Theory of Trade

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THEORIES ON INTERNATIONAL TRADE

WHY NATIONS TRADE?


 To provide their citizens with an Increased
Standard of Living
 Countries experience unequal endowments of
resources. every country cannot not enjoy equal factor of production
 Natural Resources
 Human Resources
 Capital, and
 Technology
International Trade Theory
Starting with Why Nations Trade, and
Ending with a discussion of the Benefits to Trade.
THEORIES ON INTERNATIONAL TRADE
RESOURCE ENDOWMENTS
 Lead to differing costs of production among nations.
 Economists speak of this in terms of inputs and outputs.
 They define the efficiency of production as the amount of
output that can be produced with a given amount of inputs.
 Main Topics of the Lecture
• Mercantilism
• Absolute Advantage
• Comparative Advantage
• Opportunity Cost
• Production Possibilities Curves (Frontiers)
• Terms of Trade
• Gains to Trade
MERCANTALISM
 Practiced throughout Europe to 1776.
 Believed that the possession of wealth, gold and
silver, was the sign of a strong nation.(it was also useful
when the king desired to finance a foreign war)
 Trade was conducted under the authority of governments,
and trading rights were generally sold to the highest bidder.
 Governments Generated Money From the Manipulation of
Trade Monopolies
 Export and import rights were sold.
 The idea of a wealthy society was to have exports exceed imports
so that the king’s treasure chests could be filled with money.
 David Hume showed the inconsistency of X>I in the
long run by explaining inflation.
THEORIES ON INTERNATIONAL TRADE
Advantages to Trade
1. We start with 2 countries not trading with each other
2. We define Production Possibility Curves
3. Then we introduce trade and observe the results.

Adam Smith in 1776 Published the Wealth of Nations in


which he described
 The operations of markets in a modern economy.
 The division of labor in modern industry, and
 The absolute advantage of certain resources in the
production of goods
 Society’s primary productive element is seen as
human labor
THEORIES ON INTERNATIONAL TRADE
Example:
Assume each country has 200 inputs and uses ½ its
resources to producing each product.
If they produce and consume in isolation from each
other, we can find their optimal production/consumption
point by multiplying our 2x2 matrix of outputs by 100
(1/2 of the 200 units of inputs for each country in the
production of each product.)
A country is said to posses an absolute advantage over
its trading partner when it can produce more of an
output with a given amount of inputs.
This is shown in a Table
ABSOLUTE ADVANTAGE
Resources required to produce 1 ton of wheat and rice
(Assume that 200 units of resources are available in
each country.)
COUNTRY WHEAT RICE
AUSTRALIA 10 unit 20 unit
BANGLADESH 40 10

Production and Consumption without Trade


(assume that half of its resources used to produce W
and rest half is used to produce rice).
COUNTRY WHEAT RICE
AUSTRALIA 10 ton 5 ton
BANGLADESH 2.5 10
TOTAL 12.5 15
ABSOLUTE ADVANTAGE
• Production with Specialization
COUNTRY WHEAT RICE
AUSTRALIA 20 ton 0 ton
BANGLADESH 0 20
TOTAL 20 20

• Consumption after Bangladesh trade 6 tons of rice for


6 tons of wheat with Australia.
COUNTRY WHEAT RICE
AUSTRALIA 14 ton 6 ton
BANGLADESH 6 14

• Increase in consumption as a result of Specialization and Trade.


COUNTRY WHEAT RICE
AUSTRALIA 4 ton 1 ton
BANGLADESH 3.5 4
COMPARATIVE ADVANTAGE (David Ricardo:1817)

• In a 2 product economy it can be shown that both


countries can gain from trade even if one country has the
Absolute advantage in the production of both products.
• Each country has a Comparative Advantage over its
trading partner in the production of that good for which its
Opportunity cost is lower than that of its trading partner.
• Opportunity Cost Defined: What you give up to produce the
last/next unit of a good of the next best alternative product.
• Resources required to produce 1 ton of wheat and rice
(Assume that 200 units of resources are available in each country)
COUNTRY WHEAT RICE
AUSTRALIA 10 unit 13.33 unit
BANGLADESH 40 20
COMPARATIVE ADVANTAGE
Production and Consumption without Trade
(assume that half of its resources used to produce W
and rest half is used to produce rice).
COUNTRY WHEAT RICE
AUSTRALIA 10 ton 7.5 ton
BANGLADESH 2.5 5
TOTAL 12.5 12.5

