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International Marketing StrategyPost Graduate Diploma in Management

Trade Theories and

Economic Development

Trade Institutions and

Trade Policy

These Lecture Slides summarize the key points covered in the

respective chapters in your recommended text; these slides doNOT substitute, at all , the required reading of the assignedchapter from the text. These slides also may containadditionalsupplementary material extracted from other texts and sources

outsideyourtext book. Lecturer: Adrian Mifsud MBA (IUKB), BM Dip, MIM

Trade Theories and EconomicDevelopment

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Chapter Outline

Basis for International Trade

- Production Possibility Curve

- Principle of Absolute Advantage

- Principle of Comparative/Relative Advantage

Exchange Ratios, Trade, and Gain Factor Endowment Theory

Chapter Outline

The Competitive Advantage of Nations

A Critical Evaluation of Trade Theories

- The Validity of Trade Theories

- Limitations and Suggested Refinements

Economic Cooperation

- Levels of Economic Integration

Economic and Marketing Implications

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Whenever a buyer and a seller come together, each

expects to gain something from the other.

The same expectation applies to nations that trade

with each other.

It is virtually impossible for a country to be

completely self-sufficient without incurring unduecosts.

Therefore, trade becomes a necessary activity,

though, in some cases, trade does not always work

to the advantage of the nations involved.


Virtually all governments feel political pressure when

they experience trade deficits.

Too much emphasis is often placed on the negativeeffects of trade, even though it is questionable

whether such perceived disadvantages are real or

imaginary.

The benefits of trade, in contrast, are not often

stressed, nor are they well communicated to workers

and consumers.

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One may ask whether trade is like a zero-sum game,

in the sense that one must lose so that another will

gain.

The answer is no,because,though one does not

mind gaining benefits at someone elses expense,

no one wants to engage in a transaction that

includes a high risk of loss.

For trade to take place, both nations must anticipate

gain from it.In other words, trade is apositive-sum

game. Trade is about mutual gain.

Basis for International TradeProduction possibility curve

Without trade, a nation would have to produce all commodities

by itself in order to satisfy all its needs.

Figure 2.1 shows a hypothetical example of a country with adecision concerning the production of two products: computers

and automobiles.

Figure 2.1Production possibility

curve: constant opportunity cost

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Basis for International TradeProduction possibility curve

Because each country has a unique set of resources,

each country possesses its own unique production

possibility curve.

This curve, when analyzed, provides an explanation of

the logic behind international trade.

Regardless of whether the opportunity cost is constant or

variable, a country must determine the proper mix of anytwo products and must decide whether it wants to

specialize in one of the two.

Specialization will likely occur if specialization allows the

country to improve its prosperity by trading with another

nation.

Basis for International TradePrinciple of Absolute Advantage

Adam Smith may have been the first scholar to

investigate formally the rationale behind foreign

trade. In his book Wealth of Nations, Smith used the

principle of absolute advantage as the justification

for international trade.

According to this principle, a country should export a

commodity that can be produced at a lower cost than

can other nations. Conversely, it should import a

commodity that can only be produced at a higher

cost than can other nations.

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Product USA Japan

Case 1 Computer 20 10

Automobile 10 20


Automobile 30 20

Case 3 Computer 20 10Automobile 40 20

Table 2.1Possible physical output

Table 2.1 provides hypothetical production figures for the USA and

Japan based on two products: the computer and the automobile.


Case 1 shows that, given certain resources and

labour, the USA can produce twenty computers or

ten automobiles or some combination of both. Japan is able to produce only half as many

computers.

Therefore, the USA has an absolute advantage in

computers.

But the situation is reversed for automobiles, an..d

therefore Japan has an absolute advantage in

automobiles.

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Based on Table 2.1, it should be apparent

why trade should take place between the two

countries.

The USA has an absolute advantage for

computers but an absolute disadvantage for

automobiles.

For Japan, the absolute advantage exists for

automobiles and an absolute disadvantage

for computers.


If each country specializes in the product for

which it has an absolute advantage, each

can use its resources more effectively while

improving consumer welfare at the same

time.

Since the USA would use fewer resources in

making computers, it should produce this

product for its own consumption as well as

for export to Japan.

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Based on this same rationale, the USA

should import automobiles from Japan rather

than manufacture them itself.

For Japan, of course, automobiles would be

exported and computers imported.

This can also be applied for trades: as for a

doctor is absolutely better than a mechanic in

performing surgery, whereas the mechanic is

absolutely superior in repairing cars.


