International Trade Theory PDF

BM1917 INTERNATIONAL TRADE THEORY Mercantilism The first theory of international trade, mercantilism, emerged in England in the mid-sixteenth century. The principal assertion of mercantilism was that gold and silver were the mainstays of national wealth and ess...

BM1917 INTERNATIONAL TRADE THEORY Mercantilism The first theory of international trade, mercantilism, emerged in England in the mid-sixteenth century. The principal assertion of mercantilism was that gold and silver were the mainstays of national wealth and essential to vigorous commerce. At that time, gold and silver were the currency of trade between countries; a country could earn gold and silver by exporting goods. Conversely, importing goods from other countries would result in an outflow of gold and silver from those countries. The main tenet of mercantilism was that it was in a country’s best interests to maintain a trade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige, and power. As the English mercantilist writer Thomas Mun put it in 1630: “The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value.” Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. The mercantilists saw no virtue in a large volume of trade. Rather, they recommended policies to maximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, while exports were subsidized. The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in which a gain by one country results in a loss by another.) It was left to Adam Smith and David Ricardo to show the limitations of this approach and to demonstrate that trade is a positive-sum game or a situation in which all countries can benefit. Despite this, the mercantilist doctrine is by no means dead. EXAMPLE: Donald Trump appears to advocate neo-mercantilist policies. Neo-mercantilists equate political power with economic power and economic power with a balance-of-trade surplus. Critics argue that several nations have adopted a neo-mercantilist strategy that is designed to simultaneously boost exports and limit imports. For example, critics charge that China long pursued a neo-mercantilist policy, deliberately keeping its currency value low against the U.S. dollar to sell more goods to the United States and other developed nations, and thus amass a trade surplus and foreign exchange reserves. Absolute Advantage According to Smith, 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. In Smith’s time, this suggested the English should specialize in the production of textiles, while the French should specialize in the production of wine. England could get all the wine it needed by selling its textiles to France and buying wine in exchange. Similarly, France could get all the textiles it needed by selling wine to England and buying textiles in exchange. Smith’s basic argument, therefore, is that a country should never produce goods at home that it can buy at a lower cost from other countries. Smith demonstrates that by specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade. EXAMPLE: Consider the effects of trade between two countries, Ghana and South Korea. The production of any good (output) requires resources (inputs) such as land, labor, and capital. Assume that Ghana and South Korea both have the same amount of resources and that these resources can be used to produce either rice or cocoa. Assume further that 200 units of resources are available in each country. Imagine that in Ghana it takes 10 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between these two extremes. 05 Handout 1 *Property of STI  [email protected] Page 1 of 8  BM1917 Figure 1. The theory of absolute advantage Source: International Business: Competing in the Global Marketplace, 2018, p.165 The different combinations that Ghana could produce are represented by the line GG′ in Figure 1. This is referred to as Ghana’s production possibility frontier (PPF). Similarly, imagine that in South Korea it takes 40 resources to produce 1 ton of cocoa and 10 resources to produce 1 ton of rice. Thus, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination between these two extremes. The different combinations available to South Korea are represented by the line KK′ in Figure 1, which is South Korea’s PPF. Ghana has an absolute advantage in the production of cocoa. (More resources are needed to produce a ton of cocoa in South Korea than in Ghana.) By the same token, South Korea has an absolute advantage in the production of rice. Comparative Advantage Smith’s theory of absolute advantage suggests that such a country might derive no benefits from international trade. In his 1817 book Principles of Political Economy, David Ricardo showed that this was not the case. According to Ricardo’s theory of comparative advantage, it makes sense for 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. While this may seem counterintuitive, the logic can be explained with a simple example (Hill & Hult, 2018). EXAMPLE: Assume that Ghana is more efficient in the production of both cocoa and rice; that is, Figure 2. The theory of comparative advantage Source: International Business: Competing in the Global Marketplace, 2018, p.167 Ghana has an absolute advantage in the production of both products. In Ghana, it takes 10 resources to produce 1 ton of cocoa and 13½ resources to produce 1 ton of rice. Thus, given its 200 units of resources, Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or any combination in between on its PPF (the line GG′ in Figure 2). In South Korea, it takes 40 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, South Korea can produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or any combination on its PPF (the line KK′ in Figure 2). Again, assume that without trade, each country uses half its resources to produce rice and a half to produce cocoa. Thus, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice (point A in Figure 2), while South Korea will produce 2.5 tons of cocoa and 5 tons of rice (point B in Figure 2). 