INTERNATIONAL TRADE THEORY

FREE TRADE
Free Trade – occurs when 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; no trade barriers; there is a relaxation of tariffs/ customs (international), taxes
(national)
Benefits of Trade – allow a country to specialize in the manufacture and export of products that
can be produced most efficiently in that country.
Pattern of International Trade – displays patterns that are easy to understand (Saudi Aradia: oil,
Mexico: labor intensive goods). Others are not easy to understand (Japan and cars).

PATTERN OF INTERNATIONAL TRADE

Some patterns of trade are fairly easy to explain: why Ghana exports cocoa, Brazil exports
coffee, and Saudi Arabia exports oil.
However, much of the observed pattern of international trade is more difficult to explain.
• Why does Japan export consumer electronics and automobiles?
• Why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry?
• Or why does Bangladesh exports garments?

TRADE THEORY AND GOVERNMENT POLICY

All these theories agree that international trade is beneficial to a country, they lack agreement
in their recommendations for government policy.
Ø Mercantilism is the practical translation of international trade which are imports and
exports. It makes a crude case for government involvement in promoting exports and
limiting imports.
Ø The theories of Smith, Ricardo, and Heckscher-Ohlin form part of the case for
unrestricted free trade. The argument for unrestricted free trade is that both import
controls and export incentives (such as subsidies) are self-defeating and result in wasted
resources.
Ø Both the new trade theory and Porter's theory of national competitive advantage can
be interpreted as justifying some limited government intervention to support the
development of certain export-oriented industries.
Adam Smith – father of modern economics
David Ricardo – studied most patterns of trade

MERCANTILISM: MID-16th CENTURY

A nation’s wealth depends on accumulated treasure
• Gold and silver are the currency of trade.
• Theory says you should have a trade surplus.
ü Maximize exports through subsidies.
ü Minimize imports through tariffs and quotas.
• Flaw: “Zero-sum game” – your gain is the loss of another
IS MERCANTILISM THEORY STILL VALID?
- A qualified yes, for example is Japan. Political power equates with economic power and
economic power with a trade surplus.

DAVID HUME (1752) – increased exports lead to inflation and higher prices and increased
imports lead to lower prices. In the long run, no one can keep a trade surplus.

THEORY OF ABSOLUTE ADVANTAGE

Adam Smith: Wealth of Nations (1776).
• Capability of one country to produce more of a product with the same amount of input
than another country.
• Produce only goods where you are most efficient, trade for those where you are not
efficient.
• Trade between countries is, therefore, beneficial.
• Assumes there is an absolute advantage balance among nations.
• Ghana/cocoa.

THEORY OF COMPARATIVE ADVANTAGE

David Ricardo: Principles of Political Economy (1817).
 Extends free trade argument
 Efficiency of resource utilization leads to more productivity.
 Should import even if country is more efficient in the product’s production than country
from which it is buying.
o Look to see how much more efficient. If only comparatively efficient, than
import.
 Makes better use of resources
 Trade is a positive-sum game.
Simple Extensions of the Ricardian Model
 Diminishing returns:
• the more a country produces, at some point, will require more resources.
• However:
• Free trade can increase a country’s production resources, and
• Increase the efficiency of resource utilization.

HECKSCHER (1919) - OLIN (1933) THEORY

• Eli Heckscher (1919) and Bertil Ohlin (1933)
• Comparative advantage arises from differences in national factor endowments (extent to
which a country is endowed with resources like land, labor, and capital)
ü The more abundant a factor, the lower its cost
• Heckscher and Ohlin predict that countries will export goods that make intensive use of
locally abundant factors and import goods that make intensive use of factors that are
locally scarce
THE LEONTIEF PARADOX, 1953
• Disputes Heckscher-Olin in some instances.
• Factor endowments can be impacted by government policy - minimum wage.
• US tends to export labor-intensive products, but is regarded as a capital intensive
country.

HECKSCHER VS RICARDO
• Economists prefer Heckscher on theoretical grounds but is a relatively poor predictor of
trade patterns.
• Ricardo’s Comparative Advantage Theory, regarded as too limited for predicting trade
patterns, actually predicts them with greater accuracy.
• In the end, differences in productivity may be the key to determining trade patterns.

PRODUCT LIFE-CYCLE THEORY (RAYMOND VERNON, 1966)

• Article in the Quarterly Journal of Economics.
• As products mature, both location of sales and optimal production changes.
• Affects the direction and flow of imports and exports.
• Globalization and integration of the economy makes this theory less valid.

