1. International Trade Theories Chapter – “4”

2. International Trade “…free trade ultimately benefits all countries that participates in a free trade system. Those who take this position concede that some individuals lose as a result of a shift to free trade. But in the aggregate they argue that the gains outweigh the losses.” (Charles W. L. Hill 2005, p. 144)

3. Trade Theories 1. Mercantilism (Thomas Mun 1630) Countries should Encourage Exports & Discourage Imports. 2. Absolute Advantage (Adam Smith 1776) Explains why unrestricted free trade is beneficial to a Country. 3. Comparative Advantage (David Ricardo 1817) Efficiency of production. 4. Heckscher–Ohlin Theory (Eli Heckscher 1919 & Bertil Ohlin 1933) The Leontief Paradox (Wassily Leontief 1953)

4. Mercantilism Initial trade theory that formed the foundation of economic thought from 1500 – 1800 Based on concept that a nations wealth is measured by its holding of treasure (gold) Nations often imposed restrictions on imports since they did not want “their” treasure moving to another country to pay for the imports David Hume pointed out an inconsistency in the mercantilist doctrine in 1752 The flaw was that it viewed trade as a zero sum game.

5. Absolute Advantage Absolute advantage holds that different countries produce some goods more efficiently than other countries Thus, global efficiency can be increased through international free trade

6. Smith’s Basic Argument A country should never produce goods at home that it can buy at a lower cost from other countries. By specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade.

7. Basic Message of the theory of Comparative Advantage Potential world production is greater with unrestricted trade than with restricted trade. The trade is a positive sum games in which all countries that participate realize economic gains.

8. Ricardo’s Basic Argument A country can be benefited in the international trade if it specializes in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.

9. Assumptions Only two countries and two goods Transportation cost missing Exchange rate not considered Assumed resources can transfer freely Assumed constant return to specialization Free trade does not change efficiency with which the country uses its resources.

10. 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.

11. 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. 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.

12. Trade Theories (Continued) “New Trade Theory” Economies of Scale Per unit cost reductions associated with large scale of output. Learning Effects Cost savings that come from learning by doing. First-mover advantage Economic and Strategic advantages gained by entering early in an Industry.

13. Implications of New Trade Theories  Nations may benefit from trade even when they do not differ in resource endowments or technology.  The Aerospace Example

14. Factors of Comparative Advantage 1. Land 2. Location 3. Natural Resources (Minerals, Energy) 4. Labor, and 5. Local Population Size Porter says, sustained industrial growth has hardly ever been built on above mentioned basic inherited factors. Abundance of such factors may actually undermine competitive advantage! He introduced a concept of clusters or groups of interconnected firms, suppliers, related industries, and institutions that arise in particular locations Michael Porter

15. Porter’s Diamond Theory 1.Factor Endowments. 2.Demand Conditions. 3.Related Supporting Industries. 4.Firm Strategy, Structure and Rivalry.

16. Porter’s Diamond Theory

17. Factor Endowments/Conditions Contrary to conventional wisdom, Porter argues that the "key" factors of production (or specialized factors) are created, not inherited. Specialized factors of production are skilled labor, capital and infrastructure. "Non-key" factors or general use factors, such as unskilled labor and raw materials, can be obtained by any company and, hence, do 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.

18. 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.  Case Study: The Rise of Finland’s Nokia

19. Related Supporting Industries Spatial proximity of upstream or downstream industries facilitates the exchange of information and promotes a continuous exchange of ideas and innovations.

20. Firm Strategy, Structure and Rivalry The world is dominated by dynamic conditions, and it is direct competition that impels firms to work for increases in productivity and innovation)

21. 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.

22. 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.

23. 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.

24. 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, IIS and other such institutions.

25. 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.

26. 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's, REC's has however got to be acknowledged.

27. 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 1970-1990 A study by Wacziarg and Welch updated Sachs and Warner data into the late 1990s. They found that over the period (1950-1998) countries that liberalized their trade regimes experienced on average increases in their annual growth rates of 1.5 percent compared to pre liberalization times International Trade Theory