Chapter 05 - International Trade Theory

International Trade Theory

Chapter Outline
OPENING CASE: The Ecuadorian Rose Industry INTRODUCTION AN OVERVIEW OF TRADE THEORY The Benefits of Trade The Pattern of International Trade Trade Theory and Government Policy MERCANTILISM Country Focus: Is China a Neo-Mercantilist Nation? ABSOLUTE ADVANTAGE COMPARATIVE ADVANTAGE The Gains from Trade Qualifications and Assumptions Extensions of the Ricardian Model Country Focus: Moving U.S. White Collar Jobs Offshore HECKSCHER-OHLIN THEORY The Leontief Paradox THE PRODUCT LIFE CYCLE THEORY Evaluating the Product Life Cycle Theory NEW TRADE THEORY Increasing Product Variety and Reducing Costs Economies of Scale, First Mover Advantages and the Pattern of Trade Implications of New Trade Theory

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NATIONAL COMPETITIVE ADVANTAGE: PORTERS DIAMOND Factor Endowments Demand Conditions Related and Supporting Industries Firm Strategy, Structure, Rivalry Evaluating Porters Theory Management Focus: The Rise of Finlands Nokia FOCUS ON MANAGERIAL IMPLICATIONS Location First-Mover Advantages Government Policy SUMMARY CRITICAL THINKING AND DISCUSSION QUESTIONS CLOSING CASE: Trade in Information Technology and U.S. Economic Growth

Learning Objectives
1. Understand why nations trade with each other. 2. Be familiar with the different theories explaining trade flows between nations. 3. Understand why many economists believe that unrestricted free trade between nations will raise the economic welfare of all countries that participate in a free trade system. 4. Be familiar with the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries. 5. Understand the important implications that international trade theory holds for business practice.

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Chapter Summary
This chapter focuses on the benefits of international trade and introduces several theories that help explain the patterns of international trade that are observed in practice. The discussion begins with an explanation of the theory of mercantilism, and then proceeds to discuss the theories of absolute advantage and comparative advantage. Four additional theories are discussed, including the Heckscher-Ohlin theory, the product life cycle theory, the new trade theory, and the theory of national competitive advantage. Each of these theories helps explain why certain goods are (or should be) made in certain countries. The chapter ends by discussing the link between the theories of international trade and (1) a firms decision about where (in the world) to locate its various productive activities, (2) the importance of establishing first-mover advantages, and (3) government trade policies.

Opening Case: The Ecuadorian Rose Industry

Summary The opening case describes Ecuadors rose industry. In the last 20 years, Ecuador has built its rose
industry from virtually nothing to a thriving industry generating $240 million in sales. Today, the industry employs tens of thousands of people at higher wages than the average Ecuadorian receives. Yet, there are concerns that in the quest for perfect flowers, the use of toxic chemicals such as pesticides may be hurting not only the environment, but also the health of the workers. Discussion of the case can revolve around the following questions:

QUESTION 1: Describe the benefits that the rose industry has brought to Ecuador. In your opinion, do
the benefits outweigh the disadvantages? Why or why not?

ANSWER 1: Ecuador is now the worlds fourth largest producer of roses. Rose farms in the country support tens of thousands of jobs. Revenues and taxes from the industry have been used to help pave roads, build schools, and construct irrigation systems. Many workers earn more in the industry than they could elsewhere. Many students will probably argue that indeed the industry has been beneficial to the country. Some students however, may note that in rose-growing cities like Cayambe, populations have swelled significantly putting pressure on the resources within the region. In addition, environmentalists worry that the industry is now following proprer safetyt precautions with the chemicals it uses.

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QUESTION 2: Consumer groups in Europe have pushed for reforms to Ecuadors environmental regulations for its rose industry. Other groups have encouraged trade sanctions to force Ecuadorian rose growers to be more environmentally responsible. Consider the impact these groups could have on Ecuador and workers in the rose industry if they are successful in their efforts. ANSWER 2: In response to the suggestions of consumer groups in Europe, some Ecuadorian rose growers have voluntarily joined a program certifying they are responsible growers. As part of the program , the growers must supply workers with appropriate protective gear, train them in the proper use of chemicals, and hire doctors to visit workers on a weekly basis. Most students will recognize that the cost of this type of program will affect the profits of growers, and could lead to layoffs within the industry, higher prices for consumers, or both. Teaching Tip: For more information on the rose industry in Ecuador, visit {http://www.american.edu/TED/rose.htm}.

