Globalization Exam 2

Trade Policy

The set of laws, regulations, and strategies a government uses to control the flow of goods and services across its borders, managing international trade to achieve economic and political goals.

Mercantilism

• (16th and 17th centuries) Encouraged exports and discouraged imports.

• In a country’s best interest to maintain a trade surplus-to export more than it imports

• Viewed trade as a zero-sum game: one in which a gain by one country results in a loss by another

Adam Smith (1776)

Promoted unrestricted free trade.

David Ricardo (19th century)

Built on Smith’s ideas; advocated comparative advantage.

Free Trade

Absence of barriers to the free flow of goods and services between countries. 

Benefits of Trade

• Specialize in manufacture and export of products that can be produced most efficiently in that country.

• Import products that can be produced more efficiently in other countries.

• Gains arise because international trade allows a country to specialize in the manufacture and export of products.

Pattern of International Trade

Ricardo’s theory of comparative advantage:

• Trade patterns reflect differences in labor productivity

Heckscher-Ohlin theory:

• Trade reflects the interplay between the proportions in which the factors of production are available in different countries and the proportions in which they are needed for producing particular goods.

Raymond Vernon:

• Trade patterns reflect a product’s life cycle.

New Trade Theory (Paul Krugman’s)

Trade will skew toward countries that have firms that are able to capture first-mover advantages.

National Competitive Advantage Theory (Michael Porter’s)

Country factors explain a nation’s dominance in the production and export of certain products.

Trade Theory and Government Policy

Trade Theory and Government Theory

• Mercantilism makes a case for government involvement in promoting exports and limiting imports

• Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade.

• New trade theory and Porter justify limited and selective government intervention to support development of certain export-oriented industries.

Absolute Advantage

• A country has absolute advantage in producing a product when it is more efficient than any other country in producing it.

• Smith (1776): countries differ in their ability to produce goods efficiently.

• Countries should specialize in production of goods they have an absolute advantage in and then trade these goods for goods produced by other countries.

• Trade is not a zero-sum game.

Comparative Advantage

• Ricardo (1817): What happens when one country has an absolute advantage in the production of all goods?

• A country should specialize in production of goods that it produces most efficiently and buy goods that it produces less efficiently from other countries.

• Trade is a positive-sum game in which all gain.

• Potential world production is greater with unrestricted free trade than with restricted trade.

• Provides a strong rationale for encouraging free trade.

Comparative Advantage - Qualifications and Assumptions

Qualifications and Assumptions:

1. Only two countries and two goods

2. Zero transportation costs.

3. Similar prices and values.

4. Resources can move freely from production of one good to another within a country.

5. Constant returns to scale.

6. Fixed stocks of resources.

7. No effects on income distribution within countries.

Comparative Advantage - Extensions of the Ricardian Model

Immobile Resources 

• Resources do not always move freely from one economic activity to another

• Example: labor-intensive versus knowledge-intensive goods

• Although the country as a whole gain from such a shift, certain producers will lose. 

Diminishing Returns

• Simple model assumes constant returns to specialization: the units of resources required to produce a good are assumed to remain constant.

• Assumption of diminishing returns is more realistic since not all resources are the same quality and different goods use resources in different proportions.

Comparative Advantage - Dynamic Effects and Economic Growth

• Trade might increase a country’s stock of resources as increased supplies become available from abroad.

• Free trade might increase the efficiency of resource utilization and free up resources for other uses.

• Dynamic gains will cause a country’s PPF (production possibility frontier) to shift outward.

Comparative Advantage - Trade, Jobs, and Wages: The Samuelson Critique

• Dynamic gains can lead to less beneficial outcomes.

• Technology advances allow companies to offshore service jobs that were not traditionally internationally mobile.

• Lower market clearing wage rate enough to outweigh positive benefits.

• Concedes that free trade has historically benefited rich countries, and that protectionist measures may be harmful.

Foreign Direct Investment

• A firm invests directly in new facilities to produce or market in a foreign country.

• According to U.S. Department of Commerce, FDI occurs when there is a 10. percent interest taken in a foreign business entity. 

• A firm engaged in FDI is a multinational enterprise.

Foreign Direct Investment in the World Economy

Important Terms

• Flow of FDI: amount of FDI undertaken over a given time period (normally over one year)

• Outflows of FDI: the flows of FDI out of a country

• Inflows of FDI: the flows of FDI into a country

• Stock of FDI: total accumulated value of foreign-owned assets at a specific point in time.

Trends in FDI

Both the flow and stock of FDI in the world economy have increased over the last 30 years.

FDI flow has grown more rapidly than world trade and world output.

• Firms still fear protectionist policies

• The shift toward democratic political institutions and free market economic encourages FDI.

• Globalization prompts firms to have a significant presence in many regions of the world.

The Direction of FDI

Historically, most FDI been directed at developed nations.

• United states and European are favorite targets.

More recently, developing nations have been recipients of FDI.

• Eastern Europe and Southeast Asia—particularly China—have received significant inflows.

• Latin America is also also emerging as an important region for FDI.

• China is becoming a major investor in Africa, especially in the extraction industries.

The Source of FDI

The Source of FDI

• Since World War II, the U.S. has been the largest source country for FDI.

• Other important source countries: United Kingdom, Netherlands, France, Germany, and Japan.

• Chinese firms recently emerging a major foreign investors.

Greenfield Investments

Establishing new operations in a foreign country.

Why Foreign Direct Investment?

• Exporting:  producing goods at home and then shipping them to the receiving country for sale.

• Licensing: granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit the foreign entity sells.

• Foreign investment may be both expensive and risky compared with exporting and licensing.

Limitations of Exporting

• Exporting strategy can be limited by transportation costs and trade barriers.

• When transportation costs are high, exporting can be unprofitable (Low value-to-weight ratio)

• Foreign direct investment may be a response to actual or threatened trade barriers such as import tariffs or quotas.

Internalization theory (or market imperfections approach)

• Licensing could result in a firm’s away valuable technological know-how to a potential foreign competitor.

• Licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability.

• Licensing may be difficult if the firm’s competitive advantage is not amenable to it.