MGT-372 Lec-5 Int Trade Theory Part 1

8/8/2019 MGT-372 Lec-5 Int Trade Theory Part 1

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International Trade Theory

Chapter-5



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Chapter Objectives Explain trade theories

Discuss how global efficiency can be increased

through free trade

Introduce prescriptions for altering trade

patterns

Explore how business decisions influence

international trade



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International Trade The purchase, sale, or exchange of goods and services

across national borders.

BenefitsBenefits::

Provides a countrys people with a greater choice of Provides a countrys people with a greater choice of

goods and services.goods and services.

Important engine for job creation.Important engine for job creation.

Trade in goods and services is one way by which

countries are linked economically.



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Worlds Top Service

Exporters

US USD 272.6 blln

(17.4%)

UK USD 123.1 blln

(7.8%)

Germany USD 99.6 blln

(6.3%)

Volume of International TradeWorlds Top Merchandise

Exporters

US USD 693blln (10.7%)

Germany USD 613.1 blln

(9.5%)

Japan U

SD 416.7 (6.5%)



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Independence complete economic independence

Country has no reliance on other countries for

goods, services, or technologies.

Price of independence is having to do without

goods that cannot be produced domestically.

Hinders countrys ability to borrow and adapt

existing technologies.Limits on imports are often in the interests of

domestic producers, but not domestic consumers.

Degree of Dependence



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Interdependence trade based on mutual need

Neither trading partner is likely to cut off supplies or markets for fear of retaliation.

Governments may be pressured to sustain trade.

Dependence developing countries rely heavily on:

The sale of one commodity for export earnings

25 % of emerging countries sell one commodity

Degree of Dependence



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General Types of Trade Theories

Theories of Smith, Ricardo &

Heckscher-Ohlin

Advocate free trade

µInvisible hand¶ of marketmechanism, rather than government

policy should determine Import-

ExportMakes a crude case for

government involvement

in promoting exports

and limiting imports

supports limited government

intervention to support the

development of certain

export-oriented industries

InterventionistInterventionist New Trade TheoryNew Trade TheoryFree TradeFree Trade



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Trade Theory Timeline

1500 1600 20001700 1800 1900

M

A A

C A

FPT

IPLCT

NTT

NCA



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Mercantilism Initial trade theory that formed the foundation of

economic thought from 1500 1800 century.

It was believed that it is essential to a nations welfare

to accumulate a stock of precious metals. Based on concept that a nations wealth is measured by

its holding of treasure (gold).

Nations often imposed restrictions on imports sincethey did not want their treasure moving to anothercountry to pay for the imports.

Nations should accumulate financial wealth byencouraging exports and discouraging imports.



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Thus imports were limited by tariff while exports were

subsidized.

Intended to benefit colonial powers

colonies supplied commodities to the mother country.

mother country tried to run trade surpluses with their

own colonies.

This combination continued to make coloniesdependent on raw material production and to tie their

trade to their mother country.

Mercantilism



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Favorable balance of trade: country is

exporting more than it is importing

Unfavorable balance of trade: country is

importing more than it is exporting, i.e. a trade

deficit

Mercantilism faded after 1800

Mercantilism



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In 1752, David Hume pointed out that:

Increased exports lead to inflation and higherprices

Increased imports lead to lower prices Result: Country A sells less because of high

prices and Country B sells more because of lowerprices

In the long run, no one can keep a trade surplus

Mercantilism-zero sum game



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N

eo-MercantilismCurrent term to describe the approach of countries that

try to run favorable balances-of-trade to achieve some

social or political gains.

This belief equates political power with economic

power and economic power with balance-of-trade.

For instance, a country may try to achieve full

employment by setting economic policies that encourage

its companies to produce in excess of the demand at

home & to send the surplus abroad.



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Theory of Absolute AdvantageAdam Smith argued (Wealth of Nations, 1776):

countries should specialize in the production of a

goods for which they have an absolute advantage and

then trade these goods for goods produced by another

country.

A country should produce only goods where it is most efficient, and trade for those goods where it is not

efficient.

Trade between countries is, therefore, beneficial.

Assumes there is an absolute balance among nations



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Absolute Advantage Absolute advantage holds that - different

countries produce some goods more efficiently

than other countries.

A nation with an absolute advantage can

produce greater output of a good or service

than other nations using the same amount of,

or fewer, resources. Thus, global efficiency can be increased

through international free trade.

5-6



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Country Specialization

Under the concept of absolute advantagecountries could increase efficiency because:

Labor could become more skilled by repeatingthe same tasks

Labor would not lose time in switching fromthe production of one kind of product to

another Long production runs would provide incentives

for the development of more effective workingmethods

5-7

Absolute Advantage



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Countrys advantage would either be natural oracquired.

Natural Advantage:

Countries have inherent advantages Climate

Natural resources

Labor forces

Two countries that have opposite naturaladvantages should favor trade with one another.

