Chapter-6: Chapter-7: Chapter-8: Chapter-9: Chapter-10: cr Theories of International Trade Tariff Barriers Non-Tariff Barriers (NTBs) Special Kind of NTBs Balance of PaymentsTheories of International Trade Learning Outcomes ‘After studying this chapter, you should be able to understand: Mercantilism New Trade Theory ‘Theory of Absolute Advantage / Absolute Differences in Cost ‘Theory of Comparative Advantage / Comparative Differences in Cost Modern ‘Theory of International ‘Trade / Heckscher Ohlin (H.O.) Theory Superiority of H.O. Theory over the Classical Theory / Difference between H.O. Theory and the Classical Theory ‘The Leontief Paradox Product Life Cycle Theory ‘Theory of National Competitive Advantage ‘The countries today are globally linked with each other through trade in goods and services and the Movement of factors of production. ‘This helps the countries to make optimum use of their resources through specialization, in turn, making the industries and workers more productive, These outcomes et help in lowering the cost of production of a number of products which translates into higher living standards, Without international trade, most nations would be unable to provide the basic Amenities to their citizens at current levels. In short, not only nations, companies and citizens benefit from international trade, modern life would be nearly impossible without it. In view of the above, we discuss the various theories of international trade in this chapter that explain the underlying rationale for trade among nations.64 || International Business 6.1. Mercantilism “The earliest explanations of international business became evident in England in the mid-sixteenth century, During this period, gold and silver were the most important sources of wealth. A country could earn gold and silver by exporting goods whereas importing goods would result in an outflow of gold and silver, The main principle of mercantilism was to maintain a trade surplus by maximizing exports and minimizing or restraining imports. By doing so, a country would accumulate gold and silver and consequently will increase its national prosperity. In accordance with this principle, the mercantilist doctrine recommended intervention of the government to achieve a trade surplus. The mercantilist saw no benefit in a large volume of trade. Rather, they recommended policies to maximize exports and minimize imports. To achieve this, imports were restricted by non-tariff barriers like tariffs and quota and exports were subsidized. 1n1752, a classical economist David Hume drew attention to the basic discrepancy in the mercantilist doctrine. According to him, if England had a balance of trade surplus with France, it would result in an increased inflow of gold and silver. Consequently, there'll be an increased domestic money supply resulting in inflation in England. France would have the opposite effect due to the outflow of gold and silver. There'll be a contraction of money supply in France thereby causing the prices to fall. This change in relative prices between France and England would encourage the French to buy fewer English goods that have become relatively expensive and the English to buy more French goods that have become relatively cheaper. This would cause the balance of trade position of England to decline and that of France to improve until the English surplus was eliminated. Hence, in the long run no country could en eee a surplus on the balance of trade according to Hume unlike what the mercantilists had Criticism t mes eae A, 2t0-sum game (a situation in which gain or loss by one country is Ricardo to prove ca ae = by another country), It was left to Adam Smith and David someone else's expense). Positive-sum game (a win-win situation where no one wins at - The importing firms, especially those that i ‘i . manufacture of finished goods, import raw materials and parts used in the harms the Aanaes REA TESCaE . em can buy. 8 imports limits the choice of goods the consumers Import restric i taken tan exten enbroductshortages thatmaylead to higher prices ie.infation Whet trade policy that benefits the country hoy oe eee thy neighbour policies (an internation partners, Ty that enacted it, while harming its neighbours or trade 6.2 New Trade Theory ‘The New Trade theory, as propounded by international trade which focuses on the ES ¥ Prof. Paul Krugman, is a collection of economic models it of increasing returns to scale and network effects which‘Theories of International Trade || 6.5 were developed in the late 1970s and early 1980s. The new trade theorists relaxed the assumption of constant returns to scale and suggested that using protectionist measures to build up a huge industrial base in certain industries will then allow those sectors to dominate the world market. What was new in new trade theory was the use of mathematical economics to model the increasing returns to scale and especially the use of the network effect to argue that the formation of important industries was part dependent in a way which industrial planning and judicious tariffs might control. ‘The model also showed how past dependent industrial concentrations can sometimes lead to monopolistic competition or even situations of oligopoly. Thus, it explains why countries can export and import designer clothes. This means that capital-intensive countries often dominate the most profitable industries. Being the first to develop these industries, these countries gain the first mover advantage. ‘The New Trade Theory suggests that the government has an important role in promoting new industries and supporting the growth of key industries in a developing economy to be able to achieve economies of scale, However, government intervention might be controversial, as stated by many economists, as it may encourage inefficiency in the long run if it has poor information about the new industries it is likely to support. “Thus, the New Trade Theory recognizes that economies of scale are a key factor in influencing the development of trade. It also suggests that free trade and laissez-faire government intervention may be much less desirable for developing economies who find themselves unable to compete with established. multi-nationals. 