COMM211 Chapter 5: International Trade Theories PDF

CHAPTER 5 INTERNATIONAL TRADE THEORIES Lecture 4 AGENDA International Trade theories – Mercantilism – Absolute Advantage Theory – Comparative Advantage Theory – Product Life Cycle Theory – New Trade Theory – National Competitive Advantage Theory INTERNATIONAL TRA...

CHAPTER 5 INTERNATIONAL TRADE THEORIES Lecture 4 AGENDA International Trade theories – Mercantilism – Absolute Advantage Theory – Comparative Advantage Theory – Product Life Cycle Theory – New Trade Theory – National Competitive Advantage Theory INTERNATIONAL TRADE THEORIES International Trade Theories: economic frameworks that seek to explain the patterns and benefits of international trade between countries. These theories help economists and policymakers understand why countries engage in trade, what they trade, and the potential gains from trade. INTERNATIONAL TRADE THEORIES Mercantilism (Europe 16th – 18th century): economic theory based on the belief that a nation's wealth and power could be measured by the amount of gold and silver it possessed. Best way to achieve this wealth was through international trade, particularly by maximizing exports (to get the gold and silver), and minimizing imports (to avoid spending gold and silver) = balance of trade surplus This resulted in substantial government involvement in regulating trade and the implementation of protectionist policies, such as export subsidies (to encourage export), and import tariffs and quotas (to prevent imports) INTERNATIONAL TRADE THEORIES Mercantilism : how did it work? INTERNATIONAL TRADE THEORIES Why did colonies remain loyal to their mother country?  mercantilist system imposed strict regulations on trade (i.e., colonies were prohibited from trading with other nations, and were required to purchase finished goods only from the mother country) * This allowed the mother country to control trade outcome and ensure INTERNATIONAL TRADE THEORIES Main Drawbacks of Mercantilism: Exploitative nature of trade – i.e., mother country exploited colonies for financial gain, which negatively impacted the INTERNATIONAL TRADE THEORIES Other Drawbacks of Mercantilism: By trying to minimize imports, countries strived to be self sufficient – i.e., produce everything themselves → Undermined economic efficiency by stifling specialization, innovation and productivity. INTERNATIONAL TRADE THEORIES Other Drawbacks of Mercantilism: Not a sustainable system = Inflation INTERNATIONAL TRADE THEORIES Other Drawbacks of Mercantilism: Assumption that trade is a zero-sum game – i.e., assumption that total amount of wealth in the world is fixed and therefore if one country wants to gain, another country has to necessarily lose. * Assumption has been disproven Example: Let’s assume that there exists a finite amount of ice cream. INTERNATIONAL TRADE THEORIES Absolute Advantage Theory (Adam Smith, 1776): key to understanding international trade is the concept of specialization, where each country should specialize in producing the goods or services in which it has an absolute advantage (i.e., more efficient at producing than other countries), and then trade with other countries to obtain the goods and services it cannot produce efficiently. By doing so, both countries can benefit from trade (i.e., win-win). Example: Let’s assume that Mike bakes great pizzas and Wendy makes amazing ramen INTERNATIONAL TRADE THEORIES Absolute Advantage Theory (Adam Smith, 1776): key to understanding international trade is the concept of specialization, where each country should specialize in producing the goods or services in which it has an absolute advantage (i.e., more efficient at producing than other countries), and then trade with other countries to obtain the goods and services it cannot produce efficiently. By doing so, both countries can benefit from trade (i.e., win-win). France Poland Wine 50 > > 15 Tires 10 30 INTERNATIONAL TRADE THEORIES Absolute Advantage Theory (Adam Smith, 1776): key to understanding international trade is the concept of specialization, where each country should specialize in producing the goods or services in which it has an absolute advantage, and then trade with other countries to obtain the goods and services it cannot produce efficiently. By doing so, both countries can benefit from trade. Assume that trade is a positive-sum game: i.e., total gains of all players combined are greater than the total losses Cooperation and collaboration → mutual benefit INTERNATIONAL TRADE THEORIES Comparative Advantage Theory (David Ricardo, 1817): countries can benefit from specializing in the production of goods and services in which they have a lower opportunity cost (i.e., cost of producing one unit of a good in terms of the number of