondered why we buy so much clothing from other countries? U.S. manufacturers know how to make clothing, in fact, much of clothing worn by Americans used to be made in the U.S. Now, however, the U.S. buys a lot of its textiles from places like Honduras and Guatemala. Why does Ford assemble cars made for the American market in Mexico, while BMW and Nissan manufacture cars for Americans in the U.S.? These are questions that economists have tried to answer for many years, and in this chapter we’ll look at patterns of trade and explore some of the theories that have been used to explain those patterns. First though, a definition. Free 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 country.

The Pattern of International Trade Why Do Certain Patterns Of Trade Exist? Some patterns of trade are fairly easy to explain it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Japan export automobiles, consumer electronics, and machine tools? Economists have debated the merits of free trade for centuries. In fact, we’ll begin our discussion of trade theory with mercantilism, a 16th and 17th century philosophy that encouraged countries to increase exports and limit imports. Then, we’ll go on to the theories advocated by Adam Smith and David Ricardo who promoted the notion of free trade, or a situation where government allows market forces to work, and doesn’t intervene with quotas or duties to influence what citizens can buy from other countries, or sell to other countries. Smith and Ricardo promoted the idea that international trade allows a country to specialize in the manufacture and export of products that it can produce efficiently, and import products that can be produced more efficiently in other countries. Their work was later extended by Eli Heckscher and Bertil Ohlin. You probably don’t need trade theories to explain some patterns of trade—it’s easy to see why Saudi Arabia exports oil and Brazil exports coffee, but it’s much harder to explain why Switzerland exports watches and pharmaceuticals, or why Japan exports consumer electronics. Ray Vernon answered some of these questions with his product life cycle theory that followed the production of a product over time. Paul Krugman also attempted to answer these questions with his so called, new trade theory. He argued that in some industries, the world market can only support a few firms, and that the firms that are able to build a competitive position early, will be difficult to challenge. Think of the large commercial aircraft industry for example. How many companies can you think of? Probably just two—Boeing and Airbus Industries. Michael Porter extended Krugman’s work with his theory of national competitive advantage. Porter argued that a county’s ability to be successful in certain industries depends not only on factor endowments, but also on domestic demand and domestic rivalry.

What Is Mercantilism? Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -to export more than it imports advocates government intervention to achieve a surplus in the balance of trade Mercantilism views trade as a zero-sum game - one in which a gain by one country results in a loss by another. (Smith & Ricardo criticized it as it’s a positive sum game) Now that you have got an overview of the various theories, let’s look at them in more depth. We’ll start with mercantilism. The main idea behind the mercantilist philosophy, which was around in the mid-16th century, was that the accumulation of gold and sliver were essential to the wealth, and power of a nation. So, it was in the best interests of a country to try to maximize its holdings of gold and silver by encouraging exports and discouraging imports. In order to achieve this goal, imports were limited through tariffs and quotas, while exports were maximized through government subsidies. A key flaw in the philosophy however, was that it was a zero-sum game. A country could only achieve its goal of maximizing a trade surplus at the expense of another nation. In other words, if one country successfully exported more than it imported, and consequently increased its holdings of gold and silver, another country would fail to achieve a trade surplus. This other country would in fact buy more than it sold, see its gold and silver leave the country, and become a weaker nation!

What Is Smith’s Theory Of Absolute Advantage? Adam Smith argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries (English---Textiles & French---Wine) Adam Smith challenged the mercantilist philosophy and its zero-sum approach to trade. Smith argued, in his 1776 landmark book, The Wealth of Nations, that free trade, or trade without government intervention, could be beneficial to countries if each country produced and exported those products in which it was most efficient, or in his words, those products in which the country had an absolute advantage. Smith argued that if countries specialized in the production of goods in which they had an absolute advantage they could then trade these goods for the goods produced by other countries.