Chapter Outline with Lecture Notes and Teaching Tips

INTRODUCTION A) This chapter has two goals. The first goal is to review a number of theories that explain why it is beneficial for a country to engage in international trade. The second goal is to explain the pattern of international trade that is observed in the world economy. Lecture Note: It is often worth asking students before discussing the theories why countries trade the products they do. They will frequently with a little prompting hit upon many of the ideas presented in this chapter and consequently relate better to the various theories that are discussed. AN OVERVIEW OF TRADE THEORY A) Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country. The Benefits of Trade B) The great strength of the theories of Smith, Ricardo, and Hecksher-Ohlin is that they identify with precision the specific benefits of trade. Common sense suggests that some trade is beneficial. The theories of Smith, Ricardo and Hecksher-Ohlin go beyond commonsense to show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. The gains arise because international trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, while importing products that can be produced more efficiently in other countries.

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The Pattern of International Trade C) Some patterns of trade are fairly easy to explain - it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee. Yet others are not so obvious or easily explained. Why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Japan export automobiles, consumer electronics, and machine tools? D) New trade theory stresses that in some cases countries specialize in the production and export of particular products not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of firms. So a countrys pattern of trade may be a reflection of the ability of firms in that nation to capture first-mover advantages. E) Michael Porter suggested that a countrys factor endowments as well as domestic demand and domestic rivalry are important in explaining a nations dominance in the production and export of particular products. Trade Theory and Government Policy F) While all of the trade theories discussed in the text agree that international trade is beneficial to a country, they lack agreement in their recommendations for government policy. Mercantilism makes a crude case for government involvement in promoting exports and limiting imports. Smith, Ricardo, and Heckscher-Ohlin all promote the notion of unrestricted free trade. The argument for unrestricted free trade is that both import controls and export incentives (such as subsidies) are self defeating and result in wasted resources. Yet both the new trade theory and Porters theory of national competitive advantage can be interpreted as justifying some limited and selective government intervention to support the development of certain export-oriented industries. MERCANTILISM A) The first theory of international trade emerged in England in the mid-16th century. Referred to as mercantilism, its principle assertion was that it is in a countrys best interest to maintain a trade surplus, to export more than it imports. Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. Teaching Note: A historical perspective of Mercantilism is available at {http://www.referenceforbusiness.com/encyclopedia/Man-Mix/Mercantilism.html}. B) The flaw of mercantilism was that it viewed trade as a zero-sum game, one in which a gain by one country results in a loss by another. It was left to Adam Smith and David Ricardo to show the shortsightedness of this approach and to demonstrate that trade is a positive-sum game. As an economic philosophy, mercantilism is problematic and not valid. Yet many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade.

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Country Focus: Is China a Neo-Mercantilist Nation? Summary This feature analyzes claims that China is a neo-mercantilist nation. Exports are largely responsible for Chinas recent rapid economic growth. The country, capitalizing on its cheap labor force, has been focused on converting raw materials into products that are exported to developed countries like the United States. In 2007, Chinas trade surplus was a record $262 billion, and its holdings of foreign exchange reserves were over $1.5 trillion. Some critics have suggested that China is following a neo-mercantilist policy. Suggested Discussion Questions 1. Are the claims that China is following a neo-mercantilist policy valid? Why or why not? Discussion Points: Some critics claim that Chinas deliberate steps to maintain a low currency relative to the dollar is indicative of the countrys neo-mercantilist policy which tries to simultaneously increase exports and limit imports. Many students will probably note that Chinas impressive growth in recent years is largely export led, which would support the claims of the critics. Chinas trade surplus in 2007 was $262 billion, and the country had foreign exchange reserves of more than $1.5 trillion, 70 percent of which were in U.S. dollars. At the same time, the country appears to have implemented an import substitution policy as it now produces products such as steel and paper that had been formerly imported. 2. What incentive does China have to open its markets to foreign products? Why might China resist such a move? Discussion Points: China is under significant pressure from many countries including the United States to open its markets to foreign goods. Students will probably recognize that if the country does open its markets, the impressive economic growth the country has been experiencing would probably be affected. However, students may also note that the country may have to make some changes to its polices if only to appease other nations and prevent retaliatory trade measures from being taken. Already, the country, in response to pressure from the United States, has allowed its currency to appreciate relative to the dollar.

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3. Is there evidence that China is pursuing an import substitution policy? How would this type of policy benefit the country? Discussion Points: Countries following an import substitution policy try to substitute domestic production for products that were previously imported, regardless of whether it is more efficient to produce them domestically or not. Most students will probably suggest that in Chinas case, this certainly appears to be occurring. The country used to import steel, aluminum, and paper, but now produces those products domestically, and in doing so, avoids the cash outflows that would accompany imports. With its greater reserves of foreign currencies, China gains economic power over other nations. Lecture Note: For more information on Chinas trade policy, students may want to read {http://www.businessweek.com/globalbiz/content/aug2007/gb20070823_646159.htm? chan=search}. ABSOLUTE ADVANTAGE A) In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently, and 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. According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries. The text provides a numerical example of Smiths theory. B) When each country has an absolute advantage in one product, it is clear that trade is beneficial. But what if one country has an absolute advantage in both products? COMPARATIVE ADVANTAGE A) David Ricardo took Adam Smiths theory one step further by exploring what might happen when one country has an absolute advantage in the production of all goods. Smiths theory of absolute advantage suggests that such a country might derive no benefits from international trade. In his 1817 book Principles of Political Economy, Ricardo showed that this was not the case. According to Ricardos theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself. The textbook provides a detailed example to explain the rationale of this theory.

