Chapter Five
International Trade Theory
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Overview of Trade Theory
• Free Trade occurs when a government does not attempt to influence, through quotas or duties, what its citizens can buy from another country or what they can produce and sell to another country
• The Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country
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Trade Theory-Overview
• The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish).
- Others are not so easy to understand (Japan and cars)
• The history of Trade Theory and government involvement presents a mixed case for the role of government in promoting exports and limiting imports
• Later theories appear to make a case for limited involvement
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Mercantilism: Mid-16th Century
• A nation’s wealth depends on accumulated treasure- Gold and silver are the currency of trade
• Theory says you should have a trade surplus - Maximize export through subsidies- Minimize imports through tariffs and quotas
• Flaw: “zero-sum game”
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Mercantilism-Zero-Sum Game
• In 1752, David Hume pointed out that:- Increased exports lead to inflation and higher prices- Increased imports lead to lower prices
• Result: Country A sells less because of high prices and Country B sells more because of lower prices
• In the long run, no one can keep a trade surplus
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Theory of Absolute Advantage
• Adam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more of a product with the same amount of input than another country can vary
- A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient
• Trade between countries is, therefore, beneficial • Assumes there is an absolute balance among
nations- Example: Ghana/cocoa
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Theory of Comparative Advantage
• David Ricardo (Principles of Political Economy, 1817):
- Extends free trade argument- Efficiency of resource utilization leads to more productivity- Should import even if country is more efficient in the
product’s production than country from which it is buying- Look to see how much more efficient
• If only comparatively efficient, than import
• Makes better use of resources• Trade is a positive-sum game
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Simple Extensions of the Ricardian Model
• Immobile resources:- Resources do not always move easily from one
economic activity to another
• Diminishing returns:- Diminishing returns to specialization suggests that
after some point, the more units of a good the country produces, the greater the additional resources required to produce an additional item
- Different goods use resources in different proportions
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Simple Extensions of the Ricardian Model
• Free trade (open economies):- Free trade might increase a country’s stock of
resources (as labor and capital arrives from abroad)- Increase the efficiency of resource utilization
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Heckscher (1919)-Olin (1933) Theory
• Export goods that intensively use factor endowments which are locally abundant
- Corollary: import goods made from locally scarce factors
• Note: Factor endowments can be impacted by government policy - minimum wage
• Patterns of trade are determined by differences in factor endowments - not productivity
• Remember, focus on relative advantage, not absolute advantage
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Product Life-Cycle Theory - R. Vernon (1966)
• As products mature, both location of sales and optimal production changes
• Affects the direction and flow of imports and exports• Globalization and integration of the economy makes
this theory less valid
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Product life cycle theory
Fig 4.5
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New Trade Theory
In industries with high fixed costs:- Specialization increases output, and the ability to enhance
economies of scale increases- Learning effects are high.
• These are cost savings that come from “learning by doing”
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New Trade Theory-Applications
• Typically, requires industries with high, fixed costs- World demand will support few competitors
• Competitors may emerge because of “ First-mover advantage”
- Economies of scale may preclude new entrants- Role of the government becomes significant
• Some argue that it generates government intervention and strategic trade policy
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Theory of National Competitive Advantage
• The theory attempts to analyze the reasons for a nation’s success in a particular industry
• Porter studied 100 industries in 10 nations- Postulated determinants of competitive advantage of a
nation were based on four major attributes• Factor endowments• Demand conditions• Related and supporting industries• Firm strategy, structure and rivalry
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Porter’s Diamond
• Success occurs where these attributes exist• More/greater the attribute, the higher chance of
success• The diamond is mutually reinforcing
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Porter’s Diamond
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Factor Endowments
• Factor endowments: A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry
- Basic factor endowments- Advanced factor endowments
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Basic Factor Endowments
• Basic factors: Factors present in a country- Natural resources- Climate- Geographic location
- Demographics • While basic factors can provide an initial advantage
they must be supported by advanced factors to maintain success
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Advanced Factor Endowments
• Advanced factors: The result of investment by people, companies, and government are more likely to lead to competitive advantage
- If a country has no basic factors, it must invest in advanced factors
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Advanced Factor Endowments
• Communications• Skilled labor• Research• Technology• Education
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Demand Conditions
• Demand:- creates capabilities - creates sophisticated and
demanding consumers
• Demand impacts quality and innovation
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Related and Supporting Industries
• Creates clusters of supporting industries that are internationally competitive
• Must also meet requirements of other parts of the Diamond
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Firm Strategy, Structure and Rivalry
• Long term corporate vision is a determinant of success• Management ‘ideology’ and structure of the firm can
either help or hurt you• Presence of domestic rivalry improves a company’s
competitiveness
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Porter’s Theory-Predictions
• Porter’s theory should predict the pattern of international trade that we observe in the real world
• Countries should be exporting products from those
industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable
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Implications for Business
• Location implications:- Disperse production activities to countries where they can
be performed most efficiently• First-mover implications:
- Invest substantial financial resources in building a first-mover, or early-mover advantage
• Policy implications: - Promoting free trade is in the best interests of the home
country, not always in the best interests of the firm, even though many firms promote open markets