In this chapter, we explore international trade in goods and services. We begin by examining the benefits, volume, and patterns of international trade. We then explore a number of important theories that attempt to explain why nations trade with one another.

From Bentonville to Beijing

In 1991 Walmart first became an international company.

Ambitious global expansion:

Walmart has around 5,300 stores in the United States and more than 6,200 stores in 27 other countries.

Nearly $486 billion in sales globally.

Walmart is one of the world’s largest companies.

Walmart sources inexpensive merchandise from low-cost production locations such as China.

Helping boost international trade.

Walmart (www.walmart.com) first became an international company in 1991 when it built a new store near Mexico City, Mexico.

Today, Walmart has around 5,300 stores in the United States and more than 6,200 stores in 27 other countries.

With nearly $486 billion in sales globally, Walmart is one of the world’s largest companies.

Ambitious global expansion by Walmart (and similar firms) is helping boost international trade. To fulfill its promise to deliver the lowest priced goods around the world, Walmart sources inexpensive merchandise from low-cost production locations such as China.

The actions of Walmart and other global firms have propelled world exports of goods and services to record levels.

Growth in international trade is increasing interdependence between China and other nations.

Benefits, Volume, and Patterns of International Trade (1 of 4)

International Trade: Purchase, sale, or exchange of goods and services across national borders

Benefits of International Trade:

Greater choice of goods and services

Important engine for job creation in many countries

International trade provides a country’s people with a greater choice of goods and services.

International trade is also an important engine for job creation in many countries. The U.S. Department of Commerce (www.commerce.gov) calculates that for every $1 billion increase in exports, 22,800 jobs are created in the United States.

Benefits, Volume, and Patterns of International Trade (2 of 4)

Volume of International Trade

Table 5.1 World’s Top Exporters

World’s Top Merchandise Exporters

Rank	Exporter	Value (U.S. $ billions)	Share of World Total (%)
1	China	2,275	13.8
2	United States	1,505	9.1
3	Germany	1,329	8.1
4	Japan	625	3.8
5	Netherlands	567	3.4
6	South Korea	527	3.2
7	Hong Kong	511	3.1
8	France	506	3.1
9	United Kingdom	460	2.8
10	Italy	459	2.8

World’s Top Service Exporters

Rank	Exporter	Value (U.S. $ billions)	Share of World Total (%)
1	United States	690	14.5
2	United Kingdom	345	7.3
3	China	285	6.0
4	Germany	247	5.2
5	France	240	5.0
6	Netherlands	178	3.7
7	Japan	158	3.3
8	India	155	3.3
9	Singapore	139	2.9
10	Ireland	128	2.7

Source: Based on International Trade Statistics 2013 (Geneva: World Trade Organization, November 2013), Tables I.7 and I.9, available at www.wto.org .

The value and volume of international trade continues to increase. Today, world merchandise exports are valued at more than $16.5 trillion, and service exports are worth more than $4.8 trillion. Table 5.1 shows the world’s largest exporters of merchandise and services. Perhaps not surprisingly, the United States ranks first in commercial services exports and ranks second in merchandise exports (behind China).

Benefits, Volume, and Patterns of International Trade (4 of 4)

Trade Interdependence

Trade among most nations is characterized by a degree of interdependency.

Trade dependency has been a blessing for many Central and Eastern European nations.

The dangers of trade dependency become apparent when a nation experiences economic recession or political turmoil.

Trade among most nations is characterized by a degree of interdependency. Companies in developed nations trade a great deal with companies in other developed nations.

The level of interdependency between pairs of countries often reflects the amount of trade that occurs between a company’s subsidiaries in the two nations. Emerging markets that share borders with developed countries are often dependent on their wealthier neighbors.

Trade dependency has been a blessing for many Central and Eastern European nations.

The dangers of trade dependency become apparent when a nation experiences economic recession or political turmoil, which then harms dependent nations.

Most of world merchandise trade is composed of trade in manufactured goods. The dominance of manufactured goods in the trade of merchandise has persisted over time and will likely continue to do so.

The reason is its growth is much faster than trade in the two other classifications of merchandise—mining and agricultural products.

Trade in services accounts for around 22 percent of total world trade.

Although the importance of trade in services is growing for many nations, it tends to be relatively more important for the world’s richest countries.

There has been a persistent pattern of merchandise trade among nations.

Trade between the world’s high-income economies accounts for roughly 60 percent of total world merchandise trade.

Two-way trade between high-income countries and low- and middle-income nations accounts for about 34 percent of world merchandise trade.

Meanwhile, merchandise trade between low- and middle-income nations accounts for only about 6 percent of total world trade.

