International Business Environments and Operations PDF

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Global Global edition edition edition Global For these Global Editions, the editorial team at Pearson has International Business International Business collaborated with educators across the world to address Environments and Operations a wide range of subjects and requirements, equipping students with the best possible learning tools. This Global Environments and Operations Edition preserves the cutting-edge approach and pedagogy fifteenth edition of the original, but also features alterations, customization, and adaptation from the North American version. John D. Daniels Lee H. Radebaugh Daniel P. Sullivan fifteenth edition Daniels Radebaugh Sullivan This is a special edition of an established title widely used by colleges and universities throughout the world. Pearson published this exclusive edition for the benefit ISBN-13: 978-1-292-01679-5 ISBN-10: 1-292-01679-5 of students outside the United States and Canada. If you 9 0 0 0 0 purchased this book within the United States or Canada you should be aware that it has been imported without the approval of the Publisher or Author. 9 781292 016795 Pearson Global Edition  International Business Environments and Operations Fifteenth Edition Global Edition John D. Daniels University of Miami Lee H. Radebaugh Brigham Young University Daniel P. 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ISBN 10: 1-292-01679-5 ISBN 13: 978-1-292-01679-5 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library 10 9 8 7 6 5 4 3 2 1 15 14 13 12 11 Typeset in 10/12 Palatino by Integra Software Services Private Limited Printed and bound by Courier Kendallville in United States of America A01_DANI6795_15_GE_FM.indd 2 15/04/14 9:41 PM  Connecting Countries through Trade and Factor Part Three Movements Chapter 5 Trade and Factor Mobility Theory Objectives After studying this chapter, you should be able to 1. Understand how different approaches to international trade theories help policy makers achieve economic objectives 2. Comprehend the historical and current rationale for interventionist trade theories 3. Explain how free trade improves global efficiency 4. Distinguish factors affecting national trade patterns Source: © Edelweiss - Fotolia.com 5. Recognize why a country’s export capabilities are dynamic 6. Detect why production factors, especially labor and capital, move internationally 7. Describe the relationship between foreign trade and international factor mobility 8. Grasp scenarios of possible changes in trade patterns MyManagementLab® Improve Your Grade! When you see this icon , visit www.mymanagementlab.com for activities that are applied, personalized, and offer immediate feedback. A market is not held for the sake of one person. —African (Fulani) proverb M05_DANI6795_15_GE_C05.indd 229 12/04/14 4:11 PM  Costa Rica’s Trade Case Evolution Costa Rica is a Central American country of about 4.7 million LATE 1800s–1960 people that borders the Pacific Ocean and the Caribbean arm In the latter part of the 1800s, most nations permitted goods, of the Atlantic.1 Bearing a name that means “Rich Coast,” capital, and people to move with relative freedom from one referring to its fertile soil and bountiful biodiversity, the country to another. Governments tended to interfere only min- country possesses attributes of both developed and devel- imally, and the general result was an economic environment oping countries. With a per capita GDP of $12,600 (based in which individual producers determined what to ­produce on purchasing price parity in 2012), Costa Rica depends on and where to produce it. Trade flourished and countries agricultural commodities—primarily bananas, pineapples, tended to specialize in selling what they could best produce. and coffee—for about 36 percent of its merchandise export Most Latin American countries, including Costa Rica until earnings. However, its tourism earnings are higher than for the early 1960s, specialized in either a single or a few com- those top three agricultural exports combined. (The open- modities (raw materials or agricultural products), which they ing photo is in a bio-diverse area that attracts ecotourism.) exported in exchange for other commodities and manufac- Costa Rica has a fairly high level of external debt, a literacy tured goods. Costa Rican farmers specialized first in c­ offee rate of about 95 percent, a life expectancy of 78 years, and and later, after the development of refrigerated ships, in a fairly even income distribution (the highest 10 percent ­bananas as well. For most of the period, the country was well of the population earns about 40 percent of its income). It served by this policy, primarily because commodity prices, has also enjoyed a long history of democracy and political especially coffee prices, remained high. stability. Map 5.1 shows Costa Rica’s location and major Eventually, however, three factors convinced Costa Rican export markets. leaders to encourage more diversified production and eco- nomic self-sufficiency: Four Eras Two world wars disrupted the country’s ability to export Like all countries, Costa Rica relies on international trade and its commodities and import what it did not produce. factor-mobility policies—strategies related to the movement Coffee and banana prices dropped relative to the prices of goods, services, and production factors across borders— of manufactured products, particularly as new com- to pursue its economic objectives. In any country, these two modity producers (especially in Africa) entered world sets of policies evolve as domestic and foreign conditions ­markets. change. They’re also politically sensitive, especially when Latin American countries with less open international it comes to the economic priorities and judgments of the markets had insulated themselves more from adverse nation’s leaders. international conditions. For Costa Rica, it’s convenient to trace policy evolution through four historical periods, each characterized by par- As a result of these developments, Costa Rica turned to poli- ticular strategies of international trade and factor mobility: cies centered on the idea of import substitution. Late 1800s–1960: Liberal trade—a policy calling for 1960–1982 minimal government interference in trade and ­investment In the early 1960s, Costa Rican authorities reasoned that if 1960–1982: Import substitution—a policy calling for the they limited imports (say, by taxing them heavily), they’d give local production of goods and services that would other- both home and foreign investors an incentive to produce and wise be imported sell more things within the country; this