1 Trade Theory

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International Trade Theory


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International Trade Theory

What is international trade? Exchange of raw materials and manufactured goods

(and services) across national borders

Classical trade theories: explain national economy conditions--country

advantages--that enable such exchange to happen

New trade theories: explain links among natural country advantages,

government action, and industry characteristics thatenable such exchange to happen

Implications for International Business


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Trade Theory Timeline

Prentice Hall, 2006 International Business 3e Chapter 5 - 3


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Failed Theories

1. Mercantilism (trade surplus, govt

intervention, colonization, wealth focus)

2. Factor proportion theory (he who has most

capital sells capital intensive goods) vs.

Leontief paradox

3. Absolute advantage

4. Market and government failure



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Classical Trade Theories

Mercantilism (pre-16th century) Takes an us-versus-them view of trade

Other countrys gain is our countrys loss

Free Trade theories

Absolute Advantage (Adam Smith, 1776)

Comparative Advantage (David Ricardo, 1817)

Specialization of production and free flow of goods

benefit all trading partners economies

Free Trade refined

Factor-proportions (Heckscher-Ohlin, 1919)

International product life cycle (Ray Vernon, 1966)


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The New Trade Theory

As output expands with specialization, anindustrys ability to realize economies of scale

increases and unit costs decrease

Because of scale economies, world demand

supports only a few firms in such industries (e.g.,

commercial aircraft, automobiles)

Countries that had an early entrant to such an

industry have an advantage: Fist-mover advantage

Barrier to entry


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New Trade Theory

Global Strategic Rivalry

Firms gain competitive advantage through:

intellectual property, R&D, economies of

scale and scope, experience

National Competitive Advantage

(Porter, 1990)


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Mercantilism/Neomercantilism Prevailed in 1500 - 1800

Gold & Silver as currency of trade-Maximize wealth

Export more to strangers than we import to amass treasure,

expand kingdom

Colonies (source of RM-cheap imports + Mkt for FG)-surplus

Zero-sum vs positive-sum game view of trade Government intervenes to achieve a surplus in exports

subsidy(?)Importsduties(?)

King, exporters, domestic producers: happy

Citizens: unhappy (high taxes due to subsidies) domestic goods

stay expensive and of limited variety (high import duties)

Today neo-mercantilists = protectionists: some segments ofsociety shielded short term


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Mercantilism

Nations accumulate financial wealth byencouraging exports and discouraging imports


Three pillars

Maintain trade

surplus

Government

intervention

Exploit colonies

Inherent flaws

World trade is

zero-sum game

Constrains outputand consumption

Limits colonies

market potential


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Absolute Advantage Adam Smith: The Wealth of Nations, 1776

Mercantilism weakens country in long run; enriches only a few A country

Should specialize in production of and export products for which ithas absolute advantage; import other products

Has absolute advantage when it is more productive than another

country in producing a particular product

Rice

CocoaG

G'

K

K'

G: Ghana

K: S. Korea


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Absolute Advantage

Ability of a nation to produce a good more efficiently than any other nation

(greater output using same or fewer resources)


Specialization and trade allows each to produce and

consume more

1 resource unit = 1 ton riceor

1/5 ton tea

Riceland

1 resource unit = 1/6 ton riceor

1/3 ton tea

Tealand


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Trade Gains:

Absolute Advantage



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Comparative Advantage

David Ricardo: Principles of PoliticalEconomy, 1817

Country should specialize in the production of thosegoods in which it is relatively more productive... evenif it has absolute advantage in all goods it produces

Absolute Advantage is a special case ofComparative Advantage

Rice

CocoaG

K

K' G'

G: Ghana

K: S. Korea


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Inability of a nation to produce a good more efficiently than other nations,but an ability to produce that good more efficiently than it does any other

good


Specialization and trade allows each to produce and

consume more

1 resource unit = 1 ton rice or

1/2 ton tea

Riceland

1 resource unit = 1/6 ton rice or

1/3 ton tea

Tealand


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Trade Gains:




