International Trade TheoriesProf Vishwa Ballabh

International Trade

MercantilismAbsolute and Comparative AdvantagesHeckscher and Ohlin and Theories of strategic TradeCompetitive Advantage

Mercantilism

An economic philosophy based on the belief that a nations wealth depends on the accumulated treasure, usually gold. To increase wealth, government policies should promote export and discourage imports.Nation should regulate its domestic and international affairs so as to promote its interests.Solution lies in strong foreign trade and country should achieve favorable balance of payment.Gold and silver earn would help increase income, employment and consumptions.Tariffs, quota and other commercial policies were proposed by mercantilists to achieve favorable balance of payment.

Criticism

Favorable balance of payment is short term phenomenon and over time price rise would eliminate advantages due to favorable balance of payment.

It was also static view and assumed world pie (total output) would remain constant and therefore gains from trade comes at the expense of trading partner.

International trade permits nation to take advantages of specialization and division of labor which increases the general level of output with in the nation and thus raises world output.

Absolute advantage

The capability of one nation to produce more of a good with same amount of input than another country.

The costs differences govern movement of goods among nation.

International trade and specialization would be beneficial when one nation has an absolute advantage in one good and the other nation has an absolute advantage in other.

Weakness what if some country does not have absolute advantage in production of any good? Is trade still desirable ?

Comparative advantages

A nation having absolute disadvantage in the production two goods with respect to an other nation has a comparative or relative advantage in the production of the good in which its absolute disadvantage is less.How does it work.

TABLE 1The Production Opportunities of the USA and the Brazil

Minutes Needed to Make 1 Ounce of:Amount of Meat or Potatoes Produced in 8 HoursMeatPotatoesMeatPotatoesUSA60 min/oz15 min/oz8 oz32 ozBrazil20 min/oz10min/oz24 oz48 oz

FIGURE 1If there is no trade the USA chooses this production and consumption8401632Potatoes (ounces)(a) The USAs Production Possibilities FrontierThe Production Possibilities Frontier

Panel (a) shows the combinations of meat and potatoes that the USA can produce. A

If there is no trade, the Brazil chooses this production and consumption.(b) The BRAZILs Production Possibilities FrontierMeat (ounces)241202448Potatoes (ounces)Panel (b) Shows the combinations of meat and potatoes that the Brazil can produce. Both production possibilities frontiers are derived from Table 1 and the assumption that the USA and Brazil each work 8 hours a day

B

0458AA*USAs consumption with tradeUSAs production and consumption without tradeUSAs Production with trade1617Meat (ounces)(a) The USAs Production and Consumption32Potatoes (ounces)FIGURE 2How Trade Expands the Set of Consumption OpportunitiesThe proposed trade between the USA and the Brazil offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. In panel (a), the USA gets to consume at point A* rather than point B. Trade allows each to consume more meat and more potatoes

(b) The Brazil s Production and ConsumptionMeat (ounces)2418012242727B*Brazils Production with tradeBrazils consumption with tradeBrazils production and consumption without tradePotatoes (ounces)1312B

TABLE 2The Gains from Trade: A Summary

USABrazilMeatPotatoesMeatPotatoesWithout Trade:Production and Consumption4 oz16 oz12 oz24 ozWith Trade:Production0 oz32 oz18 oz12 ozTradeGets 5 ozGives 15 ozGive 5 ozGets 15 ozConsumption5 oz17 oz13 oz27 ozGains from Trade:Increase in Consumption+ 1 oz+1 oz+ 1 oz+3 oz

TABLE 3The Opportunity Cost of Meat and Potatoes

Opportunity Cost of:1 ounce of Meat1 Ounce of PotatoesUSA4 oz potatoes oz meatBrazil2 oz potatoes oz meat

The Equilibrium without International TradeWhen an economy cannot trade in world markets, the price adjusts to balance domestic supply and demand. This figure shows consumer and producer surplus in an equilibrium without international trade for the steel market in the imaginary country of Isoland.Domestic supplyDomestic demandEquilibrium PriceEquilibrium quantity

Quantity of SteelPrice of Steel0Consumer surplusProducer surplusFIGURE 3

International Trade in an Exporting CountryOnce trade is allowed, the domestic price rises to equal the world price. The supply curve shows the quantity of steel produced domestically, and the demand curve shows the quantity consumed domestically. Exports from Isoland equal the difference between the domestic quantity supplied and the domestic quantity demanded at the world price.Price of SteelPrice after tradePrice before tradeDomestic quantity demandedDomestic quantity suppliedQuantity of SteelDomestic supplyWorld priceDomestic demandExports0FIGURE 4

