International Trade Theory Chapter 6 International Trade Theory Md. Afnan Hossain Lecturer, School of Business & Economics

An Overview of Trade Theory Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country Excise duties: inland tax on sale or production for sale of specific goods. Quotas: A government-imposed trade restriction that limits the number, or in certain cases the value, of goods and services that can be imported or exported during a particular time period. Quotas are used in international trade to help regulate the volume of trade between countries. They are sometimes imposed on specific goods and services to reduce imports, thereby increasing domestic production. In theory, this helps protect domestic production by restricting foreign competition. 2

The Benefits of Trade International trade allows a country: Smith, Ricardo and Heckscher-Ohlin show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself International trade allows a country: to specialize in the manufacture and export of products that it can produce efficiently import products that can be produced more efficiently in other countries 3

The Patterns of International Trade Some patterns of trade are fairly easy to explain - it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee. But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Japan export automobiles, consumer electronics, and machine tools? 4

The Patterns of International Trade Why does Ford assemble cars made for the American market in Mexico, while BMW and Nissan manufacture cars for Americans in the U.S.? Now, the U.S. buys a lot of its textiles from places like Honduras and Guatemala; and of course, Bangladesh too !!

Trade Theories 1. Mercantilism 2. Absolute Advantage 3. Comparative Advantage 4. Heckscher-Ohlin Theory 5. Product Life Cycle Theory 6. Porter’s Diamond Theory

Mercantilism Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -- to export more than it imports Countries conducted trade in exchange of gold and silver in the mid 16th century in England. A country could earn gold and silver by exporting, thereby increasing their gold and silver reserve-an increase in national wealth, prestige and power. The contrary takes place when a country imports. So, this theory advocated government intervention to achieve a surplus in the balance of trade. 7

Mercantilism The policy was to maximize exports and minimize imports - imports were limited by tariffs & quotas, while exports were subsidized. This theory is however criticized because trade surplus increase money supply in a country. An increase in money supply raises the demand and consequently the price of goods. The result of this is inflation. It views trade as a zero-sum game, one in which a gain by one country results in a loss by another, rather than a positive-sum game, a situation where all countries in trade can benefit. In the long run, no country can sustain a surplus on the balance of trade. 8

Absolute Advantage A nation has an Absolute advantage if it can produce a product more efficiently than any other nation. Adam Smith was against mercantilism. According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries. A country should never produce goods at home that it can buy at a lower cost from other countries. In 1776, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game and argued that countries differ in their ability to produce goods efficiently, and that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it. 9

How Does The Theory Of Absolute Advantage Work? Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa. 10

Comparative Advantage A country has a comparative advantage if it can produce one product more efficiently and at a lower cost than other products, in comparison to other nations. David Ricardo extended Adam Smith’s Theory by exploring what might happen when one country has absolute advantage in production of all goods. He extended the free trade argument and proved that trade is a positive-sum game. Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home According to Adam Smith, no benefits will be gained from international trade if a country has an absolute advantage in the production of all goods. David Ricardo showed that it was not the case. 11

How Does The Theory Of Comparative Advantage Work? Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa. 12

Comparative Advantage If each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain. Potential world production is greater with unrestricted free trade than it is with restricted trade. Comparative advantage theory provides a strong rationale for encouraging free trade. The theory therefore suggests that trade is a positive-sum game (to an even greater degree than that suggested by the theory of absolute advantage).

Heckscher-Ohlin Theory Eli Heckscher and Bertil Ohlin - Comparative advantage arises from differences in national factor endowments the extent to which a country is endowed with resources like land, labor, and capital. The more abundant a factor, the lower its cost LO2: Summarize the different theories explaining trade flows between nations. Basic factors: Natural resources Climate Geographic location Demographics While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success. Advanced factors: The result of investment by people, companies, and government are more likely to lead to competitive advantage. If a country has no basic factors, it must invest in advanced factors. The pattern of trade is determined by factor endowments Heckscher and Ohlin predict that countries will export goods that make intensive use of locally abundant factors import goods that make intensive use of factors that are locally scarce

Heckscher-Ohlin Theory Factor endowments determines cost of operation there EG: China in textile, footwear; USA in high tech product, Australia in agro and dairy products. Chinese Textile Australian Meat and Dairy Srilankan Tea

Product Life Cycle Theory According to the product life-cycle theory the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new products initially, the product would be produced and sold in the U.S. as demand grew in other developed countries, U.S. firms would begin to export demand for the new product would grow in other advanced countries over time making it worthwhile for foreign producers to begin producing for their home markets U.S. firms might set up production facilities in advanced countries with growing demand, limiting exports from the U.S.

Product Life Cycle Theory Cont… As the market in the U.S. and other advanced nations matured, the product would become more standardized, and price would be the main competitive weapon Producers based in advanced countries where labor costs were lower than the United States might now be able to export to the United States If cost pressures were intense, developing countries would acquire a production advantage over advanced countries Production became concentrated in lower-cost foreign locations, and the U.S. became an importer of the product

Product Life Cycle Theory The United States switched from being an exporter of the product to an importer of the product as production becomes more concentrated in lower- cost foreign locations

Porter’s Diamond Of Competitive Advantage Determinants of National Competitive Advantage: Porter’s Diamond

Factor Endowments Factor endowments refer to a nation’s position in factors of production necessary to compete in a given industry => competitive advantage These factors can be either basic (natural resources, climate, location, demographics) or advanced (sophisticated & skilled labor, research facilities, communication infrastructure, technological know-how) Advanced factors are a product of investment by individuals, companies & governments. 20

Demand Conditions Demand conditions refer to the nature of home demand for the industry’s product or service that influences the development of capabilities Sophisticated and demanding customers pressure firms to be competitive, by creating pressures for innovation and quality E.g. Japanese camera industry; wireless telephone equipment industry of Scandinavia and Sweden 21

Relating and Supporting Industries The presence of supplier industries and related industries that are internationally competitive can spill over and contribute to other industries E.g. Until the mid-1980s, the technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in personal computers and several other technically advanced electronic products. E.g. Adoption of the automobile took off in the USA after the construction of a national system of highways and gas stations. 22

Firm Strategy, Structure and Rivalry The conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalry impacts firm competitiveness Different management ideologies affect the development of national competitive advantage. E.g. predominance of engineers in top management at German and Japanese firms-improvement in manufacturing processes and product design E.g. predominance of finance people in top management at the US firms-overemphasis on maximizing short term financial return Vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features 23