Trade Theory Updated

8/3/2019 Trade Theory Updated

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International Trade &

Theory


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International Trade

International trade is exchange of

capital, goods, and services acrossinternational borders orterritories.

In most countries, it represents asignificant share of GDP.


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Genesis of Trade Theory

Why Do Nations trade with eachother?

Is trading a Zero-Sum game or amutually beneficial activity?

Why do Trade patterns among

countries exhibit wide variations? Can government policies influence

trade?


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Case: International Trade in

Information TechnologyEntrepreneurial enterprises in the US

invented information technology, computer,

communication hardware and software.

In the 1960s & 1970s, the information

technology Sector was led by companiessuch a IBM and DEC, which developedfirst mainframe and midrange computers.


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In the early 1980s , production of

components for computers like memorychips migrated to low cost producers in Japanand than later on Taiwan & Korea.

Intel, largest manufacture of memory chips inthe world, pulled out of the market in the mid-

1980s to focus on microprocessors.


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Soon after Hard disk drives, display screen , keyboard,computer mice and other components ere outsourced to

foreign manufacture.

By early 2000, Us factories were specializing in makinghighest value components like microprocessormade by Intel, and in final assembly.(Dell assembles PCs

in to North American facility.

However, almost every other component was madeoverseas because of cost effectiveness.

In due course, negative implication was export of highpaying manufacturing jobs to foreign producers.

Resultantly job losses in the US continued.


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During 1980s, the locus of growth shifted topersonal computer by the ay of innovation, as :

Intel introduced the microprocessor in 1971;

MITS made the first personal computer;

Apple and IBM, which drive the initialcommercialization of PCs

However, along the way something happened tothis uniquely American industry, it started tomove the production of hardware offshore


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Was this trend bad for the US economy?

Actually Not !! As per researches :

Globalization of production made IT hardwareless expensive then earlier.

Price declines supported additional investmentby businessman.

In turn, rapid diffusion of IT translated into fasterproductivity growth in US as businesses usedcomputers to streamline processes.


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Benefits

During 1995 2002 productivity grew by 2.8 percentannually in the US resulted in an additional $230 billion inaccumulated GDP.

Reduced price for hardware made possible by internationaltrade created a boom in jobs in the IT industries: Computersoftware.

Number of IT job grew by 22 percent in the US, the growthcould partly be attributed to robust demand for softwareand services within US and from foreigner tho.se were nowmaking much of hardware


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International Trade Theories

Mercantilism

Theory of Absolute Advantage

Theory of Comparative AdvantageTheory of Factor Endowment (H-OTheory)

Product Life-Cycle Theory

New Trade Theory

Theory of Competitive Advantage


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Classical Trade Theories

Mercantilism- ( Thomas Mun)The main principle of mercantilism was

Countrys interest to maintain a trade to

export more than import.

By doing so, a country would accum-

ulate gold and silver, consequently

increase its national wealth. National Govt. imposed tariff and

quota to restrict import and subsidized

production to promote exports.


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Limitation

Theory is based on Zero-sum gamewhere a nation only gain from trade if thetrading partner lost . (As exports ofnation are high only when imports oftrading partner are high)

A favorable BOP is possible only in the

short run and would automatically beeliminated in long run. As-


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Gain or Loss An influx of gold by way of more exports than

imports by a country raises the prices, leading toincrease in export price.

In turn country would loose its competitiveadvantage in terms of price.

On the other hand the loss of gold by the importing

countries would lead to a decrease in theirdomestic price level, which would boost theirexports.


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Absolute Advantage

Theory coined by Adam Smith: The Wealthof Nations

Smith emphasized on productivity andadvocated free trade as a means of increasing

global efficiency

Absolute advantage refers to the

ability to produce a good moreefficiently and cost-effective.

'


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A country : Should specialize in production of and export

products for which it has absolute advantage;

Import other product in which it has absolutedisadvantage.

Three reasons of efficiency:

1. Labour become more killed by repeating task

2. Labour would not loose time in switching fromthe production of one kind to other.

3. Long production run provide the incentive ofeffective working method.


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Example

There are two countries : Ghana and South Korea

200 units of Input for the Production in both the

countries are available. These input could be used to produce either Cocoa

or Rice.

