Diminishing Returns

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Creating the World’s Biggest Free Trade Zone

International Trade Theory

opening case

In his February 12, 2013, State of the Union address, President Barack Obama committed the United States to negotiating a free trade deal with the European Union (EU). The United States and the 28 countries that are members of the EU already make up the world’s largest and richest trading partnership, ac- counting for about half of global GDP and one-third of all international trade. Nevertheless, the announce- ment was greeted with approval on both sides of the Atlantic and, unusually for this president, from both sides of the political divide in the United States.

The reason for the enthusiasm can be traced to widespread acceptance of the key axiom of international trade theory—trade is a good thing for all countries involved in a free trade agreement. Free trade is a positive sum game; it is equivalent to the rising tide that lifts all boats. Since 2008, both the United States and the EU have been struggling with low economic growth, persistently high unemployment, and large government deficits. A new free trade deal could help economies on both sides of the Atlantic grow faster, thereby reducing unemployment, without costing another dime in government spending. A trade deal is in effect a cost-free stimulus package.

How big the economic impact will be remains to be seen. For both the United States and the EU average tariffs (taxes) on imported goods are already low, close to 3 percent by most measures. Further reduction could nonetheless stimulate additional trade, and there are some areas where tariffs are much higher, notably on agricultural goods. Beyond tariff reductions, there are many nontariff barriers to international trade that could be reduced or eliminated as the result of a deal. One example is found in the automobile industry, where the EU and United States both employ equally strict but different safety standards. This means that to sell in both the EU and United States, automobile manufacturers must adhere to two different sets of regulations. Similarly, pharmaceutical firms currently have to submit new drugs to two sets of safety tests, one in the United States and one in the EU. Such regulatory requirements are functionally equivalent to an import tariff insofar as they raise the costs of business and international trade. By some calculations, nontariff barriers such as these are equivalent to a traditional import tariff of 10–20 percent. Initial

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160 Part Three The Global Trade and Investment Environment

estimates suggest that a comprehensive and ambitious agreement that covers both tariff and nontariff barriers to trade will boost annual GDP growth by about 0.5 percent per annum on both sides of the Atlantic, producing an additional $200 billion a year in economic activity. Talks on the proposed trade deal began in July 2013. The goal is to finalize the agreement by the end of 2014. • Sources: “Transatlantic Trading,” The Economist, February 2, 2013; Andrew Walker, “EU and US Free Trade Talks Launched,” BBC News, February 13, 2013; and Paul Ames, “Parmesan Cheese: Thorn in US-EU Free Trade Deal?” GlobalPost.com, February 25, 2013; and Henry Chu, “U.S., EU Resume Negotiations on Free Trade Agreement,” Los Angeles Times, November 11, 2013.

Introduction The proposed free trade deal between the United States and the European Union is an ex- ample of the benefits of free trade. If an agreement can be reached, a reduction in tariff and nontariff barriers to the free flow of goods and services between the United States and the EU could boost economic growth rates and help bring down persistently high unemploy- ment rates, without costing anything in additional government spending.

Economists have long argued that free trade stimulates economic growth and raises living standards across the board. As the opening case illustrates, the economic argu- ments concerning the benefits of free trade in goods and services are not abstract aca- demic ones. International trade theories have shaped the economic policy of many nations for the past 60 years. They have been the driver behind the formation of the World Trade Organization and regional trade blocs such as the European Union and the North American Free Trade Agreement (NAFTA), and they underlie the current push for a free trade deal between the United States and EU. It is important to understand, therefore, what these theories are and why they have been so successful in shaping the economic policy of so many nations and the competitive environment in which interna- tional businesses compete.

This chapter has two goals that go to the heart of the debate over the benefits—and the costs—of free trade. The first is to review a number of theories that explain why it is benefi- cial for a country to engage in international trade. The second goal is to explain the pattern of international trade that we observe in the world economy. With regard to the pattern of trade, we will be primarily concerned with explaining the pattern of exports and imports of goods and services between countries. The pattern of foreign direct investment between countries is discussed in Chapter 8.

An Overview of Trade Theory We open this chapter with a discussion of mercantilism. Propagated in the sixteenth and seventeenth centuries, mercantilism advocated that countries should simultaneously en- courage exports and discourage imports. Although mercantilism is an old and largely dis- credited doctrine, its echoes remain in modern political debate and in the trade policies of many countries. Next, we will look at Adam Smith’s theory of absolute advantage. Proposed in 1776, Smith’s theory was the first to explain why unrestricted free trade is beneficial to a country. Free trade refers to a situation in which a government does not attempt to influ- ence through quotas or duties what its citizens can buy from another country, or what they can produce and sell to another country. Smith argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exports. His arguments imply that such a laissez-faire stance toward trade was in the best interests of a country. Building on Smith’s work are two additional theories that we re- view. One is the theory of comparative advantage, advanced by the nineteenth-century Eng- lish economist David Ricardo. This theory is the intellectual basis of the modern argument

Free Trade The absence of barriers to the free flow of goods and services between countries.

Chapter Six International Trade Theory 161

for unrestricted free trade. In the twentieth century, Ricardo’s work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher-Ohlin theory.

THE BENEFITS OF TRADE The great strength of the theories of Smith, Ri- cardo, and Heckscher-Ohlin is that they identify with precision the specific benefits of in- ternational trade. Common sense suggests that some international trade is beneficial. For example, nobody would suggest that Iceland should grow its own oranges. Iceland can ben- efit from trade by exchanging some of the products that it can produce at a low cost (fish) for some products that it cannot produce at all (oranges). Thus, by engaging in international trade, Icelanders are able to add oranges to their diet of fish.

The theories of Smith, Ricardo, and Heckscher-Ohlin go beyond this commonsense no- tion, however, to show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. This is a difficult concept for people to grasp. For example, many people in the United States believe that American consumers should buy products made in the United States by American companies whenever possible to help save American jobs from foreign competition. The same kind of nationalistic sentiments can be observed in many other countries.

However, the theories of Smith, Ricardo, and Heckscher-Ohlin tell us that a country’s economy may gain if its citizens buy certain products from other nations that could be pro- duced at home. The gains arise because international trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that coun- try, while importing products that can be produced more efficiently in other countries. Thus, it may make sense for the United States to specialize in the production and export of commercial jet aircraft, because the efficient production of commercial jet aircraft requires resources that are abundant in the United States, such as a highly skilled labor force and cutting-edge technological know-how. On the other hand, it may make sense for the United States to import textiles from Bangladesh because the efficient production of textiles re- quires a relatively cheap labor force—and cheap labor is not abundant in the United States.

Of course, this economic argument is often difficult for segments of a country’s popula- tion to accept. With their future threatened by imports, U.S. textile companies and their employees have tried hard to persuade the government to limit the importation of textiles by demanding quotas and tariffs. Although such import controls may benefit particular groups, such as textile businesses and their employees, the theories of Smith, Ricardo, and Heckscher-Ohlin suggest that the economy as a whole is hurt by such action. One of the key insights of international trade theory is that limits on imports are often in the interests of domestic producers, but not domestic consumers.

Trade Tutorials

In Chapter 6, we discuss benefits and costs associated with free trade, discuss the benefits of international trade, and explain the pat- tern of international trade in today’s world economy. The general idea is that international trade theories explain why it can be beneficial for a country to engage in trade across country borders even though countries are at different stages of development, have different prod- uct needs, and produce different types of products. International trade theory assumes that countries—through their governments, laws, and regulations—engage in more or less trade across borders. In reality, the vast majority of trade happens across borders by com- panies from different countries. As related to Chapter 6, check out

globalEDGE’s “trade tutorials” section where lots of information, data, and tools are compiled related to trading internationally (globaledge. msu.edu/global-resources/trade-tutorials). The potpourri of trade re- sources include export tutorials, online course modules, glossary, free trade agreement tariff tool, and much more. The glossary in- cludes lots of terms related to trade. For example, “trade surplus” is defined as a situation in which a country’s exports exceeds its im- ports (i.e., it represents a net inflow of domestic currency from for- eign markets). The opposite is called trade deficit and is considered a net outflow, but how is it really defined—the globalEDGE glossary can help.

L0 6-1 Understand why nations trade with each other.

162 Part Three The Global Trade and Investment Environment

THE PATTERN OF INTERNATIONAL TRADE The theories of Smith, Ricardo, and Heckscher-Ohlin help explain the pattern of international trade that we ob- serve in the world economy. Some aspects of the pattern are easy to understand. Climate and natural resource endowments explain why Ghana exports cocoa, Brazil exports coffee, Saudi Arabia exports oil, and China exports crawfish. However, much of the observed pat- tern of international trade is more difficult to explain. For example, why does Japan export automobiles, consumer electronics, and machine tools? Why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Bangladesh export garments? David Ricardo’s theory of comparative advantage offers an explanation in terms of inter- national differences in labor productivity. The more sophisticated Heckscher-Ohlin the- ory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, and capital) are available in different countries and the proportions in which they are needed for producing particular goods. This explanation rests on the as- sumption that countries have varying endowments of the various factors of production. Tests of this theory, however, suggest that it is a less powerful explanation of real-world trade patterns than once thought.

One early response to the failure of the Heckscher-Ohlin theory to explain the observed pattern of international trade was the product life-cycle theory. Proposed by Raymond Ver- non, this theory suggests that early in their life cycle, most new products are produced in and exported from the country in which they were developed. As a new product becomes widely accepted internationally, however, production starts in other countries. As a result, the theory suggests, the product may ultimately be exported back to the country of its orig- inal innovation.

In a similar vein, during the 1980s economists such as Paul Krugman developed what has come to be known as the new trade theory. New trade theory (for which Krugman won the Nobel Prize in 2008) stresses that in some cases countries specialize in the production and export of particular products not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of firms. (This is argued to be the case for the commercial aircraft industry.) In such industries, firms that enter the market first are able to build a com- petitive advantage that is subsequently difficult to challenge. Thus, the observed pat- tern of trade between nations may be due in part to the ability of firms within a given

nation to capture first-mover advantages. The United States is a major exporter of commercial jet aircraft because American firms such as Boeing were first movers in the world market. Boeing built a competi- tive advantage that has subsequently been difficult for firms from countries with equally favorable factor endowments to challenge (al- though Europe’s Airbus has succeeded in doing that). In a work related to the new trade theory, Michael Porter developed a theory referred to as the theory of national competitive advantage. This attempts to ex- plain why particular nations achieve international success in particular industries. In addition to factor endowments, Porter points out the im- portance of country factors such as domestic demand and domestic ri- valry in explaining a nation’s dominance in the production and export of particular products.

TRADE THEORY AND GOVERNMENT POLICY Although all these theories agree that international trade is beneficial to a country, they lack agreement in their recommendations for govern- ment policy. Mercantilism makes a crude case for government involve- ment in promoting exports and limiting imports. The theories of Smith, Ricardo, and Heckscher-Ohlin form part of the case for unrestricted free trade. The argument for unrestricted free trade is that both import con- trols and export incentives (such as subsidies) are self-defeating and result

New Trade Theory The observed pattern of trade in the world economy may be due in part to the ability of firms in a given market to capture first-mover advantages.

Switzerland has long had a national competitive advantage in the manufacture of watches.

Chapter Six International Trade Theory 163

in wasted resources. Both the new trade theory and Porter’s theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain export-oriented industries. We discuss the pros and cons of this argument, known as strategic trade policy, as well as the pros and cons of the argument for unrestricted free trade, in Chapter 7.

Mercantilism The first theory of international trade, mercantilism, emerged in England in the mid- sixteenth century. The principle assertion of mercantilism was that gold and silver were the mainstays of national wealth and essential to vigorous commerce. At that time, gold and silver were the currency of trade between countries; a country could earn gold and silver by exporting goods. Conversely, importing goods from other countries would result in an out- flow of gold and silver to those countries. The main tenet of mercantilism was that it was in a country’s best interests to maintain a trade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige, and power. As the English mercantilist writer Thomas Mun put it in 1630:

The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: to sell more to strangers yearly than we con- sume of theirs in value.1

Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. The mercantilists saw no virtue in a large volume of trade. Rather, they recommended policies to maximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, while exports were subsidized.

The classical economist David Hume pointed out an inherent inconsistency in the mer- cantilist doctrine in 1752. According to Hume, if England had a balance-of-trade surplus with France (it exported more than it imported), the resulting inflow of gold and silver would swell the domestic money supply and generate inflation in England. In France, how- ever, the outflow of gold and silver would have the opposite effect. France’s money supply would contract, and its prices would fall. This change in relative prices between France and England would encourage the French to buy fewer English goods (because they were be- coming more expensive) and the English to buy more French goods (because they were becoming cheaper). The result would be a deterioration in the English balance of trade and an improvement in France’s trade balance, until the English surplus was eliminated. Hence, according to Hume, in the long run no country could sustain a surplus on the balance of trade and so accumulate gold and silver as the mercantilists had envisaged.

The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in which a gain by one country results in a loss by another.) It was left to Adam Smith and David Ricardo to show the shortsightedness of this approach and to demonstrate that trade is a positive-sum game, or a situation in which all countries can benefit. Unfortu- nately, the mercantilist doctrine is by no means dead. Neo-mercantilists equate political power with economic power and economic power with a balance-of-trade surplus. Critics argue that many nations have adopted a neo-mercantilist strategy that is designed to simulta- neously boost exports and limit imports.2 For example, critics charge that China long pur- sued a neo-mercantilist policy, deliberately keeping its currency value low against the U.S. dollar in order to sell more goods to the United States and other developed nations, and thus amass a trade surplus and foreign exchange reserves (see the accompanying Country Focus).

