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International Trade Theory
International Trade Theory
Learning Objectives
Explain two basic kinds of import restrictions Appreciate the relevance of changing status of
tariff and non tariff barriers
Learning Objectives
Understand new definition of economic development Understand why governments change from import
substitution to export promotion
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Absolute Advantage
Example
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Absolute Advantage
Terms of Trade (Ratio of International Prices)
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Comparative Advantage
Terms of Trade at a rate of bolt of cloth for 1 ton of soybeans
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Comparative Advantage
Production Possibility Frontiers (figure 3.1)
Figure 3.1
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The theorem examines the reason for comparative cost differences in production and states that a country has comparative advantage in the production of that commodity which uses more intensively the countrys more abundant factor.
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In Heckcher-ohlin model, factors of production are regarded as scarce or abundant in relative and not abundant terms.
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Example: even if a country has more capital, than other countries, it could be poor in capital. A country can be regarded as richly endowed with capital only if the ratio of capital to other factors is higher when compared to other countries.
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of
I. In country A: supply of labor = 25 units supply of capital = 20units capital-labor ratio = 0.8 In country B: supply of labor = 12 units supply of capital = 15units capital-labor ratio = 1.25
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From this, even though country A has more capital in absolute terms, country B is more richly endowed with capital because the ratio of capital to labor in country A ( 0.8) is less than in country B ( 1.25 ).
The two-country-two commodity model of Heckscher and Ohlin is based on a number of explicit and implict assumptions. The assumptions are:
Two countries, two products and two factors: The original HeckscherOhlin model contained two countries, and had two commodities that could be produced. Since there are two (homogeneous) factors of production this model is sometimes called the "222 model". If both countries were producing all the output they could and trading only between themselvs ( only two coutries ) there should be a balance in trade.
Inputs and the outputs are perfectly competitive: the factors of production, labor and capital were exchanged in markets that paid them only what they wre worth
Production output must have constant Return to Scale Both of the countries in the simple HO model produced both commodities, and both technologies have constant returns to scale (CRS). (CRS production has twice the output if both capital and labor inputs are doubled, so the two production functions must be 'homogeneous of degree 1').
Capital mobility within countries It is further assumed that capital can shift easily into either technology, so that the industrial mix can change without adjustment costs between the two types of production. For instance, if the two industries are farming and fishing it is assumed that farms can be sold to pay for the construction of fishing boats with no transaction costs.
Both countries have identical production technology This assumption means that producing the same output of either commodity could be done with the same level of capital and labour in either country. Actually, it would be inefficient to actually use the same balance in either country (because of the relative availability of either input factor) but, in principle this would be possible. Another way of saying this is that the per-capita productivity is the same in both countries in the same technology with identical amounts of capital.
Capital immobility between countries The basic HeckscherOhlin model depends upon the relative availability of capital and labor differing internationally, but if capital can be freely invested anywhere competition (for investment) will make relative abundances identical throughout the world. (Essentially, Free Trade in capital would provide a single worldwide investment pool.)
Labour immobility between countries Like capital, labor movements are not permitted in the Heckscher-Ohlin world, since this would drive an equalization of relative abundances of the two production factors, just as in the case of capital immobility above. This condition is more defensible as a description of the modern world than the assumption that capital is confined to a single country.
Commodities have the same price everywhere The 2x2x2 model originally placed no barriers to trade, had no tariffs, and no exchange controls . It was also free of transportation costs between the countries, or any other savings that would favour procuring a local supply. If the two countries have separate currencies, this does not affect the model in any way . Since there are no transaction costs or currency issues the law of one price applies to both commodities, and consumers in either country pay exactly the same price for either good.
Perfect internal competition Neither labor nor capital has the power to affect prices or factor rates by constraining supply; a state of perfect competition exists.
Production techniques not homogeneous. Eg: textiles may be produced with handlooms which requires more labor and less capital or with highly sophisticated power looms requiring a small number of workers- the trade may not follow model. Tastes and demand patterns not identical
Production techniques not homogeneous. Eg: textiles may be produced with handlooms which requires more labor and less capital or with highly sophisticated power looms requiring a small number of workers- the trade may not follow model. Tastes and demand patterns not identical
No constant returns- but countries having rich factor endowment have high advantages of economies of scale. Transport costs influence trade- loading unloading of goods. Unrealistic assumptions of full employment and perfect competition- trade restrictions on a large scale.