6.3 Theory of Absolute Advantage/Absolute Differences in Cost 1n 1776, Adam Smith questioned the mercantilists’ assumptions by stating that the real wealth ofa country consists of the goods and services available to its citizens rather than its holdings of gold. He emphasized on the virtue of free trade that are the results of division and specialization of labour at the national and international level, However, at the international level, the division of labour requires the existence of absolute differences in cost. Absolute difference in cost arises when one country produces a commodity at alower cost than the other country and the other country produces some other commodity at a lower ost in comparison to the first country. Thus, according to this theory, every country should specialize in the production of that commodity which it can produce more cheaply than others (i.e. enjoys absolute advantage) and exchange it for those commodities which cost less in other countries (ie. in which it has absolute disadvantage). To illustrate, let there be two countries A and B producing a commodity each, X and ¥ respectively, at an absolute lower cost of production than the other. The absolute difference in cost is illustrated in Table 1, Table 4; Absolute Difference In Cost I Country Commodity X (in units) Commodity ¥ (in units) A 10 § B 5 10:6.6 || International Business ‘The table shows that country A can produce 10 units of commodity X (10X) or 5 units of commodity Y (SY) with one unit of labour and country B can produce 5 units of commodity X (5X) or 10 units of commodity ¥ (10Y) with one unit oflabour. Thus, country A has an absolute advantage in the production of commodity X (10X > 5X) and country B has an absolute advantage in the production of commodity Y (10Y > 5Y). Both the countries will benefit from trade if country A specializes in the production of commodity X and country B specializes in the production of commodity ¥ as shown in Table 2. Table 2: Gains from Trade Production before Production after Gains from trade trade (1) trade (2) (2-1) ‘Commodity x Y x Y¥ x iy Country A 10 5 20 = +10 5 B 5 10 = 20 5 +10 Total production 15 15 20 20 +5 +5 By applying one unit of labour on the production of each commodity, both the countries can produce only 15 units each of the two commodities. If country A were to specialize in the production of commodity X, its total production will be 20 units of X by using both units of labour. Similarly, if country B were to specialize in the production of commodity Y alone, its total production will be 20 units of commodity Y by using both units of labour. The combined gain from trade to both the countries will be 5 units each of commodity X and Y respectively. Commodity y Yo Ya o Commodity X % Figure. 1: Absolute Difference in Cost with the help of Production Possibility Curve (PPC) ‘The PPC of country A is Y, X, and that of country B is Y;Xq, PPC of country A shows that it cam produce either OX, of commodity X or OY, of commodity Y. Similarly, the PPC of country B shows that it can produce either OXy of commodity X or OY of commodity Y. The diagram also reveals that country A has an absolute advantage in production of commodity X (OX, > OX,) whereas country B has an absolute advantage in the production of commodity Y (OY, > OY,).Theories of International Trade || 6.7 Criticism ‘Adam Smith’s analysis of the basis of international trade is unrealistic, This is because a number of developing and underdeveloped countries have trade relations with other countries even though they do not possess absolute advantage in the production of any commodity. 6.4 Theory of Comparative Advantage/Comparative Differences in Cost According to David Ricardo, the trade relation between two countries is determined by the comparative differencesin costsand not by the absolute differences, The costs differ in countries because of geographical division of labour and specialization in production causing a country to produce one commodity at a lower cost than the other. In this way, each country specializes in the production of that commodity in which its comparative cost of production is the least. Thus, when a country enters into trade with some other country, it will export those commodities in which its comparative cost of production is less and will import those commodities in which its comparative cost of production is high. According to Ricardo, this is the basis of international trade. Statement of the Theory “Each country will specialize in the production of those commodities in which it has the greatest comparative advantage or the least comparative disadvantage’. Assumptions of the Theory ‘The theory of comparative advantage is based on the following assumptions: . There are only two countries, say India and Bangladesh producing the same two commodities, say rice and wheat, Both countries have similar tastes and preferences. Labour is the only factor of production and all its units are homogeneous, There is no change in supply of labour. Labour cost (the number of units of labour employed to produce each commodity) determines the prices of the two commodities. 6. Commodities are produced under the law of constant costs. 7. Technological knowledge remains the same. 8. 9. yaen . There is barter system of trade. ‘There is full employment of factors of production in both the countries. 10. Factors of production are perfectly mobile within countries but perfectly immobile between countries, ML. Trade is free between two countries. . There are no transportation costs. 13. The international market is perfect; therefore, the exchange ratio is the same for the two commodities.6.8 || International Business Explanation of the Theory Given these assumptions, Ricardo shows that trade is possible between two countries when one country has an absolute advantage in the production of both commodities, but a comparative advantage in the production of one commodity than in the other, This is illustrated with an example of trade between India and Bangladesh as shown in Table 3. Table 3: Man-years of Labour Required for Producing One Unit Country Rice Wheat Bangladesh 120 100 India 80 90 The table shows that the production of a unit of rice in Bangladesh needs 120 men for a year while a unit of wheat requires 100 men for a year. On the other hand, the production of a unit of rice in India requires 80 men for a year and 90 men for a year for the production of wheat. Thus, Bangladesh uses more labour than India in producing both rice and wheat. In other words, Indian labour is more efficient in producing both the commodities. Thus, India possesses an absolute advantage in the production of both rice and wheat. But India would benefit more by producing rice and exporting it to Bangladesh because it possesses greater comparative advantage in it. This is because the cost of production of rice (80/120 men) is less than the cost of producing wheat (90/100 men). On the other hand, Bangladesh should specialize in the production of wheat in which it has least comparative disadvantage. ‘This is because the cost of producing wheat in Bangladesh is less (100/90 men) as compared with rice (120/80 men). Thus, trade is beneficial for both the countries. ‘The comparative advantage theory can also be illustrated with the help of production possibility curve, IN is the production possibility curve of India and BG that of Bangladesh. India enjoys an absolute advantage in the production of both rice and wheat over Bangladesh. It produces ON of rice and Ol of wheat as against OG of rice and OB of wheat produced by Bangladesh. Wheat ° GR N Rice Figure 2: Comparative Difference in Cost with the help of PPCTheories of International Trade || 6.9. ‘The slope of BR (parallel to IN) shows that India has a greater comparative advantage in the production of rice because if it gives up resources required to produce OB of wheat, it can produce OR ofrrce which is greater than OG of rice produced by Bangladesh. On the other hand, Bangladesh has the least comparative disadvantage in the production of OB amount of wheat. Thus, India will export OR of rice to Bangladesh in exchange for OB of wheat from it. Goins from Trade Ricardo does not discuss the actual ratio at