ADM 3318 Chapter Notes - Chapter 5: New Trade Theory, Generic Drug, Mercantilism
16 Jun 2018
School
Department
Course
Professor
International Trade Theories
International Trade Theories
Western companies continue to perform research and development and
marketing activities at home
While contracting out some of their manufacturing to Indian companies
to generate a low-cost generic medicine
○
•
International trade theory has shaped the economic policy of many nations in
the past
It was the driver behind the WTO and regional trading blocs such and the
EU and NAFTA
○
•
An Overview of Trade Theory
Mercantilism advocated that countries should simultaneously encourage
exports and encourage imports
○
Adam Smith introduced the idea of absolute advantage with explains why
unrestricted free trade is beneficial to a country
Free trade refers to a situation where a government does not
attempt to influence what its citizens can buy from another country
or what can be produced to sell in another country
§
He argued the invisible hand should determine what a country
imports and exports
§
There are two theories that build on Smith's work
The theory of competitive advantage
This is the intellectual basis of the modern argument for
unrestricted free trade
®
□
Then two Swedish economists refined the theory of
competitive advantage
□
§
○
The benefits of trade
Common sense suggests that some international trade is beneficial
○
Trade can still be beneficial to a country even if they are able to produce
the products being traded
○
There is gain in international trade because it allows a country to
specialize and export the product
This means that the country that can produce oranges the most
efficient way, should be exporting them to other countries that
struggle
§
○
Limits on imports are often in the interests of domestic producers, but not
domestic consumers
Hence putting restrictions on a specific product just so domestic
producers can make them, will hurt the economy as a whole
§
○
•
The pattern of international trade
There is a reason why countries only export specific products
There is an interplay between the proportions in which the factor of
production are available in different countries and the proportions
needed for producing a specific good
§
A country with little to no oil cannot export oil just because others
are doing so
§
○
One theory tries to explain the observed pattern of international trade,
being the product life-cycle theory
This suggests that early in their life cycle, most new products are
produced in and exported from the country which they were
developed
§
As the product starts being accepted internationally, production
starts in other countries
§
As the theory suggests, the product may ultimately be exported
back to their country of its original innovation
§
○
A new theory from the 1980s has come to be known as the new trade
theory
New trade theory stresses that in some cases countries specialize in
the production and export of particular products not because of the
underlying differences in factor endowments, but because in certain
industries in the world market can only support a limited amount of
firms
This is the case for the commercial aircraft industry □
§
Firms entering this kind of market need to build a competitive
advantage that is difficult to challenge
§
Michael Porter developed a theory, related to this one, referred to
as the theory of national competitive advantage
This attempts to explain why particular nations achieve
international success in certain industries
□
§
○
•
Trade theory and government policy
These theories agree that international is beneficial, but there is no
recommendations for government policy
○
Mercantilism makes a case for government involvement in promoting
exports and limiting imports
○
The theory of national competitive advantage can be interpreted as
justifying some limited government intervention to support development
of certain export-oriented industries
○
•
Mercantilism
Mercantilism is the first theory of international trade that emerged in England in
the mid-sixteenth century
Mercantilism is a principal assertion that gold and silver were the
mainstays of national wealth and essential vigorous commerce
○
The main tenant of mercantilism was that it was a country's best
interests to maintain a trade surplus, to export more than it imported
○
Mercantilists recommended policies to maximize exports and minimize
imports
Imports were limited by tariffs and quotas, while exports were
subsidized
§
○
Economist David Hume, suggested that in the long run, no country could
sustain a surplus on the balance of trade
○
•
The flaw with mercantilism was that it viewed trade as a zero-sum game
A zero-sum game is one in which a gain by one country results in a
loss by another
§
There is an approach that demonstrates that trade is a positive-sum game
This is a situation in which all countries can benefit from trade,
some more than others
§
○
•
Absolute Advantage
When a country has an absolute advantage in the production of a product when
it is more efficient than other countries at producing it
Adam Smith believed that countries should specialize in the production of
goods for which they have the absolute advantage and then trade those
goods with other countries
A country should never produce goods if it can buy it for a lower
cost
§
○
By specializing in the production of goods in which each has an absolute
advantage, both countries benefit by engaging in trade
○
•
Comparative Advantage
This theory says countries should specialize in the production of goods and
services they can produce most efficiently
Countries buy goods that it produces less efficiently from other countries,
even if this means buying goods from other countries that it could
produce more efficiently itself
○
•
The theory of comparative advantage is that potential world production is
greater with unrestricted free trade than it is with restricted trade
•
Consumers in all nations can consume more if there are no trade restrictions •
Trade and simple extensions of the Ricardian model
Below we relax the assumption that
Resources move freely from the production of one good to
another within a country
□
Trade does not change a country's stock of resources of the
efficiency with which those resources are utilized
□
§
Immobile resources
Some resources do not always shift quite so easily from producing
one good to another
A certain amount of friction is involved□
§
If even trading will help the economy as a whole, certain producers
will lose
If there is a shift in demand from textiles to software, workers
won't be able to make that switch
□
§
○
Diminishing returns
The simple comparative advantage model assumes constant return
to specialization
This means that costs stay the same as specialization
increases
□
§
It is more realistic to assume diminishing return to specialization
Diminishing returns to specialization occurs when more units
of resources are required to produce each additional unit
□
§
It is more realistic to assume diminishing returns for two reasons
First, not as resources are the same quality
As a country tries to increase output, the quality of
those resources slowly decrease
®
This would require even more resources to produce
equal output
®
□
Secondly, different goods use resources in different
proportions
If one product requires more labour than another, the
switch would be hard on the country
®
□
§
Diminishing returns to specialization suggests that the gains from
specialization are likely to be exhausted before specialization is
complete,
In reality, most countries produce a range of goods □
§
It is worthwhile to specialize until that point where the resulting
gains from trade are outweighed by diminishing returns
§
○
Dynamic effect and economic growth
The comparative advantage model assumed that trade does not
change a country's stock of resources or the efficiency with which it
utilizes those resources
This assumption doesn't allow for the dynamic changes that
might result from trade
□
§
Trade is likely to generate dynamic gains of two sorts
Free trade might increase a country's stock of resources as
increase supplies of labour and capital from abroad become
available for use within the country
