The Theory of Trade

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Chapter 5

• The Theory of Trade
• and Investment

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Global Outsourcing Comparative Advantage Today

• Comparative advantage is still a relevant theory
  to explain why particular countries export more
  services that support the global supply chain of
  both MNEs and domestic firms.
• The comparative advantage of the 21st century,
  however, is based more on services and their
  cross-border facilitation by telecommunications
  and the Internet.

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Global Outsourcing Comparative Advantage Today

• The source of a nation's comparative advantage,
  however, is created from the mixture of its own
  factors of production
• labor skills,
• access to capital,
• land, and
• technology.

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Global Outsourcing Comparative Advantage Today

• For example, India has developed a highly
  efficient and low-cost software industry.
• This industry supplies not only the creation of
  custom software, but also call centers for
  customer support, and other information
  technology services.
• The Indian software industry is composed of both
  subsidiaries of MNEs and independent companies.

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Global Outsourcing Comparative Advantage Today
- 1

• If you own a HP computer and call the customer
  support center number for help, you are likely to
  reach a call center in India. Dell recently
  changed from this practice. Why? Its cheaper
  than using US people.
• Answering your call will be a knowledgeable
  Indian software engineer or programmer who will
  "walk" you through your problem.

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Global Outsourcing Comparative Advantage Today
- 2

• India has a large number of well-educated,
  English-speaking, technical experts who are paid
  only a fraction of the salary and overhead earned
  by their U.S. counterparts.
• Why does India have a large number of
  English-speaking people?

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Global Outsourcing Comparative Advantage Today

• By the way, this large number of English-speaking
  people will be the key to Indias prosperity in
  the 21st century.
• The overcapacity and low cost of international
  telecommunication networks today further enhances
  the comparative advantage of an Indian location.

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Global Outsourcing Comparative Advantage Today

• The extent of global outsourcing is already
  reaching out to every corner of the globe.

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Global Outsourcing Comparative Advantage Today

• From financial back-offices in Manila, to
  information technology engineers in Hungary,
  modern telecommunications now take business
  activities to labor, rather than labor migrating
  to the places of business.

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Evolution of Trade Theory

• The Age of Mercantilism
• Classical Trade Theory
• Factor Proportions Trade Theory
• International Investment and Product Cycle Theory
• The New Trade Theory Strategic Trade
• The Theory of International Investment

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The Age of MercantilismSee next slide.

• The evolution of trade into the form we see today
  reflects three events

The Collapse of Feudal Society, which met all its
needs internally.
The Emergence of the Mercantilist Philosophy.
The Life Cycle of the Colonial Systems of
the European Nation-States.
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Mercantilism

• Mixed exchange through trade with accumulation of
  wealth
• Sell a lot buy a little. Thus you accumulate
  gold silver.
• What is wrong with this idea?
• Business conducted under authority of government
• Demise of mercantilism inevitable
• Explain win-lose

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Classical Trade Theory

• The Theory of Absolute Advantage
• The ability of a country to produce a product at
  lower cost (inputs) than another country due to
  climate, soil, access to trade routes, etc.
  (Ghana chocolate)
• The Theory of Comparative Advantage
• The idea that although a country may produce both
  products more cheaply than another country, it is
  relatively better at producing one product than
  the other

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Classical Trade Theory Contributions

• Adam SmithDivision of Labor
• In the pre-industrialization society, each worker
  preformed all stages of making a product.
• The factories of the industrialized age were
  separating the production process into distinct
  stages, which would be performed by one
  individual the division of labor.
• Used lower-skilled, lower-cost labor.

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Classical Trade Theory Contributions

• This specialization increased the production of
  workers industries.
• Talk about Samuel Colt manufacturing his pistols
  and how British gun smiths objected to the colt
  methods being transformed to GB.

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Classical Trade Theory Contributions

• David RicardoComparative Advantage
• Even if a country had an absolute advantage in
  two or more products, it is probably more
  efficient in one product than the others.
• So countries can benefit from trading goods for
  which they have a comparative advantage over the
  other.

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Classical Trade Theory Contributions

• Gains From Trade
• A nation can achieve greater consumption levels
  beyond what it could produce by itself (feudal
  system).
• If the country trades products for which it has a
  comparative advantage with another country whose
  comparative advantage is in a different product.

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Classical Trade Theory Contributions

• France produces beer, wine, and cloth.
• GB produces beer, a little wine, and cloth.
• France has a comparative advantage in wine.
• GB has a comparative advantage in beer and cloth.
• GB should drink French wine, and France should
  drink British beer and use British cloth.
• Thus British and French citizens get the best
  goods at the cheapest price.

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Factor Proportions Trade Theory
Developed by Eli Heckscher
Expanded by Bertil Ohlin
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Factor Proportions Trade TheoryConsiders Two
Factors of Production

• Labor
• Capital

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Factor Proportions Trade Theory

• A country that is relatively labor abundant
  (or capital abundant) should specialize in the
  production and export of that product which is
  relatively labor intensive (or capital
  intensive).
• Examples?

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Factor Proportions Trade Theory

• What are Factors of Production other than capital
  and labor (supply)?

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Factor Proportions Trade Theory

• Access to shipping ports
• Weather
• Available arable land for farming or ranching.

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Factor Proportions Trade Theory

• All these help explain why certain countries
  export and import the goods and services they
  sell and purchase.
• For example
• Why does Saudi Arabia purchase food and sell oil?
  
• Why does China purchase raw cotton and sell
  clothes?
• OK, what about Switzerland?

