International Trade Theory

International Trade Theory

What is international trade?
Exchange of raw materials and manufactured goods (and services) across national borders

Classical trade theories:

explain national economy conditions--country advantages--that enable such exchange to happen

New trade theories:

explain links among natural country advantages, government action, and industry characteristics that enable such exchange to happen

Implications for International Business

Trade Theory Timeline

Prentice Hall, 2006

International Business 3e

Chapter 5 - 3

Failed Theories
1. Mercantilism (trade surplus, govt intervention, colonization, wealth focus) 2. Factor proportion theory (he who has most capital sells capital intensive goods) vs. Leontief paradox 3. Absolute advantage 4. Market and government failure

Prentice Hall, 2006

International Business 3e

Chapter 5 - 4

New Trade Theory

1. Flows (income) vs. stocks (wealth) 2. Government- the loser chooser (industrial policy: favor squeaky wheel) 3. Comparative advantage 4. Learning curve vs. first mover advantage 5. Resource quality vs. quantity 6. Game Theory: the prisoners dilemma
Prentice Hall, 2006 International Business 3e Chapter 5 - 5

Classical Trade Theories

Mercantilism (pre-16th century)
Takes an us-versus-them view of trade

Other countrys gain is our countrys loss

Free Trade theories

Absolute Advantage (Adam Smith, 1776) Comparative Advantage (David Ricardo, 1817) Specialization of production and free flow of goods benefit all trading partners economies

Free Trade refined

Factor-proportions (Heckscher-Ohlin, 1919)
International product life cycle (Ray Vernon, 1966)

The New Trade Theory

As output expands with specialization, an industrys ability to realize economies of scale increases and unit costs decrease Because of scale economies, world demand supports only a few firms in such industries (e.g., commercial aircraft, automobiles) Countries that had an early entrant to such an industry have an advantage:
Fist-mover advantage Barrier to entry

New Trade Theory

Global Strategic Rivalry
Firms gain competitive advantage through: intellectual property, R&D, economies of scale and scope, experience

National Competitive Advantage (Porter, 1990)

Mercantilism/Neomercantilism
Prevailed in 1500 - 1800
Gold & Silver as currency of trade-Maximize wealth Export more to strangers than we import to amass treasure, expand kingdom Colonies (source of RM-cheap imports + Mkt for FG)-surplus Zero-sum vs positive-sum game view of trade

Government intervenes to achieve a surplus in exports subsidy(?)Importsduties(?)

King, exporters, domestic producers: happy Citizens: unhappy (high taxes due to subsidies) domestic goods stay expensive and of limited variety (high import duties)

Today neo-mercantilists = protectionists: some segments of society shielded short term

Mercantilism
Nations accumulate financial wealth by encouraging exports and discouraging imports

Three pillars
Maintain trade surplus Government intervention Exploit colonies

Inherent flaws World trade is zero-sum game Constrains output and consumption Limits colonies market potential

Prentice Hall, 2006

International Business 3e

Chapter 5 - 10

Absolute Advantage
Adam Smith: The Wealth of Nations, 1776 Mercantilism weakens country in long run; enriches only a few A country
Should specialize in production of and export products for which it has absolute advantage; import other products Has absolute advantage when it is more productive than another country in producing a particular product

Cocoa

G: Ghana K: S. Korea

K K' G'

Rice

Absolute Advantage
Ability of a nation to produce a good more efficiently than any other nation (greater output using same or fewer resources)

Riceland

Tealand

1 resource unit = 1 ton rice or 1/5 ton tea

1 resource unit = 1/6 ton rice or 1/3 ton tea

Specialization and trade allows each to produce and consume more

Prentice Hall, 2006 International Business 3e Chapter 5 - 13

Trade Gains: Absolute Advantage

Prentice Hall, 2006

International Business 3e

Chapter 5 - 14

Comparative Advantage
David Ricardo: Principles of Political Economy, 1817 Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces Absolute Advantage is a special case of Comparative Advantage
G

Cocoa

G: Ghana K: S. Korea

K K' G'

Rice

Comparative Advantage
Inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other good

Riceland

Tealand

1 resource unit = 1 ton rice or 1/2 ton tea

1 resource unit = 1/6 ton rice or 1/3 ton tea

Specialization and trade allows each to produce and consume more

Prentice Hall, 2006 International Business 3e Chapter 5 - 17

Trade Gains: Comparative Advantage

Prentice Hall, 2006

International Business 3e

Chapter 5 - 18

Assumptions and Limitations

1.