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B) The simple example of comparative advantage presented in the text makes a number of assumptions: only two countries and two goods; zero transportation costs; similar prices and values; resources are mobile between goods within countries, but not across countries; constant returns to scale; fixed stocks of resources; and no effects on income distribution within countries. While these are all unrealistic, the general proposition that countries will produce and export those goods in which they are most efficient has been shown to be quite valid. Teaching Tip: For more on the ideas and philosophies of David Ricardo, go to {http://www.econlib.org/library/Enc/bios/Ricardo.html}. In addition, {http://cepa.newschool.edu/het/alphabet.htm} contains information on numerous philosophers, and {http://cepa.newschool.edu/het/profiles/ricardo.htm}contains information on Ricardo specifically. The Gains from Trade C) The theory of comparative advantage argues that trade is a positive sum gain in which all gain. It provides a strong rationale for encouraging free trade. Qualifications and Assumptions D) The simple example of comparative advantage presented in the text makes a number of assumptions: only two countries and two goods; zero transportation costs; similar prices and values; resources are mobile between goods within countries, but not across countries; constant returns to scale; fixed stocks of resources; and no effects on income distribution within countries. While these are all unrealistic, the general proposition that countries will produce and export those goods in which they are most efficient has been shown to be quite valid. Extensions of the Ricardian Model E) The text provides explores the effects of relaxing the assumptions that resources are mobile between goods within a country, and that trade does not change a countrys stock of resources or the efficiency with which those resources are utilized. Immobile Resources F) As illustrated by the example in the test, resources do not always move freely from one economic activity to another. Diminishing Returns G) The model of comparative advantage assumes constant returns to specialization (the units of resources required to produce a good are assumed to remain constant no matter where one is on a countrys production possibility frontier). However, it is more realistic to assume diminishing returns to specialization (more units of resources are required to produce each additional unit).

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H) Diminishing returns are more realistic because not all resources are of the same quality, and because different goods use resources in different proportions. Diminishing returns to specialization suggest that the gains from specialization will probably be exhausted before specialization is complete. Still, unrestricted free trade makes sense even if the gains are not as great as suggested by the constant returns case. Dynamic Effects and Economic Growth I) Opening an economy to trade is likely to generate dynamic gains of two types. First, trade might increase a country's stock of resources as increased supplies become available from abroad. Second, free trade might increase the efficiency of resource utilization, and free up resources for other uses. The Samuelson Critique J) Samuelson argues that in some cases, the dynamic gains from trade may not be so beneficial. He argues that the ability to off-shore services jobs that were traditionally not internationally mobile may have the effect of a mass inward migration into the United States, where wages fall, effectively negating the gains of international trade. Country Focus: Moving U.S. White Collar Jobs Offshore Summary This feature goes to the heart of a debate that has been played out many times over the past half centurythe transference of jobs from the United States to lower-wage countries. The difference now however, is that rather than blue-collar jobs being transferred, the new trend is for whitecollar jobs to move, jobs associated with the knowledge-based economy. Suggested Discussion Questions 1. Will the United States suffer from the loss of highly skilled and high paying jobs? What does the transference of white-collar jobs mean to the average American? Discussion Points: This hot issue is a highly sensitive one for many Americansespecially those who have seen their once secure jobs being shipped offshore. Many students will probably know someone who has suffered from this very situation, and may claim that companies have lost all loyalty to their employees and simply become profit seekers. Other students however, may point that companies are in business to make a profit, and do well for other stakeholders such as investors. Some students will simply argue that the loss of white-collar jobs is merely a manifestation of companies viewing the world as a borderless marketwhere they seek resources wherever they are cheapest, produce in the optimal location, and sell wherever there is demand.

