Early theories: Mercantilism Mercantilism is an economic philosophy based on the belief that a nation's wealth depends on

accumulated treasure, especially gold. Consequently, the aim of government policies was to increase wealth by promoting exports and discouraging imports. This was accomplished by government monopolies, the subsidisation of domestic export industries and the allocation of trading rights. Duties or quotas were imposed on imports to limit their volume. Colonies were required to provide raw materials and precious metals to their colonial masters and were often required to buy processed goods from these masters. The concept of mercantilism has two flaws. The first is the incorrect belief that gold and other precious metals have intrinsic value (this is not totally true: gold is used in dentistry and micro-electronics, but otherwise is a fairly 'useless' commodity). The second flaw is that mercantilism rather ignores the fact that production efficiency can be achieved through specialisation. Mercantilism emphasises the sheer volume of exports and imports, and equates the accumulation of wealth with the acquisition of power. This second flaw is addressed in a later theory - that of comparative advantage (see the discussion below). Some of the terminology of mercantilism has endured: the term balance of trade is still with us. A favourable balance of trade indicates that a country is exporting more than it is importing; an unfavourable balance of trade indicates the opposite.

Theory of absolute advantage

The theory of absolute advantage is also called the classical theory of trade. This is the economic theory of free trade and enterprise which found expression in the landmark book The Wealth of Nation in 1776. In this book Adam Smith rejected the concept of gold being synonymous with wealth. He insisted that nations benefit most when they trade goods which they produce more efficiently than anyone else, for goods which some other country produces most efficiently. For example, Australia is the world's most efficient producer of wool. It should trade with Japan , which is the world's most efficient producer of motor cars. This concept of absolute advantage means that a nation would produce only those goods that made the best use of its natural and acquired resources and its climatic advantages. Put more succinctly, absolute advantage is the capability of one nation to produce more of a particular product than another country with the same amount of input. This begs the question of whether a country could produce several commodities at lower cost than another country. Would it wish to trade? This question was answered in 1817 by the economist David Ricardo.

Theory of comparative advantage

Ricardo showed that both trading nations can benefit from trade even when one of those nations has an absolute advantage in the production of two or more commodities. This can be stated another way by saying that a nation having absolute disadvantages in the production of two goods with respect to another nation has a comparative or relative advantage in the production of the good in which its absolute disadvantage is less. Confusing? Read the sentence again, slowly and carefully, and then do the following Activity.

Weaknesses of early theories

The theories outlined above have a number of weaknesses: They all assume: o the existence of perfect knowledge concerning international markets and opportunities o full labour employment within each country o full mobility of labour and other factors of production within each country; and o that each country has an objective of full production efficiency. They neglect other motives for trade such as tradition, self-sufficiency and political objectives. They deal only with two commodities and two countries. In reality there are multiple commodities, countries and factors, and complex interactions between all of these. The cost focus was on labour. Transportation and the use of land and capital were not considered.

More recent theories : Heckscher-Ohlin theory of factor endowment

As noted in the previous section, Smith and Ricardo used only labour input: no consideration was given to producing goods with different combinations of factors. Not until 1933 did Ohlin, a Swedish economist building on work done by his compatriot Heckscher in 1919, develop the theory of factor endowment. The Heckscher-Ohlin theory of factor endowment states that international and regional differences in production costs occur because of deficiencies in the supply of production factors. Those goods which require a large amount of the most abundant - and thus less costly - factor will have lower production costs, enabling them to be sold for less in international markets. Thus countries such as Australia and Canada

which have large areas of land should emphasise agriculture and pastoral industry, whereas small land mass countries with capital, such as the Netherlands and Switzerland , should specialise in capital intensive products. Although this theory holds in general, it does not explain export production that arises from taste differences rather than factor differences. Examples are French wine (with Tasmanian wines now making many inroads) and Italian leather goods which are valued for their flair, quality and prestige. Also, this theory does not account for transportation costs, nor for differences in the availability of technology. An exception to the Heckscher-Ohlin theory was examined in 1953 by Leontief. He found that the capitalto-labour ratio for US exporting industries was lower than that of its import-competing industries. In other words, his results suggested that the US exported goods that were relatively labour intensive and imported commodities that were relatively capital intensive. Leontief argued that the US was two to three times more efficient than other countries. If the labour supply were adjusted to account for this efficiency, the US could be considered a labour-abundant nation. However, the US is also a capital-abundant nation. The Leontief paradox has given rise to similar studies for other countries, with similar results.

