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Concept PreviewAfter reading this chapter, you should be able to:

1. understand the theories that attempt to explain why certain goods are traded internationally

2. comprehend the arguments for imposing trade restrictions

3. explain the two basic kinds of import restrictions: tariff and nontariff barriers

4. state the agreements reached during the Uruguay Round

5. appreciate the relevance of the changing status of tariff and nontariff barriers to businesspeople

Economic Theories on International Trade,

Development, and Investment

Economic Theories on International Trade,

Development, and Investment

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Concept Preview continued After reading this chapter, you should be able to:

6. recognize the weakness of GNP/capita as an economic indicator

7. identify the common characteristics of developing nations

8. understand the new definition of economic development which includes more than economic growth

9. understand why some governments are changing from an import substitution strategy to one of export promotion and the implications of this change for businesspeople

10. explain some of the theories of foreign direct investment

Economic Theories on International Trade,

Development, and Investment

Economic Theories on International Trade,

Development, and Investment

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Economic Theories of International Trade

International trade theory Mercantilism Absolute Advantage Comparative Advantage Heckscher-Ohlin Theory of Factor Endowment

Trade restrictions Economic development International investment theories

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3-4 Theory of Mercantilism

Essential to a nation’s welfare to accumulate a stock of precious metals

Viewed as the only source of wealth Mercantilists era ended in 1700’s A “favorable” trade balance still means that a

nation exports more goods and services than it imports

Modern-day economic nationalism, industrial policy based on heavy state intervention

France nationalized key industries to make the state stockholder and financier customer and marketer policy reversed in 1986

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Theory of Absolute Advantage

Adam Smith claimed market forces, not government controls, should determine the direction, volume, and composition of international trade

Under free (unregulated) trade each nation should specialize in producing those goods it could produce most efficiently

Nation capable of producing more of a good with the same input than another nation

An absolute advantage—either natural or acquired Some goods exported to pay for imports of goods

that could be produced more efficiently elsewhere

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Theory of Absolute Advantage

Commodity US Japan TotalTons of Rice 3 1 4

Automobiles 2 4 6

Assumes perfect competition and no transportation costs in a world of two countries and two products

One unit of input (combination of land, labor, and capital) Each nation has two input units it can use to produce either rice

or automobiles Each country uses one unit of input to produce each product

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Commodity US Japan Total

Tons of Rice 6 0 6

Automobiles 0 8 8

Each nation produces only the product at which it is most efficient

With the same quantity of input units — the total output is greater

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Theory of Absolute Advantage (each country specializes)

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Theory of Absolute AdvantageTerms of trade (ratio of international prices)

Commodity US Japan TotalTons of Rice 3 3 6

Automobiles 4 4 8

With specialization the total production is greater but to consume both products the countries must trade some of their surplus

What are the limits within which the countries are willing to trade?

Japan will trade if they can get more than 1 ton of rice they get in Japan for 4 cars

American rice growers will trade their rice for Japan automobiles for less than 1.5 cars it costs in US

1.25 tons of rice per car is equal benefit

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Theory of Absolute Advantage(gains from specialization and trade)

Commodity US JapanTons of Rice 2

Automobiles 2

Both nations gain by trading Each nation specialized in producing the product in which

it was more efficient Traded its surplus for goods it could not produce as

efficiently What is one country has an absolute advantage in the

production of both rice and automobiles? Will there still be a basis for trade?

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Theory of Comparative Advantage

Ricardo 1817 Even though a nation holds an absolute

advantage in the production of two goods The two countries can still trade with

advantages The less efficient nation is not equally less

efficient in the production of both goods

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Theory of Comparative Advantage

Commodity US Japan Total

Tons of Rice 6 3 9

Automobiles 5 4 9

Compared to the US, Japan is less inefficient in automaking Japan has a relative or comparative advantage

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Theory of Comparative Advantage(each country specializes)

Commodity US Japan Total

Tons of Rice 12 0 12

Automobiles 0 8 8

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Theory of Comparative Advantage (terms of trade)

Commodity US Japan

Tons of Rice 8 4

Automobiles 4 4 Terms of trade will be somewhere between 1 ton of rice for 5/6ths of

an auto that American rice growers must pay in the US Terms of trade will be 1 1/3 automobiles Japanese automakers must

pay for 1 ton of Japanese rice

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Commodity US Japan

Tons of Rice 6 4

Automobiles 6 4 This left the US with some surplus rice and one less automobile than

before Japan has more rice and the same quantity of automobiles American rice growers should be able to trade 2 tons of surplus rice for 2

automobiles elsewhere

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Theory of Comparative Advantage (gains from specialization and trade)

Commodity US Japan

Tons of Rice 1

Automobiles 1

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Heckscher-Ohlin Theory of Factor Endowment

International and interregional differences in production costs occur because of differences in the supply of production factors

Goods that require a large amount of the abundant (thus less costly) factor will have lower production costs

Enables them to be sold for less in international markets

Prices only depend on the factor endowment this is not true-factor prices are not set in a perfect market legislated minimum wages

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Heckscher-Ohlin Theory of Factor Endowment

Ohlin assumed a given technology was universally available

Superior technology often permits a nation to produce at lower costs

Assumed a given product was either labor- or capital-intensive

Heckscher-Ohlin ignored transportation costs

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Leontief Paradox (1953) The U.S., one of the most capital-intensive countries of the

world, exports labor-intensive products. The U.S. exports technology-intensive products produced

by highly skilled labor requiring a large capital investment to educate and train.

