17/06/2010

INTERNATIONAL BUSINESS
ENVIRONMENT
(Political Economy of International Business)

Session 2
International Trade – Theories and
Reality

Today's questions ...

1. What are the main theories of international trade and foreign

direct investment?
2. What is their understanding of trade purpose? What do they say
with regards to the role played by business and governments?
3. What is the case for free trade vs. protectionism?
4. How can protectionism nonetheless be justified?

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Section 1
INTERNATIONAL TRADE THEORIES

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Main international trade theories

 Country-based trade theories

Mercantilism
Absolute advantage
Comparative advantage

 Firm-based trade theories

Vernon's product life-cycle theory
 M. Porter's attractiveness New trade theory
diamond

 Foreign direct investment

theories
J. Dunning's eclectic theory

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Mercantilism

 Original XVIIth century mercantilists, such as John Law, a Scots

financier, believed that a country's economic prosperity and
political power came from its stocks of precious metals.
 To maximise these stocks they argued against free trade,
favouring protectionist policies designed to minimise imports
and maximise exports, creating a trade surplus that could be
used to acquire more precious metal
http://www.economist.com/research/Economics/alphabetic.cfm?letter=M#mercantilism

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Mercantilism today

 Neo-mercantilism is a term used to describe a policy regime which

encourages exports, discourages imports, controls capital movement and
centralises currency decisions in the hands of a central government
 The objective of neo-mercantilist policies is to increase the level of foreign
reserves held by the government, allowing more effective monetary and
fiscal policy. This is generally believed to come at the cost of lower
standards of living of the concerned nation
 It is called "neo" because of the change in emphasis from classical
mercantilism on military development, to economic development. It also
accepted a greater level of price fixing based on market mechanisms

http://en.allexperts.com/q/Economics-2301/Differences-Mercantilist-Neo-Mercantilist-1.htm

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Absolute advantage (A. Smith)

Absolute advantage refers to the ability of a person or a country

to produce a particular good at a lower absolute cost than
another.

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Comparative advantage [1] (D. Ricardo)

Comparative advantage refers to the ability of a person or a country to

produce a particular good at a lower marginal cost and opportunity
cost than another person or country.
Comparative advantage explains how trade can create value for both
parties even when one can produce all goods with fewer resources
than the other. The net benefits of such an outcome are called gains
from trade.

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The gains from free trade [1] (from CW Hill)

Absolute advantage 200 units of resources available per country Comparative advantage
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The gains from free trade [2]

P* E*
Domestic
price

s1 d1
P1
World
price
Imports
D

Q
qs q* qd

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Example: Britain's trade in the XIXth Century

Exotic products

Food products Opium

Textile products

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Comparative advantage [2] (H-O-S model)

 Ricardo's theory of comparative advantage is based on differences

in labour productivity
 For Eli Heckscher and Bertil Ohlin, comparative advantage arises
from differences in relative national factor endowments – the
extent to which a country is endowed with resources like labour
and capital
 The Heckscher-Ohlin-Samuelson model predicts that countries will
export goods that make intensive use of those factors that are
locally abundant, while importing goods that make intensive use of
factors that are locally scarce

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Limitations of traditional trade theories

Focused on trade
between nations,
not between firms

Do not explain
Do not consider
intra-industry and
capital movements
Traditional intra-firm trade
(country-based)
trade theories

Do not analyse
Do not explain
long-term impact
trade among
of international
similar countries
specialisation

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The product life-cycle theory (Graph by CW Hill)

According to Raymond Vernon's

product life-cycle theory, both the
location of sales and the optimal
production location will change as
products mature, affecting the flow
and direction of trade

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The new trade theory (P. Krugman)

 Tries to explain why trade is growing fastest between industrial

countries
1. With similar economies and endowments of the factors of
production (intra-regional trade)
2. Trading similar goods (intra-industry trade)
 Considers
1. Markets of imperfect competition (oligopolies, national
monopolies)
2. Increasing returns to scale
3. Movement of capital (foreign direct investment)
4. Business and government strategies

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The new trade theory (ctd)

1. Trade is mutually beneficial because it allows for the specialization

of production, the realization of economies of scale, and the
production of a greater variety of products at lower prices
2. The pattern of trade may result from economies of scale and first
mover advantages (economic and strategic advantages that accrue
to early entrants into an industry)

