Chapter 4: International Trade Theory

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Theories of International Trade 1. Mercantilism:

The theory was introduced in mid-16th century in
England. The main tenet of the theory was that it was in a countrys best interests to maintain a trade surplus by means of exporting more and importing less. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth and prestige. One of the implication of the theory is beggar-thyneighbor policy. Adam Smith and all the Classical economists were critical about the theory.

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Limitations of Mercantilism:
1. Price-Specie flow mechanism by David Hume State England France

State 1
State 2 State 3 Sate 4 Sate 5

X>M: Trade Surplus

Gold reserve: Money supply Inflation: Price level International competitiveness X :M : Trade deficit

X<M: Trade Deficit

Gold reserve : Money supply Deflation: Price level International competitiveness X:M : Trade Surplus

Sate 6

Gold reserve :Deflation

Gold reserve :Inflation

2. According to Mercantilist trade is a zero sum game: trade makes one country gainer and one country loser. It has been proved later by Adam Smith and David Ricardo that trade can be a positive sum game; trade can benefit both the countries simultaneously.
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Theories of International Trade 2. Opportunity Cost theory:

Adam Smith (1776): Absolute Advantage

Theory

David Ricardo (1881) : Comparative

Advantage Theory

Hecksher (1919)-Ohlin (1933) : Factor

Endowment Theory

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2. Opportunity Cost theory (Contd.)

Assumptions: (i) 2-coutry-2-commodity model. (ii) Increasing cost. Before Trade Production Possibility Curve (PPC) Consumption=Production
Agricultural goods
a C1 e

Bangladesh ab C1

USA ed C2

C2

IC1

I Industrial Goods C
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2. Opportunity Cost theory (Contd.)

After Trade Bangladesh USA

Production
Consumption

PB
I

PU
I

Export
Import

Agricultural Goods: PBM

Industrial Goods: IM
Agricultural Goods T a PB I e M IC2 IC1 b
N

Industrial Goods: PUN

Agricultural Goods: IN

PU d

Industrial Goods

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2. Opportunity Cost theory (Contd.)

Gains from Trade of Bangladesh: Point I belongs to IC2. Before trade
consumption was at C1 which belongs to IC1. Since IC2 is higher than IC1 so there is a gain from trade on the part of Bangladesh. Gains from Trade of USA: Point I belongs to IC2. Before trade consumption of USA was at C2 which belongs to IC1. Since IC2 is higher than IC1 so there is a gain from trade on the part of USA. Balanced Balance of Trade: Notice that since there are only 2 countries under consideration so the export of Bangladesh is just equal to the import of USA. Similarly, the import of Bangladesh is just equal to the export of USA. Conclusion: The theory focuses on the gain from international trade. The theory proved that the earlier view of trade being a zero-sum game is not true as both countries of trade can be benefited from trade. A country would be gaining from international trade as long as it achieves a higher indifference curve. The theory also focuses on the determination of terms of trade (i.e., global price line). More importantly, the theory guides every country to take advantage of specialization in certain line of production.
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Limitations of Opportunity cost theory

The assumption of balanced balance of trade is not always most desirable. The assumption of perfect mobility of factors of production within the country is not true. The assumption of perfect immobility of factors across countries is not true The assumption of constant technology is invalid. This is truer for manufactured commodities than agricultural commodities. In consequence, developing countries continuously face deterioration in its terms of trade and developed countries continuously face advantages in terms of trade.

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The Leontief Paradox

Challanging the Hechscher-Ohlin (opportunity cost)
theory, Wassily Leontief observed that US exports were less capital intensive than US imports although US has abundance in capital and scarcity in labor. One possible explanation is that US has a special advantage in producing new products or goods made with innovative technologies. Thus, 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.

