Theories of International Trade

Absolute and Comparative style Click to edit Master subtitleAdvantage Factor Endowment Theory of Competitive Advantage Implications of trade theories

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Key Issues

Why do nations trade with each-other? How do different theories explain trade flows? How does free trade raise the economic welfare of all participating nations? Any disagreements? Can government actively influence a countrys competitive advantage? Why is an understanding of trade theory important for managers?
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David Ricardos theory of comparative advantage, which he used to argue against the corn laws, states that specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers.
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The Economic Basis for Trade: Comparative Advantage

A country enjoys an absolute advantage over another country in the production of a product when it uses fewer resources to produce that product than the other country does.

Absolute Advantage versus Comparative Advantage

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A country enjoys a comparative advantage in the production of a good when that good can be produced at a lower cost in terms of other goods.

Absolute Advantage versus Comparative Advantage

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Gains from Mutual Absolute Advantage

Yield Per Acre Of Wheat And Cotton NEW ZEALAND AUSTRALIA

Wheat Cotton

6 bushels 2 bales

2 bushels 6 bales

New Zealand can produce three times the wheat that Australia can on one acre of land, and Australia can produce three times the cotton. We say that the two countries have mutual absolute advantage.

Gains from Mutual Absolute Advantage

Suppose that each country divides its land to obtain equal units of cotton and wheat production as shown below:

Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres NEW ZEALAND AUSTRALIA
75 acres x 2 bushels/acre 150 bushels 25 acres x 6 bales/acre 150 bales

Wheat Cotton

25 acres x 6 bushels/acre 150 bushels 75 acres x 2 bales/acre 150 bales

Production Possibility Frontiers for Australia and New Zealand Before Trade

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Gains from Mutual Absolute Advantage

An agreement to trade 300 bushels of wheat for 300 bales of cotton would double both wheat and cotton consumption in both countries.
PRODUCTION
New Zealand Australia
0 acres 0

Production and Consumption of Wheat and Cotton after Specialization

CONSUMPTION
New Zealand
300 bushels 300 bales

Australia
300 bushels 300 bales

Wheat Cotton
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100 acres x 6 bu/acre 600 bushels 0 acres 0

100 acres x 6 bales/acre 600 bales

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Expanded Possibilities after Trade

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Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both.
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Gains from Comparative Advantage

Even if a country had a considerable absolute advantage in the production of both goods, Ricardo would argue that specialization and trade are still mutually beneficial.

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Gains from Comparative Advantage

When countries specialize in producing the goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently.

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Gains from Comparative Advantage

Assume that people in each country want to consume equal amounts of cotton and wheat, and that each country is constrained by its domestic production possibilities curve, as follows: Yield Per Acre of Wheat and Cotton
NEW ZEALAND Wheat Cotton AUSTRALIA

6 bushels 6 bales
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1 bushel 3 bales
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Gains from Comparative Advantage

Total Production of Wheat and Cotton Assuming No Trade and 100 Available Acres NEW ZEALAND Wheat Cotton
50 acres x 6 bushels/acre 300 bushels 50 acres x 6 bales/acre 300 bales

AUSTRALIA
75 acres x 1 bushels/acre 75 bushels 25 acres x 3 bales/acre 75 bales

The gains from trade in this example can be demonstrated in three stages.

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Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
Stage 1: Countries specialize
STAGE 1 New Zealand Wheat Cotton
50 acres x 6 bushels/acre 300 bushels 50 acres x 6 bales/acre 300 bales

Australia
0 acres 0 100 acres x 3 bales/acre 300 bales

Australia transfers all its land into cotton production. New Zealand cannot completely specialize in wheat production because it needs 300 bales of cotton and will not be able to get enough cotton from Australia (if countries are to consume equal amounts of cotton and wheat).
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Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
Stage 2:
STAGE 2 New Zealand Wheat Cotton

Australia
0 acres 0 100 acres x 3 bales/acre 300 bales

75 acres x 6 bushels/acre 450 bushels 25 acres x 6 bales/acre 150 bales

New Zealand transfers 25 acres out of cotton and into wheat.

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Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
Stage 3: Countries trade
STAGE 3 New Zealand Wheat
350 bushels (after trade) 200 bales (trade)

Australia
100 bushels

100 bushels (trade)

Cotton

350 bales (after trade)

100 bales

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Gains from Comparative Advantage

The real cost of producing cotton is the wheat that must be sacrificed to produce it. A country has a comparative advantage in cotton production if its opportunity cost, in terms of wheat, is lower than the Dr. S. Jain 1919 other country.

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Comparative Advantage Means Lower Opportunity Cost

Both Australia and New Zealand will gain when the terms of trade are set between 1:1 and 3:1, cotton 2/14/13 Dr. S. Jain 2020 to wheat.