which rice and cloth would exchange and how much the two countries gain from trade. The domestic trade ratios before trade in the two countries for rice and wheat are shown in Table 4. Table 4: Domestic Exchange Ratios Bangladesh India Rice 120 : 100 Wheat (6/5) Rice 80 : 90 Wheat (8/9) 1:12 1:0.89 Wheat 100 : 120 Rice (5/6) Wheat 90 : 80 Rice (9/8) 1:0.83 1: 113 ‘The cost of production of one unit of rice in Bangladesh is 120 men and that of producing one unit ‘of wheat is 100 men. It shows that the cost of producing rice is more as against wheat because one unit of rice can exchange for 1.2 units of wheat. On the other hand, the cost of producing one unit of rice in India is 80 men and that of producing one unit of wheat is 90 men. Thus the cost of producing wheat is more than that of rice because one unit of rice can exchange for 0.89 units of wheat. Let’ assume trade begins between the two countries. Bangladesh will gain ifit imports one unit of tice from India in exchange for less than 1.2 units of wheat. India will also gain if it imports one unit of wheat from. Bangladesh in exchange for more than 0.89 units of rice. ‘Table 4 also shows that the domestic exchange ratio in Bangladesh is one unit of wheat =0.83 units of rice and in India one unit of rice = 0.89 units of wheat. Assuming the exchange ratio between two countries to be 1 unit of wheat = 1 unit of rice, Bangladesh would gain 0.17 (1 - 0.83) units of rice by exporting one unit of wheat to India. Similarly, the gain to India by exporting one unit of rice to Bangladesh will be 0.11 (1 - 0.89) unit of wheat. Thus, trade is beneficial for both countries. ‘The gains from trade and their distribution are shown in Fig.3 where the line P,R, depicts the domestic exchange ratio 1 unit of wheat = 0.83 units of rice of Bangladesh and the line PR, that of India atthe domestic exchange ratio 1 unit of rice = 0.89 units of wheat.6.10 || International Business Wheat Py P, (0.89) Rice ° (0.83) Ry Figure 3: Gains from Trade “The line P,R, shows the exchange rate of trade of 1 unit of wheat = 1 unit of rice between the two countries. At this exchange rate Bangladesh gains R,R, (0.17 units) of rice while India gains P,P, (0.11 units) of wheat. Summing up, both India and Bangladesh specialize in the production of one commodity based on the comparative costs and accordingly reallocate their factors of production. Each country exports that commodity in which it has comparative advantage and imports that commodity in which it has comparative disadvantage. Both gain through trade and can increase the consumption of the two commodities. Criticism ‘The principle of comparative advantage has been the very basis of international trade for centuries but it is not free from few defects. In particular, Bertin Olin and Frank D. Graham have criticized this theory several times. Some of the important criticisms are: 1. Unrealistic Assumption of Labour Cost: It is assumed that this theory considers only labour cost and ignores non-labour costs in calculating the cost of production. This is highly unrealistic because the basis of national and international transactions is money cost and not labours cost. Further, the assumption of homogeneous labour is also unrealistic because labour is heterogeneous of different kinds, skilled and unskilled or specialized and general. No Similar Tastes: The assumption of the two countries having similar tastes and preferences unrealistic because preferences differ with different income standards in a country. Economic growth and development of trade relations also brings about a change in the tastes and preferences of people, x Assumption of Constant Costs: The theory assumes that commodities are produced under the law of constant costs which is unrealistic, Eactually, there are either increasing or diminishing costs, The comparative advantage is increased if the costs are reduced due to large scale production whereas the comparative advantage is reduced ifan increased output is the result of an increased cost of production.Theorles of International Trade || 6.11 = Transport Costs Ignored: Ricardo ignores transport costs in determining comparative advantage in trade. This is again an unrealistic assumption as transport costs play an important role in determining the pattern of world trade. For instance, the gain from international trade can be reduced or nullified due to high transportation cost. . Immobile Factors of Production Internationally: Another unrealistic assumption of this theory is that factors are perfectly mobile nationally and perfectly immobile internationally. However, within a country, factors are not freely mobile from one industry to another or from one region to another. The greater the degree of specialization in an industry, the less is the factor mobility from one industry to another. Thus, factor mobility influences costs and hence the pattern of international trade. Unrealistic Two-Country, Two Commodity Model: Ricardo’s doctrine of comparative advantage is based on trade between two countries trading two commodities. However, i reality, international trade takes place between many countries trading in many commodities. Unrealistic Assumption of Free Trade: Another drawback of this theory is that it assumes free trade among countries. This is not realistic, World trade is not free. The countries impose restrictions in the form of tariff and non-tariff barriers on the movement of goods to and from. other countries. x ‘Neglects the Role of Technology. Technological innovations in international trade are ignored by this theory which is unrealistic, Much is gained from innovations, research and development. For instance, technological changes help in increasing the supply of goods both nationally and internationally. ). One-Sided Theory: Since the theory considers only the supply side of international trade and ignores the demand side, itis considered to be a one-sided theory. 10. An Incomplete Theory: The theory is considered incomplete as it simply explains how two countries gain from trade but fails to explain how the gains from trade are distributed between the two countries. Despite these weaknesses, the theory of comparative advantage is considered to be the basis of international trade. In the words of Prof, Samuelson, “Yet for all its oversimplifications, the theory of comparative advantage has in it a most important glimpse of truth. Political economy has found few more Principles. A nation that neglects comparative advantage may have to pay a heavy price in terms of living standards and potential rates of growth.” 