MGT491 Midterm Notes Ch. 5: International Trade Theory

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1 MGT491 Midterm Notes Ch. 5: International Trade Theory In international trade, there are always winners and losers, but economists argue that the benefits to the winners outweigh the costs borne by the losers, so there is still a net gain to society. In the long run, free trade stimulates economic growth and raises living standards International trade theory was the driver behind the formation of the WTO and regional trade blocs like the EU and NAFTA AN OVERVIEW OF TRADE THEORY Mercantilism advocated that countries should simultaneously encourage exports and discourage imports o Old and largely discredited, but still remains in modern political debate and in trade policies of many countries first to explain why unrestricted free trade is beneficial to a country Free trade situation where 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 o Argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and exports o Imply that a laissez-faire attitude toward trade is in the best interests of a country Building on the theory of Smith, theory of comparative advantage by David Ricardo intellectual basis for the modern argument for unrestricted free trade th century by the Heckscher-Ohlin theory The Benefits of Trade Theories of Smith, Ricardo and Heckscher-Ohlin identify with precision the specific benefits of international trade It is beneficial for a country to engage in international trade, even for products it is able to produce for itself allows countries to specialize in the manufacture and export of products that can be produced more efficiently in that country, while importing products that can be produced more efficiently in other counties Import controls may benefit particular groups (such as domestic textile businesses and their employees) by keeping their jobs, these theories suggest that this action hurts the economy as a whole. Limits on imports are often in the interests of domestic producers but not domestic consumers The Pattern of International Trade Climate and natural resource endowments explain why certain countries produce/export the things they do productivity; H-O theory emphasizes the interplay between the proportions in which the factors of production (land, labour, and capital) are available in different countries and the proportions in which they are needed for producing particular goods. rests on the assumption that countries have varying endowments of the various factors of production. Product life cycle theory suggests that early in their life cycle, most new products are produced in and exported from the country in which they were developed. As it becomes more widely accepted internationally, production starts in other countries. Product may ultimately be exported back to the country of its original innovation. New trade theory stresses that in some cases countries specialize in the production and export of particular products not because of underlying differences in factor endowments but because in certain industries the world market can only support a certain number of firms o Ex. aircraft industry attempts to explain why particular nations achieve international success in particular industries in addition to factor endowments, he points out the importance of production and export of particular products. Trade Theory and Government Policy All these theories agree that international trade is beneficial to a country ut lack agreement in their recommendations for government policy Mercantilism government involvement in promoting exports and limiting imports Smith/Ricardo/H-O theories unrestricted free trade, argument is that both import controls and export incentives are self-defeating and result in wasted resources

2 justifying some limited government intervention to support the development of certain export-oriented industries MERCANTILISM England, mid 16 th century export more than it imports Accumulate $$, increase national wealth, prestige, power Advocates government intervention to achieve a surplus in the balance of trade No virtue in large volume of trade, recommended policies to maximize exports and minimize imports imports limited by tariffs and quotes, exports were subsidized Flaw: viewed trade as a zero-sum game (one in which a gain by one country results in a loss by another) Adam smith and David Ricardo showed how this approach was short-sighted and demonstrated that trade is a positive-sum game, where all countries can benefit Mercantilism is not dead Neo-mercantilists equate political power with economic power, and economic power with a balance-of-trade surplus Many nations have adopted a neo-mercantilist strategy that is designed to simultaneously boost exports and limit imports ex. China deliberately keeping its currency low against the US dollar in order to sell more goods to the US, therefore getting a trade surplus and foreign exchange reserves. ABSOLUTE ADVANTAGE Adam smith argued that countries differ in their ability to produce goods efficiently. manufacturers. Due to favourable climate, good soils, and accumulated expertise, the Frenc most efficient wine producers. o The English had an absolute advantage in the production of textiles, the French had an absolute advantage in the production of wine o Country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it. Countries should specialize in the production of goods for which they have an absolute advantage, and then trade these for goods produced by other countries Country should never produce goods at home that it can buy at a lower cost from other countries By specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade Production possibility frontier PPF graph that shows the different combinations of goods that a country can produce given the inputs required and the total resources available o If neither country trades with any other, each country must divide its resources to produce everything it needs, can produce much less of everything o If they focus on producing what they do best, they can make much more and export that which they As a result of specialization and trade, output of both products is increased, consumers in both nations are able to consume more therefore trade is a positive-sum game, produces net gains for all involved COMPARATIVE ADVANTAGE absolute advantage in the production of all goods 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. Without trade, combined production is lower; each country must consume what it produces. With trade, two countries can increase their combined production of goods, and consumers in both nations can consumer more of both goods. The Gains from Trade If each country produces what they have the comparative advantage at producing, this increases output. Combined output of both countries is increased. Both countries benefit - consumption in both countries can increase as a result of specialization and trade Potential world production is greater with unrestricted free trade than it is with restricted trade ons on trade, even in countries that lack an absolute advantage in any good

3 The theory of comparative advantage suggests that trade is a positive-sum gave in which all countries that participate realize economic gains Qualifications and Assumptions This model has been simplified in assuming that there are only 2 countries and 2 goods o Assumed no transportation costs between countries o Assumed no differences in prices of resource in different countries, exchange rates, assuming they can be swapped on a one-to-one basis o Assumed that resources can move freely from production of one good to another within a country o Assumed constant returns to scale specialization has no effect on the amount of resources required, in reality: both diminishing and increasing returns to specialization exist amount required may increase or decrease as a nation specializes in production of that good o a country uses its resources o Assumed no effects of trade on income distribution Conclude that free trade is mutually beneficial this basic model can be generalized to the world with many countries producing many different goods Suggested that in certain circumstances, a rich country might actually be worse off by switching to free trade with a poor nation Extensions of the Ricardian Model Relax the assumptions that resources move freely from the production of one good to another within a country, that there are constant returns to scale, a efficiency with which they are used. Immobile Resources: o o Ex. often a country will produce less of some labour-intensive goods like textiles, and more of knowledge-intensive goods like computer or biotech products. Country as a whole will gain, but textile producers will lose. o Creates friction and human suffering o Theory predicts that the benefits of free trade outweigh the costs by a significant margin, but this o Political opposition for adoption of free trade usually comes from those whose jobs are most at risk o Governments sometimes help to ease the transition by helping retrain those people who lost their jobs as a result of the move to free trade system Diminishing Returns o Constant returns to specialization units of resources required to produce a good are assumed to remain constant no matter o More realistic to assume diminishing returns to specialization occur when more units of resources are required to produce each additional unit of goods. o PPF for diminishing returns looks like right side of a rainbow arch o Diminishing returns are more realistic because: Not all resources are of the same quality as a country tries to increase its output of a certain good, it is increasingly likely to draw on marginal resources whose productivity is not as great than those initially employed. (ex. might have to use less fertile land to expand farming space), must use more land to produce the same amount of product as you could in a smaller space of better land. Different goods use resources in different proportions ex. amount of land required vs. amount of labour required. o Not feasible for a country to specialize to the degree suggested by the simple Ricardian model above, because diminishing returns to specialization suggests that gains from specialization are likely to be exhausted before specialization is complete o Worthwhile to specialize until the point where diminishing returns outweigh the resulting gains from trade Dynamic Effects and Economic Growth: o which it utilizes those resources o Opening an economy to trade is likely to generate dynamic gains: abroad become available for use

