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INTERNATIONAL BUSINESS ENVIRONMENT

(Political Economy of International Business)

Session 2 International Trade Theories and Reality

Today's questions ...

1. What are the main theories of international trade and foreign direct investment? 2. What is their understanding of trade purpose? What do they say with regards to the role played by business and governments? 3. What is the case for free trade vs. protectionism? 4. How can protectionism nonetheless be justified?

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Section 1 INTERNATIONAL TRADE THEORIES

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Main international trade theories

Country-based trade theories Mercantilism Absolute advantage Comparative advantage Firm-based trade theories Vernon's product life-cycle theory New trade theory

M. Porter's attractiveness diamond

Foreign direct investment theories J. Dunning's eclectic theory

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Mercantilism

Original XVIIth century mercantilists, such as John Law, a Scots financier, believed that a country's economic prosperity and political power came from its stocks of precious metals. To maximise these stocks they argued against free trade, favouring protectionist policies designed to minimise imports and maximise exports, creating a trade surplus that could be used to acquire more precious metal
http://www.economist.com/research/Economics/alphabetic.cfm?letter=M#mercantilism

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Mercantilism today

Neo-mercantilism is a term used to describe a policy regime which encourages exports, discourages imports, controls capital movement and centralises currency decisions in the hands of a central government The objective of neo-mercantilist policies is to increase the level of foreign reserves held by the government, allowing more effective monetary and fiscal policy. This is generally believed to come at the cost of lower standards of living of the concerned nation It is called "neo" because of the change in emphasis from classical mercantilism on military development, to economic development. It also accepted a greater level of price fixing based on market mechanisms
http://en.allexperts.com/q/Economics-2301/Differences-Mercantilist-Neo-Mercantilist-1.htm

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Absolute advantage (A. Smith)

Absolute advantage refers to the ability of a person or a country to produce a particular good at a lower absolute cost than another.

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Comparative advantage [1] (D. Ricardo)

Comparative advantage refers to the ability of a person or a country to produce a particular good at a lower marginal cost and opportunity cost than another person or country. Comparative advantage explains how trade can create value for both parties even when one can produce all goods with fewer resources than the other. The net benefits of such an outcome are called gains from trade.

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The gains from free trade [1] (from CW Hill)

Absolute advantage
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200 units of resources available per country

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Comparative advantage
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The gains from free trade [2]

P

S
P*
Domestic price

E*

P1
World price

s1 Imports

d1

D
Q

qs
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qd

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Example: Britain's trade in the XIXth Century

Exotic products

Food products Textile products

Opium

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Comparative advantage [2] (H-O-S model)

Ricardo's theory of comparative advantage is based on differences in labour productivity For Eli Heckscher and Bertil Ohlin, comparative advantage arises from differences in relative national factor endowments the extent to which a country is endowed with resources like labour and capital The Heckscher-Ohlin-Samuelson model predicts that countries will export goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce

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Limitations of traditional trade theories

Focused on trade between nations, not between firms Do not explain intra-industry and intra-firm trade

Do not consider capital movements

Traditional (country-based) trade theories

Do not analyse long-term impact of international specialisation

Do not explain trade among similar countries

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The product life-cycle theory (Graph by CW Hill)

According to Raymond Vernon's product life-cycle theory, both the location of sales and the optimal production location will change as products mature, affecting the flow and direction of trade

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The new trade theory (P. Krugman)

Tries to explain why trade is growing fastest between industrial countries

1.

With similar economies and endowments of the factors of production (intra-regional trade) Trading similar goods (intra-industry trade) Markets of imperfect competition (oligopolies, national monopolies) Increasing returns to scale Movement of capital (foreign direct investment) Business and government strategies

2.

Considers
1.

2. 3. 4.

