International Trade & Theory

International Trade
International trade is exchange of

capital, goods, and services across international borders or territories.

In most countries, it represents a

significant share of GDP.

Genesis of Trade Theory

Why Do Nations trade with each

other? Is trading a Zero-Sum game or a mutually beneficial activity? Why do Trade patterns among countries exhibit wide variations? Can government policies influence trade?

Case: International Trade in

Information Technology
Entrepreneurial

enterprises in the US invented information technology, computer, communication hardware and software.

In the 1960s & 1970s, the information

technology Sector was led by companies such a IBM and DEC, which developed first mainframe and midrange computers.

 In

the early 1980s , production of components for computers like memory chips migrated to low cost producers in Japan and than later on Taiwan & Korea.

Intel, largest manufacture of memory chips in the world, pulled out of the market in the mid1980s to focus on microprocessors.

 Soon after Hard disk drives, display screen , keyboard,

computer mice and other components ere outsourced to foreign manufacture.

By early 2000, Us factories were specializing in making

highest value components like microprocessor made by Intel, and in final assembly.(Dell assembles PCs in to North American facility.
However, almost every other component was made

overseas because of cost effectiveness.

In due course, negative implication was export of high

paying manufacturing jobs to foreign producers. Resultantly job losses in the US continued.

 During 1980s, the locus of growth shifted to

personal computer by the ay of innovation, as :

Intel introduced the microprocessor in 1971; MITS made the first personal computer;

Apple

and IBM, which commercialization of PCs

drive

the

initial

However, along the way something happened to

this uniquely American industry, it started to move the production of hardware offshore

 Was this trend bad for the US economy? Actually Not !! As per researches : Globalization of production made IT hardware less expensive then earlier.

Price declines supported additional investment by businessman. In turn, rapid diffusion of IT translated into faster productivity growth in US as businesses used computers to streamline processes.

Benefits
During 1995 2002 productivity grew by 2.8 percent

annually in the US resulted in an additional $230 billion in accumulated GDP.

Reduced price for hardware made possible by international

trade created a boom in jobs in the IT industries: Computer software.

Number of IT job grew by 22 percent in the US, the growth

could partly be attributed to robust demand for software and services within US and from foreigner tho.se were now making much of hardware

International Trade Theories

Mercantilism Theory of Absolute Advantage Theory of Comparative Advantage Theory of Factor Endowment (H-O Theory)

Product Life-Cycle Theory

New Trade Theory Theory of Competitive Advantage

Classical Trade Theories

Mercantilism- ( Thomas Mun)
The main principle of mercantilism was

Countrys interest to maintain a trade to export more than import.

By doing so, a country would accum-

ulate gold and silver, consequently increase its national wealth.

National Govt. imposed tariff and

quota to restrict import and subsidized production to promote exports.

Limitation
Theory is based on Zero-sum game where a nation only gain from trade if the trading partner lost . (As exports of nation are high only when imports of trading partner are high) A favorable BOP is possible only in the short run and would automatically be eliminated in long run. As

Gain or Loss
An influx of gold by way of more exports than imports by a country raises the prices, leading to increase in export price. In turn country would loose advantage in terms of price.

its competitive

On the other hand the loss of gold by the importing countries would lead to a decrease in their

domestic price level, which would boost their exports.

Absolute Advantage
Theory coined by Adam Smith: The Wealth of Nations Smith emphasized on productivity and advocated free trade as a means of increasing global efficiency

Absolute advantage refers

to the ability to produce a good more efficiently and cost-effective.

'

A country :
Should specialize in production of and export

products for which it has absolute advantage;

Import other product in which it has absolute

disadvantage. Three reasons of efficiency: Labour become more killed by repeating task 2. Labour would not loose time in switching from the production of one kind to other. 3. Long production run provide the incentive of effective working method.
1.

Example
There are two countries : Ghana and South Korea 200 units of Input for the Production in both the countries are available. These input could be used to produce either Cocoa or Rice. Ghana Resource utilization :
Cocoa : Rice :

1 Ton = 10 resources 1 Ton = 20 Resources

Examplecont.
Ghana could produce 20 Tons of Cocoa or 10

Tons of Rice or may be combination.