05 Handout 1 *Property of STI  [email protected] Page 2 of 8  BM1917 In light of Ghana’s absolute advantage in the production of both goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it has a comparative advantage only in the production of cocoa: Ghana can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice. Without trade, the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade, each country must consume what it produces. By engaging in trade, the two (2) countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods. Heckscher-Ohlin Theory Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of comparative advantage. They argued that comparative advantage arises from differences in national factor endowments. By factor endowments, they meant the extent to which a country is endowed with such resources as land, labor, and capital. Nations have varying factor endowments, and different factor endowments explain differences in factor costs; specifically, the more abundant a factor, the lower its cost. The Heckscher–Ohlin theory predicts that countries will export those goods that make intensive use of locally abundant factors while importing goods that make intensive use of locally scarce factors. Thus, the Heckscher–Ohlin theory attempts to explain the pattern of international trade that we observe in the world economy. Like Ricardo’s theory, the Heckscher–Ohlin theory argues that free trade is beneficial. Unlike Ricardo’s theory, however, the Heckscher– Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments, rather than differences in productivity. The Heckscher–Ohlin theory has commonsense appeal. EXAMPLE: The United States has long been a substantial exporter of agricultural goods, reflecting in part its unusual abundance of arable land. In contrast, China has excelled in the export of goods produced in labor- intensive manufacturing industries. This reflects China’s relative abundance of low-cost labor. The United States, which lacks abundant low-cost labor, has been a primary importer of these goods. Note that it is relative, not absolute, endowments that are important; a country may have larger absolute amounts of land and labor than another country but be relatively abundant in one of them. New Trade Theory The new trade theory began to emerge in the 1970s when several economists pointed out that the ability of firms to attain economies of scale might have important implications for international trade. Economies of scale are unit cost reductions associated with a large scale of output. Economies of scale have several sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipment. Economies of scale are a major source of cost reductions in many industries, from computer software to automobiles and from pharmaceuticals to aerospace. EXAMPLE: Microsoft realizes economies of scale by spreading the fixed costs of developing new versions of its Windows operating system, which runs to about $10 billion, over the 2 billion or so personal computers on which each new system is ultimately installed. Similarly, automobile companies realize economies of scale by producing a high volume of automobiles from an assembly line where each employee has a specialized task. New trade theory makes two (2) important points: (1) 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. (2) Second, in those industries in which the output required to attain economies of scale represents a significant proportion of total world demand, the global market may be able to support only a small number of enterprises. Thus, world trade in certain products may be dominated by countries whose firms were first movers in their production. 05 Handout 1 *Property of STI  [email protected] Page 3 of 8  BM1917 Increasing product variety and reducing costs Imagine first a world without trade. In industries where economies of scale are important, both the variety of goods that a country can produce and the scale of production are limited by the size of the market. If a national market is small, there may not be enough demand to enable producers to realize economies of scale for certain products. Accordingly, those products may not be produced, thereby limiting the variety of products available to consumers. Alternatively, they may be produced but at such low volumes that unit costs and prices are considerably higher than they might be if economies of scale could be realized. Now consider what happens when nations trade with each other. Individual national markets are combined into a larger world market. As the size of the market expands due to trade, individual firms may be able to better attain economies of scale. The implication, according to new trade theory, is that each nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods; thus, trade offers an opportunity for mutual gain even when countries do not differ in their resource endowments or technology. Suppose there are two (2) countries, each with an annual