Chapter 3 (International Trade Theory)

Fourth Edition

MBA(1ST ) Management StudiesSection C

International Business

Provided By : Mr.Md.Mahmudul Hasan Fouji

Jagannath University

CHAPTER 4

International Trade Theory

1st British African colony to win independence (1957).

Nkrumah (Osagyefo Kwame Nkrumah) espoused pan African socialism.High tariffs.Anti export (trade) policy.

Kept lowering tariffs on manufactured goods.Created incentives to export (trade).Reduced quotas.Reduced subsidies.1950s: 77% of employment in agriculture. Now 20%.Manufacturing GNP went from 10% to over 30%.

The Impact of Trade Policies

• Ghana• 1970

– GNP/capita • $250

• 1992– GNP/per capita

• $450

– GNP Growth/year • 1.5%

• Shift from productive uses (cocoa) to unproductive uses (subsistence agriculture).

• Korea• 1970

– GNP/per capita • $260

• 1992– GNP/per capita

• $6790– GNP Growth/year

• 9%

• Shift from non-comparative advantage uses (agriculture) to productive uses (labor-intensive manufacturing).

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McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

An Overview of Trade Theory

• Free Trade occurs when a government does not attempt to influence, through quotas or duties, what its citizens can buy from another country or what they can produce and sell to another country.

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• The Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country.

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• The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish). Others are not so easy to understand (Japan and cars).

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An Overview of Trade Theory• Free Trade occurs when a government does not attempt to influence, through

quotas or duties, what its citizens can buy from another country or what they can produce and sell to another country.


• The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish). Others are not so easy to understand (Japan and cars).

• The history of Trade Theory and Government Involvement presents a mixed case for the role of government in promoting exports and limiting imports. Later theories appear to make a case for limited involvement.

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Mercantilism: mid-16th century

• A nation’s wealth depends on accumulated treasure

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• Gold and silver are the currency of trade.

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• Theory says you should have a trade surplus.

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• Theory says you should have a trade surplus. – Maximize exports

through subsidies.

– Minimize imports through tariffs and quotas.

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Mercantilism: mid-16th century• A nation’s wealth depends on accumulated treasure• Gold and silver are the currency

of trade.• Theory says you should have

a trade surplus. – Maximize exports through

subsidies.

– Minimize imports through tariffs and quotas.

• Flaw: “zero-sum game”.

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Theory of Absolute AdvantageAdam Smith: Wealth of Nations (1776).

• Capability of one country to produce more of a product with the same amount of input than another country.

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• Produce only goods where you are most efficient, trade for those where you are not efficient.

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• Produce only goods where you are most efficient, trade for those where you are not efficient.

• Assumes there is an absolute advantage balance among nations, e.g., Ghana/cocoa.

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The Theory of Absolute Advantage

Rice

Coco

a

Figure 4.1

G’

0 5 10 15 20

5

10

1

5

20

A

BK

G

K’

The Theory of Absolute Advantage and the Gains from Trade

Production and Consumption without Trade

S. Korea 2.5 10.0

Total production 20 20

S. Korea 6.0 14.0

Resources Required to Produce 1 Ton of Cocoa and RiceCocoa Rice

Ghana 10 20S. Korea 40 10

Ghana 10.0 5.0

Total production 12.5 15.0Production with Specialization

Ghana 20 0S. Korea 0 20

Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean RiceGhana 14.0 6.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 4.0 1.0S. Korea 3.5 4.0 Table 4.1

Theory of Comparative AdvantageDavid Ricardo: Principles of Political Economy

(1817).– Should trade even if country is more efficient in

the production than its trading partner.

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Theory of Comparative Advantage

•Assume Ghana is more efficient in production of both cocoa and rice.

Scenario 1:•In Ghana it takes 10 resources to produce 1 ton of cocoa and 13 1/3 resources to produce 1 ton of rice.•Thus with 200 resources Ghana can produce 20 tons (200/10)of cocoa and no rice. Or 15 tons of rice(200/13.33) and no cocoa or any combination of the two.

•In South Korea it takes 40 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice.•Thus , with 200 resources Korea can produce 5(200/40) tons of cocoa and no rice or 10 tons of rice and no cocoa or any combination of the two on its PPF.

The Theory of Comparative Advantage

Figure 4.2

3.75

7.5

2.5

0 5 10 15 20

5

10

1

5

20

Coco

a

Rice

G

C

A

K

K’B

G’


Scenario 2: If both the countries use half of the resources to produce cocoa and half of the resources to produce rice:

•Thus with 100 resources for each of the products, Ghana can produce 10 tons (100/10)of cocoa and 7.5 tons(100/13.33) of rice.

