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Theories of InternationalTheories of InternationalTrade and InvestmentTrade and Investment
Chapter Three
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
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Review of Chapter 2Review of Chapter 2
Last week we discussed two primary waysof trading internationally…what are they?
Business can supply foreign marketsthrough both exporting and actually
manufacturing in them Where does trade take place
(developed v.s developing countries)? What are the seven global dimensions for
globalization “standardization”?
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Learning ObjectivesLearning Objectives
Understand the theories that explain why certaingoods are traded internationally
Mercantilism
Theory of Absolute Advantage (Adam Smith)
Theory of Competitive Advantage (David Ricardo)
Theory of Factor Endowment (Heckscher-Ohlin)
International Product Life Cycle (Ray Vernon)
National Competitiveness (Michael Porter)
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Learning ObjectivesLearning Objectives
Understand the various explanations for tradedirection shifts……
Economies of scale, learning curve, Imperfectcompetition, First-mover theory, Linder theory &technological life cycle
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Theories of InternationalTheories of InternationalTrade/InvestmentTrade/Investment
Business managers MUST have agood understanding of “economictheory” to understand a nation’seconomic development strategy
-what are the beliefs and education of thegovernment’s economic planners
-Watch/listen to their actions/speeches
- Be Proactive: based on your understandingof the nations leaders
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Some ExamplesSome Examples The Japanese Government has traditionally spent trillions of
Yen to push the Yen down vis-à-vis the US $ and the Euro.They keep the Yen artificially weak to reduce competitivepressures from Europe and USA..Hence, they can exportmore and import less
China has resisted all efforts to revalue their currency (Yuan).They simply have not allowed the Yuan to appreciate in
value, thus making/helping Chinese companies have strongcost-competitiveness.
-China has strong economic growth
- China has a large trade surplus Argentina pegged the Peso years ago to the US$. Financial
stability ensued but exports were too costly-recessionoccurred…. In 2002 they stopped the peg and devalued thePeso ( 1 US$ to .27cents) Imports were costly but exportsstarted to grow!
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Consider also the Free-MarketConsider also the Free-Marketreforms in Chile………..reforms in Chile………..
Salvador Allende: President 1970-1973 Military coup(September) the economy was in shambles
-Inflation>1000% annually
-High national debt
-Government highly involved in economy
- high duties on imports- huge subsides to select industries New Government: Selected Group of New Economist from
the University of Chicago “The Chicago Boys” were freemarket advocates( influenced by Milton Friedman
“Chicago Boys” proposed programs based on the Theory of Comparative Advantage which immediately reduced importduties to 10% from 1000%. All other import barriers werecompletely eliminated. Capital equipment could now beimported which encouraged “business investment”
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Continued…..Continued….. Select companies lost subsidy protection
Bottom line: A “big” correction in the economy andindustries followed
1. -Appliance Industry almost disappeared
2. -The electronics industry basically vanished
3. -Automobile Assembly plants closed
Those are products we should import. We have better opportunities for products based on our farm products, our timberlands, our fisheries and other natural resources thatwe should be making because they give us a “naturaladvantage” over other countries
It took time but by 2006 Annual growth >6% Inflation lowered and standard of living increased Chile has signed free trade arrangements with several
nations and the E.U, Mercosur, The USA and Canada Their Free market is now flourishing!!!!
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To sum up…..To sum up…..
In Chile, prudent economic Policymaking has secured long termstability in a once very unstable
country! The Keystone of many countries
economic policies is “the law of comparative advantage”
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International Trade Theory:International Trade Theory:MercantilismMercantilism
A nation’s wealth depends on accumulated treasure,usually gold A country that has no gold must import it
To increase wealth, government policies shouldpromote exports and discourage imports Importation of gold depends on exports of goods Importation of other goods tightly controlled
Economic competition is a “zero sum game”: if
country advances economically, another loses
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Theory of Absolute Advantage:Theory of Absolute Advantage:Adam Smith (1723-1790)Adam Smith (1723-1790)
Market forces, not government controls, determinethe direction, volume and composition of internationaltrade
A country will export goods in which it has an
absolute advantage over other countries To have an absolute advantage a country must beable to produce a larger amount of a good or service for the same
amount of inputs as can another country
the same amount of a good or service using fewer inputs than can another country In classic economics a “unit of input” is measured in:
land, labor, capitalLO1LO1
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Theory of Comparative Advantage:Theory of Comparative Advantage:David Ricardo 1817David Ricardo 1817
A nation may have absolute disadvantages in theproduction of two goods with respect to another nation
Yet this nation has a comparative advantage or relative advantage in the production of the good inwhich its absolute disadvantage is lower
By specializing in the production of the good inwhich the country has lower comparative
disadvantage, and importing other goods, the totalgoods available will increase
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Comparative Advantage andComparative Advantage and“offshoring” of service jobs“offshoring” of service jobs
India has a comparative advantage in production of goods &
services requiring large amounts of labor and relatively littlecapital
Good opportunities to reduce cost in specific industries by“offshoring” parts of these service industries
INDIAINDIA1 billion people1 billion people
Citizens who speakCitizens who speakEnglishEnglish
Indian IT industryIndian IT industryIs growing rapidly!Is growing rapidly!
