International Business

MMS – Sem III

International Trade Theories

An Overview Of Trade Theory• Mercantilism Free Trade

Encourage exports Unrestricted Free Trade

Comparative Advantage Heckscher-Ohlin 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.

• The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish). Others are not so easy to understand (Japan and cars).

• The history of Trade Theory and Government Involvement presents a mixed case for the role of government in promoting exports and limiting imports. Later theories appear to make a case for limited involvement.

An Overview of Trade Theory

• Explain why it is beneficial for a country to engage in international trade.

• Explain the pattern of international trade observed in the world economy.

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.

• 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.

• Assumes there is an absolute advantage balance among nations, e.g., Ghana/cocoa.

Theory of Absolute AdvantageAdam Smith: Wealth of Nations (1776).

1st British African colony to win independence (1957).Nkrumah espoused pan African socialism.High tariffs.Anti export (trade) policy.

Kept lowering tariffs on manufactured goods.Created incentives to export (trade).Reduced quotas.Reduced subsidies.1950s: 77% of employment in agriculture. Now 20%.Manufacturing GNP went from 10% to over 30%.

The Theory of Absolute Advantage

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The Theory of Absolute Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice

Ghana 10 20

Ghana 10.0 5.0

Production with Specialization

Ghana 20 0

S. Korea 0 20

Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice

Ghana 14.0 6.0

Increase in Consumption as a Result of Specialization and TradeGhana 4.0 1.0Korea 3.5 4.0

Resources Required to Produce 1 Ton of Cocoa and Ricece

Cocoa RiceGhana 10 20

S Korea 40 10Production and Consumption without Trade

Ghana 10.0 5.0Korea 2.5 10.0Total production 12.5 15.0

Production with Specialization

Ghana 20 0 Korea 0 20Total production 20 20

S. Korea 6.0 14.0

Assume 200 units

Each country devotes half resource

Theory of Comparative AdvantageDavid Ricardo: Principles of Political Economy (1817).

It makes sense for a country to specialize 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.

The Theory of Comparative Advantage

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Comparative Advantage and the Gains from Trade

S. Korea 40 20

S. Korea 2.5 5.0

S. Korea 0.0 10.0

S. Korea 4 6

Resources Required to Produce 1 Ton of Cocoa and Rice

Ghana 10 13.33

Production and Consumption without Trade

Ghana 10.0 7.5

Total production 12.5 12.5Production with Specialization

Ghana 15 3.75

Total production 15 13.75Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice

Ghana 11 7.75

Increase in Consumption as a Result of Specialization and Trade

Ghana 1.0 0.25S. Korea 1.5 1.0

Cocoa Rice

Ghana has absolute advantage

Ghana Comparative advantage is in Cocoa

Extensions of the Ricardian ModelImmobile resources:

Resources do not always move easily from one economic activity to another.

Diminishing returns:More a country produces, at some point, will require more resources (diminishing returns to specialization).

Different goods use resources in different proportions.However:

Free trade might increase a country’s stock of resources (as labor and capital arrives from abroad), and

Increase the efficiency of resource utilization.

Ghana’s PPF under Diminishing Returns

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The Influence of Free Trade on the PPFCo

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A Link Between Trade and Growth

Sachs and Warner: 1970 to 1990 study

Open economy developing countries grew 4.49%/year.Closed economy developing countries grew 0.69%/year.Open economy developed countries grew 2.29%/year.Closed economy developed countries grew 0.74%/year.

Frankel and Romer: On average, a one percentage point increase in the ratio of a country’s trade to its GDP increases income/person by at least 0.5%. For every 10% increase in the importance of international trade in an economy, average income levels will rise by at least 5%.

Heckscher (1919)-Olin (1933) Theory

• Labor is not the only Factor of production. We need to account for land, capital, and technology.

• Factor endowments: extent to which a country is endowed with such resources as land, labor, and capital.

• Export goods that intensively use factor endowments which are locally abundant.

• Corollary: import goods made from locally scarce factors.• Patterns of trade are determined by differences in factor

endowments - not productivity.• Remember, focus on relative advantage, not absolute

advantage.

• Disputes Heckscher-Olin in some instances.• Factor endowments can be impacted by

government policy - minimum wage.• US tends to export labor-intensive products,

but is regarded as a capital intensive country

The Leontief Paradox, 1953

• Article in the Quarterly Journal of Economics.• 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.

Product Life-Cycle Theory(Raymond Vernon, 1966)

• Began to be recognized in the 1970s.

• Deals with the returns on specialization where substantial economies of scale are present.

– Specialization increases output, ability to enhance economies of scale increase.

• In addition to economies of scale, learning effects also exist.– Learning effects are cost savings that come from “learning by doing”.

The New Trade Theory

• Typically, requires industries with high, fixed costs.

• World demand will support few competitors.• Competitors may emerge because “they got

there first”.• First-mover advantage.

• Some argue that it generates government intervention and strategic trade policy.

Application of the New Trade Theory

• The economic and strategic advantages that accrue to early entrants into an industry.

• Economies of scale may preclude new entrants.

• Role of the government.

First-Mover Advantage

• 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?”

Porter’s Diamond(Harvard Business School, 1990)

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

• Demand conditions:the nature of home demand for the industry’s product or service.

• Related and supporting industries:the presence or absence in a nation of supplier industries or related industries that are nationally competitive.

• Firm strategy, structure and rivalry: the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.

Determinants of National Competitive Advantage

• Success occurs where these attributes exist.– More/greater the attribute, the higher chance of

success.• The diamond is mutually reinforcing.

• The Diamond

Porter’s DiamondDeterminants of National Competitive Advantage

Factor Endowments

Firm Strategy,Structure and

Rivalry

Demand Conditions

Related and Supporting Industries

Determinants of National Competitive Advantage

Government

Company Strategy,Structure,

and Rivalry

DemandConditions

Relatedand Supporting

Industries

FactorConditions

Chance

Two external factors that influence the four determinants.

Factor Endowments

Taken from Heckscher-OlinBasic factors:

natural resourcesclimatelocationdemographics

Advanced factors:communicationsskilled laborresearchtechnology

Relationship of Basic to Advanced Factors

Basic can provide an initial advantage.Must be supported by advanced factors to maintain success.No basics, then must invest in advanced factors.

Demand Conditions

Demand creates the capabilities.Look for sophisticated and demanding consumers.

impacts quality and innovation.

Related and Supporting IndustriesCreates clusters of supporting industries that are internationally competitive.Must also meet requirements of other parts of the Diamond.

Firm Strategy, Structure and Rivalry

Management ‘ideology’ can either help or hurt you.Presence of domestic rivalry improves a company’s competitiveness.

Evaluating Porter’s TheoryIf Porter is right, we would expect his model to 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.Too soon to tell.

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.