Assignment 2.2 International Business

MGMK 4710

INTERNATIONAL BUSINESS

Chapter 6. INTERNATIONAL TRADE

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I. INTRODUCTION

Trade theory helps managers and government policymakers focus on three critical questions: What products should be imported and exported, how much should be traded, and with whom should they trade? There are two sets of trade theories: Interventionist theories and free trade theories. While interventionist theories suggest that governments should influence trade, free trade theories suggest a laissez-faire treatment of trade.

II. INTERVENTIONIST THEORIES

Interventionist trade theories prescribe government action in international trade. The most discussed interventionist theory is mercantilism. The concept of mercantilism served as the foundation of economic thought for nearly three hundred years (1500–1800). It purports that a country’s wealth is measured by its holdings of “treasure” (usually gold).

1. Governmental Policies. To export more than they imported, governments-imposed restrictions on most imports and they subsidized products for export.

2. The Concept of Balance of Trade . To amass a surplus (a favorable balance of trade), a country must export more than it imports and then collect gold and other forms of wealth from countries that run a deficit (an unfavorable balance).

III. FREE TRADE THEORIES

The concept of free trade purports that nations should neither artificially limit imports nor artificially promote exports. Free trade implies specialization. Nations as a whole specialize in the production of certain products, some consumed domestically, and some exported; export earnings can then in turn be used to pay for imported goods and services.

A. Theory of Absolute Advantage

In 1776 Adam Smith asserted that the wealth of a nation consisted of the goods and services available to its citizens. His theory of absolute advantage holds that a country can maximize its own economic well being by specializing in the production of those goods and services that it can produce more efficiently than any other nation and enhance global efficiency through its participation in (unrestricted) free trade.

B. Theory of Comparative Advantage

In 1817 David Ricardo reasoned that if a country has absolute advantage in several goods, it would still gain from trade if it specializes in the production of those goods it can produce relatively most efficiently. Ricardo’s theory of comparative advantage holds that such specialization will enhance global efficiency through its participation in (unrestricted) free trade. Assume that the United States is more efficient than Costa Rica in the production of both wheat and coffee (absolute advantage). However, the U.S. has a comparative advantage in wheat production (compared to coffee). By concentrating on the production of the product in which it has the greater advantage (wheat) and allowing Costa Rica to produce the product in which the United States is comparatively less efficient (coffee), global output can be increased, and specialization and trade will benefit both countries.

C. Theories of Specialization: Some Assumptions and Limitations

The theories of absolute and comparative advantage make certain assumptions that may not always be valid.

1. Full Employment. Both theories (absolute and comparative advantage) assume that resources are fully employed. When countries have many unemployed or underemployed resources, they may seek to restrict imports in order to employ or use idle resources.

2. Economic Efficiency. Individuals and countries often pursue objectives other than economic efficiency. Individuals may prefer activities and/or occupations that are economically less productive, and nations may choose to avoid overspecialization because of the vulnerability created by potential changes in technology and price fluctuations.

3. Two Countries, Two Commodities. Absolute and comparative advantage theories use the example of two countries and two commodities, or products, to explain trade gains. The analysis becomes more complex when 200 countries trading thousands of products are presented.

4. Transport Costs. If it costs more to deliver products than can be saved via specialization, then the gains from trade are negated.

5. Mobility. Neither the assumption that resources can move domestically from the production of one good to another at no cost, nor the assumption that resources cannot move internationally, is entirely valid. Nonetheless, domestic mobility is greater than the international mobility of resources. Clearly, the movement of resources such as capital and labor is a very real alternative to trade.

IV. OTHER TRADE THEORIES

The explanatory power of the theories of absolute and comparative advantage have their limits. Apart from nontradable goods, i.e., goods and services that are impractical to export, country size helps to explain why some countries are more dependent on trade than others and why some account for larger portions of world trade than others. There are other trade theories.