Criticism of the Heckscher-Ohlin theory and the Leontief paradox

Although these theories provide a general explanation of why nations trade, they have been criticised on several grounds: Nations do not initiate trade: this is done by individuals or individual firms within nations. There must be perfect information and perfect competition between trading partners, which is never the case. They are limited because they do not look at either the transfer of goods or direct investments. They do not recognise the influence of technology and expertise in the areas of marketing and management.

Modern theories: Product life-cycle theory Product life-cycle theory

The product life-cycle theory looks at the potential export possibilities of a product in five discrete stages in its life-cycle. Stage 1: Introduction A new product is manufactured in the innovating country and sold primarily in that domestic market (although not shown in Figure 2.1, this relates to the US ). Any overseas sales are generated through exports to other markets. At this stage the innovating company has little competition in markets abroad. Stage 2: Expansion Sales increase, as shown in Figure 3.1(a) but so does competition as other firms enter the arena. At this point, the firm begins some production abroad, as shown by Canada , Europe and Japan , to serve foreign markets and to counter the competition. Stage 3: Maturity Exports from the home country decrease, as shown in Figure 3.1(b) for the US , because of increased production in overseas locations. This is shown in Figure 3.1(b) on the intersection with the vertical line between maturity and sales decline. Price has become a critical determinant of competitiveness, so minimising costs becomes an important objective. Production may shift to less developed countries to take advantage of lower labour costs. At this point, domestic production may cease and the product is imported by the home market. Stage 4: Sales decline This occurs because competitors have achieved economies of scale equal to those of the innovator. Stage 5: Demise The innovator may cease production (thus the US curve moves under the horizonatal axis in Figure 3.1(b)) and leave the declining market to imitators. Typically, the product's popularity has also ceased and consumers seek other products. The product life-cycle theory has been found to hold primarily for products such as consumer durables, synthetic fabrics and electronic equipment; that is, those products which have a long time-span from innovation to eventual peak consumer demand. The theory does not hold for products with a short time-span between innovation and obsolescence, for example, kitchen gadgets such as electric can openers and icecream makers.

New trade theory

New trade theory as set out by Hill (2005) is important because it incorporates the concept of the first-mover (also known as prime-mover). The first-mover concept argues that the first company to enter any field is able to shape consumer preferences and to achieve economies of scale. These benefits tend to discourage new entrants or to put them at a cost disadvantage should they enter the market despite the barriers to entry. The case cited in your textbook (Hill 2005, p. 163) is that of the Boeing Company which has dominated the commercial jet aircraft industry since its inception. Boeing was lucky. Had it not been for metal fatigue in the wing which caused a number of fatal crashes, the British De Havilland company's Comet aircraft may have paved the way for De Havilland to be the industry leader. We shall return to the case of Boeing in Part B of this chapter, but finally, in Part A, we look at Porter's theory of competitive advantage.

Theory of competitive advantage: The Porter diamond

Michael Porter has during the last 25 years been one of the outstanding gurus of management. His theory of competitive advantage is challenging because much of it appears to go 'against the grain' of earlier theories. Two of his assertions illustrate this point. For an industry to flourish, domestic rivalry is nearly always necessary. Much of Japan 's success can be traced to the country's economic disadvantages. As you read the relevant section in Hill (2005), note the essential features of the four 'attributes' which are at the four points of Porter's diamond, namely: Factor endowments These are the essence of the Heckscher-Ohlin theory, but Porter distinguishes: o basic factors - natural resources, demographics, climate and location, and o advanced factors - communications, location, skilled labour, research and technological know-how. Demand conditions Home demand shapes the product. Sophisticated and demanding consumers pressure local firms to make high quality products. Japan 's camera industry is the archetype of this. Related and supporting industries The network of suppliers and related industries which are internationally competitive has an spillover effect. We see this in industry 'clusters' such as the German textile sector which includes manufacturers of high quality cotton, wool and synthetic fibres, sewing machine needles and textile machinery. Firm strategy, structure and rivalry Two points are relevant for this attribute: o The quality of management. Porter notes that firms in the two outstanding post World War II 'economic miracles' - Germany and Japan - are dominated by engineers, unlike US companies which are usually headed by people with financial or marketing backgrounds. o Domestic rivalry, which creates pressures to innovate, improve quality, reduce costs and invest in upgrading facilities.