6.5 Modern Theory of International Trade/Heckscher Ohlin (H.0.) Theory In his famous book ‘Inter-regional and International Trade (1933), Bertin Oblin criticized the classical theory of international trade and formulated the General Equilibrium or Factor Endowment or Factor Of international trade is therefore the difference in prices of commodities based on relative factor endowments and factor prices as some commodities can be bought more cheaply from the other regions an in the same region where production is possible only at high prices.6.12 || International Business Assumptions of the Theory ‘The following assumptions hold good for the 11.0, theory: » Itis a two X two X two model Le. two countries, say A and B, two commodities, say X and Y, and two factors of production, say labour and capital. . Both commodity and factor markets are perfectly competitive markets, . Resources are fully employed. |. Technology is given and constant, . There are quantitative differences in factor endowments in different countries, but qualitatively they are homogeneous. veen . Production functions of the two commodities have different factor intensities (i.e. capital intensive and labour intensive) that are non-reversible. Factors are perfectly mobile within the country and perfectly immobile between countries, 8, There are no transportation costs. 9. There is free trade between countrics, . Each commodity in each country is produced under the law of constant cost. - Tastes and preferences of consumers and their demand patterns are identical in both the countries, _ . Neither country specializes in the production of one commodity. In other words, there is incomplete specialization, = Production functions are different for different commodities, but are the same for each commodity in both countries. It means that the production function of commodity X is different from commodity ¥ but the technique of production of commodity X and commodity Y respectively in both the countries is the same, Explanation to the Theory Given these assumptions, Heckscher and Ohlin contend that the immediate cause of international trade is the difference in relative commodity prices caused by differences in relative demand and supply of factor (actor prices) as a result of differences in factor endowments between two countries, Fundamentally, the relative scarcity of factors (shortage of supply in relation to demand) is essential for trade between two countries. Commodities which use large quantities of scarce factors are imported because their prices are high while commodities which use abundant factors are exported because their prices are low. H.O. theory is explained in terms of two definitions: 1, Factor abundance (or scarcity) in terms of price criterion: In this ctitetion, richness in factot endowments Is explained by Heckscher Ohlin in terms of factor prices, Given the two countries A and B producing two commodities X and Y by employing labour and capital as factors of Production, country A is abundant in capital if (Pe/P,), < (Pe/P,)y where Pg and Py refer €0 prices of capital and labour respectively and the subscripts A and B denote the two countries. 18 other words, country A is abundant in capital if capital Is relatively cheap in it whereas countty B is abundant in labour if labour is relatively cheap in it. ‘Thus, country A will produce andx ‘Theories of International Trade || 6.13 export the capital intensive good and import labour intensive good and country B will produce and export labour intensive good and import capital intensive good. In other words, the capital abundant country will export the relatively cheap capital-intensive commodity and the labour abundant country will export the relatively cheap labout-intensive commodity. . Factor abundance in physical terms: Another way to explain the H.O. theory is in physical terms of factor abundance. According to this criterion, a country is relatively capital abundant ifitis endowed with a higher proportion of capital and labour than the other country. Ifcountry Ais relatively capital abundant and country B is relatively labour abundant, then measured in physical amounts Cy/L, > Cy/Ls, where C, and L, are the total amounts of capital and labour respectively in country A and Cyand Ly are the total amounts of capital and labour respectively in country B. Both the countries specialize and gain from trade for two reasons: first, their factor price rates are equal and second, tastes and preferences for the two commodities are similar in both countries. But the above analysis of physical terms does not show that the capital abundant country will export the capital intensive commodity and the labour abundant country will export the labour intensive commodity. Criticisms HO. Theory has been criticized on the following grounds: 1 » = 2 ‘Two-by two-by-two Model: Ohlin has been criticized for presenting two-by-two-by-two model based on oversimplified assumptions. But, he has demonstrated in the mathematical appendix to his book that the model can be extended to many countries, many commodities and many factors. Non-homogeneous Factors: The theory assumes that the factors of production in the two countries are homogeneous and factor endowment ratios can be calculated by measuring them. In reality, however, no two factors are homogeneous qualitatively between as well as within the country. .. Non-homogeneous Production Techniques: The H.O. model assumes homogeneous production techniques for each commodity in the two countries. But, the technique of production is different in the two countries for the same commodity. Distinct Tastes and Demand Patterns: The assumption of similar tastes and demand patterns of consumption in both countries is unrealistic. Innovations, diversifications and accessibility of products bring about a change in the tastes and demand patterns of consumers. . No Constant Returns: It is unrealistic to assume constant returns to scale as the advantages of economies of scale are obtained by a country having rich factor endowments through lesser production and exports. Thus, there are increasing returns to scale rather than constant returns. ‘Transport Cost Ignored: The theory ignores transport costs in trade between two countries. But, in reality, when transport costs, loading and unloading charges and other port charges that affect the price of produced commodities in the two countries are included, they lead to price differentials for the same commodity in the two countries.6.14 || International Business | Unrealistic Assumption of Full Employment and Perfect Competition: The theory assumes full employment and perfect competition to exist in both the countries which is not true. Factually, due to the existence of differentiated products, perfect competition does not exist and each country strives to achieve full employment. 8, Leontief Paradox has made the Theory Questionable: Leontief’s empirical study of Ohlin’s theorem, known as Leontief Paradox, has led to paradoxical results that the United States exports labour-intensive goods and imports capital-intensive goods, even though it is a capital- rich country. 9. Partial Equilibrium Analysis: equilibrium analysis. He equilibrium concept. Vague and Conditional Theory: As pointed out by Haberler, “With many factors of production, some of which are qualitatively incommensurable as between different countries, and with dissimilar production functions in different countries, no sweeping a priori generalization concerning the composition of trade are possible”. Despite these criticisms, Ohlins theory is definitely an improvement over the classical theory of trade as it attempts to address the basis of international trade in the general equilibrium setting. x Prof, Haberler regards Ohlin’s theory as, by and large, a partial ‘ized him for his failure to develop a comprehensive general 10. 