3 - 5 Theories of International Trade

Theories of International Trade
Absolute and Comparative Advantage Factor Endowment Theory of Competitive Advantage Implications of trade theories
Sunday, December 09, 2012
Dr. S. Jain
Key Issues
Why do nations trade with each-other? How do different theories explain trade flows? How does free trade raise the economic welfare of all participating nations? Any disagreements? Can government actively influence a countrys competitive advantage? Why is an understanding of trade theory important for managers?
Dr. S. Jain
Dr. S. Jain
The Economic Basis for Trade: Comparative Advantage

David Ricardos theory of comparative advantage, which he used to argue against the corn laws, states that specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers.
Dr. S. Jain
Absolute Advantage versus Comparative Advantage

A country enjoys an absolute advantage over another country in the production of a product when it uses fewer resources to produce that product than the other country does.
Dr. S. Jain
Absolute Advantage versus Comparative Advantage

A country enjoys a comparative advantage in the production of a good when that good can be produced at a lower cost in terms of other goods.
Dr. S. Jain
Gains from Mutual Absolute Advantage

Yield Per Acre Of Wheat And Cotton NEW ZEALAND AUSTRALIA
Wheat Cotton
6 bushels 2 bales
2 bushels 6 bales
New Zealand can produce three times the wheat that Australia can on one acre of land, and Australia can produce three times the cotton. We say that the two countries have mutual absolute advantage.

Suppose that each country divides its land to obtain equal units of cotton and wheat production as shown below:
Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres NEW ZEALAND AUSTRALIA
75 acres x 2 bushels/acre 150 bushels 25 acres x 6 bales/acre 150 bales
Wheat Cotton
25 acres x 6 bushels/acre 150 bushels 75 acres x 2 bales/acre 150 bales
Production Possibility Frontiers for Australia and New Zealand Before Trade
Dr. S. Jain

An agreement to trade 300 bushels of wheat for 300 bales of cotton would double both wheat and cotton consumption in both countries.
Production and Consumption of Wheat and Cotton after Specialization
PRODUCTION
New Zealand Australia
0 acres 0
CONSUMPTION
New Zealand
300 bushels 300 bales
Australia
300 bushels 300 bales
10
Wheat Cotton
100 acres x 6 bu/acre 600 bushels 0 acres 0
100 acres x 6 bales/acre 600 bales

Dr. S. Jain
Expanded Possibilities after Trade
Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both. Dr. S. Jain Sunday, December 09, 2012
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Gains from Comparative Advantage

Even if a country had a considerable absolute advantage in the production of both goods, Ricardo would argue that specialization and trade are still mutually beneficial.
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When countries specialize in producing the goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently.
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Assume that people in each country want to consume equal amounts of cotton and wheat, and that each country is constrained by its domestic production possibilities curve, as follows:
Yield Per Acre of Wheat and Cotton
NEW ZEALAND Wheat Cotton
AUSTRALIA
6 bushels 6 bales
Dr. S. Jain
1 bushel 3 bales
14

Total Production of Wheat and Cotton Assuming No Trade and 100 Available Acres NEW ZEALAND Wheat
50 acres x 6 bushels/acre 300 bushels
AUSTRALIA
75 acres x 1 bushels/acre 75 bushels
Cotton
The gains from trade in this example can be demonstrated in three stages.
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Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
Stage 1: Countries specialize
STAGE 1 New Zealand Australia
0 acres 0 100 acres x 3 bales/acre 300 bales 50 acres x 6 bushels/acre 300 bushels 50 acres x 6 bales/acre 300 bales
Wheat
Cotton
Australia transfers all its land into cotton production. New Zealand cannot completely specialize in wheat production because it needs 300 bales of cotton and will not be able to get enough cotton from Australia (if countries are to consume equal amounts of cotton and wheat).
Sunday, December 09, 2012 Dr. S. Jain 16
Stage 2:
STAGE 2 New Zealand Australia
0 acres 0 100 acres x 3 bales/acre 300 bales 75 acres x 6 bushels/acre 450 bushels 25 acres x 6 bales/acre 150 bales
Wheat
Cotton
New Zealand transfers 25 acres out of cotton and into wheat.
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Stage 3: Countries trade
STAGE 3 New Zealand Wheat
350 bushels (after trade) 200 bales (trade)
Australia
100 bushels
100 bushels (trade)
Cotton
350 bales (after trade)
100 bales
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Gains from Comparative Advantage The real cost of producing cotton is the wheat that must be sacrificed to produce it. A country has a comparative advantage in cotton production if its opportunity cost, in terms of wheat, is lower than the other country.
Comparative Advantage Means Lower Opportunity Cost
Both Australia and New Zealand will gain when the terms of trade are set between 1:1 and 3:1, cotton to wheat.
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Factor Endowment - Introduction

