International Trade Theories.

Politics of Trade Liberalization.

 Theories of why trade occurs:

Differences across countries in labor, labor skills,
physical capital, natural resources, and technology
Economies of scale (larger scale of production is more
efficient)

Mercantilism and Neomercantilism

Mercantilism: A belief, popular in the 16-17th
centuries, that national prosperity results from
maximizing exports and minimizing imports.
Today, some argue for neomercantilismthe idea
that a nation should run a trade surplus.
Supporters of neomercantilism include:
o
o
o

Labor unions (want to protect domestic jobs)

Farmers (want to keep crop prices high)
Some manufacturers (rely on exports)

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Jean-Baptiste Colbert

Free Trade
The absence of restrictions to the
flow of goods and services among nations

Free trade is usually best because it leads to:

o
o
o
o
o
o

More and better choices for consumers and firms

Lower prices of goods for consumers and firms
Higher profits and better worker wages (because
imported input goods are usually cheaper)
Higher living standards for consumers (because their
costs are lower)
Greater prosperity in poor countries
Spread of technology

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Adam Smith (1723-1790)

6-7

Absolute Advantage Principle

A country should produce only those products in which it has
absolute advantage or those it can produce using fewer
resources than another country.

(Labor Cost in Days of Production for One Ton)

6-8

Comparative Advantage
One of the few ideas in economics that is true
without being obvious. Paul Samuelson
The foundation concept of international trade;
answers the question of why trade is beneficial
Refers to the superior features of a country that
provide it with unique benefits in global competition
Derived either from natural endowments or from
deliberate national policies

6-9

Assumptions of Ricardian Model

Labor
The only input
Cannot migrate across borders
Is completely mobile between sectors
Fully employed

Assumptions of Ricardian Model

(contd)

Markets
Two outputs
Perfect competition
No transportation or trade costs

10

Assumptions of Ricardian Model

(contd)

Technology
Constant returns to scale
No changes in technology or skills

11

Productivity
Productivity is the amount of output obtained from
a unit of input. Since labor is the only input, we
can define labor productivity as follows:

(units of output) / (hours worked)

12

Numerical example - Absolute

Advantage
Output per Hour Worked
United States Canada
Bread
2 loaves
3 loaves
Steel
3 tons
1 ton

13

Numerical Example - No Absolute

Advantage
Output per Hour Worked
Japan
Malaysia
Cars
2
0.5
Steel
2 tons
1 ton

14

Comparative Advantage and

Opportunity Cost
The Ricardian model uses the concepts of
opportunity cost and comparative advantage.
The opportunity cost of producing something
measures the cost of not being able to produce
something else with the resources used.

15

Comparative Advantage and

Opportunity Cost (cont.)
For example, a limited number of workers
could produce either roses or computers.
The opportunity cost of producing computers is the
amount of roses not produced.
The opportunity cost of producing roses is the amount
of computers not produced.

16

Comparative Advantage and

Opportunity Cost (cont.)
Suppose that in the U.S. 10 million roses could be
produced with the same resources that could
produce 100,000 computers.
Suppose that in Colombia 10 million roses could
be produced with the same resources that could
produce 30,000 computers.
Workers in Columbia would be less productive
than those in the U.S. in manufacturing
computers.
17

Comparative Advantage and

Opportunity Cost (cont.)
Colombia has a lower opportunity cost of
producing roses.
Colombia can produce 10 million roses, compared to
30,000 computers that it could otherwise produce.
The U.S. can produce 10 million roses, compared to
100,000 computers that it could otherwise produce.

18

Comparative Advantage and

Opportunity Cost (cont.)
The U.S. has a lower opportunity cost of producing
computers.
Colombia can produce 30,000 computers, compared to 10 million
roses that it could otherwise produce.
The U.S. can produce 100,000 computers, compared to 10 million
roses that it could otherwise produce.
The U.S. can produce 30,000 computers, compared to 3.3 million
roses that it could otherwise produce.

19

Comparative Advantage and

Opportunity Cost (cont.)
A country has a comparative advantage in
producing a good if the opportunity cost of
producing that good is lower in the country than
in other countries.
The U.S. has a comparative advantage in computer
production.
Colombia has a comparative advantage in rose
production.

20

Comparative Advantage and

Opportunity Cost (cont.)
Suppose initially that Colombia produces
computers and the U.S. produces roses, and that
both countries want to consume computers and
roses.
Can both countries be made better off?

21

Table 3-1: Hypothetical Changes in

Production

22

Comparative Advantage and Trade

When countries specialize in production in which they have
a comparative advantage, more goods and services can be
produced and consumed.
Have U.S. stop growing roses and use those resources to make
100,000 computers instead. Have Colombia stop making 30,000
computers and grow roses instead.
If produce goods in which have a comparative advantage (U.S.
produces computers and Colombia roses), they could still consume
the same 10 million roses, but could consume 100,000 30,000 =
70,000 more computers.

23

Misconceptions About Comparative

Advantage
1. Free trade is beneficial only if a country is more productive
than foreign countries.
But even an unproductive country benefits from free trade by avoiding the
high costs for goods that it would otherwise have to produce domestically.
High costs derive from inefficient use of resources.
The benefits of free trade do not depend on absolute advantage, rather they
depend on comparative advantage: specializing in industries that use
resources most efficiently.

24

Misconceptions About Comparative

Advantage (cont.)
2. Free trade with countries that pay low wages hurts high
wage countries.
While trade may reduce wages for some workers, thereby affecting
the distribution of income within a country, trade benefits
consumers and other workers.
Consumers benefit because they can purchase goods more cheaply.
Producers/workers benefit by earning a higher income in the
industries that use resources more efficiently, allowing them to earn
higher prices and wages.

25

Misconceptions About Comparative

Advantage (cont.)
3. Free trade exploits less productive countries.
While labor standards in some countries are less than exemplary
compared to Western standards, they are so with or without trade.
Are high wages and safe labor practices alternatives to trade?
Deeper poverty and exploitation (ex., involuntary prostitution) may
result without export production.
Consumers benefit from free trade by having access to cheaply
(efficiently) produced goods.
Producers/workers benefit from having higher profits/wages
higher compared to the alternative.

26

Gains From Trade

Gains from trade come from specializing in the
type of production which uses resources most
efficiently, and using the income generated from
that production to buy the goods and services that
countries desire.
where using resources most efficiently means
producing a good in which a country has a
comparative advantage.

27

Gains From Trade (cont.)

Domestic workers earn a higher income from
cheese production because the relative price of
cheese increases with trade.
Foreign workers earn a higher income from wine
production because the relative price of cheese
decreases with trade (making cheese cheaper) and
the relative price of wine increases with trade.

28

Gains From Trade (cont.)

Think of trade as an indirect method of production
that converts cheese into wine or vice versa.
Without trade, a country has to allocate resources
to produce all of the goods that it wants to
consume.
With trade, a country can specialize its production
and exchange for the mix of goods that it wants to
consume.

29

Gains From Trade (cont.)

Consumption possibilities expand beyond the
production possibility frontier when trade is
allowed.
With trade, consumption in each country is
expanded because world production is expanded
when each country specializes in producing the
good in which it has a comparative advantage.

30

Fig. 3-4: Trade Expands

Consumption Possibilities

31

Examples of National Comparative Advantage

Singapore geographic location facilitates logistics.
Cote dIvoire has good environment for growing
cocoa beans.
Germany has a superior base of knowledge and
experience in producing industrial equipment.
Over time, South Korea has acquired a superior
base of electronics workers for producing computer
hardware.

6-10

Comparative Advantage Principle (cont.)

Two men can make both shoes and hats, and one is superior to the
other in both employments, but in making hats he can only exceed
his competitor by one fifth or 20 percent, and in making shoes he can
excel him by one third or 33 percent; will it not be for the interest of
both that the superior man should employ himself exclusively in
making shoes and the inferior man in making hats?

David Ricardo, 1817

International Business: The New Realities

6-12

Transportation Costs and Non-traded

Goods

The Ricardian model predicts that countries

completely specialize in production.

But this rarely happens for three main reasons:

1. More than one factor of production reduces the tendency
of specialization.
2. Protectionism.
3. Transportation costs reduce or prevent trade, which may
cause each country to produce the same good or service.

34

Transportation Costs and Non-traded

Goods (cont.)
Nontraded goods and services (ex., haircuts and
auto repairs) exist due to high transport costs.
Countries tend to spend a large fraction of national
income on nontraded goods and services.
This fact has implications for the gravity model and
for models that consider how income transfers across
countries affect trade.

35

Empirical Evidence
Do countries export those goods in which their productivity is
relatively high?
The ratio of U.S. to British exports in 1951 compared to the ratio
of U.S. to British labor productivity in 26 manufacturing
industries suggests yes.
At this time the U.S. had an absolute advantage in all 26
industries, yet the ratio of exports was low in the least productive
sectors of the U.S.

36

Fig. 3-6: Productivity and Exports

37

Empirical Evidence
Compare Chinese output and productivity with that
of Germany for various industries using 1995 data.
Chinese productivity (output per worker) was only 5
percent of Germanys on average.
In apparel, Chinese productivity was about 20 percent
of Germanys, creating a strong comparative advantage
in apparel for China.
38

Table 3-3: China versus Germany,

1995

39

Empirical Evidence
The main implications of the Ricardian model are
well supported by empirical evidence:
productivity differences play an important role in
international trade
comparative advantage (not absolute advantage)
matters for trade

40

Summary
1. Differences in the productivity of labor across
countries generate comparative advantage.
1. A country has a comparative advantage in
producing a good when its opportunity cost of
producing that good is lower than in other
countries.

41

Summary
3. Countries export goods in which they have a
comparative advantage - high productivity or
low wages give countries a cost advantage.
4. With trade, the relative price settles in between
what the relative prices were in each country
before trade.

42

Summary (cont.)
5. Trade benefits all countries due to the relative
price of the exported good rising: income for
workers who produce exports rises, and
imported goods become less expensive.
6. Empirical evidence supports trade based on
comparative advantage, although transportation
costs and other factors prevent complete
specialization in production.
43

44

Limitations of Early Trade Theories

Fail to account for international transportation costs.
Governments distort normal trade by selectively imposing
protectionism (e.g., tariffs) or investing in certain industries
(e.g., via subsidies).
Services: Some cannot be traded; others can be traded
freely via the Internet or global telephony.
For many firms, scale economies and superior business
strategies provide efficiencies and other advantages. Early
trade theories failed to account for this (e.g., Japan lacks
comparative advantages, but its firms succeeded anyway,
via superior strategies).

6-13

Factor Proportions Theory

Heckscher-Ohlin (H-O) Theory

A country will export those products that are intensive

in its abundant factor; that is, a capital-rich country will
export capital-intensive goods and import goods that
intensively use relatively scarce factors of production.

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Stopler-Samuelson Theorem
Trade will benefit the owners of locally
abundant factors and harm owners of the
scarce factors. Thus, although all
countries will benefit in absolute terms,
there will be important distributive
consequences that will favor either
capital or labor in trading countries.

Mundell equivalency
Trade in factors (capital or labor) and
trade in goods will have the same effect
and can fully substitute for one another.

Factor Price Equalization

Unlike the Ricardian model, the Heckscher-Ohlin model
predicts that factor prices will be equalized among
countries that trade.
Free trade equalizes relative output prices.
Due to the connection between output prices and factor
prices, factor prices are also equalized.
Trade increases the demand of goods produced by relatively
abundant factors, indirectly increasing the demand of these
factors, raising the prices of the relatively abundant factors.

Factor Price Equalization (cont.)

In the real world, factor prices are not equal across
countries.
The model assumes that trading countries produce the same
goods, but countries may produce different goods if their
factor ratios radically differ.
The model also assumes that trading countries have the
same technology, but different technologies could affect the
productivities of factors and therefore the wages/rates paid
to these factors.

Table 5-1: Comparative International Wage Rates

(United States = 100)

Factor Price Equalization (cont.)

The model also ignores trade barriers and transportation
costs, which may prevent output prices and thus factor
prices from equalizing.
The model predicts outcomes for the long run, but after an
economy liberalizes trade, factors of production may not
quickly move to the industries that intensively use abundant
factors.
In the short run, the productivity of factors will be determined by their
use in their current industry, so that their wage/rental rate may vary
across countries.

Does Trade Increase Income Inequality?

Over the last 40 years, countries like South Korea, Mexico,
and China have exported to the U.S. goods intensive in
unskilled labor (ex., clothing, shoes, toys, assembled
goods).
At the same time, income inequality has increased in the
U.S., as wages of unskilled workers have grown slowly
compared to those of skilled workers.
Did the former trend cause the latter trend?

Does Trade Increase

Income Inequality? (cont.)

The Heckscher-Ohlin model predicts that owners of

relatively abundant factors will gain from trade and
owners of relatively scarce factors will lose from trade.
Little evidence supporting this prediction exists.

1. According to the model, a change in the distribution of

income occurs through changes in output prices, but there
is no evidence of a change in the prices of skill-intensive
goods relative to prices of unskilled-intensive goods.

Does Trade Increase

Income Inequality? (cont.)
2. According to the model, wages of unskilled workers
should increase in unskilled labor abundant countries
relative to wages of skilled labor, but in some cases the
reverse has occurred:
Wages of skilled labor have increased more rapidly in Mexico than
wages of unskilled labor.

But compared to the U.S. and Canada, Mexico is supposed to be

abundant in unskilled workers.

3. Even if the model were exactly correct, trade is a small

fraction of the U.S. economy, so its effects on U.S. prices
and wages prices should be small.

Trade and Income Distribution

Changes in income distribution occur with every economic
change, not only international trade.
Changes in technology, changes in consumer preferences, exhaustion
of resources and discovery of new ones all affect income distribution.
Economists put most of the blame on technological change and the
resulting premium paid on education as the major cause of increasing
income inequality in the US.

It would be better to compensate the losers from trade (or

any economic change) than prohibit trade.
The economy as a whole does benefit from trade.

Trade and Income Distribution (cont.)

There is a political bias in trade politics: potential
losers from trade are better politically organized
than the winners from trade.
Losses are usually concentrated among a few, but
gains are usually dispersed among many.
Each of you pays about $8/year to restrict imports of
sugar, and the total cost of this policy is about $2
billion/year.
The benefits of this program total about $1 billion, but
this amount goes to relatively few sugar producers.

Empirical Evidence on the

Heckscher-Ohlin Model

Tests on US data
Leontief found that U.S. exports were less capitalintensive than U.S. imports, even though the U.S. is
the most capital-abundant country in the world:
Leontief paradox.

Tests on global data

Bowen, Leamer, and Sveikauskas tested the
Heckscher-Ohlin model on data from 27 countries and
confirmed the Leontief paradox on an international
level.

Leontief Paradox
Revealed that countries can successfully export
products that use less abundant resources (e.g., the
U.S. often exports labor-intensive goods).
This implies that international trade is complex and
cannot be fully explained by a single theory.

6-17

Table 5-2: Factor Content of U.S.

Exports and Imports for 1962

Table 5-3: Testing the HeckscherOhlin Model

Inter-industry and Intra-industry

Trade
Gains from inter-industry trade reflect
comparative advantage
Gains from intra-industry trade reflect
economies of scale (lower costs) and
wider consumer choices

New Trade Theory

(Strategic Trade Theory)
Allows for imperfect competition. Oligopolistic model.
Argues that economies of scale are an important
factor in some industries for superior international
performance, even in the absence of superior
comparative advantages. Some industries succeed
best as their volume of production increases.

6-23

External Economies of Scale

Specialized equipment or services may
be needed for the industry, but are only
supplied by other firms if the industry is
large and concentrated
Labor pooling: a large and concentrated
industry may attract a pool of workers,
reducing employee search and hiring
costs for each firm.

External Economies of Scale

Knowledge spillovers: workers from
different firms may more easily share
ideas that benefit each firm when a large
and concentrated industry exists

National Industrial Policy

A proactive economic development plan
employed by the government to nurture or
support promising industry sectors with potential
for regional or global dominance. Initiatives can
include:
o
o
o
o
o

Tax incentives
Monetary and fiscal policies
Rigorous educational system
Investment in national infrastructure
Strong legal and regulatory systems

6-26

Industrial Cluster
A concentration of suppliers and supporting firms
from the same industry located within the same
geographic area; similar to Porters Related and
Supporting Industries.
A strong cluster can serve as an export platform for
the nation.

6-27

Stages in Company Internationalization

Domestic Focus

6-28

Stages in Company Internationalization

Domestic Focus

Pre-export Stage

6-29

Stages in Company Internationalization

Domestic Focus

Pre-export Stage
Experimental Involvement

6-30

Stages in Company Internationalization

Domestic Focus

Pre-export Stage
Experimental Involvement
Active Involvement

6-31

Stages in Company Internationalization

Domestic Focus

Pre-export Stage
Experimental Involvement
Active Involvement
Committed Involvement
6-32

FDI-Based Explanations:
Monopolistic Advantage Theory
Argues that MNEs prefer FDI because it provides
the firm with control over resources and capabilities
in the foreign market and a degree of monopoly
power relative to foreign competitors.
Key sources of monopolistic advantage include
proprietary knowledge, patents, unique know-how,
and sole ownership of other assets.