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Assumptions and Limitations

1. Nations strive only to maximize production

and consumption

2. Only two countries produce and consume

just two goods

3. No transportation costs of trading goods

4. Labor is the only resource used to produce

goods

5. Ignores efficiency and improvement gains

from producing just one good



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Factor Proportions Theory

Countries produce and export goods that require resources

(factors) in abundance, and import goods

that require resources in short supply


Two factor types

Land and CapitalLabor


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Leontief Paradox

Research discovered evidence opposite the prediction of

factor proportions theory

US exports are more labor-intensive than US imports


Possible explanation

Theory assumes nations production factors

to be homogeneous Theory is better predictor when expenditures

on labor are considered


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International Product Life-Cycle (Vernon)

Most new products conceived / produced in the US in 20th

century US firms kept production close to their market initially

Aid decisions; minimize risk of new product introductions

Demand not based on price; low product cost not an issue

Limited initial demand in other advanced countries initially Exports more attractive than overseas production

When demand increases in advanced countries, production

follows

With demand expansion in secondary markets Product becomes standardized (commodity ?)

production moves to low production cost areas

Product now imported to US and to advanced countries

CritiqueUS is no longer the sole innovator of products / services


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International Product Life Cycle


A company begins by exporting its product and later undertakes foreign

direct investment as a product moves through its life cycle


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New Trade Theories

Increasing returns of specialization due to economies

of scale (unit costs of production decrease)

First mover advantages (economies of scale such that

barrier to entry created for second or third company)

Luck... first mover may be simply lucky.

Government assistance to home-based firms: strategic

trade policy


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New Trade Theory


Fundamentals

Gains from specialization andincreasing economies of scale

Companies first to market

create barriers to entry

Government may help byassisting home companies

First-mover advantage

Economic and strategic

advantage of being first to enter

an industry

May create a formidable barrier

to market entry for potentialrivals


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National Competitive Advantage(Porter, 1990)

Factor endowments land, labor, capital, workforce, infrastructure

(some factors can be created...)

Demand conditions large, sophisticated domestic consumer base: offers an

innovation friendly environment and a testing ground

Related and supporting industries local suppliers cluster around producers and add to

innovation

Firm strategy, structure, rivalry competition good, national governments can create

conditions which facilitate and nurture such conditions


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National Competitive Advantage


Nations competitiveness in an industry depends on the industrys capacity to

innovate and upgrade, which in turn depends on four main determinants

(plus government and chance)

Factor conditions

Demand conditions

Firm strategy, structure and rivalry

Related and supporting industries


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Porters Diamond


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Factor Conditions


Basic factorsAdvanced factorscreated not

inherited

Nations resources

(land, large workforce, natural

resources, climate and surface

features)

Result of investing in

education and innovation

(skill of workforce segments,

capital, technological infrastructure)

Basic factors can spark initial production, but advanced

factors account for sustained competitive advantage-

difficult to replicate / copy


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Demand Conditions


Sophisticated home-market buyers

drive companies to improve existing

products and develop entirely newproducts and technologies-leading to

global leadershipeg.French Wines,

Italian Leather products

This should improve the

competitiveness of the entire group of

companies in a market


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Related and Supporting Industries


Companies in an internationally competitive industry

do not exist in isolation

Supporting industries form clusters of economic

activity in the geographic areaJt research / problem-

solving , sharing of knowledge etc.

Each industry reinforces the competitiveness of every

other industry in the cluster


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Firm Strategy, Structure

and Rivalry Highly skilled managers are

essential because strategyhas

lasting effects on firmcompetitiveness

Domestic industry whose

structure and rivalrycreate an

intense struggle to survive,

strengthens its competitiveness



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So What for business?

First mover implications

Location Implications

Foreign Investment Decisions

GovernmentPolicy implications-fostering competition

Chance eventswar, major tech breakthrough, fluctuations in

exchange-rates, sudden drop in demand etc.

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1 Trade Theory