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International Business
Environments & Operations

15e

Daniels ● Radebaugh ● Sullivan

International Business Environments and Operations 15e by Daniels, Radebaugh, and Sullivan

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Chapter 5

International Trade and Factor-Mobility Theory

Chapter 5: International Trade and Factor Mobility

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Learning Objectives

Understand how different approaches to international trade theories help policy makers achieve economic objectives
Comprehend the historical and current rationale for interventionist trade theories
Explain how free trade improves global efficiency
Distinguish factors affecting national trade patterns

The Learning Objectives for this chapter are

To understand theories of international trade
To explain how free trade improves global efficiency
To identify factors affecting national trade patterns
To explain why a country’s export capabilities are dynamic
To understand why production factors, especially labor and capital, move internationally
To explain the relationship between foreign trade and international factor mobility

Learning Objectives

Recognize why a country’s export capabilities are dynamic
Detect why production factors, especially labor and capital, move internationally
Describe the relationship between foreign trade and international factor mobility
Grasp scenarios of possible changes in trade patterns

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Introduction

Learning Objective:

Understand how different approaches to international trade theories help policy makers achieve economic objectives

Learning Objective : To understand theories of international trade.

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Laissez-Faire vs. Intervention

Trade theory helps answer
What products should we import and export?
How much should we trade?
With whom should we trade?
Laissez-faire approach
Free trade theories – absolute advantage and comparative advantage
Intervention approach
Mercantilism and neomercantilism

Why do countries trade? Countries trade in order to meet certain economic objectives, but they struggle with questions on what, how much, and with whom they should trade. They need to ensure that their decisions on what to produce make sense from an efficiency standpoint, and whether there are ways to improve competitiveness.

Some countries allow market forces to determine trade relations, others intervene to control the process.

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Laissez-Faire vs. Intervention

International Operations and Economic Connections

This Figure shows that trade in goods and services and the movement of the production factors are the means by which countries are linked internationally.

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Theories of Trade Patterns

Theories explore
country size
factor proportions
country similarity
Theories explore trade competitiveness
Product life cycle
Diamond of national advantage

Theories that explain trade patterns explore how much countries depend on trade, in what products, and with which countries. Some theories suggest that governments should influence trade patterns, other support a laissez-faire approach.

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Trade Theories and Business

What Major Trade Theories Do and Don’t Discuss: A Checklist

This Figure shows the major trade theories and their emphases. Managers can use the theories to predict and understand how government policy decisions could affect business competitiveness.

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Factor Mobility Theory

A country’s competitiveness depends on
quality and quantity of production factors
Land
Labor
Capital

Factor mobility is also an important issue in trade because it influences a nation’s competitiveness. The three factors of production are land, labor, and capital.

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Interventionist Theories

Theories that support government intervention in the flow of trade
Mercantilism
Neomercantilism

Some theories including mercantilism and neomercantilism explore how governments can interfere with trade flows in order to achieve certain national objectives.

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Mercantilism

Mercantilism countries should export more than they import
Maintain a favorable balance of trade
trade surplus
Avoid an unfavorable balance of trade
trade deficit

The mercantilist theory suggests that countries should try to achieve a favorable balance of trade. This theory was the basis of economic thought from 1500 to 1800.

Under mercantilism, governments restricted imports and subsidized the production of goods that would otherwise not be competitive in domestic or export markets.

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Neomercantilism

Neomercantilism run an export surplus to achieve social or political objectives

Countries with a neomercantilist approach seek a favorable balance of trade, but do so in order to achieve some social or political objective.

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Free Trade Theories

Two theories that support free trade
Absolute advantage theory
Comparative advantage theory
Market forces should determine trade
specialization

Why shouldn’t countries just be self-sufficient? According to the theories of absolute and comparative advantage, specializing in the things a country does best and trading for everything else can be beneficial.

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Theory of Absolute Advantage

Theory of absolute advantage
different countries produce some goods more efficiently than others
Free trade brings
Specialization
natural advantage
acquired advantage

product technology

process technology

Greater efficiency
Higher global output

Adam Smith’s theory of absolute advantage suggested that a nation’s wealth is based on its available goods and services rather than on gold. Therefore, if trade is unrestricted, a country can specialize in what it can produce most efficiently, and trade for everything else.

