3 - 5 Theories of International Trade

7/30/2019 3 - 5 Theories of International Trade

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Key Issues

Why do nations trade with each-other? How do different theories explain trade flows? How does free trade raise the economic welfare

of all participating nations? Any disagreements? Can government actively influence a countrys

competitive advantage?

Why is an understanding of trade theoryimportant for managers?

Sunday, December 09, 2012 2Dr. S. Jain


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The Economic Basis for Trade:Comparative Advantage

David Ricardos theory of comparativeadvantage , which he used to argue againstthe corn laws, states that specialization andfree trade will benefit all trading partners (realwages will rise), even those that may beabsolutely less efficient producers.

Dr. S. JainSunday, December 09, 2012 4


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Absolute Advantageversus Comparative Advantage

A country enjoys an absolute advantage overanother country in the production of aproduct when it uses fewer resources toproduce that product than the other countrydoes.



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Gains from Mutual AbsoluteAdvantage

Yield Per Acre Of Wheat And Cotton

NEW ZEALAND AUSTRALIA

Wheat 6 bushels 2 bushelsCotton 2 bales 6 bales

New Zealand can produce three times the wheat that Australia can on one acre of land, and Australia canproduce three times the cotton.

We say that the two countries have mutual absolute advantage.


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Total Production Of Wheat And Cotton Assuming No Trade,Mutual Absolute Advantage, And 100 Available Acres


Wheat25 acres x 6 bushels/acre

150 bushels75 acres x 2 bushels/acre

150 bushels

Cotton 75 acres x 2 bales/acre150 bales

25 acres x 6 bales/acre150 bales

Suppose that each country divides its land to obtain equalunits of cotton and wheat production as shown below:

Gains from Mutual AbsoluteAdvantage


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Production Possibility Frontiers forAustralia and New Zealand Before Trade



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Gains from Mutual Absolute Advantage

An agreement to trade 300 bushels of wheatfor 300 bales of cotton would double bothwheat and cotton consumption in both

countries.Production and Consumption of Wheat and Cotton after Specialization

PRODUCTION CONSUMPTION

New Zealand Australia New

Zealand Australia

Wheat 100 acres x 6 bu/acre600 bushels

0 acres0

300 bushels 300 bushels

Cotton 0 acres0


300 bales 300 bales



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Expanded Possibilities after Trade

Because both countries have an absolute advantagein the production of one product, specialization and

trade will benefit both. Dr. S. JainSunday, December 09, 2012 11


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Gains from Comparative Advantage

Even if a country had a considerable absoluteadvantage in the production of both goods,Ricardo would argue that specialization and trade are still mutually beneficial .



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When countries specialize in producing thegoods in which they have a comparativeadvantage, they maximize their combinedoutput and allocate their resources moreefficiently.



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Assume that people in each country want toconsume equal amounts of cotton and wheat,and that each country is constrained by its

domestic production possibilities curve, asfollows:

Yield Per Acre of Wheat and Cotton

Wheat


6 bushels 1 bushelCotton 6 bales 3 bales



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The gains from trade in this example can bedemonstrated in three stages.

Total Production of Wheat and Cotton Assuming NoTrade and 100 Available Acres

Wheat

NEW ZEALAND AUSTRALIA50 acres x 6 bushels/acre

300 bushels75 acres x 1 bushels/acre

75 bushels





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Realizing a Gain from Trade When One CountryHas a Double Absolute Advantage

Stage 1: Countries specialize

Wheat

STAGE 1New Zealand Australia

50 acres x 6 bushels/acre300 bushels

0 acres0



Australia transfers all its land into cotton production. NewZealand cannot completely specialize in wheat productionbecause it needs 300 bales of cotton and will not be able toget enough cotton from Australia (if countries are to consumeequal amounts of cotton and wheat).



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Stage 2:

Wheat


75 acres x 6 bushels/acre450 bushels

0 acres0



New Zealand transfers 25 acres out of cotton and intowheat.



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Stage 3: Countries trade


100 bushels (trade)

Wheat 350 bushels 100 bushels

(after trade)

200 bales (trade)

Cotton 350 bales 100 bales

(after trade)



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The real cost of producing cotton isthe wheat that must be sacrificedto produce it.

