Slide-4

Have you ever wondered why we buy so much clothing from other
countries?
U.S. manufacturers know how to make clothing, in fact, much of
clothing worn by Americans used to be made in the U.S.
Now, however, the U.S. buys a lot of its textiles from places like
Honduras and Guatemala.
Why does Ford assemble cars made for the American market in
Mexico, while BMW and Nissan manufacture cars for Americans in
the U.S.?
These are questions that economists have tried to answer for
many years, and in this chapter well look at patterns of trade and
explore some of the theories that have been used to explain those
patterns.
First though, a definition. Free trade refers to 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.
Slide-5
Economists have debated the merits of free trade for centuries.
In fact, well begin our discussion of trade theory with
mercantilism, a 16th and 17th century philosophy that
encouraged countries to increase exports and limit imports.
Then, well go on to the theories advocated by Adam Smith and
David Ricardo who promoted the notion of free trade, or a
situation where government allows market forces to work, and
doesnt intervene with quotas or duties to influence what citizens
can buy from other countries, or sell to other countries.

Smith and Ricardo promoted the idea that international trade

allows a country to specialize in the manufacture and export of
products that it can produce efficiently, and import products that
can be produced more efficiently in other countries.
Their work was later extended by Eli Heckscher and Bertil Ohlin.

You probably dont need trade theories to explain some patterns

of tradeits easy to see why Saudi Arabia exports oil and Brazil
exports coffee, but its much harder to explain why Switzerland
exports watches and pharmaceuticals, or why Japan exports
consumer electronics.
Ray Vernon answered some of these questions with his product
life cycle theory that followed the production of a product over
time.
Paul Krugman also attempted to answer these questions with his
so called, new trade theory.
He argued that in some industries, the world market can only
support a few firms, and that the firms that are able to build a
competitive position early, will be difficult to challenge.
Think of the large commercial aircraft industry for example. How
many companies can you think of? Probably just twoBoeing and
Airbus Industries.
Michael Porter extended Krugmans work with his theory of
national competitive advantage.
Porter argued that a countys ability to be successful in certain
industries depends not only on factor endowments, but also on
domestic demand and domestic rivalry.

Slide-6
The main point that Smith, Ricardo, and Heckscher-Ohlin made is
that its beneficial for countries to trade with each other, even
when they could be self-sufficient.
They tried to answer the question that we asked abovewhy
should the U.S. buy textiles from other countries when it could
produce them itself?
As well explain later, Smith, Ricardo, and Heckscher-Ohlin
showed that if countries specialized in the production and export
of products that they produced most efficiently, they could trade
for products that could be produced more efficiently in other
countries.
What role does government play in trade theory?
Well, it depends.
Mercantilism suggested that government should be involved in
helping to promote exports and limit imports, while Smith,
Ricardo, and Heckscher-Ohlin argued that government should
stay out of trade and market forces should influence how
countries trade.
Slide-7
Now that you have got an overview of the various theories, lets
look at them in more depth. Well start with mercantilism.
The main idea behind the mercantilist philosophy, which was
around in the mid-16th century, was that the accumulation of
gold and sliver were essential to the wealth, and power of a
nation.
So, it was in the best interests of a country to try to maximize its
holdings of gold and silver by encouraging exports and
discouraging imports.

In order to achieve this goal, imports were limited through tariffs

and quotas, while exports were maximized through government
subsidies.
A key flaw in the philosophy however, was that it was a zero-sum
game.
A country could only achieve its goal of maximizing a trade
surplus at the expense of another nation.
In other words, if one country successfully exported more than it
imported, and consequently increased its holdings of gold and
silver, another country would fail to achieve a trade surplus.

This other country would in fact buy more than it sold, see its gold
and silver leave the country, and become a weaker nation!

Slide-8
Adam Smith challenged the mercantilist philosophy and its zerosum approach to trade.
Smith argued, in his 1776 landmark book, The Wealth of Nations,
that free trade, or trade without government intervention, could
be beneficial to countries if each country produced and exported
those products in which it was most efficient, or in his words,
those products in which the country had an absolute advantage.
Smith argued that if countries specialized in the production of
goods in which they had an absolute advantage they could then
trade these goods for the goods produced by other countries.