South Korea Resource utilization :
Cocoa : 1 Ton = 40 resources

1 Ton = 10 Resources South Korea could produce 5 Tons of Cocoa or 20 Tons of Rice and may be combination.

Rice :

CONTINUE
G: Ghana K: South Korea

Resources required to produce 1 Ton of Coca & Rice

Country
Ghana South Korea

Cocoa
10
40

Rice
20 10

Production and Consumption without Trade 10.0 5.0 Ghana 2.5 10.0 South Korea 12.5 15.0 Total

Production with Specialization Cocoa Rice

Ghana South Korea Total Production 20.0 0.0 20.0 0.0 20.0 20.0

Consumption After Ghana Trades 6 Tons of Cocoa for 6 Tons of South Korean Rice

Cocoa
Ghana South Korea
Ghana South Korea

Rice
6.0 14.0

14.0 6.0 4.0 3.5

Increase in Consumption as a result of Specialization and Trade

1.0 4.0

Examplecont.

Gains From Trade :

By engaging in trade and swapping 1 Ton of Cocoa for 1 Ton of Rice, producers in both countries could utilize more of both coca and rice. Price of 1 Ton Cocoa = Price of 1 Ton Rice If Ghana decided to export 6 Tons of Cocoa to South Korea and import 6 Tons of Rice in return. Consumption after trade would be increased as: Ghana : 4 Tons of Cocoa and 6 Tons of Rice South Korea : 3.5 Tons of Cocoa and 4.0 Tons of rice.

Comparative Advantage

Theory is coined by David Ricardo and one step further to Adam Smiths theory . As If a country has absolute advantage in both the products might derive more benefits from international trade by producing and exporting goods in which it has high efficiency and importing goods in which it has less efficiency . It can be measured in terms of comparative cost .

Comparative Advantage Assumption

Theory is based on Two countries and two commodities model. Transportation cost is not included. Production resources can move within country. Theory is based on constant return to scale. No difference in the prices of resources in different countries. Exchange rate is not considered.

Example : Comparative Advantage

Ghana has absolute advantage in producing both Coca and Rice with given 200 units of resources. As

Ghana : 10 resources = 1 Ton Cocoa 13 resources = 1 Ton Rice Ghana can produce either 20 Tons of Cocoa or 15 Tons of rice. Otherwise, any combination on its PPF.

Example : Comparative Advantage

South Korea : 40 resources = 1 Ton Cocoa 20 resources = 1 Ton Rice South Korea can produce either 5 Tons of Cocoa or 10 Tons of rice. Otherwise, any combination on its PPF.

Example : Comparative Advantage

Cocoa 20 G 15 C

Ghana = G South Korea = K A

10
5 K

2.5

B
K 3.75 5 7.5 10 G 15 Rice

20

Ghana has absolute advantage in both , Cocoa and Rice. Why it should trade with South Korea ?.

Because it has comparative advantage only in the production of Cocoa, it can produce cocoa 4 times higher than South Korea. But rice only 1.5 higher than South Korea.

Resources required to produce 1 Ton of Coca & Rice Country

Ghana South Korea

Cocoa
10 40

Rice
13.0 20

Production and Consumption without Trade 10.0 7.5 Ghana 2.5 5.0 South Korea 12.5 12.5 Total

Comparative Advantage & Gains

If Ghana specializes in the production of Cocoa to increase it output from 10 to 15 tons. It will use 150 units resources for cocoa and 50 units resources to produce 3.75 tons of rice.

South Korea specializes in the production of rice, producing 10 tons.

After specialization output of cocoa increases from 12.5 tons to 15.5 tons and rice from 12.5 tons to 13.75 tons.

Because of trade not output is higher but both countries can now benefit from trade. As: If Ghana and South Korea swap Cocoa and rice on a one-to-one basis with both countries with exchanging 4 tons of their export for 4 tons of their import, both countries are able to consume more cocoa and rice.