Ghana Resource utilization :Cocoa : 1 Ton = 10 resources

Rice : 1 Ton = 20 Resources


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Examplecont.

Ghana could produce 20 Tons of Cocoa or 10Tons of Rice or may be combination.

South Korea Resource utilization :

Cocoa : 1 Ton = 40 resources

Rice : 1 Ton = 10 Resources South Korea could produce 5 Tons of Cocoa

or 20 Tons of Rice and may be combination.


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CONTINUE

G: Ghana

K: South

Korea


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Resources required to produce 1 Ton of Coca &

Rice

Country Cocoa Rice

Ghana

South Korea

1040

20

10

GhanaSouth KoreaTotal

Production and Consumption without Trade10.0 5.02.5 10.012.5 15.0


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Production with SpecializationCocoa Rice

GhanaSouth KoreaTotal Production

20.00.020.0

0.020.020.0

Consumption After Ghana Trades 6 Tons of Cocoa for 6 Tons ofSouth Korean Rice

Cocoa Rice

GhanaSouth Korea

14.06.0

6.014.0

Increase in Consumption as a result of Specialization and Trade

GhanaSouth Korea

4.03.5

1.04.0


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Examplecont.

Gains From Trade :

By engaging in trade and swapping 1 Ton of Cocoafor 1 Ton of Rice, producers in both countriescould utilize more of both coca and rice.

Price of 1 Ton Cocoa = Price of 1 Ton Rice

If Ghana decided to export 6 Tons of Cocoa toSouth Korea and import 6 Tons of Rice in return.

Consumption after trade would be increased as:

Ghana : 4 Tons of Cocoa and 6 Tons of Rice South Korea : 3.5 Tons of Cocoa and 4.0 Tons of

rice.


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Comparative Advantage

Theory is coined by David Ricardo and onestep further to Adam Smiths theory . As

If a country has absolute advantage in both

the products might derive more benefitsfrom international trade by producing andexporting goods in which it has highefficiency and importing goods in which it

has less efficiency . It can be measured interms of comparative cost .


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Comparative Advantage Assumption

Theory is based on Two countries and twocommodities model.

Transportation cost is not included.

Production resources can move withincountry.

Theory is based on constant return to

scale.No difference in the prices of resources in

different countries. Exchange rate is notconsidered.


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Ghana has absolute advantage in producing bothCoca and Rice with given 200 units of resources. As Ghana : 10 resources = 1 Ton Cocoa 13 resources = 1 Ton Rice

Ghana can produce either 20 Tons of Cocoa or 15 Tonsof rice. Otherwise, any combination on its PPF.

Example : Comparative Advantage


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South Korea : 40 resources = 1 Ton Cocoa

20 resources = 1 Ton Rice

South Korea can produce either 5 Tons ofCocoa or 10 Tons of rice. Otherwise, anycombination on its PPF.


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Cocoa

20

15

10

5

2.5

3.75 5 7.5 10 15 20

G

G

K

KRice

Ghana = G

South Korea = KC

A

B


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Ghana has absolute advantage in both ,

Cocoa and Rice. Why it should trade with SouthKorea ?.

Because it has comparative advantage only in

the production of Cocoa, it can produce cocoa 4times higher than South Korea.

But rice only 1.5 higher than South Korea.


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Resources required to produce 1 Ton of Coca& Rice

Country Cocoa Rice

GhanaSouth Korea 1040 13.020

GhanaSouth KoreaTotal

Production and Consumption without Trade

10.0 7.52.5 5.012.5 12.5


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Comparative Advantage & Gains

If Ghana specializes in the production of Cocoa toincrease it output from 10 to 15 tons.

It will use 150 units resources for cocoa and 50 units

resources to produce 3.75 tons of rice.

South Korea specializes in the production of rice,producing 10 tons.

After specialization output of cocoa increases from 12.5tons to 15.5 tons and rice from 12.5 tons to 13.75 tons.


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Because of trade not output is higher but bothcountries can now benefit from trade. As:

If Ghana and South Korea swap Cocoa and rice on

a one-to-one basis with both countries withexchanging 4 tons of their export for 4 tons of theirimport, both countries are able to consume morecocoa and rice.