Absolute Advantage In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assump- tion that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently. In his time, the English, by virtue of their superior manufacturing processes,

Mercantilism An economic philosophy advocating that countries should simultaneously encourage exports and discourage imports.

Zero-Sum Game A situation in which an economic gain by one country results in an economic loss by another.

L0 6-2 Summarize the different theories explaining trade flows between nations.

test PREP Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go to learnsmartadvantage.com for help.

164 Part Three The Global Trade and Investment Environment

were the world’s most efficient textile manufacturers. Due to the combination of favorable climate, good soils, and accumulated expertise, the French had the world’s most efficient wine industry. The English had an absolute advantage in the production of textiles, while the French had an absolute advantage in the production of wine. Thus, 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 those produced by other countries. In Smith’s time, this suggested the English should specialize in the production of textiles, while the French should specialize in the production of wine. England could get all the wine it needed by selling its textiles to France and buying wine in exchange. Similarly, France could get all the textiles it needed by selling wine to England and buying textiles in exchange. Smith’s basic argu- ment, therefore, is that a country should never produce goods at home that it can buy at a lower cost from other countries. Smith demonstrates that, by specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade.

Consider the effects of trade between two countries, Ghana and South Korea. The produc- tion of any good (output) requires resources (inputs) such as land, labor, and capital. Assume that Ghana and South Korea both have the same amount of resources and that these resources can be used to produce either rice or cocoa. Assume further that 200 units of resources are available in each country. Imagine that in Ghana it takes 10 resources to produce 1 ton of co- coa and 20 resources to produce 1 ton of rice. Thus, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between these two extremes. The different combinations that Ghana could produce are represented by the line GG9 in Figure 6.1. This is referred to as Ghana’s production possibility frontier (PPF). Similarly, imagine that in South Korea it takes 40 resources to produce 1 ton of cocoa and 10 resources to produce 1 ton of rice. Thus, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination between these two extremes. The

Absolute Advantage A country has an absolute advantage in the production of a product when it is more efficient than any other country at producing it.

Is China a Neo-mercantilist Nation?

China’s rapid rise in economic power (it is now the world’s second- largest economy) has been built on export-led growth. The country takes raw material imports and, using its cheap labor, converts them into products that it sells to developed nations. For years, the country’s exports have been growing faster than its imports, leading some critics to claim that China is pursuing a neo-mercantilist policy, trying to amass record trade surpluses and foreign currency that will give it eco- nomic power over developed nations. By late 2013 its foreign exchange reserves exceeded $3.7 trillion, some 60 percent of which were held in U.S. denominated assets. Observers worry that if China ever decides to sell its holdings of U.S. currency, this could depress the value of the dollar against other currencies and increase the price of imports into America.

Throughout most of the 2000s China’s exports have grown faster than its imports, leading some to argue that China has been limiting imports by pursuing an import substitution policy, encouraging domes- tic investment in the production of products such as steel, aluminum, and paper, which it had historically imported from other nations. The trade deficit with America has been a particular cause for concern. In 2012, this reached a record $315 billion and it looked set to exceed $340 billion in 2013. At the same time, China long resisted attempts to let its currency float freely against the U.S. dollar. Many claim that

China’s currency is too cheap, and that this keeps the prices of China’s goods artificially low, which fuels the country’s exports.

So is China a neo-mercantilist nation that is deliberately discourag- ing imports and encouraging exports in order to increase its trade sur- plus and accumulate foreign exchange reserves, which might give it economic power? The jury is out on this issue. Skeptics suggest that going forward, the country will have no choice but to increase its im- ports of commodities that it lacks, such as oil. They also note that China did start allowing the value of the yuan (China’s currency) to appreciate against the dollar in July 2005, albeit at a slow pace. In July 2005 one U.S. dollar purchased 8.11 yuan. By January 2014, one U.S. dollar purchased 6.05 yuan, a decline of 25 percent. Despite this, China’s trade surplus with the rest of the world remains persistently high and exceeded $240 billion in 2013.

Sources: A. Browne, “China’s Wild Swings Can Roil the Global Economy,” The Wall Street Journal, October 24, 2005, p. A2; S. H. Hanke, “Stop the Mercantilists,” Forbes, June 20, 2005, p. 164; G. Dyer and A. Balls, “Dollar Threat as China Signals Shift,” Financial Times, January 6, 2006, p. 1; Tim Annett, “Righting the Balance,” The Wall Street Journal, January 10, 2007, p. 15; “China’s Trade Surplus Peaks,” Financial Times, January 12, 2008, p. 1; W. Chong, “China’s Trade Surplus to U.S. to Narrow,” China Daily, December 7, 2009; A. Wang and K. Yao, “China’s Trade Surplus Dips, Taking Heat off Yuan,” Reuters, January 9, 2011; Aaron Back, “China’s Trade Surplus Shrank in ‘11,” The Wall Street Journal, January 11, 2012; and Richard Silk, “China’s Foreign Exchange Reserves Jump Again,” The Wall Street Journal, October 15, 2013.

country FOCUS

Chapter Six International Trade Theory 165

different combinations available to South Korea are represented by the line KK9 in Figure 6.1, which is South Korea’s PPF. Clearly, Ghana has an absolute advantage in the production of cocoa. (More resources are needed to produce a ton of cocoa in South Korea than in Ghana.) By the same token, South Korea has an absolute advantage in the production of rice.

Now consider a situation in which neither country trades with any other. Each country devotes half its resources to the production of rice and half to the production of cocoa. Each country must also consume what it produces. Ghana would be able to produce 10 tons of co- coa and 5 tons of rice (point A in Figure 6.1), while South Korea would be able to produce 10 tons of rice and 2.5 tons of cocoa (point B in Figure 6.1). Without trade, the combined production of both countries would be 12.5 tons of cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons in Ghana and 10 tons in South Korea). If each coun- try were to specialize in producing the good for which it had an absolute advantage and then trade with the other for the good it lacks, Ghana could produce 20 tons of cocoa, and South Korea could produce 20 tons of rice. Thus, by special- izing, the production of both goods could be increased. Pro- duction of cocoa would increase from 12.5 tons to 20 tons, while production of rice would increase from 15 tons to 20 tons. The increase in production that would result from specialization is therefore 7.5 tons of cocoa and 5 tons of rice. Table 6.1 summarizes these figures.

By engaging in trade and swapping 1 ton of cocoa for 1 ton of rice, producers in both countries could consume more of both cocoa and rice. Imagine that Ghana and South Korea swap cocoa and rice on a one-to-one basis; that is, the price of 1 ton of cocoa is equal to the price of 1 ton of rice. If Ghana decided to export 6 tons of cocoa to South Korea and import 6 tons of rice in return, its final consumption after trade would be 14 tons of cocoa and 6 tons of rice. This is 4 tons more cocoa than it could have consumed before spe- cialization and trade and 1 ton more rice. Similarly, South Korea’s final consumption after trade would be 6 tons of co- coa and 14 tons of rice. This is 3.5 tons more cocoa than it could have consumed before specialization and trade and 4 tons more rice. Thus, as a result of specialization and trade, output of both cocoa and rice would be increased, and con- sumers in both nations would be able to consume more. Thus, we can see that trade is a positive-sum game; it pro- duces net gains for all involved.

6.1 FIGURE The Theory of Absolute Advantage

5 10 15 200 Rice

G20

10 A

K' C

oc oa

2.5

Which Products Should Always Be Produced at Home? One of the key insights of international trade theory is that limits on imports are often in the interests of domestic producers, but not domestic consumers. This is especially true if Adam Smith’s theory of absolute advantage is in play, where one country is better at producing a product than another country. The reason is that consumers typically want the best products they can get for the amount of money they are willing to pay. But what about the comparative advantage theory that was originally conceptu- alized by David Ricardo and then refined by Eli Heckscher and Bertil Ohlin? Comparative advantage theory argues that a coun- try should consider not producing products that it can actually produce reasonably well if the country can produce something else even more efficiently. In reality, not a single country has stopped all production of products they produce less efficiently than some other country. The reason is that countries always engage in a strategic balancing act! They prefer to be as effi- cient as possible (engage in international trade when advanta- geous) while also being as self-sufficient as possible (produce inside their country). So, what types of products should always be produced in the home country, and which products should always be considered for importing if other countries can pro- duce them more efficiently?

166 Part Three The Global Trade and Investment Environment

Comparative Advantage David Ricardo took Adam Smith’s theory one step further by exploring what might hap- pen when one country has an absolute advantage in the production of all goods.3 Smith’s theory of absolute advantage suggests that such a country might derive no benefits from international trade. In his 1817 book Principles of Political Economy, Ricardo showed that this was not the case. According to Ricardo’s 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, even if this means buying goods from other countries that it could produce more efficiently itself.4 While this may seem counterintuitive, the logic can be explained with a simple example.

Assume that Ghana is more efficient in the production of both cocoa and rice; that is, Ghana has an absolute advantage in the production of both products. In Ghana it takes 10 resources to produce 1 ton of cocoa and 13½ resources to produce 1 ton of rice. Thus, given its 200 units of resources, Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or any combination in between on its PPF (the line GG9 in Figure 6.2). In South Korea it takes 40 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, South Korea can produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or any combination on its PPF (the line KK9 in Figure 6.2). Again assume that without trade, each country uses half its resources to produce rice and half to produce cocoa. Thus, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice (point A in Figure 6.2), while South Korea will produce 2.5 tons of cocoa and 5 tons of rice (point B in Figure 6.2).

In light of Ghana’s absolute advantage in the production of both goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it has a comparative advantage only in the production of cocoa: Ghana

L0 6-2 Summarize the different theories explaining trade flows between nations.

6.1 TABLE Absolute Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa Rice

Ghana 10 20

South Korea 40 10

Production and Consumption Without Trade

Ghana 10.0 5.0

South Korea 2.5 10.0

Total production 12.5 15.0

Production with Specialization

Ghana 20.0 0.0

South Korea 0.0 20.0

Total production 20.0 20.0

Consumption after Ghana Trades 6 Tons of Cocoa for 6 Tons of South Korean Rice

Ghana 14.0 6.0

South Korea 6.0 14.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 4.0 1.0

South Korea 3.5 4.0

Chapter Six International Trade Theory 167

can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice.

Without trade the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade each country must consume what it pro- duces. By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods.

THE GAINS FROM TRADE Imagine that Ghana exploits its comparative advan- tage in the production of cocoa to increase its output from 10 tons to 15 tons. This uses up 150 units of resources, leaving the remaining 50 units of resources to use in producing 3.75 tons of rice (point C in Figure 6.2). Meanwhile, South Korea specializes in the production of rice, producing 10 tons. The combined output of both cocoa and rice has now increased. Before specialization, the combined output was 12.5 tons of cocoa and 12.5 tons of rice. Now it is 15 tons of cocoa and 13.75 tons of rice (3.75 tons in Ghana and 10 tons in South Korea). The source of the increase in production is summarized in Table 6.2.

Not only is output higher, but both countries also can now benefit from trade. If Ghana and South Korea swap cocoa and rice on a one-to-one basis, with both countries choosing to exchange 4 tons of their export for 4 tons of the import, both countries are able to con- sume more cocoa and rice than they could before specialization and trade (see Table 6.2). Thus, if Ghana exchanges 4 tons of cocoa with South Korea for 4 tons of rice, it is still left with 11 tons of cocoa, which is 1 ton more than it had before trade. The 4 tons of rice it gets from South Korea in exchange for its 4 tons of cocoa, when added to the 3.75 tons it now produces domestically, leave it with a total of 7.75 tons of rice, which is 0.25 of a ton more than it had before specialization. Similarly, after swapping 4 tons of rice with Ghana, South Korea still ends up with 6 tons of rice, which is more than it had before specialization. In addition, the 4 tons of cocoa it receives in exchange is 1.5 tons more than it produced before trade. Thus, consumption of cocoa and rice can increase in both countries as a result of spe- cialization and trade.

The basic message of the theory of comparative advantage is that potential world production is greater with unrestricted free trade than it is with restricted trade. Ricardo’s theory suggests that consumers in all nations can consume more if there are no restrictions on trade. This occurs even in countries that lack an absolute advantage in the production of any good. In other words, to an even greater degree than the theory of absolute advantage, the theory of comparative advantage suggests that trade is a positive-sum game in which all countries that partici- pate realize economic gains. As such, this theory provides a strong rationale for encouraging free trade. So powerful is Ricardo’s theory that it remains a major intellectual weapon for those who argue for free trade.

6.2 FIGURE The Theory of Comparative Advantage

5 7.53.75 10 15 200 Rice

10C oc

2.5

168 Part Three The Global Trade and Investment Environment

QUALIFICATIONS AND ASSUMPTIONS The conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple model. Our simple model includes many unrealistic assumptions:

1. We have assumed a simple world in which there are only two countries and two goods. In the real world, there are many countries and many goods.

2. We have assumed away transportation costs between countries. 3. We have assumed away differences in the prices of resources in different countries. We

have said nothing about exchange rates, simply assuming that cocoa and rice could be swapped on a one-to-one basis.

4. We have assumed that resources can move freely from the production of one good to another within a country. In reality, this is not always the case.