6.6 Superiority of H.0. Theory over the Classical Theory/ Difference between H.0. Theory and the Classical Theory ‘Heckscher- Olin Theory Classical Theory International trade is a special case of inter-regional/ inter-local trade. International trade is different from domestic trade. HO. theory is based on the general equilibrium theory of value. Classical theory is based on the labour theory of value. HLO. model takes two factors of production i.e. labour and capital. Labour is the only factor of production in the classical theory of trade. ‘The pattern of international trade is determined by the differences in factor supplies. Ricardian theory doesn't take note of differences in factor supplies. H.O. theory is based on relative factor prices which in turn influences the relative prices of goods. Ricardian theory considers relative prices of goods only. H.O. theory considers differences in relative productivities of labour and capital as the basis of international trade. “The classical theory considers productivity of labour alone as the basis of international trade. HO. theory is based on differences in factor endowments in different countries. Thus, it lays emphasis on both quantity and quality of factors in determining international values. Ricardian theory is based on the quality of one factor only ie. labour.Theories of International Trade || 6.15 Hedkscher- Ohlin Theory Classical Theory The merit of H.O. theory lies in explaining the causes of differences in comparative advantage satisfactorily. ‘According to Samuelson, the Ricardian theory could not explain the causes of differences in comparative advantage. HO. theory is scientific and focuses on the basis of international trade. It thus relates to the positive theory. “The classical theory demonstrates the gains from trade between the two countries. Thus, itis related to the welfare theory. ‘According to Haberler', the H.O. theory is a location theory which highlights the importance of the space factor in international trade. “The classical theory regards different countries as space less markets. The H.O. theorem is explicitly based on the assumption of production functions of the two countries. “The classical theory is based on differences in the production of the trading countries. “The H.O. model leads to complete specialization in the production of one commodity by one country and that of the other commodity by the second country when they enter into trade with each other. “The trade between two countries may or may not lead to specialization in the classical theory. Inthe H.0. theory, trade will not cease in future even if the labour becomes equally efficient in the two countries because the basis of trade is differences in factor endowments and factor prices. In the classical theory, differences in comparative costs between two countries are due to differences in efficiency of labour. Overtime, if labour in both countries becomes equally efficient in both countries, there'll be no trade between them. 67 The Leontief Paradox ‘The first comprehensive attempt to verify the Heckscher-Ohlin model was made by Wassily Leontief in1953?, The Heckscher-Ohlin theory states that relatively capital-abundant country ‘will export relatively capital-intensive goods and it will import relatively labour-intensive goods i.e. the goods in whose Production relatively large amounts of relatively scarce factor labour are required. Leontief in his study teached the paradoxical conclusion that the United States which possesses a relatively large amount of capital and a relatively small amount of labour in relation to the rest of the world, exported labour. pe goods and imported capital-intensive goods. This result has come to be known as Leontief ‘aradox, ‘Totestthe Heckscher-Ohlin prediction, Leontief used the 1947 input-output table of the US economy. He aggregated 200 groups of industries into 50 sectors of which 38 traded their products directly on the international market. He took two factors, labour and capital and estimated their requirements for Production of one million dollars worth of United States export and import competing commodities. _ 1+ BC. Swerling, “Capital Shortage and Labour Surplus inthe United States” RES Vol. 36, August, 1954, le “Factor Proportions and the Structure of Amerlean Trade November, 1956, e6.16 || International Business His results showed that in the US import-competing industries were relatively more capital. intensive than the export industries. Given the proposition that the US is relatively capital abundant, it exports labour-intensive goods. This is just contrary to the Heckscher-Ohlin theorem. Thus, it is called the Leontief Paradox. Griticism Leontief has been criticized by a majority of economists on methodological and statistical grounds Some points of criticism are as follows: 1. 1947, an unconventional year. Swerling? did not consider 1947 as a conventional year for testing the Heckscher-Ohlin theorem because by that year the disorganization of production had not been corrected. Moreover, the United States was the only major industrial economy that was saved from the destruction of the war. Thus, Leontief study was basically a description of US trade in 1947, Low Capital-Labour Ratio Industries: Swerling criticized Leontief for including certain industries with low capital-labour ratios like fisheries, agriculture and services like transport, wholesale trade etc. that biased his results. In response to this criticism, Leontief* reworked his study by taking a much wider range of studies but the results obtained were similar to the original study. 3. Consumption Patterns; The impact of consumption patterns on the US exports and imports is not considered by Leontief Paradox. The consumption pattern may be biased either towards labour-intensive or capital-intensive commodities with an increase in the per capita income. Brown's study® showed that the US consumption patterns had bias towards labour-intensive commodities rather than capital-intensive commodities. This contradicts the Leontief Paradox. Capital Durability. Buchanan criticized Leontief for using “investment-requirements coefficients” as capital coefficients in his study. Therefore, he failed to take into account the difference in the durability of capital in various industries. 5. Tariffs Not Considered: Travis argued that the pattern of trade was often distorted by tariffs and thus reflected relative factor endowments of a country. In his study, Leontief ignored the impact of US and foreign tariffs which would have otherwise affected his results. ‘Natural Resources Overlooked: Buchanan’ criticized Leontief for neglecting the role of natura resources which were very important in determining trade patterns. 7. Human Capital Ignored: Leontief, in his study, only considered physical capital and ignored the value of human capital. Kenen* found in his study that Leontief Paradox was reversed whe? human capital was added to Leontief’s physical capital. x S a AJ.Brown, “Prof. Leontief and the Pattern of World Trade” Yorkshire Bulletin of Economic and Social Research, November.1957- WE Travis, The Theory of Trade and Protection, 1964, 'NS.Buchanan, * Lines on the Leontief Paradox.” Economic Internazionale, November, 1955. P.O.Kenen, “Nature, Capital and Trade> JPE, October, 1956. Raymond Vernon “International Investment and International Trade inthe Product Cycle cof Economics 80(M7 Raymond Veron. in the Product Cycle? Quarterly Journal of Eo 8. POKenen, “Nature, Capital and Trade’ IPE, October, 1956. 