CHAPTER 5

THE THEORY OF TRADE AND INVESTMENT

The Age of Mercantilism

The evolution of trade into the form we see today reflects three events :
the collapse of feudal society, the emergence of the mercantilist philosophy, and
the life cycle of the colonial systems of the European nation-states. In the
centuries leading up to the Industrial Revolution, international commerce was
largerly conducted under the authority of goverments. Trade was therefor
conducted to fill the goverment’s treasuries, at minimum expanse to themselves
but to the detriment of their captive trade partners. Mercantilism mixed
exchange through trade with accumulation of wealth. Since goverment
controlled the patterns of commerce, it identified strength with the accumulation
of specie ( gold and silver) and maintained a general policy of exports
dominating imports. The demise of mercantilism was inevitable given class
structure and the distribution of society’s product. However, goverments still
exercise considerable power and influence on the conduct of trade.

Classical Trade Theory

• The Theory of Absolute Advantage
Refers to the ability of a party (an individual, or firm, or a country) to produce
more of good or service than competitors, using the same amount of resources.
For example, Party A can produce 5 widgets per hour with 3 employees and
Party B can produce 10 widgets per hour with 3 employees. So assuming that
the employees of both parties are paid equally, Party B has an absolute
advantage over Party A in producing widgets per hour. This is because Party B
can produce twice as many widgets as Party A can with the same number of
employees.
• The Theory of Comparative Advantage
Refers to the ability of a party (an individual, or firm, or a country) to produce a
particular good or service at a lower opportunity cost than another party. For
example, two man live alone on an isolated island. To survive they must
undertake a few basic economic activities like water carrying, fishing, cooking
and shelter construction and maintenance. The first man is young, strong and
educated. He is also faster, better, and more productive at everything. He has an
absolute advantage in all activities. The second man is old, weak, and
uneducated. He has an absolute disadvantage in all economic activities. In some
activities the difference between two is great ; in other it is small. Despite the
fact that the younger man has an absolute advantage in all activities, it is not in
the interest of either of them to work in isolation since they both can benefit
from specialization and exchange. If thw two men divide work according to the
comparative advantage the the young man will specialize in tasks at which he is
most productive, while the older man will concentrate on tasks where his
productivity is only little less than that of the young man. Such arrangement will
increase total production for a given amount of labor supplied by both men and it
will benefit both of them.
• A Numerical Example of Classical Trade
Two countries, France and England produce only two products, wheat and cloth.
England produce 2 wheat and 4 clothes and France produce 4 wheat and 2
clothes. In this numerical example england needs only two-fourths as many
labor-hours to produce a unit of wheat as France, while France needs only two-
fourths as many labor hours to produce wheat, while France has comparative
advantage in the production of cloth. A country cannot possess comparative
advantage in the production of both products, so each country has an economic
role to play International Trade.
• National Production Possibilities
The production possibilities frontiers of each country can be constructed, if the
total labor-hours available for production within a nation were devoted to the full
production of either product, wheat or cloth.
• The Gains From International Trade
Gains trade in economics refers to net benefits to agents from voluntary trading
with each other. It is commonly described as resulting from :
- Specialization in production from division of labor, economics of scale,
scope, and agglomeration and relative availiability of factor resouces in types of
output by farms, businesses, location and economics.
- A resulting increase in total output possibilities
- Trade through markets from sale of one type of output for other, more
highly valued goods.
• Concluding Points About Classical Trade Theory
Classical trade theory contributed much to the understanding of how to
production and trade operates in the world economy.
- Division of Labor. Adam Smith’s explanation of how industrial societies can
increase output using the same labor-hours as in preindustrial society is
fundamental to our thinking even today.
- Comaparative Advantage. David Ricardo’s extension of Smith’s work
explained for the first time hoe countries that seemingly had no obvious reason
for trade could individually specialize in producing what they did best and trade
for products they did not produce.
- Gain from Trade. The theory of comparative advantage argued that
nations could improve the welfare of their population through international
trade.

