enero PART THREE PART THREE THEORIES AND INSTITUTIONS: TRADE AND INVESTMENT Chapter 5 International Trade Theory Objectives ! Explain trade theories. ! Discuss how to increase global efficiency through free trade. ! Introduce prescriptions for altering trade patterns. ! Explore how business decisions influence international trade. Chapter Overview Foreign trade is an age-old phenomenon. Chapter 5 examines many of the descriptive and prescriptive theories associated with this process. Beginning with Mercantilism, the chapter presents the concepts of absolute and. comparative advantage, factor proportions theory and country size and country similarity theories. It also discusses the international product life eyele and Porter’s determinants of national competitive advantage. The chapter concludes with a discussion of the strategic reasons firms participate in the international trade process. Chapter Outline OPENING CASE: Sri Lankan Trade [See Map 5.1] This case describes the pivotal role of international trade in the development of the Sti Lankan economy. An island nation of nearly 20 million people, the country’s trade activities date back to the middle of the third century. During the colonial period, the Portuguese sought Ceylonese spices, and then the British developed tea, rubber and coconut plantations. Since receiving its independence from the UK in 1948, Sri Lanka has looked to international trade to help solve such interrelated problems as its shortage of foreign exchange, its overdependence on exports of tea and on the British market and the insufficient growth of output and employment. Specifically, Sri Lanka has been guided by four different trade policies: a liberal approach of noninterference in trade from 1948-1960, a policy of import substitution from 1960-1977, the combination of strategic (rade policy guided by import substitution from 1977-1988 and the implementation of strategic trade policy combined with an openness to imports from 1988 to the present. The move to establish strategic export industries has accomplished many of Sri Lanka’s objectives; manufacturing now accounts for 70 percent of its exports, and tea is increasingly being exported in value-added forms Teaching Tip: Carefully review the PowerPoint slides for Chapter 5. For additional visual summaries of key chapter points, also review: Table 5.2—Intemational Changes during a Product’s Life Cycle Figure 5.5 Determinants of Global Competitive Advantage in the text. L INTRODUCTION Foreign trade (importing and exporting activities) is one means by which countries are linked economically. Two general types of trade theories pertain to international business. Descriptive theories deal with the natural order of trade; they examine and explain patterns of trade under laissez-faire hitp:wob.hevatodu.crpkpnrIM_O5.him weenero t. mm. Vv. conditions. Prescriptive theories deal with the question of whether governments should seel PART THREE amount, composition and/or direction of trade. MERCANTILISM The concept of mercantilism (a zero-sum game) was popular from about 1500-1800; it purports that a country’s wealth is measured by its holdings of treasure (usually gold). To amass a surplus (a favorable balance of trade) a country must export more than it imports and then collect gold (and other forms of wealth) from countries that run a deficit (an unfavorable balance of trade). Neomercantilism represents the more recent policy of countries that try to run a favorable balance of trade in order to achieve some particular national objective via protectionism. ABSOLUTE ADVANTAGE In 1776 Adam Smith claimed the wealth of a nation consisted of the goods and services available to its citizens, His theory of absolute advantage holds that a country can maximize its own economic well being by specializing in the production of those goods it can produce more efficiently than any other nation and enhance global efficiency through its participation in (unrestricted) free trade. A. Natural Advantage ‘A country may have a natural advantage in the production of particular products because of given climatic conditions, access to certain natural resources, the availability of needed labor forees, ete. B. Acquired Advantage An acquired advantage represents a distinct advantage in skills, technology and/or capital assets, thus yielding differentiated product offerings and/or cost-competitive homogeneous products. C. Resource Efficiency Example [See Figure 5.2] Real income depends on the output of goods as compared to the resources used to produce them. The production possibilities curve shows that by specializing and trading, two countries can have more than they would without trade, thus optimizing global efficiency. COMPARATIVE ADVANTAGE In 1817 David Ricardo reasoned there would still be gains from trade if'a country specialized in the production of those things it can produce most efficiently, even if other countries can produce those things even more efficiently. Put another way, Ricardo’s theory of comparative advantage holds that a country can maximize i own economic well-being by specializing in the production of those goods it can produce relatively efficiently and enhance global efficiency through its participation in (unrestricted) free trade. A An Analogous Explanation of Comparative Advantage Would it make sense for the best physician in town, who also happens to be the most talented medical secretary, to handle all of the administrative duties of an office? No. The physician can ‘maximize both output and income by working as a physician and employing a sceretary. In the same manner, a country will gain if it concentrates its resources on the production of those products it can produce most efficiently, Production Possibility Example [See Figure 5.3] A country can simultaneously have a comparative advantage and an absolute disadvantage in the production of a given product. Assume that the United States is more efficient than Sri Lanka in the production of both wheat and tea. However, the United States has a comparative advantage in wheat production, By concentrating on the product in which it has the greater advantage (wheat) and letting Sri Lanka produce the product in which the U.S. is comparatively less efficient (tea), global output can be increased, and specialization and trade can benefit both countries. SOME ASSUMPTIONS AND LIMITATIONS OF THE THEORIES OF SPECIALIZATION The theori of absolute and comparative advantage are based upon the economic gains from specialization, i.e., concentration on the production of a limited number of products. Each holds that hitp:wob.hevatodu.crpkpnrIM_O5.him 20enero Vi. PART THREE specialization will maximize output and that subsequent trade will maximize consumer welfare. However, both theories make certain assumptions that may not always be valid, A. Full Employment Both theories assume that resources are fully employed. When countries have many un- or under- employed resources, they may seek to restrict imports in order to employ their own available workers and other assets. B. Economic Efficiency Objective Countries often pursue objectives other than economic efficiency. For example, they may intentionally avoid overspecialization because of the vulnerability created by potential changes in technology and price fluctuations. C. Division of Gains Although specialization does maximize output, it is unclear how those gains will be divided. If one country perceives a trading partner as receiving too large a share of the benefits, it may choose to forego its relatively small gains in order to prevent the other country from receiving large gains. D. Two Countries, Two Commodities ‘The world is comprised of multiple countries and multiple commodities. Nonetheless, the theories are still useful; economists have applied the same reasoning and demonstrated the economic efficieney advantages in multi-product and multi-country production and trade relationships. E, Mobility ‘Neither the assumption that resources can move domestically from the production of one good to another and at no cost, nor the assumption that resources cannot move internationally, is entirely valid. Nonetheless, domestic mobility is greater than the international mobility of resources. Clearly, the movement of resources such as labor and capital is an altemative to trade. F_ Statics and Dynamics Although the theories of absolute and comparative advantage consider gains at a given time (a static view), the relative conditions that surround a country’s advantage or disadvantage are dynamic (constantly changing). Thus one cannot assume future advantages will remain constant. Services Although the theories of absolute and comparative advantage were developed from the perspective of trade in commodities, much of the same reasoning can be applied to trade in services. ‘THE THEORY OF COUNTRY SIZE The theory of country size holds that large countries are more apt to have varied climates and natural resources, and therefore will generally be more nearly self-sufficient than small countries. Research based on country size helps explain the country-by-country differences regarding how much and what products will be traded through specialization that are not dealt with by the theories of absolute and comparative advantage. A. Variety of Resources Large countries are more apt to have varied climates and a greater assortment of natural resources than smaller countries, thus making the large countries more self-sufficient. B. Transport Costs Given the same types of terrain and modes of transportation, the greater the distance, the higher transport costs will be. Thus certain firms in large countries may face higher transportation costs in terms of serving their distant national markets than do their closer foreign competitors. C. The Size of the Economy and Production Scales Countries with large economies and high per capita incomes are mote likely to produce goods that use technologies requiring long production runs. These countries develop industries to serve their large domestic markets, which in turn tend to also be competitive in export markets. On the other hand, given its capacity the technologically intensive company from a small nation may hitp:wob.hevatodu.crpkpnrIM_O5.him ae