4Theories of International Trade || 6.17 8. Unbalanced Trade; When the trade is unbalanced, Leonticf Paradox fails as per Lerner. He found no evidence of exports being labour-intensive when he examined US trade in 1947, He only concluded that US had a trade surplus. Factor Intensity Reversals: Leontief’s results led to the presence of factor intensity reversals whereby a capital abundant country will export its labour-intensive goods. Leontief has been criticized for taking only one country (the US) in his study. If he had taken a second capital- abundant country, the results would have been different, Despite the criticisms leveled against his study, Leontief retested his results by using the average composition of US exports and imports in 1951. He increased the group of industries into 192 sectors. However, the results again confirmed the Leontief Paradox though the capital intensity over US exports reduced considerably. So, the Leontief Paradox continues to persist in the US. 6.8 Product Life Cycle Theory In a 1966 article, Raymond Vernon sought to explain international trade based on the evolutionary process that occurs in the development and diffusion of products to markets around the world. In his International Product Life Cycle (IPLC) Theory, Vernon points out that each product and its manufacturing technologies go through a continuum or cycle of evolution that consists of introduction, growth, maturity and decline. ‘The location of production will shift to serve markets according to the stage of cycle a product is therein. Introduction: Historically, a new product originated in an advanced economy, such as the US or Germany, in the Introductory stage. This is because such countries have abundant capital and research and development facilities that prove advantageous to produce new products or to produce old products in new ways, Advanced economies also have abundant, affluent (high income) consumers who are willing to try new products, which are often expensive. During the introduction stage, production of the ew product takes place in the inventing country so that the producer can obtain rapid market feedback and save upon the transportation cost, since most sales are domestic. Any export sales are mainly to advanced countries having high income consumers and who are willing to spend on novelties. Since, Production process is not standardized in this stage, it remains labour-intensive. Growth: Overtime, the market grows and enters the growth phase. The sales growth attracts Competitors to the market, particularly in other developed countries, who establish a manufacturing “Unit in their own country and develop unique product variations for the consumers of their country. However, the cost of production may still be high because of start-up problems. ° _ Growth in sales provides an incentive to companies to develop labour-saving technology but this incentive is partly offset because competitors produce differentiated products to suit the needs of their SOuntry. Thus, the production process still remains labour-intensive though less than the introductory Stage. In other words, the capital intensity is relatively more than the introductory stage. ‘The original Producing country will increase its exports, especially to developing countries, but will lose certain key “Port markets in which local production is initiated. &. Raymond Vernon, i “International Investment and International Trade in the Product Cycke” Quarterly Journal of Bconomles 80 (May 6), pp. 190-209,6.18 || International Business Maturity: As the product enters the maturity stage, the production process gets more standardized and price becomes an important competitive strategy. The demand in developing countries increases on account of reduced per-unit cost of production due to capital-intensive production. The innovating country no longer commands a production advantage, Since the innovator may earn only a narrow profit margin, the innovating country shifts its production base to developing countries where they can employ less skilled labour efficiently at a lower cost for capital-intensive production. Foreign production thus, displaces the exports from the innovating country. Decline: Once the production process is standardized, mass production becomes the dominant activity and can be accomplished using cheaper inputs and low-cost labour, Production shifts to low- income countries where competitors enjoy low-cost advantages and can economically serve export markets worldwide. The innovator country eventually becomes a net importer. ‘Quantity x omy TS | Consumption ’ Imports \’ Production Produc e-New>Ae———® 5c 50 ore Product Grown Maturity Figure 4: PLC model of international trade — innovating country Quantity * Production Imports Consumption ¥ [| Exports Product ° A 8 c D > “cyclo #— New —t— Growth 4 Product Maturity Figure 5: PLC model of Intemational trade — imitating country Source: Shenkar & Luo for both.‘Theories of International Trade || 6.19 ism + The PLC theory holds that the location of production facilities that serve world markets shifts as products move through their life cycle. Many industrial products like steel, coal etc. or basic foodstuff like salt, sugar etc. fall outside the purview of life-cycle, + The movement of the product from one stage to another is not certain. + The present stage in which the product is cannot be known with certainty. + Certain products have extremely short life cycle because of rapid innovation. Shifting production of such products from one country to another doesn't reduce their cost. Hence, there's no benefit of shifting. + The new products are introduced simultaneously in all parts of the world due to shortened life- cycle, integration of the world economy and globalization. Thus, no leads and lags exist between markets. + Luxury products for which cost is of little concern to the consumers aren't covered by the PLC theory. + The production location of products requiring technical expertise to move into their next generation of models usually does not shift. This seems to explain the US dominance of medical equipment production and German dominance in rotary printing presses. + Its difficult to predict in advance the life of the product. + The companies today develop products for worldwide market segments and so introduce the new products at home and abroad simultaneously. In so doing, they choose an initial production location (that may or may not be in the innovating country) that will minimize costs for serving markets worldwide. ‘The theory was empirically satisfactory during 1950s to 1970s but the recommendations of the theory are either unclear or not fit in today’s world. In context of shifting to low cost countries, i.e. the Comparative advantage, one of the economists comments, “In essence, it is the Ricardian story once again’ 6.9 Theory of National Competitive Advantage Schumpeter emphasized many decades ago, “Competition is profoundly dynamic in character, The ature of economic competition is not equilibrium but a perpetual state of change. Improvement and innovation in an industry are never-ending processes. Today's advantages are soon superseded or nullified”. Michael Porter, in his book, “Competitive Advantage of Nations (1990)" explained why a nation provides an environment in which firms improve and innovate and continue to do so faster and in the proper directions compared to their international rivals and why some nations’ firms achieve 'echnological superiority, produce more differentiated or higher quality products or products which are ‘more attuned to customer needs than others. 