In this topic, you will explore global patterns of international trade and : Learn about mercantilism the earliest theory of international trade.

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2 In this topic, you will explore global patterns of international trade and : Learn about mercantilism the earliest theory of international trade. Address the theories of absolute and comparative advantage. And understand more recent trade theories and their implications for international business. 2

3 International trade is defined as the purchase, sale, or exchange of goods and services across national borders. We can measure the importance of trade to a nation by examining its trade volume relative to its total output. The main benefits of international trade are that: It provides a country s people with a greater choice of goods and services. and It creates new entrepreneurial opportunities and creates jobs. 3

4 Today, world merchandise exports are valued at more than $16 trillion and service exports total nearly $3.8 trillion. Trade in merchandise is around 80% of total world trade, whereas services account for around 20%. And while higher world economic output encourages international trade, lower output slows trade. Over time, we see that world trade expands at a rate that is faster than growth in world output. 4

5 This table shows the world s largest exporters of merchandise and services. Perhaps not surprisingly, the United States ranks third in merchandise exports (behind Germany and China). United Kingdom ranks ahead of USA with regard to export of Services e.g. insurance, freight, finance 5

6 Trade volume and world output data provide insights into the international trade environment, but do not disclose who are a nation s trading partners. There is a persistent pattern of merchandise trade among nations. Trade between the world s high-income economies accounts for roughly 60 percent of total world merchandise trade. Trade between high-income countries and low- and middle-income nations accounts for around 34 percent of world merchandise trade. And Trade between low- and middle-income nations accounts for only about 6 percent of world merchandise trade. 6

7 This table gives us a more detailed idea of who trades with whom. Nearly 70 percent of Europe s exports are destined for other European nations. By contrast, intra-regional exports account for less than 56 percent of all exports in Asia, and less than 38 percent of exports in North America. We also see that whereas 28.6 percent of all merchandise entering North America comes from Asia, just 9.6 percent of all merchandise headed to Asia originates in North America. Although this trade is clearly lopsided, these figures should change as Asian economies continue to develop and consumer purchasing power rises. 7

8 Countries range from total trade dependence at one extreme and total independence at the other extreme. The trade of developing and transition nations often depends on their developed neighbors with whom they share borders. For example, Germany is the single most important trading partner of several central and eastern European nations. Dependency on trade with another nation is similar to other dependency situations: When times are good in the nation depended upon, times are often good for the dependent nation. But hard times in a nation depended upon (such as periods of economic recession or political turmoil) often spells trouble for a dependent nation. 8

9 Answer: Trade among high-income economies accounts for roughly 60 percent of total world merchandise trade. Trade between high-income countries and low- and middle-income nations accounts for about 34 percent of world merchandise trade. Intra-regional trade accounts for nearly 70 percent of Europe s exports, 56 percent of Asia s exports, and 38 percent of North America s exports. Some economists call this the Pacific century, referring to the expected future growth of Asian economies and expected shift in trade flows from the Atlantic to the Pacific Ocean. 9

10 It was not until the fifteenth century that people first put forth formal explanations for why trade occurs. Today, trade experts continue to refine existing trade theories and develop new ones. Let s now explore some of these main theories. 10

11 The trade theory of mercantilism argues that nations should accumulate financial wealth, usually in the form of gold, by encouraging exports and discouraging imports. European sea-faring nations practiced mercantilism from around 1500 to the late 1700s. These countries acquired colonies in Africa, Asia, and the Americas as sources of inexpensive raw materials and as markets for higher-priced finished goods. Mercantilist nations used profits from this trade to create armies and navies to control colonies and protect their shipping. 11

12 There are several main problems inherent in mercantilism: One flaw is that it views international trade as a zero-sum game. This is the idea that a nation benefits from trade only at the expense of other nations. Also, market potential in the colonies was less than it could have been had people there received higher prices for their resources. These actions, in turn, constrained the potential output and consumption for both the colonies and the mercantilist nations. 12

13 Absolute advantage is the ability of a nation to produce a good more efficiently than any other nation. This means that the nation can produce a greater amount of output using the same amount of, or fewer, resources. Assume a world of two countries (Riceland and Tealand), two products (rice and tea), where transporting goods costs nothing, and each nation produces and consumes its own rice and tea. In Riceland, one resource unit produces one ton of rice or one-fifth of a ton of tea. In Tealand, one resource unit produces one-sixth ton of rice or one-third ton of tea. Therefore, Riceland has an absolute advantage in rice production and Tealand has an absolute advantage in tea production. 13

14 Assume that Riceland and Tealand expend additional resource units to produce extra rice and tea, respectively, and then trades its additional output with the other nation on a one-to-one basis. This means that Riceland expends an additional resource unit to produce one extra ton of rice that it then trades with Tealand to obtain one ton of tea. Riceland gets four-fifths of a ton more tea than the one-fifth of a ton it would have produced itself with one additional a resource unit. Likewise, Tealand expends an additional resource unit to produce an extra one-third of a ton of tea that it then trades with Riceland to obtain one-third of a ton of rice. Tealand gets one-sixth of a ton more rice than the one-sixth of a ton it would have produced itself with one additional resource unit. Specialization and trade gives Riceland five times more tea than it would have produced itself, and gives Tealand two times more rice than it would have produced itself. Therefore, if each country specializes in the area in which it has an absolute advantage, world output (and consumption) of both goods increases. In other words, each nation benefits from specialization and trade. 14

15 Comparative advantage is the inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other good. This means that a country is less efficient in the production of all goods, but it is the least inefficient in the production of one good. Again, assume a world of two countries, two products, and where transporting goods costs nothing. In Riceland, one resource unit produces one ton of rice or one-half of a ton of tea. In Tealand, one resource unit produces one-sixth of a ton of rice or one-third of a ton of tea. Therefore, Riceland has absolute advantages in both goods because it is more efficient at producing each one. However, Tealand has a comparative advantage in tea production because it produces tea more efficiently than it produces rice. 15

16 Again, assume that Riceland and Tealand expend additional resource units to produce extra rice and tea, respectively, and then trades its additional output with the other nation on a one-to-one basis. This means that Riceland expends an additional resource unit to produce one extra ton of rice that it then trades with Tealand to obtain one ton of tea. Riceland gets one-half of a ton more tea than the one-half of a ton it would have produced itself with one additional a resource unit. Likewise, Tealand expends an additional resource unit to produce an extra one-third of a ton of tea that it then trades with Riceland to obtain one-third of a ton of rice. Tealand gets one-sixth of a ton more rice than the one-sixth of a ton it would have produced itself with one additional resource unit. Specialization and trade gives Riceland two times more tea than it would have produced itself, and gives Tealand two times more rice than it would have produced itself. Therefore, if Riceland holds an absolute advantage in the production of each good and Tealand holds a comparative advantage in the production of one good, world output (and consumption) of both goods increases. In other words, each nation can still benefit from specialization and trade. 16

17 The theories of absolute and comparative advantage focus on production efficiency, or productivity. Despite their powerful predictive capabilities, these are limited by their assumptions that: Nations are only driven to maximize their production and consumption; when governments get involved in trade for many reasons, including a concern for workers jobs. Only two nations are engaged in the production and consumption of two goods; when more than 180 countries and countless products are produced, traded, and consumed. It costs nothing to transport goods; when transportation costs are a major expense of international trade. Labor is the only resource in production and cannot cross national borders; when production clearly needs additional resources and labor is increasingly mobile. Adh And that specialization ili i does not result lin efficiency ffii gains; when specialization ili i actually increases knowledge of a task and causes future improvements. 17

18 To recap When a nation cannot produce a good more efficiently than other nations, but it can produce that good more efficiently than it does any other good, we say this is a case of Comparative advantage 18

19 Whereas the absolute and comparative advantage theories focus on productivity, factor proportions theory concentrates on factors of production. Factor proportions theory says that countries produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply. It predicts that a country will specialize in products that require labor if its cost is low relative to that of land and capital, and vice versa. The theory seems common sense Australia has abundant land and a small population, and its exports consist of products that require land while its imports consist of manufactured and consumer goods. 19

20 But a researcher named Wassily Leontief explored whether the United States, as predicted by the theory, exports goods requiring capital-intensive production and imports goods requiring labor-intensive production. He found that the United States exports require more, not less, labor-intensive production than its imports. This apparent contradiction became known as the Leontief Paradox. A possible explanation is that the theory considers a country s production factors to be homogeneous particularly labor although although labor skills vary greatly within a country. 20

21 The international product life cycle theory states that a company will begin exporting its product and later undertake foreign direct investment as the product moves through its life cycle. This means that a country s export will eventually become its import. The product life cycle theory is broken into three stages: In stage 1, the new product stage, high purchasing power and buyer demand encourage a company to design and introduce a new product concept. Although there is virtually no export market initially, exports increase late in this stage. In stage 2, the maturing product stage, the domestic market and markets abroad become fully aware of the existence of the product and its benefits. Demand rises and is sustained over a fairly lengthy period of time. Near the end of this stage, sales begin in developing nations and manufacturing is established there. In stage 3, the standardized product stage, competition from companies selling similar products pressures companies to lower prices to maintain sales levels. An aggressive search for low-cost production bases abroad begins and the home market may begin importing the product. 21

22 New trade theory says that: There are gains to be made from specialization and increasing economies of scale. Companies first to market can create barriers to entry. And Government may play a role in assisting its home-based companies. According to the theory, as a firm specializes and its output grows, it realizes economies of scale and its unit cost of production declines. The company can then expand, lower prices, and force competitors to produce a similar level of output if they are to remain competitive. A major part of the theory is the first-mover advantage which is the economic and strategic advantage gained by being the first company to enter an industry. This advantage creates a barrier to entry for potential rivals and may allow a country to dominate in a product. This leads some supporters to make the case that governments should work with home-based companies to help them become first movers in their industries. 22

23 Recap New trade theory says that: There are gains to be made from specialization and increasing economies of scale. A company that is first to the market and achieves a first-mover advantage can create barriers to entry. And government may play a role in assisting its home-based companies. Because new trade theory emphasizes productivity rather than a nation s resources, it is in line with the theory of comparative advantage but at odds with factor proportions theory. 23

24 National competitive advantage theory states that a nation s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade. The theory attempts to explain why some nations are more competitive in certain industries. It argues that four elements are the basis of national competitiveness: factor conditions; demand conditions; related and supporting industries; and firm strategy, structure, and rivalry. Let s now examine each of these elements more closely. 24

25 National competitive advantage theory recognizes two types of factors in any nation: Basic factors are natural endowments of resources, such as a large population, natural resources, climate, and land features. Advanced factors result from a nation s innovation and education, including the skill levels of different segments of its workforce and the quality of its technological infrastructure. The theory says that basic factors can spark initial production, but advanced factors account for a nation s sustained competitive advantage in a product. 25

26 National competitive advantage theory acknowledges the importance of demand conditions which refers to the sophistication of buyers in the home market. Sophisticated demand conditions in the domestic market drives companies to modify existing products to create new design features, and to develop new products and technologies to better satisfy customers. 26

27 Related and supporting industries also feature prominently in national competitive advantage theory. Companies in internationally competitive industries do not exist in isolation. Rather, supporting industries arise to provide inputs and form regional clusters of related activities that reinforce productivity and competitiveness. Exporting clusters those that export products or invest outside a region can become a region s source of long-term prosperity. 27

28 Firm strategy, structure, and rivalry also play roles in national competitive advantage theory. Strategic decisions have lasting effects on future competitiveness, as do industry structure and rivalry between companies. In general, the more intense the rivalry between domestic companies, the greater is their global competitiveness. Heightened competitiveness at home helps businesses to compete against imports and against foreign companies trying to develop a presence in the domestic market. 28

29 National comparative advantage theory states that a nation s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade 29

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