Chapter 6 International Trade Theory INB 372 Lecture By: Ms. Adina Malik

An Overview Of Trade Theory Free trade refers to a situation where a government does not attempt to influence through tariff and/or quota what its citizens can buy from another country or what they can produce and sell to another country Excise duties: inland tax on sale or production for sale of specific goods. (Wikipedia) Quotas: A government-imposed trade restriction that limits the number, or in certain cases the value, of goods and services that can be imported or exported during a particular time period. Quotas are used in international trade to help regulate the volume of trade between countries. They are sometimes imposed on specific goods and services to reduce imports, thereby increasing domestic production. In theory, this helps protect domestic production by restricting foreign competition. (Investopedia)

The Benefits Of Trade Smith, Ricardo and Heckscher-Ohlin show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself International trade allows a country: to specialize in the manufacture and export of products that it can produce efficiently import products that can be produced more efficiently in other countries

Trade Theories Mercantilism Absolute Advantage Comparative Advantage Heckscher-Ohlin Theory Product Life Cycle Theory Porter’s Diamond Theory

Mercantilism Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -- to export more than it imports Countries conducted trade in exchange of gold and silver in the mid 16th century in England. A country could earn gold and silver by exporting, thereby increasing their gold and silver reserve-an increase in national wealth, prestige and power. The contrary takes place when a country imports.

Mercantilism So, this theory advocated government intervention to achieve a surplus in the balance of trade. The policy was to maximize exports and minimize imports- imports were limited by tariffs & quotas, while exports were subsidized. This theory is however criticized because trade surplus increase money supply in a country. An increase in money supply raises the demand and consequently the price of goods. The result of this is inflation. In the long run, no country can sustain a surplus on the balance of trade.

Mercantilism It views trade as a zero-sum game, one in which a gain by one country results in a loss by another, rather than a positive-sum game, a situation where all countries in trade can benefit.

Absolute Advantage Adam Smith was against mercantilism. He 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 According to Smith, a country should never produce goods at home that it can buy at a lower cost from other countries. 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. In 1776, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game and argued that countries differ in their ability to produce goods efficiently, and 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.

Resources required to produce 1 (one) ton of cocoa and rice Absolute Advantage Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa. Resources required to produce 1 (one) ton of cocoa and rice Country Cocoa Rice Ghana 10 20 South Korea 40

Comparative Advantage David Ricardo extended Adam Smith’s Theory by exploring what might happen when one country has absolute advantage in production of all goods. He extended the free trade argument and proved that trade is a positive-sum game. 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 According to Adam Smith, no benefits will be gained from international trade if a country has an absolute advantage in the production of all goods. David Ricardo showed that it was not the case.

Comparative Advantage Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa. Resources required to produce 1 (one) ton of cocoa and rice Country Cocoa Rice Ghana South Korea 10 40 13.33 20

Comparative Advantage Ghana is more efficient in the production of both cocoa and rice. In Ghana, it takes 10 resources to produce one tone 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

Comparative Advantage Ghana has an absolute advantage in the production of both goods, then why should it trade with South Korea? Ghana has an absolute advantage in the production of both goods, but it has a comparative advantage only in the production of cocoa. Ghana can produce 4 times as much as cocoa as South Korea, but only 1.5 times as much rice.

Comparative Advantage 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. Potential world production is greater with unrestricted free trade than it is with restricted trade. Comparative advantage theory provides a strong rationale for encouraging free trade. The theory therefore suggests that trade is a positive-sum game (to an even greater degree than that suggested by the theory of absolute advantage).

QUESTIONS Total resources available to each country is 200 units. Resources required to produce 1 ton of each product are as follows: Q:1. Which country has an absolute advantage, and in which product? Justify and explain. Q:2. Which country has a comparative advantage, and in which product? Justify and explain. Country Biscuits Wheat India 20 10 China 40 50

Heckscher-Ohlin Theory Ricardo’s theory suggests that comparative advantage arises from differences in productivity Eli Heckscher and Bertil Ohlin argued that comparative advantage arises from differences in national factor endowments – the extent to which a country is endowed with resources like land, labor, and capital The Heckscher-Ohlin theory predicts that countries will export goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce

Heckscher-Ohlin Theory Factor endowments determines cost of operation there EG: China in textile, footwear; USA in high tech product, Australia in agro and dairy products. Chinese Textile Australian Meat and Dairy Srilankan Tea

The Product Life Cycle Theory The product life-cycle theory, proposed by Raymond Vernon, suggested that as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade Vernon argued that the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new products Vernon argued that initially, the product would be produced and sold in the U.S., later, as demand grew in other developed countries, U.S. firms would begin to export wealth and size of US market => strong incentive to develop new consumer products high cost of US labor=> an incentive to develop cost-saving process innovation production was concentrated in the innovative country so as to keep the production facilities near the market and near to the center of decision making, given the inherent risk and uncertainties attached to the launch of new product.