units of another good that could have been produced instead) and trading with other countries to obtain goods and services in which they have a higher opportunity cost. Assume that trade is a positive-sum game Cooperation and collaboration → mutual benefit INTERNATIONAL TRADE THEORIES France Poland Wine 50 > 15 Tires 10 > 5 Does this mean that these two countries shouldn’t trade? INTERNATIONAL TRADE THEORIES Opportunity cost: how many of product B is given up when you produce one unit of product A? France Poland Wine 50 > 15 Tires 10 > 5 Opportunity cost of producing tires (France): 50 / 10 = 5 wines (i.e., producing one tire costs France 5 bottles of wine) Opportunity cost of producing tires (Poland): 15 / 5 = 3 wines *** Its cheaper for Poland to produce the tires INTERNATIONAL TRADE THEORIES Analogy: INTERNATIONAL TRADE THEORIES By the way… When we talk about developing comparative advantages, we don’t always refer to a finished product. INTERNATIONAL TRADE THEORIES Ricardo defined efficiency in terms of labour productivity Heckscher-Ohlin (1919, 1930s) extend the theory of comparative advantage by arguing that efficiency depends on national factor endowments, which include labour, land and capital  Labour: size, skills (related to education, training, experience), and productivity of the workforce in a country  Land: abundance of natural resource, such as minerals, oil, gas, forests, water; climate  Capital: physical assets that are used to produce goods and services, such as equipment, technology, and infrastructure  * Entrepreneurship: ability of individuals and organizations to innovate, take risks, and create new businesses and products INTERNATIONAL TRADE THEORIES Country Production Specialization: Australia Minerals (e.g., coal, iron, gold) Brazil Coffee, sugar and soy beans China Electronics, textiles, and toys France Wine, cheese and other agricultural products Germany Luxury cars and machinery Jamaica High-quality coffee Japan High-tech electronics (e.g., computer chips, consumer electronics) Kenya Flowers (e.g., roses) Saudi Arabia Oil Switzerland High-quality watches, chocolate, and cheese United States Software, pharmaceuticals, and aerospace equipment INTERNATIONAL TRADE THEORIES Main issues with the International Trade Theories? INTERNATIONAL TRADE THEORIES Issue 1: “two countries & two goods” is an oversimplified representation of the international business world INTERNATIONAL TRADE THEORIES Issue 2: no consideration for transportation cost (financial and environmental) These theories stipulates that countries with most efficiencies should produce the good. But what if this country is very far from the market countries? - Weight of good - Need for speed - Requiring refrigeration or other special handling INTERNATIONAL TRADE THEORIES Issue 3: no consideration for resource price differences and exchange rates While country A and country B might use same amount of labor (e.g., labor hours), Country A what if labor wages in country A are Country B 30% higher than wages in country B? VS INTERNATIONAL TRADE THEORIES Issue 4: assumption that both products (representing each others’ opportunity costs) require same resources In reality, it is often difficult to assess comparative efficiencies because different sets of resources are not necessarily easily comparable. France Poland Wine 50 > 15 Tires 10 > 5  INTERNATIONAL TRADE THEORIES sue 5: no consideration for diminishing returns to specialization Diminishing returns: more production leads to decreasing gains for each additional unit produced Is it enough for only one country to produce a good? L im ite d  INTERNATIONAL TRADE THEORIES sue 5: no consideration for diminishing returns to specialization Diminishing returns: more production leads to decreasing gains for each additional unit produced Market Saturation If there isn’t enough demand for a product – is it worth for a country to specialize in the production of only one product? INTERNATIONAL TRADE THEORIES Issue 6: ignores positive effects of competition These models propose that each product is produced by the country that is most efficient at producing it = essentially no competition SUCCESS  INTERNATIONAL TRADE THEORIES Issue 1: “two countries & two goods” represents an oversimplified representation of the international business world e 2: no consideration for transportation cost (financial and environmental) ue 3: no consideration for resource price differences and exchange rates sue 4: assumption that both products require same resources e 5: no consideration for increasing and diminishing returns to specializati Issue 6: assumption that all countries have a fixed, static amount of resources, and that these resources are used with uniform efficiency Issue 7: ignores positive