policy is known as 1983–early 1990s: Liberalization of imports, export import substitution. They also realized that, unfortunately, promotion, and incentives for most types of foreign ­ the Costa Rican market was too small to support investments ­investments requiring large-scale production. Early 1990s–present: Strategic trade policy (or industrial To address this problem, Costa Rica joined with four policy) calling for the production of specific types of other countries—El Salvador, Guatemala, Honduras, and products and openness to imports Nicaragua—to form the Central American Common Market M05_DANI6795_15_GE_C05.indd 230 12/04/14 4:11 PM  Chapter 5 Trade and Factor Mobility Theory 231 Map 5.1 Costa Rica In 2011, a bit more than 50 percent of Costa Rica’s exports went to three countries. (Much of the exports shown for the Netherlands are transshipped to other European countries.) (CACM), which allowed goods produced in any member country to enter freely into the market of any other member. Thus, a company located in a member country could serve a five-country rather than a single-country market. Miscalculations and Mixed Results The results were mixed. Costa Rica’s economic dependence on agriculture was already declining before the import substitution policy, from 40.9 percent to 25.2 percent of GDP between 1950 and 1960. Thus, the decline to 18 percent by 1980 could not be attributed completely to the policy change. Likewise, most investors earmarked their new manufacturing to sell domestically and not in the larger CACM market. For example, import substitution helped attract pharmaceutical investment, but the avail- ability of a larger market was not the primary reason; in this case, the strategy worked basically because small-scale packaging and processing are efficient within this industry. So why was the strategy of import substitution, even coupled with a complementary regional trade agreement, less successful than CACM leaders had hoped? Quite simply, investors were convinced that CACM was destined for disruption—and, as it turned out, they were right. By the late 1970s, civil wars in both El Salvador and Guatemala stifled those economies, and a new regime in Nicaragua was ideologi- cally committed to complete governmental control of all aspects of the economy, including trade. In some cases, import substitution did lead to increased exports, such as for Costa Rican processed coffee and cottonseeds. Many economists and prospective investors, however, began to worry that poli- cies designed to protect local production—including price controls, import bans, and subsidies—were channeling the country’s resources toward inefficient production. For example, Costa Rica became nearly self-sufficient in rice production, but only because government policies kept lower-cost foreign-produced rice out of the market. M05_DANI6795_15_GE_C05.indd 231 12/04/14 4:11 PM  232 PART 3     Connecting Countries through Trade and Factor Movements Moreover, the government held down consumer rice prices by subsidizing domestic rice producers. The money for these subsidies came largely from higher taxes on efficient industries—industries that, in turn, found expansion hard because they were strapped for cash. Finally, some inefficient producers sur- vived because they reaped the benefits of high consumer prices, leaving consumers with less disposable income to spend on any products, domestic or foreign. At this point, Costa Rican policymakers concluded that the country must emphasize the production of goods that could compete in international markets. For one thing, they had the example of Asian countries that were achieving rapid growth by competing internationally. In 1983, therefore, Costa Rica shifted to a policy of promoting exports. 1983–Early 1990s To help ensure that only internationally competitive companies and industries were likely to survive, the government began removing import barriers. Rice imports, for example, rose substantially. Policymakers also decided to seek more outside capital and expertise to support economic reforms. Luckily, the United States launched its Caribbean Basin Initiative, which allowed products originating in the Caribbean region to enter the United States at lower tariff (or import tax) rates than those originat- ing elsewhere. To capitalize on this new opportunity, Costa Rica formed CINDE (Coalición Costarricense de Iniciativas de Desarrollo), a private organization funded by the government and by U.S. grants. The purpose of CINDE was to aid in economic development, and one of its top priorities was attracting foreign direct investment. Cinde To augment CINDE’s work, Costa Rica established an export processing zone (EPZ) that allowed exporting companies to import all inputs and equipment tax free, exempted them from paying Costa Rican income tax for eight years and taxed them at only 50 percent for the next four. By 1989, 35 companies—mainly textile and footwear producers seeking to take advantage of the country’s pool of inexpensive labor—had located in the EPZ. By this time, however, CINDE’s officials were beginning to worry about two potential problems facing its ambitious new initiatives: 1. Costa Rica could not remain cost-competitive in the type of products exported from the EPZ because other countries (mainly Mexico) were benefiting from even lower U.S. tariffs. 2. Costa Rica’s highly skilled and educated workforce was being underutilized by the types of industries attracted to the EPZ. CINDE decided to work with the Costa Rican government to identify and attract investors who matched up better with Costa Rican resources. Early 1990s–Present Costa Rica targeted industries ( a policy known as a strategic trade policy) for international com- petition (including medical instruments and appliances, electronics, and software) that promised high growth potential and could pay higher wages and salaries than most of those that had already invested in the EPZ. The government also identified characteristics of developing countries that were attracting significant amounts of the type of foreign investment it wanted: a highly educated and largely English-speaking workforce (especially the availability of engineers and technical operators), political and social stability, a relatively high level of economic freedom, and a quality of life that would appeal to the managers and technical personnel that foreign investors would bring in to work in the facilities. The conclusion? In its targeted industries, Costa Rica should be able to compete internationally. M05_DANI6795_15_GE_C05.indd 232 12/04/14 4:11 PM  Chapter 5 Trade and Factor Mobility Theory 233 What Cinde Recommended CINDE also hired the Foreign