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INTERNATIONAL BUSINESS

ENVIRONMENT(Political Economy of International Business)

Session 2

International Trade – Theories and

Reality

Today's questions ...

1. What are the main theories of international trade and foreign direct investment?

2. What is their understanding of trade purpose? What do they say with regards to the role played by business and governments?

3. What is the case for free trade vs. protectionism?

4. How can protectionism nonetheless be justified?

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INTERNATIONAL TRADE THEORIES

Section 1

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Main international trade theories

Country-based trade theories

MercantilismAbsolute advantage

Comparative advantage

Firm-based trade theories

Vernon's product life-cycle theoryNew trade theory

Foreign direct investment theories

J. Dunning's eclectic theory

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M. Porter's attractiveness diamond

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Mercantilism

Original XVIIth century mercantilists, such as John Law, a Scots financier, believed that a country's economic prosperity and political power came from its stocks of precious metals.

To maximise these stocks they argued against free trade, favouring protectionist policies designed to minimise imports and maximise exports, creating a trade surplus that could be used to acquire more precious metal

http://www.economist.com/research/Economics/alphabetic.cfm?letter=M#mercantilism

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Mercantilism today

Neo-mercantilism is a term used to describe a policy regime which encourages exports, discourages imports, controls capital movement and centralises currency decisions in the hands of a central government

The objective of neo-mercantilist policies is to increase the level of foreign reserves held by the government, allowing more effective monetary and fiscal policy. This is generally believed to come at the cost of lower standards of living of the concerned nation

It is called "neo" because of the change in emphasis from classical mercantilism on military development, to economic development. It also accepted a greater level of price fixing based on market mechanisms

http://en.allexperts.com/q/Economics-2301/Differences-Mercantilist-Neo-Mercantilist-1.htm

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Absolute advantage (A. Smith)

Absolute advantage refers to the ability of a person or a country to produce a particular good at a lower absolute cost than

another.

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Comparative advantage [1] (D. Ricardo)

Comparative advantage refers to the ability of a person or a country to produce a particular good at a lower marginal cost and opportunity

cost than another person or country.

Comparative advantage explains how trade can create value for both parties even when one can produce all goods with fewer resources

than the other. The net benefits of such an outcome are called gains from trade.

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The gains from free trade [1] (from CW Hill)

Absolute advantage Comparative advantage200 units of resources available per country

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The gains from free trade [2]

D

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qd

P1Worldprice

P*Domesticprice

P

Q

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Imports

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Example: Britain's trade in the XIXth Century

Food productsTextile products

Opium

Exotic products

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Comparative advantage [2] (H-O-S model)

Ricardo's theory of comparative advantage is based on differences in labour productivity

For Eli Heckscher and Bertil Ohlin, comparative advantage arises from differences in relative national factor endowments – the extent to which a country is endowed with resources like labourand capital

The Heckscher-Ohlin-Samuelson model predicts that countries will export goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce

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Limitations of traditional trade theories

Traditional (country-based) trade theories

Focused on trade between nations, not between firms

Do not explain intra-industry and

intra-firm trade

Do not explain trade among

similar countries

Do not analyse long-term impact of international specialisation

Do not consider capital movements

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The product life-cycle theory (Graph by CW Hill)

According to Raymond Vernon's product life-cycle theory, both the

location of sales and the optimal production location will change as

products mature, affecting the flow and direction of trade

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The new trade theory (P. Krugman)

Tries to explain why trade is growing fastest between industrial countries1. With similar economies and endowments of the factors of

production (intra-regional trade)

2. Trading similar goods (intra-industry trade)

Considers1. Markets of imperfect competition (oligopolies, national

monopolies)

2. Increasing returns to scale

3. Movement of capital (foreign direct investment)

4. Business and government strategies

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The new trade theory (ctd)

1. Trade is mutually beneficial because it allows for the specialization of production, the realization of economies of scale, and the production of a greater variety of products at lower prices

2. The pattern of trade may result from economies of scale and first mover advantages (economic and strategic advantages that accrue to early entrants into an industry)

3. Selected government intervention (strategic trade policy) may support the development of strategic or export-oriented industries

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The new trade theory (ctd)

Corporate strategies

Economies of scale, externalities

Internationalisation(horizontal, vertical)

First mover advantage

New marketsDiversification, specialisation

Government strategies

Strategic trade policyTargeted

protectionism

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Introducing foreign direct investment

Definition

Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country

Greenfield investmentEstablishment of a wholly new operation in a

foreign country

Brownfield investmentAcquisitions or mergers with existing firms in

the foreign countryJoint venture

legal entity formed between two or more parties to undertake an economic activity

together.