effects of competition ** Research shows that even considering all of these added complexities, the premise that countries should export goods they are efficient at producing increases the economic status of INTERNATIONAL TRADE THEORIES Product Life Cycle Theory (Raymond Vernon, 1960s): describes the flow of goods between countries at different stages of the product life cycle Focus: innovation Foreign Focus: production Production may Production and markets start efficiency (cost shift back to consumption of expressing minimization) as home country or product is demand for the companies are other countries. concentrated in product. competing on Continued focus the country Production price on reducing cost where the moves into Production may in order to (relatively these foreign shift to less squeeze the last expensive) markets. developed bit of profit from product was countries. Product product developed is becoming more standardized and affordable INTERNATIONAL TRADE THEORIES As the product More competitors As newer A gains popularity, enter the market technologies company domestic sales and the product emerge and the based increase rapidly. becomes more product becomes in the United The company widely adopted outdated. Sales States produces introduces the internationally. begin to decline. a new product to Japan, Growth gradually The company technology where there is slows down and needs to consider product, i.e., a high demand for the product phasing out the virtual reality new technology reaches saturation product or headset. During products. Rapid in the markets. introducing a new the introduction growth in Japan. version with stage, the Due to high updated features product is demand, introduced in the domestic and U.S. market, international where it faces competition limited demand. increases. INTERNATIONAL TRADE THEORIES Overall, the Product Life Cycle Theory suggests that patterns of international trade can be influenced by the stage of the product life cycle, and that companies and countries must adapt to changing market conditions and the evolution of their products and industries if they want to remain competitive in the global marketplace. INTERNATIONAL TRADE THEORIES New Trade Theory (1970s): trade offers more market opportunities, which translates into more products being produced and the ability to achieve economies of scale. Economies of scale: cost advantage that enterprises obtain due to their scale of operation. The more units of product a company produces, the lower unit cost they incur. Why? INTERNATIONAL TRADE THEORIES Economies of Scale Explained Bulk purchasing Efficient production INTERNATIONAL TRADE THEORIES Economies of Scale Explained Bulk purchasing Efficient production Spread of fixed costs Company Total Costs = Variable Costs + Fixed Costs Variable costs are Fixed costs are expenses expenses that vary with that do not vary with the the level of production or level of production or sales sales volume. volume. Examples: direct materials Examples: overhead, and direct labor (hourly salaries and insurance INTERNATIONAL TRADE THEORIES Fixed cost: $11,500,000 / month Company X sells 500,000 shoes Company X sells 10,000,000 shoes in October in October Fixed cost per unit: Fixed cost per unit: 11,500,000 / 500,000 = $23 11,500,000 / 10,000,000 = $1.15 INTERNATIONAL TRADE THEORIES Given advantages of economies of scale, New Trade Theory offers a new perspective of why countries might be motivated to expand internationally: to sell more product! First mover advantage Efficiency achieved through expansion versus specialization Especially, if first mover in the market INTERNATIONAL TRADE THEORIES In sum… International trade theories conclude that free trade is more beneficial than restricted trade for all countries involved. And for maximum efficiency, countries should produce and export goods and services for which they have a comparative advantage (can produce most efficiently) and economies of scale, while import goods and services which they are less efficient at producing. But… In reality, no country has stopped producing everything that they are not most efficient at producing. Rather countries try to create a balance between being as efficient as possible, but still maintaining some level of self-sufficiency. INTERNATIONAL TRADE THEORIES What goods should always be produced in home country? Essential goods: – Food, clothing, pharmaceuticals, shelter.. – Energy resources (e.g., coal, nuclear, gas, oil, wind, solar) – Goods that are essential for national security (e.g., military equipment) – Traditional / cultural goods (e.g., maple syrup, hockey gear, aboriginal art…) Strategic industries: Industries that are important for a country's economic growth and development