Chapter Five

International Trade Theory

5 - 3

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 4

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 5

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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”

5 - 6

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 7

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 8

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Theory of Absolute Advantage

5 - 9

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Absolute Advantage and the Gains From Trade

5 - 10

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 11

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Theory of Comparative Advantage

5 - 12

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Comparative Advantage and the Gains From Trade

5 - 13

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 14

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 15

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

PPF Under Diminishing Returns

5 - 16

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Influence of Free Trade on PPF

5 - 17

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 18

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 19

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Product life cycle theory

Fig 4.5

5 - 20

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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”

5 - 21

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 22

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 23

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Porter’s Diamond

• Success occurs where these attributes exist• More/greater the attribute, the higher chance of

success• The diamond is mutually reinforcing

5 - 24

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Porter’s Diamond

5 - 25

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 26

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 27

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 28

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Advanced Factor Endowments

• Communications• Skilled labor• Research• Technology• Education

5 - 29

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Demand Conditions

• Demand:- creates capabilities - creates sophisticated and

demanding consumers

• Demand impacts quality and innovation

5 - 30

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Related and Supporting Industries

• Creates clusters of supporting industries that are internationally competitive

• Must also meet requirements of other parts of the Diamond

5 - 31

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 32

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 33

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 34

McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Looking Ahead to Chapter 6

• The Political Economy of International Trade- Instruments of Trade Policy- The Case for Government Intervention- The Revised Case for Free Trade- Development of the World Trading System