How Free Trade Affects Welfare in an Exporting CountryFIGURE 5When the domestic price rises to equal the world price, sellers are better off (producer surplus rises from C to B + C+ D), and buyers are worse off (consumer surplus falls from A + B + A). Total surplus rises by an amount equal to area D, indicating that trade raises the economic well- being of the country as a whole.The area D shows the increase in total surplus and represent the gains from Trade.ExportsDomestic supplyWorld priceDomestic demandPrice of SteelPrice after tradePrice before tradeQuantity of SteelABCD

Before TradeAfter TradeChangeConsumer SurplusA + BA- BProducer SurplusCB + C + D+ ( B + D )Total SurplusA + B + CA + B + C + D+ D

FIGURE 6International Trade in an Importing CountryOnce trade is allowed, the domestic price falls to equal the world price. The supply curve shows the amount produced domestically, and the demand curve shows the amount consumed domestically. Imports equal the difference between quantity demanded and the domestic quantity supplied at the world price.ImportsPrice of SteelPrice before tradePrice after tradeDomestic demandWorld priceQuantity of Steel0Domestic supply

FIGURE 7How Free Trade Affects Welfare in an Importing CountryWhen the domestic price falls to equal the world price, buyers are better off (consumer surplus rises from A to A + B + D), and sellers are worse off (producer surplus falls from B + C to C). Total surplus rises by an amount equal to area D, indicating that trade raises the economic well- being of the country as a whole.The area D shows the increase in total surplus and represent the gains from TradeImportsDomestic demandWorld priceDomestic supplyABDCPrice of SteelPrice before tradePrice after tradeQuantity of Steel0

Before TradeAfter TradeChangeConsumer SurplusA A + B + D+ ( B + D )Producer SurplusB + C C -BTotal SurplusA + B + CA + B + C + D+ D

ECGABFDImports with tariffDomestic supplyEquilibrium without tradeWorld pricePrice with tariffPrice without tariffDomestic demandFIGURE 8Imports without tariffQuantity of SteelPrice of Steel

The Effects of a TariffA tariff reduces the quantity of imports and moves a market closer to the equilibrium that would exist without trade. Total surplus falls by an amount equal to area D + F. These two triangles represent the deadweight loss from the tariffThe area D + F shows the Fall in total surplus and represents the deadweight loss of the tariff.

Before TradeAfter TradeChangeConsumer SurplusA + B + C + D + E + F A + B - ( C + D + E + F)Producer SurplusG C + G+CGovernment RevenueNoneE+ETotal SurplusA + B + C + D + E + F + GA + B + C + D- (D+ F)

ACBEDEFGImports with quotaEquilibrium without tradeDomestic supplyDomestic supply + Import supplyEquilibrium with quotaWord priceDomestic demandQuotaPrice of SteelIsolandian price with quotaPrice without quota= worldprice0Imports without quotaQuantity of SteelFIGURE 9

The area D + F shows the fall in total surplus and represents the deadweight loss of the quota.The Effect of an Import QuotaAn Import quota, like a tariff, reduces the quantity of imports and moves a market closer to the equilibrium that would exist without trade. Total surplus falls by an amount equal to area D + F. These two triangles represents the deadweight loss from the quota . In addition, the import quota transfers E + E to whoever holds the import licenses.

Before QuotaAfter QuotaChangeConsumer SurplusA + B + C + D + E + E + F A + B - ( C + D + E + E + F)Producer SurplusG C + G+CLicense- Holder SurplusNoneE + E+(E + E)Total SurplusA + B + C + D + E + E + F + GA + B + C + E + E + G- (D+ F)

COMPARATIVE ADVANTAGE IN THE HECKSCHER OHLIN TRADE MODEL

WHAT DETERMINES TRADE IS DIFFERENCES IN FACTOR ENDOWMENTS. COUNTRIES THAT ARE RICH IN CAPITAL WILL EXPORT CAPITAL-INTENSIVE GOODS.

COUNTRIES THAT HAVE MUCH LABOUR WILL EXPORT LABOUR-INTENSIVE GOODS.

FACTOR ABUNDANCE DEFINED BY FACTOR PRICESIF P1C/P1L

FACTOR ABUNDANCE DEFINED IN PHYSICAL TERMSIF C1/L1>C2/L2

WHERE Ci = AMOUNT OF CAPITAL IN COUNTRY i Li = AMOUNT OF LABOUR IN COUNTRY i

COUNTRY 1 IS RICH IN CAPITAL AND COUNTRY 2 IS RICH IN LABOUR.

