International Trade Theories

The Gains from Trade: Ghana vs. S. Korea

•       Ghanaian government involvement in the Cocoa Trade

•       Ghana: one of the best places to grow cocoa:

•       favorable climate,  good soils, and access to the world shipping routes

•       1957- world’s largest producer of cocoa

•       Gov. created state-controlled Cocoa Marketing Board

•       Authority to fix price

•       The sole buyer of all cocoa in Ghana

•       Essentially taxing exports

•       Money used to fund nationalization & self-sufficiency policies

•       Price inflations over 1963-1979:

•       Fixed cocoa price in Ghana: 6 times

•       Average prices in Ghana: 22 times

•       Cocoa price in neighboring countries: 36 times

•       2003- Ivory Coast: 43% of world production; Ghana: 14%

•       Ghanaian government: inward-looking policies

•       Shifted resources from the profitable cocoa growth

•       Inefficient use of country resources

•       S. Korea (1950-1980): strongly outward-looking policies

•       Import tariffs: reduced from 60% to 20%

•       Tariffs on most non-agricultural items: zero

•       Items subject to import quota: 90% to zero

•       Subsidies paid to Korean exporters: 80% to zero

•       Dramatic transformation of economy

•       Initially resources shifted from agriculture to labor-intensive manufacturing

•       As labor-cost increased: shift toward capital-intensive and high-tech manufacturing, motor-vehicle, semiconductor, consumer electronics & advanced material.

•       Agriculture in nation’s economy: 77% to 20%; annual growth of GDP ~ 9%

Classical Theories of Trade

•       Mercantilism

•       Absolute advantage

•       Comparative advantage

•       Factor-proportion (Heckscher-Ohlin) Theory

•       The Product Life-Cycle Theory

Mercantilism

•       Mercantilism: emerged in 16^th century

•       Basic Premise: Countries should run a balance of trade surplus (exports>imports) to increase their gold & silver reserves.

•       Thomas Man (1630): “The ordinary means therefore to increase our wealth and treasure in by foreign trade wherein we must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value.”

•       Mercantilism views trade as a zero-sum game (win-lose).

•       David Hume (1752) fallacy: persistent trade surplus => increased money supply => inflation => change relative prices => undermines trade surplus.

•       Neo-mercantilism: misperceptions that interrelate trade surplus ~ economic power ~ political power.

Absolute Advantage

•       Adam Smith (1776) questioned the “zero-sum game” assumption

•       If countries specialize in producing goods that they are most efficient in producing (i.e., focusing on their absolute advantage), trade is a positive sum game

•       As a result of specialization and trade, world output increases, and consumers benefit

Comparative Advantage

David Ricardo (1817):

•       Even then, it makes sense for a country to specialize in the good in which it is comparatively more efficient – (where it has comparative advantage)

A similar scenario in everyday life

“A famous and wealthy impresario of stage and screen in the 1940s, Billy Rose was also a world-class typist and stenographer with many awards to his credit. He would thus have encountered enormous difficulty in hiring a secretary who could work nearly as he himself could.  Still, he hired secretaries because even though he was the world’s best at the job, he could still earn much more in a hour manipulating his stage and screen empire than he could in typing.”

Assumptions of Theories of Specialization

•       Resources can be freely employed in alternative uses (therefore Full Employment)

•       Objective: Economic Efficiency

•       Transportation costs between countries

•       Immobility of factors of production across countries

•       Constant returns to scale

Countries’ stock of resources fixed

Factor Proportion (Heckscher-Ohlin) Theory

•       Arguing against the thesis that comparative advantage arises from differences in productivity, H-O argued that CA arises from relative differences in factor endowments.

•       Thus, countries export products that make intensive use of resources that are locally abundant, and import others

Leontief Paradox

•       Leontief (Russian-born economist): based on H-O theory, US should export capital-intensive goods countries can successfully export products that use their less-abundant resources (e.g., the U.S. often exports labor-intensive goods).

•       This implies that international trade is complex and cannot be fully explained by a single theory.

The Product Life-Cycle Theory

•       The pattern of trade changes in different stages of product life-cycle

•       As products mature, both the location of sales and the optimal production location will change, affecting the direction and flow of imports and exports.

 

New Trade Theories

•       Based on substantial economies of scale/steep learning curves that accompany specialization. In such industries, only a few firms can be supported profitably in the world economy.

•       Notion of first mover advantages (due to learning curve): strategic and economic advantages that accrue to early entrants and which becomes barriers to entry

•       Role of governmental intervention and a proactive strategic trade policy rather than free trade

Porter’s Diamond Model (1990)

•       Why does a nation achieve international success in a particular industry?

–      Why does Japan do so well in the automobile industry?

–      Why is Germany tops in the chemical industry?

–      Why are the Swiss leaders in precision instruments and pharmaceutical industries?

•       4 attributes shape the environment in which local firms compete, and these promote or impede the creation of competitive advantage in the global economy

Porter’s Diamond: National Competitiveness in a Given Industry

Comparative vs. Competitive Advantage

Critical Role of Innovation in National Economic Success

•       At both the firm and national levels, competitive advantage and technological advances grow out of innovation. Innovation is a key source of competitive advantage.

