Chapter 6 International Trade Theory 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 Trade theory shows why it is beneficial for a country to engage in international trade even for products it is able to produce for itself 6-2 Why Is Free Trade Beneficial? International trade allows a country to specialize in the manufacture and export of products and services that it can produce efficiently import products and services that can be produced more efficiently in other countries limits on imports may be beneficial to producers, but not beneficial for consumers 6-3 Why Do Certain Patterns Of Trade Exist? Some patterns of trade are fairly easy to explain it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Japan export automobiles, consumer electronics, and machine tools? 6-4 What Role Does Government Have In Trade? The mercantilist philosophy makes a crude case for government involvement in promoting exports and limiting imports Smith, Ricardo, and Heckscher-Ohlin 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 6-5 What Is Mercantilism? Mercantilism (mid-16th century) 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 6-6 What Is Smith's Theory Of Absolute Advantage? Adam Smith (1776) 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 goods produced by other countries 6-7 How Does The Theory Of Absolute Advantage Work? Absolute Advantage and the Gains from Trade 6-8 What Is Ricardo's Theory Of Comparative Advantage? David Ricardo asked what happens when one country has an absolute advantage in the production of all goods The theory of comparative advantage (1817) 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 6-9 How Does The Theory Of Comparative Advantage Work? Comparative Advantage and the Gains from Trade 6-10 How Does The Theory Of Comparative Advantage Work? Comparative advantage theory provides a strong rationale for encouraging free trade total output is higher both countries benefit Trade is a positive sum game 6-11 What Is The Heckscher-Ohlin Theory? Eli Heckscher (1919) and Bertil Ohlin (1933) - comparative advantage arises from differences in national factor endowments the extent to which a country is endowed with resources like land, labor, and capital The more abundant a factor, the lower its cost 6-12 What Is The Heckscher-Ohlin Theory? The pattern of trade is determined by factor endowments Heckscher and Ohlin predict that countries will export goods that make intensive use of locally abundant factors import goods that make intensive use of factors that are locally scarce 6-13 Does The Heckscher-Ohlin Theory Hold? Wassily Leontief (1953) theorized that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods. However, he found that U.S. exports were less capital intensive than U.S. imports Since this result was at variance with the predictions of trade theory, it became known as the Leontief Paradox 6-14 What Is The Product Life Cycle Theory? The product life-cycle theory - as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade proposed by Ray Vernon in the mid-1960s At this time most of the world's new products were developed by U.S. firms and sold first in the U.S. 6-15 What Is The Product Life Cycle Theory? According to the product life-cycle theory the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new products initially, the product would be produced and sold in the U.S. as demand grew in other developed countries, U.S. firms would begin to export demand for the new product would grow in other advanced countries over time making it worthwhile for foreign producers to begin producing for their home markets 6-16 What Is The Product Life Cycle Theory? U.S. firms might set up production facilities in advanced countries with growing demand, limiting exports from the U.S. As the market in the U.S. and other advanced nations matured, the product would become more standardized, and price would be the main competitive weapon 6-17 What Is The Product Life Cycle Theory? Producers based in advanced countries where labor costs were lower than the United States might now be able to export to the United States If cost pressures were intense, developing countries would acquire a production advantage over advanced countries Production became concentrated in lower-cost foreign locations, and the U.S. became an importer of the product 6-18 What Is The Product Life Cycle Theory? The Product Life Cycle Theory 6-19 Does The Product Life Cycle Theory Hold? The product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the United States in the 1960s and 1970s mature industries leave the U.S. for low cost assembly locations 6-20 Does The Product Life Cycle Theory Hold? But, the globalization and integration of the world economy has made this theory less valid today the theory is ethnocentric production today is dispersed globally products today are introduced in multiple markets simultaneously 6-21 What Is New Trade Theory? New trade theory suggests that the ability of firms to gain economies of scale (unit cost reductions associated with a large scale of output) can have important implications for international trade Countries may specialize in the production and export of particular products because in certain industries, the world market can only support a limited number of firms new trade theory emerged in the 1980s Paul Krugman won the Nobel prize for his work in 2008 6-22 What Is New Trade Theory? 1. Through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods 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 6-23 What Is New Trade Theory? 2. In those industries when output required to attain economies of scale represents a significant proportion of total world demand, the global market may only be able to support a small number of enterprises first mover advantages - the economic and strategic advantages that accrue to early entrants into an industry economies of scale first movers can gain a scale based cost advantage that later entrants find difficult to match 6-24 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 6-25 What Is Porter's Diamond Of Competitive Advantage? Michael Porter (1990) tried to explain why a nation achieves international success in a particular industry identified four attributes that promote or impede the creation of competitive advantage 1. 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) 6-26 What Is Porter's Diamond Of Competitive Advantage? 2. 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 3. Relating and supporting industries - the presence or absence of supplier industries and related industries that are internationally competitive can spill over and contribute to other industries successful industries tend to be grouped in clusters in countries 6-27 What Is Porter's Diamond Of Competitive Advantage? 4. 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 6-28 What Is Porter's Diamond Of Competitive Advantage? Determinants of National Competitive Advantage: Porter's Diamond 6-29 Does Porter's Theory Hold? Government policy can affect demand through product standards influence rivalry through regulation and antitrust laws impact the availability of highly educated workers and advanced transportation infrastructure. The four attributes, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage So far, Porter's theory has not been sufficiently tested to know how well it holds up 6-30 What Are The Implications Of Trade Theory For Managers? 1. 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 2. First-mover implications - a first-mover advantage can help a firm dominate global trade in that product 3. Policy implications - firms should work to encourage governmental policies that support free trade want policies that have a favorable impact on each component of the diamond 6-31 What Is The Balance Of Payments? A country's balance of payments accounts keep track of the payments to and receipts from other countries for a particular time period double entry bookkeeping sum of the current account balance, the capital account and the financial account should be zero 6-32 What Is The Balance Of Payments? There are three main accounts The current account records transactions of goods, services, and income, receipts and payments current account deficit - a country imports more than it exports current account surplus - a country exports more than it imports 2. The capital account records one time changes in the stock of assets 3. The financial account records transactions that involve the purchase or sale of assets net change in U.S. assets owned abroad foreign owned assets in the U.S. 1. 6-33 What Is The Balance Of Payments? United States Balance of Payments Accounts, 2010 6-34 Is A Current Account Deficit Bad? Question: Does current account deficit in the United States matter? A current account deficit implies a net debtor so, a persistent deficit could limit future economic growth But, even though capital is flowing out of the U.S. as payments to foreigners, much of it flows back in as investments in assets Yet, suppose foreigners stop buying U.S. assets and sell their dollars for another currency a dollar crisis could occur 6-35