THEORY OF
TRADE &
INVESTMENT
Mercantilism
₪ Mercantilism – an economic philosophy based on the belief that:◦ A nation’s wealth depends on accumulated treasure (usually gold)
◦ To increase wealth, government policies should promote exports and discourage
imports
₪ Feudal society was a state of autarky, a society that did not trade because
all of its needs were met internally.
₪ In the centuries leading to up the Industrial Revolution, international
commerce was largely conducted under the authority of governments. The
goals of trade were therefore the goals of governments.
₪ The demise of mercantilism was inevitable given class structure and the
distribution of society’s product.
The Evolution of Trade Theory
THEORY OF ABSOLUTE
ADVANTAGE (ADAM SMITH )
THEORY OF COMPARATIVE
ADVANTAGE (DAVID RICARDO)
THEORY OF FACTOR
PROPORTIONS (ELI HECKSHER &
BERTIL OHLIN)
THE LEONTIEF
PARADOX (WASSILY
LEONTIEF)
OVERLAPPING
PRODUCT RANGES
THEORY (STAFFAN
LINDER)
PRODUCT CYCLE
THEORY (RAYMOND
VERNON)
IMPERFECT
MARKETS &
STRATEGIC TRADE
(PAUL KRUGMAN)
THE COMPETITIVE ADVANTAGE
OF NATIONS (MICHAEL PORTER)
The Theory of Absolute
Advantage
₪ Proposed by Adam Smith (1776)
₪ Smith noted that some countries owing to the skills of their workers or the
quality of natural resources, could produce the same product as others
with fewer labor-hours . He termed this efficiency absolute advantage.
₪ The factories of the industrializing world separated production processes
into distinct stages – in which each stage would be performed exclusively
by one individual (division of labor). This specialization increased
productivity.
₪ Smith extended his division of labor in the production process to division
of labor and specialized product across countries.
The Theory of Absolute
Advantage
₪ Each country would specialize in a product for which it was uniquely
suited. More would be produced for less.
₪ Thus, by each country specializing in products for which it possessed
absolute advantage in production, countries will produce more in total
and exchange products for goods that were cheaper in price than
those that were produced at home.
Theory of Comparative
Advantage
₪ Proposed by David Ricardo (1819).
₪ He noted that even if a country possessed absolute advantage in the
production of two products, it still must be relatively more efficient
than the other country in one good’s production than the other.
₪ He termed this comparative advantage. The country should then
specialize in the production and export of that good in exchange for
importation of the other good.
Factor Proportions Trade
Theory
₪ Developed by Eli Heckscher and later expanded by his former student, Bertil
Ohlin.
₪ It considers two factors of production: labor and capital. Technology
determines the way they combine to form a good.
₪ Different goods required different proportions of the two factors of
production e.g. a labor-intensive good requires more input units of labor
than capital to be produced. Conversely, a capital-intensive good requires
more input units of capital than labor to be produced.
Assumptions of the theory:
a)
Two countries, two products, two factors of production: 2×2×2.
b)
Markets for inputs and outputs are perfectly competitive.
c)
Increasing production of a product experiences diminishing returns.
d)
Both countries use identical technologies
e)
Labor and capital are immobile
Theory of Factor Proportions
₪ Factor prices of labor and capital determine cost differences and thus
determines comparative advantage in production and export.
₪ Factor prices are determined by the endowments of labor and capital that
a country has. This in turn determines the relative costs of labor and
capital as compared with other countries.
₪ With the underlying assumptions, the theory states that a country should
specialize in the production and export of those products that use
intensively its relative abundant factor. Be it labor or capital.
₪ A relatively labor-abundant country should specialize in producing and
exporting labor-intensive products and import capital-intensive products
in exchange. The reverse is also true.
The Leontief Paradox
₪ It set out to prove if the factor proportions could be used to explain the
types of goods the U.S exported.
₪ The input-output analysis was a method devised by him to investigate this.
It is a technique of decomposing a good into values and quantities of the
labor, capital and other potential factors employed in the good’s
manufacture.
₪ The hypothesis was that U.S exports should be relatively capital-intensive
than U.S imports.
₪ The results were different. Leontief found that U.S firms’ exports were
relatively more labor-intensive than the products the U.S imported. This is
what has come to be known as the Leontief Paradox.
