MBA(1ST ) Management Studies

Section C

International Business
Provided By : Mr.Md.Mahmudul Hasan
Fourth Edition
Fouji
Jagannath University

CHAPTER 4
International Trade Theory

1st British African colony to win independence (1957).

Nkrumah (Osagyefo Kwame Nkrumah) espoused pan
African socialism.
High tariffs.
Anti export (trade) policy.

Kept lowering tariffs on manufactured goods.

Created incentives to export (trade).
Reduced quotas.
Reduced subsidies.
1950s: 77% of employment in agriculture. Now 20%.
Manufacturing GNP went from 10% to over 30%.

The Impact of Trade Policies

Ghana
1970
GNP/capita
$250

1992
GNP/per capita
$450

GNP Growth/year
1.5%

Shift from productive uses

(cocoa) to unproductive uses
(subsistence
agriculture).
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4-6

Korea
1970
GNP/per capita
$260

1992
GNP/per capita
$6790
GNP Growth/year
9%

Shift from non-comparative

advantage uses (agriculture)
to productive uses (laborintensive manufacturing).
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4-7

An Overview of Trade Theory

Free Trade occurs when 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.

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4-7

An Overview of Trade Theory

Free Trade occurs when 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.

The Benefits of Trade allow a country to

specialize in the manufacture and export
of products that can be produced most
efficiently in that country.

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4-7

An Overview of Trade Theory

Free Trade occurs when 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.
The Benefits of Trade allow a country to specialize in the
manufacture and export of products that can be produced most
efficiently in that country.

The Pattern of International Trade

displays patterns that are easy to
understand (Saudi Arabia/oil or
China/crawfish). Others are not so
easy to understand (Japan and cars).
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4-7

An Overview of Trade Theory

Free Trade occurs when 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.
The Benefits of Trade allow a country to specialize in the manufacture and export
of products that can be produced most efficiently in that country.
The Pattern of International Trade displays patterns that are easy to understand
(Saudi Arabia/oil or China/crawfish). Others are not so easy to understand (Japan
and cars).

The history of Trade Theory and Government

Involvement presents a mixed case for the role
of government in promoting exports and
limiting imports. Later theories appear to make
a case for limited involvement.

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Mercantilism: mid-16th century

4-8

A nations wealth depends on accumulated

treasure

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Mercantilism: mid-16th century

4-8

A nations wealth depends on accumulated

treasure
Gold and silver are the currency
of trade.

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Mercantilism: mid-16th century

4-8

A nations wealth depends on accumulated

treasure
Gold and silver are the currency
of trade.
Theory says you should have
a trade surplus.

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Mercantilism: mid-16th century

4-8

A nations wealth depends on accumulated

treasure
Gold and silver are the currency
of trade.
Theory says you should have
a trade surplus.
Maximize exports
subsidies.
Minimize imports through tariffs
and quotas.
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through

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Mercantilism: mid-16th century

4-8

A nations wealth depends on accumulated treasure

Gold and silver are the currency
of trade.
Theory says you should have
a trade surplus.
Maximize exports
subsidies.
Minimize imports through tariffs
quotas.

through
and

Flaw: zero-sum game.

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Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

4-10

Capability of one country to produce

more of a product with the same amount
of input than another country.

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Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

4-10

Capability of one country to produce

more of a product with the same amount
of input than another country.
Produce only goods where you are most
efficient, trade for those where you are
not efficient.

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Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

4-10

Capability of one country to produce more of

a product with the same amount of input than
another country.
Produce only goods where you are most
efficient, trade for those where you are not
efficient.
Assumes there is an
absolute advantage balance among
nations, e.g., Ghana/cocoa.
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The Theory of Absolute

Advantage

10

A
Figure 4.1

Cocoa

15

20

B
K

G
0

10

Rice

15

20

The Theory of Absolute Advantage

and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice

Ghana
S. Korea

Cocoa

10
40

Rice

20
10

Production and Consumption without Trade

Ghana
10.0
S. Korea
2.5
Total production 12.5

5.0
10.0
15.0

Ghana
S. Korea
Total production

20
0
20

0
20
20

Ghana
S. Korea

14.0
6.0

6.0
14.0

Ghana
S. Korea

4.0
3.5

1.0
4.0

Production with Specialization

Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice

Increase in Consumption as a Result of Specialization and Trade

Table 4.1

4-13

Theory of Comparative Advantage

David Ricardo: Principles of Political Economy
(1817).
Should trade even if country is more efficient in
the production than its trading partner.

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Theory of Comparative
Advantage
Assume Ghana is more efficient in production of both cocoa and
rice.
Scenario 1:
In Ghana it takes 10 resources to produce 1 ton of cocoa and 13 1/3
resources to produce 1 ton of rice.
Thus with 200 resources Ghana can produce 20 tons (200/10)of
cocoa and no rice. Or 15 tons of rice(200/13.33) and no cocoa or any
combination of the two.
In South Korea it takes 40 resources to produce 1 ton of cocoa and
20 resources to produce 1 ton of rice.
Thus , with 200 resources Korea can produce 5(200/40) tons of
cocoa and no rice or 10 tons of rice and no cocoa or any combination
of the two on its PPF.

The Theory of Comparative

Advantage
20

Cocoa

15

10

A
Figure 4.2

K
B

2.5

0 3.75

5 7.5

K
10

Rice

15

20

Theory of Comparative
Advantage
Scenario 2:
If both the countries use half of the resources to produce cocoa
and half of the resources to produce rice:
Thus with 100 resources for each of the products, Ghana can
produce 10 tons (100/10)of cocoa and 7.5 tons(100/13.33) of rice.
In the same way with 100 resources Korea would produce 2.5
tons(100/40) of cocoa and 5 tons(100/20) of rice.
So without trade the total production would be 12.5(10+2.5) tons
of cocoa and 12.5(7.5+5) tons of rice.

The Theory of Comparative

Advantage (Specialization)

Cocoa

15

20

10

A(100 resources for each

(10 cocoa & 7.5 rice))

A (100 resources for each, 2.5 cocoa

and 5 rice)
K

2.5

0 3.75

5 7.5

10

Rice

15

20

Theory of Comparative
Advantage
Scenario 3: International Trade takes Place:
Cocoa to Rice Ratio in Ghana: 10: 7.5 or 4:3 or 1: 0.75
Cocoa to Rice ratio in Korea: 2.5:5 or 1:2
Cocoa is cheaper in Ghana. So Ghana can sell 1 unit of cocoa to
Korea and get 2 units of Rice whereas she can only get 0.75 units
of rice in exchange of giving up 1 unit of cocoa production in her
own country.
So, Ghana would export cocoa and import rice.

Theory of Comparative
Advantage
On the other hand,
Rice to cocoa Ratio in korea:5:2.5 or 1:0.5
Rice to cocoa Ratio in Ghana:7.5:10 or 1: 1.33
Rice is cheaper in Korea because Korea can sell 1 unit of Rice to
Ghana and get 1.33 units of cocoa whereas she can only get 0.5
units of cocoa by sacrificing the same amount of rice in her own
country.
SO Comparative Advantage comes into effect

Comparative Advantage and the Gains from

Trade
Resources Required to Produce 1 Ton of Cocoa and Rice

Ghana
S. Korea

Cocoa

10
40

Rice

13.33
20

Production and Consumption without Trade

Ghana
10.0
S. Korea
2.5
Total production 12.5

7.5
5.0
12.5

Ghana
S. Korea
Total production

15
0.0
15

3.75
10.0
13.75

Ghana
S. Korea

11
4

7.75
6

Ghana
S. Korea

1.0
1.5

0.25
1.0

Production with Specialization

Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice

Increase in Consumption as a Result of Specialization and Trade

Table 4.2

The Theory of Comparative

Advantage
20

Cocoa

15

10

A
Figure 4.2

K
B

2.5

0 3.75

5 7.5

K
10

Rice

15

20

The Basic Message of the Theory of

Comparative Advantage
Potential world Production is higher
greater with unrestricted free trade than
it is with restricted trade.
Trade is a positive-sum game where all
countries that participate realize
economic gains.

4-16

Extensions of the Ricardian Model

Immobile resources:
Resources do not always move easily from one
economic activity to another.

Diminishing returns:
More a country produces, at some point, will require
more resources (diminishing returns to specialization).
Different goods use resources in different proportions.

However:
Free trade might increase a countrys stock of
resources (as labor and capital arrives from abroad),
and
Increase the efficiency of resource utilization.

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Ghanas PPF under Diminishing

Returns

Cocoa

Figure 4.3

G
0

Rice

The Influence of Free Trade on the

PPF
PPF2

Cocoa

PPF1

Figure 4.4

Rice

4-20

Heckscher (1919)-Olin (1933)

Theory

Labor is not the only Factor of

production. We need to account for
land, capital, and technology.
Ricardo Had highlighted Labor
Productivity. Whichever country had
more labor productivity in a particular
goods production would be able to
export that good.
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4-20

Heckscher (1919)-Olin (1933)

Theory

Factor endowments: extent to which a country

is endowed with such resources as land,
labor, and capital.
Comparative Advantage arises out of national
factor endowments. USA exports agricultural
products because it has huge arable land.
China excels in exporting labor-intensive
manufactured goods like textile and footwear
due to its abundance of low-cost labor.

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4-20

Heckscher (1919)-Olin (1933)

Theory

Export goods that intensively use factor

endowments which are locally
abundant.

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4-20

Heckscher (1919)-Olin (1933)

Theory

Export goods that intensively use factor

endowments which are locally abundant.

Corollary: import goods made from

locally scarce factors.
So, the US exports agricultural products
and imports textile goods.
Ivory cost exports Ivory, imports
automobiles.
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4-20

Heckscher (1919)-Olin (1933)

Theory

Patterns of trade are determined by

differences in factor endowments - not
productivity.
Remember, focus on relative
advantage, not absolute advantage.
e.g.Venezuela May have absolute
advantage in oil but does not have a
relative advantage over Saudi Arabia.
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4-21

The Leontief (Wassily Leontief)

Paradox, 1953
Disputes Heckscher-Olin in some instances.
Factor endowments can be impacted by
government policy - minimum wage.
US tends to export labor-intensive products,
but is regarded as a capital intensive country.

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The Leontief Paradox?

No answer as yet
Maybe because the US has advantages in
innovative technologies which are less
capital intensive but rather skill based
(Computer Software)on the other hand
she may import products that require
heavy machinery and in turn large
amounts of capital.

Dilemma Between Ricardo and H-O

H-O theoretically stronger but Ricardo more accurate
in predicting patterns of international trade.
The US exports commercial aircraft and imports cars
not because it lacks the necessary factor
endowments for cars but because it is more efficient
in producing aircrafts. Same true for Japan.
H-O assumes technology is same across countries.
So the solution to this dilemma maybe to resort to
the Ricardian idea of productivity. Once technology is
same then H-O comes into play.

4-23

Product Life-Cycle Theory

(Raymond Vernon, 1966)
Article in the Quarterly Journal of Economics.
As products mature, both location of sales and optimal
production changes.
Affects the direction and flow of imports and exports.
Globalization and integration of the economy makes this
theory less valid.

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The Product Life-Cycle Theory

160
140
120
100
80
60
40
20
0
160
140
120
100
80
60
40
20
0

4-24

production

United States
Exports

Imports

Other Advanced Countries

consumption

Exports

Imports

160
140
120
100
80
60
40
20
0

Developing Countries
Exports
Imports
New Product

Maturing Product

Standardized Product

Figure 4.5

Stages of Production Development

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4-25

The New Trade Theory

Began to be recognized in the 1970s.
Deals with the returns on specialization where
substantial economies of scale are present.
Specialization increases output, ability to enhance
economies of scale increase.

In addition to economies of scale, learning effects

also exist.
Learning effects are cost savings that come from
learning by doing.

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Application of the New Trade

Theory

4-26

Typically, requires industries with high,

fixed costs.
World demand will support few competitors.
Competitors may emerge because they
got there first.
First-mover advantage.

Some argue that it generates government

intervention and strategic trade policy.

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4-27

First-Mover Advantage
Economies of scale may preclude new entrants.
Role of the government.

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4-28

Porters Diamond
(Harvard Business School, 1990)
The Competitive Advantage of Nations.
Looked at 100 industries in 10 nations.
Thought existing theories didnt go far enough.
Question: Why does a nation achieve
international success in a particular industry?

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Determinants of National
Competitive Advantage
Factor endowments:nations position in factors
of production such as skilled labor or
infrastructure necessary to compete in a given
industry.

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Determinants of National
Competitive Advantage
Factor endowments:nations position in factors
of production such as skilled labor or
infrastructure necessary to compete in a given
industry.
Demand conditions:the nature of home
demand for the industrys product or service.

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Determinants of National
Competitive Advantage
Factor endowments:nations position in factors of
production such as skilled labor or infrastructure
necessary to compete in a given industry.
Demand conditions:the nature of home demand for
the industrys product or service.
Related and supporting industries:the presence or
absence in a nation of supplier industries or related
industries that are nationally competitive.

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Determinants of National Competitive

Advantage
Factor endowments:nations position in factors of
production such as skilled labor or infrastructure
necessary to compete in a given industry.
Demand conditions:the nature of home demand for the
industrys product or service.
Related and supporting industries:the presence or
absence in a nation of supplier industries or related
industries that are nationally competitive.
Firm strategy, structure and rivalry:the conditions in the
nation governing how companies are created, organized,
and managed and the nature of domestic rivalry.
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Porters Diamond

4-30

Determinants of National Competitive

Advantage
Firm Strategy,
Structure and
Rivalry
Factor Endowments

Figure 4.6

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Demand Conditions
Related and
Supporting
Industries
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4-31

The Diamond
Success occurs where these attributes exist.
More/greater the attribute, the higher chance of
success.

The diamond is mutually reinforcing.

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Determinants of
National Competitive Advantage
Chance

Two external
factors that
influence the
four
determinants.

Company Strategy,
Structure,
and Rivalry
Factor
Conditions

Government

McGraw-Hill/Irwin

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Demand
Conditions
Related
and Supporting
Industries

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Factor Endowments

4-33

Taken from Heckscher-Olin

Basic factors:
natural resources
climate
location
demographics
Advanced factors:
communications
skilled labor
research
technology
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4-34

Advanced Factor Endowments

More likely to lead to competitive
advantage.
Are the result of investment by people,
companies, government.

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4-35

Relationship of Basic to
Advanced Factors
Basic can provide an initial advantage.
Must be supported by advanced factors to
maintain success.
No basics, then must invest in advanced factors.

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4-36

Demand Conditions
Demand creates the capabilities.
Look for sophisticated and
demanding consumers.
impacts quality and innovation.

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Related and Supporting

Industries

4-37

Creates clusters of supporting industries that are

internationally competitive.
Must also meet requirements of other parts of
the Diamond.

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4-38

Firm Strategy, Structure and

Rivalry
Management ideology can either help or hurt you.
Presence of domestic rivalry improves a companys
competitiveness.

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4-39

Evaluating Porters Theory

If Porter is right, we would expect his model to

predict the pattern of international trade that we
observe in the real world. Countries should be
exporting products from those industries where all
four components of the diamond are favorable,
while importing in those areas where the
components are not favorable.
Too soon to tell.

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Implications for Business

Location implications:makes sense to disperse
production activities to countries where they can
be performed most efficiently.
First-mover implications:It pays to invest
substantial financial resources in building a firstmover, or early-mover, advantage.
Policy implications:promoting free trade is
generally in the best interests of the home-country,
although not always in the best interests of the
firm. Even though, many firms promote open
markets.