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Chapter
InternationalTrade Theory
4
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Case - The hollowing out of the U.S.
based economy Economic assumption: free trade produces gains for all
participating countries (trade is a win-win game)
Recently, US economy indicates a movement of knowledge based jobs to developing economies.
Economists believe that:
Only routine skill jobs go overseas. Most managerial and
marketing and R&D jobs are retained within the country USA). Lower price of services means consumer can consume more
for less (consumer savings)
Economic growth overseas will benefit the U.S.
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Trade Theory An overview
Free Trade is said to have occurred when a government/
independent customs territory does not attempt to
influence, through quotas or duties, what its citizens canbuy from another country or what they can produce and sell
to another country (comparative advantage).
The Benefits of Trade allow a country to specialize in the
manufacturing and export of products that can be producedmost efficiently in that country.
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Trade Theory An overview
The Pattern of International Trade displays ascenario that is easy to understand (e.g. Saudi
Arabia/oil or Pakistan/cotton). Others are not so
easy to understand (e.g. Japan and cars) The history of Trade Theory and government
involvement presents a mixed case for the roleof government in promoting exports and
limiting imports (mercantilism/beggar thyneighbor)
Later theories appear to make a case for limitedinvolvement (trade liberalization)
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Mercantilism: mid-16th century
A nation¶s wealth depends on accumulated treasure
Gold and silver used to serve as a currency for
payments in international trade
Theory says you should have a trade surplus.
Maximize export through subsidies.
Minimize imports through imposition of tariffs
and quotas
Flaw in the above approach: ³zero-sum game´
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Mercantilism-zero-sum game
David Hume in 1752 pointed out that:
Increased exports leads to inflation and higher prices
Increased imports lead to lower prices Result: Country µA¶ sells less because of high
prices and Country µB¶ sells more because of lower
prices
In the long run, no one can keep a trade surplus
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Theory of absolute advantage
Fig 4.1
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Absolute advantage and the gains
from trade
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Theory of comparative advantage
David Ricardo: Principles of Political Economy(1817). Extends free trade argument
Efficiency of resource utilization leads to more productivity. Should import even if country is more efficient in the
product¶s production than country from which it isbuying/importing.
Look to see how much more efficient. If onlycomparatively efficient than import.
Makes better use of resources
Trade is a positive-sum game (everyone gains)
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Theory of comparative advantage
Fig 4.2
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Comparative advantage and gains from trade
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Qualifications & Assumptions
The simple model of free trade proposed by classical
economists makes certain unrealistic assumptions to simplify
complex real world phenomenon: -
World comprises two countries, two goods & one factor of production
i.e. labour;
There is no transportation costs and no trade barriers;
T here are no price difference for resources in two countries;
Resources are freely within country but not between the countries;
There are constant return to scale;
Countries have fixed quantity and quality of production resources;
Tastes are similar and preferences of people are represented by
indifference curves.
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Simple extensions of the Ricardian
model Immobile resources:
Resources do not always move easily from oneeconomic activity to another
Diminishing returns:
Diminishing returns to specialization suggests that after some point, the more units of a good the
country produces, the greater the additionalresources required to produce an additional item
Different goods use resources in different proportions
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Simple extensions of the Ricardian
model
Free trade (open economies):
Free trade might increase a countrys stockof resources (as labor and capital arrivesfrom abroad)
Increase the efficiency of resourceutilization
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PPF under diminishing returns
Fig 4.3
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Influence of free trade on PPF
Fig 4.4
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Heckscher (1919)-Ohlin (1933) Theory
Export goods that intensively use factorendowments which are locally abundant
Corollary: import goods made from locallyscarce factors Note: Factor endowments can be influenced by
government policy - minimum wage/rentals
Patterns of trade are determined by differences
in factor endowments - not productivity Remember, this model focuses on relative
advantage, not absolute advantage
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Product life-cycle Theory - R. Vernon,(1966)
As products mature, both location of sales and
optimal production changes
Affects the direction and flow of the imports andexports
Globalization and integration of the world
economy, however, makes this theory less valid
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Product life cycle theory
Fig 4.5
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New trade theory
In industries with high fixed costs:
Specialization increases output, and theability to enhance economies of scaleincreases
Learning effects are high. These are cost savings that come from learning bydoing transfer of technology.
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New trade theory-applications
Typically, requires industries with high, fixedcosts
World demand will support few competitors
Competitors may emerge because of First-mover advantage
Economies of scale may preclude new entrants
Role of the government becomes significant Some argue that it generates government
intervention and strategic trade policy
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Theory of national competitive
advantage The theory attempts to analyze the reasons for
a nations success in a particular industry
Porter studied 100 industries in 10 nations
he postulated determinants of competitiveadvantage of a nation were based on fourmajor attributes
Factor endowments
Demand conditionsRelated and supporting industries
Firm strategy, structure and rivalry
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Porters diamond
Success occurs where these attributes exist.
More/greater the attribute, the higher chance of success
The diamond is mutually reinforcing
Fig 4.6
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Factor endowments
Factor endowments:- A nations positionin factors of production such as skilled
labor, capital or infrastructure necessaryto compete in a given industry. FactorEndowments are of two types:
Basic factor endowments Advanced factor endowments
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Basic factor endowments
Basic factors: Factors present in a country
Natural resources
Climate Geographic location
Demographics
While basic factors can provide an initialadvantage they must be supported byadvanced factors to maintain success
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Advanced factor endowments
Advanced factors: Are the result of investment by people, companies,
government and are more likely to lead tocompetitive advantage
If a country has no basic factors,
it must invest in the advanced factors i.e.high technical skills, education and HRD andmanagement etc.
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Advanced factor endowments
Communications
Skilled labor
Research
Technology Education
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Demand conditions
Demand:
creates capabilities
createssophisticated anddemandingconsumers
Demand impacts qualityand innovation
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Related & supporting industries
Creates clusters of supporting industriesthat are internationally competitive
Must also meet requirements of otherparts of the Poters Diamond
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Firm Strategy, Structure and Rivalry
Long term corporate vision is a
determinant of success Management ideology and structure of
the firm can either help or hurt you
Presence of domestic rivalry improves acompanys competitiveness
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Determinants of Competitive
Advantage in nations
GovernmentGovernment
Company Strategy,Structure,and Rivalry
DemandConditions
Relatedand Supporting
Industries
FactorConditions
ChanceChance
Two externalfactors thatinfluence thefourdeterminants.
Fig 4.8
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Porters Theory-predictions
Porters theory should predict the patternof international trade that we observe inthe real world
Countries should be exporting productsfrom those industries where all four
components of the diamond arefavorable, while importing in those areaswhere the components are not favorable
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Implications for business
Location implications:
Disperse production activities to countries wherethey can be performed most efficiently
First-mover implications: Invest substantial financial resources in building a
first-mover, or early-mover advantage
Policy implications:
Promoting free trade is in the best interests of thehome-country, not always in the best interests of the firm, even though, many firms promote openmarkets