INTERNATIONAL ECONOMICS

International Trade TheoriesLecture 3

The Importance of Trade Theory

Trade theory helps managers and government policymakers focus on three critical questions;

What products should we import and export?How much should we trade?With whom should we trade?

While descriptive theories suggest a laissez-faire treatment of trade, prescriptive theories suggest that governments should influence trade patterns.

What is laissez- faire????

Trade and Investment Policies

Import substitution: a policy of developing domestic industries to manufacture goods and provide services that would otherwise be imported

Strategic trade policy: the identification and development of targeted domestic industries in order to improve their competitiveness at home and abroad

International Trade TheoriesInterventionist TheoriesMeaning that government intervention in trade or trade related aspects;

Mercantilism Neo-mercantilism

Free Trade TheoriesWhich supports the argument of nations should neither artificially limit imports or promote exports;

Absolute advantage Comparative advantage

International Trade Theories cont…Theories Explaining Patterns of Trade

Theories which examine trade patterns such as; How much countries depend on trade, what products they trade and with which partner nations they trade, etc…Country SizeFactor proportionCountry similarity

Theories dealing with dynamics & stability of countriesProduct Life CyclePorter Diamond

Interventionist TheoriesInterventionist trade theories prescribe government action with respect to the international trade process.

Mercantilism: A theory that purports that a country’s wealth ismeasured by its holdings of treasure (usually gold)

To amass a surplus (a favorable balance of trade), a country must export more than it imports and then collect gold and other forms of wealth from countries that run trade deficits (unfavorable balances of trade).

Neomercantilism: the more recent strategy of countries that use protectionist trade policies in an attempt to run favorable balances of trade and/or accomplish particular social or political objectives.

Free Trade Theories:Absolute Advantage

Absolute advantage [Adam Smith, 1776]: A country can;

(i) maximize its own economic well being by specializing in the production of those goods and services that it produces more efficiently than any other nation and

(ii) Enhance global efficiency through its participation in free trade.

Free Trade Theories:Absolute Advantage cont…

Smith reasoned that:Workers become more skilled by repeating

the same tasksWorkers do not lose time in switching from

the production of one kind of product to another

Longer production runs provide greater incentives for the development of more effective working methods

Natural vs. Acquired AdvantagesA natural advantage may exist because of:

given climatic conditionsaccess to particular resourcesthe availability of labour, etc.

An acquired advantage may exist because of:superior skillsbetter technologygreater capital assets, etc.

Real income depends on the output of products as compared to the resources used to produce them.

Free Trade Theories:Comparative Advantage

Comparative advantage [David Ricardo, 1817]:A country can;

(i) maximize its own economic wellbeing by specializing in the production of those goods and services it can produce relatively efficiently and

(ii) enhance global efficiency via its participation in free trade.

Free Trade Theories:Comparative Advantage cont...

Ricardo also reasoned that:A country can simultaneously have an absolute

and a comparative advantage in the production of a given product.

By concentrating on the production of the product in which it has the greater advantage, a country can further enhance both global output and its own economic well-being

Production Possibilities with comparative advantage

Assumptions and Limitations of free trade theories

The theories of absolute and comparative advantage both make assumptions that may not be entirely valid.

Full employment of resources Exclusive pursuit of economic efficiency

objectives Equitable division of gains from

specialization Only two countries and two commodities Exclusion of transport costs A static rather than a dynamic view Exclusion of services Unrestricted factor mobility

Theories Explaining Patterns of Trade: Country Size/How much a country trade?

Large countries differ from small countries in at least two critical ways:

Large countries tend to export a smaller portion of their output and import a small portion of their consumption.

Large countries are more apt to have varied climates and a greater assortment of natural resources than smaller countries, thus making large countries more self-sufficient.

Large countries tend to have higher transportation costs for exported and imported products.

Given the same types of terrain and modes of transportation, the greater the distance, the higher the associated transport costs. Thus, firms in large countries often face higher transport costs in terms of sourcing inputs from and delivering outputs to distant foreign markets than do their closer foreign competitors.

Leading 2003 Exporting and Importing Nations: Merchandise Trade

Theories Explaining Patterns of Trade: Factor Proportions Theory/What type of products

Factor proportions [Eli Heckscher, 1919; Bertil Ohlin, 1933]:

Differences in a country’s relative endowments of land, labour, and capital explain differences in the cost of production factors.

A country will tend to export products that utilize relatively abundant production factors because they are relatively cheaper than scarce factors.The composition of a country’s trade depends on both its natural and acquired advantages. With respect to the latter, both production and product technology can

be very important.

World Trade by Major Product Category as a Percentage of World Trade for Selected Years

Source: International Trade Statistics, 2004 (Geneva: World Trade Organization)

Country Similarity TheoryWhen a firm develops a new product in response to observed conditions in its home market, it is likely to turn to those foreign markets that are most similar to its domestic market when commencing its initial international expansion activities. This tendency is reflective of:the cultural similarity of nationsthe similarity of national political/economic

intereststhe economic similarity of industrialized

countriesCountries that are near to one another enjoy relatively lower transportation costs than those that are more distant, but they may or may not be similar with respect to culture, level of economic development, and/or political/economic interests.

Product Life Cycle (PLC) TheoryThe optimal location for the production of certain

types of goods and services shifts over time as they pass through the stages of: (i) introduction, (ii) growth, (iii) maturity, and (iv) decline.

Exceptions to the typical pattern of the PLC would include:products that have very short life cyclesluxury goods and servicesproducts that require specialized labourproducts that are differentiated from competitive

offeringsproducts for which transportation costs are relatively

highDuring the decline stage, a product is often imported by the country where it was initially developed; however, the importing firm may or may not be the innovating firm.

Porter’s Diamond of NationalCompetitive Advantage [1990]

The Porter Diamond theorizes that national competitive advantage is embedded in four determinants:factor endowmentsdemand conditionsrelated and supporting industriesfirm strategy, structure, and rivalry

All four determinants are interlinked and generally must be favourable for a given national industry to attain global competitiveness.At times, determinants can be affected by the roles of chance and government.

Implications/ConclusionsProduction factors are neither as mobile nor

as immobile as theories assume.While the free trade theories of absolute and

comparative advantage are descriptive in nature, the interventionist theories of mercantilism and neomercantilism are prescriptive in nature.

The theories of country size, factor proportions, and country similarity help explain patterns of trade; the product life cycle and Porter’s Diamond help explain the dynamics of trade.