Production with Specialization


(assume that Australia uses 150 units to produce wheat
and 50 units is used to produce rice).
COUNTRY WHEAT RICE
AUSTRALIA 15 ton 3.75 ton
BANGLADESH 0 10
TOTAL 15 13.75
COMPARATIVE ADVANTAGE
• Australia has absolute advantage in the production of
both product.
• The opportunity cost in each country is determined by
how much wheat production must be given up to
produce more rice.
• Now assume that each country specializes in The
production of that product for which it has a
Comparative Advantage
• Australia has a Comparative Advantage in Wheat
• Bangladesh has a Comparative Advantage in Rice
COMPARATIVE ADVANTAGE
• Consumption after Bangladesh trade 4 tons of rice for
4 tons of wheat with Australia.
COUNTRY WHEAT RICE
AUSTRALIA 11 ton 7.75 ton
BANGLADESH 4 6
• Increase in consumption as a result of Specialization and Trade.
COUNTRY WHEAT RICE
AUSTRALIA 1 ton 0.25 ton
BANGLADESH 1.5 1

Thus, consumption of wheat and rice can increase in


both countries as a result of specialization and trade.
COMPARATIVE ADVANTAGE

Unrealistic assumptions:
• A world with only two countries and two goods.
• No transportation costs between countries.
• No differences in the prices of resources in different
countries.
• Said nothing about exchange rate, assuming that
wheat and rice can be swapped on a 1-to-1 basis.
• Resources can move freely from the production of
one good to another within a country.
• Constant returns to scale. In reality, both diminishing
and increasing returns to specialization exist.
COMPARATIVE ADVANTAGE

• Each country has a fixed stock of resources and that


free trade does not change the efficiency with which
a country uses its resources.
• Assumed away the effects of trade on income
distribution within a country.
• Despite those shortcomings, research suggest that
the basic proposition that countries will export the
goods that they are most efficient at producing is
borne out by the data.
Heckscher-Ohlin Theory
• Ricardo’s theory stresses that comparative advantage
arises from differences in productivity.
• Australia is more efficient than Bangladesh in the production
of wheat depends on how productively it uses its resources.
• Swedish economists Eli Heckscher(1919) and Bertil
Ohlin(1933) put forward a different explanation of
comparative advantage.
• They argued that comparative advantage arises from
differences in national factor endowments(FE).
• By FE 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;
• the more abundant a factor, the lower its cost.
Heckscher-Ohlin Theory
• The H-O theory predicts that countries will export those
goods that makes intensive use of factors that are
locally abundant, while importing goods that makes
intensive use of factors that are locally scarce.
• Thus, H-O theory attempts to explain the pattern of IT
that we observe in the international economy.
• Like Ricardo’s theory, the H-O theory argues that free
trade is beneficial.
• Unlike Ricardo’s theory, the H-O theory argues that the
pattern of IT is determined by differences in FE, rather
than differences in productivity.
• The H-O theory has commonsense appeal. For exam,
the US has long been substantial exporter of agricultural
goods, reflecting in part its unusual abundance of arable
land.
Heckscher-Ohlin Theory
• The model starts with the presumption that country A produces
two products: food (X) and textiles (Y).
• These two kinds of production need two different inputs, territory
(T) and labour (L), which are available in limited quantities.
• In the same time, food production (X) requires more land, so it
can be said it is territory intensive and textile (Y) production
requires more labour, being in this way labour intensive.
• Beginning with these presumptions, the Heckscher-Ohlin model
explains the implications trade between two countries A and B
has, if the countries produce the same products: food (X) and
textiles (Y).
• In our case, country A is relative abundant in territory (T) and
will specialize in producing food (X) and country B is relative
abundant in labour (L) so it will specialize in producing textiles
(Y). In this case, trade may benefit both countries involved.
Heckscher-Ohlin Theory
Country Inputs and The relative abundance
production without and trade
trade specialization in the
product for which there
is a factor intensity.
Product Labour (L) Territory L/T T/L
(T)
Country A X Y X -
X (Food) 20 95 0.21 4.75
Y (Textile) 10 5 2.00 0.50
Total 30 100 0.30 3.33
Country B X Y - Y
X (Food) 3 5 0.60 1.66
Y (Textile) 10 2 5.00 1.20
Total 13 7 1.85 0.53
THEORIES ON INTERNATIONAL TRADE
• This reflects China’s relative abundance of low cost labor.
• In contrast, China excels in the export of goods
produced in labor-intensive manufacturing industries,
such as textiles and footwear.
• The US, 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.
The Leontief Paradox
H-O theory has been one of the most influential theoretical ideas in
international economics. Economists prefer the H-O to Ricardo’s
theory because it makes fewer simplifying assumptions.
THEORIES ON INTERNATIONAL TRADE
Because of its influence, the theory has been subjected to many
empirical tests. Wassily Leontief (Nobel Winner in 1973)
raised questions about the theories’ validity.
He assumed that since the US was relatively abundant in capital
compared to other nations, it would be an exporter of capital-
intensive goods and importer of labor-intensive goods.
However, he found that US exports were less capital-intensive
than US imports. Since the results was at variance with the
predictions of the theory, it has become known as Leontief
Paradox.

