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International Trade (2)Alternative Trade Theories

References

• Hill, C W “International Business” (6th edit., 2007), Chapter 5

• Ball, D et al. “International Business” (11th edit., 2008), Chapter 3

• Sloman, John, “Economics” (8th edit) – chapter 24.1

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Assumptions of Comparative Advantage

The theory of comparative advantage provides a strong argument in favour of free trade but it is however based on a number of simplifying assumptions which are sometimes unrealistic

1)In the real world there are many countries and many goods – not just two

2)Transportation costs between countries have to be taken into account

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3) There are differences in the prices of resources in different countries. We ignored exchange rates and assumed that cocoa and rice swapped on a one-to-one basis

4) We have assumed resources can move freely from the production of one good to another within a country – this is not necessarily the case

5) We have assumed constant returns to scale. In reality, both diminishing and increasing returns to specialisation exist

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6) We have assumed that each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resources

7) We have ignored the effects of trade on income distribution within a country – can we therefore say that free trade has unequivocally benefitted a country

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Free Trade and Economic Growth

• If these assumptions are dropped the theory of comparative advantage is less robust

• Free trade can change a country's stock of resources – i.e. labour and capital from abroad

• It might also increase the efficiency with which a country uses those resources

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• Economies of scale in production are likely to become available as the size of the total market increases

• Trade might make better technology from abroad available to domestic firms

• Opening an economy to foreign competition is likely to stimulate domestic producers to look for ways to increase their efficiency

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Free Trade and the Production Possibility Frontier

• Free trade increases the quantity of goods which can be produced by pushing out the boundaries of the PPF

• Higher levels of productivity and/or greater quantities of land, labour and capital increase production

• This means consumers can enjoy the benefits of these higher levels of production and prices fall

• Global competition also forces down prices

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• When we accept the assumption of diminishing returns to specialisation then the PPF is CONVEX to the origin instead of being straight - what are the implications of this?

Cocoa

Rice

After growth - 2015

Before growth - 2005

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The Heckscher-Ohlin Model

• David Ricardo suggested that comparative advantage was caused by differences in labour productivity – e.g. skilled labour

• Two Swedish economists - Heckscher (1919) and Ohlin (1933) developed an alternative explanation for comparative advantage

• They argued that it arises from differences in national FACTOR ENDOWMENTS - e.g. land, labour and capital

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• The extent to which a country has more of a particular resource – e.g. land

• In this case the cost of the abundant factor will be lower

• Countries will export goods that make intensive use of factors that are locally abundant

• E.g. The United States exports agricultural goods because it has large areas of arable land – this means that land is relatively cheap

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The Leontief Paradox

• Studies to test the HO theory on US imports and exports were conducted by W Leontief (1953)

• Since the US has a relative abundance in capital compared to many other countries it should be an exporter of capital intensive goods and an importer of labour intensive goods

• The study however showed this was not the case

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• In fact US exports were less capital intensive than imports

• One explanation put forward to explain this is that : -

• The US may be exporting new goods which use highly skilled labour e.g. computer software and at the same time importing simple mass produced machinery which is capital intensive

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• The problem for economists is that the labour productivity theory of trade put forward by Ricardo is better than the Heckscher-Ohlin theory at explaining trade patterns

• However if the role of technology is also considered then the HO theory becomes stronger

• Technology will improve productivity

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The Product Life Cycle

• Raymond Vernon - a US economist (1960’s)

• Found that a large proportion of new products were developed in the USA

• e.g. TV’s, cars, computers

• He argued that this was due to the fact that the USA was a large and wealthy market

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• Companies had an incentive to produce goods for this market using skilled labour and capital in the most efficient way

• The production and marketing of a new product occurs in a number of stages

1) First of all firms sell the new product in the US market

2) They start to export the product to other industrialised countries for sale to a few high income earners

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3) Demand grows in these countries and domestic producers start to make similar products

4) This creates competition for US producers who cut back production

5) The market becomes mature and US consumers begin to purchase foreign goods – especially where local labour or capital is cheaper

6) The process then continues on to less developed countries who in turn begin production at more competitive prices

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• Is the theory valid?

• From 1945 to 1975 most new products were introduced in US

• BUT today many products are introduced simultaneously in US, Japan and the advanced European nations

• e.g. laptop computers, compact disks, and electronic cameras

• The theory may have been valid in the post war period but comparative advantage provides a better explanation for differences in production and efficiency

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The New Trade Theory

• This theory emerged during the 1970s based on scale economies and intra-industry trade

• Economists (Paul Samuelson) questioned the assumption of diminishing returns to specialisation in international trade

• In many industries economies of scale give increasing returns – average fixed costs fall as output rises

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• In some industries world demand is limited and supports only a few firms

• Therefore countries export certain products because they have a firm that was an EARLY ENTRANT into that industry known as ‘FIRST-MOVER ADVANTAGE’

• E.g. commercial aircraft industry – Boeing and Airbus discourage new entrants

• Economies of scale increase productivity - an important source of comparative advantage

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• How useful is this theory in explaining trade patterns?

• It stresses the role of luck, entrepreneurship and innovation in giving a firm first-mover advantages.

• It also provides an excuse for government intervention - e.g. Boeing's R&D was largely paid for by the US government as a spin-off from its military programs

• Using subsidies governments can help domestic firms become ‘first movers’

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National Competitive AdvantagePorter’s Diamond

• Porter (1990) examined the success of certain industries in certain countries

• He argued that success relied on 4 main elements :-

1) Factor Endowments

2) Demand Conditions

3) Relating or Supporting Industries

4) Firm Strategy, Structure and Competition

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• Success depended upon how the 4 elements of the ‘Diamond’ interact with each other : -

(a) Factor endowments

• Not just basic factors such as land, climate and natural resources but also includes man made endowments

• e.g. Government investment in education, communications infrastructure and research facilities

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(b) Demand conditions

• home demand for the industry's product or service - a nation's firms gain competitive advantage if their domestic consumers are sophisticated and demanding

(c) Relating and supporting industries

• the presence or absence of suppliers’ industries and related industries that are internationally competitive

• successful industries tend to be in clusters of related industries

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• (d) Firm strategy, structure and competition

• how companies are organised and managed and how they compete

• E.g. predominance of engineers in the German and Japanese firms - emphasis on improving manufacturing processes and product design