VI. International Trade Theory (ies)

Def. of free trade

Government does not influence what citizens can buy or sell from/to another country

Many economists believe that it raises economic welfare of countries

Three main trade theories

Mercantilist: encourage exports and limit imports

Absolute/comparative advantage theory: specific benefits of international trade

Product Life-Cycle Theory**: no es relevante hoy

New trade theory/ Porter: In some industries the gobal market may be able to support only a small number of enterprises

General considerations of mercantilist theory

Country’s best interests: maintain a trade surplus

Export more than it import

Government intervention: to achieve surplus

Imports: limited by tariffs and quotas

Exports: subsidized

Trade as a zero-sum game: someone who wins and someone who loses

Critics/ limitations of mercantilist theory

Doesn’t take into account the reaction of prices to the accumulation of wealth: inflation that can lead to a change in prices (make foreign goods more convenient)

Not sustainable

Absolute advantage

Developed by Adam Smith

A country has an absolute advantage in the production of a product when it is more efficient than any other country at producing it

Countries should specialise and trade that products

A country should never produce goods at home that it can buy at a lower cost from other countries

Trade increases the efficiency of the economy

Comparative advantage

Developed by Ricardo

What might happen when one country has an absolute advantage in the production of all goods?

A country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries

Even if this means buying goods from other countries that it could produce more efficiently itself due to opportunity cost

If the world production increases = consumption in both countries increases

Def. of opportunity cost

The cost of using the resources to produce one product rather than other

Limitations of absolute/comparative advantage theory

Draw from a very simple model, and has unrealistic assumptions

7 (Unrealistic) assumptions of absolute/comparative advantage theory

A simple world in which there are only two countries and two goods. In the real world, there are many countries and many goods.

We have assumed away transportation costs between countries

No differences in price of resources

Assumption that resources can move freely across industries (not take into account adjustment costs)

Constant returns to scale: assume that the units of resources required to produce a good will remain constant, however they may decrease or increase when a nation specializes

Each country has a fixed stock of resources and free trade does not change the efficiency with which a country uses its resources

We have assumed away the effects of trade on income distribution within a country

Extensions of the Ricardian Model (to overcome limitation)

Immobile resources

Diminishing returns

Dynamic Effects of Trade and Economic Growth

Immobile resources

Response to effects of trade on income distribution within a country

Shift to free trade may create unemployment or relocation of jobs, as a result political opposition to free trade typically comes from those whose jobs are most at risk

Governments responses: help to retrain those who lost their jobs such as compensation

Pain caused free trade transition: short-term phenomenon

Gains from trade once the transition is done: significant and enduring

Diminishing returns

Response to constant returns to scale

They occur when more units of resources are required to produce each additional unit
Free trade still beneficial, but gains may not be as great as in case with constant returns

Response: Specialize until you reach the diminishing returns

Dynamic Effects of Trade and Economic Growth

Response to fixed stock of resources

It is not ture that a country has a fixed stock of resources. Resources change

But, with trade you may: increase a country’s stock of resources, increase the efficiency with which a country uses its resources, and increase productivity and competition

Samuelson Critique

What happens when a rich country enters into a free trade agreement with a poor country that rapidly improves its productivity after the introduction of a free trade regime? Dynamic gains can lead to less beneficial outcomes

(i.e. Being able to purchase groceries 20 percent cheaper at Wal-Mart (due to international trade) does not necessarily make up for the wage losses (in America))

Link between trade and growth

Evidence suggests that countries open to trade have higher growth rates, and they raise income levels and living standards

Protectionist measures may be more harmful than free trade (tariffs, subsidiaries)

Free trade has historically benefited rich countries

Heckscher-Ohlin Theory

Comparative advantage arises from differences in national factor endowments

Countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce

Free trade is beneficial

Main difference of Ricardian theory and Heckscher-Ohlin Theory

Heckscher–Ohlin theory - international trade is determined by differences in factor endowments

Ricardo- international trade is determined by differences in productivity.

Leontief paradox

In theory, Heckscher–Ohlin makes more sense that the Ricardian model, however in practice theory of comparative advantage, actually predicts trade patterns with greater accuracy

Comes after analysing the US case (using the logic of Heckscher–Ohlin because the United States was relatively abundant in capital compared to other nations, the United States would be an exporter of capital-intensive goods and an importer of labor-intensive goods. However, he found that U.S. exports were less capital intensive than U.S. imports)

What explains the Leontief paradox

Role of technology: once you control for differences in technologies across countries, HO theory seems to gain predictive power.

(once differences in technology across countries are controlled for, countries do indeed export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce.)

Product Life-Cycle Theory by Vernon

A very large proportion of the world’s new products had been developed by U.S. firms and sold first in the U.S. market

Wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new consumer products. The high cost of U.S. labor gave U.S. firms an incentive to develop cost-saving process innovations.

Product could be developed by a U.S. firm and first sold in the U.S. market, but later produced abroad at some low-cost location and then exported back into the United States.

Accurate during the period of American global dominance, today due to glob. the theory is less valid.

New trade theory

Economies of scale become the source of comparative advantage

Nations may benefit from trade even when they do not differ in resource endowments or technology

Def of economies of scale

Unit cost reductions associated with a large scale of output

First-mover advantages

Economic and strategic advantages that accrue to early entrants into an industry

Ability to capture scale economies ahead of later entrants, and thus ben- efit from a lower cost structure

Luck, entrepreneurship, and innovation give a firm first-mover advantages

4 determinants of national competitive advantage (Porter’s diamond)

Factor Endowments

Demand Conditions

Related and Supporting Industries

Firm Strategy, Structure, and Rivalry

Factor Endowments

Recalls the HO theory, however Porter identifies 2 types of factors:

Basic factors: natural resources, climate

Advanced factors: knowledge, education, research infrastructures

Demand Conditions

Demand of local customers

Nation’s firms gain competitive advantage if their domestic consumers are sophisticated and demanding

Related and Supporting Industries

Presence of suppliers or related industries that are internationally competitive

Different players of the value chain are located in the same place

Firm Strategy, Structure, and Rivalry

Different management ideologies, will either help them or do not help them build national competitive advantage

Domestic rivalry - look new ways to improve efficiency - makes them better international competitors

Implications of Porter’s theory

Government can influence each of the four components of the diamond, positively or negatively

Has not been subjected to detailed empirical

Managerial implications of International Trade Theory

Location: disperse productive activities to those countries where, according to the theory of international trade, they can be performed most efficiently

First-mover advantages: invest in trying to build an early advantage (even if that means several years of losses, later recompensed)

Government policy: the government should invest in education, infrastructure, and basic research. Advantageous for local firms