- a country should export a commodity that

can be produced at a lower cost than can

other nations

- or import a commodity that can only be

produced at a higher cost than can other

nations

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Basis for International TradePrinciple of Comparative/Relative Advantage

One problem with the principle of absolute

advantage is that it fails to explain whether

trade will take place if one nation has

absolute advantage for all products under

consideration.

Case 2 of Table 2.1 shows this situation.


Product USA Japan


Automobile 10 20


Automobile 30 20


Automobile 40 20


Table 2.1 provides hypothetical production figures for the USA and

Japan based on two products: the computer and the automobile.

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In Case 2, the USA has absolute advantage

for both products, resulting in absolute

disadvantage for Japan for both.

The efficiency of the USA enables it to

produce more of both products at lower cost.

At first glance, it may appear that the USA

has nothing to gain from trading with Japan.


British economist David Ricardo, perhaps the

first economist to fully appreciate relative

costs as a basis for trade, argues thatabsolute production costs are irrelevant.

More meaningful are relative production

costs, which determine what trade should

take place and what items to export or

import.

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According to Ricardos principle of relative (or

comparative) advantage, one country may be

better than another country in producing

many products but should produce only what

it produces best.

Essentially, it should concentrate on either aproduct with the greatest comparative

advantage or a product with the least

comparative disadvantage.


Conversely, it should import either a product

for which it has the greatest comparative

disadvantage or one for which it has the leastcomparative advantage.

The advantage ratio for computers is 2:1

(i.e., 20:10) in favour of the USA.

Also in favour of the USA, but to a lesser

extent, is the ratio for automobiles, 1.5:1 (i.e.,

30:20).

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These two ratios indicate that the USA

possesses a 100% advantage over Japan for

computers but only a 50% advantage for

automobiles.

The USA has a greater relative advantage for

the computer product and should specializein producing the computer product.

For Japan, having the least comparative

disadvantage in automobiles,it should make

and export automobiles to the USA.


These two ratios indicate that the USA

possesses a 100% advantage over Japan for

computers but only a 50% advantage forautomobiles.

The USA has a greater relative advantage for

the computer product and should specialize

in producing the computer product.

For Japan, having the least comparative

disadvantage in automobiles,it should make

and export automobiles to the USA.

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It should be pointed out that comparative

advantage is not a static concept.

John Maynard Keynes, an influential English

economist, opposed Indias industrialization

efforts in 1911 based on his assumption of

Indias static comparative advantage inagriculture!


Alexander Hamilton endorsed the doctrine of

dynamic comparative advantage as a basis of

international trade. This doctrine explains why Taiwan and Indias

Bangalore have now become high technology

centres!

It also explains why or how the United Kingdom, lost

the lead to the USA in 1900 in the steel industry.

Andrew Carnegies mills among others were able to

produce twice as much steel as Great Britain three

decades later.

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Principle of Comparative/Relative

Advantage

- a country should export either a product with

the greatest comparative advantage (or with

the least comparative disadvantage)

- or import either a product for which it has the

greatest comparative disadvantage (or the

least comparative advantage)

Basis for International TradeExchange Ratios, Trade and Gain

Although an analysis of relative advantage

can indicate what a country should export

and import, that analysis cannot explainexactly how a country will gain from trading

with a partner.

In order to determine the extent of trading

gain, an examination of the domestic

exchange ratio is required.

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Theoretically, trade should equalize the

previously unequal domestic exchange ratios

and bring about a new ratio, known as the world

market exchange ratio, or terms of trade.

This ratio will lie between the limits established

by the pre-trade domestic exchange ratios. Such benefits derived from trade do not imply

that trade must always take place and that all

nations will always gain from trade.


Product USA Japan


Automobile 10 20


Automobile 30 20


Automobile 40 20


Case 3 of Table 2.1, the USA now makes forty automobiles

where the exchange ratio in both products is 2:1.

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Not only does the USA have absolute advantage for

both products, but it also has the same domestic

exchange ratio as that of Japan.

This situation is graphically expressed by two

parallel production possibility curves (Figure 2.2).

Figure 2.2Absolute advantage without

relative advantage (identical

domestic exchange ratios)


Under these circumstances, trade probably

will not occur for two principal reasons

USA is 100% better than Japan for each product,

the relative advantage for the USA is identical for

both products.

Since both countries have the identical domestic

exchange ratio, there is no incentive or gain from

trading for either party.

