International Trade Theory

Chapter 3:International Trade Theory Introduction: The economic arguments surrounding the benefits and costs of free trade in goods and services are not abstract academic ones. International trade theory has shaped the economic policy of many nations for the past 50 years. It was the driver behind the formation of the World Trade Organization and regional trade blocks such as the European Union and North American Free Trade Agreement (NAFTA).

Introduction Since 1990, there was a global move toward greater free trade. It is crucially important to understand, therefore, what these theories are and why they have been so successful in shaping the economic policy of so many nations and the competitive environment in which international business compete.

An Overview of Trade Theory Mercantilism – countries should simultaneously encourage exports and discourage imports. Absolute advantage – unrestricted free trade is beneficial to a country (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 Benefits of Trade Specialization in production Optimum utilization of resources Maximization of social welfare Division of labor Cost minimization Reduce monopolistic competition Protect economic interest of all countries Consumption of unproduced products Increase international peace and assistance.

The Pattern of International Trade Comparative advantage offers an explanation in terms of international differences in labor productivity. The more sophisticated theory emphasizes the interplay between the proportions in which the factors of production are available in different countries and the proportions in which they are needed for producing particular goods.

The Pattern of International Trade New trade theory stress that in some cases countries specialize in the production and export of particular products not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of firms. Thus the observed pattern of trade between nations may be due in part to the ability of firm within a given nation to capture first-mover advantages.

Trade Theory and Government Policy Although all theories agree that international trade is beneficial to a country, they lack agreement in their recommendations for government policy. Mercantilism makes a crude case for government involvement in promoting exports and limiting imports. According to unrestricted free trade both import and export are self-defeating. New trade theory justifies some limited government intervention to support the development of certain export-oriented industries.

1. Mercantilism The main tenet of mercantilism was that it was in a country’s best interest to maintain a trade surplus, to expand more that it imported. By doing so, a country would accumulate gold and silver and consequently, increase its national wealth, prestige and power. The mercantilist advocated government intervention to achieve a surplus in the balance of trade. The mercantilist saw no virtue in a large volume of trade. Rather, they recommend policies to maximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, while exports were subsidized.

2. Absolute Advantage Theory The theory was introduced by Professor Adam Smith. According to this theory every country will be specialized in producing a product in which it has more advantage than other country. Absolute cost advantage means, here is less production cost for a particular product compare to other countries. Since a particular country will produce

Absolute Advantage Theory a particular product only, there may be excess of production of a commodity and shortage of other. In this situation the country will export its excess production to other non-producing countries and it will import the non-produced product from other producing countries. This theory assumes the followings:

Absolute Advantage Theory 1. Only two countries and two products. 2. Labor is the only factor of production. 3. Supply of labor is constant. 4. Labor is movable only within the country. 5. Constant opportunity cost. 6. Unchanged production technology. 7. Free trade between countries. 8. No transportation cost. 9. Full employment level.

Absolute Advantage Theory Example: Country Rice Wheat MRT (Sacrifice ratio) X 100 50 2:1 Y 1:2 In the above example, the country X can produce 100 units of rice and 50 units of wheat whereas country Y can produce

Absolute Advantage Theory 50 units of rice and 100 units of wheat by using same level of resources. From the table it is observed that if country X wants to produce 2 units of rice then it has to sacrifice 1 unit of wheat. The production possibility frontier for country X represents this exchange ratio of 2:1. So in case of producing rice country X is in advantageous position.

Absolute Advantage Theory Rice 100 X 50 Y Wheat 50 100

Absolute Advantage Theory Again, in case of country Y it has to sacrifice 1 unit of rice for producing 2 units of wheat. Thus country Y is in advantageous position of producing wheat. So country Y will be specialized in producing wheat. Gain from trade: Production and consumption without trade: Country Rice Wheat Total resource Tk.200. X requires Tk.10 for 1 unit of rice & Tk.20 for 1 unit of wheat. Y requires Tk.40 for 1 unit of rice & Tk.10 for 1 unit of wheat. X 10 5 Y 2.5 Total 12.5 15

Comparative Cost Advantage Theory Production without specialization Production with specialization Consumption after trade of 5 units each Gain from specialization and trade Country Rice (Tk.100) Wheat (Tk.100) Wheat X 10 7.5 20 15 5 -2.5 Y 2.5 Total 12.5

