International Trade Theory Overview Mercantilism Absolute Advantage Comparative

International Trade Theory ¥Overview ¥Mercantilism ¥Absolute Advantage ¥Comparative Advantage ¥Heckscher-Olin Theory ¥New Trade Theory ¥Porter’s Diamond © Mc. Graw Hill Companies, Inc. , 2000 4 -1

International Trade Theory Ø What is international trade? ¤Exchange of raw materials and manufactured goods across national borders Ø Classical trade theories: ¤explain national economy conditions--country advantages--that enable such exchange to happen Ø New trade theories: ¤explain links among natural country advantages, government action, and industry characteristics that enable such exchange to happen Ø Implications for International Business

Classical Trade Theories Ø Mercantilism (pre-16 th century) ¤ Takes an us-versus-them view of trade ¤ Other country’s gain is our country’s loss Ø Free Trade theories ¤ Absolute Advantage (Adam Smith, 1776) ¤ Comparative Advantage (David Ricardo, 1817) ¤ Specialization of production and free flow of goods benefit all trading partners’ economies Ø Free Trade refined ¤ Factor-proportions (Heckscher-Ohlin, 1919) ¤ International product life cycle (Ray Vernon, 1966)

The New Trade Theory Ø As output expands with specialization, an industry’s ability to realize economies of scale increases and unit costs decrease Ø Because of scale economies, world demand supports only a few firms in such industries (e. g. , commercial aircraft, automobiles) Ø Countries that had an early entrant to such an industry have an advantage: ¤Fist-mover advantage ¤Barrier to entry Ø Global Strategic Rivalry ¤Firms gain competitive advantage trough: intellectual property, R&D, economies of scale and scope, experience Ø National Competitive Advantage (Porter, 1990)

Mercantilism: mid-16 th century ¥A nation’s wealth depends on accumulated treasure ¥Gold and silver are the currency of trade. ¥Theory says you should have trade surplus. ¤Maximize exports through ¤Minimize imports through tariffs and quotas. a subsidies.

Theory of Absolute Advantage ¥ Adam Smith: Wealth of Nations (1776). Ø A country ¤ Should specialize in production of and export products for which it has absolute advantage; import other products ¤ Has absolute advantage when it is more productive than another country in producing a particular product ¥ Capability of one country to produce more of a product with the same amount of input than another country. ¥ Produce only goods where you are most efficient, trade for those where you are not efficient. ¤ Trade between countries is, therefore, beneficial. ¥ Assumes there is an absolute advantage balance among nations.

10 A Figure 4. 1 K 5 Cocoa 15 20 Theory of Absolute Advantage G 0 B 5 G’ 10 Rice 15 K’ 20 4 -9

Theory of Comparative Advantage ¥ David Ricardo: Principles of Political Economy (1817). Country should specialize in the production of those goods in which it is relatively more productive. . . even if it has absolute advantage in all goods it produces ¤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.

20 Theory of Comparative G Advantage Cocoa 15 C 5 10 A Figure 4. 2 K B 2. 5 0 3. 75 5 7. 5 K’ 10 Rice G’ 15 20 4 -12

Heckscher (1919)-Olin (1933) Theory ¥Export goods that intensively use factor endowments which are locally abundant. ¤Corollary: import goods made from locally scarce factors. ¥Patterns of trade are determined by differences in factor endowments - not productivity. ¥Remember, focus on relative advantage, not absolute advantage. 4 -18

Theory of Relative Factor Endowments (Heckscher-Ohlin) Ø Factor endowments vary among countries Ø Products differ according to the types of factors that they need as inputs Ø A country has a comparative advantage in producing products that intensively use factors of production (resources) it has in abundance Ø Factors of production: labor, capital, land, human resources, technology

Classic Theory Conclusion Ø Free Trade expands the world “pie” for goods/services Theory Limitations: Ø Simple world (two countries, two products) Ø no transportation costs Ø no price differences in resources Ø resources immobile across countries Ø constant returns to scale Ø each country has a fixed stock of resources and no efficiency gains in resource use from trade Ø full employment

New Trade Theories Ø Increasing returns of specialization due to economies of scale (unit costs of production decrease) Ø First mover advantages (economies of scale such that barrier to entry crated for second or third company) Ø Luck. . . first mover may be simply lucky. Ø Government intervention: strategic trade policy

Application of the New Trade Theory ¥Typically, requires industries with high, fixed costs. ¥World demand will support few competitors. ¥Competitors may emerge because “they got there first”. ¤first-mover advantage. ¥Some argue that it generates government intervention and strategic trade policy. © Mc. Graw Hill Companies, Inc. , 2000 4 -24

Porter’s Diamond (Harvard Business School, 1990) ¥The Competitive Advantage of Nations. ¥Looked at 100 industries in 10 nations. ¤Thought existing theories didn’t go far enough. ¥Question: “Why does a nation achieve international success in a particular industry? ”

National Competitive Advantage Ø Factor endowments (Porter, 1990) • land, labor, capital, workforce, infrastructure (some factors can be created. . . ) Ø Demand conditions • large, sophisticated domestic consumer base (knowledge of fashion and culture): offers an innovation friendly environment and a testing ground Ø Related and supporting industries • local suppliers cluster around producers and add to innovation Ø Firm strategy, structure, rivalry(competition for the same objective) • competition good, national governments can create conditions which facilitate and nurture such conditions

Porter’s Diamond Determinants of National Competitive Advantage Firm Strategy, Structure and Rivalry Factor Endowments Figure 4. 6 © Mc. Graw Hill Companies, Inc. , 2000 Demand Conditions Related and Supporting Industries 4 -31

The Diamond ¥Success occurs where these attributes exist. ¤More/greater the attribute, the higher chance of success. ¥The diamond is mutually reinforcing (strengthen or support ). © Mc. Graw Hill Companies, Inc. , 2000 4 -32

Factor Endowments ¥Taken from Heckscher-Olin ¥Basic factors: ¤natural resources, ¤climate, ¤location. ¥Advanced factors: ¤communications, ¤skilled labor, ¤technology. © Mc. Graw Hill Companies, Inc. , 2000 4 -33

Determinants of National Competitive Advantage Chance Two external factors that influence the four determinants. Company Strategy, Structure, and Rivalry Factor Conditions Government Demand Conditions Related and Supporting Industries

“So What” for business? ØFirst mover implications ØLocation Implications ØForeign Investment Decisions ØGovernment Policy implications