PPT Lecture Note 4

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Alternative Theories of International Trade

Main topics:Intra-Industry TradeIncreasing returns to scale;Posner’s technological gap theory (1961);Vernon’s theory of product life cycle (1966)Linder’s thesis of overlapping demand (1961)

Week 4 Lecture

Learning ObjectivesMeasure the extent of intra-industry tradeDiscuss the two kinds of product differentiation and their roles in international tradeExplain how increasing returns to scale together with differentiated products can explain intra-industry trade and trade among countries with similar factor endowmentsExplain how the technological gap model can explain intra-industry trade and trade among countries with similar factor endowmentsExplain how the product life cycle model can explain intra-industry trade and trade among countries with similar factor endowmentsExplain how Linder’s thesis of overlapping demand can explain trade among countries with similar factor endowments

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Different Types of Trade:

Inter-industry tradeIt occurs when a country either exports or imports goods in different industries

• For example, U.S. trades machines for cloths with India.

Intra-industry tradeIt occurs when a country exports and imports goods within the same industry or product group

• For example, U.S. trades autos for autos with Canada.

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Intra-Industry Trade

Measuring Intra-Industry Trade

IIT = 0 No intra-industry trade IIT = 1 X=M of the product, Maximum intra-industry

trade

Note: sensitivity to industrial classification. The broader, the greater the value of IIT.

( )MX

MXIIT

+−

−= 1

Example 1:US imports $150,000 of cloth from India

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Intra-industry Versus Inter-industry Trade

Example 2: US imports $150,000 of computers from Japan and exports $150,000 computers to Japan.

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Intra-industry trade Index: It indicates the amount of intra-industry trade embodied in a country’s international trade.

The index is expressed as 1 minus the ratio of the absolute value of exports minus imports divided by exports plus imports.

IIT ranges from 0 (no intra-industry trade) to 1 (100 percent intra-industry trade).

The closer to 0, the less intra-industry trade relative to inter-industry trade.The closer to 1, the more intra-industry trade relative to inter-industry trade.


Defining Intra-industry Trade

The Increasing Importance on Intraindustry Trade

Why???

What Implications?

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Product Differentiation

Vertical product differentiation: difference in quality.

- Mercedes-Benz passenger car vs Volkswagen; a Sony

TV vs a Teac of the same size

Horizontal product differentiation: product varieties

- Neckties of same materials and style but different colours; ice cream of different flavours; Honda Civics of different colours

Alternative Theories of International Trade

Four theories explaining intra-industry trade and possibly trade among countries with similar factor endowments: • Increasing returns to scale;• Posner’s technological gap theory (1961); • Vernon’s theory of product life cycle (1966); and• Linder’s thesis of overlapping demand (1961)

The construction of Smith-Ricardian-H-O models: uses the deductive approach, i.e., deducing results from a list of assumptions or axioms. An example in finance is the CAPM model. The construction of the alternative theories: uses what we called the inductive approach, that is, from observations to hypotheses. Examples abound in the area of behavioural finance

Increasing Returns to Scale

Increasing returns to scale: output grows proportionately more than the increase in inputsThis theory suggests that by widening the market size, international trade permits longer production runs and larger production batches, which leads to economies of scale (and perhaps economies of experience). The basis of trade is lower production cost due to mass production of differentiated products.Mutually beneficial trade can take place even when both nations are identical Each nation would specialize completely It does not matter which nation specializes in which commodity

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Increasing Returns to Scale: ExampleAssume that the car industries in Australia and New Zealand produce both medium-sized Sedans and compact SUVs, and both industries possess the same production technology and cost structure so that they share the same average cost curve (AC). In addition, assume that both countries produce QA number of medium-sized sedans and QA’ number of compact SUVs. Because the cost structures (and possibly prices) are the same, there is no basis for trade.Now, assume that the two countries decide to trade with each other. The combined larger demand for each type of cars would allow the two countries to benefit from economies of scale if they selected to specialise in their production. - Let’s say Australia chooses to specialise in medium-sized passenger Sedans, it would double its production from QA to QB and average cost would decline from ACA to ACB. Similarly, New Zealand would also reap the benefit of economies of scale by doubling its production of compact SUVs. With free trade, Australia would export medium-sized sedans and import compact SUVs, and New Zealand would do the opposite. Both benefit from trade.