These figures reveal the low purchasing power of the world’s poorest nations and indicate their general lack of economic development.

Asia’s role in merchandise trade is increasing as the region’s economies continue to expand. Some economists call this century the “Pacific century,” referring to the expected growth of Asian economies and the resulting shift in the majority of trade flows from the Atlantic Ocean to the Pacific. It will be increasingly important for managers to understand the varying and rich cultures in Asia.

For some pointers on doing business in Pacific Rim nations, see this chapter’s Culture Matters feature, titled “Business Culture in the Pacific Rim.”

See the latest issue of the IMF magazine “Finance and Development” - SEPTEMBER 2018 ISSUE | SOUTHEAST ASIA: REGION ON THE RISE https :// www.imf.org/external/pubs/ft/fandd/index.htm

International Trade Theories

Trade between different groups of people has occurred for many thousands of years. But it was not until the fifteenth century that people began trying to explain why trade occurs and how trade can benefit both parties to an exchange.

Figure 5.1 shows a timeline of when the main theories of international trade were proposed.

International Trade Theories: Basics

Theory of Competitive Advantage: Specialization increases production efficiency.

Imperfect Markets Theory: Factors of production are somewhat immobile, providing incentive to seek out foreign opportunities.

Product Cycle Theory: As a firm matures, it recognizes opportunities outside its domestic market.

Mercantilism (1 of 3)

Figure 5.1 Trade Theory Timeline

Trade between different groups of people has occurred for many thousands of years. But it was not until the fifteenth century that people tried to explain why trade occurs and how trade can benefit both parties to an exchange. Figure 5.1 shows a timeline of when the main theories of international trade were proposed.

Mercantilism (2 of 3)

How Mercantilism Worked

Mercantilism: Trade theory that nations should accumulate financial wealth, usually in the form of gold, by encouraging exports and discouraging imports

Three Pillars

Maintain Trade Surplus

Government Intervention

Colonialism

The trade theory that nations should accumulate financial wealth, usually in the form of gold, by encouraging exports and discouraging imports is called mercantilism.

Trade Surpluses: Nations believed they could increase their wealth by maintaining a trade surplus—the condition that results when the value of a nation’s exports is greater than the value of its imports. In mercantilism, a trade surplus means that a country takes in more gold on the sale of its exports than it pays out for its imports. A trade deficit is the opposite

Government Intervention: According to mercantilism, the accumulation of wealth depends on increasing a nation’s trade surplus, not necessarily expanding its total value or volume of trade. The governments of mercantilist nations did this by either banning certain imports or imposing various restrictions on them, such as tariffs or quotas. At the same time, the nations subsidized industries based in the home country in order to expand exports. Governments also typically outlawed the removal of their gold and silver to other nations.

Colonialism: Mercantilist nations acquired territories (colonies) around the world to serve as sources of inexpensive raw materials and as markets for higher-priced finished goods. These colonies were the source of essential raw materials, including tea, sugar, tobacco, rubber, and cotton. These resources would be shipped to the mercantilist nation, where they were incorporated into finished goods such as clothing, cigars, and other products. These finished goods would then be sold to the colonies. Trade between mercantilist countries and their colonies was a huge source of profits for the mercantilist powers. The colonies received low prices for basic raw materials but paid high prices for finished goods.

It states that other measures of a nation’s well-being, such as living standards or human development, are irrelevant.

Nation-states in Europe followed this economic philosophy from about 1500 to the late 1700s.

The most prominent mercantilist nations included Britain, France, the Netherlands, Portugal, and Spain.

Mercantilism (3 of 3)

Flaws of Mercantilism

World trade is a zero-sum game.

Mercantilist nations believed that the world’s wealth was limited and that a nation could increase its share of the pie only at the expense of its neighbors—a situation called a zero-sum game.

Restricts international trade

The main problem with mercantilism is that, if all nations were to barricade their markets from imports and push their exports onto others, international trade would be severely restricted.

Limits colonies’ market potential

Mercantilism has several inherent flaws:

First, it views international trade as a zero-sum game. This is the idea that a nation benefits from trade only at the expense of other nations.

Second, If all nations were to barricade their markets from imports and push their exports onto others, international trade would be severely restricted.

Third, market potential in the colonies was less than it could have been had people there received higher prices for their resources.

Theories of Absolute and Comparative Advantage

Scottish economist Adam Smith first put forth the trade theory of absolute advantage in 1776.

The ability of a nation to produce a good more efficiently than any other nation is called an absolute advantage.

In other words, a nation with an absolute advantage can produce a greater output of a good or service than other nations using the same amount of, or fewer, resources.

