International Trade and Investment:

International trade theoryMuhammad Shafiqforshaf@gmail.com

http://www.slideshare.net/forshaf

Indian economy

International Trade Theories

• Mercantilism• Absolute Advantage• Comparative Advantage

Mercantilism

• Countries should export more than they import

• Theory was famous during 1500 to 1800• Emphasis on benefit rather than

disadvantageous foreing trade• Concept of Balance of payment

Balance of payment

Absolute advantage

• Developed by Adam Smith “ different countries produce some goods more efficiently than other countries: hence, global efficiency can increase through free trade

• Citizen should purchase those goods which are cheaper rather than local

• Concept of free trade

Absolute advantage…

• Smith says that if trade were unrestricted– Labor become more skilled by repetition– Labor would not waste time in switching job– Long production would provide incentive and

development of more effective working methods

Absolute advantage…

Advantage could either natural or equiredNatural considers climate and natural resources:

Sri Lanka, Bangladesh, PakistanAcquired advantages considers technology and skill development;

Denmark silver tablewareJapan Steel, Jamaica Ice

Comparative advantage theory(CAT)

• Advancement of Adam Smith Theory absolute advantage by David Ricardo in 1817.

• Gain from trade will occur even in a country that has absolute advantages in all products because the county must give-up less efficient output to produce more efficient output.

• Based on specialization

CAT:An analogical example

• Example of best doctor in town who is best known for his administrative work

• country must concentrates it recources on producing the commodities it can produce most efficiently

CAT: production possibility example

• Tea & wheat

The Principle of Comparative Advantage: Ricardo

Before Specialization (labor hours / unit) Timber Wheat Total Western WA 25 40 65 Eastern WA 30 25 55 (units) 2 2 120 After Specialization (labor hours / unit) Total Savings Western WA 50 0 50 15 Eastern WA 0 50 50 5 (units) 2 2 100 20

Consequences:1. Trade powerfully shapes local production systems2. Specialization lowers total production costs3. And large markets allow exploitation of scale economies: “the division of

labor is governed by the size of the market” – Adam Smith 1776

But, Transport Costs are Crucial in Determining if Trade will Occur

Before Specialization (labor hours / unit) Timber Wheat Total Western WA 25 40 65 Eastern WA 30 25 55 (units) 2 2 120 After Specialization (labor hours / unit) + Transport Costs

Total Savings

Western WA 55 0 55 10 Eastern WA 0 53 53 2 (units) 2 2 108 12

Trade Feasible in this Case

But, Transport Costs are Crucial in Determining if Trade will Occur

Trade Not Feasible in this Case

Before Specialization (labor hours / unit) Timber Wheat Total Western WA 25 40 65 Eastern WA 30 25 55 (units) 2 2 120 After Specialization (labor hours / unit) + Transport Costs

Total Savings

Western WA 65 0 65 0 Eastern WA 0 55 55 0 (units) 2 2 120 0

Long-run reduction in transport costs has promoted more trade

CAT: Assumptions & Limitation

• Full employment• Economic efficiency objective• Division of gain• Two countries, two commodities• Transport costs• Mobility• services

Theory of country size

• ToAA and TCA do not deal with country -by-country differences in how much and what products will be traded through specialization.

• Difference are there

Differences country by country

• Variety of resources• Transport costs• Size of economy and production scales

Factor proportion theoryHeckscher theory

• Factors in relative abundance are cheaper than factors in relative scarcity

• Srilanka, Netherland, and Hong Kong• Three important characteristics:

– Land-labor relationship– Labor capital relationship– Technological complexity

The product life cycle theory of tradeRemond Vernon

• 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• Location and importance of technology• Export and labor

– Stage 2 :Growth Stage 3: Maturity– Stage 4: Decline

• Verification and limitation of PLC theory

Country similarity theory

• Most trade theories emphasize differences among countries in climate, factor endowment, and innovative capability

• Different type of similarities:– Economic similarity of industrial countries– Similarity of location– Cultural similarity– Similarity of political and economic interest

Strategic Trade policy

• Countries seek to improve their trade capabilities by:– Altering condition for industries in gnernal– Targeting condition for a specific industry

Why companies trade internationally• The porter diamond

Firm strategy structure and rivalry

Demand conditionFactor condition

Related and supporting industries

Points and limitations of the porter diamond

• Most trade theories are based on national perspective, but decision to trade are usually made by companies

Companies role in trade

• Strategic advantages of exports• Use of excess capacity• Cost reduction• Greater profitability• Risk spreading

• Strategic advantages of import• Cheaper supplies• Additions to product line• Reduction of risk of no supply

Porter’s “Diamond”Factor Conditions – human, physical, capital, knowledge-based, infrastructure

Demand Conditions

Supporting IndustriesFirm Strategy, StructureAnd Competition –The importance ofAgglomerations/clusters

Porter’s Traded Clusters

VideoRecorded ProductEntertainment EquipmentEntertainment related servicesEntertainment venuesDistribution & wholesalingMarketing & promotionRelated attractionsNews syndicatesAudio & video equipment

? NontradedEntertainment?

Typical Cluster Representation

Source: A.J. Scott, Regional Studies, Vol. 36, no. 9, p. 966

Typical Cluster Flow Chart

MusiciansLive PerformancesFor audiences

RecordingNo Audience

Equipment: Purchase, rental, repair, manufacture

Replaying musicAM/FM/TVWebMuzakMobile DJ’s

Training& Education

• Venues• Performance/Recording Support• Business Support• Composers

Distribution of recordings:CD’sTapes/files for broadcastFilm scoresGames, Ring-tonesMusic Heritage Organizations

Royalties & Licensing

Presenters/Producing Orgs.

From Beyers, Bonds & Wenzl study of Seattle Music Industry

International Trade and Investment

• Explaining the theoretical basis for international trade and factor flows, including comparative and competitive advantage

• Understanding trade barriers (tariffs)• Examining the dynamics of FDI• Understanding the financing of international

trade• To appreciate trade organizations such as

GATT and WTO

International TradeThe huge national differences in factor endowments;

Long-term shift from barter to money trade

Should be in constant $

Clear shift towardsmore production ofhigher value goods