Comparative Advantage & Gains

If Ghana export 4 tons cocoa to South Korea for 4 tons of rice it still left with 11 tons of Cocoa with increase of 1 ton and rice quantity increases from 7.5 tons to 7.75 tons with increase of 0.25 tons. Similarly after swapping 4 tons of rice with Ghana, South Korea still ends up with 6 Tons of rice and cocoa increases from 2.5 to 4.0 tons. It receives 1.5 tons more cocoa.

Production with Specialization Cocoa Rice

Ghana South Korea Total Production 15.0 0.0 15.0 3.75 10.0 13.75

Consumption After Ghana Trades 4 Tons of Cocoa for 4 Tons of South Korean Rice

Cocoa
Ghana South Korea
Ghana South Korea

Rice
7.75 6.0

11.0 4.0 1.0 1.5

Increase in Consumption as a result of Specialization and Trade

0.25 1.0

MEASURING COMPARATIVE ADVNTAGE

Balassa index is useful tool to measure Revealed

Comparative Advantage .
RCA is based on the assumptions: The commodity pattern of trade reflects the inter-

country difference in relative cost as well non-price factors like, structural changes, improved world demand.

RCA is defined as: Countrys share of world export of commodity divided by its share in total export. Index of commodity j from country i as:

RCAij = (xij/Xwj)/Xi/Xj)
Xij = ith countrtys export of j commodity Xwj = world export of commodity j Xi = total world export

If the value of index is greater than unity (1), the country has RCA in the commodity.
RCA is consistent with the changes in the
economys factor endowment and productivity. However, it cannot distinguish between the improvements in factor endowment and the impact of the trade policies.

RCA INDEX OF SPECIALIATION

INDUSTRY China India Manufact ures Chemical Clothing Electroni cs Fresh Food IT Leather product 0.96 0.42 3.46 1.04 0.68 2.43 3.34 1.36 1.06 3.09 0.23 2.23 0.1 2.18 Hong Kong 0.5 0.43 3.01 1.94 0.23 2.33 4.12 Japan Mexico Thailand 0.99 0,87 0 1.64 0 1.2 0 0.69 0.34 1.29 1.53 0.8 1.75 0 0.6 0.65 1.56 1.55 2.33 2.11 1.4 UK 0.8 1.41 0.43 0.63 0.4 1.01 0.34 US 0.63 1.18 0.23 1.33 1.52 0.92 0

Theory of Relative Factor Endowments (Heckscher-Ohlin)

As

per Ricardo, comparative advantage arises because of differences in productivity.

Heckscher in (1919) and Berlin Ohlin (in 1933) argued comparative advantage arises from differences in national factor endowments which leads cost difference.

Eli

Theory of Relative Factor Endowments (Heckscher-Ohlin)

Factor endowments refers the extent to

which a country is endowed with such resources as land, labour and capital.
As the more abundant the factor,

the lower

its cost.
According to the theory, the more different the

countries are - regarding the capital-to-labor ratio the greater the economic gain from specialization and trade.

Theory of Relative Factor Endowments (Heckscher-Ohlin)

H-O Theory predicts Country will export those goods, which are produced by intensive use of factors that are locally abundant. Import those goods that makes intensive use of factors that are locally scarce. This theory argues that pattern of international trade determines by differences in factor endowment, rather than differences in productivity.

Example
China & India excel in export of good produced in labour-intensive manufacturing industries, such as:

Textiles and Footwear It reflects Chinas & Indias low-costlabour

The

US has been primary importer because it lacks abundant low cost labour

Example cont.
India excels in the area of software

engineering and Medical tourism because of abundance of professionals.

Hence, relative not absolute endowments

are important; a country may have larger amounts of land and labour than other country, but be relatively abundant in one of them.

Assumption
The major factors of production, namely labor and capital, are not available in the same proportion in both countries. The two goods produced either require relatively more capital or relatively more labor. Labor and capital do not move between the two

countries. There are no costs associated with transporting the goods between countries. The citizens of the two trading countries have the same needs.