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Factor Proportions Trade Theory

• How about this
• The US is capital intensive and does not have a
  large population.
• Yet one of its biggest exports is agricultural
  products.
• How does that fit in the Factor Proportions Trade
  Theory?

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Product Cycle Theory

• Raymond Vernon
• Focus on the product, not its factor proportions
• Two technology-based premises

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Product Cycle TheoryVernons Premises

• Technical innovations leading to new and
  profitable products require large quantities of
  capital and skilled labor.
• The product and the methods for manufacture go
  through three stages to maturity.

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Stages of the Product Cycle
The New Product The Maturing Product The
Standardized Product
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The Product Cycle and Trade Implications

• Increased emphasis on technologys impact on
  product cost.
• Explained international investment.
• Limitations
• Most appropriate for technology-based products
• Some products not easily characterized by stages
  of maturity
• Most relevant to products produced through mass
  production.

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The Product Cycle and Trade Implications

• Explain the Xerox copier
• Invented in the US sold _at_ a high price
• Exported to highly industrialized countries
• Manufacturing moved to Japan and Europe for those
  markets as product became more standardized
• Manufacturing moved to cheaper locals as newer
  manufacturers entered the market
• Cheaper models now imported into the US.

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The New Trade Theory Strategic Trade

• Two New Contributions
• Paul Krugman-How trade is altered when markets
  are not perfectly competitive or when production
  of specific products possesses economies of
  scale.
• Michael Porter-Examined competitiveness of
  industries on a global basis.

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Strategic Trade

• Krugmans Economics of Scale

Internal Economies of Scale
External Economies of Scale
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Internal Economies of Scale

• When the per unit cost of manufacturing depends
  on the size of the individual firms output, the
  larger the firm the greater the scale of
  manufacturing benefits.
• A firm with internal economies of scale could
  potentially monopolize an industry creating an
  imperfect the market.

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Internal Economies of Scale

• If it produces more, lowering the cost per unit,
  it can lower the market price.
• It can, therefore, sell more products because it
  SETS the market price.
• It looks like we are talking about lowering the
  price we pay for certain products.
• So what is wrong with this?

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Internal Economies of Scale

• The link between dominating an industry and
  influencing international trade comes from taking
  the assumption of imperfect markets back to the
  original concept of competitive advantage.

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Internal Economies of Scale

• For the firm to expand sufficiently to enjoy its
  economies of scale, it must take resources away
  from other domestic industries in order to
  expend. What is wrong with that thought?
• A country then sees its own range of products in
  which it specializes narrowing,
• This provides an opportunity for other countries
  in these so called abandoned product ranges.

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External Economies of Scale

• When the cost per unit of output depends on the
  size of an industry, not the size of the
  individual firm, the industry of that country may
  produce at lower costs than the same industry
  that is smaller in size in other countries.

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External Economies of Scale

• A country can potentially dominate world markets
  in a particular product, not because it has one
  massive firm producing enormous quantities (for
  example, Intel or Microsoft),
• But rather because it has many small firms that
  interact to create a large, competitive, critical
  mass (for example, semiconductors in Penang,
  Malaysia, Japanese auto industry).

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External Economies of Scale

• No single firm need be all that large, but
  several small firms in total may create such a
  competitive industry that firms in other
  countries cannot ever break into the industry on
  a competitive basis.

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External Economies of Scale

• Unlike internal economies of scale, external
  economies of scale may not necessarily lead to
  imperfect markets.
• But they may result in an industry maintaining
  its dominance in its field in world markets.

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External Economies of Scale

• This provides an explanation as to why all
  industries do not necessarily always move to the
  country with the lowest-cost energy, resources,
  or labor.
• What gives rise to this critical mass of small
  firms and their inter-relationships is a much
  more complex question.

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Take a Stand

• Many MNCs are following a very similar strategy
  of moving their manufacturing facilities out of
  large, industrialized countries like the U. S.,
  Germany, and the UK, and relocating them to
  countries in which labor is much cheaper, such as
  mainland China.

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Take a Stand

• However, this is very controversial given slow
  economic growth and growing unemployment in the
  industrial countries.

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Take a Stand

• According to most theories of international
  trade, once the technology of an industry has
  matured and countries have deregulated their
  economies sufficiently to allow capital to flow
  across borders relatively freely firms in
  industries that can use lower-cost labor-assuming
  sufficient skills are available-should move their
  manufacturing to those lower-labor-cost
  countries.

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Take a Stand

• The competitive strategy argument is that if one
  firm does not relocate to countries where it can
  reduce its costs, and another does, the first
  will be unable to compete in the future.

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Take a Stand

• For Discussion
• MNCs should not continue to move their
  manufacturing out of industrial countries.

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Take a Stand

• They are
• Contributing to rising unemployment
• Undermining the economies of countries like the
  U. S. and Germany, and are
• Simply serving as devices to exploit cheap labor
  in developing countries.
• Discuss.

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Take a Stand

• Why does using cheap labor constitute
  exploiting cheap labor in developing
  countries?
• My students comments about maquiladoras.
• Sweat shops in El Salvador.

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Take a Stand

• Governments are capable of protecting their
  citizens from exploitation by foreign firms.

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Take a Stand

• 2. MNCs must continue to take whatever actions
  are necessary, including moving manufacturing to
  lower-cost countries, to remain competitive.

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Take a Stand

• The people, the workers, and the economies of
  countries like the U. S. and Germany cannot
  artificially protect their economies from global
  competition it would only serve to create
  countries of lesser and lesser competitiveness in
  the coming years.
• Discuss.

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• The end of chapter 5.