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2. What does the transference of white-collar jobs mean to recipient countries such as India and the Philippines? Discussion Points: For developing countries like India and the Philippines, the transference of white-collar jobs from the United States not only generates new jobs, it also brings new skills and knowledge that could be vital to the countries as they continue on the path toward greater economic development. Students should recognize that greater employment levels will of course have the effect of pushing wages up, and creating greater economic prosperity in these nations. This in turn should be beneficial for American companies as new export markets develop. 3. Why do American companies transfer white-collar jobs to countries like India and the Philippines? Discussion Points: India offers companies a well-educated workforce that is willing to work for a fraction of what companies would pay in the United States. By transferring skilled jobs to India or the Philippines, American companies increase their global competitiveness and profitability. Students will probably note that the trend to outsource is likely to continue as companies seek an edge wherever they can find one. Already, the trend is being seen in new industries such as healthcare where not only paperwork but even radiology services are now being routinely outsourced. Lecture Note: Outsourcing is not always beneficial for companies. To extend this discussion, consider discussing why outsourcing may not be possible. For more on this topic, go to {http://www.businessweek.com/smallbiz/content/jul2007/sb20070720_787886.htm}. Lecture Note: Outsourcing call centers is common in many industries today, however it can also be controversial. Many people dislike speaking to foreigners who may not have a complete grasp of their language, and get frustrated with the responses they receive. To extend the discussion of outsourcing to include this angle, consider {http://www.businessweek.com/managing/content/sep2007/ca20070927_836850.htm? chan=search}. Evidence for the Link between Trade and Growth K) Studies exploring the relationship between trade and economic growth suggest that countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade. HECKSCHER-OHLIN THEORY A) Hecksher and Ohlin argued that comparative advantage arises from differences in national factor endowments (land, labor, and capital). As a result, the Heckscher-Ohlin theory 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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Teaching Tip: A more complete description of the Heckscher-Ohlin theory is available at {http://cepa.newschool.edu/het/alphabet.htm}. The Leontief Paradox B) Using the Heckscher-Ohlin theory, Leontief, in 1953 postulated that since the United States was relatively abundant in capital compared to other nations, the United States would be an exporter of capital intensive goods and an importer of labor-intensive goods. To his surprise, 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 the theory, it has become know as the Leontief Paradox. Teaching Tip: A more extensive description of the Leontief Paradox is available at {http://cepa.newschool.edu/het/alphabet.htm}. C) Recent research suggests that the Heckscher-Ohlin theory gains predictive power if the impact of differences in technology on productivity is controlled for. THE PRODUCT LIFE CYCLE THEORY A) Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s. According to the theory as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade. B) According to Vernon, early in the life cycle of a typical new product, while demand is starting to grow in the United States, demand in other advanced countries is limited to high-income groups. The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the United States to those countries. Over time, however, demand for the new product starts to grow in other advanced countries. As it does, it becomes beneficial for foreign producers to being producing for their home markets. In addition, U.S. firms might set up production facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States. C) As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon. One result is that producers based in advanced countries where labor costs are lower than the United States might now be able to export to the United States. D) If cost pressures become intense, the process might not stop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated once more as developing countries begin to acquire a production advantage over advanced countries.

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E) The consequences of these trends for the pattern of world trade is that the United States switches from being an exporter of the product to an importer of the product as production becomes more concentrated in lower-cost foreign locations. Evaluating the Product Life Cycle Theory F) While 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, the increasing globalization and integration of the world economy has made this theory less valid in today's world. NEW TRADE THEORY A) New trade theory suggests that the ability of firms to realize economies of scale (unit cost reductions associated with a large scale of output) may help explain international trade patterns. B) New trade theory makes two important points. First, trade can increase the variety of goods available to consumers and decrease the average cost of those goods. Second, in industries where the output necessary to attain economies of scale is significant relative to total world demand, only a few companies may be able to survive. Being a first mover in these industries is important. Increasing Product Variety and Reducing Costs C) According to new trade theory, a nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods. Economies of Scale, First Mover Advantages, and the Pattern of Trade D) A second theme in new trade theory is that the pattern of trade we observe in the world economy may be the result of first mover advantages (economic and strategic advantages that accrue to early entrants into an industry) and economies of scale. Implications of New Trade Theory E) New trade theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology. The theory also suggests that a country may predominate in the export of a good simply because it was lucky enough to have first mover firms. F) New trade theory is at variance with the Hecksher-Ohlin theory, which suggests that a country will predominate in the export of a product when it is particularly well endowed with those factors used intensively in its manufacture. New trade theory does not contradict the theory of comparative advantage, but instead identifies a source of comparative advantage.

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G) An obvious and controversial extension of new trade theory is the implication that governments should consider strategic trade policies. Strategic trade policies would suggest that governments should nurture and protect firms and industries where first mover advantages and economies of scale are likely to be important, as doing so can make it more likely that a firm will build economies of scale and eventually end up a winner in the global competitive race. NATIONAL COMPETITIVE ADVANTAGE: PORTERS DIAMOND A) Porters 1990 study tried to explain why a nation achieves international success in a particular industry. This study found four broad attributes factor endowments, demand conditions, relating and supporting industries, and firm strategy, structure, and rivalry - that promote or impede the creation of competitive advantage. These are shown as a diamond in Figure 5.6. Porter argues that firms are most likely to succeed in industries where the diamond is favorable. Factor Endowments B) A nation's position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry can be critical. These factors can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how). While either can be important, advanced factors are more likely to lead to competitive advantage. Demand Conditions C) The nature of home demand for the industries product or service influences the development of capabilities. Sophisticated and demanding customers pressure firms to be competitive. Relating and Supporting Industries D) The presence in a nation 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 - having world class producers of semi-conductor processing equipment can lead to (and be a result of having) a competitive semi-conductor industry. Firm Strategy, Structure, and Rivalry E) The conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalry impacts firms' competitiveness. Firms that face strong domestic competition will be better able to face competitors from other firms.