The U.S. imports goods made with mature technology requiring capital-intensive mass production processes operated by unskilled labor.

Economists Assumptions differences in taste (preferences) are neglected marketers cannot ignore because of ‘taste’ products flow in a direction completely

contrary to international trade theory

Heckscher-Ohlin Theory of Factor Endowment III

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International Trade Theory-Money

Price per Unit

Commodity United States Japan

Total cost of land, labor, and capital to produce the daily output of rice or automobiles is $10,000 in the US and 2.5 million yen in Japan.

To determine if it is more advantageous to buy locally or import traders need an exchange rate to determine prices in their own currencies.

yen/automillion.6254

yenmillion 2.5 o$5,000/aut2

$10,000 sAutomobile

yen/tonmillion2.51

yenmillion 2.5 $3,330/ton3

$10,000 rice, of Tons

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International Trade Theory-Money (exchange rate)

Price per Unit (dollars)Commodity United States Japan

Ton of Rice $3,330 $10,000

Automobiles 5,000 2,500

Price per Unit (yen) Commodity United States Japan

Ton of Rice 0.83 million yen 2.5 million yen

Automobiles 1.25 million yen 0.625 million yen

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Influence of exchange rate Currency devaluation

lower its prices in terms of other currencies

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Some Newer Explanations for the Direction of Trade

Economies of scale and the experience curve most industries benefit from economies of scale as a firm produces more products it learns ways to

improve production

First mover theory firms that enter the market first will soon dominate it

Linder theory of overlapping demand another explanation is needed to explain trade in

manufactured goods tastes are strongly affected by income levels—

therefore a nation’s per capita level determines the kinds of goods they will demand

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3-20 Porter’s Competitive Advantage of Nations

Demand conditions nature of the domestic demand

Factor conditions level and composition of factors of production

Related and supporting industries suppliers and support services

Firm strategy, structure and rivalry the extent of domestic competition, barriers to entry,

and firms’ management style and organization

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Arguments for Trade Restrictions

National defense certain industries need protection

from imports because they are vital to national defense

Infant industries in the long run these firms will have a

comparative advantage but these firms need protection from imports until labor i trained

eventually protection will not be needed

Protect domestic jobs projectionists argue that low foreign

hourly wages will produce cheap goods and flood local market

wage costs are not all the costs of production

Scientific tariff or fair competition want to eliminate “unfair”

advantage that a foreign competitor might have due to superior technology, low raw material costs, lower taxes or lower labor costs

“equalize” the process for fair competition

Retaliation industry that has exports with

import restrictions placed by another country want retaliation with similar restrictions

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Trade Restrictions

Dumping—sell a product abroad… for less than the cost of production the price in the home market the price to third countries

New types of dumping—unfair competition caused by… social dumping--firms in developing nations that have

lower labor costs and poorer working conditions environmental dumping--a country’s lax environmental

standards financial services dumping--a nation’s low

requirements for bank capital/asset ratios cultural dumping--cultural barriers aiding local firms

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IITrade Restrictions

Subsidies A government makes to firms either to encourage

exports or to protect it from imports Cash payments Government participation in ownership Low-cost loans to foreign buyers and exporters Preferential tax treatment

Countervailing duties offset the effects of a subsidy

Other arguments for trade restrictions permit diversification of the domestic economy improve the balance of trade

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Number of countervailing Duty (CD) and Antidumping (AD) Measures in Force by GATT Members

Measures & Country 1990 1991 1992 1993CD measures

United States 94 87 93 122

European Union (12) — 1 — 2

Canada 31 30 29 29

Australia 1 5 12 12

Brazil — 1 13 13

Chile — 2 4 0

New Zealand — — — 1

AD measures United States 201 216 267 304

European Union (12) 137 144 159 150

Canada 78 69 73 85

Australia 24 30 44 76

Brazil 6 19 23 28

Other 12 19 33 38Note: — = not available.

Source: A. Chapman and Po-Ye Lee, “Canadian and International Use of Anti-Dumping and Countervailing Measures,” Research Branch, Canadian International Trade Tribunal, July 1995, p. 14.