Instruments of trade policy

We noted in the previous section that some barriers to trade are obvious while others are less so. As the WTO becomes effective in removing the obvious barriers we can expect the more subtle impediments to become more common. Your textbook provides a good explanation of seven major instruments of trade policy. The following catalogue is included for interest and to show that there are more than seven ways for governments to influence trade. Tariffs A tariff or customs duty is a tax levied on imports or exports. o Import duties are levied on goods entering a country. They serve two purposes: revenue and protection. If the duties are for revenue purposes, they must be relatively low or they will discourage the import of such items and limit the amount of revenue that can be collected. If the duties are for protection, they can be relatively high, such as the 490% tariff placed on imports of foreign rice into Japan . o Export duties on goods leaving a country serve three purposes: to provide revenue, conserve domestic resources, and/or stimulate the growth of domestic industries. For example, if export duties make it more cost-effective for local raw material suppliers to sell to local

o o

manufacturers than to international markets, international supply of these materials will be limited. This increases the price of the materials to overseas producers and gives local manufacturers a relative cost-advantage in export markets. Penalty duties are levied on imports for the violation of some customs rules of the importing country, such as importing jewellery at a fictitiously low cost. Anti-dumping duties are levied on goods which are sold below the fair market value in the importing country or below the cost of production in the exporting country. For example, Brazilian orange juice and South American crayfish have in recent years been 'dumped' on the Australian market. Retaliatory duties may be levied as a tit-for-tat measure by a nation for discriminatory treatment of its products. For example, Australia and other rice-growing countries might tax Japanese products in retaliation for Japan 's refusal prior to 1995 to allow the importing of rice. Preferential duties are sometimes granted to maintain ties with certain countries for political or economic reasons. Former British colonies, after gaining independence, were often granted preferential treatment by the mother country.

Subsidies A subsidy is a government payment to a domestic producer. By receiving subsidies, manufacturers are able to set prices that are not completely dependent on the cost of production. Countries which import these subsidised products usually retaliate by levying a countervailing duty (a tariff) to offset the advantage of the subsidy. Quantitative controls Quantitative controls take the form of import quotas, export quotas and voluntary quotas: o Import quotas are used to foster infant industries or to protect domestic industry from foreign competition. An example is the Australian car industry. o Export quotas limit the quantity of raw materials or manufactured goods leaving a country. They are used to encourage domestic use of raw materials or to maintain high prices abroad. For example, South Africa has the world's largest source of chromium. By limiting supply, South Africa has some ability to control the price of chromium. o Voluntary quotas are a response to pressure exerted by domestic producers or organised labour. An example of this was the voluntary quota adopted by the Japanese government in 1981 to limit the number of vehicles exported to the US . Anther example is the limit on textile imports imposed by the US against China in 1983: in retaliation, China stopped buying cotton, synthetic fibres and soya beans from the US . Embargoes and boycotts o An embargo is an official act to prohibit the import or export of a product. Embargoes may be imposed for military objectives, to prevent the entry of exotic diseases, protect the health of a population from mislabelled foods, protect its morals from pornographic material or to protect national treasures. For example, Egypt has an embargo on the export of ancient Egyptian artefacts. o A boycott is an unofficial act to discourage relations with a person, firm or country. Certain Arab nations, for example, have boycotted firms that trade with Israel . Exchange controls Exchange controls are used generally in wartime (although Germany employed them before World War II) to prevent the flight of capital, to conserve gold stocks and to limit the import of those commodities which do not fit government plans. Other non-tariff barriers o Local content regulations specify that a certain percentage of a product must be from domestic sources. The Button Plan for Australian automobiles originally required 85% of a car to be manufactured locally. o Export licences in the US are issued to prevent the export of equipment used for military purposes. For example, there was a total ban on the export of super-computers to the USSR during the Cold War. The ban on the export of war materials to Iraq before the Gulf War in

1991 was circumvented by a British company which exported components of a 'super gun' to Iraq as 'industrial pipes'. State-owned corporations enter markets with the financial backing of governments so that they are able to outbid private firms. Australian Defence Industries (ADI) which manufactures armaments is such a State-owned organisation. ADI bids in competition with overseas arms manufacturers, some of whom are privately owned. Administrative impediments, two examples of which are France requiring customs and import documents to be written in French to protect the French language and culture and the Japanese insistence on opening a large proportion of express packages to check for pornography.

