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Chapter 5:International Trade

Theory

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Theories of International Trade 1. Mercantilism:

• The theory was introduced in mid 16th century in England. The main tenet of the theory was that it was in a country’s best interests to maintain a trade surplus by means of exporting more and importing less. By doing so, a country would accumulate gold and silver and consequently, increase its national wealth and prestige. One of the implication of the theory is “beggar-thy-neighbor policy.” Adam Smith and all the Classical economists were critical about the theory.

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Limitations of Mercantilism:

State England FranceState 1

X>M: Trade Surplus ↑ X<M: Trade Deficit ↑

State 2

Gold reserve↑: Money supply↑

Gold reserve↓ : Money supply↓

State 3

Inflation: Price level ↑

Deflation: Price level ↓

Sate 4

International competitiveness ↓

International competitiveness ↑

Sate 5

X ↓:M ↑: Trade deficit

X↑:M ↓: Trade Surplus

Sate 6

Gold reserve ↓:Deflation

Gold reserve ↑:Inflation

2. According to Mercantilist, trade is a zero sum game: trade makes one country gainer and one country loser. It has been proved later by Adam Smith and David Ricardo that trade can be a positive sum game; trade can benefit both the countries simultaneously.

1. Price-Specie flow mechanism by David Hume

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Theories of International Trade 2. Opportunity Cost theory

Industrial Goods

Agricultural Goods

IM

N

IC2IC1

a

b

e

d

T

T

Assumptions: (i) 2-coutry-2-commodity model. (ii) Increasing cost.Before Trade Bangladesh USAProduction Possibility Curve (PPC)

ab ed

Consumption=Production C1 C2

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2. Opportunity Cost theory (Contd.)

Industrial Goods

Agricultural Goods

IM

N

IC2IC1

a

b

e

d

T

T

After Trade

Bangladesh USA

Production PB PU

Consumption

I I

Export Agricultural Goods: PBM

Industrial Goods: PUN

Import Industrial Goods: IM

Agricultural Goods: IN

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2. Opportunity Cost theory (Contd.)

• Gains from Trade of Bangladesh: Point I belongs to IC2. Before trade consumption was at C1 which belongs to IC1. Since IC2 is higher than IC1, there is a gain from trade on the part of Bangladesh.

• Gains from Trade of USA: Point I belongs to IC2. Before trade consumption of USA was at C2 which belongs to IC1. Since IC2 is higher than IC1, there is a gain from trade on the part of USA.

• Balance Budget: Since there are only 2 countries under consideration, the export of Bangladesh is just equal to the import of USA. Similarly, the import of Bangladesh is just equal to the export of USA.

• Conclusion: The theory focuses on the gain from international trade. The theory proved that trade being a zero-sum game is not true as both countries can be benefitted from trade. A country would be gaining from international trade as long as it achieves a higher indifference curve. The theory also focuses on the determination of terms of trade (i.e., global price line). More importantly, the theory guides every country to take advantage of specialization in certain line of production.

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Limitations of Opportunity cost theory• The assumption of identical preference

pattern of different countries is not true.• The assumption of perfect mobility of

factors of production within the country and perfect immobility across countries is not true.

• The assumption of constant technology is invalid. This is truer for manufactured commodities than agricultural commodities. In consequence, developing countries continuously face deterioration in its terms of trade and developed countries continuously face advantages in terms of trade.

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Heckscher-Ohlin Theory• Swedish economist Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of comparative advantage.

• They argued that comparative advantage arises from Factor Endowments (the extent to which a country is endowed with such resources as land, labor and capital).

• The theory predicts that countries will export those goods that make intensive use of factors that are locally abundant while import goods that make intensive use of factors that are locally scarce.

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The Leontief Paradox

• Challanging the Hechscher-Ohlin (opportunity cost) theory, Wassily Leontief observed that US exports were less capital intensive than US imports although US has abundance in capital and scarcity in labor. One possible explanation is that US has a special advantage in producing new products or goods made with innovative technologies. Thus, US may be exporting goods that heavily use skilled labor and innovative entrepreneurship, such as computer software; while importing heavy manufacturing products that use large amounts of capital.

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Political implication of the trade theory: Prebisch-Singer Hypothesis

• In 1950s Prebisch and Singer studied the terms of trade (defined as the export price divided by import price) of developing countries and observed a secular decline in the terms of trade of developing countries due to low income and price inelasticity of demand for agricultural goods. They argued that the decline would continue in future. Between 1977 and 1997, the terms of trade of developing countries declined by 60% and a purchasing power flowed continuously from developing countries to developed countries. Moreover, the developed countries’ policy of agricultural subsidy restricted the import from developing countries. Thus, the apparently innocent trade theory has the serious implication of making the developed countries richer and developing countries marginalized.

