CHAPTER 5

INTERNATIONAL TRADE THEORY

Benefits of trade:

Proponents of international trade theories are Smith, Richardo, and Heckcher-Ohlin.

According to them,

- No country is self sufficient. So a country must depend on another country for the goods which they cannot produce.

- It is beneficial for a country to engage in international trade even for products it is able to produce itself. The gains arise because it allows a country to specialize in the manufacture and export of products that can be produced more efficiently.

International trade theories help us to understand and explain the pattern of international trade that we observe in the economy.

1. Theory of Mercantilism

The main tenet of mercantilism is:

It is in a country’s best interest to maintain trade surplus, to export more than import.

Countries used to conduct trade in exchange of gold and silver. So if a country imported more than export, then gold and silver reserve will reduce. Contrarily, if they exported more, then they will accumulate gold and silver and consequently, will gain national wealth and prestige.

So to maintain trade surplus government intervenes.

This theory is criticized because,

- Trade surplus increase money supply in a country. So people have more money in their hands. So they spend more which raises the demand and consequently, price of goods. The result of this is inflation.

- This theory leads to a zero sum game (when one country losses and another country gains) rather than a positive sum game (When both/all the countries are benefited).

2. Theory of Absolute Advantage:

Proponent: The proponent of this theory is Adam Smith. He is against mercantilism.

A country has absolute advantage in the production of a product when it is more efficient than other country in producing it.

A country should never produce goods at home that it can buy at a lower cost from other countries.

E.g. Ghana and South Korea. (Page 149-150)

2. Theory of Comparative Advantage:

David Ricardo extended Adam Smith’s Theory by exploring what might happen when one country has absolute advantage in production of all goods.

He extended the free trade argument and proved that trade is a positive-sum game.

According to Richardo’s theory of comparative advantage, it 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.

E.g. Example in page 151 & 152.

3. Heckcher-Ohlin Theory

The Proponents of the theory are Eli Heckscher and Bertil Ohlin.

They argued comparative advantage arises from differences in national factor endowment such as land, labor and capital.

Nations have varying factor endowment and different factor endowment explain differences in factor cost. The theory argues that

countries will export those goods that make intensive use of factors that are locally abundant and import those goods which make use of factors that are locally scarce.

Factor prices dictate manufacturing costs.• A labor abundant country will manufacture and export labor intensiveproducts.• A capital abundant country will manufacture and export capitalintensive products.

Ricardo’s theory: National differenced in productivity determines comparative advantage.

Heckcher-Ohlin Theory: National factor endowment determines comparative advantage.

E.g. China and USA example (pg. 158) 4. The Product Life-Cycle Theory

The production location for many products moves from one country to another depending on the stage in the product’s life cycle.

Stage 1: Introduction Innovation, production, and sales in same country (usually USA) Innovation in response to observed need Exporting by the innovative country to other advanced nations

(like, Great Britain, France, Germany and Japan). However, the demand is limited to the high income people. So it is not yet worthwhile to produce the products in these countries.

Evolving product = non-standardized products

Stage 2: Growth More competition in the home market Demand in other advanced countries is increased which also raises

the exports by the innovating country Increased capital intensity Some foreign production starts in other advanced countries who

were previously importers. The innovating country starts exporting to LDCs.

Stage 3: Early Maturity Decline in exports from the innovating country. Other advanced

nations exports to LDC and USA/innovating country’s export to LDCs decline.

At later stage USA/innovative country starts importing from other advanced nations.

Stage 4: Late Maturity Increased competitiveness in the home market of the innovative

country. It is not efficient to produce only for innovative country’s home market.

So the innovative country becomes the net importer rather that net exporter. It starts importing the product from other advanced nations

Stage 5: Decline Product becomes standardized Increased competitiveness of price Production startups in LDCs and gradually production concentrates

in LDCs. The innovative country and other advanced nations become the net

importer of the standardized product.

Net exporter

Net importer

New product (Brands Like IBM, Apple)

Phase IAll

production in US

US exports to advanced

countries like Europe, Japan

Phase IIProduction started in

other advanced nations

US exports mostly to

LDCs

Phase IIIOther

advanced nations

export to LDCs

US exports to LDCs displaced

Phase IVEurope

exports to US

Phase VProduction shifted to developing countries

like India, China,Malaysia through investment and

alliances and then exported.

Time

Figure 4.1: The product life cycle Source: Wells (1972), as cited by Dicken (2003), p.203.

5. National Competitive Advantage: Porter’s Diamond

In 1990, Michael Porter of Harvard Business School published his study on 100 industries from 10 nations.

The study was attempted to determine why some nations succeed and other nations fail in international competition.

Porter believes that four broad attributes of a nation shape the environment in which local firms compete.

Factor Endowment:

Basic factors: Natural resources, climate, location and demographics

Advanced factors: Communication infrastructure, sophisticated and skilled labor, research facilities, technological know-how.

Basic factors are naturally given but advance factors are product of investment by individuals, companies and government.

Advance factors are keys to develop sustainable competitive advantage.

E.g. Government investment in higher education has created large pool of educated workers in India which is an example of advanced factor. This advanced factor is the key to development of the IT industry of India.

Demand Condition:

Firms are typically most sensitive to the needs of their closest customers. Thus the characteristics of home demand are particularly important in shaping the attributes of domestically made products and in creating pressures for innovation and quality.

E.g. Technologically sophisticated consumers of Japan pressure camera companies to improve product quality and introduce innovative models.

Related and supporting industries:

Presence of suppliers and related industries are one of the reasons of competitive advantage.

Investment by supplier or related industry for creating advanced factors can be the source of competitive advantage.

E.g. Technological leadership of US semiconductor industry is the source of competitive advantage of US personal computer industry.

Firm strategy, structure and rivalry:

- First, different nations are characterized by different management ideologies. E.g. German and Japanese firm put more emphasis on manufacturing process and product design as they have predominance of engineers in the top management. Conversely, predominance of financial experts in the top management in the US companies make US firms to put emphasis on short-term financial gains. This prevented US firms to achieve success in engineering-based industries.

- Second, domestic rivalry also induces firms to look ways to improve efficiency, to innovate, to improve quality, to reduce cost and to invest in upgrading advanced factors. E.g. after MFA phase-out, garment manufacturers of Bangladesh face immense competition from other local manufacturers for international buyers. This domestic competition has increased the efficiency of the manufacturers.

Government policy and Chance

Porter also contends that government can influence each of the four components of the diamond. Like,

Factor endowments can be affected by subsidies, policies toward capital market, policies toward education etc.

Domestic demand can be affected by local product standards or with regulations that mandate or influence buyers needs.

Government policy can influence supporting and related industries through regulation

Firm rivalry can be influenced through capital market regulation, tax policy and antitrust laws.

The competitiveness of the four components can be affected by another factor and that is chance. This chance may arise from any new agreement, opening of a new market. Like, Multi-Fiber Agreement of WTO created huge chance for the ready-made garments industry of the developing nations.