How Does The Theory Of Absolute Advantage Work? Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between Let’s look at an example of Smith’s ideas. Assume that two countries, Ghana and South Korea, both have 200 units of resources that they could use either to produce rice or to produce cocoa. Now, suppose that in Ghana, it takes 10 units of resources to produce one ton of cocoa, and 20 units of resources to produce one ton of rice. What could Ghana produce? Well, Ghana could use all of its resources to produce 20 tons of cocoa, or it could put all of its resources into the production of 10 tons of rice. Or, Ghana could produce some combination of rice and cocoa. What about South Korea? Suppose in South Korea that it takes 40 units of resources to produce one ton of cocoa, and 10 units of resources to produce one ton of rice. South Korea’s production options then are to devote all of its resources to producing 5 tons of cocoa, or all of its resources to producing 20 tons of rice, or to share its resources and produce some combination of rice and cocoa. Based on this information, we would say that Ghana has an absolute advantage in the production of cocoa—it is more efficient at producing cocoa than South Korea. Remember, more resources are needed to produce a ton of cocoa in South Korea than in Ghana. You’ve probably guessed that South Korea then has an absolute advantage in the production of rice.

How Does The Theory Of Absolute Advantage Work? Without trade Ghana would produce 10 tons of cocoa and 5 tons of rice South Korea would produce 10 tons of rice and 2.5 tons of cocoa With specialization and trade Ghana would produce 20 tons of cocoa South Korea would produce 20 tons of rice Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice After trade Ghana would have 14 tons of cocoa left, and 6 tons of rice South Korea would have 14 tons of rice left and 6 tons of cocoa If each country specializes in the production of the good in which it has an absolute advantage and trades for the other, both countries gain So, we’ve got these two countries that could be self-sufficient and produce their own rice and cocoa. Let’s suppose that they choose to do so, and that Ghana uses its resources to produce 10 tons of cocoa and 5 tons of rice. South Korea might use its resources to produce 10 tons of rice and 2 and half tons of cocoa. So, both countries have the option of consuming both products. Now, let’s think about Adam Smith’s ideas of specializing in what you do best and trading for other products. Would this help Ghana and South Korea? Well, if Ghana specializes in producing cocoa, it would devote all of its resources to cocoa production and produce 20 tons of cocoa. South Korea’s absolute advantage was in the production of rice, so it would devote all of its resources to produce 20 tons of rice. Now, suppose Ghana traded 6 tons of its 20 tons of cocoa to South Korea in exchange for 6 tons of South Korea’s 20 tons of rice. Are the countries better off? Was trade beneficial? The answer is yes! After trade, Ghana would still have 14 tons of cocoa left, and it would acquire 6 tons of rice. Remember, when it tried to be self sufficient it was only able to produce 10 tons of cocoa and 5 tons of rice, so with trade it’s gained 4 tons of cocoa and 1 ton of rice. Trade would also benefit South Korea. By trading, South Korea would have 14 tons of rice left, and it would acquire 6 tons of cocoa. Again, recall that without trade, South Korea could only produce 10 tons of rice, and 2 and a half tons of cocoa. So, South Korea has gained 3 and a half tons of cocoa, and 4 tons of rice. Both countries gained from trade.

How Does The Theory Of Absolute Advantage Work? Absolute Advantage and the Gains from Trade The table shows a visual of absolute advantage and the gains from trade.

What Is Ricardo’s Theory Of Comparative Advantage? David Ricardo asked what might happen when one country has an absolute advantage in the production of all goods Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home You may be thinking that Smith’s ideas are great if you’ve got two countries where one is clearly better at producing one product and the other is clearly more efficient at producing the other product. But what happens if one country has an absolute advantage in the production of all products? Is trade still beneficial? In 1817, David Ricardo tried to answer these questions with his theory of comparative advantage. Ricardo argued that at it still makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.

How Does The Theory Of Comparative Advantage Work? Assume Ghana is more efficient in the production of both cocoa and rice in Ghana, it takes 10 resources to produce one ton of cocoa, and 13 1/3 resources to produce one ton of rice So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two in South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice so, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two Let’s look at this a little more closely. Going back to our example of Ghana and South Korea, suppose that Ghana is more efficient at producing both cocoa and rice. Suppose that in Ghana it takes 10 resources to produce one ton of cocoa, and 13 and one third resources to produce one ton of rice. Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two. Now, suppose that in South Korea it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice. South Korea could use all of its resources to produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two. As you can see, Ghana has an absolute advantage in the production of both products! Why should it trade with South Korea? Ricardo argued that it’s still beneficial for Ghana to trade because it has a comparative advantage in the production of cocoa. In other words, while Ghana can produce more cocoa and more rice than South Korea, it can produce four times as much cocoa, and only one and a half times as much rice. Ghana is comparatively more efficient at producing cocoa!

