Global Business

28 January 2025
International Trade Theory
• Why do countries trade with each other?
• What is Free Trade?
• Unrestricted free trade
• Restricted free trade
• Some terms we will see in this topic
• Mercantilism
• Absolute advantage
• Comparative advantage
• New Trade Theory
• National Competitive Advantage
Trade Theory and Government
Policy
• Unrestricted free trade theorists argue against import
controls and export incentives
• Their argument is that import controls and export
incentives are self-defeating and result in wasted
resources
• Some of the biggest names in Unrestricted free trade
• Adam Smith
• David Ricardo
• Eli Heckscher
• Bertil Ohlin
Mercantilism
• Emerged in England in the mid-sixteenth century
• Exporting goods results in the country accumulating
gold and silver
• Importing goods results in country paying out gold and
silver
• It is in the best interests of a country to maintain trade
surplus with the country it is trading with
• Would this be possible?
Mercantilism
• Mercantilists saw no benefit to a large volume of trade
• Advocated for large amount of exports and as little of
imports as possible
• As a country’s balance of trade increases
ÞIts reserves of gold/silver will increase
ÞMore money supply
ÞGoods and other services cost will increase
ÞNow exports will reduce (David Hume)
Mercantilism
• Mercantilists see trade as a zero-sum game
• Later economists like Adam Smith and David Ricardo
pointed out the flaw in these arguments further
• However, we are unfortunately seeing a return to this
kind of thinking
• Former US President Donald Trump
• Neo-mercantilism equates political power with economic
power and economic power with balance-of-trade
surplus
Absolute Advantage
• Adam Smith attacked the mercantilist assumption that
trade is a zero-sum game
• Smith argued that countries differ in their ability to
produce goods efficiently
• A country has an absolute advantage in the production of
a product when it is more efficient than any other country
at producing it
• According to Smith, countries should specialize in the
production of goods for which they have an absolute
advantage and then trade these goods for those produced
by other countries
Absolute Advantage
Absolute
Advanta
ge
Comparative Advantage
• David Ricardo took Adam Smith’s theory one step
further
• What will happen when one country has an absolute
advantage in the production of all goods?
• This country will not at all benefit from international
trade according to Adam Smith
• Ricardo showed that this was not the case
Comparative Advantage
• According to Ricardo’s theory of comparative
advantage, it makes sense for a country to specialize in
the production of those goods that it produces most
efficiently and to buy the goods that it produces less
efficiently from other countries, even if this means
buying goods from other countries that it could produce
more efficiently itself
Comparative Advantage
Comparati
ve
Advantag
e
Real World
• Real World gets complicated by a number of things
• Not just two countries and two goods
• Transportation costs are a thing
• Resource price differences exist. On top of that exchange rate
differences exist
• No barriers to movement of resources between countries
• Constant returns to scale assumed
• Assumed fixed stock of resources and that free trade does not
affect the efficiency with which a country uses these resources
• Not considering the effect of trade on income distribution within a
country
• Is free trade still mutually beneficial?
Some assumptions relaxed
• Immobile resources
• Diminishing returns not constant returns
Diminishi
ng
returns
Some assumptions relaxed
• Immobile resources
• Diminishing returns not constant returns
• Dynamic effects and economic growth
Dynamic
effects
and
economic
growth
The influence of free
trade on the PPF
Some assumptions relaxed
• Immobile resources
• Diminishing returns not constant returns
• Dynamic effects and economic growth
• Trade, jobs, and wages: The Samuelson critique
Trade, jobs, and wages: The
Samuelson Critique
• Paul Samuelson’s critique looks at what happens when a rich
country—the United States—enters into a free trade agreement
with a poor country—China—that rapidly improves its
productivity after the introduction of a free trade regime
• Samuelson’s model suggests that the lower prices that U.S.
consumers pay for goods imported from China following the
introduction of a free trade regime may not be enough to
produce a net gain for the U.S. economy if the dynamic effect of
free trade is to lower real wage rates in the United States
• Samuelson was particularly concerned about the ability to
offshore service jobs that traditionally were not internationally
mobile
Trade, jobs, and wages: The
Samuelson Critique
• When coupled with rapid advances in the productivity of
foreign labour due to better education, the effect on middle-
class wages in the United States, according to Samuelson,
may be similar to mass inward migration into the country
• Samuelson concedes that free trade has historically benefited
rich countries (as data discussed later seem to confirm)
• He notes that introducing protectionist measures (e.g., trade
barriers) to guard against the theoretical possibility that free
trade may harm the United States in the future may produce a
situation that is worse than the disease they are trying to
prevent
Heckscher–Ohlin Theory
• Ricardo’s theory stresses that comparative advantage
arises from differences in productivity
• Ricardo stressed labour productivity and argued that
differences in labour productivity between nations
underlie the notion of comparative advantage
• Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put
forward a different explanation of comparative
advantage
• They argued that comparative advantage arises from
differences in national factor endowments
Heckscher–Ohlin Theory
• By factor endowments, they meant the extent to which
a country is endowed with such resources as land,
labour, and capital.
