International trade theory
International trade theory
In this reading a number of international trade theories are explained to help the reader better understand why it is beneficial for a country to engage in international trade, and explains the patterns of international trade that is observed in the world economy. It is understood how the theories of Smith, Ricardo, and Heckscher-Ohlin all make strong cases for unrestricted free trade. In contrast, the mercantilist doctrine and, to a lesser extent, the new trade theory can be interpreted to support government intervention to promote exports through subsidies and to limit imports through tariffs and quotas.
In explain the pattern of international trade, the exception of mercantilism, which is silent on this issue, the different theories offer largely complementary explanation. Although no one theory may explain the apparent pattern of international trade, taken together, the theory of comparative advantage, the Heckscher-Ohlin theory, the product life-cycle theory, the new trade theory, and Porter’s theory of national competitive advantage do suggest which factors are important. Comparative advantage tells us that productivity differences are important: Heckscher-Ohlin tells us that factor endowment matter; the product life-cycle theory informs the reader that where a new product is introduced is important; the new trade theory inform the reader that increasing returns to specialization and first mover advantages matter; and Porter theory states that all these factors may be important in so far as they affect the four components of the national diamond.
International Trade is the exchange of capital, goods, and services across international borders of territories. In most countries, such trade represents a significant share of gross domestic product also known as GDP. While international trade has been present throughout much of history, its economic, social, and political importance has been on the rise in recent eras. People trade because they believe that they benefit from the exchange. They may need or want the goods or services. Industrialization advanced in technology transportation, globalization, multinational corporations, and out outsourcing are all having a major impact on the international trade system. Increasing international trade is crucial to the continuance of globalization. Without international trade, nations would be limited to the goods and services produced within their borders. International trade is, in principle, not different from domestic trade as the motivation and the behavior of parties involved in a trade do not change fundamentally regardless of whether trade is across a border or not.
The main difference is that international trade is typically more costly than domestic trade. The focus of this essay is to understand the different theories in international trade. First, the discussion of mercantilism, even though mercantilism is an old and largely discredited doctrine that method echoes remain in modern political debate and in the trade policies of many countries. Secondly, the absolute advantage theory by Adam Smith. Smith’s theory was the first to explain why unrestricted free trade is beneficial to a country.
Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizen can buy from another country, or what they produce and sell to another country. Smith argues that the “invisible hand” of the mechanism, rather than government policy, should determine what a country imports and what are exports. His arguments imply that such a laissez-faire stance toward trade was in the best interests of a country. Building on Smith’s work are two additional theories that we shall review. One is the theory of comparative advantage, advanced by the 19th century English economist David Ricardo. This theory is the intellectual basis of the modern argument for unrestricted free trade. As the 20th century approach, two Swedish economists, Eli Heckscher and Bertil Ohlin, who theory is known as the Heckscher- Ohlin Theory, refined Ricardo’s work.
The Benefits of Trade
The dominant strength of the theories by these economists was that they identify with precision the specific benefits of international trade. Common sense suggests that some international trade is beneficial. For example, nobody would suggest America produce their own oil, due to lack of resources. America could benefit from trade by exchanging some of the products it can produce at a low cost wheat for some products in cannot produce at all oil. Thus by engaging in international trade, China gains wheat and America gains oil.
The theories of Smith, Ricardo, and Heckscher-Ohlin go beyond this common sense notion, however, to show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. This is a difficult concept for people to grasp. For example many people in the United States believe that American consumers should buy products produced in the United States by American companies whenever possible to help save American jobs from foreign competition. The same kind of nationalistic sentiments can be observed in many other countries.
However, the theories of the economists give an understanding that a country’s 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 specialize in the manufacture and export of products that can be produced most efficiently in that country, while importing products that be produced more efficient in other countries. The economic argument is often difficult for segments of a country’s population to accept. With their future threatened by imports, American textile companies and their employees have tried to persuade the U.S. government to limit the importation of textiles by demanding quotas and tariffs.