How Does The Theory Of Comparative Advantage Work? With trade Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice Ghana will still have 11 tons of cocoa, and 4 additional tons of rice South Korea still has 6 tons of rice and 4 tons of cocoa if each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain Comparative advantage theory provides a strong rationale for encouraging free trade By specializing and trading, Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice. This will leave Ghana with 11 tons of cocoa left, and 4 more tons of rice. South Korea benefits too, it has 6 tons of rice left, and has gained 4 tons of cocoa. Again, both countries gain from trade!

How Does The Theory Of Comparative Advantage Work? Comparative Advantage and the Gains from Trade This table shows a visual of comparative advantage and the gains from trade.

What Is The Heckscher-Ohlin Theory? Eli Heckscher and Bertil Ohlin - comparative advantage arises from differences in national factor endowments – the extent to which a country is endowed (gifted) with resources like land, labor, and capital predict that countries will export goods that make intensive use of those factors that are locally abundant, and import goods that make intensive use of factors that are locally scarce. (US export agricultural goods--- abundant land, while China export textiles and footwear--- cheap labor) Eli Heckscher and Bertil Ohlin extended Ricardo’s work by suggesting that a country’s comparative advantage is a result of differences in national factor endowments. Heckscher and Ohlin argued that countries will export goods that make intensive use of factors of production like land, labor, and capital that are locally abundant. At the same time, countries will import goods that make intensive use of factors that are locally scarce. So, a country like China with abundant low-cost labor will produce and export products that are labor intensive like textiles, while the U.S., which lacks abundant low cost labor, imports textiles from China. Notice that this theory explains trade patterns using differences in factor endowments, while Ricardo explains trade patterns using differences in productivity.

Does The Heckscher-Ohlin Theory Hold? Wassily Leontief theorized that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods. However, he found that U.S. exports were less capital intensive than U.S. imports Since this result was at variance with the predictions of trade theory, it became known as the Leontief Paradox Wassily Leontief tested the Heckscher-Ohlin theory in 1953. Leontief expected that since the U.S. was relatively abundant in capital compared to other countries, the U.S. should export capital intensive goods, and import labor intensive goods. But, Leontief, contrary to what common sense would tell us, actually found that U.S. exports were less capital intensive than U.S. imports. His findings have come to be known as the Leontief Paradox.

What Is The Product Life Cycle Theory? The product life-cycle theory - (Raymond Vernon) - as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new products initially, the product would be produced and sold in the U.S. as demand grew in other developed countries, U.S. firms would begin to export demand for the new product would grow in other advanced countries over time making it worthwhile for foreign producers to begin producing for their home markets Now, let’s go back to a question we asked earlier. Why are some products that used to be made at home, now imported from other countries, especially less developed ones? The answer to this question may lie in where the product is in its life cycle. The product life cycle theory which was developed in the mid-1960s by Ray Vernon who suggested that as products mature, both the sales location, and the optimal production location will change, and of course, as these change, so will the flow and direction of trade. In other words, products move through different stages over their life, and as they do, where they are produced and sold change, too. Vernon observed, at the time, that most of the world’s new products were developed by American firms and sold initially in the U.S. He attributed this to the wealth and size of the U.S. market. Vernon argued that rather than producing these new products in other countries, manufacturers preferred to produce them locally to be closer to the market, and to the firm’s decision making. Vernon suggested that while demand was growing in the U.S., there would be only limited demand by high-income consumers in other advanced countries. Therefore, there would be little incentive for firms in the foreign countries to produce the product, and the other developed markets would be served by exports from the U.S.