Case: Moving US White-Collar Jobs Offshore

During early 2001, the global economy slowed down and corporate profits slumped, white-collar

jobs were moved from US to developing countries because of cost effectiveness.

Bank of America had to reduced 5000 jobs from its information technology workforce, which were being transferred to India, where it costs $20 an hour in place of $ 100 an hour in US.

 One beneficiary Bank of Americas downsizing

is Infosys Technologies Ltd., where 250 engineers develop IT applications for the Bank.

In Wipro Ltd., five radiologist interpret 30 CT scans a

day for Massachusetts General Hospital and used to send on internet.

Not only India, but in Philippines also utilized for cost

effective service like Accenture, large US management consulting and IT firm, recently moved 5,000 jobs in software development & accounting to the Philippines

 Procter

&Gamble employs 650 professionals who prepare the companys global tax returns. Initially it is used to be done in US now it is done in Manila.

Flour Corp., California based construction

firm employs 1,200 engineers and draftsmen in the Philippines, Poland and India to turn layouts of industrial facilities into detailed specification.

 Outsourcing of such skilled jobs from

developed countries to developing countries due to good supply of skilled & professional manpower is indication of huge benefits from lower costs, enhanced competitiveness in the global economy.

Criticism
Japans success in exporting Automobiles in

the 1970s and 1980s was based not just on the relative abundance of capital, but also on its development of innovative manufacturing technology which leads higher productivity levels in automobile production than other countries that also had abundant capital.

Leontief Paradox
As

per empirical research of Wassily Leontief conducted in USA:

USA

exports were less capital intensive and more labour intensive, however USA has capital in abundance than labour. Actually, H-O theory does not hold true.

Explanation of Leontief Paradox

USA exports labour intensive product because of higher productivity of labour.

As workers in the U.S. have a lot of

knowledge & entrepreneurial skills.

Explanation of Leontief Paradox

Actually, USA exports aircraft and imports textiles not because of capital is in

abundance and labour is not but USA is relatively more efficient in manufacturing aircrafts than textiles . And
Also on its development of innovative manufacturing technology which leads

higher productivity.

The New Trade Theory

Nations may benefit from trade even

when they do not differ in resource endowment or technology because Increasing return to scale might exist in some industries.
Economies of scale ( unit cost reduction

associated with a large scale of output) represent important source of increasing returns.

The New Trade Theory

This theory is based on two types of

economies of scale as-

Internal Economies of ScaleFirms benefit by economies of scale

when the cost per unit of output depends upon the size of the firm.
Larger the size of firm higher are the

economies of scale.

The New Trade Theory

Internal economies of scale may lead a firm to specialize in a narrow product line

to produce benefit.

in volume to achieve cost

Companies requiring massive investment

in R & D and creating manufacturing facilities such as Microsoft, microprocessor by Intel and aircrafts by Boeing or Airbus need to have global market base so as to achieve internal economies of scale and compete effectively.

The New Trade Theory

External Economies of Scale Cost per unit of output based on size of

the industry not on size of the firm, it is referred to external economies of scale.
Higher external economies of scale is attributed to the large size of industry that has several small firms, which lead large production and competitive price.

The New Trade Theory

External economies of scale enable the countrys industry to achieve global competitiveness by including small firms

Example
Semiconductor industry in Malaysia and

automotive component industry of India

Industrial

cluster

like

brassware

in

Moradabad,
hosiery in Tirupur , carpet in Bhadoi, Semi precious stones in Jaipur.

The New Trade Theory

The higher economies of scale lead to increase in returns, enabling countries to

specialize in the production of such good and trade with countries with similar consumption pattern.
Besides, intra-industry trade , this theory also explains intra-firm trade between

MNEs & their subsidiaries with a motive to take advantage of scale economies and increase their return.

Example
Suppose there are two automobile manufacturing countries, each country has market for 1 million automobiles customers, if they enter into trade there will be combined market of 2 million cars.
Because of large market more models of

car can be produced for customer on the basis of economies of scale (lower average cost).

