Chapter 4 International Trade Theory -trade patterns in the World

1. 2. Explain key trade theories. Evaluate the rationale for government policies to control trade. Evaluate the effects of governments and pressure groups on trade policies. Compare and contrast the various approaches to trade control. International Factor Movements

3.
4.

5.

1. An Overview Of Trade Theory

International free trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, and import products that can be produced more efficiently in other countries . Questions should be focused are:

what products should we import and export?

How much should we trade? With whom should we trade?

Theories of International Trade

1500
Year
Mercantilism

1600

1700

1800

1900

2000

Absolute Advantage

Comparative Advantage Factor Proportions Theory

International Product Life Cycle

New Trade Theory Global Competitive Advantage

1.1MERCANTILISM
Mercantilism, which emerged in England in the mid-16th century, asserted that it is in a countrys best interest to maintain a trade surplus, to export more than it imports. Mercantilism advocated government intervention to achieve a surplus in the balance of trade, many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade; It viewed trade as a zero-sum game, one in which a gain by one country results in a loss by another.

1.2 Classical Trade Theory

The Theory of Absolute Advantage The ability of a country to produce a product with fewer inputs than another country. Hence, different countries produce some goods more efficiently than other countries Thus, global efficiency can be increased through international free trade The Theory of Comparative Advantage The notion that although a country may produce both products more cheaply than another country, it is relatively better at producing one product than the other

ABSOLUTE ADVANTAGE
In 1776, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game and 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. Through specialization, countries could increase their efficiency because of three reasons: Labor could become more skilled by repeating the same tasks; Labor would not lose time in switching from the production of one kind of product to another; Long production runs would provide incentives for the development of more effective working methods.

But in what products should a country specialize? Smith believed the marketplace would make the determination, he thought that a countrys advantage would be either natural or acquired.

Absolute Trade Advantage

COMPARATIVE ADVANTAGE
In 1817, 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. 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.

Heckscher and Ohlin argued that comparative advantage arises from differences in national factor endowments. 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

Absolute/Comparative Advantage are Theories of Specialization

Adam SmithDivision of Labor Industrial societies increase output using same labor-hours as preindustrial society David RicardoComparative Advantage Countries with no obvious reason for trade can specialize in production, and trade for products they do not produce Possible invalid assumptions of these theories Full employment may be compromised Economic efficiency objective may not be fully held (culture, etc.) Unequal division of gains may put off some countries Transportation costs can drive down an advantage Mobility of factors is not always the case, especially HR Dynamics of technological innovation, etc. change the landscape quickly and give advantage

The Leontief Paradox

Theories explaining trade patterns How much does a country trade? What types of products does a country trade? With whom do countries trade? A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive). In 1953, Wassily Leontief postulated that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods. 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 known as the Leontief Paradox

1.3 Factor Proportions Trade Theory

Developed by Eli Heckscher Expanded by Bertil Ohlin

Labor Capital

Factor Proportions

Land-labor relationship Labor-capital relationship Technological complexities

1.4 THE PRODUCT LIFE CYCLE THEORY

In the mid-1960s, Raymond Vernon proposed the product lifecycle theory that suggested that as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade. According to the PLF theory of trade, the production location moves from one country to another depending on the stage in the products life cycle.

Life cycle stage

Life cycle stage Introduction stage is marked by Innovation in response to observed need Exporting by the innovative country evolving product characteristics Growth is characterized by Increase in exports by innovating country More competition Increased capital intensity Some foreign production Maturity is characterized by A decline in exports from innovating country More product standardization More capital intensity Increased competitiveness of price Production start-ups in emerging economies

Decline is characterized by A concentration of production in developing countries An innovating country becoming a net importer

Limitations of PLC Theory

Products with extremely short PLCs Luxury products where cost may be of little concern Businesses with products that follow a differentiation strategy Products that require specialized technical labor for subsequent product generations Global start-ups

1.5 The New Trade Theory: Strategic Trade

Two New Contributions of Strategic Trade Paul Krugman-How trade is altered when markets are not perfectly competitive Michael Porter-Examined competitiveness of industries on a global basis
New trade theory suggests that because of economies of scale (unit cost reductions associated with a large scale of output) and increasing returns to specialization, in some industries there are likely to be only a few profitable firms Firms with first mover advantages (the economic and strategic advantages that accrue to many entrants into an industry) will develop economies of scale and create barriers to entry for other firms