• There is supply side constraint as well. Supply curve of developing countries is inelastic due to “institutional rigidities". According to Cobweb theorem, current demand of agricultural product reflects in the supply of next year that hardly matches the current demand. Thus, even if demand increases, the suppliers of agricultural products can not take advantages of that.

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Agricultural Subsidies of Developed Countries

• Developing countries, producers of agricultural product face Intense competitions from developed countries due to huge agricultural subsidy. Per farmer subsidy is $19,000 both in Europe (43% of value) and USA (22% of value), $21,000 in Japan (62% of value), $8,000 in Canada (18% of gross farm receipts). Such subsidies are currently running $20 billion annually. UN observed that it affects developing countries export worth $50 billion which is equivalent to the annual foreign aid flow of developed countries to developing countries.

• Realizing the problem, some of the developing countries have started to concentrate in the export of manufactured goods rather than agricultural goods. However, United Nations observed in 2001 that such exports of LDCs face high import restrictions of developed countries and lose almost 2% of their GNP worth $100 billion annually.

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3. Internalization Theory:The market imperfection approach to FDI is typically referred to as internalization theory of international business. The perfect market assumption of earlier trade theories (comparative advantage theory) is not commonly valid due to many kinds of market imperfections in the world. Internalization (imperfect market) theory suggests that international business aims at capitalizing the market imperfections. It can be originated from:

¤ Impediments to exporting like import duty, quota and other barriers. (Ref: Japanese auto companies in USA). Taking these impediments under consideration, an international business makes direct foreign investment rather than export.

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Internalization Theory (Cont..)

• Technological constraints may force the international business to make direct investment rather than export. Technological know-how (Nokia), production process (Toyota), marketing know-how (Kellogg, Heinz) and management know-how make some companies highly profitable and that profit potential is more if they can capture bigger market. American RCA licensed its leading color TV technology to Japan, but Matsushita and Sony quickly assimilated RCA’s technology and used it to enter and capture the US market. Under this situation, it would have been wiser for RCA to make direct FDI rather than issuing the license.

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Implication of Internalization Theory

• Despite the presence of WTO (and previously GATT), market imperfections are gradually increasing in the form of countervailing effects, regional integration, environmental protection, consumers’ safety, human rights and so on. Nature of such imperfections is changing in favor of developed countries. Introduction of ISO transfers developing nations’ funds to developed countries at least to an extent of 2% of their national income. This increases price creating dead weight loss to consumers. TRIPS creates market imperfections as well.

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4. Product Life–Cycle Theory

• Reymond Vernon introduced this theory in mid-1960s. The theory tells us how the location of production and consumption of different products change during its life-cycle. The products include mass-produced automobiles, televisions, instant cameras, photocopiers, personal computers and semi-conductor chips.

• Vernon observed that for most of the 20th century, a very large proportion of the world’s new products had been developed by US firms and sold first in the US market because of the wealth and size of US market. Due to high labor cost in USA, the technology of production of these products was capital intensive. During the early cycle of product life, these products were exported to other countries for limited number of consumers. Later cycle experienced production in other countries with almost similar kind of technology.

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Product Life–Cycle Theory (Cont..)

• In the matured cycle of product life, developing countries take part in the production to export it back to developed countries. Thus, although USA introduced the product and during the initial cycle, USA was an exporter of the product, but over time, other developed countries who were initially the importers of the product, start exporting to USA. Later when the product becomes standardized, developing countries take part in export as well.

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4. Criticism and implications of Product Life–Cycle Theory

• The theory suffers from the US biasness as the founder Vernon over focused the US contribution in the introduction of modern products. Products are now global products. The contribution of Indian designers and Japanese technology can not be denied in the development of computers.

• The theory concludes that developing countries are the ultimate beneficiaries as manufacturers and exporters of the products. This is not true. Producers of developed countries identify the potentials of developing countries much earlier than the local entrepreneurs of developing countries and capture the overseas production. Thus, it is the IBM of USA that holds the Argentine and Mexican mainframe production. In addition to profit repatriation, huge money goes back home in the form of royalty, patent and trademark. The WTO efforts of making TRIPS operational, safeguards the interests of developed countries’ producers in this regard.