C i Ad & G i


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Comparative Advantage & Gains

If Ghana export 4 tons cocoa to South Korea for 4

tons of rice it still left with 11 tons of Cocoa withincrease of 1 ton and rice quantity increases from7.5 tons to 7.75 tons with increase of 0.25 tons.

Similarly after swapping 4 tons of rice with Ghana,South Korea still ends up with 6 Tons of rice andcocoa increases from 2.5 to 4.0 tons. It receives 1.5tons more cocoa.


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Production with SpecializationCocoa Rice

GhanaSouth KoreaTotal Production

15.00.015.0

3.7510.013.75

Consumption After Ghana Trades 4 Tons of Cocoa for 4 Tons ofSouth Korean Rice

Cocoa Rice

GhanaSouth Korea

11.04.0

7.756.0

Increase in Consumption as a result of Specialization and Trade

GhanaSouth Korea

1.01.5

0.251.0


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MEASURING COMPARATIVE

ADVNTAGE Balassa index is useful tool to measure Revealed

Comparative Advantage .

RCA is based on the assumptions:

The commodity pattern of trade reflects the inter-

country difference in relative cost as well non-pricefactors like, structural changes, improved worlddemand.


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RCA is defined as:

Countrys share of world export of comm-odity divided by its share in total export.Index of commodity j from country i

as:RCAij = (xij/Xwj)/Xi/Xj)

Xij = ith countrtys export of j commodity Xwj = world export of commodity j Xi = total world export


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If the value of index is greater than unity(1), the country has RCA in the

commodity.

RCA is consistent with the changes in theeconomys factor endowment and productivity.

However, it cannot distinguish between the

improvements in factor endowment andthe impact of the trade policies.

RCA INDEX OF SPECIALIATION


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INDUSTRY China India HongKong

Japan Mexico Thailand UK US

Manufactures 0.96 1.36 0.5 0.99 0.69 0.6 0.8 0.63

Chemical 0.42 1.06 0.43 0,87 0.34 0.65 1.41 1.18

Clothing 3.46 3.09 3.01 0 1.29 1.56 0.43 0.23

Electronics

1.04 0.23 1.94 1.64 1.53 1.55 0.63 1.33

Fresh

Food

0.68 2.23 0.23 0 0.8 2.33 0.4 1.52

IT 2.43 0.1 2.33 1.2 1.75 2.11 1.01 0.92

Leatherproduct

3.34 2.18 4.12 0 0 1.4 0.34 0

RCA INDEX OF SPECIALIATION


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As per Ricardo, comparative advantagearises because of differences in

productivity.

Eli Heckscher in (1919) and Berlin Ohlin

(in 1933) argued comparative advantagearises from differences in national factorendowments which leads cost difference.

Theory of Relative Factor Endowments

(Heckscher-Ohlin)


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Factor endowments refers the extent towhich a country is endowed with such

resources as land, labour and capital.

As the more abundant the factor, the lower

its cost.According to the theory, the more different the

countries are - regarding the capital-to-labor ratio -the greater the economic gain from specialization

and trade.


(Heckscher-Ohlin)


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H-O Theory predicts-

Country will export those goods, which areproduced by intensive use of factors that are

locally abundant. Import those goods that makes intensive use

of factors that are locally scarce.

This theory argues that pattern ofinternational trade determines by differencesin factor endowment, rather than differencesin productivity.


(Heckscher-Ohlin)

Example


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Example China & India excel in export of good

produced in labour-intensive manufacturingindustries, such as:

Textiles and Footwear

It reflects Chinas & Indias low-cost-labour

The US has been primary importerbecause it lacks abundant low cost labour


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India excels in the area of softwareengineering and Medical tourism becauseof abundance of professionals.

Hence, relative not absolute endowmentsare important; a country may have larger

amounts of land and labour than othercountry, but be relatively abundant in oneof them.

Example cont.


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The major factors of production, namely labor

and capital, are not available in the sameproportion in both countries.

The two goods produced either require relativelymore capital or relatively more labor.

Labor and capital do not move between the twocountries.

There are no costs associated with transportingthe goods between countries.

The citizens of the two trading countries have thesame needs.

Assumption

Case: Moving US White-Collar Jobs


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Case: Moving US White-Collar JobsOffshore

During early 2001, the global economy sloweddown and corporate profits slumped, white-collar

jobs were moved from US to developingcountries because of cost effectiveness.

