1. Innovation Economics
Class 6

2. International Trade Theory
This is a test

3. International Trade Theory
What is international trade?
Exchange of raw materials and manufactured goods (and services) across national borders
Classical trade theories:
explain national economy conditions--country advantages--that enable such exchange to happen
New trade theories:
explain links among natural country advantages, government action, and industry characteristics that enable such exchange to happen
Implications for International Business

4. Classical Trade Theories
Mercantilism (pre-16th century)
Takes an us-versus-them view of trade
Other country’s gain is our country’s loss
Free Trade theories
Absolute Advantage (Adam Smith, 1776)
Comparative Advantage (David Ricardo, 1817)
Specialization of production and free flow of goods benefit all trading partners’ economies
Free Trade refined
Factor-proportions (Heckscher-Ohlin, 1919)
International product life cycle (Ray Vernon, 1966)

5. The New Trade Theory
As output expands with specialization, an industry’s ability to realize economies of scale increases and unit costs decrease
Because of scale economies, world demand supports only a few firms in such industries (e.g., commercial aircraft, automobiles)
Countries that had an early entrant to such an industry have an advantage:
Fist-mover advantage
Barrier to entry

6. New Trade Theory Global Strategic Rivalry
Firms gain competitive advantage trough: intellectual property, R&D, economies of scale and scope, experience
National Competitive Advantage (Porter, 1990)

7. Absolute Advantage Adam Smith: The Wealth of Nations, 1776
Mercantilism weakens country in long run; enriches only a few
A country
Should specialize in production of and export products for which it has absolute advantage; import other products
Has absolute advantage when it is more productive than another country in producing a particular product G
Cocoa
G: Ghana
K: S. Korea K K'
Rice G'

9. Comparative Advantage
David Ricardo: Principles of Political Economy, 1817
Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces
Absolute Advantage is a special case of Comparative Advantage G
Cocoa
Example: Medical Specialist is also the best medical secretary. Should this doctor spend any time on the secretarial part of the business? No? Why?
Lets continue with SL and the USA...
This time the terms have changed to give the USA the absolute adv. in both tea and wheat...
G: Ghana
K: S. Korea K K' G'
Rice

11. Heckscher (1919)-Ohlin (1933)
Differences in factor endowments not on differences in productivity determine patterns of trade
Absolute amounts of factor endowments matter
Leontief paradox:
US has relatively more abundant capital yet imports goods more capital intensive than those it exports
Explanation(?):
US has special advantage on producing new products made with innovative technologies
These may be less capital intensive till they reach mass-production state

12. Theory of Relative Factor Endowments (Heckscher-Ohlin)
Factor endowments vary among countries
Products differ according to the types of factors that they need as inputs
A country has a comparative advantage in producing products that intensively use factors of production (resources) it has in abundance
Factors of production: labor, capital, land, human resources, technology

13. International Product Life-Cycle (Vernon)
Firms kept production close to their market initially
Aid decisions; minimize risk of new product introductions
Demand not based on price; low product cost not an issue
Limited initial demand in other advanced countries initially
Exports more attractive than overseas production
When demand increases in advanced countries, production follows
With demand expansion in secondary markets
Product becomes standardized
production moves to low production cost areas
Product now imported to US and to advanced countries

14. Classic Theory Conclusion
Free Trade expands the world “pie” for goods/services
Theory Limitations:
Simple world (two countries, two products)
no transportation costs
no price differences in resources
resources immobile across countries
constant returns to scale
each country has a fixed stock of resources and no efficiency gains in resource use from trade
full employment
Real world: many countries and many goods
Transportation costs may decline with specialization
Prices in different countries can be (are) effected by exchange rates. Wheat and Tea are not necessarily a one-to-one swap
resources can move from country to country: labor (Mexico to US), capital
(constant returns to scale: specialization does not effect the amount of resources required to produce one ton of wheat or tea) both diminishing and increasing returns to specialization exist
assumed fixed stock of resources in each country. Trade can change the efficiency with which the resources are used and the stock of resources may change too (more people, more natural resources, more efficient use due to technology)
Full employment implies use of resources at full efficiency...

