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Growing importance of trade in world economy & foreign trade theories

International Trade and the World Economy


The world economy is taking big strides and moving ahead at a remarkable pace. Globalization has affected the economies of various nations. Due to the rapid development of efficient communication tools and increase in corporate events, economies worldwide are all set to adapt themselves to the dynamic market conditions. International trade and the world economy are two inseparable entities and need to be addresses simultaneously. Hence, an international trade system ought to be designed, which meets the requirements of the changing world economy.

Trends manifested in international trade and the world economy:


More and more companies are making their global presence felt by a strong network. This has given rise to diversification in international transactions. It may include direct investments, trade and services. There is an increase in economic activities in all nations. This has necessitated the introduction of certain guidelines, which govern international transactions. In the absence of these guidelines, there could be disharmony among the trading nations.Due to international capital movements, the lacunae prevailing in the economy of a particular country are revealed. This may affect the economy of other countries as well. This may happen through external assets, trade and investments.

Key factors in international trade and the world economy:


International trade can be referred to as successful, only when the trading nations are equally benefited. It is obligatory for a particular nation to have more production output for exporting goods to another nation. In the absence of trade, the relative prices of goods differ from one country to another. The relative prices, then indicate the comparative advantage. When there is trade, relative prices of commodities are equal. This is further ensured by arbitrage.

Benefit of International trade is enjoyed by both, the exporting nations as well as importing nations. Some feel that the commodities imported is the actual benefit of international trade, whereas, export activities involve a lot of expenses. The "Balance of Payments", including payment for services as well as goods; yearly capital fluxes entering in and moving out of a country, is more or less stable and remains in equilibrium and requires few adjustments. Studies have revealed that United States of America, has a highly competitive market, and by investing in America, the returns are good. International trade has reduced inequalities and facilitated growth in economy of different countries. Studies revealed that majority of the countries of the European Economic Community, manifested very little tendency towards convergence in income during the period 1870 through World War II.

Due to international trade, a new trend has been observed. Countries, all over the world are making all efforts to adhere to monetary policies, which have zero inflation, thereby reducing restrictions in trade worldwide. After conducting research on international trade, it was found out that if a particular nation reduces its tariffs, it is enough to boost long term growth of the other economies as well. However, if there is unanimous reductions in tariffs, the growth is even faster. It was also observed that , majority of the countries, adopted methods of ensuring growth on a long term basis. These countries, manifested a trend, where the levels of income were also high.

Theories of foreign trade


Theory of Mercantilism Absolute Advantage Theory Comparative Advantage Theory Hecksher-Ohlin Theory

The new product life cycle theory


The new Trade Theory Porters Diamond Model

Implications for International Business

Introduction
International trade theory explains why it is beneficial for countries to engage in international trade helps countries formulate their economic policy explains the pattern of international trade in the world economy

An Overview of Trade Theory


Question: What is free trade?
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

Mercantilism
A nations wealth depends on build up wealth of

Gold and silver as they were the currency of trade in that age.
Mercantilism (mid-16th century England) asserted that

it is in a countrys best interest to maintain a trade surplus, to export more than it imports Maximize export through subsidies Minimize imports through tariffs and quotas it 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) Stayed from 1500-1800, and trade strategy of many nations were boost exports and limit import.

Limitation of Mercantilism: Zero-Sum Game


In 1752, David Hume pointed out that: Increased exports lead to inflation and higher prices Increased imports lead to lower prices Result: Country A sells less because of high

prices and Country B sells more because of lower prices In the long run, no one can keep a trade surplus Mercantilism is problematic and not economically valid, yet many political views today have the goal of boosting exports while limiting imports

Theory of Absolute Advantage


Adam Smith 1723-1790

In 1776, Adam Smith in his book The Wealth Of Nations argued: Countries differ in their ability to produce goods efficiently. A country has an absolute advantage when it is the most efficient in producing a particular product. (Countries should specialize in producing products for which they have an absolute advantage, and trade these goods for those produced more efficiently by other countries.) Such trade will be beneficial to both countries. Thus it is a positive-sum game

Absolute Advantage: An Example


20 Ghana and South Korea can each produce and consume cocoa and rice. Each country has 200 units of resources
Ghana (G) has the resources to produce any combination of cocoa and/or rice that lies on its Production Possibility Frontier (PPF).
South Korea (K) has the resources to produce these combinations of cocoa and/or rice. Without trade, each country devotes half of its resources to each product (points A and B).

