Summary about global business
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CH6.pptxChapter 6
International Trade Theory
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
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Learning Objectives
LO 6-1 Understand why nations trade with each other.
LO 6-2 Summarize the different theories explaining trade flows between nations.
LO 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.
LO 6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.
LO 6-5 Understand the important implications that international trade theory holds for management practice.
©McGraw-Hill Education.
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International Trade
Why should countries depend on others for trade, instead of being self sufficient and self dependent?
Why should countries get engaged in international trade, even if they could be self sufficient?
Following International Trade Theories answer this question:
Absolute Advantage Theory
Comparative Advantage Theory
New Trade Theory
Porter’s Diamond Of Competitive Advantage
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Why is Free Trade Beneficial?
Free trade - a situation where a government does not attempt to influence (through quotas or duties) what its citizens can buy from another country or what they can produce and sell to another country.
International Trade theory shows why it is beneficial for a country to engage in international trade even for the products it is able to produce for itself.
International trade theory argues that:
Countries should specialize manufacturing and exporting of the products that it can produce most efficiently as compare to other countries.
And
Import other products that can be produced more efficiently in other countries
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Have you ever wondered why we buy so much clothing from other countries?
U.S. manufacturers know how to make clothing, in fact, much of clothing worn by Americans used to be made in the U.S.
Now, however, the U.S. buys a lot of its textiles from places like Honduras and Guatemala.
Why does Ford assemble cars made for the American market in Mexico, while BMW and Nissan manufacture cars for Americans in the U.S.?
These are questions that economists have tried to answer for many years, and in this chapter we’ll look at patterns of trade and explore some of the theories that have been used to explain those patterns.
First though, a definition. Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country.
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Why Do Certain Patterns of Trade Exist?
Some patterns of trade are fairly easy to explain
it is obvious why:
Saudi Arabia exports oil,
US exports wheat.
Ghana exports cocoa,
Malaysia exports rubber,
Pakistan exports cotton, and
Brazil exports coffee
But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry?
Why does Ford assemble cars made for the American market in Mexico.
Why does Japan export automobiles, consumer electronics, and machine tools?
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Economists have debated the merits of free trade for centuries. In fact, we’ll begin our discussion of trade theory with mercantilism, a 16th and 17th century philosophy that encouraged countries to increase exports and limit imports.
Then, we’ll go on to the theories advocated by Adam Smith and David Ricardo who promoted the notion of free trade, or a situation where government allows market forces to work, and doesn’t intervene with quotas or duties to influence what citizens can buy from other countries, or sell to other countries.
Smith and Ricardo promoted the idea that international trade allows a country to specialize in the manufacture and export of products that it can produce efficiently, and import products that can be produced more efficiently in other countries.
Their work was later extended by Eli Heckscher and Bertil Ohlin.
You probably don’t need trade theories to explain some patterns of trade—it’s easy to see why Saudi Arabia exports oil and Brazil exports coffee, but it’s much harder to explain why Switzerland exports watches and pharmaceuticals, or why Japan exports consumer electronics.
Ray Vernon answered some of these questions with his product life cycle theory that followed the production of a product over time.
Paul Krugman also attempted to answer these questions with his so called, new trade theory.
He argued that in some industries, the world market can only support a few firms, and that the firms that are able to build a competitive position early, will be difficult to challenge.
Think of the large commercial aircraft industry for example. How many companies can you think of? Probably just two—Boeing and Airbus Industries.
Michael Porter extended Krugman’s work with his theory of national competitive advantage.
Porter argued that a county’s ability to be successful in certain industries depends not only on factor endowments, but also on domestic demand and domestic rivalry.
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What Role Does Government Have in Trade?
The mercantilist philosophy makes a crude case for government involvement in promoting exports and limiting imports .
Adam Smith and Ricardo, (theories of absolute and comparative advantage) promote unrestricted free trade.
New trade theory and Porter’s theory of national competitive advantage justify limited and selective government intervention to support the development of certain export-oriented industries.
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The main point that Smith, Ricardo, and Heckscher-Ohlin made is that it’s beneficial for countries to trade with each other, even when they could be self-sufficient.
They tried to answer the question that we asked above—why should the U.S. buy textiles from other countries when it could produce them itself?
As we’ll explain later, Smith, Ricardo, and Heckscher-Ohlin showed that if countries specialized in the production and export of products that they produced most efficiently, they could trade for products that could be produced more efficiently in other countries.
What role does government play in trade theory?
Well, it depends.
