1. © 2001 Prentice Hall5-1 International Business by Daniels and Radebaugh Chapter 5 International Trade Theory

2. © 2001 Prentice Hall5-2 Objectives To explain trade theories To discuss how global efficiency can be increased through free trade To introduce prescriptions for altering trade patterns To explore how business decisions influence international trade

3. © 2001 Prentice Hall5-3 Companies’ International Operations Link Countries Economically OBJECTIVES STRATEGY MEANS OF OPERATING Importing and exporting goods and services (trade) Transferring production factors, such as labor and capital, internationally Country B Country A

4. © 2001 Prentice Hall5-4 Introduction Trade in goods and services is one means by which countries are linked economically Types of trade theories Descriptive—deal with natural order of trade –examine and explain trade patterns under laissez-faire conditions Prescriptive—concerned with government interference in the free movement of goods and services –considers governments’ affect on the amount, composition, and direction of trade Both types of theories –provide insights about markets for exports and potentially successful export products –help companies determine where to locate production facilities

5. © 2001 Prentice Hall5-5 Mercantilism Foundation of economic thought from 1500—1800 Intended to benefit colonial powers –colonies supplied commodities to the mother country –mother country tried to run trade surpluses with their own colonies A country’s wealth determined by its holding of treasure, usually gold Countries should export more than they import –favorable balance of trade –governments imposed restrictions on imports –governments subsidized many products that could not otherwise compete in domestic or export markets Mercantilism faded after 1800 Neomercantilism—attempt to achieve favorable trade balances to achieve social or political objectives

6. © 2001 Prentice Hall5-6 Absolute Advantage Adam Smith—different countries produce some goods more efficiently than other countries Free trade increases global efficiency Each country will specialize in products that give it a competitive advantage –labor becomes more skilled by repeating tasks –no time lost switching from production of one kind to production of another kind –long production runs provide incentives for development of more effective work methods Natural advantage—stems from climatic conditions, access to certain natural resources, or availability of certain labor forces Acquired advantage— based on technology and skill development –product technology –process technology

7. © 2001 Prentice Hall5-7 Production Possibilities with Absolute Advantage ASSUMPTIONS for Sri Lanka 1. 100 units of resources available 2. 10 units to produce a ton of wheat 3. 4 units to produce a ton of tea 4. Uses half of total resources per product when there is no foreign trade ASSUMPTIONS for United States 1. 100 units of resources available 2. 5 units to produce a ton of wheat 3. 20 units to produce a ton of tea 4. Uses half of total resources per product when there is no foreign trade PRODUCTION Tea Wheat (tons) (tons) Without Trade: Sri Lanka (point A) 12.5 5 U.S. (point B) 2.5 10 Total 15.0 15 With Trade: Sri Lanka (point C) 25 0 U.S. (point D) 0 20 Total 25 20 U.S. production possibilities 10 Quantity of Wheat (tons) 0515 20 25 5 10 15 20 25 Quantity of Tea (tons) A B C D Sri Lankan production possibilities

8. © 2001 Prentice Hall5-8 Comparative Advantage David Ricardo—gains from trade will occur even in a country that has absolute advantage in all products because the country must give up less-efficient output to produce more-efficient output Country should specialize in products it can make most efficiently, even if other countries can make the product more efficiently Theory accepted by most economists Theory is influential in promoting policies for freer trade

9. © 2001 Prentice Hall5-9 Production Possibilities with Comparative Advantage ASSUMPTIONS for Sri Lanka 1. 100 units of resources available 2. 10 units to produce a ton of wheat 3. 10 units to produce a ton of tea 4. Uses half of total resources per product when there is no foreign trade PRODUCTION Tea Wheat (tons) (tons) Without Trade: Sri Lanka (point A) 5 5 U.S. (point B) 10 12.5 Total 15 17.5 With Trade (increasing tea production): Sri Lanka (point C) 10 0 U.S. (point D) 6 17.5 Total 16 17.5 ASSUMPTIONS for United States 1. 100 units of resources available 2. 4 units to produce a ton of wheat 3. 5 units to produce a ton of tea 4. Uses half of total resources per product when there is no foreign trade 10 Quantity of Wheat (tons) 0515 20 25 5 10 15 20 25 Quantity of Tea (tons) C D E U.S. production possibilities A B Sri Lankan production possibilities With Trade (increasing tea production): Sri Lanka (point C) 10 0 U.S. (point E) 5 18.75 Total 15 18.75

10. © 2001 Prentice Hall5-10 Assumptions and Limitations of Theories of Specialization Both absolute and comparative advantage theories are based on specialization Countries should trade output based on their own specialization for the output from other countries specialization Full employment— not valid assumption Economic efficiency objective—countries’ goals may not be limited to economic efficiency Division of gains—if trading partner is perceived to be gaining too large a share of benefits, other partner may forgo absolute gains to prevent relative losses Two countries, two commodities—original two-country, two-product logic applies to more complex situations Transport costs—may negate advantages of trading Size of economy and production scales—longer production runs, less production abroad