□
Free trade might also increase the efficiency with which a
country uses its resources
□
§
Trade might make better technology from abroad available to
domestic firms
Better technology can increase labour productivity or the
productivity of the land
□
§
Opening an economy to foreign competition might stimulate
domestic producers to look for ways to increase their efficiency
§
○
The Samuelson Critique
This critique looks at what happens when a rich country (US) enters
into a free trade agreement with a poor country (China) that rapidly
improves its productivity after the introduction of free trade regime
§
The lower the prices that US consumers pay for goods imported
from China, following free trade introduction, may not be enough to
produce a net gain for the US economy
Being able to pay less for something, does not necessarily
make up for the wage losses
□
§
Free trade has historically benefited rich countries
§
○
Evidence for the Link Between Trade and Growth
The relationship between trade and economic growth suggest that
countries that adopt a more open stance toward international
trade, enjoy higher growth rates than those in a close economy
Adopt an open economy and embrace free trade, and over
time your nation will be rewarded with higher economic
growth rates
□
Higher growth will raise income levels and living standards □
§
○
•
Heckscher-Ohlin Theory
Eli Heckscher and Bertil Ohlin argued that comparative advantage arises from
differences in national factor endowments
Factor endowments are the extent to which a country is endowed with
such resources as land, labour, and capital
○
Nations have varying factor endowments, and different factor
endowments explain differences in factor costs
The more abundant a factor, the lower it costs
§
○
The theory predicts that countries will export those goods that make
intensive use of factors that are locally abundant, while importing goods
with factors that are scarce
○
Heckscher-Ohlin theory argues that the pattern of international trade is
determined by the differences in factor endowment rather than
productivity
○
Factor endowments are relative and not absolute
○
This has been one of the most influential theoretical ideas in international
economics
○
•
The Leontief Paradox
The Heckscher-Ohlin theory has been subjected to many empirical tests
Leontief postulated that since the US was relatively abundant in
capital compared to other nations, then they would be an exporter
of capital-intensive goods and importer of labour-intensive goods
He discovered the US exports were less capital intensive than
their exports
□
This is known as the Leontief Paradox □
§
○
The Heckscher-Ohlin is a great theory on theoretical grounds, but it a
relatively poor predictor of real-world international trade patterns
○
•
The Product Life-Cycle Theory
Vernon proposed this theory in the mid-1960s•
This theory was based on the observation that for most of the twentieth
century
A very large proportion of the world's new products have been developed
by US firms and first sold in the US market
○
•
Vernon argued that the wealth and size of the US market gave US firms a strong
incentive to develop new consumer products
Plus high cost of US labour gave firms an incentive to develop cost-saving
process
○
•
Vernon argued that, as demand increases in the US for a new product, it will
increase demand in other advanced countries
Since the demand is only to high-income group, other countries see no
point in manufacturing the product
○
As the popularity grows, foreign companies begin producing for their
home markets
○
As the markets mature, the product becomes more standardized, and
price becomes the main competitive weapon
This is when cost considerations start to play a greater role in the
competitive process
§
○
•
Evaluating the Product Life-Cycle Theory
In the past this theory seems to be an accurate explanation of
international trade patterns
○
Mature industries tend to go outside of the US and into low-cost
assemble locations
○
Now products are just being introduced in the US
New products are releasing in Europe or Japan first
§
○
This theory may be useful explaining international trade of the US global
dominance, but it the modern world its seen as limited
○
•
The New Trade Theory
This theory emerged in the 1970s when economists pointed out that the
ability to attain economies of scale might have important implications for
international trade
○
Economies of scale are unit cost reductions associated with a large scale
output
They have a number of sources
The ability to spread fixed costs over a large volume□
The ability of large-volume producers to utilize less
specialized employees and equipment
□
§
Economies of scale are a great source of cost reduction in many
industries
§
○
New trade theory makes two important points
Through its impact on economies of scale, trade can increase the
variety of goods available to consumers and decrease the average
cost of those goods
§
In those industries when the output required to attain economies of
scale represents a significant proportion of the total demand, the
global market may be able to only support a small number of
enterprises
Trade would be dominated by countries whose firms where
first movers
□
§
○
Increasing product variety and reducing costs
In a closed economy…
If national market is small, there may not be enough demand to
enable producers to realize economies of scale for certain products
§
Little units available limits the variety of products available to
consumers
§
Low volume of unit costs and prices could be higher than they might
be if economies of scale could be realized
§
○
In an open economy…
Individual national markets are combined into one big global
economy
§
Are the markets grow due to trade, firms are able to better attain
economies of scale
§
Each country will be able to increase the variety of goods available
to consumers, and lower the costs of those goods
§
○
•
Economies of scale, first-mover advantages, and the pattern of trade
First-mover advantages are the economic and strategic advantages that
accrue to early entrants into an industry
They have the ability to capture economies of scale before anyone
else, thus benefiting from a lower cost structure
§
○
The first-mover in an industry can gain a scale-based cost advantage that
later entrants find almost impossible to match
○
•
Implications of new trade theory
New trade theory has significance
Trade allows nations to specialize in production of certain products,
attaining scale economies and lowering the costs of production,
while importing products it cannot produce
Trade allows consumers to have a variety of products □
§
The first movers in an industry may get a lock on the world market
that discourages entry
First movers also have the advantage of an entry barrier being
created
□
§
○
•
Use of the theory
Empirical studies seem to support the predictions of the theory that trade
increases the specialization of production within an industry, increases
the variety of products available to consumers, and results in lower prices
○
First-mover advantages is an important factor in explaining the
dominance of firms from certain nations in specific industries
○
New trade theory stress the role of luck, entrepreneurship, and
innovation in giving a firm first-mover advantages
○
•
National Competitive Advantage - Porter's Diamond
Porter developed a diamond, consisting of four attributes
Factor endowments□
Demand conditions□
Related and supporting industries □
Firm strategy, structure, and rivalry □
He argues that firms are most likely to succeed in industries or
industry segments where the diamond is most favourable
The diamond is a mutually reinforcing system □
The effect of one attribute is contingent on the state of others □
§
There are two additional variables that can influence the national
diamond in important ways
Chance
Chance events, like major innovations, can reshape the
industry structure and provide the opportunity for one
nation's firm to supplant another's
®
□
Government
By its choice of policies, government can detract from
or improve national advantage
®
Regulations can alter home demand conditions, polices
can influence intense rivalry within an industry, etc.