Why do we observe the L-P?


One possible explanation is that the US has a special advantage
in producing new products or goods made with innovative
technologies. Such products may be less capital-intensive.
THEORIES ON INTERNATIONAL TRADE
Thus, the US may be exporting goods that heavily use skilled
labor and innovative entrepreneurship, such as computer
software, while importing heavy manufacturing products that
use large amounts of capital.
Stril, using data for a large number of countries confirm the
existence of the L-P.
This leaves economists with difficult dilemma.
They prefer the H-O theory on theoretical grounds, but it is a
relatively poor predictor of real-world IT patterns.
The best solution to this dilemma may be to return to the Ricardian
idea that trade patterns are largely driven by international
differences in productivity.
Thus, one might argue that US exports IT products not because of
its factor endowments but because it is relatively more
efficient at producing those.
THEORIES ON INTERNATIONAL TRADE
A key assumption in the H-O theory is that technologies are same
across countries. This may not be the case.
Differences in technology may lead to differences in productivity,
which in turn, drive international trade pattern.
Thus, Japan's success in exporting auto is based not just on the
relative abundance of capital but also on its development of
innovative manufacturing technology than other countries.
The new research shows that once the impact of differences of
technology on productivity is controlled for, the H-O theory
seems to gain predictive power.
New Trade Theory (NTT)
Began to emerge at 1970 when a no of economists pointed
out that the ability of firms to attain economies of scale
(EOS) might have important implications for IT.
EOS unit cost reductions associated with a large scale of
output.. ability to spread fixed costs over a large volume,
and the ability of large volume producers to utilize
specialized employees and equipments that are more
productive than less specialized employees and equipment.
EOS are a major source of cost reductions in many
industries from computer software to automobile and
pharmaceuticals to aerospace.
NTT makes two important points: (1) through EOS, its
impact on increase the variety of goods available to
consumers and decrease the average cost of those goods
New Trade Theory (NTT)
and (2) in those industries when the output required to
attain EOS represents a significant proportion of total world
demand, the global market may only be able to support a
no of enterprises.
Thus, world trade in certain products may be dominated by
countries whose firms were first movers in their production.
 Increasing Product Variety and Reducing Costs
Suppose two countries each have an annual market for 1
million auto. By trading with each other, these countries can
create a combined market for 2 million cars.
In this combine market, due to ability of better realize EOS,
more varieties of cars can be produced at a lower average
costs than in either market alone.
For exam, demand for a sport car may be limited to 55000
units in each national market while a total output of at least
100000 per year may be required to realize significant EOS
New Trade Theory (NTT)
Similarly, demand for minivan may be 80000 units in each
national market, and again a total output of at least 100000
per year may be required to realize significant EOS.
Faced with limited domestic demand, firms in each nation
may decide not to produce a sports car since costs are too
great at low volume.
Although they produce minivans, the costs of doing so will
be higher in absence of EOS.
Once the 2 countries decide to trade however, a firm in one
nation may specialize in producing sports car, while a firm
in the other nation may produce minivans.
The combined demand for 110000 sports car and 160000
minivans allows each firm to realize EOS.
Trade is thus mutually beneficial because it allows for the
specialization of production, the realization of EOS,
New Trade Theory (NTT)
the production of greater variety of product, and lower
prices.
First Mover Advantages (FMA)—A Second Theme
FMA are the economic and strategic advantages that
accrue to early entrants into an industry.
Ability to capture EOS ahead of later entrants, and thus
benefit from a lower cost structure, is an important FMA.
For exam, consider the commercial aerospace industry.
There are substantial scale economy that come from the
ability to spread the fixed cost of developing a new jet
aircraft over a large no of scales.
It is costing Airbus some $14bn to develop its new super-
jumbo jet, the 550-seat A380. To recoup those costs and
BEP, Airbus will have to sell at least 250 planes. If Airbus
can sell over 350, it will apparently be profitable venture.
First Mover Advantages (FMA)—A Second Theme

