1. Chapter 3 International Trade Theory

2. Mercantilism It argues that; A nation’s wealth depends on accumulated treasure, usually, gold, silver, precious stones, metals, etc. To increase wealth, nations should increase exports and reduce imports. Trade surplus in gold and silver would make a nation wealthier.

3. Mercantilism It relies on the fact that exports bring in money, so it is positive, and imports cause outflow of money, so it is negative. Today, there is still mercantilism in the form of economic nationalism. For example, Japan is called “fortress of mercantilism”. They have an impenetrable market with traditional preoccupation with self- sufficiency, and “us against them” mentality. There are no obvious trade barriers against foreign products, but have “cultural barriers” where Japanese don’t buy foreign prıducts.

4. Theory of Absolute Advantage Absolute advantage is the capability of one nation to produce more of a good with the same amount of inputs than other countries. It means the nation is producing same amount of goods using fewer resources. A nation has an absolute advantage if it is producing a good better and more efficiently than other countries. This theory is developed by Adam Smith.

5. Example Before trade Specialization After trade Commodity US Japan Total Tons of rice3 1 46 0 63 3 6 Cars2 4 60 8 84 4 8

6. Theory of Comparative Advantage If a country does not have an absolute advantage in producing neither of the goods, but it can produce one good more efficiently than the others, it is still beneficial if it trades. Comparative advantage arises when a country produces one good better and more efficiently than it is producing other goods. This theory is developed by David Ricardo.

7. Example Before trade Specialization After trade Commodity US Japan Total Tons of rice6 3 912 0 126 6 12 Cars5 4 90 8 84 4 8

8. Theory of Factor Endowments It argues that countries export goods that contain the abundant factor of production in that country, and they import goods with large intake of scarce factor of production. If a factor of production is abundant, it means that it is less costly. So the good will have a lower price, thus it will be demanded by other countries. The thoery is developed by Hecksher-Ohlin.

9. Leontief Paradox Wassily Leontief, in 1953, found that US is exporting labor-intensive products, while US is claiming that it is a capital-,ntensive country.

10. Theory of International Product Life-Cycle It is a theory explaining why a product that begins as a nation’s export eventually becomes its import. This theory applies only to trade in manufactured goods.

11. IPLC theory At the introductory stage, firms have invested and developed a product. They need rich and sophisticated customers to sell the products. So they target the customers in the developed countries. Also at the early stages, the product has to be close to the market, because the product is still at the developing stage. Management can quickly react to the customer feedback. At this stage exports increase, too. At the maturity stage, competitors fill the market, profits and sales are stabilized. Firms look for cheaper ways of producing the goods to lower the cost of production. Exports start declining. At decline stage, firms start producing in overseas markets. The product is imported from foreign markets.

12. Economies of Scale and the Experience Curve Countries benefit from economies of scale; that is, as plants get larger and more efficient equipment is used, per unit cost of production declines. Reasons for economies of scale: Larger and more efficient equipment is used. Companies get volume discounts on purchases. FC allocated over larger volume of units. Learning curve – as firms increase production, they learn ways of improving production technology and reduce cost of production.

13. First Mover Theory This theory argues that firms that enter the market first (first movers) will dominate that market. As the first mover increases production and gains a large market share, it starts benefiting from economies of scale. The firms that enter the market after that cannot compete with the cost advantages of the first movers. 70% of the largest global firms are first movers. The new firms can dominate the market through technology and innovation. They either find a way of reducing costs and/or innovate a new product.

14. Theory of Overlapping Demand This theory emphasizes demand factors in international trade. It is only applying to manufactured goods. Linder states that a nation’s per capita income level will determine what type of goods it will demand. International trade in manufactured goods will be more intense between the countries with similar per capita income levels, than between countries with dissimilar income levels. So there is overlapping demand between the goods that are traded, where consumers in both countries are demanding the same product. The intra-industry trade occurs because of product differentiation.