Consumers benefit from free trade and specialization with lower prices and more choices.

A country’s advantage in the production of a particular good may be a result of a natural advantage like climate, or an acquired advantage like technology.

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Theory of Absolute Advantage

Production Possibilities under Conditions of Absolute Advantage

This Figure illustrates the production possibilities for two countries under the conditions of absolute advantage. Notice that with free trade and specialization both countries benefit.

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Theory of Comparative Advantage

Theory of comparative advantage
free trade can increase global output even if one country has an absolute advantage in the production of all products
Consider
comparative advantage
absolute disadvantage

What happens when a country can produce all products at an absolute advantage? Well, there are still gains to be made from specialization and free trade.

David Ricardo explored this issue in 1817 and discovered that gains from trade occur even in a country that has an absolute advantage in all products because the country gives up less efficient output in order to focus on more efficient output.

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Theory of Comparative Advantage

Production Possibilities under Conditions of Comparative Advantage

This Figure illustrates the production possibilities for two countries under the conditions of comparative advantage. Notice that by specializing in the production of goods in which a country has a comparative advantage and trading for goods in which a country has an absolute disadvantage both countries still gain.

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Theories of Specialization: Assumptions and Limitations

Learning Objective:

Explain how free trade improves global efficiency

Learning Objective : To explain how free trade improves global efficiency.

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Theories of Specialization: Assumptions and Limitations

Theories of specialization make assumptions that may not be valid
full employment
economic efficiency
division of gains
transport costs
statics and dynamics
services
production networks
mobility

While the theories of specialization – absolute advantage and comparative advantage – offer policymakers a greater understanding of free trade, they are based on a number of assumptions that may not always be valid.

Specifically, the theories assume that full employment exists, that economic efficiency is the primary goal of countries, that the division of gains is acceptable to both countries, that the world is composed of only two countries and two products, that there are no transportation costs, that advantages are static, and that while resources can move freely within a country, they are immobile internationally.

Keep in mind that the theories can apply to trade in services as well as trade in products and that they apply to situations in which multi-country production takes place.

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Trade Pattern Theories

Learning Objective:

Distinguish factors affecting national trade patterns

Learning Objective : To identify factors affecting national trade patterns.

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How Much Does A Country Trade?

Theory of country size
large countries depend less on trade than small countries
Large countries usually
export a smaller portion of output and import a smaller part of consumption
have higher transportation costs for foreign trade

Every country produces so-called nontradeable goods like haircuts. When it comes to tradeable goods though, country size can be a determining factor in the production choice. Larger countries typically have more varied climates and natural resources and are usually more self-sufficient than smaller countries.

Moreover, because production and market centers in large countries are more likely to be located farther away from other countries, transportation costs are higher.

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What Types of Products Does A Country Trade?

Factor proportions theory
factors in relative abundance are cheaper than factors that are relatively scarce
But
production factors are not homogenous
labor
Process technology
capital versus labor

What types of products does a country trade? We can use the factor proportions theory to help answer that question. The theory suggests that factor costs are determined by a country’s relative endowments of land, labor, and capital. These costs then determine which goods can be produced most efficiently.

Keep in mind though that not all production factors are equal especially when it comes to labor. Moreover, how a product is produced – with capital or labor – is important as is the size of the production run required for greatest efficiency.

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What Does A Country Trade?

Worldwide Trade by Major Sectors

This Figure shows the changing composition of world trade. Most new products are developed in industrialized countries.

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With Whom Do Countries Trade?

Country similarity theory
most trade occurs among developed countries
share similar market characteristics
produce and consume much more than developing countries
Trading partners are affected by
Cultural similarity
Political relations between countries
Distance

With whom do countries trade? Well, developed countries largely trade with other developed countries. Companies create new products in response to market conditions in their home market, and then look for markets that are close to home and most similar to what they’re accustomed to.

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The Statics and
Dynamics of Trade

Learning Objective:

Recognize why a country’s export capabilities are dynamic

Learning Objective : To explain why a country’s export capabilities are dynamic.