Mercantilism suggested that government should be involved in helping to promote exports and limit imports, while Smith, Ricardo, and Heckscher-Ohlin argued that government should stay out of trade and market forces should influence how countries trade.
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What is Mercantilism?
Mercantilism is the economic system used during the 16th to 18th centuries. The main goal was to increase a nation's wealth by imposing government regulation concerning all of the nation's commercial interests.
Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -to export more than it imports.
advocates government intervention to achieve a surplus in the balance of trade.
Mercantilism views trade as a zero-sum game - one in which a gain by one country results in a loss by another.
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Now that you have got an overview of the various theories, let’s look at them in more depth. We’ll start with mercantilism.
The main idea behind the mercantilist philosophy, which was around in the mid-16th century, was that the accumulation of gold and sliver were essential to the wealth, and power of a nation.
So, it was in the best interests of a country to try to maximize its holdings of gold and silver by encouraging exports and discouraging imports.
In order to achieve this goal, imports were limited through tariffs and quotas, while exports were maximized through government subsidies.
A key flaw in the philosophy however, was that it was a zero-sum game.
A country could only achieve its goal of maximizing a trade surplus at the expense of another nation.
In other words, if one country successfully exported more than it imported, and consequently increased its holdings of gold and silver, another country would fail to achieve a trade surplus.
This other country would in fact buy more than it sold, see its gold and silver leave the country, and become a weaker nation!
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What is Smith’s Theory of Absolute Advantage?
Adam Smith argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it.
countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries.
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Adam Smith challenged the mercantilist philosophy and its zero-sum approach to trade.
Smith argued, in his 1776 landmark book, The Wealth of Nations, that free trade, or trade without government intervention, could be beneficial to countries if each country produced and exported those products in which it was most efficient, or in his words, those products in which the country had an absolute advantage.
Smith argued that if countries specialized in the production of goods in which they had an absolute advantage they could then trade these goods for the goods produced by other countries.
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How Does the Theory of Absolute Advantage Work?
Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa
In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice
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 the two extremes
In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice
South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between
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Let’s look at an example of Smith’s ideas.
Assume that two countries, Ghana and South Korea, both have 200 units of resources that they could use either to produce rice or to produce cocoa.
Now, suppose that in Ghana, it takes 10 units of resources to produce one ton of cocoa, and 20 units of resources to produce one ton of rice.
What could Ghana produce?
Well, Ghana could use all of its resources to produce 20 tons of cocoa, or it could put all of its resources into the production of 10 tons of rice.
Or, Ghana could produce some combination of rice and cocoa.
What about South Korea?
Suppose in South Korea that it takes 40 units of resources to produce one ton of cocoa, and 10 units of resources to produce one ton of rice.
South Korea’s production options then are to devote all of its resources to producing 5 tons of cocoa, or all of its resources to producing 20 tons of rice, or to share its resources and produce some combination of rice and cocoa.
Based on this information, we would say that Ghana has an absolute advantage in the production of cocoa—it is more efficient at producing cocoa than South Korea.
Remember, more resources are needed to produce a ton of cocoa in South Korea than in Ghana.
You’ve probably guessed that South Korea then has an absolute advantage in the production of rice.
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How Does the Theory of Absolute Advantage Work?
Without trade
Ghana would produce 10 tons of cocoa and 5 tons of rice
South Korea would produce 10 tons of rice and 2.5 tons of cocoa
Total Production: 15 tons of rice and 12.5 tons of cocoa
With specialization and trade
Ghana would produce 20 tons of cocoa
South Korea would produce 20 tons of rice
Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice
After trade
Ghana would have 14 tons of cocoa left, and 6 tons of rice
South Korea would have 14 tons of rice left and 6 tons of cocoa
If each country specializes in the production of the good in which it has an absolute advantage and trades for the other, both countries gain
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So, we’ve got these two countries that could be self-sufficient and produce their own rice and cocoa.
Let’s suppose that they choose to do so, and that Ghana uses its resources to produce 10 tons of cocoa and 5 tons of rice.
South Korea might use its resources to produce 10 tons of rice and 2 and half tons of cocoa.
So, both countries have the option of consuming both products.
Now, let’s think about Adam Smith’s ideas of specializing in what you do best and trading for other products.
Would this help Ghana and South Korea?
Well, if Ghana specializes in producing cocoa, it would devote all of its resources to cocoa production and produce 20 tons of cocoa. South Korea’s absolute advantage was in the production of rice, so it would devote all of its resources to produce 20 tons of rice.
