Explain the modern theory of international trade.

How is it an improvement over the

classical theory?

Introduction

International trade is the exchange of goods and

services between countries. This type of trade gives rise to

a world economy, in which prices, r supply and demand,

affect and are affected by global events. Political change in

Asia, for example, could result in an increase in the cost of labor, thereby increasing the

manufacturing costs for an American sneaker company based in Malaysia, which would

then result in an increase in the price that you have to pay to buy the tennis shoes at

your local mall. A decrease in the cost of labor, on the other hand, would result in you

having to pay less for your new shoes. [ CITATION inv1 \l 1033 ].

International trade theories are simply different theories that explain international

trade. Trade is the concept of exchanging goods and services between two people or

entities. International trade is then the concept of this exchange between people or

entities in two countries. People or entities trade because they believe that they benefit

from the exchange. They may need or want the gomod and services.
 Economists have developed theories to explain the mechanisms of global trade.

The main historical theories are called classical and are from the perspective of a

country or country based. By mid- twentieth century, the theories began to shift to

explain trade from a form rather than a country perspective. These theories are referred

to as modern and are firm-based or company based.

Classical theory Modern Theory

Mercantilism Product Life Cycle
Absolute Advantage Porter National Competitive advantage
Comparative Advantage Global Strategic Rivalry Theory
Country Similarity Theory

Heckscher-Ohlin

Modern Based Trade Theories

Modern firm based theories emerged after World War II and was developed in

large part by business but not economists. It evolved with the growth of the multinational

company. Modern Based Trade theories is inability of the country-based theories to

explain and predict the existence and grown of intraindustry trade. Modern trade

theories incorporate other product and service factors including brand and customer

loyalty, technology and quality. Example: Japanese consumers buy BNW and German

consumers buy Toyotas 40% of world trade

Country Similarity Theory

 Swedish economist Staffan Burenstam Linder proposed the Country Similarity

Theory in 1961 to describe a pattern of international trade . He is also refer to as the

Linder hypothesis that states that countries with similar per capita incomes are most

likely to engage in trade with one another. However mostly developing countries do not

trade between themselves as the surplus of these countries would be raw materials and

agricultural products and their requirements would be technology and high technology-

oriented products. For example Vietnam and Ethiopia .

It also observed that country with similar incomes are likely to share consumer

preferences .According to the theory the companies that develop new products for the

domestic market, export the products to those countries that are similar level of

development after meeting the needs of the domestic market. This theory is often more

useful in understanding trade in goods where brand names and product reputations are

import factors in the buyers decision making and purchasing processes .

The basis for trade among countries

a) Similarity of location

Countries prefer to export to the neighboring countries in order to have the advantages

of less transportation cost.

For example Finland is a major exporter to Russia due to less transportation

cost.

b) Cultural Similarity
 Countries prefer to export to those countries having similar culture.

For example, exports and imports among European countries, between USA

and Canada, among the Asian countries, and among the Islamic countries .

c) Similarity of political and economic interest

Similar political interests close political relations and economic interests enable

the countries to enter into agreements for exports and imports. Countries prefer

to trade with their politically friendly countries.

Military conflicts disrupt trade partners

Political animosity may interfere with trading channels

For example, India used to export to the former USSR. The enmity of the USA

with Cuba resulted in the USA importing of sugar from Mexico by abandoning

sugar import from Cuba

Product Life cycle theory

Product life cycle theory is an economic theory that is developed By Raymond

suggested that as products mature both the location of sales and production will change

affecting flow and direction of trade.

This theory suggest that early in a products life cycle all the parts and labor

associated with that product come from the area in which it was invented. The

production location of many products moves from one country to another depending on

the stage in the product life cycle. .According to this theory the cycle of products life

includes three phases: new product, mature product and standardized product. Table

1.0 highlights these stages.

a) Introduction

- In this stages a firm introduces an innovative product in response to felt need in the

domestic market. As the fortunes of the products is unknown it is produced in limited

quantity and it sold mainly in the domestic market. Exports are either nonexistent or

take place in a limited way gradually growing late in the product stage.

- The specialists in marketing of the respective firm will have to attentively study the

users reaction in order to give assurance that the product satisfies the necessities to

which is addressed. Receiving the message that is transmitted on the market is very

important as the product will be first presented on the internal market and produced in

these countries in which capacities of research development are proper.

b) Growth

- This initial stage of the product life cycle is characterized by high prices, high profits

and wide promotion of the product. International followers have not had time to develop

imitations. The supplier of the product may export it, even into follower economies.

- Sales growth attracts competitors to the market, particularly in other developed

countries. For example innovator is in the United States and a competitor puts a

manufacturing in Japan. The Japanese production is sold mainly in Japan for several

reasons

i) The growing demand there does not allow for much attention to other markets

ii) Procedures there stay occupied in developing unique product variations for Japanese

consumers

iii) Japanese costs may still be high because of production start-up problems.

The sales growth will create an incentive for companies to develop labor-saving process

technology but this incentive is partly offset because competitors are differentiating their

products especially to fit the needs of different countries.

c) Maturity

In the maturity phase of the product life cycle, demand levels off and sales

volume increases at a slower rate. Imitations appear in foreign markets and export sales

decline. The original supplier may reduce prices to maintain market share and support

sales. Profit margins decrease, but the business remains attractive because volume is

high and costs, such as those related to development and promotion, are also lower.