market for 1 million automobiles. By trading with each other, these countries can create a combined market for 2 million cars. In this combined market, due to the ability to better realize economies of scale, more varieties (models) of cars can be produced, and cars can be produced at a lower average cost, than in either market alone. For example, demand for a sports car may be limited to 55,000 units in each national market, while a total output of at least 100,000 per year may be required to realize significant scale economies. Similarly, demand for a minivan maybe 80,000 units in each national market, and again a total output of at least 100,000 per year may be required to realize significant scale economies. Faced with limited domestic market demand, firms in each nation may decide not to produce a sports car, because the costs of doing so at such low volume are too great. Although they may produce minivans, the cost of doing so will be higher, as will prices, than if significant economies of scale had been attained. Once the two (2) countries decide to trade, however, a firm in one nation may specialize in producing sports cars, while a firm in the other nation may produce minivans. The combined demand for 110,000 sports cars and 160,000 minivans allows each firm to realize scale economies. Consumers in this case benefit from having access to a product (sports cars) that were not available before international trade and from the lower price for a product (minivans) that could not be produced at the most efficient scale before international trade. Trade is thus mutually beneficial because it allows the specialization of production, the realization of scale economies, the production of a greater variety of products, and lower prices. Economies of scale, first-mover advantages, and the pattern of trade The second theme in the new trade theory is that the pattern of trade we observe in the world economy may be the result of economies of scale and first-mover advantages. First-mover advantages are the economic and strategic advantages that accrue to early entrants into an industry. The ability to capture scale economies ahead of later entrants, and thus benefit from a lower cost structure, is an important first-mover advantage. New trade theory argues that for those products where economies of scale are significant and represent a substantial proportion of world demand, the first movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match. Thus, the pattern of trade that we observe for such products may reflect first-mover advantages. Countries may dominate in the export of certain goods because economies of scale are important in their production and because firms located in those countries were the first to capture scale economies, giving them a first-mover advantage. Implications of the New Trade Theory The theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology. Trade allows a nation to specialize in the production of certain products, attaining scale economies and lowering the costs of producing those products, while buying products that it does not produce from other nations that specialize in the production of other products. By this mechanism, the variety of products available to consumers in each nation is increased, while the average costs of those products should fall, as should their price, freeing resources to produce other goods and services. 05 Handout 1 *Property of STI  [email protected] Page 4 of 8  BM1917 The theory also suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good. Because they can gain economies of scale, the first movers in an industry may get a lock on the world market that discourages subsequent entry. First-movers’ ability to benefit from increasing returns creates a barrier to entry. National Competitive Advantage: Porter’s Diamond Michael Porter, the famous Harvard strategy professor, has also written extensively on international trade. Porter and his team looked at 100 industries in 10 nations. Like the work of the new trade theorists, Porter’s work was driven by a belief that existing theories of international trade told only part of the story. For Porter, the essential task was to explain why a nation achieves international success in a particular industry. Why does Japan do so well in the automobile industry? Why does Switzerland excel in the production and export of precision instruments and pharmaceuticals? Why do Germany and the United States do so well in the chemical industry? These questions cannot be answered easily by the Heckscher–Ohlin theory, and the theory of comparative advantage offers only a partial explanation. The theory of comparative advantage would say that Switzerland excels in the production and export of precision instruments because it uses its resources very productively in these industries. Although this may be correct, this does not explain why Switzerland is more productive in this industry than Great Britain, Germany, or Spain. Porter tries to solve this puzzle. Porter theorizes that four (4) broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage (see Figure 3). These attributes are: Figure 3. Porter's Diamond Source: International Business: Competing in the Global Marketplace, 2018, p.180 1. Factor endowments – A nation’s position in factors of production, such as skilled labor or the infrastructure necessary to compete in a given industry. 2. Demand conditions – The nature of home demand for the industry’s product or service. 