Factor Endowment Introduction

In the real world, while trade is partly explained by differences in labor productivity, it also reflects differences in countries resources. The Heckscher-Ohlin theory:

Emphasizes resource differences as the only source of trade Shows that comparative advantage is influenced by:
21 Dr. S. Jain Relative factor abundance (refers4-21 to Slide

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AssumptionsBasics

There are

two countries, Home and Foreign two goods, Cloth and Food, and two resources, Labor and Land

these are used to produce Cloth and Food

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Prices of Goods

Let PC and PF denote the nominal prices of cloth and food. Then, PC/PF is the relative price of cloth (in units of food) and PF/PC is the relative price of food (in units of cloth)

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Prices of Factors

Let w be the nominal price (or, wage) of labor. Let r be the nominal price (or, rent) of land Then w/r is the relative price of labor (in units of land) and r/w is the relative price of land (in units of labor)
Example: If w = $10 per hour for one worker and r = $100 per hour for one acre of land, then the relative wage for one worker is 1/10 acres of land Dr. S. Jain relative rent on an acre of and the 2/14/13 2424

Nominal Prices

The nominal price of a commodity is simply the number of dollars (or any other relevant unit of account) that must be paid to buy one unit of the commodity For example, the nominal price of laboralso called the nominal wage may be $8 per hour
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Real Prices
The real price of commodity X, in units of commodity Y, is the amount of Y that costs the same as one unit of X For example, if the nominal price of labor is $8 per hour and the nominal price of a cup of coffee is $2, then the real price of labor is 4 cups of coffee per hour Real prices are also called relative 2/14/13 Dr. S. Jain 2626 prices

Real and Nominal Prices

Real Price of X, in units of Y, is equal to Nominal Price of X / Nominal Price of Y So, if w is the nominal wage and P is the nominal price of a cup of coffee, then the real wage is w / P. For example, if w is $8 per hour and P is $2, then the real wage is w / P = 8/2 = 4 cups of coffee per hour, as in the previous slide.
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Figure 1: Factor Prices and Goods Prices

Relativ e price of cloth, PC/PF 17 FPG P

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Wagerent ratio, w/r

As labor becomes more expensive relative to land, cloth, which is labor-intensive in production, finds itself at a disadvantage and becomes relatively more expensive compared to food As both Home and Foreign use the same technologies, the same FPGP curve is applicable in 2828 countries both

Figure 1: Factor Prices and Goods Prices

Relativ e price of cloth, PC/PF 17 FPG P

Under free trade, the relative price of cloth will be the same in both countries Therefore, the wage-rent ratio will also be the same in the two countries

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Wagerent ratio, w/r

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Figure 2: Factor Prices and Input Choices

Wagerent ratio, w/r Cloth productio n Food productio n

As labor becomes relatively more expensive, relatively more land is used in production of both food and cloth

1 2

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Acres of Land per worker, T/L

But the number of acres of land per worker is always higher in food production, reflecting the assumption that food production 3030 is land intensive

Figure 2: Factor Prices and Input Choices

Wagerent ratio, w/r Cloth productio n

As both Home and Foreign use the same technologies, Food productio these two curves n must be true in both countries. As free trade equalizes the wage-rent ratio worldwide, acres of land per worker in cloth production must be the same Same must worldwide. be true for food production. Therefore, Foreign, which has more land per worker than Home, must3131 produce

1 2

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Acres of Land per worker, T/L

Relative Supplies

Therefore, if the same w/r prevails in both countries, then QF/QC must be higher in Foreign than in Home. Equivalently, QC/QF must be higher in Home than in Foreign.

This result is called the Rybczynski effect;

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Relative Supplies

From the FPGP Curve in Fig. 1, any particular value of w/r is linked to a specific value of PC/PF. Therefore, if the same w/r prevails in the two countries, then the same PC/PF must also prevail in the two countries. And at that common value of PC/PF

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QF/QC must be higher in Foreign than in Home. Equivalently,

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Figure 3.1: Relative Supplies

Relativ e price of cloth, PC/PF 17 RSFORE IGN RSHO ME In Figure 2, we saw that at w/r = 5, Foreign must produce relatively more food and Home must produce relatively more cloth. In Figure 1 we saw that w/r =5 corresponds to PC/PF = 17. Therefore, Home must produce relatively more Yards of cloth cloth at PC/PF = 17, produced per or indeed at any calorie of food other relative price. produced, QC/QF

As cloth becomes more expensive relative to food, the output of cloth will increase relative to food, Therefore, the relative 2/14/13 Dr. S. Jain supply curves slope upward.

