Chapter 4 International Trade Theory

8/2/2019 Chapter 4 International Trade Theory

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Chapter 4 International Trade Theory

-trade patterns in the World

1. Explain key trade theories.

2. Evaluate the rationale for government policies to

control trade.

3. Evaluate the effects of governments and pressure

groups on trade policies.

4. Compare and contrast the various approaches to trade

control.5. International Factor Movements


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1. An Overview Of Trade Theory

International free trade allows a country to specialize in themanufacture and export of products that can be produced mostefficiently in that country, and import products that can beproduced more efficiently in other countries .

Questions should be focused are:

what products should we import and export?

How much should we trade?

With whom should we trade?


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Theories of International Trade

1500 1600 1700 1800 1900 2000

Year

Mercantilism Absolute Advantage

Comparative Advantage

Factor Proportions Theory

International Product Life Cycle

New Trade Theory

Global Competitive Advantage


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1.1MERCANTILISM

Mercantilism, which emerged in England in the mid-16thcentury, asserted that it is in a countrys best interest tomaintain a trade surplus, to export more than it imports.

Mercantilism advocated government intervention toachieve a surplus in the balance of trade, many political viewstoday have the goal of boosting exports while limitingimports by seeking only selective liberalization of trade;

It viewed trade as a zero-sum game, one in which a gain by

one country results in a loss by another.


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1.2 Classical Trade Theory

The Theory of Absolute Advantage

The ability of a country to produce a productwith fewer inputs than another country. Hence,different countries produce some goods more

efficiently than other countries Thus, global efficiency can be increased

through international free trade

The Theory of Comparative Advantage

The notion that although a country may

produce both products more cheaply thananother country, it is relatively better atproducing one product than the other


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ABSOLUTE ADVANTAGE

In 1776, Adam Smith attacked the mercantilist assumption that trade is azero-sum game and argued that countries differ in their ability to producegoods efficiently, and that a country has an absolute advantage in theproduction of a product when it is more efficient than any other country inproducing it. According to Smith, countries should specialize in theproduction of goods for which they have an absolute advantage and then

trade these goods for the goods produced by other countries.Through specialization, countries could increase their efficiency because ofthree reasons:

Labor could become more skilled by repeating the same tasks;

Labor would not lose time in switching from the production of one kind

of product to another; Long production runs would provide incentives for the development ofmore effective working methods.

But in what products should a country specialize? Smith believed the

marketplace would make the determination, he thought that a countrys

advantage would be either natural or acquired.


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Absolute Trade Advantage


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COMPARATIVE ADVANTAGE

In 1817, David Ricardo took Adam Smiths theory one step further byexploring what might happen when one country has an absolute advantage inthe production of all goods. According to Ricardos theory ofcomparativeadvantage, it makes sense for a country to specialize in the production ofthose goods that it produces most efficiently and to buy the goods that itproduces less efficiently from other countries.

Heckscher and Ohlin argued that comparative advantage arises from

differences in national factor endowments. Countries will export goods

that make intensive use of those factors that are locally abundant, while

importing goods that make intensive use of factors that are locally scarce


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Absolute/Comparative Advantage are

Theories of Specialization

Possible invalid assumptions of these theories

Full employment may be compromised

Economic efficiency objective may not be fully held (culture, etc.) Unequal division of gains may put off some countries

Transportation costs can drive down an advantage

Mobility of factors is not always the case, especially HR

Dynamics of technological innovation, etc. change the landscape quickly

and give advantage

Adam SmithDivision of Labor

Industrial societies increase output using same labor-hours as pre-industrial society

David RicardoComparative Advantage

Countries with no obvious reason for trade can specialize inproduction, and trade for products they do not produce


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The Leontief Paradox

A country that is relatively labor abundant (capital abundant) should specializein the production and export of that product which is relatively labor intensive(capital intensive).

In 1953, Wassily Leontief postulated that since the U.S. was relativelyabundant in capital compared to other nations, the U.S. would be an exporter ofcapital intensive goods and an importer of labor-intensive goods.

However, he found that U.S. exports were less capital intensive than U.S.imports

Since this result was at variance with the predictions of the theory, it hasbecome known as the Leontief Paradox

Theories explaining trade patterns

How much does a country trade?

What types of products does a country trade?

With whom do countries trade?