Figure 4.1: Average cost curves

Q

B

A

AC

QB QA

ACB

ACA

Q’

AC

B’

A’

AC’

QB’ QA’

ACB’

ACA’

Medium-sized sedans

Compact SUVs

Posner’s Technological Gap Theory (1961)

Posner: a great deal of international trade among industrialised countries is based on innovation, i.e., the introduction and export of new products or production processes or both. Countries that are relatively sophisticated in technology, such as US, Japan, Germany, tend to be innovative over time and have a competitive edge because of this ability. Therefore, a great deal of international trade can be explained by export of new products and processes from the innovators to other countries.

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Posner’s Theory: a microeconomic point of view

Suppose an innovative firm has a temporary monopoly based on patents and copyrights. It is able to export its new product or production process overseas without foreign competition. According to the theory of imperfect competition, a monopoly produces at the point where marginal revenue equals marginal cost and enjoys an economic profit, denoted by area p*ABG.

Figure 4.2: Short-run profit

Q

p*

0

p

MC

AC

AC*

Q* MR

DD

B

A

Profit = area p*ABG

G

Posner’s Theory: a microeconomic point of view

When firms from other countries are able to close the technology gap, the export market of the innovative firm shrinks and its profit dwindles. Over time, the followers are able to produce at a lower cost than that of the innovator, therefore export the product back to the country of origin. And the comparative advantage shifts from the innovator to the followers. Eventually, the innovator earns normal profit.

Figure 4.3: Long-run profit

Q 0

p

MC AC

p’ = AC’

Q’ MR’

DD’

A’

Profit = 0

Vernon’s Theory of Product Life Cycle (1966)

The theory suggests that a new product once exported can end up being imported as the product matured and its standardised production technology is transferred to low cost countries. The direction of trade changes with the production requirements associated with the product life cycle . - Generalization & extension of tech-gap model - New Product: Highly skilled labor - Maturing Process: mass acceptance; production standardized. Can be produced by mass production techniques and less skilled labor - Production shifts to less advanced nations with cheaper labor - May be accompanied by FDI

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The Product Cycle Model

Quantity

Time

Stage I Stage II Stage III Stage IV Stage V

Exports

Exports

Imports

ImportsInnovating

Country

Imitating

Country

O A B C D

technological diffusion, standardization, and

lower costs bring the end

Linder’s Thesis of Overlapping Demand (1961)

All the theories discussed so far hypothesised the source of comparative advantage arising from on the supply side. Stefan Linder (1961) argued that comparative advantage could arise from the demand side, and suggests that intra-industry trade in manufactured products is unimportant for countries with very different per capita income levels. International trade tends to be more pronounced between countries with similar income and cultural traits, therefore similar demand pattern of goods and services (i.e., overlapping demand).Linder hypothesis: a nation tends to export those manufactures for which a large domestic market exists [i.e. goods appealing to majority tastes are tested in the home market before export]. Imports cater to minority tastes. Such trade tends to occur among countries with similar tastes and income levels.

The following questions answered:

1. What is the basis for trade and what are the gains from trade?

2. How are gains from trade generated? How large and how are they divided among the trading nations?

3. What is the pattern of trade? How trade affects income distribution?

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Remaining Questions:How to calculate the trade balance and balance of payment for a nation?How does the change of exchange rates affect a trading firm?What is the foreign exchange market and how does it work? Why important?How is the exchange rate determined?

Lectures in Weeks 5 through 13

The joy ends here!

Next:

V. Bilateral Exchange Rates and the Market for Foreign Exchange

Reading: Moosa, I. A. (2007). International Finance: An Analytical Approach. 2nd ed. North Ryde, New South Wales: McGraw-Hill, pp. 28-40, 43-53, and 57-59 of Chapter 2.

PPT Lecture Note 4

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