5. We have assumed constant returns to scale; that is, that specialization by Ghana or South Korea has no effect on the amount of resources required to produce one ton of cocoa or rice. In reality, both diminishing and increasing returns to specialization exist. The amount of resources required to produce a good might decrease or increase as a nation specializes in production of that good.

6. We have assumed that each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resources. This static assumption makes no allowances for the dynamic changes in a country’s stock of resources and in the efficiency with which the country uses its resources that might result from free trade.

7. We have assumed away the effects of trade on income distribution within a country.

Given these assumptions, can the conclusion that free trade is mutually beneficial be ex- tended to the real world of many countries, many goods, positive transportation costs, vola- tile exchange rates, immobile domestic resources, nonconstant returns to specialization, and dynamic changes? Although a detailed extension of the theory of comparative advantage is beyond the scope of this book, economists have shown that the basic result derived from our

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

6.2 TABLE Comparative Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa Rice

Ghana 10 13.33

South Korea 40 20

Production and Consumption Without Trade

Ghana 10.0 7.5

South Korea 2.5 5.0

Total production 12.5 12.5

Production with Specialization

Ghana 15.0 3.75

South Korea 0.0 10.0

Total production 15.0 13.75

Consumption after Ghana Trades 4 Tons of Cocoa for 4 Tons of South Korean Rice

Ghana 11.0 7.75

South Korea 4.0 6.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 1.0 0.25

South Korea 1.5 1.0

Chapter Six International Trade Theory 169

simple model can be generalized to a world composed of many countries producing many different goods.5 Despite the shortcomings of the Ricardian model, research suggests that the basic proposition that countries will export the goods that they are most efficient at producing is borne out by the data.6

However, once all the assumptions are dropped, the case for unrestricted free trade, while still positive, has been argued by some economists associated with the “new trade theory” to lose some of its strength.7 We return to this issue later in this chapter and in the next when we discuss the new trade theory. In a recent and widely discussed analysis, the Nobel Prize– winning economist Paul Samuelson argued that contrary to the standard interpretation, in certain circumstances the theory of comparative advantage predicts that a rich country might actually be worse off by switching to a free trade regime with a poor nation.8 We con- sider Samuelson’s critique in the next section.

EXTENSIONS OF THE RICARDIAN MODEL Let us explore the effect of relaxing three of the assumptions identified earlier in the simple comparative advantage model. Next, we relax the assumptions that resources move freely from the production of one good to another within a country, that there are constant returns to scale, and that trade does not change a country’s stock of resources or the efficiency with which those resources are utilized.

Immobile Resources In our simple comparative model of Ghana and South Korea, we assumed that producers (farmers) could easily convert land from the production of cocoa to rice and vice versa. While this assumption may hold for some agricultural products, re- sources do not always shift quite so easily from producing one good to another. A certain amount of friction is involved. For example, embracing a free trade regime for an advanced economy such as the United States often implies that the country will produce less of some labor-intensive goods, such as textiles, and more of some knowledge-intensive goods, such as computer software or biotechnology products. Although the country as a whole will gain from such a shift, textile producers will lose. A textile worker in South Carolina is probably not qualified to write software for Microsoft. Thus, the shift to free trade may mean that she becomes unemployed or has to accept another less attractive job, such as working at a fast- food restaurant.

Resources do not always move easily from one economic activity to another. The process creates friction and human suffering too. While the theory predicts that the benefits of free trade outweigh the costs by a significant margin, this is of cold comfort to those who bear the costs. Accordingly, political opposition to the adoption of a free trade regime typically comes from those whose jobs are most at risk. In the United States, for example, textile workers and their unions have long opposed the move toward free trade precisely because this group has much to lose from free trade. Governments often ease the transition toward free trade by helping retrain those who lose their jobs as a result. The pain caused by the movement toward a free trade regime is a short-term phenomenon, while the gains from trade once the transition has been made are both significant and enduring.

Diminishing Returns The simple comparative advantage model developed above as- sumes constant returns to specialization. By constant returns to specialization we mean the units of resources required to produce a good (cocoa or rice) are assumed to remain constant no matter where one is on a country’s production possibility frontier (PPF). Thus, we assumed that it always took Ghana 10 units of resources to produce 1 ton of cocoa. How- ever, it is more realistic to assume diminishing returns to specialization. Diminishing returns to specialization occur when more units of resources are required to produce each addi- tional unit. While 10 units of resources may be sufficient to increase Ghana’s output of co- coa from 12 tons to 13 tons, 11 units of resources may be needed to increase output from 13 to 14 tons, 12 units of resources to increase output from 14 tons to 15 tons, and so on. Di- minishing returns imply a convex PPF for Ghana (see Figure 6.3), rather than the straight line depicted in Figure 6.2.

Constant Returns to Specialization The units of resources required to produce a good are assumed to remain constant no matter where one is on a country’s production possibility frontier.

170 Part Three The Global Trade and Investment Environment

It is more realistic to assume diminishing returns for two reasons. First, not all resources are of the same quality. As a country tries to increase its output of a certain good, it is in- creasingly likely to draw on more marginal resources whose productivity is not as great as those initially employed. The result is that it requires ever more resources to produce an equal increase in output. For example, some land is more productive than other land. As Ghana tries to expand its output of cocoa, it might have to utilize increasingly marginal land that is less fertile than the land it originally used. As yields per acre decline, Ghana must use more land to produce 1 ton of cocoa.

A second reason for diminishing returns is that different goods use resources in different proportions. For example, imagine that growing cocoa uses more land and less labor than growing rice and that Ghana tries to transfer resources from rice production to cocoa pro- duction. The rice industry will release proportionately too much labor and too little land for efficient cocoa production. To absorb the additional resources of labor and land, the cocoa industry will have to shift toward more labor-intensive methods of production. The effect is that the efficiency with which the cocoa industry uses labor will decline, and returns will diminish.

Diminishing returns show that it is not feasible for a country to specialize to the degree suggested by the simple Ricardian model outlined earlier. Diminishing returns to specializa- tion suggest that the gains from specialization are likely to be exhausted before specializa- tion is complete. In reality, most countries do not specialize, but instead produce a range of goods. However, the theory predicts that it is worthwhile to specialize until that point where the resulting gains from trade are outweighed by diminishing returns. Thus, the basic con- clusion that unrestricted free trade is beneficial still holds, although because of diminishing returns, the gains may not be as great as suggested in the constant returns case.

Dynamic Effects and Economic Growth The simple comparative advantage model assumed that trade does not change a country’s stock of resources or the efficiency with which it utilizes those resources. This static assumption makes no allowances for the dynamic changes that might result from trade. If we relax this assumption, it becomes appar- ent that opening an economy to trade is likely to generate dynamic gains of two sorts.9 First, free trade might increase a country’s stock of resources as increased supplies of labor and capital from abroad become available for use within the country. For example, this has been occurring in eastern Europe since the early 1990s, with many Western businesses investing significant capital in the former communist countries.

Second, free trade might also increase the efficiency with which a country uses its re- sources. Gains in the efficiency of resource utilization could arise from a number of factors.

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

6.3 FIGURE Ghana’s PPF under Diminishing Returns

C oc

Rice 0

Chapter Six International Trade Theory 171

For example, economies of large-scale production might become available as trade expands the size of the total market available to domestic firms. Trade might make better technology from abroad available to domestic firms; better technology can increase labor productivity or the productivity of land. (The so-called green revolution had this effect on agricultural outputs in developing countries.) Also, opening an economy to foreign competition might stimulate domestic producers to look for ways to increase their efficiency. Again, this phe- nomenon has arguably been occurring in the once-protected markets of eastern Europe, where many former state monopolies have had to increase the efficiency of their operations to survive in the competitive world market.

Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized will cause a country’s PPF to shift outward. This is illustrated in Fig- ure 6.4, where the shift from PPF1 to PPF2 results from the dynamic gains that arise from free trade. As a consequence of this outward shift, the country in Figure 6.4 can produce more of both goods than it did before introduction of free trade. The theory suggests that opening an economy to free trade not only results in static gains of the type discussed earlier but also results in dynamic gains that stimulate economic growth. If this is so, then one might think that the case for free trade becomes stronger still, and in general it does. How- ever, as noted above, one of the leading economic theorists of the twentieth century, Paul Samuelson, argued that in some circumstances, dynamic gains can lead to an outcome that is not so beneficial.

The Samuelson Critique Paul Samuelson’s critique looks at what happens when a rich country—the United States—enters into a free trade agreement with a poor country—China—that rapidly improves its productivity after the introduction of a free trade regime (i.e., there is a dynamic gain in the efficiency with which resources are used in the poor country). Samuelson’s model suggests that in such cases, the lower prices that U.S. consumers pay for goods imported from China following the introduc- tion of a free trade regime may not be enough to produce a net gain for the U.S. econ- omy if the dynamic effect of free trade is to lower real wage rates in the United States. As he stated in a New York Times interview, “Being able to purchase groceries 20 percent cheaper at Wal-Mart (due to international trade) does not necessarily make up for the wage losses (in America).”10

Samuelson goes on to note that he is particularly concerned about the ability to 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 (see the accompanying Country Focus for details). Recent advances in communications technology

6.4 FIGURE The Influence of Free Trade on the PPF

C oc

Rice 0

PPF2

PPF1

172 Part Three The Global Trade and Investment Environment

Moving U.S. White-Collar Jobs Offshore

Economists have long argued that free trade produces gains for all countries that participate in a free trading system. As the next wave of globalization sweeps through the U.S. economy, many people are won- dering if this is true. During the 1980s and 1990s, free trade was as- sociated with the movement of low-skill, blue-collar manufacturing jobs out of rich countries such as the United States and toward low- wage countries—textiles to Costa Rica, athletic shoes to the Philip- pines, steel to Brazil, electronic products to Thailand, and so on. While many observers bemoaned the “hollowing out” of U.S. manufacturing, economists stated that high-skill and high-wage white-collar jobs as- sociated with the knowledge-based economy would stay in the United States. Computers might be assembled in Thailand, so the argument went, but they would continue to be designed in Silicon Valley by highly skilled U.S. engineers, and software applications would be written in the United States by programmers at Apple, Microsoft, Adobe, Oracle, and the like.

Developments over the past several decades have people ques- tioning this assumption. Many American companies have been mov- ing white-collar, “knowledge-based” jobs to developing nations where they can be performed for a fraction of the cost. During the long economic boom of the 1990s, Bank of America had to compete with other organizations for the scarce talents of information technol- ogy specialists, driving annual salaries to more than $100,000. How- ever, with business under pressure during the 2000s, the bank cut nearly 5,000 jobs from its 25,000-strong, U.S.-based information technology workforce. Some of these jobs were transferred to India, where work that costs $100 an hour in the United States could be done for $20 an hour.

One beneficiary of Bank of America’s downsizing is Infosys Tech- nologies Ltd., a Bangalore, India, information technology firm where 250 engineers now develop information technology applications for the bank. Other Infosys employees are busy processing home loan applica- tions for U.S. mortgage companies. Nearby in the offices of another Indian firm, Wipro Ltd., radiologists interpret 30 CT scans a day for Massachusetts General Hospital that are sent over the Internet. At yet another Bangalore business, engineers earn $10,000 a year designing leading-edge semiconductor chips for Texas Instruments. Nor is India the only beneficiary of these changes.

Some architectural work also is being outsourced to lower-cost locations. Flour Corp., a California-based construction company, em- ploys some 1,200 engineers and draftsmen in the Philippines, Poland, and India to turn layouts of industrial facilities into detailed specifica- tions. For a Saudi Arabian chemical plant Flour is designing, 200 young engineers based in the Philippines earning less than $3,000 a year collaborate in real time over the Internet with elite U.S. and British en- gineers who make up to $90,000 a year. Why does Flour do this? According to the company, the answer is simple. Doing so reduces the prices of a project by 15 percent, giving the company a cost-based competitive advantage in the global market for construction design. Most disturbing of all for future job growth in the United States, some high-tech start-ups are outsourcing significant work right from in- ception. For example, Zoho Corporation, a California-based start-up offering online web applications for small businesses, has about 20 employees in the United States and more than 1,000 in India!

Sources: P. Engardio, A. Bernstein, and M. Kripalani, “Is Your Job Next?” BusinessWeek, February 3, 2003, pp. 50–60; “America’s Pain, India’s Gain,” The Economist, January 11, 2003, p. 57; M. Schroeder and T. Aeppel, “Skilled Workers Mount Opposition to Free Trade, Swaying Politicians,” The Wall Street Journal, October 10, 2003, pp. A1, A11; D. Clark, “New U.S. Fees on Visas Irk Outsources,” The Wall Street Journal, August 16, 2010, p. 6; and J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” The Wall Street Journal, January 18, 2012, p. B1.

country FOCUS

Companies like Infosys in India provide many jobs through servicing U.S.-based companies.

have made this possible, effectively expanding the labor market for these jobs to include educated people in places such as India, the Philippines, and China. When coupled with rapid advances in the productivity of foreign labor due to better education, the effect on middle-class wages in the United States, according to Samuelson, may be similar to mass inward migration into the country: It will lower the market clearing wage rate, perhaps by enough to outweigh the positive benefits of international trade.

