International Trade Theories

International Trade Theories
International Trade Theory

AN OVERVIEW OF TRADE THEORY Free trade refers to a situation where 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.
Reasons for international trade
Not self-sufficient as different resources owned / endowments
Higher quality of foreign goods

Cheaper product :It is cheaper to import a good than to produce it themselves.
The Basis for International Trade
The basis for international trade is that a nation can import a particular good or service at a lower cost than if it were produced domestically In other words, if you can buy it cheaper than you can make it you buy it This maxim is true for individuals and nations

The Benefits of Trade The theories of Smith, Ricardo and Heckscher-Ohlin show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. International trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, and import products that can be produced more efficiently in other countries

The Pattern of International Trade
Some patterns of trade are fairly easy to explain - it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Japan export automobiles, consumer electronics, and machine tools?

Trade Theory and Government Policy Trade theories lack agreement in their recommendations for government policy. Mercantilism makes a crude case for government involvement in promoting exports and limiting imports The theories of Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade New trade theory and Porters theory of national competitive advantage justify limited and selective government intervention to support the development of certain export-oriented industries
International Trade theories : MERCANTILISM

Mercantilism, which emerged in England in the mid16th century, asserted that it is in a countrys best interest to maintain a trade surplus, to export more than it imports. The doctrine of mercantilism was that gold and silver constitute national wealth
So, more exports would increase gold reserves and lead to a favourable balance of payments.
Decay of Gold standard reduced the validity of this theory.
MERCANTILISM
Mercantilism advocated government intervention to achieve a surplus in the balance of trade. It viewed trade as a zero-sum game, one in which a gain by one country results in a loss by another As an economic philosophy, mercantilism is problematic and not valid, yet many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade
International Trade theories : ABSOLUTE ADVANTAGE

In 1776, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game and argued that countries differ in their ability to produce goods efficiently, and that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it He strongly advocated FREE TRADE According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries Based on the principal of DIVISION OF LABOUR
What is Absolute Advantage?
The ability to produce a good using fewer resources than another country (same output with less input)
The meaning of absolute advantage is that a country is more productive than another country in producing a good (same input with more output).
Absolute Advantage

Absolute advantage deals with the ability of a country to turn inputs into outputs A country is said to have an absolute advantage if it takes less input to turn out a unit of a good than it does for another country. Hence a country should never produce a product that it can buy at a cheaper price from another country It is possible for one country to have an absolute advantage in everything or nothing
Absolute advantage : Justification / implications

Natural Distribution of resources Acquired advantage of technology and skill Regional Division of Labour Inefficiency in production can be avoided Benefit to Customers Industrial and National Development by increase in Global Productivity
Absolute Advantage model : Example
The theory is based on 2x2x1 model i.e 2 countries, 2 products and 1 factor of production-labour
Output per one day of labour Product/country Brazil tea coffee 20 kg 80 kg India 65 kg 25kg
Hence India has absolute advantage in production of tea and Brazil in coffee. Both countries are better off in producing only 1 product and trading it with another country for the second product.
Absolute Advantage : Criticism

Practically no absolute advantage Different Country Size Variety of resources Transport cost Absolute advantage for more than one products.
International Trade Theories : COMPARATIVE ADVANTAGE

In 1817, David Ricardo took Adam Smiths theory one step further by exploring what might happen when one country has an absolute advantage in the production of all goods According to Ricardos theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself
The Model of Comparative Advantage Trade is still possible and mutually beneficial even if one country has an absolute advantage over another in producing both goods, provided that each country enjoys a comparative advantage in the production of one good.
Comparative Advantage
Comparative advantage means that a country has a lower opportunity cost of producing a good than another country Every country must have a comparative advantage in something Specialization generates potential gains from trade that can make both trading partners better off.
Comparative Cost Advantage : Example
Assuming a single person can produce in 10 days :