The Pattern of International Trade
The theories of Smith, Ricardo, and Heckscher-Ohlin also help to explain the pattern of international trade that we observe in the world economy. Some aspects of the patterns are east to understand. Climate and natural resources endowments explain why certain countries export certain products. For example, Ghana exports cocoa, Brazil exports coffee, Saudi Arabia exports oil, and China exports catfish. David Ricardo’s theory of comparative advantage offers an explanation in terms of international differences in labor productivity. The more sophisticated 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 proportion in which they are needed for producing particular goods.
One early response to the failure of the Heckscher-Ohlin theory to explain the observed pattern of international trade was the product life-cycle theory. Proposed by Raymond Vernon, this theory suggested 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. By the 1980s, Paul Krugman an economist from Massachusetts Institute of Technology (MIT) developed the revolutionary theory of trade known as the new trade theory. New trade theory stresses that in some cases countries specialize in the production and export of particular product not because of essential differences in factor endowment, but because in certain industries the world market can support only limited number of firms
The main theory of mercantilism was that it was in a country’s best interests to maintain a trade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and consequently, increase its national wealth and prestige. Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. The mercantilists saw no virtue in “large volume of trade.” Rather, the recommended policies to maximize exports and minimize imports. To achieve this imports, were limited by tariffs and quotas, while exports were subsidized. Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop an economic theory. This theory stated that a country’s wealth was determined by the amount of its gold and silver holdings. In its simplest sense, mercantilists believed that a country should increase its holdings of gold and silver by promoting exports and discouraging imports. In other words, if people in other countries buy more from you (exports) than they sell to you (imports), then they have to pay you the difference in gold and silver.
The objective of each country was to have a trade surplus, or a situation where the value of exports are greater than the value of imports, and to avoid a trade deficit, or a situation where the value of imports is greater than the value of exports. A closer look at world history from the 1500s to the late 1800s helps explain why mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers wanted to strengthen their nations by building larger armies and national institutions. By increasing exports and trade, these rulers were able to amass more gold and wealth for their countries. One way that many of these new nations promoted exports was to impose restrictions on imports. This strategy is called protectionism and is still used today. Nations expanded their wealth by using their colonies around the world in an effort to control more trade and amass more riches. The British colonial empire was one of the more successful examples; it sought to increase its wealth by using raw materials from places ranging from what are now the Americas and India. France, the Netherlands, Portugal, and Spain were also successful in building large colonial empires that generated extensive wealth for their governing nations.
Although mercantilism is one of the oldest trade theories, it remains part of modern thinking. Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor exports and discourage imports through a form of neo-mercantilism in which the countries promote a combination of protectionist policies and restrictions and domestic-industry subsidies. Nearly every country, at one point or another, has implemented some form of protectionist policy to guard key industries in its economy. While export-oriented companies usually support protectionist policies that favor their industries or firms, other companies and consumers are hurt by protectionism.
Taxpayers pay for government subsidies of select exports in the form of higher taxes. Import restrictions lead to higher prices for consumers, who pay more for foreign-made goods or services. Free-trade advocates highlight how free trade benefits all members of the global community, while mercantilism’s protectionist policies only benefit select industries, at the expense of both consumers and other companies, within and outside of the industry. 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.) 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, or a situation in which all countries can benefit. The mercantilist doctrine is by no means dead.
In 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth of Nations. Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation. Smith attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently. Smith reasoned that trade between countries shouldn’t be regulated or restricted by government policy or intervention. He stated that trade should flow naturally according to market forces. Hypothetically, say two-country world, if Country A could produce a good cheaper or faster (or both) than Country B, then Country A had the advantage and could focus on specializing on producing that good. Similarly, if Country B was better at producing another good, it could focus on specialization as well. By specialization, countries would generate efficiencies, because their labor force would become more skilled by doing the same tasks. Production would also become more efficient, because there would be an incentive to create faster and better production methods to increase the specialization. The absolute advantage occurs 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 then trade these for goods produced by other countries. In Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t be judged by how much gold and silver it had but rather by the living standards of its people. Smith’s basic argument therefore, is that a country should never produce goods at home that it can buy at a lower cost from other countries. According to Smith, by specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade.