®
□
§
○
Factor Endowments
This is a nation's position in factor of production such as skilled labour or
the infrastructure necessary to compete in a given industry
○
Advanced factors are the most significant for competitive advantage
Advanced factors are a product of investment by individuals,
companies, and governments
§
Government invests in basic and higher education, the general skill
and knowledge level rises, which stimulates research at higher
education
§
○
Basic factors can provide an initial advantage that is subsequently
reinforced and extended by investment in advanced factors
Disadvantages in basic factors can create pressure to invest in
advanced factors
§
○
•
Demand Conditions
This is the nature of home demand for the industry's product or service
○
Porter emphasizes the role of domestic demand plays in upgrading
competitive advantage
○
Firms are most sensitive to the needs of their closest customers
The characteristics of home demand are particularly important in
shaping the attributes of domestic products and in creating
pressure for innovation and quality
§
○
•
Related and Supporting Industries
This is the presence or absence of supplier industries and related
industries that are internationally competitive
○
The benefits of investments in advanced factors of production by related
and supporting industries can spill over into an industry, thereby helping
achieve a strong competitive position internationally
One consequence is that successful industries within a country tend
to be grouped into clusters of related industries
Such clusters are important because valuable knowledge can
flow between the firms within a geographic cluster,
benefitting all within that cluster
□
§
○
•
Firm, Strategy, structure, and rivalry
These are the conditions governing how companies are created,
organized, and managed and the nature of domestic rivalry
○
There are two important points
Different nations are characterized by different management
ideologies
This can either help them or do not help them to build
national competitive advantage
□
§
There is a strong association between vigorous domestic rivalry and
the creation and persistence of competitive advantage in an
industry
This induces firms to look for ways to improve efficiency,
which makes them better international competitors
□
Domestic rivalry creates pressure to innovate, to improve
quality, to reduce costs, and to invest in upgrading advanced
factors
This helps create world-class competitors, like Japan
®
□
§
○
•
Evaluating Porter's theory
Porter argues that the presence of all four components is usually required
for this diamond to boost competitive performance
○
Porter also contends that government can influence each of the four
components of the diamond, positively or negatively
The government can shape domestic demand through local product
standards or with regulations that mandate or influence buyer
needs
§
○
If Porter is correct, his model would predict the pattern of international
trade that we observe in the real world
His theory is yet to be subjected to independent empirical testing
§
○
•
Chapter 5
Monday, January 22, 2018
11:10
International Trade Theories
International Trade Theories
Western companies continue to perform research and development and
marketing activities at home
While contracting out some of their manufacturing to Indian companies
to generate a low-cost generic medicine
○
•
International trade theory has shaped the economic policy of many nations in
the past
It was the driver behind the WTO and regional trading blocs such and the
EU and NAFTA
○
•
An Overview of Trade Theory
Mercantilism advocated that countries should simultaneously encourage
exports and encourage imports
○
Adam Smith introduced the idea of absolute advantage with explains why
unrestricted free trade is beneficial to a country
Free trade refers to a situation where a government does not
attempt to influence what its citizens can buy from another country
or what can be produced to sell in another country
§
He argued the invisible hand should determine what a country
imports and exports
§
There are two theories that build on Smith's work
The theory of competitive advantage
This is the intellectual basis of the modern argument for
unrestricted free trade
®
□
Then two Swedish economists refined the theory of
competitive advantage
□
§
○
The benefits of trade
Common sense suggests that some international trade is beneficial
○
Trade can still be beneficial to a country even if they are able to produce
the products being traded
○
There is gain in international trade because it allows a country to
specialize and export the product
This means that the country that can produce oranges the most
efficient way, should be exporting them to other countries that
struggle
§
○
Limits on imports are often in the interests of domestic producers, but not
domestic consumers
Hence putting restrictions on a specific product just so domestic
producers can make them, will hurt the economy as a whole
§
○
•
The pattern of international trade
There is a reason why countries only export specific products
There is an interplay between the proportions in which the factor of
production are available in different countries and the proportions
needed for producing a specific good
§
A country with little to no oil cannot export oil just because others
are doing so
§
○
One theory tries to explain the observed pattern of international trade,
being the product life-cycle theory
This suggests that early in their life cycle, most new products are
produced in and exported from the country which they were
developed
§
As the product starts being accepted internationally, production
starts in other countries
§
As the theory suggests, the product may ultimately be exported
back to their country of its original innovation
§
○
A new theory from the 1980s has come to be known as the new trade
theory
New trade theory stresses that in some cases countries specialize in
the production and export of particular products not because of the
underlying differences in factor endowments, but because in certain
industries in the world market can only support a limited amount of
firms
This is the case for the commercial aircraft industry
□
§
Firms entering this kind of market need to build a competitive
advantage that is difficult to challenge
§
Michael Porter developed a theory, related to this one, referred to
as the theory of national competitive advantage
This attempts to explain why particular nations achieve
