Trade and Factor Mobility Theory Chapter 5 Trade and Factor Mobility Theory Chapter 5: Trade and Factor Mobility Theory Copyright © 2015 Pearson Education Ltd.

Laissez-Faire vs. Intervention Trade theory helps answer What products should we import and export? How much should we trade? With whom should we trade? Laissez-faire approach Free trade theories – absolute advantage and comparative advantage Intervention approach Mercantilism and neomercantilism Why do countries trade? Countries trade in order to meet certain economic objectives, but they struggle with questions on what, how much, and with whom they should trade. They need to ensure that their decisions on what to produce make sense from an efficiency standpoint, and whether there are ways to improve competitiveness. Some countries allow market forces to determine trade relations, others intervene to control the process. Copyright © 2015 Pearson Education Ltd.

Theories of Trade Patterns Theories explore country size factor proportions country similarity Theories explore trade competitiveness Product life cycle Diamond of national advantage Theories that explain trade patterns explore how much countries depend on trade, in what products, and with which countries. Some theories suggest that governments should influence trade patterns, other support a laissez-faire approach. Copyright © 2015 Pearson Education Ltd.

Factor Mobility Theory A country’s competitiveness depends on quality and quantity of production factors Land Labor Capital Factor mobility is also an important issue in trade because it influences a nation’s competitiveness. The three factors of production are land, labor, and capital. Copyright © 2015 Pearson Education, Inc.

Interventionist Theories Theories that support government intervention in the flow of trade Mercantilism Neomercantilism Some theories including mercantilism and neomercantilism explore how governments can interfere with trade flows in order to achieve certain national objectives. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education Ltd. Mercantilism Mercantilism countries should export more than they import Maintain a favorable balance of trade trade surplus Avoid an unfavorable balance of trade trade deficit The mercantilist theory suggests that countries should try to achieve a favorable balance of trade. This theory was the basis of economic thought from 1500 to 1800. Under mercantilism, governments restricted imports and subsidized the production of goods that would otherwise not be competitive in domestic or export markets. Copyright © 2015 Pearson Education Ltd.

Copyright © 2015 Pearson Education Ltd. Neomercantilism Neomercantilism run an export surplus to achieve social or political objectives Countries with a neomercantilist approach seek a favorable balance of trade, but do so in order to achieve some social or political objective. Copyright © 2015 Pearson Education Ltd.

Copyright © 2015 Pearson Education, Inc. Free Trade Theories Two theories that support free trade Absolute advantage theory Comparative advantage theory Market forces should determine trade specialization Why shouldn’t countries just be self-sufficient? According to the theories of absolute and comparative advantage, specializing in the things a country does best and trading for everything else can be beneficial. Copyright © 2015 Pearson Education, Inc.

Theory of Absolute Advantage different countries produce some goods more efficiently than others Free trade brings Specialization natural advantage acquired advantage product technology process technology Greater efficiency Higher global output Adam Smith’s theory of absolute advantage suggested that a nation’s wealth is based on its available goods and services rather than on gold. Therefore, if trade is unrestricted, a country can specialize in what it can produce most efficiently, and trade for everything else. Consumers benefit from free trade and specialization with lower prices and more choices. A country’s advantage in the production of a particular good may be a result of a natural advantage like climate, or an acquired advantage like technology. Copyright © 2015 Pearson Education, Inc.

Theory of Absolute Advantage Production Possibilities under Conditions of Absolute Advantage This Figure illustrates the production possibilities for two countries under the conditions of absolute advantage. Notice that with free trade and specialization both countries benefit. Copyright © 2015 Pearson Education Ltd.

Theory of Comparative Advantage free trade can increase global output even if one country has an absolute advantage in the production of all products Consider comparative advantage absolute disadvantage What happens when a country can produce all products at an absolute advantage? Well, there are still gains to be made from specialization and free trade. David Ricardo explored this issue in 1817 and discovered that gains from trade occur even in a country that has an absolute advantage in all products because the country gives up less efficient output in order to focus on more efficient output. Copyright © 2015 Pearson Education Ltd.

Theory of Comparative Advantage Production Possibilities under Conditions of Comparative Advantage This Figure illustrates the production possibilities for two countries under the conditions of comparative advantage. Notice that by specializing in the production of goods in which a country has a comparative advantage and trading for goods in which a country has an absolute disadvantage both countries still gain. Copyright © 2015 Pearson Education, Inc.

Theories of Specialization: Assumptions and Limitations Theories of specialization make assumptions that may not be valid full employment economic efficiency division of gains transport costs statics and dynamics services production networks mobility While the theories of specialization – absolute advantage and comparative advantage – offer policymakers a greater understanding of free trade, they are based on a number of assumptions that may not always be valid. Specifically, the theories assume that full employment exists, that economic efficiency is the primary goal of countries, that the division of gains is acceptable to both countries, that the world is composed of only two countries and two products, that there are no transportation costs, that advantages are static, and that while resources can move freely within a country, they are immobile internationally. Keep in mind that the theories can apply to trade in services as well as trade in products and that they apply to situations in which multi-country production takes place. Copyright © 2015 Pearson Education, Inc.

How Much Does A Country Trade? Theory of country size large countries depend less on trade than small countries Large countries usually export a smaller portion of output and import a smaller part of consumption have higher transportation costs for foreign trade Every country produces so-called nontradeable goods like haircuts. When it comes to tradeable goods though, country size can be a determining factor in the production choice. Larger countries typically have more varied climates and natural resources and are usually more self-sufficient than smaller countries. Moreover, because production and market centers in large countries are more likely to be located farther away from other countries, transportation costs are higher. Copyright © 2015 Pearson Education Ltd.

