Chapter 2: International Trade Theory and Application Chapter 2 International Trade Theory and...

Chapter 2: International Trade Theory and Application

Chapter 2

International Trade Theory and Application

International Business

Oded Shenkar and Yadong Luo


Do You Know?

• What are the major theories of international trade?

• How do governments limit trade with other countries, and what are their reasons for doing so?

• How do different technological levels define a country’s trade relationships?

• Why do countries with similar levels of technology trade more than countries with disparate technology levels?


International Trade Theories

• International trade is the exchange of goods and services across borders.

• Export structures vary across countries.

• A number of international trade theories can explain these different structures.


The Mercantilist Doctrine

• Mercantilism is a 16th Century doctrine stating that a nation should export more goods that it imports.

• Government’s job is to create policy that promotes heavy exportation, collection of revenue, and industrial development internally.

• In practice, it serves to make the State the stockholder, financier, customer, marketer, collector, and enforcer of contracts with other nations.


Absolute Advantage Theory

• In 1776, Adam Smith proposed that market forces rather than government desires were a better predictor of trade.

• Laissez-Faire policy where government has no influence should promote trade better.

• Nations will export to pay for goods they import.


Absolute Advantage Theory

• Nations could specialize in producing and exporting goods where they have a natural or acquired Absolute Advantage and import those goods they don’t produce as well.

Exhibit 2-1: Labor hours required to product one unit of a good.


Comparative Advantage Theory

• David Ricardo indicated in 1817 there may be a better explanation since few States actually specialize like that.

• Ricardo indicated that nations that are comparatively more efficient at production will make those goods even though they may not have an absolute advantage.

• Comparative Advantage explains and predicts trade of goods where absolute advantages may not exist.



• Opportunity Cost – the amount of other goods which have to be given up to product one unit of a good.

Exhibit 2-3: Opportunity costs for producing wine and cloth.

Exhibit 2-2: Labor hours required to produce one unit of a good.



• Comparative Advantage must be explained by:– Comparative Production Cost – depends

on the commodity’s production process.– Production Factors – such as labor, land,

capital, and natural resources.


Heckscher-Ohlin Theorem

• Countries export goods that make intensive use of the country’s abundant factor.

• Countries import goods that make intensive use of the country’s scarce factor.

• Differences in comparative advantage are attributed to differences in the structure of the economy.



• Assumptions:– Countries vary in the availability of various

factors of production.– The Production Function is identical

anywhere in the world.• The amount of output produced by using any

given amount of capital and labor.

– Technology is constant in all trading countries.

– Conditions of demand for production factors are the same in all countries.



• Implications– Trade should be greatest between

countries with the greatest differences in economic structure.

– Trade should cause countries to specialize more.

– Trade policy should take the form of trade restrictions.

– Countries should export goods that make use of the abundant factors.



• Implications– Free trade should equalize factor prices

between countries with similar relative factor endowments.

– Factor prices should be nearly equal between countries with more liberal mutual trade.

– International investment should be stimulated by difference in factor endowments.


The Leontief Paradox

• Leontief challenges Heckscher-Ohlin on a number of grounds.– The U.S (a capital intensive nation) exports labor-

intensive goods.– The U.S also exports technically sophisticated

goods that require skilled labor.– The U.S imports capital intensive goods made with

unskilled labor.

Exhibit 2-4: Capital position in U.S. exports and imports


The Leontief Paradox

• Stimulated a search for explanations. Demand bias for capital-investment

goods. Existence of trade barriers. Importance of natural resources Prevalence of factor-intensity reversals.


Human Skills and Technology-Based View

• Keesing indicated that trade direction and flow is predicted by gaps in human skills and technology.

• Nations with higher levels of humans skills and technology will produce and export goods to nations with lower levels.


Human Skills and Technology-Based View

• Human Skills are predicted by– Level of development in the scientific,

technical, managerial, and skilled labor sectors.

• Technology level is predicted by:– capital-intensive technology

development

– imitation lag that exists as technology innovations diffuse to developing areas.


The Product Life-Cycle Model

• Product innovation and initial use occurs first in higher income countries

• Diffuses to middle and lower income countries as technology and skills gaps overcome and consumer preferences switch to the newer products.



• Several trends emerge in PLC:– The export performance of the mature

innovating country is better than others.– Technology is better in the mature

countries – as products diffuse production tends to move from technology-intensive to labor-intensive.

– Countries that were innovators can fall from that place.

– Trade may increase in later stages of product maturity as costs and prices decline and production economies rise.



Exhibit 2-5: Product cycle model of international trade – innovating country



Exhibit 2-6: Product cycle model of international trade – imitating country


Linder’s Income-Preference Similarity Theory

• Developed countries trade more than less developed countries (assumption)

• Trade should take place between developed nations producing manufactured products and less developed nations producing primary products (e.g. natural resources) and labor-intensive goods.

• According to Linder, the range of production is determined by internal demand.

• Countries with similar internal demand conditions should therefore trade. This is called Preference Similarity.


The New Trade Theory

• Countries do not specialize and trade solely to take advantages of differences.

• They also trade because of increasing returns.

• Because of economies of scale, there are increasing returns to specialization.

• Economies of scale – reduction of manufacturing cost per unit as a result of increased production quantity during a given period.


The New Trade Theory

• Inter-industry trade determined by Heckscher-Ohlin.