In the real world, while trade is partly explained by differences in labor productivity, it also reflects differences in countries resources. The Heckscher-Ohlin theory:
Emphasizes resource differences as the only source of trade Shows that comparative advantage is influenced by:
Relative factor abundance (refers to countries) Relative factor intensity (refers to goods)
Is also referred to as the factor-proportions theory

Slide 4-21
Dr. S. Jain Sunday, December 09, 2012
AssumptionsBasics
There are
two countries, Home and Foreign two goods, Cloth and Food, and two resources, Labor and Land
these are used to produce Cloth and Food
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Prices of Goods
Let PC and PF denote the nominal prices of cloth and food. Then, PC/PF is the relative price of cloth (in units of food) and PF/PC is the relative price of food (in units of cloth)
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Prices of Factors
Let w be the nominal price (or, wage) of labor. Let r be the nominal price (or, rent) of land Then w/r is the relative price of labor (in units of land) and r/w is the relative price of land (in units of labor)
Example: If w = $10 per hour for one worker and r = $100 per hour for one acre of land, then the relative wage for one worker is 1/10 acres of land and the relative rent on an acre of land is 10 hours of labor.
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Nominal Prices
The nominal price of a commodity is simply the number of dollars (or any other relevant unit of account) that must be paid to buy one unit of the commodity For example, the nominal price of laboralso called the nominal wagemay be $8 per hour
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Real Prices
The real price of commodity X, in units of commodity Y, is the amount of Y that costs the same as one unit of X For example, if the nominal price of labor is $8 per hour and the nominal price of a cup of coffee is $2, then the real price of labor is 4 cups of coffee per hour Real prices are also called relative prices
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Real and Nominal Prices

Real Price of X, in units of Y, is equal to Nominal Price of X / Nominal Price of Y So, if w is the nominal wage and P is the nominal price of a cup of coffee, then the real wage is w / P. For example, if w is $8 per hour and P is $2, then the real wage is w / P = 8/2 = 4 cups of coffee per hour, as in the previous slide.
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Figure 1: Factor Prices and Goods Prices

Relative price of cloth, PC/PF
FPGP
17
As labor becomes more expensive relative to land, cloth, which is labor-intensive in production, finds itself at a disadvantage and becomes relatively more expensive compared to food
5
Wage-rent ratio, w/r

Dr. S. Jain
As both Home and Foreign use the same technologies, the same FPGP curve is applicable in both countries
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Figure 1: Factor Prices and Goods Prices

FPGP
Under free trade, the relative price of cloth will be the same in both countries Therefore, the wagerent ratio will also be the same in the two countries
17
5
Wage-rent ratio, w/r

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Figure 2: Factor Prices and Input Choices

Wage-rent ratio, w/r Cloth production Food production
As labor becomes relatively more expensive, relatively more land is used in production
of both food and cloth

5
4
12
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Acres of Land per worker, T/L
But the number of acres of land per worker is always higher in food production, reflecting the assumption that food production is land intensive
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Figure 2: Factor Prices and Input Choices

Wage-rent ratio, w/r Cloth production Food production
As both Home and Foreign use the same technologies, these two curves must be true in both countries.
As free trade equalizes the wage-rent ratio worldwide, acres of land per worker in cloth production must be the same worldwide.
Same must be true for food production.
4 12 Acres of Land per worker, T/L
Dr. S. Jain
Therefore, Foreign, which has more land per worker than Home, must produce relatively 31 more food
Figure 3.1: Relative Supplies

