ISG investment theory chapter 1

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ISG BBA PROGRAM Fall semester
BUS 450 European Business
LECTURE 6 Chapter 4 European International
Trade Theory - Part 1
Tuesday, November 7th 2006
Guillaume Sarrat de Tramezaigues
www.gstblog.com
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Content

• Overview of trade theory
• Mercantilism
• Absolute advantage
• Comparative advantage
• Chapter 5
• Heckscher-Ohlin Theory
• The product life cycle theory
• New trade theory
• Implications for european businesses

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An overview of trade theory

• The benefits of trade
• The great strength of the theories of Smith,
  Ricardo and Hechscher-Ohlin is that they identify
  with precision the specific benefits of
  international trade.
• They show why it is beneficial for a country to
  engage in international trade even for products
  it is able to produce for itself.

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An overview of trade theory

• The benefits of trade
• A countrys economy may gain if its citizens buy
  certain products from other nations that could be
  produced at home.
• The gains arise because international trade
  allows a country to specialise in the manufacture
  and export of products that can be produced most
  efficiently in that country, while importing
  products that can be produced more efficiently in
  other countries.

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An overview of trade theory

• The benefits of trade
• It is however an argument that is difficult for
  segments of a countrys population to accept.
• By limiting specific imports, the economy as a
  whole is hurt. Limits on imports are often in the
  interests of domestic producers, but not domestic
  consumers.

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An overview of trade theory

• The pattern of international trade
• Climate and natural-resource endowments partly
  explain the pattern of international trade.
• David Ricardo explains the other part through his
  theory of comparative advantage in terms of
  international differences in labor productivity.

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An overview of trade theory

• The pattern of international trade
• The Heckscher-Ohlin theory emphasizes the
  interplay between the proportions in which the
  factors of production (such as land, labor and
  capital) are available in different countries and
  the proportions in which they are needed for
  producing particular goods.
• This explanation rests on the assumption that
  countries have varying endowments of the various
  factors of production.

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An overview of trade theory

• The pattern of international trade
• As The Heckscher-Ohlin theory proved to be
  limited, an early reponse to this was the Product
  Life Cycle theory of Paul Vernon.
• It suggests that early in their life cycle, most
  new products are produced in and exported from
  the country in which they were developed. As a
  new product becomes widely accepted
  internationally, however, production starts in
  other countries.

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An overview of trade theory

• The pattern of international trade
• As a result, the theory suggests , the product
  may ultimately be exported back to the country of
  its original innovation.
• In the 80s, Paul Krugman developed the New Trade
  Theory. It stresses that in some cases countries
  specialise in the production and export of
  particular products not because of underlying
  differences in factor endowments, but because in
  certain industries the world market can support
  ...

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An overview of trade theory

• The pattern of international trade
• only a limited number of firms. In such
  industries, firms that enter the market first
  build a competitive advantage that is
  subsequently difficult to challenge. Thus, the
  observed pattern of trade between nations may be
  due in part to the ability of firms within a
  given nation to capture first-mover advantages.

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An overview of trade theory

• The pattern of international trade
• Michael Porter developed the Theory of National
  Competitive Advantage. He points out the
  importance of country factor such as domestic
  demand and domestic rivalry in explaining a
  nations dominance in the productionand export of
  particular products.

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An overview of trade theory

• Trade theory and government policy
• All these theories agree that international trade
  is beneficial to a country, they lack agreement
  in their recommendations for government policy.
  Mercantilism makes a crude case for government
  involvement in promoting exports and limiting
  imports. All the previous theories form part of
  the case for unrestricted free trade the
  argument being that both imports controls and
  export incentives are self-defeating and result
  in wasted resources.