The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas. In contrast, another country may not have any useful absolute advantages. To answer this challenge, David Ricardo, an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned that even if Country A had the absolute advantage in the production of both products, specialization and trade could still occur between two countries. Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, it can produce that product better and more efficiently than it does other goods. The difference between these two theories is subtle. Comparative advantage focuses on the relative productivity differences, whereas absolute advantage looks at the absolute productivity. Let’s look at a simplified hypothetical example to illustrate the subtle difference between these principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal services. It turns out that Miranda can also type faster than the administrative assistants in her office, who are paid $40 per hour.
Even though Miranda clearly has the absolute advantage in both skill sets, should she do both jobs? No. For every hour Miranda decides to type instead of do legal work, she would be giving up $460 in income. Her productivity and income will be highest if she specializes in the higher-paid legal services and hires the most qualified administrative assistant, who can type fast, although a little slower than Miranda. By having both Miranda and her assistant concentrate on their respective tasks, their overall productivity as a team is higher. This is comparative advantage. A person or a country will specialize in doing what they do relatively better. In reality, the world economy is more complex and consists of more than two countries and products. Barriers to trade may exist, and goods must be transported, stored, and distributed. However, this simplistic example demonstrates the basis of the comparative advantage theory.
Heckscher-Ohlin Theory (Factor Proportions Theory)
The theories of Smith and Ricardo didn’t help countries determine which products would give a country an advantage. Both theories assumed that free and open markets would lead countries and producers to determine which goods they could produce more efficiently. In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a country could gain comparative advantage by producing products that utilized factors that were in abundance in the country. Their theory is based on a country’s production factors—land, labor, and capital, which provide the funds for investment in plants and equipment. They determined that the cost of any factor or resource was a function of supply and demand. Factors that were in great supply relative to demand would be cheaper; factors in great demand relative to supply would be more expensive.
Their theory, also called the factor proportions theory, stated that countries would produce and export goods that required resources or factors that were in great supply and, therefore, cheaper production factors. In contrast, countries would import goods that required resources that were in short supply, but higher demand. For example, China and India are home to cheap, large pools of labor. Hence these countries have become the optimal locations for labor-intensive industries like textiles and garments.
In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US economy closely and noted that the United States was abundant in capital and, therefore, should export more capital-intensive goods. However, his research using actual data showed the opposite: the United States was importing more capital-intensive goods. According to the factor proportions theory, the United States should have been importing labor-intensive goods, but instead it was actually exporting them. His analysis became known as the Leontief Paradox because it was the reverse of what was expected by the factor proportions theory. In subsequent years, economists have noted historically at that point in time, labor in the United States was both available in steady supply and more productive than in many other countries; hence it made sense to export labor-intensive goods.
Over the decades, many economists have used theories and data to explain and minimize the impact of the paradox. However, for what remains clear is that international trade is a complex and has impacted numerous and often-changing factors. Trade cannot be explained neatly by one single theory, and more importantly, our understanding of international trade theories continues to evolve. Product Life Cycle Theory
Raymond Vernon, a Harvard Business School professor, developed the product life cycle theory in the 1960s. The theory, originating in the field of marketing, stated that a product life cycle has three distinct stages: (1) new product, (2) the growth of the product (3)maturing product (4) the decline in the product. The theory assumed that production of the new product will occur completely in the home country of its innovation. In the 1960s this was a useful theory to explain the manufacturing success of the United States. US manufacturing was the globally dominant producer in many industries after World War II. It has also been used to describe how the personal computer (PC) went through its product cycle. The PC was a new product in the 1970s and developed into a mature product during the 1980s and 1990s.
Today, the PC is in the standardized product stage, and the majority of manufacturing and production process is done in low-cost countries in Asia and Mexico. The product life cycle theory has been less able to explain current trade patterns where innovation and manufacturing occur around the world. For example, global companies even conduct research and development in developing markets where highly skilled labor and facilities are usually cheaper. Even though research and development is typically associated with the first or new product stage and therefore completed in the home country, these developing or emerging-market countries, such as India and China, offer both highly skilled labor and new research facilities at a substantial cost advantage for global firms.