Now, suppose Ghana traded 6 tons of its 20 tons of cocoa to South Korea in exchange for 6 tons of South Korea’s 20 tons of rice.
Are the countries better off? Was trade beneficial?
The answer is yes!
After trade, Ghana would still have 14 tons of cocoa left, and it would acquire 6 tons of rice.
Remember, when it tried to be self sufficient it was only able to produce 10 tons of cocoa and 5 tons of rice, so with trade it’s gained 4 tons of cocoa and 1 ton of rice.
Trade would also benefit South Korea.
By trading, South Korea would have 14 tons of rice left, and it would acquire 6 tons of cocoa.
Again, recall that without trade, South Korea could only produce 10 tons of rice, and 2 and a half tons of cocoa.
So, South Korea has gained 3 and a half tons of cocoa, and 4 tons of rice.
Both countries gained from trade.
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What is Ricardo’s Theory of Comparative Advantage?
David Ricardo asked what might happen when one country has an absolute advantage in the production of all goods
Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home
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You may be thinking that Smith’s ideas are great if you’ve got two countries where one is clearly better at producing one product and the other is clearly more efficient at producing the other product.
But what happens if one country has an absolute advantage in the production of all products?
Is trade still beneficial?
In 1817, David Ricardo tried to answer these questions with his theory of comparative advantage.
Ricardo argued that at it still makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy 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.
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How Does the Theory of Comparative Advantage Work?
Assume
Ghana is more efficient in the production of both cocoa and rice
in Ghana, it takes 10 resources to produce one ton of cocoa, and 13 .33 resources to produce one ton of rice
So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two
in South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice
so, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two
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Let’s look at this a little more closely.
Going back to our example of Ghana and South Korea, suppose that Ghana is more efficient at producing both cocoa and rice.
Suppose that in Ghana it takes 10 resources to produce one ton of cocoa, and 13 and one third resources to produce one ton of rice.
Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two.
Now, suppose that in South Korea it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice.
South Korea could use all of its resources to produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two.
As you can see, Ghana has an absolute advantage in the production of both products!
Why should it trade with South Korea?
Ricardo argued that it’s still beneficial for Ghana to trade because it has a comparative advantage in the production of cocoa.
In other words, while Ghana can produce more cocoa and more rice than South Korea, it can produce four times as much cocoa, and only one and a half times as much rice.
Ghana is comparatively more efficient at producing cocoa!
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How Does the Theory of Comparative Advantage Work?
With trade
Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice
Ghana will still have 11 tons of cocoa, and 4 additional tons of rice
South Korea still has 6 tons of rice and 4 tons of cocoa
if each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain
Comparative advantage theory provides a strong rationale for encouraging free trade
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By specializing and trading, Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice.
This will leave Ghana with 11 tons of cocoa left, and 4 more tons of rice. South Korea benefits too, it has 6 tons of rice left, and has gained 4 tons of cocoa.
Again, both countries gain from trade!
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This table shows a visual of comparative advantage and the gains from trade.
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Is Unrestricted Free Trade Always Beneficial?
Unrestricted free trade is beneficial, but the gains may not be as great as the simple model of comparative advantage would suggest
immobile resources
diminishing returns
Opening a country to trade could increase
a country's stock of resources as increased supplies become available from abroad
the efficiency of resource utilization and so free up resources for other uses
economic growth
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Is free trade always best?
Well, suppose we say that resources are not mobile, that a country can’t simply decide to produce cocoa instead of rice. Or, that you couldn’t simply ask a textile worker to go write software programs for Microsoft.
In reality, this is more likely to be the case, and creates a strong argument against free trade.
If a government follows a free trade policy, what happens to the textile worker? Well, perhaps the government could help retrain the textile worker, but at least in the short-term, he’s likely to feel some pain!
So, keep in mind, that while free trade may be best in the long run, there may be some short-term pain involved.
Now, suppose we allow for the dynamic effects that are likely to come from trade.
Free trade can increase a country’s stock of resources.
For example, since the early 1990s, Western companies have been investing in Eastern Europe increasing the amount of capital that’s available to use there.
Free trade can also increase the efficiency of resource utilization.
For example, if firms can sell to a bigger market, they can gain from the economies associated with large scale production.
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Could A Rich Country Be Worse off With Free Trade?
Paul Samuelson - the dynamic gains from trade may not always be beneficial
free trade may ultimately result in lower wages in the rich country.
