Theories of International Trade

International Trade Theories Introduction

In the 1600 and 1700 centuries, mercantilism stressed that countries should simultaneously encourage exports and discourage imports. Although mercantilism is an old theory it echoes in modern politics and trade policies of many countries. The neoclassical economist Adam Smith, who developed the theory of absolute advantage, was the first to explain why unrestricted free trade is beneficial to a country. Smith argued that 'the invisible hand' of the market mechanism, rather than government policy, should determine what a country imports and what it exports. Two theories have been developed from Adam Smith's absolute advantage theory. The first is the English neoclassical economist David Ricardo's comparative advantage. Two Swedish economists, Eli Hecksher and Bertil Ohlin, develop the second theory. The Heckscher-Ohlin theory is preferred on theoretical grounds, but in real-world international trade pattern it turned out not to be easily transferred, referred to as the Leontief paradox. Another theory trying to explain the failure of the HecksherOhlin theory of international trade was the international product life cycle IPLC theory developed by Raymond Vernon.

Mercantilism Mercantilism was a sixteenth-century economic philosophy that maintained that a country's wealth was measured by its holdings of gold and silver. This recquired the countries to maximise the difference between their exports and imports by promoting exports, and discouraging imports. The logic was transparent to sixteenth-century policy makers-if foreigners buy more goods from you than you buy from them, then the foreigners have to pay you the difference in gold and silver, enabling you to amass more treasure. With the treasure acquired the realm could build greater armies and navies and hence expand the nation’s global influence. Politically, mercantilism was popular with many manufactures and their workers. Export-oriented manufacturers favoured mercantilist trade policies, such as those giving subsidies or tax rebates, which stimulated their sales to foreigners. Domestic manufacturers threatened by foreign imports endorsed mercantilist trade policies, such as those imposing tariffs or quotas, which protected them from foreign competition. Most members of society are hurt by such policies. Government subsidies of exports for selected industries are paid for by taxpayers. Mercantilist terminology is still used today, an example when television commentators and newspaper headlines report that a country suffered an ‘unfavourable’ balance of trade-that is, its exports were less than its imports. Mercantilist policies are still politically attractive to some firms and their workers, as mercantilism benefits certain members of society. Modern supporters of these policies are known as neo-mercantilists, or protectionists The mercantilists were a group of economists who preceded Adam Smith. They judged the success of trade by the size of the trade balance

Absolute Advantage The theory of absolute advantage, suggests that a country should export those goods and services for which it is more productive than other countries, and

import those goods and services for which other countries are more productive than it is. Adam Smith was the first to come up with the theory of absolute advantage. According to Adam Smith, mercantilism’s basic problem is that it confuses the acquisition of treasure with the acquisition of wealth. In An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Smith attacked the intellectual basis of mercantilism and demonstrated that mercantilism actually weakens a country. Smith maintained that a country’s true wealth is measured by the wealth of all its citizens, not just that of its monarch. A country is said to be more productive than another country, if it can produce more output (goods) for a given quantity of input, such as labour or energy inputs. An example is that there are only two countries, Australia and Japan. They both produce computers and wine, and only one factor of production, labour. Japan produces 6 computers for every 1 bottle of wine, where as Australia produces only 4 computers for every 3 bottles of wine. This suggests that Australia should export some of its wine to Japan, and Japan should export some of its computers to Australia. Australia has an absolute advantage over Japan, when producing wine, and Japan has an absolute advantage over Australia, when producing computers. Economists use the term absolute advantage when comparing the productivity of one person, firm or nation with that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.

Comparative Advantage The theory of comparative advantage, states that a country should produce and export those goods and services for which it is relatively more productive than are other countries and import those goods and services for which other countries are relatively more productive than it is. David Ricardo, the early nineteenth-century British economist solved the problem of the theory of absolute advantage, by developing the theory of comparative advantage. Absolute advantage suggests that no trade would occur if one country has an absolute advantage over both products. The differences between absolute and comparative advantage theories are subtle. Absolute advantage looks at absolute productivity differences, comparative advantage looks at relative productivity differences. Take Australia, and Japan again as examples, this time Australia is better than Japan at producing both products computers and wine, and only one factor of production, labour. Australia produces 6 computers for every 4 bottles of wine, and Japan produces 5 computers for every 1 bottle of wine. Absolute advantage suggests that no trade should occur, because Australia is more productive than Japan in producing both goods. The theory of comparative advantage, suggests that trade should still occur, as Australia is comparatively better than Japan in wine production, whereas Japan is comparatively better than Australia in the production of computers. Economists use the term comparative advantage when describing the opportunity cost of two producers. The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.

