1 Lectures 18-22: International Trade Theory Managers thinking on trade Economists view on trade...

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Lectures 18-22: International Trade Theory

Managers’ thinking on tradeEconomists’ view on trade

What and why to trade?Justification of free trade

Major theories of trade

2 Fall 2007 NU-FAST Zahid Siddique

Conventional manager’s thinking about trade…

• Companies engage in internationally for several reasons– Expand Sales: going abroad allows firms to increase

the size of the market to which they offer their products– Acquire Resources: foreign capital, technology, labor,

components can help a firm become more competitive– Diversify Sources of Sales and Supplies: working

abroad protect firms from economic downturns in any single country, from shortages due to economic, social, or political disruptions in any single country

• Several factors have contributed in recent trade-expansion– Technological expansion– Cross-border liberalization– Growth of support industries (Int. banking & delivery)– FDI (equity funds invested in other nations)


Conventional manager’s thinking about trade…

• International business takes several forms– Export & import of merchandise– Export & import of services

• Tourism and Transportation• Rendering of some services• Use of assets (e.g. patents, trademarks etc)

– Investment• FDI: occurs when an investor gains a controlling

interest (may be 100% or less) in a foreign company

• Portfolio investment: non-controlling investment in a foreign company (purchase of stock in a foreign company)


Economists have other ideas

• Economists ask different and more fundamental questions:– What to trade and why?

• i.e. what is the basis and trends of trade• Many theories to explain above two questions

– Absolute Advantage (1776)– Comparative Advantage (1817)– Heckscher-Ohlin (H-O) theorem (1919-1933)– Product life-cycle approach (1960)

• We briefly outline the main argument of each one of them


Absolute Advantage: The model

• Country should specialize in, and export, that product which it can produce using less resources

• Consider a two-goods-two-country model

• We can clearly see that– A is absolutely more efficient in producing X– B is absolutely more efficient in producing Y

• More of both X and Y produced if– A specializes in X, while B in Y

• Countries trade surpluses and increase consumption of both goods in both countries

Goods / Country

X Y

A 2 4

B 4 2

Each entry shows number of labor hours needed to produce one unit of a good; i.e. production technologies of a country


Absolute Advantage: Specialization

• To see assume that each country has initial resource endowment of 6 labor hours (LH)

• Given that both countries need both goods for consumption– A would produce 1x (using 2 LH) and 1y (using 4 LH)– B would produce 1x (using 4 LH) and 1y (using 2 LH)

• Without trade, both would have 1x and 1y for consumption• Before trade world production of both goods is given by:

• After agreeing on trade– A would specialize in x, produce 3x (using 6 LH) and no y– B would specialize in Y, produce 3Y (using 6 LH) and no X

• World output of both goods greater now; i.e. Xw = 3, Yw = 3

baw XXX baw YYY

211 wX 211 wY


Absolute Advantage: Trade and welfare

• If both countries agree on exchanging 1x for 1y (ignore determination of rate of exchange for the moment), then– A can export 1x to B and import 1y– A has 2x-1y, while B has 1x-2y available for consumption

• Consumption possibilities of both increased• Trade good for all participants

• Result same even if we assume incomplete-specialization• But this model assumed both countries have absolute

advantage in one good– What if a country is more efficient in producing all

goods?– Is trade possible now?

• Answer: yes– Ricardo presents Comparative, not Absolute, Advantage

as basis of trade


Comparative Advantage

• CA says that a country should specialize in, and export, that product which it can produce sacrificing less resources

• Consider the following set of data

• To understand the possibilities of trade, calculate the opportunity cost of producing x and y in both countries

Goods / Country

X Y

A 2 4

B 4 12

A clearly more efficient in producing both goods as compared to B

LHX pa 2 LHY p

a 4

yX ca 2

11 xY ca 21

A sacrifices ½ units of y to produce 1x

and 2 units of x to produce 1y


Comparative Advantage

• Similarly for country B

• So we have the following cost matrix

• If each country specializes in its area of advantage– world output greater and countries can trade surpluses– consumption of both goods in both countries increase