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Evaluating Porters Theory F) In addition to these four main attributes, government policies and chance can impact any of the four. Government policy can affect demand through product standards, influence rivalry through regulation and antitrust laws, and impact the availability of highly educated workers and advanced transportation infrastructure. G) The four attributes of the diamond, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage. To date, Porters theory has not be subjected to detailed empirical testing. Management Focus: The Rise of Finlands Nokia Summary This feature is about the growth of the cellular telephone equipment industry, and more specifically, about the rise in competitiveness of Nokia, a Finnish cellular telephone company. The feature explains the reasons that Nokia was particularly well positioned to take advantage of the growth of the global cellular telephone industry. Nokia is one of the most dominant players in the mobile phone industry, holding 39 percent of the worlds market in 2007. Suggested Discussion Questions 1. Using the new trade theory and Porters theory of national competitive advantage, describe why Nokia emerged as a leading competitor in the global cellular telephone equipment industry. Discussion Points: New trade theory suggests that a country may be the dominant exporter of a particular product simply because it was lucky enough to a first mover firm for the product. The theory would suggest that Nokia was able to benefit from its innovations that helped it gain first mover advantages, but also that it was simply lucky enough to be in the right place at the right time. Porter argues that a nations competitive advantage is dependent on its factor endowments, demand conditions, relating and supporting industries, and firm strategy, structure and rivalry. Students will probably recognize that Finlands limited traditional telephone service (see question 2 below) meant that demand was strong. At the same time, the company was able to benefit from the fact that the country does not have a national telephone monopoly. Instead, about 50 companies all battle for market share. For Nokia, that meant a focus on bringing costs down, while remaining on the leading edge of technology.

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2. Explain why the cellular telephone industry caught on in Finland and the other Scandinavian countries faster than the rest of the world. Discussion Points: Geography appears to be the key reason why cellular telephone service appears to have caught on in Scandinavian countries more quickly than in other parts of the world. With its cold climate and sparse population, Scandinavia found traditional wire-line service costly, and embraced the cheaper alternative of cellular service. Students will probably recognize that this situation combined with the need for communication services meant that countries like Finland had a greater incentive to develop the industrywhich of course helped Nokia become a leading player in the industry. 3. Why didnt the development of the cellular telephone equipment industry take place in Mexico or another Central or South American country rather than Finland, Sweden, and the United States? Base your answer of the international trade theories described in this chapter. Discussion Points: Students will probably recognize that the conditions in Scandinavia set the stage for the development of cellular telephone service. Not only were Scandinavians open and able to try new products, they also needed communications services. Governments like Finlands also saw the benefits of developing the industry as a cheaper alternative to traditional services. Teaching Tip: For more information on the company, go to Nokias homepage at {http://www.nokia.com/}. FOCUS ON MANAGERIAL IMPLICATIONS A) There are at least three main implications of the material discussed in this chapter for international businesses: location implications, first-mover implications, and policy implications. Location B) One way in which the material discussed in this chapter matters to an international business concerns the link between the theories of international trade and a firms decision about where to locate its various productive activities. Underlying most of the theories is the notion that different countries have particular advantages in different productive activities. Thus, from a profit perspective, it makes sense for a firm to disperse its various productive activities to those countries where, according to the theory of international trade, they can be performed most efficiently. Being a first mover can have important competitive implications, especially if there are economies of scale and the global industry will only support a few competitors. Firms need to be prepared to undertake huge investments and suffer losses for several years in order to reap the eventual rewards.

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First Mover Advantages C) Being a first mover can have important competitive implications, especially if there are economies of scale and the global industry will only support a few competitors. Firms need to be prepared to undertake huge investments and suffer losses for several years in order to reap the eventual rewards. Government Policy D) The theories of international trade also matter to international businesses because business firms are major players on the international trade scene. Because of their pivotal role in international trade, business firms can and do exert a strong influence on government trade policy. Government policies with respect to free trade or protecting domestic industries can significantly impact global competitiveness. E) One of the most important implications for businesses is that they should work to encourage governmental policies that support free trade. If a business is able to get its goods from the best sources worldwide, and compete in the sale of products into the most competitive markets, it has a good chance to survive and prosper. If such openness is restricted, a businesss long-term survival will be in greater question. Teaching Tip: For information about foreign governments and their approaches to international trade, visit the Electronic Embassy at {http://www.embassy.org/}. This site provides links to all of the foreign embassies located in Washington D.C.

