Slide international business 6e by CHarless hill 07IBChapter 05

Overview of Trade 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

Chapter Five

International Trade Theory

Overview of Trade 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

Trade Theory-Overview

• 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

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: “zero-sum game”

Mercantilism-Zero-Sum Game

• In 1752, David Hume pointed out that:

- Increased exports lead to inflation and higher prices

- Increased imports lead to lower prices

• Result: Country A sells less because of high

prices and Country B sells more because of lower

prices

• In the long run, no one can keep a trade surplus

Theory of Absolute Advantage

• Adam Smith argued (Wealth of Nations, 1776):

Capability of one country to produce more of a product

with the same amount of input than another country

can vary

- 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

Theory of Absolute Advantage

Absolute Advantage and the

Gains From Trade

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

Theory of Comparative Advantage

Comparative Advantage and the

Gains From Trade

Simple Extensions of the

Ricardian Model

• Immobile resources:

- Resources do not always move easily from one

economic activity to another

• Diminishing returns:

- Diminishing returns to specialization suggests that

after some point, the more units of a good the country produces, the greater the additional resources

required to produce an additional item

- Different goods use resources in different proportions

Simple Extensions of the

Ricardian Model

• Free trade (open economies):

- Free trade might increase a country’s stock of

resources (as labor and capital arrives from abroad)

- Increase the efficiency of resource utilization

PPF Under Diminishing Returns

Influence of Free Trade on PPF

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

Product Life-Cycle Theory - R Vernon (1966)

• 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

Fig 4.5

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”

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

Theory of National Competitive Advantage

• The theory attempts to analyze the reasons for a

nation’s success in a particular industry

• Porter studied 100 industries in 10 nations

- Postulated determinants of competitive advantage of a

nation were based on four major attributes

• Factor endowments

• Demand conditions

• Related and supporting industries

• Firm strategy, structure and rivalry

Porter’s Diamond

• Success occurs where these attributes exist

• More/greater the attribute, the higher chance of

success

• The diamond is mutually reinforcing

Porter’s Diamond

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

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

Advanced Factor Endowments

people, companies, and government are more

likely to lead to competitive advantage

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

factors

Advanced Factor Endowments

Related and Supporting

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

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

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

Looking Ahead to Chapter 6

• The Political Economy of International Trade

- Instruments of Trade Policy

- The Case for Government Intervention

- The Revised Case for Free Trade

- Development of the World Trading System