international success in certain industries
□
§
○
•
Trade theory and government policy
These theories agree that international is beneficial, but there is no
recommendations for government policy
○
Mercantilism makes a case for government involvement in promoting
exports and limiting imports
○
The theory of national competitive advantage can be interpreted as
justifying some limited government intervention to support development
of certain export-oriented industries
○
•
Mercantilism
Mercantilism is the first theory of international trade that emerged in England in
the mid-sixteenth century
Mercantilism is a principal assertion that gold and silver were the
mainstays of national wealth and essential vigorous commerce
○
The main tenant of mercantilism was that it was a country's best
interests to maintain a trade surplus, to export more than it imported
○
Mercantilists recommended policies to maximize exports and minimize
imports
Imports were limited by tariffs and quotas, while exports were
subsidized
§
○
Economist David Hume, suggested that in the long run, no country could
sustain a surplus on the balance of trade
○
•
The flaw with mercantilism was that it viewed trade as a zero-sum game
A zero-sum game is one in which a gain by one country results in a
loss by another
§
There is an approach that demonstrates that trade is a positive-sum game
This is a situation in which all countries can benefit from trade,
some more than others
§
○
•
Absolute Advantage
When a country has an absolute advantage in the production of a product when
it is more efficient than other countries at producing it
Adam Smith believed that countries should specialize in the production of
goods for which they have the absolute advantage and then trade those
goods with other countries
A country should never produce goods if it can buy it for a lower
cost
§
○
By specializing in the production of goods in which each has an absolute
advantage, both countries benefit by engaging in trade
○
•
Comparative Advantage
This theory says countries should specialize in the production of goods and
services they can produce most efficiently
Countries buy goods that it produces less efficiently from other countries,
even if this means buying goods from other countries that it could
produce more efficiently itself
○
•
The theory of comparative advantage is that potential world production is
greater with unrestricted free trade than it is with restricted trade
•
Consumers in all nations can consume more if there are no trade restrictions •
Trade and simple extensions of the Ricardian model
Below we relax the assumption that
Resources move freely from the production of one good to
another within a country
□
Trade does not change a country's stock of resources of the
efficiency with which those resources are utilized
□
§
Immobile resources
Some resources do not always shift quite so easily from producing
one good to another
A certain amount of friction is involved□
§
If even trading will help the economy as a whole, certain producers
will lose
If there is a shift in demand from textiles to software, workers
won't be able to make that switch
□
§
○
Diminishing returns
The simple comparative advantage model assumes constant return
to specialization
This means that costs stay the same as specialization
increases
□
§
It is more realistic to assume diminishing return to specialization
Diminishing returns to specialization occurs when more units
of resources are required to produce each additional unit
□
§
It is more realistic to assume diminishing returns for two reasons
First, not as resources are the same quality
As a country tries to increase output, the quality of
those resources slowly decrease
®
This would require even more resources to produce
equal output
®
□
Secondly, different goods use resources in different
proportions
If one product requires more labour than another, the
switch would be hard on the country
®
□
§
Diminishing returns to specialization suggests that the gains from
specialization are likely to be exhausted before specialization is
complete,
In reality, most countries produce a range of goods □
§
It is worthwhile to specialize until that point where the resulting
gains from trade are outweighed by diminishing returns
§
○
Dynamic effect and economic growth
The comparative advantage model assumed that trade does not
change a country's stock of resources or the efficiency with which it
utilizes those resources
This assumption doesn't allow for the dynamic changes that
might result from trade
□
§
Trade is likely to generate dynamic gains of two sorts
Free trade might increase a country's stock of resources as
increase supplies of labour and capital from abroad become
available for use within the country
□
Free trade might also increase the efficiency with which a
country uses its resources
□
§
Trade might make better technology from abroad available to
domestic firms
Better technology can increase labour productivity or the
productivity of the land
□
§
Opening an economy to foreign competition might stimulate
domestic producers to look for ways to increase their efficiency
§
○
The Samuelson Critique
This critique looks at what happens when a rich country (US) enters
into a free trade agreement with a poor country (China) that rapidly
improves its productivity after the introduction of free trade regime
§
The lower the prices that US consumers pay for goods imported
from China, following free trade introduction, may not be enough to
produce a net gain for the US economy
Being able to pay less for something, does not necessarily
make up for the wage losses
□
§
Free trade has historically benefited rich countries
§
○
Evidence for the Link Between Trade and Growth
The relationship between trade and economic growth suggest that
countries that adopt a more open stance toward international
trade, enjoy higher growth rates than those in a close economy
Adopt an open economy and embrace free trade, and over
time your nation will be rewarded with higher economic
growth rates
□
Higher growth will raise income levels and living standards □
§
○
•
Heckscher-Ohlin Theory
Eli Heckscher and Bertil Ohlin argued that comparative advantage arises from
differences in national factor endowments
Factor endowments are the extent to which a country is endowed with
such resources as land, labour, and capital
○
Nations have varying factor endowments, and different factor
endowments explain differences in factor costs