What Is The Product Life Cycle Theory? U.S. firms might set up production facilities in advanced countries with growing demand, limiting exports from the U.S. As the market in the U.S. and other advanced nations matured, the product would become more standardized, and price the main competitive weapon Producers based in advanced countries where labor costs were lower than the United States might now be able to export to the United States If cost pressures were intense, developing countries would acquire a production advantage over advanced countries Production became concentrated in lower-cost foreign locations, and the United States became an importer of the product Then, as demand for the new product grew in other advanced countries, foreign producers would begin to produce the product. U.S. producers, in an effort to capitalize on foreign demand, would also begin to produce in the foreign markets. What happened to trade flows? Well, exports from the U.S. slowed down as they were replaced by foreign production. As the U.S. market and the foreign markets matured, the product became more standardized, and price became more important to consumers. Some foreign producers with lower wage costs exported to the U.S. market during this stage. Later, production shifted to developing countries where wages were even lower, and the U.S. became an importer of the product.

Does The Product Life Cycle Theory Hold? The product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the United States in the 1960s and 1970s But, the globalization and integration of the world economy has made this theory less valid today the theory is ethnocentric production today is dispersed globally products today are introduced in multiple markets simultaneously If you think the product life cycle seems out of touch with the modern world, you’re right! While the product life cycle was useful for explaining trade patterns for products like photocopiers that were developed in the 1960s and 1970s, today, given the effects of globalization and the integration of the world economy, the theory doesn’t hold up well. Today, you can think of many products that were designed and introduced outside the U.S., like videogame consoles that were initially introduced in Japan, or Europe’s wireless phones. In addition, many products are introduced simultaneously in the U.S., Japan, and Europe. Production of these new products is often globally dispersed from the start

What Is New Trade Theory? New trade theory suggests that the ability of firms to gain economies of scale (unit cost reductions associated with a large scale of output) can have important implications for international trade Through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods without trade, nations might not be able to produce those products where economies of scale are important with trade, markets are large enough to support the production necessary to achieve economies of scale so, trade is mutually beneficial because it allows for the specialization of production, the realization of scale economies, and the production of a greater variety of products at lower prices In an effort to resolve some of the shortcomings of other theories, researchers in the 1970s began to search for other explanations of trade. This new vein of thought, aptly called, new trade theory, argued that because of the unit cost reductions that are associated with a large scale of output, some industries can support only a few firms. These cost reductions are called economies of scale. Achieving economies of scale can be very important to firms. Microsoft for example, is able to spread the costs of developing new versions of Windows over millions of PCs. Why is this important? Well, suppose we live in a world without trade. Small markets might find that they don’t have certain products available if producers can’t sell enough to achieve economies of scale, or if the products are available, prices will probably be very high. But, if countries trade with each other, markets are bigger, and firms have the opportunity to sell enough to achieve scale economies. Consumers have more choice and lower prices!

What Is New Trade Theory? In those industries when output required to attain economies of scale represents a significant proportion of total world demand, the global market may only be able to support a small number of enterprises first mover advantages - the economic and strategic advantages that accrue to early entrants into an industry economies of scale first movers can gain a scale based cost advantage that later entrants find difficult to match However, in some industries, to achieve economies of scale, firms have to have a major share of the world’s market. The costs of developing new aircraft, for example, are so high, that firms have to hold a significant share of the world market in order to gain economies of scale. Remember, that there are only two makers of large commercial aircraft in the world! Now, it’s important to consider the effects of first mover advantages because the pattern of trade we see in the world economy may be the result of first mover advantages and economies of scale. Firms that achieve first mover advantages will develop economies of scale, and create barriers to entry for other firms. Airbus, for example, is currently enjoying the first mover advantages associated with its super jumbo plane. Airbus has to sell at least 250 super jumbos just to break even on the project. The market over the next twenty years is expected to be just 400 to 600 planes, so it’s not worthwhile for Boeing to even get in the market. Airbus has first mover advantages based on scale economies.

What Are The Implications Of New Trade Theory For Nations? Nations may benefit from trade even when they do not differ in resource endowments or technology a country may dominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good Governments should consider strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important What can we learn from new trade theory? Well, new trade theory suggests that countries might benefit from trade even if they don’t differ in resource endowments or technology. The theory also suggests that a country might be dominant in the export of a good just because it was lucky enough to have companies that were among the first to produce the product. Remember our example of Airbus and its super jumbo jet! Keep in mind that new trade theory is at odds with the Heckscher-Ohlin theory which, remember, suggested that countries would produce and export those products which made intensive use of abundant factors of production. But, new trade theory doesn’t contradict comparative advantage theory because it actually identifies a source of comparative advantage. So, governments might use this information to implement strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important.