The ability to offshore services jobs that were traditionally not internationally mobile may have the effect of a mass inward migration into the United States, where wages would then fall.
But protectionist measures could create a more harmful situation than free trade.
Offshoring refers to relocation of manufacturing or supporting processes from one country to another.
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Sometimes though, dynamic gains from trade can lead to negative outcomes.
When one of the leading economists of the twentieth century, Paul Samuelson, looked at what happened when a rich country like the U.S. entered into a free trade agreement with a poor country like China that achieved rapid gains after entering into the agreement, Samuelson found that the rich country might actually lose!
In our example, the losses would occur because real wage rates in the U.S. would fall as a result of the free trade agreement and the cheaper prices it meant on imported products.
Samuelson is particularly concerned with the trend to offshore service jobs that have traditionally not been mobile.
He believes the effect of this trend will be similar to a mass inward migration to the U.S.
Despite concerns like those of Samuelson, studies show that there is a link between trade and economic growth.
Specifically, countries that adopt a more open stance toward international trade tend to have higher growth rates than those that close their economies to trade.
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What is New Trade Theory?
New trade theory suggests that in a Free trade the ability of firms to gain economies of scale can have important implications for international trade.
Through economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods.
without trade, nations might not be able to produce those products where economies of scale are important.
with trade, markets are large enough to support the production necessary to achieve economies of scale.
so, trade is mutually beneficial because it allows for the specialization of production, the realization of scale economies, and the production of a greater variety of products at lower prices
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In an effort to resolve some of the shortcomings of other theories, researchers in the 1970s began to search for other explanations of trade.
This new vein of thought, aptly called, new trade theory, argued that because of the unit cost reductions that are associated with a large scale of output, some industries can support only a few firms. These cost reductions are called economies of scale.
Achieving economies of scale can be very important to firms. Microsoft for example, is able to spread the costs of developing new versions of Windows over millions of PCs.
Why is this important?
Well, suppose we live in a world without trade.
Small markets might find that they don’t have certain products available if producers can’t sell enough to achieve economies of scale, or if the products are available, prices will probably be very high.
But, if countries trade with each other, markets are bigger, and firms have the opportunity to sell enough to achieve scale economies.
Consumers have more choice and lower prices!
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What is New Trade Theory?
Economies of Scale - are the cost advantages that companies obtain due to size, output, or scale of operation, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output.
First mover advantages - the economic and strategic advantages that accrue to early entrants into an industry
first movers can gain a scale-based cost advantage that later entrants find difficult to match
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However, in some industries, to achieve economies of scale, firms have to have a major share of the world’s market.
The costs of developing new aircraft, for example, are so high, that firms have to hold a significant share of the world market in order to gain economies of scale.
Remember, that there are only two makers of large commercial aircraft in the world!
Now, it’s important to consider the effects of first mover advantages because the pattern of trade we see in the world economy may be the result of first mover advantages and economies of scale.
Firms that achieve first mover advantages will develop economies of scale, and create barriers to entry for other firms.
Airbus, for example, is currently enjoying the first mover advantages associated with its super jumbo plane.
Airbus has to sell at least 250 super jumbos just to break even on the project.
The market over the next twenty years is expected to be just 400 to 600 planes, so it’s not worthwhile for Boeing to even get in the market.
Airbus has first mover advantages based on scale economies.
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What are the Implications of New Trade Theory For Nations?
Nations may benefit from trade even when they do not differ in resource endowments or technology
a country may dominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good.
Governments should consider strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important.
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What can we learn from new trade theory?
Well, new trade theory suggests that countries might benefit from trade even if they don’t differ in resource endowments or technology.
The theory also suggests that a country might be dominant in the export of a good just because it was lucky enough to have companies that were among the first to produce the product.
Remember our example of Airbus and its super jumbo jet!
Keep in mind that new trade theory is at odds with the Heckscher-Ohlin theory which, remember, suggested that countries would produce and export those products which made intensive use of abundant factors of production.
But, new trade theory doesn’t contradict comparative advantage theory because it actually identifies a source of comparative advantage.
So, governments might use this information to implement strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important.
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What is Porter’s Diamond of Competitive Advantage?
Determinants of National Competitive Advantage: Porter’s Diamond
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This Figure shows the four factors that comprise Michael Porter’s Diamond of Competitive Advantage.
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What is Porter’s Diamond of Competitive Advantage?