• Intra-industry trade driven by increasing returns resulting from specialization within the industry.

• Externality – when the actions of one agent directly affect the environment of another.


Theory Assessment

• These theories provide insights in international trade.

• No theorem can fully explain the range of motives for international trade.


International Trade Volume and Growth

• International trade continues to grow briskly– In 2000, global merchandise exports

reached $6.2 trillion• Increase of 12.5% over 1999

– Global exports of commercial services reached $1.4 trillion

• Increase of 6% over 1999

– Significant change in in the share of various world regions.



Exhibit 2-7: World merchandise trade by major product group, 1950 - 2000



Exhibit 2-8: World merchandise trade by region and selected economy



Exhibit 2-8: World merchandise trade by region and selected economy (cont)


Service Trade

• The import and export of:– Financial services– Information services– Education and training– Travel and tourism– Healthcare– Consulting and advisory services

• Accounts for about one quarter of global trade, but rapidly growing.


Service Trade

Exhibit 2-9: Trade in commercial services of the U.S.


Trade Measurement

• Trade measurement is generally a difficult exercise since nations do not use similar indexed systems.

• Different trade data is collected for different purposes and aggregations may be biased.

• Major sources of reliable data – U.S Department of Commerce– World Trade Organization– Shippers Export Declarations– World Bank


Major Exporters and Importers

• In merchandise trade, top exporters and importers are developed countries.

Exhibit 2-10a: Top 10 leading exporters and importers in world merchandise trade, 2000


Major Exporters and Importers

• In commercial services, top exporters and importers are developed countries.

Exhibit 2-10b: Top 10 leading exporters and importers in world trade in commercial services, 2000


U.S. Trade Partners

• Canada is the largest trade partner

• Followed by the EU, Mexico, and Japan– Developed economies

• Canada and Mexico benefit from proximity and NAFTA membership.


U.S. Trade Partners

Exhibit 2-11: Merchandise trade of the U.S. by region and economy, 2000


U.S. Trade Partners

• Trade with Japan– Flow of foodstuff from U.S. to Japan

explained by factor endowments– Japan exports 10 times more vehicles to

the U.S. than vice versa.• Trade barriers• Currency exchange rates• Rising fuel prices


U.S. Trade Partners

Exhibit 2-12a: U.S. Exports to Japan (Top ten commodities)


U.S. Trade Partners

Exhibit 2-12b: U.S. Imports from Japan (Top ten commodities)


Trade Balance

• Balance of trade – exports minus imports of goods and services

• The U.S. has the largest trade deficit

• Low as a percentage of GDP.

Exhibit 2-13: Balance of Trade


Opposition to Free Trade

• Opponents of free trade in opposition to “globalization”.

• Countries take the position that trade needs to protect the interests of their citizens.

• In one survey, 48% of Americans said foreign trade is bad for the U.S.

• Trade impacts at the micro level, as well as the macro.

• People with lower incomes tend to be more negatively disposed to trade.


The Sovereignty Argument

• Moving production to the most efficient location deprives a country’s economic viability.

• Makes countries too dependent on other nations.

• Particularly relevant to national security.

• Threat to national culture and institutions.


The Lowest Common Denominator Argument

• Product shifts to nations with the least protection.

• Potentially adverse to the environment and safety.

• Everyone will end up paying for the adverse effects.

• One of the main complaints of the antiglobalization movement.


Trade Reciprocity

• Benefits from trade can be not only economic but also political and social.

• Passive reciprocity – a country refuses to lower or eliminate barriers to trade until the other does the same.

• Active or aggressive reciprocity – the threat of retaliation.


Types of Trade Barriers

• Tariff barriers – official constraints on the importation of certain goods or services.– Takes the form of a limitation or a special

levy.

• Non-tariff barriers – indirect measures that discriminate against foreign manufacturers.


Tariffs

• Surcharges that importer must pay above and beyond taxes leveled on domestic goods and services.

• Transparent and based on the value of the product or service.

• Optimal Tariff theory – governments can capture a portion of the manufactures profit margin.

• Infant Industry theory – a industry new to a country can be protected against established global players.


Tariffs

Exhibit 2-14: Average import tariff rates


Quotas

• Quantitative limits on the importation of goods.

• Definitive, quantifiable protection of the domestic producers.

• Rule of origin – administration of tariffs and quotes based on the country origin.


Export Controls

• Limitation of the type of products that can be exported to other countries.– National security risks– Dual purpose products– Goods vital to domestic industry

• Companies often argue that countries will get the products from a competitor.


Dumping and Anti-Dumping

• Dumping - Selling a product at an unfairly low price.

• Undermines the principles of comparative advantage.

• WTO allows anti-dumping laws where there has been “material injury” to the domestic industry.


Non-Tariff Barriers

• Administrative Barriers – used to block the entry of products while arguing that no barrier exists

• Production Subsidies – payments provided by a government to domestic companies to make them more competitive.

• Emergency Import Protection – implemented to protect against a surge in imports

• Foreign Sales Corporations – offshore corporations that market products and services of firms in foreign countries.


Non-Tariff Barriers

• Embargoes – the prohibition of exportation to a designated country.

• Boycotts – the blank prohibition on importation of all or some goods from a designated country.

• Technical Standards – requiring a company to demonstrate that their products meet the country’s domestic standards.

• Corruption• Barriers to Service Trade

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