Chapter 5.pptx

Chapter Five: Connecting Countries through Trade and Factor Movements - TRADE AND FACTOR MOBILITY THEORY Dr. Hadeel Abdellatif Trade Theory Trade theory helps managers and government policymakers focus on three critical questions: 1. What products should be imp...

Chapter Five: Connecting Countries through Trade and Factor Movements - TRADE AND FACTOR MOBILITY THEORY Dr. Hadeel Abdellatif Trade Theory Trade theory helps managers and government policymakers focus on three critical questions: 1. What products should be imported and exported? 2. How much should be traded? 3. and with whom should they trade? Interventionist and Free Trade Theories Interventionist trade theories endorse great governmental intervention in trade movements (mercantilism and neomercantilism) while free trade theories endorse laissez-faire approach of no governmental intervention. A. Mercantilism it was the foundation of economic thought for nearly three hundred years (1500–1800). It claims that a country’s wealth is measured by its holdings of “treasure” (usually gold). 1. Governmental Policies. To export more than they imported, governments imposed restrictions on most imports and they subsidized products for export. 2. The Concept of Balance of Trade. To amass a surplus (a favorable balance of trade), a country must export more than it imports and then collect gold and other forms of wealth from countries that run a deficit (an unfavorable balance of trade). B. Neomercantilism. is the running of a favorable balance of trade (run an export surplus) to achieve some social or political objective. Free Trade Theories Theory of Absolute Advantage In 1776 Adam Smith asserted that the wealth of a nation consisted of the goods and services available to its citizens. His theory of absolute advantage holds that a country can maximize its own economic well-being by specializing in the production of those goods and services that it can produce more efficiently than any other nation and enhance global efficiency through its participation in (unrestricted) free trade. Smith reasoned that: (i) workers become more skilled by repeating the same tasks; (ii) workers do not lose time in switching from the production of one kind of product to another; and (iii) long production runs provide greater incentives for the development of more effective working methods. Smith also asserted that country-specific advantages can either be natural or acquired. 1. Natural Advantage. A country may have a natural advantage in the production of particular products because of given climatic conditions, access to particular resources, the availability of labor, etc. Variations in natural advantages among countries help to explain where particular products can be produced most efficiently. 2. Acquired Advantage. An acquired advantage represents a distinct advantage in product or process technology that yields differentiated product offerings and/or cost-competitive homogeneous products. Technology, in particular, has created new products, displaced old products, and altered trading-partner relationships. 3. How Does Resource Efficiency Work? Real income depends on the output of products as compared to the resources used to produce them. By defining the cost of production in terms of the resources needed to produce a product, the production possibilities curve shows that through the use of specialization and trade, the output of two countries will be greater, thus optimizing global efficiency. Theory of Comparative Advantage In 1817 David Ricardo reasoned that there would still be gains from trade if a country specialized in the production of those things it can produce most efficiently, even if other countries can produce those same things even more efficiently. Put another way, Ricardo’s theory of comparative advantage holds that a country can maximize its own economic well-being by specializing in the production of those goods and services it can produce relatively efficiently and enhance global efficiency through its participation in (unrestricted) free trade. 1. Comparative Advantage by Analogy. Would it make sense for the best physician in town, who also happens to be the most talented medical secretary, to handle all of the administrative duties of an office? No. The physician can maximize both output and income by working as a physician and employing a less skilled secretary.. In the same manner, a country will gain if it concentrates its resources on the production of the goods and services it can produce most efficiently. 2. Production Possibility. A country can simultaneously have a comparative advantage and an absolute advantage in the production of a given product. Assume that the United States is more efficient than Costa Rica in the production of both wheat and coffee; however, the U.S. has a comparative advantage in wheat production. By concentrating on the production of the product in which it has the greater advantage (wheat) and allowing Costa Rica to produce the product in which the United States is comparatively less efficient (coffee), global output can be increased, and specialization and trade will benefit both countries Theories of Specialization: Some Assumptions and Limitations The theories of absolute and comparative advantage are based upon the economic gains from specialization, i.e., concentration on the production of a limited number of products. Each holds that specialization will maximize output and that countries will be best off by trading the output from their own specialization for the output from other countries’ specialization. However, both theories make certain assumptions that may not always be valid. 