international trade theories

Theories

of

International

Trade

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Learning Objectives To understand the traditional arguments

of how and why international trade improves the welfare of all countries

To review the history and compare the implications of trade theory from the original work of Adam Smith to the contemporary theories of Michael Porter

To examine the criticisms of classical trade theory and examine alternative viewpoints of which business and economic forces determine trade patterns between countries

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Evolution of Trade Theories

Mercantilism Absolute advantage (Classical) Comparative advantage Factor Proportions Trade International Product Cycle New Trade Theory National competitive advantage

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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 export through subsidies. Minimize imports through tariffs

and quotas Flaw: restrictions, impaired growth

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Defining mercantilism …

… trade theory holding that nations should accumulate financial wealth, usually in the form of gold (forget things like living standards or human development) by encouraging exports and discouraging imports

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Theory of absolute advantage

Adam Smith: Wealth of Nations (1776) argued: Capability of one country to produce more of

a product with the same amount of input than another country

A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient

Trade between countries is, therefore, beneficial Assumes there is an absolute balance among

nations

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Theory of absolute advantage

… destroys the mercantilist idea since there are gains to be had by both countries party to an exchange

… questions the objective of national governments to acquire wealth through restrictive trade policies

… measures a nation’s wealth by the living standards of its people

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Theory of absolute advantage

PPF – Production Possibility Frontier

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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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Theory of comparative advantage

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Comparative advantage and the gains from trade

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Comparative advantage: Bollywood

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Assumptions and limitations

Driven only by maximization of production and consumption

Only 2 countries engaged in production and consumption of just 2 goods?

What about the transportation costs? Only resource – labour (that too, non-

transferable) No consideration for ‘learning theory’

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Factor proportions theory

Heckscher (1919) - Olin (1933) Theory Export goods that intensively use factor endowments

which are locally abundant Corollary: import goods made from locally

scarce factors Note: Factor endowments can be impacted by

government policy - minimum wage Patterns of trade are determined by differences in

factor endowments - not productivity Remember, focus on relative advantage, not absolute

advantage

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Factor proportions theory

… trade theory holding that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply

Example: Australia – lot of land and a small population

(relative to its size) So what should it export and import?

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Factor Proportions Trade TheoryConsiders Two Factors of Production

Labor

Capital

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Factor Proportions Trade Theory

A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive)

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The Leontief Paradox

The Test: Could Factor Proportions Theory be used

to explain the types of goods the United States imported and exported?

The Method:Input-output analysis

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The Leontief Paradox

The Findings:The U.S. exported labor-intensive products and imported capital-intensive products.

The Controversy:Findings were the opposite of what was generally believed to be true!

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Product life-cycle TheoryR.Vernon (1966)

… trade theory holding that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its lifecycle

As products mature, both location of sales and optimal production changes

Affects the direction and flow of imports and exports

Globalization and integration of the economy makes this theory less valid

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Product life cycle theory

Fig 4.5

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The Product Cycle and Trade Implications

Increased emphasis on technology’s impact on product cost

Explained international investment Limitations

Most appropriate for technology-based products

Some products not easily characterized by stages of maturity

Most relevant to products produced through mass production

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New trade theory

In industries with high fixed costs: Specialization increases output, and the

ability to enhance economies of scale increases

Learning effects are high. These are cost savings that come from ‘learning by doing’

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New trade theory - applications

Typically, requires industries with high, fixed costs World demand will support few competitors

Competitors may emerge because of “ First-mover advantage” Economies of scale may preclude new entrants Role of the government becomes significant

Some argue that it generates government intervention and strategic trade policy

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Theory of national competitive advantage

The theory attempts to analyze the reasons for a nations success in a particular industry

Porter studied 100 industries in 10 nations postulated determinants of competitive advantage

of a nation based on four major attributes Factor endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry

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Porter’s 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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Factor endowments

Factor endowments:- A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry

Basic factor endowments Advanced factor endowments

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Basic factor endowments

Basic factors: Factors present in a country Natural resources Climate Geographic location Demographics

While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success

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Advanced factor endowments

Advanced factors: Are the result of investment by people, companies, government and are more likely to lead to competitive advantage

If a country has no basic factors, it must invest in advanced factors

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Advanced factor endowments

communications skilled labor research Technology education

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Demand conditions

Demand: creates capabilities creates sophisticated

and demanding consumers

Demand impacts quality and innovation

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Related and supporting industries

Creates clusters of supporting industries that are internationally competitive

Must also meet requirements of other parts of the Diamond

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Firm Strategy, Structure and Rivalry

Long term corporate vision is a determinant of success

Management ‘ideology’ and structure of the firm can either help or hurt you

Presence of domestic rivalry improves a company’s competitiveness

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Determinants of Competitive Advantage in nations

GovernmentGovernment

Company Strategy,Structure,

and Rivalry

DemandConditions

Relatedand Supporting

Industries

FactorConditions

ChanceChance

Two external factors that influence the four determinants.

Fig 4.8

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Porter’s Theory-predictions

Porter’s theory should predict the pattern of international trade that we observe in the real world

Countries should be exporting products from

those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable

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Implications for business

Location implications: Disperse production activities to countries

where they can be performed most efficiently First-mover implications:

Invest substantial financial resources in building a first-mover, or early-mover advantage

Policy implications: Promoting free trade is in the best interests of the

home-country, not always in the best interests of the firm, even though, many firms promote open markets

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India in the global competitiveness report