International Trade Theory by Md. Nuruzzaman, Ph.D. Director (Training), NAPD

International Trade Theory  Overview  Mercantilism  Absolute Advantage  Comparative Advantage  Heckscher-Olin Theory  Product Life Cycle Theory  New Trade Theory  Porter’s Diamond 1

 1st British African colony to win independence (1957).  Nkrumah espoused pan African socialism.  High tariffs.  Anti-exporting policy. 2

 Kept lowering tariffs on manufactured goods.  Created incentives to export.  Reduced quotas.  Reduced subsidies.  1950s: 77% of employment in agriculture. Now 20%.  Manufacturing GNP went from 10% to over 30%. 3

The Impact of Trade Policies  Ghana  1970  GNP/capita $250  1992  GNP/per capita $450  GNP Growth/year 1.5%  Shift from productive uses (cocoa) to unproductive uses (subsistence agriculture).  Korea  1970  GNP/per capita $260  1992  GNP/per capita $6790  GNP Growth/year 9%  Shift from non-comparative advantage uses (agriculture) to productive uses (labor- intensive manufacturing). 4

An Overview of Trade Theory  Free Trade occurs when 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.  The Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country.  The Pattern of International Trade displays patterns that are are easy to understand (Saudi Arabia/oil or Mexico/labor intensive goods). Others are not so easy to understand (Japan and cars). 4-5

Mercantilism: mid-16 th century  A nation’s wealth depends on accumulated treasure  Gold and silver are the currency of trade.  Theory says you should have a trade surplus.  Maximize exports through subsidies.  Minimize imports through tariffs and quotas.  Flaw: “Zero-sum game”. 6

David Hume  Increased exports leads to inflation and higher prices.  Increased imports lead to lower prices.  Result: Country A sells less because of high prices and Country B sells more because of lower prices.  In the long run, no one can keep a trade surplus. 7

Zero–sum game  In game theory and economic theory, a zero–sum game is a mathematical representation of a situation in which a participant's gain (or loss) of utility is exactly balanced by the losses (or gains) of the utility of the other participant(s).game theoryeconomic theory mathematical representationutility  If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero.  Thus cutting a cake, where taking a larger piece reduces the amount of cake available for others, is a zero–sum game if all participants value each unit of cake equally (see marginal utility).cutting a cakemarginal utility  In contrast, non-zero–sum describes a situation in which the interacting parties' aggregate gains and losses are either less than or more than zero. A zero–sum game is also called a strictly competitive game while non-zero–sum games can be either competitive or non-competitive

 The zero-sum property (if one gains, another loses) means that any result of a zero-sum situation is Pareto optimal (generally, any game where all strategies are Pareto optimal is called a conflict game).Pareto optimal  Zero-sum games are a specific example of constant sum games where the sum of each outcome is always zero. Such games are distributive, not integrative; the pie cannot be enlarged by good negotiation.  Situations where participants can all gain or suffer together are referred to as non-zero–sum. Thus, a country with an excess of bananas trading with another country for their excess of apples, where both benefit from the transaction, is in a non-zero–sum situation. Other non-zero–sum games are games in which the sum of gains and losses by the players are sometimes more or less than what they began with.

Choice 1 Choice 2 Choice 1–A, AB, –B Choice 2C, –C–D, D Generic zero-sum game

Theory of Absolute Advantage  Adam Smith: Wealth of Nations (1776).  Capability of one country to produce more of a product with the same amount of input than another country.  Produce only goods where you are most efficient, trade for those where you are not efficient.  Trade between countries is, therefore, beneficial.  Assumes there is an absolute advantage balance among nations.  Ghana/cocoa.

The Theory of Absolute Advantage A B K G K’G’ Rice Cocoa Figure 4.1

The Theory of Absolute Advantage and the Gains from Trade Resources Required to Produce 1 Ton of Cocoa and Rice Cocoa Rice Ghana S. Korea Production and Consumption without Trade Ghana S. Korea Total production Production with Specialization Ghana 20 0 S. Korea 0 20 Total production Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice Ghana S. Korea Increase in Consumption as a Result of Specialization and Trade Ghana S. Korea Table 4.1

Theory of Comparative Advantage  David Ricardo: Principles of Political Economy (1817).  Extends free trade argument  Efficiency of resource utilization leads to more productivity.  Should import even if country is more efficient in the product’s production than country from which it is buying. Look to see how much more efficient. If only comparatively efficient, than import.  Makes better use of resources  Trade is a positive-sum game.

The Theory of Comparative Advantage Cocoa Rice Figure G C A G’ B K K’

Comparative Advantage and the Gains from Trade Resources Required to Produce 1 Ton of Cocoa and Rice Ghana S. Korea Production and Consumption without Trade Ghana S. Korea Total production Production with Specialization Ghana S. Korea Total production Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice Ghana S. Korea 4 6 Increase in Consumption as a Result of Specialization and Trade Ghana S. Korea Cocoa Rice Table 4.2

Simple Extensions of the Ricardian Model  Diminishing returns:  More a country produces, at some point, will require more resources.  However:  Free trade can increase a country’s production resources, and  Increase the efficiency of resource utilization.