Bank of America had to reduced 5000 jobsfrom its information technology workforce, whichwere being transferred to India, where it costs

$20 an hour in place of $ 100 an hour in US.


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One beneficiary Bank of Americas downsizing isInfosys Technologies Ltd., where 250 engineersdevelop IT applications for the Bank.

In Wipro Ltd., five radiologist interpret 30 CT scans aday for Massachusetts General Hospital and used to

send on internet.

Not only India, but in Philippines also utilized for costeffective service like Accenture, large US management

consulting and IT firm, recently moved 5,000 jobs insoftware development & accounting to the Philippines


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Procter &Gamble employs 650

professionals who prepare the companysglobal tax returns. Initially it is used to bedone in US now it is done in Manila.

Flour Corp., California based constructionfirm employs 1,200 engineers and

draftsmen in the Philippines, Poland andIndia to turn layouts of industrial facilitiesinto detailed specification.


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Outsourcing of such skilled jobs fromdeveloped countries to developingcountries due to good supply of skilled

& professional manpower is indicationof huge benefits from lower costs,enhanced competitiveness in the

global economy.


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Japans success in exporting Automobiles inthe 1970s and 1980s was based not just onthe relative abundance of capital, but also on

its development of innovative manufacturingtechnology which leads higher productivitylevels in automobile production than other

countries that also had abundant capital.

Criticism

L i f P d


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As per empirical research of WassilyLeontief conducted in USA:

USA exports were less capital intensiveand more labour intensive, however

USA has capital in abundance thanlabour. Actually, H-O theory does nothold true.

Leontief Paradox


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Explanation of Leontief Paradox

USA exports labour intensive

product because of higher

productivity of labour.

As workers in the U.S. have a lot of

knowledge & entrepreneurial skills.


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Explanation of Leontief Paradox

Actually, USA exports aircraft and importstextiles not because of capital is in

abundance and labour is not but USA is

relatively more efficient in manufacturing

aircrafts than textiles . And

Also on its development of innovative

manufacturing technology which leads

higher productivity.

Th N T d Th


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The New Trade Theory

Nations may benefit from trade evenwhen they do not differ in resourceendowment or technology becauseIncreasing return to scalemight existin some industries.

Economies of scale ( unit cost reductionassociated with a large scale of output)represent important source of increasingreturns.

Th N T d Th


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This theory is based on two types ofeconomies of scale as-

Internal Economies of Scale-

Firms benefit by economies of scale

when the cost per unit of output

depends upon the size of the firm.

Larger the size of firm higher are the

economies of scale.

Th N T d Th


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Internal economies of scale may lead afirm to specialize in a narrow product line

to produce in volume to achieve cost

benefit.

Companies requiring massive investment

in R & D and creating manufacturing

facilities such as Microsoft, microprocessor

by Intel and aircrafts by Boeing or Airbusneed to have global market base so as to

achieve internal economies of scale and

compete effectively.

Th N T d Th


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The New Trade TheoryExternal Economies of Scale -

Cost per unit of output based on size of

the industry not on size of the firm, it is

referred to external economies of scale.

Higher external economies of scale is

attributed to the large size of industry

that has several small firms, which lead

large production and competitive price.



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External economies of scale enable thecountrys industry to achieve global

competitiveness by including small firms

Example

Semiconductor industry in Malaysia and

automotive component industry of India

Industrial cluster like brassware inMoradabad,

hosiery in Tirupur , carpet in Bhadoi, Semi

precious stones in Jaipur.

Th N T d Th


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The higher economies of scale lead toincrease in returns, enabling countries to

specialize in the production of such good

and trade with countries with similar

consumption pattern.

Besides, intra-industry trade , this theory

also explains intra-firm trade betweenMNEs & their subsidiaries with a motive to

take advantage of scale economies and

increase their return.

E l


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ExampleSuppose there are two automobile

manufacturing countries, each countryhas market for 1 million automobilescustomers, if they enter into trade there

will be combined market of 2 millioncars.

Because of large market more models ofcar can be produced for customer on thebasis of economies of scale (loweraverage cost).

Example


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Example

There are two countries, in each countrydemand of sports car is limited to 55,000unit but total output of 100,000 car per yearis required to achieve economies of scale

and specialization.

