International Business Exam 2

Free trade

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.

• Adam Smith’s theory of absolute advantage.

• David Ricardo’s theory of comparative advantage.

• Heckscher–Ohlin theory

Pattern of international trade

Much of the observed pattern of international trade is more difficult to explain.

• Ricardo’s theory of comparative advantage focuses on differences in productivity.

• Heckscher–Ohlin theory focuses on factors of production.

• Vernon’s product life-cycle theory focuses on production location changes as products become more widely accepted internationally.

• Krugman’s new trade theory focuses on first-mover advantages.

Trade theory and government policy

• Mercantilism advocates government involvement in promoting exports and limiting imports.

• Smith, Ricardo, and Heckscher–Ohlin call for unrestricted free trade.

• New trade theory and Porter’s national competitive advantage theory justify limited government intervention for certain export-oriented industries

Mercantilism

It is in a country’s best interest to maintain a trade surplus — to export more than it imports. Government intervention —> achieve a surplus in the balance of trade.

Flaw is that it views trade as a zero sum game when in reality a gain by one country results in a loss by another.

Adam Smith — absolute advantage

Attacked the mercantilist assumption of zero-sum game.

Promoted absolute advantage:

• Country has an absolute advantage in producing a product

when it is more efficient than any other country at

producing it.

• Countries should specialize in the production of goods for

which they have an absolute advantage and then trade

these goods for those produced by other countries.

• Both countries benefit by engaging and trading.

David Ricardo — comparative advantage

Promoted comparative advantage:

• A country should specialize in the production of goods it produces most efficiently and buy the goods it produces less efficiently from other countries, even if it can produce those goods more efficiently itself.

This theory suggests that trade is a positive-sum game in which all countries that participate realize economic gains

Extensions of the Ricardian model: diminishing returns

• Comparative advantage model assumes constant returns to specialization.

• More realistic to assume diminishing returns to specialization.

• Not all resources are the same quality.

• Different goods use resources in different proportions.

Extensions of the Ricardian model: dynamic effects and economic growth

Free trade can result in two types of dynamic gains:

1. Increase a country’s stock of resources as increased supplies of labor and capital from abroad become available within the country.

2. Increase the efficiency with which a country uses its resources.

• Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized will cause a country’s PPF to shift outward

The Samuelson critique

• Paul Samuelson asks: what happens when a rich country (United States) enters into a free trade agreement with a poor country (China) that rapidly improves its productivity after the introduction of a free trade regime?

• Lower prices may not make up for lower wages in the United States.

• Concerned with offshoring service jobs.

• Historically, free trade has benefited rich countries.

• Introducing protectionist measures may be harmful to United States.

Heckscher-Ohlin Theory

Factor Endowments

Comparative advantage arises from differences in national factor endowments.

• Extent to which a country is endowed with resources such as land, labor, and capital.

Countries will export goods that make intensive use of factors that are locally abundant.

Countries will import goods that make intensive use of factors that are locally scarce

The leontief paradox

• Raised questions about the validity of the Heckscher– Ohlin theory.

• Found that U.S. exports were less capital intensive than U.S. imports.

Raymond Vernon’s Product Life-Cycle Theory

A product is often invented and initially produced in a developed country, but as it becomes standardized and competition increases, production may shift to countries with lower production costs.

• other countries can now produce product at lower costs, limiting the potential of U.S exports

• now it is ethnocentric and dated

New Trade Theory

It argues that international trade benefits countries not only through specialization, but also through larger markets, lower production costs, greater product variety, and advantages for early-entering firms

Porter’s Diamond

• Tries to explain why a nation achieves international success in a particular industry.

• Four broad attributes of a nation shape the environment in which local firms compete:

1. Factor endowments.

2. Demand conditions.

3. Related and supporting industries.

4. Firm strategy, structure, and rivalry

Porter’s diamond cont.

Firms are most likely to succeed in industries or industry segments where the diamond is most favorable.

• The diamond is a mutually reinforcing system.

• Two additional variables can influence the national diamond:

1. Chance

2. Government

Why do countries trade? What do they trade?

Companies trade because there are “gains from trade” - no gain, no trade

Countries trade

• commodities - oil, wheat, soybeans

• manufactured goods - textiles, automobiles, airplanes

• services - call centers, tourism, consulting

“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

John Maynard Keynes’s quote means that even people who believe they think independently are often influenced by ideas created by other people long ago

Liberation day tariff with China

The U.S. government used the trade deficit with China to justify a 34% “reciprocal” tariff. The government treated the trade imbalance as a measure of unfairness but a trade deficit does not automatically prove unfair trade.

Absolute advantage

• Simplified economic model of two countries

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

– France makes wine

– Scotland makes wool

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

Comparative advantage

• A country should specialize in the production of goods it produces most efficiently and buy the goods it produces less efficiently from other countries, even if it can produce those goods more efficiently itself

– France makes wine – even if it can make wool more efficiently than Scotland

– Scotland makes wool – because it is comparatively more efficient at producing wool than wine

Heckscher-Ohlin Theory

• Comparative advantage arises from differences in national factor endowments

– Land

– Labor

– Capital

• Countries will export goods that make intensive use of factors that are locally abundant

• Countries will import goods that make intensive use of factors that are locally scarce

Product Life-Cycle Theory

• New products developed and sold in one country – typically the United States

• Over time, demand grows in other countries

–Product becomes standardized

–Price becomes the main competitive weapon —> countries that are low-cost producers

Import tariffs

• Generally ad valorem -- % of value of imported good

• Tax paid by the importer, exporting country government gains revenue

Export tariffs (more rare)

• U.S. ban on crude oil exports in 1975

• Potential diesel export ban in 2026

Instruments of trade policy - subsidies

Government payment to a domestic producer

1. Cash grants

2. Low-interest loans

3. Tax breaks

4. Government equity participation

• Winners: Domestic producers

• Losers: Consumers and taxpayers absorb the costs, foreign producers

Other types of trade policy

• Import quota - direct restrictions on quantity of some good that may be imported

• Voluntary Export Restraints/Voluntary Restraint Agreements

• Local content requirements

• Administrative policies - makes imports difficult

• Antidumping rules - dumping occurs when companies sell goofs at a foreign market below their costs of production or fair market value

National content rules — production is hard to move and the monopoly example

Making products entirely in America can be much more expensive and difficult when the manufacturing supply chain is concentrated overseas, especially in China.

The Monopoly game is an example of the challenges of bringing manufacturing back to the United States; it is much more expensive to produce it in the States

Misconduct can cause revocation of memberships

Misconduct can cause revocation of memberships

Arguments for government intervention

• protecting jobs and industries

• protecting national security

• government should use threat of intervention as a bargaining tool to open foreign markets (risky however)

• furthering foreign policy objectives

• protecting human rights

• strategic trade theory - government support can sometimes help domestic firms win a larger share of the global market and increase national income

Infant industry argument

Governments should temporarily support new industries until they have grown strong enough to meet international competition.

• Support comes through tariffs, import quotas, and subsidies.

Two criticisms:

1. Protection of manufacturing from foreign competition does no good unless it helps make the industry efficient.

2. Assumes firms are unable to make efficient long-term investments by borrowing money from the domestic or international capital market.

Corn Laws (corn = cereal grains)

Corn Laws in effect 1815-1846

• End of the Napoleonic Wars in 1815 —> cheap agricultural exports from Europe

• High tariffs on grains imported into Great Britain

• British landholders benefitted –> higher prices domestic grains

• Potato famine in Ireland contributed to repeal in 1846

• UK effectively “pro free trade” after that

Morrill Act and U.S. Civil War

Morrill Act raised tariffs on imported goods to generate government revenue and provide protection for American manufacturers from foreign competition.

The civil war affected its passage: the legislation passed the House in 1860, but it passed the Senate in 1861 after several Southern senators resigned following their states' secession. Tariffs were sought by northern manufacturers

Jones Act and WWI

• Enacted by Congress to stimulate shipping industry in the wake of WWI

• Mandates American ships only for transporting cargo between domestic ports

• Effectively outlaws foreign ships from operating between U.S. ports

Agriculture “in” GATT in 1947; “out” by 1955

GATT focused on reducing tariffs on goods

• The United States was a large net exporter after World War II and U.S. manufacturers wanted to compete outside the United States under more favorable terms

• In 1951, a Dutch ship carrying cheese prompted a unilateral U.S. cheese ban. U.S. State Department feared wrath of politicians like Sen. Joe McCarthy

• In 1955, another boat full of cheese prompted United States to seek waiver from GATT to exclude agriculture

– Every other nation then excluded agriculture from GATT

– This effectively made trade wars “legal” for agricultural goods

Foreign direct investment

When a firm invests directly in new facilities to produce or market a good or service in a foreign country.

• 10 percent or greater interest.

Once a firm undertakes FDI, it becomes a multinational enterprise.

Trends in FDI

Increase in both flow and stock of FDI over past 30 years.

Growing more rapidly than world trade and world output.

• A way to circumvent trade barriers.

• Driven by political and economic changes.

• Shift toward democratic political institutions and free market economies.

• Globalization has had a positive effect.

Source of FDI

• United States largest source since World War II.

• Other important source countries are UK, France, Germany, Japan, and the Netherlands.

• China became a major foreign investor around, especially in less developed nations.

Forms of FDI

Greenfield investment

• Establish a new operation in a foreign country

Acquire an existing company

• Quicker to execute

• Can acquire valuable strategic assets

• Can increase the efficiency of acquired business by transferring capital, technology and management skills

Theories of FDI

1. One set of theories: Why firms favor FDI over exporting or licensing

2. Another set of theories: Why firms undertake FDI at the same time and why they favor the same locations

3. “Eclectic paradigm” attempts to combine the two perspectives to single explanation – John Dunning

FDI is one set of decisions that companies make

• Allocating capital is what management teams, their boards, and their investors do

• FDI is one type of capital allocation

• Management teams weigh it against alternatives, including

–Exporting

–Licensing

–Other countries – and other strategies in other countries

Two alternatives to FDI

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

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

FDI is expensive and risky compared with exporting and licensing, however there are limitations to the two.

Political ideology of FDI: the radical view

• Roots in Marxist political and economic theory.

• Idea that multinational enterprises (MNEs) are an instrument of imperialist domination.

• Influential view from 1945 to 1980s, but no longer widely accepted.

• Its influence declined as communist economies struggled and some capitalist developing economies grew.

Political ideology of FDI: the free market view

• Roots in classical economic theory and trade theories of Adam Smith and David Ricardo.

• International production should be distributed among countries according to the theory of comparative advantage.

• FDI benefits both the source country and host country

• Political reality - wealthy people want to allocate their capital

Political ideology of FDI: pragmatic nationalism

• FDI has both benefits and costs

• Government pursues policies designed to maximize the national benefits and minimize the national costs

• They may offer foreign companies tax breaks or grants to persuade them to build factories, offices, or other facilities in their country

Quota rent

The extra profit that producers make when supply is artificially limited by an import quota

Regional trade blocs promote regional economic integration

• WTO must be notified.

• Economists believe free trade agreements produce gains from trade for all member countries.

• GATT and WTO seek to reduce trade barriers but reaching agreements is difficult.

• EU has been the most ambitious move toward regional economic integration.

• NAFTA, USMCA, Mercosur, and RCEP

Several levels of economic integration are possible in theory

From least to most integrated:

• Free trade area

• Customs union

• Common market

• Economic union

• Political union

Levels of economic integration: free trade area

Eliminates all barriers to the trade of goods and services among member countries.

Each country is allowed to determine its own trade policies regarding nonmembers.

• Rules of origin.

Most enduring is the European Free Trade Association (EFTA) between Norway, Iceland, Liechtenstein, and Switzerland.

NAFTA and USMCA.

Levels of economic integration: customs union

• Eliminates trade barriers between member countries and adopts a common external trade policy.

• The EU began as a customs union.

• Andean Community (formerly the Andean Pact) includes Bolivia, Colombia, Ecuador, and Peru.

Levels of economic integration: common market

No restrictions on immigration, emigration, or cross-border flows of capital among member countries.

Requires harmony and cooperation on fiscal, monetary, and employment policies.

• Has proved very difficult.

Mercosur (Argentina, Brazil, Paraguay, and Uruguay) is hoping to establish a common market.

• Venezuela accepted for membership but was suspended due to undemocratic policies.

Levels of economic integration: economic union

• Free flow of products and factors of production among member countries and the adoption of a common external trade policy.

• Requires a high degree of integration, a coordinating bureaucracy, and the sacrifice of national sovereignty to the bureaucracy.

• European Union (EU)

Levels of economic integration: political union

• Central political apparatus coordinates economic, social, and foreign policy of member states.

• EU headed toward at least partial political union, and the United States is an even closer example of political union

Economic case for integration

All countries gain from free trade and investment is a positive-sum game.

• Assumes an absence of barriers.

• Motivated by desire to exploit gains from free trade and investment.

Political case for integration

• Linking countries together and making them more dependent on each other promotes political cooperation.

• Reduces the likelihood of violent conflict.

• Gives countries greater political clout when dealing with other nations

Reasons why it has not been easy to achieve integration

1. While a nation as a whole may benefit from a regional free trade agreement, certain groups will lose.

2. It implies a loss of national sovereignty

European has two trade blocs:

1. European Union (EU):

• Twenty-seven members.

• British left at the beginning of 2020.

2. European Free Trade Association (EFTA):

• Four members.

What did the treaty of rome establish?

The European community

• provided for the creation of a common market

• later became the European Union

Regional economic integration in the americas

There is a move toward greater regional economic integration in the Americas.

• The biggest effort is the North American Free Trade Agreement (NAFTA), currently superseded by the USMCA.

• Other efforts include the Andean Community and Mercosur

NAFTA

• Abolished tariffs on 99 percent of goods traded between members.

• Removed barriers on the cross-border flow of services.

• Protects intellectual property rights.

• Removes most restrictions on FDI between members.

• Allows each country to apply environmental standards.

• Established two commissions to impose fines and remove trade privileges when environmental standards or legislations involving health and safety, minimum wages, or child labor are ignored.

The Case for NAFTA

Mexico would benefit from:

• Increased jobs as low-cost production moves south and more rapid economic growth as a result.

United States and Canada would benefit from:

• Access to a large and increasingly prosperous market.

• Lower prices for consumers from goods produced in Mexico.

• Low-cost labor and ability to be competitive in world markets.

• Increased imports by Mexico.

The case against NAFTA

• Jobs would be lost and wage levels would decline in the United States and Canada.

• Pollution would increase due to Mexico's more lax standards.

• Mexico would lose its sovereignty.

The results of NAFTA

• NAFTA’s early impact was subtle, and both advocates and detractors may have been guilty of exaggeration.

• Overall impact small but positive.

• Employment effects of NAFTA have been moderate to small.

• Mexico and the United States saw small welfare gains.

The United States–Mexico–Canada Agreement (USMCA)

NAFTA renegotiated to the USMCA.

• Automakers must produce 75 percent of content in North America.

• By 2023, 40 percent of parts for tariff-free vehicles must come from a “high-wage” factory.

• Open up the Canadian dairy market to U.S. producers.

• To become law, must be ratified by legislators in all three countries

Andean Community

Formed in 1969 based on EU model.

Had failed to achieve objectives by the mid-1980s.

Was relaunched in 1990.

• Goal to become a common market by 1995 not reached.

Renamed the Andean Community in 1997.

Signed an agreement in 2005 with Mercosur to restart negotiations toward the creation of a free trade area.

Mercosur

Originated in 1988 as a free trade pact between Brazil and Argentina.

Expanded in 1990 to include Paraguay and Uruguay and in 2012 with the addition of Venezuela.

• Venezuela suspended in 2016.

May be diverting trade rather than creating trade, and local firms are investing in industries that are not competitive on a worldwide basis.

Efforts stalled on reducing trade barriers between member states.

ASEAN

Foster freer trade between member countries and achieve cooperation in industrial policies.

ASEAN Free Trade Area (AFTA) between the six original members of ASEAN came into effect in 2003.

• ASEAN and AFTA moving toward establishing a free trade zone

The single European act

• Remove all frontier controls among EC countries.

• Apply the principle of “mutual recognition” to product standards.

• Institute open public procurement to nonnational suppliers.

• Lift barriers to competition in the retail banking and insurance businesses.

• Remove all restrictions on foreign exchange transactions between member countries by the end of 1992.

• Abolish restrictions on cabotage by the end of 1992

Impact of the single European act

• Impetus for restructuring substantial sections of industry.

• Fostered faster economic growth.

• Established legal, cultural, and language differences create uneven implementation.