3. Related and supporting industries – The presence or absence of supplier industries and related industries that are internationally competitive. 4. Firm strategy, structure, and rivalry – The conditions governing how companies are created, organized, and managed and the nature of the domestic rivalry. Porter speaks of these four (4) attributes as constituting the diamond. He argues that firms are most likely to succeed in industries or industry segments where the diamond is most favorable. He also argues that the diamond is a mutually reinforcing system. The effect of one attribute is contingent on the state of others. For example, Porter argues favorable demand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firms to respond to them. Porter maintains that two (2) additional variables can influence the national diamond in important ways: chance and government. Chance events, such as major innovations, can reshape industry structure and provide the opportunity for one nation’s firms to supplant another’s. The government, by its choice of policies, can detract from or improve national advantage. For example, regulation can alter home demand conditions, antitrust 05 Handout 1 *Property of STI  [email protected] Page 5 of 8  BM1917 policies can influence the intensity of rivalry within an industry, and government investments in education can change factor endowments. Factor Endowments Factor endowments lie at the center of the Heckscher–Ohlin theory. While Porter does not propose anything radically new, he does analyze the characteristics of factors of production. He recognizes hierarchies among factors, distinguishing between basic factors (e.g., natural resources, climate, location, and demographics) and advanced factors (e.g., communication infrastructure, sophisticated and skilled labor, research facilities, and technological know-how). He argues that advanced factors are the most significant for competitive advantage. Unlike the naturally endowed basic factors, advanced factors are a product of an investment by individuals, companies, and governments. Thus, government investments in basic and higher education, by improving the general skill and knowledge level of the population and by stimulating advanced research at higher education institutions, can upgrade a nation’s advanced factors. The relationship between advanced and basic factors is complex. Basic factors can provide an initial advantage that is subsequently reinforced and extended by investment in advanced factors. Conversely, disadvantages in basic factors can create pressures to invest in advanced factors. An obvious example of this phenomenon is Japan, a country that lacks arable land and mineral deposits, and yet through investment has built a substantial endowment of advanced factors. Porter notes that Japan’s large pool of engineers (reflecting a much higher number of engineering graduates per capita than almost any other nation) has been vital to Japan’s success in many manufacturing industries. Demand Conditions Porter emphasizes the role home demand plays in upgrading competitive advantage. Firms are typically most sensitive to the needs of their closest customers. Thus, the characteristics of home demand are particularly important in shaping the attributes of domestically made products and in creating pressures for innovation and quality. Porter argues that a nation’s firms gain a competitive advantage if their domestic consumers are sophisticated and demanding. Such consumers pressure local firms to meet high standards of product quality and to produce innovative products. For example, Porter notes that Japan’s sophisticated and knowledgeable buyers of cameras helped stimulate the Japanese camera industry to improve product quality and to introduce innovative models. Related and Supporting Industries The third broad attribute of national advantage in an industry is the presence of suppliers or related industries that are internationally competitive. The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally. Swedish strength in fabricated steel products (e.g., ball bearings and cutting tools) has drawn on strengths in Sweden’s specialty steel industry. Technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in personal computers and several other technically advanced electronic products. Similarly, Switzerland’s success in pharmaceuticals is closely related to its previous international success in the technologically related dye industry. One consequence of this process is that successful industries within a country tend to be grouped into clusters of related industries. This was one of the most pervasive findings of Porter’s study. One such cluster Porter identified was in the German textile and apparel sector, which included high-quality cotton, wool, synthetic fibers, sewing machine needles, and a wide range of textile machinery. Such clusters are important because valuable knowledge can flow between the firms within a geographic cluster, benefiting all within that cluster. Knowledge flows occur when employees move between firms within a region and when national industry associations bring employees from different companies together for regular conferences or workshops. Firm Strategy, Structure, and Rivalry The fourth broad attribute of national competitive advantage in Porter’s model is the strategy, structure, and rivalry of firms within a nation. Porter makes two (2) important points here: 05 Handout 1 *Property of STI  [email protected] Page 6 of 8  BM1917 First, different nations are characterized by different management ideologies, which either help them or do not help them build national competitive advantage. EXAMPLE: Porter noted the predominance of engineers in top management at German and Japanese firms. He attributed this to these firms’ emphasis on improving manufacturing processes and product design. In contrast, Porter noted a predominance of people with finance backgrounds leading many U.S. firms. He linked this to U.S. firms’ lack of attention to improving manufacturing processes and product design. He argued that the dominance of finance led to an overemphasis on maximizing short-term financial returns. According to Porter, one consequence of these different management ideologies was a relative loss of U.S. competitiveness in those engineering-based industries where manufacturing processes and product design issues are all-important (e.g., the automobile industry). Porter’s second point is that 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. Domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced factors. All this helps create world-class competitors. Porter cites the case of Japan: “Nowhere is the role of domestic rivalry more evident than in Japan, where it is all-out warfare in which many companies fail to achieve profitability. With goals that stress market share, Japanese companies engage in a continuing struggle to outdo each other. Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings measure which companies are most popular with university graduates. The rate of new product and process development is breathtaking.” Balance of Payments Balance-of-Payments Accounts The balance of payments divides transactions in two (2) accounts: the current account and the capital account. Sometimes the capital account is called the financial account, with a separate, usually very small, capital account listed separately. The current account includes transactions in goods, services, investment income, and current transfers. The capital account, broadly defined, includes transactions in financial instruments and central bank reserves. Narrowly defined, it includes only transactions in financial instruments. The current account is included in calculations of national output, while the capital account is not. The sum of all transactions recorded in the balance of payments must be zero, as long as the capital account is defined broadly. The reason is that every credit appearing in the current account has a corresponding debit in the capital account, and vice-versa. If a country exports an item (a current account transaction), it effectively imports foreign capital when that item is paid for (a capital account transaction). If a country cannot fund its imports through exports of capital, it must do so by running down its reserves. This situation is often referred to as a balance of payments deficit, using the narrow definition of the capital account that excludes central bank reserves. In reality, however, the broadly defined balance of payments must add up to zero by definition. In practice, statistical discrepancies arise due to the difficulty of accurately counting every transaction between an economy and the rest of the world, including discrepancies caused by foreign currency translations. Economic Policy and Balance of Payments Balance of payments and international investment position data are critical in formulating national and international economic policy. Certain aspects of the balance of payments data, such as payment imbalances and foreign direct investment, are key issues that a nation's policymakers seek to address. Economic policies are often targeted at specific objectives that, in turn, impact the balance of payments. For example, one country might adopt policies specifically designed to attract foreign investment in a particular sector, while another might attempt to keep its currency at an artificially low level to stimulate exports and build up its currency reserves. The impact of these policies is ultimately captured in the balance of payments data. 05 Handout 1 *Property of STI  [email protected] Page 7 of 8  BM1917 Imbalances Between Countries While a nation's balance of payments necessarily zeroes out the current and capital accounts, imbalances can and do appear between different countries' current accounts. According to the World Bank, the U.S. had the world's largest current account deficit in 2018, at $491 billion. Germany had the world's largest surplus, at $291 billion. Figure 4.U.S. Balance on Current Account: 1999-2018 Source: https://www.investopedia.com/terms/b/bop.asp Such imbalances can generate tensions between countries. Donald Trump campaigned in 2016 on a platform of reversing the U.S.'s trade deficits, particularly with Mexico and China. The Economist argued in 2017 that Germany's surplus "puts an unreasonable strain on the global trading system," since "to offset such surpluses and sustain enough aggregate demand to keep people in work, the rest of the world must borrow and spend with equal abandon." REFERENCES Hill, C. W., & Hult, G. T. (2018). International business: Competing in the global marketplace (12th ed.). New York: McGraw-Hill Education. Kenton, W. (2020, April 23). Balance of Payments. Retrieved April 27, 2020, from Investopedia: https://www.investopedia.com/terms/b/bop.asp 05 Handout 1 *Property of STI  [email protected] Page 8 of 8