International Trade Theory

1
Chapter 3

• International Trade Theory

2
Mercantilism

• It argues that
• A nations wealth depends on accumulated
  treasure, usually, gold, silver, precious stones,
  metals, etc.
• To increase wealth, nations should increase
  exports and reduce imports.
• Trade surplus in gold and silver would make a
  nation wealthier.

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Mercantilism

• It relies on the fact that exports bring in
  money, so it is positive, and imports cause
  outflow of money, so it is negative.
• Today, there is still mercantilism in the form of
  economic nationalism.
• For example, Japan is called fortress of
  mercantilism. They have an impenetrable market
  with traditional preoccupation with
  self-sufficiency, and us against them
  mentality. There are no obvious trade barriers
  against foreign products, but have cultural
  barriers where Japanese dont buy foreign
  priducts.

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Theory of Absolute Advantage

• Absolute advantage is the capability of one
  nation to produce more of a good with the same
  amount of inputs than other countries.
• It means the nation is producing same amount of
  goods using fewer resources.
• A nation has an absolute advantage if it is
  producing a good better and more efficiently than
  other countries.
• This theory is developed by Adam Smith.

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Example
Before trade Specialization After trade
Commodity US Japan Total US Japan Total US Japan Total
Tons of rice 3 1 4 6 0 6 3 3 6
Cars 2 4 6 0 8 8 4 4 8
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Theory of Comparative Advantage

• If a country does not have an absolute advantage
  in producing neither of the goods, but it can
  produce one good more efficiently than the
  others, it is still beneficial if it trades.
• Comparative advantage arises when a country
  produces one good better and more efficiently
  than it is producing other goods.
• This theory is developed by David Ricardo.

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Example
Before trade Specialization After trade
Commodity US Japan Total US Japan Total US Japan Total
Tons of rice 6 3 9 12 0 12 6 6 12
Cars 5 4 9 0 8 8 4 4 8
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Theory of Factor Endowments

• It argues that countries export goods that
  contain the abundant factor of production in that
  country, and they import goods with large intake
  of scarce factor of production.
• If a factor of production is abundant, it means
  that it is less costly. So the good will have a
  lower price, thus it will be demanded by other
  countries.
• The thoery is developed by Hecksher-Ohlin.

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Leontief Paradox

• Wassily Leontief, in 1953, found that US is
  exporting labor-intensive products, while US is
  claiming that it is a capital-,ntensive country.

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Theory of International Product Life-Cycle

• It is a theory explaining why a product that
  begins as a nations export eventually becomes
  its import.
• This theory applies only to trade in manufactured
  goods.

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IPLC theory

• At the introductory stage, firms have invested
  and developed a product. They need rich and
  sophisticated customers to sell the products. So
  they target the customers in the developed
  countries. Also at the early stages, the product
  has to be close to the market, because the
  product is still at the developing stage.
  Management can quickly react to the customer
  feedback. At this stage exports increase, too.
• At the maturity stage, competitors fill the
  market, profits and sales are stabilized. Firms
  look for cheaper ways of producing the goods to
  lower the cost of production. Exports start
  declining.
• At decline stage, firms start producing in
  overseas markets. The product is imported from
  foreign markets.

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Economies of Scale and the Experience Curve

• Countries benefit from economies of scale that
  is, as plants get larger and more efficient
  equipment is used, per unit cost of production
  declines.
• Reasons for economies of scale
• Larger and more efficient equipment is used.
• Companies get volume discounts on purchases.
• FC allocated over larger volume of units.
• Learning curve as firms increase production,
  they learn ways of improving production
  technology and reduce cost of production.

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First Mover Theory

• This theory argues that firms that enter the
  market first (first movers) will dominate that
  market.
• As the first mover increases production and gains
  a large market share, it starts benefiting from
  economies of scale. The firms that enter the
  market after that cannot compete with the cost
  advantages of the first movers. 70 of the
  largest global firms are first movers.
• The new firms can dominate the market through
  technology and innovation. They either find a way
  of reducing costs and/or innovate a new product.

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Theory of Overlapping Demand

• This theory emphasizes demand factors in
  international trade. It is only applying to
  manufactured goods.
• Linder states that a nations per capita income
  level will determine what type of goods it will
  demand. International trade in manufactured goods
  will be more intense between the countries with
  similar per capita income levels, than between
  countries with dissimilar income levels. So there
  is overlapping demand between the goods that are
  traded, where consumers in both countries are
  demanding the same product.
• The intra-industry trade occurs because of
  product differentiation.