Having said this, it should be noted that Samuelson concedes that free trade has histori- cally benefited rich counties (as data discussed later seem to confirm). Moreover, he notes that introducing protectionist measures (e.g., trade barriers) to guard against the theoretical possibility that free trade may harm the United States in the future may produce a situation that is worse than the disease they are trying to prevent. To quote Samuelson: “Free trade

Chapter Six International Trade Theory 173

may turn out pragmatically to be still best for each region in comparison to lobbyist- induced tariffs and quotas which involve both a perversion of democracy and non-subtle deadweight distortion losses.”11

One recent study found evidence in support of Samuelson’s thesis. The study looked at every county in the United States for its manufacturers’ exposure to competition from China.12 The researchers found that regions most exposed to China tended not only to lose more manufacturing jobs but also to see overall employment decline. Areas with higher ex- posure to China also had larger increases in workers receiving unemployment insurance, food stamps, and disability payments. The costs to the economy from the increased government payments amounted to two-thirds of the gains from trade with China. In other words, many of the ways trade with China has helped the United States—such as providing inexpensive goods to U.S. consumers—have been wiped out. Even so, the authors of this study argued that in the long run, free trade is a good thing. They note, however, that the rapid rise of China has resulted in some large adjustment costs that, in the short run, sig- nificantly reduce the gains from trade.

Other economists have dismissed Samuelson’s fears.13 While not questioning his anal- ysis, they note that as a practical matter, developing nations are unlikely to be able to upgrade the skill level of their workforce rapidly enough to give rise to the situation in Samuelson’s model. In other words, they will quickly run into diminishing returns. How- ever, such rebuttals are at odds with recent data suggesting that Asian countries are rap- idly upgrading their educational systems. For example, about 56 percent of the world’s engineering degrees awarded in 2008 were in Asia, compared with 4 percent in the United States!14

Evidence for the Link Between Trade and Growth Many economic studies have looked at the relationship between trade and economic growth.15 In general, these studies suggest that as predicted by the standard theory of comparative advantage, countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade. Jeffrey Sachs and Andrew Warner created a mea- sure of how “open” to international trade an economy was and then looked at the relation- ship between “openness” and economic growth for a sample of more than 100 countries from 1970 to 1990.16 Among other findings, they reported:

We find a strong association between openness and growth, both within the group of developing and the group of developed countries. Within the group of developing countries, the open economies grew at 4.49 percent per year, and the closed econo- mies grew at 0.69 percent per year. Within the group of developed economies, the open economies grew at 2.29 percent per year, and the closed economies grew at 0.74 percent per year.17

A study by Wacziarg and Welch updated the Sachs and Warner data through the late 1990s. They found that over the period 1950–1998, countries that liberalized their trade regimes experienced, on average, increases in their annual growth rates of 1.5 percent com- pared to pre-liberalization times.18 An exhaustive survey of 61 studies published between 1967 and 2009 concluded: “The macroeconomic evidence provides dominant support for the positive and significant effects of trade on output and growth.”19

The message seems clear: Adopt an open economy and embrace free trade, and your na- tion will be rewarded with higher economic growth rates. Higher growth will raise income levels and living standards. This last point has been confirmed by a study that looked at the relationship between trade and growth in incomes. The study, undertaken by Jeffrey Frankel and David Romer, found that on average, a 1 percentage point increase in the ratio of a country’s trade to its gross domestic product increases income per person by at least 0.5 percent.20 For every 10 percent increase in the importance of international trade in an econ- omy, average income levels will rise by at least 5 percent. Despite the short-term adjustment costs associated with adopting a free trade regime, trade would seem to produce greater economic growth and higher living standards in the long run, just as the theory of Ricardo would lead us to expect.21

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

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174 Part Three The Global Trade and Investment Environment

Heckscher-Ohlin Theory Ricardo’s theory stresses that comparative advantage arises from differences in productivity. Thus, whether Ghana is more efficient than South Korea in the production of cocoa de- pends on how productively it uses its resources. Ricardo stressed labor productivity and ar- gued that differences in labor productivity between nations underlie the notion of comparative advantage. Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of comparative advantage. They argued that com- parative advantage arises from differences in national factor endowments.22 By factor endowments they meant the extent to which a country is endowed with such resources as land, labor, and capital. Nations have varying factor endowments, and different factor endowments explain differences in factor costs; specifically, the more abundant a factor, the lower its cost. The Heckscher-Ohlin theory predicts that countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. Thus, the Heckscher-Ohlin theory at- tempts to explain the pattern of international trade that we observe in the world economy. Like Ricardo’s theory, the Heckscher-Ohlin theory argues that free trade is beneficial. Un- like Ricardo’s theory, however, the Heckscher-Ohlin theory argues that the pattern of inter- national trade is determined by differences in factor endowments, rather than differences in productivity.

The Heckscher-Ohlin theory has commonsense appeal. For example, the United States has long been a substantial exporter of agricultural goods, reflecting in part its unusual abundance of arable land. In contrast, China has excelled in the export of goods produced in labor-intensive manufacturing industries. This reflects China’s relative abundance of low- cost labor. The United States, which lacks abundant low-cost labor, has been a primary im- porter of these goods. Note that it is relative, not absolute, endowments that are important; a country may have larger absolute amounts of land and labor than another country, but be relatively abundant in one of them.

THE LEONTIEF PARADOX The Heckscher-Ohlin theory has been one of the most influential theoretical ideas in international economics. Most economists prefer the Heckscher-Ohlin theory to Ricardo’s theory because it makes fewer simplifying assump- tions. Because of its influence, the theory has been subjected to many empirical tests. Begin-

ning with a famous study published in 1953 by Wassily Leontief (winner of the Nobel Prize in economics in 1973), many of these tests have raised questions about the validity of the Heckscher-Ohlin theory.23 Using the Heckscher-Ohlin theory, Leontief postulated that be- cause the United States was relatively abundant in capital compared to other nations, the United States would be an exporter of capital-intensive goods and an importer of labor- intensive goods. To his surprise, however, he found that U.S. exports were less capital- intensive than U.S. im- ports. Because this result was at variance with the predic- tions of the theory, it has become known as the Leontief paradox.

No one is quite sure why we observe the Leontief par- adox. One possible explanation is that the United States has a special advantage in producing new products or goods made with innovative technologies. Such products may be less capital-intensive than products whose tech- nology has had time to mature and become suitable for mass production. Thus, the United States may be export- ing goods that heavily use skilled labor and innovative en- trepreneurship, such as computer software, while importing heavy manufacturing products that use large

L0 6-2 Summarize the different theories explaining trade flows between nations.

Factor Endowments A country’s endowment with resources such as land, labor, and capital.

Should Factor Endowments or Productivity Drive Trade? Ricardo’s theory of trade suggests that it makes sense for a country to specialize in production of those products that it pro- duces most efficiently and to buy the products that it produces less efficiently from other countries, even if this means that the country is buying products that in reality it could produce more efficiently itself. This means that Ricardo showed that a country can derive advantages by trade even though it has an absolute advantage in producing all products. The Heckscher-Ohlin theory of trade suggests that comparative advantage for a country arises from differences in national factor endowments (i.e., the extent to which a country is endowed with such resources as land, labor, and capital). Ricardo’s argument focused on relative productivity, while Heckscher-Ohlin’s argument focused on hav- ing important resources. If you can only have one of the two— better relative productivity or lots of resources such as land, labor, and capital—which would you prefer, any why?

Chapter Six International Trade Theory 175

amounts of capital. Some empirical studies tend to confirm this.24 Still, tests of the Heck- scher-Ohlin theory using data for a large number of countries tend to confirm the existence of the Leontief paradox.25

This leaves economists with a difficult dilemma. They prefer the Heckscher-Ohlin the- ory on theoretical grounds, but it is a relatively poor predictor of real-world international trade patterns. On the other hand, the theory they regard as being too limited, Ricardo’s theory of comparative advantage, actually predicts trade patterns with greater accuracy. The best solution to this dilemma may be to return to the Ricardian idea that trade patterns are largely driven by international differences in productivity. Thus, one might argue that the United States exports commercial aircraft and imports textiles not because its factor endow- ments are especially suited to aircraft manufacture and not suited to textile manufacture, but because the United States is relatively more efficient at producing aircraft than textiles. A key assumption in the Heckscher-Ohlin theory is that technologies are the same across countries. This may not be the case. Differences in technology may lead to differences in productivity, which in turn, drives international trade patterns.26 Thus, Japan’s success in exporting automobiles from the 1970s onward has been based not only on the relative abun- dance of capital but also on its development of innovative manufacturing technology that enabled it to achieve higher productivity levels in automobile production than other coun- tries that also had abundant capital. More recent empirical work suggests that this theoreti- cal explanation may be correct.27 The new research shows that once differences in technology across countries are controlled for, countries do indeed export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. In other words, once the impact of differences of technology on productivity is controlled for, the Heckscher-Ohlin theory seems to gain predictive power.

The Product Life-Cycle Theory Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s.28 Ver- non’s theory was based on the observation that for most of the twentieth century a very large proportion of the world’s new products had been developed by U.S. firms and sold first in the U.S. market (e.g., mass-produced automobiles, televisions, instant cameras, photocopi- ers, personal computers, and semiconductor chips). To explain this, Vernon argued that the wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new con- sumer products. In addition, the high cost of U.S. labor gave U.S. firms an incentive to de- velop cost-saving process innovations.

Just because a new product is developed by a U.S. firm and first sold in the U.S. market, it does not follow that the product must be produced in the United States. It could be pro- duced abroad at some low-cost location and then exported back into the United States. However, Vernon argued that most new products were initially produced in America. Apparently, the pioneering firms believed it was better to keep production facilities close to the market and to the firm’s center of decision making, given the uncertainty and risks in- herent in introducing new products. Also, the demand for most new products tends to be based on nonprice factors. Consequently, firms can charge relatively high prices for new products, which obviates the need to look for low-cost production sites in other countries.

Vernon went on to argue that early in the life cycle of a typical new product, while de- mand is starting to grow rapidly in the United States, demand in other advanced countries is limited to high-income groups. The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the United States to those countries.

Over time, demand for the new product starts to grow in other advanced countries (e.g., Great Britain, France, Germany, and Japan). As it does, it becomes worthwhile for foreign producers to begin producing for their home markets. In addition, U.S. firms might set up production facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States.

L0 6-2 Summarize the different theories explaining trade flows between nations.

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176 Part Three The Global Trade and Investment Environment

As the market in the United States and other advanced nations matures, the product be- comes more standardized, and price becomes the main competitive weapon. As this occurs, cost considerations start to play a greater role in the competitive process. Producers based in advanced countries where labor costs are lower than in the United States (e.g., Italy and Spain) might now be able to export to the United States. If cost pressures become intense, the process might not stop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated once more, as developing countries (e.g., Thai- land) begin to acquire a production advantage over advanced countries. Thus, the locus of global production initially switches from the United States to other advanced nations and then from those nations to developing countries.

The consequence of these trends for the pattern of world trade is that over time the United States switches from being an exporter of the product to an importer of the product as production becomes concentrated in lower-cost foreign locations. Figure 6.5 shows the growth of production and consumption over time in the United States, other advanced countries, and developing countries.

PRODUCT LIFE-CYCLE THEORY IN THE TWENTY-FIRST CENTURY Historically, the product life-cycle theory seems to be an accurate explana- tion of international trade patterns. Consider photocopiers; the product was first developed in the early 1960s by Xerox in the United States and sold initially to U.S. users. Originally, Xerox exported photocopiers from the United States, primarily to Japan and the advanced countries of western Europe. As demand began to grow in those countries, Xerox entered into joint ventures to set up production in Japan (Fuji-Xerox) and Great Britain (Rank- Xerox). In addition, once Xerox’s patents on the photocopier process expired, other foreign competitors began to enter the market (e.g., Canon in Japan and Olivetti in Italy). As a consequence, exports from the United States declined, and U.S. users began to buy some photocopiers from lower-cost foreign sources, particularly Japan. More recently, Japanese companies found that manufacturing costs are too high in their own country, so they have begun to switch production to developing countries such as Thailand. Thus, initially the United States and now other advanced countries (e.g., Japan and Great Britain) have switched from being exporters of photocopiers to importers. This evolution in the pattern of international trade in photocopiers is consistent with the predictions of the product life-cycle theory that mature industries tend to go out of the United States and into low- cost assembly locations.

However, the product life-cycle theory is not without weaknesses. Viewed from an Asian or European perspective, Vernon’s argument that most new products are developed and introduced in the United States seems ethnocentric and increasingly dated. Although it may be true that during U.S. dominance of the global economy (from 1945 to 1975), most new products were introduced in the United States, there have always been important ex- ceptions. These exceptions appear to have become more common in recent years. Many new products are now first introduced in Japan (e.g., video-game consoles) or South Korea (e.g., Samsung smartphones). Moreover, with the increased globalization and integration of the world economy discussed in Chapter 1, an increasing number of new products (e.g., tablet computers, smartphones, and digital cameras) are now introduced simultaneously in the United States and many European and Asian nations. This may be accompanied by globally dispersed production, with particular components of a new product being pro- duced in those locations around the globe where the mix of factor costs and skills is most favorable (as predicted by the theory of comparative advantage). In sum, although Vernon’s theory may be useful for explaining the pattern of international trade during the period of American global dominance, its relevance in the modern world seems more limited.

New Trade Theory The new trade theory began to emerge in the 1970s when a number of economists pointed out that the ability of firms to attain economies of scale might have important implica- tions for international trade.29 Economies of scale are unit cost reductions associated

L0 6-2 Summarize the different theories explaining trade flows between nations.