G 15 Cocoa 10

A K

B
2.5

5 Rice

G 10

K 15 20

Absolute Advantage: An Example of Gains from


Trade
Cocoa Rice
20 10 5.0 10.0 15.0 0.0 20.0 20.0 6.0 14.0 1.0 4.0

Resources Required to Produce 1 Ton of Cocoa and Rice. Production and Consumption without Trade.

Ghana S. Korea Ghana S. Korea Total Production

10 40 10.0 2.5 12.5 20.0 0.0 20.0 14.0 6.0 4.0 3.5

Production with Specialization

Ghana S. Korea Total Production

Consumption After Ghana Trades 6 Tons of Cocoa for 6 Tons of S. Korean Rice Increase in Consumption as a result of Specialization and Trade

Ghana S. Korea Ghana S. Korea

David Ricardo and Theory of Comparative Advantage


In 1817, David Ricardo in his book The Principles of Political Economy extended Smiths free trade argument:
A country should specialize in the production of goods that it produces

more efficiently in comparison to other goods even if the country doesnt hold an absolute advantage for that good. The country should import the goods it produces less efficiently, even if it can produce that good all by itself. Due to increased efficiency (better use of limited resources), potential world production is greater with unrestricted free trade. Comparative Advantage maximize countries combined output Therefore, free trade is universally beneficial (a positive-sum game) even when nations do not have an absolute advantage.

The Theory of Comparative Advantage


Ghana and South Korea can each produce and consume cocoa and rice. Ghana (G) produces both cocoa and rice, with a G comparative advantage in cocoa. South Korea (K) is more efficient in producing rice than cocoa a comparative advantage in C rice. Ghana is more efficient than S. Korea in the production of both cocoa and rice an A absolute advantage in both products. Without trade, each country would devote half of its resources to each product (points A and K B). With trade, and specialization in cocoa, Ghana B can produce at point C.
3.75 7.5

5
2.5

Cocoa 10

15

20

K 10 Rice

G 15 20

Comparative Advantage: An Example of Gains from Trade


Cocoa Rice
13.3 20 7.5 5.0 12.5 3.75 10.0 13.75 7.75 6.0 0.25

Resources Required to Produce 1 Ton of Cocoa and Rice. Production and Consumption without Trade (points A and B).

Ghana S. Korea Ghana S. Korea


Total Production

10 40 10.0 2.5 12.5 15.0 0.0 15.0 11.0 4.0 1.0

Production with Specialization (points C and K) Consumption After Ghana Trades 4 Tons of Cocoa for 4 Tons of S. Korean Rice Increase in Consumption as a result of Specialization and Trade

Ghana S. Korea Total Production Ghana S. Korea Ghana

S. Korea

1.5

1.0

Absolute Advantage Versus Comparative Advantage


Absolute advantage
Adam Smith's Absolute

Comparative advantage
But Comparative

Advantage can gain by production of one good A country enjoys an absolute advantage over another country in the production of a product if it uses fewer resources to produce that product than the other country does.

advantage can gain in production of more than one good


A country enjoys a

comparative advantage in the production of a good if that good can be produced at a lower cost in terms of

Assumptions for Absolute advantage and comparative advantage


The conclusion that free trade is universally beneficial is rather bold for such a simple model as previously shown. The model has many unrealistic assumptions, such as
There are only two economies, producing two goods. There are no transport costs. Resource prices are identical in the two countries. Trade does not affect income distribution within a country. Resources can move from the production of one good to

another within a country. There are constant returns to scale. That free trade does not change the efficiency with which a country uses its resources, or the stock of resources.

Limitations of Absolute advantage theory and comparative advantage theory


Immobile resources: Resources do not always move easily from one economic activity to another Diminishing returns: Diminishing returns to specialization suggests that after some point, the more units of a good the country produces, the greater the additional resources required to produce an additional item Different goods use resources in different proportions

Heckscher-Ohlin Theory
Comparative advantage arise from differences in

Productivity. Swedish economists Eli Heckscher (in 1919), and Bertil Ohlin (in 1933) had another explanation for comparative advantage. Comparative advantage did not stem from differences in productivity (as theorized by Ricardo), but from differences in national factor endowments. (the extent to which a country is gifted with resources such as land, labor, capital, human resources, capital) A country should export goods that intensively use factor endowments which are abundantly available in the country. A country should Import goods that make intensive use of factors which are scarce.