Cost / Country

CX CY

A ½ Y 2x

B ⅓ Y 3x

LHX pb 4 LHY p

b 12

yX cb 3

11 xY cb 31

B sacrifices 1/3 units of y to produce 1x

and 3 units of x to produce 1y

Clearly, B is more efficient in producing x (as it needs to sacrifice less resources to produce 1x) while A in y


Comparative Advantage: graphical representation

• Assume 100 LH available to both countries– A, with 2 LH to produce 1x and 4 LH for 1y, can produce

– 50 units of x, or– 25 units of y, or– any “straight line” combination of the two

– B, with 4 LH to produce 1x and 12 LH for 1y, can produce– 25 units of x, 8.33 units of y, or any linear

combination• So with no trade:

– A Max. 50x, or 25y– B Max 25x, or 8.33y

• After trade– A 25y, B 25x– Exchange surpluses, total output greater, consumption

increase



Y

X

Country AB

Output of YOutput of Y without without tradetrade

Output of x without tradeOutput of x without trade

50

25

25

8.33Before trade Before trade

production production pointspoints

Summing up vectors Summing up vectors gives world outputgives world output



Y

X

AB

Output of YOutput of Y without without tradetrade

Output of x without tradeOutput of x without trade

50

25

25

8.5

After Trade: After Trade: A A produces produces onlyonly Y, B Y, B only only xxTotal output Total output

higher, surpluses higher, surpluses tradedtraded

X output with X output with tradetrade

Y output Y output with tradewith trade

Modern Modern approach much approach much more more complicated complicated than this than this simple one!simple one!


Determination of international prices

• Exchange rates of goods can be determined from cost matrix

• For 1 unit of x– maximum A would pay is ½y (otherwise it will produce

itself)– minimum B would accept is ⅓ y (otherwise it won’t cover

cost), • thus we have price of x

• For 1 unit of y– maximum B would pay is 3x– minimum A would accept is 2x, thus we have price of y

Cost / Country

CX CY

A ½ Y 2x

B ⅓ Y 3x

where country A produces only Y while B

only x

yPy x 2

1

3

1

xPx y 32


Import quantity with free-trade

• How much to import depends upon domestic D-S situation• Consider the following D-S curves with domestic eqb. at e• Let world price (Pw) be Rs 20/kg (a country imports if Pw < Pd)• After free-trade is allowed

– demanders would purchase from int. mkt. as it costs less– suppliers would be forced to sell at Pw

0

Dd

Sd

PS

Sugar

Pd=25

1

e

Sw

Pw

– Pd falls towards Pw where all exchanges take place

• Line at Pw shows world supply curve (Sw)—demanders can buy any amount at this price

• At Pw, domestic supply is Sd

– domestic demand is Dd

• Import (M) = Dd - Sd (gap b/w domestic D & S ) at Pw

Sd Dd

M


H-O Theorem: behind comparative advantage

• Recardian theory explains trends and gains from trade via labor-productivity– Differences in labor productivity leads to comparative

advantage• H-O theorem argues that CA arises due to differences in

factor endowments (labor, capital)– the more abundant a factor, the lower its price (or cost)

• H-O theorem: country exports goods that make intensive use of its abundant factor, and import that make intensive use of its scarce factor– Pakistan labor-intensive, so should export labor-

intensive goods; e.g. agriculture, sheep breeding– US capital-intensive, so should export capital-intensive

goods; e.g. computers, air-crafts etc.• But theory does not stand to empirical tests


H-O Theorem: Leontief paradox

• Leontief found that US imports were about 30% more K-intensive than its exports– exactly opposite to H-O theorem—standard trade-mantra

• Did not reject H-O theorem, rather rationalized it– US labor 3-times more productive than that of foreign– so US is labor-abundant when multiplied by productivity-

factor• but this is absurd as US-capital is also more

productive• Many lame-excuses advanced to save sacred cow; i.e. theory

– 1947 data was not true representative– Ignored Human-capital element while measuring physical

productivity– and many more…

• Economists try to explain away result, rather than question the theory—that is why labelled “Leontief paradox”