4 Increase the efficiency with which a country uses its resources Ex. economies of large-scale production might become available as trade expands the size of the total market available to domestic firms Opening to competition might stimulate domestic producers to look for ways to increase efficiency o o Suggests that opening an economy to free trade not only results in static gains but results in dynamic gains that stimulate economic growth Samuelson Critique o Argued that in some circumstances, dynamic gains can lead to an outcome that is not so beneficial o Samuelson model suggests that in cases where a rich country enters into a free trade agreement with a poor country, and there is a dynamic gain in the efficiency with which resources are used in the poor country, the lower prices paid by rich country consumers may not be enough to produce a net gain for the rich country economy because the dynamic effect of free trade might be the need to lower wages in the rich country o Concern about ability to transfer service jobs offshore that were not traditionally internationally mobile, such as software troubleshooting, call centres, etc. (even MRI analysis) o Recent advances in communications technology have made this trend possible o According to Samuelson, effect on middle class wages in the US may be that there may be a lowering of the market clearing wage rate, perhaps by enough to outweigh the positive benefits of international trade o Introducing protectionist measures (trade barriers) to guard against the theoretical possibility that free trade may harm the US in the future may produce a situation worse than the problem these protectionists are trying to prevent o Critique of his fears: developing nations are unlikely to be able to upgrade the skill level of their Evidence for the Link Between Trade and Growth: o As predicted by the standard theory of comparative advantage, countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade o nship between strong association between them, for developing and developed countries open economies grow faster o Message: adopt an open economy and embrace free trade, and the nation will be rewarded with higher economic growth rates. Higher growth will raise income levels and living standards For every 10% increase in the importance of international trade in an economy, average income levels will rise by at least 5%. o Short-term adjustment required to adopting free trade, but it produces greater economic growth and higher living standards in the long run HECKSCHER-OHLIN THEORY H-O argued that comparative advantage arises from differences in national factor endowments Factor endowments extent to which a country is endowed with resources such as land, labour, and capital. Nations have varying factor endowments, different factor endowments explain differences in factor costs, specifically Theory predicts that countries will export those goods that make intensive use of factors that are locally scarce Says that free trade is beneficial, however argues that the pattern of international trade is determined by differences in factor endowments, rather than differences in productivity Ex. US exports agricultural goods, reflecting its abundance of arable land. China exports goods produced in labour-intensive manufacturing industries such as textiles and footwear, reflecting its abundance of low cost labour. It is not absolute endowments, but relative endowments that are important a country may have larger absolute amounts of land and labour than another country, but be relatively abundant in one of them. Leontief Paradox H-O theory is one of the most influential theoretical ideas in international economics Most economics prefer the H- Using the H-O theory, Leontief postulated that since the US was relatively abundant in capital compared to other nations, the US would be an exporter of capital-intensive goods and an importer of labour-intensive

5 goods. However, found that US exports were less capital intensive than US imports. This result is at variance Possible explanation is that the US has a special advantage in producing new products or goods made with innovative technologies, which may be less capital intensive than products whose technology has matured and become suitable for mass production HO theory is better on theoretical grounds, but is a relatively poor predictor of real-world international trade de patterns with greater accuracy. May be that the US exports commercial aircraft and imports textiles, not because its factor endowments are suited to aircraft manufacture and not to textile manufacture, but because the US is relatively more efficient at producing aircraft than textiles. Differences in technology may lead to differences in productivity, which drives international trade patterns. Once differences in technologies across countries are controlled for, countries do in fact export those goods that make intensive use of factors that are locally abundant, and import foods that make use of factors that are locally scarce. THE PRODUCT LIFE-CYCLE THEORY Based on the observation that for most of the 20 th products had been developed by US firms and sold first in the US market. Argued that the wealth and size of the US market gave US firms a strong incentive to develop new consumer products High cost of US labour gave US firms an incentive to develop cost-saving process innovations the US could be produced abroad at lower cost and then exported back into the US Most new products initially produced in the US of decision making, given the uncertainty and risks inherent in producing new products Demand for most new products tends to be based on non-price factors firms can charge relatively high prices for new products which alleviates the need to look for low cost production sites in other countries Early in the life cycle of a typical new product, while demand is starting to grow rapidly in the US, demand in other advanced countries is limited to high-income groups start producing the new product, but it does necessitate some exports from the US to those countries Over time, demand for the new product grows in other advanced countries, as it does; it becomes worthwhile for foreign producers to being producing for their home market. Also, US firms might set up production facilities in those advanced countries where demand is growing. Production within other advanced countries limits