Tax, Financial services,Tax, Financial services,
Insurance, telemarketingInsurance, telemarketing
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Heckscher-Ohlin TheoryHeckscher-Ohlin Theoryof Factor Endowmentsof Factor Endowments
Countries export products requiring large amounts of their abundant production factors Lower cost to produce; more attractive abroad Imported products have low relative cost as
producing locally would require large amounts of the importing country’s scarce production factors
For example….
--India: Has a large labor force (1 billion)
so they should concentrate on labor intensive goods.
--Germany: Has more capital than labor so they should concentrate on capital
intensive goods.
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Heckscher-Ohlin TheoryHeckscher-Ohlin Theoryof Factor Endowmentsof Factor Endowments
Leontief Paradox- the US was one of the mostcapital-intensive countries in the world, wasexporting relatively labor-intensive products inexchange for relatively capital-intensive products
Differences in Taste
- A demand- side construct that is always difficult todeal with in economic theory
-Transportation cost can be toohigh
-Training skilled workers is critical- Some consumers simply will buyexpensive items (cars..perfumes..ect)
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Currency Exchange Rates InfluenceCurrency Exchange Rates InfluenceThe Direction of TradeThe Direction of Trade
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Goods are valued in the currency of the country inwhich they are produced
An importer in another country must use theprevailing exchange rates to price the product about
to be imported The relative purchasing power of currencies is not
always reflected in official exchange rates Government policy can give an advantage to one
currency over another to induce exports
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Some Newer ExplanationsSome Newer ExplanationsFor The Direction Of TradeFor The Direction Of Trade
1. International Product Life Cycle (IPLC) Most new products initially conceived and produced
in the U.S. in 20th century U.S. firms kept production close to the market
Aids decisions and minimizes risk of newproduct introductions
Demand not based on price yet so lowproduction cost not an issue
Limited initial demand in other advanced countries Initially, exports to these markets more
attractive than production
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Some Newer ExplanationsSome Newer ExplanationsFor The Direction Of TradeFor The Direction Of Trade
With demand increase in advanced countriesProduction follows there from the U.S.
With demand expansion elsewhere
Product becomes standardizedProduction moves to low production cost areasProduct now imported to U.S. and to advanced
countries
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International Product Life CycleInternational Product Life Cycle
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Newer ExplanationsNewer ExplanationsFor The Direction Of TradeFor The Direction Of Trade
2. Linder Theory of Overlapping Demand Customers’ tastes are strongly affected by income levels
Income per capita determines the kinds of goods indemand
3. Technology Life Cycle Production technology application of the IPLC
Distinguishes between new products and newtechnologies used in the production of products
Technology follows the IPLC pattern
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Newer ExplanationsNewer ExplanationsFor The Direction Of TradeFor The Direction Of Trade
4. Economies of Scale and Learning Curve Economies of scale: as a plant gets larger, output
increases, per unit production cost decreases Learning curve: as firms produce more products, they
learn ways to improve production efficiency further
reducing costs A nation’s industries are now low cost producers andexporters
5. Imperfect Competition--Paul Krugman Economies of scale together with differentiated products
induces intraindustry foreign trade
6. First-Mover Theory Pattern of trade in goods subject to scale economies is
determined by historical factors that induce first movers
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Newer ExplanationsNewer ExplanationsFor The Direction Of TradeFor The Direction Of Trade
7. National Competitive Advantage
Porter’s Diamond Model
National Competitiveness: a nation’s relative
ability to design, produce, distribute, or serviceproducts while earning increasing returns onresources
Four variables: factor endowments, demandconditions, related and supporting industries, andfirm strategy, structure, and rivalry
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Newer ExplanationsNewer ExplanationsFor The Direction Of TradeFor The Direction Of Trade
Factor endowments
land, labor, capital, workforce, infrastructure
Demand conditions
large, sophisticated domestic consumer base: offers an
innovation friendly environment and a testing ground Related and supporting industries
local suppliers cluster around producers and add toinnovation
Firm strategy, structure, rivalry
competition good
national governments can create conditions whichfacilitate and nurture such condition
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Variables Impacting CompetitiveVariables Impacting CompetitiveAdvantage: Porter’s DiamondAdvantage: Porter’s Diamond
Source: Reprinted by permission of the Harvard Business Review . “The Competitive Advantage of Nations” by Michael E. Porter,March–April 1990, p. 77. Copyright © 1990 by The President and Fellows of Harvard College; all rights reserved. LO1LO1
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Synopsis: Trade TheorySynopsis: Trade Theory
Trade among countries results from relative pricedifferences that stem from different production costs Different production costs come from differences inEndowments of factors of production Levels of technology that determine the factor
intensities usedEfficiencies with which factor intensities are used Foreign exchange rates
Differences in tastes can reverse the direction of tradepredicted by theory
Nations attain a higher quality of life by specializing inthose products for which they have a comparativeadvantage and by importing the rest
Trade restrictions harm a nation’s welfare in the LRLO1LO1