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Figure 3.2: Relative Demand

Relativ e price of cloth, PC/PF 17

The H-O assumptions about preferences imply that that consumer behavior can be summarized by this Relative Demand curve and that the same curve is true in both Home and Foreign

3
In this figure, when the price of a yard of cloth is 17 times the price of a calorie of food, the number of yards of cloth consumed is 3 times the number of calories of food consumed, for 2/14/13 every individual worldwide. Why Dr. S. Jain isnt the

Yards of cloth consumed per calorie of food consumed, QC/QF

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Figure 3: Relative Supplies and Demands

Relative price of cloth, PC/PF

RSFOREI GN

RSHOM E

Foreign

Home

RD

Yards of cloth produced per calorie of food produced, QC/QF

The relative supplies and demands can be combined to find the autarky relative prices in Home and Foreign Clearly, they are3636 different

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Who will export what?

In autarky, the labor-intensive good is relatively cheaper in the laborabundant country Therefore, under free trade, the laborintensive good is exported by the labor-abundant Jain 2/14/13 Dr. S.

PC/PF

Foreign
autark y

Free Trade Home

Foreign : land abundant, labor scarce Home: land scarce, labor abundant 3737 Cloth: labor intensive

Summary
The Heckscher-Ohlin model, in which two goods are produced using two factors of production, emphasizes the role of resources in trade. A rise in the relative price of the labor-intensive good will shift the distribution of income in favor of labor:
The real wage of labor will rise in terms 2/14/13of both goods, while the real income of 38 2/14/13 Dr. S. Jain
Slide 4-38

Summary

For any given commodity prices, an increase in a factor of production increases the supply of the good that uses this factor intensively and reduces the supply of the other good.
The Heckscher-Ohlin theorem predicts the following pattern of trade:

A country will export that commodity which uses intensively its abundant factor and import that commodity which 2/14/13 39 2/14/13 Dr. S. Jain uses intensively its scarce factor.4-39 Slide

Summary

The owners of a countrys abundant factors gain from trade, but the owners of scarce factors lose.

In reality, complete factor price equalization is not observed because of wide differences in resources, barriers to trade, and international differences in technology. S. Jain 2/14/13 40 2/14/13 Dr.

Slide 4-40

Theory of Competitive Advantage

Harvard Business School

1980: The Five Competitive Forces

The Competitive Advantage of Nations, 1990.

First strategist, a field that is, basically, straight economics

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Enormous popularity

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The Five Competitive Forces

the threat of new entrants, the bargaining power of customers, the bargaining power of suppliers, the threat of substitute products or services, and the jockeying among current contestants.S. Jain 2/14/13 Dr. 4242

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Porter and Strategy Today

Strategy has now become a regular field in management schools. It is mostly a haven for economists. They address Value Creation, which is finding an approach, a cost-reduction technique, or some manner permitting the firm to compete effectively.

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The essence of strategy formulation is coping with competition. Different forces take on prominence, of course, in shaping competition in each industry. Every industry has an underlying structure, or a set of fundamental economic and technical characteristics, whether an industry is dealing Dr. S. Jain in services or selling 2/14/13 4545

Establishing a Strategic Agenda

Threat of Entry

New entrants to an industry bring new capacity, the desire to gain market share, and often substantial resources. There are six major sources of barriersDr. S. Jain to 2/14/13

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Barriers to Entry

Economies of scale - - These economies deter entry by forcing the aspirant either to come in on a large scale or to accept a cost disadvantage. Product differentiation -- Brand identification creates a barrier by forcing entrants to spend heavily on marketing
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Barriers to Entry

Cost disadvantages independent of size -- Entrenched companies may have cost advantages not available to potential rivals, no matter what their size and attainable economies of scale.

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Barriers to Entry

Access to distribution channels -The newcomer must, of course, secure distribution of its product or service. Government policy -- Governments can limit or even foreclose entry to industries with such controls as license requirements and limits on access to raw materials.
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Powerful Suppliers and Buyers

The power of each important supplier or buyer group depends on a number of characteristics of its market situation and on the relative importance of its sales or purchases to the industry compared with its overall business.

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Powerful Suppliers and Buyers

A company's choice of suppliers to buy from or buyer groups to sell to should be viewed as a crucial strategic decision. Most common is the situation of a company being able to choose whom it will sell to, in other words, buyer selection.

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Substitute Products

Substitute products place a ceiling on prices a competing firm can charge, limiting the potential of an industry. Substitutes not only limit profits in normal times; they also reduce the bonanza an industry can reap in boom times.

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Substitute Products

Substitutes often come rapidly into play if some development increases competition in their industries and causes price reduction or performance improvement.

