International Trade Theory Chapter 4 © McGraw Hill Companies, Inc., 2000

International Trade Theory Overview Mercantilism Absolute Advantage Comparative Advantage Heckscher-Olin Theory Product Life Cycle Theory New Trade Theory Porter’s Diamond 4-1 © McGraw Hill Companies, Inc.,2000

1st British African colony to win independence (1957). Nkrumah espoused pan African socialism. High tariffs. Anti-exporting policy. 4-2 © McGraw Hill Companies, Inc., 2000

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%. 4-3 © McGraw Hill Companies, Inc., 2000

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 $6790 GNP Growth/year 9% Shift from non-comparative advantage uses (agriculture) to productive uses (labor-intensive manufacturing). © McGraw Hill Companies, Inc.,2000 4-4

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 © McGraw Hill Companies, Inc.,2000

Mercantilism: mid-16th 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”. 4-6 © McGraw Hill Companies, Inc.,2000

David Hume - 1752 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. 4-7 © McGraw Hill Companies, Inc.,2000

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. 4-8 © McGraw Hill Companies, Inc.,2000

The Theory of Absolute Advantage 5 10 15 20 Cocoa A Figure 4.1 K B G’ K’ 0 5 10 15 20 Rice 4-9 © McGraw Hill Companies, Inc., 2000

The Theory of Absolute Advantage and the Gains from Trade Resources Required to Produce 1 Ton of Cocoa and Rice Cocoa Rice Ghana 10 20 S. Korea 40 10 Production and Consumption without Trade Ghana 10.0 5.0 S. Korea 2.5 10.0 Total production 12.5 15.0 Production with Specialization Ghana 20 0 S. Korea 0 20 Total production 20 20 Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice Ghana 14.0 6.0 S. Korea 6.0 14.0 Increase in Consumption as a Result of Specialization and Trade Ghana 4.0 1.0 Table 4.1 S. Korea 3.5 4.0 4-10 © McGraw Hill Companies, Inc., 2000

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. 4-11 © McGraw Hill Companies, Inc.,2000

The Theory of Comparative Advantage 5 10 15 20 Cocoa A Figure 4.2 K B 2.5 K’ G’ 0 5 10 15 20 3.75 7.5 Rice 4-12 © McGraw Hill Companies, Inc., 2000

Comparative Advantage and the Gains from Trade Resources Required to Produce 1 Ton of Cocoa and Rice Cocoa Rice Ghana 10 13.33 S. Korea 40 20 Production and Consumption without Trade Ghana 10.0 7.5 S. Korea 2.5 5.0 Total production 12.5 12.5 Production with Specialization Ghana 15 3.75 S. Korea 0.0 10.0 Total production 15 13.75 Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice Ghana 11 7.75 S. Korea 4 6 Increase in Consumption as a Result of Specialization and Trade Ghana 1.0 0.25 Table 4.2 S. Korea 1.5 1.0 4-13 © McGraw Hill Companies, Inc., 2000

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. 4-14 © McGraw Hill Companies, Inc.,2000

Ghana’s PPF under Diminishing Returns Cocoa Figure 4.3 G’ Rice 4-15 © McGraw Hill Companies, Inc., 2000

The Influence of Free Trade on the PPF Cocoa Figure 4.4 G’ Rice 4-16 © McGraw Hill Companies, Inc., 2000

Is the Mercantilist Theory Still Valid? A qualified Yes. Equate political power with economic power and economic power with a trade surplus. Japan 4-17 © McGraw Hill Companies, Inc.,2000

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. 4-18 © McGraw Hill Companies, Inc.,2000

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. 4-19 © McGraw Hill Companies, Inc.,2000

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. 4-20 © McGraw Hill Companies, Inc.,2000

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. 4-21 © McGraw Hill Companies, Inc.,2000

International Product Trade Cycle Model High Income Countries production Exports Imports consumption Quantity 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Medium Income Countries Exports Imports 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Low Income Countries Exports Imports 1 Time 2 3 4 5 6 7 8 9 10 11 12 13 14 15 New Product Maturing Product Standardized Product Figure 4.5 Stages of Production Development 4-22 © McGraw Hill Companies, Inc.,2000

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. 4-23 © McGraw Hill Companies, Inc.,2000

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. 4-24 © McGraw Hill Companies, Inc.,2000

First-Mover Advantage Economies of scale may preclude new entrants. Role of the government. 4-25 © McGraw Hill Companies, Inc.,2000

Founded 1915 by William Boeing Largest commercial airplane manufacturer. 9,000 commercial jetliners in service. 4-26 © McGraw Hill Companies, Inc.,2000

Western Europe buying 25% of aircraft ,but selling only 10%. 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 © McGraw Hill Companies, Inc.,2000

Airbus vs Boeing Airplane Orders 4-28 © McGraw Hill Companies, Inc.,2000 4-28

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?” 4-29 © McGraw Hill Companies, Inc.,2000

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. 4-30 © McGraw Hill Companies, Inc., 2000

Porter’s Diamond Determinants of National Competitive Advantage Firm Strategy, Structure and Rivalry Factor Endowments Demand Conditions Related and Supporting Industries Figure 4.6 4-31 © McGraw Hill Companies, Inc.,2000

The Diamond Success occurs where these attributes exist. More/greater the attribute, the higher chance of success. The diamond is mutually reinforcing. 4-32 © McGraw Hill Companies, Inc.,2000

Factor Endowments Taken from Heckscher-Olin Basic factors: natural resources, climate, location. Advanced factors: communications, skilled labor, technology. 4-33 © McGraw Hill Companies, Inc.,2000

Advanced Factor Endowments More likely to lead to competitive advantage. Are the result of investment by people, companies, government. 4-34 © McGraw Hill Companies, Inc.,2000

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. 4-35 © McGraw Hill Companies, Inc.,2000

Demand Conditions Demand creates the capabilities. Look for sophisticated and demanding consumers. impacts quality and innovation. 4-36 © McGraw Hill Companies, Inc.,2000

Related and Supporting Industries Creates clusters of supporting industries that are internationally competitive. Must also meet requirements of other parts of the Diamond. © McGraw Hill Companies, Inc.,2000 4-37

Firm Strategy, Structure and Rivalry Management ‘ideology’ can either help or hurt you. Presence of domestic rivalry improves a company’s competitiveness. 4-38 © McGraw Hill Companies, Inc.,2000

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 4-39 © McGraw Hill Companies, Inc.,2000

Determinants of National Competitive Advantage Chance Company Strategy, Structure, and Rivalry Two external factors that influence the four determinants. Factor Conditions Demand Conditions Related and Supporting Industries Government Source: Michael Porter, The Competitive Advantage of Nations 4-40 © McGraw Hill Companies, Inc.,2000

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. 4-41 © McGraw Hill Companies, Inc.,2000

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. 4-42 © McGraw Hill Companies, Inc., 2000