MODULE 3 – CONNECTING COUNTRIES THROUGH TRADE AND 61

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MODULE 3 – CONNECTING COUNTRIES THROUGH TRADE AND FACTOR

MOVEMENTS

INTRODUCTION

Everybody will agree that theories had always been played a vital role in every
types of businesses. This had served a framework in the operations of a business.
In this lesson, we will understand the different approaches to international trade
theories as well as how it was very useful in addressing the explanation of various
trade patterns.

Along with this, it also been part in trading to protect the welfare of organization,
human resources, financial resources and the environmental resources. In the
same manner how to protect business process. In this module, you will also be
learning how policymakers continue to struggle with international trade controls
and how governmental agencies interferes.

Lastly, we will also be learning on the different approaches to economic integration

and the pros and cons of being a member. Information on why countries rely on
exporting their commodity and how fluctuations in foreign currencies can be
controlled an international organization will be discussed in this module.

LEARNING OUTCOMES

After reading this module, the learner should be able to:

1. Understand how different approaches to international trade theories help
policy makers achieve economic objectives.
2. Detect why production factors, especially labor and capital, move
internationally.
3. Explain why governments try to enhance and restrict trade.
4. Demonstrate the business uncertainties and opportunities created by
governmental trade policies.
5. Identify how the different approaches to economic integration can be a
free trade agreement, a customs union, or a common market.
6. Compare and contrast different regional trading groups.

TIME

The time allotted for this module is five (5) hours.

LEARNER DESCRIPTION

The participants in this module are BSBA third year students.

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MODULE CONTENTS

LESSON 3.1. Trade and Factor Mobility Theory

Laissez-Faire Versus Interventionist Approaches to Exports and Imports

Once countries set economic and political objectives, officials enact policies—
including trade policies—to achieve desired results. This influences which
countries can produce given products more efficiently and whether countries will
permit imports to compete against their domestically produced goods and services.

Some nations take a more laissez-faire approach, one that allows market forces
to determine trading relations. Free-trade theories (absolute advantage and
comparative advantage) take a complete laissez-faire approach because they
prescribe that governments should not intervene directly to affect trade. At the
other extreme are mercantilism and neomercantilism, which prescribe a great deal
of government intervention in trade. Whether taking a laissez-faire or
interventionist approach, countries rely on trade theories to guide policy
development.

Figure 3.1.1. International Operations and Economic Connections

Source: International Business: Environments and Operations by Daniels, Radebaugh, & Sullivan
(2019)

To meet its international objectives, a company must gear its strategy to trading
and transferring its means of operation across borders––say, from (Home) Country
A to (Host) Country B. Once this process has taken place, the two countries are
connected economically.

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Theories of Trade Patterns

Some trade theories prescribe that governments should influence trade patterns;
others propose a laissez-faire treatment of trade.

Trade Theories and Business

Table 3.1.1. summarizes the major trade theories and their emphases. These
different theories expand our understanding of how government trade policies
might affect business competitiveness.

For instance, they provide insights on favorable locales and products for exports,
thereby helping companies determine where to locate their production facilities
when governments do or do not impose trade restrictions.

TABLE 3.1.1. What major trade theories Do and Don’t Discuss: A Checklist
Source: International Business: Environments and Operations by Daniels, Radebaugh, & Sullivan
(2019)

Factor-Mobility Theory
Because the stability and dynamics of countries’ competitive positions depend
largely on the quantity and quality of their production factors (land, labor, capital,
technology), we’ll conclude this chapter with a discussion of factor mobility.

Interventionist Theories

Mercantilism
Mercantilism holds that a country’s wealth is measured by its holdings of
“treasure,” which usually means its gold. According to this theory, which formed
the foundation of economic thought from about 1500 to 1800,2 countries should
export more than they import and, if successful, receive gold from countries that
run deficits. Nation-states were emerging during this period, and gold empowered
central governments to raise armies and invest in national institutions so as to
solidify the people’s primary allegiance to the new nations.
• Governmental Policies
• The Concept of Balance of Trade

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Neomercantilism
The term neomercantilism describes the approach of countries that try to run
favorable balances of trade in an attempt to achieve some social or political
objective. A country may aim for increased employment by setting economic
policies that encourage its companies to produce in excess of the demand at home
and send the surplus abroad. Or it may attempt to maintain political influence in an
area by sending more merchandise there than it receives from it, such as a
government granting aid or loans to a foreign government to use to purchase the
granting country’s excess production.

Free-Trade Theories

Theory of Absolute Advantage

In 1776, Adam Smith questioned the mercantilists’ assumptions by stating that the
real wealth of a country consists of the goods and services available to its citizens
rather than its holdings of gold. This theory of absolute advantage holds that
different countries produce some goods more efficiently than others, and questions
why the citizens of any country should have to buy domestically produced goods
when they can buy them more cheaply from abroad. Smith reasoned that
unrestricted trade would lead a country to specialize in those products that gave it
a competitive advantage. Its resources would shift to the efficient industries
because it could not compete in the inefficient ones. Through specialization, it
could increase its efficiency for three reasons:
1. Labor could become more skilled by repeating the same tasks.
2. Labor would not lose time in switching production from one kind of product
to another.
3. Long production runs would provide incentives for developing more
effective working methods.

