Chapter 7:

International Trade
and Investment
This Chapter looks at the changing pattern and growth of
international trade.

First, some of the most common theories dealing with the

gains from trade will be illustrated.
This will be followed by a discussion of trade policies,
particularly barriers to trade and arguments against free trade.
East Asia’s experience will highlight the effectiveness of two
of the most commonly cited trade regimes: import
substitution and export promotion.
Finally, the patterns of trade in East Asia and how
dramatically trade has changed over the years across asia
Theories of International Trade
Gains from Trade
An introduction to international trade usually begins with an autarkic economy.
When trade is introduced, the economy can gain through two main avenues:
consumption and production.

Consumption Gains. With trade, it is possible to reach higher indifference curves

through gains realized by consumers.
Production Gains. The production gains from trade also arises because of
expanded production, through utilizing economies of scale resulting from larger
markets or technology transfers which help to expand the production possibility
frontier.
Ricardian Theory of Trade
The Ricardian Theory says that differences in technology
determine comparative advantage. The theory considers the
units of labor or labor hours required to produce a unit of a
certain commodity.

A major point from the Ricardian model is that trade

patterns can be explained by technological differences or labor
productivity differences between countries. Counties need not
be competitive relative to the other country to gain from trade.
Heckscher – Ohlin Theorem
According to the Heckscher – Ohlin (H – O)
theorem, countries will specialize and trade in goods
which are relatively abundant. Thus, labor rich
countries will specialize in the production of labor –
intensive products while countries with abundant
capital relative to labor will specialize and trade inn
commodities that are capital intensive in nature.
Imperfect Competition
Both the Ricardian and the HOS model establish a linkage between
economic efficiency, factor endowments, and the direction of
international trade. They make many simplifying assumptions,
including the existence of perfect competition in commodity, factor
markets, and the homogeneity of production factors.
To address these aspects, the theory of imperfect competition is
applied to international trade. In this framework, the direction of intra –
industry trade is determined in large part by differences in relative factor
endowments while production differentiation and relative market size
determine the volume and composition of international trade.
Trade Experience of East Asia
Pattern of Growth in International Trade: Some Facts
International Trade volume has grown faster than income in
the past thirty years for the world as a whole and also for Asia.
The share of East and Southeast Asia in world exports is now
more than 20 percent compared with 12 percent in 1990. it is
nearly twice as much as the export share of North America and
is greater than the total exports of Latin America, South Asia,
Eastern Europe, the former Soviet Union the Middle East and
North Africa and Africa combined.
Actual Evolution of Trade
• It is often thought that trade should be greatest between countries
that have the greatest differences in economic structures. In reality,
the major part of trade takes place between rich countries that have
similar factor endowments and relative prices.
• The factor price equalization theorem states that factor prices will
tend to be more equal as trade takes place. In reality, the factor
price equalization theorem does not seem to hold.
Issues/Considerations In Trade
Within a physically large country like Australia or the
United states that is composed of a number of different
administrative areas, there is essentially free trade of goods
and services across these provincial or state boarders. Within
the European Union, there is now virtually free trade among
the member countries of the Union. In other regions of the
world, there are fewer examples of free trade although the
North American Free Trade (NAFTA) and the MERCOSUR
Free Trade Area in Latin America are committed to gradually
establishing free trade within their respective areas.
Employment, Migration, and Skills Issues
Education and timing had a lot to do with the difference in
how technology was adopted in different parts of Asia. East
Asia had an already highly educated labor force, and thus was
able to adopt overseas technology either by licensing or
purchasing directly. These countries, especially Japan and
Taiwan, also had high saving rates or they borrowed heavily
from overseas to augment their saving. As a result, they had
very small amounts of foreign direct investment, with the
exception of Japanese investments in Korea.
Institutional Frameworks that Facilitate Trade