Economic hype of comparative advantage

• Principal of CA seems impressive and fervently believed in by most economists:– “The principle of comparative advantage holds that

each country will benefit if it specializes in the production and export of those goods that it can produce at relatively low cost. Conversely, each country will benefit if it imports those goods which it produces at relatively high cost. This simple principle provides the unshakable basis for international trade.” (Samuelson 300)

– “Notwithstanding its limitations, the theory of comparative advantage is one of the deepest truths in all of economics. Nations that disregard comparative advantage pay a heavy price in terms of their living standards and economic growth.” (308)


Behind the hype of comparative advantage

• But model makes some extreme assumptions– Full employment of all factors of production

• Otherwise countries would not be on “Production Possibility Frontier”

– Costless mobility of factors of production between sectors• Labor and capital can be moved from computer

production to shoe production without loss of productivity

– Immobility of factors between countries• Otherwise gains in one country would accrue to

factor owners in another country– Identical technology used in production everywhere

• Let’s work out an example to see what they mean


Behind the veil of comparative advantage

• Consider the following ‘2×2’ (two-countries-two-goods) model: – production of sheep (L-intensive) and steel (K-intensive)– Pakistan (L-intensive) and Japan (K-intensive countries)

• Both countries produce both goods before trade• After trade, Pakistan specializes in sheep while Japan in steel• But question is: “How do you turn a steel mill into a sheep dip?”“How do you turn a steel mill into a sheep dip?”

– Economic theory…


Absolute Destruction of Capital…

Pre-tradeprices

Steel pricefalls

Open up trade

Capitaldestroyed

Less capacity,depressed areas

Build sheep dips

• Economic theory ignoresEconomic theory ignores– timetime– uniqueness of capitaluniqueness of capital– specific skills of laborspecific skills of labor

Sell

Stee

l Mill


Comparative Reality

Sheep (“labour intensive”)

Ste

el (“

cap

ital in

ten

sive”)

ProductiveProductivecapacitycapacityfalls…falls…

Unprofitable capitalUnprofitable capitalin less competitivein less competitiveindustry destroyedindustry destroyed

Associated regionsAssociated regionsdepressed,depressed,

labour unemployed…labour unemployed…


Comparative Reality

• Can’t “convert” capital or labour from one use to another without loss– Amount lost a function of speed of change– Instant cut in tariff/trade barriers

• destroys capital invested in less competitive industries

– deskills workers (e.g., Steel in Pakistan, rice in Japan)

• Inflates $ value of capital in competitive industry, increases use of existing capacity, but significant time lag before new capacity built


Product life cycle (PLC) approach

• Raymond Vernon advanced PLC theory in 1960s– Trade and production location for certain goods shifts as

they go through their life cycle• Observed that during 20th century, most new products were

produced by US firms, sold within US first and imported later• He offers four-steps in PLC as model of his explanation

– more of a management-style model1. Introduction

– Innovation in response to observed need– Exporting by innovative country

• producing in other advanced countries not profitable b/c of low initial demand

• production kept at home initially to avoid risk– Evolving product features

• Low capital intensive production



2. Growth– Increase in exports by innovative country– More competition

• foreign firms start producing for home market• US firms may also set up production in those countries

– Increased capital intensity3. Maturity

– Decline in exports from innovative country• potential for export is limited for US firms after

production starts in emerging economies– Standardization of product

• price factor and cost consideration more important– High capital-intensive production

• foreign firms might have CA due to low-wages at home and start exporting it to US



4. Decline– Concentration of production in developing countries

• to make use of low-wage labor– Innovative country becomes importer

• The theory fails to explain– complex patterns of international trade

• production of parts and assembling taking place at different places

– many new products produced at several places simultaneously


Other horizons on trade theory: Porter’s diamond

• Alternative ideas are also reflected to explain trade-patterns• Porter presented “Competitive Advantage of Nations”• Direct attack on relevance of conventional economics:

– “Why do some nations succeed and others fail in international competition? This question is perhaps the most frequently asked … of our times…

– Yet … it is the wrong question… We must focus instead on another, much narrower one…

– why does a nation become the home base for successful international competitors in an industry?...