The country could then use its excess specialized production to buy more imports
than it otherwise could have produced. Although Smith believed the marketplace
would make the determination, he thought that a country’s advantage would be
either natural or acquired.

Theory of Comparative Advantage

We have just described absolute advantage, which is often confused with
comparative advantage. In 1817, David Ricardo examined the question, “What
happens when one country can produce all products at an absolute advantage?”
His resulting theory of comparative advantage says that global efficiency gains
may still result from trade if a country specializes in what it can produce most
efficiently—regardless of other countries’ absolute advantage.

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Don’t Confuse Comparative and Absolute Advantage

Most economists accept the comparative advantage theory and its influence in
promoting policies for freer trade. Nevertheless, many government policymakers,
journalists, managers, and workers confuse comparative advantage with absolute
advantage and do not understand how a country can simultaneously have a
comparative advantage and absolute disadvantage in the production of a given
product.

Theories of Specialization: Some Assumptions and Limitations

Both absolute and comparative advantage theories are based on increasing output
and trade through specialization. However, these theories make assumptions,
some of which are not always valid.
• Full Employment. Full employment is not a valid assumption of absolute
and comparative advantage.
• Economic Efficiency. Countries’ goals may not be limited to economic
efficiency.
• Division of Gains. Although specialization brings potential economic
benefits to all trading countries, the earlier discussion did not indicate how
countries will divide increased output.
• Transport Costs If it costs more to transport the goods than is saved
through specialization, the advantages of trade are negated.
• Statics and Dynamics The theories of absolute and comparative
advantage address countries statically—by looking at them at one point in
time.
• Services The theories of absolute and comparative advantage deal with
products rather than services.
• Production Networks Both theories deal with trading one product for
another. Increasingly, however, portions of a product may be made in
different countries.
• Mobility These theories assume that resources can move domestically
from the production of one good to another—and at no cost. But this
assumption is not completely valid.

Trade Pattern Theories

The free trade theories demonstrate how economic growth occurs through
specialization and trade; however, they do not deal with trade patterns such as
how much a country trades what products it trades, or who will be its trading
partners when following a free trade policy.

How Much Does A Country Trade?

Free-trade theories of specialization neither propose nor imply that only one
country should or will produce a given product or service. Nontradable goods—
products and services (haircuts, retail grocery distribution, etc.) that are seldom

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practical to export because of high transportation costs—are produced in every

country. However, among tradable goods, some countries depend on imports and
exports more than others. We will now examine theories that help explain country
differences.
• Theory of Country Size
Land area is an obvious way to measure a country’s size and largely
explains countries’ relative dependence on trade. The theory of country size
holds that large countries usually depend less on trade than small ones.
• Size of the Economy
While land area helps explain the relative dependence on trade, countries’
economic size helps explain differences in the absolute amount of trade.

What Types of Products Does A Country Trade?

In our discussion of absolute advantage, we indicated that this advantage might
be either natural or acquired. Here, we discuss theories that help explain what
types of products result from these natural and acquired advantages. We won’t
delve again into those factors we’ve already discussed (climate and natural
resources) that give a country a natural advantage; however, we will examine the
factor endowment theory of trade.
Factor-Proportions Theory Eli Heckscher and Bertil Ohlin developed the
factor-proportions theory, maintaining that differences in countries’
endowments of labor compared to land or capital endowments explain
differences in the cost of production factors.
o People and Land. Factor-proportions theory appears logical.
o Manufacturing Locations. Casual observation of manufacturing
locations also seems to substantiate the theory.
o Capital, Labor Rates, and Specialization. In countries where little
capital is available for investment and the amount of investment per
worker is low, managers might expect to find cheap labor rates and
export competitiveness in products that need large amounts of labor
relative to capital.
o Process Technology. Factor-proportions analysis becomes more
complicated when the same product can be created by different
methods, such as with labor or capital.
o Product Technology. The technology depends, in turn, on a large
number of highly educated people (especially scientists and
engineers) and a large amount of capital to invest in R&D.

With Whom Do Countries Trade?

They also trade primarily with each other, whereas developing countries mainly
export primary and labor-intensive products to developed countries in exchange
for new and technologically advanced products.

