International Trade Theory

Chapter 4

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 International Trade Theory
Overview
Mercantilism
Absolute Advantage
Comparative Advantage
Heckscher-Olin Theory
Product Life Cycle Theory
New Trade Theory
Porters Diamond
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 1st British African colony to win
independence (1957).
Nkrumah espoused pan African
socialism.
High tariffs.
Anti-exporting policy.

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 Kept lowering tariffs on manufactured goods.
Created incentives to export.
Reduced quotas.
Reduced subsidies.
1950s: 77% of employment in agriculture.
Now 20%.
Manufacturing GNP went from 10% to over
30%.
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 The Impact of Trade Policies
Ghana Korea
1970 1970
GNP/capita GNP/per capita
$250 $260
1992 1992
GNP/per capita GNP/per capita
$450 $6790
GNP Growth/year GNP Growth/year
1.5% 9%
Shift from productive uses Shift from non-comparative
(cocoa) to unproductive uses advantage uses (agriculture)
(subsistence to productive uses (labor-
agriculture). intensive manufacturing).
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4-4
 An Overview of Trade Theory
Free Trade occurs when 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.
The Benefits of Trade allow a country to specialize
in the manufacture and export of products that can be
produced most efficiently in that country.
The Pattern of International Trade displays patterns
that are are easy to understand (Saudi Arabia/oil or
Mexico/labor intensive goods). Others are not so easy
to understand (Japan and cars).
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 Mercantilism: mid-16th century
A nations wealth depends on accumulated
treasure
Gold and silver are the currency
of trade.
Theory says you should have a
trade surplus.
Maximize exports through
subsidies.
Minimize imports through tariffs and
quotas.
Flaw: Zero-sum game.
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 David Hume - 1752
Increased exports leads 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.

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 Theory of Absolute Advantage
Adam Smith: Wealth of Nations (1776).
Capability of one country to produce more of a product
with the same amount of input than another country.
Produce only goods where you are most efficient, trade for
those where you are not efficient.
Trade between countries is, therefore, beneficial.
Assumes there is an absolute advantage
balance among nations.
Ghana/cocoa.

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 The Theory of Absolute
G
20
15 Advantage
Cocoa

A
10

Figure 4.1
K
5

B
G K
0 5 10 15 20
Rice
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The Theory of Absolute Advantage and
the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 20
S. Korea 40 10
Production and Consumption without Trade
Ghana 10.0 5.0
S. Korea 2.5 10.0
Total production 12.5 15.0
Production with Specialization
Ghana 20 0
S. Korea 0 20
Total production 20 20
Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice
Ghana 14.0 6.0
S. Korea 6.0 14.0
Increase in Consumption as a Result of Specialization and Trade
Ghana 4.0 1.0
S. Korea 3.5 4.0 Table 4.1
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 Theory of Comparative Advantage

David Ricardo: Principles of Political Economy

(1817).
Extends free trade argument
Efficiency of resource utilization leads to more productivity.
Should import even if country is more efficient in the
products production than country from which it is buying.
Look to see how much more efficient. If only comparatively
efficient, than import.
Makes better use of resources
Trade is a positive-sum game.
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 The Theory of Comparative
20 G Advantage
C
15
Cocoa

A
10

Figure 4.2
K
5

2.5 B
K G
0 3.75 5 7.5 10 15 20
Rice
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Comparative Advantage and the Gains from
Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 13.33
S. Korea 40 20
Production and Consumption without Trade
Ghana 10.0 7.5
S. Korea 2.5 5.0
Total production 12.5 12.5
Production with Specialization
Ghana 15 3.75
S. Korea 0.0 10.0
Total production 15 13.75
Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice
Ghana 11 7.75
S. Korea 4 6
Increase in Consumption as a Result of Specialization and Trade
Ghana 1.0 0.25
S. Korea 1.5 1.0 Table 4.2
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 Simple Extensions of the
Ricardian Model
Diminishing returns:
More a country produces, at some point, will
require more resources.
However:
Free trade can increase a countrys production
resources, and
Increase the efficiency of resource utilization.
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 Ghanas PPF under Diminishing
Returns
Cocoa G

Figure 4.3 G
0 Rice

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 The Influence of Free Trade on
the PPF
PPF2

PPF1
Cocoa

Figure 4.4 G
0 Rice

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 Is the Mercantilist Theory Still
Valid?
A qualified Yes.
Equate political power with economic
power and economic power with a trade
surplus.
Japan

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 Heckscher (1919)-Olin (1933)
Theory
Export goods that intensively use factor
endowments which are locally abundant.
Corollary: import goods made from locally scarce
factors.
Patterns of trade are determined by differences in
factor endowments - not productivity.
Remember, focus on relative advantage, not
absolute advantage.

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 The Leontief Paradox, 1953

Disputes Heckscher-Olin in some instances.

Factor endowments can be impacted by
government policy - minimum wage.
US tends to export labor-intensive products,
but is regarded as a capital intensive country.