The more abundant a factor, the lower it costs
§
○
The theory predicts that countries will export those goods that make
intensive use of factors that are locally abundant, while importing goods
with factors that are scarce
○
Heckscher-Ohlin theory argues that the pattern of international trade is
determined by the differences in factor endowment rather than
productivity
○
Factor endowments are relative and not absolute
○
This has been one of the most influential theoretical ideas in international
economics
○
•
The Leontief Paradox
The Heckscher-Ohlin theory has been subjected to many empirical tests
Leontief postulated that since the US was relatively abundant in
capital compared to other nations, then they would be an exporter
of capital-intensive goods and importer of labour-intensive goods
He discovered the US exports were less capital intensive than
their exports
□
This is known as the Leontief Paradox □
§
○
The Heckscher-Ohlin is a great theory on theoretical grounds, but it a
relatively poor predictor of real-world international trade patterns
○
•
The Product Life-Cycle Theory
Vernon proposed this theory in the mid-1960s•
This theory was based on the observation that for most of the twentieth
century
A very large proportion of the world's new products have been developed
by US firms and first sold in the US market
○
•
Vernon argued that the wealth and size of the US market gave US firms a strong
incentive to develop new consumer products
Plus high cost of US labour gave firms an incentive to develop cost-saving
process
○
•
Vernon argued that, as demand increases in the US for a new product, it will
increase demand in other advanced countries
Since the demand is only to high-income group, other countries see no
point in manufacturing the product
○
As the popularity grows, foreign companies begin producing for their
home markets
○
As the markets mature, the product becomes more standardized, and
price becomes the main competitive weapon
This is when cost considerations start to play a greater role in the
competitive process
§
○
•
Evaluating the Product Life-Cycle Theory
In the past this theory seems to be an accurate explanation of
international trade patterns
○
Mature industries tend to go outside of the US and into low-cost
assemble locations
○
Now products are just being introduced in the US
New products are releasing in Europe or Japan first
§
○
This theory may be useful explaining international trade of the US global
dominance, but it the modern world its seen as limited
○
•
The New Trade Theory
This theory emerged in the 1970s when economists pointed out that the
ability to attain economies of scale might have important implications for
international trade
○
Economies of scale are unit cost reductions associated with a large scale
output
They have a number of sources
The ability to spread fixed costs over a large volume□
The ability of large-volume producers to utilize less
specialized employees and equipment
□
§
Economies of scale are a great source of cost reduction in many
industries
§
○
New trade theory makes two important points
Through its impact on economies of scale, trade can increase the
variety of goods available to consumers and decrease the average
cost of those goods
§
In those industries when the output required to attain economies of
scale represents a significant proportion of the total demand, the
global market may be able to only support a small number of
enterprises
Trade would be dominated by countries whose firms where
first movers
□
§
○
Increasing product variety and reducing costs
In a closed economy…
If national market is small, there may not be enough demand to
enable producers to realize economies of scale for certain products
§
Little units available limits the variety of products available to
consumers
§
Low volume of unit costs and prices could be higher than they might
be if economies of scale could be realized
§
○
In an open economy…
Individual national markets are combined into one big global
economy
§
Are the markets grow due to trade, firms are able to better attain
economies of scale
§
Each country will be able to increase the variety of goods available
to consumers, and lower the costs of those goods
§
○
•
Economies of scale, first-mover advantages, and the pattern of trade
First-mover advantages are the economic and strategic advantages that
accrue to early entrants into an industry
They have the ability to capture economies of scale before anyone
else, thus benefiting from a lower cost structure
§
○
The first-mover in an industry can gain a scale-based cost advantage that
later entrants find almost impossible to match
○
•
Implications of new trade theory
New trade theory has significance
Trade allows nations to specialize in production of certain products,
attaining scale economies and lowering the costs of production,
while importing products it cannot produce
Trade allows consumers to have a variety of products □
§
The first movers in an industry may get a lock on the world market
that discourages entry
First movers also have the advantage of an entry barrier being
created
□
§
○
•
Use of the theory
Empirical studies seem to support the predictions of the theory that trade
increases the specialization of production within an industry, increases
the variety of products available to consumers, and results in lower prices
○
First-mover advantages is an important factor in explaining the
dominance of firms from certain nations in specific industries
○
New trade theory stress the role of luck, entrepreneurship, and
innovation in giving a firm first-mover advantages
○
•
National Competitive Advantage - Porter's Diamond
Porter developed a diamond, consisting of four attributes
Factor endowments□
Demand conditions□
Related and supporting industries □
Firm strategy, structure, and rivalry □
He argues that firms are most likely to succeed in industries or
industry segments where the diamond is most favourable
The diamond is a mutually reinforcing system □
The effect of one attribute is contingent on the state of others □
§
There are two additional variables that can influence the national
diamond in important ways
Chance
Chance events, like major innovations, can reshape the
industry structure and provide the opportunity for one
nation's firm to supplant another's
®
□
Government
By its choice of policies, government can detract from
or improve national advantage
®
Regulations can alter home demand conditions, polices
can influence intense rivalry within an industry, etc.