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Whether in the USA or in Japan, one unit of

computer will fetch two automobiles.

When such other costs as paperwork and

transportation are taken into account, it

becomes too expensive to export a product

from one country to another. Thus international trade is a function of the

varying domestic exchange ratios, and these

ratios cause variations in comparative costs

or prices.

Factor Endowment Theory

The principles of absolute and relative

advantage provide a primary basis for trade

to occur. One basic assumption is that the advantage,

whether absolute or relative, is determined

solelyby labour in terms of time and cost.

Labour then determines comparative

production costs and subsequent product

prices for the same commodity.

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It is misleading to analyse labour costs

without also considering the quality of that

labour.

A country may have high labour cost on an

absolute basis; yet this cost can be relatively

low if productivity is high. Any subsequent productivity gains usually

result in higher wages and currency

appreciation.


Since product price is not determined by

labour efficiency alone, other factors of

production must be taken into consideration,including land and capital.

Together, all contribute significantly to the

creation of value within a particular product.

Different commodities require different factor

inputs and that no country is well endowed in

all production factors.

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Different commodities require different factor

inputs and that no country is well endowed in

all production factors.

The varying proportion of these factors

embodied in various goods has a great deal

of impact on what a country should produce. Corn needs land, Oil exploraton needs capital and clothing

needs a labour-intensive market.


The HeckscherOhlin theory of factor

endowment holds that the inequality of

relative prices is a function of regional factorendowments and that comparative

advantage is determined by the relative

abundance of such endowments.

According to Ohlin, there is a mutual

interdependence among production factors, factor

movements, income, prices, and trade a change

in one affects the rest.

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Since countries have different factor

endowments, a country would have a relative

advantage in a commodity that embodies in

some degree that countrys comparatively

abundant factors.

A country should thus export that commoditywhich is relatively plentiful (i.e., in

comparison to other commodities) within the

relatively abundant factor (i.e., in comparison

to other countries).


This exported item may then be exchanged

for goods that would use large quantities of

the countrys scarce factors if domesticallyproduced.

A country that is relatively abundant in labour but

relatively scarce in capital is likely to have:

a comparative advantage in the production of labour-

intensive goods

deficiencies in the relatively less labour and land

because of expensive equipment and specialized

personnel.

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Factors of Production

- labour

- land

- capital

- others (technology, education, etc.)

inequality of relative prices is a function of regionalfactor endowments

comparative advantage is determined by relativeabundance of such endowments


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Michael PorterThe Competitive Advantage of Nations

Michael Porters book, The CompetitiveAdvantage of Nations, has received a greatdeal of interest all over the world.

Based on his analysis of over a hundredcase studies of industries in ten leading

developed nations, Porter has identified fourmajor determinants of internationalcompetitiveness:

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(1) factor conditions,

(2) demand conditions,

(3) related and supporting industries, and

(4) firm strategy, structure, and rivalry.

These four determinants interact and formthe diamond which provides the context inwhich a nations firms are born and compete.


A nation is competitive when it has

specialized assets and skills necessary for

competitive advantage in an industry.

Firms gain competitive advantage in

industries when their home base offers better

ongoing information into product and process

needs.

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They gain competitive advantage when

owners, managers, and employees support

intense commitment and sustained

investment.

In the end, nations succeed in particular

industries because their dynamic homeenvironment stimulates firms to upgrade and

widen their advantages over time.


Therefore, the effect of one determinant is

determined by the state of the others: the

advantages in one determinant can enhancethe advantages in others.

Porters theory also includes two additional

variables: chance and government.

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Chance events are developments outside

the control of firms, and they include pure

inventions, breakthroughs in basic

technologies, wars, external political

developments, and major shifts in market

demand. Government at all levels, on the other hand,

can improve or detract from a countrys

national advantage.


Regulations and investment policies can

affect domestic rivalry and home demand

conditions.

The diamond promotes the clustering of

a nations competitive industries.

The countrys successful industries are

usually linked through vertical

(buyer/supplier) or horizontal (common

customers, technology) relationships.

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Porter does offer a number of explanations or

qualifications.

A countrys national competitive advantage in

a particular industry may be eroded when

conditions in the national diamond no longer

support investment and innovation to matchthe industrys evolving structure.

Some important reasons for the loss of

advantage are:


deterioration of factor conditions,

local needs not compatible with global

demand,

loss of home buyers sophistication,

technological change,

firms adjustment inflexibility, and

reduction in domestic rivalry.