the potential for exports from the US. As the market in the US and other advanced nations matures, product becomes more standardized, price becomes main competitive point. Cost considerations start to play a greater role in the competitive process; producers based in countries where labour costs are lower than in the US might be able to export to the US. Then those other countries might lose their competitive edge as developing countries like Thailand acquire production advantage over advanced countries Locus of global production initially goes from US to other advanced nations then to developing countries Over time the US switches from being an exporter to an importer of the same product *see fig. 5.5 p. 185* Evaluating the Product Life Cycle Theory Historically, this theory is a pretty good explanation of international trade patterns Mature industries tend to go out of the US and into low-cost assembly locations (ex. Xerox p. 184) Weakness: view that most new products are developed and introduced in the US is ethnocentric o This may have been a bit more realistic during the US dominance of the global economy many years ago, but many exceptions, especially in recent years o Many new products now first introduced in Japan or Europe o With increased globalization and increased integration of world economy, growing number of new products are introduced simultaneously in the US, Japan and advanced European nations o Global product introductions may be accompanied by globally dispersed production o Particular components of a new product being produced wherever around the globe the mix of factor costs and skills is most favourable (as predicted by the theory of comparative advantage) Therefore, this theory may be useful for explaining the pattern of international trade during the brief period of American global dominance, but now relevance is limited in the modern world.

6 NEW TRADE THEORY Emerged when a number of economists pointed out that the ability of firms to attain economies of scale might have important implications for international trade Economies of scale unit cost reductions associated with a large scale of output o Number of sources, including ability to spread fixed costs over a large volume, ability of large volume producers to utilize specialized employees and equipment that are more productive than less specialized equipment and employees. o Major source of cost reductions in many industries New trade theory has 2 important points: o Through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average costs of those goods o In industries when the output required to attain economies of scale represents a significant proportion of total world demand, the global market may only be able to support a small number of enterprises, thus world trade in certain products may be dominated by countries whose firms were first movers in production. Increasing Product Variety and Reducing Costs When nations trade with each other, individual national markets are combined into a larger world market As the size of the market expands due to trade, individual firms may be able to better attain economies of scale Implication is that each 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 also increase the variety of goods available to its consumers and lower the costs of these goods. Trade offers an opportunity for mutual gain even when countries do not differ in their resource endowments or technology Consumers benefit from having access to products that were not available before international trade, and from the lower price for the product that could not be produced at the most efficient scale before international trade. Trade is mutually beneficial because it allows for the specialization of production, the realization of scale economies, the production of a greater variety of products, and lower prices 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 economies of scale and first mover advantages. First mover advantages economic and strategic advantages that come to early entrants into an industry. o Ability to capture scale economies ahead of later entrance, benefit from lower cost structure New trade theory says that for those products where economies of scale are significant and represent a substantial portion of world demand, first movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match Countries may dominate in the export of certain goods because economies of scale are important in their production, and because firms located in those countries were the first to capture scale economies, giving them a first-mover advantage Ex. airbus and Boeing p. 187 airbus may have captured a first-mover advantage based on scale economies that will be difficult for rivals to match, and that will result in the EU becoming the leading exporter of very large jet aircraft Implications of New Trade Theory Theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology Trade allows a nation to specialize in the production of certain products, attaining scale economies and lowering the costs of producing those products, while buying products that it does not produce from other nations that specialize in the production of other products Variety of products available to consumers in each nation is increased; average costs of those products should fall, along with price, freeing resources to produce other goods and services. Also suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good able to gain economies of scale, first movers may get a lock on the world market that discourages subsequent entry o o Dominance is further reinforced because global demand may not be sufficient to profitably support another producer.

