International Trade Ulvi Vaarja 2015. What is trade? Trade - concept of exchanging goods and services between two people or entities. International trade.

International Trade

Ulvi Vaarja 2015

What is trade?

• Trade - concept of exchanging goods and services between two people or entities.

• International trade - concept of this exchange between people or entities in two different countries.

Why does trade occur?

• Differences in:– Technology– Resources– Demand

• Existence of economies of scale in production• Existence of government policies

Theories of trade

• The main historical theories are called classical and are from the perspective of a country, or country-based.

• The theories from the 20th century are called modern and are firm or company-based.

Classical theories

• Mercantilism• Absolute advantage• Comparative advantage• Heckscher-Ohlin theory

Modern theories

• Country similarity• Product life cycle• Global strategic rivalry• Porter’s national comparative advantage

Silk route

Mercantilism

• Based on the idea of stronger nations in the early 16th century

• Developed in 16th century• A country’s wealth determined by the amount

of its gold and silver holdings. • The objective of each country was to have a

trade surplus.• Importance of government regulations

Mercantilism

• Although mercantilism is one of the oldest trade theories, it remains part of modern thinking.

• Some countries use neo-mercantilism - promote a combination of protectionist policies and restrictions and domestic-industry subsidies.

• Taxpayers pay for government subsidies of select exports in the form of higher taxes.

• Import restrictions lead to higher prices for consumers, who pay more for foreign-made goods or services

Price-specie flow mechanism

• Developed by David Hume in the 18th century• when a country had a positive balance of trade,

gold would flow into the country in the amount that the value of exports exceeds the value of imports.

• Money supply increases• Inflation increases – prices rise• Import starts to increase• Gold flows out again

Historic trade routes

Liberalism

• Began in the end of the 17th century• Governments should not influence economy• 1776 – Adam Smith “Wealth of Nations”• David Ricardo – developed Smith’s theory

Why trade?

• Autarchy – the situation in the domestic market without trade

• The equilibrium is where supply and demand are equal

• Both producers and consumers get a surplus in the equilibrium.

Autarchy

Two markets and trade

• Assume only 2 markets – Estonia and the rest of the world

• Arbitrage – buying a good in one market and selling it in another with the goal of making a profit

• International trade causes prices to change

Two markets and trade

Two markets and trade

• The free trade equilibrium is created at the price where import demand equals export supply

• Trade influences welfare in both trading parties

• For measuring the total and the different groups’ welfare a one-dollar-one-vote-yardstick is used.

How trade influences welfareEstonia Estonia Estonia Rest of the

worldRest of the world

Surplus with trade

Surplus in autarchy

Influence of trade

Influence of trade

consumers a+b+c+d c a+b+d consumers -(j+k)

producers e a+e -a producers j+k+n

Consumers+producers

a+b+c+d+e c+a+e b+d Consumers+producers

n

Which country gains more from trade?

• Trade is not a 0-sum, but a positive-sum “game”

• The profit gained from trade depends on price changes

• Domestic profit/rest of the world profit = x/y

Absolute advantage

• a new trade theory by Adam Smith in 1776 • focused on the ability of a country to produce

a good more efficiently than another nation. • The value of goods was measures in labour

hours• The production costs of a product are

absolutely lower in one country than another– That country has lower absolute production costs

for the product

Absolute advantage• If one country can produce a good cheaper or

faster (or both) than another country, then the first country has the advantage and can focus on specializing on producing that good.

• By specialization, countries would generate efficiency, because their labour force would become more skilled by doing the same tasks.

• Production would also become more efficient, because there would be an incentive to create faster and better production methods to increase the specialization.

Absolute advantage• Assumptions for the

example:– 2 goods, 2 countries

(Estonia produces bread, Finland produces vodka)

– both have absolute advantage in their product

– Specialization– Labour theory of value

• Labour is the only production factor

• Trade depends on the labour hours

– The unit of labour is equal in both countries

– The production possibilities curve is linear and costs constant

– Labour is mobile domestically but not internationally

– Total competition– No transport costs or trade

barriers– Barter trade

Absolute advantageProduction costs in hours of labour

Estonia Finland

bread 2 2,5

vodka 4 1

Comparative costsEstonia Finland

1 vodka = 2 bread

1 vodka = 0,4 bread

1 bread = ½ vodka

1 bread = 2,5 vodka

i.e Estonia has absolute advantage in bread and Finland in vodka

Absolute advantage

Unit costsEstonia Finland

bread 0,5 2,5

vodka 2 0,4

• When trade occurs, the price will settle at the level of 1 bread = 1 vodka. This equilibrium is called the terms of trade.