Strategic Trade
Porters Diamond of National Advantage Innovation is what drives and sustains competitiveness Four components of competition Factor Conditions Demand Conditions Related and Supporting Industries Firm Strategy, Structure, and Rivalry Government can play a beneficial role when markets are not purely competitive Theory expands to governments role in international trade Four circumstances exist that involve imperfect competition in which strategic trade may apply

National Competitive Advantage: Porters Diamond

Porters 1990 study tried to explain why a nation achieves international success in a particular industry and identified four attributes that promote or impede the creation of competitive advantage: Factor Endowments A nation's position in factors of production can lead to competitive advantage These factors can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how)

Demand Conditions
The nature of home demand for the industrys product or service influences the development of capabilities Sophisticated and demanding customers pressure firms to be competitive Relating and Supporting Industries The presence 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 manufacturers of semi-conductor processing equipment can lead to (and be a result of having) a competitive semi-conductor industry

Porters Diamond of competitive

Porters Diamond of competitive advantage is shown in following figure

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 . The four attributes, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage

2 Movements in Factors of Production

Movements in factors of production include

labor migration the transfer of financial assets through international borrowing and lending transactions of multinational corporations involving direct ownership of foreign firms

Like movements of goods and services (trade), movements of factors of production are politically sensitive and are often restricted.

Restrictions on immigration Restrictions on financial asset flows (less common today in Europe and U.S.) Restrictions on the activities of multinational corporations

2.1 Labor migration

To show the effects of labor migration (mobility), lets build a simple model with only one composite good called output. Suppose that there are only two important factors of production: land and labor. On a fixed parcel of land, the productivity of workers eventually diminishes as each works more hours and as more workers produce on that fixed parcel of land.

The marginal productivity of labor eventually decreases.

Fig. 1 The Marginal Product of Labor

International Labor Mobility (cont.)

Workers in the domestic country have an incentive to move to the foreign country until the purchasing power of wages between the countries are equal.

Emigration from the domestic country raises real wages of the remaining workers there. It increases the supply of labor services and decreases the real wage in the foreign country.

Fig. 5-2: Causes and Effects of International Labor Mobility

Labor migration between the domestic country and the foreign country is also predicted to increase the value of world output.

The value of foreign output rises by the area under its MPL* curve from OL1 to OL2 The value of domestic output falls by the area under its MPL curve from OL2 to OL1

The value of world output is maximized when the marginal productivity of labor is the same across countries.

International Labor Mobility (cont.) model predicts that trade in goods is an alternative to factor The Heckscher-Ohlin
mobility. Services from factors of production are embodied in goods, so that the value of goods reflects the value or productivity of the factors of production that produced them. But equalization of factor prices with labor mobility does not really occur for reasons that are similar to the reasons given in the Heckscher-Ohlin model:

The model assumes that trading countries produce the same goods, but countries may produce different goods so that marginal productivities of labor are not comparable. The model assumes that trading countries have the same technology, but different technologies could affect the productivities of factors and therefore the wages and income paid to these factors. Barriers to immigration and emigration and transportation costs may prevent the purchasing power of wages from equalizing. Barriers to movements for

other factors of production, like land and capital, are also important.

2.2 International Borrowing and Lending

International capital mobility refers to mobility of financial assets, or capital, across countries. Financial capital is a source of funds used to build physical capital (ex., factories and equipment). International capital mobility can be interpreted as intertemporal trade: trade of goods consumed today by borrowers in return for goods consumed in the future by lenders. For any economy, there is a trade-off (opportunity cost) between consuming today and saving for the future: resources can either be consumed or saved. To save and invest more today typically means that economies need to consume less today. We represent this concept by drawing a special kind of production possibility frontier, an intertemporal production possibility frontier.

International Borrowing and Lending (cont.)