A country has a comparativeadvantage in cotton production if its opportunity cost, in terms of

wheat, is lower than the othercountry.



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Comparative AdvantageMeans Lower Opportunity Cost

Both Australia and New Zealand will gain when the terms of

trade are set between 1:1 and 3:1, cotton to wheat.Dr. S. JainSunday, December 09, 2012 20


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Slide 4-21 Sunday, December 09, 2012

Factor Endowment - Introduction

In the real world, while trade is partly explainedby differences in labor productivity, it also reflectsdifferences in countries resources.

The Heckscher-Ohlin theory : Emphasizes resource differences as the only source of

trade

Shows that comparative advantage is influenced by: Relative factor abundance (refers to countries) Relative factor intensity (refers to goods)

Is also referred to as the factor-proportions theory Dr. S. Jain


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Assumptions Basics

There are two countries, Home and Foreign two goods, Cloth and Food, and two resources, Labor and Land

these are used to produce Cloth and Food



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Prices of Goods

Let PC and PF denote the nominal prices of cloth and food.

Then, PC/ PF is the relative price of cloth (inunits of food) and

PF/ PC is the relative price of food (in units of cloth)



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Prices of Factors

Let w be the nominal price (or, wage) of labor. Let r be the nominal price (or, rent) of land Then w/r is the relative price of labor (in units of

land) and r/w is the relative price of land (in units of labor)

Example: If w = $10 per hour for one worker and r = $100per hour for one acre of land, then the relative wage forone worker is 1/10 acres of land and the relative rent onan acre of land is 10 hours of labor.



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Nominal Prices

The nominal price of a commodity is simplythe number of dollars (or any other relevantunit of account) that must be paid to buy oneunit of the commodity

For example, the nominal price of labor alsocalled the nominal wage may be $8 per hour



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Real Prices The real price of commodity X , in units of

commodity Y , is the amount of Y that coststhe same as one unit of X

For example, if the nominal price of labor is $8per hour and the nominal price of a cup of coffee is $2, then the real price of labor is 4cups of coffee per hour

Real prices are also called relative prices



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Figure 1: Factor Prices and GoodsPrices

Wage-rentratio, w/r

Relativeprice of cloth,P C /P F

As labor becomes moreexpensive relative toland, cloth, which islabor-intensive inproduction, finds itself at a disadvantage andbecomes relatively moreexpensive compared tofood

FPGP

As both Home andForeign use the sametechnologies, the sameFPGP curve is applicablein both countries

5

17



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Figure 1: Factor Prices and GoodsPrices

Wage-rentratio, w/r

Relativeprice of cloth,P C /P F

Under free trade, therelative price of clothwill be the same in bothcountries

FPGP

Therefore, the wage-rent ratio will also bethe same in the twocountries

5

17



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Figure 2: Factor Prices and InputChoices

Wage-rentratio, w/r

Acres of Land perworker, T/L

Clothproduction

Foodproduction

As labor becomesrelatively moreexpensive, relativelymore land is used inproduction

But the number of acresof land per worker isalways higher in foodproduction, reflectingthe assumption thatfood production is landintensive

of both food andcloth

4 12

5



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Figure 2: Factor Prices and InputChoices

Wage-rentratio, w/r

Acres of Land per

worker, T/L

Clothproduction

Foodproduction

As both Home andForeign use the sametechnologies, these twocurves must be true inboth countries.

4 12

5

As free trade equalizes thewage-rent ratio worldwide,acres of land per worker incloth production must be thesame worldwide.

Therefore, Foreign, which hasmore land per worker thanHome, must produce relativelymore food

Same must be true for foodproduction.



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Figure 3.1: Relative Supplies

Relativeprice of cloth,

P C /P F

Yards of cloth producedper calorie of foodproduced, QC /Q F

RSFOREIGN

RSHOME

17

In Figure 2, we saw that atw/r = 5, Foreign mustproduce relatively morefood and Home mustproduce relatively morecloth.

In Figure 1 we saw that w/r =5 corresponds to P C /P F =17.

Therefore, Home mustproduce relatively more

cloth at P C /P F = 17, orindeed at any other relativeprice.

