com p11 m8 e-text

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PAPER No. : 11 MODULE No. : 8

Subject COMMERCE

Paper No and Title 11: International Business

Module No and Title 8: International trade theory: modern theories of trade- ii

Module Tag COM_P11_M8

TABLE OF CONTENTS

1. Learning Outcomes 2. Introduction 3. New Trade Theory3.1 Increasing Product Variety and Reducing Costs

3.2 Economies of Scale, First-Mover Advantages and Pattern of Trade 4. Porter’s Diamond: National Competitive Advantage

4.1 Factor Endowments 4.2 Demand Conditions 4.3 Related and Supporting Industries 4.4 Firm Strategy, Structure, and Rivalry

5. Intra-Industry Trade Theory 5.1 Suitability of trade theories to certain kinds of products

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6. Summary

1. Learning Outcomes

After studying this module, you shall be able to

• Appreciate the role of New Trade Theory in explaining trade patterns in certain industries.

• Evaluate the diamond of Porter’s theory of national competitive advantage. • Understand Intra-Industry Trade Theory explaining suitability of trade theories to certain

kinds of products.

2. Introduction

Figure 1

3. New Trade Theory

Comparative Advantage theory was based on constant returns to scale. However, the supposition of diminishing returns to specialization seems more realistic. This happens when more units of

You must be aware of Country Similarity Theory and Product Life Cycle Theory. This module provides an insight on the other modern theories of trade that is New Trade Theory and Porter’s Diamond National Competitive Advantage Model. These theories are shown in Figure 1 below:

Modern Firm-Specific Theories

Porter's National Competitive

Advantage TheoryNew Trade Theory

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resources are needed to manufacture each additional unit. But in the 1970s, certain economists questioned the presumption of diminishing returns to specialization in international trade. They pointed that countries trade not only to take the benefit of their distinctions but to attain increasing returns that makes specialization advantageous. Hence, this leads to the exposure of New Trade Theory in the 1970s by Paul Krugman and other economists. This trade theory is also known as Strategic Trade Theory.

Several contributions are made to the understanding and enlargement of international trade:

v An industrial organization view has been incorporated in the new trade theory where new trade theorists contendedthat increasing returns to scale prevails due to economies of scale. Economy of Scale is curtailment in the cost per unit as a consequence of large quantity of output. The assumption of increasing returns gives revive to imperfectly competitive markets. For instance, automobile companies experience economies of scale by manufacturing large quantity of automobiles from an assembly line where unique task is performed by each employee.Thus, by analyzing the major effect on economies of scale, trade will give consequence by enhancing the variety of products available to consumers and simultaneously there will be curtailment in the average costs.

v New trade theorists suggest that factors of Heckscher-Ohlin Theory are determined by inter-industry trade. On the other side, increasing returns which results from specialization within the industry drives intra-industry trade. Hence, there is coexistence between comparative advantage from factor endowment differences and increasing returns from economies of scale because of differences in the application of inter-verses intra-industry trade.

3.1 Increasing Product Variety and Reducing Costs

v Importance of externality is realized by new trade theory in international trade. Externality prevails when the actions of one agent directly affect the environment of another agent. Government policies, political relations between countries, consumption differences between different cultures etc are included in externalities. These externalities are considered as alternatives to comparative advantage which directly influence international trade.

New trade theory significantly focuses on two points:

1. Increasing Product Variety and Reducing Costs 2. Economies of Scale, First-Mover Advantages and Pattern of Trade

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Figure 2 describes New Trade Theory which results in realizing economies of scale, incorporating real-life imperfect competition in international trade and also suggesting intra-industry trade between nations.

Figure 2

Strategic trade policies have been instituted by the national governments to assist industries in achieving national competitive advantage. The main aim of these types of policies is to make a

Considering that there is no world trade, it is difficult for producers to of scale for products whose market is not wide. Thus, this results in limited production of products in the market. On the contrary, size of the market expandsother. In such a case, economies of scale are realized. According to new trade theory, trade is mutually beneficial as it brings in specialization of production, realization of economies of scale, the production of wide variety of products and lower prices.

3.2 Economies of Scale, First-Mover Advantages and Pattern of Trade

International Trade is influenced by economies of scale and first mover advantages. The advantages that accrue to early entrants into an industry are first-mover advantages. The output that is required to achieve economies of scale signifies a larger proportion of total world demand of that product. Under such a situation, only few firms get support and the firms first to establish enjoy the first-mover advantage.

New Trade Theory

Increasing Returns to Scale

Imperfect Competition and Product Differentiation

Intra-Industry Trade between similar nations

Gain for all factors of production, not the abundant factor and Specialization even if both the nations have same factor endowments.

Will lead to

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shift from perfect competition to managed competition. This theory mainly covers oligopolistic industries like aerospace industry.