Economies of Scale Cost advantages associated with large- scale production.

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Chapter Six International Trade Theory 177

with a large scale of output. Economies of scale have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less special- ized employees and equipment. Economies of scale are a major source of cost reductions in many industries, from computer software to automobiles and from pharmaceuticals to aerospace. For example, Microsoft realizes economies of scale by spreading the fixed costs of developing new versions of its Windows operating system, which runs to about

6.5 FIGURE The Product Life-Cycle Theory Source: Adapted from Ramond Vernon and Louis T. Wells, The Economic Environment of International Business, 5th edition. ©1991. Reproduced by permission of Pearson Education, Inc., Upper Saddle River, New Jersey.

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Consumption

Production

Consumption

Production

Consumption

Maturing Product

New Product

Standardized Product

Stages of Product Development

Exports Imports

Expo rts

Imp orts

178 Part Three The Global Trade and Investment Environment

$10 billion, over the 2 billion or so personal computers upon which each new system is ultimately installed. Similarly, automobile companies realize economies of scale by pro- ducing a high volume of automobiles from an assembly line where each employee has a specialized task.

New trade theory makes two important points: First, through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods. Second, in those industries when the output required to attain economies of scale represents a significant proportion of total world demand, the global market may be able to support only a small number of enterprises. Thus, world trade in certain products may be dominated by countries whose firms were first movers in their production.

INCREASING PRODUCT VARIETY AND REDUCING COSTS Imagine first a world without trade. In industries where economies of scale are impor- tant, both the variety of goods that a country can produce and the scale of production are limited by the size of the market. If a national market is small, there may not be enough demand to enable producers to realize economies of scale for certain products. Accord- ingly, those products may not be produced, thereby limiting the variety of products avail- able to consumers. Alternatively, they may be produced, but at such low volumes that unit costs and prices are considerably higher than they might be if economies of scale could be realized.

Now consider what happens when nations trade with each other. Individual national markets are combined into a larger world market. As the size of the market expands due to trade, individual firms may be able to better attain economies of scale. The implication, according to new trade theory, is that each nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods—thus trade offers an opportunity for mutual gain even when countries do not differ in their resource endow-

ments or technology. Suppose there are two countries, each with an annual

market for 1 million automobiles. By trading with each other, these countries can create a combined market for 2 million cars. In this combined market, due to the ability to better realize economies of scale, more varieties (mod- els) of cars can be produced, and cars can be produced at a lower average cost, than in either market alone. For example, demand for a sports car may be limited to 55,000 units in each national market, while a total output of at least 100,000 per year may be required to realize significant scale economies. Similarly, demand for a mini- van may be 80,000 units in each national market, and again a total output of at least 100,000 per year may be required to realize significant scale economies. Faced with limited domestic market demand, firms in each nation may decide not to produce a sports car, because the costs of doing so at such low volume are too great. Although they may produce minivans, the cost of doing so will be higher, as will prices, than if significant economies of scale had been attained. Once the two countries decide to trade, however, a firm in one nation may specialize in pro- ducing sports cars, while a firm in the other nation may produce minivans. The combined demand for 110,000 sports cars and 160,000 minivans allows each firm to re- alize scale economies. Consumers in this case benefit from having access to a product (sports cars) that was not

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

Can We Continue to Rely on Economies of Scale? Economies of scale are unit cost reductions associated with a large scale of output. As we discuss in the text, economies of scale have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equip- ment. Economies of scale have been a major source of cost re- ductions in many industries—from computer software to automobiles and from pharmaceuticals to aerospace. But some of these economies of scale advantages were realized when production platforms for computers, automobiles, and so on were used for years and spread across large numbers of cus- tomers. With more and more innovations coming on the market faster and faster every year, and more and more customers wanting customized products (even if the customization is small), how can companies continue to rely on economies of scale as a strategic advantage? Will large, mass market–type companies that are selling large quantities of specific products always have economies of scale advantages vis-à-vis small and medium-sized companies?

Chapter Six International Trade Theory 179

available before international trade and from the lower price for a product (minivans) that could not be produced at the most efficient scale before international trade. Trade is thus mutually beneficial because it allows the specialization of production, the realization of scale economies, the production of a greater variety of products, and lower prices.

ECONOMIES OF SCALE, FIRST-MOVER ADVANTAGES, AND THE PATTERN OF TRADE A second theme in new trade theory is that the pat- tern of trade we observe in the world economy may be the result of economies of scale and first-mover advantages. First-mover advantages are the economic and strategic advantages that accrue to early entrants into an industry.30 The ability to capture scale economies ahead of later entrants, and thus benefit from a lower cost structure, is an important first-mover advantage. New trade theory argues that for those products where economies of scale are significant and represent a substantial proportion of world demand, the first movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match. Thus, the pattern of trade that we observe for such products may reflect first-mover advantages. Countries may dominate in the export of certain goods because economies of scale are important in their production, and because firms located in those countries were the first to capture scale economies, giving them a first-mover advantage.

For example, consider the commercial aerospace industry. In aerospace there are substan- tial scale economies that come from the ability to spread the fixed costs of developing a new jet aircraft over a large number of sales. It has cost Airbus some $15 billion to develop its new superjumbo jet, the 550-seat A380. To recoup those costs and break even, Airbus will have to sell at least 250 A380 planes. If Airbus can sell more than 350 A380 planes, it will apparently be a profitable venture. Total demand over the next 20 years for this class of air- craft is estimated to be between 400 and 600 units. Thus, the global market can probably profitably support only one producer of jet aircraft in the superjumbo category. It follows that the European Union might come to dominate in the export of very large jet aircraft, primarily because a European-based firm, Airbus, was the first to produce a superjumbo jet aircraft and realize scale economies. Other potential producers, such as Boeing, might be shut out of the market because they will lack the scale economies that Airbus will enjoy. By pioneering this market category, Airbus may have captured a first-mover advantage based on scale economies that will be difficult for rivals to match, and that will result in the European Union becoming the leading exporter of very large jet aircraft.

IMPLICATIONS OF NEW TRADE THEORY New trade theory has im- portant implications. The theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology. Trade allows a nation to specialize in the production of certain products, attaining scale economies and lowering the costs of producing those products, while buying products that it does not produce from other nations that specialize in the production of other products. By this mechanism, the variety of products available to consumers in each nation is increased, while the average costs of those products should fall, as should their price, freeing resources to produce other goods and services.

The theory also suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to pro- duce that good. Because they are able to gain economies of scale, the first movers in an industry may get a lock on the world market that discourages subsequent entry. First movers’ ability to benefit from increasing returns creates a barrier to entry. In the com- mercial aircraft industry, the fact that Boeing and Airbus are already in the industry and have the benefits of economies of scale discourages new entry and reinforces the domi- nance of America and Europe in the trade of midsize and large jet aircraft. This domi- nance is further reinforced because global demand may not be sufficient to profitably support another producer of midsize and large jet aircraft in the industry. So although Japanese firms might be able to compete in the market, they have decided not to enter the industry but to ally themselves as major subcontractors with primary producers

First-Mover Advantages Advantages accruing to the first to enter a market.

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

180 Part Three The Global Trade and Investment Environment

(e.g., Mitsubishi Heavy Industries is a major subcontractor for Boeing on the 777 and 787 programs).

New trade theory is at variance with the Heckscher-Ohlin theory, which suggests a coun- try will predominate in the export of a product when it is particularly well endowed with those factors used intensively in its manufacture. New trade theorists argue that the United States is a major exporter of commercial jet aircraft not because it is better endowed with the factors of production required to manufacture aircraft, but because one of the first mov- ers in the industry, Boeing, was a U.S. firm. The new trade theory is not at variance with the theory of comparative advantage. Economies of scale increase productivity. Thus, the new trade theory identifies an important source of comparative advantage.

This theory is quite useful in explaining trade patterns. Empirical studies seem to support the predictions of the theory that trade increases the specialization of production within an industry, increases the variety of products available to consumers, and results in lower aver- age prices.31 With regard to first-mover advantages and international trade, a study by Harvard business historian Alfred Chandler suggests the existence of first-mover advantages is an important factor in explaining the dominance of firms from certain nations in specific industries.32 The number of firms is very limited in many global industries, including the chemical industry, the heavy construction-equipment industry, the heavy truck industry, the tire industry, the consumer electronics industry, the jet engine industry, and the computer software industry.

Perhaps the most contentious implication of the new trade theory is the argument that it generates for government intervention and strategic trade policy.33 New trade theorists stress the role of luck, entrepreneurship, and innovation in giving a firm first-mover advan- tages. According to this argument, the reason Boeing was the first mover in commercial jet aircraft manufacture—rather than firms such as Great Britain’s De Havilland and Hawker Siddeley, or Holland’s Fokker, all of which could have been—was that Boeing was both lucky and innovative. One way Boeing was lucky is that De Havilland shot itself in the foot when its Comet jet airliner, introduced two years earlier than Boeing’s first jet airliner, the 707, was found to be full of serious technological flaws. Had De Havilland not made some serious technological mistakes, Great Britain might have become the world’s leading ex- porter of commercial jet aircraft. Boeing’s innovativeness was demonstrated by its indepen- dent development of the technological know-how required to build a commercial jet airliner. Several new trade theorists have pointed out, however, that Boeing’s R&D was largely paid for by the U.S. government; the 707 was a spin-off from a government-funded military program (the entry of Airbus into the industry was also supported by significant government subsidies). Herein is a rationale for government intervention; by the sophisti- cated and judicious use of subsidies, could a government increase the chances of its domestic firms becoming first movers in newly emerging industries, as the U.S. government appar- ently did with Boeing (and the European Union did with Airbus)? If this is possible, and the new trade theory suggests it might be, we have an economic rationale for a proactive trade policy that is at variance with the free trade prescriptions of the trade theories we have re- viewed so far. We consider the policy implications of this issue in Chapter 7.

National Competitive Advantage: Porter’s Diamond Michael Porter, the famous Harvard strategy professor, has also written extensively on in- ternational trade.34 Porter and his team looked at 100 industries in 10 nations. Like the work of the new trade theorists, Porter’s work was driven by a belief that existing theories of international trade told only part of the story. For Porter, the essential task was to ex- plain why a nation achieves international success in a particular industry. Why does Japan do so well in the automobile industry? Why does Switzerland excel in the production and export of precision instruments and pharmaceuticals? Why do Germany and the United States do so well in the chemical industry? These questions cannot be answered easily by the Heckscher-Ohlin theory, and the theory of comparative advantage offers only a partial

L0 6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

L0 6-2 Summarize the different theories explaining trade flows between nations.

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Chapter Six International Trade Theory 181

explanation. The theory of comparative advantage would say that Switzerland excels in the production and export of precision instruments because it uses its resources very productively in these industries. Although this may be correct, this does not explain why Switzerland is more productive in this industry than Great Britain, Germany, or Spain. Porter tries to solve this puzzle.

Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage (see Figure 6.6). These attributes are:

• Factor endowments—a nation’s position in factors of production, such as skilled labor or the infrastructure necessary to compete in a given industry.

• Demand conditions—the nature of home demand for the industry’s product or service. • Related and supporting industries—the presence or absence of supplier industries and

related industries that are internationally competitive. • Firm strategy, structure, and rivalry—the conditions governing how companies are

created, organized, and managed and the nature of domestic rivalry.

Porter speaks of these four attributes as constituting the diamond. He argues that firms are most likely to succeed in industries or industry segments where the diamond is most favor- able. He also argues that the diamond is a mutually reinforcing system. The effect of one attribute is contingent on the state of others. For example, Porter argues favorable demand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firms to respond to them.

Porter maintains that two additional variables can influence the national diamond in im- portant ways: chance and government. Chance events, such as major innovations, can re- shape industry structure and provide the opportunity for one nation’s firms to supplant another’s. Government, by its choice of policies, can detract from or improve national ad- vantage. For example, regulation can alter home demand conditions, antitrust policies can influence the intensity of rivalry within an industry, and government investments in educa- tion can change factor endowments.

FACTOR ENDOWMENTS Factor endowments lie at the center of the Heckscher-Ohlin theory. While Porter does not propose anything radically new, he does analyze the characteristics of factors of production. He recognizes hierarchies among factors, distinguishing between basic factors (e.g., natural resources, climate, loca- tion, and demographics) and advanced factors (e.g., communication infrastructure, so- phisticated and skilled labor, research facilities, and technological know-how). He argues that advanced factors are the most significant for competitive advantage. Unlike the naturally endowed basic factors, advanced factors are a product of investment by individuals, companies, and governments. Thus, government investments in basic and higher education, by improving the general skill and knowledge level of the population

6.6 FIGURE Determinants of National Competitive Advantage: Porter’s Diamond Source: From “The Competitive Advantage of Nations” by Michael E. Porter, Harvard Business Review, p.77, March-April, 1990. Copyright ©1990 by the Harvard Business School Publishing Corporation. All rights reserved. Reprinted by permission.

Demand Conditions

Factor Endowments

Related and Supporting Industries

Firm Strategy, Structure, and Rivalry

182 Part Three The Global Trade and Investment Environment

and by stimulating advanced research at higher education institutions, can upgrade a nation’s advanced factors.