As cloth becomes more expensive relative tofood, the output of cloth will increase relativeto food, Therefore, the relative supply curvesslope upward.Sunday, December 09, 2012 34Dr. S. Jain


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17

3

Figure 3.2: Relative Demand

Relativeprice of cloth,P

C /P

F

Yards of cloth consumedper calorie of foodconsumed, QC /Q F

The H-O assumptionsabout preferences implythat that consumerbehavior can besummarized by thisRelative Demand curveand that the same curve istrue in both Home andForeign

In this figure, when the price of a yard of cloth is 17times the price of a calorie of food, the number of yardsof cloth consumed is 3 times the number of calories of

food consumed, for every individual worldwide. Whyisnt the latter ratio different for different people? Sunday, December 09, 2012 35Dr. S. Jain


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Who will export what?

In autarky, the labor-intensive good is relativelycheaper in the labor-

abundant country Therefore, under free

trade, the labor-intensivegood is exported by thelabor- abundant country

and the land -intensivegood is exported by theland-abundant country

Foreign

Home

Free Trade

PC/ PF

autarky

Foreign : land abundant, labor scarceHome: land scarce, labor abundantCloth: labor intensive production

Food: land intensive productionSunday, December 09, 2012 37Dr. S. Jain


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The Heckscher-Ohlin model, in which twogoods are produced using two factors of production, emphasizes the role of resources

in trade. A rise in the relative price of the labor-

intensive good will shift the distribution of income in favor of labor:

The real wage of labor will rise in terms of bothgoods, while the real income of landowners willfall in terms of both goods.

Summary

Dr. S. Jain


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For any given commodity prices, an increase ina factor of production increases the supply of the good that uses this factor intensively andreduces the supply of the other good.

The Heckscher-Ohlin theorem predicts the followingpattern of trade:

A country will export that commodity which usesintensively its abundant factor and import thatcommodity which uses intensively its scarce factor.

Summary

Dr. S. Jain


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Summary The owners of a countrys abundant factors

gain from trade, but the owners of scarcefactors lose.

In reality, complete factor price equalization isnot observed because of wide differences inresources, barriers to trade, and internationaldifferences in technology.

Empirical evidence is mixed on the Heckscher-Ohlin model.

Most researchers do not believe that differences inresources alone can explain the pattern of worldtrade or world factor prices.

Dr. S. Jain


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Theory of Competitive Advantage

Harvard Business School

1980: The Five Competitive Forces

The Competitive Advantage of Nations,1990.

First strategist, a field that is,basically, straight economics

Enormous popularity



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The Five Competitive Forces

the threat of new entrants, the bargaining power of customers, the bargaining power of suppliers, the threat of substitute products or services,

and

the jockeying among current contestants.



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Porter and Strategy Today Strategy has now become a regular field in

management schools. It is mostly a haven foreconomists.

They address Value Creation, which is finding anapproach, a cost-reduction technique, or somemanner permitting the firm to compete effectively.



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Establishing a Strategic Agenda

The essence of strategy formulation is copingwith competition. Different forces take on prominence, of

course, in shaping competition in eachindustry.

Every industry has an underlying structure, ora set of fundamental economic and technical

characteristics, whether an industry is dealingin services or selling products.



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Threat of Entry New entrants to an

industry bring newcapacity, the desireto gain market share,and often substantialresources.

There are six majorsources of barriers to entry:

http://search.gallery.yahoo.com/search/corbis_id?p=cid:10416615


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Barriers to Entry

Economies of scale - - These economies deterentry by forcing the aspirant either to come inon a large scale or to accept a costdisadvantage.

Product differentiation -- Brand identificationcreates a barrier by forcing entrants to spendheavily on marketing



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Barriers to Entry

Cost disadvantages independent of size --Entrenched companies may have cost

advantages not available to potential rivals, nomatter what their size and attainableeconomies of scale.



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Barriers to Entry Access to distribution channels -- The

newcomer must, of course, secure distributionof its product or service.

Government policy -- Governments can limitor even foreclose entry to industries with suchcontrols as license requirements and limits on

access to raw materials.



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Powerful Suppliers and Buyers

The power of each important supplier orbuyer group depends on a number of characteristics of its market situation and onthe relative importance of its sales orpurchases to the industry compared with itsoverall business.



