International Trade Theory

Overview of 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 (For instance, Iceland)

Trade Theory-Overview The Pattern of International Trade displays patterns that are easy to understand (for example, climate and natural resources Saudi Arabia/oil, Ghana/Cocoa, Brazil/Coffee. Others are not so easy to understand Japan and cars/electronics The history of Trade Theory and government involvement presents a mixed case for the role of government in promoting exports and limiting imports Later theories appear to make a case for limited involvement

Mercantilism: Mid-16th Century A nation’s wealth depends on accumulated treasure Gold and silver are the currency of trade Theory says you should have a trade surplus Maximize export through subsidies Minimize imports through tariffs and quotas Flaw: “zero-sum game” (gain in one country results in loss in another country)

Mercantilism-Zero-Sum Game In 1752, David Hume pointed out that: Increased exports lead to inflation and higher prices Increased imports lead to lower prices Result: Country A sells less because of high prices and Country B sells more because of lower prices In the long run, no one can keep a trade surplus critics charge that China is pursuing a neo-mercantilist policy, deliberately keeping its currency value low against the U.S. dollar in order to sell more goods to the United States, and thus amass a trade surplus and foreign exchange reserves.

Theory of Absolute Advantage Adam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more of a product with the same amount of input than another country can vary A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient Trade between countries is, therefore, beneficial Assumes there is an absolute balance among nations Example: Ghana/cocoa

Theory of Absolute Advantage Figure 5.1, p. 170

Absolute Advantage and the Gains From Trade Table 5.1, p. 171

Theory of Comparative Advantage David Ricardo (Principles of Political Economy, 1817): Extends free trade argument Efficiency of resource utilization leads to more productivity Should import even if country is more efficient in the product’s production than country from which it is buying Look to see how much more efficient If only comparatively efficient, than import Makes better use of resources Trade is a positive-sum game

Comparative Advantage Theory of Comparative Advantage Figure 5.2, p. 173

Comparative Advantage and the Gains From Trade Table 5.2, p. 173

Simple Extensions of the Ricardian Model Immobile resources: Resources do not always move easily from one economic activity to another Diminishing returns: Diminishing returns to specialization suggests that after some point, the more units of a good the country produces, the greater the additional resources required to produce an additional item Different goods use resources in different proportions

Simple Extensions of the Ricardian Model Free trade (open economies): Free trade might increase a country’s stock of resources (as labor and capital arrives from abroad) Increase the efficiency of resource utilization

PPF Under Diminishing Returns Figure 5.3, p. 176

Influence of Free Trade on PPF Fig. 5.4, p. 177

Heckscher (1919)-Olin (1933) Theory Export goods that intensively use factor endowments which are locally abundant Corollary: import goods made from locally scarce factors Note: Factor endowments can be impacted by government policy - minimum wage Patterns of trade are determined by differences in factor endowments - not productivity Remember, focus on relative advantage, not absolute advantage

Product Life-Cycle Theory - R. Vernon (1966) As products mature, both location of sales and optimal production changes Affects the direction and flow of imports and exports Globalization and integration of the economy makes this theory less valid

Product life cycle theory Figure 5.5, p. 183

New Trade Theory In industries with high fixed costs: Specialization increases output, and the ability to enhance economies of scale increases Learning effects are high. These are cost savings that come from “learning by doing”

New Trade Theory-Applications Typically, requires industries with high, fixed costs World demand will support few competitors Competitors may emerge because of “ First-mover advantage” Economies of scale may preclude new entrants Role of the government becomes significant Some argue that it generates government intervention and strategic trade policy

Theory of National Competitive Advantage The theory attempts to analyze the reasons for a nation’s success in a particular industry Porter studied 100 industries in 10 nations Postulated determinants of competitive advantage of a nation were based on four major attributes Factor endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry

Porter’s Diamond Success occurs where these attributes exist More/greater the attribute, the higher chance of success The diamond is mutually reinforcing

Porter’s Diamond Figure 5.6, p. 188

Factor Endowments Factor endowments: A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry Basic factor endowments Advanced factor endowments

Basic Factor Endowments Basic factors: Factors present in a country Natural resources Climate Geographic location Demographics While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success

Advanced Factor Endowments Advanced factors: The result of investment by people, companies, and government are more likely to lead to competitive advantage If a country has no basic factors, it must invest in advanced factors

Advanced Factor Endowments Communications Skilled labor Research Technology Education

Demand Conditions Demand: Demand impacts quality and innovation 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

Looking Ahead to Chapter 6 The Political Economy of International Trade Instruments of Trade Policy The Case for Government Intervention The Revised Case for Free Trade Development of the World Trading System