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1.3 Factor Proportions Trade

Theory

Developed by Eli Heckscher

Expanded by Bertil Ohlin

Labor

Capital


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Factor Proportions Land-labor relationship

Labor-capital relationship

Technological complexities


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1.4 THE PRODUCT LIFE CYCLE THEORY

In the mid-1960s, Raymond Vernon proposed the product life-cycle theory that suggested that as products mature both thelocation of sales and the optimal production location will changeaffecting the flow and direction of trade.

According to the PLF theory of trade, the production location

moves from one country to another depending on the stage in theproducts life cycle.


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Life cycle stage

Maturity ischaracterized by

A decline in exportsfrom innovating countryMore productstandardizationMore capital intensityIncreased

competitiveness of priceProduction start-ups inemerging economies

Growth ischaracterized

byIncrease inexports byinnovatingcountryMorecompetitionIncreasedcapital intensitySome foreignproduction

Introductionstage is

marked byInnovation inresponse toobserved needExporting bythe innovativecountry evolvingproductcharacteristics

Decline is

characterized byA concentrationof production indevelopingcountriesAn innovatingcountry becoming

a net importer

Life cycle stage


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Limitations of PLC Theory

Products with extremely short PLCs

Luxury products where cost may be of little concern

Businesses with products that follow a differentiation strategy

Products that require specialized technical labor for subsequentproduct generations

Global start-ups


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1.5 The New Trade Theory:Strategic Trade

Two New Contributions ofStrategic Trade

Paul Krugman-How trade is altered when markets are not perfectly

competitive

Michael Porter-Examined competitiveness of industries on a global

basis

New trade theory suggests that because ofeconomies of scale (unit costreductions associated with a large scale of output) and increasing returns to

specialization, in some industries there are likely to be only a few profitablefirms

Firms with first mover advantages (the economic and strategicadvantages that accrue to many entrants into an industry) will developeconomies of scale and create barriers to entry for other firms


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Strategic Trade

Government can play a beneficial role when markets are not

purely competitive Theory expands to governments role in international trade

Four circumstances exist that involve imperfect competition inwhich strategic trade may apply

Porters Diamond of National Advantage

Innovation is what drives and sustains competitiveness

Four components of competition

Factor Conditions

Demand Conditions Related and Supporting Industries

Firm Strategy, Structure, and Rivalry


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National Competitive Advantage: PortersDiamond

Porters 1990 study tried to explain why a nation achieves

international success in a particular industry and identified

four attributes that promote or impede the creation of

competitive advantage:

Factor Endowments

A nation's position in factors of production can lead to

competitive advantage

These factors can be either basic (natural resources, climate,

location) or advanced (skilled labor, infrastructure,

technological know-how)


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Demand Conditions

The nature of home demand for the industrys product orservice influences the development of capabilities

Sophisticated and demanding customers pressure firms to becompetitive

Relating and Supporting Industries

The presence supplier industries and related industries that areinternationally competitive can spill over and contribute to otherindustries

Successful industries tend to be grouped in clusters incountries - having world class manufacturers of semi-conductorprocessing equipment can lead to (and be a result of having) acompetitive semi-conductor industry


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Porters Diamond of competitive

Porters Diamond of competitive advantage is shown in

following figure

Government policy can affectdemand through product standards,influence rivalry through regulationand antitrust laws, and impact the

availability of highly educatedworkers and advanced transportationinfrastructure

.

The four attributes, governmentpolicy, and chance work as a

reinforcing system, complementingeach other and in combinationcreating the conditions appropriate forcompetitive advantage


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2 Movements in Factors of Production

Movements in factors of production include labor migration

the transfer of financial assets through internationalborrowing and lending

transactions of multinational corporations involving directownership of foreign firms

Like movements of goods and services (trade), movements of factors of

production are politically sensitive and are often restricted.

Restrictions on immigration

Restrictions on financial asset flows (less common today in Europe

and U.S.)

Restrictions on the activities of multinational corporations


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2.1 Labor migration To show the effects of labor migration

(mobility), lets build a simple model with

only one composite good called output. Suppose that there are only two important

factors of production: land and labor.

On a fixed parcel of land, the productivity ofworkers eventually diminishes as eachworks more hours and as more workersproduce on that fixed parcel of land.

Fig. 1 The Marginal Product of Labor

The marginalproductivity of laboreventually decreases.


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International Labor Mobility(cont.)

Workers in the domestic country have an incentive to move tothe foreign country until the purchasing power of wagesbetween the countries are equal.

Emigration from the domestic country raises real wages ofthe remaining workers there.