PRODUCT LIFE CYCLE

v It accurately explains what has happened for products like photocopiers and other high
technology products developed in the U.S. in the 1960s and 1970s.
v Globalization and integration of the world economy has made this theory less valid
today.
v Viewed from an Asian or European perspective, Vernon's argument that most new
products are developed and introduced in the United States seems ethnocentric and
increasingly dated; production today is dispersed globally and products today are
introduced in multiple markets simultaneously.
THE NEW TRADE THEORY (1970)
Paul Krugman
• Suggests that the ability of firms to gain economies of scale can have important
implications for international trade.
• In these global industries with very large economies of scale, there is likely to be limited
competition, with the market dominated by early firms who entered, leading to a form
of monopolistic competition.
Through its impact on economies of scale, trade can increase the variety of goods available to
consumers and decrease the average cost of those goods.
Ø Without trade, nations might not be able to produce those products where economies
of scale are important; with trade, markets are large enough to support the production
necessary to achieve economies of scale.
Ø In those industries where output required to attain economies of scale represents a
significant proportion of total world demand, the global market may only be able to
support a small number of enterprises.
Ø First mover advantage - refers to an advantage gained by a company that first
introduces a product or service to the market. The first-mover advantage allows a
company to establish strong brand recognition and product/service loyalty
before other entrants
Ø Nations may benefit from trade even when they do not differ in resource endowments
or technology.
Ø Governments should consider strategic trade policies that nurture and protect
firms and industries where first-mover advantages and economies of scale are
important.

APPLICATION OF THE NEW TRADE THEORY

• Typically, requires industries with high, fixed costs.
• World demand will support few competitors.
• Competitors may emerge because “they got there first”.
• first-mover advantage.
• Some argue that it generates government intervention and strategic trade policy.

BOEING
• Founded 1915 by William Boeing
• Largest commercial airplane manufacturer.
• 9,000 commercial jetliners in service.
AIRBUS INDUSTRIES
• Established 1967
• Western Europe buying 25% of aircraft ,but selling only 10%.
• France, Germany, Great Britain
• To date: 3,203 orders - 1,890 deliveries.

PORTER’S DIAMOND (HARVARD BUSINESS SCHOOL, 1990)

• The Competitive Advantage of Nations.
 • Looked at 100 industries in 10 nations.
• Thought existing theories didn’t go far enough.
• Question: “Why does a nation achieve international success in a particular industry?”

DETERMINANTS OF NATIONAL COMPETITIVE ADVANTAGE

• Factor endowments: nation’s position in factors of production such as skilled labor or
infrastructure necessary to compete in a given [Link] can either be basic
(natural resources, climate, location, etc) or advanced (skilled labor, infrastructure,
technological know-how, etc)
• Demand conditions: the nature of home demand for the industry’s product or
service ,influences the development of capabilities. Sophisticated and demanding
customers pressure firms to be competitive.
• Related and supporting industries: the presence or absence in a nation of supplier
industries or related industries that are nationally competitive can spill over and
contribute to other industries; successful industries tend to be grouped in clusters in
countries.
• Firm strategy, structure and rivalry:the conditions in the nation governing how
companies are created, organized, and managed and the nature of domestic rivalry.
(1) different nations are characterized by different management ideologies, which either help
them or do not help them to build national competitive advantage;
(2) There is a strong association between vigorous domestic rivalry and the creation and
persistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to
look for ways to improve efficiency, which makes them better international competitors

PORTER’S DIAMOND DETERMINANTS OF NATIONAL COMPETITIVE ADVANTAGE

THE DIAMOND: IMPLICATIONS

• Success occurs where these attributes exist.
• More/greater the attribute, the higher chance of success.
• The diamond is mutually reinforcing.
FACTOR ENDOWMENTS
• Taken from Heckscher-Olin
• Basic factors:
• natural resources,
• climate,
• location.
• Advanced factors:
• communications,
• skilled labor,
• technology.

ADVANCED FACTORS ENDOWMENTS

• More likely to lead to competitive advantage.
• Are the result of investment by people, companies, government.

RELATIONSHIP OF BASIC TO ADVANCED FACTORS

• Basic can provide an initial advantage.
• Must be supported by advanced factors to maintain success.
• No basics, then must invest in advanced factors.

DEMAND CONDITIONS
• Demand creates the capabilities.
• Look for sophisticated and demanding consumers.
• impacts quality and innovation.

RELATED AND SUPPORTING INDUSTRIES

• Creates clusters of supporting industries that are internationally competitive.
• Must also meet requirements of other parts of the Diamond.