Among other things, Smith reasoned that international trade should not be banned or restricted by tariffs and quotas but allowed to flow as dictated by market forces.

Theories of Absolute and Comparative Advantage (1 of 5)

Absolute Advantage: Ability of a nation to produce a good more efficiently than any other nation

Blank	Units Required for Production Rice	Units Required for Production Tea
Riceland	1	5
Tealand	6	3

Another way of stating each nation’s efficiency in the production of rice and tea is:

In Riceland, 1 unit of resources =

In Tealand, 1 unit of resources =

Case—Riceland and Tealand: Assume that Riceland and Tealand produce rice and tea, transporting goods costs nothing, and each nation produces and consumes its own rice and tea.

In Riceland, one resource unit produces one ton of rice or one-fifth of a ton of tea.

In Tealand, one resource unit produces one-sixth ton of rice or one-third ton of tea.

This means that Riceland has an absolute advantage in rice production and Tealand has an absolute advantage in tea production.

Theories of Absolute and Comparative Advantage (2 of 5)

Specialization and trade:

+ Riceland gets five times more tea than it would have produced itself.

+ Tealand gets two times more rice than it would have produced itself.

Figure 5.2 Gains from Specialization and Trade: Absolute Advantage

Assume that Riceland and Tealand expend additional resource units to produce extra rice and tea, respectively, and then trade additional output with the other nation on a one-to-one basis.

This means that Riceland expends an additional resource unit to produce one extra ton of rice that it then trades with Tealand to obtain one ton of tea. Riceland gets four-fifths of a ton more tea than the one-fifth of a ton it would have produced itself with one additional resource unit.

Tealand expends an additional resource unit to produce an extra one-third of a ton of tea that it then trades with Riceland to obtain one-third of a ton of rice. Tealand gets one-sixth of a ton more rice than the one-sixth of a ton it would have produced itself with one additional resource unit.

Specialization and trade gives Riceland five times more tea than it would have produced itself, and gives Tealand two times more rice than it would have produced itself.

This means that if each country specializes in the area in which it has an absolute advantage, world output (and consumption) of both goods increases. In other words, each nation benefits from specialization and trade.

As this example shows, the theory of absolute advantage destroys the mercantilist idea that international trade is a zero-sum game. Instead, because there are gains to be had by both countries party to an exchange, international trade is a positive-sum game. The theory also calls into question the objective of national governments to acquire wealth through restrictive trade policies. It argues that nations should instead open their doors to trade so that their people can obtain a greater quantity of goods more cheaply. The theory does not measure a nation’s wealth by how much gold and silver it has on reserve but by the living standards of its people.

Despite the power of the theory of absolute advantage in showing the gains from trade, there is one potential problem. What happens if a country does not hold an absolute advantage in the production of any product? Are there still benefits to trade, and will trade even occur? To answer these questions, let’s take a look at an extension of absolute advantage: the theory of comparative advantage.

Theories of Absolute and Comparative Advantage

An English economist named David Ricardo developed the theory of comparative advantage in 1817. He proposed that if one country (in our example of a two-country world) held absolute advantages in the production of both products, specialization and trade could still benefit both countries.

A country has a comparative advantage when it is unable to produce a good more efficiently than other nations but produces the good more efficiently than it does any other good. In other words, trade is still beneficial even if one country is less efficient in the production of two goods, as long as it is less inefficient in the production of one of the goods.

Theories of Absolute and Comparative Advantage (3 of 5)

Comparative Advantage: Inability of a nation to produce a good more efficiently than other nations but an ability to produce that good more efficiently than it does any other good

Blank	Units Required for Production Rice	Units Required for Production Tea
Riceland	1	2
Tealand	6	3

Another way of stating each nation’s efficiency in the production of rice and tea is:

In Riceland, 1 unit of resources =

In Tealand, 1 unit of resources =

Comparative advantage is the inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other good.

This means that a country is less efficient in the production of all goods, but it is less inefficient in the production of one good.

Again, assume two countries, two products, and transporting goods costs nothing.

In Riceland, one resource unit produces one ton of rice or one-half of a ton of tea.

In Tealand, one resource unit produces one-sixth of a ton of rice or one-third of a ton of tea.

This means that Riceland has absolute advantages in both goods because it is more efficient at producing each one.

However, Tealand has a comparative advantage in tea production because it produces tea more efficiently than it produces rice.

Theories of Absolute and Comparative Advantage (4 of 5)

Specialization and trade:

+ Riceland gets two times more tea than it would have produced itself.

+ Tealand gets two times more rice than it would have produced itself.

Figure 5.3 Gains from Specialization and Trade: Comparative Advantage

Comparative advantage is the inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other good.