COUNTRY 1 WILL PRODUCE CAPITAL-INTENSIVE GOOD AND COUNTRY 2 WILL PRODUCE LABOUR-INTENSIVE GOOD.

COUNTRY 1 MAY/MAY NOT EXPORT CAPITAL-INTENSIVE GOOD AND COUNTRY 2 MAY/MAY NOT EXPORT LABOUR-INTENSIVE GOOD.

DEMAND FACTOR IN THE DOMESTIC COUNTRY WILL DETERMINE THE ACTUAL OUTCOME

COMMODITY AND FACTOR PRICES UNDER TRADEIF THERE ARE NO IMPEDIMENTS TO TRADE COMMODITY PRICES WILL BE THE SAME IN BOTH THE COUNTRIES WHICH ARE TRADING WITH EACH OTHER.

IF FACTORS ARE FULLY MOBILE INTERNATIONALLY THEN FACTOR PRICES WILL BE THE SAME IN ALL THE COUNTRIES.

IN CASE OF FACTOR IMMOBILITY WITHIN COUNTRIES TRADE IN GOODS CAN BE VIEWED AS A SUBSTITUTION FOR FACTOR MOBILITY WHICH IN TERN ENSURES COMPLETE FACTOR-PRICE EQUALISATION.

EMPERICAL EVIDENCE OF HECKSCHER-OHLIN THEOREM--THE LEONTIEF PARADOX: POSSIBLE EXPLANATIONS

SKILLED LABOURR&D-ORIENTED INDUSTRIESNATURAL RESOURCES INDUSTRIESINTERNAL DEMANDPRODUCT LIFE CYCLEINTRA-INDUSTRY TRADE

NEW THEORIES OF INTERNATIONAL TRADETHEORIES OF STRATEGIC TRADETHEORY OF COMPETITIVE ADVANTAGE

THE ECONOMICS GAINS FROM TRADE: THEORIES OF STRATEGIC TRADEWHAT IS STRATEGIC TRADE?POLICIES DESIGNED TO SECURE RENTS

1.ONE COUNTRY HAS MARKET POWER--WHEN ONE COUNTRY EXERCISES SIGNIFICANT MARKET POWER OVER THE SUPPLY OF A GOOD.

IN SUCH SITUATION,

AN EXPORTING COUNTRY MAY BE ABLE TO INCREASE THE PRICE OF ITS EXPORTS BY RESTRICTING OUTPUT.

AN IMPORTING COUNTRY MAY GAIN BACK SOME OF THE RENTS ACCRUING TO A MONOPOLY EXPORTER BY IMPOSING A TARIFF

THE ECONOMICS GAINS FROM TRADE: THEORIES OF STRATEGIC TRADE2. ECONOMIES OF SCALE IN PRODUCTION--IN INDUSTRIES CHARACTORISED BY LARGE ECONOMIES OF SCALE IN PRODUCTION THE GOVERNMENT IN A LARGE MARKET CAN PROVIDE A DOMESTIC FIRM WITH AN ADVANTAGE OVER FOREIGN PRODUCERS BY CLOSING THE MARKET.

AC0ACU.S. Producers Average CostsForeign Producers Average CostsQusAnnual ProductionAverage Unit Cost

THE ECONOMIC GAINS FROM TRADE: THEORIES OF STRATEGIC TRADELEARNING BY DOING (THE INFANT INDUSTRY ARGUMENT )--IF THE NATION WITH THE LARGEST CUMULATIVE PRODUCTION IN AN INDUSTRY HAS THE LOWEST COSTS THEN COMPARATIVE ADVANTAGE CAN BE CREATED, NOT MERELY INHERITED.

EXTERNAL ECONOMIES--INNOVATION AND KNOWLEDGE GENERATION CREATE POSITIVE EXTERNALITIES---------- GENERATING SOCIAL RETURNS BEYOND THOSE CAPTURED BY THE INNOVATING FIRM.