Linder’s Overlapping Product
Ranges Theory
₪ Developed by Staffan Burenstam Linder.
₪ He acknowledged that in the natural resource-based industries, trade was
determined by relative costs of production and factor endowments.
₪ He however argued that trade in manufactured goods was dictated not by
cost concerns, but rather by the similarity in product demands across
countries.
₪ His theory is based on the following principles:1. As income (per capita income) rises, the complexity and quality level of the
products demanded by the country’s residents also rises.
2. The entrepreneurs directing the firms that produce society’s needs are more
knowledgeable about their own domestic market than about foreign markets.
Linder’s Overlapping Product
Ranges Theory
₪ Thus countries that would see the most intensive trade are those with
similar par-capita levels, because they would possess a greater
likelihood of overlapping product demands.
₪ The overlapping ranges of product sophistication represent the
products that entrepreneurs would know well from their home
markets and could therefore potentially export and compete with in
foreign markets.
₪ The overlapping product ranges described by Linder would today be
termed market segments.
Product Cycle Theory
₪ Proposed by Raymond Vernon (1966)
₪ The theory tries to explain why a product that begins as a nation’s export
eventually becomes its import.
₪ Using many of the same basic tools and assumptions of factor proportions
theory, he added the following premises:a) Technical innovations leading to new and profitable products require large
quantities of capital and highly skilled labor.
b) These same technical innovations, both the product itself and more importantly
the methods for its manufacture, go through three stages of maturation as the
product becomes increasingly commercialized.
As the manufacturing becomes more standardized, and low-skill labor intensive,
the comparative advantage in its production and export shifts across countries
Stages of the Product Cycle
₪ Stage I: The New Product. Innovation requires highly skilled labor and
large quantities of capital for research and development.
◦ The innovator enjoys monopoly power: high profit margins
₪ Stage II: The Maturing Product. As production expands, its process
becomes increasingly standardized.
◦ Firm faces critical decision: Lose market share to foreign-based manufacturers
losing lower-cost labor or to invest abroad to maintain its market share by
exploiting the comparative advantages of factor costs in other countries
₪ Stage III: The Standardized Product. The product is completely
standardized in its manufacture.
◦ The country of production is the one with cheapest unskilled labor.
◦ Profit margins are thin and competition is fierce.
Economies of Scale & Imperfect
Competition (P. Krugman)
₪ Internal Economies of Scale: When cost per unit of output depends on
the size of an individual firm, the larger the firm the greater the scale
benefits and the lower the cost per unit. This causes creation of
monopolies hence imperfect markets.
₪ To continue enjoying monopoly power firms must take resources away
from other domestic industries for expansion. A country’s range of
products in which it specializes thus narrows, providing an opportunity
for other countries to specialize in these ‘abandoned product ranges’.
Countries again search out and exploit comparative advantage.
₪ This internal economies of scale provides an explanation of intraindustry trade i.e. when a country seemingly imports and exports the
same product.
Economies of Scale &
Imperfect Competition
₪ External economies of scale: when the cost per unit depends on the
size of an industry, the industry of that country may produce at lower
costs than the same industry that is smaller in size in other countries.
₪ A country can potentially dominate world markets in a particular
product because it has many firms that interact to create a large,
competitive, critical mass.
₪ External economies of scale may not necessarily lead to imperfect
markets but may result in an industry maintaining its dominance in its
field in world markets.
The Competitive Advantage of
Nations
₪ Developed by Michael Porter
₪ He claimed that a nation’s competitiveness depends on the capacity of its
industry to innovate and upgrade; not necessarily on its endowments as
earlier trade theories had suggested
₪ He then proposed four major components of the ‘diamond of national
advantage’:1. Factor conditions – The appropriateness of the nation’s factors of production to
compete successfully in a specific industry.
2. Demand conditions – The degree of health and competition the firm must face in its
original home market.
3. Related and supporting industries – The competitiveness of all related industries
and suppliers to the firm.
4. Firm strategy, structure and rivalry – The conditions in the home-nation that neither
hinder or aid in the firm’s creation and sustaining of international competitiveness
Porter’s Diamond
FIRM STRATEGY,
STRUCTURE & RIVALRY
DEMAND CONDITIONS
FACTOR CONDITIONS
RELATED &
SUPPORTING
INDUSTRIES