1. Trade and Factor Mobility Theory
Chapter 5
Trade and Factor Mobility Theory
Chapter 5: Trade and Factor Mobility Theory
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2. 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.
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3. 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.
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4. 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.
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5. 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.
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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.
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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.
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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.
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9. 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.
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10. 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.
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11. 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.
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12. 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.
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13. 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.
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14. 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.
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15. 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.
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16. 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.
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17. 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.
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18. 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.
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19. 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.
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20. 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.
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21. 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.
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22. 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.
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23. 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.
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24. 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.
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25. 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.
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26. 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?
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27. 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.
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