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Theory of Competitive Advantage of Nations

• Michael Porter argues that a firms ability to
  become global will depend on four factors.
• The place that provides those four factors is
  called a global platform.
• These four factors will have a determining impact
  on the ability of the lcoal firms to gain
  competitive advantage.

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Porters Diamond

• Demand conditions It is the nature of domestic
  demand. Sophisticated and demanding customers
  will force the firms to innovate and improve the
  quality of their products.
• Factor conditions It is the level and
  composition of factors of production.
• Basic factors are classical factors of
  production
• Advanced factors are improved factors of
  production like, educated workforce, free ports,
  advanced communication systems, infrastructure,
  etc.

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Porters Diamond

• Related and supporting industries Suppliers of
  industry and industry support services are
  important for competitive success by providing a
  network of suppliers, subcontractors, and a
  commercial infrastructure.
• Firms Strategy, structure, and rivalry It is
  the extend of domestic competition, the existence
  of barriers to entry, and the firms management
  style and and organization.

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Arguments for trade restrictions

• National defense argument
• Infant industry argument
• Protecting domestic jobs
• Retaliation

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National defense argument

• Certain industries must continue to exist for
  national defense purposes. They may not have any
  kind of advantage, but the country will rely on
  them in wartime.
• Counterargument?The army needs so many products.
  If the resources are used to produce all of them
  the economy will lose efficiency.

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Infant industry argument

• Infant industry needs protection from imports,
  until the labor force is trained, production
  techniques are mastered, and economies of scale
  is achieved. Without protection, the industry can
  not compete with low-cost imports.
• Counterargument?Without competition, the firm
  will never improve efficiency and quality.

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Protecting domestic jobs

• If imports flood the market and domestic
  industries close down, local jobs are lost and
  unemployment increases.
• Counterargument?Productivitiy of labor is higher
  in developed countries because of capital input.
  Also if we stop imports, other countries will
  stop our exports.

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Scientific tariff

• An import duty to equalize the price of imports
  to the prices of goods produced domestically.
• Rebuttal?The consumers will be penalized

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Retaliation

• Exporters in other countries may ask to stop
  imports from this country, if the country stops
  imports.

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Dumping

• It is selling a product abroad for less than
• the cost of production,
• the price in the home market, or
• the price to third countries.

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New kinds of dumping

1. Social dumping?unfair competition by developing
   countries that have lower labor costs and poorer
   working conditions.
2. Environmental dumping?unfair competition because
   of countrys relaxed environmental standards.
3. Financial services dumping?unfair competition
   because of countrys low capital/asset ratio.
4. Cultural dumping?unfair competition caused by
   cultural barriers aiding local firms.

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Subsidies

• They are financial contributions, provided
  directly or indirectly by the government, which
  provides benefits to the firm, like grants,
  preferential tax treatment, government assessment
  of business expenses, etc.

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Countervailing duties

• Additional import taxes levied on imports that
  have benefited from export subsidies.

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Other arguments for trade restrictions

• 1) There should be trade restrictions to permit
  diversification of domestic economy.
• 2) There should be trade restrictions to improve
  trade balance.

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KINDS OF TRADE RESTRICTIONS

• Tariff barriers
• Ad valorem duty
• Specific duty
• Compound duty
• Variable levy
• Non-tariff barriers (Quantitative barriers)
• Quotas
• Voluntary export restraints
• Orderly marketing arrangements
• Non-quantitative, non-tariff barriers
• Direct government participation in trade
• Customs and other administrative procedures
• Standards

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Tariff barriers

1. Ad valorem duty is levied as a percentage of the
   invoice value of the imported good.
2. Specific duty is a fixed sum levied on a physical
   unit of the imported good.
3. Compound duty is a combination of ad valorem and
   specific duties.
4. Variable levy is an import duty set at the
   difference between the world market prices and
   local government-supported prices.

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Quotas are numerical limits placed on specific
classes of imports

• It is absolute quotas if further imports are
  prohibited after the number for the year is
  reached.
• It is tariff-rate quotas if the imports have no
  duties (or low duties) up to an amount and then a
  tariff is levied for the rest.