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Product Life Cycle Theory

The product life cycle theory
the production location of certain manufactured products shifts as they go through their life cycle
Four stages
Introduction
Growth
Maturity
Decline

How do countries develop, maintain, and lose their competitive advantages? The international product life cycle theory, or PLC, offers one explanation.

According to the PLC, companies manufacture products initially in the country where they were developed and researched – typically a developed country. Later, production shifts to foreign locations, and in the later stages of the product’s life, to developing economies.

The theory is based on four stages: introduction, growth, maturity, and decline.

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Product Life Cycle Theory

Life Cycle of the International Product

This Figure provides more details on exactly what occurs at each stage in a product’s life cycle. Keep in mind that while the theory holds for many products, it does not explain all products. In fact, today, many products are introduced at home and abroad simultaneously. Moreover, because costs drive production decisions, the initial production location may or may not be in the home country.

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Diamond of National Advantage

The diamond of national advantage
Four conditions are important for gaining and maintaining competitive superiority
Factor conditions
Demand conditions
Related and supporting industries
Firm strategy, structure, and rivalry

Another theory that helps explain why some countries have developed and sustained different competitive advantages is the diamond of national advantage theory. According to this theory, four conditions must be favorable for an industry: demand conditions, factor conditions, related and supporting industries, and firm strategy, structure, and rivalry.

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Diamond of National Advantage

The Diamond of National Competitive Advantage

This Figure provides more details on each factor that makes up the diamond of national advantage. Keep in mind though, that the existence of all four factors does not guarantee that an industry will develop, nor is it necessary given globalization. For example, today, because capital and managers are internationally mobile, it may not be necessary to depend on domestic factor conditions. Similarly, thanks to freer trade and advances in transportation, local related and supporting industries are not as important.

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Factor Mobility Theory

Learning Objective:

Detect why production factors, especially labor and capital, move internationally

Learning Objective : To understand why production factors, especially labor and capital, move internationally.

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Why Production Factors Move

Factor mobility theory
focuses on why production factors move, the effects of that movement on transforming factor endowments, and the impact of international factor mobility on world trade
Capital and labor move internationally to
gain more income
flee adverse political situations

The mobility of capital, technology, and people affects trade and relative competitive positions. The factor mobility theory helps explain why production factors move, and what that means for transforming factor endowments, as well as the impact of international factor mobility on world trade.

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Effects of Factor Movements

Factor movements alter factor endowments
Factor movements can be substantial for some countries, and insignificant for others
The movement of labor and capital are intertwined
Pros and cons of outward and inward migration
Brain drain
Remittances

The mobility of capital and population plays a role in a country’s factor endowments. For some countries, the movement of people can be significant. In Luxembourg for example, foreign- born people make up some 20 percent of the total population, but in Japan, account for just 2 percent.

Outward migration can have a negative impact on a country if it involves the departure of educated people, but if these people then send remittances back home, it can have a positive effect.

Finally, keep in mind that the movement of capital and labor is intertwined – think for example, about skilled foreign workers.

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Trade and Factor Mobility

Learning Objective:

Describe the relationship between foreign trade and international factor mobility

Learning Objective : To explain the relationship between foreign trade and international factor mobility.

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Trade and Factor Mobility

There are pressures for the most abundant factors to move to areas of scarcity
The lowest costs occur when trade and production factors are both mobile

What is the relationship between trade and factor mobility? In general, if free trade is coupled with the free moving factors of production, the most efficient resource allocation should occur.

The most abundant factors should move to areas of scarcity.

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Trade and Factor Mobility

Unrestricted Trade, Factor Mobility, and the Cost of Tomatoes

This Figure illustrates the substitutability of trade and factor movements under different scenarios.

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Trade and Factor Mobility

Factor mobility through foreign investment often stimulates trade because of
the need for components
the parent’s ability to sell complimentary products
the need for equipment for subsidiaries

When companies invest abroad they often stimulate exports from their home country through sales of components, equipment, and complimentary products.

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In What Direction
Will Trade Winds Blow?