Maximum possible production cotton India Bangladesh 100 units 40 units jute 100 units 80 units
India has an advantage in both cotton and jute. However, cotton : India is 2.5 times better Jute : India is 1.25 times better, Hence, India has comparatively more advantage in cotton .
Comparative Cost Advantage : Example
Continuing with the same example with differential wage rates in the two countries. COST COMPARISON country Product Wage Labour rate/day days 3 rs. 3 rs 10 10 Total wages 30 rs. 30 rs Total Cost per production unit 100 units 100 units 0.30 rs/unit 0.30 rs/unit 0.50 rs./unit 0.25 rs/unit
India
Cotton Jute
Banglad Cotton esh Jute
2 rs 2rs
10 10
20 rs. 20 rs.
40 units 80 units
Implications
1. 2. 3.
Efficient allocation of global resources Maximisation of global production at least possible cost Product prices become almost equal throught the world Better concept because it applies the principles of Division of labour Specialization Opportunity cost
Limitations
Limitation of 2x2x1 model Transportation cost ignored Factor mobility ignored Exchange rate fluctuations ignored Not applicable to trade in services Economic efficiency is not the sole aim of international trade Gains to both nations may in different ratios.

Technology and Opportunity Cost:
Production Requirements Camera Computer Opportunity Cost 1 Camera 1 Computer
Germany United States
8 hours 10 hours
160 hours 100 hours
1/20 computer 1/10 computer
20 cameras 10 cameras
Without Specialization and Trade:

Maximum Production Cameras Germany United States 25,000 20,000 or or Computers 1,250 2,000 Diversified Production* Cameras 12,500 10,000 and and Computers 625 1,000
*Assuming countries have 200,000 available hours and split their time evenly between cameras and computers.
With Specialization and Trade:

Specialized Production Cameras Computers Germany United States 25,000 --2,000 Consumption Cameras 12,500 12,500 and and Computers 625 1,375
*Assuming that Germany specializes in cameras, and the U.S. specializes in computers, and they trade 12,500 cameras for 625 computers (Trading price: 20 cameras = 1 computer).

United States
Computers
2,000
Germany
Computers
1,250 1,000
625
Cameras
10,000 20,000 12,500 25,000
Cameras
U.S. opportunity cost: 1 computer = 10 cameras
German opportunity cost: 1 computer = 20 cameras

United States
Computers
2,000
Germany
Computers
1,250 1,000
Potential Gains From Trade
Potential Gains From Trade
625
Cameras
10,000 20,000 12,500 25,000
Cameras
U.S. opportunity cost: 1 computer = 10 cameras
<
Mutually Beneficial Terms of Trade
<
German opportunity cost: 1 computer = 20 cameras
International Trade theories : Heckscher- Ohlin theory of Relative factor Endowments

Heckscher and Ohlin argued that comparative advantage arises from differences in national factor endowments Nations differ in factor endowments such as land, labour and capital and thus differ in factor costs also. The Heckscher-Ohlin theory predicts that countries will export goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce Eg: US rich in capital, India in labour, Saudi Arabia in oil reserves, south Africa in gold mines
Heckscher- Ohlin theory of Relative factor Endowments
Countries export those products which they can produce and sell at lower rates than the other countries. This price is indirectly dependent on factors of production : their availability and factor prices. If labour is available in abundance in relation to land and capital, the price of labour would be low and price of land and capital would be high.
Product price
Product Demand
Product Supply
Consumer wants
Price of other products
Consumers income
Production technology
Factor prices
Condition of factor ownership
Factor price
Factor demand
Factor supply
Implications
1. 2. 3.
Generally, abundant factor supply will be supported by low demand creating a favourable condition for international trade. This factor proportions theory implies he following relationships : Land labour relationship Labour capital relationship Technology- labour raltionships
Criticism
The Leontief Paradox In 1953, Wassily Leontief postulated that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods. However, he found that U.S. exports were less capital intensive than U.S. imports due to availability of skilled labour Since this result was at variance with the predictions of the theory, it has become known as the Leontief Paradox
Criticism
Ignores the role of product differentiation Based on 2x2x2 model , practically not possible Ignores international factor mobility As per this theory, trade would not occur among nations having similar factor endowments, however fact differs. Ingnores transportations costs and trade barriers