3. Selected government intervention (strategic trade policy) may

support the development of strategic or export-oriented
industries

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The new trade theory (ctd)

Government strategies

Corporate strategies
Targeted
Strategic trade policy
protectionism
Economies of scale, externalities

Internationalisation
(horizontal, vertical)

First mover Diversification,

New markets
advantage specialisation

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Introducing foreign direct investment

Definition
Foreign direct investment (FDI) occurs when a firm invests directly in new
facilities to produce and/or market in a foreign country

Greenfield investment
Establishment of a wholly new operation in a
foreign country

Brownfield investment
Acquisitions or mergers with existing firms in
the foreign country
Joint venture
legal entity formed between two or more
parties to undertake an economic activity
together.

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Foreign direct investment drivers

Strategic rivalry
Advantage to first mover
Bandwagon effect
Multipoint competition

Export substitution Export complementarity

Transport costs Optimisation of value chain
Trade barriers (vertical integration)

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Dunning's "eclectic theory" of FDI (ILO)

Internalisation
• Response to actual or threatened trade barriers
• Need to control foreign business activity

Location
• Resource endowments (capital, labour) or assets (incl.
location externalities) that are tied to a particular location

Ownership
• Firms endowed with a distinctive competitive advantage
(technology, brand, economies of scale) will try to take
advantage of large number of markets

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M. Porter's diamond

Government
M. Porter's thesis is Firm strategy,
that national structure and
competitive advantage rivalry
is not dependent on
factor endowment,
but depends on
various factors that Factor Demand
interact with each endowments conditions
other to create
conditions where
innovation and
improved Related and
competitiveness supporting
occurs industries
Chance

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Conclusion: internationalisation drivers

Supply factors Demand factors

Natural resources New markets

Production (labour) costs/productivity (incl. economies of scale)
Distribution costs Response to customer's mobility
Key technologies Response to trade barriers
Location externalities Economic incentives

Strategic rivalry

Advantage to 1st mover - Bandwagon effect/Herd behaviour - Multipoint competition

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Protectionism or free trade?

 Mercantilism promotes government involvement in supporting exports

and limiting imports
 Smith, Ricardo and Heckscher-Ohlin show that it is beneficial for a country
to engage in international trade even for products it is able to produce for
itself. International trade allows a country:
 To specialize in the manufacture and export of products that it can produce
efficiently
 To import products that can be produced more efficiently in other countries
 The new trade theory supports international trade but justifies limited
and selective government intervention to support the development of
certain export-oriented industries

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Food for thought …

"An international economics course should drive

home to students the point that international trade is
not about competition, it is about mutually beneficial
exchange.
Even more fundamentally, we should be able to teach
students that imports, not exports, are the purpose
of trade. That is, what a country gains from trade is
the ability to import what it wants.
Exports are not an objective in and of themselves:
the need to export is a burden that the country must
bear because its import suppliers are crass enough to
demand payment".
Paul KRUGMAN, in Pop Internationalism

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Section 2
THE REALITY OF INTERNATIONAL TRADE

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From theory to reality

Most nations are

nominally committed to
free trade

In practise, governments
intervene to protect the
interests of powerful
groups

TRADE POLICY

Trade restriction Trade promotion

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Free vs. "managed" trade

 Partisans of a "managed trade" (or fair trade) consider that national

governments should actively intervene in international trade to ensure
that :
 Domestic firms are offered an equitable share of foreign markets
 Imports are controlled to minimize losses of domestic jobs and market share
in specific industries
 "Fair traders" also argue that a government should ensure a level playing
field on which foreign and domestic firms get the same opportunity to
compete

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Government goals in international trade

Economic goals

Social goals Trade policy Political goals

Foreign policy goals

Various goals can be in conflict

Goals are dynamic: objectives may change over time (homeostasis)

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Justifications to trade restriction/promotion

 Political arguments
 Protecting consumers from "dangerous" products
 Protecting jobs
 Protecting industries deemed important for national security
 Retaliating to unfair foreign competition
 Furthering the goals of foreign policy
 Protecting the human rights of individuals in exporting countries
 Economic arguments
 Protecting infant – or declining – industries
 Strategic trade policy, supporting the development of strategic industries and
technologies
 The "big country" argument
 Preserving access to natural resources ...

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The "candle tax", a case of public choice?