Issues to consider

Displacement of jobs as developed countries shift production to more rapidly developing countries

Relationships among land, labor, and capital will continue to evolve

Continued trend toward a more finely tuned specialization of production among countries

Will the trend toward the freer movement of trade and production factors continue?

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In What Direction
Will Trade Winds Blow?

Monitor
As economies grow, efficiencies of multiple production locations also grow because they can all gain sufficient economies of scale
Small-scale production methods may enable countries to produce many goods efficiently for their own consumption
Output from 3D printers
Services are growing more rapidly than products as a portion of production and consumption within developed countries

We don’t know what the future will hold, but these four interrelated factors could cause product trade to become relatively less significant in the future.

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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

OBJECTIVES

STRATEGY

Country A Country B

MEANS OF OPERATIONS

Importing and exporting goods and services (trade) Transferring production factors, such as labor and capital, internationally

•

Q u

an ti ty

o f C

o ff ee

( to

n s)

0 5 10

B D

15 Quantity of Wheat (tons)

20 25

121/2

21/2

ASSUMPTIONS for Costa Rica 1. 100 units of resources available 2. 10 units to produce a ton of wheat 3. 4 units to produce a ton of coffee 4. Uses half of total resources per product when there is no foreign trade

PRODUCTION

Without Trade:

Coffee (tons)

Costa Rica (point A) United States (point B) Total

With Trade: Costa Rica (point C ) United States (point D ) Total

121/2 21/2 15

25 0

ASSUMPTIONS for United States 1. 100 units of resources available 2. 5 units to produce a ton of wheat 3. 20 units to produce a ton of coffee 4. Uses half of total resources per product when there is no foreign trade

U.S. production possibilities

Costa Rican production possibilities

Wheat (tons)

5 10 15

0 20 20

5 6

C B

D E

252015 171/2121/2

Quantity of Wheat (tons)

ASSUMPTIONS for Costa Rica 1. 100 units of resources available 2. 10 units to produce a ton of wheat 3. 10 units to produce a ton of coffee 4. Uses half of total resources per product when there is no foreign trade

PRODUCTION

Without Trade:

Coffee (tons)

Costa Rica (point A ) United States (point B ) Total

With Trade (increasing coffee production): Costa Rica (point C ) United States (point D ) Total

With Trade (increasing wheat production): Costa Rica (point C ) United States (point E ) Total

5 10 15

10 6

10 5

ASSUMPTIONS for United States 1. 100 units of resources available 2. 4 units to produce a ton of wheat 3. 5 units to produce a ton of coffee 4. Uses half of total resources per product when there is no foreign trade

U.S. production possibilities

Costa Rican production possibilities

Q u

an ti ty

o f C

o ff ee

( to

n s)

183/4 105

Wheat (tons)

5 121/2 171/2

0 171/2 171/2

0 183/4 183/4

100

Pe rc

en ta

Commercial services

Agricultural products

Fuels and mining products

Manufactured products

1980

0 1990 2000 2011

3.7

27.7

14.7

2.8

14.2

12.3

53.9

70.7

19.3

10.9

7.5

62.3

19.5

18.7

7.8

54.0

Factor conditions: Are sufficient quantities and combinations of the quality of labor, capital, and raw materials available at acceptable prices?

The Diamond of National Competitive Advantage

Demand conditions: Are consumers likely to buy what we can produce with the factor conditions above and at the price we can deliver to them?

Development

Sustainability

Related and supporting industries: Can we outsource production of sufficient components and services to allow us to concentrate our efforts on what we can do best?

Firm strategy, structure, and rivalry: Will competitive conditions and our reactions to them enable us to evolve our operations to sustain and improve our market position?

1. U.S. labor = $1.25 2. Mexican labor = $0.25 3. Mexican labor in the United States (including incremental costs) = $1.15 4. U.S. capital = $0.30 5. Mexican capital = $0.50 6. U.S. capital in Mexico = $0.40 7. Transport for exports = $0.75 8. Transport of Mexican workers to the United States = $0.90

(a) No trade or factor mobility

(b) Trade mobility but no factor mobility

Assumptions, cost per bushel:

$1.55

(d) Both trade and factor mobility

$0.75

$1.50

$0.75

$1.45

$0.65 $ $

$1.40

$0.65