THE PRODUCT LIFE CYCLE THEORY In the mid-1960s, Raymond Vernon proposed the product life-cycle theory that suggested that as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade. Early in the life cycle of a typical new product, while demand is starting to grow in the U.S., demand in other advanced countries is limited to high-income groups, and so it is not worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the U.S. to those countries

Over time, demand for the new product starts to grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets U.S. firms might also set up production facilities in those advanced countries where demand is growing limiting the exports from the U.S. As the market in the U.S. and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon
Currency movements and the trade balance

Currency Appreciation: An increase in the value of a currency as measured by the amount of foreign currency it can buy. Currency Depreciation: A decrease in the value of a currency as measured by the amount of foreign currency it can buy.
Domestic goods become more expensive for foreigners.
Foreign goods become less expensive for domestic buyers.
Domestic goods become less expensive for foreigners.
Foreign goods become more expensive for domestic buyers.
Exports tend to fall.
Imports tend to rise.
Exports tend to rise.
Imports tend to fall.
Tendency toward Current Account Deficit
Tendency toward Current Account Surplus

Producers based in advanced countries where labor costs are lower than the United States might now be able to export to the U.S.If cost pressures become intense, developing countries begin to acquire a production advantage over advanced countries The United States switches from being an exporter of the product to an importer of the product as production becomes more concentrated in lower-cost foreign locations

Evaluating the Product Life Cycle Theory While the product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the US in the 1960s and 1970s, the increasing globalization and integration of the world economy has made this theory less valid in today's world.

NEW TRADE THEORY New trade theory suggests that because of economies of scale (unit cost reductions associated with a large scale of output) and increasing returns to specialization, in some industries there are likely to be only a few profitable firms Firms with first mover advantages (the economic and strategic advantages that accrue to many entrants into an industry) will develop economies of scale and create barriers to entry for other firms

Increasing Product Variety and Reducing Costs A nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods
Economies of Scale, First Mover Advantages, and the Pattern of Trade The pattern of trade we observe in the world economy may be the result of first mover advantages and economies of scale

NATIONAL COMPETITIVE ADVANTAGE: PORTERS DIAMOND Porters 1990 study tried to explain why a nation achieves international success in a particular industry and identified four attributes that promote or impede the creation of competitive advantage: Factor Endowments A nation's position in factors of production can lead to competitive advantage These factors can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how)
International Trade Theories Demand Conditions

The nature of home demand for the industrys product or service influences the development of capabilities Sophisticated and demanding customers pressure firms to be competitive Relating and Supporting Industries The presence supplier industries and related industries that are internationally competitive can spill over and contribute to other industries Successful industries tend to be grouped in clusters in countries - having world class manufacturers of semi-conductor processing equipment can lead to (and be a result of having) a competitive semi-conductor industry
Porters Diamond of competitive advantage

Firm Strategy, Structure, and Rivalry
The conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalry impacts firm competitiveness

Evaluating Porters Theory Government policy can affect demand through product standards, influence rivalry through regulation and antitrust laws, and impact the availability of highly educated workers and advanced transportation infrastructure. The four attributes, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage

FOCUS ON MANAGERIAL IMPLICATIONS There are at least three main implications for international businesses: location implications, first-mover implications, and policy implications. Location One way in which the material discussed in this chapter matters to an international business is the link between the theories and a firms decision about where to locate its productive activities It makes sense for a firm to disperse its various productive activities to those countries where they can be performed most efficiently

First Mover Advantages
Being a first mover can have important competitive implications, especially if there are economies of scale and the global industry will only support a few competitors

Government Policy Government policies with respect to free trade or protecting domestic industries can significantly impact global competitiveness Businesses should work to encourage governmental policies that support free trade

International Trade Theories

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International Trade Theories

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International Trade Theories

International Trade Theory

Reasons for international trade

Not self-sufficient as different resources owned / endowments

Higher quality of foreign goods

The Basis for International Trade