Chapter Three

Theories of International Trade and Investment

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Review of Chapter 2
Last week we discussed two primary ways of trading internationallywhat are they? Business can supply foreign markets through both exporting and actually manufacturing in them Where does trade take place (developed v.s developing countries)? What are the seven global dimensions for globalization standardization?

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Learning Objectives

Understand the theories that explain why certain goods are traded internationally Mercantilism Theory of Absolute Advantage (Adam Smith) Theory of Competitive Advantage (David Ricardo) Theory of Factor Endowment (Heckscher-Ohlin) International Product Life Cycle (Ray Vernon) National Competitiveness (Michael Porter)

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Learning Objectives

Understand the various explanations for trade direction shifts

Economies of scale, learning curve, Imperfect competition, First-mover theory, Linder theory & technological life cycle

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Theories of International Trade/Investment

Business

managers MUST have a good understanding of economic theory to understand a nations economic development strategy -what are the beliefs and education of the

governments economic planners -Watch/listen to their actions/speeches - Be Proactive: based on your understanding of the nations leaders

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Some Examples

The Japanese Government has traditionally spent trillions of Yen to push the Yen down vis--vis the US $ and the Euro. They keep the Yen artificially weak to reduce competitive pressures from Europe and USA..Hence, they can export more and import less China has resisted all efforts to revalue their currency (Yuan). They simply have not allowed the Yuan to appreciate in value, thus making/helping Chinese companies have strong cost-competitiveness. -China has strong economic growth - China has a large trade surplus Argentina pegged the Peso years ago to the US$. Financial stability ensued but exports were too costly-recession occurred. In 2002 they stopped the peg and devalued the Peso ( 1 US$ to .27cents) Imports were costly but exports started to grow!
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Consider also the Free-Market reforms in Chile..

Salvador Allende: President 1970-1973 Military coup (September) the economy was in shambles -Inflation>1000% annually -High national debt -Government highly involved in economy - high duties on imports - huge subsides to select industries New Government: Selected Group of New Economist from the University of Chicago The Chicago Boys were free market advocates( influenced by Milton Friedman Chicago Boys proposed programs based on the Theory of Comparative Advantage which immediately reduced import duties to 10% from 1000%. All other import barriers were completely eliminated. Capital equipment could now be imported which encouraged business investment
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Continued..
1. 2. 3.

Select companies lost subsidy protection Bottom line: A big correction in the economy and industries followed -Appliance Industry almost disappeared -The electronics industry basically vanished -Automobile Assembly plants closed Those are products we should import. We have better opportunities for products based on our farm products, our timberlands, our fisheries and other natural resources that we should be making because they give us a natural advantage over other countries It took time but by 2006 Annual growth >6% Inflation lowered and standard of living increased Chile has signed free trade arrangements with several nations and the E.U, Mercosur, The USA and Canada Their Free market is now flourishing!!!!
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To sum up..
In

Chile, prudent economic Policy making has secured long term stability in a once very unstable country! The Keystone of many countries economic policies is the law of comparative advantage

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International Trade Theory: Mercantilism

A nations wealth depends on accumulated treasure, usually gold A country that has no gold must import it To increase wealth, government policies should promote exports and discourage imports Importation of gold depends on exports of goods Importation of other goods tightly controlled Economic competition is a zero sum game: if country advances economically, another loses

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Theory of Absolute Advantage: Adam Smith (1723-1790)

Market forces, not government controls, determine the direction, volume and composition of international trade A country will export goods in which it has an absolute advantage over other countries To have an absolute advantage a country must be able to produce a larger amount of a good or service for the same amount of inputs as can another country the same amount of a good or service using fewer inputs than can another country In classic economics a unit of input is measured in: land, labor, capital
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Theory of Comparative Advantage: David Ricardo 1817

A nation may have absolute disadvantages in the production of two goods with respect to another nation Yet this nation has a comparative advantage or relative advantage in the production of the good in which its absolute disadvantage is lower By specializing in the production of the good in which the country has lower comparative disadvantage, and importing other goods, the total goods available will increase
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Comparative Advantage and offshoring of service jobs

INDIA 1 billion people

Citizens who speak English

Indian IT industry Is growing rapidly!

