International

Business
Fourth Edition
CHAPTER 4

International Trade Theory

 Chapter Focus
• Explain why it is beneficial for a country to
engage in international trade.
 Chapter Focus
• Explain why it is beneficial for a country to
engage in international trade.
• Explain the pattern of international trade
observed in the world economy.
• 1st British African colony to win independence
(1957).
• Nkrumah espoused pan African socialism.
• High tariffs.
• Anti export (trade) policy.
• Kept lowering tariffs on manufactured goods.
• Created incentives to export (trade).
• Reduced quotas.
• Reduced subsidies.
• 1950s: 77% of employment in agriculture. Now 20%.
• Manufacturing GNP went from 10% to over 30%.
 4-6

The Impact of Trade Policies

• Ghana • Korea
• 1970 • 1970
– GNP/capita – GNP/per capita
• $250 • $260
• 1992 • 1992
– GNP/per capita – GNP/per capita
• $450 • $6790
– GNP Growth/year – GNP Growth/year
• 1.5% • 9%
• Shift from productive uses • Shift from non-comparative
(cocoa) to unproductive uses advantage uses (agriculture)
(subsistence to productive uses (labor-
agriculture). intensive manufacturing).
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 4-7

An Overview of Trade Theory

• Free Trade occurs when a government
does not attempt to influence, through
quotas or duties, what its citizens can buy
from another country or what they can
produce and sell to another country.

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 4-7

An Overview of Trade Theory

• Free Trade occurs when a government does not attempt to influence,
through quotas or duties, what its citizens can buy from another country or
what they can produce and sell to another country.

• The Benefits of Trade allow a country to

specialize in the manufacture and export
of products that can be produced most
efficiently in that country.

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 4-7

An Overview of Trade Theory

• Free Trade occurs when a government does not attempt to influence,
through quotas or duties, what its citizens can buy from another country or
what they can produce and sell to another country.
• The Benefits of Trade allow a country to specialize in the manufacture and
export of products that can be produced most efficiently in that country.

• The Pattern of International Trade displays

patterns that are easy to understand
(Saudi Arabia/oil or China/crawfish).
Others are not so easy to understand
(Japan and cars).

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 4-7

An Overview of Trade Theory

• Free Trade occurs when a government does not attempt to influence, through quotas or
duties, what its citizens can buy from another country or what they can produce and sell to
another country.
• The Benefits of Trade allow a country to specialize in the manufacture and export of
products that can be produced most efficiently in that country.
• The Pattern of International Trade displays patterns that are easy to understand (Saudi
Arabia/oil or China/crawfish). Others are not so easy to understand (Japan and cars).

• The history of Trade Theory and Government

Involvement presents a mixed case for the role of
government in promoting exports and limiting
imports. Later theories appear to make a case for
limited involvement.

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 4-8

Mercantilism: mid-16th century

• A nation’s wealth depends on accumulated
treasure

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 4-8

Mercantilism: mid-16th century

• A nation’s wealth depends on accumulated
treasure
• Gold and silver are the currency
of trade.

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 4-8

Mercantilism: mid-16th century

• A nation’s wealth depends on accumulated
treasure
• Gold and silver are the currency
of trade.
• Theory says you should have
a trade surplus.

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 4-8

Mercantilism: mid-16th century

• A nation’s wealth depends on accumulated
treasure
• Gold and silver are the currency
of trade.
• Theory says you should have
a trade surplus.
– Maximize exports through
subsidies.
– Minimize imports through tariffs
and quotas.

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 4-8

Mercantilism: mid-16th century

• A nation’s wealth depends on accumulated treasure
• Gold and silver are the currency of
trade.
• Theory says you should have a
trade surplus.
– Maximize exports through
subsidies.
– Minimize imports through tariffs and
quotas.
• Flaw: “zero-sum game”.

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 4-10

Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

• Capability of one country to produce more

of a product with the same amount of input
than another country.

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 4-10

Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

• Capability of one country to produce more

of a product with the same amount of input
than another country.
• Produce only goods where you are most
efficient, trade for those where you are
not efficient.

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 4-10

Theory of Absolute Advantage

Adam Smith: Wealth of Nations (1776).

• Capability of one country to produce more of a

product with the same amount of input than
another country.
• Produce only goods where you are most
efficient, trade for those where you are not
efficient.
• Assumes there is an
absolute advantage balance among
nations, e.g., Ghana/cocoa.

