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International
Business
Fourth Edition
CHAPTER 4
International Trade Theory
4-3
Chapter Focus
Review several trade theories that explain why it
is beneficial for a country to engage in
international trade.
Explain the pattern of international trade
observed in the world economy.
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1st British African colony to win
independence (1957).
Nkrumah espoused pan African
socialism.
High tariffs.
Anti-exporting policy.
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Kept lowering tariffs on manufactured goods.
Created incentives to export.
Reduced quotas.
Reduced subsidies.
1950s: 77% of employment in agriculture. Now 20%.
Manufacturing GNP went from 10% to over 30%.
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The Impact of Trade Policies
Ghana
1970
GNP/capita
$250
1992
GNP/per capita
$450
GNP Growth/year
1.5%
Shift from productive uses
(cocoa) to unproductive
uses
(subsistence agriculture).
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Korea
1970
GNP/per capita
$260
1992
GNP/per capita
$6790
GNP Growth/year
9%
Shift from non-comparative
advantage uses (agriculture)
to productive uses (laborintensive 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.
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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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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David Hume - 1752
Increased exports leads to inflation and higher prices.
Increased imports lead to lower prices.
Result: Country A sells less because of high prices and
Country B sells more because of lower prices.
In the long run, no one can keep a trade surplus.
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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.
Trade between countries is,
therefore, beneficial.
Assumes there is an
absolute advantage balance among
nations.
Ghana/cocoa.
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The Theory of Absolute Advantage
A
10
Cocoa
15
20
G
Figure 4.1
K
5
B
K’
G’
0
McGraw-Hill/Irwin
5
10
Rice
15
20
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The Theory of Absolute Advantage
and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Ghana
S. Korea
Cocoa
Rice
10
40
20
10
Production and Consumption without Trade
Ghana
10.0
S. Korea
2.5
Total production 12.5
5.0
10.0
15.0
Ghana
S. Korea
Total production
20
0
20
0
20
20
Ghana
S. Korea
14.0
6.0
6.0
14.0
Ghana
S. Korea
4.0
3.5
1.0
4.0
Production with Specialization
Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice
Increase in Consumption as a Result of Specialization and Trade
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Table 4.1
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Theory of Comparative Advantage
David Ricardo: Principles of Political Economy (1817).
Extends free trade argument
Efficiency of resource utilization leads to more
productivity.
Should import even if country is more efficient in the
product’s production than country from which it is
buying.
Look to see how much more efficient. If only
comparatively efficient, than import.
Makes better use of resources
Trade is a positive-sum game.
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The Theory of Comparative Advantage
20
G
Cocoa
15
C
10
A
Figure 4.2
5
K
B
2.5
0 3.75
5 7.5
K’
10
G’
15
20
Rice
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Comparative Advantage and the Gains from Trade
Resources Required to Produce 1 Ton of Cocoa and Rice
Ghana
S. Korea
Cocoa
10
40
Rice
13.33
20
Production and Consumption without Trade
Ghana
10.0
S. Korea
2.5
Total production 12.5
7.5
5.0
12.5
Ghana
S. Korea
Total production
15
0.0
15
3.75
10.0
13.75
Ghana
S. Korea
11
4
7.75
6
Ghana
S. Korea
1.0
1.5
0.25
1.0
Production with Specialization
Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice
Increase in Consumption as a Result of Specialization and Trade
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Table 4.2
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Simple 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
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Rice
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The Influence of Free Trade on the PPF
PPF2
Cocoa
PPF1
G’
Figure 4.4
0
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Rice
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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%.
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Heckscher (1919)-Olin (1933) Theory
Factor endowments: extent to which a country is
endowed with such resources as land, labor, and capital.
Export goods that intensively use factor endowments
which are locally abundant.
Corollary: import goods made from locally scarce
factors.
Patterns of trade are determined by differences in
factor endowments - not productivity.
Remember, focus on relative advantage, not absolute
advantage.
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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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Heckscher vs Ricardo
Economists prefer Heckscher on theoretical
grounds but is a relatively poor predictor of
trade patterns.
Ricardo’s Comparative Advantage Theory,
regarded as too limited for predicting trade
patterns, actually predicts them with greater
accuracy.
In the end, differences in productivity may be
the key to determining trade patterns.
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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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The Product Life-Cycle Theory
160
140
120
100
80
60
40
20
0
160
140
120
100
80
60
40
20
0
160
140
120
100
80
60
40
20
0
production
United States
Exports
Imports
Other Advanced Countries
consumption
Exports
Imports
Developing Countries
Exports
Imports
New Product
Maturing Product
Standardized Product
Figure 4.5
Stages of Production Development
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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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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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First-Mover Advantage
Economies of scale may preclude new entrants.
Role of the government.
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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
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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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Porter’s Diamond
Determinants of National Competitive Advantage
Firm Strategy,
Structure and
Rivalry
Factor Endowments
Figure 4.6
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Demand Conditions
Related and
Supporting
Industries
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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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Determinants of
National Competitive Advantage
Chance
Company Strategy,
Structure,
and Rivalry
Two external
factors that
influence the
four
determinants.
Factor
Conditions
Government
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Demand
Conditions
Related
and Supporting
Industries
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Factor Endowments
Taken from Heckscher-Olin
Basic factors:
natural resources
climate
location
demographics
Advanced factors:
communications
skilled labor
research
technology
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Advanced Factor Endowments
More likely to lead to competitive
advantage.
Are the result of investment by people,
companies, government.
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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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Demand Conditions
Demand creates the capabilities.
Look for sophisticated and demanding
consumers.
impacts quality and innovation.
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Related and Supporting Industries
Creates clusters of supporting industries that are
internationally competitive.
Must also meet requirements of other parts of
Diamond.
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the
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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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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 earlymover, 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.
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