The relationship between advanced and basic factors is complex. Basic factors can pro- vide an initial advantage that is subsequently reinforced and extended by investment in ad- vanced factors. Conversely, disadvantages in basic factors can create pressures to invest in advanced factors. An obvious example of this phenomenon is Japan, a country that lacks ar- able land and mineral deposits and yet through investment has built a substantial endow- ment of advanced factors. Porter notes that Japan’s large pool of engineers (reflecting a much higher number of engineering graduates per capita than almost any other nation) has been vital to Japan’s success in many manufacturing industries.

DEMAND CONDITIONS Porter emphasizes the role home demand plays in up- grading competitive advantage. Firms are typically most sensitive to the needs of their closest customers. Thus, the characteristics of home demand are particularly important in shaping the attributes of domestically made products and in creating pressures for innovation and quality. Porter argues that a nation’s firms gain competitive advantage if their domestic con- sumers are sophisticated and demanding. Such consumers pressure local firms to meet high standards of product quality and to produce innovative products. For example, Porter notes that Japan’s sophisticated and knowledgeable buyers of cameras helped stimulate the Japa- nese camera industry to improve product quality and to introduce innovative models.

RELATED AND SUPPORTING INDUSTRIES The third broad attribute of national advantage in an industry is the presence of suppliers or related industries that are internationally competitive. The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally. Swedish strength in fabricated steel products (e.g., ball bearings and cutting tools) has drawn on strengths in Sweden’s specialty steel industry. Technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in personal computers and several other technically advanced elec- tronic products. Similarly, Switzerland’s success in pharmaceuticals is closely related to its previous international success in the technologically related dye industry.

One consequence of this process is that successful industries within a country tend to be grouped into clusters of related industries. This was one of the most pervasive findings of Porter’s study. One such cluster Porter identified was in the German textile and apparel sec- tor, which included high-quality cotton, wool, synthetic fibers, sewing machine needles, and a wide range of textile machinery. Such clusters are important because valuable knowledge can flow between the firms within a geographic cluster, benefiting all within that cluster. Knowledge flows occur when employees move between firms within a region and when national industry associations bring employees from different companies together for regu- lar conferences or workshops.35

FIRM STRATEGY, STRUCTURE, AND RIVALRY The fourth broad at- tribute of national competitive advantage in Porter’s model is the strategy, structure, and rivalry of firms within a nation. Porter makes two important points here. First, different nations are characterized by different management ideologies, which either help them or do not help them build national competitive advantage. For example, Porter noted the pre- dominance of engineers in top management at German and Japanese firms. He attributed this to these firms’ emphasis on improving manufacturing processes and product design. In contrast, Porter noted a predominance of people with finance backgrounds leading many U.S. firms. He linked this to U.S. firms’ lack of attention to improving manufacturing pro- cesses and product design. He argued that the dominance of finance led to an overemphasis on maximizing short-term financial returns. According to Porter, one consequence of these different management ideologies was a relative loss of U.S. competitiveness in those engi- neering-based industries where manufacturing processes and product design issues are all- important (e.g., the automobile industry).

EVALUATING PORTER’S THEORY Porter contends that the degree to which a nation is likely to achieve international success in a certain industry is a func- tion of the combined impact of factor endowments, domes- tic demand conditions, related and supporting industries, and domestic rivalry. He argues that the presence of all four components is usually required for this diamond to boost competitive performance (although there are exceptions). Porter also contends that government can influence each of the four components of the diamond—either positively or negatively. Factor endowments can be affected by subsidies, policies toward capital markets, policies toward education, and so on. Government can shape domestic demand through local product standards or with regulations that mandate or influence buyer needs. Government policy can influence sup- porting and related industries through regulation and influence firm rivalry through such devices as capital market regulation, tax policy, and antitrust laws.

If Porter is correct, 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. Is he correct? We simply do not know. Por- ter’s theory has not been subjected to detailed empirical testing. Much about the theory rings true, but the same can be said for the new trade theory, the theory of comparative ad- vantage, and the Heckscher-Ohlin theory. It may be that each of these theories, which com- plement each other, explains something about the pattern of international trade.

L0 6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

How Important Is Education? Both the Heckscher-Ohlin and Michael Porter theories of trade focus to a large degree on “factor endowments.” The Heck- scher-Ohlin theory specifies endowments such as resources as land, labor, and capital as being critical, while the Porter theory recognizes hierarchies among these factor endowments. Educa- tion-related endowments such as skilled labor, research facili- ties, and technological know-how are what Porter calls “advanced factors.” A long-standing argument across multiple governmental organizations, research studies, and prominent individuals is that education drives economic, social, and envi- ronmental well-being of countries (i.e., countries adopt sustain- ability principles the more educated the people in the country are relative to people in the global marketplace—see Chapter 5). The extension of this argument is that education helps people become better citizens of a country. But, what do you think edu- cation does to a customer’s product needs and wants—do they want more foreign products if they have more years of education (e.g., graduate degree) compared with fewer years of education (e.g., high school)? Or, does education not influence the type of products bought by customers (i.e., foreign-made or home- country made)?

Sources: T. Healy and S. Cote, “The Well-being of Nations: The Role of Human and Social Capital,” Organisation for Economic Cooperation and Development (OECD), 2001; S. Samuel, “Importance of Education in a Country’s Progress,” HowToLearn. com, March 13, 2013; and K. Matsui, “The Economic Benefi ts of Educating Women,” Bloomberg Businessweek, March 7, 2013.

FOCUS ON MANAGERIAL IMPLICATIONS

LOCATION, FIRST-MOVER ADVANTAGES, AND GOVERNMENT POLICY Why does all this matter for business? There are at least three main implications for inter- national businesses of the material discussed in this chapter: location implications, first- mover implications, and government policy implications.

L0 6-5 Understand the important implications that international trade theory holds for business practice.

Chapter Six International Trade Theory 183

Porter’s second point is that there is a strong association between vigorous domestic rivalry and the creation and per- sistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competi- tors. Domestic rivalry creates pressures to innovate, to im- prove quality, to reduce costs, and to invest in upgrading advanced factors. All this helps create world-class competi- tors. Porter cites the case of Japan:

Nowhere is the role of domestic rivalry more evident than in Japan, where it is all-out warfare in which many companies fail to achieve profitability. With goals that stress market share, Japanese companies en- gage in a continuing struggle to outdo each other. Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings mea- sure which companies are most popular with univer- sity graduates. The rate of new product and process development is breathtaking.36

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184 Part Three The Global Trade and Investment Environment

Location Underlying most of the theories we have discussed is the notion that different countries have particular advantages in different productive activities. Thus, from a profit perspective, it makes sense for a firm to disperse its productive activities to those countries where, ac- cording to the theory of international trade, they can be performed most efficiently. If de- sign can be performed most efficiently in France, that is where design facilities should be located; if the manufacture of basic components can be performed most efficiently in Singa- pore, that is where they should be manufactured; and if final assembly can be performed most efficiently in China, that is where final assembly should be performed. The result is a global web of productive activities, with different activities being performed in different lo- cations around the globe depending on considerations of comparative advantage, factor en- dowments, and the like. If the firm does not do this, it may find itself at a competitive disadvantage relative to firms that do.

First-Mover Advantages According to the new trade theory, firms that establish a first-mover advantage with regard to the production of a particular new product may subsequently dominate global trade in that product. This is particularly true in industries where the global market can profitably support only a limited number of firms, such as the aerospace market, but early commit- ments may also seem to be important in less concentrated industries. For the individual firm, the clear message is that it pays to invest substantial financial resources in trying to build a first-mover, or early-mover, advantage, even if that means several years of losses be- fore a new venture becomes profitable. The idea is to preempt the available demand, gain cost advantages related to volume, build an enduring brand ahead of later competitors, and, consequently, establish a long-term sustainable competitive advantage. Although the details of how to achieve this are beyond the scope of this book, many publications offer strategies for exploiting first-mover advantages and for avoiding the traps associated with pioneering a market (first-mover disadvantages).37

Government Policy The theories of international trade also matter to international businesses because firms are major players on the international trade scene. Business firms produce exports, and business firms import the products of other countries. Because of their pivotal role in inter- national trade, businesses can exert a strong influence on government trade policy, lobby- ing to promote free trade or trade restrictions. The theories of international trade claim that promoting free trade is generally in the best interests of a country, although it may not always be in the best interest of an individual firm. Many firms recognize this and lobby for open markets.

For example, when the U.S. government announced its intention to place a tariff on Japanese imports of liquid crystal display (LCD) screens in the 1990s, IBM and Apple Com- puter protested strongly. Both IBM and Apple pointed out that (1) Japan was the lowest-cost source of LCD screens; (2) they used these screens in their own laptop computers; and (3) the proposed tariff, by increasing the cost of LCD screens, would increase the cost of laptop computers produced by IBM and Apple, thus making them less competitive in the world market. In other words, the tariff, designed to protect U.S. firms, would be self-defeating. In response to these pressures, the U.S. government reversed its posture.

Unlike IBM and Apple, however, businesses do not always lobby for free trade. In the United States, for example, restrictions on imports of steel have periodically been put into place in response to direct pressure by U.S. firms on the government. In some cases, the government has responded to pressure by getting foreign companies to agree to “voluntary” restrictions on their imports, using the implicit threat of more comprehensive formal trade barriers to get them to adhere to these agreements (historically, this has occurred in the automobile industry). In other cases, the government used what are called “antidumping” actions to justify tariffs on imports from other nations (these mechanisms will be discussed in detail in the next chapter).

Chapter Six International Trade Theory 185

As predicted by international trade theory, many of these agreements have been self-de- feating, such as the voluntary restriction on machine tool imports agreed to in 1985. Shielded from international competition by import barriers, the U.S. machine tool industry had no incentive to increase its efficiency. Consequently, it lost many of its export markets to more efficient foreign competitors. Because of this misguided action, the U.S. machine tool industry shrunk during the period when the agreement was in force. For anyone schooled in international trade theory, this was not surprising.38

Finally, Porter’s theory of national competitive advantage also contains policy implica- tions. Porter’s theory suggests that it is in the best interest of business for a firm to invest in upgrading advanced factors of production, for example, to invest in better training for its employees and to increase its commitment to research and development. It is also in the best interests of business to lobby the government to adopt policies that have a favorable impact on each component of the national diamond. Thus, according to Porter, businesses should urge government to increase investment in education, infrastructure, and basic re- search (since all these enhance advanced factors) and to adopt policies that promote strong competition within domestic markets (since this makes firms stronger international com- petitors, according to Porter’s findings).

free trade, p. 160 new trade theory, p. 162 mercantilism, p. 163 zero-sum game, p. 163 absolute advantage, p. 164

constant returns to specialization, p. 169 factor endowments, p. 174 economies of scale, p. 176 first-mover advantages, p. 179 balance-of-payments accounts, p. 189

current account, p. 189 current account deficit, p. 189 current account surplus, p. 189 capital account, p. 190 financial account, p. 191

Key Terms

Summary

This chapter reviewed a number of theories that explain why it is beneficial for a country to engage in international trade and explained the pattern of international trade ob- served in the world economy. The theories of Smith, Ricardo, and Heckscher-Ohlin all make strong cases for unrestricted free trade. In contrast, the mercantilist doc- trine and, to a lesser extent, the new trade theory can be interpreted to support government intervention to pro- mote exports through subsidies and to limit imports through tariffs and quotas. In explaining the pattern of international trade, this chapter shows that, with the exception of mercantilism, which is silent on this issue, the different theories offer largely complementary explanations. Although no one theory may explain the apparent pattern of international trade, taken together, the theory of comparative advan- tage, the Heckscher-Ohlin theory, the product life-cycle theory, the new trade theory, and Porter’s theory of national competitive advantage do suggest which factors are important. Comparative advantage tells us that pro- ductivity differences are important; Heckscher-Ohlin tells us that factor endowments matter; the product life- cycle theory tells us that where a new product is intro- duced is important; the new trade theory tells us that increasing returns to specialization and first-mover

advantages matter; and Porter tells us that all these fac- tors may be important insofar as they affect the four com- ponents of the national diamond. The chapter made the following points:

1. Mercantilists argued that it was in a country’s best interests to run a balance-of-trade surplus. They viewed trade as a zero-sum game, in which one country’s gains cause losses for other countries.

2. The theory of absolute advantage suggests that countries differ in their ability to produce goods efficiently. The theory suggests that a country should specialize in producing goods in areas where it has an absolute advantage and import goods in areas where other countries have absolute advantages.

3. The theory of comparative advantage suggests that it makes sense for a country to specialize in producing those goods that it can produce most efficiently, while buying goods that it can produce relatively less efficiently from other countries—even if that means buying goods from other countries that it could produce more efficiently itself.

4. The theory of comparative advantage suggests that unrestricted free trade brings about increased world production, that is, that trade is a positive-sum game.

186 Part Three The Global Trade and Investment Environment

5. The theory of comparative advantage also suggests that opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. The empirical evidence seems to be consistent with this claim.

6. The Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce.

7. The product life-cycle theory suggests that trade patterns are influenced by where a new product is introduced. In an increasingly integrated global economy, the product life-cycle theory seems to be less predictive than it once was.

8. New trade theory states that trade allows a nation to specialize in the production of certain goods, attaining scale economies and lowering the costs of producing those goods, while buying goods that it does not produce from other nations that are similarly specialized. By this mechanism, the variety of goods available to consumers in each nation is increased, while the average costs of those goods should fall.

9. New trade theory also states that in those industries where substantial economies of scale imply that the world market will profitably support only a few firms, countries may predominate in the export of certain products simply because they had a firm that was a first mover in that industry.