Michael Porter tried to explain how a nation achieves international success in a particular industry
He identified four attributes that promote the creation of competitive advantage
Factor endowments - a nation’s position in factors of production necessary to compete in a given industry
can lead to competitive advantage
can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how)
Demand conditions - the nature of home demand for the industry’s product or service
influences the development of capabilities
sophisticated and demanding customers pressure firms to be competitive
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Have you ever wondered why some countries have certain industries that seem to be superior to those of other countries? Why for example, is Japan so strong in the global auto industry? Why does Switzerland dominate the pharmaceutical industry?
These are questions that intrigued Michael Porter, who in 1990, believing that the theories at the time still left gaps in our understanding of trade patterns, tried to explain why a country might achieve international success in a particular industry.
Porter identified four factors that he argued promoted or impeded the creation of competitive advantage in an industry.
Together, he called these factors the diamond of competitive advantage.
The first factor, called factor endowments, refers to a country’s position in the factors of production that can lead to a competitive advantage.
Here Porter included things like the skilled labor or infrastructure that were important to achieving a competitive advantage in a particular industry.
Demand conditions, the second factor, refers to the nature of home demand for the industry’s product or service.
Porter argued that sophisticated and demanding customers pressured firms to be more competitive.
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What is Porter’s Diamond of Competitive Advantage?
Relating 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
different management ideologies affect the development of national competitive advantage
vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features
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The third factor, relating and supporting industries, refers to the presence or absence of supplier and related industries that are internationally competitive and contribute to other industries.
According to Porter, successful industries will be grouped in clusters in countries, so if a country has world class manufacturers of semi-conductor processing equipment, it will tend to have a competitive semi-conductor industry.
Finally, the fourth factor, firm strategy, structure, and rivalry, refers to the conditions in the nation that govern how companies are created, organized, and managed, and the nature of domestic rivalry.
Porter suggest that when domestic rivalry is strong, there’s greater pressure to innovate, improve quality, reduce costs, and invest in advanced product features.
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Porter’s Theory and Government Role
Government policy can
affect demand through product standards
influence rivalry through laws and regulation
impact the availability of highly educated workers and advanced transportation infrastructure.
The four attributes and government policy in combination create the conditions appropriate for competitive advantage
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Was Porter successful at increasing our understanding of trade patterns?
Porter argued that a nation’s success in an industry is a function of the combined impact of the four points on his diamond.
He also suggested that government could play a role.
For example, government imposed subsidies could affect factor endowments, or by imposing local product standards, a government could change demand conditions.
Rivalry among firms could be influenced by antitrust laws, and so on.
If his arguments are correct, his model ought to predict the patterns of trade we see in the real world.
Unfortunately, at this time, his theory hasn’t been well tested. While it seems to make sense, without empirical testing, we really don’t know.
Remember that the Heckscher Ohlin theory made sense, until Leontief decided to test it, that is!
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What are the Implications of Trade Theory for Managers?
Location implications - a firm should disperse its various productive activities to those countries where they can be performed most efficiently.
firms that do not, may be at a competitive disadvantage
First-mover implications - a first-mover advantage can help a firm dominate global trade in that product
Policy implications - firms should work to encourage governmental policies that support free trade
firms should lobby the government to adopt policies that have a favorable impact on each component of the diamond
according to Porter, government should invest in education, infrastructure, and basic research
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What can managers learn from the various theories of trade?
Well, there are three key points: location implications, first-mover implications, and policy implications.
Let’s look at each one beginning with location implications.
The theories that we’ve discussed point out that countries have particular advantages for different productive activities. Remember for example, that China’s low cost work force makes it a better place to produce textiles than the U.S.
So, there is a link between the theories and the decision of where to locate productive activities. Firms should disperse their productive activities to those countries where they are most efficient.
The theories also tell us that first-mover advantages can be critical to success in some industries. Being a first mover in an industry can have important competitive implications, especially in industries where economies of scale are critical and the global industry can only support a few companies.
Third, there is a link between trade theory and government policy. A government’s policy on free trade has important implications for a firm’s global competitiveness.
Firms can influence government policy decisions through government lobbying. U.S. steel producers for example, have been successful in influencing government policy.
Keep in mind, that while the actions of these industries may help the firms within the industry, the decisions that are made as a result of their influence are not always beneficial to the country as a whole!
For example, while the steel industry was successful at getting protection from foreign competition in the early 2000s, the higher prices that resulted from the protection meant that the auto industry suffered.
Finally, remember, that no one theory explains all trade patterns, but taken together, they help us understand what’s happening in the world today.
