3. International Trade and International Economics
LECTURE 1
“Trade is always political” Robert Kuttner
“In the absence of a world government, cross border trade is always subject to rules that
must be politically negotiated among nations that are sovereign in their own realm but not
outside their borders” Robert Kuttner
Between 1960 to 1995 world trade increased from a total of $629 billion to more than $5
trillion (both figures in constant 1995 dollars)
Three directions pulling the issue of TRADE-reflecting the three main schools of thought in
International Economics
1) a large consensus that a liberal international trading system is desirable
2)Within that liberal consensus..individual nation states try to pursue mercantilist
policies of tariff based protectionism for certain industries.
3)This can result in direct subsidies and various other forms of direct state aid to
certain activities (structuralist)
Historic progression of ideas related to Trade
16th-18th Centuries-mercantilism- pursuit by European powers of trade surpluses..a
close connection seen between trading power, military might, and international prestige.
Exemplified by the Spanish Empire-its conquest of South America-the pursuit of Gold and
Silver
Adam Smith proposed a distinctly liberal theory
of trade ,in direct reaction to the abuses of
mercantilism.
Generally saw trade as a mechanism to assist
nations in the process of specialization and
exchangeà increased global wealth and
prosperity
DAVID RICARDO 1772-1823
Ricardo developed and refined Smith’s views on International Trade…his work on the LAW
OF COMPARITIVE ADVANTAGE demonstrated that free trade increased efficiency and had
the potential to make all better off.
Furthermore demonstrated that even if a nation possessed an ABSOLUTE advantage in the
production of certain goods, it would still be better off if it concentrated its efforts upon the
activity in which it possessed the GREATEST COMPARITIVE ADVANTAGE
This is because RICARDO introduced the important concept of OPPORTUNITY COST into
the debate, namely trade should occur because nations need to consider not only what it
costs them to produce something,but must also consider WHAT OPPORTUNITY THEY
FOREGO IN PRODUCING THAT PRODUCT.
E.G. Perhaps it is possible for the USA to produce all it needs…but is it better for it, and world
trade, for it to concentrate upon the activities at which it has the GREATEST COMPARITIVE
ADVANTAGE.Permitting less advantaged nations to produce those things in which they
experience the LEAST COMPARITIVE DISAVANTAGE
However the dominance of LIBERAL attitudes to FREE TRADE were being challenged as the
19th Century progressed by Alexander Hamilton and Friedrich List
Both saw the dominance of the FREE TRADE concept as being no more than an academic
justification for England to maintain its dominant advantage over its trading partners.
Hamilton argued that US infant industries and national independence and security required
the employment of trade protectionist measures.
List similarly argued that in a climate of rising economic nationalism, protectionist trade
policies such as import tariffs and export subsidies were necessary if Europe's infant
industries were to compete on an equal footing with the UK
Mercantilists next challenged the assumption that comparative advantage unconditionally
benefits both parties. .Pointing out that the assumptions of liberal free trade theory is that the
process of the working out of the consequences of comparative advantage is
DYNAMIC….BUT IN REALITY the shift from one form of activity to another is often slow and
painful, and may not occur at all.
In fact if one sector of an economy faces collapse due to foreign competition, then the
process of the reallocation of the unemployed resources is IN IITSELF enormously
costly…thus generating a further set of costs derived from adherence to pure free
trade.Resources are not as mobile or as flexible as FREE TRADERS would assume.
- Mercantilists also stress the POLITICS of TRADE…STATES naturally desire to protect
themselves and their industries from the negative effects of trade
- Farmers for example often appeal to and receive protection form the rigours of FREE
TRADE
- they tend to be over –represented in the national legislatures of the USA, Western
Europe,and Japan
- Nation states FEAR becoming too dependent upon other nations for certain goods.
- By the turn of the 20th century protectionist trade policies were on the rise.
This led to the Great Depression of the 1930s…trade protectionism spiraled upwards, whilst
international trade crashed …causing unprecedented hardship in both the USA and western
Europe
FACT0R PROPORTIONS THEORY [Heckscher-Ohlin]
Maximize output …Factor endowment varies among countries
China has a large pool of unskilled labour
Saudi Arabia has large crude oil reserves
Goods differ according to the types of factors that are used to produce them
Wheat requires land, clothing requires unskilled labour
Countries will have a comparative advantage in producing products that intensively use
resources it has in its advantage.
The Heckscher-Ohlin theory presents the issue that international and interregional differences
in production costs occur because of the differences in the supply of production factors (Ball,
McCulloch, 1999). Those goods that require a large amount of the abundant, thus less costly
factor will have lower production costs, enabling them to be sold for less in international
markets (Salvatore, 1995).
Countries such as Australia with relatively large amounts of land do export land intensive
products (eg, grain and cattle) whereas a country like China would export labour intensive
products.
There are exceptions to the Heckscher-Ohlin theory which are due to the assumptions that
Ohlin drew.
One assumption was that the prices of the factor depended only on the factor endowment.
This is however untrue as factor prices are not set in a perfect market. There are such factors
to consider such as legislated minimum wages and benefits force the cost of labour to rise to
a point greater than the value of the product than many workers can produce (Ball,
McCulloch, 1999).
Country Similarity Theory
Country similarity theory was developed by a Swedish economist named Steffan Linder
Rests on the concept of “Intra industry trade” is trade between two countries of goods
produced by the same industry. Intra industry trade accounts for approximately 40 per cent of
world trade.
