1. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 chapter three Concept Preview After reading this chapter, you should be able to: 1. understand the theories that attempt to explain why certain goods are traded internationally 2. comprehend the arguments for imposing trade restrictions 3. explain the two basic kinds of import restrictions: tariff and nontariff barriers 4. state the agreements reached during the Uruguay Round 5. appreciate the relevance of the changing status of tariff and nontariff barriers to businesspeople Economic Theories on International Trade, Development, and Investment

2. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 chapter three Concept Preview continued After reading this chapter, you should be able to: 6. recognize the weakness of GNP/capita as an economic indicator 7. identify the common characteristics of developing nations 8. understand the new definition of economic development which includes more than economic growth 9. understand why some governments are changing from an import substitution strategy to one of export promotion and the implications of this change for businesspeople 10. explain some of the theories of foreign direct investment Economic Theories on International Trade, Development, and Investment

3. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-3 Economic Theories of International Trade  International trade theory  Mercantilism  Absolute Advantage  Comparative Advantage  Heckscher-Ohlin Theory of Factor Endowment  Trade restrictions  Economic development  International investment theories

4. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-4 Theory of Mercantilism  Essential to a nation’s welfare to accumulate a stock of precious metals  Viewed as the only source of wealth  Mercantilists era ended in 1700’s  A “favorable” trade balance still means that a nation exports more goods and services than it imports  Modern-day economic nationalism, industrial policy based on heavy state intervention  France nationalized key industries to make the state  stockholder and financier  customer and marketer  policy reversed in 1986

5. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-5 Theory of Absolute Advantage  Adam Smith claimed market forces, not government controls, should determine the direction, volume, and composition of international trade  Under free (unregulated) trade each nation should specialize in producing those goods it could produce most efficiently  Nation capable of producing more of a good with the same input than another nation  An absolute advantage—either natural or acquired  Some goods exported to pay for imports of goods that could be produced more efficiently elsewhere

6. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Theory of Absolute Advantage CommodityUSJapanTotal Tons of Rice314 Automobiles246  Assumes perfect competition and no transportation costs in a world of two countries and two products  One unit of input (combination of land, labor, and capital)  Each nation has two input units it can use to produce either rice or automobiles  Each country uses one unit of input to produce each product 3-6

7. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 CommodityUSJapanTotal Tons of Rice606 Automobiles088  Each nation produces only the product at which it is most efficient  With the same quantity of input units — the total output is greater 3-7 Theory of Absolute Advantage (each country specializes)

8. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Theory of Absolute Advantage Terms of trade (ratio of international prices) CommodityUSJapanTotal Tons of Rice336 Automobiles448  With specialization the total production is greater but to consume both products the countries must trade some of their surplus  What are the limits within which the countries are willing to trade?  Japan will trade if they can get more than 1 ton of rice they get in Japan for 4 cars  American rice growers will trade their rice for Japan automobiles for less than 1.5 cars it costs in US  1.25 tons of rice per car is equal benefit 3-8

9. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Theory of Absolute Advantage (gains from specialization and trade) CommodityUSJapan Tons of Rice2 Automobiles2  Both nations gain by trading  Each nation specialized in producing the product in which it was more efficient  Traded its surplus for goods it could not produce as efficiently  What is one country has an absolute advantage in the production of both rice and automobiles?  Will there still be a basis for trade? 3-9

10. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Theory of Comparative Advantage  Ricardo 1817  Even though a nation holds an absolute advantage in the production of two goods  The two countries can still trade with advantages  The less efficient nation is not equally less efficient in the production of both goods 3-10

11. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Theory of Comparative Advantage CommodityUSJapanTotal Tons of Rice639 Automobiles549 Compared to the US, Japan is less inefficient in automaking  Japan has a relative or comparative advantage 3-11 Theory of Comparative Advantage (each country specializes) CommodityUSJapanTotal Tons of Rice12012 Automobiles 08 8

12. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Theory of Comparative Advantage (terms of trade) CommodityUSJapan Tons of Rice84 Automobiles44  Terms of trade will be somewhere between 1 ton of rice for 5/6ths of an auto that American rice growers must pay in the US  Terms of trade will be 1 1/3 automobiles Japanese automakers must pay for 1 ton of Japanese rice 3-12 CommodityUSJapan Tons of Rice64 Automobiles64  This left the US with some surplus rice and one less automobile than before  Japan has more rice and the same quantity of automobiles  American rice growers should be able to trade 2 tons of surplus rice for 2 automobiles elsewhere

13. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Theory of Comparative Advantage (gains from specialization and trade) CommodityUSJapan Tons of Rice1 Automobiles1 3-13

14. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-14 Heckscher-Ohlin Theory of Factor Endowment  International and interregional differences in production costs occur because of differences in the supply of production factors  Goods that require a large amount of the abundant (thus less costly) factor will have lower production costs  Enables them to be sold for less in international markets  Prices only depend on the factor endowment  this is not true-factor prices are not set in a perfect market  legislated minimum wages I

15. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-15 Heckscher-Ohlin Theory of Factor Endowment  Ohlin assumed a given technology was universally available  Superior technology often permits a nation to produce at lower costs  Assumed a given product was either labor- or capital-intensive  Heckscher-Ohlin ignored transportation costs II

16. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-16  Leontief Paradox (1953)  The U.S., one of the most capital-intensive countries of the world, exports labor-intensive products.  The U.S. exports technology-intensive products produced by highly skilled labor requiring a large capital investment to educate and train.  The U.S. imports goods made with mature technology requiring capital-intensive mass production processes operated by unskilled labor.  Economists Assumptions  differences in taste (preferences) are neglected  marketers cannot ignore  because of ‘taste’ products flow in a direction completely contrary to international trade theory Heckscher-Ohlin Theory of Factor Endowment III

17. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 International Trade Theory-Money Price per Unit CommodityUnited StatesJapan  Total cost of land, labor, and capital to produce the daily output of rice or automobiles is $10,000 in the US and 2.5 million yen in Japan.  To determine if it is more advantageous to buy locally or import traders need an exchange rate to determine prices in their own currencies. 3-17

18. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 International Trade Theory-Money (exchange rate) Price per Unit (dollars) Commodity United States Japan Ton of Rice$3,330$10,000 Automobiles 5,000 2,500 Price per Unit (yen) Commodity United States Japan Ton of Rice0.83 million yen2.5 million yen Automobiles 1.25 million yen0.625 million yen 3-18  Influence of exchange rate  Currency devaluation  lower its prices in terms of other currencies

19. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-19 Some Newer Explanations for the Direction of Trade  Economies of scale and the experience curve  most industries benefit from economies of scale  as a firm produces more products it learns ways to improve production  First mover theory  firms that enter the market first will soon dominate it  Linder theory of overlapping demand  another explanation is needed to explain trade in manufactured goods  tastes are strongly affected by income levels— therefore a nation’s per capita level determines the kinds of goods they will demand

20. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-20 Porter’s Competitive Advantage of Nations  Demand conditions  nature of the domestic demand  Factor conditions  level and composition of factors of production  Related and supporting industries  suppliers and support services  Firm strategy, structure and rivalry  the extent of domestic competition, barriers to entry, and firms’ management style and organization

21. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Arguments for Trade Restrictions  National defense  certain industries need protection from imports because they are vital to national defense  Infant industries  in the long run these firms will have a comparative advantage but these firms need protection from imports until labor i trained  eventually protection will not be needed  Protect domestic jobs  projectionists argue that low foreign hourly wages will produce cheap goods and flood local market  wage costs are not all the costs of production  Scientific tariff or fair competition  want to eliminate “unfair” advantage that a foreign competitor might have due to superior technology, low raw material costs, lower taxes or lower labor costs  “equalize” the process for fair competition  Retaliation  industry that has exports with import restrictions placed by another country want retaliation with similar restrictions 3-21

22. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Trade Restrictions  Dumping—sell a product abroad…  for less than the cost of production  the price in the home market  the price to third countries  New types of dumping—unfair competition caused by…  social dumping--firms in developing nations that have lower labor costs and poorer working conditions  environmental dumping--a country’s lax environmental standards  financial services dumping--a nation’s low requirements for bank capital/asset ratios  cultural dumping--cultural barriers aiding local firms 3-22 I

23. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-23 II Trade Restrictions  Subsidies  A government makes to firms either to encourage exports or to protect it from imports  Cash payments  Government participation in ownership  Low-cost loans to foreign buyers and exporters  Preferential tax treatment  Countervailing duties  offset the effects of a subsidy  Other arguments for trade restrictions  permit diversification of the domestic economy  improve the balance of trade

24. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Number of countervailing Duty (CD) and Antidumping (AD) Measures in Force by GATT Members Measures & Country 1990199119921993 CD measures United States948793122 European Union (12)—1—2 Canada31302929 Australia1 51212 Brazil—11313 Chile—240 New Zealand———1 AD measures United States201216267304 European Union (12)137144159150 Canada78697385 Australia24 304476 Brazil6192328 Other12193338 Note: — = not available. Source: A. Chapman and Po-Ye Lee, “Canadian and International Use of Anti-Dumping and Countervailing Measures,” Research Branch, Canadian International Trade Tribunal, July 1995, p. 14. 3-24 Table 3.1

25. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-25 III Trade Restrictions  Tariffs  Ad Valorum-a percentage of the invoice value  Specific-fixed sum of money charged for a physical unit  Compound—combination of ad valorum and specific  Official prices  price used by customs when actual invoice price is lower  Variable levy  Lower duty for more local input  Non-tariff barriers  Quantitative  quotas-numerical limit for a specific type of good  tariff-rate quotas  Non Quantitative  direct government participation in trade  customs and other administrative procedures  standards  Costs of barriers to trade

26. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Tariff barriersNontariff Barriers Import dutiesQuantitative  Ad valoremQuotas  Specific  Tariff-rate quotas  Compound  Global  Variable levies  Discriminatory Official prices Voluntary export restrictions Orderly marketing arrangements Nonquantitative Direct government participation in trade  Subsidy  Buy domestically  Import licenses  Manipulation of exchange rates  Local content requirements Customs and other administrative procedures  Tariff classifications  Documentation requirements  Product valuation standards  Health, safety, and product quality  Packaging and labeling  Product testing methods Kinds of Import Restrictions 3-26 Table 3.2

27. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-27 Economic Development  Levels of economic development—World Bank  low income ($750 or less)  lower middle income ($766-$3,035)  upper middle income ($3,036-$9,385)  high income ($9,385 or more)  GNP/capita as an economic indicator  underground economy  currency conversion  Purchasing Power Parity  number of units of a currency required to buy the same amounts of goods and services in the domestic market as one dollar would buy in the U.S.

28. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-28 Annual Costs to American Consumers for Import Protection Cost per American Number ofTotal Cost Product GroupJob SavedJobs Involved ($ million) Benzoid Chemicals$1,000,000216$ 216 Luggage 933,628226 211 Softwood Lumber758,678605 459 Sugar 600,1772,2611,357 Polyethylene resins590,604298 176 Dairy Products497,8972,3781,184 Frozen Con. O.J.461,412609 281 Ball bearings438,356146 64 Maritime415,3254,4111,832 Ceramic tiles400,576347 139 Machine tools348,349169 59 Apparel & textiles340,72712,6244,301 Source: Gary C Hufbauer and Kimberley Ann Elliott, Measuring the Cost of Protection in the United States (Washington, D.C.: Institute for International Economics, 1994), pp. 11-13. Table 3.3

29. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-29 Underground Economies (percentage of GDP, 1994) Figure 3.4 Source: “Light on the Shadows,” The Economist, May 3, 1997, p. 64.

30. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-30 Table 3.4 GNP/Capita based on UN ICP for Selected Countries in 1994 GNP/Capita in US$ GNP/Capita in US$ based Converted at World Bankon Purchasing Power CountryAdjusted Exchange Rates Parity (PPP) Switzerland$37,930$25,150 Japan 34,630 21,140 Denmark 27,970 19,880 Norway 26,390 20,210 USA 25,880 25,880 Mexico 4,180 7,040 Indonesia 880 3,600 China 530 2,510 India 320 1,280 Uganda 190 1,410 Source: World Development Report 1996, Table 1, pp. 188-89.

31. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Economic Development Common Characteristics of Developing Nations  GNP/capita <$6,000  Unequal distribution of income  Technological dualism  Regional dualism  >80% agriculture and/or unproductive agriculture  Disguised unemployment or underemployment  High population growth (2.5—4.0% annually)  High illiteracy  High malnutrition rates and poor health  Political instability  Reliance on few products for export  Difficult topography  Low savings rate 3-31

32. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-32 Economic Development Human-needs Approach  Defines economic development as the elimination of poverty and unemployment as well as increases in income  Long and healthy life  Ability to acquire knowledge  Access to resources needed for a decent standard of living  Elements measured by:  life expectancy  adult literacy  GDP/capita  Investment in human capital  more than just capital accumulation is needed for growth  must be investment in education of people  managers can ensure capital is productive  can maintain the capital equipment

33. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-33 Economic Development  Import substitution  local production of goods to replace imports  a method for developing countries to lessen their dependence on developed countries  protection granted to local industries  local manufacturers feel no pressure to become competitive in world markets  domestic firms that must buy from local suppliers cannot export due to excessive costs

34. section one Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 3-34 International Investment Theories  Monopolistic Advantage Theory (Stephen Hymer)  foreign direct investment occurred largely in oligopolistic industries rather than in industries operating in near-perfect competition  Product and Factor Market Imperfections (Caves)  superior knowledge permits the investing firm to produce differentiated products that consumers would prefer to locally made goods  International Product Life Cycle  foreign direct investment is a natural stage in the life of a product  Follow-the-leader (Knickerbocker)  when one firm, especially the leader in an oligopolistic industry, entered a market, other firms in the industry followed (defensive strategy)  Cross-investment (Graham)  in certain oligopolistic industries, European firms tended to invest in the US when American firms had gone to Europe  Internationalization  extension of the market imperfection theory  a firm has superior knowledge, but it may obtain a higher price for that knowledge by using it than by selling it in the open market  Dunning’s Eclectic Theory of International Production  ownership specific— the extent to which a firm has or can get tangible and intangible assets not available to other firms  internalization—in the firm’s best interests to use its ownership-specific advantages (internalize) rather than license them to foreign owners (externalize)  location-specific— the firm will profit by locating part of its production facilities overseas