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Jockeying for Position

Intense rivalry is related to the presence of a number of factors:

Competitors are numerous or are roughly equal in size and power.

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Jockeying for Position

Industry growth is slow, precipitating fights for market share that involve expansion-minded members.

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Jockeying for Position

The product or service lacks differentiation or switching costs, which lock in buyers and protect one combatant from raids on its customers, by another.
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Jockeying for Position

Fixed costs are high or the product is perishable, creating strong temptation to cut prices. Capacity is normally augmented inJain 2/14/13 Dr. S.

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Formulation of Strategy
1. Positioning the company Positioning the company so that its capabilities provide the best defense against the competitive force.
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Formulation of Strategy
2. Influencing the balance Influencing the balance of the forces through strategic moves, thereby improving the company's position.
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Formulation of Strategy

3. Exploiting industry change

Anticipating shifts in the factors underlying the forces and responding to them, with the hope of exploiting change by choosing a strategy appropriate for the new competitive balance before opponents recognize it.

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Formulation of Strategy

4. Recognizing Multifaceted Rivalry

Porter and numerous other authorities have stressed the need to look beyond product to function in defining a business, beyond national boundaries to potential international competition, and beyond the ranks of one's competitors tomorrow.
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Formulation of Strategy
to formulate strategy we must

understand our resources and capabilities understand the environment, and combine knowledge of strategy and organizational architecture.

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Conclusions

The key to growth -- even survival -is to stake out a position that is

less vulnerable to attack from head-tohead opponents, whether established or new, and less vulnerable to erosion from the direction of buyers, suppliers, and substitute goods.
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Conclusions

Establishing such a position can take many forms

solidifying relationships with favorable customers, differentiating the product either substantively or psychologically through marketing, integrating forward or backward, or establishing technological leadership.
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The ratio at which a country can trade domestic products for imported products is the terms of trade. The terms of trade determine how the gains from trade are distributed among trading partners.

Implications of trade theories Terms of Trade

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Arguments for Restricting Trade

Methods of restricting trade

tariffs quotas administrative barriers other infant industry argument changing comparative advantage to prevent dumping
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Arguments for restricting trade

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Arguments for Restricting Trade

Arguments for restricting trade (cont.)

to prevent establishment of a foreignbased monopoly to spread risks externalities pursuing national interests (but against world interests)

exploiting monopoly power protecting declining industries

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Arguments for Restricting Trade

Problems with protection

protection as second best world multiplier effects retaliation cushions inefficiency bureaucracy

Measuring the efficiency loss from protection

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World Attitudes towards Trade and Protection

History of protection

Pre-war growth in protection Post-war reduction in protection and the role of GATT

the growth in world trade

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REALITIES OF INTERNATIONAL TRADE

import tariff - A tax imposed on imports nontariff barriers (NTBs) restrict imports but are not in the usual form of a tariff:
subsidies, import quotas, export restraints, local content requirements, administrative policies, antidumping duties, over-elaborate or inadequate infrastructure, buy national" policy, bribery and corruption, unfair customs procedures, restrictive licenses, etc.

deadweight costs - Net losses that occur in an economy as the result of tariffs
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REALITIES OF INTERNATIONAL TRADE

import quotas - Restrictions on the quantity of imports for specific period of time voluntary export restraints (VRAs) superficial policy to show that exporting countries voluntarily agree to restrict their exports local content requirements - A requirement that a certain - proportion of the value of the goods made in one country originate from that country.
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REALITIES OF INTERNATIONAL TRADE

antidumping duties - Costs levied on imports that have been dumped (selling below costs or below exporters home market price to unfairly drive domestic firms out of business)

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Economic Arguments Against Free Trade

Prominent among economic arguments against free trade include: The need to protect domestic industries - The oldest and most frequently used economic argument against free trade is the urge to protect domestic industries, firms, and jobs from unfair foreign competition - in short, protectionism
1.

The necessity to shield infant industries - belief that if domestic firms are as young as infants, in the absence of government intervention, they stand no chance of surviving and will be crushed by mature foreign rivals
2.

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Political Arguments against Free Trade

Political arguments against free trade advance a nations political, social, and environmental agenda regardless of possible economic gains from trade These arguments include: (1) national security (2) consumer protection (3) foreign policy (4) environmental and social responsibility

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Classical Theories versus New Realities

Classical theorists and their modern-day disciples argue that the United States and India trade by tapping into each others comparative advantage. India leverages its abundant, high-skill, and lowwage labor. Americans will channel their energy and resources to higher skill, higher paying jobs. Regrettably, certain Americans will lose jobs, but the nation as a whole benefits. Are the theories still valid?
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