Investment Advisory Service (FIAS) of the World Banks’ International Finance Corporation to study whether and how to attract companies in these industries. FIAS concluded that attracting the right number of the right companies was well within Costa Rica’s reach, and suggested areas within this selection of targeted industries, such as power technologies, that best fit with the coun- try’s main advantage—a labor force that was well educated in relation to its cost. It also recommended that officials target companies that supported the electronics and computer industries, such as plastics and metalworking. Finally, FIAS noted that Costa Rica needed to improve the English proficiency of its tech- nicians and engineers and the protection of intellectual property rights. In response, Costa Rica put English language skills in a revised curriculum for training mid-level technicians and set up Spanish-language training for the personnel brought in by foreign investors. Progress Report Setting out to attract investments in electronics and software, Costa Rica landed such high-tech investors as Reliability, Protek, Colorplast, and Sensortronics. By far, the largest investor was the c­ omputer-chip giant Intel. CINDE officials worked to attract Intel. They drew up a list of all the questions and concerns Intel might have and prepared knowledgeable responses to them. They also involved top government and corporate leaders in meetings with Intel executives, even enlisting the country’s president, José Figueres, to pilot them on a helicopter survey of plant sites. Since then, Costa Rica has turned its attention to medical devices, and attracted investments by such companies as Abbott Laboratories, Baxter, and Procter & Gamble. Although exports of coffee and bananas are still important to the nation’s economy, about 60 percent of Costa Rica’s merchandise exports are now manufactured goods, with high-tech products constituting the backbone of the economy and export earnings. Questions 5-1. Using the framework in Table 5.1, explain which of the theories relate to Costa Rican trade policy during each of the four eras described in the case. 5-2. Map 5.1 shows that a bit over 50 percent of Costa Rican exports go to only three countries. Which trade theories may help to explain this concentration and why? Introduction The preceding case shows how Costa Rica has used trade and factor mobility (movement of capital, technology, and people) to help achieve its economic objectives. Figure 5.1 shows that countries are linked internationally by trade in goods and services and the movement of production factors. Like Costa Rica, other countries wrestle with the questions of what, how much, and with whom to trade. These questions are intertwined with considerations of what they can produce competitively by boosting the quality and quantity of capital, techni- cal competence, and worker skills. Trade theory helps managers and government policymakers focus on these questions: Laissez-Faire Versus Interventionist What products should we Approaches to Exports and Imports import and export? How much should we trade? Once countries set economic and political objectives, officials enact policies—including trade With whom should we policies—to achieve desired results. This influences which countries can produce given prod- trade? ucts more efficiently and whether countries will permit imports to compete against their M05_DANI6795_15_GE_C05.indd 233 12/04/14 4:11 PM  234 PART 3     Connecting Countries through Trade and Factor Movements Figure 5.1 International Operations and Economic Connections OBJECTIVES To meet its international objectives, a company must gear its strategy to trading and transferring its means STRATEGY of operation across borders––say, from (Home) Country A to (Host) Country B. Once this process has taken place, the two countries are MEANS OF OPERATIONS connected economically. Importing and exporting goods and services (trade) Transferring production factors, such as labor and capital, internationally Country A Country B C o n ce p t C h ec k domestically produced goods and services. Some nations take a more laissez-faire approach, one that allows market forces to determine trading relations. Free-trade theories (absolute Compare Figure 5.1 with Figure 1.1, which outlines advantage and comparative advantage) take a complete laissez-faire approach because they certain conditions that may prescribe that governments should not intervene directly to affect trade. At the other extreme affect a firm’s operations when are mercantilism and neomercantilism, which prescribe a great deal of government interven- it decides to do business on tion in trade. Whether taking a laissez-faire or interventionist approach, countries rely on an international scale. Here trade theories to guide policy development. the graphic focuses in on operational adjustments that a company faces when it takes specific strategic actions to Theories of Trade Patterns go international—namely, to trade and transfer means of After taking a look at theories dealing with trade intervention, we examine those that help production. explain trade patterns (how much countries depend on trade, in what products, and with whom), including theories of country size, factor proportions, and country similarity. We then Some trade theories prescribe consider theories dealing with the dynamics of countries’ trade competitiveness for particular that governments should products, which include the product life cycle theory and the diamond of national competitive influence trade patterns; advantage theory. others propose a laissez-faire treatment of trade. Trade Theories And Business Table 5.1 summarizes the major trade theories and their emphases. These different theories expand our understanding of how government trade policies might affect business com- petitiveness. For instance, they provide insights on favorable locales and products for exports, thereby helping companies determine where to locate their production facilities when gov- ernments do or do not impose trade restrictions. Factor-Mobility Theory Because the stability and dynamics of countries’ competitive positions depend largely on the quantity and quality of their production factors (land, labor, capital, technology), we’ll con- clude this chapter with a discussion of factor mobility. M05_DANI6795_15_GE_C05.indd 234 12/04/14 4:11 PM  Chapter 5 Trade and Factor Mobility Theory 235 Table 5.1 What Major Trade Theories Do and Don’t Discuss: A Checklist A check mark indicates that a theory of trade concerns itself with the question asked at the head of the column; if there’s a dash, it doesn’t. In columns 4–7, you can see how each theory