THE DEBET OVER STRATEGIC GOVERNMENT INTERVENTIONEUROPEANS FIRMS: AIRBUSPRODUCE W/O SUBSIDYDONT PRODUCEProduce w/o SubsidyAmerican Firms: BoeingDont Produce-5-5600010000

EUROPEAN FIRMS: AIRBUSProduce w/o SubsidyProduce w/ SubsidyDont ProduceProduce w/o SubsidyAmerican Firms: BoeingDont Produce-5-55-5010060070000

EUROPEAN FIRMS: AIRBUSProduce w/o SubsidyAmerican Firms: BoeingProduce w/ SubsidyDont Produce-5-5-556005-5557000100011000Produce w/o SubsidyProduce w/subsidyDont Produce

CRITICS OF STRATEGIC TRADE THEORIESTHE THEORIES ARE BASED ON ASSUMPTION THAT OTHER COUNTRIES WILL NOT RETALIATE AGAINST THE COUNTRY THAT INITIATES RESTRICTIVE POLICIES WHICH MAY NOT HOLD IN THE REAL WORLD.

THE JUSTIFICATIONS FOR INTERVENTIONS ARE CRITICALLY DEPENDENT ON OBSCURE ASSUMPTIONS ABOUT INDUSTRY STRUCTURE AND BEHAVIOUR

THE THEORIES ASSUME THAT HOME MARKET PROTECTION WILL STRENGTHEN, NOT WEAKEN, DOMESTIC FIRMS WHICH IS QUESTIONABLE

THE POLICIES SUGGESTED ARE EXTREMELY DIFFICULT TO IMPLEMENT

COMPETITIVE ADVANTAGE OF NATIONSPORTER POSED THREE QUESTIONS: WHY DOES A NATION SUCCEED INTERNATIONALLY IN A PARTICULAR INDUSTRY?WHAT IS THE INFLUENCE OF THE NATION ON COMPETITION IN SPECIFIC INDUSTRIES AND INDUSTRY SEGMENTS?WHY DO A NATIONS FIRMS SELECT PARTICULAR STRATEGIES?

FOUR KEY PREMISES:THE NATURE OF COMPETITION AND THE SOURCES OF COMPETITIVE ADVANTAGE DIFFER WIDELY AMONG INDUSTRIES (AND EVEN AMONG INDUSTRY SEGMENTS);

SUCCESSFUL GLOBAL COMPETITORS PERFORM SOME ACTIVITIES IN THE VALUE CHAIN OUTSIDE THEIR HOME COUNTRY AND DRAW COMPETITIVE ADVANTAGES FROM THEIR ENTIRE WORLDWIDE NETWORK RATHER THAN FROM JUST THEIR HOME BASE;

FIRMS GAIN AND SUSTAIN COMPETITIVE ADVANTAGE IN MODERN INTERNATIONAL COMPETITION THROUGH INNOVATION;

FIRMS THAT SUCCESSFULLY GAIN COMPETITIVE ADVANTAGE IN AN INDUSTRY ARE THOSE THAT MOVE EARLY AND AGGRESSIVELY TO EXPLOIT A NEW MARKET OR TECHNOLOGY.

THE DETERMINANTS OF NATIONAL COMPETITIVE ADVANTAGEFIRM STRATEGY, STRUCTURE AND RIVALRYFACTOR CONDITIONSRELATED AND SUPPORTING INDUSTRIESDEMAND CONDITIONS

FACTOR CONDITIONS

A NATIONS ENDOWNMENT OF FACTORS PLAY A MORE COMPLEX ROLE IN DETERMINING NATIONAL COMPETITIVE ADVANTAGE THAN GENERALLY ACKNOWLEDGED.FACTOR ENDOWNMENT ARE DYNAMIC, AND COULD BE UPGRADED, CREATED AND SPECIALISED.FACTORS ARE DIVIDED INTO: HUMAN RESOURCESPHYSICAL RESOURCESCLIMATIC CONDIITONSKNOWLEDGE RESOURCESLOCATIONSCAPITAL RESOURCESINFRASTRUCTUREFACTORS

BASICADVANCEDGENERALISED SPECIALISED

DEMAND CONDITIONS IN THE HOME MARKETELEMENTS OF PORTERS FRAMEWORK ARE:

THE NATURE OF DOMESTIC BUYERS NEEDS THE SIZE AND PATTERNS OF GROWTH OF THE DOMESTIC MARKET

THE MECHANISM BY WHICH DOMESTIC BUYERS NEEDS ARE COMMUNICATED TO FOREIGN FIRMS

PRESENCE OF VIGOROUS SUPPILYER AND RELATED INDUSTRIES

STRATEGY, STRUCTURE AND RIVALRY

GOVERNMENT ACTIONS CHANCE EVENTS

IMPLICATIONS FOR GOVERNMENT POLICY

*************************************