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Powerful Suppliers and Buyers

A company's choice of suppliers to buy fromor buyer groups to sell to should be viewed asa crucial strategic decision. Most common is

the situation of a company being able tochoose whom it will sell to, in other words,buyer selection.



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Substitute Products

Substitute products place a ceiling onprices a competing firm can charge, limitingthe potential of an industry. Substitutes not

only limit profits in normal times; they alsoreduce the bonanza an industry can reap inboom times.



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Substitute Products

Substitutes often come rapidly into play if

some development increases competition intheir industries and causes price reduction orperformance improvement.



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Jockeying for Position

Intense rivalry isrelated to the presenceof a number of factors:

Competitors arenumerous or areroughly equal in size

and power.



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Industry growth is slow,precipitating fights formarket share that

involve expansion-minded members.



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Jockeying for PositionThe product or servicelacks

differentiation orswitching costs, whichlock in buyers andprotect one combatantfrom raids on its

customers, by another.



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Fixed costs are high orthe product isperishable, creating

strong temptation tocut prices.

Capacity is normally

augmented in largeincrements .



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Formulation of Strategy

1. Positioning the companyPositioning the company sothat its capabilities provide

the best defense against thecompetitive force.



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2. Influencing the balanceInfluencing the balance of theforces through strategic

moves, thereby improvingthe company's position.



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3. Exploiting industry changeAnticipating shifts in the factors underlyingthe forces and responding to them, with thehope of exploiting change by choosing astrategy appropriate for the new competitivebalance before opponents recognize it.



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to formulate strategy we must understand our resources and capabilities understand the environment, and combine knowledge of strategy and

organizational architecture.



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Conclusions

The key to growth -- even survival -- is to stakeout a position that is

less vulnerable to attack from head-to-headopponents, whether established or new, and

less vulnerable to erosion from the direction of buyers, suppliers, and substitute goods.



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Conclusions

Establishing such a position can take manyforms

solidifying relationships with favorable customers, differentiating the product either substantively or

psychologically through marketing, integratingforward or backward, or

establishing technological leadership.


Implications of trade theories


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Implications of trade theoriesTerms of Trade

The ratio at which a country can tradedomestic products for imported products isthe terms of trade .

The terms of trade determine how the gainsfrom trade are distributed among tradingpartners.



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Arguments for Restricting Trade Methods of restricting trade

tariffs quotas administrative barriers other

Arguments for restricting trade

infant industry argument changing comparative advantage to prevent dumping



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Arguments for Restricting Trade Arguments for restricting trade (cont.)

to prevent establishment of a foreign-based monopoly to spread risks externalities pursuing national interests (but against world

interests)

exploiting monopoly power protecting declining industries

non-economic arguments



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Arguments for Restricting Trade Problems with protection

protection as second best

world multiplier effects

retaliation

cushions inefficiency

bureaucracy

Measuring the efficiency loss from protection



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History of protection

Pre-war growth in protection

Post-war reduction in protection and the role of GATT

the growth in world trade

World Attitudes towards Trade and Protection



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REALITIES OF INTERNATIONAL TRADE

import quotas - Restrictions on the quantityof imports for specific period of timevoluntary export restraints (VRAs) - superficial policy to

show that exporting countries voluntarily agree to restrict their exportslocal content requirements - A requirement that a certain -proportion of the value of the goods made in one country

originate from that country.



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REALITIES OF INTERNATIONAL TRADE

antidumping duties - Costs levied on importsthat have been dumped (selling below costs or below exporters home marketprice to unfairly drive domestic firms out of business)



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Economic Arguments Against Free Trade

Prominent among economic arguments against free trade include:

1. The need to protect domestic industries - The oldest and mostfrequently used economic argument against free trade is the urge toprotect domestic industries, firms, and jobs from unfair foreigncompetition - in short, protectionism

2. The necessity to shield infant industries - belief that if domestic firmsare as young as infants, in the absence of government intervention, theystand no chance of surviving and will be crushed by mature foreign rivals



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Political Arguments against Free Trade

Political arguments against free trade advance a nationspolitical, social, and environmental agenda regardless of possibleeconomic gains from tradeThese arguments include:

(1) national security(2) consumer protection(3) foreign policy(4) environmental and social responsibility



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Documents

3 - 5 Theories of International Trade