• Nations have varying factor endowments, and different
factor endowments explain differences in factor costs
• The more abundant a factor, the lower its cost
• Heckscher–Ohlin theory predicts that countries will
export those goods that make intensive use of factors
that are locally abundant, while importing goods that
make intensive use of factors that are locally scarce
Heckscher–Ohlin Theory
• Like Ricardo’s theory, the Heckscher–Ohlin theory
argues that free trade is beneficial
• Unlike Ricardo’s theory, however, the Heckscher–Ohlin
theory argues that the pattern of international trade is
determined by differences in factor endowments, rather
than differences in productivity
Product Life-Cycle Theory
• Raymond Vernon initially proposed the product life-cycle
theory in the mid-1960s
• Based on the observation that, for most of the twentieth
century, a very large proportion of the world’s new
products had been developed by U.S. firms and sold first
in the U.S. market
• Vernon argued that the wealth and size of the U.S. market
gave U.S. firms a strong incentive to develop new
consumer products
• The high cost of U.S. labour gave U.S. firms an incentive to
develop cost-saving process innovations
Product Life-Cycle Theory
• Vernon argued that most new products were initially
produced in America. The pioneering firms believed it
was better to keep production facilities close to the
market and to the firm’s centre of decision making,
given the uncertainty and risks inherent in introducing
new products
• Also, the demand for most new products tends to be
based on nonprice factors. Consequently, firms can
charge relatively high prices for new products, which
obviates the need to look for low-cost production sites
in other countries.
Product Life-Cycle Theory
• Early in the life cycle of a typical new product, while demand is starting to
grow rapidly in the United States, demand in other advanced countries is
limited to high-income groups
• The limited initial demand in other advanced countries does not make it
worthwhile for firms in those countries to start producing the new product,
but it does necessitate some exports from the United States to those
countries
• Over time, demand for the new product starts to grow in other advanced
countries
• As it does, it becomes worthwhile for foreign producers to begin producing
for their home markets or US firms to set up production facilities in
advanced countries
• Production within other advanced countries begins to limit the potential for
exports from the US
Product Life-Cycle Theory
• As the market in the United States and other advanced nations
matures, the product becomes more standardized, and price
becomes the main competitive weapon.
• Cost considerations start to play a greater role in the competitive
process
• Producers based in advanced countries where labour costs are
lower than in the US might now be able to export to the US
• If cost pressures become intense, the process might not stop
there
• The locus of global production initially switches from the United
States to other advanced nations and then from those nations to
developing countries
International Product Life-Cycle
Theory
• Local innovation
• Overseas innovation
• Maturity
• World-wide imitation
• Reversal
Product
Life-
Cycle
Theory
Product Life-Cycle Theory
• Vernon’s argument that most new products are
developed and introduced in the United States seems
ethnocentric and dated
• An increasing number of new products are now
introduced simultaneously around the world
• May be accompanied by globally dispersed production,
with particular components of a new product being
produced in those locations around the globe where the
mix of factor costs and skills is most favourable (as
predicted by the theory of comparative advantage)
New Trade Theory
• Began to emerge in the 1970s when a number of economists pointed
out that the ability of firms to attain economies of scale might have
important implications for international trade
• Economies of scale are unit cost reductions associated with a large
scale of output
• Economies of scale have a number of sources, including the ability to
spread fixed costs over a large volume and the ability of large-
volume producers to utilize specialized employees and equipment
that are more productive than less specialized employees and
equipment
• Economies of scale are a major source of cost reductions in many
industries, from computer software to automobiles and from
pharmaceuticals to aerospace
New Trade Theory
• New trade theory makes two important points
• Through its impact on economies of scale, trade can increase
the variety of goods available to consumers and decrease the
average cost of those goods.
• Second, in those industries in which the output required to
attain economies of scale represents a significant proportion
of total world demand, the global market may be able to
support only a small number of enterprises. Thus, world trade
in certain products may be dominated by countries whose
firms were first movers in their production.