7 New trade theory is at a variance with the H-O theory, which suggests that a country will predominate in the export of a product when it is particularly well endowed with those factors used intensively in its manufacture o New trade theorists argue that the US is a major exporter of commercial jet aircraft not because it is better endowed with the factors of production required to manufacture aircraft, but because it was one of the first movers in the industry New trade theory is not at a variance with the theory of comparative advantage economies of scale increase productivity, therefore the new trade theory identifies an important source of comparative advantage Useful theory for explaining trade patterns trade increases the specialization of production within an industry, increases the variety of products available to consumers, results in lower average prices shown by empirical studies o Suggested that the existence of first-mover advantages is an important factor in explaining the dominance of firms from certain nations in specific industries o Number of firms is very limited in many global industries, including the chemical industry, heavy construction equipment, heavy truck, tire, consumer electronics, jet engine, computer software. Argument generated for government intervention and strategic trade policy o New trade theorists stress the role of luck, entrepreneurship and innovation in giving a firm first mover advantages o Rationale for government intervention by the sophisticated and judicious use of subsidies, a government could increase the chances of its domestic firms becoming first movers in newly emerging industries, such as the US government apparently did with Boeing. Porter tried to determine why some nations succeed and others fail in international competition trade told only part of the story Essential task was to explain why a nation achieves international success in a particular industry why does Japan do so well in the auto industry, Switzerland in precision instruments and pharmaceuticals, Germany and the US in chemical industry Porter theorizes that 4 broad attributes of a nation shape the environment in which local firms compete, these attributes promote or impede the creation of competitive advantage: o Factor endowments infrastructure necessary to compete in a given industry o Demand conditions o Relating and supporting industries presence or absence of supplier industries and related industries that are internationally competitive o Firm strategy, structure, and rivalry conditions governing how companies are created, organized, and managed and the nature of domestic rivalry Firms are most likely to succeed in industries or industry segments where the diamond is most favourable The diamond is a mutually reinforcing system the effect of one attribute is contingent upon the state of other attributes Ex. favourable demand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firms to respond to them See p. 189 fig. 5.6 the diamond 2 additional variables can influence the national diamond: o Chance events major innovations, can reshape industry structure and provide the opportunity for o Government by its choice of policies, can detract from or improve national advantage. Ex. regulation can alter home demand conditions, anti-trust policies can influence the intensity of rivalry within an industry, and government investments in education can change factor endowments. Factor Endowments Porter does not propose anything radically new from the HO theory, but he analyzes the characteristics of factors of production Hierarchies among factors, distinguished between basic factors (ex. natural resources, climate, location, demographics) and advanced factors (communication infrastructure, sophisticated and skilled labour, research facilities, technological know-how) Advanced factors are the most important for competitive advantage o Product of investment by individuals, companies, and governments

8 o Government investments in basic and higher education, by improving the general skill and advanced factors Relationship between advanced and basic factors is complex basic factors can provide an initial advantage that is subsequently reinforced and extended by investment in advanced factors o Disadvantages in basic factors can create pressures to invest in advanced factors o Ex. Japan lacks arable land and mineral deposits, through investment has built a substantial endowment of advanced factors o Demand Conditions Emphasizes the role home demand plays in upgrading competitive advantage Firms are typically most sensitive to needs of their closest customers Characteristics of home demand are important in shaping the attributes of domestically made products and creating pressures for innovation and quality pressure on local firms to meet high standards of quality and to produce innovative products o Ex. digital cameras in Japan, cell phones in Finland and Sweden Related and Supporting Industries Presence of suppliers or related industries that are internationally competitive Benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, helping it achieve a strong competitive position internationally Consequence of this process is that successful industries within a country tend to be grouped into clusters of related industries German textile and apparel sector Such clusters are important because valuable knowledge can flow between the firms within a geographic cluster, benefitting all within that cluster Knowledge flows occur when employees move between firms within a region and when national industry associations bring employees from different companies together for conferences or workshops Firm Strategy, Structure, and Rivalry Different nations are characterized by different management ideologies, which either help them or not to build national competitive advantages. o Ex. predominance of engineers in top management at German and Japanese firms design o Predominance of people with finance backgrounds leading many US firms, linked this to lack of attention to improving manufacturing processes and product design, overemphasis on maximizing short-term financial returns o