responds to the specific question; again, a dash indicates that the theory does not address the question. Description of Natural Trade Prescription of Trade Relationships How What With Should What With Whom Much Products Whom Government How Much Products Should Is Are Does Trade Control Should Be Should Be Trade Take Theory Traded Traded? Take Place? Trade? Traded? Traded? Place? Mercantilism — — — yes ✓ ✓ ✓ Neomercantilism — — — yes ✓ — — Absolute advantage — ✓ — no — ✓ — Comparative advantage — ✓ — no — ✓ — Country size ✓ ✓ — — — — — Factor proportions — ✓ ✓ — — — — Country similarity — ✓ ✓ — — — — Product life cycle (PLC) — ✓ ✓ — — — — Diamond of national — ✓ — — — — — competitive advantage Interventionist Theories Let’s begin with mercantilism because it is the oldest trade theory, out of which neomer- cantilism has more recently emerged. These theories are based on some of the reasons for governmental intervention, but there are other reasons as well that we discuss in the next chapter. Mercantilism According to mercantilism, Mercantilism holds that a country’s wealth is measured by its holdings of “treasure,” which countries should export more usually means its gold. According to this theory, which formed the foundation of economic than they import. thought from about 1500 to 1800,2 countries should export more than they import and, if successful, receive gold from countries that run deficits. Nation-states were emerging during this period, and gold empowered central governments to raise armies and invest in national institutions so as to solidify the people’s primary allegiance to the new nations. Governmental Policies To export more than they imported, governments restricted ­imports and subsidized production that otherwise could not compete in domestic or export markets. Some countries used their colonies to support this trade objective by having the colonies supply commodities that the colonial powers would otherwise have to purchase from nonassociated countries and by running trade surpluses as an additional way to obtain gold. They did this not only by monopolizing colonial trade but also by forcing their colonies to export less highly valued raw materials to them and import more highly valued manufac- tured products from them. As the influence of the mercantilist philosophy weakened after 1800, the governments of colonial powers seldom directly intended to limit the development of industrial capabili- ties within their colonies. However, their home-based companies had technological leader- ship, ownership of raw material production abroad, and usually some degree of protection from foreign competition—a combination that continued to make colonies dependent on raw material production and tie their trade to their industrialized mother countries. We still see vestiges of these relationships, which we discuss in the next chapter. M05_DANI6795_15_GE_C05.indd 235 12/04/14 4:11 PM  236 PART 3     Connecting Countries through Trade and Factor Movements The Concept of Balance of Trade Some terminology of the mercantilist era has endured. Running a favorable balance For example, a favorable balance of trade (also called a trade surplus) still ­indicates that of trade is not necessarily a country is exporting more than it imports. An unfavorable balance of trade (also known beneficial. as a trade deficit) indicates the opposite. Many of these terms are misnomers. For exam- ple, the word favorable implies “benefit,” and the word unfavorable suggests “disadvantage.” In fact, it is not necessarily beneficial to run a trade surplus or detrimental to run a trade deficit. A country with a favorable balance of trade is, for the time being, supplying people in foreign countries with more than it receives from them.3 In the mercantilist period, the difference was made up by a transfer of gold; today it is made up by granting credit to the deficit country by holding its currency or investments denominated in that currency. If that credit cannot eventually buy sufficient goods and ­services, the so-called favorable trade balance actually may turn out to be disadvantageous for the country with the surplus. Neomercantilism A country that practices The term neomercantilism describes the approach of countries that try to run favorable neomercantilism attempts balances of trade in an attempt to achieve some social or political objective. A country may to run an export surplus to aim for increased employment by setting economic policies that encourage its companies to achieve a social or political objective. produce in excess of the demand at home and send the surplus abroad. Or it may attempt to maintain political influence in an area by sending more merchandise there than it receives from it, such as a government granting aid or loans to a foreign government to use to ­purchase the granting country’s excess production. C o n ce p t C h ec k Free-Trade Theories In Chapter 1, we observe that Why do countries need to trade at all? Why can’t Costa Rica (or any other country) be content nations are currently in the with the goods and services it produces? In fact, many countries following mercantilist policy mood to reduce barriers to the tried to become as self-sufficient as possible. In this section, we discuss two theories support- movement of trade, capital, technology, and people; we ing free trade: absolute advantage and comparative advantage. also explain that this policy Both theories hold that nations should neither artificially limit imports nor promote reflects a couple of key facts— exports.4 The market will determine which producers survive as consumers buy those namely, that consumers want ­products that best serve their needs. Both free trade theories imply specialization. Just as indi- a greater variety of goods viduals and families produce some things that they exchange for things that others produce, and services at lower prices national specialization means producing some things for domestic consumption and export and that competition spurs while using the export earnings to buy imports of products and services produced abroad. efficiency. Theory of Absolute Advantage In 1776, Adam Smith questioned the mercantilists’ assumptions by stating that the real wealth of a country consists of the goods and services available to its citizens rather than According to Adam Smith, a its holdings of gold. This theory of absolute advantage holds that different countries pro- country’s wealth is based on its duce some goods more efficiently than others, and questions why the citizens of any country available goods and services should have to buy domestically produced goods when they can buy them more cheaply rather than on gold. from abroad. Smith reasoned that unrestricted trade would lead a country to specialize in those products that gave it a competitive advantage. Its resources would shift to the efficient industries because it could not compete in the inefficient ones. Through specialization, it could increase its efficiency for three reasons: 1. Labor could become more skilled by repeating the same tasks. 