It increases the supply of labor services and decreases thereal wage in the foreign country.


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Fig. 5-2: Causes and Effects ofInternational Labor Mobility

Labor migration between thedomestic country and theforeign country is also predictedto increase the value of worldoutput.

The value of foreign output

rises by the area under itsMPL* curve from OL1 toOL2

The value of domesticoutput falls by the areaunder its MPL curve fromOL2

toOL1

The value of world output

is maximized when themarginal productivity oflabor is the same acrosscountries.


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International Labor Mobility(cont.)

The Heckscher-Ohlin model predicts that trade in goods is an alternative to factormobility.

Services from factors of production are embodied in goods, so that the

value of goods reflects the value or productivity of the factors of production

that produced them. But equalization of factor prices with labor mobility does

not really occur for reasons that are similar to the reasons given in theHeckscher-Ohlin model:

The model assumes that trading countries produce the same goods, butcountries may produce different goods so that marginal productivities of laborare not comparable.

The model assumes that trading countries have the same technology, butdifferent technologies could affect the productivities of factors and thereforethe wages and income paid to these factors.

Barriers to immigration and emigration and transportation costs may prevent

the purchasing power of wages from equalizing. Barriers to movements forother factors of production, like land and capital, are also important.


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2.2 International Borrowing andLending

International capital mobility refers to mobility of financial assets, orcapital, across countries. Financial capital is a source of funds used to build physical capital

(ex., factories and equipment). International capital mobility can be interpreted as intertemporal

trade: trade of goods consumed today by borrowers in return for goods

consumed in the future by lenders. For any economy, there is a trade-off (opportunity cost) between consuming

today and saving for the future: resources can either be consumed or saved. To save and invest more today typically means that economies need to

consume less today. We represent this concept by drawing a special kind of production possibility

frontier, an intertemporal production possibility frontier.


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International Borrowing andLending (cont.)

Suppose that the domestic country has a comparative advantage in(bias towards) current consumption, while the foreign country has acomparative advantage (bias towards) future consumption.

In the absence of international borrowing and lending, the relative price

of current consumption should be lower in the domestic country. But what is the relative price of current consumption?

The price of borrowing 1 unit of output/income to consume today is theoutput/income that needs to be repaid in the future:

principal + interest = 1+r, where ris the interest rate

The price of current consumption relative to future consumption is 1/(1+r)

The opportunity cost of consuming 1 unit of output/ income today is theoutput/income that could be earned by saving it:

principal + interest = 1+r, where ris the interest rate

The opportunity cost of current consumption relative to future

consumption is 1/(1+r)


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3. FOCUS ON MANAGERIAL

IMPLICATIONS

The conditions in the nation governing how companies are created,organized, and managed, and the nature of domestic rivalry impacts firmcompetitiveness

There are at least three main implications for international businesses:

location implications, first-mover implications, and policy implications.

Location

One way in which the material discussed in this chapter matters to aninternational business is the link between the theories and a firmsdecision about where to locate its productive activities

It makes sense for a firm to disperse its various productive activities tothose countries where they can be performed most efficiently


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First Mover AdvantagesBeing a first mover can have important competitive implications,

especially if there are economies of scale and the global industry willonly support a few competitors

Government policies with respect to free trade or protecting domesticindustries can significantly impact global competitiveness

Businesses should work to encourage governmental policies thatsupport free trade


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4. A test for international trade theory

Destination WorldNorth

America

South andCentral

AmericaEurope

CIS AfricaMiddleEast

Asia

Origin

World 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0North America 13.0 37.5 28.3 5.5 3.1 7.3 9.7 9.6

South and Central

America 3.8 6.2 27.2 1.8 1.7 3.7 1.9 2.6

Europe 41.0 17.6 16.6 69.7 46.4 40.5 30.5 12.5

Commonwealth of

Independent States

(CIS) 4.5 1.3 1.7 6.0 26.1 2.3 4.0 2.0

Africa 3.5 4.5 3.2 3.2 0.3 11.7 2.3 2.9

Middle East 6.5 4.3 1.2 1.9 1.4 8.0 19.8 14.6

Asia 27.7 28.6 21.9 11.9 21.0 26.5 31.8 55.9

Shares of regional trade flows in world merchandise exports, 2008 (Percentage)

World merchandise exports by region and


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World merchandise exports by region andselected economy (Billion dollars andpercentage)