Consequence of these different management ideologies relative loss of US competitiveness in those engineering-based industries where manufacturing processes and product design issues are all-important (like the auto industry) Strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry o Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competitors o Domestic rivalry creates pressures to innovate, improve quality, reduce costs, invest in upgrading advanced factors o Helps create world-class competitors Degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry Presence of all 4 components is usually required for this diamond to boost competitive performance Government can influence each of the 4 components of the diamond either positively or negatively o Factor endowments can be affected by subsidies, policies toward capital markets, education, etc. o Can shape domestic demand through local product standards or with regulations that mandate or influence buyer neds

9 o Influence supporting and related industries through regulation o Influence firm rivalry through devices like capital market regulation, tax policy, antitrust laws If porter is correct, expect his model to predict the pattern of international trade we observe in the real world o Countries should be exporting products from industries where all 4 components of the diamond are favourable, importing in those areas where the components are not favourable o Best to use this theory, with the new trade theory, the theory of comparative advantage, and the HO theory in conjunction with each other to learn about the pattern of international trade IMPLICATIONS FOR MANAGERS 3 main implications for international businesses: location implications, first-mover implications, and policy implications Location Underlying most of the theories is the notion that different countries have particular advantages in different productive activities From a profit perspective, makes sense for a firm to disperse its productive activities to those countries where, according to the theory of international trade, they can be performed most efficiently Result is a global web of productive activities, with different activities being performed in different locations around the world, depending on considerations of comparative advantage, factor endowments, etc. Example: production of a laptop: 4 steps: o Research and development of the product design requires a pool of highly skilled and educated workers, 2 countries that have comparative advantage in this are Japan and the US so producers will locate their R&D facilities in one or both of those countries o Manufacture of standard electronic components capital intensive process requiring semiskilled labour, cost pressures are intense. Best locations for this are Taiwan, Malaysia, South Korea, pools of relatively skilled, moderate cost labour. o Manufacture of advanced components capital intensive requiring skilled labour. Cost pressures not so intense at this stage, components can be and are manufactured in countries with high labour costs that have pools of highly skilled labour (Japan and US) o Final assembly relatively labour-intensive process requiring low-skilled labour, cost pressures are intense. May be carried out in a country such as Mexico, which has an abundance of low-cost, lowskilled labour. By dispersing production activities to different locations around the world, the US manufacturer is taking advantage of the differences between countries identified by the various theories of international trade First-Mover Advantages According to new trade theory, firms that establish a first-mover advantage with regard to the production of a particular new product may subsequently dominate global trade in that product Particularly true in industries where the global market can profitably support only a limited number of firms, such as the aerospace market Also important in less concentrated industries such as the market for cell phone equipment Clear that it pays to invest substantial financial resources in trying to build a first mover or early mover advantage, even if that means several years of losses before a new venture becomes profitable Idea is to pre-empt the available demand, gain cost advantages related to volume, build an enduring brand ahead of later competitors, and establish long-term sustainable competitive advantage Government Policy Firms are major players on the international trade scene Business firms produce exports, import products of other countries Pivotal role in international trade, businesses can exert a strong influence on government trade policy, lobbying to promote free trade or trade restrictions Promoting free trade is generally in the best interest of a country but may not always be in the best interest of an individual firm o Ex. US government intended to place a tariff on Japanese imports of LCD screens, but IBM and Apple protested, saying that it is the lowest cost source of LCD screens, they used them in their own laptops, and by increasing the cost of the screens through tariffs it raises the price and makes them less competitive in the world market the tariff designed to protect US firms would be selfdefeating

10 Businesses do not always lobby for free trade in the US, restrictions of imports of steel are the result of US on the government Antidumping actions justify tariffs on imports from other nations As international trade theory predicts, many of these agreements have been self-defeating, like some voluntary restrictions tage also contains policy implications o It is in the best interest of business for a firm to invest in upgrading advanced factors of production, ex. to invest in better training for its employees and increase commitment to research and development o Also in best interests of a business to lobby the government to adopt policies that have a favourable impact on each component of the national diamond o Urge governments to increase investment in education, infrastructure, and basic research, and adopt policies that promote strong competition within domestic markets since this makes firms stronger international competitors. See chapter summary p