Absolute Advantage Theory Rice 20 X A 10 5 Y B 2.5 Wheat 5 10 20

3. Comparative Cost Advantage Theory This theory was introduced by David Recardo. According to this theory a country should produce product in which it has comparative cost advantage position to other products, may be produced by itself. Any country may be in comparative cost advantage position for producing more than one products than other countries. But the country should not produce all the products, because for producing all products it will have to import

Comparative Cost Advantage Theory resources from other countries or resources available in countries where not in use. Example: Country Rice Wheat MRT (Sacrifice ratio) X 100 1:1 Y 30 90 1:3

Comparative Cost Advantage Theory Rice 100 X Y 30 Wheat 90 100

Comparative Cost Advantage Theory It is noticed from the table that country X can produce one unit of rice by sacrificing one unit of wheat. Thus its sacrifice ratio i.e. MRT is 1:1. On the other hand, country Y can produce one unit of rice by sacrificing 3 units of wheat. Thus its sacrifice ratio i.e. MRT is 1:3. It is assumed that both countries can desired quantity of rice and wheat by using same level of resources.

Comparative Cost Advantage Theory Here it is mentionable that the opportunity cost of country Y is higher in case of producing rice than that of country X. Country Y is in advantageous position for producing wheat. Country X can produce both products at higher level than country Y, but it should not do that. It should be specialized in producing rice. If it goes for producing both products then it will have to import resource from other countries while its domestic resources may be unutilized.

Comparative Cost Advantage Theory Available resource is Tk.200. Country X requires Tk.10 for 1 unit of rice and Tk.13.33 for 1 unit of wheat. Country Y requires Tk.40 for 1 unit of rice and Tk.20 for 1 unit of wheat.

Comparative Cost Advantage Theory Production without specialization Production with specialization Consumption after trade of 4 units each Gain from specialization and trade Country Rice (Tk.100) Wheat (Tk.100) Wheat X 10 7.5 15 3.75 11 7.75 1 0.25 Y 2.5 5 4 6 1.5 Total 12.5 13.75 1.25

Heckscher-Ohlin Theory Eli Heckscher and Bertil Ohlin argued that comparative advantage arises from differences in national factor endowments. By factor endowments they meant the extent to which a country is endowed with such resources as land, labor and capital. Nations have varying factor endowments, and different factor endowments explain differences in factor costs; specially, the more abundant a factor, the lower its cost.

Heckscher-Ohlin Theory This theory predicts that countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. This theory argues for free trade.

National Competitive Advantage: Porter’s Diamond Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete and these attributes promote or impede the creation of competitive advantage. These attributes are: 1. Factor endowments – a nation’s position in factor of production such as skilled labor or the infrastructure necessary to compete in a given industry.

National Competitive Advantage: Porter’s Diamond 2. Demand conditions – the nature of home demand for the industry’s product or service. 3. Relating and supporting industries – the presence or absence of supplier industries and related industries that are internationally competitive. 4. Firm strategy, structure and rivalry – the conditions governing how companies are created, organized and managed and the nature of domestic rivalry.

First-Mover Advantages According to the new trade theory, firms that establish a first-mover advantage with regard to the production of a particular new product may subsequently dominate global trade in that product. This is particularly true in industries where the global market can profitably support only a limited number of firms, such as the aerospace market, but early commitments also seem to be important in less concentrated

First-Mover Advantages industries such as the market for cellular telephone equipment. For the individual firm the clear message is that it pays to invest substantial financial resources in trying to build a first-mover or early-mover advantage even if that means several years of losses before a new venture becomes profitable. The idea is to preempt the available demand, gain cost advantages related to volume, build an enduring brand ahead of later competitors, and consequently, establish a long-term sustainable competitive advantage.

Government Policy The theories of international trade matter to international businesses because firms are major players on the international trade scene. Business firms produce exports and business firms import the products of other countries. Because of their pivotal role in international trade, businesses can exert a strong influence on government trade policy,

Government Policy lobbying to promote free trade or trade restrictions. The theories of international trade claim that promoting free trade is generally in the best interest of a country, although it may not always be in the best interest of an individual firm. Many firms recognize this and lobby for open markets.