7 Why does a nation achieve international success in a particular industry? The answer lies in four broad attributes of a nation that shape the environment in which local firms compete that promote OF impede the creation of competitive advantage. ‘These determinants are: (1) Factor Conditions;6.20 || International Business (2) Demand Conditions; (3) Related and Supporting Industries; and (4) Firm’s Strategy, Structure and Rivalry. The Porter’s model also points out two additional determinants that influence the four main determinants, These are governmental policy and the role of chance events. 1, Factor Conditions: The factors most important to competitive advantage in industries in advanced economies are not inherited but are created within a nation. To understand the role of factors in competitive advantage, it is necessary to distinguish between types of factors. The first demarcation is between advanced and basic factors, Advanced factors of production are skilled labour, knowledge, capital and infrastructure. Basic factors such as unskilled labour and raw material can be obtained by any company and do not generate competitive advantage, ‘The second distinction is between specialized and generalized factors. Specialized factors involve narrowly skilled personnel, infrastructure with specific properties, knowledge bases in particular fields and other factors with relevance to a limited range or even to just a single industry; for eg a port specialized in handling bulk chemicals or a pool of venture capital seeking to fund software companies etc. 2, Demand Conditions: ‘The second broad determinant of national competitive advantage is demand conditions, The main factor is home demand conditions which have influence in nearly every industry. The composition of home demand shapes how firms perceive, interpret and respond to buyer needs. Nations gain competitive advantage in industries where the home demand gives local firms a clearer or earlier picture of buyer needs than foreign rivals. Iti not merely the size of the market that is important but it is the intensity and sophistication of the demand that is significant for competitive advantage. If consumers are sophisticated, they will make demands for sophisticated products and that in turn will help the production of sophisticated products. Gradually, the country will achieve competitive advantage in such production. As significant as early home market penetration so is early or abrupt saturation. Early saturation forces companies to continue innovating and upgrading as well as finding international markets for their products. In consumer electronic products, saturation in the Japanese home market is rapid and product life cycles are extremely short. This is because buyers have homogeneous tastes combined with sophistication and status consciousness. This combination gives them competitive advantage in comparison with foreign rivals. . Related and Supporting Industries: The third broad determinant is related and supporting industries. The presence of internationally competitive supplier industries in a nation creates advantages in subsequent industries. It gives efficient, early, rapid and sometimes preferential access to the most cost-effective inputs. The benefit of home-based suppliers may be found in the process of innovation and upgrading, Firms gain quick access to information, to new ideas and insights and to supplier innovations. ‘The presence in a nation of competitive industries that are related, often leads to new competitive industries, Related industries are those in which firms can co-ordinate or share activities in the value chain when competing. An example is pharmaceutical firms who use the same university when testing new drugs. . Firm Strategy, Structure and Rivalry: The fourth and last broad determinant is firm strates) structure and rivalry. Many aspects of a nation, too numerous to generalize, influence the Ways in which firms are organized and managed. Some of the most important aspects are attitudes towards authority norms of interpersonal interaction, attitudes of workers towards management »Theories of International Trade || 6.21 and vice-versa, social norms of individualistic or group behavior and professional standards. ‘These in turn grow out of the educational system, social and religious history, family structures and many other unique national conditions. Sharp differences exist within and among nations in the goals that the firms seek to achieve as well as the motivations of the employees and managers. Domestic rivalry creates particularly visible pressure on each other to improve vigorous local competition. It not only sharpens advantages at home but pressures domestic firms to sell abroad in order to grow. ‘These four main determinants are influenced by the governmental policy through various regulatory and de-regulatory measures. Policies implemented without consideration of how they influence the entire system of determinants are as likely to undermine national advantage as enhance them. Government affects factor conditions in many ways, Among the most important roles of government is creating and upgrading factors. The government procurement can be a positive force for upgrading national competitive advantage if they provide early demand for advanced new sophisticated products or services from local firms. The government must support the related and supporting industries in the same way as the industries that have the advantage. Government has an important role in the nurturing and reinforcing clusters. Government's policy has numerous ways of influencing how firms are created, organized, how they ‘manage their goals and how they compete. Sustaining and enhancing competitive advantage requires that nation’s firms take a global approach to strategy. Government policy should seek to avoid currency restrictions, restrictions on foreign investments and restrictions on the inflow and outflow of skilled personnel that impede internationalization. Few roles of the government are more important to the upgrading of an economy than ensuring vigorous domestic rivalry and this requires strong antitrust policies because a dominant domestic competitor rarely results in international competitive advantage. ‘The last determinant that influences the four main determinants is chance events. Chance events are developments outside the control of firms (and usually the nation’s government) such as pure inventions, breakthroughs in basic technologies, wars, external political developments and