1. Full Employment. Both theories (absolute and comparative advantage) assume that resources are fully employed. When countries have many unemployed or underemployed resources, they may seek to restrict imports in order to employ or use idle resources. 2. Economic Efficiency. Individuals and countries often pursue objectives other than economic efficiency. Individuals may prefer activities and/or occupations that are economically less productive, and nations may choose to avoid overspecialization because of the vulnerability created by potential changes in technology and price fluctuations. 3. Division of Gains. Although specialization does maximize output, it is not always clear how those gains will be divided. If one country believes that a trading partner is receiving too large a share of the benefits, it may choose to forego its relatively smaller gains in order to prevent the partner country from receiving larger gains. 4. Transport Costs. If it costs more to deliver products than can be saved via specialization, then the gains from trade are negated. 5. Insufficient Demand. If trade increases production by more than normally acceptable tea and wheat consumption, there still an advantage. The consumers in the two countries can gain access to sufficient output by working fewer hours, thus giving them more leisure time. 6. Statics and Dynamics. Although the theories of absolute and comparative advantage consider gains at a given time (a static view), the relative conditions that surround a country’s particular advantage or disadvantage are dynamic (constantly changing). Thus, one cannot assume that future advantages will remain constant. (This idea will also be relevant to the discussion of the dynamics of the location of production and export sources.) 7. Services. Although the theories of absolute and comparative advantage were developed from the perspective of trade in commodities, much of the same reasoning can be applied to trade in services. 8. Production Networks. While both theories deal with the trading of one product for another, increasingly there are divisions by components and function as well as within a company’s value chain network. The firm’s value chain can include a number of countries; however, the argument for specialization still remains valid. 9. Mobility. Neither the assumption that resources can move domestically from the production of one good to another at no cost, nor the assumption that resources cannot move internationally, is entirely valid. Nonetheless, domestic mobility is greater than the international mobility of resources. Clearly, the movement of resources such as capital and labor is a very real alternative to trade. Theories to Explain National Trade Patterns The free trade theories demonstrate how output growth occurs through specialization and free trade; however, they do not deal with trade patterns such as how much a country trades, what products it trades, or who will be its trading partners. In this section, we discuss the theories that help explain these patterns. A. How Much Does a Country Trade? Apart from non-tradable goods, i.e., goods and services that are impractical to export, country size helps to explain why some countries are more dependent on trade than others and why some account for larger portions of world trade than others. 1. Theory of Country Size. The theory of country size holds that large countries tend to export a smaller portion of their output and import a smaller portion of their consumption. Large countries are more apt to have varied climates and a greater assortment of natural resources than smaller economies, thus making the large countries more self-sufficient. Further, given the same types of terrain and modes of transportation, the greater the distance, the higher the associated transport costs. Thus, firms in large countries often face higher transportation costs in terms of sourcing inputs from and delivering output to distant foreign markets than do their closer foreign competitors. 2. Size of the Economy. Countries can be compared on the basis of their economic size, using indicators that include the value and share of world trade. Ten of the world’s top trading nations are high-income countries. Despite its low per capita income, China also has a large economy because of its very large population. Together, the top ten nations account for more than one-half of all of the world’s trade B. What Types of Products Does a Country Trade? The composition of a country’s trade depends on both its natural and acquired advantages. With respect to the latter, both production and product technology can be very important. 1. Factor-Proportions Theory. Developed by Eli Heckscher and Bertil Ohlin, the factor-proportions theory holds that countries have their best trade advantage when depending on their relatively abundant production factors. The following are few observations about the factor-proportions theory: a) Factor proportions theory appears logical, and a general observation gives many examples that conform to the theory; b) The factor proportions theory assumes production factors to be homogeneous, tests to substantiate the theory have been mixed; c) Factor proportions analysis becomes more complicated when the same product can be created by different methods, such as with labor versus capital intensity. d) Most new products originate in developed countries. Developing countries depend much more on the production of primary products; thus, they depend more on natural advantage. C. With Whom Do Countries Trade? High-income countries trade primarily with each other, and emerging economies primarily export primary and labor-intensive products. Nonetheless, it is also true that economic and cultural similarities, political interests, and distance affect the determination of trading partners. 1. Country-Similarity Theory. The country-similarity theory says that companies create new products in response to market conditions in their home market. They then turn to markets they see as most similar to what they are accustomed, especially those markets where consumers have comparable levels of per capita income a. Specialization and Acquired Advantage. In order to export, a company must provide consumers abroad with an advantage over what they could buy from their domestic producers. b. Product differentiation. Product differentiation causes countries to conduct two-way trade in seemingly similar products. c. The Effects of Cultural Similarity. Importers and exporters perceive greater ease in doing business in countries that are culturally similar to their home country, such as those that speak a common language. Likewise, historic colonial relationships explain much of the trade between specific developed and developing economies d. The Effects of Political Relationships and Economic Agreements. Political relationships and economic agreements among countries may discourage or encourage trade between them. e. The Effects of Distance. Although no single factor fully explains specific pairs of trading partners, the geographic distance between two countries is important in as much as transport costs increase with distance. The Dynamics of Export Capabilities Both the product life cycle theory and Porter’s diamond of national advantage theory help to explain how countries develop, maintain, and possibly lose their competitive advantages. A. Product Life Cycle (PLC) Theory Product life cycle theory states that the production location of certain manufactured products shifts as they go through their life cycle. The cycle consists of four stages: introduction, growth, maturity, and decline. 1. Introduction. Innovation, production, and sales occur in the domestic (innovating) country. Because the product is not yet standardized, the production process tends to be relatively labor-intensive, and innovative customers tend to accept relatively high introductory prices. 2. Growth. As demand grows, competitors enter the market. Foreign demand, competition, exports, and often-direct investment activities also begin to accelerate. 3. Maturity. Worldwide demand begins to level off, although it may be growing in some countries and declining in others. Production processes are relatively standardized and global price competition forces production site relocation to lower-cost developing countries. 4. Decline. Market factors and cost pressures dictate that almost all production occur in developing countries. The product is then imported by the country where it was initially developed—the importing firm may or may not be the innovating firm. 5. Verification and Limitations of PLC Theory. Exceptions to the typical pattern of the product life cycle theory would include: products with high transport costs, products that have very short life cycles, luxury goods and services, products that require specialized labor, products that can be differentiated from direct competitors, and products for which transportation costs are relatively high. B. The Diamond of National Competitive Advantage Introduced by Michael Porter, the diamond of national competitive advantage is a theory showing four features as important for competitive superiority: demand conditions; factor conditions; related and supporting Industries; and firm strategy, structure, and rivalry. Usually, all four conditions need to be favorable for an industry within a country to attain and maintain global supremacy. 1. Facets of the Diamond. Demand Conditions. The nature and level of demand in the home market lead to the establishment of production facilities to meet that demand. Factor Conditions. Resource availability (inputs, labor, capital, and technology) contributes to the competitiveness of both firms and countries that compete in particular industries. Related and Supporting Industries. The local presence of internationally competitive suppliers and other related industries contributes to both the cost effectiveness and strategic competitiveness of firms. Firm Strategy, Structure, and Rivalry. The creation and persistence of national competitive advantage requires leading-edge product and process technologies and business strategies. 2. Limitations of the Diamond of National Advantage Theory. The existence of the four favorable conditions may represent a necessary but insufficient condition for the development of a particular national industry. Even when abundant, resources are ultimately limited; thus, firms must make choices regarding their pursuit of existing opportunities. Further, given the ability of firms to gain market information and production inputs from abroad, the absence of favorable conditions within a country may be overcome by their existence internationally. 