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Quotas are

• global (applied to all imports), or
• allocated (certain numbers are allocated to
  certain countries).
• Allocated quotas are discriminatory in nature

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Voluntary export restraints

• They are export quotas imposed by the exporting
  nation.

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Orderly marketing arrangements

• They are formal agreements between exporting and
  importing countries that stipulate the import or
  export quotas each nation will have for a good.
  (Multi-fiber arrangement, eg)

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3) Non-quantitative, non-tariff barriers

• Direct government participation in trade
• Subsidy Financial contribution provided directly
  or indirectly by a government, which confers a
  benefit, like grants, preferential tax treatment,
  government assessment of business expenses, etc.
• Government procurement policies Government
  prefers domestic producers in purchases. (minimum
  local content law, eg)

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Lower duty for more local input

• Import duties are set in such a way to encourage
  local input. Semi-finished goods or intermediate
  goods may pay lower import duties, eg.

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b) Customs and other administrative procedures

• c) Standards

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Categories based on levels of economic development

• Developed nations are industrialized nations
  which are technically most developed.
• Developing nations are worlds lower-income
  countries which are less technically developed.
• Newly industrialized countries (NIC) are the four
  Asian Tigers and middle-income economies, like
  Brazil, Mexico, Malasia, Turkey, Chile, Thailand.
• Transition countries are the former communist
  countries, like Hungary, Russia, Kazakhstan, etc.
  

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World Bank classification

• Low-income countries where per-capita income is
  less than 750/year.
• Lower-middle income countries where per capita
  income is between 750-3000/year.
• Upper-middle income countries where per capita
  income is between 3000-9000/year.
• High-income countries where per capita income is
  above 9000/year.

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Problems of GNP per capita as an indicator

• Unregistered and underground economy are not
  reflected
• Income distribution is overlooked
• Purchasing power parity (PPP) is not shown

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Characteristics of less-developed countries

• GNP/capita less than 6000/year.
• Unequal distribution of income.
• Technological dualism.
• Regional dualism.
• High proportion of population in agricultural
  sector.
• Disguised unemployment.
• High population growth.
• High rate of illiteracy and insufficient
  educational facilities.
• Malnutrition and health problems.
• Political instability.
• Few export goods, generally agricultural goods
  and minerals.
• Difficult topography.
• Low saving rates and inadequate banking
  facilities.

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Human-Needs Approach

• It stresses that economic development is
  elimination of poverty and unemployment as well
  as an increase in income.
• Poverty is illiteracy, malnutrition, diseases,
  early deaths.
• Import substitution is locally producing the
  goods to replace imports. It is necessary for
  economic development in Human-needs Approach.

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Contemporary Theories of FDI

• Monopolistic Advantage Theory
• Product and Market Imperfections Theory
• International Product Life-Cycle Theory
• Follow the leader Theory
• Cross-Investment Theory
• Internationalization Theory
• Eclectic Theory of International Production

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1) Monopolistic Advantage Theory (by Hymer)

• FDI is made by the firms in oligopolistic
  industries posessing technical and other
  advantages over indigenous firms.

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2) Product and Market Imperfections Theory (by
Caves)

• Expanded Hymers work and added that superior
  knowledge permitted the investing firm to produce
  differentiated products that the consumers would
  prefer to similar locally made goods and thus
  would give the firm some control over the selling
  price and advantage over the indigenous firms.

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3) International Product Life-Cycle Theory (by
Vernon)

• To avoid losing a market, firms are forced to
  invest in overseas facilities to compete with
  cheap imports at home.

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4) Cross-Investment Theory (by Graham)

• Oligopolistic firms invest in eachothers home
  countries as a defense measure.

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5) Follow-the-leader Theory (by Knickerbocker)

• When the leader firm enters foreign markets,
  other firmws in the industry follow the leader.

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6) Internationalization Theory (by Aliber)

• If a firm obtains a highe rprice for its
  knowledge by using it than selling it, it will
  prefer FDI.

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7) Eclectic Theory of International Production
(by Dunning)

• The firm will invest overseas if it has three
  kinds of advantages
• a. Ownership specific?the extend to which
  tangible and intangible assets not available to
  other firms
• b. Internationalization?if it is the firms
  interest to use its ownership-specific advantages
  (internationalize) rather than license them to
  foreigners
• c. Location-specific?the firm will profit by
  locating its production facilities overseas