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Mercantilism
The first theory of international trade emerged
in England in the mid-16th century and is
referred to as mercantilism. Its principal
assertion was that gold and silver were the
mainstays of national wealth and essential to
vigorous commerce. The main tenet of mercantilism
was that it was in a countrys best interests to
maintain a trade surplus, to export more than it
imported.
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Mercantilism
By doing so, a country would accumulate gold and
silver and, consequently, increase its national
wealth, prestige, and power. Consistent with
this belief, the mercantilist doctrine advocated
government intervention to achieve a surplus in
the balance of trade. There was no virtue in a
large volume of trade rather, it recommended
policies to maximise exports and minimise
imports. To achieve this, imports were limited by
tariffs and quotas, while exports were subsidised.
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Mercantilism
David Hume pointed out an inherent inconsistency
in the mercantilist doctrine in 1752 if England
had a balance of trade surplus with France, the
resulting inflow of gold and silver would swell
the domestic money suply and generate inflation
in England (Spain and gold rush of the Colomb
era). In France, however, the outflow of gold and
silver would have the opposite effect. Frances
money supply would contract, and its prices would
fall.
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Mercantilism
This change in relative prices between France and
England would encourage the French to buy fewer
English goods and the English to buy more French
goods. The result would be a deterioration in the
English balance of trade and an improvement in
Frances trade balance, until the English surplus
was eliminated. Hence, according to Hume, in the
long run no country could sustain a surplus in
the balance of trade and so accumulate gold and
silver as the mercantilists had envisaged.
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Mercantilism
The flaw with mercantilism was that it viewed
trade as a zero-sum game. A zero-sum game is one
in which a gain by one country results in a loss
by another. Adam Smith and David Ricardo have
shown the shortsightedness of this approach and
demonstrated that trade is a positive-sum game. A
positive-sum game is a situation in which all
countries can benefit.
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Mercantilism
The mercantilist doctrine is by no means dead
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Absolute advantage
In his 1776 landmark book The Wealth of Nations,
Adam Smith attacked the mercantilist assumption
that trade is a zero-sum game. A country has an
absolute advantage in the production of a product
when it is more efficient than any other country
in producing it countries should therefore
specialise in the production of goods for which
they have an absolute advantage and then trade
these for goods produced by othe rcountries.
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Absolute advantage
Thus, trade is a positive-sum game it produces
net gains for all involved
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Comparative advantage
David Ricardo took Adam Smiths theory one step
further by exploring what might happen when one
country has an absolute advantage in the
production of all goods. Smiths theory of
absolute advantage suggests that such a country
might derive no benefits from international
trade Ricardo showed that it was not the case.
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Comparative advantage
According to Ricardos theory of comparative
advantage, it makes sense for a country to
specialise 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.
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Comparative advantage

• Qualifications and assumptions
• Ricardos model remain rather bold and includes
  many unrealistic assumptions
• Only two countries and two goods
• Transportation costs between countries
• Free movements of resources
• Differences in prices

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Comparative advantage

• Qualifications and assumptions
• Constant returns to scale resources
• Fixed stock of resources
• Income distribution

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Comparative advantage

• Qualifications and assumptions
• Given these assumptions, can the conclusion that
  free trade is mutually beneficial be extended to
  the real world of many countries, many goods,
  positive transportation costs, volatile exchange
  rates, immobile domestic resources, nonconstant
  returns to specialisation, and dynamic changes?

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Comparative advantage

• Qualifications and assumptions
• The theory remains despite of its limits but
  extensions of the ricardian model have been
  performed.

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Comparative advantage

• Extensions of the Ricardian Model
• Three of the assumptions revisited
• Immobile resources
• Diminishing returns
• Dynamic effects and economic growth
• And the Samuelson critique
• ? Free trade area between a rich and a poor
  country lower prices may not make up for the
  wage losses

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Comparative advantage

• Extensions of the Ricardian Model
• Evidence for the link between trade and growth
• As predicted by the standard theory of
  comparative advantage, countries that adopt a
  more open stance toward international trade enjoy
  higher growth rates than those that close their
  economies to trade.

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Comparative advantage

• Extensions of the Ricardian Model
• Evidence for the link between trade and growth
• Jeffrey Sachs and Andrew Warner have created a
  mesure of how open to international trade an
  economy was and then looked at the relationship
  between openness and economic growth the link
  has been clearly demonstrated.

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Comparative advantage

• Extensions of the Ricardian Model
• Evidence for the link between trade and growth
• Wacziarg and Welch updated the Sachs and Warner
  data through the late 90s.
• According to their findings, countries that
  liberalised their trade regimes experienced, on
  average, increases in their annual growth rates
  of 1,5 compared to preliberalisation times.

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Comparative advantage

• Extensions of the Ricardian Model
• Evidence for the link between trade and growth
• The message of this study is clear Adopt an open
  economy and embrace free trade, and over time
  your nation will be rewarded with higher economic
  growth rates. Higher growth will raise income
  levels and living standards.
• This last point has been confirmed by a study
  that looked at the relationship between trade and
  growth in incomes.

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Comparative advantage

• Extensions of the Ricardian Model
• Evidence for the link between trade and growth
• The study, undertaken by Jeffrey Frankel and
  David Romer, found that on average,
• A one percent point increase in the ratio of
  a countrys trade to its GDP increases income per
  person by at least 0,5.
• This would be the final confirmation of David
  Ricardos theory being correct.

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Next week
Lecture 7 Chapter 5 European-International
Theory Part 2