World market prices

0,5 ≤ P bread ≤ 2,5 0,4 ≤ P vodka ≤ 2

Absolute advantageEstonia Finland

autarchy 1 bread = 0,5 vodka 1 bread = 2,5 vodka

autarchy 1 vodka = 2 bread 1 vodka = 0,4 bread

With trade 1 bread = 1 vodka 1 bread = 1 vodka

Influence of trade 0,5 additional units of vodka

0,6 additional units of bread

Influence of trade 1 unit of bread less 1,5 additional units of vodka

Absolute advantage

Comparative advantage• theory introduced by David Ricardo, an English

economist in 1817• even if one country has the absolute advantage

in the production of both products, specialization and trade could still occur between two countries.

• Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, it can produce that product better and more efficiently than it does other goods.

Comparative advantageProduction costs in units of labour

Estonia Finland

bread 2 1,5

vodka 4 1

Estonia Finland

1 vodka = 2 bread 1 vodka = 0,67 bread

1 bread = 0,5 vodka 1 bread = 1,5 vodka

World market prices

0,5 ≤ P bread ≤ 1,5 0,67 ≤ P vodka ≤ 2

Trade price 1 bread = 1 vodka

Comparative costs

Prices:

P vodka in Estonia = 2 breadP vodka in Finland = 0,67 bread

P bread in Estonia = 0,5 vodkaP bread in Finland = 1,5 vodka

i.e Estonia has a comparative advantage in vodka and Finland in bread

Heckscher-Ohlin theory

• Developed in the early 1900s by two Swedish economists - Eli Heckscher and Bertil Ohlin

• based on a country’s production factors—land, labor, and capital

• also called the factor proportions theory• Countries produce and export goods that

require resources or factors that are in great supply and therefore cheaper

Leontief Paradox • Developed In the early 1950s by Russian-born

American economist Wassily W. Leontief • On the example of United States – United States was abundant in capital and, therefore,

should export more capital-intensive goods. • According to the factor proportions theory, the

United States should have been importing labour-intensive goods, but instead it was actually exporting them.

• international trade is complex and is impacted by numerous and often-changing factors

Contemporary air agreements

Modern or Firm-Based Trade Theories

• emerged after World War II and was developed in large part by business school professors

• The firm-based theories evolved with the growth of the multinational company (MNC).

• incorporate other product and service factors, including brand and customer loyalty, technology, and quality, into the understanding of trade flows.

Country Similarity Theory

• developed by Swedish economist Steffan Linder in 1961

• On the basis of the concept of intra-industry trade. • Linder’s assumption: companies first produce for

domestic consumption. • When they explore exporting, they find that markets

that similar to their domestic one offer the most potential for success.

• Theory: Most trade in manufactured goods will be between countries with similar per capita incomes, and intra-industry trade will be common.

Product Life Cycle Theory

• Developed by Raymond Vernon, a Harvard Business School professor, in the 1960s.

• The theory states that a product life cycle has three stages: – new product– maturing product– standardized product.

• The theory assumes that production of the new product will occur completely in the home country of its innovation.

Global Strategic Rivalry Theory • emerged in the 1980s based on the work of

economists Paul Krugman and Kelvin Lancaster. • focus on MNCs and their efforts to gain a

competitive advantage against other global firms in their industry.

• barriers to entry into an industry - the critical ways that firms can obtain a sustainable competitive advantage.

• The barriers to entry refer to the obstacles a new firm may face when trying to enter into an industry or new market.

Porter’s National Competitive Advantage Theory

• developed in 1990 by Michael Porter of Harvard Business School

• model to explain national competitive advantage. • nation’s competitiveness in an industry depends

on the capacity of the industry to innovate and upgrade.

• His theory focused on explaining why some nations are more competitive in certain industries.

Porter’s theory

Porter’s theory• Local market resources and capabilities (factor conditions).

– Porter added to the basic factors in factor proportion theory a new list of advanced factors, which he defined as skilled labour, investments in education, technology, and infrastructure.

• Local market demand conditions. – Porter believed that a sophisticated home market is critical to ensuring ongoing

innovation, thereby creating a sustainable competitive advantage. – Companies whose domestic markets are sophisticated, trendsetting, and

demanding are forced to continuous innovation and the development of new products and technologies.

• Local suppliers and complementary industries. – To remain competitive, large global firms benefit from having strong, efficient

supporting and related industries to provide the inputs required by the industry. • Local firm characteristics.

– Local firm characteristics include firm strategy, industry structure, and industry rivalry.

– Local strategy affects a firm’s competitiveness.