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Foreign direct investment drivers

Strategic rivalryAdvantage to first mover

Bandwagon effectMultipoint competition

Export complementarityOptimisation of value chain

(vertical integration)

Export substitutionTransport costsTrade barriers

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Dunning's "eclectic theory" of FDI (ILO)

• Response to actual or threatened trade barriers

• Need to control foreign business activity

Internalisation

• Resource endowments (capital, labour) or assets (incl. location externalities) that are tied to a particular location

Location

• Firms endowed with a distinctive competitive advantage (technology, brand, economies of scale) will try to take advantage of large number of markets

Ownership

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M. Porter's diamond

Firm strategy, structure and

rivalry

Demand conditions

Related and supporting industries

Factor endowments

M. Porter's thesis is that national

competitive advantage is not dependent on factor endowment,

but depends on various factors that

interact with each other to create

conditions where innovation and

improved competitiveness

occurs

Government

Chance

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Conclusion: internationalisation drivers

Supply factors

Natural resources

Production (labour) costs/productivity

Distribution costs

Key technologies

Location externalities

Demand factors

New markets(incl. economies of scale)

Response to customer's mobility

Response to trade barriers

Economic incentives

Strategic rivalry

Advantage to 1st mover - Bandwagon effect/Herd behaviour - Multipoint competition

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Protectionism or free trade?

Mercantilism promotes government involvement in supporting exports and limiting imports

Smith, Ricardo and Heckscher-Ohlin show that it is beneficial for a country to engage in international trade even for products it is able to produce for itself. International trade allows a country:

To specialize in the manufacture and export of products that it can produce efficiently

To import products that can be produced more efficiently in other countries

The new trade theory supports international trade but justifies limited and selective government intervention to support the development of certain export-oriented industries

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Food for thought …

"An international economics course should drive home to students the point that international trade is not about competition, it is about mutually beneficial

exchange.

Even more fundamentally, we should be able to teach students that imports, not exports, are the purpose of trade. That is, what a country gains from trade is

the ability to import what it wants.

Exports are not an objective in and of themselves: the need to export is a burden that the country must bear because its import suppliers are crass enough to

demand payment".

Paul KRUGMAN, in Pop Internationalism

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THE REALITY OF INTERNATIONAL TRADE

Section 2

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From theory to reality

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Most nations are nominally committed to

free trade

In practise, governments intervene to protect the

interests of powerful groups

TRADE POLICY

Trade restriction Trade promotion

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Free vs. "managed" trade

Partisans of a "managed trade" (or fair trade) consider that national governments should actively intervene in international trade to ensure that :

Domestic firms are offered an equitable share of foreign markets

Imports are controlled to minimize losses of domestic jobs and market share in specific industries

"Fair traders" also argue that a government should ensure a level playing field on which foreign and domestic firms get the same opportunity to compete

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Trade policy

Economic goals

Political goals

Foreign policy goals

Social goals

Various goals can be in conflictGoals are dynamic: objectives may change over time (homeostasis)

Government goals in international trade

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Justifications to trade restriction/promotion

Political arguments

Protecting consumers from "dangerous" products

Protecting jobs

Protecting industries deemed important for national security

Retaliating to unfair foreign competition

Furthering the goals of foreign policy

Protecting the human rights of individuals in exporting countries

Economic arguments

Protecting infant – or declining – industries

Strategic trade policy, supporting the development of strategic industries and technologies

The "big country" argument

Preserving access to natural resources ...

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The "candle tax", a case of public choice?