2. Labor would not lose time in switching production from one kind of product to another. 3. Long production runs would provide incentives for developing more effective working methods. M05_DANI6795_15_GE_C05.indd 236 12/04/14 4:11 PM  Chapter 5 Trade and Factor Mobility Theory 237 The country could then use its excess specialized production to buy more imports than it otherwise could have produced. But in what products should a country specialize? Although Smith believed the marketplace would make the determination, he thought that a country’s advantage would be either natural or acquired. Natural advantage considers Natural Advantage A country’s natural advantage in creating a product or service comes climate, natural resources, and from climatic conditions, access to certain natural resources, or availability of certain labor labor force availability. forces. As we saw in our opening case, Costa Rica’s climate and soil support the produc- tion of bananas, pineapples, and coffee, while its biodiversity supports a thriving ecotourism industry. Costa Rica imports wheat. If it were to increase its wheat production, for which its climate and terrain are less suited, it would have to use land now devoted to the cultivation of bananas, pineapples, and coffee, or convert some of its biodiverse national park areas to agricultural production, thus reducing those earnings. Conversely, the United States could produce coffee (perhaps in climate-controlled build- ings), but at the cost of diverting resources away from products such as wheat, for which its climate and terrain are naturally suited. Trading coffee for wheat and vice versa is a goal more easily achieved than if these two countries were to try to become self-sufficient in the pro- duction of both. The more the two countries’ natural advantages differ, the more likely they will favor trade with one another. Variations among countries in natural advantages also help explain where certain manu- factured or processed items might best be produced, particularly if a company can reduce transportation costs by processing an agricultural commodity or natural resource prior to exporting. Processing coffee beans into instant coffee reduces bulk and is likely to reduce transport costs on coffee exports; producing canned latte could add weight, lessening the industry’s internationally competitive edge. Acquired Advantage Most of today’s world trade is of manufactured goods rather than agricultural goods and natural resources. Countries that are competitive in manufactured Acquired advantage consists goods have an acquired advantage, usually in either product or process technology. An of either product or process advantage of product technology is that it enables a country to produce a unique product or technology. one that is easily distinguished from those of competitors. For example, Denmark exports ­silver tableware, not because there are rich Danish silver mines but because Danish compa- nies have developed distinctive products. An advantage in process technology is a country’s ability to efficiently produce a homoge- neous product (one not easily distinguished from that of competitors). Japan has exported steel despite having to import iron and coal to produce it because its steel mills have encom- passed new labor- and material-saving processes. Thus, countries that develop distinctive or less expensive products have acquired advantages, at least until producers in another country emulate them successfully. Acquired advantage through technology has created new products, displaced old ones, and altered trading-partner relationships. The most obvious examples of change are pro- duction and export of new products and services, such as software. Products that existed in ­earlier periods have increased their share of world trade because of technological changes in the production process. For example, early hand-tooled automobiles reached only elite markets, but a succession of manufacturing innovations, from assembly lines to robotics, has enabled automobiles to reach an ever-widening mass market. In other cases, companies have developed new uses for old products, such as aloe in sunscreen. Other products, such as artificial fibers, have partially displaced traditional ones. Finally, technology may be used to overcome natural advantages. Iceland now exports t­ omatoes grown near the Arctic Circle, while Brazil exports quality wine produced near the equator—both of which were impossible until the development of fairly recent Free trade will bring technology.5 Specialization. Greater efficiency. How Does Resource Efficiency Work? We can demonstrate absolute trade advan- Higher global output. tage here by examining two countries and two commodities. Because we are not yet M05_DANI6795_15_GE_C05.indd 237 12/04/14 4:11 PM  238 PART 3     Connecting Countries through Trade and Factor Movements Figure 5.2 Production ASSUMPTIONS ASSUMPTIONS Possibilities under for Costa Rica for United States Conditions of Absolute 1. 100 units of resources available 1. 100 units of resources available 2. 10 units to produce a ton of wheat 2. 5 units to produce a ton of wheat Advantage 3. 4 units to produce a ton of coffee 3. 20 units to produce a ton of coffee In short, specialization increases 4. Uses half of total resources per product 4. Uses half of total resources per product potential output. when there is no foreign trade when there is no foreign trade PRODUCTION Coffee Wheat C 25 U.S. production possibilities (tons) (tons) Costa Rican production possibilities Without Trade: 20 Quantity of Coffee (tons) Costa Rica (point A) 121/2 5 United States (point B) 21/2 10 Total 15 15 15 With Trade: A 121/2 Costa Rica (point C ) 25 0 10 United States (point D ) 0 20 Total 25 20 5 B 2/ 1 2 D 0 5 10 15 20 25 Quantity of Wheat (tons) considering the concepts of money and exchange rates, we define the cost of production in terms of the resources needed to produce either commodity. This example is realistic because real income depends on the output of goods compared to the resources used to produce them. Say that Costa Rica and the United States are the only two countries and each has the same amount of resources (land, labor, and capital) to produce either coffee or wheat. Using Figure 5.2, let’s say that 100 units of resources are