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 The Theory of Absolute
Advantage
G
20
15
Cocoa

A
10

Figure 4.1
K
B
5

G’ K’

0 5 10 15 20
Rice
The Theory of Absolute Advantage
and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 20
S. Korea 40 10
Production and Consumption without Trade
Ghana 10.0 5.0
S. Korea 2.5 10.0
Total production 12.5 15.0
Production with Specialization
Ghana 20 0
S. Korea 0 20
Total production 20 20
Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice
Ghana 14.0 6.0
S. Korea 6.0 14.0
Increase in Consumption as a Result of Specialization and Trade
Ghana 4.0 1.0
S. Korea 3.5 4.0 Table 4.1
 Theory of Comparative Advantage 4-13
David Ricardo: Principles of Political Economy
(1817).

– Should trade even if country is more efficient in

the production than its trading partner.

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 The Theory of Comparative
Advantage
G
20

C
15
Cocoa

A
10

K Figure 4.2
5

B
2.5 K’
G’
0 3.75 5 7.5 10 15 20
Rice
Comparative Advantage and the Gains from
Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 13.33
S. Korea 40 20
Production and Consumption without Trade
Ghana 10.0 7.5
S. Korea 2.5 5.0
Total production 12.5 12.5
Production with Specialization
Ghana 15 3.75
S. Korea 0.0 10.0
Total production 15 13.75
Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice
Ghana 11 7.75
S. Korea 4 6
Increase in Consumption as a Result of Specialization and Trade
Ghana 1.0 0.25
S. Korea 1.5 1.0 Table 4.2
 4-16

Extensions of the Ricardian Model

• Immobile resources:
– Resources do not always move easily from one economic
activity to another.
• Diminishing returns:
– More a country produces, at some point, will require more
resources (diminishing returns to specialization).
– Different goods use resources in different proportions.
• However:
– Free trade might increase a country’s stock of resources (as
labor and capital arrives from abroad), and
– Increase the efficiency of resource utilization.

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 Ghana’s PPF under Diminishing
Returns
Cocoa G

Figure 4.3
G’
0 Rice
 The Influence of Free Trade on the
PPF

PPF2

PPF1
Cocoa

Figure 4.4 G’

0 Rice
 A Link Between Trade and
Growth
Sachs and Warner: 1970 to 1990 study
Open economy developing countries grew 4.49%/year.
Closed economy developing countries grew 0.69%/year.
Open economy developed countries grew 2.29%/year.
Closed economy developed countries grew 0.74%/year.

Frankel and Romer:

On average, a one percentage point increase in the ratio
of a country’s trade to its GDP increases income/person
by at least 0.5%. For every 10% increase in the
importance of international trade in an economy, average
income levels will rise by at least 5%.
 4-20

Heckscher (1919)-Olin (1933)

Theory
• Labor is not the only Factor of
production. We need to account for
land, capital, and technology.

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 4-20

Heckscher (1919)-Olin (1933)

Theory
• Factor endowments: extent to which a
country is endowed with such
resources as land, labor, and capital.

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 4-20

Heckscher (1919)-Olin (1933)

Theory
• Export goods that intensively use factor
endowments which are locally
abundant.

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 4-20

Heckscher (1919)-Olin (1933)

Theory
• Export goods that intensively use factor
endowments which are locally
abundant.
• Corollary: import goods made from
locally scarce factors.

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 4-20

Heckscher (1919)-Olin (1933)

Theory
• Patterns of trade are determined by
differences in factor endowments - not
productivity.
• Remember, focus on relative
advantage, not absolute advantage.

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 4-21

The Leontief Paradox, 1953

• Disputes Heckscher-Olin in some instances.

• Factor endowments can be impacted by
government policy - minimum wage.
• US tends to export labor-intensive products, but
is regarded as a capital intensive country.

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 4-23

Product Life-Cycle Theory

(Raymond Vernon, 1966)
• Article in the Quarterly Journal of Economics.
• As products mature, both location of sales and optimal
production changes.
• Affects the direction and flow of imports and exports.
• Globalization and integration of the economy makes this
theory less valid.

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 4-24

The Product Life-Cycle Theory

160
140
United States production
120
100
80
60 Exports Imports consumption
40
20
0

160
140
120
100 Other Advanced Countries Exports
80
60
40
20
0 Imports
160
140
120 Developing Countries
100
80
60 Exports
40
20
0 Imports

New Product Maturing Product Standardized Product Figure 4.5

Stages of Production Development

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 4-25

The New Trade Theory

• Began to be recognized in the 1970s.
• Deals with the returns on specialization where
substantial economies of scale are present.
– Specialization increases output, ability to enhance economies
of scale increase.
• In addition to economies of scale, learning effects also
exist.
– Learning effects are cost savings that come from “learning by
doing”.