The Product Life Cycle Theory Over time, demand for the new product would grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets U.S. firms might also set up production facilities in those advanced countries where demand was growing limiting the 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

The Product Life Cycle Theory Producers based in advanced countries where labor costs were lower than the United States might now be able to export to the U.S. If cost pressures became intense, developing countries would begin to acquire a production advantage over advanced countries The United States switched from being an exporter of the product to an importer of the product as production becomes more concentrated in lower-cost foreign locations

Product Life-Cycle Theory Net exporter Net importer New product (Brands Like IBM, Apple) Phase I All production in US US exports to advanced countries like Europe, Japan Phase II Production started in other advanced nations US exports mostly to LDCs Phase III Other advanced nations export to LDCs US exports to LDCs displaced Phase IV Europe exports to US Phase V Production shifted to developing countries like India, China, Malaysia through investment and alliances and then exported. Time Figure 4.1: The product life cycle Source: Wells (1972), as cited by Dicken (2003), p.203. Introduction Growth Early Maturity Late Maturity Decline

The Product Life Cycle Theory 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 US in the 1960s and 1970s But, the increasing globalization and integration of the world economy has made this theory less valid in today's world

National Competitive Advantage: Porter’s Diamond Michael Porter tried to explain why a nation achieves international success in a particular industry and identified four attributes that promote or impede the creation of competitive advantage: Factor endowments (skilled labor, infrastructure) Demand conditions (the nature of home demand) Relating and supporting industries (the presence or absence of supplier industries and related industries that are internationally competitive) Firm strategy, structure, and rivalry (how companies are created, organized and managed & the nature of domestic rivalry) Why does Japan do so well in the automobile industry? Why do Germany and the United States do so well in the chemical industry? These four broad attributes of a nation shape the environment in which local firms compete.

National Competitive Advantage: Porters Diamond by Michael Porter in 1990 Porter argues that firms are most likely to succeed in industries or industry segments where the diamond is most favorable.

Factor Endowments Factor endowments refer to a nation’s position in factors of production necessary to compete in a given industry=> competitive advantage These factors can be either basic (natural resources, climate, location, demographics) or advanced (sophisticated & skilled labor, research facilities, communication infrastructure, technological know-how) Advanced factors are a product of investment by individuals, companies & governments. Basic factors are initial advantage that is subsequently reinforced and extended by investments in advanced factors. Disadvantages in basic factors can create pressures to invest in advanced factors. E.g. Japan lacks arable land and mineral deposits. Japan invested on advanced factors to build up large pool of engineers, that points towards the success of Japan in many manufacturing industries.

Demand Conditions Demand conditions refer to the nature of home demand for the industry’s product or service that influences the development of capabilities Sophisticated and demanding customers pressure firms to be competitive, by creating pressures for innovation and quality E.g. Japanese camera industry; wireless telephone equipment industry of Scandinavia and Sweden

Relating And Supporting Industries The presence of supplier industries and related industries that are internationally competitive can spill over and contribute to other industries E.g. Until the mid-1980s, the technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in personal computers and several other technically advanced electronic products. E.g. Adoption of the automobile took off in the USA after the construction of a national system of highways and gas stations.

Firm Strategy, Structure, And Rivalry The conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalry impacts firm competitiveness Different management ideologies affect the development of national competitive advantage. E.g. predominance of engineers in top management at German and Japanese firms-improvement in manufacturing processes and product design E.g. predominance of finance people in top management at the US firms- overemphasis on maximizing short term financial return Vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features

Evaluating Porter’s Theory Government policy can: affect demand through product standards influence rivalry through regulation and antitrust laws impact the availability of highly educated workers and advanced transportation infrastructure. The four attributes, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage 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.

Evaluating Porter’s Theory Chance events are occurrences that are outside of control of a firm. They are important because they create discontinuities in which some gain competitive positions and some lose. E.g. This chance may arise from any new agreement, opening of a new market. like, expiry of Multi-Fiber Agreement of WTO created huge chance for the ready-made garments industry of the developing nations. E.g. unexpected oil price rises, wars, political unrest, etc. The Multi Fibre Arrangement (MFA) governed the world trade in textiles and garments from 1974 through 2004, imposing quotas on the amount developing countries could export to developed countries. It expired on 1 January 2005. (Wikipedia) For example the European Union (EU) imposed no restrictions or duties on imports from the emerging countries, such as Bangladesh, leading to a massive expansion of the industry there. (Wikipedia)