1. International Trade Theory Chapter 4
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2. International Trade Theory
Mercantilism
Free-Trade
Absolute Advantage
Comparative Advantage
Heckscher-Ohlin Theory
Product Life Cycle Theory
New Trade Theory
Porter’s Diamond
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3. An 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. Why Iceland should not produce oranges?
The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or Mexico/labor intensive goods). Others are not so easy to understand (Japan/cars and USA/Aircraft).
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4. 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 exports through subsidies.
Minimize imports through tariffs and quotas.
Flaw: “Zero-sum game”.
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5. Is the Mercantilist Theory Still Valid?
A qualified Yes.
Equate political power with economic power and economic power with a trade surplus.
Japan
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6. David Hume
Increased exports leads 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.
Eg- England vs France.
In the long run, no one can keep a trade surplus.
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7. Theory of Absolute Advantage
Adam Smith: Wealth of Nations (1776).
Capability of one country to produce more of a product with the same amount of input than another country.
Produce only goods where you are most efficient, trade for those where you are not efficient.
Trade between countries is, therefore, beneficial.
Assumes there is an absolute advantage balance among nations- POSITIVE SUM-GAME
Ghana/cocoa.
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8. The Theory of Absolute Advantage
Cocoa A
Figure 4.1 K B G’ K’
Rice
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9. The Theory of Absolute Advantage and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana
S. Korea
Production and Consumption without Trade
Ghana
S. Korea
Total production
Production with Specialization
Ghana
S. Korea
Total production
Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice
Ghana
S. Korea
Increase in Consumption as a Result of Specialization and Trade
Ghana
Table 4.1
S. Korea
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10. 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.
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11. The Theory of Comparative Advantage
Cocoa A
Figure 4.2 K B
2.5 K’ G’
3.75
7.5
Rice
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12. Comparative Advantage and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana
S. Korea
Production and Consumption without Trade
Ghana
S. Korea
Total production
Production with Specialization
Ghana
S. Korea
Total production
Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice
Ghana
S. Korea
Increase in Consumption as a Result of Specialization and Trade
Ghana
Table 4.2
S. Korea
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13. Unrealistic Assumptions of the Ricardian Model
A simple world with two countries and two goods
No transportation costs between countries
No differences in prices of resources in different countries (exchange rates?)
Resources move freely from production of one good to another within a country.
Constant returns to scale.
Each country has fixed stock of resources and free trade does not change the efficiency with which a country uses its resources.
No effects of trade on income distribution within a country.
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14. Extensions of the Ricardian Model
1) Immobile Resources:
Resources do not shift easily from producing one good to another. Certain amount of Friction. Eg- Capital-intensive US will deprive the textile manufacturers.
Causes Human suffering, though benefits outweigh costs.
2) Diminishing Returns:
In reality, no Constant Returns to specialization (units of resources to produce a good remains constant regardless on their position in the PPF).
Quality of resources are not the same.
Different goods use resources in different proportions. Eg-both cocoa and rice are labor-intensive goods.
In reality, gains from specialization will exhaust before specialization is complete.
Most countries do not specialize.

15. Ghana’s PPF under Diminishing Returns
Cocoa
Figure 4.3 G’
Rice
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16. Extensions of the Ricardian Model
3) Dynamic effects and Economic Growth:
Free trade increases a country’s stock of resources as increased supplies of labor and capital from abroad become available for use within the country.
Free trade increases efficiency with which a country uses its resources. Sources are:
- Economies of scale due to huge production for market size expansion.
- Increased labor or land productivity due to better technology.
- Dynamic gains in resources and efficiency cause PPF to shift outward; hence countries can produce more of both goods.

17. The Influence of Free Trade on the PPF
Cocoa
Figure 4.4 G’
Rice
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18. Heckscher-Ohlin Theory
Comparative advantage arises from the national factor endowment
The country 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.
The pattern of international trade is determined by differences in factor endowments rather than differences in productivity.

19. Limitation to Heckscher-Ohlin Theory- The Leontief Paradox
A key assumption in the Heckscher-Ohlin Theory is that technologies are the same across countries. This is not the case. Differences in technology may lead to differences in productivity, which in turn, drives international trade patterns. Eg- US exporting aircraft not for factor endowments; for efficiencies.
Heckscher vs Ricardo
Economists prefer Heckscher on theoretical grounds but is a relatively poor predictor of trade patterns.
Ricardo’s Comparative Advantage Theory, regarded as too limited for predicting trade patterns, actually predicts them with greater accuracy.
In the end, differences in productivity may be the key to determining trade patterns.