However, total demand over the next 20 years is estimated


to be somewhere between 400-600 units.
Thus the global market can probably only profitably support
one producer of jet aircraft in the super-jumbo category.
Other potential producer (Boeing) might be shut out because
they will lack EOS that Airbus will enjoy because of FMA.
Implications of NTT
The theory suggests that nations may benefit from trade even
when they do not differ in resource endowments or technology.
NTT is at variance with H-O. NTT argues that because of
the FMA in the industry US exports Boeing.
NTT is not at variance with Ricardo’s comparative advantage
model. EOS increase productivity. Thus NTT identifies an
important source of comparative advantage.
NTT is quite useful in explaining trade patterns.
Implications of New Trade Theory

Chandler suggests that existence of FMA is an important factor


explaining the dominance of firms from certain nations in specific
industry.
The no. of firms is very limited in many global industries including
the chemical, heavy construction equipments, heavy truck tire,
consumer electronic, jet engine, computer software etc.
Perhaps the most contentious implications is the argument that it
generates for govt intervention and strategic trade policy.
NTT stresses the role of luck, entrepreneurship, and innovation in
giving a firm FMA.
Boeing was both lucky and innovative that Hawker (UK) and
Fokker(Hollands). DeHavilland (another jet) shot itself in the foot
when 707 was found to be full of serious technological flaws
although it introduced 2 years earlier than Boeing.
US govt largely paid for Boeing’s R&D. Airbus also supported by
significant govt subsidies. That is a variance with the free trade
prescriptions of the trade theories.
National Competitive Advantage: Porter Diamond
Why some countries succeed and other fail in international
competition? Why does Japan do well in the auto industry?
Switzerland in precision instruments and pharma? Germany and
US in Chemical? Cannot be answered easily by H-O.
Michael Porter (1990) and his team looked at 100 industries
in 10 nations. He believes that existing theories told only the
part of story. He tries to solve why one country is more
productive than others.
Four broad attributes of a nation shape the environment in
which the local firms compete, these attributes promote or
impede the creation of competitive advantage. These are:
1. Factor Endowments—skilled labor or infrastructure
2. Demand Condition—nature of home demand
3. Relating and Supporting Industry—the presence or absence of
R&D
National Competitive Advantage: Porter Diamond
4. Firm Strategy, Structure and Rivalry—how are they created,
organized and managed and nature of domestic rivalry.
Porter speaks of these 4 attributes as constituting the diamond.
He argues that the diamond is a mutually reinforcing system. The
effect of one attribute is contingent on the state of others.
For exam, favorable demand condition will not result in
competitive advantage unless the state of rivalry is sufficient
to cause firms to respond them.
Porter maintains that 2 additional variable can influence
the national diamond in important ways: chance and govt.
Chance events (major innovations) can reshape industry
structure and provide the opportunity for one nation’s firms to
supplant another’s.
Govt, by its choice of policies can detract from or improve national
advantage. For exam, regulation can alter home demand conditions,
antitrust policies can influence the intensity of rivalry.
National Competitive Advantage: Porter Diamond
1. Factor Endowments
Porter analyses the characteristics of factors of production.
He recognizes hierarchies among factors, distinguishing
between basic factors (natural resources, climate location,
and demographics)
and advanced factors (communication infrastructure, skilled and
sophisticated labor, research facilities, and technical know-how).
He argues that advanced factors (AF) are the most significant
for competitive advantage. These factors are a product of
investment by individuals, companies, and govts.
Thus, govt investment in basic and higher education, by
improving the general skill and knowledge level of the population
and by stimulating advanced research at higher educational
institutions, can upgrade a nation’s advanced factors.
The relationship between AF and BF is complex.
National Competitive Advantage: Porter Diamond
BF can provide an initial advantage that is subsequently
reinforced and extended by investment in AF.
Conversely, disadvantage in BF can create pressures to
investment in AF.
An obvious exam of this phenomenon is Japan, a country that
lacks arable land and mineral deposits and yet through
investment has built a substantial endowment of AF.
Porter notes that Japan’s large pull of engineers (reflecting as
much higher no of engineering graduates per capita than any
other nation) has been vital to Japan’s success in many
manufacturing industry.
2. Demand Conditions
Porter emphasize the role of home demand plays in
upgrading competitive advantage. It creates pressure for
innovation and quality.
National Competitive Advantage: Porter Diamond
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.
A similar exam can be found in the wireless telephone
industry, where sophisticated and demanding local customers
in Scandinavia helped push Nokia of Finland and Ericsson of
Sweden to invest in cellular phone technology long before
demand took off in other developed nation.