Europe has been accused of going back on world leaders' pledge to avoid exacerbating the recession by throwing up new barriers against international trade, just a month after the London G20 summit. Brussels will slap tariffs of up to 60% on

imports of cut-price Chinese candles this month, in one of four measures ­identified by the World Bank president, Robert ­Zoellick, on a blacklist of anti-free

trade decisions taken since the summit. […]

Britain's retailers are furious about the import tax on candles […]. They say the measure protects German and Polish candle-makers – and estimate that the

sanction, which will stay in place for five years, will cost retailers up to £10m. […]

The EU has also imposed temporary "anti-dumping" taxes, which are meant to protect against cut-price subsidised imports, on three other products: Chinese wire, iron and steel pipes, and aluminium foil from Armenia, Brazil and China.

The Guardian, 4 May 2009

http://www.guardian.co.uk/business/2009/may/04/eu-blocks-free-trade

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Trade restriction instruments

Tariffs, quantitative barriers

Tariffs(Incl. anti-dumping)

Quotas Voluntary export

restraintsSubsidies

Non-tariff barriers

Local content requirements

Norms and standards

Administrative barriers

Exchange rate manipulation

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Food for thought …

Why do intergovernmental organisations like the WTO consider that custom duties are preferable both to quotas and non-tariff

barriers

Tariffs ...

... are transparent

... Create less distortion than quotas

... Are easier to lift than non-tariff obstacles such as norms or standards

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The consequences of protection ("small" country)

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d1

d2

q1q2

P1Worldprice

P2WorldPrice+ tariff

P*Domesticprice

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Trade restriction: business implications

Generally speaking, trade barriers raise export costs

Antidumping actions limit a firm's ability to pursue aggressive pricing to gain market share

Voluntary export restraints (VERs) and quotas limit a firm's ability to serve a country from locations outside that country

To conform to local content requirements, a firm may have to locate more production activities in a given market than it would otherwise

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The other side of protection: trade promotion

Subsidies

Cash, tax breaks, price supports(e.g. former US foreign sales

corporations)

Export financing programmes

Low-interest loans, loan guarantees(e.g. French COFACE)

Foreign trade zones

Products are subject lower customs duties and/or fewer customs

procedures(e.g. Mexican maquiladoras)

Government agencies

Trade missions for officials and businesses, export-promotion offices,

help import products the home nation does not produce

(e.g. Japanese JETRO)

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Export promotion bodies: the US case

Export-Import Bank of the United States (http://www.exim.gov): official export credit agency of the United States. Assists in financing the export of U.S. goods and services to international markets

Overseas Private Investment Corporation (http://www.opic.gov): helps U.S. businesses invest overseas by managing risks associated with foreign direct investment

US government export portal (http://www.export.gov): brings together resources from across the U.S. Government to assist American businesses in planning their international sales strategies

International Trade Administration (http://trade.gov/about.asp): strengthens the competitiveness of U.S. industry, promotes trade and investment, and ensures fair trade through the rigorous enforcement of our trade laws and agreements.

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Protection-based development strategies

Import substitution

Protectionist barriers: protect infant industries

Support to domestically-oriented production

Export promotion

Protectionist barriers: support savings and

investment vs. consumption

Support to export-led industries

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Example: the "dragons" and China

The growth champions of the past few decades – Japan in the 1950s and 1960s, South Korea from the 1960s to the 1980s, and China

since the early 1980s – have all had activist governments collaborating closely with large business. All aggressively promoted investment and exports while discouraging (or remaining agnostic

about) imports.

China’s pursuit of a high-saving, large-trade-surplus economy in recent years embodies mercantilist teachings.

http://www.europeanceo.com/news/commentaries//article672.html

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Food for thought …

What are the limitations of neo-mercantilist policies

"Beggar-thy-neighbour" policy, that works at the expense of trade partners

Will lead to global depression if applied by all players

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Application: the prisoner's dilemma

Gains / Losses

Extra-growth, trade and financial surpluses, job creation ...

Germany

Support to domestic demand

Support to external

competitiveness

Other European countries Support to

domestic demand

3

3

2

-2

Support to external competitiveness

-2

2

-1

-1