•       Firms innovates in four major ways. Develop:

                (1)          A new product or improve an existing product

(2)          New ways of manufacturing

                (3)          New ways of marketing

                (4)          New ways of organizing company operations

•       Many innovative firms in a nation leads to national
competitive advantage

Critical Role of Productivity in National Economic Success

•       Productivity is the value of the output produced by a unit of labor or capital.

•       It is a key source of competitive advantage for firms.

•       The greater the productivity of the firm, the more efficiently it uses its resources.

•       The greater the aggregate productivity of the firms in a nation, the more efficiently the nation uses its resources.

•       Aggregate productivity is a key determinant of the nation’s standard of living.

National Industrial Policy

•       Nations can develop these endowments through a proactive national industrial policy and economic development plan which nurture and support promising industry sectors with potential for regional or global dominance.

•       Initiatives can include:

§  Tax incentives

§  Monetary and fiscal policies

§  Rigorous educational system

§  Investment in national infrastructure

§  Strong legal and regulatory systems

Examples of National Industrial Policy

•       In the 1990s, Vietnam’s government privatized state enterprises and modernized the economy, emphasizing competitive, export-driven industries. Vietnam became one of the fastest-growing economies, averaging around 8 percent annual GDP growth.

•       Singapore adopted pro-business, pro-investment, export-oriented policies, combined with state-directed investments in strategic corporations. The approach stimulated economic growth that averaged 8 percent annually from 1960 to 1999.

Examples of National Industrial Policy

•       In the 1990s, Ireland implemented various pro-business policies—fiscal, monetary, tax; investment in education; and emphasis on high-value industries such as pharma and IT—that dramatically grew GDP and reduced unemployment.

Stages in Company Internationalization

•       The internationalization process model was developed in 1970s to describe how companies expand abroad.

According to this model, internationalization takes place in incremental stages over a long period of time. Initially, firms only have a domestic interest.

How Firms Gain and Sustain International Competitive Advantage

•       Because the MNE was traditionally the major player in international business, scholars have theorised and offered numerous explanations of what makes these firms pursue, and succeed in, internationalization.

•       Because FDI has been MNEs’ main strategy in international expansion, theoretical explanations have tended to emphasize it.

FDI-Based Explanations: Monopolistic Advantage Theory

•       Argues that MNEs prefer FDI because it provides the firm with control over resources and capabilities in the foreign market and a degree of monopoly power relative to foreign competitors.

•       Key sources of monopolistic advantage include proprietary knowledge, patents, unique know-how, and sole ownership of other assets.

•       Example
Novartis earns substantial profits by marketing various patent medications through its subsidiaries worldwide.

FDI-Based Explanations: Internalization Theory

•       Explains how the MNE chooses to acquire and retain one or more value-chain activities inside itself.

•       Such “internalization” provides the MNE with greater control over its foreign operations.

•       Internalization avoids the drawbacks of dealing with external partners, such as reduced quality control and the risk of losing proprietary assets to outsiders.

•       Example

•       In China, Intel owns much of its value chain, which ensures that Intel knowledge, patents, and other assets are not misused or illicitly obtained by potential rivals.

FDI-Based Explanations: Dunning’s Eclectic Paradigm

•       Professor John Dunning proposed the eclectic/general paradigm as a framework for determining the extent and pattern of the value-chain operations that companies own abroad.

•       Three conditions determine whether or not a company will enter a given foreign country via FDI:

1. Ownership-specific advantages: Knowledge, skills, capabilities, relationships, or physical assets that the firm owns and that are the basis of its competitive advantages
2. Location-specific advantages: Similar to comparative advantages; specific advantages that exist in the country that the MNE has entered, or is seeking to enter, such as natural resources, low-cost labor, or skilled labor
3. Internalization advantages: Control derived from internalizing foreign-based manufacturing, distribution, or other value-chain activities

Example of the Eclectic Paradigm: Sony in China

•       Ownership-Specific Advantages.  Sony possesses a huge stock of knowledge and patents in the consumer electronics industry, as represented by products like the Playstation and Vaio laptop.

•       Location-Specific Advantages. Sony desires to manufacture in China in order to take advantage of China’s low-cost, highly knowledgeable labor force.

•       Internalization Advantages. Sony wants to maintain control over its knowledge, patents, manufacturing processes, and quality of its products.

Non-FDI-Based Explanations: International Collaborative Ventures

•       A form of cooperation between two or more firms. Partners pool resources and capabilities to create synergies and share the risk of joint efforts.

•       Starting in the 1980s, firms increasingly began using collaborative ventures to expand abroad.

•       Collaboration provides access to foreign partners’ know-how, capital, distribution channels, and marketing assets.  It also helps overcome government-imposed obstacles.

Two Types of International Collaborative Ventures

•       Equity-based joint ventures result in the formation of a new legal entity. In contrast to the wholly owned FDI, the firm collaborates with local partner(s) to reduce risk and commitment of capital.

•       Project-based alliances do not require equity commitment from the partners, but simply a willingness to cooperate in R&D, manufacturing, design, or any other value-adding activity.

•       Because project-based alliances have a narrowly defined scope of activities and timeline, they provide greater flexibility to the firm than equity-based ventures.