The Limitation of Heckscher-Ohlin Theory: The Leontief Paradox


The Leontief Paradox: In 1953 Wassily Leontief disputed

the Hechscher-Ohlin theory in some instances. The US is abundant in capital relative to most other nations. So, according to Hecksher-Ohlin, the US should be an exporter of capital-intensive goods, and an importer of labor-intensive goods. Actually, in 1953, US exports were less capital-intensive than US imports. Heckscher-Ohlin is a relatively poor predictor of realworld trade patterns. Ricardos theory is more accurate. In the end, differences in productivity may be the key to determining trade patterns.

Product Life-Cycle Theory - Raymond. Vernon (1966)


Most new products initially conceived & produced in the US in 20th century US firms kept production close to the market
Work out the innovations of new product introductions Demand not based on price yet so low production cost not

an issue

Limited initial demand in other advanced countries Exports more attractive than production in other countries
When demand increases in advanced countries Produce in foreign countries when demand necessitate

As developed market demand matures, new demand

comes from less developed countries


Product becomes standardized production moves to low production cost areas

Product now imported to US and to advanced countries

Product Life-Cycle Theory

Product Life-Cycle Theory - R. Vernon (1966)


Limitation: This theory was based upon what was occurring at that time in the US. Globalization and integration of the economy makes this theory less valid today.

The New Trade Theory


The New Trade Theory emerged in the 1970s. It deals with the returns on specialization where substantial economies of scale are present
Output increases with increased production. Economies of scale increase with increased output.

Unit costs of production should decrease along with

economies of scale.
The world economy will profitably support only a few

firms in industries with substantial economies of scale.

The first mover advantage.


Early entries to an industry may gain a lock on the market

as they are first to gain economies of scale; this discourages new entries the first mover advantage. 1. Because of economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods 2. In those industries Where demand become more crucial, the global market may only be able to support a small number of firms Important factors to first-mover advantage are:
luck
entrepreneurship innovation government intervention.

Limitation of first mover advantage


There may be an economic rationale for a strategic or

proactive trade policy if it helps domestic firms become first movers in an industry; this is in conflict with earlier free-trade theories

National Competitive Advantage: Porters Diamond

Michael Porter (1990), of HBS, tried to explain why a nation achieves international success in a particular industry Porter identified four attributes he calls the diamond that promote or impede the creation of competitive advantage 1. Factor endowments 2. Demand conditions 3. Related and supporting industries 4. Firm strategy, structure, and rivalry In addition, Porter identified two additional variables (chance and government) that can influence the diamond in important ways

Porters Diamond
The conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.
A nations position in factors of production, such as skilled labor or infrastructure necessary to compete in a given industry.

The nature of home demand for the industrys product or service.

The presence or absence in a nation of supplier industries or related industries that are nationally competitive.

Factor Endowments

Factor endowments: A nations position in

factors of production such as skilled labor or infrastructure necessary to compete in a given industry
Basic factor endowments (Natural resources, Climate, Geographic location, Demographics) Advanced factor endowments

Advanced Factor Endowments


Advanced factors: The result of investment by people, companies, and government are more likely to lead to competitive advantage
If a country has no basic factors, it must invest in advanced factors
Communications
Skilled labor Research

Technology
Education

Demand Conditions
Demand: creates capabilities creates sophisticated and demanding consumers
Demand impacts quality

and innovation

Related and Supporting Industries


Creates clusters of supporting industries that are

internationally competitive (like suppliers or related industries)

Firm Strategy, Structure and Rivalry


Long term corporate vision is a determinant of

success Management ideology and structure of the firm can either help or hurt you Presence of domestic rivalry improves a companys competitiveness

Porters Theory-Predictions
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

Implications for Business


Location implications:
Separate production activities to countries where they can be performed

most efficiently Ex: If design can performed most efficiently in France, it is where design facility should be kept.

First-mover implications:
Invest substantial financial resources in building a first-mover, or early-

mover advantage

Policy implications:
Promoting free trade is in the best interests of the home country, not

always in the best interests of the firm, even though many firms promote open markets

Thank you!

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