15. Theory of Competitive Advantage of Nations Michael Porter argues that a firm’s ability to become global will depend on four factors. The place that provides those four factors is called a global platform. These four factors will have a determining impact on the ability of the lcoal firms to gain competitive advantage.

16. Porter’s Diamond Demand conditions – It is the nature of domestic demand. Sophisticated and demanding customers will force the firms to innovate and improve the quality of their products. Factor conditions – It is the level and composition of factors of production. Basic factors are classical factors of production Advanced factors are improved factors of production; like, educated workforce, free ports, advanced communication systems, infrastructure, etc.

17. Porter’s Diamond Related and supporting industries – Suppliers of industry and industry support services are important for competitive success by providing a network of suppliers, subcontractors, and a commercial infrastructure. Firm’s Strategy, structure, and rivalry – It is the extend of domestic competition, the existence of barriers to entry, and the firm’s management style and and organization.

18. Arguments for trade restrictions National defense argument Infant industry argument Protecting domestic jobs Retaliation

19. National defense argument Certain industries must continue to exist for national defense purposes. They may not have any kind of advantage, but the country will rely on them in wartime. Counterargument→ The army needs so many products. If the resources are used to produce all of them the economy will lose efficiency.

20. Infant industry argument Infant industry needs protection from imports, until the labor force is trained, production techniques are mastered, and economies of scale is achieved. Without protection, the industry can not compete with low-cost imports. Counterargument→Without competition, the firm will never improve efficiency and quality.

21. Protecting domestic jobs If imports flood the market and domestic industries close down, local jobs are lost and unemployment increases. Counterargument→Productivitiy of labor is higher in developed countries because of capital input. Also if we stop imports, other countries will stop our exports.

22. Scientific tariff An import duty to equalize the price of imports to the prices of goods produced domestically. Rebuttal→The consumers will be penalized

23. Retaliation Exporters in other countries may ask to stop imports from this country, if the country stops imports.

24. Dumping It is selling a product abroad for less than; the cost of production, the price in the home market, or the price to third countries.

25. New kinds of dumping 1)Social dumping→unfair competition by developing countries that have lower labor costs and poorer working conditions. 2)Environmental dumping→unfair competition because of country’s relaxed environmental standards. 3)Financial services dumping→unfair competition because of country’s low capital/asset ratio. 4)Cultural dumping→unfair competition caused by cultural barriers aiding local firms.

26. Subsidies They are financial contributions, provided directly or indirectly by the government, which provides benefits to the firm, like grants, preferential tax treatment, government assessment of business expenses, etc.

27. Countervailing duties Additional import taxes levied on imports that have benefited from export subsidies.

28. Other arguments for trade restrictions 1) There should be trade restrictions to permit diversification of domestic economy. 2) There should be trade restrictions to improve trade balance.

29. KINDS OF TRADE RESTRICTIONS 1.Tariff barriers Ad valorem duty Specific duty Compound duty Variable levy 2.Non-tariff barriers (Quantitative barriers) Quotas Voluntary export restraints Orderly marketing arrangements 3.Non-quantitative, non-tariff barriers Direct government participation in trade Customs and other administrative procedures Standards

30. Tariff barriers 1)Ad valorem duty is levied as a percentage of the invoice value of the imported good. 2)Specific duty is a fixed sum levied on a physical unit of the imported good. 3)Compound duty is a combination of ad valorem and specific duties. 4)Variable levy is an import duty set at the difference between the world market prices and local government-supported prices.

31. Quotas are numerical limits placed on specific classes of imports It is absolute quotas if further imports are prohibited after the number for the year is reached. It is tariff-rate quotas if the imports have no duties (or low duties) up to an amount and then a tariff is levied for the rest.

