International Trade Theory

International Trade Theory

International Trade TheoryWhat is international trade? Exchange of raw materials and manufactured goods (and services) across national bordersClassical trade theories: explain national economy conditions--country advantages--that enable such exchange to happenNew trade theories: explain links among natural country advantages, government action, and industry characteristics that enable such exchange to happenImplications for International Business

Classical Trade TheoriesMercantilism (pre-16th century)Takes an us-versus-them view of tradeOther countrys gain is our countrys lossFree Trade theoriesAbsolute Advantage (Adam Smith, 1776)Comparative Advantage (David Ricardo, 1817)Specialization of production and free flow of goods benefit all trading partners economiesFree Trade refinedFactor-proportions (Heckscher-Ohlin, 1919)International product life cycle (Ray Vernon, 1966)

The New Trade TheoryAs output expands with specialization, an industrys ability to realize economies of scale increases and unit costs decreaseBecause of scale economies, world demand supports only a few firms in such industries (e.g., commercial aircraft, automobiles)Countries that had an early entrant to such an industry have an advantage:Fist-mover advantageBarrier to entry

New Trade TheoryGlobal Strategic RivalryFirms gain competitive advantage trough: intellectual property, R&D, economies of scale and scope, experienceNational Competitive Advantage (Porter, 1990)

Mercantilism/NeomercantilismPrevailed in 1500 - 1800Export more to strangers than we import to amass treasure, expand kingdomZero-sum vs positive-sum game view of tradeGovernment intervenes to achieve a surplus in exportsKing, exporters, domestic producers: happySubjects: unhappy because domestic goods stay expensive and of limited varietyToday neo-mercantilists = protectionists: some segments of society shielded short term

Absolute AdvantageAdam Smith: The Wealth of Nations, 1776Mercantilism weakens country in long run; enriches only a fewA country Should specialize in production of and export products for which it has absolute advantage; import other productsHas absolute advantage when it is more productive than another country in producing a particular productRiceCocoa G G' K K' G: GhanaK: S. Korea

Comparative AdvantageDavid Ricardo: Principles of Political Economy, 1817Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it producesAbsolute Advantage is a special case of Comparative AdvantageRiceCocoa G K K' G' G: GhanaK: S. Korea

Heckscher (1919)-Ohlin (1933)Differences in factor endowments not on differences in productivity determine patterns of tradeAbsolute amounts of factor endowments matterLeontief paradox: US has relatively more abundant capital yet imports goods more capital intensive than those it exportsExplanation(?): US has special advantage on producing new products made with innovative technologiesThese may be less capital intensive till they reach mass-production state

Theory of Relative Factor Endowments (Heckscher-Ohlin)Factor endowments vary among countriesProducts differ according to the types of factors that they need as inputsA country has a comparative advantage in producing products that intensively use factors of production (resources) it has in abundanceFactors of production: labor, capital, land, human resources, technology

International Product Life-Cycle (Vernon)Most new products conceived / produced in the US in 20th centuryUS firms kept production close to their market initiallyAid decisions; minimize risk of new product introductionsDemand not based on price; low product cost not an issueLimited initial demand in other advanced countries initiallyExports more attractive than overseas productionWhen demand increases in advanced countries, production followsWith demand expansion in secondary marketsProduct becomes standardizedproduction moves to low production cost areasProduct now imported to US and to advanced countries

Classic Theory ConclusionFree Trade expands the world pie for goods/servicesTheory Limitations:Simple world (two countries, two products)no transportation costsno price differences in resourcesresources immobile across countriesconstant returns to scaleeach country has a fixed stock of resources and no efficiency gains in resource use from tradefull employment

New Trade TheoriesIncreasing returns of specialization due to economies of scale (unit costs of production decrease)First mover advantages (economies of scale such that barrier to entry crated for second or third company)Luck... first mover may be simply lucky.Government intervention: strategic trade policy

National Competitive Advantage (Porter, 1990)Factor endowments land, labor, capital, workforce, infrastructure (some factors can be created...)Demand conditionslarge, sophisticated domestic consumer base: offers an innovation friendly environment and a testing groundRelated and supporting industrieslocal suppliers cluster around producers and add to innovationFirm strategy, structure, rivalrycompetition good, national governments can create conditions which facilitate and nurture such conditions

Porters Diamond

So What for business?First mover implicationsLocation ImplicationsForeign Investment Decisions Government Policy implications

This is a testExample: Medical Specialist is also the best medical secretary. Should this doctor spend any time on the secretarial part of the business? No? Why?

Lets continue with SL and the USA...

This time the terms have changed to give the USA the absolute adv. in both tea and wheat...Real world: many countries and many goodsTransportation costs may decline with specializationPrices in different countries can be (are) effected by exchange rates. Wheat and Tea are not necessarily a one-to-one swapresources can move from country to country: labor (Mexico to US), capital(constant returns to scale: specialization does not effect the amount of resources required to produce one ton of wheat or tea) both diminishing and increasing returns to specialization existassumed fixed stock of resources in each country. Trade can change the efficiency with which the resources are used and the stock of resources may change too (more people, more natural resources, more efficient use due to technology)Full employment implies use of resources at full efficiency...Commercial jet industry: studies show that 3 major manufacturers can survive. Boeing, McDonnell Douglas and Airbus already there... New entries discouraged... however, the largest potential customer is China and they want the capacity to produce... hence the battle Boeing is having with unions... either give China some of the value added activity to keep them out of mainline or lose out to Airbus or to a non-economic decision to start an industry.

Luck: DeHaviland in 50s. Comet fell out of sky. 707 captured the market. (some say it was not only luck but resources. B. had produced 707 on the back of technology developed for US military--spillover effect?? what of our claim that Airbus was subsidized??)

Factor Endowments:basic factors: natural resources, climate, location, demographicsadvanced factors: communications infrastructure, sophisticated and skilled labor, R&D, technological know-howadvanced factors are most important: they are the result of investment by individuals, companies and government (education, general skill and knowledge stimulation, basic R&D support)Demand conditions: sophisticated home demand can create impetus for enhancing competitive advantage (Japanese consumer knowledgeable on cameras pushed J. industry to create advantage)Related and Supporting industries:internationally competitive suppliers. Creation of clusters of related industries. ex. German textile and apparel sector (high qual. cotton, wool, synthetic fibers, sewing machine needles, textile machinery)Firm Strategy, Structure, and Rivalry within a nation: Management ideologies: predominance of engineers in TMTs of Germ. and J. cos. helped improve manufacturing processes and product designs (Porter found top execs with finance backgrounds in US 70s. most CEOs of the 40 companies I studies were marketing specialists). Vigorous domestic rivalry creates persistent comp. advantage in and industry: impr. efficiency and leads to international competitiveness.

Location: To produce laptop four stages: Basic research and development of product design (US, Japan: Apple, IBM, Motorola, TI, Toshiba, Sony)manufacture of standard electronic components (capital intensive, semi-skilled labor, high unit cost pressures: Sing., Taiwan, Malaysia)manuf. of advanced components (screens) (cap. intensive, high skilled labor, no cost pressure: Japan)final assembly (labor intensive, low skill, intense cost pressures: Mexico)

First mover implications: high initial investment with years of losses... Japan LCD displays, US abandoned early tech. leadership in this technology.Policy: Apple and IBM lobbied against tariffs on LCD display imports: J. was the low cost producer, A. and IBM used these displays, the increase in import duty would reduce the world competitiveness of the A. and IBM products...Auto industry induced govt. to negotiate voluntary restraints in machine tools. result: limited competition from world-wide efficient suppliers caused the US companies to lose their WW competitive edge and lost its WW share since 85.