What Types of Products Does A Country Trade? Factor proportions theory factors in relative abundance are cheaper than factors that are relatively scarce But production factors are not homogenous labor Process technology capital versus labor What types of products does a country trade? We can use the factor proportions theory to help answer that question. The theory suggests that factor costs are determined by a country’s relative endowments of land, labor, and capital. These costs then determine which goods can be produced most efficiently. Keep in mind though that not all production factors are equal especially when it comes to labor. Moreover, how a product is produced – with capital or labor – is important as is the size of the production run required for greatest efficiency. Copyright © 2015 Pearson Education Ltd.

What Does A Country Trade? Worldwide Trade by Major Sectors This Figure shows the changing composition of world trade. Most new products are developed in industrialized countries. Copyright © 2015 Pearson Education Ltd.

With Whom Do Countries Trade? Country similarity theory most trade occurs among developed countries share similar market characteristics produce and consume much more than developing countries Trading partners are affected by Cultural similarity Political relations between countries Distance With whom do countries trade? Well, developed countries largely trade with other developed countries. Companies create new products in response to market conditions in their home market, and then look for markets that are close to home and most similar to what they’re accustomed to. Copyright © 2015 Pearson Education Ltd.

Product Life Cycle Theory The product life cycle theory the production location of certain manufactured products shifts as they go through their life cycle Four stages Introduction Growth Maturity Decline How do countries develop, maintain, and lose their competitive advantages? The international product life cycle theory, or PLC, offers one explanation. According to the PLC, companies manufacture products initially in the country where they were developed and researched – typically a developed country. Later, production shifts to foreign locations, and in the later stages of the product’s life, to developing economies. The theory is based on four stages: introduction, growth, maturity, and decline. Copyright © 2015 Pearson Education Ltd.

Product Life Cycle Theory Life Cycle of the International Product This Figure provides more details on exactly what occurs at each stage in a product’s life cycle. Keep in mind that while the theory holds for many products, it does not explain all products. In fact, today, many products are introduced at home and abroad simultaneously. Moreover, because costs drive production decisions, the initial production location may or may not be in the home country. Copyright © 2015 Pearson Education Ltd.

Diamond of National Advantage The diamond of national advantage Four conditions are important for gaining and maintaining competitive superiority Factor conditions Demand conditions Related and supporting industries Firm strategy, structure, and rivalry Another theory that helps explain why some countries have developed and sustained different competitive advantages is the diamond of national advantage theory. According to this theory, four conditions must be favorable for an industry: demand conditions, factor conditions, related and supporting industries, and firm strategy, structure, and rivalry. Copyright © 2015 Pearson Education Ltd.

Diamond of National Advantage The Diamond of National Competitive Advantage This Figure provides more details on each factor that makes up the diamond of national advantage. Keep in mind though, that the existence of all four factors does not guarantee that an industry will develop, nor is it necessary given globalization. For example, today, because capital and managers are internationally mobile, it may not be necessary to depend on domestic factor conditions. Similarly, thanks to freer trade and advances in transportation, local related and supporting industries are not as important. Copyright © 2015 Pearson Education Ltd.

Why Production Factors Move Factor mobility theory focuses on why production factors move, the effects of that movement on transforming factor endowments, and the impact of international factor mobility on world trade Capital and labor move internationally to gain more income flee adverse political situations The mobility of capital, technology, and people affects trade and relative competitive positions. The factor mobility theory helps explain why production factors move, and what that means for transforming factor endowments, as well as the impact of international factor mobility on world trade. Copyright © 2015 Pearson Education, Inc.

Effects of Factor Movements Factor movements alter factor endowments Factor movements can be substantial for some countries, and insignificant for others The movement of labor and capital are intertwined Pros and cons of outward and inward migration Brain drain Remittances The mobility of capital and population plays a role in a country’s factor endowments. For some countries, the movement of people can be significant. In Luxembourg for example, foreign- born people make up some 20 percent of the total population, but in Japan, account for just 2 percent. Outward migration can have a negative impact on a country if it involves the departure of educated people, but if these people then send remittances back home, it can have a positive effect. Finally, keep in mind that the movement of capital and labor is intertwined – think for example, about skilled foreign workers. Copyright © 2015 Pearson Education, Inc.

Trade and Factor Mobility There are pressures for the most abundant factors to move to areas of scarcity The lowest costs occur when trade and production factors are both mobile What is the relationship between trade and factor mobility? In general, if free trade is coupled with the free moving factors of production, the most efficient resource allocation should occur. The most abundant factors should move to areas of scarcity. Copyright © 2015 Pearson Education Ltd.

Trade and Factor Mobility Factor mobility through foreign investment often stimulates trade because of the need for components the parent’s ability to sell complimentary products the need for equipment for subsidiaries When companies invest abroad they often stimulate exports from their home country through sales of components, equipment, and complimentary products. Copyright © 2015 Pearson Education Ltd.

In What Direction Will Trade Winds Blow? Issues to consider Displacement of jobs as developed countries shift production to more rapidly developing countries Relationships among land, labor, and capital will continue to evolve Continued trend toward a more finely tuned specialization of production among countries Will the trend toward the freer movement of trade and production factors continue? Copyright © 2015 Pearson Education Ltd.

In What Direction Will Trade Winds Blow? Monitor As economies grow, efficiencies of multiple production locations also grow because they can all gain sufficient economies of scale Small-scale production methods may enable countries to produce many goods efficiently for their own consumption Output from 3D printers Services are growing more rapidly than products as a portion of production and consumption within developed countries We don’t know what the future will hold, but these four interrelated factors could cause product trade to become relatively less significant in the future. Copyright © 2015 Pearson Education Ltd.