®
□
§
○
Factor Endowments
This is a nation's position in factor of production such as skilled labour or
the infrastructure necessary to compete in a given industry
○
Advanced factors are the most significant for competitive advantage
Advanced factors are a product of investment by individuals,
companies, and governments
§
Government invests in basic and higher education, the general skill
and knowledge level rises, which stimulates research at higher
education
§
○
Basic factors can provide an initial advantage that is subsequently
reinforced and extended by investment in advanced factors
Disadvantages in basic factors can create pressure to invest in
advanced factors
§
○
•
Demand Conditions
This is the nature of home demand for the industry's product or service
○
Porter emphasizes the role of domestic demand plays in upgrading
competitive advantage
○
Firms are most sensitive to the needs of their closest customers
The characteristics of home demand are particularly important in
shaping the attributes of domestic products and in creating
pressure for innovation and quality
§
○
•
Related and Supporting Industries
This is the presence or absence of supplier industries and related
industries that are internationally competitive
○
The benefits of investments in advanced factors of production by related
and supporting industries can spill over into an industry, thereby helping
achieve a strong competitive position internationally
One consequence is that successful industries within a country tend
to be grouped into clusters of related industries
Such clusters are important because valuable knowledge can
flow between the firms within a geographic cluster,
benefitting all within that cluster
□
§
○
•
Firm, Strategy, structure, and rivalry
These are the conditions governing how companies are created,
organized, and managed and the nature of domestic rivalry
○
There are two important points
Different nations are characterized by different management
ideologies
This can either help them or do not help them to build
national competitive advantage
□
§
There is a strong association between vigorous domestic rivalry and
the creation and persistence of competitive advantage in an
industry
This induces firms to look for ways to improve efficiency,
which makes them better international competitors
□
Domestic rivalry creates pressure to innovate, to improve
quality, to reduce costs, and to invest in upgrading advanced
factors
This helps create world-class competitors, like Japan
®
□
§
○
•
Evaluating Porter's theory
Porter argues that the presence of all four components is usually required
for this diamond to boost competitive performance
○
Porter also contends that government can influence each of the four
components of the diamond, positively or negatively
The government can shape domestic demand through local product
standards or with regulations that mandate or influence buyer
needs
§
○
If Porter is correct, his model would predict the pattern of international
trade that we observe in the real world
His theory is yet to be subjected to independent empirical testing
§
○
•
Chapter 5
Monday, January 22, 2018 11:10
International Trade Theories
International Trade Theories
Western companies continue to perform research and development and
marketing activities at home
While contracting out some of their manufacturing to Indian companies
to generate a low-cost generic medicine
○
•
International trade theory has shaped the economic policy of many nations in
the past
It was the driver behind the WTO and regional trading blocs such and the
EU and NAFTA
○
•
An Overview of Trade Theory
Mercantilism advocated that countries should simultaneously encourage
exports and encourage imports
○
Adam Smith introduced the idea of absolute advantage with explains why
unrestricted free trade is beneficial to a country
Free trade refers to a situation where a government does not
attempt to influence what its citizens can buy from another country
or what can be produced to sell in another country
§
He argued the invisible hand should determine what a country
imports and exports
§
There are two theories that build on Smith's work
The theory of competitive advantage
This is the intellectual basis of the modern argument for
unrestricted free trade
®
□
Then two Swedish economists refined the theory of
competitive advantage
□
§
○
The benefits of trade
Common sense suggests that some international trade is beneficial
○
Trade can still be beneficial to a country even if they are able to produce
the products being traded
○
There is gain in international trade because it allows a country to
specialize and export the product
This means that the country that can produce oranges the most
efficient way, should be exporting them to other countries that
struggle
§
○
Limits on imports are often in the interests of domestic producers, but not
domestic consumers
Hence putting restrictions on a specific product just so domestic
producers can make them, will hurt the economy as a whole
§
○
•
The pattern of international trade
There is a reason why countries only export specific products
There is an interplay between the proportions in which the factor of
production are available in different countries and the proportions
needed for producing a specific good
§
A country with little to no oil cannot export oil just because others
are doing so
§
○
One theory tries to explain the observed pattern of international trade,
being the product life-cycle theory
This suggests that early in their life cycle, most new products are
produced in and exported from the country which they were
developed
§
As the product starts being accepted internationally, production
starts in other countries
§
As the theory suggests, the product may ultimately be exported
back to their country of its original innovation
§
○
A new theory from the 1980s has come to be known as the new trade
theory
New trade theory stresses that in some cases countries specialize in
the production and export of particular products not because of the
underlying differences in factor endowments, but because in certain
industries in the world market can only support a limited amount of
firms
This is the case for the commercial aircraft industry □
§
Firms entering this kind of market need to build a competitive
advantage that is difficult to challenge
§
Michael Porter developed a theory, related to this one, referred to
as the theory of national competitive advantage
This attempts to explain why particular nations achieve
international success in certain industries
□
§
○
•
Trade theory and government policy
These theories agree that international is beneficial, but there is no
recommendations for government policy
○
Mercantilism makes a case for government involvement in promoting
exports and limiting imports
○
The theory of national competitive advantage can be interpreted as
justifying some limited government intervention to support development
of certain export-oriented industries
○
•
Mercantilism
Mercantilism is the first theory of international trade that emerged in England in
the mid-sixteenth century
Mercantilism is a principal assertion that gold and silver were the
mainstays of national wealth and essential vigorous commerce
○
The main tenant of mercantilism was that it was a country's best
interests to maintain a trade surplus, to export more than it imported
○
Mercantilists recommended policies to maximize exports and minimize
imports
Imports were limited by tariffs and quotas, while exports were
subsidized
§
○