1948 1953 1963 1973 1983 1993 2003 2008

Value

World 59 84 157 579 1838 3676 7377 15717

Share

World 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0United States 21.7 18.8 14.9 12.3 11.2 12.6 9.8 8.2

South and Central America 11.3 9.7 6.4 4.3 4.4 3.0 3.0 3.8

Brazil 2.0 1.8 0.9 1.1 1.2 1.0 1.0 1.3

Europe 35.1 39.4 47.8 50.9 43.5 45.4 45.9 41.0

Commonwealth of Independent States

(CIS) b - - - - - - 2.6 4.5

Asia 14.0 13.4 12.5 14.9 19.1 26.1 26.2 27.7

China 0.9 1.2 1.3 1.0 1.2 2.5 5.9 9.1

Japan 0.4 1.5 3.5 6.4 8.0 9.9 6.4 5.0

India 2.2 1.3 1.0 0.5 0.5 0.6 0.8 1.1

Six East Asian traders 3.4 3.0 2.4 3.4 5.8 9.7 9.6 9.0


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Leading exporters and importers in world


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Leading exporters and importers in worldmerchandise trade, 2008 (Billion dollars andpercentage)

Rank Importers Value Share

Annual

percentag

e change

1 United

States

2169.5 13.2 7

2 Germany 1203.8 7.3 14

3 China 1132.5 6.9 18

4 Japan 762.6 4.6 23

5 France 705.6 4.3 14

6 United

Kingdom

632.0 3.8 1

7Netherlands

573.2 3.5 16

8 Italy 554.9 3.4 8

9 Belgium 469.5 2.9 14

10 Korea,

Republic of

435.3 2.7 22

Rank Exporters Value Share

Annual

percentag

e change

1 Germany 1461.9 9.1 11

2 China 1428.3 8.9 17

3 United States 1287.4 8.0 124 Japan 782.0 4.9 9

5 Netherlands 633.0 3.9 15

6 France 605.4 3.8 10

7 Italy 538.0 3.3 8

8 Belgium 475.6 3.0 10

9

Russian

Federatio

n 471.6 2.9 33

10

United

Kingdom 458.6 2.9 4


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Exports in commercial services of selectedeconomies by origin and destination, 2007

Value Share Annual percentage change

07 07 04-07 06 07World 1586629 100.0 14 13 21

European Union (27) 918349 57.9 14 13 20

United States 186557 11.8 10 11 14

Japan 26376 1.7 5 -4 14

Russian Federation 25930 1.6 32 20 43

China 24001 1.5 30 9 45

Singapore 15491 1.0 19 24 19

Australia 14617 0.9 19 10 28

India 12754 0.8 42 38 45

Hong Kong, China 11218 0.7 9 -15 28

Korea, Republic of 9804 0.6 13 16 16

Brazil 8693 0.5 24 15 33


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Leading importers in world trade in commercialservices (excluding intra-EU (27) trade), 2008

Rank Importers Value Share

Annual percentage

change

1 Extra-EU (27) imports 620.7 23.9 13

2 United States 367.9 14.2 8

3 Japan 167.4 6.4 13

4 China 158.0 6.1 22

5 Korea, Republic of 91.8 3.5 12

6 Canada 86.6 3.3 6

7 India 83.6 3.2 18

8 Singapore 78.9 3.0 6

9 Russian Federation 74.6 2.9 29

10 Thailand 46.3 1.8 21


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Leading exporters in world trade in commercialservices (excluding intra-EU (27) trade), 2008

Rank Exporters Value Share

Annual percentage

change

1 Extra-EU (27) exports 743.2 26.9 11

2 United States 521.4 18.8 103 China 146.4 5.3 20

4 Japan 146.4 5.3 15

5 India 102.6 3.7 17

6 Hong Kong, China 92.3 3.3 9

7 Singapore 82.9 3.0 3

8 Switzerland 75.2 2.7 16

9 Korea, Republic of 74.1 2.7 20

10 Canada 64.8 2.3 2


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Exports of the United States by origin and

destination, 2008

Destination Value Share

Annual percentage

change

2008 2000 2008 2007 2008

World 1287.4 100.0 100.0 12 12

North America 413.2 37.0 32.1 6 7Asia 329.4 27.6 25.6 11 8

Europe 311.1 23.6 24.2 16 14

South and Central

America 135.0 7.5 10.5 21 28

Middle East 55.0 2.4 4.3 21 22

Africa 28.8 1.4 2.2 28 20

CIS 13.8 0.4 1.1 49 32

European Union (27) 271.8 21.6 21.1 15 11

Canada 260.9 22.6 20.3 8 5

Mexico 151.2 14.3 11.7 2 11

China 69.7 2.1 5.4 17 11Ja an 65.1 8.4 5.1 5 7


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Imports of the United States by origin anddestination, 2008