Europe has been accused of going back on world leaders' pledge to avoid
exacerbating the recession by throwing up new barriers against international trade,
just a month after the London G20 summit. Brussels will slap tariffs of up to 60% on
imports of cut-price Chinese candles this month, in one of four measures
-identified by the World Bank president, Robert -Zoellick, on a blacklist of anti-free
trade decisions taken since the summit. […]
Britain's retailers are furious about the import tax on candles […]. They say the
measure protects German and Polish candle-makers – and estimate that the
sanction, which will stay in place for five years, will cost retailers up to £10m. […]
The EU has also imposed temporary "anti-dumping" taxes, which are meant to
protect against cut-price subsidised imports, on three other products: Chinese
wire, iron and steel pipes, and aluminium foil from Armenia, Brazil and China.
The Guardian, 4 May 2009
http://www.guardian.co.uk/business/2009/may/04/eu-blocks-free-trade

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Trade restriction instruments

Tariffs, quantitative barriers

Tariffs Voluntary export

Quotas Subsidies
(Incl. anti-dumping) restraints

Non-tariff barriers

Local content Norms and Administrative Exchange rate

requirements standards barriers manipulation

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Food for thought …


Why do intergovernmental organisations like the WTO consider
that custom duties are preferable both to quotas and non-tariff
barriers


Tariffs ...
... are transparent
... Create less distortion than quotas
... Are easier to lift than non-tariff obstacles such as norms or
standards

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The consequences of protection ("small" country)

P* E*
Domestic
price

P2 s2 d2
World
Price
+ tariff
s1 d1
P1
World
price
D

Q
c1 c2 q* q2 q1

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Trade restriction: business implications

 Generally speaking, trade barriers raise export costs

 Antidumping actions limit a firm's ability to pursue aggressive

pricing to gain market share
 Voluntary export restraints (VERs) and quotas limit a firm's ability
to serve a country from locations outside that country
 To conform to local content requirements, a firm may have to
locate more production activities in a given market than it would
otherwise

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The other side of protection: trade promotion

Subsidies Export financing programmes

Cash, tax breaks, price supports Low-interest loans, loan guarantees
(e.g. former US foreign sales (e.g. French COFACE)
corporations)

Foreign trade zones Government agencies

Products are subject lower customs
duties and/or fewer customs
procedures
(e.g. Mexican maquiladoras)
Trade missions for officials and
businesses, export-promotion offices,
help import products the home
nation does not produce
(e.g. Japanese JETRO)

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Export promotion bodies: the US case

 Export-Import Bank of the United States (http://www.exim.gov): official

export credit agency of the United States. Assists in financing the export
of U.S. goods and services to international markets
 Overseas Private Investment Corporation (http://www.opic.gov): helps
U.S. businesses invest overseas by managing risks associated with foreign
direct investment
 US government export portal (http://www.export.gov): brings together
resources from across the U.S. Government to assist American businesses
in planning their international sales strategies
 International Trade Administration (http://trade.gov/about.asp):
strengthens the competitiveness of U.S. industry, promotes trade and
investment, and ensures fair trade through the rigorous enforcement of
our trade laws and agreements.

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Protection-based development strategies

Import substitution Export promotion

Protectionist barriers:
Protectionist barriers:
support savings and
protect infant industries
investment vs. consumption

Support to domestically- Support to export-led

oriented production industries

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Example: the "dragons" and China

The growth champions of the past few decades – Japan in the 1950s
and 1960s, South Korea from the 1960s to the 1980s, and China
since the early 1980s – have all had activist governments
collaborating closely with large business. All aggressively promoted
investment and exports while discouraging (or remaining agnostic
about) imports.
China’s pursuit of a high-saving, large-trade-surplus economy in
recent years embodies mercantilist teachings.
http://www.europeanceo.com/news/commentaries//article672.html

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Food for thought …


What are the limitations of neo-mercantilist policies


"Beggar-thy-neighbour" policy, that works at the expense of

trade partners
Will lead to global depression if applied by all players

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Application: the prisoner's dilemma

Gains / Losses Germany

Extra-growth, trade and financial surpluses,

job creation ...
Support to Support to
domestic demand external
competitiveness

Other European 3 2
countries Support to
domestic demand 3 -2
Support to -2 -1
external
competitiveness 2 -1

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