Chapter 3 - International trade theory. This chapter examines the development of international trade theory from the seventeenth century through the second half of the twentieth century. The main goals of this chapter are to: Outline and critically evaluate the major theories that attempt to explain why nations should engage in international trade and the patterns of international trade; show, via simple examples, the case for free trade and how all countries can benefit from free trade;...
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Chapter 3 International trade theory
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Lecture plan
• Mercantilism
• Absolute advantage
• Comparative advantage
• Comparative advantage versus
competitive advantage
• Factor endowments
• The new trade theory
• Porter’s diamond
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Mercantilism: mid-16th century
• A nation’s wealth depends on accumulation of precious metals (e.g holdings of gold and silver).
• Theory says you should have a trade surplus
– maximise exports through subsidies
– minimise imports through tariffs and quotas.
• David Hume (1752): persistent trade surplus will affect money supply and in the long run close the trade surplus.
• Key problem: ‘zero-sum game’.
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Theories of international trade:
absolute advantage
• Exporting country holds superiority in availability of certain goods Reasons:
– climate, quality of land, and natural resources – differences in labour, capital, technology and – entrepreneurship
Beef Computer Printers
(tonnes) (units)
Japan 400 500
• Australia has an absolute advantage in beef, while Japan has an absolute advantage in printers.
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Theory of competitive advantage
• David Ricardo (1817)
• One country has a comparative advantage over another in the production of a certain commodity if its opportunity cost of
producing that commodity is lower
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Alternative production possibilities from 100 units of resources
Commodity
Country
Cheese (tonnes)
Cloth (bolts)
Source: Table 3.2
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Opportunity cost and comparative advantage
Production Australia UK
1 tonne of
cheese
0.8 bolts
of cloth
1.5 bolts of cloth
1 bolt of cloth 1.25 tonne
of cheese
0.67 tonnes
of cheese
Source: Table 3.3
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Diversified production before trade production/consumption
(units)
Cloth (bolts)
Source: adapted from Table 3.4
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Theory of comparative advantage and the gains from trade
Production and Consumption without Trade
Cheese (tonnes) Cloth (bolts)
Australia 125 60
UK 40 60
Total production 165 120
Production with Trade Specialisation
Australia 200
-UK - 120
Total production 200 120
Consumption after UK trades 60 bolts of cloth for 60 tons of Australian cheese
Australia 140 60
UK 60 60
Total consumption 200 120
Increase in consumption as a result of specialisation and trade
Australia 15 0
UK 20 0
Total consumption 35 0
Source: adapted from Table 3.5
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Comparative vs competitive
advantage
• Comparative advantage is a concept
based on relative costs of production (and opportunity cost) between nations
• Competitive advantage is a concept used
to compare the ability of two companies to compete in the same business
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Factor Endowments (Heckscher
and Ohlin)
• Explains differences in opportunity costs.
• Factor endowment: a country’s share of factors of
production (e.g land,capital, labour, enterprise).
• Countries will specialise in those goods which
make more intensive use of abundant/cheap
factors.
– cheese: land-intensive
– cloth: labour-intensive
• The theory can explain Australia-Japan trade
patterns.
• Explains difference in opportunity costs.
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Limitations of the trade theory
• The theory disregards a number of
considerations:
– the difficulty in moving resources in the desired industries
– fluctuations in demand
– trade barriers
– other political restraints
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The new trade theory
• Began to be recognised in 1970s.
• Deals with returns on specialisation where
substantial economies of scale are present.
– Specialisation increases output; ability to
enhance economies of scale increase.
– In some industries there are likely to be only a few profitable firms.
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The new trade theory cont.
• Thus firms with first mover advantages
will develop economies of scale and
create barriers to entry for other firms
• The commercial aircraft industry is an
excellent example (e.g Boeing, Airbus)
• New trade theory does NOT contradict
the theory of comparative advantage, but instead identifies a source of comparative advantage
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Implications from the application of 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
(e.g the need to nurture and protect ‘first movers’).
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National competitive advantage:
Porter’s diamond
(Harvard Business School, 1990)
• Looked at 100 industries in 10 nations
– thought existing theories didn’t go far
enough
• Results contained in The Competitive
Advantage of Nations.
• Question: ‘Why does a nation achieve
international success in a particular
industry?’ (e.g Switzerland in watches and pharmaceuticals; Finland in mobile
phones)
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Determinants of national
competitive advantage
Firm Strategy Structure, and Rivalry
Related and Supporting Industries
Demand Conditions
Factor
Endowments
Government Chance
Source: Fig 3.1
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Porter’s diamond
• Success occurs where these attributes
exist
• More/greater the attribute, the higher
chance of success
• The four attributes, government policy and chance work as a reinforcing system
• Nokia is a good example of a firm which has built its competitive advantage as a
result of factors in Porter’s diamond
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Evaluating Porter’s theory
• If Porter is right, his model is expected to
predict the pattern of international trade in the real world:
– a country’s exports should reflect the
presence of the four ‘diamond’
components – countries will import in those areas where the components are not favorable
• This theory is too new; requires
independent empirical testing