Economist David Hume, suggested that in the long run, no country could
sustain a surplus on the balance of trade
○
•
The flaw with mercantilism was that it viewed trade as a zero-sum game
A zero-sum game is one in which a gain by one country results in a
loss by another
§
There is an approach that demonstrates that trade is a positive-sum game
This is a situation in which all countries can benefit from trade,
some more than others
§
○
•
Absolute Advantage
When a country has an absolute advantage in the production of a product when
it is more efficient than other countries at producing it
Adam Smith believed that countries should specialize in the production of
goods for which they have the absolute advantage and then trade those
goods with other countries
A country should never produce goods if it can buy it for a lower
cost
§
○
By specializing in the production of goods in which each has an absolute
advantage, both countries benefit by engaging in trade
○
•
Comparative Advantage
This theory says countries should specialize in the production of goods and
services they can produce most efficiently
Countries buy goods that it produces less efficiently from other countries,
even if this means buying goods from other countries that it could
produce more efficiently itself
○
•
The theory of comparative advantage is that potential world production is
greater with unrestricted free trade than it is with restricted trade
•
Consumers in all nations can consume more if there are no trade restrictions •
Trade and simple extensions of the Ricardian model
Below we relax the assumption that
Resources move freely from the production of one good to
another within a country
□
Trade does not change a country's stock of resources of the
efficiency with which those resources are utilized
□
§
Immobile resources
Some resources do not always shift quite so easily from producing
one good to another
A certain amount of friction is involved□
§
If even trading will help the economy as a whole, certain producers
will lose
If there is a shift in demand from textiles to software, workers
won't be able to make that switch
□
§
○
Diminishing returns
The simple comparative advantage model assumes constant return
to specialization
This means that costs stay the same as specialization
increases
□
§
It is more realistic to assume diminishing return to specialization
Diminishing returns to specialization occurs when more units
of resources are required to produce each additional unit
□
§
It is more realistic to assume diminishing returns for two reasons
First, not as resources are the same quality
As a country tries to increase output, the quality of
those resources slowly decrease
®
This would require even more resources to produce
equal output
®
□
Secondly, different goods use resources in different
proportions
If one product requires more labour than another, the
switch would be hard on the country
®
□
§
Diminishing returns to specialization suggests that the gains from
specialization are likely to be exhausted before specialization is
complete,
In reality, most countries produce a range of goods □
§
It is worthwhile to specialize until that point where the resulting
gains from trade are outweighed by diminishing returns
§
○
Dynamic effect and economic growth
The comparative advantage model assumed that trade does not
change a country's stock of resources or the efficiency with which it
utilizes those resources
This assumption doesn't allow for the dynamic changes that
might result from trade
□
§
Trade is likely to generate dynamic gains of two sorts
Free trade might increase a country's stock of resources as
increase supplies of labour and capital from abroad become
available for use within the country
□
Free trade might also increase the efficiency with which a
country uses its resources
□
§
Trade might make better technology from abroad available to
domestic firms
Better technology can increase labour productivity or the
productivity of the land
□
§
Opening an economy to foreign competition might stimulate
domestic producers to look for ways to increase their efficiency
§
○
The Samuelson Critique
This critique looks at what happens when a rich country (US) enters
into a free trade agreement with a poor country (China) that rapidly
improves its productivity after the introduction of free trade regime
§
The lower the prices that US consumers pay for goods imported
from China, following free trade introduction, may not be enough to
produce a net gain for the US economy
Being able to pay less for something, does not necessarily
make up for the wage losses
□
§
Free trade has historically benefited rich countries
§
○
Evidence for the Link Between Trade and Growth
The relationship between trade and economic growth suggest that
countries that adopt a more open stance toward international
trade, enjoy higher growth rates than those in a close economy
Adopt an open economy and embrace free trade, and over
time your nation will be rewarded with higher economic
growth rates
□
Higher growth will raise income levels and living standards □
§
○
•
Heckscher-Ohlin Theory
Eli Heckscher and Bertil Ohlin argued that comparative advantage arises from
differences in national factor endowments
Factor endowments are the extent to which a country is endowed with
such resources as land, labour, and capital
○
Nations have varying factor endowments, and different factor
endowments explain differences in factor costs
The more abundant a factor, the lower it costs
§
○
The theory predicts that countries will export those goods that make
intensive use of factors that are locally abundant, while importing goods
with factors that are scarce
○
Heckscher-Ohlin theory argues that the pattern of international trade is
determined by the differences in factor endowment rather than
productivity
○
Factor endowments are relative and not absolute
○
This has been one of the most influential theoretical ideas in international
economics
○
•
The Leontief Paradox
The Heckscher-Ohlin theory has been subjected to many empirical tests
Leontief postulated that since the US was relatively abundant in
capital compared to other nations, then they would be an exporter
of capital-intensive goods and importer of labour-intensive goods
He discovered the US exports were less capital intensive than
their exports
□
This is known as the Leontief Paradox □
§
○
The Heckscher-Ohlin is a great theory on theoretical grounds, but it a
relatively poor predictor of real-world international trade patterns
○
•
The Product Life-Cycle Theory
Vernon proposed this theory in the mid-1960s•
This theory was based on the observation that for most of the twentieth
century
A very large proportion of the world's new products have been developed
by US firms and first sold in the US market
○
•
Vernon argued that the wealth and size of the US market gave US firms a strong
incentive to develop new consumer products
Plus high cost of US labour gave firms an incentive to develop cost-saving
process
○
•
Vernon argued that, as demand increases in the US for a new product, it will
increase demand in other advanced countries
Since the demand is only to high-income group, other countries see no
point in manufacturing the product
○
As the popularity grows, foreign companies begin producing for their
home markets
○
As the markets mature, the product becomes more standardized, and
price becomes the main competitive weapon
This is when cost considerations start to play a greater role in the
competitive process
§
○
•
Evaluating the Product Life-Cycle Theory