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The new trade theory (ctd)

1. Trade is mutually beneficial because it allows for the specialization of production, the realization of economies of scale, and the production of a greater variety of products at lower prices 2. The pattern of trade may result from economies of scale and first mover advantages (economic and strategic advantages that accrue to early entrants into an industry)

3. Selected government intervention (strategic trade policy) may support the development of strategic or export-oriented industries

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The new trade theory (ctd)

Government strategies

Corporate strategies
Strategic trade policy Targeted protectionism

Economies of scale, externalities

Internationalisation
(horizontal, vertical)

First mover advantage

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New markets

Diversification, specialisation
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Introducing foreign direct investment

Definition Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country

Greenfield investment Establishment of a wholly new operation in a foreign country Brownfield investment Acquisitions or mergers with existing firms in the foreign country

Joint venture legal entity formed between two or more parties to undertake an economic activity together.
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Foreign direct investment drivers

Strategic rivalry
Advantage to first mover Bandwagon effect Multipoint competition

Export substitution
Transport costs Trade barriers

Export complementarity
Optimisation of value chain (vertical integration)

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Dunning's "eclectic theory" of FDI (ILO)

Internalisation Response to actual or threatened trade barriers Need to control foreign business activity Location Resource endowments (capital, labour) or assets (incl. location externalities) that are tied to a particular location Ownership Firms endowed with a distinctive competitive advantage (technology, brand, economies of scale) will try to take advantage of large number of markets

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M. Porter's diamond
M. Porter's thesis is that national competitive advantage is not dependent on factor endowment, but depends on various factors that interact with each other to create conditions where innovation and improved competitiveness occurs Government Firm strategy, structure and rivalry

Factor endowments

Demand conditions

Related and supporting industries

Chance
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Conclusion: internationalisation drivers

Supply factors
Natural resources Production (labour) costs/productivity Distribution costs Key technologies Location externalities

Demand factors
New markets (incl. economies of scale) Response to customer's mobility Response to trade barriers Economic incentives

Strategic rivalry
Advantage to 1st mover - Bandwagon effect/Herd behaviour - Multipoint competition

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Protectionism or free trade?

Mercantilism promotes government involvement in supporting exports and limiting imports Smith, Ricardo and Heckscher-Ohlin show that it is beneficial for a country to engage in international trade even for products it is able to produce for itself. International trade allows a country:

To specialize in the manufacture and export of products that it can produce efficiently To import products that can be produced more efficiently in other countries

The new trade theory supports international trade but justifies limited and selective government intervention to support the development of certain export-oriented industries

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Food for thought

"An international economics course should drive home to students the point that international trade is not about competition, it is about mutually beneficial exchange. Even more fundamentally, we should be able to teach students that imports, not exports, are the purpose of trade. That is, what a country gains from trade is the ability to import what it wants. Exports are not an objective in and of themselves: the need to export is a burden that the country must bear because its import suppliers are crass enough to demand payment".
Paul KRUGMAN, in Pop Internationalism
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Section 2 THE REALITY OF INTERNATIONAL TRADE

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From theory to reality

Most nations are nominally committed to free trade In practise, governments intervene to protect the interests of powerful groups TRADE POLICY

Trade restriction

Trade promotion

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Free vs. "managed" trade

Partisans of a "managed trade" (or fair trade) consider that national governments should actively intervene in international trade to ensure that :
Domestic firms are offered an equitable share of foreign markets Imports are controlled to minimize losses of domestic jobs and market share in specific industries

"Fair traders" also argue that a government should ensure a level playing field on which foreign and domestic firms get the same opportunity to compete

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Government goals in international trade

Economic goals

Social goals

Trade policy

Political goals

Foreign policy goals

Various goals can be in conflict Goals are dynamic: objectives may change over time (homeostasis)

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Justifications to trade restriction/promotion

Political arguments

Protecting consumers from "dangerous" products Protecting jobs Protecting industries deemed important for national security Retaliating to unfair foreign competition Furthering the goals of foreign policy Protecting the human rights of individuals in exporting countries Protecting infant or declining industries Strategic trade policy, supporting the development of strategic industries and technologies The "big country" argument Preserving access to natural resources ...

Economic arguments

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The "candle tax", a case of public choice?

