International Trade Theory

International Trade Theory

What is international trade?
Exchange of raw materials and manufactured

goods (and services) across national borders

Classical trade theories:

explain national economy conditions--country

advantages--that enable such exchange to happen

New trade theories:

explain links among natural country advantages,

government action, and industry characteristics that enable such exchange to happen

Implications for International Business

Classical Trade Theories

Mercantilism (pre-16th century)
Takes an us-versus-them view of trade Other countrys gain is our countrys loss

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

Free Trade refined

Factor-proportions (Heckscher-Ohlin, 1919)
International product life cycle (Ray Vernon, 1966)

The New Trade Theory

As output expands with specialization, an industrys ability to realize economies of

scale increases and unit costs decrease Because of scale economies, world demand supports only a few firms in such industries (e.g., commercial aircraft, automobiles) Countries that had an early entrant to such an industry have an advantage:
Fist-mover advantage Barrier to entry

New Trade Theory

Global Strategic Rivalry
Firms gain competitive advantage

trough: intellectual property, R&D, economies of scale and scope, experience

National Competitive Advantage

(Porter, 1990)

Mercantilism/Neomercantilism
Prevailed in 1500 - 1800 Export more to strangers than we import to amass treasure, expand kingdom Zero-sum vs positive-sum game view of trade Government intervenes to achieve a surplus in

exports
King, exporters, domestic producers: happy
Subjects: unhappy because domestic goods stay

expensive and of limited variety

Today neo-mercantilists = protectionists: some

segments of society shielded short term

EXCEPTIONS TO FREE TRADE

Military Security
Encouragement of local industry

BENEFITS OF INTERNATIONAL TRADE

Improves the standard of living
Accelerates economic development Stimulates production

Generates foreign exchange earnings

Promotes product specialization Promotes product specialization Increases consumers satisfaction

BASES OF INTERNATIONAL TRADE

Price Difference
Technological Difference Distribution of Natural Resources

Absolute Advantage
Adam Smith: The Wealth of

Nations, 1776 Mercantilism weakens country in long run; enriches only a few 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

Cocoa

G: Ghana K: S. Korea

K K' G'

Rice

THEORY OF COMPARATIVE ADVANTAGE

A country should export

goods in which it has the greatest comparative advantage and should import the goods in which it has the greatest comparative disadvantage

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 Absolute Advantage is a special case of Comparative Advantage
G

Cocoa

G: Ghana K: S. Korea

K K' G'

Rice

Countries

PRODUCTS

Wine

Cloth

Portugal

80 days

90 days

England

120 days

100 days

* Portugal has a comparative advantage in the production of wine while England has a lesser disadvantage in the production of cloth Portugal has a greater advantage in the production of wine than in the production of cloth 40 days (80 and 120 days), 10 days in cloth (90 days and 100 days

From Smith & Ricardo to Mill

Comparative advantage explains the pattern of trade. It also furnishes a strong argument for trade gains and tells much about readjustment of production and the basic laws that determine the real rate of exchanges between the exportable and importable goods. But to explain the actual pattern of

production, or the exact terms at which one countrys products exchange for those of another, we also need detailed knowledge of demand and supply. This was firstly verbalized by John Stuart Mill and then put into graphic form by Alfred Marshall and F.Y. Edgeworth.

Adam Smith and David Ricardo both told us that the rate of exchange in international market must fall into the range with domestic exchange rates of the two countries as the two extremes. When we talk about how to determine the real international exchange rate we could only imagine that a serious competition between the two countries determined the real international exchange rate. We could also say nothing about why a country might be more profitable to its trade partner and why the latter could only obtain less gain.

THE THEORY OF MILL

John Stuart Mill

introduced the theory of comparative advantage based on labour productivity

Theoretical Contribution of John Stuart Mill

Mill firstly revealed the mechanism of

how to determine the rate of exchange in international market and how to distribute the total gains from trade between the two traders by detailing specific relationship between them.

COUNTRIES

LABOR INPUTS

OUTPUTS

days

wine

Cloth (bolts)

Portugal

100

50 barrels

30

England

100

25 barrels

20

Portugal has an absolute advantage in the production of both wine and cloth, BUT is has a greater compartaive advantage in the production of wine tha in cloth England its least comparative disadvatange is in the production of cloth Portugal should export wine, England should export cloth and import wine

Dual Status of Traders

As what Mill argued that in trade between two

countries each country takes status both as the seller and the buyer. As a seller each of them offers its exports to the other. And, simultaneously, each country imports particular goods from its trade partner as a buyer in international market. For any country in trade buyer is its original status while seller is just the derived status.

Principle of Reciprocal Demand

That is to say the two participants of trade in Recardian

model must establish a specific relationship with each other, this is the reciprocal demand relationship. It is this reciprocal demand that actually determines the prevailing terms of trade and how much gains obtained by a particular country. In other words John Stuart Mill had resolved the problem of how to exactly reach the rate of exchange in international market. Comparative advantage and law of reciprocal demand due to John Stuart Mill constitute the two basic building blocks of the classical theory of international trade.

Reasons for Trade

In Mills view at least two reasons that

will lead to the actual international trade: It is cheaper to import some products from the other country than to produce. It is difficult to seek more profitable employment for the production resources.

 Some things it is physically impossible to produce,

except in particular circumstances of heat, soil, water, or atmosphere. But there are many things which, though they could be produced at home without difficulty, and in any quantity, are yet imported from a distance. The explanation which would be popularly given of this would be, that it is cheaper to import than to produce them: and this is the true reason. Just because this true reason England might import corn from Poland and pay for it in cloth, even though England had a decided advantage over Poland in the production of both the one and the other. England might send cottons to Portugal in exchange for wine, although Portugal might be able to produce cottons with a less amount of labor and capital than England.

Profit Equalization in the Home Country

Mill argued that these sorts of trade could only

take place between two countries separated from each other with a long distance rather between the two places in the same country. Mill noticed, trade could not happen between adjacent places because factor movement makes it possible to reach profit equalization thus no one will enjoy advantages over the other traders. An example of profit equalization:
If the north bank of the Thames possessed an advantage over the south bank in the production of shoes, no shoes would be produced on the south side; the shoemakers would remove themselves and their capitals to the north bank, or would have established themselves there originally. The shoemakers could increase their profits by simply crossing a river.

Profit Differentiation among Countries

Between distant places, and especially between different

countries, profits may continue different because persons do not usually remove themselves or their capitals to a distant place without a very strong motive. It needs but a small motive to transplant capital, or even persons, from Warwickshire to Yorkshire; but a much greater to make them remove to India, the colonies, or Ireland. To France, Germany, Switzerland, capital moves perhaps as readily as to the colonies; the differences of language and government being scarcely so great a hindrance as climate and distance. To countries still barbarous, or, like Russia and Turkey, only beginning to be civilized, capital will not migrate, unless under the inducement of a very great extra profit.

Profit Inequalities among Countries Cause Trade

Between all distant places therefore in some degree,

but especially between different countries, there may exist great inequalities in return to labor and capital, without causing them to move from one place to the other in such quantity as to level those inequalities. The capital belonging to a country will, to a great extent, remain in the country, even if there be no mode of employing it in which it would not be more productive elsewhere. Yet even a country thus circumstanced might, and probable would, carry on trade with other countries.

Heckscher Ohlin's H-O Theory

The Modern Theory of

international trade has been advocated by Bertil Ohlin. Ohlin has drawn his ideas from Heckscher's General Equilibrium Analysis. Hence it is also known as Heckscher Ohlin (HO) Model / Theorem / Theory

Theory of Relative Factor Endowments (Heckscher-Ohlin)

Factor endowments vary among countries

Products differ according to the types of factors that they need as inputs
A country has a comparative advantage in

producing products that intensively use factors of production (resources) it has in abundance
Factors of production: labor, capital, land,

human resources, technology

Differences in factor endowments not on differences in productivity determine patterns

Heckscher (1919)-Ohlin (1933)

of trade Absolute amounts of factor endowments matter Leontief paradox:

US has relatively more abundant capital yet

imports goods more capital intensive than those it exports Explanation(?):

US has special advantage on producing new products made with innovative technologies These may be less capital intensive till they reach massproduction state

Assumptions of Heckscher Ohlin's H-O Theory

There are two countries involved. Each country has two factors (labour and capital). Each country produce two commodities or goods (labour intensive and capital intensive). There is perfect competition in both commodity and factor markets. All production functions are homogeneous of the first degree i.e. production function is subject to constant returns to scale. Factors are freely mobile within a country but immobile between countries. Two countries differ in factor supply. Each commodity differs in factor intensity. The production function remains the same in different countries for the same commodity. For e.g. If commodity A requires more capital in one country then same is the case in other country. There is full employment of resources in both countries and demand are identical in both countries. Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers. There are no transportation costs. Given these assumption, Ohlin's thesis contends that a country export goods which use relatively a greater proportion of its abundant and cheap factor. While same country import goods whose production requires the intensive use of the nation's relatively scarce and expensive factor.

 Understanding The Concept of Factor Abundance

In the two countries, two commodities & two factor model,

implies that the capital rich country will export capital intensive commodity and the labour rich country will export labour intensive commodity. But the concept of country being rich in one factor or other is not very clear. Economists quite often define factor abundance in terms of factor prices. Ohlin himself has followed this approach. Alternatively factor abundance can be defined in physical terms. In this case, physical amounts of capital & Labour are to be compared

Limitations of Heckscher Ohlin's H-O Theory

Heckscher Ohlin's Theory has been criticised on basis of following grounds :Unrealistic Assumptions : Besides the usual assumptions of two countries, two commodities, no transport cost, etc. Ohlin's theory also assumes no qualitative difference in factors of production, identical production function, constant return to scale, etc. All these assumptions makes the theory unrealistic one. Restrictive : Ohlin's theory is not free from constrains. His theory includes only two commodities, two countries and two factors. Thus it is a restrictive one. One-Sided Theory : According to Ohlin's theory, supply plays a significant role than demand in determining factor prices. But if demand forces are more significant, a capital abundant country will export labour intensive good as the price of capital will be high due to high demand for capital. Static in Nature : Like Ricardian Theory the H-O Model is also static in nature. The theory is based on a given state of economy and with a given production function and does not accept any change. Wijnholds's Criticism : According to Wijnholds, it is not the factor prices that determine the costs and commodity prices but it is commodity prices that determine the factor prices. Consumers' Demand ignored : Ohlin forgot an important fact that commodity prices are also influenced by the consumers' demand. Haberler's Criticism : According to Haberler, Ohlin's theory is based on partial equilibrium. It fails to give a complete, comprehensive and general equilibrium analysis. Leontief Paradox : American economist Dr. Wassily Leontief tested H-O theory under U.S.A conditions. He found out that U.S.A exports labour intensive goods and imports capital intensive goods, but U.S.A being a capital abundant country must export capital intensive goods and import labour intensive goods than to produce them at home. This situation is called Leontief Paradox which negates H-O Theory. Other Factors Neglected : Factor endowment is not the sole factor influencing commodity price and international trade. The H-O Theory neglects other factors like technology, technique of production, natural factors, different qualities of labour, etc., which can also influence the international trade.

Comparison - H.O Theory Vs Ricardian Theory

The advantage or superiority of

Ohlin's Modern Theory over the Ricardian Classical Theory of international trade gets highlighted from the following important points of comparison. According to the Classical economists, there is a need for a separate theory of international trade because of the differences between internal and international trade. But according to Ohlin, there is no need for a separate theory of international trade, as fundamental principle of both is same.

LEONTIEF PARADOX
Wassily Leontief received a

Nobel prize in 1973 for his contribution to the inputoutput analysis. Three of his students, Paul Samuelson, Robert Solow and Vernon Smith are also recipients The United States which appears as the worlds most abundant capital country appeared to be exporting goods which are labor intensive

 The first serious attempt to test the theory was made by

Professor Wassily W. Leontief in 1954. To perform the test, Leontief used the 1947 input-output table of the US economy (He received his Nobel prize for his contribution to input-output analysis later). He aggregated industries into 50 sectors, but only 38 industries produced commodities that enter the international markets, and the remaining 12 sectors were created for accounting identities and nontraded goods. He also aggregated factors into two categories, labor and capital. He then estimated the capital and labor requirements to produce: One million dollars' worth of typical exportable and importable bundles in 1947.

Capital Requirement Exports Imports aKx = 2.550780 aKm = 3.091339

Labor Requirement aLx = 182.313 man-years aLm = 170.114 man-years

capital-labor ratios

kx = aKx/aLx = $14,300 (exports) km = aKm/aLm = $18,200 (imports)

The US seems to have been endowed with more capital per worker than any other country in the world in 1947. Thus, the HO theory predicts that the US exports would have required more capital per worker than US imports. However, Leontief was surprised to discover that US imports were 30% more capital-intensive than US exports,
km = 1.30 kx.

At first, Leontief was criticized on statistical grounds. Swerling (1953) complained that 1947 was not a typical year: the postwar disorganization of production overseas was not corrected by that time.

LEONTIEF
2nd TEST In 1956 Leontief repeated the

test for US imports and exports which prevailed in 1951. In his second study, Leontief aggregated industries into 192 industries. He found that US imports were still more capitalintensive than US exports. US imports were 6% more capital-intensive(km = 1.06 kx). (The transition of the US economy from a wartime to peace time economy was not complete until the 1960s.)

 Baldwin's Third Test

More recently, Professor

Robert Baldwin (1971) used the 1962 US trade data and found that US imports were 27% more capital-intensive than US exports. The paradox continued. [There were some computational problems in this study.] km = 1.27 kx.

JAPAN
Tatemoto and Ichimura (1959) studied Japan's trade

pattern and discovered another paradox. Japan was a laborabundant country, but exported capital-intensive goods and imported labor- intensive goods. Japan's overall trade pattern was inconsistent with HO. Explanation: They said that Japan's place in the world was somewhere between advanced and LDCs. 25% of Japan's exports went to advanced industrial countries. 75% of exports went to LDCs. For the US-Japan trade, the trade pattern was consistent with HO prediction. Japan-LDC, consistent.

East Germany
Stolper and Roskamp (1961) applied Leontief's

method to the trade pattern of East Germany. East Germany's exports were capital-intensive. About 3/4 of EG's trade was with the communist bloc, and EG was capital abundant relative to its trading partners. Thus, the EG case was consistent with the HO theory.

South Korea
Hong (1975) analyzed Korea's

CANADA
Wahl (1961) studied Canada's

trade pattern (1966-72), which was consistent with the HO theory.

trade pattern. Canadian exports were capitalintensive. Most of Canadian trade was with the US. The result was inconsistent with HO.

INDIA
Bharawaj (1962) studied India's trade pattern. India's

exports were labor-intensive. Consistent with HO theory. However, Indian trade with the US was not. Indian exports to the US were capital-intensive.

Explanations of Paradox
Statistical Error
Factor Intensity Reversal Demand Conditions

Trade Restrictions
Efficiency of US Workers Natural Resources

 1. Leontief: US was more efficient Leontief Leontief himself suggested an explanation for his own

paradox. He argued that US workers may be more efficient than foreign workers. Perhaps U.S. workers were three times as effective as foreign workers. Note that this increased effectiveness of the American workers was not due to a higher capital-labor ratio, because we assume that countries have identical technologies and hence identical capital- labor ratios. It means that the average American worker is three times as effective as he would be in the foreign country. Given the same K/L ratio, Leontief attributed the superior efficiency of American labor to superior economic organization and economic incentives in the U.S. However, Leontief found very few believers among economists.

 Most new products conceived / produced in the US in

International Product Life-Cycle (Vernon)

20th century US firms kept production close to their market initially

Aid decisions; minimize risk of new product introductions Demand not based on price; low product cost not an issue

Limited initial demand in other advanced countries

initially

Exports more attractive than overseas production

When demand increases in advanced countries,

production follows With demand expansion in secondary markets

Product becomes standardized production moves to low production cost areas Product now imported to US and to advanced countries

Classic Theory Conclusion

Free Trade expands the world pie for goods/services

Theory Limitations:
Simple world (two countries, two products) no transportation costs no price differences in resources resources immobile across countries constant returns to scale each country has a fixed stock of resources and no

efficiency gains in resource use from trade full employment

New Trade Theories

Increasing returns of specialization due to

economies of scale (unit costs of production decrease)

First mover advantages (economies of scale such that

barrier to entry crated for second or third company)

Luck... first mover may be simply lucky.

Government intervention: strategic trade policy

National Competitive Advantage

(Porter, 1990)
Factor endowments

land, labor, capital, workforce, infrastructure (some factors can be created...) large, sophisticated domestic consumer base: offers an innovation friendly environment and a testing ground local suppliers cluster around producers and add to innovation competition good, national governments can create conditions which facilitate and nurture such conditions

Demand conditions

Related and supporting industries

Firm strategy, structure, rivalry

Porters Diamond

So What for business?

First mover implications Location Implications Foreign Investment Decisions Government Policy implications