In the past this theory seems to be an accurate explanation of
international trade patterns
○
Mature industries tend to go outside of the US and into low-cost
assemble locations
○
Now products are just being introduced in the US
New products are releasing in Europe or Japan first
§
○
This theory may be useful explaining international trade of the US global
dominance, but it the modern world its seen as limited
○
•
The New Trade Theory
This theory emerged in the 1970s when economists pointed out that the
ability to attain economies of scale might have important implications for
international trade
○
Economies of scale are unit cost reductions associated with a large scale
output
They have a number of sources
The ability to spread fixed costs over a large volume□
The ability of large-volume producers to utilize less
specialized employees and equipment
□
§
Economies of scale are a great source of cost reduction in many
industries
§
○
New trade theory makes two important points
Through its impact on economies of scale, trade can increase the
variety of goods available to consumers and decrease the average
cost of those goods
§
In those industries when the output required to attain economies of
scale represents a significant proportion of the total demand, the
global market may be able to only support a small number of
enterprises
Trade would be dominated by countries whose firms where
first movers
□
§
○
Increasing product variety and reducing costs
In a closed economy…
If national market is small, there may not be enough demand to
enable producers to realize economies of scale for certain products
§
Little units available limits the variety of products available to
consumers
§
Low volume of unit costs and prices could be higher than they might
be if economies of scale could be realized
§
○
In an open economy…
Individual national markets are combined into one big global
economy
§
Are the markets grow due to trade, firms are able to better attain
economies of scale
§
Each country will be able to increase the variety of goods available
to consumers, and lower the costs of those goods
§
○
•
Economies of scale, first-mover advantages, and the pattern of trade
First-mover advantages are the economic and strategic advantages that
accrue to early entrants into an industry
They have the ability to capture economies of scale before anyone
else, thus benefiting from a lower cost structure
§
○
The first-mover in an industry can gain a scale-based cost advantage that
later entrants find almost impossible to match
○
•
Implications of new trade theory
New trade theory has significance
Trade allows nations to specialize in production of certain products,
attaining scale economies and lowering the costs of production,
while importing products it cannot produce
Trade allows consumers to have a variety of products □
§
The first movers in an industry may get a lock on the world market
that discourages entry
First movers also have the advantage of an entry barrier being
created
□
§
○
•
Use of the theory
Empirical studies seem to support the predictions of the theory that trade
increases the specialization of production within an industry, increases
the variety of products available to consumers, and results in lower prices
○
First-mover advantages is an important factor in explaining the
dominance of firms from certain nations in specific industries
○
New trade theory stress the role of luck, entrepreneurship, and
innovation in giving a firm first-mover advantages
○
•
National Competitive Advantage - Porter's Diamond
Porter developed a diamond, consisting of four attributes
Factor endowments□
Demand conditions□
Related and supporting industries □
Firm strategy, structure, and rivalry □
He argues that firms are most likely to succeed in industries or
industry segments where the diamond is most favourable
The diamond is a mutually reinforcing system □
The effect of one attribute is contingent on the state of others □
§
There are two additional variables that can influence the national
diamond in important ways
Chance
Chance events, like major innovations, can reshape the
industry structure and provide the opportunity for one
nation's firm to supplant another's
®
□
Government
By its choice of policies, government can detract from
or improve national advantage
®
Regulations can alter home demand conditions, polices
can influence intense rivalry within an industry, etc.
®
□
§
○
Factor Endowments
This is a nation's position in factor of production such as skilled labour or
the infrastructure necessary to compete in a given industry
○
Advanced factors are the most significant for competitive advantage
Advanced factors are a product of investment by individuals,
companies, and governments
§
Government invests in basic and higher education, the general skill
and knowledge level rises, which stimulates research at higher
education
§
○
Basic factors can provide an initial advantage that is subsequently
reinforced and extended by investment in advanced factors
Disadvantages in basic factors can create pressure to invest in
advanced factors
§
○
•
Demand Conditions
This is the nature of home demand for the industry's product or service
○
Porter emphasizes the role of domestic demand plays in upgrading
competitive advantage
○
Firms are most sensitive to the needs of their closest customers
The characteristics of home demand are particularly important in
shaping the attributes of domestic products and in creating
pressure for innovation and quality
§
○
•
Related and Supporting Industries
This is the presence or absence of supplier industries and related
industries that are internationally competitive
○
The benefits of investments in advanced factors of production by related
and supporting industries can spill over into an industry, thereby helping
achieve a strong competitive position internationally
One consequence is that successful industries within a country tend
to be grouped into clusters of related industries
Such clusters are important because valuable knowledge can
flow between the firms within a geographic cluster,
benefitting all within that cluster
□
§
○
•
Firm, Strategy, structure, and rivalry
These are the conditions governing how companies are created,
organized, and managed and the nature of domestic rivalry
○
There are two important points
Different nations are characterized by different management
ideologies
This can either help them or do not help them to build
national competitive advantage
□
§
There is a strong association between vigorous domestic rivalry and
the creation and persistence of competitive advantage in an
industry
This induces firms to look for ways to improve efficiency,
which makes them better international competitors
□
Domestic rivalry creates pressure to innovate, to improve
quality, to reduce costs, and to invest in upgrading advanced
factors
This helps create world-class competitors, like Japan
®
□
§
○
•
Evaluating Porter's theory
Porter argues that the presence of all four components is usually required
for this diamond to boost competitive performance
○
Porter also contends that government can influence each of the four
components of the diamond, positively or negatively
The government can shape domestic demand through local product
standards or with regulations that mandate or influence buyer
needs
§
○
If Porter is correct, his model would predict the pattern of international
trade that we observe in the real world
His theory is yet to be subjected to independent empirical testing
§
○
•
Chapter 5
Monday, January 22, 2018 11:10