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 4-26

Application of the New Trade

Theory
• Typically, requires industries with high, fixed
costs.
• World demand will support few competitors.
• Competitors may emerge because “they got there
first”.
• First-mover advantage.
• Some argue that it generates government
intervention and strategic trade policy.

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 4-27

First-Mover Advantage
• Economies of scale may preclude new entrants.
• Role of the government.

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 4-28

Porter’s Diamond
(Harvard Business School, 1990)
• The Competitive Advantage of Nations.
• Looked at 100 industries in 10 nations.
– Thought existing theories didn’t go far enough.
• Question: “Why does a nation achieve international
success in a particular industry?”

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 Determinants of National
Competitive Advantage
• Factor endowments:nation’s position in factors
of production such as skilled labor or
infrastructure necessary to compete in a given
industry.

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 Determinants of National
Competitive Advantage
• Factor endowments:nation’s position in factors
of production such as skilled labor or
infrastructure necessary to compete in a given
industry.
• Demand conditions:the nature of home demand
for the industry’s product or service.

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 Determinants of National
Competitive Advantage
• Factor endowments:nation’s position in factors of
production such as skilled labor or infrastructure
necessary to compete in a given industry.
• Demand conditions:the nature of home demand for the
industry’s product or service.
• Related and supporting industries:the presence or
absence in a nation of supplier industries or related
industries that are nationally competitive.

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 Determinants of National
Competitive Advantage
• Factor endowments:nation’s position in factors of production
such as skilled labor or infrastructure necessary to compete in
a given industry.
• Demand conditions:the nature of home demand for the
industry’s product or service.
• Related and supporting industries:the presence or absence in
a nation of supplier industries or related industries that are
nationally competitive.
• Firm strategy, structure and rivalry:the conditions in the
nation governing how companies are created, organized,
and managed and the nature of domestic rivalry.

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 4-30

Porter’s Diamond
Determinants of National Competitive
Advantage
Firm Strategy,
Structure and
Rivalry

Factor Endowments Demand Conditions

Related and
Supporting
Figure 4.6
Industries

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 4-31

The Diamond
• Success occurs where these attributes exist.
– More/greater the attribute, the higher chance of success.
• The diamond is mutually reinforcing.

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 4-32

Determinants of
National Competitive Advantage
Chance
Company Strategy,
Structure,
and Rivalry

Two external
factors that Factor Demand
influence the Conditions Conditions
four
determinants.
Related
and Supporting
Industries
Government

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 4-33

Factor Endowments
• Taken from Heckscher-Olin
• Basic factors:
– natural resources
– climate
– location
– demographics
• Advanced factors:
– communications
– skilled labor
– research
– technology

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 4-34

Advanced Factor Endowments

• More likely to lead to competitive
advantage.
• Are the result of investment by people,
companies, government.

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 4-35

Relationship of Basic to
Advanced Factors
• Basic can provide an initial advantage.
• Must be supported by advanced factors to maintain
success.
• No basics, then must invest in advanced factors.

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 4-36

Demand Conditions
• Demand creates the capabilities.
• Look for sophisticated and
demanding consumers.
– impacts quality and innovation.

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 4-37

Related and Supporting

Industries
• Creates clusters of supporting industries that are
internationally competitive.
• Must also meet requirements of other parts of
the Diamond.

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 4-38

Firm Strategy, Structure and

Rivalry
• Management ‘ideology’ can either help or hurt you.
• Presence of domestic rivalry improves a company’s
competitiveness.

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 4-39

Evaluating Porter’s Theory

• If Porter is right, we would expect his model to predict the
pattern of international trade that we observe in the real
world. Countries should be exporting products from those
industries where all four components of the diamond are
favorable, while importing in those areas where the
components are not favorable.
• Too soon to tell.

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 Implications for Business
• Location implications:makes sense to disperse
production activities to countries where they can be
performed most efficiently.
• First-mover implications:It pays to invest
substantial financial resources in building a first-
mover, or early-mover, advantage.
• Policy implications:promoting free trade is
generally in the best interests of the home-country,
although not always in the best interests of the
firm. Even though, many firms promote open
markets.