Theories of International Trade Dr.C S Shylajan Faculty, IBS Hyderabad

Internationaliasation of Trade  Why capital flows internationally?  Why international trade of goods and services takes place?  International trade theory is concerned with the reasons for trade, the direction of trade and the gains from trade

Gains from Trade  Faster Economic growth  Increasing returns to scale  Increase in the quality of the goods we consume  An increase in competition within the domestic market

Why do nations trade? Any theoretical explanation? (i) Nations are different Efficiency  Specialization - Unequal distribution of natural resources - Difference in Technology - Cost Advantages: Cost of production for the same product differs among different locations - Different Preferences: Due to different income levels (ii) To achieve economies of scale in production

Absolute Advantage Theory  Adam Smith  There is international benefit from trade  When one country can produce a unit of good with less factor(s) of production (i.e. more efficiently) than another country, the first country has an absolute advantage in producing that good

Theory of Absolute Advantage  Assume, two countries, country A and country B Producing only two commodities, x and y  Suppose, A can produce x cheaper than B, and B can produce y cheaper than A  Means, A has an absolute advantage in the production of x and B in the production of y  Thus, A will be better off concentrating on the production of x and B on the production of y  A will export x to B, and B will export y to A

Theory of Absolute Advantage  Both countries will gain from the trade Results in specialization Increases productivity and economic growth  But what happens if A has absolute advantage in the production of both x and y ?  i.e., if A can produce x cheaper than B and it can produce y much cheaper than B  Should A produce both x and y and B nothing?

Comparative Advantage Theory  David Ricardo extended AA Theory  Nations can still gain from trade even without an absolute advantage.  Difference in opportunity cost

Comparative Advantage Theory  The world economy will be better off if A concentrates on the production of y, which it can produce much cheaper than B and B concentrates on the production of x which it can produce relatively less expensively than A

Comparative Advantage Theory  Even if countries do not have an absolute advantage, they can gain from trade by allocating resources based on their comparative advantage and trade with each other.  Countries operating at different levels of efficiency give rise to comparative advantage

Comparative Advantage Theory  Each country will benefit if it specializes in the production and export of those goods that it can produce at relatively low cost  Each country will benefit if it imports those goods which it produces at relatively high cost  Hence export –import takes place

Ricardian Model of Comparative Advantage– An overview  Illustrates the potential benefits from trade  Trade leads to international specialization  Labour, the only factor, moves from relatively less efficient industries/sectors to relatively more efficient industries/sectors

Assumptions of Recardian Model  Labour is the only factor.  There is full employment of resource in both the countries  Labour is fully mobile between sectors, but immobile between countries  No technological change

The Heckscher – Ohlin Model  Cause of trade International differences in labour productivity – Ricardian view Differences in countries’ resources – H-O model.  Developed by Eli Heckscher and Bertil Ohlin

The Heckscher – Ohlin Model  Also called Factor-proportions Theory  Emphasis the interplay between the proportions in which different factors of production are available in different countries and the proportion in which they are used in producing different goods

Assumptions Two factors of production – capital & labour Two countries, differ in factor abundance/ endowments Two commodities – for example, Steel and Cloth Steel is more capital intensive and Cloth is more labour intensive in both countries Both goods uses both factors and the relative factor intensities are the same for each good in the two countries (i.e, countries have same technologies) Free trade (no trade controls or transportation costs) Both commodity and factor markets are perfectly competitive

H-O Model  Model predicts that:  The capital surplus country specializes in the production and export of capital-intensive goods and the labour surplus country specializes in the production and export of labour-intensive goods.

The H-O Theorem  Definition of Factor Abundance A country in which capital is relatively cheap and labour is relatively expensive, is regarded as a capital abundant country A country is relatively capital abundant if and only if it is endowed with a higher proportion of capital to labour than the other country. If capital is relatively cheap in one country, that country must be abundant in capital supply – Ohlin’s view

The H-O Theorem Countries tend to export goods whose production is intensive in factors with which they are abundantly endowed.  Criticism  Leontief Paradox: The findings of empirical study on US by Wassily Leontief that the US exports are more labour-intensive than capital-intensive.