5-8

Absolute Advantage



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Acquired Advantage

Most contemporary trade is manufactured

goods and services rather than agricultural

goods or natural resources

Countries with an acquired advantage produce

manufactured goods and services competitively

Product technology- Danish Silver tableware(distinctive product)

Process technology Japanese steel

(homogeneous product)

Absolute Advantage



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Assumptions:

market forces, not government controls, shoulddetermine the direction, volume, and

composition of international tradeUnder free (unregulated) trade each nation

should specialize in producing those goods it could produce most efficiently

Nation capable of producing more of a goodwith the same input than another nation

An absolute advantageeither natural oracquired

Absolute Advantage



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Assumptions:

Some goods exported to pay for imports of goods that could be produced more efficiently

elsewhere. Assumes perfect competition and no

transportation costs in a world of two countries

and two products.

Each nation has two input units it can use to

produce.

With the same quantity of input units the

total output is greater.

Absolute Advantage



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Production PossibilityFrontier

Absolute Advantage



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Question: Ghana-Cocoa & South Korea-Rice

200 units of resources are available in each country

Ghana= 10 resources to produce one ton of cocoa20 resources to produce one ton of rice

South Korea = 40 resources to produce one ton of cocoa

10 resources to produce one ton of rice

Production & Consumption without trade

Production & Consumption with trade

Absolute Advantage



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Absolute Advantage

Resources required Cocoa Rice

Ghana 10 20

South Korea 40 10

Production & Consumption without trade

Ghana 10 5

South Korea 2.5 10

Total 12.5 15.0

Production & Consumption with trade

Ghana 20 0

South Korea 0 20

Total 20 20



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Comparative Advantage David Ricardo (Principles of Political Economy,

1817):

Extends free trade argument

Also proposes specialization through freetrade because it says that total global output can increase even if one country has anabsolute advantage in the production of all

products. Consider how much more efficient

If only comparatively efficient, than import



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There are still global gains to be made if a countryspecializes in products it produces moreefficiently than other products

The theory suggest that a country shouldspecialize in producing those goods that it produces more efficiently and buy goods that it produces less efficiently from the other countries,

even if this means buying goods from othercountries that it could produce more efficientlyitself.

5-11

Comparative Advantage



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Trade is a positive-sum game in which all

courtiers that participate realize economic

gains

Potential world production is greater withunrestricted trade than it is with restricted

trade




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5-12

Ghana has Absolute advantage in producing both the goods.However, Ghana is comparatively more efficient at producing Cocoa.

Comparative AdvantageResources required to produce 1 ton of Cocoa & Rice

Cocoa Rice

South Korea 4 5

Ghana 2 4Production & Consumption without trade (100 units)

South Korea 12.5 10

Ghana 25 12.5

Total Production 37.5 22.5



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Production With

specialization

Cocoa Rice

South Korea 25 (100/4 unit) 0

Ghana 20 (40/2 unit) 30 (60/2 unit)

Total Production 45.0 30.0




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Basic AssumptionsBoth absolute and comparative advantage theoriesare based on specialization.Full employment

Economic efficiency is sought

Differences in the price of resources

Constant return to scale

Two countries/two commodities

Transportation costs

MobilityStatic and dynamics

Services



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Extension of Ricardian Model

Immobile Resources: the theory assumed that

resources are mobile but in reality it might not be the

case.

Diminishing Return: the theory the theory assumedconstant return to specialization but in reality it might

not be true.

law of diminishing returns states that if you add more

units to one of the factors of production and keep the

rest constant, the quantity or output created by theextra units will eventually get smaller to a point where

it will begin to fall ("Diminishing Returns").



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New Trade Theory

The theory was initially associated with Paul

Krugman in the early 1970s

There are gains to be made from specialization

and increasingEOS.

New Trade Theory primarily focuses on two

major concepts:

EOS

First-mover advantage

Government may play a role in assisting its home

companies.



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Economies of Scale:

The theory suggest that nation may benefit from trade

even when they do not differ in resource endowment.

Trade allows a nation to specialize in the production of certain products, attaining economies of scale and

lowering the cost of production. Simultaneously

facilitates buying other products from other nations

who have similar specialization.

Through this mechanism variety of products available

to consumers in each nation is increased at a lower

cost.

New Trade Theory



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First Movers Advantage:

A second theme in New Trade Theory is that the

pattern of trade in the world may be the result of

first movers advantage.

First Mover Advantage are the economic and

strategic advantage that accrue to early entrants

into an industry.

This theory is also successful in explaining trade

pattern

New Trade Theory



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New trade theory argues that for those

products where

EOS are significant and

Represent a substantial proportion of worlddemand,

The first mover in an industry can gain a scale

based cost advantage that later entrants find

almost impossible to match.

Exe: Aircraft Manufacturing Industry.

New Trade Theory



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This theory supports that comparativeadvantage theory, it identifies and important source of CA (EOS)

New Trade theorists challenge the assumptionof diminishing returns to scale, and some arguethat using protectionist measures to build up

a huge industrial base in certain industries willthen allow those sectors to dominate the worldmarket

New Trade Theory



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New trade theory also stresses on role of luck,entrepreneurship and innovation in giving afirm FMA.

The most contentious implication of this theoryis the argument that it generates forgovernment intervention.

New Trade Theory

MGT-372 Lec-5 Int Trade Theory Part 1

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