Over time, market saturation causes the product market to enter the maturity stage,

during which the sales curve again flattens, and revenue is generated predominantly by

sales to existing customers rather than to new customecustomer0TTTTTTTTTT

d) Declined

as product moves into decline stage, those factors occurring during the mature stage

will continue to evolve. Meanwhile the markets in the developed countries decline more

rapdically then those in the developing enconomies as the customer demands ever

newer is in the developing conutries. At this time the market and the cost factors have

dictated that almost all the production is in the developing enconomies that export to

the declining or small niche markets in the developing country

This theory provides important insights of how the nature of competition changes

as markets mature. As consumer adoption approaches saturation, future revenue

growth depends not on attracting new customers but rather on delivering greater value

customers who already in the market.

Porter National Competitive advantage

Micheal Porter of Harvard Business School developed a new model to

explain national competitive in 1990. This theory stated that a nation competitiveness is

an industry depends on the capacity in the industry to innovate and upgrade. Porter

focuses on explaining why some nations are more competitive in industry certain. The

disagreement is that the national home base of an organization provides organizations

with specific factors, which will potentially create competitive advantages on a global

scale.

Porters diamond model include

a) Demand Conditions

b) Factor Conditions

c) Related and supporting industries

c) Firm Strategy, structure and rivalry

(See figure 1.1)

 Demand Conditions

The importance of demand conditions as a factor influencing competitive

advantage stems from the fact that in a market economy the direction of production, that

is, the kinds of goods which are produced, is determined by the needs of buyers. The

importance of demand conditions as a factor influencing competitive advantage stems

from the fact that in a market economy the direction of production, that is, the kinds of

goods which are produced, is determined by the needs of buyers.

For example Japanese consumers have historically been more demanding of

electrical and electronic equipment than western consumers. This has partly founded

the success of Japanese manufacturers within this sector.

Factors Conditions

Porter recognized that the value of the factor proportions theory which considers

a nation resources such as natural resources and available labor as the key factors that

determines what products a country will import and export. The concept goes beyond as

it explains that availability of the factors of production is not important, rather their

contribution to the creation and upgrading of product is crucial for competitive

advantage.

For example Japan possesses competitive advantage in the production of

automobiles, it is not simply because Japan has easy access to iron ore, but because

the country has skilled labor force for making this industry competitive.

Factor conditions being the inputs which affect competition in any industry comprise 6

categories:
 Human resources: the quantity, skills, and cost of personnel (including
management);
Physical resources: the abundance, quality, accessibility, and cost of the
nations land, water, mineral, or timber deposits, hydroelectric power sources,
fishing grounds, and other physical traits.
Knowledge resources: the accumulated scientific, technical, and market
knowledge in a nation in the sphere of goods and services
Capital resources: the stock of capital available in a country and the cost of
its deployment;
Infrastructure resources: the characteristics (including type, quality) and
the cost of using the infrastructure available.

Local suppliers and complementary industries.

Firm operating along with its competitors as well as its complementary firms

gathers benefit through a close working relationship in form of competition or backward

and forward linkages. When local supporting industries and suppliers are competitive,

home country companies will potentially get more cost efficient and receive more

innovative parts and products. This will potentially lead to greater competitiveness for

national firms. For example, the Italian shoe industry benefits from a highly competent

pool of related businesses and industries, which has strengthened the competitiveness

of the Italian shoe industry world-wide.

Firm Strategy, structure and rivalry

The strategy and structure of firms is also influenced by the management style

and culture of the country in which they are located and Porter noted that no single

management style guaranteed success.

For example, manufacturing firms are typically small and medium sized; operated in

fragmented industries; managed like extended families; and employ a strategy geared

towards meeting the needs of small market niches. By contrast in Germany, successful

organizations tend to be hierarchical; emphasize technical/engineering content; and

involve precision manufacturing and a highly disciplined management structure.

The degree to which a nation is able to achieve international success in the industry is a

function of the combined impact of the four sources. He also contends that government

can influence each of the four components in the diamond either positively or negatively

by pursuing appropriate policies and that chance factors - like oil price shocks,

earthquakes, floods or the sudden discovery of a major energy saving process - can

also play a role.

By using Porter's diamond, business leaders may analyze which competitive

factors may reside in their company's home country, and which of these factors may be

exploited to gain global competitive advantages. Business leaders can also use the

Porter's diamond model during a phase of internationalization, in which leaders may use

the model to analyze whether or not the home market factors support the process of

internationalization, and whether or not the conditions found in the home country are

able to create competitive advantages on a global scale.

Global strategic rivalry

Global strategic rivalry theory emerged in the 1980s and was based on the work of

economists Paul Krugman and Kelvin Lancaster. This theory is focused on multi national

company and their efforts to gain a competitive advantage against other Global firms in the

industry. According to this view, many firm struggle to develop some sustainable competitive

advantage, which they can then exploit to dominate the global marketplace. This effect the

decisions affet both international trade and international investment.

Firms competing in global marketplace have numerous ways of obtaining a sustainable

competitivesustainable competitive advantage. The most popular ones are the owing of

intellectual property rights, investing ininvesting in R&d, achieving economies of scale and

exploiying the experience curve.