– why certain industries grow in one country than others?• why is Germany home base for world’s leading

makers of printing presses, luxury cars, & chemicals?• why is tiny Switzerland home base for international

leaders in pharmaceuticals, chocolate…?” (1)


Porter’s irrelevant factors

• Focus not on “natural endowment” (comparative advantage) & broadly defined industries (L-intensive, K-intensive) but– Innovation & very specific industries

• Luxury cars (Germany)• Ski boots (Italy)• Mobile phones (Finland!)

• Porter’s theory aware of recent economic trends:– “The long-dominant paradigm … is inadequate…

• the rise of the multinational corporation … [has] weakened the traditional explanations of why and where a nation exports…” (2)

• Porter instead “seeks to isolate … the national attributes that foster competitive advantage in an industry…” (3)



• Dismisses other conventional explanations for trade– Good macroeconomic policies?

• “Nations have enjoyed rapidly rising living standards despite budget deficits (Japan, Italy & Korea), appreciating currencies (Germany & Switzerland), and high interest rates (Italy & Korea)…” (3)

– Cheap labor?• “The ability to compete despite paying high wages

would seem to represent a far more desirable national target”

– Natural resources?• Even “within nations such as Korea, the United

Kingdom, and Germany, it is the resource-poor regions that are prospering relative to the resource-rich ones” (4)

– Government intervention?• “has occurred only in a subset of industries, and is far

from universally successful even in Japan and Korea.”



• Management style?– “What is celebrated as good management practice in

one industry would be disastrous in another.” (4)• Labor relations?

– “Unions are very powerful in Germany and Sweden, with representation by law in management (Germany) and on boards of directors (Sweden)… both nations … contain some of the most internationally preeminent firms and industries of any country.” (5)

• Rejects characterization of nations as competitive– “We must abandon the whole notion of a ‘competitive

nation’…”– And focus instead on “specific industries and industry

segments…” (9)



• Rejects comparative advantage:– “the assumptions underlying factor comparative

advantage … are unrealistic in many industries.– The standard theory assumes that there are no

economies of scale, that technologies everywhere are identical, that products are undifferentiated, and that the pool of national factors is fixed.” (12)• (same reservations as discussed earlier)

– “The theory … is also frustrating for firms because … [it] assumes away a role for firm strategy, such as improving technology or differentiating products … most managers exposed to the theory find that it assumes away what they find to be most important and provides little guidance for appropriate company strategy.” (12-13)

• “firms can and do choose strategies that differ…


Competitive Advantage: methodology

• Theory developed by empirical research:– 10 countries examined at deep industry level: Denmark

(5.1 million people in 1987); Germany (61m); Italy 57; Japan 122; Korea 42; Singapore 2.6; Sweden 8.4; Switzerland 6.5; UK 57; USA 244 m

• Statistical technique used to select industries/firms in which each country was outstanding competitor in 1985– 100 industries selected

• From obvious (Japan semiconductors)• To obscure (British biscuits)• Industry classifications show how specific “capital” is

– Machines essential for one industry useless in another

• Key point in critique of conventional theory• The complete list by country:


Competitive Advantage: methodology

SWEDENcar carrierscommunication products for handicapped personsenvironmental control equipmentheavy trucksmining equipment

teller-operated cash dispensersnewsprintrefrigerated shippingrock drillssemihard wood flooring

UNITED STATESadvertisingagricultural chemicalscommercial aircraft*commercial refrigeration and air-conditioningcomputer software

construction equipmentdetergentsengineering/constructionmotion picturespatient monitoring equipmentsyringeswaste management services

KOREAapparelautomobilesconstructionfootwearpianos

semiconductorsshipbuildingsteeltravel goodsvideo and audio recording tapewigs

SINGAPOREairlinesapparelbeveragesship repairtrading

SWITZERLANDbankingchocolateconfectionerydyestuffsfire protection equipment

freight forwardinghearing aidsheating controlsinsurancemarine enginespaper product manufacturing machinerypharmaceuticals

surveying equipmenttextile machinery

tradingwatches

DENMARKagricultural machinerybuilding maintenance servicesconsultancy engineeringdairy productsfood additives

furnitureindustrial enzymespharmaceuticalsspecialty electronicstelecommunications equipmentwaste treatment equipment