Linder believed that international trade of manufactured goods occurred between countries at
the same stage of economic development that shared the same consumer preferences.
Therefore the country similarity theory consists of the value that most trade in manufactured
goods should be between nations with similar per capita income, and that intra industry trade
in manufactured goods should be common
More recent developments in theoretical approaches in Economics to International Trade
move away from a COUNTRY BASED approach and move towards a FIRM BASED
approach.
International Product Life Cycle Theory (IPLC) analyses the effects of product evolution on
the global scale.
Applies to established companies in industrialised countries who expand their product range.
The theory is broken up into five major stages
1) Release: As competition in Industrialised countries tends to be fierce, ‘Manufactures are
therefore forced to search constantly for better ways to satisfy their customer needs.’ (Ball et
al, 1999). The core elements in new product design are gained from customer feedback from
previous models. Once the product enters the domestic market and begins to create a
positive reputation, the demand increases and hence we come to an end of the first stage of
the IPLC.
2)Exports: As the product receives positive customer response, the international demand for
the product begins. The manufacturer begins exporting to increase its market share. An
example of this was the personal computer (PC) craze of the early 1980’s. In 1985 55,000
PCs were sold in the United States, by 1984 the industry had experienced a 136-fold increase
to 7 million PCs (Richter-Buttery, 1998
3)Foreign Production begins: As demand increases with the new global market, it becomes
economically feasible to begin local production in various nations. By sharing technology on
the manufacturing of the product, the company has lost an advantage. The end of this stage
signifies the highest point in the International Product Life Cycle Theory.
4)Foreign Competition in exports markets: This is a threatening stage for the company. Local
manufactures have gained experience in producing and selling their product, hence their
costs have fallen. As they have saturated their initial market, they may begin to look
elsewhere (i.e.. other nations) to promote their product. The reason that this is threatening is
that this other nation may have a competitive advantage and this places stress on the
company’s own domestic market share.
5)Import Competition in Home Market: If the competitors have a competitive advantage, or
they reach the economies of scale needed, they will enter the original home market. At this
stage the competitors will have a quality product which will be able to undersell the original
manufactures. Eventually they will be pushed out from the market and imports will supply the
home nation. These nations have a competitive edge with their low labour costs. ‘With future
innovations and new products and services the eventuality is that it’s value and hence its
price are likely to diminish’ (Lendrum, 1995). The IPLC theory does have its disadvantages.
Perhaps the most recognisable is the assumption that products are released initially in the
domestic markets. Many globalised companies tend to release their new product lines
internationally, not domestically.
THEORY OF NATIONAL COMPETITIVE ADVANTAGE
Originator of the Michael Porter’s Theory of National Competitive Advantage/Porter’s
Diamond published in 1990 was based on a study of 100 firms in 10 developed nations.
Porter develops a new theory of how nations, states, and regions compete and their sources
of economic prosperity
Porter questions how Switzerland, a nation with few natural resources, is a world leader in the
production of chocolates, and Japan, a country whose economy was in shambles after World
War 2, is now a global leader in making low cost, mass-produced, quality, high-technology
products. Porter outlines a number of factors beyond mere natural resources…
Porter’s Diamond:
FACTORS which MICHAEL PORTER BELIEVED EXTENDED BEYOND NATURAL
ENDOWMENT INCLUDE….
- a sizeable demand from sophisticated consumers,
- an educated and skilled workforce,
- intense competition in the industry
- the existence of related and supporting suppliers.
Porter also discusses external influences such as government and chance Demand
Conditions: Porter argues that companies should be ‘participating in national markets with the
strongest rivals and most demanding customers, in order to build international
competitiveness’ (Yip, 1995).
A company facing a more competitive environment will strive to make itself more efficient in
order to maximise profits.
Factors of production are nothing more than the inputs to compete in any industry, such as
Labour, arable land, natural resources, capital, and infrastructure….these are clearly
important but PORTER now believes they are less vital to success than before.
Porter suggests that the factors most important to competitive advantage in most industries,
especially in the industries most vital to productivity growth in advanced economies, are not
inherited but are created within a nation, through processes that differ widely across nations
and among industries.
Firm Strategy, Structure and Rivalry: A key determinant is the context in which firms are
created, organised and managed as well as the nature of domestic rivalry. The pattern of
rivalry at home also has a profound role to play in the process of innovation and the ultimate
prospects for international success (Porter, 1980). A firm strategy & competition in domestic
market shapes its performance in the international market.
Global Strategic Rivalry Theory was developed in the 1980s as a means to ‘examine the
impact on trade flows arising from global strategic rivalry between Multi National
Corporations.’ (Mahoney, et al 1998). It explores the notion that in order to stay viable, firms
should exploit their competitive advantage globally and try to keep it sustainable.
- Investing in research
- Owning intellectual property rights
- Exploiting previous experience
- Achieving economies of scale or scope
A good example of strategic alliance which gave two companies a competitive advantage, is
Qantas and British Airways.
Qantas had solid air route throughout the Asia Pacific region, likewise British airways had
strong network within Europe, North Atlantics, and North America. By forming an alliance in
1993, both companies strategically positioned themselves to have a strong worldwide
network.
This global strategic alliance gave them a competitive advantage.(Mahoney, et al 1998).