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International TradeTheory
Lecture-3
Ravikesh Srivastava
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Trade ?
Primary intensive-Agriculture, mines
Technology intensive- PCs Knowledge intensive- Software
Capital intensive- Constructionmachinery & equipments
Combination of all intensive- Telecomproducts, pharmaceuticals, airplanes,automobiles
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The Importance of Trade Theory
Trade theory helps managers and govern-ment policymakers focus on three critical
questions: What products should be imported and exported?
How much should be traded?
With whom should they trade?
While descriptive theories suggest a laissez-fairetreatment of trade, prescriptive theories suggest that
governments should influence trade patterns.
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Trade and Investment Policies
importsubstitution: a policy of developingdomestic industriestomanufacture goodsand provide servicesthatwould otherwisebe imported
strategic trade policy: the identification
and developmentoftargeted domesticindustriesinordertoimprove theircompetitivenessathome and abroad
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The Mercantilist Doctrine First or Pre-classical theory of Trade
Demonstrated by David Hume in 1752
Focus on Two Goals: Increase the wealth of Nation by acquiring
precious metals eg. Gold
To extract Trade Gains with max Export and MinImport
Overlooked other sources of a countryswealth accumulation as capital, skill of work force,land and other natural resources.
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Free Trade Theories:Absolute & Comparative Advantage
The theories of absolute and comparative advantagedemonstrate how economic growth can occur viaspecialization and trade.
Free trade (apositive-sumgame) implies speciali-zation and requires that nations neither artificiallylimit imports nor artificially promote exports.
The invisible hand of the market determineswhich competitors survive, as customers buy
those products that best serve their needs.Nations specialize in the production ofcertain products, someof which may be exported; export earnings can in turn be usedto pay for imported goods and services.
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Absolute Advantage Theory In 1776, Adam Smith introduced doctrine of
Laissez-faire to IT.
Focus on Freedom of enterprise and freedom ofcommerce
Individual countries to specialize in goods theywere best suited to produce because of naturaladvantage
Stated that a nations import should consist ofgoods made more efficiently abroad while exportsshould consist of goods made more efficiently athome.
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Absolute Advantage Theory
Country Wheat ( 1 unit) Coffee ( 1 Unit)
USA 2 8
Colombia 10 2
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Comparative Advantage Theory
In 1817, David Ricardo introduced book on thePrinciples of Political Economy and Taxation.
Focus on comparative advantage of a nation inproducing a good relative to other nation.
Based on opportunity cost theory
A country has a comparative advantage in
producing a good if the opportunity cost forproducing the good is lower than in other country.
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Comparative Advantage Theory
Country Wine ( 1 gallon) cloth ( 1 yard)
England 120 100
Portugal 80 90
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Comparative Advantage Theory
Country Opportunity cost
for Wine
Opportunity
cost forCloth
England 120/100=1.2 100/120=0.83
Portugal 80/90=0.89 90/80=1.13
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Theory of Comparative Advantage
Comparative advantage [DavidRicardo, 1817]:A country can(i) maximize its owneconomic well-beingby specializing inthe productionofthosegoods andservices itcanproduce relativelyefficiently and(ii) enhance global efficiency viaits participationin free trade.Ricardoalsoreasonedthat:
acountry cansimultaneously have anabsoluteandacomparative advantage inthe productionofagivenproduct
by concentratingonthe productionofthe productinwhich ithas the greateradvantage,acountrycan furtherenhance both global outputandits
owneconomic well-being
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Assumptions and Limitations
of the Free Trade Theories
The theories of absolute and comparative advantage bothmake assumptions that may not be entirely valid.
Full employment of resources Exclusive pursuit of economic efficiency objectives
Equitable division of gains from specialization
Only two countries and two commodities
Exclusion of transport costs A static rather than a dynamic view
Exclusion of services
Unrestricted factor mobility
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Heckscher-Ohlin Theorem
In 1933, heckscher & Ohlin explained link betweennational factor endowments & comparative
advantage on nations. A country would export commodities whose
production is intensive in its relatively abundantfactor.
Theorem assumes constant in input, technology,demand for factor of production with difference inrelative supply will lead to differences in therelative price between two countries.
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Implication of H-O Theorem Trade as well as trade gains should be greatest
between countries with the greatest differences ineconomic structure.
Trade should cause countries to specialize more inproducing and exporting goods that are distinctlydifferent from their imports.
Countries should export goods that make intensiveuse of their relatively abundant factors.
Factor prices should be nearly equal betweencountries with more liberal mutual trade.
International investment should be stimulated bydifferences in factor endowments.
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The Leontief Paradox
Demand bias for capital-intensive goods.
Existence of trade barriers
Importance of natural resources
Prevalence of factor-intensity reversals
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The Product Life-Cycle Model
Proposed by Raymond Vernon in 1960s.
Focus on imitation-gap approach.
As product cycle develops, the cost advantage willchange accordingly and a comparative advantagein innovative capacity may be offset by a costdisadvantage.
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International Product Life-Cycle (Vernon)
Limited initial demand in other advanced
countries initially
Exports more attractive than overseas production
When demand increases in advanced countries,
production follows
With demand expansion in secondary markets
Product becomes standardized production moves to low production cost areas
Product now imported to US and to advanced
countries
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Product Life Cycle (PLC) phases
The optimal location for the production of certaintypes of goods and services shifts over time asthey pass through the stages of: (i) introduction,
(ii) growth, (iii) maturity, and (iv) decline.Exceptions to the typical pattern of the PLC would include:
products that have very short life cycles luxury goods and services products that require specialized labor products that are differentiated from competitive
offerings products for which transportation costs are relatively high
During the decline stage, a product is often imported by the countrywhere it was initially developed; however, the importing firm may or
may not be the innovating firm.
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Product Life Cycle Characteristics
Stage Intro. Growth Maturity Decline
PRODUCTION Innovating Innovating Indl + DevelopingLOCATION(S) country + other indl developing countries
MARKET Innovating Industrial Industrial + Developing
LOCATIONS + other indl countries developing countries
COMPETITI VE Uniqueness Rising comp. Price compe- Declining
FACTORS & demand tition demand
PRODUCTION Short prodn Capital input Economies Rationali-
TECHNNOLOGY runs increases of scale zation
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The New Trade Theory
As output expands with specialization, an
industrys ability to realize economies of scale
increases and unit costs decrease
Because of scale economies, world demand
supports only a few firms in such industries
(e.g., commercial aircraft, automobiles)
Countries that had an early entrant to such anindustry have an advantage:
Fist-mover advantage
Barrier to entry
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New Trade Theory
Global Strategic Rivalry
Firms gain competitive advantagetrough: intellectual property, R&D,economies of scale and scope,
experienceNational Competitive Advantage(Porter, 1990)
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New Trade Theories
Increasing returns of specialization due to
economies of scale (unit costs of production
decrease)
First mover advantages (economies of scale such
that barrier to entry crated for second or third
company)
Luck... first mover may be simply lucky.
Government intervention: strategic trade policy