Porter’s Diamond model - competitive advantage of nations

In the mid-1980s, Professor Michael Porter of Harvard Business School developed a framework to assess the competitiveness of regions, states and nations. In the early 1980s, U.S. industry saw its economic competitiveness eroded by Japanese and European competitors. Porter concluded that classical international trade theories, which mainly focused on slowly changing, “inherited” variables such as natural resources, climate, size of working population, etc., could only partially explain why nations gain competitive advantage in a given industry. This observation initiated a four year study of ten major trading nations and 100 industries that covered 50% of total world exports in 1985. Successful international industries tend to be located within particular cities and regions. Geographic concentration is vital for firms to efficiently draw on each others resources and capabilities and to benefit from a shared culture and learning experience, supply capabilities and local infrastructure. Industry clusters are geographical concentrations of interconnected businesses, suppliers, and associated institutions in a particular field. Clusters lead to productivity increases, higher innovation rates and faster new business developments. Porter argued that productivity is the main factor for international competitiveness and that the standard of living of a country’s population can be improved as a direct result of increases in that factor. Clusters may take different forms between firms producing different products across value-added chains or between firms producing similar products at different stages of the same chain. Examples are banking in London and New York, chemical transport in Rotterdam, Houston and Singapore, film in Mumbai and Hollywood and Internet/Software in Silicon Valley and Bangalore. Porter’s Diamond of competitive advantage model of nations consists of four main attributes that shape the national environment in which local, connected firms compete:

1. FACTOR CONDITIONS The nation’s relative position in vital industrial production factors such as skilled labour or infrastructure, are important determinants of national competiveness. Both the level of individual factors and the overall composition of the resource mix must be considered. Factors can be country specific or industry specific. For example, Japan’s large pool of engineers -- reflected by a much higher number of engineering graduates per capita than almost any other nation -- has been vital to Japan’s success in many manufacturing industries. 2. DEMAND CONDITIONS The nature of home demand for an industry’s products and services requires considering both the quantity and quality of the demand. For example, Japan’s sophisticated and knowledgeable buyers of

cameras helped stimulate the Japanese camera industry to improve product quality and to launch new, innovative models. 3. RELATED AND SUPPORTING INDUSTRIES The presence or absence in the nation of internationally competitive supplier and related industries is a key factor. Until the mid-1980s for example, the technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in personal computers and several other technically advanced electronic products. Adoption of the automobile took off in the USA after the construction of a national system of highways and gas station. 4. FIRM STRATEGY, STRUCTURE, AND RIVALRY The national conditions that determine how companies are created, organised and managed, as well as the nature and extent of domestic rivalry. For example, the predominance of engineers on the top-management teams of German and Japanese firms results in emphasising the improvement of the manufacturing processes and product design. Furthermore, domestic rivalry creates pressure to launch new products, to improve quality, to reduce costs and to invest in new, more advanced technologies. Porter stated two additional variables that indirectly influence the diamond: 5. CHANCE EVENTS Disruptive developments outside the control of firms and governments that allow in new players who exploit opportunities arising from a reshaped industry structure. For example, radical innovations, unexpected oil prise rises, revolutions, wars, etc. 6. GOVERNMENT Government choice of policies can influence each of the four determinants. Successful government policies work in those industries where underlying determinants of national advantage are present and reinforced by government actions. Government can raise the odds of gaining competitive advantage but lacks the power to create advantages on its own. These six attributes promote or impede the creation of competitive advantages of firms, clusters, and nations. All conditions need to be present and favourable for an industry/company within a country to attain global supremacy. Managers can use the diamond model during their internationalisation efforts to determine if the home market can support and sustain a successful internationalisation effort or to asses in which country to invest next. The model helps entrepreneurs decide where to start their next venture. Government officials can use the model for guidance on how to best build a supporting policy framework for a given industry.

The Heckscher-Ohlin Theory of Factor Endowment It has been previously stated that the difference in relative commodity prices between two nations is evidence of their comparative advantage and forms the basis for mutually beneficial trade. Factor Endowments and the Heckscher-Ohlin theory take this one step further by analysing the effect that international trade has on the earnings of factors of production in the two trading nations. 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 labor intensive products. There are exceptions to the Heckscher-Ohlin theory which are to do with 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. Many economists attempted to disprove the Heckscher-Ohlin theory. The most notable effort was by Wassily Leontief. His paradox was self named (Leontief Paradox) and disputed the theory as a predictor of the direction of trade. This paradox failed to empirically validate the country based Heckschler-Ohlin theory (Mankiw, 1997).

International Product Life Cycle Theory (IPLC)

The International product life cycle theory is a valuable instrument in analysing the effects of product evolution on the global scale. The IPLC generally applies to established companies in industrialised countries who expand their product range. The theory is broken up into five major areas; 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. 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 80’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) 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. 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 for our company is that this other nation may have a competitive advantage and this places stress on our market share. 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. Eventually, as the product’s technology becomes more renowned, developing nations will enter the market. This will begin the International Product Life Cycle again, as 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 diminishs.

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; hence this theory can not be applied to many of today’s products.

Globalisation: Globalisation is the worldwide inter connection at the cultural, political and economic level resulting from the elimination of communication and trade barriers. Dimensions of Globalisation: Most writers used the term globalisation to refer to one or more of the following elements. •

Worldwide Scope: Global can simply be used as a geographic term. A firm with operations around the world can be labelled a global company to distinguish it from the firms that are local or regional in scope. For example, Coke and McDonald are operating globally.