Critical Thinking and Discussion Questions

1. Mercantilism is a bankrupt theory that has no place in the modern world. Discuss. Answer: Mercantilism, in its purest sense, is a bankrupt theory that has no place in the modern world. The principle tenant of mercantilism is that a country should maintain a trade surplus, even if it means that imports are limited by government intervention. This policy is bankrupt for at least two reasons. First, it is inconsistent with the general notion of globalization which is becoming more and more prevalent in the world. A policy of mercantilism will anger potential trade partners because it will exclude their goods from free access to the mercantilist countrys markets. Eventually, a country will find it difficult to export if it imposes oppressive quotas and tariffs on its trading partners. Second, mercantilism is bankrupt because it hurts the consumers in the mercantilist country. By denying its consumers access to either cheaper goods from other countries or more sophisticated goods from other countries, the mercantilist countrys ordinary consumers suffer.

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2. Is free trade fair? Discuss! Answer: This question is designed to stimulate class discussion. Trade theory suggests that specialization and free trade benefits all countries. However, a case can be made in some situations for imposing trade barriers. For example, if a developing country is trying to establish a new industry, trade barriers may be needed in the short term until the industry can become competitive. While it could be argued that another country could make the product more efficiently already, is it fair to limit a countrys ability to develop its industrial base? 3. Unions in developed nations often oppose imports from low-wage countries and advocate trade barriers to protect jobs from what they often characterize as unfair import competition. Is such competition unfair? Do you think that this argument is in the best interests of (a) the unions, (b) the people they represent, and/or (c) the country as a whole? Answer: The theory of comparative advantage suggests that a country should specialize in producing those goods that it can produce most efficiently, while buying goods that it can produce relatively less efficiently from other countries. Furthermore, the theory suggests that opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. Therefore, it would follow that if low-wage countries can make certain products more efficiently than high wage countries, the low wage countries should produce and export those products. While trade barriers may protect workers and companies, they are a short-term fix at best. Moreover, by protecting industries, the government is not encouraging companies to become more efficient. Instead, they are promoting inefficiency. Consumers lose out because they have higher prices and less choice. 4. What are the potential costs of adopting a free trade regime? Do you think governments should do anything to reduce these costs? What? Answer: Students will probably be divided on this question, and a lively debate should ensue. For example, students will probably recognize that by adopting a free trade regime, jobs will be lost in some industries, however they may not agree on exactly what should be done about the jobs losses. Some students might suggest that the government provide retraining programs while others may argue that people lose their jobs everyday and dont get government assistance to find new ones.

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5. Reread the Country Focus on Is China a Neo-Mercantilist Nation? a) Do you think China is pursuing an economic policy that can be characterized as neoMercantilist? b) What should the United States, and other countries, do about this? Answer: Many students will probably suggest that indeed, China appears to be following a neomercantilist philosophy. China has run a trade surplus for years. In fact, in 2007, the country hit a record trade surplus of $262 billion. Some critics have suggested that China is limiting its imports by following an import substitution policy. Other students however, may note that in the last three months of 2007, the growth in Chinas imports actually exceeded the growth in its exports. Students may argue that this indicates a change in Chinas policy. Most students will probably suggest that in order to correct the countrys massive trade surplus, foreign countries like the United States should continue to pressure China to allow its currency to appreciate, and maintain open markets. 5. Reread the country focus feature on moving white collar jobs off shore. a) Who benefits from the outsourcing of skilled white collar jobs to developing nations? Who are the losers? b) Is there a difference between the transference of high paying white collar jobs such as computer programming and accounting, to developing nations, and low paying blue collar jobs? If so, what is the difference, and should government do anything to stop the flow of white collar jobs out of the country to countries like India? Answer: This question is likely to generate a lively debate. Many students will suggest that the outward flow of white-collar jobs is indeed a serious issue, one that should be the focus of government attention. Students taking this perspective are likely to suggest that white-collar jobs are more important to the nations future, and therefore they should remain at home. Other students however, may argue that companies cannot afford to pay the higher wages commanded by white-collar jobs and still remain profitable. Therefore, the argument might be that by taking these jobs outside the country, the company is able to remain viable, and keep other people employed.