Boeing-Airbus instance can explain this theory. Assuming there is only room for one firm in the international aircraft market. If two firms decide to produce, then both will incur losses. But if one firm produces, then producing firm will generate profits. In this situation, if large amount is committed by the European government to subsidize the production of aircrafts by Airbus rather than the expected loss if both firms remain in the market, then Airbus will be the leader of whole market. Simultaneously, Boeing will quit. Thus, government intervention is very crucial when firms play strategically in international markets. However, WTO rules prescribe that no subsidies should be given and these create barriers to free trade.

Implications- Strategic Trade Theory

4. Porter’s Diamond: National Competitive Advantage

The early trade theory emphasizes on the country or particular nation and analyzes the factors which enhance competitiveness. Later on it switches to the industry or product level leaving behind competitiveness at the national level. Now, the notice has been given to how the conditions can be altered within a country by countries, governments and private industries so as to maintain the competitiveness of its firms.

Initially country’s competitiveness was intuitively measured so as to determine its share in the world market. However, the real measure of competitiveness is productivity. Through this,

1. The theory suggests that trade provides an advantage for mutual gain irrespective ofdifferences in resource endowments. This results in economies of scale that is increasing the variety of products and lowering the costs.

2. The Boeing-Airbus instance shows country dominance in the export of good because it feels lucky to have one or more firms among the first to produce that good. The first movers in an industry may get locked in the world market that discourages subsequent entry because of their ability to gain economies of scale.

3. Heckscher-Ohlin theory explains only the part of trade which is at variance with new trade theory. However, this theory does not replace Heckscher-Ohlin Theory but complements it. Hence, the theory suggests the predominance of a country in the export of a product when it is well endowed with those factors used intensively in its manufacture.

4. On the other hand, new trade theory is not at variance with comparative advantage theory. This theory identifies an important source of comparative advantage as economies of scale increase productivity.

Michael Porter of Harvard Business School is the renowned leader in this research area. In 1990, Michael Porter framed a theory of national competitive advantage that is originally published in his book, The Competitive Advantage of Nations. He felt that old theories of international trade explain only a part of the story. Thus, his task is to explore the achievement of international success in a particular industry by a nation.

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nations will get support of high wages, return on capital, strong currency etc. Moreover, it is the companies that export rather than nations. An economy cannot achieve comparative advantage unless the companies operating there are competitive. Figure 3 shows the microeconomic foundations of productivity that focus on two aspects: sophistication with which companies operate and quality which microeconomic business environment possess.

Figure 3

Highly skilled labour, information, improved infrastructure, advanced research institutions and competitive pressures are required for sophisticated operations and strategy of company. There has been focus on shifting from comparative advantage to competitive advantage. Different strategies have been suggested for low-income, middle-income and high income countries by Porter because it is the weaknesses at the advanced level which were strengths at the earliest level. Now the effort has been taken to move to sophisticated ways of competing which depends on changes taking place in the microeconomic environment. This microeconomic environment has been termed as “determinants of national competitive advantage”.

Four broad areas have been defined by Porter to shape the environment in which local firms compete and which leads to creation of national competitive advantage. The graphic representation of these four areas referred as “diamond” is shown in Figure 4.

Microeconomic, Political, Legal and Social Context for Development Sophistication of Company Quality of the Microeconomic Operations and Strategy Business Environment

Microeconomic Foundations of Development

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Figure 4Determinants of National Competitive Advantage: Porter’s Diamond

The four determinants are discussed as follows:

4.1 Factor Conditions or Factor Endowments:

Heckscher-Ohlin Theory proposed that comparative advantage emerge due to distinctions in factor endowments. Factor endowments explained the endowment of the country with resources like land, labour and capital. Porter differentiated between two factors- basic factors and advanced factors. Basic factors are naturally equipped factors which include natural resources, climate, location, demographics. On the contrary, advanced factors include communication infrastructure, skilled labour, research facilities and technological know-how. The complexity is seen in the relationship between these two factors. Investment by individuals, companies and governments constitute a product of advanced factors. There is a proposition that advanced factors are necessary for achieving national competitive advantage. Initial advantage is guided by basic factors which require an extension in investment of advanced factors. It is basically the disadvantages in basic elements that results in making theinvestment in advanced factors.

4.2 Demand Conditions:

4.4 Firm Strategy, Structure and Rivalry

This makes important characterization of nations by different ideologies of management that either assist them or do not assist them in achieving national competitive advantage. Moreover, there is a strong link between domestic rivalry which pressurizes firms for better efficiency in order to become good competitors and creation of competitive advantage in an industry.

Home demand plays a necessary role in providing competitive advantage. Needs of customers should be taken into account. Competitive advantage is accomplished by firms in a particular nation only if their domestic consumers are well demanding. Efforts have been made by domestic firms to pursue innovative ideas in manufacturing products of good quality.