•In the same way with 100 resources Korea would produce 2.5 tons(100/40) of cocoa and 5 tons(100/20) of rice.

•So without trade the total production would be 12.5(10+2.5) tons of cocoa and 12.5(7.5+5) tons of rice.

The Theory of Comparative Advantage (Specialization)

3.75

7.5

2.5

0 5 10 15 20

5

10

1

5

20

Coco

a

Rice

G

A(100 resources for each (10 cocoa & 7.5 rice))

K

K’G’

A’ (100 resources for each, 2.5 cocoa and 5 rice)


Scenario 3: International Trade takes Place:

Cocoa to Rice Ratio in Ghana: 10: 7.5 or 4:3 or 1: 0.75

Cocoa to Rice ratio in Korea: 2.5:5 or 1:2

Cocoa is cheaper in Ghana. So Ghana can sell 1 unit of cocoa to Korea and get 2 units of Rice whereas she can only get 0.75 units of rice in exchange of giving up 1 unit of cocoa production in her own country.

So, Ghana would export cocoa and import rice.


On the other hand,

Rice to cocoa Ratio in korea:5:2.5 or 1:0.5

Rice to cocoa Ratio in Ghana:7.5:10 or 1: 1.33

Rice is cheaper in Korea because Korea can sell 1 unit of Rice to Ghana and get 1.33 units of cocoa whereas she can only get 0.5 units of cocoa by sacrificing the same amount of rice in her own country.

SO Comparative Advantage comes into effect

Comparative Advantage and the Gains from Trade

S. Korea 40 20

S. Korea 2.5 5.0

S. Korea 0.0 10.0

S. Korea 4 6

Resources Required to Produce 1 Ton of Cocoa and Rice

Ghana 10 13.33

Production and Consumption without TradeGhana 10.0 7.5

Total production 12.5 12.5Production with Specialization

Ghana 15 3.75

Total production 15 13.75Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean

RiceGhana 11 7.75

Increase in Consumption as a Result of Specialization and TradeGhana 1.0 0.25

S. Korea 1.5 1.0

Cocoa Rice

Table 4.2

The Theory of Comparative Advantage

Figure 4.2

3.75

7.5

2.5

0 5 10 15 20

5

10

1

5

20

Coco

a

Rice

G

C

A

K

K’B

G’

The Basic Message of the Theory of Comparative Advantage

•Potential world Production is higher greater with unrestricted free trade than it is with restricted trade.

•Trade is a positive-sum game where all countries that participate realize economic gains.

Extensions of the Ricardian Model• Immobile resources:

– Resources do not always move easily from one economic activity to another.

• Diminishing returns:– More a country produces, at some point, will require

more resources (diminishing returns to specialization).– Different goods use resources in different proportions.

• However:– Free trade might increase a country’s stock of

resources (as labor and capital arrives from abroad), and

– Increase the efficiency of resource utilization.

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Ghana’s PPF under Diminishing Returns

Coco

a

Rice

G’

G

0

Figure 4.3

The Influence of Free Trade on the PPF

Figure 4.4

Coco

a

Rice

G’

PPF2

0

PPF1

Heckscher (1919)-Olin (1933) Theory

• Labor is not the only Factor of production. We need to account for land, capital, and technology.

• Ricardo Had highlighted Labor Productivity. Whichever country had more labor productivity in a particular good’s production would be able to export that good.

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• Factor endowments: extent to which a country is endowed with such resources as land, labor, and capital.

• Comparative Advantage arises out of national factor endowments. USA exports agricultural products because it has huge arable land. China excels in exporting labor-intensive manufactured goods like textile and footwear due to its abundance of low-cost labor.

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• Export goods that intensively use factor endowments which are locally abundant.

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• Export goods that intensively use factor endowments which are locally abundant.

• Corollary: import goods made from locally scarce factors.

• So, the US exports agricultural products and imports textile goods.

• Ivory cost exports Ivory, imports automobiles.

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• Patterns of trade are determined by differences in factor endowments - not productivity.

• Remember, focus on relative advantage, not absolute advantage.

e.g.Venezuela May have absolute advantage in oil but does not have a relative advantage over Saudi Arabia.

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The Leontief (Wassily Leontief) Paradox, 1953

• Disputes Heckscher-Olin in some instances.• Factor endowments can be impacted by

government policy - minimum wage.• US tends to export labor-intensive products,

but is regarded as a capital intensive country.