Nations strive only to maximize production and consumption

Only two countries produce and consume just two goods

2.

3.
4.

No transportation costs of trading goods

Labor is the only resource used to produce goods

5.

Ignores efficiency and improvement gains from producing just one good

Prentice Hall, 2006

International Business 3e

Chapter 5 - 19

Factor Proportions Theory

Countries produce and export goods that require resources (factors) in abundance, and import goods that require resources in short supply

Labor

Land and Capital

Two factor types

Prentice Hall, 2006

International Business 3e

Chapter 5 - 20

Leontief Paradox
Research discovered evidence opposite the prediction of factor proportions theory
US exports are more labor-intensive than US imports

Possible explanation
Theory assumes nations production factors to be homogeneous Theory is better predictor when expenditures on labor are considered

Prentice Hall, 2006

International Business 3e

Chapter 5 - 21

International Product Life-Cycle (Vernon)

Most new products conceived / produced in the US in 20th century US firms kept production close to their market initially
Aid decisions; minimize risk of new product introductions Demand not based on price; low product cost not an issue

Limited initial demand in other advanced countries initially

Exports more attractive than overseas production

When demand increases in advanced countries, production follows With demand expansion in secondary markets
Product becomes standardized (commodity ?) production moves to low production cost areas Product now imported to US and to advanced countries
CritiqueUS is no longer the sole innovator of products / services

International Product Life Cycle

A company begins by exporting its product and later undertakes foreign direct investment as a product moves through its life cycle

Prentice Hall, 2006

International Business 3e

Chapter 5 - 23

New Trade Theories

Increasing returns of specialization due to economies of scale (unit costs of production decrease) First mover advantages (economies of scale such that barrier to entry created for second or third company) Luck... first mover may be simply lucky. Government assistance to home-based firms: strategic

trade policy

New Trade Theory

Fundamentals

First-mover advantage

Gains from specialization and increasing economies of scale

Companies first to market create barriers to entry

Government may help by assisting home companies

Economic and strategic advantage of being first to enter an industry May create a formidable barrier to market entry for potential rivals

Prentice Hall, 2006

International Business 3e

Chapter 5 - 25

National Competitive Advantage

(Porter, 1990)

Factor endowments
land, labor, capital, workforce, infrastructure (some factors can be created...)

Demand conditions
large, sophisticated domestic consumer base: offers an innovation friendly environment and a testing ground

Related and supporting industries

local suppliers cluster around producers and add to innovation

Firm strategy, structure, rivalry

competition good, national governments can create conditions which facilitate and nurture such conditions

National Competitive Advantage

Nations competitiveness in an industry depends on the industrys capacity to innovate and upgrade, which in turn depends on four main determinants (plus government and chance) Factor conditions Demand conditions

Related and supporting industries

Firm strategy, structure and rivalry
Prentice Hall, 2006 International Business 3e Chapter 5 - 27

Porters Diamond

Factor Conditions
Basic factors
Nations resources
(land, large workforce, natural resources, climate and surface features)

Advanced factors created not inherited

Result of investing in education and innovation

(skill of workforce segments, capital, technological infrastructure)

Basic factors can spark initial production, but advanced factors account for sustained competitive advantage Prentice Hall, 2006 Business 3e / copy Chapter 5 - 29 difficultInternational to replicate

Demand Conditions
Sophisticated home-market buyers drive companies to improve existing products and develop entirely new products and technologies-leading to global leadershipeg.French Wines, Italian Leather products

This should improve the competitiveness of the entire group of companies in a market

Prentice Hall, 2006

International Business 3e

Chapter 5 - 30

Related and Supporting Industries

Companies in an internationally competitive industry do not exist in isolation

Supporting industries form clusters of economic activity in the geographic areaJt research / problemsolving , sharing of knowledge etc.
Each industry reinforces the competitiveness of every other industry in the cluster

Prentice Hall, 2006

International Business 3e

Chapter 5 - 31

Firm Strategy, Structure and Rivalry

Highly skilled managers are

essential because strategy has lasting effects on firm competitiveness

Domestic industry whose

structure and rivalry create an intense struggle to survive, strengthens its competitiveness

Prentice Hall, 2006

International Business 3e

Chapter 5 - 32

So What for business?

First mover implications

Location Implications
Foreign Investment Decisions
Government Policy implications-fostering competition Chance eventswar, major tech breakthrough, fluctuations in exchange-rates, sudden drop in demand etc.