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Yet by advocating clustering, the theory also

looks static in the sense that it implies that

newcomers (nations) will have difficulties in

gaining competitive advantage in a new area.

Figure 2.4 shows the world competitiveness

scoreboard for nations for 2007 and 2015.

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Determinants of InternationalCompetitiveness

- factor conditions

- demand conditions

- related and supporting industries

- firm strategy, structure, and rivalry

- chance

- government

A Critical Evaluation of TradeTheories - Validity of Trade Theories

Several studies have investigated the validityof the classical trade theories.

The evidence collected by MacDougallshortly after World War II showed thatcomparative cost was useful in explainingtrade patterns.

Other studies using different data and timeperiods have yielded results similar toMacDougalls.

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The studies conducted by Leontief revealedthat the USA actually exports labour-intensive goods and imports capital-intensiveproducts.

These paradoxical findings are now called

the Leontief Paradox. Thus, the findings are ambiguous, indicating

that, in its simplest form, the HeckscherOhlin theory is not supported by theevidence.


In theory, the more different two countries are

different, the more they stand to gain by

trading with each other.

There is no reason why a country should

want to trade with another that is a mirror

image of itself.

However, a look at world trade casts some

doubt on the validity of classical trade

theories.

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Developed countries trade more among

themselves than with developing countries.

There is a tendency for corporations in

developed countries to prefer to form direct-

investment ties in the other more stable,

developed countries while avoiding heavyinvestment in the fast-growing developing

world.


The trade pattern shown is surprising

theoretically, because advanced economies

have similar climate and factor proportionsand thus should not trade with one another

since there are no comparative advantages.

Apparently, other variables in addition to

factor endowment play a significant role in

determining trade volume and practices

because considerable trade does occur

between developed nations.

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A Critical Evaluation of TradeTheories - Limitations and suggested refinements

Trade theories provide logical explanations about

why nations trade with one another, but limited by

their underlying assumptions.

Most of the worlds trade rules are based on a

traditional model that assumes that

(1) trade is bilateral,

(2) trade involves products originating primarily in the

exporting country,

(3) the exporting country has a comparative advantage, and

(4) competition focuses primarily on the importing countrys

market.


However, todays realities are quite different.

Trade is a multilateral process.

Trade is often based on products assembled from

components that are produced in various

countries.

It is not easy to determine a countrys

comparative advantage.

Competition usually extends beyond the importing

country to include the exporting country and third

countries.

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One limitation of classical trade theories is

that the factors of production are assumed to

remain constant for each country because of

the assumed immobility of such resources

between countries.

On the other hand, outsourcing and foreigndirect investment are a means to gain or use

foreign land.


Cosideirng the level of quality of the

production factors, each factor should not be

assumed to be homogeneous worldwide.

Some countries have relatively better-trained

personnel, better equipment, better-quality

land, and better climate.

Although a country should normally export

products, a country can substitute one

production factor for another to a certain

extent.

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The discussion so far has dealt with an

emphasis of trade theories on the supply

side, but demand is just as critical, and

demand reversal (when it occurs) may serve

to explain why the empirical evidence is

mixed. Tastes should not be assumed to be the

same among various countries.


In some market situations, it is possible for

product quality to be too high.

Companies in developed countries, for

example, sometimes manufacture products

with too many refinements, which make the

products too costly for consumers elsewhere.

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The most serious shortcoming of classical trade

theories is that they ignore the marketing aspect of

trade.

These theories are concerned primarily with

commodities rather than with manufactured goods or

value-added products.

It is assumed that all suppliers have identical

products with similar physical attributes and quality.

This habit of assumingproduct homogeneity is not

likely to occur among those familiar with marketing.


A further shortcoming of classical trade

theories is that the trade patterns as

described in the theories are in realityfrequently affected by trade restrictions.

A country can create a relative advantage by

relying on outsourcing and other trade

barriers, such as tariffs and quotas.

Protectionism can thus alter the trade

patterns as described by trade theories.

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The new trade theory states that trade is

based on increasing returns to scale,

historical accidents, and government

policies.

Japans targeted industry strategy, for

example, does not adhere to free-marketprinciples.

Therefore, a moderate degree of protection

may promote domestic output and welfare.