major shifts in foreign demand, They create discontinuities that can unfreeze or reshape industry structure and provide pportunity for one nation's firms to supplant another's. Chance has played an important role in shifting Competitive advantage in many industries. A shift that changed competitive advantage was the oil shock in the 1970s. The oil shock ultimately helped upgrade Japanese industry. Because Japan was especially vulnerable to energy costs and therefore, took aggressive steps towards energy conservation. Ina nutshell, the Porter's Diamond must be seen as a system wherein the effect of one determinant offen depends on the state of other determinants. Giticism ‘The Theory of Competitive ‘Advantage suffers from the following criticisms/limitations- 1. Porter feels that sizeable domestic demand must be present for attaining competitive advantage but there are industries that have flourished only because of demand from foreign consumers. For eg. Nestle; a major share of its earnings comes from foreign sales.6.22 || International Business 2. Where domestic suppliers of inputs are not available, the backward linkage will be meaningless ‘as the determinant related and supporting industries doesn't exist in that nation. |. Availability of national resources, according to Porter, is not the only condition for attaining competitive advantage. There must be other factors also. But, a study has shown that some Canadian industries emerged on the global map only on the basis of such natural resource availability. Nevertheless, these limitations do not undermine the significance of Porter's national competitive advantage theory, especially in advanced industries located in advanced countries. : pees “Review Questions : ; 1. Analyze the product life cycle theory of international trade in detail. What criticisms are leveled 2. » i 5 against it? [D.U. B. Com (Hons.)2010] ‘What are the main differences between the factor proportions and product life cycle theories of international trade? [D.U. B. Com (Hons.)2011] Explain Porter's theory of national competitive advantage as a theory of international trade. [D.U. B.Com (Hons.) 2014] Explain the Product Life Cycle Theory of International Trade. [D.U. B.Com (Hons.) 2015] How is the factor proportion theory superior to the classical theory of international trade? Critically examine the Leontief Paradox. What are the assumptions and criticisms of Ricardo’s theory of international trade? Explain the absolute and comparative advantage theory of international trade. ‘What are the main sources of national competitive advantage? What are the sources of competitive advantage that explain the success of a product that you think is very successful in your country? ‘Write a short note on: (a) Leontief Paradox (b), Mercantilism () New Trade Theory Critically examine the Heckscher-Ohlin theory of international trade. gaa7 Tariff Barriers Learning Outcomes After studying this chapter, you should be able to understand: > Tariff: Meaning > ‘Types of Tariffs > Effects of Tariff 7.1 Toriff: Meaning A tariff is a tax or duty levied on goods when they enter and/or leave the geographical territory or boundary of a country, In this sense a tariff refers to import and export duties. However practically, a tariffis synonymous with import or custom duties. 7.2 Types of Tariffs Tariffs can be classified 1. On the basis of purpose. The purpose of levying tariffs is twofold, that is, for revenue and for Protection, Based on the purpose for which a tariff is levied, it can be (i) Revenue Tariff: The sole purpose of revenue tariff is to provide revenue to the state. Revenue duties are generally imposed on luxury consumer goods. More revenue is earned by the state of lower import duties are in force this is because the imposition of low import duties does not increase the price of the imported goods much and so the consumers do not normally shift the demand to other domestically produced goods.7.2 || International Business (ii) Protective tariff: The government levies protective tariff (import duties) with the objective of encouraging domestic production and discouraging imports. In this context Haberler has rightly said, “protective tariffs are meant to maintain and encourage those branches of home industry protected by the duties’, 2. Onthebasis of origin and destination. The following type of tariffs are levied by the government on the basis of origin and destination— (i) Ad-valorem duty: It is levied as as a percentage of the total value of the import duty. The import duty is a fixed percentage of the c.if (cost, insurance and freight) value of the commodity. It may be 20% 25% 50% etc. of the total value of the import duty. (ii) Specific Duty: Itis levied per physical unit of the imported commodity. For instance, Rs.X per car, cloth per meter, oil per litre etc, (iii) Compound Duty: A combination of the ad-valorem and specific duty levied by the government is termed as compound duty. In this case, a percentage ad-valorem duty is levied on the total value of goods imported as well as a specific duty is imposed on each unit of the commodity imported. For example, an Indian importer country may impose an import duty on a car at a fixed rate of rupees 100000 + 10% on the price of the car. (iv) Sliding scale duty: the duty that varies with the price of the imported commodities is known as sliding scale duty. It can be either ad valorem duty or specific duty. Normally sliding scale duties are imposed on specific basis. 3. On the basis of country wise discrimination. The following types of tariffs are levied on the basis of country wise discrimination- (Single Column Tariff: A single column tariff is said to be imposed when a uniform rate of duty is imposed on all similar commodities irrespective of the country from which they are imported. It is a very simple and easily administered non discriminatory tariff butits not elastic and adequate. Double Column Tariff: When two different rates of duty exist for either all or some of the commodities, it is known as double column tariff. Both the rates of the tariff are declared by the government either at the beginning or one at the beginning and another after t* rates are agreed upon under trade agreements. Double column tariffs can be further classified as: (a) General and conventional tariff: ‘The list of tariffs announced by the government st the beginning of the year, as its annual tariff policy, is known as the general tarifs It is a particular tariff rate which is charged from all the countries, On the contr} conventional tariff rates are based on trade agreements/treaties with other countries Such tariffs may be different for different countries and for different commodities Since they can only be changed with mutual consent, conventional tariffs are °° flexible and therefore hamper the expansion of trade. (©) Maximum and Minimum Tariffs: In order to import the same commodity fo" different countries, the governments usually fix two tariff rates; a minimum tari 2 and a maximum tariff rate. A minimum tariff rate is imposed on the imports from countries with which it has a commercial agreement or treaty whereas a maxi’ tariff rate is imposed on imports from the rest of the countries, (i) |