ITALYceramic tilesdance club and theater equipmentdomestic appliancesengineering/constructionfactory automation equipment

footwearpackaging and filling equipmentski bootswool fabrics

GERMANYautomobileschemicalscutleryeyeglass framesharvesting/threshing combines

optical instrumentspackaging, bottling equipmentpens and pencilsprinting pressesrubber, plastic working machineryX-ray apparatus

JAPANair-conditioningmachineryhome audio equipmentcar audiocarbon fibers

continuous synthetic weavesfacsimileforklift trucksmicrowave and satellite communications equipmentmusical instrumentsoptical elements and instrumentsrobotics

semiconductorssewing machinesshipbuildingtires for trucks and buses

truckstypewritersvideocassette recorderswatches


Competitive Advantage: observations

• “Successful firms are frequently concentrated in particular cities or states within a nation. In the United States …– many of the nation’s leading real estate developers are

based in Houston, Texas;– oil & gas equipment suppliers in Houston;– hospital management chains in … Nashville…;– carpet producers in Dalton, Georgia;…– Something about these locations provides a fertile

environment for firms in these particular industries.” (29)


Industry defined

• Narrow and meaningful definition of industry used:– “Many discussions of competition … employ overly broad

definitions such as banking, chemicals, or machinery.– These are not strategically meaningful industries b/c both

the nature of competition and sources of competitive advantage vary a great deal within them

– Machinery, e.g., is not one industry but dozens of strategi-cally distinct industries such as weaving machinery, rubber processing equipment, and printing machinery … each with its own unique requirements for competitive success.” (34)

• Delineates 5 forces shaping an industry:– “The threat of new entrants;– The threat of substitute products or services;– The bargaining power of suppliers;– The bargaining power of buyers; and– The rivalry among existing competitors” (35)


Meaning of competitive advantage

• Competitive advantage is reflected in two basic features:– “lower cost and differentiation” (37)

• “It is difficult, though not impossible, to be both lower-cost and differentiated relative to competitors.” (38)

• “Any successful strategy, however, must pay close attention to both types of advantage while maintaining a clear commitment to superiority on one.” (38)

– 3rd important feature is “competitive scope”—how broad industry is & how much of it firm covers



• Combination of cost & differentiation give different forms of competitive advantage:



• Innovation crucial– First mover advantage can last well past “short run”

• “German and Swiss dye companies (Bayer, Hoecsht, BASF, Sandoz,… Ciba-Geigy) have sustained their positions as international leaders since before World War I…” (47)

• “Early movers gain advantages such as being first to reap economies of scale, reducing costs through cumulative learning…” (47)

• Schumpeter’s assumption confirmed: “Often, innovators are ‘outsiders’ … to existing industry.” (48) Also…– “larger companies were often supplanted by smaller

ones…” (49)


Behind Competitive Advantage

• 4 key determinants of Competitive Advantage:– Factor conditions

• Only one considered by comparative advantage• Concerns innovation as well as “endowment”

– Demand conditions…– Related & supporting industries…– Firm strategy, structure, and rivalry.” (71)


Porter’s diamond

• Porter’s “National Diamond”– “Advantages

throughout the ‘diamond’ are necessary for achieving and sustaining competitive success … [but]• Advantage in every

determinant is not a prerequisite…” (73)


Porter’s diamond: factor one—Inputs

• Factors matter but may enhance CA through their absence:– “an abundance of factors may undermine instead of

enhance competitive advantage. Selective disadvantages in factors, through influencing strategy and innovation, often contribute to sustained competitive success.” (74)• Opposite of economic theory belief

– Gives example of Holland’s advantage in flowers “despite its cold, grey climate”…

• Second factor also important for Dutch flowers:– Home demand

• Quality more important than quantity• Discerning consumers drive product innovation


Porter’s diamond: factor 2—Home demand

• “Nations gain competitive advantage … where the home demand gives local firms a clearer or earlier picture of buyer needs…

• if home buyers pressure local firms to innovate faster…” (86)

• “A product’s fundamental or core design nearly always reflects home market needs.” (87)– “small nations can be competitive in segments which

represent an important share of local demand but a smaller share of demand elsewhere, even if the absolute size of the segment is greater in other nations.” (88)