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Country-Similarity Theory. The theories explaining why trade takes place

have focused so far on the differences among countries in terms of natural
conditions and factor endowment proportions.
o Specialization and Acquired Advantage. However, in order to
export, a company must provide consumers abroad with an
advantage over what they could buy from their domestic producers.
Trade occurs because countries’ producers spend more on R&D in
some sectors than in others, thus leading to countries’ specialization
and acquired advantage.
o Product Differentiation. Trade also occurs because companies
differentiate products, thus creating two-way trade in seemingly
similar products.
o The Effects of Cultural Similarity. Importers and exporters
perceive greater ease in doing business in countries that are
culturally similar to home, such as those that speak a common
language.
o The Effects of Political Relationships and Economic
Agreements. Political relationships and economic agreements
among countries may discourage or encourage trade between them.
o The Effects of Distance. Although no single factor fully explains
specific pairs of trading partners, the geographic distance between
two countries is important.
o Overcoming Distance Transport cost is not the only factor in trade
partner choice.

The Statics and Dynamics of Trade

Product Life Cycle (PLC) Theory

The international product life cycle (PLC) theory of trade states that the production
location of certain manufactured products shifts as they go through their life cycle.
The cycle consists of four stages: introduction, growth, maturity, and decline.

Introduction
Once a company has created a new product, theoretically it can manufacture it
anywhere in the world. The introduction stage is marked by
• Innovation in response to observed need.
• Exporting by the innovative country.
• Evolving product characteristics.

Growth is characterized by
• Increases in exports by the innovating country.
• More competition.
• Increased capital intensity.
• Some foreign production.

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TABLE 3.1.2. Life Cycle of the International Product

Source: International Business: Environments and Operations by Daniels, Radebaugh, & Sullivan
(2019)

Maturity is characterized by
• A decline in exports from the innovating country.
• More product standardization.
• More capital intensity.
• Increased competitiveness of price.
• Production start-ups in emerging economies.

Decline is characterized by
• A concentration of production in developing countries.
• An innovating country becoming a net importer.

Verification and Limitations of PLC Theory.

The PLC theory holds that the location of production facilities that serve world
markets shifts as products move through their life cycle.

The Diamond of National Competitive Advantage

According to the diamond of national competitive advantage theory, companies’
development and maintenance of internationally competitive products depends on
favorable
• Demand conditions.
• Factor conditions.
• Related and supporting industries.
• Firm strategy, structure, and rivalry.

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Figure 3.1.2. The Diamond of National Competitive Advantage

Source: Based on Michael E. Porter, “The Competitive Advantage of Nations,” Harvard Business
Review, Vol. 68, No. 2, March-April 1990.

The interaction of these conditions must usually be favorable if an industry in a

country is to develop and sustain itself. The theory was developed with domestic
conditions in mind, but globalization results in favorable conditions that may come
from anywhere.

Facets of the Diamond. Usually, all four conditions need to be favorable

for an industry within a country to attain and maintain global supremacy.
• Demand Conditions. Demand conditions are the first feature in the
theory.
• Factor Conditions.
• Related and Supporting Industries. The third feature—the
existence of nearby related and supporting industries (enamels and
glazes)—was also favorable.
• Firm Strategy, Structure, and Rivalry. The combination of three
features—demand, factor conditions, and related and supporting
industries—influenced companies’ decisions to initiate production

Limitations of the Diamond of National Advantage Theory. The

existence of the four favorable conditions does not guarantee that an
industry will develop in a given locale.

Using the Diamond for Transformation. By expanding the diamond of

national advantage theory to include changes brought about by
globalization, we can see its validity for countries’ economic policies.

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Factor-Mobility Theory

As both the quantity and quality of countries’ factor conditions change, their relative
capabilities change as well, possibly because of internal circumstances. For
instance, if savings rates increase, countries have more capital relative to their
factors of land and labor. If they spend relatively more on education, they improve
the quality of the labor factor.

Why Production Factors Move

Capital. Capital, especially short-term capital, is the most internationally
mobile production factor.

People. People are less mobile than capital.

Effects of Factor Movements

Neither international capital nor population mobility is a new occurrence.

The Relationship Between Trade and Factor Mobility

Factor movement is an alternative to trade that may or may not be a more efficient
use of resources.
Substitution. When the factor proportions vary widely among countries,
pressures exist for the most abundant factors to move to countries with
greater scarcity, where they can command a better return.
Complementarity. Factor mobility through foreign investment often
stimulates trade because of
• The need for components.
• The parent company’s ability to sell complementary products.
• The need for equipment for subsidiaries.

Activity 3.1.

 Read Chapter 5. Trade and Factor Mobility Theory on pages 229-270 of

International Business: Environments and Operations by Daniels,
Radebaugh, & Sullivan.

Study Questions

1. How do different approaches to international trade theories help policy

makers achieve economic objectives?

2. Why do production factors, especially labor and capital, move

internationally?

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References

Daniels, J. D., Radebaugh, L. H., & Sullivan, D. P. (2019). International business:

Environments and operations. PEARSON.

Dawson, C. (2017). International trade. Larson & Keller.

Luthans, F. and Doh, J. P. (2015). International management: Culture, society and

behavior. McGraw-Hill

MGT 8 – INTERNATIONAL BUSINESS AND TRADE