1. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea US EU Australia China Chapter 3: International Trade Theory Comparative advantage New Trade Theory 3-1 Absolute advantage Absolute advantage PORTER’S DIAMOND FACTOR ENDOWMENTS

2. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea TOPIC PLAN: l Mercantilism Absolute advantage l Comparative advantage l Comparative advantage versus competitive advantage l Factor endowments l The New Trade Theory l Porter’s Diamond 3-2

3. Mercantilism: mid-16 th century A nation’s wealth depends on accumulation of precious metals (e.g. holdings of gold and silver). l Theory says you should have a trade surplus. »Maximize exports through subsidies. »Minimize imports through tariffs and quotas. l David Hume (1752): persistent trade surplus will affect the money supply and in the long run close the trade surplus l Key problem: “Zero-sum game”. 3 - 3 Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea

4. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Theories of International Trade: Absolute Advantage l The exporting country holds a superiority in the availability of certain goods. Reasons: » Climate,quality of land, and natural resources. » Differences in labour, capital, technology and entrepreneurship Beef Computer Printers (tonnes) (units) Australia 800200 Japan 400 500 Australia has an absolute advantage in beef, while Japan has an absolute advantage in printers.. 3 -4

5. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Theory of Comparative Advantage l David Ricardo (1817) l One country has a comparative advantage over another in the production of a certain commodity if its opportunity cost of producing that commodity is lower 3.5

6. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Alternative production possibilities from 100 units of resources 3.6

7. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Opportunity Cost and Comparative Advantage 3.7

8. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Diversified production before trade Production/Consumption 3.8

9. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea The Theory of Comparative Advantage and the Gains from Trade Cheese (tonnes) Cloth (bolts) Production and Consumption without Trade Australia 125 60 U.K. 40 60 Total production 165 120 Production with Trade Specialization Australia 200 - U.K - 120 Total production 200 120 Consumption after U.K. Trades 60Bolts of Cloth for 60 tons of Australian Cheese Australia 140 60 U.K. 60 60 Increase in Consumption as a Result of Specialization and Trade Australia 15 0 U.K 20 0 3- 9 Total consumption 35 0

10. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Comparative versus Competitive Advantage l Comparative advantage is a concept based on relative costs of production (and opportunity cost) between nations. l Competitive advantage is a concept used to compare two company’s ability to compete in the same business. 3- 10

11. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Factor Endowments (Heckscher and Ohlin) l Explains differences in opportunity costs l Factor endowment: A country’s share of factors of production (e.g. land,capital, labour,enterprise). l Countries will specialise in those goods which make more intensive use of the abundant/cheap factors. » Cheese:land-intensive » Cloth: labour-intensive l The theory can explain the Australia-Japan trade patterns 3-11

12. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Limitations of the Trade Theory l The theory disregards a number of considerations : »The difficulty in moving resources in the desired industries »Fluctuations in demand »Trade barriers »Other political restraints 3-12

13. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea The New Trade Theory l Began to be recognised in the 1970s. l Deals with the returns on specialisation where substantial economies of scale are present. »Specialisation increases output, ability to enhance economies of scale increase. » In some industries there are likely to be only a few profitable firms. 3-13

14. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea The New Trade Theory l Thus firms with first mover advantages will develop economies of scale and create barriers to entry for other firms. l The commercial aircraft industry is an excellent example (eg. Boeing, Airbus) l New trade theory does NOT contradict the theory of comparative advantage, but instead identifies a source of comparative advantage 3-14

15. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Implications from the application of the New Trade Theory l Typically, requires industries with high, fixed costs. l World demand will support few competitors. l Competitors may emerge because “they got there first” »first-mover advantage. l Some argue that it generates government intervention and strategic trade policy (e.g. the need to nurture and protect “first movers”) 3-15

16. National Competitive Advantage: Porter’s Diamond ( Harvard Business School, 1990) l Looked at 100 industries in 10 nations. »Thought existing theories didn’t go far enough. l Results contained in The Competitive Advantage of Nations. l Question: “Why does a nation achieve international success in a particular industry?” (e.g. Switzerland in Watches and Pharmaceuticals; Finland in Mobile Phones) 3-16 Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea

17. Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Determinants of National Competitive Advantage Firm Strategy Structure, and Rivalry Related and Supporting Industries Demand Conditions Factor Endowments Government Chance 3-17

18. The Diamond l Success occurs where these attributes exist. »More/greater the attribute, the higher chance of success. l The four attributes, government policy and chance work as a reinforcing system. l Nokia is a good example of a firm which has built its competitive advantage as a result of factors in Porter’s diamond. 3-18 Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea

19. Evaluating Porter’s Theory l If Porter is right, his model is expected to predict the pattern of international trade in the real world: » a country’s exports should reflect the presence of the four ‘diamond’ components. » Countries will import in those areas where the components are not favorable. l This theory is too new. Requires independent empirical testing. 3-19 Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea