c hapter 5

international business, 5th edition

chapter 5International Trade Theory

International Trade Theory

• An overview of trade theory

• Mercantilism

• Absolute advantage

• Comparative advantage

• Heckscher-Ohlin Theroy

• The Product Life-Cycle Theory

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International Trade Theory

• New Trade Theory

• National Competitive Advantage

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Case openingpage 158

Bangladesh's Textile Trade

• The case is about comparative advantage over China!

• Bangladesh’s textile industry.

• Surprise, that the industry was saved from the financial crisis of 2008.

• $10.7Billion in export in 2008.

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• What is the secret?

1.One of the world’s low cost producers.

2.Wal-Mart’s target after 2008.

3.This was a benefit for producers and consumers alike.

4.Labour costs are low

5.Wage rate in textile $40-$50 a month- half the minimum wage in China

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• Per capita income is $470 per year.

• Source of employment for 2.5 Million people. 85% women.

• Supply advantage- supporting local industries saving transport of supply giving them cost advantage.

Another secret is that Western importers want to diversify their supply sources and seek alternative sources.

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An overview of trade theory

• Free trade: refers to a situation where a government does not attempt to influence its citizens to buy from or sell to another country.

• Adam smith and the Invisible hand.

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An overview of trade theory

• This chapter will show you the benefits of trade and the pattern of international trade via Smith, Ricardo, Heckschler-Ohlin and others.

• The new trade theory.

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Mercantilism

• Keep your gold and silver (currency).

• In England mid-16th century.

• Achieve surplus in the balance of trade.

• Govt Policies are needed

• Subsidizing.

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Mercantilism

• Is wrong for both countries

• Zero Sum Game (win-lose game).

• What Adam Smith and David Ricardo says about this?

• Positive sum game.

• Neo-Mercantilism – China

•

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International Trade

• Trade is the voluntary exchange of goods, services, assets, or money between one person or organization and another.

• International trade is a trade between residents of two countries.

• Why does international trade occur? Both parties believe they benefit from that.

• Figure shows the dramatic growth in world trade.

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Figure 6.1 Growth of World Merchandise Exports

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Figure 6.2 Sources of World’s Merchandise Exports, 2004


Trade Theories• The benefits of international

trade is obvious.

• Scholars have developed theories to explain why nations trade.

• Two main types: Classical country-based and modern-firm based theories.

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Mercantilism

• A country’s wealth is measured by its holdings of gold and silver

• A country’s goal should be to enlarge holdings of gold and silver by

– Promoting exports

– Discouraging imports

• So foreigners will pay you more than you pay them and they have to pay that in gold and silver. Therefore, the country has more wealth.


Mercantilism 2• In spite of the fact that mercantilism

is very much criticized it is still attractive to some. Those are called neomercantilists or protectionists.

• Nearly every country has adopted some mercantilists policies to protect industries in in its economy.

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Disadvantages of Mercantilism

According to Adam Smith, Mercantilism:• Confuses the acquisition of treasure with the

acquisition of wealth. Nation wealth should be measured by the amount of goods and services available to its citizens.

• Weakens the country because it robs individuals of the ability – To trade freely and benefit from voluntary

exchanges. Are you free with STC?– Gov. subsidies of exports are paid by higher

taxes, while import restrictions are paid by consumers’ high prices.

• Forces countries to produce products it would otherwise not in order to minimize imports

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Absolute Advantage(Adam Smith)

• The Wealth of Nations

• Export those goods and services for which a country is more productive than other countries.

• Import those goods and services for which other countries are more productive than it is.

Absolute Advantage(Adam Smith)

• Efficiency and specialization

• Why should you produce what you can buy at a less cost from someone else.

• Both will benefit by engaging in trade.

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Example:

Output Per hour of labor (resource) France Japan

Perfume 2 1

Clock Radio 3 5

• France has an absolute advantage in the production of perfumes, while Japan has an absolute advantage in producing clock radios. Therefore, France should specialize in perfume and Japan in Clock radio and trade with each other.

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Comparative Advantage(Ricardo)

• What happens to trade if one country has an absolute advantage in both products?

• Produce and export those goods and services for which it is relatively more productive than other countries

• Import those goods and services for which other countries are relatively more productive than it is


Comparative Advantage 2• This theory is based on the idea that a country

should produce goods for which they have the greatest relative advantage.

• Assume that France has an absolute advantage in producing both goods. Therefore, trade is not profitable with Japan based on absolute advantage theory. However, according to comparative advantage gains from trade will occur even in a country that has absolute advantage in all products because the country should give up less efficient output to produce more efficient output.


Comparative Advantage 3Cost Per Unit

France Japan

P.1 50 200

P.2 100 200

•In France the cost of one unit of p.1 is 50% of one unit of P.2. So one unit of p.1 can be exchanged for ½ unit of p.2. So if France can get more than ½(2/3) unit of product 2 for one unit of p.1 it will gain.

•In Japan the cost of one unit of p.2 is the same. But if it gets one unit of p.1 for 2/3 unit of p. 2 it will also gain.

Comparative Advantage

• With out trade each country must consume what it produces.

• With trade the two countries can increase their combined production of what they produce(rice and coco) and consumers of both countries can consume more.

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Comparative Advantage

• The message is that: potential world production is greater with unrestricted free trade than it is with restricted trade.

• Consumers in all nations can consume more if there are no restrictions on trade.

• So consume, consume and consume and be happy- spoil them too

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Qualification and assumptions of this theory

• Too simplistic –two countries

• Nothing about differences in prices and exchange rate between countries.

• No scarce resources- affluence in resources.

• Fixed stock of resources

• Other assumption.

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Relative Factor Endowments

• Heckscher-Ohlin Theory• What determines the products for which a

country will have a comparative advantage?

– Factor endowments vary among countries (Argentina has much fertile lands and Saudi Arabia has large oil reserves)

– Goods differ according to the types of factors that are used to produce them (wheat requires fertile land and oil production requires crude oil reserves)

Heckscher-Ohlin Theory

“A country will have a comparative advantage in producing products that intensively use resources (factors of production) it has in abundance.”

Argentina has comparative advantage in wheat growing because of it abundance of fertile land, and Saudi Arabia because of its abundance of oil reserves.

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Continued….

• Based on the theory, a country should export those goods that intensively use those factors of production that are relatively abundant in the country.

• US should export capital-intensive goods like steel and import labor-intensive goods like clothes and shoes.

• What about Sudan?

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Product Life Cycle Theory

• According to this theroy the international product life cycle consists of three stages:– New product: innovation introduced (usually in a developed

country) in response to local demand. Limited export

– Maturing product: Expanding in capacity to meet domestic and foreign demands. Domestic and foreign competitors emerge.

– Standardized product: the market for the product stabilizes. Product becomes more of a commodity. Shifting manufacturing to countries with low labor cost. The product now is being imported to the innovating country.

– In summary, domestic production in stage 1, peaks in stage 2, and slumps in stage 3.

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Stages in the Product Life Cycle

New Product Stage

Maturing Product Stage

Standardized Product Stage

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Figure 6.4a The International Product Life Cycle: Innovating Firm’s Country

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Figure 6.4b The International Product Life Cycle: Other Industrialized Countries

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Figure 6.4c The International Product Life Cycle: Less Developed Countries

New Trade Theory

• NTT in the 70s

• Its about the ability to attain ECONOMIES OF SCALE

• Look at the difference between two types of bakeries one small and manual and the other is large and automatic.

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New Trade Theory

• Economies of Scale: are unit cost reductions associated with large scale output.

• Microsoft spreading $5 billion of fixed cost over 250 million PCs.

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New Trade Theory

Two important points for international trade:

1. Through EofScale, trade can increase variety for consumers ( different models of cars, different bars of chocolate, different types of bread) and decrease the average cost for goods.

2. Global market support small number of enterprises. The big three in the US. The big three in KSA (STC, Mobily, and Zain). First movers. EofScale is a barrier to entry.

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New Trade Theory

• The above increases the size of the global market.

• Is good with country specialization.

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New Trade Theory

• Second point is:

EofScale, first mover advantage, and the pattern of trade.

First mover advantage?

Consider the commercial aerospace industry. Airbus is a first mover in the 550 seat A30. what will happen to Boeing? Go out of business- no the market is more than enough for two players

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New Trade TheoryImplications

• New trade theory is in support of the comparative advantage theory.

• Heavy industries like chemical, construction equipment, computer industry, auto industry....etc.

• Govt intervention and strategic trade policy

• Luck, innovation, and entrepreneurship

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4- Porter’s Diamond of National Competitive Advantage

Firm Strategy, Structure, and Rivalry

Related and SupportingIndustries

FactorConditions

DemandConditions

Porter’s

• Success in international trade comes from 4 elements:

1- Factor’s conditions: A country’s endowment of factors of production affects its ability to compete internationally. labor, land, capital, education level, and infrastructure.

2- Demand Conditions: The existence of a large, sophisticated domestic consumer base often stimulates the development and distribution of innovative products as firms struggle for dominance in their domestic markets.

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Porter’s- Cont…

3-Related and Supporting Industries. The emergence of an industry often stimulates the development of local suppliers eager to meet that industry’s production, marketing, and distribution needs. An industry located close to its suppliers will enjoy better communication and the exchange of cost-saving ideas and inventions with those suppliers. Competition among these input suppliers leads to lower prices, higher-quality products, and technological innovations in the input market, in turn reinforcing the industry’s competitive advantage in world markets.

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Porter’s- Cont…

4- Firm Strategy, Structure, and Rivalry: The domestic environment in which firms compete shapes their ability to compete in international markets. To survive, firms facing vigorous competition domestically must continuously strive to reduce costs, boost product quality, raise productivity, and develop innovative products. Many of the investments they have made to succeed in the domestic market are transferable to international markets at low cost.

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Chapter summary and guidelines

• Start your chapter by reading and understanding opening case page 158 and 159.

• In the traditional theories of mercantilism, absolute advantage, comparative advantage, you need to concentrate on the main concepts and what these theories mainly talk about.

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• What is the difference between zero sum game and positive sum game?

• Who is Adam smith and the invisible hand?

• Specifically pages 169-174 were not discussed

• What Hekscher-Ohlin theory and how it differs from previous ones- page 174.

• What is the product life cycle theory – only the main concepts

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• New trade theory is very important up to the mid of page 185.

• Porter theory of competitive advantage is specially important theory.

• Answer case questions at the end of page 1990 for the Ecuadorean Rose Industry.

Good Luck

Summer Luck

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