available in each country. In Costa Rica, assume that it takes four units to produce a ton of coffee and 10 units per ton of wheat. The purple Costa Rican production possibility line shows that Costa Rica can pro- duce 25 tons of coffee and no wheat, 10 tons of wheat and no coffee, or some combination of the two. In the United States, it takes 20 units per ton of coffee and five units per ton of wheat. The green U.S. production possibility line indicates that the country can produce five tons of coffee and no wheat, 20 tons of wheat and no coffee, or some combination of the two. Costa Rica is more efficient (that is, takes fewer resources to produce coffee), while the United States is more efficient in wheat production. How can production be increased through specialization and trade? Let’s say the two countries have no foreign trade. We could start from any place on each production possibil- ity line; for convenience, let’s assume that if each country devotes half of its 100 resources to production of each product, Costa Rica can produce 12.5 tons of coffee (divide 50 by 4) and five tons of wheat (divide 50 by 10), shown as point A in Figure 5.2, while the United States can produce 2.5 tons of coffee (divide 50 by 20) and 10 tons of wheat (divide 50 by 5), shown as point B in Figure 5.2. Because each country has only 100 units of resources, neither can increase wheat pro- duction without decreasing coffee production, or vice versa. Without trade, the combined production is 15 tons of coffee (12.5 + 2.5) and 15 tons of wheat (5 + 10). If each country specialized in the commodity for which it had an absolute advantage, Costa Rica could then produce 25 tons of coffee and the United States 20 tons of wheat (points C and D in the figure). You can see that specialization increases the production of both products. By trading, global efficiency is optimized, and the two countries can have more coffee and more wheat than they would without trade. M05_DANI6795_15_GE_C05.indd 238 12/04/14 4:11 PM  Chapter 5 Trade and Factor Mobility Theory 239 Theory of Comparative Advantage We have just described absolute advantage, which is often confused with comparative ­advantage. In 1817, David Ricardo examined the question,“What happens when one country Gains from trade will occur can produce all products at an absolute advantage?” His resulting theory of comparative even in a country that has advantage says that global efficiency gains may still result from trade if a country specializes absolute advantage in all in what it can produce most efficiently—regardless of other countries’ absolute advantage. products, because the country must give up less efficient output to produce more Comparative Advantage by Analogy Although this theory may seem initially incongru- efficient output. ous, an analogy should clarify its logic. Imagine that the best physician in town also happens to be the best medical administrator. It would not make economic sense for the physician to handle all the administrative duties of the office, because of earning more money by con- centrating on medical duties, even though that means having to employ a less-skilled office administrator. In the same manner, a country gains if it concentrates its resources on the commodities it can produce most efficiently. It then trades some of those for commodities produced abroad. The following discussion clarifies this theory. Production Possibility Assume the United States is more efficient in producing coffee and wheat than Costa Rica is, thus having an absolute advantage in the production of both.6 Take a look at Figure 5.3. As in our earlier example, it assumes that there are only two countries, each with a total of 100 units of resources available, and half of each used in each product. It takes Costa Rica 10 units of resources to produce either a ton of coffee or a ton of wheat, whereas it takes the United States only five units to produce a ton of coffee and four for a ton of wheat. Costa Rica can produce five tons of coffee and five tons of wheat (point A on the purple line), and the United States can produce 10 tons of coffee and 12.5 tons of wheat (point B on the green line). Without trade, neither country can increase its coffee production without sacrificing some wheat production, or vice versa. Although the United States has an absolute advantage in producing both commodities, its comparative advantage is only in wheat. This is because its wheat production is 2.5 times that of Costa Rica, whereas its coffee production is only twice as much. Although Costa Rica has an absolute disadvantage in the production of both products, it has a comparative Figure 5.3 Production ASSUMPTIONS ASSUMPTIONS Possibilities under for Costa Rica for United States Conditions of Comparative 1. 100 units of resources available 1. 100 units of resources available 2. 10 units to produce a ton of wheat 2. 4 units to produce a ton of wheat Advantage 3. 10 units to produce a ton of coffee 3. 5 units to produce a ton of coffee There are advantages to trade even 4. Uses half of total resources per product 4. Uses half of total resources per product if one country enjoys an absolute when there is no foreign trade when there is no foreign trade advantage in the production of all products. PRODUCTION Coffee Wheat U.S. production possibilities (tons) (tons) 20 Costa Rican production possibilities Without Trade: Costa Rica (point A ) 5 5 Quantity of Coffee (tons) United States (point B ) 10 121/2 15 Total 15 171/2 With Trade (increasing C B coffee production): 10 Costa Rica (point C ) 10 0 D United States (point D ) 6 171/2 6 E Total 16 171/2 5 A With Trade (increasing wheat production): Costa Rica (point C ) 10 0 0 5 10 121/2 15 171/2 20 25 United States (point E ) 5 183/4 183/4 Total 15 183/4 Quantity of Wheat (tons) M05_DANI6795_15_GE_C05.indd 239 12/04/14 4:11 PM  240 PART 3     Connecting Countries through Trade and Factor Movements advantage (or less of a comparative disadvantage) in coffee. Why? Because its production is half as efficient in coffee and only 40 percent as efficient in wheat. Without trade, the combined production is 15 tons of coffee (5 in Costa Rica plus 10 in the United States) and 17.5 tons of wheat (5 plus 12.5). Through trading, the combined pro- duction of the commodities within the two countries can be increased. For example, if the combined wheat production is unchanged from when there was no trade, the United States could produce all 17.5 tons by using 70 units of resources (17.5 tons times 4 units per ton). The remaining 30 units could be used for producing six tons of coffee (30 units divided by 5 units per ton), shown by point D in Figure 5.3. Costa Rica would use all its resources to produce 10 tons of coffee (point C). The combined wheat production has stayed at 17.5 tons, but the coffee production has increased from 15 to 16 tons. If the combined coffee production is unchanged from the time before trade, Costa Rica could use all its resources to produce coffee, yielding 10 tons (point C in Figure 5.3). The United States could produce the remaining five tons of coffee by using 25 units, with its remaining 75 units being used to produce 18.75 tons of wheat (75 divided by 4). This produc- tion possibility is point E. Without sacrificing any of the coffee available before trade, wheat production has increased from 17.5 to 18.75 tons. If the United States were to produce somewhere between points D and E, both coffee and wheat production would increase over what was possible before trade took place. Whether the production target is a rise in coffee or wheat or a combination of the two, both countries can gain by having Costa Rica trade some of its coffee production to the United States for some U.S. wheat output. Don’t Confuse Comparative and Absolute Advantage Most economists accept the comparative advantage theory and its influence in promoting policies for freer trade. Nevertheless, many government policymakers, journalists, managers, and workers confuse comparative advantage with absolute advantage and do not understand how a country can simultaneously have a comparative advantage and absolute disadvantage in the production of a given product. Theories of Specialization: Some Assumptions and Limitations Both absolute and comparative advantage theories are based on increasing output and trade through specialization. However, these theories make assumptions, some of which are not always valid. Full employment is not a valid Full Employment The physician/administrator analogy we used earlier assumed that the assumption of absolute and physician could stay busy full time practicing medicine. If not, the physician might perform comparative advantage. the administrative work without sacrificing earnings from medical duties. The theories of absolute and comparative advantage both assume that resources are fully employed. When countries have many unemployed or unused resources, they may seek to restrict imports to employ or use idle resources. Countries’ goals may not be Economic Efficiency Our analogy also assumes that the physician is interested primarily limited to economic efficiency. in maximizing income. Yet there are a number of reasons for choosing not to work full time at medical tasks, such as finding administrative work relaxing and self-fulfilling, fearing that a hired administrator would be unreliable, or wishing to maintain administrative skills in the somewhat unlikely event that administrators will command higher wages than physicians in the future. Often, countries also pursue objectives other than output efficiency. They may avoid overspecialization because of the vulnerability created by changes in technology and by price fluctuations or because they do not trust foreign countries to always supply them with essential goods. M05_DANI6795_15_GE_C05.indd 240 12/04/14 4:11 PM  Chapter 5 Trade and Factor Mobility Theory 241 C o n ce p t C h ec k Division of Gains Although specialization brings potential economic benefits to all trading Recall from Chapter 2 countries, the earlier discussion did not indicate how countries will divide increased output. our discussion of “Work In the case of our wheat and coffee example, if both the United States and Costa Rica receive Motivation,” in which we some share of the higher output, both will be better off economically through specialization explain that in cultures ranking and trade. However, many people are concerned with relative as well as absolute economic high on so-called masculinity, gains. If they perceive that a trading partner is gaining too large a share of benefits, they may people tend to value economic prefer to forgo absolute gains for themselves so as to prevent others from gaining a relative achievement over certain economic advantage.7 other values; we also observe, however, that in other cultures “work to live” is valued over Transport Costs If it costs more to transport the goods than is saved through specializa- economic performance. tion, the advantages of trade are negated. In other words, in our two-country scenario, some workers would need to forgo producing coffee or wheat in order to work in transporting the coffee and wheat abroad. However, as long as the diversion reduces output by less than what the two countries gain from specialization, there are still gains from trade. Statics and Dynamics The theories of absolute and comparative advantage address coun- tries statically—by looking at them at one point in time. However, the relative conditions that give countries production advantages and disadvantages change. For example, the resources needed to produce coffee or wheat in either Costa Rica or the United States could change because of advancements in and acceptance of genetically modified crops. In fact, most trade today is due to acquired advantage; thus, technical dynamics cause countries to gain or lose both absolutely and relatively.8 As we show in our opening case, when Costa Rica focused on goods that could compete in international markets, it developed and enhanced a competitive advantage in some prom- ising high-tech industries. Thus, we should not assume that future absolute or comparative advantages will remain as they are today. We return to this theme later in the chapter as we examine theories to explain the dynamics of competitive production locations. Services The theories of absolute and comparative advantage deal with products rather than services. However, with a growing portion of world trade made up of services, the theories apply because resources must also go into service production. For instance, the United States C o n ce p t C h ec k sells an excess of such services as education to foreign countries (many foreign ­students attend As we point out in discussing U.S. universities). At the same time, it buys an excess of foreign shipping services. To become the ramifications of more self-sufficient in international shipping, the United States might have to divert resources globalization in Chapter 1, from its more efficient use in higher education or in the production of competitive products. although any given product may carry a “made in” label Production Networks Both theories deal with trading one product for another. Increasingly, (as in “Made in Taiwan”), such however, portions of a product may be made in different countries. A company might conduct labels may actually obscure R&D