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6. Drawing upon the new trade theory and Porters theory of national competitive advantage, outline the case for government policies that would build national competitive advantage in biotechnology. What kind of policies would you recommend that the government adopt? Are these policies at variance with the basic free trade philosophy? Answer: Porters theory of national competitive advantage argues that four broad attributes of a nation shape the environment in which local firms compete, and that these attributes promote or impede the creation of competitive advantage. These attributes are: factor endowments, demand conditions, related and supporting industries, and firm strategy, structure, and rivalry. Porter goes on to argue that firms are most likely to succeed in industries in which the diamond (which are the four attributes collectively) is favorable. Porter adds two factors to the list of attributes described above: chance and government policy. The New Trade theory addresses a separate issue. This theory argues that due to the presence of substantial scale economies, world demand will support only a few firms in many industries. Underpinning this argument is the notion of first-mover advantages, which are the economic and strategic advantages that accrue to early entrants into an industry. One could argue that when the attributes of a nation are conductive to the production of a product, and when the manufacturers of that product have experienced some chance events that have provided them first-mover advantages, the governmental policies of that nation should promote the building of national competitive advantage in that particular area. This could be accomplished through government R&D grants, policies that favor the industry in capital markets, policies towards education, the creation of a favorable regulatory atmosphere, tax abatements, and the like. Ask your students whether they think this policy is at variance with the basic free trade philosophy. One could argue that it is, because the government intervention is creating the basis for comparative advantage. Conversely, one could argue that if a country establishes a comparative advantage in a particular area that is based on a unique set of attributes (such as Swiss production of watches), world output will be favorably impacted by letting that country pursue its area of comparative advantage. 7. The worlds poorest countries are at a competitive disadvantage in every sector of their economies. They have little to export. They have no capital; their land is of poor quality; they often have too many people given available work opportunities; and they are poorly educated. Free trade cannot possibly be in the interests of such nations! Discuss. Answer: This is a difficult question. Certainly, most students will recognize that these countries are in dire straights and need assistance from richer countries. Most students will probably be sympathetic to their cause and suggest various aid programs including education and monetary support to help the countries develop. However, others may be more cautious and promote the notion that assistance would have to come in an organized form with multiple nations working together. The question is an interesting one that should provide students with an eye-opening discussion.

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Closing Case: Trade in Information Technology and U.S. Economic Growth

Summary The closing case explores the implications of the shift of computer hardware production to offshore low cost locations. Initially, all computer production took place in the United States, but by the early 1990s production of commodity components had moved offshore, and by the early 2000s, nearly all production took place in low cost markets. Critics worried that the trend was bad for the U.S. economy, but the evidence shows that the United States actually benefited from the shift. Discussion of the case can center on the following questions: QUESTION 1: During the 1990s and 2000s computer hardware companies in certain developed nations progressively moved the production of hardware components offshore, often outsourcing them to producers in developing nations. What does international trade theory suggest about the implications of this trend for economic growth in those developed nations? ANSWER 1: When production of computers began to shift to low cost locations, critics worried that the U.S. economy would suffer. However, research shows that just the opposite occurred. The price declines in computer hardware that resulted from the lower cost production supported new investments in the industry. Diffusion of computers through the U.S. market was faster, allowing companies to use computers to streamline their operations and increase productivity. Together, this contributed to a higher U.S. Gross Domestic Product for the period 1995 -2002. QUESTION 2: Is the experience of the United States, as described in the case, consistent with the predictions of international trade theory? ANSWER 2: International trade theory would suggest that the lower prices of computers resulting from outsourcing means that the average American consumer could consume more goods and services, thereby boosting their economic well-being. Of course, if the average American has seen his job disappear, he may not agree. Furthermore, in the case of the computer industry, the location of R&D may be a factor. Currently, most R&D takes place in technology hot spots within the country. Shifting R&D activities would eliminate or at least minimize the benefits associated with being in a hot spot.

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QUESTION 3: What are the implications of the theory and data for a) government policy in advanced nations such as the United States, and b) the strategy of a firm in the computer industry, such as Dell or Apple Computer? ANSWER 3: The globalization of the production of information technology hardware contributed to lower prices in the industry and the faster diffusion of the technology to businesses and households. In addition, it spawned growth in two related industries computer software and services. New trade theory would suggest that government could play a significant role in maintaining these benefits by pursuing policies that allow these trends to continue. Most students will recognize that Porters diamond of competitive advantage theory suggests that firms like Dell and Apple Computer should actively lobby governments to adopt policies that facilitate their growth in the industry, and that the firms should pursue strategies that allow them to capitalize on the cheaper cost of production in developing countries.

Continuous Case Concept

In the last few decades, the auto industry has shifted from one in which a few, large companies primarily manufactured in their domestic markets and sold in their domestic markets, to one in which a few large companies serve the world market, manufacturing around the globe to capture competitive advantages wherever they can. Ask students to reflect on the changes in the industry. Why do companies like Toyota and Nissan have large operations in the U.S. market? Why dont American companies have a large presence in Japan? Next, consider why BMW and Mercedes have established manufacturing operations in the U.S. market, while American companies are shifting their production to places like Mexico. Finally, ask students to use the theories presented in the chapter to explain the changes in the industry, and to predict what may occur in the next decade. Toyota, for example, has begun production in Russia, and in 2008, Nissan was on track to establish production operations in India, and China. In addition, Nissan and Renault have a joint venture to build an electric car in Israel by 2011.