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Political implication of the trade theory: Prebisch-Singer Hypothesis

As early as in 1950s Prebisch and Singer studied the terms of trade (defined
as the export price divided by import price) of developing countries and observed that there was a secular decline in the terms of trade of developing countries due to the fact of low income and price elasticity of demand for agricultural goods. They argued that the decline would continue in future, as well, which is evidential that between 1977 and 1997 the terms of trade of developing countries declined by 60%. Due to the decline in terms of trade there is a continuous flow of purchasing power from developing countries to developed countries. Moreover, the developed country policy of agricultural subsidy restricted the import to hinder the export growth of developing countries. Thus, the apparently innocent trade theory has the serious implication of making the developed countries more rich and developing countries marginalized. There is supply side constraint as well. Supply curve of developing countries is inelastic due to institutional rigidities". According to Cobweb theorem current demand of agricultural product reflects in the supply of the next year that hardly matches the current demand. Thus, even if demand increases the suppliers of agricultural product can not take advantages of that.
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Agricultural Subsidies of Developed Countries

Developing country producers of agricultural product face
Intense competitions from developed countries due to huge agricultural subsidy. Per farmer subsidy $19,000 both in Europe (43% of value) and USA (22% of value), $21,000 in Japan (62% of value), $8,000 in Canada (18% of the value of gross farm receipts). Such subsidies are currently running $20 billion annually. UN observed that it affects developing countries export worth $50 billion which is equivalent to the annual foreign aid flow of developed countries to developing countries. Realizing the problem, some of the developing countries have recently started to concentrate in the export of manufactured goods rather than agricultural goods. However, United Nations observed in 2001 that such exports of LDCs face more import restrictions of developed countries for what LDCs lose as much as 2% of their GNP worth $100 billion annually.

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3. Product LifeCycle Theory

Reymond Vernon introduced this theory in the mid-1960s. The theory tells
us how the location of production and consumption of different products change during the life-cycle of the product. The products include massproduced automobiles, televisions, instant cameras, photocopiers, personal computers, and semi-conductor chips. Vernon observed that for most of the 20-th century a very large proportion of the worlds new products had been developed by US firms and sold first in the US market due to the wealth and size of the US market. Due to high labor cost in USA, the technology of production of these products was capital intensive technology. During the early cycle of product life these product were exported to other countries for limited number of consumers. Later cycle experienced production in other countries as well with almost similar kind of technology. In the matured cycle of product life developing countries took part in the production to export it back to developed countries. Thus, although USA introduced the product and during the initial cycle USA was an exporter of the product, but overtime other developed countries who were initially the importers of the product, starts exporting to USA. Later, when the product becomes standardized product, developing countries takes part in export as well.
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3. Criticism and implications of Product LifeCycle Theory

The theory suffers from the US biasness as the founder Vernon over
focused the US contribution in the introduction of most modern products. Products are now global products like the contribution of Indian designers and Japanese technology can not be denied in the development of computers. The theory concludes that developing countries are the ultimate beneficiaries as manufacturers and exporters of the products. This is not true. Producers of developed countries identify the potentials of developing countries much earlier than the local entrepreneurs of developing countries, and captures the overseas production. Thus, it is the IBM of USA that holds the production of Argentine and Mexican production of the mainframe production. In addition to profit repatriation, huge money goes back home in the form of royalty, patent and trademark. The WTO efforts of making TRIPS operational safeguards the interest of developed country producers in this regard.
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4. The New Trade Theory

During 1970s most economists argued that the increasing cost or
decreasing return assumption of traditional trade theories is questionable. Due to the economies of scale and learning effects there should be increasing return or decreasing costs for higher level of output. For example, the Boeing spent $5 billion to develop its Boeing 777 jetliner. If the variable cost of production for labor, equipment and parts equal $80 million per aircraft, then selling 100 units would make a cost of $130 million per aircraft and selling 500 would make a cost of $ 90 million. Thus, average cost falls significantly with increased volume of production. If learning effect is taken under consideration then variable cost further goes down to further reduce the average cost. Learning effect is more effective in cost reduction of complex manufacturing product than easy process. Taking both under consideration the Boeing can make $70 million per unit for 500 units of production compared to $130 million per unit for 500 units of production.