Tax, Financial services, Insurance, telemarketing

India has a comparative advantage in production of goods & services requiring large amounts of labor and relatively little capital Good opportunities to reduce cost in specific industries by offshoring parts of these service industries
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Heckscher-Ohlin Theory of Factor Endowments

Countries export products requiring large amounts of their abundant production factors Lower cost to produce; more attractive abroad Imported products have low relative cost as producing locally would require large amounts of the importing countrys scarce production factors For example.

--India: Has a large labor force (1 billion) so they should concentrate on labor intensive goods. --Germany: Has more capital than labor LO1 so they should concentrate on capital intensive goods.

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Leontief Paradox- the US was one of the most capital-intensive countries in the world, was exporting relatively labor-intensive products in exchange for relatively capital-intensive products Differences in Taste - A demand- side construct that is always difficult to deal with in economic theory -Transportation cost can be too high -Training skilled workers is critical - Some consumers simply will buy expensive items (cars..perfumes..ect)
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Heckscher-Ohlin Theory of Factor Endowments

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Currency Exchange Rates Influence The Direction of Trade

Goods are valued in the currency of the country in which they are produced An importer in another country must use the prevailing exchange rates to price the product about to be imported The relative purchasing power of currencies is not always reflected in official exchange rates Government policy can give an advantage to one currency over another to induce exports

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Some Newer Explanations For The Direction Of Trade

1.

International Product Life Cycle (IPLC) Most new products initially conceived and produced in the U.S. in 20th century U.S. firms kept production close to the market Aids decisions and minimizes risk of new product introductions Demand not based on price yet so low production cost not an issue Limited initial demand in other advanced countries Initially, exports to these markets more attractive than production
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Some Newer Explanations For The Direction Of Trade

With demand increase in advanced countries Production follows there from the U.S. With demand expansion elsewhere Product becomes standardized Production moves to low production cost areas Product now imported to U.S. and to advanced countries

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International Product Life Cycle

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Newer Explanations For The Direction Of Trade

2.

Linder Theory of Overlapping Demand

Customers tastes are strongly affected by income levels Income per capita determines the kinds of goods in demand Production technology application of the IPLC Distinguishes between new products and new technologies used in the production of products Technology follows the IPLC pattern

3.

Technology Life Cycle

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Newer Explanations For The Direction Of Trade

4.

Economies of Scale and Learning Curve

Economies of scale: as a plant gets larger, output increases, per unit production cost decreases Learning curve: as firms produce more products, they learn ways to improve production efficiency further reducing costs A nations industries are now low cost producers and exporters Economies of scale together with differentiated products induces intraindustry foreign trade Pattern of trade in goods subject to scale economies is determined by historical factors that induce first movers
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5.

Imperfect Competition--Paul Krugman

6.

First-Mover Theory

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Newer Explanations For The Direction Of Trade

7.

National Competitive Advantage Porters Diamond Model National Competitiveness: a nations relative ability to design, produce, distribute, or service products while earning increasing returns on resources Four variables: factor endowments, demand conditions, related and supporting industries, and firm strategy, structure, and rivalry

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Newer Explanations For The Direction Of Trade

Factor endowments land, labor, capital, workforce, infrastructure Demand conditions large, sophisticated domestic consumer base: offers an innovation friendly environment and a testing ground Related and supporting industries local suppliers cluster around producers and add to innovation Firm strategy, structure, rivalry competition good national governments can create conditions which facilitate and nurture such condition
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Variables Impacting Competitive Advantage: Porters Diamond

Source: Reprinted by permission of the Harvard Business Review. The Competitive Advantage of Nations by Michael E. Porter, MarchApril 1990, p. 77. Copyright 1990 by The President and Fellows of Harvard College; all rights reserved.

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Synopsis: Trade Theory

Trade among countries results from relative price differences that stem from different production costs Different production costs come from differences in Endowments of factors of production Levels of technology that determine the factor intensities used Efficiencies with which factor intensities are used Foreign exchange rates Differences in tastes can reverse the direction of trade predicted by theory Nations attain a higher quality of life by specializing in those products for which they have a comparative advantage and by importing the rest Trade restrictions harm a nations welfare in the LR
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