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Lectures 18-22: International Trade Theory

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1 Lectures 18-22: International Trade Theory
Managers’ thinking on trade Economists’ view on trade What and why to trade? Justification of free trade Major theories of trade

2 Conventional manager’s thinking about trade…
Companies engage in internationally for several reasons Expand Sales: going abroad allows firms to increase the size of the market to which they offer their products Acquire Resources: foreign capital, technology, labor, components can help a firm become more competitive Diversify Sources of Sales and Supplies: working abroad protect firms from economic downturns in any single country, from shortages due to economic, social, or political disruptions in any single country Several factors have contributed in recent trade-expansion Technological expansion Cross-border liberalization Growth of support industries (Int. banking & delivery) FDI (equity funds invested in other nations) Fall NU-FAST Zahid Siddique

3 Conventional manager’s thinking about trade…
International business takes several forms Export & import of merchandise Export & import of services Tourism and Transportation Rendering of some services Use of assets (e.g. patents, trademarks etc) Investment FDI: occurs when an investor gains a controlling interest (may be 100% or less) in a foreign company Portfolio investment: non-controlling investment in a foreign company (purchase of stock in a foreign company) Fall NU-FAST Zahid Siddique

4 Economists have other ideas
Economists ask different and more fundamental questions: What to trade and why? i.e. what is the basis and trends of trade Many theories to explain above two questions Absolute Advantage (1776) Comparative Advantage (1817) Heckscher-Ohlin (H-O) theorem ( ) Product life-cycle approach (1960) We briefly outline the main argument of each one of them Fall NU-FAST Zahid Siddique

5 Absolute Advantage: The model
Country should specialize in, and export, that product which it can produce using less resources Consider a two-goods-two-country model We can clearly see that A is absolutely more efficient in producing X B is absolutely more efficient in producing Y More of both X and Y produced if A specializes in X, while B in Y Countries trade surpluses and increase consumption of both goods in both countries Goods / Country X Y A 2 4 B Each entry shows number of labor hours needed to produce one unit of a good; i.e. production technologies of a country Fall NU-FAST Zahid Siddique

6 Absolute Advantage: Specialization
To see assume that each country has initial resource endowment of 6 labor hours (LH) Given that both countries need both goods for consumption A would produce 1x (using 2 LH) and 1y (using 4 LH) B would produce 1x (using 4 LH) and 1y (using 2 LH) Without trade, both would have 1x and 1y for consumption Before trade world production of both goods is given by: After agreeing on trade A would specialize in x, produce 3x (using 6 LH) and no y B would specialize in Y, produce 3Y (using 6 LH) and no X World output of both goods greater now; i.e. Xw = 3, Yw = 3 Fall NU-FAST Zahid Siddique

7 Absolute Advantage: Trade and welfare
If both countries agree on exchanging 1x for 1y (ignore determination of rate of exchange for the moment), then A can export 1x to B and import 1y A has 2x-1y, while B has 1x-2y available for consumption Consumption possibilities of both increased Trade good for all participants Result same even if we assume incomplete-specialization But this model assumed both countries have absolute advantage in one good What if a country is more efficient in producing all goods? Is trade possible now? Answer: yes Ricardo presents Comparative, not Absolute, Advantage as basis of trade Fall NU-FAST Zahid Siddique

8 Comparative Advantage
CA says that a country should specialize in, and export, that product which it can produce sacrificing less resources Consider the following set of data To understand the possibilities of trade, calculate the opportunity cost of producing x and y in both countries Goods / Country X Y A 2 4 B 12 A clearly more efficient in producing both goods as compared to B A sacrifices ½ units of y to produce 1x and 2 units of x to produce 1y Fall NU-FAST Zahid Siddique

9 Comparative Advantage
Similarly for country B So we have the following cost matrix If each country specializes in its area of advantage world output greater and countries can trade surpluses consumption of both goods in both countries increase B sacrifices 1/3 units of y to produce 1x and 3 units of x to produce 1y Cost / Country CX CY A ½ Y 2x B ⅓ Y 3x Clearly, B is more efficient in producing x (as it needs to sacrifice less resources to produce 1x) while A in y Fall NU-FAST Zahid Siddique

10 Comparative Advantage: graphical representation
Assume 100 LH available to both countries A, with 2 LH to produce 1x and 4 LH for 1y, can produce 50 units of x, or 25 units of y, or any “straight line” combination of the two B, with 4 LH to produce 1x and 12 LH for 1y, can produce 25 units of x, 8.33 units of y, or any linear combination So with no trade: A Max. 50x, or 25y B Max 25x, or 8.33y After trade A 25y, B 25x Exchange surpluses, total output greater, consumption increase Fall NU-FAST Zahid Siddique