Porter’s diamond: factor 3—Supporting industries

• Related & supporting industries– Suppliers assist

“process of innovation and upgrading…

– Suppliers help firms perceive new methods and opportunities to apply new technology.” (103)

• The full pattern of interlinking industries is very complex…



• A more disaggregated view…



– Competitive advantage in suppliers means spin offs from one industry can be means to develop new ones

– “Italian world leadership in gold and silver jewelry has been sustained … because other Italian firms produce two-thirds of the world’s jewelry-making machinery.” (101)

– Related industries give strength to each other…



• Competitive advantage in related industries

TABLE 3-1 Internationally Competitive Related IndustriesNation Industry Related IndustryDenmark Dairy products, brewing Industrial enzymesGermany Chemicals Printing inkItaly Lighting FurnitureJapan Cameras CopiersKorea VCRs VideotapeSingapore Port services Ship repairSweden Automobiles TrucksSwitzerland Pharmaceuticals FlavoringsUnited Kingdom Engines Lubricants, antiknock preparationsUnited States Electronic test and measuring equipment Patient monitoring equipment



• “Japan's strength in long-filament synthetic textile fibers reflects a long tradition of success in silk, as does a leading export position in silk-like continuous synthetic weaves, woven from long-filament synthetic fibers. Carbon fibers employ technology closely related to synthetic filament fibers and many of the same competitors participate in both.

• Also, while not overall leaders in textile machines, Japanese firms are leaders in water jet weaving machines, used to weave long-filament synthetic fibers into synthetic weaves. Such groups of linked competitive industries in a nation are common.” (105)


Porter’s diamond: factor 4—Firm structure

• Firm strategy structure & rivalry– “No one management system is universally

appropriate”– But character of national management structure needs

to suit needs of industry.• “Nations will tend to succeed … where the

management practices and modes of organization favored by the national environment are well suited to the industries’ sources of competitive advantage.

• Italian firms … are world leaders in a range of fragmented industries … operating in small niches…

• In Germany … the engineering and technical background of many senior executives produces a strong inclination towards methodical product and process improvement…” (108)


Porter’s diamond: factor 4—Firm structure

• National goals– Short term focus of US firms—advantage in accounting– Long term focus of German/Japanese—advantage in

engineering…• Domestic rivalry

– Desire to beat own national competitors often drives innovation• Italian super cars; Japanese electronics; US software,

computers…– “With little domestic rivalry, firms are more

content to rely on the home market.” (119)


Where competitive advantage?

• Japan in particular has large number of internationally competitive firms in different industries:

TABLE 3-2 Estimated Number of Japanese Rivals in Selected Industries, 1987Air conditioners 13 Motorcycles 4Audio equipment 25 Musical instruments 4Automobiles 9 Personal computers 16Cameras 15 Semiconductors 34Car audio 12 Sewing machines 20Carbon fibers 7 Shipbuilding 33Construction equipment 15 Steel 5Copiers 14 Synthetic fibers 8Facsimile machines 10 Television sets 15Lift trucks 8 Truck and bus tires 5Machine tools 112 Trucks 11Mainframe computers 6 Typewriters 14Microwave equipment 5 Videocassette recorders 10



• National competitive advantage therefore tends to occur in clusters– Geographic clusters

• “Many of the Italian jewelry firms, for example, are located around two towns, Arezzo and Valenca Po…” (120)

• Similarly, Sports industry is concentrated in Sialkot in Pakistan

– Industry clusters• Related industries and supplier-buyer chains



• “The individual determinants that define the national environment are mutually dependent because the effect of one often depends on the state of the others…” (129)

• Example of clustering: Denmark



• Geographic clustering also strikingly obvious:

• Clustering of internationally competitive industries in Italy:



• Interactions in the “Diamond” for Italian Ski Boot industry:


It is so sad

• The theory seems rich of explanation– but is not so much a model in economic sense– more of a description of process– therefore not considered by economists

• But probably better guide to feasible policy than “comparative advantage”

1 Lectures 18-22: International Trade Theory Managers thinking on trade Economists view on trade...

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