Chapter Five International Trade Theory 5-3 Overview of Trade Theory • Free Trade occurs when 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 • The Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 5-4 Trade Theory-Overview • The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish) - Others are not so easy to understand (Japan and cars) • The history of Trade Theory and government involvement presents a mixed case for the role of government in promoting exports and limiting imports • Later theories appear to make a case for limited involvement McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 5-5 Mercantilism: Mid-16th Century • A nation’s wealth depends on accumulated treasure - Gold and silver are the currency of trade • Theory says you should have a trade surplus - Maximize export through subsidies - Minimize imports through tariffs and quotas • Flaw: “zero-sum game” McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 5-6 Mercantilism-Zero-Sum Game • In 1752, David Hume pointed out that: - Increased exports lead to inflation and higher prices - Increased imports lead to lower prices • Result: Country A sells less because of high prices and Country B sells more because of lower prices • In the long run, no one can keep a trade surplus McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 5-7 Theory of Absolute Advantage • Adam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more of a product with the same amount of input than another country can vary - A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient • Trade between countries is, therefore, beneficial • Assumes there is an absolute balance among nations - Example: Ghana/cocoa McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 5-8 Theory of Absolute Advantage McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 5-9 Absolute Advantage and the Gains From Trade McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 10 Theory of Comparative Advantage • David Ricardo (Principles of Political Economy, 1817): - Extends free trade argument - Efficiency of resource utilization leads to more productivity - Should import even if country is more efficient in the product’s production than country from which it is buying - Look to see how much more efficient • If only comparatively efficient, than import • Makes better use of resources • Trade is a positive-sum game McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 20 New Trade Theory In industries with high fixed costs: - Specialization increases output, and the ability to enhance economies of scale increases - Learning effects are high • These are cost savings that come from “learning by doing” McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 21 New Trade Theory-Applications • Typically, requires industries with high, fixed costs - World demand will support few competitors • Competitors may emerge because of “ Firstmover advantage” - Economies of scale may preclude new entrants - Role of the government becomes significant • Some argue that it generates government intervention and strategic trade policy McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 22 Theory of National Competitive Advantage • The theory attempts to analyze the reasons for a nation’s success in a particular industry • Porter studied 100 industries in 10 nations - Postulated determinants of competitive advantage of a nation were based on four major attributes • • • • Factor endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 23 Porter’s Diamond • Success occurs where these attributes exist • More/greater the attribute, the higher chance of success • The diamond is mutually reinforcing McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 24 Porter’s Diamond McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 25 Factor Endowments • Factor endowments: A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry - Basic factor endowments - Advanced factor endowments McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 26 Basic Factor Endowments • Basic factors: Factors present in a country - Natural resources - Climate - Geographic location - Demographics • While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 27 Advanced Factor Endowments • Advanced factors: The result of investment by people, companies, and government are more likely to lead to competitive advantage - If a country has no basic factors, it must invest in advanced factors McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 28 Advanced Factor Endowments • Communications • Skilled labor • Research • Technology • Education McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 29 Demand Conditions • Demand: - creates capabilities - creates sophisticated and demanding consumers • Demand impacts quality and innovation McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 30 Related and Supporting Industries • Creates clusters of supporting industries that are internationally competitive • Must also meet requirements of other parts of the Diamond McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 31 Firm Strategy, Structure and Rivalry • Long term corporate vision is a determinant of success • Management ‘ideology’ and structure of the firm can either help or hurt you • Presence of domestic rivalry improves a company’s competitiveness McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 32 Porter’s Theory-Predictions • Porter’s theory should predict the pattern of international trade that we observe in the real world • Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 33 Implications for Business • Location implications: - Disperse production activities to countries where they can be performed most efficiently • First-mover implications: - Invest substantial financial resources in building a firstmover, or early-mover advantage • Policy implications: - Promoting free trade is in the best interests of the home country, not always in the best interests of the firm, even though many firms promote open markets McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved - 34 Looking Ahead to Chapter • The Political Economy of International Trade - Instruments of Trade Policy The Case for Government Intervention The Revised Case for Free Trade Development of the World Trading System McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved ... McGraw -Hill/ Irwin International Business, 6/e © 2007 The McGraw -Hill Companies, Inc., All Rights Reserved 5 - 24 Porter’s Diamond McGraw -Hill/ Irwin International Business, 6/e © 2007 The McGraw -Hill. .. game McGraw -Hill/ Irwin International Business, 6/e © 2007 The McGraw -Hill Companies, Inc., All Rights Reserved 5 - 11 Theory of Comparative Advantage McGraw -Hill/ Irwin International Business, ... utilization McGraw -Hill/ Irwin International Business, 6/e © 2007 The McGraw -Hill Companies, Inc., All Rights Reserved 5 - 15 PPF Under Diminishing Returns McGraw -Hill/ Irwin International Business, 6/e