11 Comparative Advantage: graphical representation
Any confusion? World output with no trade Y 25 Output of Y without trade and now trade... Summing up vectors gives world output 8.33 Before trade production points Country A B 25 50 X Output of x without trade Fall NU-FAST Zahid Siddique

12 Comparative Advantage: graphical representation
After Trade: A produces only Y, B only x Y Y output with trade Total output higher, surpluses traded 25 Output of Y without trade Modern approach much more complicated than this simple one! X output with trade 8.5 A B 25 50 X Output of x without trade Fall NU-FAST Zahid Siddique

13 Determination of international prices
Exchange rates of goods can be determined from cost matrix For 1 unit of x maximum A would pay is ½y (otherwise it will produce itself) minimum B would accept is ⅓ y (otherwise it won’t cover cost), thus we have price of x For 1 unit of y maximum B would pay is 3x minimum A would accept is 2x, thus we have price of y Cost / Country CX CY A ½ Y 2x B ⅓ Y 3x where country A produces only Y while B only x Fall NU-FAST Zahid Siddique

14 Import quantity with free-trade
How much to import depends upon domestic D-S situation Consider the following D-S curves with domestic eqb. at e Let world price (Pw) be Rs 20/kg (a country imports if Pw < Pd) After free-trade is allowed demanders would purchase from int. mkt. as it costs less suppliers would be forced to sell at Pw Pd falls towards Pw where all exchanges take place Line at Pw shows world supply curve (Sw)—demanders can buy any amount at this price At Pw, domestic supply is Sd domestic demand is Dd Import (M) = Dd - Sd (gap b/w domestic D & S ) at Pw PS Sd Pd=25 e Pw Sw M Dd Sd 1 Dd Sugar Fall NU-FAST Zahid Siddique

15 H-O Theorem: behind comparative advantage
Recardian theory explains trends and gains from trade via labor-productivity Differences in labor productivity leads to comparative advantage H-O theorem argues that CA arises due to differences in factor endowments (labor, capital) the more abundant a factor, the lower its price (or cost) H-O theorem: country exports goods that make intensive use of its abundant factor, and import that make intensive use of its scarce factor Pakistan labor-intensive, so should export labor-intensive goods; e.g. agriculture, sheep breeding US capital-intensive, so should export capital-intensive goods; e.g. computers, air-crafts etc. But theory does not stand to empirical tests Fall NU-FAST Zahid Siddique

16 H-O Theorem: Leontief paradox
Leontief found that US imports were about 30% more K-intensive than its exports exactly opposite to H-O theorem—standard trade-mantra Did not reject H-O theorem, rather rationalized it US labor 3-times more productive than that of foreign so US is labor-abundant when multiplied by productivity-factor but this is absurd as US-capital is also more productive Many lame-excuses advanced to save sacred cow; i.e. theory 1947 data was not true representative Ignored Human-capital element while measuring physical productivity and many more… Economists try to explain away result, rather than question the theory—that is why labelled “Leontief paradox” Fall NU-FAST Zahid Siddique

17 Economic hype of comparative advantage
Principal of CA seems impressive and fervently believed in by most economists: “The principle of comparative advantage holds that each country will benefit if it specializes in the production and export of those goods that it can produce at relatively low cost. Conversely, each country will benefit if it imports those goods which it produces at relatively high cost. This simple principle provides the unshakable basis for international trade.” (Samuelson 300) “Notwithstanding its limitations, the theory of comparative advantage is one of the deepest truths in all of economics. Nations that disregard comparative advantage pay a heavy price in terms of their living standards and economic growth.” (308) Fall NU-FAST Zahid Siddique

18 Behind the hype of comparative advantage
But model makes some extreme assumptions Full employment of all factors of production Otherwise countries would not be on “Production Possibility Frontier” Costless mobility of factors of production between sectors Labor and capital can be moved from computer production to shoe production without loss of productivity Immobility of factors between countries Otherwise gains in one country would accrue to factor owners in another country Identical technology used in production everywhere Let’s work out an example to see what they mean Fall NU-FAST Zahid Siddique

19 Behind the veil of comparative advantage
Consider the following ‘2×2’ (two-countries-two-goods) model: production of sheep (L-intensive) and steel (K-intensive) Pakistan (L-intensive) and Japan (K-intensive countries) Both countries produce both goods before trade After trade, Pakistan specializes in sheep while Japan in steel But question is: “How do you turn a steel mill into a sheep dip?” Economic theory… That's clear, isn't it? Reality?... Fall NU-FAST Zahid Siddique

