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chapter three

Theories of International Trade and Investment

McGraw-Hill/Irwin International Business, 11/e

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserv

Learning Objectives

Explain the theories that attempt to explain Discuss the arguments for imposing trade
restrictions

why certain goods are traded internationally

Explain two basic kinds of import restrictions:


tariff and nontariff trade barriers

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Learning Objectives

Appreciate the relevance of changing status of


tariff and nontariff barriers to managers

Explain some of the theories of foreign direct


investment

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International Trade Theory


Mercantilism
Economic philosophy based on belief that (1) a nations wealth depends on accumulated treasure, usually gold, and (2) to increase wealth, government policies should promote exports and discourage imports

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Theory of Absolute Advantage


Absolute advantage
Theory that a nation has absolute advantage when it can produce a larger amount of a good or service for the same amount of inputs as can another country or When it can produce the same amount of a good or service using fewer inputs than could another country

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Absolute Advantage
Example

Each Country Specializes

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Absolute Advantage
Terms of Trade (Ratio of International Prices)

Gains from Specialization and Trade

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Theory of Comparative Advantage


Comparative Advantage
A nation having absolute disadvantages in the production of two goods with respect to another nation has a comparative or relative advantage in the production of the good in which its absolute disadvantage is less

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Theory of Comparative Advantage


Example

Each Country Specializes

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Comparative Advantage
Terms of Trade at a rate of bolt of cloth for 1 ton of soybeans

Terms of Trade at a rate of 1 bolt of cloth for 1 ton of soybeans

Gains from Specialization and Trade

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Comparative Advantage
Production Possibility Frontiers (figure 3.1)
Figure 3.1

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Heckscher-Ohlin Theory of Factor Endowment


Factor Endowment
Heckscher-Ohlin theory that countries export products requiring large amounts of their abundant production factors and import products requiring large amounts of their scarce production factors

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Heckscher-Ohlin Theory of Factor Endowment


Leontief Paradox
The United States, one of the most capital-intensive countries in the world, was exporting relatively laborintensive products in exchange for relatively capitalintensive products

Differences in Taste
A demand-side construct that is always difficult to deal with in economic theory

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How Can Money Change The Direction of Trade?


Example

Exchange Rate the price of one currency stated in terms of another currency

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How Can Money Change The Direction of Trade?


Influences of Exchange Rate
Currency devaluation The lowering of a currencys price in terms of other currencies

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Some Newer Explanations For The Direction Of Trade


Linder Theory of Overlapping Demand
Customers tastes are strongly affected by income levels; therefore a nations income per capita level determines the kinds of goods they will demand

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Some Newer Explanations For The Direction Of Trade


International Product Life Cycle (IPLC)
Explains why a product that begins as export eventually becomes import (figure 3.2) U.S. exports Foreign production begins Foreign competition in export market Import competition in the United States

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Figure 3.2 International Product Life Cycle

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Some Newer Explanations For The Direction Of Trade


Technology Life Cycle
Production technology application of IPLC

Economies of Scale and Experience Curve


As a plant gets larger and output increase, the average cost of producing each unit of output decreases As firms produce more products, they learn ways to improve production efficiency

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Some Newer Explanations For The Direction Of Trade


Imperfect Competition
Economies of scale with the existence of differentiated products--Paul Krugman

First-Mover Theory
Pattern of trade in goods subject to scale economies may be determined by historical factors

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Some Newer Explanations For The Direction Of Trade


National Competitive Advantage from Regional Clusters: Porters Diamond Model (figure 3.3)
National Competitiveness: a nations relative ability to design, produce, distribute, or service products while earning increasing returns on resources Demand conditions Factor Conditions Related and supporting industries Firm strategy, structure, and rivalry

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Figure 3.3 Variable Impacting Competitive Advantage: Porters Diamond

Source: Reprinted by permission of the Harvard Business Review. The Competitive Advantage of Nations by Michael E. Porter, MarchApril 1990, p. 77. Copyright 1990 by The President and Fellows of Harvard College; all rights reserved.

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Trade Restrictions: Arguments For


National Defense Sanctions to Punish Offending Nations Protect Infant (or Dying) Industry Protect Domestic Jobs from Cheap Foreign Labor Scientific Tariff or Fair Competition

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Trade Restrictions
Retaliation
Dumping: selling a product abroad for less than the cost of production, the price in the home market, or the price to third countries Social dumping Environmental dumping Financial services dumping Cultural dumping Tax dumping
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Trade Restrictions
Subsidies: Financial contributions, provided directly or indirectly by a government, which confer a benefit; include grants, preferential tax treatment, and government assumption of normal business expenses (figure 3.4) Countervailing duties: Additional import taxes levied on imports that have benefited from export subsidies

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Figure 3.4 Value of OECD Member Farm Subsidies

Source: Agriculture: Support Estimates, 2004, OECD in Figures: Statistics on the Member Countries. Accessed 7/2005 Link: http://dx.doi.org/10.1787/758034618756.

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Tariff Barriers
Tariff
Taxes on imported goods for the purpose of raising their price to reduce competition for local producers or stimulate local production

Ad Valorem Duty
An import duty levied as a percentage of the invoice value of imported goods

Specific Duty
A fixed sum levied on a physical unit of an imported good
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Tariff Barriers
Compound Duty
A combination of specific and ad valorem duties

Official Prices Variable Levy


An import duty set at the difference between world market prices and local governmentsupported prices

Lower Duty for more local Input


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Nontariff Barriers
Nontariff barriers (NTBs)
All forms of discrimination against imports other than import duties

Quantitative
Quotas: numerical limits placed on specific classes of imports Voluntary export restraints (VERs): Export quotas imposed by exporting nation

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Nontariff Barriers
Orderly Marketing Arrangements
Formal agreements between exporting and importing countries that stipulate the import or export quotas each nation will have for a good

Nonquantitative Nontariff Barriers


Direct government participation in trade Customs and other administrative procedures Standards
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From Multinational to Globally Integrated Manufacturing Systems


Close least efficient plants, and supply their markets with imports from other subsidiaries Change multidomestic manufacturing system to globally integrated system in which each plant performs the activities at which it is most efficient

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International Investment Theories


Monopolistic Advantage Theory
Theory that FDI is made by firms in oligopolistic industries possessing technical and other advantages over indigenous firms

Product and Factor Market Imperfections


Superior knowledge leads to differentiated products, and they lead to firm control on price and advantage over indigenous firm (Hymer and Caves)

Financial Factors
Imperfections in the foreign exchange markets (Aliber)

International Product Life Cycle


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International Investment Theories


Follow The Leader Cross Investment
Foreign direct investment by oligopolistic firms in each others home countries as a defense measure

Internalization Theory
An extension of the market imperfection theory: to obtain a higher return on its investment, a firm will transfer its superior knowledge to a foreign subsidiary rather than sell it in the open market

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International Investment Theories


Dynamic Capabilities
Theory that for a firm to successfully invest overseas, it must have ownership of unique knowledge or resources and the ability to dynamically create and exploit these capabilities

Dunnings Eclectic Theory Of International Production


Theory that for a firm to invest overseas, it must have three kinds of advantages: ownership-specific, internalization, and location-specific

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