INTERNATIONAL BUSINESS MANAGEMENT

TRADE THEORIES
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Learning objectives
To understand and evaluate several trade theories. To assess the implications of trade theories on international business.

Explain the pattern of international trade observed in the world economy.

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# The case of US Information Technology manufacturing. # Countrys economy may gain if its citizens buy certain products from other country international trade allows a country to specialize in manufacturing and export of products that can be produced most efficiently, while importing products that can be produced more efficiently in other countries.

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The pattern of international trade Ghana exports cocoa, Brazil exports coffee, Saudi arabia exports oil, china exports crawfish But why does japan export automobiles, consumer electronics. Why swiss export chemicals, pharmaceuticals, jewelry and watches.

Intervention of govt. policies.

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INTERNATIONAL TRADE THEORIES

Mercantilism 16th & 17th century simultaneously to encourage export, discourage imports ( Zero sum game)

1776, Theory of Absolute advantage by Adam smiths explained unrestricted free trade is beneficial to country
Theory of comparative advantage by 19th century economist David Ricardo, - through his book Principles of Political economy in 1817

Eli Heckscher (1919) & Bertil ohlin(1933) , - Heckscher Ohlin theory

1953, The Leontief paradox 1966, Product life-cycle theory by Raymond Vermon 1970, New trade theory by Paul Krugman of the Massachusetts institute of technology Economies of Scale, First-Mover advantages 1990, Theory of national competitive advantage by Michael Porter of HBS
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Mercantilism: mid-16th century

A nations wealth depends on accumulated treasure Gold and silver are the currency of trade. Theory says you should have a trade surplus. Maximize exports through subsidies. Minimize imports through tariffs and quotas. Flaw: zero-sum game.

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Mercantilism-(zero-sum game)
David Hume in 1752 pointed out that:
Increased exports leads to inflation and higher prices Increased imports lead to lower prices

Result: Country A sells less because of high prices and Country B sells more because of lower prices In the long run, no one can keep a trade surplus
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Theory of Absolute Advantage Adam Smith: Wealth of Nations (1776).

Capability of one country to produce more of a product with the same amount of input than another country. Produce only goods where you are most efficient, trade for those where you are not efficient. Assumes there is an absolute advantage balance among nations, e.g., Ghana/cocoa.
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The Theory of Absolute Advantage

G 20

Cocoa

15

A 10 K 5

B G K 15 20
9

0
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Rice
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The Theory of Absolute Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa

Rice

Ghana S. Korea

10 40

20 10
5.0 10.0 15.0 0 20

Production and Consumption without Trade (equal resource for both crops

Ghana 10.0 S. Korea 2.5 Total production 12.5 Ghana 20 S. Korea 0 Total production 20

Production with Specialization

20

Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice

Ghana S. Korea
Ghana S. Korea
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14.0 6.0
4.0 3.5

6.0 14.0
1.0 4.0
10

Increase in Consumption as a Result of Specialization and Trade

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Theory of Comparative Advantage David Ricardo: Principles of Political Economy (1817).

Should trade even if country is more efficient in the production than its trading partner.

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The Theory of Comparative Advantage

G 20

Cocoa

15

A 10 K 5

2.5

3.75

7.5

10

G 15

20

Rice
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Comparative Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa

Rice

Ghana S. Korea

10 40

13.33 20 7.5 5.0 12.5 3.75 10.0 7.75 6 0.25 1.0

13

Production and Consumption without Trade

Ghana 10.0 S. Korea 2.5 Total production 12.5 Ghana 15 S. Korea 0.0 Total production 15 Ghana S. Korea Ghana S. Korea
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Production with Specialization

13.75

Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice

11 4 1.0 1.5

Increase in Consumption as a Result of Specialization and Trade

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Extensions of the Ricardian Model

Immobile resources: Resources do not always move easily from one economic activity to another. Diminishing returns: More a country produces, at some point, will require more resources (diminishing returns to specialization). Different goods use resources in different proportions. Dynamic effects and economic growth : However: Free trade might increase a countrys stock of resources (as labor and capital arrives from abroad), and Increase the efficiency of resource utilization.
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Ghanas PPF under Diminishing Returns

G

Figure 4.3 0
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Cocoa

Rice
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The Influence of Free Trade on the PPF

PPF2

Cocoa

PPF1

Figure 4.4

G 0

Rice
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THE SAMUELSON CRITIQUE

Rich country, US enter into free trade agreement with a poor country, China rapidly improves its productivity dynamic gain for China Samuelson model suggests that the lower prices that US consumers pay for goods imported from china, may not be enough to produce a net gain for the US economy Samuelson is concerned about the ability to send offshore service jobs that traditionally were not internationally mobile, such as software debugging, call center jobs, accounting jobs and even medical diagnosis of MRI scans. Samuelson concedes that free trade has historically benefitted rich countries introducing protectionist measure will harm US 4/1/2013 a.velsamy, sona school of management 17

A Link Between Trade and Growth

Sachs and Warner: 1970 to 1990 study Open economy developing countries grew 4.49%/year. Closed economy developing countries grew 0.69%/year. Open economy developed countries grew 2.29%/year. Closed economy developed countries grew 0.74%/year. Frankel and Romer: On average, a one percentage point increase in the ratio of a countrys trade to its GDP increases income/person by at least 0.5%. For every 10% increase in the importance of international trade in an economy, average income levels will rise by at least 5%.
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Heckscher (1919)-Olin (1933) Theory

Patterns of trade are determined by differences in factor endowments - not productivity. Remember, focus on relative advantage, not absolute advantage. Labor is not the only Factor of production. We need to account for land, capital, and technology.
Factor endowments: extent to which a country is endowed with such resources as land, labor, and capital. Export goods that intensively use factor endowments which are locally abundant. (Corollary: import goods made from locally scarce factors.)
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The Leontief Paradox, 1953

Disputes Heckscher-Olin in some instances. Factor endowments can be impacted by government policy - minimum wage. US tends to export labor-intensive products, but is regarded as a capital intensive country.

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Product Life-Cycle Theory (Raymond Vernon, 1966) Article in the Quarterly Journal of Economics. As products mature, both location of sales and optimal production changes. Affects the direction and flow of imports and exports. Globalization and integration of the economy makes this theory less valid.

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The International Product Life Cycle: Innovating Firms Country

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The International Product Life Cycle: Other Industrialized Countries

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The International Product Life Cycle: Less Developed Countries

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The Product Life-Cycle Theory

160 140 120 100 80 60 40 20 0
160 140 120 100 80 60 40 20 0 160 140 120 100 80 60 40 20 0

United States
Exports Imports

production consumption

Other Advanced Countries

Imports

Exports

Developing Countries
Exports Imports
New Product Maturing Product Standardized Product

Stages of Production Development

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The New Trade Theory

Began to be recognized in the 1970s. Deals with the returns on specialization where substantial economies of scale are present. Specialization increases output, ability to enhance economies of scale increase. In addition to economies of scale, learning effects also exist. Learning effects are cost savings that come from learning by doing.
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Application of the New Trade Theory

Typically, requires industries with high, fixed costs. World demand will support few competitors. Competitors may emerge because they got there first.
First-mover advantage.

Some argue that it generates government intervention and strategic trade policy.
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First-Mover Advantage
Economies of scale may preclude new entrants. Role of the government.

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Porters Diamond (Harvard Business School, 1990)

The Competitive Advantage of Nations. Looked at 100 industries in 10 nations. Thought existing theories didnt go far enough. Question: Why does a nation achieve international success in a particular industry?

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Determinants of National Competitive Advantage

Factor endowments: nations position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry. Demand conditions: the nature of home demand for the industrys product or service. Related and supporting industries: the presence or absence in a nation of supplier industries or related industries that are nationally competitive. Firm strategy, structure and rivalry: the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry.
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Porters Diamond
Determinants of National Competitive Advantage
GOVERNMENT

CHANCE

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The Diamond
Success occurs where these attributes exist.
More/greater the attribute, the higher chance of success.

The diamond is mutually reinforcing.

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Factor Endowments
Taken from Heckscher-Olin Basic factors: natural resources climate location demographics Advanced factors: communications skilled labor research technology

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Advanced Factor Endowments

More likely to lead to competitive advantage. Are the result of investment by people, companies, government.

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Relationship of Basic to Advanced Factors

Basic can provide an initial advantage. Must be supported by advanced factors to maintain success. No basics, then must invest in advanced factors.
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Demand Conditions
Demand creates the capabilities. Look for sophisticated and demanding consumers.
impacts quality and innovation.

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Related and Supporting Industries

Creates clusters of supporting industries that are internationally competitive. Must also meet requirements of other parts of the Diamond.

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Firm Strategy, Structure and Rivalry

Management ideology can either help or hurt you. Presence of domestic rivalry improves a companys competitiveness.

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Evaluating Porters Theory

If Porter is right, we would expect his model to predict the pattern of international trade that we observe in the real world. Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable. Too soon to tell.

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Implications for Business

Location implications: makes sense to disperse production activities to countries where they can be performed most efficiently. First-mover implications: It pays to invest substantial financial resources in building a first-mover, or early-mover, advantage. Policy implications: promoting free trade is generally in the best interests of the home-country, although not always in the best interests of the firm. Even though, many firms promote open markets.
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Theories of International Trade

Country-Based Theories Country is unit of analysis Emerged prior to WWII Developed by economists Explain interindustry trade Include Mercantilism Absolute advantage Comparative advantage Relative factor endowments Firm-Based Theories Firm is unit of analysis Emerged after WWII Developed by business school professors Explain intraindustry trade Include Country similarity theory Product life cycle Global strategic rivalry National competitive advantage

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Stay tuned
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