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© McGraw Hill Companies, Inc., 2000
International Trade Theory Chapter 4
International Trade Theory Overview Mercantilism Absolute Advantage Comparative Advantage Heckscher-Olin Theory Product Life Cycle Theory New Trade Theory Porter’s Diamond
© McGraw Hill Companies, Inc.,2000 4-1
© McGraw Hill Companies, Inc., 2000
1st British African colony to win independence (1957).
Nkrumah espoused pan African socialism.
High tariffs. Anti-exporting policy.
4-2
© McGraw Hill Companies, Inc., 2000
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%.4-3
The Impact of Trade Policies Ghana 1970
GNP/capita • $250
1992 GNP/per capita
• $450
GNP Growth/year • 1.5%
Shift from productive uses (cocoa) to unproductive uses (subsistence agriculture).
Korea 1970
GNP/per capita • $260
1992 GNP/per capita
• $6790
GNP Growth/year• 9%
Shift from non-comparative advantage uses (agriculture) to productive uses (labor-intensive manufacturing).
© McGraw Hill Companies, Inc.,2000 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).
© McGraw Hill Companies, Inc.,2000 4-5
Mercantilism: mid-16th century A nation’s 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”.© McGraw Hill Companies, Inc.,2000 4-6
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.
© McGraw Hill Companies, Inc.,2000 4-7
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.
© McGraw Hill Companies, Inc.,2000 4-8
© McGraw Hill Companies, Inc., 2000
The Theory of Absolute Advantage
0 5 10 15 20
5
10
1
5
20
A
BK
G
K’G’
Rice
Coco
a
Figure 4.1
4-9
© McGraw Hill Companies, Inc., 2000
The Theory of Absolute Advantage and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and RiceCocoa Rice
Ghana 10 20S. Korea 40 10
Production and Consumption without TradeGhana 10.0 5.0S. Korea 2.5 10.0
Total production 12.5 15.0Production with Specialization
Ghana 20 0S. Korea 0 20
Total production 20 20Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean
RiceGhana 14.0 6.0 S. Korea 6.0 14.0
Increase in Consumption as a Result of Specialization and TradeGhana 4.0 1.0
S. Korea 3.5 4.0 Table 4.1
4-10
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
product’s 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.
© McGraw Hill Companies, Inc.,2000 4-11
© McGraw Hill Companies, Inc., 2000
The Theory of Comparative Advantage
0 5 10 15 20
5
10
1
5
20
Coco
a
Rice
Figure 4.2
3.75
7.5
2.5
G
C
A
G’
B
K
K’
4-12
© McGraw Hill Companies, Inc., 2000
Comparative Advantage and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Ghana 10 13.33S. Korea 40 20
Production and Consumption without TradeGhana 10.0 7.5S. Korea 2.5 5.0
Total production 12.5 12.5Production with Specialization
Ghana 15 3.75S. Korea 0.0 10.0Total production 15 13.75Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean
RiceGhana 11 7.75 S. Korea 4 6
Increase in Consumption as a Result of Specialization and TradeGhana 1.0
0.25S. Korea 1.5 1.0
Cocoa Rice
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 country’s production
resources, and Increase the efficiency of resource utilization.
© McGraw Hill Companies, Inc.,2000 4-14
© McGraw Hill Companies, Inc., 2000
Ghana’s PPF under Diminishing Returns
Coco
a
Rice
G’
G
0
Figure 4.3
4-15
© McGraw Hill Companies, Inc., 2000
The Influence of Free Trade on the PPF
Coco
a
Rice
G’
PPF2
0
Figure 4.4
PPF1
4-16
Is the Mercantilist Theory Still Valid?
A qualified Yes. Equate political power with economic
power and economic power with a trade surplus.
Japan
© McGraw Hill Companies, Inc.,2000 4-17
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.
© McGraw Hill Companies, Inc.,2000 4-18
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.
© McGraw Hill Companies, Inc.,2000 4-19
Heckscher vs Ricardo Economists prefer Heckscher on theoretical
grounds but is a relatively poor predictor of trade patterns.
Ricardo’s 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.
© McGraw Hill Companies, Inc.,2000 4-20
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.
© McGraw Hill Companies, Inc.,2000 4-21
International Product Trade Cycle Model
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
1 3 4 5 6 7 8 9 10 11 12 13 14 15
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
High Income Countries
Medium Income Countries
Low Income Countries
Time
Stages of Production Development
New Product Standardized ProductMaturing Product
Quantity
production
consumption
2
Exports Imports
Imports
Exports
Exports
Imports
© McGraw Hill Companies, Inc.,2000
Figure 4.5
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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.
© McGraw Hill Companies, Inc.,2000 4-23
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.
© McGraw Hill Companies, Inc.,2000 4-24
First-Mover Advantage
Economies of scale may preclude new entrants.
Role of the government.
© McGraw Hill Companies, Inc.,2000 4-25
Founded 1915 by William Boeing Largest commercial airplane manufacturer. 9,000 commercial jetliners in service.
© McGraw Hill Companies, Inc.,2000 4-26
Established 1967 Western Europe buying 25% of aircraft ,but
selling only 10%. France, Germany, Great Britain To date: 3,203 orders - 1,890 deliveries.
© McGraw Hill Companies, Inc.,2000 4-27
Airbus vs Boeing
0
100
200
300
400
500
600
700
800
85 86 87 88 89 90 91 92 93 94 95 96 97
BoeingAirbus
Airplane Orders
© McGraw Hill Companies, Inc.,2000 4-28
Porter’s Diamond(Harvard Business School, 1990)
The Competitive Advantage of Nations. Looked at 100 industries in 10 nations.
Thought existing theories didn’t go far enough.
Question: “Why does a nation achieve international success in a particular industry?”
© McGraw Hill Companies, Inc.,2000 4-29
© McGraw Hill Companies, Inc., 2000
Determinants of National Competitive Advantage
Factor endowments:nation’s 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 industry’s 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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Porter’s DiamondDeterminants of National Competitive Advantage
Factor Endowments
Firm Strategy,Structure and
Rivalry
Demand Conditions
Related and Supporting Industries
© McGraw Hill Companies, Inc.,2000
Figure 4.6
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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.
© McGraw Hill Companies, Inc.,2000 4-32
Factor Endowments
Taken from Heckscher-Olin Basic factors:
natural resources, climate, location.
Advanced factors: communications, skilled labor, technology.
© McGraw Hill Companies, Inc.,2000 4-33
Advanced Factor Endowments
More likely to lead to competitive advantage.
Are the result of investment by people, companies, government.
© McGraw Hill Companies, Inc.,2000 4-34
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.
© McGraw Hill Companies, Inc.,2000 4-35
Demand Conditions Demand creates the capabilities. Look for sophisticated and
demanding consumers. impacts quality and
innovation.
© McGraw Hill Companies, Inc.,2000 4-36
Related and Supporting Industries
Creates clusters of supporting industries that are internationally competitive.
Must also meet requirements of other parts of the Diamond.
© McGraw Hill Companies, Inc.,2000 4-37
Firm Strategy, Structure and Rivalry
Management ‘ideology’ can either help or hurt you.
Presence of domestic rivalry improves a company’s competitiveness.
© McGraw Hill Companies, Inc.,2000 4-38
Evaluating Porter’s 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.
© McGraw Hill Companies, Inc.,2000
World Trade
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Determinants of National Competitive Advantage
Company Strategy,Structure,
and Rivalry
DemandConditions
Relatedand Supporting
Industries
FactorConditions
GovernmentGovernmentSource: Michael Porter, The Competitive Advantage of Nations
ChanceChance
© McGraw Hill Companies, Inc.,2000
Two external factors that influence the four determinants.
4-40
Porter’s 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.
© McGraw Hill Companies, Inc.,2000 4-41
© McGraw Hill Companies, Inc., 2000
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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