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MGX9660: International Business Theory & Practice Lecture 3 Theories of International Business Dr Alex Newman

Port of Rotterdam: gateway to the world

Why does trading make the Netherlands one of the richest nations in the world even if intermediaries such as the Port of Rotterdam take a substantial share of the benefits?

International Trade
International trade is a hot topic in politics as the benefits of trade are often unevenly distributed. This lecture starts by outlining the theoretical foundations for international trade. These theories provide a structured way of thinking and analyzing issues that are central to both businesses and government policy. They tell us why trade occurs and the role of governments in facilitating trade

International Trade

Why Nations Trade

Most nations actively participate in international trade consisting of exporting (selling abroad) and importing (buying from abroad). (Table 5.1) Trade is undertaken by firms from different nations rather than by governments Trade contribute to the trade deficit (a surplus of imports over exports) or to the trade surplus (a surplus of exports over imports) of nation states. The theories of international trade are examined in the order in which they evolved: Mercantilism, Absolute advantage, comparative advantage, product life cycle, strategic trade national competitive advantage. The first three are often regarded as classical trade theories. The last three are viewed as modern trade theories.

Theory of mercantilism 1600 and 1700s Wealth of the world (measured in gold and silver) is fixed and that a nation that exports more and imports less would enjoy the net inflows of gold and silver and thus become richer; international trade is viewed as a zerosum game. Protectionism Idea that governments should actively protect domestic industries from imports and vigorously promote exports.

Is a trade theory. Mercantilism held the view that a countrys wealth was measured by its holdings of treasure which usually meant its gold. Countries should export more than import. Receive gold in return.

Mercantilism promoted protectionism

Zero-Sum Game Tariffs Quotas Subsidies Tax rebates Misallocation of resources Income redistribution Enforced trade relationships


Free Trade Theory

Adam Smith
Theory of Absolute Advantage Proposed in 1776 Free trade Laissez-faire policy benefits a country

David Ricardo
19th century English Economist The Theory of Comparative Advantage

Attempted to gain favourable balance of trade.
Difference between import costs and export earnings. To achieve some social and political objectives Employment generation Surplus production to export

Theory of Absolute Advantage

Real wealth of a country consists of the goods and services available to its citizens Based on efficiency principle Different countries produce some goods more efficiently than other countries Global efficiency can be achieved through free trade A country could then use its excess specialised production to buy more imports.

Absolute Advantage
Free trade (Adam Smith 1776) Buying and selling of goods and services with little or no government intervention Theory of absolute advantage Nation gains by specialising in economic activities in which that nation has an absolute advantage. Absolute advantage To be more efficient than anyone else in the production of any good or service

With 800 Resources

4,000 cars

40 Aircrafts

Table 5.2 Absolute Advantage

Comparative Advantage
Consists of climate, natural resources, labour force availability

Consists of either product or process technology

Theory of Comparative Advantage

This is the intellectual basis of modern argument for unrestricted free trade. Pioneer, David Ricardo an English Economist
Global efficiency can be gained from trade if a country specialises in those products (not all) that in can produce more efficiently A country must give up less efficient outputs to produce more efficient output If a country has an absolute advantage in two products it should abandon one, other wise there will be no trade.

Comparative Advantage

Nation A has an absolute advantage in production of all goods compared to Nation B. As long as Nation B is not equally less efficient in the production of both goods, Nation B can still choose to specialise in the production of one good in which it has comparative advantage. Comparative advantage Relative (not absolute) advantage in one economic activity that one nation enjoys in comparison with other nations. Opportunity cost Cost of pursuing one activity at the expense of another activity, given the alternatives.

Figure 5.3 Comparative Advantage

Ricardo in 1817. suggests that even if America has an absolute advantage over Europe in both cars and aircraft, as long as Europe is not equally less efficient in the production of both goods, Europe can still choose to specialise in the production of one good (such as cars) in which it has comparative advantage defined as the relative (not absolute) advantage in one economic activity that one country enjoys in comparison with other country.

Where do absolute and comparative advantages come from?

Smith looked at absolute productivity differences, and Ricardo emphasised relative productivity differences. But what leads to such productivity differences? Swedish economists Heckscher and Ohlin argued that absolute and comparative advantages stem from different resource endowments namely, the extent to which different countries possess various resources, such as labour, land and technology. These resources are known as factors of production. The factor endowment theory suggests that nations tend to export goods whose production requires a lot of those resources that the country has a lot of. Nations develop comparative advantage based on their locally abundant factors.

Difference between Two theories is subtle.
Absolute advantage theory looks at absolute

productivity differences.
Comparative advantage theory looks at

relative productivity differences.

Comparative advantage theory incorporates the concept of opportunity costs in determining which goods a country should produce.

Opportunity Costs
Japan uses 0.8 hours to produce 4 clock radios. Japan produces two bottles of wine in 2 hours. Only one hour of labour is needed by France to produce 2 bottles of wine. By producing 4 clock radios, and trading them to France for two bottles of wine, Japan saves 1.2 hours of labour. The saved` labour can be used to produce more clock radios, which the Japanese can then use themselves or trade to France for more wine.

Japan Uses 0.8 hours to produce 4 clock radios 2 hours in producing two bottles of wine France I hour to produce 2 bottles of wine 2 hours to produce 4 Clock radios

Heckscher-Ohlin Theory
Eli Heckscher and Bertil Ohlin (Swedish Economists) Refined the Ricardos theory of Comparative Advantage Developed Factor-Proportion Theory

Factor Proportion Theory

This is based on countries production factors- land, labour and capital (investment funds) Differences in countries endowment of labour compared to their endowments of land and capital make difference in the cost of production factors.

Relative Factor Endowments Factor endowments (types and quality of resources) vary between countries Goods differ according to the types of factors/resources used in production Factor endowments vary, due to - natural resources
- local and foreign investment - population size - political and social stability


Hong Kong & the Netherlands
Land price is `very high Regardless of climate and soil condition Hong Kong and the Netherlands would not go for production of goods that require large amount of land wool & wheat.

Australia and Canada will produce these goods

because ...

Classical Theories
In summary, classical theories, (1) mercantilism, (2) absolute advantage and (3) comparative advantage (which includes resource endowments), evolved from approximately 300 years ago to the beginning of the 20th century. More recently, three modern theories, outlined next, emerged.

Product life cycle Strategic trade theory National competitive advantage of industries

Product Life Cycle

Vernon developed the product life cycle theory, which was the first dynamic theory to account for changes in the patterns of trade over time. Vernon divided the world into three categories: lead innovation nation (which, according to him, is typically the USA), other developed nations developing nations.

Product Life Cycle Theory (PLC) (Raymond Vernon, 1966)

PLC theory states that the location of production of certain kinds of products shifts as they go through their life cycle. 1. Introduction 2. Growth 3. Maturity 4. Decline

International Changes During Products Life Cycle

Product Location Market Location An innovating country Mainly in innovating country with some exports

In innovating and industrial countries Mainly in industrial countries. Shifts production in export markets as foreign production replaces exports Fast growing demand No of competitors increases Competitors begin price cutting Product become standardised Capital input increases Methods more standardized

Multiple countries Growth in developing countries. Some decrease in industrial countries

Mainly in developing countries Mainly in developing countries Some developing country exports

Competitive Factors

Near monopoly position Sales based on price and uniqueness Product characteristics evolve

Established demand Number of competitors decreases Price competition

Demand declines Pressure to cut price /adjustment No of producers decline

Production Technology

Short production run Methods evolve High labour input relative to capital

Long production run using high capital inputs Highly standardized Less labour skill needed

Unskilled labour on mechanised long production runs

The International Product Life Cycle

Limitation of PLC Theory

Ethnocentric in nature Only based on the US experience. Recent trends: No more US dominance (1945-75) New players from Europe and Asia Simultaneous launch/introduction of new products across the world market. Globally dispersed production is also applicable to innovative new products. Still have some relevance

Strategic Trade Theory

This suggests that strategic intervention by governments in certain industries can enhance their odds for international success.

How did strategic trade policy contribute to the creation of the Airbus A380?

Government Subsidy

Strategic trade theorists do not advocate a mercantilist policy to promote all industries. They propose to help a few strategically important ones.

National competitive advantage of industries

Porter argues that the dynamic interaction of these four aspects explains what is behind the competitive advantage of leading industries in different nations.

This is the first multilevel theory to realistically connect firms, industries and nations.

Trade Barriers: Tariffs

There are two broad types of trade barriers: (1) tariff barriers and (2) nontariff barriers (NTBs). As a major tariff barrier, an import tariff is a tax imposed on imports. Figure 5.6 uses rice tariffs in Japan as a hypothetical example to show that there are unambiguously net losses known as deadweight loss.

Non-Tariff Barriers Taken together, trade barriers reduce or eliminate international trade. NTBs include (1) subsidies, (2) import quotas, (3) export restraints, (4) local content requirements, (5) administrative practices and (6) antidumping duties. Import quotas are restrictions on the quantity of imports. Import quotas are worse than tariffs because with tariffs, foreign goods can still be imported if tariffs are paid. Import quotas are protectionist and there are political costs that countries have to shoulder in largely pro-free trade environment. Voluntary export restraints (VERs) have been developed to show that on the surface, exporting countries voluntarily agree to restrict their exports. The arsenal of trade warriors also includes antidumping duties levied on imports that have been sold at less than a fair price or dumped and thus harm domestic firms.

Impact of Trade Barriers

Was the EU right to slam quotas on imports of clothing from China?

Next Week Firm Specific Theories Guideline on individual assignment

Free Trade?
The economic arguments against free trade include: the need to protect domestic industries > At the height of the recession in 2009, British workers at the Lindsey oil refinery went on strike to protest against IREM, an Italian construction company, bringing its Italian and Portuguese workers into the country to conduct expansion work. the necessity to shield infant industries. > 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. Thus, it is imperative that governments
level the playing field by assisting infant industries.