15. New Trade Theories
Increasing returns of specialization due to economies of scale (unit costs of production decrease)
First mover advantages (economies of scale such that barrier to entry crated for second or third company)
Luck... first mover may be simply lucky.
Government intervention: strategic trade policy
Commercial jet industry: studies show that 3 major manufacturers can survive. Boeing, McDonnell Douglas and Airbus already there... New entries discouraged... however, the largest potential customer is China and they want the capacity to produce... hence the battle Boeing is having with unions... either give China some of the value added activity to keep them out of mainline or lose out to Airbus or to a non-economic decision to start an industry.
Luck: DeHaviland in 50s. Comet fell out of sky. 707 captured the market. (some say it was not only luck but resources. B. had produced 707 on the back of technology developed for US military--spillover effect?? what of our claim that Airbus was subsidized??)

16. National Competitive Advantage (Porter, 1990)
Factor endowments
land, labor, capital, workforce, infrastructure (some factors can be created...)
Demand conditions
large, sophisticated domestic consumer base: offers an innovation friendly environment and a testing ground
Related and supporting industries
local suppliers cluster around producers and add to innovation
Firm strategy, structure, rivalry
competition good, national governments can create conditions which facilitate and nurture such conditions
Factor Endowments:
basic factors: natural resources, climate, location, demographics
advanced factors: communications infrastructure, sophisticated and skilled labor, R&D, technological know-how
advanced factors are most important: they are the result of investment by individuals, companies and government (education, general skill and knowledge stimulation, basic R&D support)
Demand conditions: sophisticated home demand can create impetus for enhancing competitive advantage (Japanese consumer knowledgeable on cameras pushed J. industry to create advantage)
Related and Supporting industries:
internationally competitive suppliers. Creation of clusters of related industries. ex. German textile and apparel sector (high qual. cotton, wool, synthetic fibers, sewing machine needles, textile machinery)
Firm Strategy, Structure, and Rivalry within a nation:
Management ideologies: predominance of engineers in TMTs of Germ. and J. cos. helped improve manufacturing processes and product designs (Porter found top execs with finance backgrounds in US 70s. most CEOs of the 40 companies I studies were marketing specialists).
Vigorous domestic rivalry creates persistent comp. advantage in and industry: impr. efficiency and leads to international competitiveness.

17. Porter’s Diamond

18. “So What” for business? First mover implications Location Implications
Foreign Investment Decisions
Government Policy implications
Location: To produce laptop four stages:
Basic research and development of product design (US, Japan: Apple, IBM, Motorola, TI, Toshiba, Sony)
manufacture of standard electronic components (capital intensive, semi-skilled labor, high unit cost pressures: Sing., Taiwan, Malaysia)
manuf. of advanced components (screens) (cap. intensive, high skilled labor, no cost pressure: Japan)
final assembly (labor intensive, low skill, intense cost pressures: Mexico)
First mover implications: high initial investment with years of losses... Japan LCD displays, US abandoned early tech. leadership in this technology.
Policy:
Apple and IBM lobbied against tariffs on LCD display imports: J. was the low cost producer, A. and IBM used these displays, the increase in import duty would reduce the world competitiveness of the A. and IBM products...
Auto industry induced govt. to negotiate voluntary restraints in machine tools. result: limited competition from world-wide efficient suppliers caused the US companies to lose their WW competitive edge and lost its WW share since 85.

19. New Growth Theory
New growth theory emphasizes the role of technology rather than capital in the growth process.

20. Technology
Technology is the result of investment in creating technology (research and development).
Growth theory separates investment in capital from investment in technology.
Increases in technology are not as directly linked to investment as is capital.

21. Technology
Increases in technology often have enormous positive spillover effects.
Positive externalities – positive effects on others not taken into account by the decision maker.
Technological advances in one sector of the economy lead to advances in completely different unrelated sectors.

22. Technology Some basic research is protected by patents.
Patents – legal ownership of a technological innovation that gives the owner of the patent sole rights to its use and distribution for a limited time.

23. Technology
Once people have seen the new technology, they figure out a sufficiently different way to achieving the same end to avoid the patent.

24. Learning by Doing New growth theory also highlights learning by doing.
Learning by doing – improving the methods of production through experience.
By increasing the productivity of workers, learning by doing also overcomes the law of diminishing marginal productivity.

25. Increasing Returns to Scale
Output
All inputs
Production function with increasing returns

26. Technological Lock-In
Technological lock-in occurs when old technologies become entrenched in the market.
They become locked into new products despite the fact that more efficient technologies are available.

27. Technological Lock-In
One reason for technological lock-in is network externalities.
Network externalities – an externality in which the use of a good by one individual makes that technology more valuable to other people.

28. Technological Lock-In
Switching from a technology exhibiting network externalities to a superior technology is expensive and sometimes nearly impossible.