Validity of Trade Theories

Leontief Paradox Tendency for countries with similar endowments

to trade among themselves Offshoring

Factor Mobility and Substitution

Demand

Marketing

Trade Barriers

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Levels of Economic Cooperation

Given inherent constraints in any system,

conditions for the best policy rarely exist.

A policy maker must then turn to the second-

best policy.

This practice applies to international trade as

well. Worldwide free trade is ideal, but cannot

be attained.


The theory of second best suggests that

the optimum policy is to have economic

cooperation on a smaller scale.

In an attempt to reduce trade barriers and

improve trade,many countries within the

same geographic area often join together to

establish various forms of economic

cooperation.

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Free Trade Area

Customs Union

Common Market

Economic and Political Union

Political Union


Free Trade Area

- elimination of internal duties

Customs Union

- free trade area + establishment of commonbarriers

Common Market

- customs union + removal of restrictions onmovement of production factors

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Economic and Monetary Union

- common market

- + harmonization of national economic

policies

- + one money Political Union

- harmonization of national political policies

Trade Institutions and

Trade Policy

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Transnational Institutions AffectingWorld Trade

ITO (International Trade Organization): Proposed at BrettonWoods Conference (1944) but was never ratified by the USCongress.

GATT (General Agreement on Tariffs and Trade): A set of rules fornon discrimination, transparent procedures and settlementof disputes in international trade. Agreed upon in Genevaand adopted by 23 countries in1947.

Purpose: provide an international forum to encourage free

trade among member statesMeans: 1. regulation and reduction of tariffs on tradedgoods, 2. provision of a common mechanism for resolvingtrade disputes

Name changed to World Trade Organization (WTO) onJanuary 1, 1995 (by Uruguay Round)

Transnational Institutions AffectingWorld Trade

WTO is the new legal and institutional foundation for amultilateral trading system. It currently it has 153member countries.

Functions: Administering WTO trade agreements Forum for trade negotiations Handling trade disputes (empowered with ability toenforce rulings)

Monitoring national trade policies (countries found inviolation of WTO rules are expected to change policiesor else face sanctions)

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World Banking Group, 1944

Five major components:

- International Bank for Reconstruction andDevelopment (IBRD) - WB

- International Development Association (IDA) -WB

- International Finance Corporation (IFC) - WBG

- Multilateral Investment Guarantee Agency

(MIGA) - WBG- International Center for Settlement of InvestmentDisputes (ICSID) - WPG

World Bank: Current areas of focus

- Sustainable growth and development.

- Clean technologies.

- Addressing higher commodity prices.

- Agricultural assistance for combating inflation in food.

- Liberalization of world trade.

- Greater participation of rising economic powers anddeveloping nations in the banks governance.

- Reconstruction of war-torn countries.

- Assists fledging economies to participate in moderneconomic trade.

- Resolving debt problems of developing nations.

- Bringing market economy to former Eastern bloc nations.

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Trade Positions

International trade positions have changed

substantially when measured in terms of world

market share.

The U. S share of total world export has declined

precipitously since 1950s.

Another important development is the rise of China,India and Brazils trade positions.

The impact of international trade and marketing on

individuals is highlighted when trade is scrutinized

from a per-capita perspective.

Trade Positions (contd.)

Factors behind the decline in U.S. internationalcompetitiveness:

Attitude of the American policy makers.

Ignoring domestic firms in an attempt toboost the development of foreign economiesPerception amongst US manufacturers aboutinternational marketing being risky andcomplicated.

Lack of global interest

Inadequacy of information.

Unfamiliarity with international marketconditions.

Complicated trade regulations.

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The Impact of Trade andInvestment

The effect of trade Importance of Exports:

Create a trade balance by reducing trade

deficits.

Affect the currency values and fiscal and

monetary policies of the government.

Shape public perception aboutcompetitiveness.

Determine the affordable levels of imports for

a country.

Help achieve economies of scale.


The effect of trade Importance of imports:

Firms are exposed to new competition.

Gives rise to new marketing approaches,

better processes or better products and

services.

Competitive pressures keep quality high and

price low.

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The effect of international investment

Almost one in seven U.S. manufacturingemployees works for a foreign affiliate.

To some extent, foreign direct investmentssubstitute for trade activities.

Even though theory suggests openinvestment policy, some uneasiness existsabout the rapid growth of such investment.


Restriction on investments may

Permit more domestic control over

industries. Deny access to foreign capital and often

innovation.

Tightening up credit markets higherinterest rates, and a decrease inwillingness to adapt to changing worldmarket conditions

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