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 Heckscher vs Ricardo
Economists prefer Heckscher on theoretical
grounds but is a relatively poor predictor of
trade patterns.
Ricardos Comparative Advantage Theory,
regarded as too limited for predicting trade
patterns, actually predicts them with greater
accuracy.
In the end, differences in productivity may be
the key to determining trade patterns.
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 Product Life-Cycle Theory
(Raymond Vernon, 1966)
Article in the Quarterly Journal of Economics.
As products mature, both location of sales and
optimal production changes.
Affects the direction and flow of imports and
exports.
Globalization and integration of the economy makes
this theory less valid.

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International Product Trade Cycle Model
High Income Countries production

Exports Imports consumption

Q
u 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

a Medium Income Countries Exports

n
t
i Imports
t 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

y Low Income Countries

Exports
Imports
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Time
New Product Maturing Product Standardized Product Figure 4.5
Stages of Production Development
4-22
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 The New Trade Theory
Began to be recognized in the 1970s.
Deals with the returns on specialization
where substantial economies of scale are
present.
Specialization increases output, ability to
enhance economies of scale increase.

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 Application of the New Trade
Theory
Typically, requires industries with high, fixed
costs.
World demand will support few competitors.
Competitors may emerge because they got
there first.
first-mover advantage.
Some argue that it generates government
intervention and strategic trade policy.
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 First-Mover Advantage
Economies of scale may preclude new
entrants.
Role of the government.

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 Founded 1915 by William Boeing
Largest commercial airplane manufacturer.
9,000 commercial jetliners in service.

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 Established 1967
Western Europe buying 25% of aircraft ,but
selling only 10%.
France, Germany, Great Britain
To date: 3,203 orders - 1,890 deliveries.

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 Airbus vs Boeing
Airplane Orders
800
700
600
500
Boeing
400
Airbus
300
200
100
0
85 86 87 88 89 90 91 92 93 94 95 96 97

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 Porters Diamond
(Harvard Business School, 1990)
The Competitive Advantage of Nations.
Looked at 100 industries in 10 nations.
Thought existing theories didnt go far enough.
Question: Why does a nation achieve
international success in a particular
industry?
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 Determinants of National
Competitive Advantage
Factor endowments:nations position in factors of production
such as skilled labor or infrastructure necessary to compete in a
given industry.
Firm strategy, structure and rivalry:the conditions in the
nation governing how companies are created, organized, and
managed and the nature of domestic rivalry.
Demand conditions:the nature of home demand for the
industrys product or service.
Related and supporting industries:the presence or absence in
a nation of supplier industries or related industries that are
nationally competitive.
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 Porters Diamond
Determinants of National Competitive Advantage

Firm Strategy,
Structure and
Rivalry

Factor Endowments Demand Conditions

Related and
Supporting
Figure 4.6 Industries
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 The Diamond
Success occurs where these attributes exist.
More/greater the attribute, the higher chance of
success.
The diamond is mutually reinforcing.

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 Factor Endowments
Taken from Heckscher-Olin
Basic factors:
natural resources,
climate,
location.
Advanced factors:
communications,
skilled labor,
technology.
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 Advanced Factor Endowments
More likely to lead to competitive
advantage.
Are the result of investment by
people, companies, government.

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 Relationship of Basic to
Advanced Factors
Basic can provide an initial advantage.
Must be supported by advanced factors to
maintain success.
No basics, then must invest in advanced
factors.

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 Demand Conditions
Demand creates the capabilities.
Look for sophisticated and
demanding consumers.
impacts quality and
innovation.

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 Related and Supporting
Industries
Creates clusters of supporting industries
that are internationally competitive.
Must also meet requirements
of other parts of the
Diamond.

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 Firm Strategy, Structure and
Rivalry
Management ideology can either help or
hurt you.
Presence of domestic rivalry improves a
companys competitiveness.

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 Evaluating Porters Theory
If Porter is right, country exports should
reflect the presence of the four diamond
components. Countries will import goods
from industries where some or all the
components are missing.
Too soon to tell.
rade
World T

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 Determinants of
National Competitive Advantage

Chance
Company Strategy,
Structure,
and Rivalry

Two external
factors that Factor Demand
influence the Conditions Conditions
four
determinants.
Related
and Supporting
Industries
Government
Source: Michael Porter, The Competitive Advantage of Nations

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 Porters diamond, but...
Double Diamond - look to attributes of
both countries.
Professor Alan Rugman, University of Toronto
Home country may sound good, but
Company can rely on the host country.
Neighboring countries can too.
Canada and the U.S.

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 Implications for Business
Location implications:makes sense to disperse
production activities to countries where they can be
performed most efficiently.
First-mover implications:It pays to invest
substantial financial resources in building a first-
mover, or early-mover, advantage.
Policy implications:promoting free trade is
generally in the best interests of the home-country,
although not always in the best interests of the firm.
Even though, many firms promote open markets.
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