3. Using the Diamond for Transformation. Understanding and having the necessary conditions to be globally competitive are important, but these conditions are neither static nor purely domestic. For instance, the Costa Rican government altered its educational system to tailor the country’s human resource development to fit the needs of targeted industries. Likewise, it developed local supplies and attracted sufficient numbers of foreign firms so that their combined presence assured a vibrant competitive environment. The Theory and Major Effects of Factor Mobility Over time factor conditions change in both quality and quantity. Concomitantly, the mobility of capital, technology, and people also affects the relative capabilities of countries. Factor-mobility theory focuses on why production factors move, the effects of that movement on transforming factor endowments, and the impact of international factor mobility (especially people) on world trade. A. Why Production Factors Move 1. Capital. While capital is the most internationally mobile factor, short-term capital is the most mobile of all. Capital is primarily transferred because of differences in expected returns, although firms may also respond to government incentives. 2. People. People transfer internationally in order to work abroad, either on a temporary or a permanent basis. It may be difficult to distinguish between economic and political motives associated with international labor mobility, because poor economic conditions often accompany repressive and/or uncertain political conditions. B. Effects of Factor Movements Neither international capital nor population movements are new occurrences. Immigrants bring human capital, thus adding to the base of a country’s skills and enabling competition in new areas. Inflows of capital to those same countries can be used to develop infrastructure and natural and other acquired advantages, thus enabling increased participation in the international trade arena. 1. What Happens When People Move? Although capital and labor are in fact different production factors, they are intertwined. Countries lose potentially productive resources when educated people leave, a situation known as brain drain, but they may in turn gain from the remittances that citizens who are working abroad send home. Countries receiving human resources may also incur the cost of social services for acculturating people into a new culture and language. The Relationship between Trade and Factor Mobility Factor movement is an alternative to trade that may or may not be a more efficient allocation of resources. A. Substitution. When factor proportions vary widely among countries, pressures exist for the most abundant factors to move to countries with greater scarcity. Thus, in countries where labor is relatively abundant compared to capital, workers tend to be poorly paid or unemployed; many will attempt to go to countries that enjoy full employment and offer higher wages. Likewise, capital tends to move away from countries where it is abundant to those where it is relatively scarce. In some cases, however, the inability to gain sufficient access to foreign production factors may stimulate efficient methods of domestic substitution, such as the development of alternatives for traditional production methods. B. Complementarity. Factor mobility via foreign direct investment may in fact stimulate foreign trade because of the need for components, the parent company’s ability to sell complementary products, and the need for equipment for subsidiaries. Closing Case: LUKOIL While both Russia and LUKOIL must export to meet their economic objectives, political relations within and outside of Russia could impair LUKOIL’s future ability to export. Thus, foreign investment and ties to Western oil companies are very important to the firm’s ultimate success. Controlling 19 percent of Russia’s oil production and refining capacity, LUKOIL has become Russia’s largest oil company. High market prices have enabled LUKOIL to amass sufficient capital to make substantial foreign investments. While much of its FDI has been directed to nearby countries, LUKOIL has also acquired 100 percent of Getty Petroleum in the United States, as well as 2,000 U.S. stations from ConocoPhillips. Forward integration into filling stations will guarantee LUKOIL market access and enable the company to sell its crude oil during times of global oversupply. Further, LUKOIL sees its foreign acquisitions as a means of gaining experienced personnel, technology, and competitive know-how to help it compete more efficiently and effectively both at home and abroad.  What theories of trade help explain Russia’s position as an oil exporter? Why? Which ones don’t? Why not? How do global political and economic conditions affect global oil markets and prices. Discuss the following statement as it applies to Russia and LUKOIL: Regardless of the advantages a country may gain by trading, international trade will begin only if companies within that country have competitive advantages that enable them to be viable traders—and they must foresee profits in exporting and importing. In LUKOIL’s situation, what is the relationship between factor mobility and exports?