The case for government intervention (political)

The closing comment in the previous section suggested that restrictions on trade seldom achieve what they are designed to achieve. The argument against trade barriers is well presented in your textbook and it will not be repeated here. Instead, in this section we will draw attention to the political reasons for trade barriers and issue some cautionary comment. Despite the often overwhelming logic of economic arguments against trade barriers, there are often compelling political reasons for their imposition. Protect infant industry Advocates for the protection of an infant industry claim that in the long run, the industry does have a comparative advantage but needs protection from imports until the labour force is trained, production techniques mastered and economies of scale achieved. This protection is meant to be temporary, but firms rarely admit that they have matured. The usual government reaction to force a competitive stance is to withdraw the subsidy to the industry. Belatedly, this has happened within the Australian automobile industry, established after World War II. The industry is now almost able to stand on its own feet, despite the absence of economies of scale enjoyed by overseas competition. However, if there had been no support to get the industry started, there would now be no Australian car industry. Protect jobs from cheap foreign labour This argument compares wages in the exporting country with those in the home country. There are two fallacies with this argument: o Productivity per worker is often much greater in the developed country, so labour costs are lower even though wages are higher. o Wages are not the only - and frequently not the major - cost of production. Where wage rates are low, capital costs are usually high and thus production costs may actually be higher in a low-wage nation. This is the situation in the Brazilian car industry. National security Countries sometimes wish to protect industries considered vital for national defence even though they are at a comparative disadvantage with respect to foreign competitors. There are some compelling examples of this. Both Israel and South Africa built up their defence industries to avoid embargoes being imposed on them by other countries. Both countries are now self-sufficient in arms and both are exporters of high quality equipment (for example, the Uzi machine pistol from Israel and a 105mm howitzer from South Africa ). Retaliation In the world of realpolitik, nations use trade barriers as weapons to gain better deals with other countries. The sparring between the US and China in the late 1990s over a range of issues including bananas and copyright is testimony to the effectiveness of this weapon. Protecting consumers Lobby groups increasingly pursue governments to protect consumers from real and potential environmental hazards. Examples include hormone treated animal products (see the Country Focus section in Hill 2005, p. 189), genetically modified foods and the formulation of dieseline to reduce harmful particulates. Furthering foreign policy objectives The examples given in your textbook (Hill 2005, p. 190) are largely concerns of the US . Governments may decide to grant preferential trade or use trade sanctions depending on their foreign policy objectives. Protecting human rights Throughout the world, the last few decades have seen increasing concern for the rights of the

individual. (See pages 190-191 of your textbook and note that human rights sometimes take precedence over trade but perhaps just as frequently, trade takes precedence over human rights. In this context, think about Australian relations with Indonesia and China .)

The case for government intervention (economic)

In the previous section it was noted that the Australian car industry was until recently a 'protected animal' - protected by tariffs on imported vehicles. It is now achieving world competitive standards, but it would not have existed without the protection of infant industry tariffs. This may be symptomatic of a changing economic view. Until the 1980s economists saw little benefit in government intervention and strongly advocated free trade policies. Economists now note that the WTO recognises the infant industry argument as a legitimate reason for protection. A second point made by your textbook is that, given the development of global capital markets over the last twenty years, governments may no longer need to subsidise infant industries: they can now borrow money from capital markets. The other economic argument for government intervention concerns industries in which the existence of substantial scale economies implies that world markets will profitably support only a few large firms. This is the case in the aircraft industry: the dominance of Boeing has already been mentioned. The second element of strategic trade policy is that it might pay governments to intervene in an industry if it helps domestic firms overcome barriers to entry created by firms that have reaped firstmover advantages. Japanese production of LCD components used in computers following their invention in the US is a good example cited in your textbook (page 192). Now turn to your textbook to catch up on the political and economic arguments for government intervention in international trade

Strategic trade policy

A useful summary of a number of trade theories we have discussed is provided in Figure 3.2 to assist you in revision.