FIRM STRATEGY, STRUCTURE, AND RIVALRY

• Management ‘ideology’ can either help or hurt you.
• Presence of domestic rivalry improves a company’s competitiveness.

EVALUATING PORTER’S THEORY

• If Porter is right, country exports should reflect the presence of the four ‘diamond’
components. Countries will import goods from industries where some or all the
components are missing.
IMPLICATIONS FOR BUSINESS
• Location implications: makes sense to disperse production activities to countries where
they can be performed most efficiently.
• First-mover implications: It pays to invest substantial financial resources in building a
first-mover, or early-mover, advantage.
• Policy implications: promoting free trade is generally in the best interests of the home-
country, although not always in the best interests of the firm. Even though, many firms
promote open markets.
BALANCE OF PAYMENTS
• Balance of payments (BOP) is the record of all international trade and financial
transactions made by a country's residents (Amadeo, 2020).
• A country’s balance of trade refers to the difference in how much a country is importing
versus exporting.
• The three components of the balance of payments are the current account, financial
account, and capital account.
• An economy’s reliance on consumption and low prices has created a large deficit in the
balance of payments.
• Unchecked, a long-term rising deficit can lead to inflation and a lower standard of living.
A balance of payments deficit means the country imports more goods, services, and capital than
they export. It must borrow from other countries to pay for its imports.

BALANCE OF PAYMENTS DEFICIT

• the country becomes a net consumer, not a producer, of the world's economic output.
• It will have to go into debt to pay for consumption instead of investing in future growth.
• If the deficit continues long enough, the country may have to sell its assets to pay its
creditors. These assets include natural resources, land, and commodities.

BALANCE OF PAYMENTS SURPLUS

A balance of payments surplus means the country exports more than it imports. It provides
enough capital to pay for all domestic production. The country might even lend outside its
borders.
Ø There are enough excess savings to lend to countries that buy its products.
 Ø The increased exports boost production in its factories, allowing them to hire more
people.
Ø In the long run, the country becomes too dependent on export-driven growth. It must
encourage its residents to spend more.
Ø A larger domestic market will protect the country from exchange rate fluctuations. It also
allows its companies to develop goods and services by using its own people as a test
market.

BALANCE OF PAYMENTS ACCOUNTS

Current Account: Trade Balance
The trade balance measures a country's imports and exports. This portion is the largest
component of the current account, which is itself the largest component of the balance of
payments. Most countries try to avoid a trade deficit, but it's a good thing for emerging market
countries. It helps them grow faster than they could if they maintained a surplus.

Current Account
The current account measures a country's trade balance plus the effects of net income and
direct payments. When the activities of a country's people provide enough income and savings
to fund all their purchases, business activity, and government infrastructure spending, then the
current account is in balance

A current account deficit exist when a country's residents spend more on imports than they
save. Other countries lend funds or invest in, the deficit country's businesses To fund that
national deficit. The lender country is usually willing to pay for the deficit because its businesses
profit from exports to the deficit country. In the short run, the current account deficit is a
win/win for both nations.

Current Account: Trade Deficit Definition

A trade deficit is a result of a country's importing more than it exports. Imports are any goods
and services produced in a foreign country, even if these are produced overseas by a domestic
company.
A trade deficit can then occur even if all the imports are being sold by, and sending profit to, a
domestic firm. With the rise of multinational corporations and job outsourcing, trade deficits
are on the rise.

current account deficit

If the current account deficit continues for a long time, it will slow economic growth. Foreign
lenders will begin to wonder whether they will get an adequate return on their investment. If
demand falls off, the value of the borrowing country's currency may also decline. This fall in
currency value leads to inflation as import prices rise. It also creates higher interest rates as the
government must pay higher yields on its bonds.

Financial Account
The financial account measures changes in domestic ownership of foreign assets and foreign
ownership of domestic assets. If foreign ownership increases more than domestic ownership
does, it creates a deficit in the financial account. This increase means the country is selling its
assets, like gold, commodities, and corporate stocks, faster than the nation is acquiring foreign
assets.

Capital Account
The capital account measures financial transactions that don't affect a country's income,
production, or savings. For example, it records international transfers of drilling rights,
trademarks, and copyrights. Many capital account transactions rarely happen, such as cross-
border insurance payments. The capital account is the smallest component of the balance of
payments.

BALANCE OF PAYMENTS
National Tax Allocation – formerly International Revenue Allocation
Tariff – Taxes
Quota – Volume Requirement
Transaction cost – included in service expenses
Value = Benefit > Cost
Profit = Revenue – Cost