10. Some new trade theorists have promoted the idea of strategic trade policy. The argument is that government, by the sophisticated and judicious use of subsidies, might be able to increase the chances of domestic firms becoming first movers in newly emerging industries.

11. Porter’s theory of national competitive advantage suggests that the pattern of trade is influenced by four attributes of a nation: (a) factor endowments, (b) domestic demand conditions, (c) related and supporting industries, and (d) firm strategy, structure, and rivalry.

12. Theories of international trade are important to an individual business firm primarily because they can help the firm decide where to locate its various production activities.

13. Firms involved in international trade can and do exert a strong influence on government policy toward trade. By lobbying government, business firms can promote free trade or trade restrictions.

Critical Thinking and Discussion Questions

1. Mercantilism is a bankrupt theory that has no place in the modern world. Discuss.

2. Is free trade fair? Discuss! 3. Unions in developed nations often oppose imports

from low-wage countries and advocate trade barriers to protect jobs from what they often characterize as “unfair” import competition. Is such competition “unfair”? Do you think that this argument is in the best interests of (a) the unions, (b) the people they represent, and/or (c) the country as a whole?

4. What are the potential costs of adopting a free trade regime? Do you think governments should do anything to reduce these costs? What?

5. Reread the Country Focus “Is China a Neo- mercantilist Nation?” a. Do you think China is pursuing an economic policy

that can be characterized as neo-mercantilist? b. What should the United States, and other countries,

do about this? 6. Reread the Country Focus on moving white-collar jobs

offshore. a. Who benefits from the outsourcing of skilled white-

collar jobs to developing nations? Who are the losers?

b. Will developed nations like the United States suffer from the loss of high-skilled and high- paying jobs?

c. Is there a difference between the transference of high-paying white-collar jobs, such as computer programming and accounting, to developing nations, and low-paying blue-collar jobs? If so, what is the difference, and should government do anything to stop the flow of white-collar jobs out of the country to countries such as India?

7. Drawing upon the new trade theory and Porter’s theory of national competitive advantage, outline the case for government policies that would build national competitive advantage in biotechnology. What kinds of policies would you recommend that the government adopt? Are these policies at variance with the basic free trade philosophy?

8. The world’s poorest countries are at a competitive disadvantage in every sector of their economies. They have little to export. They have no capital; their land is of poor quality; they often have too many people given available work opportunities; and they are poorly educated. Free trade cannot possibly be in the interests of such nations. Discuss.

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One of the great success stories in international trade in recent years has been the strong growth of India’s pharmaceutical industry. The country used to be known for producing cheap knockoffs of patented drugs discovered by Western and Japanese pharmaceutical companies. This made the indus- try something of an international pariah. Because they made copies of pat- ented products, and therefore violated intellectual property rights, Indian companies were not allowed to sell these products in developed markets. With no assurance that their intellectual property would be protected, for- eign drug companies refused to invest in, partner with, or buy from their Indian counterparts, further limiting the business opportunities of Indian companies. In developed markets such as the United States, the best that Indian companies could do was to sell low-cost generic pharmaceuticals (generic pharmaceuticals are products whose patents have expired).

In 2005, however, India signed an agreement with the World Trade Or- ganization that brought the country into compliance with WTO rules on in- tellectual property rights. Indian companies stopped producing counterfeit products. Secure in knowledge that their patents would be respected, for- eign companies started to do business with their Indian counterparts. For India, the result has been dramatic growth in its pharmaceutical sector. The sector generated sales of close to $30 billion in 2012–2013, more than two and a half times the figure of 2005. Driving this growth have been surging exports, which grew at 15 percent per annum between 2006 and 2012. In 2000, pharmaceutical exports from India amounted to around $1 billion. By 2012–2013, the figure was around $14.7 billion!

Much of this growth has been the result of partnerships between West- ern and Indian firms. Western companies have been increasingly outsourc- ing manufacturing and packaging activities to India while scaling back some of these activities at home and in places such as Puerto Rico, which historically has been a major manufacturing hub for firms serving the U.S. market. India’s advantages in manufacturing and packaging include relatively low wage rates, an educated workforce, and the widespread use

of English as a business language. Western companies have continued to perform high value-added R&D, marketing, and sales activities, and these remain located in their home markets.

During India’s years as an international pariah in the drug business, its nascent domestic industry set the foundations for today’s growth. Local start-ups invested in the facilities required to discover and produce phar- maceuticals, creating a market for pharmaceutical scientists and workers in India. In turn, this drove the expansion of pharmaceutical programs in the country’s universities, thereby increasing the supply of talent. More- over, the industry’s experience in the generic drug business during the 1990s and early 2000s has given it expertise in dealing with regulatory agencies in the United States and European Union. After 2005, this

The Rise of India’s Drug Industry

Chapter Six International Trade Theory 187

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. The World Trade Organization International Trade Statistics is an annual report that provides comprehensive, comparable, and updated statistics on trade in merchandise and commercial services. The report allows an assessment of world trade flows by country, region, and main product or service categories. Using the most recent statistics available, identify the top 10 countries that lead in the export and import of merchandise trade, respectively. Which countries appear in the top 10 in both exports and imports? Can you explain why these countries appear at the top of both lists?

2. Food in an integral part of understanding different countries, cultures, and lifestyles. You run a chain of high-end premium restaurants in the United States, and you are looking for unique Australian wines you can import. However, you must first identify which Australian suppliers can provide you with premium wines. After searching through the Australian supplier directory, identify three to four companies that can be potential suppliers. Then develop a list of criteria you would need to ask these companies to select which one to work with.

Research Task http://globalEDGE.msu.edu

Generic drugs manufactured by Indian firms help the country to emerge as a major exporter of pharmaceuticals.

know-how made Indian companies more attractive as partners for Western enterprises. Combined with low labor costs, all these factors came together to make India an increasingly attractive location for the manufacturing of pharmaceuticals.

The U.S. Federal Drug Administration (FDA) responded to the shift of manufacturing to India by opening two offices there to oversee manufactur- ing compliance and make sure safety was consistent with FDA-mandated standards. Today, the FDA has issued approvals to produce pharmaceuticals for sale in the United States to some 900 plants in India, giving Indian com- panies a legitimacy that potential rivals in places such as China lack.

For Western enterprises, the obvious attraction of outsourcing drug manufacturing to India is that it lowers their costs, enabling them to protect their earnings in an increasingly difficult domestic environment where gov- ernment health care regulation and increased competition have put pres- sure on the pricing of many pharmaceuticals. Arguably, this also benefits consumers in the United States because lower pharmaceutical prices mean lower insurance costs, smaller copays, and ultimately lower out-of- pocket expenses than if those pharmaceuticals were still manufactured domestically. Offset against this economic benefit, of course, must be the

cost of jobs lost in U.S. pharmaceutical manufacturing. Indicative of this trend, total manufacturing employment in this sector fell by 5 percent be- tween 2008 and 2010.

Sources: H. Timmons, “A Pharmaceutical Future,” The New York Times, July 7, 2010, pp. B1, B4; K. K. Sharma, “On the World Stage,” Business Today, January 9, 2011, pp. 116–17; M. Velterop, “The Indian Perspective,” Pharmaceutical Technology Europe, September 2010, pp. 40–41; “Pharma Exports Expected to Touch Rs 75,000 in 2012–2013,” Business Standard, February 27, 2013; and Lynne Taylor, “India: Exports of Generics Growing 24% a Year,” PharmaTimes, October 21, 2013.

CASE DISCUSSION QUESTIONS 1. How might (a) U.S. pharmaceutical companies and (b) U.S. consumers

benefit from the rise of the Indian pharmaceutical industry? 2. Who might have lost out as a result of the recent rise of the Indian

pharmaceutical industry?

3. Do the benefits from trade with the Indian pharmaceutical sector outweigh the losses?

4. What international trade theory (or theories) best explain the rise of India as a major exporter of pharmaceuticals?

188 Part Three The Global Trade and Investment Environment

Chapter Six International Trade Theory 189

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International Trade and the Balance of Payments International trade involves the sale of goods and services to residents in other countries (exports) and the purchase of goods and services from residents in other countries (imports). A country’s balance-of-payments accounts keep track of the payments to and receipts from other countries for a particular time period. These include payments to foreigners for imports of goods and services, and receipts from foreigners for goods and services exported to them. A summary copy of the U.S. balance-of-payments accounts for 2011 is given in Table A.1. Any transaction resulting in a payment to other countries is entered in the bal- ance-of-payments accounts as a debit and given a negative (2) sign. Any transaction result- ing in a receipt from other countries is entered as a credit and given a positive (1) sign. In this appendix, we briefly describe the form of the balance-of-payments accounts, and we discuss whether a current account deficit, often a cause of much concern in the popular press, is something to worry about.

Balance-of-Payments Accounts Balance-of-payments accounts are divided into three main sections: the current account, the capital account, and the financial account (to confuse matters, what is now called the capital account was until recently part of the current account, and the financial account used to be called the capital account). The current account records transactions that pertain to three categories, all of which can be seen in Table A.1. The first category, goods, refers to the ex- port or import of physical goods (e.g., agricultural foodstuffs, autos, computers, and chemi- cals). The second category is the export or import of services (e.g., intangible products such as banking and insurance services). The third category, income receipts and payments, refers to income from foreign investments and payments that have to be made to foreigners investing in a country. For example, if a U.S. citizen owns a share of a Finnish company and receives a dividend payment of $5, that payment shows up on the U.S. current account as the receipt of $5 of investment income. Also included in the current account are unilateral current transfers, such as U.S. government grants to foreigners (including foreign aid) and private payments to foreigners (such as when a foreign worker in the United States sends money to his or her home country).

A current account deficit occurs when a country imports more goods, services, and in- come than it exports. A current account surplus occurs when a country exports more goods, services, and income than it imports. Table A.1 shows that in 2012 the United States ran a current account deficit of $534.7 billion. This is often a headline-grabbing figure and is widely reported in the news media. In recent years, the U.S. current account deficit has

Balance-of-Payments Accounts National accounts that track both payments to and receipts from foreigners.

Current Account In the balance of payments, records transactions involving the export or import of goods and services.

Current Account Deficit The current account of the balance of payments is in deficit when a country imports more goods and services than it exports. Current Account Surplus The current account of the balance of payments is in surplus when a country exports more goods and services than it imports.

190 Part Three The Global Trade and Investment Environment

been quite large, primarily because America imports far more physical goods than it exports. (The United States typically runs a surplus on trade in services and is close to balance on income payments.)

The 2006 current account deficit of $803 billion was the largest on record and was equiv- alent to about 6.5 percent of the country’s GDP. The deficit has shrunk since then, in re- sponse to the economic crisis and prolonged recession of 2008–2009 as much as anything else. Many people find these figures disturbing, the common assumption being that high imports of goods displaces domestic production, causes unemployment, and reduces the growth of the U.S. economy. For example, The New York Times responded to the record cur- rent account deficit in 2006 by stating:

A growing trade deficit acts as a drag on overall economic growth. Economists said that they expect that, in light of the new numbers, the government will have to revise its estimate of the nation’s fourth quarter gross domestic product to show slightly slower expansion.39

However, the issue is somewhat more complex than implied by statements like this. Fully understanding the implications of a large and persistent deficit requires that we look at the rest of the balance-of-payments accounts.

The capital account records one-time changes in the stock of assets. As noted earlier, until recently this item was included in the current account. The capital account includes capital transfers, such as debt forgiveness and migrants’ transfers (the goods and financial assets that accompany migrants as they enter or leave the country). In the big scheme of things this is a relatively small figure amounting to $6,956 million in 2012.

Capital Account In the balance of payments, records transactions involving one-time changes in the stock of assets.

A.1 TABLE U.S. Balance-of-Payments Accounts, 2012 Source: Bureau of Economic Analysis.

Current Account $ Millions

Exports of goods, services, and income receipts 2,986,949

Goods 1,561,239

Services 649,346

Income receipts 776,364

Imports of goods, services, and income payments 23,297,677

Goods 22,302,714

Services 2442,527

Income payments 2552,437

Unilateral current transfers (net) 2126,688

Current account balance 2534,656

Capital Account

Capital account transactions (net) 6,956

Financial Account

U.S.-owned assets abroad (net) 297,469

U.S. official reserve assets 24,460

U.S. government assets 85,331

U.S. private assets 2178,341

Foreign-owned assets in the United States 543,884

Foreign official assets in the United States 393,922

Other foreign assets in the United States 149,962

Statistical discrepancy 25,891

Chapter Six International Trade Theory 191

The financial account (formerly the capital account) records transactions that involve the purchase or sale of assets. Thus, when a German firm purchases stock in a U.S. company or buys a U.S. bond, the transaction enters the U.S. balance of payments as a credit on the capital account. This is because capital is flowing into the country. When capital flows out of the United States, it enters the capital account as a debit.

The financial account is comprised of a number of elements. The net change in U.S.- owned assets abroad includes the change in assets owned by the U.S. government (U.S. official reserve assets and U.S. government assets) and the change in assets owned by private individu- als and corporations. As can be seen from Table A.1, in 2012 there was a 2$97.5 billion reduc- tion in U.S. assets owned abroad due to a fall in the amount of foreign assets owned by the U.S. government and private individuals and corporations. In other words, these entities were selling off foreign assets, such as foreign bonds and currencies, during 2012.