Suppose that the domestic country has a comparative advantage in (bias towards) current consumption, while the foreign country has a comparative advantage (bias towards) future consumption. In the absence of international borrowing and lending, the relative price of current consumption should be lower in the domestic country. But what is the relative price of current consumption? The price of borrowing 1 unit of output/income to consume today is the output/income that needs to be repaid in the future: principal + interest = 1+r, where r is the interest rate The price of current consumption relative to future consumption is 1/(1+r)

The opportunity cost of consuming 1 unit of output/ income today is the output/income that could be earned by saving it: principal + interest = 1+r, where r is the interest rate The opportunity cost of current consumption relative to future consumption is 1/(1+r)

3. FOCUS ON MANAGERIAL IMPLICATIONS

The conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalry impacts firm competitiveness There are at least three main implications for international businesses: location implications, first-mover implications, and policy implications.
Location One way in which the material discussed in this chapter matters to an international business is the link between the theories and a firms decision about where to locate its productive activities

It makes sense for a firm to disperse its various productive activities to those countries where they can be performed most efficiently

First Mover Advantages

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 Government policies with respect to free trade or protecting domestic industries can significantly impact global competitiveness

Businesses should work to encourage governmental policies that support free trade

4. A test for international trade theory

Shares of regional trade flows in world merchandise exports, 2008 (Percentage)
North America 100.0 37.5 6.2 17.6

Destination Origin World North America South and Central America Europe Commonwealth of Independent States (CIS) Africa Middle East Asia

World 100.0 13.0 3.8 41.0

South and Central America

100.0 28.3 27.2 16.6

Europe

CIS 100.0 3.1 1.7 46.4

Africa 100.0 7.3 3.7 40.5

Middle East 100.0 9.7 1.9 30.5

Asia

100.0 5.5 1.8 69.7

100.0 9.6 2.6 12.5

4.5 3.5 6.5 27.7

1.3 4.5 4.3 28.6

1.7 3.2 1.2 21.9

6.0 3.2 1.9 11.9

26.1 0.3 1.4 21.0

2.3 11.7 8.0 26.5

4.0 2.3 19.8 31.8

2.0 2.9 14.6 55.9

World merchandise exports by region and selected economy (Billion dollars and percentage)
1948 1953 1963 1973 Value World Share World United States South and Central America Brazil Europe Commonwealth of Independent States (CIS) b 100.0 21.7 11.3 2.0 35.1 100.0 18.8 9.7 1.8 39.4 100.0 14.9 6.4 0.9 47.8 100.0 12.3 4.3 1.1 50.9 100.0 11.2 4.4 1.2 43.5 100.0 12.6 3.0 1.0 45.4 100.0 9.8 3.0 1.0 45.9 2.6 100.0 8.2 3.8 1.3 41.0 4.5 59 84 157 579 1838 3676 7377 15717 1983 1993 2003 2008

Asia
China Japan India Six East Asian traders

14.0
0.9 0.4 2.2 3.4

13.4
1.2 1.5 1.3 3.0

12.5
1.3 3.5 1.0 2.4

14.9
1.0 6.4 0.5 3.4

19.1
1.2 8.0 0.5 5.8

26.1
2.5 9.9 0.6 9.7

26.2
5.9 6.4 0.8 9.6

27.7
9.1 5.0 1.1 9.0

World merchandise imports by region and selected economy (Billion dollars and percentage)
Value 1948 World Share World 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 59 1953 84 1963 157 1973 579 1983 1838 1993 3676 2003 7377 2008 15717

North America
United States South and Central America Brazil Europe

28.1
21.7 11.3 2.0 35.1 7.3 2.0 14.0 0.9 0.4 2.2 3.4

24.8
18.8 9.7 1.8 39.4 6.5 2.7 13.4 1.2 1.5 1.3 3.0

19.9
14.9 6.4 0.9 47.8 5.7 3.2 12.5 1.3 3.5 1.0 2.4

17.3
12.3 4.3 1.1 50.9 4.8 4.1 14.9 1.0 6.4 0.5 3.4

16.8
11.2 4.4 1.2 43.5 4.5 6.8 19.1 1.2 8.0 0.5 5.8

18.0
12.6 3.0 1.0 45.4 2.5 3.5 26.1 2.5 9.9 0.6 9.7

15.8
9.8 3.0 1.0 45.9 2.6 2.4 4.1 26.2 5.9 6.4 0.8 9.6

13.0
8.2 3.8 1.3 41.0 4.5 3.5 6.5 27.7 9.1 5.0 1.1 9.0

Commonwealth of Independent States (CIS) b

Africa Middle East Asia China Japan India Six East Asian traders

Leading exporters and importers in world merchandise trade, 2008 (Billion dollars and percentage)
Annual percentag e change 7 7.3 6.9 14 18 Annual percentag e change 11 17 12 9 15 10 8 10