Europe has been accused of going back on world leaders' pledge to avoid exacerbating the recession by throwing up new barriers against international trade, just a month after the London G20 summit. Brussels will slap tariffs of up to 60% on imports of cut-price Chinese candles this month, in one of four measures -identified by the World Bank president, Robert -Zoellick, on a blacklist of anti-free trade decisions taken since the summit. [] Britain's retailers are furious about the import tax on candles []. They say the measure protects German and Polish candle-makers and estimate that the sanction, which will stay in place for five years, will cost retailers up to 10m. [] The EU has also imposed temporary "anti-dumping" taxes, which are meant to protect against cut-price subsidised imports, on three other products: Chinese wire, iron and steel pipes, and aluminium foil from Armenia, Brazil and China.
The Guardian, 4 May 2009 http://www.guardian.co.uk/business/2009/may/04/eu-blocks-free-trade

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Trade restriction instruments

Tariffs, quantitative barriers

Tariffs
(Incl. anti-dumping)

Quotas

Voluntary export restraints

Subsidies

Non-tariff barriers

Local content requirements

Norms and standards

Administrative barriers

Exchange rate manipulation

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Food for thought

Why do intergovernmental organisations like the WTO consider that custom duties are preferable both to quotas and non-tariff barriers Tariffs ...
... are transparent ... Create less distortion than quotas ... Are easier to lift than non-tariff obstacles such as norms or standards

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The consequences of protection ("small" country)

P

S
P*
Domestic price

E* s2 s1 d2 d1

P2
World Price + tariff

P1
World price

D
Q

c1
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q1

Trade restriction: business implications

Generally speaking, trade barriers raise export costs Antidumping actions limit a firm's ability to pursue aggressive pricing to gain market share Voluntary export restraints (VERs) and quotas limit a firm's ability to serve a country from locations outside that country To conform to local content requirements, a firm may have to locate more production activities in a given market than it would otherwise

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The other side of protection: trade promotion

Subsidies
Cash, tax breaks, price supports (e.g. former US foreign sales corporations)

Export financing programmes

Low-interest loans, loan guarantees (e.g. French COFACE)

Foreign trade zones

Products are subject lower customs duties and/or fewer customs procedures (e.g. Mexican maquiladoras)

Government agencies
Trade missions for officials and businesses, export-promotion offices, help import products the home nation does not produce (e.g. Japanese JETRO)

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Export promotion bodies: the US case

Export-Import Bank of the United States (http://www.exim.gov): official export credit agency of the United States. Assists in financing the export of U.S. goods and services to international markets Overseas Private Investment Corporation (http://www.opic.gov): helps U.S. businesses invest overseas by managing risks associated with foreign direct investment US government export portal (http://www.export.gov): brings together resources from across the U.S. Government to assist American businesses in planning their international sales strategies International Trade Administration (http://trade.gov/about.asp): strengthens the competitiveness of U.S. industry, promotes trade and investment, and ensures fair trade through the rigorous enforcement of our trade laws and agreements.

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Protection-based development strategies

Import substitution

Export promotion

Protectionist barriers: protect infant industries

Protectionist barriers: support savings and investment vs. consumption

Support to domesticallyoriented production

Support to export-led industries

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Example: the "dragons" and China

The growth champions of the past few decades Japan in the 1950s and 1960s, South Korea from the 1960s to the 1980s, and China since the early 1980s have all had activist governments collaborating closely with large business. All aggressively promoted investment and exports while discouraging (or remaining agnostic about) imports. Chinas pursuit of a high-saving, large-trade-surplus economy in recent years embodies mercantilist teachings.
http://www.europeanceo.com/news/commentaries//article672.html

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Food for thought

What are the limitations of neo-mercantilist policies

"Beggar-thy-neighbour" policy, that works at the expense of trade partners Will lead to global depression if applied by all players

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Application: the prisoner's dilemma

Gains / Losses
Extra-growth, trade and financial surpluses, job creation ...

Germany

Support to domestic demand

Support to external competitiveness

Other European countries

3
Support to domestic demand Support to external competitiveness

2 -2 -1 -1

3 -2 2

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