MGT520 - International Business - Lecture Handout 20

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INTERNATIONAL TRADE THEORY

Absolute Advantage:

  1. Adam Smith argued that countries differed in their ability to produce goods efficiently, and they should specialize in the production of the goods they can produce the most efficiently.
  2. If Britain were to specialize in textile production and France in wine production, Smith argued that both Britain and France could consume more textiles and wine than if each only produced for their own consumption. Thus trade is a positive sum game.
  3. These gains from trade can be showed graphically by looking again at Ghana and South Korea. Figure 4.1 shows both countries' production possibilities frontiers.
  4. Table 4.1 can be used to show how consumers in both countries can be better off with specialization of production and trade.
  5. When each country has an absolute advantage in one of the products, it is clear that trade is beneficial. But what if one country has an absolute advantage in both products? Then we should consider the country’s comparative advantage.

Comparative advantage:

  1. Ricardo showed how it makes sense for a country to specialize in the production of goods in which it simply has a comparative advantage, even if it can produce both more efficiently than the other country.
  2. Figure 4.2 shows the production possibilities frontiers for Ghana and South Korea when Ghana has an absolute advantage in both cocoa and rice. Points A & B illustrate possible levels of consumption and production without trade.
  3. Ghana has a comparative advantage in the production of cocoa since it can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than rice.
  4. Points C and K' in Figure 4.2 show a possible new production point for each country. Table 4.2 shows how, with trade, both Ghana and South Korea can increase consumption of both products.
  5. This simple example makes a number of assumptions: only two countries and two goods; zero transportation costs; similar prices and values; resources are mobile between goods within countries, but not across countries; constant returns to scale; fixed stocks of resources; and no effects on income distribution within countries. While these are all unrealistic, the general proposition that countries will produce and export those goods that they are the most efficient at producing remains quite valid.
  6. Diminishing returns to specialization simply suggest that after some point, the more of a good that a country produces, the greater will be the units of resources required to produce each additional item. If crops are grown on increasingly less fertile land, mining is done on less productive ore regions, or less skilled personnel need to be hired to perform high skilled jobs, production per unit of input will decrease. Diminishing returns implies a PPF which is convex (as shown in Figure 4.3). In reality countries do not specialize entirely, but produce a range of goods. It is worthwhile to specialize up until that point where the resulting gains from trade are offset by diminishing returns.
  7. Opening an economy to trade is likely to generate dynamic gains of two types. First, trade might increase a country's stock of resources as increased supplies become available from abroad. Secondly, free trade might increase the efficiency of resource utilization, and free up resources for other uses. Figure 4.4 shows how dynamic gains can shift a country's PPF outwards.

Hecksher-Ohlin Theory:

  1. The Hecksher-Ohlin theory predicts that countries will export those goods that make intensive use of factors of production that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. Thus it focuses on differences in relative factor endowments rather than differences in relative productivity.
  2. When we look at US agricultural exports (abundant fertile land), Icelandic and Norwegian fish exports (coastal waters climates conducive to good fish), Canadian lumber exports (plentiful forests with few people), Saudi oil exports, and South African gold exports, the Hecksher-Ohlin theory seems to make sense.
  3. Using the Hecksher-Ohlin theory, Leontief postulated that the US should be an exporter of capital intensive goods and an importer of labor intensive goods. To his surprise, however, he found that US imports were less capital intensive than US exports. Hence, while we can see some support for Hecksher-Ohlin, other evidence contradicts it.

The Product Life Cycle Theory:

  1. Vernon suggested that as products mature; both the location of sales and the optimal production location will change, affecting the direction and flow of imports and exports. The effects of this theory are illustrated in Figure 4.5.
  2. While the product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the US in the 1960s and 1970s, the increasing globalization and integration of the world economy has made this theory less valid in today's world.

The New Trade Theory:

  1. New trade theory suggests that because of economies of scale and increasing returns to specialization, in some industries there are likely to be only a few profitable firms. Thus, firms with first mover advantages will develop economies of scale and create barriers to entry for other firms. The commercial aircraft industry is an excellent example. Boeing, established in the early 1910s, has long had a superior advantage over other aircraft manufacturers that have not had the advantage of governmental subsidies (like Airbus).
  2. Productive efficiency may not be the result of factor endowments or specific national characteristics, but instead be a result a firm's first mover advantages.
  3. New trade theory does not contradict the theory of comparative advantage, but instead identifies a source of comparative advantage.
  4. An obvious and controversial extension of new trade theory is the implication that governments should consider strategic trade policies. Strategic trade policies would suggest that governments should nurture and protect firms and industries where first mover advantages and economies of scale are likely to be important, as doing so can make it more likely that a firm will build economies of scale and eventually end up a winner in the global competitive race.

National Competitive Advantage: Porter's Diamond:

  1. Porter's study tried to explain why a nation achieves international success in a particular industry. This study found four broad attributes that promote or impede the creation of competitive advantage. These are shown in Figure 4.6.
  2. Factor Endowments: A nation's position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry can be critical. These factors can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how). While either can be important, advanced factors are more likely to lead to competitive advantage
  3. Demand Conditions: The nature of home demand for the industries product or service influences the development of capabilities. Sophisticated and demanding customers pressure firms to be competitive.
  4. Relating and Supporting Industries: The presence in a nation of supplier industries and related industries that are internationally competitive can spill over and contribute to other industries. Successful industries tend to be grouped in clusters in countries - having world class manufacturers of semi-conductor processing equipment can lead to (and be a result of having) a competitive semiconductor industry.
  5. Firm Strategy, Structure, and Rivalry: The conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalry impacts firms' competitiveness. Firms that face strong domestic competition will be better able to face competitors from other international firms.
  6. In addition to these four main attributes, government policies and chance can impact any of the four. Government policy can affect demand through product standards, influence rivalry through regulation and antitrust laws, and impact the availability of highly educated workers and advanced transportation infrastructure.
  7. The four attributes of the diamond, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage. The Management Focus on Nokia, provides a good example of how this Finnish firm built its competitive advantage as a result of factors in Porter’s diamond.
  8. Like the other theories we have studied in this chapter, the diamond makes sense in some situations. There is also anecdotal evidence of its applicability in certain situations. Yet some forms of trade are much more simply explained by simple absolute advantage (Saudi Arabia’s oil exports). And this or any theory does not easily explain other trade patterns.

Implications for Business:

  1. Most of the theories discussed have implications for the location of production activities. Firms will attempt to locate different activities in the location that is optimal for the production of that good, component, or service.
  2. Being a first mover can have important competitive implications, especially if there are economies of scale and the global industry will only support a few competitors. Firms need to be prepared to undertake huge investments and suffer losses for several years in order to reap the eventual rewards.
  3. Governmental policies with respect to free trade or protecting domestic industries can significantly impact global competitiveness. The opening case showed how Ghana's policies negatively impacted the global success of its cocoa business. While new trade theory may suggest that governments subsidize specific industries, Porter's theory focuses how policies can influence the attributes of the diamond.
  4. One of the most important implications for business is that they should work to encourage governmental policies that support free trade. If a business is able to get its goods from the best sources worldwide, and compete in the sale of products into the most competitive markets, it has a good chance to survive and prosper. If such openness is restricted, a business’s long-term survival will be in greater question.

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