Rank 1 2 3

Importers United States Germany China

Value 2169.5 1203.8 1132.5

Share 13.2

Rank 1 2 3 4 5 6 7 8

Exporters Germany China United States Japan Netherlands France Italy Belgium Russian Federatio n United Kingdom

Value 1461.9 1428.3 1287.4 782.0 633.0 605.4 538.0 475.6

Share 9.1 8.9 8.0 4.9 3.9 3.8 3.3 3.0

4
5 6 7

Japan
France United Kingdom Netherlands

762.6
705.6 632.0 573.2

4.6
4.3 3.8 3.5 3.4 2.9 2.7

23
14 1 16 8 14 22

8 9 10

Italy Belgium Korea, Republic of

554.9 469.5 435.3

9 10

471.6 458.6

2.9 2.9

33 4

Exports in commercial services of selected economies by origin and destination, 2007

Value 07 Share 07 Annual percentage change 04-07 06 07

World
European Union (27) United States Japan Russian Federation China Singapore Australia India Hong Kong, China Korea, Republic of

1586629
918349 186557 26376 25930 24001 15491 14617 12754 11218 9804

100.0
57.9 11.8 1.7 1.6 1.5 1.0 0.9 0.8 0.7 0.6

14
14 10 5 32 30 19 19 42 9 13

13
13 11 -4 20 9 24 10 38 -15 16

21
20 14 14 43 45 19 28 45 28 16

Brazil

8693

0.5

24

15

33

imports in commercial services of selected economies by origin and destination, 2007

Value 07 World European Union (27) United States Japan 1371589 823565 168917 18427 Share 07 100.0 60.0 12.3 1.3 Annual percentage change 04-07 12 12 9 13 06 10 10 5 11 07 19 19 14 14

China
Russian Federation Hong Kong, China Singapore India Australia Egypt Croatia

18386
16020 10919 9548 9333 8378 7590 6599

1.3
1.2 0.8 0.7 0.7 0.6 0.6 0.5

27
18 20 16 23 10 13 16

28
11 18 10 15 4 -1 9

26
19 34 29 32 14 23 12

Leading importers in world trade in commercial services (excluding intra-EU (27) trade), 2008
Rank 1 2 3 4 5 6 Importers Extra-EU (27) imports United States Japan China Korea, Republic of Canada Value 620.7 367.9 167.4 158.0 91.8 86.6 Share 23.9 14.2 6.4 6.1 3.5 3.3

Annual percentage change

13 8 13 22 12 6

7
8 9 10

India
Singapore Russian Federation Thailand

83.6
78.9 74.6 46.3

3.2
3.0 2.9 1.8

18
6 29 21

Leading exporters in world trade in commercial services (excluding intra-EU (27) trade), 2008
Rank
1 2 3

Exporters
Extra-EU (27) exports United States China

Value
743.2 521.4 146.4

Annual percentage Share change 26.9 18.8 5.3 11 10 20

4
5 6 7

Japan
India Hong Kong, China Singapore

146.4
102.6 92.3 82.9

5.3
3.7 3.3 3.0

15
17 9 3

8
9 10

Switzerland
Korea, Republic of Canada

75.2
74.1 64.8

2.7
2.7 2.3

16
20 2

Exports of the United States by origin and destination, 2008

Destination Value 2008 World North America Asia Europe South and Central America Middle East Africa CIS European Union (27) Canada Mexico China Japan 1287.4 413.2 329.4 311.1 135.0 55.0 28.8 13.8 271.8 260.9 151.2 69.7 65.1 2000 100.0 37.0 27.6 23.6 7.5 2.4 1.4 0.4 21.6 22.6 14.3 2.1 8.4 Share 2008 100.0 32.1 25.6 24.2 10.5 4.3 2.2 1.1 21.1 20.3 11.7 5.4 5.1 Annual percentage change 2007 12 6 11 16 21 21 28 49 15 8 2 17 5 2008 12 7 8 14 28 22 20 32 11 5 11 11 7