32. Quotas are global (applied to all imports), or allocated (certain numbers are allocated to certain countries). Allocated quotas are discriminatory in nature

33. Voluntary export restraints They are export quotas imposed by the exporting nation.

34. Orderly marketing arrangements They are formal agreements between exporting and importing countries that stipulate the import or export quotas each nation will have for a good. (Multi- fiber arrangement, eg)

35. 3) Non-quantitative, non-tariff barriers a.Direct government participation in trade Subsidy: Financial contribution provided directly or indirectly by a government, which confers a benefit, like grants, preferential tax treatment, government assessment of business expenses, etc. Government procurement policies: Government prefers domestic producers in purchases. (minimum local content law, eg)

36. Lower duty for more local input Import duties are set in such a way to encourage local input. Semi-finished goods or intermediate goods may pay lower import duties, eg.

37. b) Customs and other administrative procedures c) Standards

38. Categories based on levels of economic development Developed nations are industrialized nations which are technically most developed. Developing nations are world’s lower-income countries which are less technically developed. Newly industrialized countries (NIC) are the four Asian Tigers and middle-income economies, like Brazil, Mexico, Malasia, Turkey, Chile, Thailand. Transition countries are the former communist countries, like Hungary, Russia, Kazakhstan, etc.

39. World Bank classification: 1)Low-income countries; where per-capita income is less than $750/year. 2)Lower-middle income countries; where per capita income is between $750-$3000/year. 3)Upper-middle income countries; where per capita income is between $3000-$9000/year. 4)High-income countries; where per capita income is above $9000/year.

40. Problems of GNP per capita as an indicator: 1)Unregistered and underground economy are not reflected 2)Income distribution is overlooked 3)Purchasing power parity (PPP) is not shown

41. Characteristics of less-developed countries: 1)GNP/capita less than $6000/year. 2)Unequal distribution of income. 3)Technological dualism. 4)Regional dualism. 5)High proportion of population in agricultural sector. 6)Disguised unemployment. 7)High population growth. 8)High rate of illiteracy and insufficient educational facilities. 9)Malnutrition and health problems. 10)Political instability. 11)Few export goods, generally agricultural goods and minerals. 12)Difficult topography. 13)Low saving rates and inadequate banking facilities.

42. Human-Needs Approach It stresses that economic development is elimination of poverty and unemployment as well as an increase in income. Poverty is illiteracy, malnutrition, diseases, early deaths. Import substitution is locally producing the goods to replace imports. It is necessary for economic development in Human-needs Approach.

43. Contemporary Theories of FDI 1)Monopolistic Advantage Theory 2)Product and Market Imperfections Theory 3)International Product Life-Cycle Theory 4)“Follow the leader” Theory 5)Cross-Investment Theory 6)Internationalization Theory 7)Eclectic Theory of International Production

44. 1) Monopolistic Advantage Theory (by Hymer) FDI is made by the firms in oligopolistic industries posessing technical and other advantages over indigenous firms.

45. 2) Product and Market Imperfections Theory (by Caves) Expanded Hymer’s work and added that superior knowledge permitted the investing firm to produce differentiated products that the consumers would prefer to similar locally made goods and thus would give the firm some control over the selling price and advantage over the indigenous firms.

46. 3) International Product Life-Cycle Theory (by Vernon) To avoid losing a market, firms are forced to invest in overseas facilities to compete with cheap imports at home.

47. 4) Cross-Investment Theory (by Graham) Oligopolistic firms invest in eachother’s home countries as a defense measure.

48. 5) “Follow-the-leader” Theory (by Knickerbocker) When the leader firm enters foreign markets, other firmws in the industry follow the leader.

49. 6) Internationalization Theory (by Aliber) If a firm obtains a highe rprice for its knowledge by using it than selling it, it will prefer FDI.

50. 7) Eclectic Theory of International Production (by Dunning) The firm will invest overseas if it has three kinds of advantages: a. Ownership specific→the extend to which tangible and intangible assets not available to other firms b. Internationalization→if it is the firm’s interest to use its ownership-specific advantages (internationalize) rather than license them to foreigners c. Location-specific→the firm will profit by locating its production facilities overseas