Relative price of cloth, PC/PF 17 RSFOREIGN RSHOME In Figure 2, we saw that at w/r = 5, Foreign must produce relatively more food and Home must produce relatively more cloth. In Figure 1 we saw that w/r =5 corresponds to PC/PF = 17. Therefore, Home must produce relatively more cloth at PC/PF = 17, or indeed at any other relative price.
As cloth becomes more expensive relative to food, the output of cloth will increase relative to food, Therefore, the relative supply curves slopeSunday, December 09, 2012 upward.
Yards of cloth produced per calorie of food produced, QC/QF

Dr. S. Jain 34
Figure 3.2: Relative Demand

Relative price of cloth, PC/PF 17
The H-O assumptions about preferences imply that that consumer behavior can be summarized by this Relative Demand curve and that the same curve is true in both Home and Foreign
3
In this figure, when the price of a yard of cloth is 17 times the price of a calorie of food, the number of yards of cloth consumed is 3 times the number of calories of food consumed, for every individual worldwide. Why Sunday, December 09, 2012 Dr. S. Jain isnt the latter ratio different for different people?
Yards of cloth consumed per calorie of food consumed, QC/QF

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Figure 3: Relative Supplies and Demands

The relative supplies and demands can be combined to find the autarky relative prices in Home and Foreign Clearly, they are different Therefore, trade will occur if it is allowed Since Home and Foreign differ only in their relative factor endowments, that difference must be the reason why trade occurs
RSFOREIGN RSHOME
Foreign
Home
RD
Dr. S. Jain
Yards of cloth produced per calorie of food produced, QC/QF
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Who will export what?

In autarky, the laborintensive good is relatively cheaper in the laborabundant country Therefore, under free trade, the labor-intensive good is exported by the labor-abundant country and the land-intensive good is exported by the land-abundant country
Sunday, December 09, 2012 Dr. S. Jain
PC/PF
Foreign
autarky
Free Trade Home
Foreign : land abundant, labor scarce Home: land scarce, labor abundant Cloth: labor intensive production Food: land intensive production 37
Summary
The Heckscher-Ohlin model, in which two goods are produced using two factors of production, emphasizes the role of resources in trade. A rise in the relative price of the laborintensive good will shift the distribution of income in favor of labor:
The real wage of labor will rise in terms of both goods, while the real income of landowners will fall in terms of both goods.
Slide 4-38
Summary
For any given commodity prices, an increase in a factor of production increases the supply of the good that uses this factor intensively and reduces the supply of the other good.
The Heckscher-Ohlin theorem predicts the following pattern of trade:
A country will export that commodity which uses intensively its abundant factor and import that commodity which uses intensively its scarce factor.
Slide 4-39
Summary
The owners of a countrys abundant factors gain from trade, but the owners of scarce factors lose. In reality, complete factor price equalization is not observed because of wide differences in resources, barriers to trade, and international differences in technology. Empirical evidence is mixed on the HeckscherOhlin model.
Most researchers do not believe that differences in resources alone can explain the pattern of world trade or world factor prices.
Slide 4-40
Theory of Competitive Advantage

Harvard Business School
1980: The Five Competitive Forces
The Competitive Advantage of Nations, 1990.

First strategist, a field that is, basically, straight economics Enormous popularity
The Five Competitive Forces

the threat of new entrants, the bargaining power of customers, the bargaining power of suppliers, the threat of substitute products or services, and the jockeying among current contestants.
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Porter and Strategy Today

Strategy has now become a regular field in management schools. It is mostly a haven for economists. They address Value Creation, which is finding an approach, a cost-reduction technique, or some manner permitting the firm to compete effectively.
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Establishing a Strategic Agenda