in Country A, secure components in Countries B and C, assemble final products in Country rather than clarify the origins of products, which nowadays D, manage finances in Country E, and carry out call-center services in Country F. Although this often include components or type of development adds complexity to the analysis, it fits well with the concept of advantages ingredients from a surprising through specialization. In other words, costs are saved by having activities take place in those variety of countries. countries where there is an absolute or comparative advantage for their production. Mobility These theories assume that resources can move domestically from the produc- tion of one good to another—and at no cost. But this assumption is not completely valid. For example, steelworkers might not move easily into software development jobs because of different skill needs. Even if they do, they may be less productive than before.9 The ­theories also assume that resources cannot move internationally. Increasingly, however, they do, and the movement affects countries’ production capabilities. For instance, over 300 thousand Nicaraguans have moved to Costa Rica, mainly because of better job opportunities there.10 Further, foreign companies have moved both personnel and capital to support their invest- ments there, which has contributed to changing Costa Rican capabilities. Such movement is clearly an alternative to trade, a topic discussed later in the chapter. However, it is safe to say that resources are more mobile domestically than they are internationally. M05_DANI6795_15_GE_C05.indd 241 12/04/14 4:11 PM  242 PART 3     Connecting Countries through Trade and Factor Movements Trade Pattern Theories The free trade theories demonstrate how economic growth occurs through specialization and 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 when following a free trade policy. In this section, we discuss the theories that help explain these patterns. How Much Does A Country Trade? Free-trade theories of specialization neither propose nor imply that only one country should or will produce a given product or service. Nontradable goods—products and services (haircuts, retail grocery distribution, etc.) that are seldom practical to export because of high transportation costs—are produced in every country. However, among tradable goods, some countries depend on imports and exports more than others. We will now examine theories that help explain country differences. Theory of Country Size Land area is an obvious way to measure a country’s size and Bigger countries differ in largely explains countries’ relative dependence on trade. The theory of country size holds several ways from smaller that large countries usually depend less on trade than small ones. Countries with large land countries. They areas are apt to have varied climates and an assortment of natural resources, making them Tend to export a smaller portion of output and more self-sufficient than smaller ones. Most large countries (such as Brazil, China, India, import a smaller part of the United States, and Russia) import much less of their consumption needs and export consumption. much less of their production output than do small nations (such as Uruguay, Belgium, Have higher transport costs and Taiwan). for foreign trade. Furthermore, distance to foreign markets affects large and small countries differently. Normally, the farther the distance, the higher the transport costs, the longer the inventory carrying time, and the greater the uncertainty and unreliability of timely product delivery. The following example illustrates why distance is more pronounced for a large country than for a small one. Assume that the normal maximum distance for transporting a given product is 100 miles because prices rise too much at greater distances. Although almost any loca- tion in tiny Belgium is within 100 miles of a foreign country, the same isn’t true for its two l­argest neighbors, France and Germany. Thus, Belgium’s dependence on trade as a percentage of its ­production and consumption is greater than the comparable figures in either France or Germany, a fact that can be partially explained by the distance factor due to country size. Size of the Economy While land area helps explain the relative dependence on trade, countries’ economic size helps explain differences in the absolute amount of trade. Nine of the world’s top 10 exporters in 2012 were developed countries, and the only exception was China, which is the world’s second largest economy. Similarly, developed countries account for well over half of the world’s exports. Simply put, they produce so much that they have more to sell, both domestically and internationally. In addition, because they produce so much, incomes are high and people buy more from both domestic and foreign sources. At the same time, most of developing countries’ trade is with developed countries, but there has been a recent upsurge of trade among developing countries mainly because of economic growth in China and India that has increased their demand for raw materials found mainly in developing countries.11 The United States offers a good example of the difference between relative and ­absolute dependence on trade because it is the third largest country in area and the largest economi- cally. Although its dependence on either imports or exports is comparatively low, it is the world’s largest trader (imports + exports). Map 5.2 illustrates the large U.S. economic size by showing how each of its states compares economically with countries. M05_DANI6795_15_GE_C05.indd 242 12/04/14 4:11 PM  Chapter 5 Trade and Factor Mobility Theory 243 Map 5.2 U.S. States’ Economies Compared to National Economies The U.S. size, both geographically and economically, results in its being one of the world’s largest traders while also depending relatively less than most countries on imports and exports. Source: GDP figures for U.S. states based on “Gross Domestic Product by State,” http://lwd.dol.state.nj.us/labor/lpa/industry/gsp/gsp_index.html (accessed June 26, 2013). Country GDP figures came from Wikipedia,“List of Countries by GDP (Nominal)” http://en.wikipedia.org/wiki/List_of_countries_by_GDP_%28nominal%29 (accessed June 26, 2013). WA UAE ME MT ND Bulgaria Macao Ghana OR MN Algeria ID Malaysia WI SD Philippines NY Sudan Mexico WY Costa Rica MI Serbia Thailand IA PA NE Saudi Arabia NV Hungary IL OH Slovakia Vietnam UT Switzerland IN Belgium CA Angola CO Nigeria WV Cuba VA India Finland KS MO KY Taiwan Vietnam Chile Ukraine NC TN Argentina AZ OK Hong Kong NM Kuwait AR SC Singapore Oman Morocco Ukraine AL GA MS Qatar Austria Slovakia TX LA Spain Israel AK Slovenia FL