11. © 2001 Prentice Hall5-11 Factor-Proportion Theory Eli Heckscher and Bertil Ohlin—relative factor costs lead countries to excel in the production and export of products that used their abundant, and therefore cheaper, production factors Land-labor relationship—in countries in which there are many people relative to the amount of land, land price is very high because it’s in demand Land costs and technology dictate what types of industries choose to locate in a country Labor-capital relationship— production factors, especially labor, are not as homogeneous as assumed Labor skills vary within and among countries due to differences in training and education –led to international specialization by task to produce a given product Technological complexities—the same product can be produced by different methods (labor or capital)

12. © 2001 Prentice Hall5-12 Product Life Cycle Theory of Trade (PLC) Raymond Vernon—the production location for many products moves from one country to another depending on the stage in the product’s life cycle Stage 1: Introduction Innovation, production, and sales in same country –new products developed in response to nearby observed need and markets for them –early production occurs in domestic location Location and importance of technology –most new technology that results in new products and production methods originates in industrial countries Exports and labor –export small part of production –production process likely to be labor intensive –capital machinery for large-scale production develops later in industrialized countries

13. © 2001 Prentice Hall5-13 Product Life Cycle Theory of Trade (cont.) Stage 2: Growth Increases in exports by the innovating country More competition Increased capital intensity –growing sales offer incentives to companies to develop process technology Some foreign production Stage 3: Maturity Decline in exports from the innovating country More product standardization More capital intensity Increased competitiveness of price Production start-ups in emerging countries Stage 4: Decline Production increased in emerging economies Innovating country becoming net importer

14. © 2001 Prentice Hall5-14 Product Life Cycle Theory of Trade (cont.) Verification and limitations of plc theory High transportation costs limit export opportunities, regardless of the life cycle stage Shifts in production site do not change for many types of products –innovating country maintains its export ability throughout the life cycle »products with very short life cycles »luxury products for which cost is not a concern for the consumer »products used to promote differentiation strategy »products requiring specialized technical labor to evolve MNEs increasingly introduce new products at home and abroad simultaneously

15. © 2001 Prentice Hall5-15 Country-Similarity Theory Economic similarity of industrial countries Most of the world’s trade occurs among countries that have similar characteristics –country similarity theory—once a company has developed a new product to serve needs in a local market, it will turn to markets it sees as most similar to those at home –most trade takes place among industrial countries because: »growing importance of acquired advantage as opposed to natural advantage »markets in industrial countries can support products and their variations »importance of industrial markets due to their size »incomes are high and people buy more Few emerging countries trade with each other

16. © 2001 Prentice Hall5-16 World Trade by Major Product Category as Percentage of Total World Trade for Selected Years 198019901998 100 80 60 40 20 0 Percentage 53.9 27.7 14.7 3.7 70.7 14.2 12.3 2.8 62.8 7.9 8.6 20.7 Commercial services Manufactured products Mining products Agricultural products

17. © 2001 Prentice Hall5-17 Country-Similarity Theory (cont.) Similarity of location Distances among countries accounts for many world trade relationships Methods to overcome distance disadvantages are difficult to maintain Cultural similarity Importers and exporters find it easier to do business in a country perceived as being similar Historic colonial relationships explain much of international trade Similarity of political and economic interests Political relationships and economic agreements among countries may discourage or encourage trade between them or their companies Military conflicts disrupt trade patterns Political animosity may interfere with trading channels

18. © 2001 Prentice Hall5-18 Degree of Dependence Independence—complete economic independence Country has no reliance on other countries for goods, services, or technologies Price of independence is having to do without goods that cannot be produced domestically Hinders country’s ability to borrow and adapt existing technologies Interdependence— trade based on mutual need Neither trading partner is likely to cut off supplies or markets for fear of retaliation Governments may be pressured to sustain trade Dependence—developing countries rely heavily on: The sale of one commodity for export earnings –25 % of emerging countries sell one commodity One country as supplier or customer Industrialized countries

19. © 2001 Prentice Hall5-19 Strategic Trade Policy Governmental role and influence in affecting the acquired advantage of production within their borders Alter conditions for industries in general –change conditions that affect factor proportions, efficiency, and innovation Target conditions for a specific industry –typically results in no more than small payoffs »hard to identify and target appropriate industries »too many countries identify the same industry, leading to excessive competition »relative conditions change, causing relative capabilities to change as well –have been a few notable government successes in targeting a specific industry

20. © 2001 Prentice Hall5-20 The Porter Diamond Indicates four important conditions for competitive superiority Demand conditions—observation of need or demand –usually in home country –production started near the observed market Factor conditions— availability and terms for acquiring them Related and supporting industries—existence of infrastructure Firm strategy, structure, and rivalry –influenced by other three conditions Existence of the four favorable conditions does not guarantee that an industry will develop in a locale Absence of one of the four conditions from a country may not inhibit companies from becoming globally competitive

21. © 2001 Prentice Hall5-21 Determinants of Global Competitive Advantage: The Porter Diamond Demand Conditions Factor Conditions Related and Supporting Industries Firm Strategy, Structure, and Rivalry

22. © 2001 Prentice Hall5-22 Companies’ Role in Trade Most trade theories based on a national perspective Decisions to trade are usually made by companies Strategic advantages of exports Use of excess capacity—companies leverage their competencies by using them abroad Cost reduction –experience curve effect—cost reductions stemming from increased output Freater profitability—may have higher profit margins in foreign markets Risk spreading—counterbalance business cycles in different countries Strategic advantages of imports Procurement of supplies abroad may lower costs Foreign products complement existing products Reduces dependence on single suppliers