New Trade Theory
• Imagine first a world without trade
• In industries where economies of scale are important, both the
variety of goods that a country can produce and the scale of
production are limited by the size of the market
• There may not be enough demand to enable producers to
realize economies of scale for certain products
• Those products may not be produced, thereby limiting the
variety of products available to consumers
• Alternatively, they may be produced but at such low volumes
that unit costs and prices are considerably higher than they
might be if economies of scale could be realized
New Trade Theory
• Now, when trade is allowed
• Individual national markets are combined into a larger world
market
• As the size of the market expands due to trade, individual firms
may be able to better attain economies of scale
• This means each nation may be able to specialize in producing a
narrower range of products than it would in the absence of trade,
yet by buying goods that it does not make from other countries,
each nation can simultaneously increase the variety of goods
available to its consumers and lower the costs of those goods
• Trade offers an opportunity for mutual gain even when countries
do not differ in their resource endowments or technology
New Trade Theory
• The pattern of trade we observe in the world economy may be
the result of economies of scale and first-mover advantages
• What are first-mover advantages?
• The ability to capture scale economies ahead of later
entrants, and thus benefit from a lower cost structure, is an
important first-mover advantage
• New trade theory argues that for those products where
economies of scale are significant and represent a substantial
proportion of world demand, the first movers in an industry
can gain a scale-based cost advantage that later entrants find
almost impossible to match
New Trade Theory
• Thus, the pattern of trade that we observe for such
products may reflect first-mover advantages
• Countries may dominate in the export of certain goods
because economies of scale are important in their
production and because firms located in those countries
were the first to capture scale economies, giving them a
first-mover advantage
New Trade Theory
• Suggests that nations may benefit from trade even when
they do not differ in resource endowments or technology
• Trade allows a nation to specialize in the production of
certain products, attaining scale economies and lowering
the costs of producing those products, while buying
products that it does not produce from other nations that
specialize in the production of other products
• As a result, the variety of products available to consumers
in each nation is increased, while the average costs of
those products should fall, as should their price, freeing
resources to produce other goods and services
New Trade Theory
• The theory also suggests that a country may predominate
in the export of a good simply because it was lucky enough
to have one or more firms among the first to produce that
good
• Because they are able to gain economies of scale, the first
movers in an industry may get a lock on the world market
that discourages subsequent entry
• New trade theory is at variance with the Heckscher–Ohlin
theory, which suggests a country will predominate in the
export of a product when it is particularly well endowed
with those factors used intensively in its manufacture
New Trade Theory
• Perhaps the most contentious implication of the new
trade theory is the argument that it generates for
government intervention and strategic trade policy
• New trade theorists stress the role of luck,
entrepreneurship, and innovation in giving a firm first-
mover advantages
• Boeing and Airbus are often cited as an examples
New Trade Theory
• However, Boeing’s research and development (R&D) was largely paid
for by the U.S. government
• The 707 (Boeing’s first successful jetliner) was a spin-off from a government-
funded military program
• The entry of Airbus into the industry was also supported by significant
government subsidies
• Herein is a rationale for government intervention
• By the sophisticated and judicious use of subsidies, could a
government increase the chances of its domestic firms becoming first
movers in newly emerging industries?
• Possible economic rationale for a proactive trade policy that is at
variance with the free trade prescriptions of the trade theories we
have reviewed so far
National Competitive Advantage
• Michael Porter wrote extensively on international trade
• Porter’s work was driven by a belief that existing
theories of international trade told only part of the story
• He wanted to explain why a nation achieves
international success in a particular industry?
• Porter theorized that four broad attributes of a nation
shape the environment in which local firms compete,
and these attributes promote or impede the creation of
competitive advantage
National
Competiti
ve
Advantag
e
Porter’s
Diamond
National Competitive Advantage:
Porter’s Diamond
• Factor endowments – a nation’s position in factors of
production, such as skilled labour or the infrastructure necessary
to compete in a given industry (Basic factor and Advanced
factors)
• Demand conditions – the nature of home-country demand for
the industry’s product or service
• Related and supporting industries – the presence or
absence of supplier industries and related industries that are
internationally competitive
• Firm strategy, structure, and rivalry – the conditions
governing how companies are created, organized, and managed
and the nature of domestic rivalry
National Competitive Advantage:
Porter’s Diamond
• Porter argues that firms are most likely to succeed in industries
or industry segments where the diamond is most favourable
• Also argues that the diamond is a mutually reinforcing system.
The effect of one attribute is contingent on the state of others
• Porter maintains that two additional variables can influence the
national diamond in important ways: chance and government
• Chance events, such as major innovations, can reshape industry
structure and provide the opportunity for one nation’s firms to
supplant another’s
• Government, by its choice of policies, can detract from or
improve national advantage
Managerial Implications of all this?
• Location
• First-mover advantage
• Government policy (or intervention)