Imports of the United States by origin and destination, 2008

Origin World Value 2008 2169.5 Share 2000 100.0 2008 100.0 Annual percentage change 2007 5 2008 7

Asia
North America Europe South and Central America Africa Middle East CIS European Union (27) China

762.4
559.0 409.6 167.4 117.3 115.3 38.5 377.9 356.6

37.8
29.4 20.3 6.2 2.3 3.2 0.8 18.7 8.5

35.1
25.8 18.9 7.7 5.4 5.3 1.8 17.4 16.4

5
5 6 1 14 8 5 7 11

1
5 4 18 23 44 45 4 5

Canada
Mexico Japan

339.1
218.6 143.6

18.5
10.9 12.0

15.6
10.1 6.6

3
6 -2

7
3 -4

Exports and imports of China:20042008

Items
The value of Exports and imports(1000 us$) The value of Exports (1000 us$) The value of imports(1000 us$)

2008
2,561,600,00 0.00

2007
2,173,726,01 7.00

2006
1,760,396,00 0.00

2005
1,421,910,00 0.00

2004
1,154,550,00 0.00

1,428,500,00 0.00

1,217,775,75 6.01

968,935,601. 01

761,953,000. 00

593,326,000. 00

1,133,100,00 0.00

955,950,261. 33

791,460,867. 85

659,953,000. 00

561,229,000. 00

Main indicators of China (units%)

Indicator Population

1978 22.3

1980 22.1

1990 21.6

2000 20.8

2005 20.2

2006 20.1

2007 20.0

Gross Domestic Product

Foreign Trade Total Exports Imports

1.75
0.79 0.76 0.82 36.35 12.13 14.24

1.72
0.93 0.89 0.96

1.62
1.65 1.80 1.50

3.75
3.60 3.86 3.35

4.98
6.66 7.27 6.08

5.47
7.18 8.00 6.37

6.04
7.73 8.76 6.73

Foreign Direct Investment

Rice, Paddy Wheat Maize

0.11
36.00 12.54 15.81

1.68
36.95 16.58 20.11

2.91
31.69 17.00 17.92

7.55
28.81 15.55 19.49

5.15
28.59 17.46 20.82

4.56
28.70 18.10 19.36

Soybeans

10.09

9.83

10.15

9.55

7.63

6.97

7.22

Source: FAO Database; UNSD Database; World Bank Database; IMF

The share of high technology to exports

Country or Area World 1990 15.9 2000 23.0 2003 21.0 2004 20.9 2005 20.9 2006 20.5

High Income
Middle Income Low Income China Hong Kong, China

17.2

24.1
19.5 3.9 18.6 23.3

21.5
20.1 3.9 27.1 12.7

21.5
19.4 29.8 14.3

21.7
19.0 30.6 15.6

20.6
20.4 30.3 11.3 13.2 21.6 32.0

India
Indonesia Japan Korea, Rep.

2.4
1.2 23.8 17.8

5.0
16.2 28.3 34.8

4.8
14.5 24.1 32.1

4.9
16.1 23.7 32.8

4.8
16.3 22.5 32.3

Malaysia
Pakistan Philippines Singapore Thailand

38.2
0.1 39.7 20.7 33.0

59.5
0.4 72.6 62.6 33.3

58.9
1.3 73.6 56.3 30.2

55.6
1.1 72.6 56.6 28.1

54.7
1.4 70.7 56.6 26.6

53.8
1.4 67.6 57.8 27.3 30.1

Viet Nam
United States

11.0
33.5

5.6
30.7

4.5
30.2

5.3
29.9

Exchange Rate in 2009

Item 01 02 03 04 05 06 07 08 09

Yuan per SDR ( End of Period )

10.20

10.03

10.22

10.22

10.58

10.60

10.61

10.69

10.82

Yuan per US Dollar ( End of Period )

6.84

6.84

6.84

6.82

6.83

6.83

6.83

6.83

6.83

Yuan per US Dollar ( Period Average )

6.84

6.84

6.83

6.83

6.82

6.83

6.83

6.83

6.83