International trade theories provide explanations for why trade occurs between countries. The main classical theories are mercantilism, absolute advantage, and comparative advantage. More modern theories include Heckscher-Ohlin theory based on factor endowments and country similarity theory, which proposes that countries with similar development levels will trade similar goods. International trade benefits countries by allowing them to specialize in producing goods where they have a comparative advantage.
International trade theories provide explanations for why trade occurs between countries. The main classical theories are mercantilism, absolute advantage, and comparative advantage. More modern theories include Heckscher-Ohlin theory based on factor endowments and country similarity theory, which proposes that countries with similar development levels will trade similar goods. International trade benefits countries by allowing them to specialize in producing goods where they have a comparative advantage.
International trade theories provide explanations for why trade occurs between countries. The main classical theories are mercantilism, absolute advantage, and comparative advantage. More modern theories include Heckscher-Ohlin theory based on factor endowments and country similarity theory, which proposes that countries with similar development levels will trade similar goods. International trade benefits countries by allowing them to specialize in producing goods where they have a comparative advantage.
International trade theories provide explanations for why trade occurs between countries. The main classical theories are mercantilism, absolute advantage, and comparative advantage. More modern theories include Heckscher-Ohlin theory based on factor endowments and country similarity theory, which proposes that countries with similar development levels will trade similar goods. International trade benefits countries by allowing them to specialize in producing goods where they have a comparative advantage.
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Chapter Three
International Trade International Trade Theory
An Overview of Trade Theory
What Is International Trade? Trade is the concept of exchanging goods and
services between two people or entities.
International trade theories are simply different
theories to explain international trade
International Trade Theory International trade is then the concept of this exchange between people or entities in two different countries there is a great deal of theory, policy, and business
strategy that constitutes international trade
What Are the Different International Trade Theories? International Trade Theory (1) Classical or Country Based Theories It is the main historical theories which are from the perspective of a country, or country-based. (A) Mercantilism (B) Absolute Advantage (C) Comparative Advantage (D) Heckscher-Ohlin Theory (Factor Proportions Theory) (A) Mercantilism Mercantilism (mid-16th century) suggests that it is in a countrys best interest to maintain a trade surplus -to export more than it imports This theory stated that a countrys wealth was determined by the amount of its gold and silver holdings. In its simplest sense, mercantilists believed that a country should increase its holdings of gold and silver by promoting exports and discouraging imports. Mercantilism The objective of each country was to have a trade surplus and to avoid a trade deficit Although mercantilism is one of the oldest trade theories, it remains part of modern thinking. Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor exports and discourage imports through a form of neo- mercantilism in which the countries promote a combination of protectionist policies and restrictions and domestic-industry subsidies. Mercantilism Nearly every country, at one point or another, has implemented some form of protectionist policy to guard key industries in its economy While export-oriented companies usually support protectionist policies that favor their industries or firms, other companies and consumers are hurt by protectionism
Mercantilism
Taxpayers pay for government subsidies of select
exports in the form of higher taxes. Import restrictions lead to higher prices for consumers, who pay more for foreign-made goods or services Thus, mercantilisms protectionist policies only benefit select industries, at the expense of both consumers and other companies, within and outside of the industry Mercantilism In general, Mercantilism views trade as a zero-sum game - one in which a gain by one country results in a loss by another (B) Absolute Advantage In 1776, Adam Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation. In other word, Adam Smith (1776) argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it Absolute Advantage Smith reasoned that trade between countries shouldnt be regulated or restricted by government policy or intervention. He stated that trade should flow naturally according to market forces countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for goods produced by other countries Absolute Advantage How Does The Theory Of Absolute Advantage Work? Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes Absolute Advantage In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between Without trade Ghana would produce 10 tons of cocoa and 5 tons of rice South Korea would produce 10 tons of rice and 2.5 tons of cocoa Absolute Advantage With specialization and trade Ghana would produce 20 tons of cocoa South Korea would produce 20 tons of rice Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice After trade Ghana would have 14 tons of cocoa left, and 6 tons of rice South Korea would have 14 tons of rice left and 6 tons of cocoa Absolute Advantage If each country specializes in the production of the good in which it has an absolute advantage and trades for the other, both countries gain trade is a positive sum game (C) Comparative Advantage David Ricardo asked what happens when one country has an absolute advantage in the production of all goods The theory of comparative advantage (1817) - countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries Comparative Advantage Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, it can produce that product better and more efficiently than it does other goods. This implies that Comparative advantage focuses on the relative productivity differences, whereas absolute advantage looks at the absolute productivity. Comparative Advantage How Does The Theory Of Comparative Advantage Work? Assume Ghana is more efficient in the production of both cocoa and rice In Ghana, it takes 10 resources to produce one ton of cocoa, and 13 1/3 resources to produce one ton of rice So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two Comparative Advantage In South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice So, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two Comparative Advantage With trade Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice Ghana will still have 11 tons of cocoa, and 4 additional tons of rice South Korea still has 6 tons of rice and 4 tons of cocoa if each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain Comparative Advantage Comparative advantage theory provides a strong rationale for encouraging free trade totaloutput is higher both countries benefit
Trade is a positive sum game
(D) Heckscher-Ohlin Theory (Factor Proportions Theory) The theories of Smith and Ricardo didnt help countries determine which products would give a country an advantage. Both theories assumed that free and open markets would lead countries and producers to determine which goods they could produce more efficiently. Heckscher-Ohlin Theory (Factor Proportions Theory Eli Heckscher (1919) and Bertil Ohlin (1933) - comparative advantage arises from differences in national factor endowments Their theory is based on a countrys production factorsland, labor, and capital, which provide the funds for investment in plants and equipment. Heckscher-Ohlin Theory (Factor Proportions Theory They determined that the cost of any factor or resource was a function of supply and demand. Factors that were in great supply relative to demand would be cheaper; factors in great demand relative to supply would be more expensive. Heckscher-Ohlin Theory (Factor Proportions Theory Their theory stated that countries would produce and export goods that required resources or factors that were in great supply and, therefore, cheaper production factors. In contrast, countries would import goods that required resources that were in short supply, but higher demand Heckscher-Ohlin Theory (Factor Proportions Theory For example, China and India are home to cheap, large pools of labor. Hence these countries have become the optimal locations for labor-intensive industries like textiles and garments. Heckscher-Ohlin Theory (Factor Proportions Theory Does The Heckscher-Ohlin Theory Hold? Wassily Leontief (1953) theorized that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods. However, he found that U.S. exports were less capital intensive than U.S. imports Since this result was at variance with the predictions of trade theory, it became known as the Leontief Paradox (2) Modern Firm or Company Based Theories By the mid-twentieth century, the theories began to shift to explain trade from a firm, rather than a country, perspective. (A) Country Similarity Theory (B) Product Life Cycle Theory (A) Country Similarity Theory Swedish economist Steffan Linder developed the country similarity theory in 1961, as he tried to explain the concept of intra industry trade. Linders theory proposed that consumers in countries that are in the same or similar stage of development would have similar preferences. In this firm-based theory, Linder suggested that companies first produce for domestic consumption. When they explore exporting, the companies often find that markets that look similar to their domestic one, in terms of customer preferences, offer the most potential for success. Country Similarity Theory Linders country similarity theory then states that most trade in manufactured goods will be between countries with similar per capita incomes, and intra industry trade will be common. This theory is often most useful in understanding trade in goods where brand names and product reputations are important factors in the buyers decision-making and purchasing processes (B) Product Life Cycle Theory The product life-cycle theory - as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade proposed by Ray Vernon in the mid-1960s Atthis time most of the worlds new products were developed by U.S. firms and sold first in the U.S. Product Life Cycle Theory According to the product life-cycle theory the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new products initially, the product would be produced and sold in the U.S.