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5. The New Trade Theory• During 1970s, most economists argued that the increasing

cost or decreasing return assumption of traditional trade theories is questionable. Due to the economies of scale and learning effects, there should be increasing return or decreasing costs for higher level of output. For example, the Boeing spent $5 billion to develop its Boeing 777 jetliner. If the variable cost of production for labor, equipment and parts equal $80 million per aircraft, then selling 100 units would cost $130 million per aircraft and selling 500 would cost $90 million. Thus, average cost falls significantly with increased volume of production.

• If learning effect is taken under consideration, then variable cost goes down to further reduce the average cost. Learning effect is more effective in complex manufacturing products. Taking both under consideration, the Boeing can make $70 million per unit for 500 units of production compared to $130 million per unit for 100 units of production.

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5. Implication of new trade theory: • There is an important implication of the new trade

theory. The world market is too small for too many large firms with significant volume of production. The first mover takes the advantage so much that subsequent entrant finds it difficult to compete against the first movers. Thus Japan made a complementary role to Boeing and Airbus rather than competing with them.

• To facilitate the potential first mover, the respective government should come forward by extending different kinds of fiscal incentives and subsidies. This would increase the competitiveness of the respective firms and shift the marginal cost curve downward. Once being the first mover, the firm would generate abnormal profit, the profit would be repatriated home contributing to (i) increased purchasing power of the country, (ii) increased donation for social welfare and (iii) increased tax compensating the subsidies allowed earlier. Thus the country would be far more benefited than the subsidies issued earlier.

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FSC: Tax Break on Export• Introduction: Foreign Sales Corporation (FSC)

introduced in USA in 1971 as an income tax break for US exporters. Sales should be channeled through shell companies known as foreign sales corporation which are registered in offshore tax heaven like Bermuda.

• Beneficiaries: 6,000 US companies saved $3.5b of income taxes in 1998. Boeing saved $130 million, General Electric saved $150m.

• In 1998, European Union filed complaint with WTO claiming that FSC is an illegal export subsidy and was in clear violation of WTO rules.

• US arguments: ¤ EU follows similar tax waivers on export (EU claims

commodity tax rather than income tax). ¤ There was a “Gentle man’s agreement” that the entity

would not attack each other, which was broken. ¤ Internal matters of USA outside the jurisdiction of

trade policy.

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FSC: Tax Break on Export (Contd..)• WTO arbitration in 2000 agreed with EU that the tax

break was illegal and suggested USA to revise the tax code.

• In retaliation, USA not only retained the tax break, but also expanded the coverage costing the treasury $25b to compensate the EU rebate of VAT on export.

• EU threatened USA to introduce punitive tariffs worth $4 billion on US exports to the EU. This indicated the introduction of the biggest trade war of the world.

• In 2000, USA replaced it with a new system that offered up to $6 billion a year in tax breaks to large exporters such as Boeing and Microsoft.

• EU filed a brief with WTO seeking permission for $4 billion tariffs and WTO gave the permission in 2002.

• Current status: EU did not impose the sanction and USA indicated to change the offending law in future.

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5. National Competitive Advantage: Porter’s Diamond

Firm’s Strategy, structure, and

Rivalry

Factor Endowments

Demand Conditions

Related and Supporting Industries

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5. National Competitive Advantage:

Porter’s Diamond (Contd.)• Factor Endowments: Both basic factors (natural

resources, climate, location and demographics) and advanced factors (communication infrastructure, sophisticated and skilled labor, research facilities and technological know-how) play role. Example: Investment in education is the key to the outstanding success of South Korea which had the same per capita income of India during 1960s. Japan’s investment in engineers results in manufacturing sector development.

• Related and supporting industries: The benefits of investment in advanced factors of production by related and supporting industry can spill over into industry giving competitive advantage internationally. Technological leadership in the US semiconductor industry until mid 1980s provided the basis of US success in personal computers. Switzerland’s success in pharmaceuticals is the spill over effect of its previous success in the technologically related dye industry.

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5. National Competitive Advantage:

Porter’s Diamond (Contd.)• Demand Condition: Home demand play in upgrading

competitive advantage. Example: Japan’s sophisticated and knowledgeable buyers of camera contributed to the improvement of Japanese cameras’ product quality to international standard.

• Firm strategy, structure and rivalry: Different nations are characterized by different management ideologies which shape the building of national competitiveness. Porter notes the pre-dominance of engineers in top management in German and Japanese firms contributed to the improvement of manufacturing and designing. In contrast, US concentration of finance people in top management failed to contribute to product innovation. The domestic rivalry contributes to competitiveness as well. (Nokia in Finland: Case study)

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Lessons for Int’l Business