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Table 3.1

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IIITrade Restrictions

Tariffs Ad Valorum-a percentage of the invoice value Specific-fixed sum of money charged for a physical unit Compound—combination of ad valorum and specific

Official prices price used by customs when actual invoice price is lower

Variable levy Lower duty for more local input Non-tariff barriers

Quantitative quotas-numerical limit for a specific type of good tariff-rate quotas

Non Quantitative direct government participation in trade customs and other administrative procedures standards

Costs of barriers to trade

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Tariff barriers Nontariff BarriersImport duties QuantitativeAd valorem Quotas Specific Tariff-rate quotas Compound Global

Variable levies DiscriminatoryOfficial prices Voluntary export restrictions

Orderly marketing arrangementsNonquantitative

Direct government participation in tradeSubsidyBuy domesticallyImport licensesManipulation of exchange ratesLocal content requirementsCustoms and other administrative proceduresTariff classifications

Documentation requirementsProduct valuation standardsHealth, safety, and product qualityPackaging and labelingProduct testing methods

Kinds of Import Restrictions3-26

Table 3.2

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Economic Development

Levels of economic development—World Bank low income ($750 or less) lower middle income ($766-$3,035) upper middle income ($3,036-$9,385) high income ($9,385 or more)

GNP/capita as an economic indicator underground economy currency conversion Purchasing Power Parity

number of units of a currency required to buy the same amounts of goods and services in the domestic market as one dollar would buy in the U.S.

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Annual Costs to American Consumers for Import Protection

Cost per American Number of Total Cost

Product Group Job Saved Jobs Involved ($ million)Benzoid Chemicals $1,000,000 216 $ 216

Luggage 933,628 226 211

Softwood Lumber 758,678 605 459

Sugar 600,177 2,261 1,357

Polyethylene resins 590,604 298 176

Dairy Products 497,897 2,378 1,184

Frozen Con. O.J. 461,412 609 281

Ball bearings 438,356 146 64

Maritime 415,325 4,411 1,832

Ceramic tiles 400,576 347 139

Machine tools 348,349 169 59

Apparel & textiles 340,727 12,624 4,301

Source: Gary C Hufbauer and Kimberley Ann Elliott, Measuring the Cost of Protection in the United States (Washington, D.C.: Institute for International Economics, 1994), pp. 11-13.

Table 3.3

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Underground Economies (percentage of GDP, 1994) Figure 3.4

26%

23%

21%

18% 18% 18%

15%14% 14% 14%

13% 13%12%

10%9%

7%6%

0%

10%

20%

30%

Italy

Spain

Belgiu

m

Sweden

Norway

Denmark

Irelan

d

Canad

a

France

German

y

Netherla

nds

Austra

lia

United K

ingdom

United S

tate

s

Japan

Austria

Switzerla

nd

Source: “Light on the Shadows,” The Economist, May 3, 1997, p. 64.

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Table 3.4GNP/Capita based on UN ICP for Selected Countries in 1994

GNP/Capita in US$ GNP/Capita in US$ based

Converted at World Bank on Purchasing Power

Country Adjusted Exchange Rates Parity (PPP)

Switzerland $37,930 $25,150

Japan 34,630 21,140

Denmark 27,970 19,880

Norway 26,390 20,210

USA 25,880 25,880

Mexico 4,180 7,040

Indonesia 880 3,600

China 530 2,510

India 320 1,280

Uganda 190 1,410

Source: World Development Report 1996, Table 1, pp. 188-89.

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Economic DevelopmentCommon Characteristics of Developing Nations

GNP/capita <$6,000 Unequal distribution of

income Technological dualism Regional dualism >80% agriculture and/or

unproductive agriculture

Disguised unemployment or underemployment

High population growth (2.5—4.0% annually)

High illiteracy High malnutrition rates and

poor health Political instability Reliance on few products for

export Difficult topography Low savings rate

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Economic Development

Human-needs Approach Defines economic development as the elimination of

poverty and unemployment as well as increases in income Long and healthy life Ability to acquire knowledge Access to resources needed for a decent standard of living Elements measured by:

life expectancy adult literacy GDP/capita

Investment in human capital more than just capital accumulation is needed for growth must be investment in education of people managers can ensure capital is productive can maintain the capital equipment

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Economic Development

Import substitution local production of goods to replace imports a method for developing countries to lessen their

dependence on developed countries protection granted to local industries local manufacturers feel no pressure to become

competitive in world markets domestic firms that must buy from local suppliers

cannot export due to excessive costs

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International Investment Theories Monopolistic Advantage Theory (Stephen Hymer)

foreign direct investment occurred largely in oligopolistic industries rather than in industries operating in near-perfect competition

Product and Factor Market Imperfections (Caves) superior knowledge permits the investing firm to produce differentiated products that consumers

would prefer to locally made goods International Product Life Cycle foreign direct investment is a natural stage in the life of a product

Follow-the-leader (Knickerbocker) when one firm, especially the leader in an oligopolistic industry, entered a market, other firms in the

industry followed (defensive strategy) Cross-investment (Graham) in certain oligopolistic industries, European firms tended to invest in the US when American firms

had gone to Europe

Internationalization extension of the market imperfection theory a firm has superior knowledge, but it may obtain a higher price for that knowledge by using it than

by selling it in the open market

Dunning’s Eclectic Theory of International Production ownership specific— the extent to which a firm has or can get tangible and intangible assets not

available to other firms internalization—in the firm’s best interests to use its ownership-specific advantages (internalize)

rather than license them to foreign owners (externalize) location-specific— the firm will profit by locating part of its production facilities overseas