Global Strategic Rivalry Theory
Global strategic rivalry theory emerged in the 1980s and was based on the work of economists Paul Krugman and Kelvin Lancaster. Their theory focused on MNCs and their efforts to gain a competitive advantage against other global firms in their industry. Firms will encounter global competition in their industries and in order to prosper, they must develop competitive advantages. The critical ways that firms can obtain a sustainable competitive advantage are called the barriers to entry for that industry. The barriers to entry refer to the obstacles a new firm may face when trying to enter into an industry or new market. The barriers to entry that corporations may seek to optimize include: research and development, the ownership of intellectual property rights, economies of scale, unique business processes or methods as well as extensive experience in the industry, and the control of resources or favorable access to raw materials.
Porter’s National Competitive Advantage Theory
In the continuing evolution of international trade theories, Michael Porter of Harvard Business School developed a new model to explain national competitive advantage in 1990. Porter’s theory stated that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade. His theory focused on explaining why some nations are more competitive in certain industries. To explain his theory, Porter identified four determinants that he linked together. The four determinants are (1) local market resources and capabilities, (2) local market demand conditions, (3) local suppliers and complementary industries, and (4) local firm characteristics. Factor Conditions). Porter recognized the value of the factor proportions theory, which considers a nation’s resources (e.g., natural resources and available labor) as key factors in determining what products a country will import or export. Porter added to these basic factors a new list of advanced factors, which he defined as skilled labor, investments in education, technology, and infrastructure. He perceived these advanced factors as providing a country with a sustainable competitive advantage.
Demand conditions. Porter believed that a sophisticated home market is critical to ensuring ongoing innovation, thereby creating a sustainable competitive advantage. Companies whose domestic markets are sophisticated, trendsetting, and demanding forces continuous innovation and the development of new products and technologies. Many sources credit the demanding US consumer with forcing US software companies to continuously innovate, thus creating a sustainable competitive advantage in software products and services. Related and Supporting industries. To remain competitive, large global firms benefit from having strong, efficient supporting and related industries to provide the inputs required by the industry. Certain industries cluster geographically, which provides efficiencies and productivity.
Local firm characteristics. Local firm characteristics include firm strategy, industry structure, and industry rivalry. Local strategy affects a firm’s competitiveness. A healthy level of rivalry between local firms will spur innovation and competitiveness. In addition to the four determinants of the diamond, Porter also noted that government and chance play a part in the national competitiveness of industries. Governments can, by their actions and policies, increase the competitiveness of firms and occasionally entire industries. Porter’s theory, along with the other modern, firm-based theories, offers an interesting interpretation of international trade trends. Nevertheless, they remain relatively new and minimally tested theories.
Today’s Dominate International Trade Theory
The theories covered in this reading explain the evolution of the international trade theory. While they have helped economists, governments, and businesses better understand international trade and how to promote, regulate, and manage it, these theories are occasionally contradicted by real-world events. Countries don’t have absolute advantages in many areas of production or services and, in fact, the factors of production aren’t neatly distributed between countries. Some countries have a disproportionate benefit of some factors. The United States has ample arable land that can be used for a wide range of agricultural products. It also has extensive access to capital. While it’s labor pool may not be the cheapest, it is among the best educated in the world. These advantages in the factors of production have helped the United States become the largest and richest economy in the world.
Nevertheless, the United States also imports a vast amount of goods and services, as US consumers use their wealth to purchase what they need and want—much of which is now manufactured in other countries that have sought to create their own comparative advantages through cheap labor, land, or production costs. As a result, it’s not clear that any one theory is dominant around the world. This section has sought to highlight the basics of international trade theory to enable you to understand the realities that face global businesses. In practice, governments and companies use a combination of these theories to both interpret trends and develop strategy. Just as these theories have evolved over the past five hundred years, they will continue to change and adapt as new factors impact international trade.