CHAPTER 4
INTERNATIONAL TRADE THEORY
Chapter Outline
OPENING CASE: The Gains From Trade-Ghana and South Korea
INTRODUCTION
AN OVERVIEW OF TRADE THEORY
The Benefits of Trade
Country Focus: Crawfish Wars
The Pattern of International Trade
Trade Theory and Government Policy
MERCANTILISM
ABSOLUTE ADVANTAGE
COMPARATIVE ADVANTAGE
The Gains From Trade
Qualifications and Assumptions
Trade and Simple Effects of the Ricardian Model
Management Focus: Free Trade and REI
HECKSCHER-OHLIN THEORY
The Leontief Paradox
THE PRODUCT LIFE CYCLE THEORY
Evaluating the Product Life Cycle Theory
THE NEW TRADE THEORY
The Aerospace Example
Implications
NATIONAL COMPETITIVE ADVANTAGE: PORTER’S DIAMOND
Factor Endowments
Demand Conditions
Related and Supporting Industries
Firm Strategy, Structure, Rivalry
Management Focus: The Rise of Finland’s Nokia
Evaluating Porter’s Theory
IMPLICATIONS FOR BUSINESS
Location Implications
First-Mover Implications
Policy Implications
SUMMARY OF CHAPTER
CRITICAL THINKING AND DISCUSSION QUESTIONS
INTERNET EXERCISES
CLOSING CASE: The Rise of The Indian Software Industry
Learning Objectives
1. Understand why nations trade with each other.
2. Be conversant with the different theories that have been offered to explain trade flows between nations.
3. Understand why many economists believe that unrestricted (free) trade between nations will raise the economic welfare of all countries that participate in a free trade system.
4. Be familiar with the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.
5. Understand the important implications that international trade theory holds for business practice.
Chapter Summary
This chapter focuses on the benefits of international trade and introduces several theories that help explain the patterns of international trade that are observed in practice. The discussion begins with an explanation of the theory of mercantilism, and then proceeds to discuss the theories of absolute advantage and comparative advantage. Four additional theories are discussed, including the Heckscher-Ohlin theory, the Product Life Cycle theory, the New Trade theory, and the theory of National Competitive Advantage. Each of these theories helps explain why certain goods are (or should be) made in certain countries. The chapter ends by discussing the link between the theories of international trade and (1) a firm’s decision about where (in the world) to locate its various productive activities, (2) the importance of establishing first-mover advantages, and (3) government trade policies.
OPENING CASE: The Gains From Trade – Ghana and South Korea
Summary
The opening case provides a comparison of the economic development and trade policies of Ghana and South Korea during the latter half of the 20th century. Whereas Ghana implemented an import substitution policy, South Korea had a very outward oriented pro-trade policy. The net effect is that South Korea has developed economically much faster than Ghana. Discussion of the case can center on the following questions:
QUESTION 1: Many countries have followed an import substitution policy. Explain the rationale behind this policy.
ANSWER 1: Many countries felt that they were being left behind as the “developed” world built larger and more extensive industries. They were afraid that they would be stuck only producing commodity products (e.g., cocoa, bananas, rubber), and importing all advanced good from other countries. They wanted to be able to develop their own industries for advanced manufactured goods.
QUESTION 2: What were the main elements of an import substitution policy?
ANSWER 2: The key to an import substitution policy is being able to produce a good that can be heavily taxed upon export in order to fund the development of other industries. In the case of Ghana, this was cocoa. Government tax revenues from the export of cocoa were used to subsidize the development of other industries that would replace imported goods (e.g., radios, household items). It was felt that once these industries got going, not only would they be able to supply the domestic market and lead to self-sufficiency in manufactured goods, the country would be able to export these goods and develop the capability for making ever more sophisticated manufactured goods.
QUESTION 3: Why was the import substitution policy such a failure?
ANSWER 3: The import substitution policy caused Ghana to shift productive resources away from goods in which it had an absolute advantage (cocoa), and into goods where its costs of production were much higher than that of other nations. Consumers were forced to pay higher prices for generally inferior goods, and productive resources were used in relatively unproductive pursuits. These inefficiencies put a brake on economic development.
QUESTION 4: In contrast, why has South Korea performed so well?
ANSWER 4: Part of the explanation for South Korea’s success lies in its much more open trade policies. South Korea’s policies allowed its resources to be put to their best productive use, and it liberally imported and exported goods. Thus, consumers were able to get the most for their money, and workers were able to earn higher wages.
Chapter Outline With Lecture Notes and Teaching Tips
INTRODUCTION
A) This chapter has two goals. The first goal is to review a number of theories that explain why it is beneficial for a country to engage in international trade. The second goal is to explain the pattern of international trade that is observed in the world economy.
Teaching Tip: It is often worth asking students before discussing the theories why countries trade the products they do. They will frequently – with a little prompting hit upon many of the ideas presented in this chapter and consequently relate better to the various theories that are discussed.
AN OVERVIEW OF TRADE THEORY
A) Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country. Having completely free trade is certain to hurt some domestic industries that are not competitive on a worldwide basis.
