lecture two presentation on theories of international trade

04/09/23 London School of Commerce 1

Lecture Two

Theories of International Trade

Dr. Bernadette Warner


International Trade Objectives Introduction International trade theory Barriers to trade Non-tariff barriers to trade Other economic developments


Objectives

Define the term international trade and discuss the role of mercantilism in modern international trade.

Contrast the theories of absolute advantage and comparative advantage.

Relate the importance of international product life cycle theory to the study of international economics.

Explain some of the most commonly used barriers to trade and other economic developments that affect international economics.

Discuss some of the reasons for the tensions between the theory of free trade and the widespread practice of national trade barriers.


Introduction International trade: the branch of

economics concerned with the exchange of goods and services with foreign countries.

We will focus on: International trade theory Barriers to trade.


An Overview Of Trade TheoryFree trade refers to a situation where 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


Why do nations trade?Trade theories: Mercantilism; Theory of absolute advantage; Theory of comparative advantage; Factor endowment theory; International product cycle theory; Other considerations.


Mercantilism A trade theory which holds that a

government can improve the well-being of the country by encouraging exports and stifling imports.

Cf.) Neo mercantilism: without the reliance on precious metal (gold).


Mercantilism

Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -- to export more than it importsMercantilism advocates government intervention to achieve a surplus in the balance of trade It views trade as a zero-sum game - one in which a

gain by one country results in a loss by another


Theory of Absolute Advantage A trade theory which holds that by specializing in

the production of goods, which they can produce more efficiently than any others, nations can increase their economic well-being.An example

Assume: labour is the only cost of production; lower labour-hours per unit of production

means lower production costs and higher productivity of labour.


Theory of Absolute Advantage

North has an absolute advantage in the production of cloth.South has an absolute advantage in the production of grain.

It follows that:If North produces cloth and South produces grain, and an exchange ratio can be arranged, both the countries will benefit from trade.


Comparative AdvantageDavid Ricardo asked what might happen when one country has an absolute advantage in the production of all goods Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home


Theory of Comparative Advantage A trade theory which holds that nations should

produce those goods for which they have the greatest relative advantage.

An example Assume:

labour is the only cost of production; lower labour-hours per unit of production

means lower production costs and higher productivity of labour.


Theory of Comparative Advantage

North has an absolute advantage in the production of both cloth and grain but the relative costs differ (i.e. gains from trade).In North, one unit of cloth costs 50/100 hours of grain.In South, one unit of cloth costs 100/100 hours of grain.

It follows that:If North can import more than a half unit of grain for one unit of cloth, it will gain from trade.If South can import one unit of cloth for less than one unit of grain, it will also gain from trade.Under the circumstance presented in the above example, both countries can benefit from trade.


Qualifications And AssumptionsThe simple example of comparative advantage assumes:only two countries and two goodszero transportation costssimilar prices and valuesresources are mobile between goods within countries, but not across countriesconstant returns to scalefixed stocks of resourcesno effects on income distribution within countries


Extensions Of The Ricardian ModelResources do not always move freely from one economic activity to another, and job losses may occurUnrestricted free trade is beneficial, but because of diminishing returns, the gains may not be as great as the simple model would suggest

Opening a country to trade:might increase a country's stock of resources as increased supplies become available from abroadmight increase the efficiency of resource utilization, and free up resources for other uses might increase economic growth


Factor Endowment Theory Also known as the Heckscher-Ohlin theory,

It extends the concept of comparative advantage by bringing into consideration the endowment and cost of factors of production and helps to explain why nations with relatively large labour forces will concentrate on producing labour-intensive goods, whereas, countries with relatively more capital than labour will specialize in capital-intensive goods.

Weaknesses of factor endowment theory: Some countries have minimum wage laws that result in high prices for

relatively abundant labour. The Leontief paradox: countries like the United States actually export

relatively more labour-intensive goods and import capital-intensive goods.

No single theory can explain the role of economic factors in trade theory.


International Product Life Cycle Theory (IPLC) A theory of the stages of production for a product

with new “know-how”: it is first produced by the parent firm, then by its foreign subsidiaries and finally anywhere in the world where costs are the lowest; it helps to explain why a product that begins as a nation’s export often ends up as an import.