Ghana’s PPF under Diminishing Returns Cocoa Rice G’ G 0 Figure

The Influence of Free Trade on the PPF Cocoa Rice G’ PPF 2 0 Figure 4.4 PPF 1

Is the Mercantilist Theory Still Valid?  A qualified Yes.  Equate political power with economic power and economic power with a trade surplus.  Japan 17

Heckscher (1919)-Olin (1933) Theory  Export goods that intensively use factor endowments which are locally abundant.  Corollary: import goods made from locally scarce factors.  Patterns of trade are determined by differences in factor endowments - not productivity.  Remember, focus on relative advantage, not absolute advantage. 18

The Leontief Paradox, 1953  Disputes Heckscher-Olin in some instances.  Factor endowments can be impacted by government policy - minimum wage.  US tends to export labor-intensive products, but is regarded as a capital intensive country. 19

Heckscher vs Ricardo  Economists prefer Heckscher on theoretical grounds but is a relatively poor predictor of trade patterns.  Ricardo’s Comparative Advantage Theory, regarded as too limited for predicting trade patterns, actually predicts them with greater accuracy.  In the end, differences in productivity may be the key to determining trade patterns. 20

Product Life-Cycle Theory ( Raymond Vernon, 1966 )  Article in the Quarterly Journal of Economics.  As products mature, both location of sales and optimal production changes.  Affects the direction and flow of imports and exports.  Globalization and integration of the economy makes this theory less valid. 21

International Product Trade Cycle Model High Income Countries Medium Income Countries Low Income Countries Time Stages of Production Development New ProductStandardized ProductMaturing Product QuantityQuantity production consumption 2 ExportsImports Exports Imports Figure

The New Trade Theory  Began to be recognized in the 1970s.  Deals with the returns on specialization where substantial economies of scale are present.  Specialization increases output, ability to enhance economies of scale increase. 23

Application of the New Trade Theory  Typically, requires industries with high, fixed costs.  World demand will support few competitors.  Competitors may emerge because “they got there first”.  first-mover advantage.  Some argue that it generates government intervention and strategic trade policy. 24

First-Mover Advantage  Economies of scale may preclude new entrants.  Role of the government. 25

 Founded 1915 by William Boeing  Largest commercial airplane manufacturer.  9,000 commercial jetliners in service. 26

 Established 1967  Western Europe buying 25% of aircraft,but selling only 10%.  France, Germany, Great Britain  To date: 3,203 orders - 1,890 deliveries. 4-27

Airbus vs Boeing Airplane Orders 28

Porter’s Diamond ( Harvard Business School, 1990)  The Competitive Advantage of Nations.  Looked at 100 industries in 10 nations.  Thought existing theories didn’t go far enough.  Question: “Why does a nation achieve international success in a particular industry?” 29

Determinants of National Competitive Advantage  Factor endowments: nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry.  Firm strategy, structure and rivalry: the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.  Demand conditions: the nature of home demand for the industry’s product or service.  Related and supporting industries: the presence or absence in a nation of supplier industries or related industries that are nationally competitive. 30

Porter’s Diamond Determinants of National Competitive Advantage Factor Endowments Firm Strategy, Structure and Rivalry Demand Conditions Related and Supporting Industries Figure

The Diamond  Success occurs where these attributes exist.  More/greater the attribute, the higher chance of success.  The diamond is mutually reinforcing. 32

Factor Endowments  Taken from Heckscher-Olin  Basic factors:  natural resources,  climate,  location.  Advanced factors:  communications,  skilled labor,  technology. 33

Advanced Factor Endowments  More likely to lead to competitive advantage.  Are the result of investment by people, companies, government. 34

Relationship of Basic to Advanced Factors  Basic can provide an initial advantage.  Must be supported by advanced factors to maintain success.  No basics, then must invest in advanced factors. 35

Demand Conditions  Demand creates the capabilities.  Look for sophisticated and demanding consumers.  impacts quality and innovation. 36

Related and Supporting Industries  Creates clusters of supporting industries that are internationally competitive.  Must also meet requirements of other parts of the Diamond. 37

Firm Strategy, Structure and Rivalry  Management ‘ideology’ can either help or hurt you.  Presence of domestic rivalry improves a company’s competitiveness. 38

Evaluating Porter’s Theory  If Porter is right, country exports should reflect the presence of the four ‘diamond’ components. Countries will import goods from industries where some or all the components are missing.  Too soon to tell. World Trade 39

Determinants of National Competitive Advantage Company Strategy, Structure, and Rivalry Demand Conditions Related and Supporting Industries Factor Conditions Government Source: Michael Porter, The Competitive Advantage of Nations Chance Two external factors that influence the four determinants. 40

Porter’s diamond, but...  ‘Double Diamond’ - look to attributes of both countries.  Professor Alan Rugman, University of Toronto  Home country may ‘sound’ good, but  Company can rely on the host country.  Neighboring countries can too.  Canada and the U.S. 41

Implications for Business  Location implications: makes sense to disperse production activities to countries where they can be performed most efficiently.  First-mover implications: It pays to invest substantial financial resources in building a first- mover, or early-mover, advantage.  Policy implications: promoting free trade is generally in the best interests of the home-country, although not always in the best interests of the firm. Even though, many firms promote open markets. 42