Example
There are two countries, in each country

demand of sports car is limited to 55,000 unit but total output of 100,000 car per year is required to achieve economies of scale and specialization.
Similarly demand for a small car in each

country is limited to 80,000 units but to achieve specialization output of 100,000 is required.

Example
Once the two countries decide to trade, they will adopt following trade pattern:

A firm in one nation may specialize in producing sport cars and will get combined market of 1,10,000 customers.
While other nations firm may produce small car and will get combined market of 1,60,000 customers. Ultimately, customers get accessibility to both the cars and choice for car.

The International Product LifeCycle (Vernon) Theory

This theory is founded by Raymond Vernon. It

is based on the observation:

In 20th century, a very large proportion of the

world product had been developed by US firms and sold first in the US market (e.g. automobile, TV, Instant Cameras, Photocopier, Computers, Semiconductor chips)

The International Product Life-Cycle (Vernon) Theory

International market tend to follow a cyclical pattern due to variety of factors over a period of time. As Level of innovation and technology Size of market Gap in technology

Preference and ability of the customers

The International Product Life-Cycle (Vernon) Theory

Development and marketing of newly innovated product in the world economy can be divided into following stages:

Stage 1: Introduction:
Invention of new product takes place in developed countries because of high R & D investment.

Initially price of

product is also higher which could be affordable for the customer of developed countries.

The International Product LifeCycle (Vernon) Theory

Stage 2 : Growth :
The demand of product increase in

international market therefore firm gets better opportunities to export in other developed countries.
Because of competition in target market

even firm establishes its production location in other developed nations.

The International Product Life-Cycle (Vernon) Theory

Stage

3 : Maturity

As the technical know- how of the innovative process becomes widely known, the firms begin to establish its operation in middle-income and low-income countries in order to take advantage of resources available at competitive prices.

The International Product LifeCycle (Vernon) Theory

Stage 4 : Decline In this stage emphasis of the firm is on

most cost-effective locations rather than producing themselves. Now it shifted to even LDCs and as result developed countries begins to import such goods from other developing countries.

The International Product LifeCycle (Vernon) Theory

Example :
Xerox Machine, invented in US (1960) Initially Xerox exported machine to Japan and Europe. After increasing demand Xerox entered in these location through JVs (Fuji-Xerox) and Great Britain (Rank-Xerox)

The International Product Life-Cycle (Vernon) Theory

Once patent of Xerox expired other foreign competitors began to enter (Canon in Japan , Olivetti in Italy)
US start buying from low cost locations Japan found cost of production is very high

and they shifted location to Singapore and Thailand.

Other developed nation Japan also start

importing.

The International Product LifeCycle (Vernon) Theory

This theory is not holding true in case like: Laptop computers, which were introduced in a number of major national markets by Toshiba.
However, various components are manufactured in Japan (e.g. display screen, memory chips) Other components are manufactured in

Singapore and Taiwan (e.g. hard drives and microprocessor). After final assembly in Singapore it is shipped to the world market.

New Product

Maturing Product

Standardized Product

National Competitive Advantage

This theory is given by Michel Porter. It explains why a nation achieves international success in a

particular industry. As Why does Japan do well in Automobile

Industry? Why does Switzerland excel in the production and export of Pharmaceutical? Why do Germany and United States do so well in the Chemical Industry?

Porters Diamond

National Competitive Advantage

Porter has focused four broad factors of

a Nation to shape the environment in which local firms compete and these factors promote or impede the creation of competitive advantage. These factors are:
Factor endowments : a nations position in factors of production such as skilled labour or the infrastructure necessary to compete.

National Competitive Advantage

In a country , not only natural resources are important but the factors created by meticulous planning and implementation such as Capital, Human and knowledge resources play important role

National Competitive Advantage

Demand Conditions: The nature of home demand for the industrys product or service. Relating and Supporting Industries: The presence or absence of supplier industries and

related industries that are internationally competitive. Firm Strategy, and Rivalry: The conditions governing how companies are created, organized and managed and the nature of domestic rivalry.

So What for business?

First mover implications Location Implications Foreign Investment Decisions Government Policy implications