20 Absolute Destruction of Capital…
Open up trade Pre-trade prices Sell Steel Mill Less capacity, depressed areas Build sheep dips Steel price falls Economic theory ignores time uniqueness of capital specific skills of labor Capital destroyed Fall NU-FAST Zahid Siddique

21 Add free trade... Comparative Reality
Unprofitable capital in less competitive industry destroyed Productive capacity falls… Steel (“capital intensive”) Associated regions depressed, labour unemployed… Sheep (“labour intensive”) Fall NU-FAST Zahid Siddique

22 Fall 2007 NU-FAST Zahid Siddique
Comparative Reality Can’t “convert” capital or labour from one use to another without loss Amount lost a function of speed of change Instant cut in tariff/trade barriers destroys capital invested in less competitive industries deskills workers (e.g., Steel in Pakistan, rice in Japan) Inflates $ value of capital in competitive industry, increases use of existing capacity, but significant time lag before new capacity built Fall NU-FAST Zahid Siddique

23 Product life cycle (PLC) approach
Raymond Vernon advanced PLC theory in 1960s Trade and production location for certain goods shifts as they go through their life cycle Observed that during 20th century, most new products were produced by US firms, sold within US first and imported later He offers four-steps in PLC as model of his explanation more of a management-style model Introduction Innovation in response to observed need Exporting by innovative country producing in other advanced countries not profitable b/c of low initial demand production kept at home initially to avoid risk Evolving product features Low capital intensive production Fall NU-FAST Zahid Siddique

24 Product life cycle (PLC) approach
Growth Increase in exports by innovative country More competition foreign firms start producing for home market US firms may also set up production in those countries Increased capital intensity Maturity Decline in exports from innovative country potential for export is limited for US firms after production starts in emerging economies Standardization of product price factor and cost consideration more important High capital-intensive production foreign firms might have CA due to low-wages at home and start exporting it to US Fall NU-FAST Zahid Siddique

25 Product life cycle (PLC) approach
Decline Concentration of production in developing countries to make use of low-wage labor Innovative country becomes importer The theory fails to explain complex patterns of international trade production of parts and assembling taking place at different places many new products produced at several places simultaneously Fall NU-FAST Zahid Siddique

26 Other horizons on trade theory: Porter’s diamond
Alternative ideas are also reflected to explain trade-patterns Porter presented “Competitive Advantage of Nations” Direct attack on relevance of conventional economics: “Why do some nations succeed and others fail in international competition? This question is perhaps the most frequently asked … of our times… Yet … it is the wrong question… We must focus instead on another, much narrower one… why does a nation become the home base for successful international competitors in an industry?... why certain industries grow in one country than others? why is Germany home base for world’s leading makers of printing presses, luxury cars, & chemicals? why is tiny Switzerland home base for international leaders in pharmaceuticals, chocolate…?” (1) Fall NU-FAST Zahid Siddique

27 Porter’s irrelevant factors
Focus not on “natural endowment” (comparative advantage) & broadly defined industries (L-intensive, K-intensive) but Innovation & very specific industries Luxury cars (Germany) Ski boots (Italy) Mobile phones (Finland!) Porter’s theory aware of recent economic trends: “The long-dominant paradigm … is inadequate… the rise of the multinational corporation … [has] weakened the traditional explanations of why and where a nation exports…” (2) Porter instead “seeks to isolate … the national attributes that foster competitive advantage in an industry…” (3) Fall NU-FAST Zahid Siddique

28 Porter’s irrelevant factors
Dismisses other conventional explanations for trade Good macroeconomic policies? “Nations have enjoyed rapidly rising living standards despite budget deficits (Japan, Italy & Korea), appreciating currencies (Germany & Switzerland), and high interest rates (Italy & Korea)…” (3) Cheap labor? “The ability to compete despite paying high wages would seem to represent a far more desirable national target” Natural resources? Even “within nations such as Korea, the United Kingdom, and Germany, it is the resource-poor regions that are prospering relative to the resource-rich ones” (4) Government intervention? “has occurred only in a subset of industries, and is far from universally successful even in Japan and Korea.” Fall NU-FAST Zahid Siddique

29 Porter’s irrelevant factors
Management style? “What is celebrated as good management practice in one industry would be disastrous in another.” (4) Labor relations? “Unions are very powerful in Germany and Sweden, with representation by law in management (Germany) and on boards of directors (Sweden)… both nations … contain some of the most internationally preeminent firms and industries of any country.” (5) Rejects characterization of nations as competitive “We must abandon the whole notion of a ‘competitive nation’…” And focus instead on “specific industries and industry segments…” (9) Fall NU-FAST Zahid Siddique