The Benefits Of Trade
B) While it is easy to see why it makes sense to trade for goods that a country cannot easily produce, it is sometimes harder to understand why a country should not make goods that it can easily produce. There is little reason why the USA should not be able to produce all the sneakers and jeans demanded by its citizens. All of the raw materials required for these goods are available in the USA, as is labor. Nevertheless, the USA imports most of the sneakers and jeans consumed. This is because production is fairly labor intensive, and American labor is much more costly than labor in other parts of the world. American consumers would have to pay a great deal more for these goods if they were only made domestically. Thus it is beneficial for consumers to purchase goods from their least expensive source, and better that labor produce goods that take advantage of the educational level of most American workers
The Pattern of International Trade
C) Some patterns of trade are fairly easy to explain - it is obvious why Saudi Arabia exports oil, the US exports agricultural products, and Mexico exports labor intensive goods. Yet others are not so obvious or easily explained. The US ships Jeep Cherokees to Scandinavia, and Scandinavia ships Volvo station wagons to the US. Clearly it would be technically possible for Scandinavian firms to produce Jeeps and American firms to produce high quality station wagons.
Trade Theory and Government Policy
D) While all of the trade theories discussed in the text agree that international trade is beneficial to a country, they lack agreement in their recommendations for government policy. Mercantilism discussed below makes a crude case for government involvement in promoting exports and limiting imports. While, the theories of Smith, Ricardo, and Heckscher-Ohlin discussed below form a part of the case for unrestricted free trade the argument for unrestricted free trade is that both import controls and export incentives (such as subsidies) are self defeating and result in wasted resources. Yet both the new trade theory and Porter’s theory of national competitive advantage discussed below can be interpreted as justifying some limited and selective government intervention to support the development of certain export-oriented industries.
MERCANTILISM
A) The first theory of international trade emerged in England in the mid-16th century. Referred to as mercantilism, its principle assertion was that it is in a country’s best interest to maintain a trade surplus, to export more than it imports. Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade.
Teaching Note: A historical perspective of Mercantilism is available at the following site {http://www.egss.ulg.ac.be/EconomieInternationale/Swe/SWEglobal.htm}.
B) The flaw of mercantilism was that it viewed trade as one in which a gain by one country results in a loss by another. It was left to Adam Smith and David Ricardo to show the shortsightedness of this approach and to demonstrate that trade is a positive-sum game.
As an economic philosophy, mercantilism is problematic and not valid. Yet many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade.
ABSOLUTE ADVANTAGE
A) In his 1776 landmark book The Wealth of Nations, 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, and that a country has an absolute advantage in the production of a product when it is more efficient than any other country in 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 the goods produced by other countries. The text provides a numerical example of Smith’s theory.
B) When each country has an absolute advantage in one of the products, it is clear that trade is beneficial. But what if one country has an absolute advantage in both products?
COMPARATIVE ADVANTAGE
A) David Ricardo took Adam Smith’s theory one step further by exploring what might happen when one country has an absolute advantage in the production of all goods. Smith’s theory of absolute advantage suggests that such a country might derive no benefits from international trade. In his 1817 book Principles of Political Economy, Ricardo showed that this was not the case. 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. The textbook provides a detailed example to explain the rationale of this theory. This simple example of comparative advantage presented in the text makes a number of assumptions: only two countries and two goods; zero transportation costs; similar prices and values; resources are mobile between goods within countries, but not across countries; constant returns to scale; fixed stocks of resources; and no effects on income distribution within countries. While these are all unrealistic, the general proposition that countries will produce and export those goods that they are the most efficient at producing has been shown to be quite valid.
Teaching Tip: An overview of the ideas and philosophies of David Ricardo, from which his theory of comparative advantage emerged, is available at {http://www.econlib.org/library/Enc/bios/Ricardo.html}. Students might also consult {http://cepa.newschool.edu/het/alphabet.htm}.
The Gains from Trade
B) The theory of comparative advantage argues that trade is a positive sum gain in which all gain. It provides a strong rationale for encouraging free trade.
Qualifications and Assumptions
C) The simple example of comparative advantage presented in the text makes a number of assumptions: only two countries and two goods; zero transportation costs; similar prices and values; resources are mobile between goods within countries, but not across countries; constant returns to scale; fixed stocks of resources; and no effects on income distribution within countries. While these are all unrealistic, the general proposition that countries will produce and export those goods that they are the most efficient at producing has been shown to be quite valid.
Trade and Simple Extensions of the Ricardian Model
D) The text provides explores the effects of relaxing the assumptions that resources are mobile between goods within a country, and that trade does not change a country’s stock of resources or the efficiency with which those resources are utilized.
Immobile Resources
F) As illustrated by the example in the test, resources do not always move freely from one economic activity to another.
Dynamic Effects and Economic Growth
G) Opening an economy to trade is likely to generate dynamic gains of two types. First, trade might increase a country's stock of resources as increased supplies become available from abroad. Secondly, free trade might increase the efficiency of resource utilization, and free up resources for other uses.
Evidence for the Link between Trade and Growth
H) Most studies exploring the relationship between trade and economic growth suggest that countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade.
HECKSCHER-OHLIN THEORY
A) Hecksher and Ohlin argued that comparative advantage arises from differences in national factor endowments. As a result, the Heckscher-Ohlin theory 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.
Teaching Tip: A more complete description of the Heckscher-Ohlin theory is available at {http://cepa.newschool.edu/het/alphabet.htm}.
The Leontief Paradox
B) Using the Heckscher-Ohlin theory, Leontief, in 1953 postulated that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods. To his surprise, however, he found that U.S. exports were less capital intensive than U.S. imports. Since this result was at variance with the predictions of the theory, it has become know as the Leontief Paradox.
Teaching Tip: A more complete description of the Leontief Paradox is available at {http://cepa.newschool.edu/het/alphabet.htm}.
The Product Life Cycle Theory
A) Raymond Vernon initially proposed the product life-cycle theory in the mid 1960s. According to the theory as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade.