International Trade Theories and Global Business Environment

Global Business Environment: International Trade Theory

Learning Objectives

Understand why nations trade with each other.
Summarize the different theories explaining trade flows between nations.
Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.
Understand the important implications that international trade theory holds for management practice.

What is International Trade?

Exchange of raw materials and manufactured goods (and services) across national borders.
Free trade: where 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.

An Overview of Trade Theory

Modern Trade Theories: Explains the many factors that influence why certain countries produce and trade certain items (e.g., Japan – electronics, Thailand – rice).
Classical Trade Theories: Explain why trade happens and how it benefits the world economy.

Mercantilism (16th and 17th Centuries)

It is in a country’s best interest to maintain a trade surplus—to export more than it imports.
Governments should intervene to promote exports and to minimize imports.
Export products and in return, get wealth, gold, and silver.

Winners and Losers of Mercantilism

Benefited: Governments and domestic producers.
Domestic producers got support to export, and had no foreign competition at home.
Harmed: Consumers (higher prices, fewer choices).
Donald Trump and others are ‘neo-mercantilist’ or protectionist.

Why is the Concept of Mercantilism Incorrect?

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

Protectionism

Example: When Obama in 2009 imposed tariffs on Chinese tire imports, it temporarily preserved 1,200 jobs, but the cost to U.S. consumers was more than $1 billion.
As tires got more expensive, tire buyers had less money to spend, leading to a loss of 3,731 jobs in retail employment (Businessweek, Jan 27-Feb 4 2014).

Absolute Advantage

Adam Smith (1776): Countries differ in their ability to produce goods efficiently.
A country has an absolute advantage in producing a product when it is more efficient than any other country in producing it.
According to Smith:
- Trade is not a zero-sum game.
- Countries should specialize in the production of goods they have an absolute advantage in and then trade these goods for goods produced by other countries.

The Theory of Absolute Advantage

Illustrative graphs and tables demonstrating resource allocation and gains from trade through specialization.
Example provided demonstrates the advantages of Ghana specializing in cocoa production and South Korea specializing in rice production to maximize total production and consumption.

In-Class Exercise

An exercise example suggests redoing the table assuming countries are Hong Kong and the United States, with products being toys and computers, to further demonstrate absolute advantage.

Quote from Adam Smith

Referenced from "The Wealth of Nations," highlighting the importance of foreign commerce and the limitations faced by countries that restrict trade.

Comparative Advantage

David Ricardo (1817): What happens when one country has an absolute advantage in the production of all goods?
Proposed theory of comparative advantage.
A country should specialize in the production of goods that it produces most efficiently and buy goods that it produces less efficiently from other countries.

The Theory of Comparative Advantage

Graphs and tables illustrating comparative advantage, indicating how countries can still benefit from trade even if one country has an absolute advantage in producing all goods.
Example: Ghana specializes in cocoa and South Korea in rice.

Comparative Advantage and the Gains from Trade

Resources required and production/consumption scenarios showing gains from specialization and trade.

In-Class Exercise

Repeat the example, assuming resources required for toys in Hong Kong is 20 and in the U.S. is 16.6, while for computers, it's 25 in Hong Kong and 10 in the U.S.
Starting position requires each country to use an equal amount of resources producing each of the two products.
After specialization, the U.S. still devotes 25% of its resources to making toys, and the countries trade 4.5 computers for 4.5 toys.

Comparative Advantage Takeaways

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.
TRADE IS GOOD!

Qualifications and Assumptions of Comparative Advantage

Only two countries and two goods.
Zero transportation costs.
Similar prices and values.
Resources are mobile between the production of one good to another within a country.
Constant returns to scale.
Fixed stocks of resources.
No effects on income distribution within countries.

Contemporary Trade Theory

Why does each country specialize in the things that it does, and why does each country import different things?
Heckscher-Ohlin Theory.
Product Life Cycle Theory.
Strategic Trade Policy.
Porter’s National Diamond.

Heckscher-Ohlin Theory

Comparative advantage reflects differences in national factor endowments – extent to which a country is endowed with resources such as land, labor, and capital.
Theory has commonsense appeal.
Export goods that make intensive use of factors that are locally abundant.
Import goods that make intensive use of factors that are locally scarce.

Heckscher-Ohlin Theory: The Leontief Paradox

Leontief (1953): Since the U.S. was relatively abundant in capital, it would export capital-intensive goods and import labor-intensive goods.
U.S. exports were less capital intensive than U.S. imports.
Possible explanations were given, but a general recognition emerged that although endowments are important, other things are also important.