6-33

FDI-Based Explanations:
Internalization Theory
Explains how the MNE chooses to acquire and retain
one or more value-chain activities inside itself.
Such internalization provides the MNE with greater
control over its foreign operations.
Internalization avoids the drawbacks of dealing with
external partners, such as reduced quality control and
the risk of losing proprietary assets to outsiders.

6-34

FDI-Based Explanations:
Dunnings Eclectic Paradigm
Three conditions determine whether or not a
company will enter a given foreign country via FDI:
1. Ownership-specific advantages: Knowledge, skills,
capabilities, relationships, or physical assets that the firm owns
and that are the basis of its competitive advantages
2. Location-specific advantages: Similar to comparative
advantages; specific advantages that exist in the country that
the MNE has entered, or is seeking to enter, such as natural
resources, low-cost labor, or skilled labor
3. Internalization advantages: Control derived from internalizing
foreign-based manufacturing, distribution, or other value-chain
activities

6-35

Example of the Eclectic Paradigm: Sony in China

Ownership-Specific Advantages. Sony possesses a
huge stock of knowledge and patents in the consumer
electronics industry, as represented by products like
the Playstation and Vaio laptop.
Location-Specific Advantages. Sony desires to
manufacture in China in order to take advantage of
Chinas low-cost, highly knowledgeable labor force.
Internalization Advantages. Sony wants to maintain
control over its knowledge, patents, manufacturing
processes, and quality of its products.

6-36

Non-FDI-Based Explanations:
International Collaborative Ventures
A form of cooperation between two or more firms.
Partners pool resources and capabilities to create
synergies and share the risk of joint efforts.
Starting in the 1980s, firms increasingly began using
collaborative ventures to expand abroad.
Collaboration provides access to foreign partners
know-how, capital, distribution channels, and
marketing assets. It also helps overcome
government-imposed obstacles.

6-37

Two Types of
International Collaborative Ventures
Equity-based joint ventures result in the formation of
a new legal entity. In contrast to the wholly owned FDI,
the firm collaborates with local partner(s) to reduce risk
and commitment of capital.
Project-based alliances do not require equity
commitment from the partners, but simply a
willingness to cooperate in R&D, manufacturing,
design, or any other value-adding activity. Because
project-based alliances have a narrowly defined scope
of activities and timeline, they provide greater flexibility
to the firm than equity-based ventures.

6-38

Instruments of Trade Policy.

Tariffs.
The oldest form of domestic market
protection.
Good for domestic producers / Reduces
efficiency
Increases costs of goods

Instruments of Trade Policy.

Subsidies.
Government payment to domestic
producer:
in cash, low-interest loans, tax breaks,
government participation in a company.
Overproduction, inefficiency, reduction of
trade

Instruments of Trade Policy.

Quota.
Restriction of the imported good quantity.
Voluntary export restraint (VER)
Trade quota imposed by exporter upon the
request of importing country.

Instruments of Trade Policy.

Other.
Local content requires specific part of
the good to be produced domestically.
Administrative policies.

Modern Trade Regime

Born in conflict between American and
British negotiators at the Bretton Woods
Conference (1944).
In 1948 the United States with principal
partners created General Agreement on
Tariffs and Trade (GATT)

GATT Principles
Fixed-rule trading system (compare to
results-oriented)
Multilateralism
Reciprocity (general, later specific)
Disputes adjudication

GATT Limitations
Negotiating forum rather than
international organization
No authority to deal with disputes related
to agriculture, services, intellectual
property rights, or FDI
The rationale for WTO creation.

Evolution of GATT
Kennedy Round (1964-1967): general
reciprocity substituted for the product-byproduct approach (specific reciprocity);
manufactures barriers lowered by 33%,
anti-dumping regulations.
Tokyo Round (1973-1979): significant
tariff cuts, liberalization of agriculture,
reduction of non-tariff barriers. Didnt
solve American-European dispute, claims
of emerging markets.

Uruguay Round of GATT

Influences: changes in trade,
protectionism of 1970s, new
regionalism
Results: reduction of formal tariffs on
merchandise goods to a very low level,
rules extended to agriculture, textiles,
intellectual property, services, and foreign
investments.

World Trade Organization

Rules are more binding
Better dispute-settlement mechanism
WTO can levy fines on countries
Biennial ministerial meetings
BUT: Certain areas of trade (agriculture,
textiles) is still highly protected; emerging
markets have high barriers; change of public
opinion.

New Trade Agenda

Free Trade v. Fair Trade?

Productivity Levels in Selected Countries

(Output per hour in manufacturing, 19852005; Indices, where 1992=100)

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