Similarly demand for a small car in each

country is limited to 80,000 units but toachieve specialization output of 100,000 isrequired.

Example


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Example Once the two countries decide to trade,

they will adopt following trade pattern:

A firm in one nation may specialize inproducing sport cars and will get combined

market of 1,10,000 customers.

While other nations firm may produce smallcar and will get combined market of 1,60,000

customers.

Ultimately, customers get accessibility to both

the cars and choice for car.


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The International Product Life-Cycle (Vernon) Theory

This theory is founded by Raymond Vernon. Itis based on the observation:

In 20th century, a very large proportion of theworld product had been developed by USfirms and sold first in the US market (e.g.

automobile, TV, Instant Cameras,Photocopier, Computers, Semiconductorchips)

The International Product


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The International Product

Life-Cycle (Vernon) Theory

International market tend to follow a

cyclical pattern due to variety of factorsover a period of time. As-

Level of innovation and technology

Size of market

Gap in technology

Preference and ability of the customers

The International Product Life Cycle


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The International Product Life-Cycle(Vernon) Theory

Development and marketing of newlyinnovated product in the world economy can be

divided into following stages:

Stage 1: Introduction:Invention of new product takes place in

developed countries because of high R & D

investment.

Initially price of product is also higher

which could be affordable for the customer

of developed countries.

The International Product Life-


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The International Product LifeCycle (Vernon) Theory

Stage 2 : Growth :The demand of product increase in

international market therefore firm gets

better opportunities to export in otherdeveloped countries.

Because of competition in target marketeven firm establishes its production

location in other developed nations.

The International Product Life-Cycle


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(Vernon) Theory

Stage 3 : Maturity

As the technical know- how of the

innovative process becomes widely known,the firms begin to establish its operation in

middle-income and low-income countries

in order to take advantage of resources

available at competitive prices.


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Stage 4 : Decline

In this stage emphasis of the firm is onmost cost-effective locations rather than

producing themselves. Now it shifted to

even LDCs and as result developedcountries begins to import such goods from

other developing countries.

Th I t ti l P d t Lif


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Example :

Xerox Machine, invented in US (1960)

Initially Xerox exported machine to Japan

and Europe.

After increasing demand Xerox entered in

these location through JVs (Fuji-Xerox) and

Great Britain (Rank-Xerox)



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y

(Vernon) Theory

Once patent of Xerox expired other foreign

competitors began to enter (Canon in

Japan , Olivetti in Italy)

US start buying from low cost locations

Japan found cost of production is very high

and they shifted location to Singapore and

Thailand.

Other developed nation Japan also startimporting.

The International Product Life-


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Cycle (Vernon) TheoryThis theory is not holding true in case like:

Laptop computers, which were introduced in anumber of major national markets by Toshiba.

However, various components aremanufactured in Japan (e.g. display screen,memory chips)

Other components are manufactured inSingapore and Taiwan (e.g. hard drives andmicroprocessor).

After final assembly in Singapore it is shipped

to the world market.

St d di d


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New ProductMaturing

Product

Standardized

Product


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National Competitive Advantage

This theory is given by Michel Porter. It explainswhy a nation achieves international success in aparticular industry. As -

Why does Japan do well in AutomobileIndustry?

Why does Switzerland excel in the productionand export of Pharmaceutical?

Why do Germany and United States do so wellin the Chemical Industry?

Porters Diamond


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Porter has focused four broad factors of

a Nation to shape the environment in which localfirms compete and these factors promote orimpede the creation of competitive advantage.

These factors are:

Factor endowments : a nations position infactors of production such as skilled labour orthe infrastructure necessary to compete.


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In a country , not only natural resources

are important but the factors created by

meticulous planning and implementationsuch as Capital, Human and knowledge

resources play important role


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Demand Conditions:The nature of homedemand for the industrys product or service.

Relating and Supporting Industries: The

presence or absence of supplier industries andrelated industries that are internationallycompetitive.

Firm Strategy, and Rivalry: The conditionsgoverning how companies are created,organized and managed and the nature ofdomestic rivalry.

So What for business?


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So What for business?

First mover implications

Location Implications

Foreign Investment Decisions

Government Policy implications

Documents

Trade Theory Updated