30 Porter’s irrelevant factors
Rejects comparative advantage: “the assumptions underlying factor comparative advantage … are unrealistic in many industries. The standard theory assumes that there are no economies of scale, that technologies everywhere are identical, that products are undifferentiated, and that the pool of national factors is fixed.” (12) (same reservations as discussed earlier) “The theory … is also frustrating for firms because … [it] assumes away a role for firm strategy, such as improving technology or differentiating products … most managers exposed to the theory find that it assumes away what they find to be most important and provides little guidance for appropriate company strategy.” (12-13) “firms can and do choose strategies that differ… Fall NU-FAST Zahid Siddique

31 Competitive Advantage: methodology
Theory developed by empirical research: 10 countries examined at deep industry level: Denmark (5.1 million people in 1987); Germany (61m); Italy 57; Japan 122; Korea 42; Singapore 2.6; Sweden 8.4; Switzerland 6.5; UK 57; USA 244 m Statistical technique used to select industries/firms in which each country was outstanding competitor in 1985 100 industries selected From obvious (Japan semiconductors) To obscure (British biscuits) Industry classifications show how specific “capital” is Machines essential for one industry useless in another Key point in critique of conventional theory The complete list by country: Fall NU-FAST Zahid Siddique

32 Competitive Advantage: methodology
Fall NU-FAST Zahid Siddique

33 Competitive Advantage: observations
“Successful firms are frequently concentrated in particular cities or states within a nation. In the United States … many of the nation’s leading real estate developers are based in Houston, Texas; oil & gas equipment suppliers in Houston; hospital management chains in … Nashville…; carpet producers in Dalton, Georgia;… Something about these locations provides a fertile environment for firms in these particular industries.” (29) Fall NU-FAST Zahid Siddique

34 Fall 2007 NU-FAST Zahid Siddique
Industry defined Narrow and meaningful definition of industry used: “Many discussions of competition … employ overly broad definitions such as banking, chemicals, or machinery. These are not strategically meaningful industries b/c both the nature of competition and sources of competitive advantage vary a great deal within them Machinery, e.g., is not one industry but dozens of strategi-cally distinct industries such as weaving machinery, rubber processing equipment, and printing machinery … each with its own unique requirements for competitive success.” (34) Delineates 5 forces shaping an industry: “The threat of new entrants; The threat of substitute products or services; The bargaining power of suppliers; The bargaining power of buyers; and The rivalry among existing competitors” (35) Fall NU-FAST Zahid Siddique

35 Meaning of competitive advantage
Competitive advantage is reflected in two basic features: “lower cost and differentiation” (37) “It is difficult, though not impossible, to be both lower-cost and differentiated relative to competitors.” (38) “Any successful strategy, however, must pay close attention to both types of advantage while maintaining a clear commitment to superiority on one.” (38) 3rd important feature is “competitive scope”—how broad industry is & how much of it firm covers Fall NU-FAST Zahid Siddique

36 Meaning of competitive advantage
Combination of cost & differentiation give different forms of competitive advantage: Fall NU-FAST Zahid Siddique

37 Meaning of competitive advantage
Innovation crucial First mover advantage can last well past “short run” “German and Swiss dye companies (Bayer, Hoecsht, BASF, Sandoz,… Ciba-Geigy) have sustained their positions as international leaders since before World War I…” (47) “Early movers gain advantages such as being first to reap economies of scale, reducing costs through cumulative learning…” (47) Schumpeter’s assumption confirmed: “Often, innovators are ‘outsiders’ … to existing industry.” (48) Also… “larger companies were often supplanted by smaller ones…” (49) Fall NU-FAST Zahid Siddique

38 Behind Competitive Advantage
4 key determinants of Competitive Advantage: Factor conditions Only one considered by comparative advantage Concerns innovation as well as “endowment” Demand conditions… Related & supporting industries… Firm strategy, structure, and rivalry.” (71) Fall NU-FAST Zahid Siddique

39 Fall 2007 NU-FAST Zahid Siddique
Porter’s diamond Porter’s “National Diamond” “Advantages throughout the ‘diamond’ are necessary for achieving and sustaining competitive success … [but] Advantage in every determinant is not a prerequisite…” (73) Fall NU-FAST Zahid Siddique