•

Worldwide Similarities: Global can also refer to homogeneity around the world. For example, if a company decides to sell the same product in all of its international markets it is also referred to as a global product as opposed to a local product. For example, Gillette Toiletries and Kodak films.

•

Worldwide Integration of business units: Global can be referred to the word as one tightly linked system. For instance a global market can be said to exist if events in one country are significantly impacted by events in other geographic markets. For example, the Whirlpool refrigerator has its R&D in the UK, its design in Canada, its marketing distribution in Australia and its compressor in Brazil.

Drivers of globalisation: According to Yip (1992) ‘to achieve the benefits of globalisation, the managers of a world wide business need to recognise when industry conditions provide the opportunity to use global strategy levers. Yip identified four drivers which determined the nature and extent of globalisation in an industry. These are market drivers, cost drivers, government drivers and competitive drivers.

Yip developed a framework that can be used to measure the degree and extent of globalization in an industry, as well as measure the extent to which a business’s strategy is global, and the extent to which it has local characteristics. According to Yip, 4 drivers determine the degree and extent of globalization: Market drivers, cost drivers, government drivers and competitive drivers. The chart below summarizes the factors to be considered when analyzing the 4 drivers:

Market drivers ▪ common customer needs ▪ global customers ▪ global distribution channels ▪ transferable marketing techniques ▪ a presence in lead countries

Cost drivers ▪ global scale economies ▪ steep experience curve ▪ sourcing efficiencies ▪ favorable logistics ▪ differences in country costs ▪ high product development costs ▪ rapidly changing technology

Government drivers Competitive drivers ▪ favorable trade policies ▪ high exports and imports ▪ compatible technical standards ▪ competitors from different continents ▪ common marketing regulations ▪ interdependence of countries ▪ government owned competitors and▪ competitors globalized customers ▪ host government concerns

•

Market globalization drivers – the degree of globalization in the market depends upon the extent to which there are common customer needs, global customers, global distribution channels, transferable marketing and lead countries.

•

Cost globalization drivers – If there are substantial cost advantages to configuring the value chain globally, then an industry will tend to be global. Factors to consider include global scale economies, sourcing efficiencies, favorable logistics, differences in country costs and rapidly changing technology and high product development costs (which encourage globalization to recoup investment). Economies of scale/ scope Experience curve

•

Government globalization drivers – The reduction of trade barriers by national governments, and the creation of supranational bodies to encourage free trade (like the WTO), have encouraged globalization. Factors to consider include favorable trade policies, compatible technical standards, government owned competitors and attitudes of host governments toward globalization. Trade block, Emerging economies Free trade organizations

•

Competitive globalization drivers – Global competition in an industry will become more intense (and thus increase globalization) when there is a high level of imports and exports between countries, competitors in the industry are widely spread, economies are interdependent and competitors in the industry are globalized. Yip’s framework assesses the extent and degree of globalization in an industry. Greater globalization in an industry will encourage a business itself to become globalized. Yip’s framework can also be used to identify which parts of an organization’s strategy are global, and which parts have local characteristics.

Global Strategic Decision A global aspirant has to make 4 key decisions: 1. 2. 3. 4.

Which product to use for global trade? Which market to choose? Mode of entry: How to enter? Speed of entry => how fast?

1. Which Product? The most attractive product for global trade should be high in profit and low in the degree of its adaptation. For instance the Marriot Hotel in the U.S had four product line, motel, retirement home, long-term stay and 5 stars. Applying the matrix of product for global trade they realised that the retirement home was least attractive while the five star hotel was most attractive.

Previous experience 2. Which Market? Strategic decisions in terms of which market depends on firm’s experience with regards to operating in a particular region, market’s specific government influences, trends in general, growth and size of the economy e.g. Brick Nations. In global trade, firms should be looking for beach head/bridge head that is operating in the market similar to the target market but has lower risk. For example, the target market of Gallerie La Fayette was USA which was not the right choice because USA is the graveyard in the retail business. Therefore, the beach head for La Fayette could have been Canada because La Fayette is a French company and Canadian culture is, to some extent, similar to French culture, even the language. Beach head: target market is similar but less risk 3. Mode of entry: There are many ways of entering a market such as franchising, licensing, joint ventures, foreign direct investment. In global trade join ventures are the most desirable and important mode of entry because of government regulations, where the linguistic or cultural and geographical distance are great, and where the risks of asymmetric learning are low. Profit without partnership Ownership of assets: Franchising  Joint Venture  FDI Where the risk of asymmetric learning is low fair exchange Speed of Entry: There are two kind of movers, fast and late movers. According to Sun Tzu ‘if you want to win a battle you have to be in the battle field first’. As Michael Porter discussed ‘first mover advantage’. However, there is another argument of late mover advantage because they can avoid mistakes made by earlier movers. For example, McDonald’s as a later mover avoided the mistakes made by Wimpy. Pizza Hut learnt from the mistakes of Pizza Land. Vary fast: Sun Tzu Michael Porter’s first mover advantage Late mover advantage: Learning form mistake, Product positioning IT IS THE MATTER OF GETTING THE TIMEING RIGHT