The first two parts of this exercise can be used either at the beginning of a discussion of trade theory, or threaded through the discussion of the material. The last question works well as a way of applying the theories to a real world situation, and makes a nice conclusion to the discussion of the theories.

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globalEDGE Exercises
Use the globalEDGE Resource Desk {http://globalEDGE.msu.edu/ResourceDesk/} to complete the following exercises.

Exercise 1
You work for a rice production company and your current project is to determine the ten countries which in your estimation should have an advantage in producing rice. Using a resource that tracks statistics on economic factors like worldwide rice production, develop a list and brief report about the top 10 rice producing countries with data from the most recent year. Were you surprised by any countries listed? Why (or, why not)? Answer: The data can be accessed by searching the term statistics on economic factors at http://globaledge.msu.edu/ResourceDesk/. Geohive: Global Statistics is a resource that provides a wide variety of economic and other data for much of the world. By following the link to Global Data and looking under the Agriculture heading, the desired data is available. Search Phrase: statistics on economic factors Resource Name: Geohive: Global Statistics Website: http://www.geohive.com/earth/ag_rice.aspx globalEDGE Category: Research: Statistical Data Sources

Exercise 2
Your coffee firm is looking to find new locations to source coffee from in order to sustain growth as it internationalizes. Currently, your company only purchases green coffee beans from South America and is hoping to begin purchasing coffee from the Central American countries of Costa Rica, El Salvador, Guatemala, Honduras, and Panama. Applying the most current information from FAOSTAT, a United Nations agency website that gathers data on food and agricultural trade flows, determine which three countries have the highest export value of green coffee as well as growth of export value over the last year of data available. Answer: The quickest way to reach this information would be to search globalEDGE using the phrase FAOSTAT at http://globaledge.msu.edu/ResourceDesk/. FAOSTAT provides a wide array of country-level time-series data on food, agriculture, and other related products. Once at the FAOSTAT website, click on Trade at the top of the webpage, and then click on TradeSTAT. In the TradeSTAT page, click on Detailed Trade Data, and then search as per the guidelines in the question. Search Phrase: FAOSTAT Resource Name: FAOSTAT Website: http://faostat.fao.org/ globalEDGE Category: Research: Statistical Data Sources

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Additional Readings and Sources of Information

Economists Rethink Free Trade http://www.businessweek.com/magazine/content/08_06/b4070032762393.htm?chan=search A Radical Plan to Manage Globalization http://www.businessweek.com/bwdaily/dnflash/content/feb2007/db20070213_790933.htm? chan=search Outsourcing at Home http://www.businessweek.com/technology/content/apr2008/tc2008043_261385.htm?chan=search The New Economics of Outsourcing http://www.businessweek.com/technology/content/apr2008/tc2008043_531737.htm?chan=search Global Outsourcing to Grow 8% in 2008 http://www.businessweek.com/globalbiz/content/jan2008/gb20080110_489999.htm?chan=search Outsourcing Rivalry Doesnt Faze Malaysia http://www.businessweek.com/globalbiz/content/dec2007/gb20071214_820595.htm?chan=search Drawing on the new trade theory and Porter's theory of national competitive advantage, outline the case for government policies designed to build a national competitive advantage in biotechnology. What kind of policies would you recommend the government adopt? Are these policies at variance with the basic free trade philosophy?

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Porters theory of national competitive advantage argues that four broad attributes of a nation shape the environment in which local firms compete, and that these attributes promote or impede the creation of competitive advantage. These attributes are: factor endowments, demand conditions, related and supporting industries, and firm strategy, structure, and rivalry. Porter goes on to argue that firms are most likely to succeed in industries in which the diamond (which are the four attributes collectively) is favorable. Porter adds two factors to the list of attributes described above: chance and government policy. The New Trade theory addresses a separate issue. This theory argues that due to the presence of substantial scale economies, world demand will support only a few firms in many industries. Underpinning this argument is the notion of first-mover advantages, which are the economic and strategic advantages that accrue to early entrants into an industry. One could argue that when the attributes of a nation are conductive to the production of a product, and when the manufacturers of that product have experienced some chance events that have provided them first-mover advantages, the governmental policies of that nation should promote the building of national competitive advantage in that particular area. This could be accomplished through government R&D grants, policies that favor the industry in capital markets, policies towards education, the creation of a favorable regulatory atmosphere, tax abatements, and the like. Ask your students whether they think this policy is at variance with the basic free trade philosophy. One could argue that it is, because the government intervention is creating the basis for comparative advantage. Conversely, one could argue that if a country establishes a comparative advantage in a particular area that is based on a unique set of attributes (such as Swiss production of watches), world output will be favorably impacted by letting that country pursue its area of comparative advantage.

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