Factor Proportions of Trade Theory

1. Factor Intensity in Production
The Heckscher-Ohlin theory considered two factors of produuction, labor and
capital. The production of one unit of good X requires 4 units of labor and 1 unit
of capital. At the same time, to produce 1 unit of good Y requires 4 units of labor
and 2 units of capital. Good X therefore requires more units of labor per unit of
capital (4 to 1) relative to Y (4 to 2). X is therefore classified as a relatively labor-
intensitive product, and Y is relatively capital intensive.

2. Factor Endowments, Factor Prices, and Comparative Advantage

If there is no difference in technology or productivity of factors across countries,
what then determines comparative advantage in production and export? The
answer is that factor prices determine cost differences. And these prices and
determined by the endowments of labor and capital the country possesses. The
theory assumes that labor and capital are immobile ; factors cannot move across
borders. Therefore, the country’s endowment determines the relative costs of
labor and capital as compared with other countries. Factor proportions theory
stated that a country should specialize in the production and export og those
products that use intensively its relatively abundant factor.

3. Assumptions of The Factor Proportions Theory

- The theory assumes two countries, two products, and two factors of
production, the so-called 2x2x2 assumption.
- The markets for the inputs and the outputs are perfectly competitive.
 - Increasing production of a product experiences diminishing returns. This
meant that as a country increasingly specialized in the production of one
of the two outputs, it eventually would require more and more inputs per
unit of output.
- Both countries were using identical technologies. Each product was
produced in the same way in both countries. This meant the only way that
a good could be produced more cheaply in one country than in the other
was if the factors of production (labor and capital) used were cheaper.

4. The Leontief Paradox

According to the theory, the test of the factor proportions theory which resulted
in unexpected finding that the United States was actually exporting products
that were relatively labor intensive, rather than the capital intensive products
that a relatively capital abundant country should.

5. Linder’s Overlapping Product Ranges Theory

The type, complexity, and diversity of product demands of a country increase as
the country’s income increase. International trade patterns would follow this
principle, so that countries of similiar income per capita levels will trade most
intensively having overlapping products demand.

International Investment and Product Cycle Theory

A very different path was taken by Raymond Vernon in 1966 concerning what
is now termed product cycle theory. Vernon added two technology based
premises to the factor cost emphasis of existing theory :
1. Technical innovations leading to new and profitable products require large
quantities of capital and highly skilled labor. These factors of production
are predominantly available in highly industrialized capital intensive
countries.
2. These same technical innovations, both the product itself and more
importantly the methods for its manufacture , go though three stages of
maturation as the product becomes increasingly commercialized.

The Stages of The Product Cycle

Product cycle theory is both supply-side (cost of production) and demand-side
(income levels of consumers) in its orientation. Vernon described combines
differing elements of each.
• Stage I : The New Product
In this development stage, the product is nonstandardized. The production
processrequires a high degree of flexibility (meaning continued use of highly
skilled labor). Costs of production are therefore quite high. The innovator at this
stage in a monopolist and therefore enjoys all of the benefits of monopoly
power ; including the high profit margins required to repay the high development
costs and expensive production process. Price elasticity of demand at this stage
is low ; high-income consumers buy it regardless of cost.
• Stage II : The Maturing Product
The innovating country increases its sales to other countries. Competitors with
slight variations develop, putting downward pressure on prices and profit
margins. Production costs are an increasing concern. Venon argues that the firm
faces critical decision at this stage, either to lose market share to foreign based
manufacturers using lower cost labor or to invest abroad to maintain its market
shared by exploiting the comparative advantages of factor costs in other
countries. This is one of the first theoretical expalnations of how trade and
investment become increasingly intertwined.
 • Stage III : The Standardized Product
In this final stage, the product is completely standardized in its manufacture.
Profits margins are thin, and competitions is fierce. The country of comparative
advantage has therefore shifted as the ttechnology of the product’s manufacture
has matured. But according to venon, such advantage are fleeting. As knowledge
and technology continually change, so does the country of that product’s
comparative advantage.

Trade Implications of The Product Cycle

Product cycle theory shows how specific products were first produced and
exported from one country but, through product and competitive evolution,
shifted their location of production and export to other countries over time.