This means that a country is less efficient in the production of all goods, but it is less inefficient in the production of one good.

Again, assume two countries, two products, and transporting goods costs nothing.

In Riceland, one resource unit produces one ton of rice or one-half of a ton of tea.

In Tealand, one resource unit produces one-sixth of a ton of rice or one-third of a ton of tea.

This means that Riceland has absolute advantages in both goods because it is more efficient at producing each one.

However, Tealand has a comparative advantage in tea production because it produces tea more efficiently than it produces rice.

Theories of Absolute and Comparative Advantage (5 of 5)

Assumptions and Limitations

Nations strive only to maximize production and consumption.

Only two countries produce and consume just two goods.

No transportation costs of traded goods.

Labor is the only resource used to produce goods and it cannot cross borders.

Specialization does not create efficiency and improvement gains.

The theories of absolute and comparative advantage focus on production efficiency, or productivity. Despite their powerful predictive capabilities, these theories are limited.

They assume that nations strive only to maximize production and consumption. But governments get involved in trade for many reasons, including a concern for workers’ jobs.

They assume that only two countries produce and consume two goods. But more than 180 countries and countless products are produced, traded, and consumed.

They assume that it costs nothing to transport goods. But transportation costs are a major expense of international trade.

They assume that labor is the only resource used to produce goods and that it cannot cross borders. But production clearly needs additional resources and labor is increasingly mobile.

And they assume that specialization does not create efficiency gains. But specialization actually increases knowledge of a task and causes future improvements.

Factor Proportions Theory (1 of 2)

Factor Proportions Theory: Trade theory stating that countries produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply

Factor proportions theory resulted from the research of two economists, Eli Heckscher and Bertil Ohlin, and is therefore sometimes called the Heckscher–Ohlin theory.

Factor proportions theory differs considerably from the theory of comparative advantage. Whereas the theory of comparative advantage focus on the productivity of the production process for a particular good, factor proportions theory says that a country specializes in producing and exporting goods using the factors of production that are most abundant and thus cheapest—not the goods in which it is most productive.

Labor versus Land and Capital Equipment

Factor proportions theory breaks a nation’s resources into two categories: labor on the one hand, land and capital equipment on the other. It predicts that a country will specialize in products that require labor if the cost of labor is low relative to the cost of land and capital. Alternatively, a country will specialize in products that require land and capital equipment if their cost is low relative to the cost of labor.

Factor Proportions Theory (2 of 2)

The Leontief Paradox

The Apparent Paradox

Leontief found evidence opposite of that predicted by the factor proportions theory.

U.S. exports require more labor-intensive production than U.S. imports.

Leontief’s findings are supported by more-recent research.

Paradox between the predictions using the factor proportions theory and the actual trade flows

What might account for the paradox?

Factor proportions theory assumes nation’s production factors to be homogeneous.

Factor proportions theory seems to be supported when expenditures on labor are taken into account.

Evidence on Factor Proportions Theory: The Leontief Paradox

Despite its conceptual appeal, factor proportions theory is not supported by studies that examine the trade flows of nations. The first large-scale study to document such evidence was performed by a researcher named Wassily Leontief in the early 1950s. Leontief tested whether the United States, which uses an abundance of capital equipment, exports goods requiring capital-intensive production and imports goods requiring labor-intensive production. Contrary to the predictions of the factor proportions theory, his research found that U.S. exports require more labor-intensive production than its imports. This apparent paradox between the predictions using the theory and the actual trade flows is called the Leontief paradox. Leontief’s findings are supported by more-recent research on the trade data of a large number of countries.

What might account for the paradox? One possible explanation is that factor proportions theory considers a country’s production factors to be homogeneous—particularly labor. But we know that labor skills vary greatly within a country—more highly skilled workers emerge from training and development programs. When expenditures on improving the skills of labor are taken into account, the theory seems to be supported by actual trade data. Further studies examining international trade data will help us better understand what reasons actually account for the Leontief paradox.

Because of the drawbacks of each of the international trade theories mentioned so far, researchers continue to propose new ones. Let’s now examine a theory that attempts to explain international trade based on the life cycle of products.

International Product Life Cycle (1 of 2)

Stages of the Product Life Cycle

International Product Life Cycle: Theory stating that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its life cycle

Figure 5.4 International Product Life Cycle

Raymond Vernon put forth an international trade theory for manufactured goods in the mid-1960s. His international product life cycle theory says that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its life cycle. The theory also says that, for a number of reasons, a country’s export eventually becomes its import.

The international product life cycle theory follows the path of a good through its life cycle (from new to maturing to standardized product) in order to determine where it will be produced (see Figure 5.4).

