INTERNATIONAL TRADE THEORY WEEK 2 INTERNATIONAL TRADE THEORY

Objectives To understand theories of international trade To identify factors affecting national trade patterns To explain why a country’s export capabilities are dynamic

Trade – is the voluntary exchange of goods, services, or money between one person or organization to another Both parties must believe they will gain from the exchange

Why we need to study Trade Theory? Trade theory helps managers and governmental policy makers focus on: What products should we import and export ? How much should we trade ? With whom should we trade ? Some theories explain trade patterns that exist in the absence of governmental interference. Some theories explain what governmental actions should strive for trade.

Why we need to study Trade Theory? Free Trade occurs when 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 Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country

International Trade Theories Interventionist trade theory Mercantilism – 16th Century ( Thomas Mun) Free Trade Theories Absolute Advantage – 17th Century ( Adam Smith) Comparative Advantage - 18th Century ( David Ricardo) Factor-proportion theory - Hecksher-Ohlin Theory The Statics and Dynamic of Trade Production Life Cycle Theory Porter’s Diamond-National Competitive Advantage

What the major trade theories Do and Don’t discuss

Interventionist trade theory (Mercantilism theory) mid-16th century Promote by Thomas Mun (1630) Used by the economies from 1500 to 1800 Holding that a country’s wealth is measured by its holdings treasure usually gold and silver Gold and silver are the currencies of trade If foreigners by more goods from one country, the foreigners have to pay the country in gold and silver, enabling the country to increase its wealth. Theory says country should have a trade surplus. Should export more than import Maximize export through subsidies. Minimize imports through tariffs and quotas To export more that import, government should restricted import and subsidized production.

Free Trade Theories (Theory of absolute advantage) Adam Smith: Wealth of Nations (1776) Concluded that: Different countries produce some products more efficiently that others A country should export goods and services for which it is more productive than other countries A country should import goods and services for which other countries are more productive than it is Free trade enables a country to expand goods and services by specializing in the production of goods and services. Through specialization countries could increase their efficiency because: Skilled labor – operate the same tasks Reduce time - switching production More incentive

Country has two advantages Natural advantage – in producing product or services because of climate condition to natural resources, availability of labor forces (eg. Malaysia - Palm oil, rubber, Ghana – Cocoa) Acquired advantage – have competitive in manufacturing good through process or technology. eg. product technology – produce unique products,

Absolute advantage and the gains from trade – how do efficiency work? Assumes there is an absolute balance among nations. Example: Ghana/cocoa, Korea/rice Ghana may produce: 20 ton cocoa or 10 rice. Or 10 ton cocoa and 5 ton rice Korea may produce: 5 on cocoa or 20 ton rice Or 2.5 ton cocoa and 10 ton rice. Total Productions: before specialization cocoa Rice Ghana 10 5 Korea 2.5 10 Total 12.5 15 Total Productions: after Ghana 20 0 Korea 0 20 Total 20 20 Assumptions: 200 resources are available in each country either to produce cocoa or rice Ghana takes 10 resources to produce I ton cocoa & 20 resources to produce 1 tan rice. Korea takes 40 resources to produce 1 ton cocoa & 10 resources to produce 1 ton rice. No trade between both countries. They consume all production.

Theory of absolute advantage- how do efficiency work? Ghana has an absolute advantage of production in both cocoa and rice over Korea. Ghana may produce: 20 ton cocoa or 10 rice. Or 10 ton cocoa and 5 ton rice Korea may produce: 5 on cocoa or 20 ton rice Or 2.5 ton cocoa and 10 ton rice. Total Productions: before specialization cocoa Rice Ghana 10 5 Korea 2.5 10 Total 12.5 15 Total Productions: after specialization Ghana 20 0 Korea 0 20 Total 20 20

Free Trade Theories (Theory of comparative advantage) David Ricardo: Principles of Political Economy (1817). Country should produce and export those goods and services which it relatively more efficient at producing than other country. Efficiency of resource utilization leads to more productivity. Look to see how much more efficient. If only comparatively efficient, than import. Makes better use of resources Trade is a positive-sum game

Theory of comparative advantage Fig 4.2

Comparative advantage and the gains from trade

Trade Pattern Theory - Heckscher & Olin Theory The theory is based on country production factors (labor, land and capital) Differences in countries endowments of labors compared to their endowment of lands or capital explain differences in the cost of productions factors If surplus of labor compared to land and capital – labor cost would be low relative to land and capital costs. Less labor – high labor cost than land and capitals

The Statics and Dynamic of Trade - Product life-cycle Theory- Raymond. Vernon,(1966) Location of production shift as they go through their life cycle Affects the direction and flow of imports and exports 4 stages Introduction Growth Maturity Decline

The Diamond of National Advantage The theory attempts to analyze the reasons for a nations success in a particular industry Porter studied 100 industries in 10 nations postulated determinants of competitive advantage of a nation were based on four faced of diamond Factor conditions Demand conditions Related and supporting industries Firm strategy, structure and rivalry Success occurs where facets exist.

Determinants of Competitive Advantage in nations Government Company Strategy, Structure, and Rivalry Demand Conditions Related and Supporting Industries Factor Chance Two external factors that influence the four determinants.

Factor Condition A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry Basic and advanced conditions

Demand conditions Demand: creates capabilities creates sophisticated and demanding consumers Demand impacts quality and innovation

Related and supporting industries Creates clusters of supporting industries that are internationally competitive Must also meet requirements of other parts of the Diamond

Firm Strategy, Structure and Rivalry Long term corporate vision is a determinant of success Management ‘ideology’ and structure of the firm can either help or hurt you Presence of domestic rivalry improves a company’s competitiveness

Porter’s Theory-predictions Porter’s theory should predict 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 are favorable, while importing in those areas where the components are not favorable

Implications for business Location implications: Disperse production activities to countries where they can be performed most efficiently First-mover implications: Invest substantial financial resources in building a first-mover, or early-mover advantage Policy implications: Promoting free trade is in the best interests of the home-country, not always in the best interests of the firm, even though, many firms promote open markets

Test your understanding Do you think international business theories are still relevant to the present condition of international business? Discuss What is the major differences between Absolute Advantage and Comparative Advantage? The Malaysian Government is currently promoting commercialization of agriculture based activities. In your opinion, is there any relevance theory of international business explain the rationales of the strategy adopted by the government. Discuss.