20. Hecscher-Ohlin Theory gets justification
Once the differences in technology across countries are controlled for, countries do indeed 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.
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21. PRODUCT LIFE CYCLE THEORY
Raymond Vernon (1966) developed the product life cycle theory, which was the first dynamic theory to account for changes in the patterns of trade over time.
Vernon divided the world into three categories:
lead innovation nation (which, according to him, is typically the USA),
other developed nations (GB, Germany, Japan, France etc)
developing nations.
First being produced at US (demand based on non-price factors like branding, tastes & preferences, seasonal considerations etc), then export to other developed nations, then production facilities switched to other (consequently reduces exports from US).
As markets become mature in advanced countries low-cost locations, product becomes standardized and price become competitive weapon- then production switched to locations of lower-cost of labor (Italy & Spain), which export to US
Developing countries (Thailand) produces and exports to US.
This theory has been criticised on two accounts:
it assumes that the USA will always be the lead innovation nation for new products (sic).
It assumes a stage-by-stage migration of production that takes at least several years (if not decades).
An increasing number of firms now simultaneously launching new products (such as iPods or game consoles) around the globe.

22. PLC Theory: Evolution of trade
PLC theory states that the location of production of certain kinds of products shifts as they go through their life cycle.
Eg- Xerox Photocopier: First in US-> exported to Japan & GB-> formed Joint ventures Fuji-Xerox and Rank-Xerox respectively->New entrants entered (Canon in Japan & Olivetti in Italy) upon license expiring of Xerox and later shifted from Japan to Thailand -> US switched to imports from exports
Observation based on the US market
As products mature, both location of sales and optimal production changes.
Affects the direction and flow of imports and exports.

23. PLC Theory: Evolution of trade
Stage 1: Introduction: New products are introduced to meet local (i.e., national) needs, and new products are first exported to similar countries, countries with similar needs, preferences, and incomes. E.g., the IBM PCs were produced in the US and spread quickly throughout the industrialized countries.)
Stage 2: Growth: A copy product is produced elsewhere- production is moved to other countries, usually on the basis of cost of production. (E.g., the clones of the early IBM PCs were not produced in the US.)
Stage 3: Maturity: The industry contracts and the lowest cost producer wins here. (E.g., the many clones of the PC produced)
Stage 4: Saturation: This stage is characterized by Saturation of sales and standardization of products.

24. International Changes during plc

25. Limitations of plc theory
Ethnocentric in nature
Only based on the US experience.
Recent trends:
No more US dominance ( )
New players from Europe and Asia (Samsung smartphones at south Korea)
Simultaneous launch/introduction of new products across the world market (tablet computers, digital cameras).
Globally dispersed production is also applicable to innovative new products where mix of factor costs and skills is most favorable.

26. International Product Trade Cycle Model
High Income Countries
production
Exports
Imports
consumption
Quantity 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Medium Income Countries
Exports
Imports 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Low Income Countries
Exports
Imports 1
Time 2 3 4 5 6 7 8 9 10 11 12 13 14 15
New Product
Maturing Product
Standardized Product
Figure 4.5
Stages of Production Development
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28. The New Trade Theory
Began to be recognized in the 1970s- showed ability of firms to attain scale economies to have implication on International Trade.
Deals with the returns on specialization where substantial economies of scale are present.
Specialization increases output, ability to enhance economies of scale (Per unit cost reductions associated with large scale of output).
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29. Trade Theories (Continued) “New Trade Theory”
Increasing product variety & reducing costs
Eg- World with and without trade.
- Each nation be able to specialize in producing a narrower range of products and buy goods that it does not produce and thereby increase varieties and lower the total costs.
First-mover advantage
Economic and Strategic advantages gained by entering early in an Industry.
Ability to capture scale economies ahead of others and also benefit from lower cost structure.
Eg- Airbus A380

30. Implications of New Trade Theories
Nations may benefit from trade even when they do not differ in resource endowments or technology.
Luck, entrepreneurship, innovation give first-mover advantage.
The Aerospace Example. GB’ De Havilland vs Boeing 707

31. Porter’s Diamond (Harvard Business School, 1990)
The Competitive Advantage of Nations.
Looked at 100 industries in 10 nations.
Thought existing theories didn’t go far enough.
Question: “Why does a nation achieve international success in a particular industry?”
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32. Porter’s Diamond Theory
Porter & team (1990) researched 100 industries in 10 nations:
Factor Endowments (nation’s factors of production needed to compete in an industry).
Demand Conditions (home demand for industry’s products).
Related Supporting Industries (presence or absence of supplier industries that are internationally competitive).
Firm Strategy, Structure and Rivalry (conditions showing how firms are created, organized and managed and nature of domestic rivalry.

33. Porter’s Diamond Theory

34. The Diamond Success occurs where these attributes exist.
More/greater the attribute, the higher chance of success.
The diamond is mutually reinforcing.
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35. Factor Endowments/Conditions
Contrary to conventional wisdom, Porter argues that the "key" factors of production (or advanced factors) are created, not inherited.
Eg- communication infrastructure, sophisticated & skilled labor, research facilities, technological know-how.
"Non-key" factors or basic factors, such as natural resources, climate, location and demographics might not generate sustained competitive advantage.
However, specialized factors involve heavy, sustained investment. They are more difficult to duplicate. This leads to a competitive advantage, because if other firms cannot easily duplicate these factors, they are valuable.

36. Demand Conditions
The more demanding the customers in an economy, the greater the pressure facing firms to constantly improve their competitiveness via innovative products, through high quality, etc.

37. Related Supporting Industries
Spatial proximity of upstream or downstream industries facilitates the exchange of information and promotes a continuous exchange of ideas and innovations.
Form ‘geographic cluster’ allows flow of knowledge. Eg- German textile & apparel sector.

38. Firm Strategy, Structure and Rivalry
Different management ideologies help or hinder build national competitive advantage. Eg- Japan vs USA managers.
Vigorous domestic rivalry and creation and persistence of competitive advantage are strongly associated. Domestic competition that impels firms to work for increases in productivity and reduce costs and make them better international competitors.

39. Evaluating Porter’s Theory
If Porter is right, country exports should reflect the presence of the four ‘diamond’ components. Countries will import goods from industries where some or all the components are missing.
Too soon to tell.
World Trade
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40. Implications for Business
Location implications: makes sense to disperse production activities to countries where they can be performed most efficiently.
First-mover implications: It pays to invest substantial financial resources in building a first-mover, or early-mover, advantage.
Policy implications: promoting free trade is generally in the best interests of the home-country, although not always in the best interests of the firm. Even though, many firms promote open markets.
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41. The role of government in Porter's Diamond Model
It is acting as a catalyst and challenger; it is to encourage - or even push - companies to raise their aspirations and move to higher levels of competitive performance.
They must encourage companies to raise their performance, stimulate early demand for advanced products, focus on specialized factor creation and to stimulate local rivalry by limiting direct cooperation and enforcing anti-trust regulations.

42. The Indian IT industry growth. A quick analysis:
Factor Conditions:
India had a large number of well trained engineers, who did not have much demand for their skills. Too many of engineers were running after very few jobs.

43. The Indian IT industry growth. A quick analysis:
Demand conditions :
The Indian IT market was very small but demanding, IBM etc. had moved out since they felt that their IP was not adequately protected. This was a window of opportunity for Indian firms. It also led to many with experience of having worked in high quality MNC's.

44. The Indian IT industry growth. A quick analysis:
Related and Supporting Industries:
Bangalore where it all started had a higher concentration of engineering talent than most other Indian cities, thanks to HAL (Hindustan Aeronautics Limited), IIS (Indian Institute of Science) and other such institutions.

45. The Indian IT industry growth. A quick analysis:
Firm Strategy, Structure and Domestic Rivalry:
As everyone knows there is cut-throat competition in the industry, both for clients and employees. As for structure, since these were new companies they did not inherit vast bureaucracies or hierarchical structures and could be quick, nimble and fleet footed to outfox the competition.

46. The Indian IT industry growth. A quick analysis:
The Role of Government :
In the case of India, the government has had a very negative role in terms of economic growth. Thanks to British colonial rule, followed by Nehruvian Fabianism, an entrenched bureaucracy (a British legacy) and a fascination with socialist centralized planning, the Indian entrepreneurial spirit had been suppressed for almost three centuries. The private sector therefore reacted to the absence of government hurdles/ road blocks as if it was active encouragement or promotion. The governments role in promoting the IIT (Indian Institute of technology)'s, REC (Rural Electrification Corporation Ltd (India)'s has however got to be acknowledged.

47. International Trade Theory
Evidence for the link between Trade and Growth
Jeffery Sach and Andrew Warner created a measure of how open to international trade an economy was and looked at the relationship between “openness’ and economic growth for a sample of more than 100 countries from
A study by Wacziarg and Welch updated Sachs and Warner data into the late 1990s. They found that over the period ( ) countries that liberalized their trade regimes experienced on average increases in their annual growth rates of 1.5 percent compared to pre liberalization times