The essence of strategy formulation is coping with competition. Different forces take on prominence, of course, in shaping competition in each industry. Every industry has an underlying structure, or a set of fundamental economic and technical characteristics, whether an industry is dealing in services or selling products.
Threat of Entry
New entrants to an industry bring new capacity, the desire to gain market share, and often substantial resources. There are six major sources of barriers to entry:
Barriers to Entry
Economies of scale - - These economies deter entry by forcing the aspirant either to come in on a large scale or to accept a cost disadvantage. Product differentiation -- Brand identification creates a barrier by forcing entrants to spend heavily on marketing
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Barriers to Entry
Cost disadvantages independent of size -Entrenched companies may have cost advantages not available to potential rivals, no matter what their size and attainable economies of scale.
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Barriers to Entry
Access to distribution channels -- The newcomer must, of course, secure distribution of its product or service. Government policy -- Governments can limit or even foreclose entry to industries with such controls as license requirements and limits on access to raw materials.
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Powerful Suppliers and Buyers

The power of each important supplier or buyer group depends on a number of characteristics of its market situation and on the relative importance of its sales or purchases to the industry compared with its overall business.
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Powerful Suppliers and Buyers

A company's choice of suppliers to buy from or buyer groups to sell to should be viewed as a crucial strategic decision. Most common is the situation of a company being able to choose whom it will sell to, in other words, buyer selection.
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Substitute Products
Substitute products place a ceiling on prices a competing firm can charge, limiting the potential of an industry. Substitutes not only limit profits in normal times; they also reduce the bonanza an industry can reap in boom times.
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Substitute Products
Substitutes often come rapidly into play if some development increases competition in their industries and causes price reduction or performance improvement.
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Jockeying for Position

Intense rivalry is related to the presence of a number of factors: Competitors are numerous or are roughly equal in size and power.
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Industry growth is slow, precipitating fights for market share that involve expansionminded members.
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The product or service lacks differentiation or switching costs, which lock in buyers and protect one combatant from raids on its customers, by another.
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Fixed costs are high or the product is perishable, creating strong temptation to cut prices. Capacity is normally augmented in large increments.
Formulation of Strategy
1. Positioning the company Positioning the company so that its capabilities provide the best defense against the competitive force.
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2. Influencing the balance Influencing the balance of the forces through strategic moves, thereby improving the company's position.
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3. Exploiting industry change Anticipating shifts in the factors underlying the forces and responding to them, with the hope of exploiting change by choosing a strategy appropriate for the new competitive balance before opponents recognize it.
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4. Recognizing Multifaceted Rivalry Porter and numerous other authorities have stressed the need to look beyond product to function in defining a business, beyond national boundaries to potential international competition, and beyond the ranks of one's competitors tomorrow.
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to formulate strategy we must understand our resources and capabilities understand the environment, and combine knowledge of strategy and organizational architecture.
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Conclusions
The key to growth -- even survival -- is to stake out a position that is
less vulnerable to attack from head-to-head opponents, whether established or new, and less vulnerable to erosion from the direction of buyers, suppliers, and substitute goods.
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Conclusions
Establishing such a position can take many forms
solidifying relationships with favorable customers, differentiating the product either substantively or psychologically through marketing, integrating forward or backward, or establishing technological leadership.
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Implications of trade theories Terms of Trade

The ratio at which a country can trade domestic products for imported products is the terms of trade. The terms of trade determine how the gains from trade are distributed among trading partners.
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Arguments for Restricting Trade

Methods of restricting trade
tariffs quotas administrative barriers other
Arguments for restricting trade

infant industry argument changing comparative advantage to prevent dumping

Arguments for restricting trade (cont.)
to prevent establishment of a foreign-based monopoly
to spread risks externalities pursuing national interests (but against world interests)
exploiting monopoly power
protecting declining industries
non-economic arguments

Problems with protection
protection as second best
world multiplier effects
retaliation
cushions inefficiency bureaucracy
Measuring the efficiency loss from protection