3. Related and Supporting Industries (R & SI)


The 3rd broad attribute of national advantage is an industry is the
presence of supplier or related industry that are initially competitive.
The benefits of investment in AF by R & SI can spill over into
an industry, thereby helping it achieve a strong competitive
position initially.
National Competitive Advantage: Porter Diamond
Swedish strength in fabricated steel production (ball bearings
and cutting tools) has drawn on strength in Sweden’s
specialty steel industry.
Technical leadership in the US semi-conductor industry
provided the basis for US success in PC and other technically
advanced electronic products.
Similarly, Switzerland’s success in Pharma is closely related
to its previous international success in the technically related
dye industry.
4. Firm Strategy, Structure, and Rivalry
Porter makes 2 important points: (1) different nations are
characterized by different mgt ideologies, which either help them
or do not help them to build national competitive advantage.
For exam, Porter noted the predominance of engineers in top
mgt at German and Japanese firms emphasis on improving
National Competitive Advantage: Porter Diamond
manufacturing process and product design.
In contrast, a predominance of people with finance back grounds
leading many US firms.
He linked this to US firm’s lack of attention to improving manufact
process and product design.
He argued that the dominance of finance-led to an overemphasis on
maximizing short term financial return.
Consequence of these different mgt ideologies was a relative loss of
US competitiveness in those engineering based industry where
manuf process and prod design issues are important (auto indust).
Porter’s 2nd point is that there is a strong association between
vigorous domestic rivalry (VDR) and the creation and persistent of
competitive advantage in an industry.
VDR induces firms to looks for way to improve off, which makes
them better international competitors.
National Competitive Advantage: Porter Diamond
It creates pressure to innovate, to improve quality, reduce costs and
invest in upgrading AFs. All this help to create world class
competitors.

Evaluating Porter’s Theory


Porter contends that govt can influence each of the 4 components of
diamond—positively or negatively.
FE can be affected by subsidies, policies toward capt mkt,
education, etc.
Govt can shape domestic demand through local prod standards or
with regulations that mandate or influence buyer needs.
Govt policy can influence supporting and related industries through
regulation and influence firm rivalry through such devices as CM
regulation, tax policy, and antitrust laws.
National Competitive Advantage: Porter Diamond
If Porter is correct, countries should be exporting products from
those ind where all 4 component of the diamond are favorable, while
importing.. –not favorable.
Porter theory has not been subjected to detailed empirical testing.

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