40 Porter’s diamond: factor one—Inputs
Factors matter but may enhance CA through their absence: “an abundance of factors may undermine instead of enhance competitive advantage. Selective disadvantages in factors, through influencing strategy and innovation, often contribute to sustained competitive success.” (74) Opposite of economic theory belief Gives example of Holland’s advantage in flowers “despite its cold, grey climate”… Second factor also important for Dutch flowers: Home demand Quality more important than quantity Discerning consumers drive product innovation Fall NU-FAST Zahid Siddique

41 Porter’s diamond: factor 2—Home demand
“Nations gain competitive advantage … where the home demand gives local firms a clearer or earlier picture of buyer needs… if home buyers pressure local firms to innovate faster…” (86) “A product’s fundamental or core design nearly always reflects home market needs.” (87) “small nations can be competitive in segments which represent an important share of local demand but a smaller share of demand elsewhere, even if the absolute size of the segment is greater in other nations.” (88) Fall NU-FAST Zahid Siddique

42 Porter’s diamond: factor 3—Supporting industries
Related & supporting industries Suppliers assist “process of innovation and upgrading… Suppliers help firms perceive new methods and opportunities to apply new technology.” (103) The full pattern of interlinking industries is very complex… Fall NU-FAST Zahid Siddique

43 Porter’s diamond: factor 3—Supporting industries
A more disaggregated view… Fall NU-FAST Zahid Siddique

44 Porter’s diamond: factor 3—Supporting industries
Competitive advantage in suppliers means spin offs from one industry can be means to develop new ones “Italian world leadership in gold and silver jewelry has been sustained … because other Italian firms produce two-thirds of the world’s jewelry-making machinery.” (101) Related industries give strength to each other… Fall NU-FAST Zahid Siddique

45 Porter’s diamond: factor 3—Supporting industries
Competitive advantage in related industries Fall NU-FAST Zahid Siddique

46 Porter’s diamond: factor 3—Supporting industries
“Japan's strength in long-filament synthetic textile fibers reflects a long tradition of success in silk, as does a leading export position in silk-like continuous synthetic weaves, woven from long-filament synthetic fibers. Carbon fibers employ technology closely related to synthetic filament fibers and many of the same competitors participate in both. Also, while not overall leaders in textile machines, Japanese firms are leaders in water jet weaving machines, used to weave long-filament synthetic fibers into synthetic weaves. Such groups of linked competitive industries in a nation are common.” (105) Fall NU-FAST Zahid Siddique

47 Porter’s diamond: factor 4—Firm structure
Firm strategy structure & rivalry “No one management system is universally appropriate” But character of national management structure needs to suit needs of industry. “Nations will tend to succeed … where the management practices and modes of organization favored by the national environment are well suited to the industries’ sources of competitive advantage. Italian firms … are world leaders in a range of fragmented industries … operating in small niches… In Germany … the engineering and technical background of many senior executives produces a strong inclination towards methodical product and process improvement…” (108) Fall NU-FAST Zahid Siddique

48 Porter’s diamond: factor 4—Firm structure
National goals Short term focus of US firms—advantage in accounting Long term focus of German/Japanese—advantage in engineering… Domestic rivalry Desire to beat own national competitors often drives innovation Italian super cars; Japanese electronics; US software, computers… “With little domestic rivalry, firms are more content to rely on the home market.” (119) Fall NU-FAST Zahid Siddique

49 Where competitive advantage?
Japan in particular has large number of internationally competitive firms in different industries: Fall NU-FAST Zahid Siddique

50 Where competitive advantage?
National competitive advantage therefore tends to occur in clusters Geographic clusters “Many of the Italian jewelry firms, for example, are located around two towns, Arezzo and Valenca Po…” (120) Similarly, Sports industry is concentrated in Sialkot in Pakistan Industry clusters Related industries and supplier-buyer chains Fall NU-FAST Zahid Siddique

51 Where competitive advantage?
“The individual determinants that define the national environment are mutually dependent because the effect of one often depends on the state of the others…” (129) Example of clustering: Denmark Fall NU-FAST Zahid Siddique

52 Where competitive advantage?
Fall NU-FAST Zahid Siddique

53 Where competitive advantage?
Geographic clustering also strikingly obvious: Clustering of internationally competitive industries in Italy: Fall NU-FAST Zahid Siddique

54 Where competitive advantage?
Interactions in the “Diamond” for Italian Ski Boot industry: Fall NU-FAST Zahid Siddique

55 Fall 2007 NU-FAST Zahid Siddique
It is so sad The theory seems rich of explanation but is not so much a model in economic sense more of a description of process therefore not considered by economists But probably better guide to feasible policy than “comparative advantage” Next Topic: Trade Policy Fall NU-FAST Zahid Siddique

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