World Attitudes towards Trade and Protection

History of protection
Pre-war growth in protection Post-war reduction in protection and the role of GATT
the growth in world trade
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REALITIES OF INTERNATIONAL TRADE

import tariff - A tax imposed on imports nontariff barriers (NTBs) restrict imports but are not in the usual form of a tariff:
subsidies, import quotas, export restraints, local content requirements, administrative policies, antidumping duties, over-elaborate or inadequate infrastructure, buy national" policy, bribery and corruption, unfair customs procedures, restrictive licenses, etc.
deadweight costs - Net losses that occur in an economy as the result of tariffs
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import quotas - Restrictions on the quantity of imports for specific period of time voluntary export restraints (VRAs) - superficial policy to show that exporting countries voluntarily agree to restrict their exports local content requirements - A requirement that a certain proportion of the value of the goods made in one country originate from that country.
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antidumping duties - Costs levied on imports that have been dumped (selling below costs or below exporters home market price to unfairly drive domestic firms out of business)
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Economic Arguments Against Free Trade

Prominent among economic arguments against free trade include: 1. The need to protect domestic industries - The oldest and most frequently used economic argument against free trade is the urge to protect domestic industries, firms, and jobs from unfair foreign competition - in short, protectionism 2. The necessity to shield infant industries - belief that if domestic firms are as young as infants, in the absence of government intervention, they stand no chance of surviving and will be crushed by mature foreign rivals
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Political Arguments against Free Trade

Political arguments against free trade advance a nations political, social, and environmental agenda regardless of possible economic gains from trade These arguments include: (1) national security (2) consumer protection (3) foreign policy (4) environmental and social responsibility
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Classical Theories versus New Realities

Classical theorists and their modern-day disciples argue that the United States and India trade by tapping into each others comparative advantage. India leverages its abundant, high-skill, and low-wage labor. Americans will channel their energy and resources to higher skill, higher paying jobs. Regrettably, certain Americans will lose jobs, but the nation as a whole benefits. Are the theories still valid?
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Theories of International Trade

Sunday, December 09, 2012

Sunday, December 09, 2012

Sunday, December 09, 2012

The Economic Basis for Trade: Comparative Advantage

Sunday, December 09, 2012

Absolute Advantage versus Comparative Advantage

Sunday, December 09, 2012

Absolute Advantage versus Comparative Advantage

Sunday, December 09, 2012

Gains from Mutual Absolute Advantage

Gains from Mutual Absolute Advantage

25 acres x 6 bushels/acre 150 bushels 75 acres x 2 bales/acre 150 bales

Sunday, December 09, 2012

Gains from Mutual Absolute Advantage

100 acres x 6 bu/acre 600 bushels 0 acres 0

100 acres x 6 bales/acre 600 bales

Sunday, December 09, 2012

Expanded Possibilities after Trade

Gains from Comparative Advantage

Sunday, December 09, 2012

Gains from Comparative Advantage

Sunday, December 09, 2012

Gains from Comparative Advantage

Gains from Comparative Advantage

50 acres x 6 bales/acre 300 bales

25 acres x 3 bales/acre 75 bales

Sunday, December 09, 2012

New Zealand transfers 25 acres out of cotton and into wheat.

Sunday, December 09, 2012

100 bushels (trade)

350 bales (after trade)

Sunday, December 09, 2012

Comparative Advantage Means Lower Opportunity Cost

Sunday, December 09, 2012

Factor Endowment - Introduction

Is also referred to as the factor-proportions theory

Sunday, December 09, 2012

Sunday, December 09, 2012

Sunday, December 09, 2012

Sunday, December 09, 2012

Sunday, December 09, 2012

Real and Nominal Prices

Sunday, December 09, 2012

Figure 1: Factor Prices and Goods Prices

Wage-rent ratio, w/r

Figure 1: Factor Prices and Goods Prices

Wage-rent ratio, w/r

Figure 2: Factor Prices and Input Choices

of both food and cloth

Acres of Land per worker, T/L

Figure 2: Factor Prices and Input Choices

Sunday, December 09, 2012

Figure 3.1: Relative Supplies

Yards of cloth produced per calorie of food produced, QC/QF

Figure 3.2: Relative Demand

Yards of cloth consumed per calorie of food consumed, QC/QF

Figure 3: Relative Supplies and Demands

Relative price of cloth, PC/PF

Sunday, December 09, 2012

Yards of cloth produced per calorie of food produced, QC/QF

Who will export what?

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