Slide-12

You may be thinking that Smiths ideas are great if youve got two
countries where one is clearly better at producing one product
and the other is clearly more efficient at producing the other
product.
But what happens if one country has an absolute advantage in
the production of all products?
Is trade still beneficial?
In 1817, David Ricardo tried to answer these questions with his
theory of comparative advantage.
Ricardo argued that at it still makes sense for a country to
specialize in the production of those goods that it produces most
efficiently and to buy goods that it produces less efficiently from
other countries, even if this means buying goods from other
countries that it could produce more efficiently itself.
Slide-16
Is free trade always best?
Well, suppose we say that resources are not mobile, that a
country cant simply decide to produce cocoa instead of rice. Or,
that you couldnt simply ask a textile worker to go write software
programs for Microsoft.
In reality, this is more likely to be the case, and creates a strong
argument against free trade.
If a government follows a free trade policy, what happens to the
textile worker? Well, perhaps the government could help retrain
the textile worker, but at least in the short-term, hes likely to feel
some pain!
So, keep in mind, that while free trade may be best in the long
run, there may be some short-term pain involved.

Now, suppose we allow for the dynamic effects that are likely to
come from trade.
Free trade can increase a countrys stock of resources.
For example, since the early 1990s, Western companies have
been investing in Eastern Europe increasing the amount of capital
thats available to use there.
Free trade can also increase the efficiency of resource utilization.
For example, if firms can sell to a bigger market, they can gain
from the economies associated with large scale production.
Slide-17
Sometimes though, dynamic gains from trade can lead to
negative outcomes.
When one of the leading economists of the twentieth century,
Paul Samuelson, looked at what happened when a rich country
like the U.S. entered into a free trade agreement with a poor
country like China that achieved rapid gains after entering into
the agreement, Samuelson found that the rich country might
actually lose!
In our example, the losses would occur because real wage rates in
the U.S. would fall as a result of the free trade agreement and the
cheaper prices it meant on imported products.
Samuelson is particularly concerned with the trend to offshore
service jobs that have traditionally not been mobile.
He believes the effect of this trend will be similar to a mass
inward migration to the U.S.
Despite concerns like those of Samuelson, studies show that there
is a link between trade and economic growth.

Specifically, countries that adopt a more open stance toward

international trade tend to have higher growth rates than those
that close their economies to trade.
Slide-18
Eli Heckscher and Bertil Ohlin extended Ricardos work by
suggesting that a countrys comparative advantage is a result of
differences in national factor endowments.
Heckscher and Ohlin argued that countries will export goods that
make intensive use of factors of production like land, labor, and
capital that are locally abundant.
At the same time, countries will import goods that make intensive
use of factors that are locally scarce.
So, a country like China with abundant low-cost labor will produce
and export products that are labor intensive like textiles, while the
U.S., which lacks abundant low cost labor, imports textiles from
China.
Notice that this theory explains trade patterns using differences in
factor endowments, while Ricardo explains trade patterns using
differences in productivity.
Slide-19
Wassily Leontief tested the Heckscher-Ohlin theory in 1953.
Leontief expected that since the U.S. was relatively abundant in
capital compared to other countries, the U.S. should export
capital intensive goods, and import labor intensive goods.
But, Leontief, contrary to what common sense would tell us,
actually found that U.S. exports were less capital intensive than
U.S. imports.
His findings have come to be known as the Leontief Paradox.

A business is considered to be capital-intensive based on the ratio of the capital required to

the amount of labor that is required. Some capital-intensive industries include
oil production and refining, telecommunications, and transportation, such as railways, autos
and airlines.

Slide-20
Now, lets go back to a question we asked earlier. Why are some
products that used to be made at home, now imported from other
countries, especially less developed ones?
The answer to this question may lie in where the product is in its
life cycle.
The product life cycle theory which was developed in the mid1960s by Ray Vernon who suggested that as products mature,
both the sales location, and the optimal production location will
change, and of course, as these change, so will the flow and
direction of trade.
In other words, products move through different stages over their
life, and as they do, where they are produced and sold change,
too.
Vernon observed, at the time, that most of the worlds new
products were developed by American firms and sold initially in
the U.S.
He attributed this to the wealth and size of the U.S. market.
Vernon argued that rather than producing these new products in
other countries, manufacturers preferred to produce them locally
to be closer to the market, and to the firms decision making.
Vernon suggested that while demand was growing in the U.S.,
there would be only limited demand by high-income consumers in
other advanced countries.

Therefore, there would be little incentive for firms in the foreign

countries to produce the product, and the other developed
markets would be served by exports from the U.S.
Slide-21
Then, as demand for the new product grew in other advanced
countries, foreign producers would begin to produce the product.
U.S. producers, in an effort to capitalize on foreign demand, would
also begin to produce in the foreign markets.
What happened to trade flows? Well, exports from the U.S.
slowed down as they were replaced by foreign production.
As the U.S. market and the foreign markets matured, the product
became more standardized, and price became more important to
consumers.
Some foreign producers with lower wage costs exported to the
U.S. market during this stage.
Later, production shifted to developing countries where wages
were even lower, and the U.S. became an importer of the product.
Slide-23
If you think the product life cycle seems out of touch with the
modern world, youre right!
While the product life cycle was useful for explaining trade
patterns for products like photocopiers that were developed in the
1960s and 1970s, today, given the effects of globalization and the
integration of the world economy, the theory doesnt hold up well.
Today, you can think of many products that were designed and
introduced outside the U.S., like videogame consoles that were
initially introduced in Japan, or Europes wireless phones.

In addition, many products are introduced simultaneously in the

U.S., Japan, and Europe.
Production of these new products is often globally dispersed from
the start
Slide-24
In an effort to resolve some of the shortcomings of other theories,
researchers in the 1970s began to search for other explanations
of trade.
This new vein of thought, aptly called, new trade theory, argued
that because of the unit cost reductions that are associated with a
large scale of output, some industries can support only a few
firms. These cost reductions are called economies of scale.
Achieving economies of scale can be very important to firms.
Microsoft for example, is able to spread the costs of developing
new versions of Windows over millions of PCs.
Why is this important?
Well, suppose we live in a world without trade.
Small markets might find that they dont have certain products
available if producers cant sell enough to achieve economies of
scale, or if the products are available, prices will probably be very
high.
But, if countries trade with each other, markets are bigger, and
firms have the opportunity to sell enough to achieve scale
economies.
Consumers have more choice and lower prices!
Slide-25
However, in some industries, to achieve economies of scale, firms
have to have a major share of the worlds market.

The costs of developing new aircraft, for example, are so high,

that firms have to hold a significant share of the world market in
order to gain economies of scale.
Remember, that there are only two makers of large commercial
aircraft in the world!
Now, its important to consider the effects of first mover
advantages because the pattern of trade we see in the world
economy may be the result of first mover advantages and
economies of scale.
Firms that achieve first mover advantages will develop economies
of scale, and create barriers to entry for other firms.
Airbus, for example, is currently enjoying the first mover
advantages associated with its super jumbo plane.
Airbus has to sell at least 250 super jumbos just to break even on
the project.
The market over the next twenty years is expected to be just 400
to 600 planes, so its not worthwhile for Boeing to even get in the
market.
Airbus has first mover advantages based on scale economies.

Slide-26
What can we learn from new trade theory?
Well, new trade theory suggests that countries might benefit from
trade even if they dont differ in resource endowments or
technology.
The theory also suggests that a country might be dominant in the
export of a good just because it was lucky enough to have
companies that were among the first to produce the product.

Remember our example of Airbus and its super jumbo jet!

Keep in mind that new trade theory is at odds with the HeckscherOhlin theory which, remember, suggested that countries would
produce and export those products which made intensive use of
abundant factors of production.
But, new trade theory doesnt contradict comparative advantage
theory because it actually identifies a source of comparative
advantage.
So, governments might use this information to implement
strategic trade policies that nurture and protect firms and
industries where first mover advantages and economies of scale
are important.
Slide-27
Have you ever wondered why some countries have certain
industries that seem to be superior to those of other countries?
Why for example, is Japan so strong in the global auto industry?
Why does Switzerland dominate the pharmaceutical industry?
These are questions that intrigued Michael Porter, who in 1990,
believing that the theories at the time still left gaps in our
understanding of trade patterns, tried to explain why a country
might achieve international success in a particular industry.
Porter identified four factors that he argued promoted or impeded
the creation of competitive advantage in an industry.
Together, he called these factors the diamond of competitive
advantage.
The first factor, called factor endowments, refers to a countrys
position in the factors of production that can lead to a competitive
advantage.

Here Porter included things like the skilled labor or infrastructure

that were important to achieving a competitive advantage in a
particular industry.
Demand conditions, the second factor, refers to the nature of
home demand for the industrys product or service.
Porter argued that sophisticated and demanding customers
pressured firms to be more competitive.
Slide-28
The third factor, relating and supporting industries, refers to
the presence or absence of supplier and related industries that
are internationally competitive and contribute to other industries.
According to Porter, successful industries will be grouped in
clusters in countries, so if a country has world class
manufacturers of semi-conductor processing equipment, it will
tend to have a competitive semi-conductor industry.
Finally, the fourth factor, firm strategy, structure, and rivalry,
refers to the conditions in the nation that govern how companies
are created, organized, and managed, and the nature of domestic
rivalry.
Porter suggest that when domestic rivalry is strong, theres
greater pressure to innovate, improve quality, reduce costs, and
invest in advanced product features.
Slide-30
Was Porter successful at increasing our understanding of trade
patterns?
Porter argued that a nations success in an industry is a function
of the combined impact of the four points on his diamond.
He also suggested that government could play a role.

For example, government imposed subsidies could affect factor

endowments, or by imposing local product standards, a
government could change demand conditions.
Rivalry among firms could be influenced by antitrust laws, and so
on.
If his arguments are correct, his model ought to predict the
patterns of trade we see in the real world.
Unfortunately, at this time, his theory hasnt been well tested.
While it seems to make sense, without empirical testing, we really
dont know.
Remember that the Heckscher Ohlin theory made sense, until
Leontief decided to test it, that is!
Slide-31
What can managers learn from the various theories of trade?
Well, there are three key points: location implications, first-mover
implications, and policy implications.
Lets look at each one beginning with location implications.
The theories that weve discussed point out those countries have
particular advantages for different productive activities.
Remember for example, that Chinas low cost work force makes it
a better place to produce textiles than the U.S.
So, there is a link between the theories and the decision of where
to locate productive activities. Firms should disperse their
productive activities to those countries where they are most
efficient.
The theories also tell us that first-mover advantages can be
critical to success in some industries. Being a first mover in an
industry can have important competitive implications, especially

in industries where economies of scale are critical and the global

industry can only support a few companies.
Third, there is a link between trade theory and government policy.
A governments policy on free trade has important implications
for a firms global competitiveness.
Firms can influence government policy decisions through
government lobbying. U.S. steel producers for example, have
been successful in influencing government policy.
Keep in mind, that while the actions of these industries may help
the firms within the industry, the decisions that are made as a
result of their influence are not always beneficial to the country as
a whole!
For example, while the steel industry was successful at getting
protection from foreign competition in the early 2000s, the higher
prices that resulted from the protection meant that the auto
industry suffered.
Finally, remember, that no one theory explains all trade patterns,
but taken together, they help us understand whats happening in
the world today.

Slide-32
You may be wondering how we know what countries are exporting
and importing. Well, all of that information is contained in a
countrys balance of payments.
The balance of payments account keeps track of the payments
to and receipts from other countries for a particular time period.
It has three main accounts.
The first is called the current account. This is the account you
often hear about in the news because it contains a record of all

exports and imports of goods, services, and income, receipts, and

payments.
So for example, youve probably heard of a current account
deficit where a country imports more than it exports or a
current account surplus where a country exports more than it
imports. Well talk more about these in a moment. First though,
lets look at the other main accounts of the balance of payments.
The second account is the capital account which records one
time changes in the stock of assets. This account used to be
included as part of the current account, but was recently
separated out.
Finally, the third account is the financial account. This account
used to be called the capital account. It records transactions that
involve the purchase or sale of assets. So, a transaction where a
foreign firm buys stock in a U.S. company would be recorded in
this account.
Slide-34
Now, lets get back to the current account deficit.
You may have noticed that a current account deficit is usually
reported negatively. This is because a current account deficit
represents a drain on assets.
Recall for a moment that a current account deficit occurs when a
nation imports more than it exports. So, if the United States has a
current account deficit, its buying more than its selling. How
does the U.S. pay for all these goods? You guessed it by
borrowing from foreigners!
If the U.S. continually borrows, eventually its payments on its debt
will be so large that it wont be able to invest in its own market,
and economic growth at home will be affected.

But, what happens if foreigners invest some of the money they

receive back in the United States?
Well, this is whats been happening for the last 25 years or so,
and as you know, the U.S. economy has continued to grow during
this time despite some temporary slowdowns.
So, some people think that a persistent current account deficit
may not be as bad as it initially seems, but caution that if
foreigners suddenly decide to sell off their dollar-based assets for
other currencies, a dollar crisis could trigger a global economic
slowdown.