4.3 Related and Supporting Industries:

This determinant represents the presence or absence of related and supporting industries which show their competitiveness in an international economy. Investments made by suppliers and related industries in advanced factors assist in getting a strong competitive position internationally. The main result of this determinant is that industries which have achieved success comprise of a group. This group is signified as a cluster of related industries. Formation of clusters is necessary so that there is movement of knowledge whenever employees shift between firms within a region. For instance: German textile and apparel sector is a cluster which includes better quality of cotton, wool, sewing machine needles etc. This cluster is benefitting all within that cluster.

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Evaluation of Porter’s Theory

1. Porter’s theory is a hybrid theory which shows that presence of all four determinants is essential for “diamond” to achieve national competitive advantage.

2. There is contention that endowments are affected by government regulations which simultaneously is affected by subsidies, capital market policies or policies that influence consumer needs. Related and supporting industries are affected by government policy that influence firm rivalry through tax policy, anti-trust laws etc.

3. This theory creates a favorable environment in which firms are actors who actually engaged in international trade.

4. Countries should be exporting products from those countries where four components of the diamond are favourable while importing products in those areas where the components are not favourable.

5. Intra-Industry Trade Theory

Diamond Conditions of the Japanese VCR Industry Factor Endowments: Japanese manufacturers had prior expertise in audio and video technologies through the production of home audio equipment, tape recorders and TVs. There is a pool of talented electrical engineers. Large-scale capital investment is allowed from banks with low-cost loans. Japanese Home Demand: As domestic consumers are sophisticated and demanding, thus there is a demand for compact, high- performance units. Related and Supporting Industries: High performance parts are developed where VCR makers worked with parts makers. There is a cluster of competitive Japanese suppliers of magnetic heads, tuners, tape decks, volume regulators, other electronic parts etc. Japanese Rivalry: Fierce domestic competition is seen between VHS (JVC) and Beta (Sony) camps that led to constant innovation and upgrading.

Mini-file

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It is difficult to measure country’s comparative advantage. This problem is related with the fact that an economy might export products that use the similar comparative advantage. However, it is difficult to determine which kind of products dominate. Moreover, a large share of international trade is not based on comparative advantage. There is creation of a model which focuses on economic relations is affected by comparative advantage. Exceptional cases are ignored that become important over time.

Intra-industry trade means trade within the same industry which explains why countries often export the same products they import. This also describes how the countries get advantage from this type of trade.Usually, there is common intra-industry trade between countries which is due to acquired advantage over natural advantage. There is a reflection of country-similarity theory which is also in the process of intra-industry trade.

5.1 Suitability of trade theories to certain kinds of products

It is known that traditional theories are useful for homogeneous, undifferentiated products whereas modern theories are useful for heterogeneous, differentiated products. Newer trade theories relaxed the supposition of constant returns to scale. These theories are based on the premise of economies of scale or decreasing costs. New trade theories also rely on imperfect competition.

Evidence shows that intra-industry trade is greater in high-tech industries where the rapid growth of new products leads to product differentiation. As nation’s income increases, this kind of trade also increases. Big firms experience the advantage of internal economies. But in case of external economies, the size or scale effects are located in the industry and not the firm. Internal economies lead to monopolistic competition. Entry of new firms increases competition which leads to decrease in price. Each firm sells few units of output by dividing the market and therefore, costs rise. Hence, the presence of internal economies is the reason why firms want to enter export markets.

Intra-industry trade provides two advantages:

1. Market share is enhanced which leads to decrease in costs. 2. Increasing competition pressurizes firms to pass their lower cost benefit to consumers.

Thus, pattern of international trade enables these firms to produce effectively thereby achieving higher efficiency. High level of efficiency would raise everyone’s income through reduction in prices. This would also increase consumer choices.

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5. Summary

• New trade theory was developed by Paul Krugman and others in 1970. This theory focuses on two points: increasing product variety and reducing costs and economies of scale, first-mover advantages and the pattern of trade.

• New trade theory describes that in industries where there is substantial economies of scale, imply that world market will profitably support only few firms. However, countries may predominate in the export of certain kind of products because they had a firm that was a first mover in that industry.

• Some new trade theorists have promoted the idea of strategic trade policy. • Porter’s theory of national competitive advantage focuses on four broad areas: factor

endowments, demand conditions, relating and supporting industries, firm strategy, structure and rivalry.

• These four determinants constitute a “diamond”. The effect of one determinant is contingent on the state of others.

• Two additional variables that influence national diamond are chance and government. Chance events such as innovation and creative idea can reshape the structure of industry. On the contrary, government can detract from or improve national advantage by using its policies.

• Intra-industry trade is the trade within the same industry. For example: steel for steel. • Intra-industry trade is based on imperfect competition, economies of scale and

product differentiation. • New trade theories are suitable in high-tech industries showing heterogeneity of the

products. • Hence, theories of international trade are crucial to an individual business firm as

they can assist the firm determine where to situate its various production activities.

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