Factor prices do not determine commodity prices. Vague and conditional theory.
According to the opportunity cost theory, the basis of international trade is the differences between nations in the opportunity costs of production of commodities. Though it same as comparative cost theory, there is difference in measuring the cost of producing wine in terms of labor or in terms of any real cost, but in OP.cost theory, it is measured in contrast to the comparative cost approach, the cost of producing wine in terms of the amount of cloth foregone in order to produce one more unit of wine.
The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% - 2%).
The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages.
Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.). In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise) with another option is the opportunity cost.
limitations
1. Fails to explain the determination of terms of trade. 2. Develops trade theory in barter terms rather paper standards. 3. Unable to recognize the role of capital flows
There are four stages : Introduction - domestic location a small part of the production to the customers in foreign markets new product Growth new product is in dd than competitors enter the market Maturity dd begins to raise, it may be growing in some countries and declining in others Decline
As products mature, both location of sales and optimal production changes. Affects the direction and flow of imports and exports. Globalization and integration of the economy makes this theory less valid.
Q u a n ti t y
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Exports
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Time
New Product
Maturing Product
Standardized Product
Figure 4.5
Began to be recognised in the 1970s. Deals with the returns on specialisation where substantial economies of scale are present. Specialisation increases output, ability to enhance economies of scale increase. In some industries there are likely to be only a few profitable firms.
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Founded 1915 by William Boeing Largest commercial airplane manufacturer. 9,000 commercial jetliners in service.
Established 1967 Western Europe buying 25% of aircraft ,but selling only 10%. France, Germany, Great Britain To date: 3,203 orders - 1,890 deliveries.
Boeing and Airbus: Boeing spent nearly 5 billion US dollar to develop Boeing 777 jet liner. if Boeing manufactures a large output then this fixed cost will get spread, and fixed cost per unit will be small. On the other hand, if it manufactures only a limited number then unit fixed cost will be high. In aerospace industry, as the output of accumulated airframes doubled, its cost declined by 20%. Thus Boeing and Airbus were able to enter earlier they were able to capture most of the market share. Organizations from other nations like Japan, instead of directly entering into the industry, sub-contractors with primary manufacturers.
Some argue that it generates government intervention and strategic trade policy (e.g. the need to nurture and protect first movers)
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Demand Conditions
demanding, firms will produce high-quality and innovative products gaining competitive advantage
Suppliers and
Factor Conditions
Level and consumption of factors of production Lack of natural endowments has caused nations to invest in the creation of advanced factors
Factor Endowments
Taken from Heckscher-Olin Basic factors: natural resources, climate, location. Advanced factors: communications, skilled labor, technology.
Demand Conditions
Demand creates the capabilities. Look for sophisticated and demanding consumers. impacts quality and innovation.
The Diamond
Success occurs where these attributes exist. More/greater the attribute, the higher chance of success. The four attributes, government policy and chance work as a reinforcing system. Nokia is a good example of a firm which has built its competitive advantage as a result of factors in Porters diamond.
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Factor Conditions
Demand Conditions
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3. Wars 4. Significant shifts in world financial markets or exchange rates. 5. Surges in world or regional demand, and 6. Major technological breakthroughs
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Role of governments: 1. Subsidies 2. Education policies 3. The regulation or deregulation of capital markets 4. The purchase of goods and services 5. Tax-laws and 6. Anti-trust regulation.
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2. Companies and countries are not dependent entirely on domestic factor conditions. For example, capital and managers are now internationally mobile. 3. If related and supporting industries are not available locally, materials and components are now more easily brought in from abroad because of advancements in transportation and the relaxation of import restrictions.
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4. Companies react not only to domestic rivals but also to foreign-based rivals they compete with at home and abroad.
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Conclusion
The theories of international trade is important to an individual business firm primarily because they can help the firm to decide to locate its various production activities. Firms involved in IT can do exert a strong influence on government policy toward trade. By govt., business firms can promote free trade or trade restrictions.
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