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4. Implication of new trade theory:

There is an important implication of the new trade theory. The world
market is too small for too many large firms with significant large volume of production. The first mover takes the advantage so much that subsequent entrant finds it difficult to compete against the first movers. Thus Japan made a complementary role to Boeing and Airbus rather than competing with them. To facilitate the potential first mover, the respective government should come forward by extending different kinds of fiscal incentives and subsidies initially. This would increase the competitiveness of the respective firms and shift the marginal cost curve downward. The firm would be qualified to be the first mover. Once being the first mover, the firm would generate abnormal profit, the profit would be repatriated home contributing to (i) increased purchasing power of the country, (ii) increased donation for social welfare and (iii) increased tax compensating the subsidies allowed earlier. Thus the country would be far more benefited than the subsidies issued earlier.

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FSC: Tax Break on Export

Introduction: Foreign Sales Corporation (FSC) introduced in USA in
1971 as an income tax break for US exporters. Sales should be channeled through shell companies, known as foreign sales corporation which are registered in offshore tax heaven like Bermuda. Beneficiaries: 6,000 US companies saved $3.5 b of income taxes in 1998. Boeing saved $130 million, General Electric saved $150m. In 1998, European Union filed complaint with WTO claiming that FSC is an illegal export subsidy that was in clear violation of WTO rules. US arguments: EU follows similar tax wavers on export (that EU claims commodity tax rather than income tax). There was a Gentle mans agreement that the entity would not attack each other, which was broken. Internal matters of USA outside the jurisdiction of trade policy.

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FSC: Tax Break on Export (Contd..)

WTO arbitration in 2000 agreed with EU that the tax break was
illegal, and suggested USA to revise the tax code. In retaliation USA not only retained the tax break but also expanded the coverage costing the treasury $25 b to compensate the EU rebate of VAT on export. EU threatened USA to introduce punitive tariffs worth $4 billion on US export to the EU. This indicated an introduction of the biggest trade war of the world. In 2000, USA replaced it with a new system that offered up to $6 billion a year in tax breaks to large exporters such as Boeing and Microsoft. EU filed a brief with WTO seeking permission for $4 billion tariffs, and WTO finally gave the permission in 2002. Current status: EU did not impose the sanction, and USA indicated it would change the offending law.

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5. National Competitive Advantage: Porters Diamond

Firms Strategy, structure, and Rivalry

Factor Endowments

Demand Conditions

Related and Supporting Industries

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5. National Competitive Advantage: Porters Diamond (Contd.)

Factor Endowments: Both basic factors (like natural resources,
climate, location, and demographics) and advanced factors (like communication infrastructure, sophisticated and skilled labor, research facilities, and technological know-how) play role. Example: Investment in education is the key to the outstanding success of South Korea which had the same per capita income like India during 60s. Japans investment in engineers results in manufacturing sector development. Related and supporting industries: The benefits of investment in advanced factors of production by related and supporting industry can spill over into industry giving competitive advantage internationally. Technological leadership in the US semiconductor industry until mid1980s provided the basis of US success in personal computers. Switzerlands success in pharmaceuticals is the spill over effect of its previous success in the technologically related dye industry
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5. National Competitive Advantage: Porters Diamond (Contd.)

Demand Condition: Home demand play in upgrading
competitive advantage. Example: Japans sophisticated and knowledgeable buyers of camera contributed to the improvement of product quality of international standard. Firm strategy, structure and rivalry: Different nations are characterized by different management ideologies, which shapes the building of national competitiveness. Porters notes the predominance of engineers in top management in German and Japan firms contributed to the improvement of manufacturing and designing. In contrast, US concentration of finance people in top management failed to contribute to product innovation. Second point is the domestic rivalry that contributes to competitiveness as well. (Nokia in Finland: Case study)

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