In Stage 1, the new product stage, the high purchasing power and demand of buyers in an industrialized country drive a company to design and introduce a new product concept. Because the exact level of demand in the domestic market is highly uncertain at this point, the company keeps its production volume low and based in the home country.

In Stage 2, the maturing product stage, the domestic market and markets abroad become fully aware of the existence of the product and its benefits. Demand rises and is sustained over a fairly lengthy period of time. As exports begin to account for an increasingly greater share of total product sales, the innovating company introduces production facilities in the countries with the highest demand. Near the end of the maturity stage, the product begins generating sales in developing nations, and perhaps some manufacturing presence is established there.

In Stage 3, the standardized product stage, competition from other companies selling similar products pressures companies to lower prices in order to maintain sales levels. As the market becomes more price sensitive, the company begins searching aggressively for low-cost production bases in developing nations to supply a growing worldwide market. Furthermore, as most production now takes place outside the innovating country, demand in the innovating country is supplied with imports from developing countries and other industrialized nations. Late in this stage, domestic production might even cease altogether.

International Product Life Cycle (2 of 2)

Vernon developed his model around the United States.

The theory’s ability to accurately depict the trade flows of nations is weak.

The United States is no longer the sole innovator of products in the world.

Today, there is quicker product obsolescence.

Older theories might better explain today’s global trade patterns.

The theory seemed to explain world trade patterns quite well when the United States dominated world trade. But today, the theory’s ability to accurately depict the trade flows of nations is weak.

The United States is no longer the sole innovator of products in the world. New products spring up everywhere as companies continue to globalize their research-and-development activities.

Furthermore, companies today design new products and make product modifications at a very quick pace. The result is quicker product obsolescence and a situation in which companies replace their existing products with new product introductions.

In fact, older theories might better explain today’s global trade patterns. Much production in the world today more closely resembles what is predicted by the theory of comparative advantage.

New Trade Theory - is a collection of economic models in international trade which focuses on the role of increasing returns to scale and network effects, which were developed in the late 1970s and early 1980s.

Fundamentals

Gains from specialization and increasing economies of scale

Barriers to entry

Role of government

First-Mover Advantage

Economic and strategic advantage

Formidable barrier to market entry for potential rivals

Country’s export and home-based firm

The new trade theory states that (1) there are gains to be made from specialization and increasing economies of scale, (2) the companies first to market can create barriers to entry, and (3) government may play a role in assisting its home companies. Because the theory emphasizes productivity rather than a nation’s resources, it is in line with the theory of comparative advantage but at odds with factor proportions theory.

A first-mover advantage is the economic and strategic advantage gained by being the first company to enter an industry. This first-mover advantage can create a formidable barrier to entry for potential rivals. The new trade theory also states that a country may dominate in the export of a certain product because it has a home-based firm that has acquired a first-mover advantage.

National Competitive Advantage – Porter Diamond

Factor Conditions

Basic Factors

Advanced Factors

Demand Conditions

Sophisticated Buyers

Related and Supporting Industries

Clusters

Firm Strategy, Structure, and Rivalry

Competitiveness

Government and Chance

Role of Government

Chance Events

Michael Porter put forth a theory in 1990 to explain why certain countries are leaders in the production of certain products. His national competitive advantage theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade.

Michael Porter identifies four elements that are present to varying degrees in every nation and that form the basis of national competitiveness. The Porter diamond consists of (1) factor conditions, (2) demand conditions, (3) related and supporting industries, and (4) firm strategy, structure, and rivalry.

Factor Conditions: Porter acknowledges the value of a nation’s resources, which he terms basic factors, but he also discusses the significance of what he calls advanced factors. Advanced factors include the skill levels of different segments of the workforce and the quality of the technological infrastructure in a nation.

Demand Conditions: Sophisticated buyers in the home market are also important to national competitive advantage in a product area. A sophisticated domestic market drives companies to add new design features to products and to develop entirely new products and technologies.

Related and Supporting Industries: Supporting industries spring up to provide the inputs required by the industry.

Firm Strategy, Structure, and Rivalry: Essential to successful companies is the industry structure and rivalry between a nation’s companies. The more intense the struggle to survive between a nation’s domestic companies, the greater will be their competitiveness.

Government and Chance: Apart from the four factors identified as part of the diamond, Porter identifies the roles of government and chance in fostering the national competitiveness of industries. First, governments, by their actions, can often increase the competitiveness of firms and perhaps even entire industries. Second, although chance events can help the competitiveness of a firm or an industry, it can also threaten it.

1 ton of rice or ton of tea

ton of rice or ton of tea

1 ton of rice or ton of tea