The New Trade Theory : Strategic Trade

Global trade development in the 1980 and 1990s led to much critism of existing
theories of trade. Firt, although there was rapid growth in trade, much of it was
not expalined by current theory. Secondly, the massive size of the merchandise
trade deficit of the U.S. and the associated decline of many U.S
- Economies of Scale and Imperfect Competition
Paul Krugman focused on two types of economics of scale, in ternal economies of
scale and external economies of scale.
 Internal Economies of Scale
May lead a firm to specialize in a narrow product line (to produce the volume
necessary for economies of scale costs benefits), other firms in other countries
may produce products that are similiarly narrow, yet extremely similiar product
differentiation.
 External Economies of Scale
May not necessarily lead to imperfect markets, but they may result in an
industry maintaining its dominance in its field in world markets.

- Strategic Trade
Goverment can play a beneficial role when markets are not purely competitive.
This theory has now been expanded to goverment’s role in internatinal trade as
well. There are (at least) four specific circumtances involving imperfect
competition, which we denote as price, cost, repetition, and eternalities.

- The Competitive Advantage of Nations

Component if the diamond of national advantage are factor conditions, demand
conditions, related and supporting industrie, and firm strategy, structure, and
rivalry.

- Cluster and The New Economics

According to the Michael Porter are “critical masses in one place of unusual
competitive success in particular fields.” Cluster theory suggests that
competition is altered in at least three ways when clusters from successfully.
1. By increasing the productivity of the companies besed in the area.
2. By driving and suppoting the momentumof innovation in the area.
3. By stimulating the creation of new companies and new configurations of
business in the area.

- The Theory of International Investment

International investment theory expalins the flow of investment capital into and
out of a country by investors who want to maximize the return on their
investments. One of the major factors that influeces international investment is
the potential return on alternative investment in the home country or other
foreign markets.

- The Foreign Direct Investment Decision

Foreign Direct Investment (FDI) is the other part of international investment
theory, and is an active investment in a foreign country. Instead of investing in
securities, investors directly build factories or gain controlling interest in foreign
businesses to earn profits.

- The Theory of Foreign Direct Investment

In general, it is helpful to look at FDI theories as an attempt to answer the “who,
what, when, where, why, and how” of a particular investment, and to determine
whether the economic factors involved justify making foreign investment.

- Firms as Seeker
A firm that expands across border may be seeking any of a number of specific
sources of profit or opportunity seeking resources, seeking factor advantages,
seeking knowledge, seeking security, and seeking markets.

- Firms as Exploiters of Imperfections

These market imperfection cover the entire range of supply and demand of the
market trade policy (tarrifs and quotas), tax policies and incentives, preferential
purchasing arrangements established by goverments themselves, and financial
restrictions on the access of foreign firms to domestic capital markets.

- Firms at Internalizers
By establishing their own multinational operations they can internalize the
production, thus keeping confidential the information that is at the core of the
firm’s competitiveness. Managements contracts or licensing agreements don’t
allow the effect transmission of the knowladge or represent too serious a threat
to the loss of the knowladge to allow the firm to successfully achieve the hoped
for benefitsof international investment.

EXERCISE Page 179

The purpose of a company is to maximize profit. For example, if we have 3

employees and workers can produce 9 products, why do we have to choose 5
workers who produce the same amount of products, 9 products. Of course it will
only be a waste of variable costs. The remaining capital should be used to retain
the services of these employees can bu utilized to cover other costs such as
property costs, tax payments, and various other fixed costs or may increase the
amount of product production. Although the use of labor that can be paid at a
price that is cheaper and produces a number of products and quality equal to
that paid labor is more expensive would be more practical, but it will be
controversial with the code of ethics. Workers who have good skills entitled to
salary in accordance with his expertise. Lower-costs principle would not satisfy
many of the workers. For example chinese and German people. In general,
Chinese people do not mind going to lower-costs while the German people do not
want low-paid, so it will be many workers who do not agree with these
assessment and they will strike. This will have rising unemployment. China and
Germany should be able to compete well to get a job and pay accordingly. A
successful company is a company that values their employees and realize a
mutual benefit between the two.