Currency Exchange Rate

The currency exchange rate is by far the most important
factor in deciding trade policy. Since the exchange rate
determines the international value of the domestic currency,
it directly affects the profit – ability of firms producing for
the international market, or firms facing foreign
competition. Economists use the concept of an equilibrium
exchange rate to determine whether a currency is
overvalued or undervalued.
Capital Movements
International capital markets became more
competitive and open during the 1980s and 1990s.
Funds could move freely into the developing
countries. In the 1970s, most of the international
capital movements were in the form of loans from
Western Banks – primarily those from the United
States – into Latin America.
Why has the share of Intra – Asian Trade in Total
Asian Trade increased so much over time?
There are four basic reasons why this has occurred. First,
the growth in income and the geographic proximity within the
region have stimulated trade. This is to be expected, as there is
considerable evidence that, other things being equal, trade is
more likely to take place between countries which are close to
each other.
Secondly, there has been rapid growth in different kinds of
regional cooperation arrangements that have facilitated trade.
 Thirdly, other factors such as fluctuating exchange
rates, technological developments in
telecommunications, and lower transport costs have
helped to stimulate trade within the region.

Finally, as incomes have grown and developing Asia

has begun to produce more manufactured goods, their
trading pattern has begun to resemble that of the OECD
countries.
Economic Growth, Exports, and Product Variation

Intense competition for export markets within Asia has

resulted in specialization in high – technology exports, which
has generally raised the level of comparative advantage and
economic efficiency.

One danger of the production system that has evolved is the

reliance upon foreign firms to drive innovation and research
and development. Domestic innovators have been few and far
between.
Bilateral Trade Agreements
• APEC ( Asia – Pacific Economic Cooperation)
- Is an inter – governmental forum for 21 member economies
in the Pacific Rim that promotes free trade throughout the
Asia – Pacific region.
• ASEAN (Association of Southeast Asian Nations)
- Is a regional governmental organization comprising ten
countries in Southeast Asia, which promotes
intergovernmental cooperation and facilitates economic,
political, security, military, educational and sociocultural
integration among its members and other countries in Asia.
• WTO (World Trade Organization)
- Is an intergovernmental organization that is concerned with the
regulation of international trade between nations.
• NAFTA (North American Free Trade Agreement)
- Is an agreement signed by Canada, Mexico, and the United States
creating a trilateral trade bloc in North America. NAFTA trade bloc is
one of the largest trade blocs in the world by gross domestic product.
• EU (European Union)
- Is a political and economic union of 27 member states that are located
primarily in Europe.
• SAARC (South Asian Association for Regional Cooperation)
- Is the regional intergovernmental organization and geopolitical union
of states in Southeast Asia.
Industrial Policies and Exports:
Some case studies from Asia
• JAPAN – Steel automobiles, textiles, shipbuilding, and
aluminum smelting, electronics and semiconductors
• KOREA – heavy and chemical industries, iron and steel,
metal products, machinery, electronics, and industrial
chemicals
• TAIWAN – developed two large industrial parks
• MALAYSIA – steel, automobiles, cement and paper
• INDONESIA AND THAILAND – Aircraft industry and
railway rolling stock in Indonesia and Eastern Seaboard
Development authority in Thailand
Issues in International Trade and
the Balance of Payments
Since the Asian financial crisis there has been a dramatic
shift in the current – account balance and the level of reserves
of the Asian economies. This reflects the weaknesses of those
countries that did not have a strong reserve position and were
experiencing significant current account deficits. The
economies with large international reserves were able to hold
their exchange rates steady or suffered only modest
depreciations while the other crisis countries suffered
extensive currency weaknesses.
Should Capital Flows be Regulated?
Since the Asian financial crisis, there has been a
debate about whether short – term capital inflows
should be controlled. Those advocating controls note
the destabilizing role that short – term portfolio
movements had in creating a speculative bubble in the
mid – 1990s, and then in destabilizing the economies
once the crisis had begun by withdrawing these funds
en masse.