Origin Value Share Annual percentage change

2008 2000 2008 2007 2008

World 2169.5 100.0 100.0 5 7

Asia 762.4 37.8 35.1 5 1

North America 559.0 29.4 25.8 5 5

Europe 409.6 20.3 18.9 6 4

South and Central America 167.4 6.2 7.7 1 18

Africa 117.3 2.3 5.4 14 23

Middle East 115.3 3.2 5.3 8 44

CIS 38.5 0.8 1.8 5 45European Union (27) 377.9 18.7 17.4 7 4

China 356.6 8.5 16.4 11 5

Canada 339.1 18.5 15.6 3 7

Mexico 218.6 10.9 10.1 6 3

Japan 143.6 12.0 6.6 -2 -4


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Exports and imports of China:2004-2008

Items 2008 2007 2006 2005 2004

The value of

Exports and

imports(1000

us$)

2,561,600,00

0.00

2,173,726,01

7.00

1,760,396,00

0.00

1,421,910,00

0.00

1,154,550,00

0.00

The value of

Exports (1000

us$)

1,428,500,00

0.00

1,217,775,75

6.01

968,935,601.

01

761,953,000.

00

593,326,000.

00

The value of

imports(1000

us$)

1,133,100,000.00

955,950,261.33

791,460,867.85

659,953,000.00

561,229,000.00


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Main indicators of China (units%)

Indicator 1978 1980 1990 2000 2005 2006 2007

Population 22.3 22.1 21.6 20.8 20.2 20.1 20.0

Gross Domestic Product 1.75 1.72 1.62 3.75 4.98 5.47 6.04

Foreign Trade Total 0.79 0.93 1.65 3.60 6.66 7.18 7.73

Exports 0.76 0.89 1.80 3.86 7.27 8.00 8.76

Imports 0.82 0.96 1.50 3.35 6.08 6.37 6.73

Foreign Direct Investment 0.11 1.68 2.91 7.55 5.15 4.56

Rice, Paddy 36.35 36.00 36.95 31.69 28.81 28.59 28.70

Wheat 12.13 12.54 16.58 17.00 15.55 17.46 18.10

Maize14.24 15.81 20.11 17.92 19.49 20.82 19.36

Soybeans 10.09 9.83 10.15 9.55 7.63 6.97 7.22

Source: FAO Database; UNSD Database; World Bank Database; IMF

The share of high technology to


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The share of high technology toexports

Country or Area 1990 2000 2003 2004 2005 2006

World 15.9 23.0 21.0 20.9 20.9 20.5High Income 17.2 24.1 21.5 21.5 21.7 20.6

Middle Income 19.5 20.1 19.4 19.0 20.4

Low Income 3.9 3.9

China 18.6 27.1 29.8 30.6 30.3

Hong Kong, China 23.3 12.7 14.3 15.6 11.3India 2.4 5.0 4.8 4.9 4.8

Indonesia 1.2 16.2 14.5 16.1 16.3 13.2

Japan 23.8 28.3 24.1 23.7 22.5 21.6

Korea, Rep. 17.8 34.8 32.1 32.8 32.3 32.0

Malaysia 38.2

59.5

58.9

55.6

54.7

53.8

Pakistan 0.1 0.4 1.3 1.1 1.4 1.4

Philippines 72.6 73.6 72.6 70.7 67.6

Singapore 39.7 62.6 56.3 56.6 56.6 57.8

Thailand 20.7 33.3 30.2 28.1 26.6 27.3

Viet Nam 11.0

5.6

4.5

5.3

United States 33.0 33.5 30.7 30.2 29.9 30.1


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Exchange Rate in 2009

Item 01 02 03 04 05 06 07 08 09

10.20 10.03 10.22 10.22 10.58 10.60 10.61 10.69 10.82Yuan per SDR

( End ofPeriod )

6.84 6.84 6.84 6.82 6.83 6.83 6.83 6.83 6.83Yuan per USDollar

( End ofPeriod )

Yuan per US

Dollar

( Period

Average )6.84 6.84 6.83 6.83 6.82 6.83 6.83 6.83 6.83

Chapter 4 International Trade Theory

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