Also included in the financial account are foreign-owned assets in the United States. These are divided into assets owned by foreign governments (foreign official assets) and as- sets owned by other foreign entities such as corporations and individuals (other foreign as- sets in the United States). As can be seen, in 2012 foreigners increased their holdings of U.S. assets, including Treasury bills, corporate stocks and bonds, and direct investments in the United States, by $544 billion. Some $394 billion of this was due to an increase in the hold- ing of U.S. assets by foreign governments, while foreign private corporations and individu- als increased their holdings of U.S. assets by $150 billion.

A basic principle of balance-of-payments accounting is double-entry bookkeeping. Every international transaction automatically enters the balance of payments twice—once as a credit and once as a debit. Imagine that you purchase a car produced in Japan by Toyota for $20,000. Because your purchase represents a payment to another country for goods, it will enter the balance of payments as a debit on the current account. Toyota now has the $20,000 and must do something with it. If Toyota deposits the money at a U.S. bank, Toyota has purchased a U.S. asset—a bank deposit worth $20,000—and the transaction will show up as a $20,000 credit on the financial account. Or Toyota might deposit the cash in a Japanese bank in return for Japanese yen. Now the Japanese bank must decide what to do with the $20,000. Any action that it takes will ultimately result in a credit for the U.S. balance of pay- ments. For example, if the bank lends the $20,000 to a Japanese firm that uses it to import personal computers from the United States, then the $20,000 must be credited to the U.S. balance-of-payments current account. Or the Japanese bank might use the $20,000 to pur- chase U.S. government bonds, in which case it will show up as a credit on the U.S. balance- of-payments financial account.

Thus, any international transaction automatically gives rise to two offsetting entries in the balance of payments. Because of this, the sum of the current account balance, the capital ac- count, and the financial account balance should always add up to zero. In practice, this does not always occur due to the existence of “statistical discrepancies,” the source of which need not concern us here (note that in 2012, the statistical discrepancy amounted to 2$5.9 billion).

Does the Current Account Deficit Matter? As discussed earlier, there is some concern when a country is running a deficit on the current account of its balance of payments.40 In recent years, a number of rich countries, including most notably the United States, have run persistent and growing current account deficits. When a country runs a current account deficit, the money that flows to other countries can then be used by those countries to purchase assets in the deficit country. Thus, when the United States runs a trade deficit with China, the Chinese use the money that they receive from U.S. consumers to purchase U.S. assets such as stocks, bonds, and the like. Put another way, a deficit on the current account is financed by selling assets to other countries; that is, by a surplus on the financial account. Thus, the persistent U.S. current account deficit is being financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to other countries. In short, countries that run current account deficits become net debtors.

For example, as a result of financing its current account deficit through asset sales, the United States must deliver a stream of interest payments to foreign bondholders, rents to

Financial Account In balance of payments, transactions that involve the purchase or sale of assets.

192 Part Three The Global Trade and Investment Environment

foreign landowners, and dividends to foreign stockholders. One might argue that such pay- ments to foreigners drain resources from a country and limit the funds available for invest- ment within the country. Since investment within a country is necessary to stimulate economic growth, a persistent current account deficit can choke off a country’s future economic growth. This is the basis of the argument that persistent deficits are bad for an economy.

However, things are not this simple. For one thing, in an era of global capital markets money is efficiently directed toward its highest value uses, and over the past quarter of a century many of the highest value uses of capital have been in the United States. So even though capital is flowing out of the United States in the form of payments to foreigners, much of that capital finds its way right back into the country to fund productive investments in the United States. In short, it is not clear that the current account deficit chokes off U.S. economic growth. In fact, notwithstanding the 2008–2009 recession, the U.S. economy has grown substantially over the past 30 years, despite running a persistent current account deficit and despite financing that deficit by selling U.S. assets to foreigners. This is precisely because foreigners reinvest much of the income earned from U.S. assets, and from exports to the United States, right back into the United States. This revisionist view, which has gained in popularity in recent years, suggests that a persistent current account deficit might not be the drag on economic growth it was once thought to be.41

Having said this, there is still a nagging fear that at some point the appetite that foreign- ers have for U.S. assets might decline. If foreigners suddenly reduced their investments in the United States, what would happen? In short, instead of reinvesting the dollars that they earn from exports and investment in the United States back into the country, they would sell those dollars for another currency, European euros, Japanese yen, or Chinese yuan, for ex- ample, and invest in euro-, yen-, and yuan-denominated assets instead. This would lead to a fall in the value of the dollar on foreign exchange markets, and that in turn would increase the price of imports, and lower the price of U.S. exports, making them more competitive, which should reduce the overall level of the current account deficit. Thus, in the long run, the persistent U.S. current account deficit could be corrected via a reduction in the value of the U.S. dollar. The concern is that such adjustments may not be smooth. Rather than a controlled decline in the value of the dollar, the dollar might suddenly lose a significant amount of its value in a very short time, precipitating a “dollar crisis.”42 Because the U.S. dollar is the world’s major reserve currency, and is held by many foreign governments and banks, any dollar crisis could deliver a body blow to the world economy and at the very least trigger a global economic slowdown. That would not be a good thing.

Endnotes

1. H. W. Spiegel, The Growth of Economic Thought (Durham, NC: Duke University Press, 1991).

2. M. Solis, “The Politics of Self-Restraint: FDI Subsidies and Japanese Mercantilism,” The World Economy 26 (February 2003), pp. 153–70.

3. S. Hollander, The Economics of David Ricardo (Buffalo: University of Toronto Press, 1979).

4. D. Ricardo, The Principles of Political Economy and Taxation (Homewood, IL: Irwin, 1967, first published in 1817).

5. For example, R. Dornbusch, S. Fischer, and P. Samuelson, “Comparative Advantage: Trade and Payments in a Ricardian Model with a Continuum of Goods,” American Economic Re- view 67 (December 1977), pp. 823–39.

6. B. Balassa, “An Empirical Demonstration of Classic Comparative Cost Theory,” Review of Economics and Statistics, 1963, pp. 231–38.

7. See P. R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1 (Fall 1987), pp. 131–44.

8. P. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Global- ization,” Journal of Economic Perspectives 18, no. 3 (Summer 2004), pp. 135–46.

9. P. Samuelson, “The Gains from International Trade Once Again,” Economic Journal 72 (1962), pp. 820–29.

10. S. Lohr, “An Elder Challenges Outsourcing’s Orthodoxy,” The New York Times, September 9, 2004, p. C1.

11. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Global- ization,” p. 143.

12. D. H. Autor, D. Dorn, and Gordon H. Hanson, “The China Syndrome: Local Labor Market Effects of Import Competi- tion in the United States,” MIT Working Paper, August 2011.

13. See A. Dixit and G. Grossman, “Samuelson Says Nothing about Trade Policy,” Princeton University, 2004, accessed from http://depts.washington.edu/teclass/ThinkEcon/readings/ Kalles/Dixit%20and%20Grossman%20on%20Samuelson.pdf.

Chapter Six International Trade Theory 193

14. J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” The Wall Street Journal, January 18, 2012, p. B1.

15. For example, J. D. Sachs and A. Warner, “Economic Reform and the Process of Global Integration,” Brookings Papers on Economic Activity, 1995, pp. 1–96; J. A. Frankel and D. Romer, “Does Trade Cause Growth?” American Economic Review 89, no. 3 (June 1999), pp. 379–99; and D. Dollar and A. Kraay, “Trade, Growth and Poverty,” Working Paper, Development Research Group, World Bank, June 2001. Also, for an acces- sible discussion of the relationship between free trade and economic growth, see T. Taylor, “The Truth about Globaliza- tion,” Public Interest, Spring 2002, pp. 24–44; D. Acemoglu, S. Johnson, and J. Robinson, “The Rise of Europe: Atlantic Trade, Institutional Change and Economic Growth,” Ameri- can Economic Review 95, no. 3 (2005), pp. 547–79; and T. Singh, “Does International Trade Cause Economic Growth?” The World Economy 33, no. 11 (2010), pp. 1517–64.

16. Sachs and Warner, “Economic Reform and the Process of Global Integration.”

17. Ibid., pp. 35–36.

18. R. Wacziarg and K. H. Welch, “Trade Liberalization and Growth: New Evidence,” National Bureau of Economic Research Working Paper Series, working paper no. 10152, December 2003.

19. Singh, “Does International Trade Cause Economic Growth?”

20. Frankel and Romer, “Does Trade Cause Growth?”

21. A recent skeptical review of the empirical work on the rela- tionship between trade and growth questions these results. See Francisco Rodriguez and Dani Rodrik, “Trade Policy and Economic Growth: A Skeptic’s Guide to the Cross-National Evidence,” National Bureau of Economic Research Working Paper Series, working paper no. 7081, April 1999. Even these au- thors, however, cannot find any evidence that trade hurts economic growth or income levels.

22. B. Ohlin, Interregional and International Trade (Cambridge, MA: Harvard University Press, 1933). For a summary, see R. W. Jones and J. P. Neary, “The Positive Theory of International Trade,” in Handbook of International Economics, R. W. Jones and P. B. Kenen, eds. (Amsterdam: North Holland, 1984).

23. W. Leontief, “Domestic Production and Foreign Trade: The American Capital Position Re-examined,” Proceedings of the American Philosophical Society 97 (1953), pp. 331–49.

24. R. M. Stern and K. Maskus, “Determinants of the Structure of U.S. Foreign Trade,” Journal of International Economics 11 (1981), pp. 207–44.

25. See H. P. Bowen, E. E. Leamer, and L. Sveikayskas, “Multi- country, Multifactor Tests of the Factor Abundance Theory,” American Economic Review 77 (1987), pp. 791–809.

26. D. Trefler, “The Case of the Missing Trade and Other Mysteries,” American Economic Review 85 (December 1995), pp. 1029–46.

27. D. R. Davis and D. E. Weinstein, “An Account of Global Fac- tor Trade,” American Economic Review, December 2001, pp. 1423–52.

28. R. Vernon, “International Investments and International Trade in the Product Life Cycle,” Quarterly Journal of

Economics, May 1966, pp. 190–207; and R. Vernon and L. T. Wells, The Economic Environment of International Business, 4th ed. (Englewood Cliffs, NJ: Prentice Hall, 1986).

29. For a good summary of this literature, see E. Helpman and P. Krugman, Market Structure and Foreign Trade: Increasing Re- turns, Imperfect Competition, and the International Economy (Boston: MIT Press, 1985). Also see P. Krugman, “Does the New Trade Theory Require a New Trade Policy?” World Economy 15, no. 4 (1992), pp. 423–41.

30. M. B. Lieberman and D. B. Montgomery, “First-Mover Ad- vantages,” Strategic Management Journal 9 (Summer 1988), pp. 41–58; and W. T. Robinson and Sungwook Min, “Is the First to Market the First to Fail?” Journal of Marketing Re- search 29 (2002), pp. 120–28.

31. J. R. Tybout, “Plant and Firm Level Evidence on New Trade Theories,” National Bureau of Economic Research Working Paper Series, working paper no. 8418, August 2001 (paper available at www.nber.org); and S. Deraniyagala and B. Fine, “New Trade Theory versus Old Trade Policy: A Continuing Enigma,” Cambridge Journal of Economics 25 (November 2001), pp. 809–25.

32. A. D. Chandler, Scale and Scope (New York: Free Press, 1990).

33. Krugman, “Does the New Trade Theory Require a New Trade Policy?”

34. M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990). For a good review of this book, see R. M. Grant, “Porter’s Competitive Advantage of Nations: An As- sessment,” Strategic Management Journal 12 (1991), pp. 535–48.

35. B. Kogut, ed., Country Competitiveness: Technology and the Or- ganizing of Work (New York: Oxford University Press, 1993).

36. Porter, The Competitive Advantage of Nations, p. 121.

37. Lieberman and Montgomery, “First-Mover Advantages.” See also Robinson and Min, “Is the First to Market the First to Fail?”; W. Boulding and M. Christen, “First Mover Disad- vantage,” Harvard Business Review, October 2001, pp. 20–21; and R. Agarwal and M. Gort, “First Mover Advantage and the Speed of Competitive Entry,” Journal of Law and Economics 44 (2001), pp. 131–59.

38. C. A. Hamilton, “Building Better Machine Tools,” Journal of Commerce, October 30, 1991, p. 8; and “Manufacturing Trou- ble,” The Economist, October 12, 1991, p. 71.

39. J. W. Peters, “U.S. Trade Deficit Grew to Another Record in 06,” The New York Times, February 14, 2007, p. 1.

40. P. Krugman, The Age of Diminished Expectations (Cambridge, MA: MIT Press, 1990).

41. D. Griswold, “Are Trade Deficits a Drag on U.S. Economic Growth?” Free Trade Bulletin, March 12, 2007; and O. Blanchard, “Current Account Deficits in Rich Countries,” National Bureau of Economic Research Working Paper Series, working paper no. 12925, February 2007.

42. S. Edwards, “The U.S. Current Account Deficit: Gradual Correction or Abrupt Adjustment?” National Bureau of Eco- nomic Research Working Paper Series, working paper no. 12154, April 2006.

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learning objectives

7-1 Identify the policy instruments used by governments to influence international trade flows.

7-2 Understand why governments sometimes intervene in international trade.

7-3 Summarize and explain the arguments against strategic trade policy.

7-4 Describe the development of the world trading system and the current trade issue.

7-5 Explain the implications for managers of developments in the world trading system.