The International Product Life-Cycle Theory

Raymond Vernon (mid-1960s).
For most of the 20th century, the majority of the world’s new products were produced and sold in the U.S. market.
At the time, the wealth and size of the U.S. market gave a strong incentive for U.S. firms to develop new products.
Initially, demand for products in other countries was limited to high-income groups.
As products mature, both the location of sales and optimal production location will change, affecting the flow and direction of trade.
The product becomes standardized, and price becomes the main competitive weapon.
U.S. switches from an exporter to an importer as production goes to lower-cost foreign locations.

International Product Life Cycle

A diagram illustrates the shifts in production and consumption patterns of a product from its introduction in a developed country to its standardization and production in developing countries.

International Product Life-Cycle Theory in the Twenty-First Century

Product life cycle may not be as relevant today.
Many products are now introduced in Japan, South Korea, or other emerging markets.
Many new products are introduced simultaneously into the U.S., Europe, and Asia.
Firms use globally dispersed production from the start.

New Trade Theory (Strategic Trade Theory)

Classical theories assumed constant returns to scale.
Economies of scale: unit cost reductions associated with large-scale output.
First movers (inventor countries) can gain economies of scale before other countries begin to produce.
This price advantage gained (first-mover advantages) makes it difficult for other countries to compete (entry barriers).
Patterns of trade explained by who gains economies of scale first.

Implications of New Trade Theory

A country may predominate in the export of goods because it was lucky enough to have one or more firms be the first to produce them.
New trade theory is at variance with the Heckscher-Ohlin theory.
New trade theory provides an economic rationale for proactive trade policy that is at variance with other free trade theories.

National Competitive Advantage: Porter’s Diamond

Porter believed existing theories of international trade only told part of the story.
Wanted to explain why a nation achieves international success in a particular industry.
Porter’s Diamond – Four attributes of a nation that shape the environment in which local firms compete.
Chance and government can influence the national diamond.

The Determinants of National Competitive Advantage: Porter’s Diamond

A diagram of Porter’s Diamond, highlighting Factor Conditions, Demand Conditions, Related and Supporting Industries, and Firm Strategy, Structure, and Rivalry.

Porter's Diamond Model Factors

Chance: Random events, natural disasters, scientific breakthroughs, market turmoil, changes in social structure, war, political situations, terrorist attacks.
Firm Strategy, Structure and Rivalry: Company strategies, structure of the organization, managerial systems, intense competition between local rivals.
Factor Conditions: Natural resources, human resources, capital resources, infrastructure, scientific knowledge, technological innovation.
Demand Conditions: Size of the domestic market, sophisticated and demanding domestic customers, customer needs that anticipate those elsewhere.
Related and Supporting Industries: Presence of competitive related and supporting industries, domestic suppliers that are strong global players themselves.
Government: Government policies, industry regulation, government role as a catalyst and a challenger.

National Competitive Advantage: Porter’s Diamond Details

Factor Endowments:
- Basic: Natural resources, climate, location, demographics.
- Advanced: Communication infrastructure, skilled labor, technological know-how.
- Advanced factors are more significant for competitive advantage.
Demand Conditions:
- Size and nature of home demand for an industry’s product or service.
- Sophisticated and demanding customers pressure firms to be more competitive and produce high-quality, innovative products.
Related and Supporting Industries:
- Presence of supplier industries and related industries that are internationally competitive.
- These industries can spill over and contribute to success in other industries.
- Successful industries are grouped in clusters within countries, prompting knowledge flows between firms.
Firm Strategy, Structure, and Rivalry:
- Strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry.
Porter’s model has been used by many governments worldwide to identify industries where a country may have a competitive advantage and to invest in enhancing their diamonds so as to help these industries.
Hong Kong’s science park is an example of this.
Empirical testing of Porter’s framework is limited, but it may be the best model we have for understanding why countries are competitive in certain industries.

Focus on Managerial Implications

Location, First-Mover Advantages, and Government Policy.
- Location: Underlying thought in most theories.
- First-mover advantages: Particularly true in industries where the global market can profitably support a limited number of firms.
- Government policy: Businesses can exert a strong influence on government trade policy.

Summary

Understood why nations trade with each other.
Summarized the different theories explaining trade flows between nations.
Recognized why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.
Explained the arguments of those who maintain that governments can play a proactive role in promoting national competitive advantage in certain industries.
Understood the important implications that international trade theory holds for business practice.