The Product Life Cycle TheoryThe product life-cycle theory, proposed by Raymond Vernon, suggested that as products mature both the location of sales and the optimal production location will change affecting the flow and direction of tradeVernon argued that the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new productsVernon argued that initially, the product would be produced and sold in the U.S., later, as demand grew in other developed countries, U.S. firms would begin to export Over time, demand for the new product would grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets


New Trade TheoryNew trade theory suggests that the ability of firms to gain economies of scale (unit cost reductions associated with a large scale of output) can have important implications for international trade

New trade theory suggests that:through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goodsin those industries when output required to attain economies of scale represents a significant proportion of total world demand, the global market may only be able to support a small number of enterprises


Increasing Product Variety And Reducing Costs

Without trade, nations might not be able to produce those products where economies of scale are importantWith trade, markets are large enough to support the production necessary to achieve economies of scaleSo, trade is mutually beneficial because it allows for the specialization of production, the realization of scale economies, and the production of a greater variety of products at lower prices


Economies Of Scale, First Mover Advantages, And The Pattern Of TradeThe pattern of trade we observe in the world economy may be the result of first mover advantages (the economic an strategic advantages that accrue to early entrants into an industry) and economies of scale New trade theory suggests that for those products where economies of scale are significant and represent a substantial proportion of world demand, first movers can gain a scale based cost advantage that later entrants find difficult to match


Implications Of New Trade TheoryNations may benefit from trade even when they do not differ in resource endowments or technologyA country may dominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good While this is at variance with the Heckscher-Ohlin theory, it does not contradict comparative advantage theory, but instead identifies a source of comparative advantage An extension of the theory is the implication that governments should consider strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important


National Competitive Advantage: Porter’s Diamond

Figure 5.6: Determinants of National Competitive Advantage: Porter’s Diamond


Evaluating Porter’s TheoryGovernment policy can:affect demand through product standardsinfluence rivalry through regulation and antitrust lawsimpact the availability of highly educated workers and advanced transportation infrastructure.

The four attributes, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage


Implications For Managers

There are three main implications for international

businesses:location implicationsfirst-mover implicationspolicy implications


LocationDifferent countries have advantages in different productive activitiesIt makes sense for a firm to disperse its various productive activities to those countries where they can be performed most efficientlyInternational trade theory suggests that firm sthat fail to do this, may be at a competitive disadvantage


First-Mover AdvantagesBeing a first mover can have important competitive implications, especially if there are economies of scale and the global industry will only support a few competitorsFirms that establish a first-mover advantage may dominate global trade in that product


Government PolicyGovernment policies with respect to free trade or protecting domestic industries can significantly impact global competitivenessBusinesses should work to encourage governmental policies that support free tradeFirms should also lobby the government to adopt policies that have a favorable impact on each component of the diamond


Barriers to trade


Reasons for Barriers to Trade Protect local jobs by shielding home-country business from foreign

competition. Encourage local production to replace imports. Protect infant industries that are just getting started. Reduce reliance on foreign suppliers. Encourage local and foreign direct investment. Reduce balance of payments problems. Promote export activity. Prevent foreign firms from dumping, that is, selling goods below cost

in order to achieve market share. Promote political objectives such as refusing to trade with countries

that practice apartheid or deny civil liberties to their citizens.


Commonly Used Barriers to Trade Price-based barriers

Tariffs: a tax on goods shipped internationally Quantity limits

Quotas: a quantity limit on imported goods Embargos: a quota set to zero

International price fixing A cartel: a group of firms that collectively agree to fix prices or

quantities sold in an effort to control price Non-tariff barriers Financial limits

Exchange controls: controls that restrict the flow of currency Foreign investment controls

Limits on FDI Limits on transfer or remittance of funds


Non-Tariff Barriers to Trade

Quotas “Buy national” restrictions Customs valuation Technical barriers Antidumping legislation, subsidies and

countervailing duties Agricultural product regulations and subsidies Export restraints.


Other Economic Developments

Counter-trade: barter trade in which the exporting firm receives payments in products from the importing country.

Trade in services: as high-income countries move toward a service economy, trade in services has grown.

Free trade zones: a designated area where importers can defer payment of customs duty while further processing of products takes place (as a foreign trade zone).

lecture two presentation on theories of international trade

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