What Are The Implications Of Trade Theory For Managers? Location implications - a firm should disperse its various productive activities to those countries where they can be performed most efficiently firms that do not, may be at a competitive disadvantage First-mover implications - a first-mover advantage can help a firm dominate global trade in that product Policy implications - firms should work to encourage governmental policies that support free trade firms should lobby the government to adopt policies that have a favorable impact on each component of the diamond What can managers learn from the various theories of trade? Well, there are three key points: location implications, first-mover implications, and policy implications. Let’s look at each one beginning with location implications. The theories that we’ve discussed point out that countries have particular advantages for different productive activities. Remember for example, that China’s low cost work force makes it a better place to produce textiles than the U.S. So, there is a link between the theories and the decision of where to locate productive activities. Firms should disperse their productive activities to those countries where they are most efficient. The theories also tell us that first-mover advantages can be critical to success in some industries. Being a first mover in an industry can have important competitive implications, especially in industries where economies of scale are critical and the global industry can only support a few companies. Third, there is a link between trade theory and government policy. A government’s policy on free trade has important implications for a firm’s global competitiveness. Firms can influence government policy decisions through government lobbying. U.S. steel producers for example, have been successful in influencing government policy. Keep in mind, that while the actions of these industries may help the firms within the industry, the decisions that are made as a result of their influence are not always beneficial to the country as a whole! For example, while the steel industry was successful at getting protection from foreign competition in the early 2000s, the higher prices that resulted from the protection meant that the auto industry suffered. Finally, remember, that no one theory explains all trade patterns, but taken together, they help us understand what’s happening in the world today.

What Is The Balance Of Payments? A country’s balance of payments accounts keep track of the payments to and receipts from other countries for a particular time period Balance of payments accounting uses double entry bookkeeping so, the sum of the current account balance, the capital account and the financial account should always add up There are three main accounts The current account records transactions that pertain to goods, services, and income, receipts and payments current account deficit - a country imports more than it exports current account surplus – a country exports more than it imports The capital account records one time changes in the stock of assets The financial account records transactions that involve the purchase or sale of assets net change in U.S. assets owned abroad foreign owned assets in the United States You may be wondering how we know what countries are exporting and importing. Well, all of that information is contained in a country’s balance of payments. The balance of payments account keeps track of the payments to and receipts from other countries for a particular time period. It has three main accounts. The first is called the current account. This is the account you often hear about in the news because it contains a record of all exports and imports of goods, services, and income, receipts, and payments. So for example, you’ve probably heard of a current account deficit where a country imports more than it exports or a current account surplus where a country exports more than it imports. We’ll talk more about these in a moment. First though, lets look at the other main accounts of the balance of payments. The second account is the capital account which records one time changes in the stock of assets. This account used to be included as part of the current account, but was recently separated out. Finally, the third account is the financial account. This account used to be called the capital account. It records transactions that involve the purchase or sale of assets. So, a transaction where a foreign firm buys stock in a U.S. company would be recorded in this account.

Is A Current Account Deficit Bad? Does current account deficit in the United States matter? a current account deficit implies a net debtor so, a persistent deficit could limit future economic growth But, even though capital is flowing out of the United States as payments to foreigners, much of it flows back in as investments in assets Yet, suppose foreigners stop buying U.S. assets and sell their dollars for another currency A dollar crisis could occur Now, let’s get back to the current account deficit. You may have noticed that a current account deficit is usually reported negatively. This is because a current account deficit represents a drain on assets. Recall for a moment that a current account deficit occurs when a nation imports more than it exports. So, if the United States has a current account deficit, it’s buying more than it’s selling. How does the U.S. pay for all these goods? You guessed it – by borrowing from foreigners! If the U.S. continually borrows, eventually its payments on its debt will be so large that it won’t be able to invest in its own market, and economic growth at home will be affected. But, what happens if foreigners invest some of the money they receive back in the United States? Well, this is what’s been happening for the last 25 years or so, and as you know, the U.S. economy has continued to grow during this time despite some temporary slowdowns. So, some people think that a persistent current account deficit may not be as bad as it initially seems, but caution that if foreigners suddenly decide to sell off their dollar-based assets for other currencies, a dollar crisis could trigger a global economic slowdown.