Classic Theory’s Limitations  Simple world (two countries, two products)  no transportation costs  no price differences in resources  resources immobile across countries  constant returns to scale  each country has a fixed stock of resources and no efficiency gains in resource use from trade  full employment

Imitation-Gap Theory/Technology Gap Theory  Introduced by Posner  H-O model assumed that identical technology between countries

Imitation-Gap Theory  Imitation Gap theory hypothesis that: Technology evolves through innovation Technological differences are temporary  Improvement in technology is a continuous process and the resulting inventions and innovations in existing products give rise to trade between countries

Imitation-Gap Theory  Degree of trade depend on the difference between the demand lag and the imitation gap  Demand lag: Time taken for consumers in partner countries to demand the new good.  Imitation gap: Gap between the time of introduction of the product and time taken for the new technology to become available in the partner country.

Imitation-Gap Theory  Factors influencing Demand Lag: Speed and effectiveness of information flow Readiness for adaptation for consumption in the second country Attitude towards new technology Ability to purchase the new product  Factors influencing Imitation Lag: Absorptive capacity of producers in the other country Patent protection laws Sophistication of the technology

Imitation-Gap Theory Reason for Trade  Imitation Gap > Demand Gap First cycle to trade: due to Imitation Gap > Demand Gap Once imitated, trade come down Second cycle : if new technological innovations in the first country Reversal of cycle: If the second country comes with new technology

Product Cycle Theory  Introduced by Raymond Vernon  Differs from previous trade theories  Focus on the product, not its factor proportions  Puts less emphasis on comparative cost doctrine  Increased emphasis on technology’s impact on product cost the innovation, the effects of scale economies, and the roles of ignorance and uncertainty in influencing trade patterns  Explains international investment

Product Cycle Theory Vernon uses the same basic assumptions of factor proportions theory, but adds two technology-based propositions: New products are developed in the developed countries Technical innovations leading to new and profitable products require large quantities of capital and skilled labor The product and the methods for manufacture go through three stages of maturation

Stages of the Product Cycle  Stage 1: The New Product  Innovation stage  Requires highly skilled labour and large amount of capital for R&D  Production near the firm  Non-standardized product  High flexibility in the production process  High cost of production, small market  Innovator is a monopolist, charges high price  Very low price elasticity of demand

Stages of the Product Cycle  Stage 2: The Maturity stage  Production expands to other developed countries  Process become more or less standardized  Looks for economies of scale, export begins  Competition with slight variation products emerges from other developed countries  Downward pressure on price and profit margins  Major task is to maintain market share  Invest abroad to exploit the comparative advantage of low costs in other countries  A theoretical explanation of the intertwining between trade and investment

Stages of the Product Cycle  Stage 3: The Standardized Product  Product is completely standardized in its manufacturing and can produce with unskilled labour  Access to capital in the world capital market  Uses mostly unskilled labour in the production  Shifts the location of production. Other less developed countries also start producing.

The Product Cycle and Trade Implications  Explains the competitive evolution of a product, shifting location of production and export to other countries  Same firm moving production locations  Changing pattern of trade is due to shifting location of production  Therefore, country of comparative advantage would change  Explains international investment – recognizing the mobility of capital (factor mobility) across countries Limitations Most appropriate for technology-based products Some products not easily characterized by stages of maturity

The Instruments of Trade Policy

Topics of Discussion  Trade Policies and Instruments  Why governments impose restrictions on international trade (imports for instance)?  Protecting domestic industries  Is protectionism sound trade policy?  Is free trade a sound policy?  Why?  Impacts of Import Tariff on Price, Domestic supply and Employment

Protectionism Vs Free Trade  Protectionism prevents the forces of comparative advantage  Free Trade promotes a mutually beneficial division of labor among nations

Instruments of Trade Policy  What should a nation’s trade policy be?  Different trade policies include:-  Trade Barriers Tariffs Non-tariff barriers  Subsidies  Quotas  Local Content Requirements etc

Tariff  Simplest and the oldest form of trade policy  It is a tax levied when a good is imported  Purposes – to provide revenue to the Govt. and also  To protect particular domestic sector  Specific Tariff – Fixed charge for each unit of good imported  Ad Valorem Tariff – levied as a fraction of the value of the imported goods

Effect of a Tariff  Tariff is like a cost of transportation

Effect of a Tariff  A tariff will tend to raise price, lower the amounts consumed and imported, and raise domestic production

Costs and Benefit of a Tariff Effect of a Tariff:  Prices – rise in the importing country  Consumers – loss in the importing country  Government – gains revenue through tariff

Other Instruments of Trade Policy Export Subsidies – Theory  Export subsidy is a payment to a firm or individual that ships a good abroad.  It can be either specific or ad valorem