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The Leontief Paradox?• No answer as yet

• Maybe because the US has advantages in innovative technologies which are less capital intensive but rather skill based (Computer Software)on the other hand she may import products that require heavy machinery and in turn large amounts of capital.

Dilemma Between Ricardo and H-O

• H-O theoretically stronger but Ricardo more accurate in predicting patterns of international trade.

• The US exports commercial aircraft and imports cars not because it lacks the necessary factor endowments for cars but because it is more efficient in producing aircrafts. Same true for Japan.

• H-O assumes technology is same across countries.

• So the solution to this dilemma maybe to resort to the Ricardian idea of productivity. Once technology is same then H-O comes into play.

Product Life-Cycle Theory(Raymond Vernon, 1966)

• Article in the Quarterly Journal of Economics.• 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.

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The Product Life-Cycle Theory

production

consumption

Figure 4.5

Exports

160140120100 80 60 40 200

United States

Other Advanced Countries

Developing Countries

Stages of Production Development

New Product Standardized ProductMaturing Product

Imports

Imports

Exports

Exports

Imports

160140120100 80 60 40 200

160140120100 80 60 40 200

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The New Trade Theory• Began to be recognized in the 1970s.• Deals with the returns on specialization where

substantial economies of scale are present.– Specialization increases output, ability to enhance

economies of scale increase.

• In addition to economies of scale, learning effects also exist.– Learning effects are cost savings that come from

“learning by doing”.

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Application of the New Trade Theory

• Typically, requires industries with high, fixed costs.

• World demand will support few competitors.

• Competitors may emerge because “they got there first”.

• First-mover advantage.

• Some argue that it generates government intervention and strategic trade policy.

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First-Mover Advantage• Economies of scale may preclude new entrants.• Role of the government.

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Porter’s Diamond(Harvard Business School, 1990)

• The Competitive Advantage of Nations.• Looked at 100 industries in 10 nations.

– Thought existing theories didn’t go far enough.• Question: “Why does a nation achieve

international success in a particular industry?”

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Determinants of National Competitive Advantage

• Factor endowments:nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry.




• Demand conditions:the nature of home demand for the industry’s product or service.





• Related and supporting industries:the presence or absence in a nation of supplier industries or related industries that are nationally competitive.





• Related and supporting industries:the presence or absence in a nation of supplier industries or related industries that are nationally competitive.

• Firm strategy, structure and rivalry:the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.


Porter’s DiamondDeterminants of National Competitive

Advantage

Factor Endowments

Firm Strategy,Structure and

Rivalry

Demand Conditions

Related and Supporting IndustriesFigure 4.6

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The Diamond• Success occurs where these attributes exist.

– More/greater the attribute, the higher chance of success.

• The diamond is mutually reinforcing.

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GovernmentGovernment

Company Strategy,Structure,

and Rivalry

DemandConditions

Relatedand Supporting

Industries

FactorConditions

ChanceChance

Two external factors that influence the four determinants.

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Factor Endowments

• Taken from Heckscher-Olin

• Basic factors:– natural resources– climate– location– demographics

• Advanced factors:– communications– skilled labor– research– technology

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Advanced Factor Endowments

• More likely to lead to competitive advantage.

• Are the result of investment by people, companies, government.

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Relationship of Basic to Advanced Factors

• Basic can provide an initial advantage.• Must be supported by advanced factors to

maintain success.• No basics, then must invest in advanced factors.

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Demand Conditions

• Demand creates the capabilities.

• Look for sophisticated and demanding consumers.– impacts quality and innovation.

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Related and Supporting Industries

• Creates clusters of supporting industries that are internationally competitive.

• Must also meet requirements of other parts of the Diamond.

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Firm Strategy, Structure and Rivalry

• Management ‘ideology’ can either help or hurt you.• Presence of domestic rivalry improves a company’s

competitiveness.

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Evaluating Porter’s Theory• If Porter is right, we would expect his model to

predict the pattern of international trade that we observe in the real world. Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable.

• Too soon to tell.

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Implications for Business• Location implications:makes sense to disperse

production activities to countries where they can be performed most efficiently.

• First-mover implications:It pays to invest substantial financial resources in building a first-mover, or early-mover, advantage.

• Policy implications:promoting free trade is generally in the best interests of the home-country, although not always in the best interests of the firm. Even though, many firms promote open markets.

Chapter 3 (International Trade Theory)

Business

havea trade surplus

national competitive advantage

free trade occurs

nations wealth depends

free trade

competitive advantage

nationally competitive

absolute advantage