as demand grew in other developed countries, U.S. firms
would begin to export demand for the new product would grow in other advanced countries over time making it worthwhile for foreign producers to begin producing for their home markets Product Life Cycle Theory
U.S. firms might set up production facilities in
advanced countries with growing demand, limiting exports from the U.S. As the market in the U.S. and other advanced nations matured, the product would become more standardized, and price would be the main competitive weapon Product Life Cycle Theory Producers based in advanced countries where labor costs were lower than the United States might now be able to export to the United States If cost pressures were intense, developing countries would acquire a production advantage over advanced countries Production became concentrated in lower-cost foreign locations, and the U.S. became an importer of the product Product Life Cycle Theory Does The Product Life Cycle Theory Hold? The product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the United States in the 1960s and 1970s mature industries leave the U.S. for low cost assembly locations But, the globalization and integration of the world economy has made this theory less valid today the theory is ethnocentric production today is dispersed globally products today are introduced in multiple markets simultaneously (c) Global Strategic Rivalry or new trade Theory
Global strategic rivalry theory emerged in the
1980s and was based on the work of economists Paul Krugman and Kelvin Lancaster. Their theory focused on MNCs and their efforts to gain a competitive advantage against other global firms in their industry. Global Strategic Rivalry or new trade Theory
Firms will encounter global competition in their
industries and in order to prosper, they must develop competitive advantages. The critical ways that firms can obtain a sustainable competitive advantage are called the barriers to entry for that industry. The barriers to entry refer to the obstacles a new firm may face when trying to enter into an industry or new market. Global Strategic Rivalry or new trade Theory
The barriers to entry that corporations may seek to
optimize include: o research and development, o the ownership of intellectual property rights, o economies of scale, o unique business processes or methods as well as extensive experience in the industry, and o the control of resources or favorable access to raw materials. Global Strategic Rivalry or new trade Theory
New trade theory suggests that the ability of firms
to gain economies of scale can have important implications for international trade Countries may specialize in the production and export of particular products because in certain industries, the world market can only support a limited number of firms Global Strategic Rivalry or new trade Theory
What Are The Implications Of New Trade Theory
For Nations? Nations may benefit from trade even when they do not differ in resource endowments or technology a country may dominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good Governments should consider strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important (D) Porters National Competitive Advantage Theory Michael Porter (1990) tried to explain why a nation achieves international success in a particular industry identified four attributes that promote or impede the creation of competitive advantage 1. Factor endowments - a nations position in factors of production necessary to compete in a given industry can lead to competitive advantage can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how) Porters National Competitive Advantage Theory
2. Demand conditions - the nature of home demand
for the industrys product or service influences the development of capabilities sophisticated and demanding customers pressure firms to be competitive 3. Relating and supporting industries - the presence or absence of supplier industries and related industries that are internationally competitive can spill over and contribute to other industries successful industries tend to be grouped in clusters in countries Porters National Competitive Advantage Theory
4. Firm strategy, structure, and rivalry - the conditions
governing how companies are created, organized, and managed, and the nature of domestic rivalry different management ideologies affect the development of national competitive advantage vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features Determinants of National Competitive Advantage: Porters Diamond Porters National Competitive Advantage Theory
What Are The Implications Of Trade Theory For
Managers? 1. Location implications - a firm should disperse its various productive activities to those countries where they can be performed most efficiently firms that do not may be at a competitive disadvantage 2. First-mover implications - a first-mover advantage can help a firm dominate global trade in that product 3. Policy implications - firms should work to encourage governmental policies that support free trade want policies that have a favorable impact on each component of the diamond Which Trade Theory Is Dominant Today? While they have helped economists, governments, and businesses better understand international trade and how to promote, regulate, and manage it, these theories are occasionally contradicted by real-world events Which Trade Theory Is Dominant Today? As a result, its not clear that any one theory is dominant around the world. This section has sought to highlight the basics of international trade theory to enable you to understand the realities that face global businesses. In practice, governments and companies use a combination of these theories to both interpret trends and develop strategy. Just as these theories have evolved over the past five hundred years, they will continue to change and adapt as new factors impact international trade. The Political Economy of International Trade Introduction Free trade refers to a situation where a govt does not attempt to restrict what its citizens can buy from another country or what they can sell to another country While many nations are nominally committed to free trade, they tend to intervene in international trade to protect the interests of politically important groups Instruments of Trade Policy
There are seven main instruments of trade policy
1. Tariffs 2. Subsidies 3. Import quotas and Voluntary export restraints 4. Local content requirements 5. Administrative policies 6. Antidumping policies Tariffs A tariff - a tax levied on imports that effectively raises the cost of imported products relative to domestic products Specific tariffs are levied as a fixed charge for each unit of a good imported Ad valorem tariffs are levied as a proportion of the value of the imported good Why Tariffs? Tariffs increase government revenues provide protection to domestic producers against foreign competitors by increasing the cost of imported foreign goods force consumers to pay more for certain imports