A. Factor-Proportions Theory.

Developed by Eli Heckscher and Bertil Ohlin, the factor-proportions theory holds that (i) differences in a country’s relative endowments of land, labor, and capital explain differences in the cost of production factors and (ii) a country will tend to export products that utilize relatively abundant factors of production because they are relatively cheaper than scarce factors. Leontieff however pointed out that even though the US is abundant in capital, its exports were more labor-intensive. This came to be known as the Leontieff paradox.

B. Country-Similarity Theory.

The country-similarity theory states that when a firm develops a new product in response to observed conditions in its home market, it is likely to turn to those foreign markets that are most similar to its domestic market when commencing its initial international expansion activities. So much trade takes place among industrialized countries because of the growing importance of acquired advantages, i.e., skills and technology. In addition, markets in most industrialized countries are large enough to support new product introductions and the subsequent variants across the product life cycle. At the same time, trade in differentiated products occurs because over time firms in different countries develop product variants for particular market segments. Cultural similarity also facilitates trade. In particular, a common language and a common religion represent two major facilitators of the international trade and investment process. Historical and political relationships, as well as economic agreements, may encourage or discourage trade with particular countries.

C. Product Life Cycle (PLC) Theory

Product life cycle theory states that the optimal location for the production of certain types of goods and services shifts over time as they pass through the stages of market introduction, growth, maturity, and decline.

1. Introduction: A great majority of the new technology that results in new products and production methods originates in developed countries. Innovation, production, and sales occur in the domestic (innovating) country. Because the product is not yet standardized, the production process tends to be relatively labor-intensive, and innovative customers tend to accept relatively high introductory prices.

2. Growth: As demand grows, competitors enter the market. Foreign demand, competition, exports, and direct investment activities also begin to accelerate.

3. Maturity: Worldwide demand begins to level off, although it may be growing in some countries and declining in others. Production processes are relatively standardized and global price competition forces production site relocation to lower-cost developing countries.

4. Decline: Market factors and cost pressures dictate that almost all production occurs in developing countries. The product is then imported by the country where it was initially developed—the importing firm may or may not be the innovating firm.

D. The Diamond of National Advantage

Introduced by Michael Porter, the diamond of national advantage theorizes that national competitive advantage is embedded in four determinants: (i) factor conditions, (ii) demand conditions, (iii) related and supporting industries, and (iv) firm strategy, structure, and rivalry:

1. Factor conditions: Resource availability (inputs, labor, capital, and technology) contributes to the competitiveness of both firms and countries that compete in particular industries.

2. Demand conditions: The nature and level of demand in the home market lead to the establishment of production facilities to meet that demand.

3. Related and supporting industries: The local presence of internationally competitive suppliers and other related industries contributes to both the cost effectiveness and strategic competitiveness of firms.

4. Firm strategy, structure, and rivalry: The creation and persistence of national competitive advantage requires leading-edge product and process technologies and business strategies.

VI. V. FACTOR-MOBILITY THEORY

Over time factor conditions change in both quality and quantity. Furthermore, the mobility of capital, technology, and people also affect the relative capabilities of countries. Factor-mobility theory concerns the free movement of factors of production, such as labor and capital, across national borders. Free movement can affect trade. Neither international capital nor population movements are new occurrences.

Immigrants bring human capital, thus adding to the base of a country’s skills and enabling competition in new areas. Countries lose potentially productive resources when educated people leave, a situation known as brain drain, but they may in turn gain from the remittances that citizens who are working abroad send home. Countries receiving human resources may also incur the cost of social services for acculturating people into a new culture and language.

Inflows of capital to those same countries can be used to develop infrastructure and natural resources and other acquired advantages, thus enabling increased participation in the international trade arena. Factor mobility via foreign direct investment may in fact stimulate foreign trade because of the need for equipment or subsidiaries, components, and/or complementary products in the destination country. Alternatively, trade may be restricted by local content laws, or when foreign direct investment leads to import substitution.