So, tariffs are unambiguously pro-producer and
anti-consumer, and tariffs reduce the overall efficiency of the world economy Subsidies A subsidy - a government payment to a domestic producer Subsidies help domestic producers compete against low-cost foreign imports gain export markets
Consumers typically absorb the costs of subsidies
Import Quotas and Voluntary Export Restraints An import quota - a direct restriction on the quantity of some good that may be imported into a country Tariff rate quotas - a hybrid of a quota and a tariff where a lower tariff is applied to imports within the quota than to those over the quota Voluntary export restraints - quotas on trade imposed by the exporting country, typically at the request of the importing countrys government A quota rent - the extra profit that producers make when supply is artificially limited by an import quota Local Content Requirements A local content requirement demands that some specific fraction of a good be produced domestically can be in physical terms or in value terms Local content requirements benefit domestic producers and jobs, but consumers face higher prices Administrative policies Administrative trade polices - bureaucratic rules that are designed to make it difficult for imports to enter a country These polices hurt consumers by denying access to possibly superior foreign products Antidumping polices Dumping - selling goods in a foreign market below their cost of production, or selling goods in a foreign market at below their fair market value a way for firms to unload excess production in foreign markets may be predatory behavior, with producers using substantial profits from their home markets to subsidize prices in a foreign market with a view to driving indigenous competitors out of that market, and later raising prices and earning substantial profits Antidumping polices Antidumping polices - designed to punish foreign firms that engage in dumping the goal is to protect domestic producers from unfair foreign competition firms that believe a foreign firm is dumping can file a complaint with the government ifthe complaint has merit, antidumping duties, also known as countervailing duties may be imposed The Case for Government Intervention
There are two types of arguments
1. Political arguments - concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consumers) 2. Economic arguments - concerned with boosting the overall wealth of a nation (to the benefit of all, both producers and consumers) Political arguments for government intervention Political arguments for government intervention include 1. protecting jobs 2. protecting industries deemed important for national security 3. retaliating to unfair foreign competition 4. protecting consumers from dangerous products 5. furthering the goals of foreign policy 6. protecting the human rights of individuals in exporting countries Political arguments for government intervention 1. Protecting jobs and industries - the most common political reason for trade restrictions typically the result of political pressures by unions or industries that are "threatened" by more efficient foreign producers, and have more political clout than the consumers who will eventually pay the costs 2. National Security - governments protect certain industries such as aerospace or advanced electronics because they are important for national security this argument is less common today than in the past Political arguments for govt intervention
3. Retaliation - when governments take, or threaten to
take, specific actions, other countries may remove trade barriers can be a risky strategy if threatened governments dont back down, tensions can escalate and new trade barriers may be enacted 4. Protecting Consumers - protecting consumers from unsafe products is also be an argument for restricting imports often involves limiting or banning the import of certain products Political arguments for govt intervention
can be used to support foreign policy objectives preferential trade terms can be granted to countries that a government wants to build strong relations with rogue states that do not abide by international laws or norms can be punished However, it might cause other countries to undermine unilateral trade sanctions Political arguments for govt intervention
.6. Protecting Human Rights - governments can use
trade policy to improve the human rights policies of trading partners unless a large number of countries choose to take such action, however, it is unlikely to prove successful Some critics have argued that the best way to change the internal human rights of a country is to engage it in international trade Economic arguments for intervention Economic arguments for government intervention in international trade include 1. The infant industry argument 2. Strategic trade policy Economic arguments for intervention 1. The infant industry argument - suggests that an industry should be protected until it can develop and be viable and competitive internationally thishas been accepted as a justification for temporary trade restrictions under the WTO However, this argument has been criticized because it is useless unless it makes the industry more efficient if a country has the potential to develop a viable competitive position, its firms should be capable of raising necessary funds Economic arguments for intervention 2. Strategic Trade Policy - suggests that in cases where there may be important first mover advantages, governments can help firms from their countries attain these advantages also suggests that govts can help firms overcome barriers to entry into industries where foreign firms have an initial advantage The Revised Case for Free Trade New trade theorists believe govt intervention in international trade is justified classic trade theorists disagree Some new trade theorists believe that while strategic trade theory is appealing in theory, it may not be workable in practice they suggest a revised case for free trade Two situations where restrictions on trade may be inappropriate Retaliation Domestic Policies Retaliation and War Krugman - strategic trade policies aimed at establishing domestic firms in a dominant position in a global industry are beggar-the-neighbor policies that boost national income at the expense of other countries A country that attempts to use such policies will probably provoke retaliation a trade war could leave both countries worse off Domestic Policies Governments can be influenced by special interest groups a governments decision to intervene in a market may appease a certain group, but not necessarily the support the interests of the country as a whole End of Chapter Three