Chapter 6

The Theory of Trade and Investment

Learning Objectives
To understand the traditional arguments of how and why international trade improves the welfare of all countries To review the history and compare the implications of trade theory from the original work of Adam Smith to the contemporary theories of Michael Porter To examine the criticisms of classical trade theory and examine alternative viewpoints of which business and economic forces determine trade patterns between countries To explore the similarities and distinctions between international trade and international investment
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Evolution of Trade Theory

The Age of Mercantilism Classical Trade Theory Factor Proportions Trade Theory International Investment and Product Cycle Theory The New Trade Theory: Strategic Trade The Theory of International Investment
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Mercantilism
Mixed exchange through trade with accumulation of wealth Conducted under authority of government Demise of mercantilism inevitable

Classical Trade Theory

The Theory of Absolute Advantage
The ability of a country to produce a product with fewer inputs than another country

The Theory of Comparative Advantage

The notion that although a country may produce both products more cheaply than another country, it is relatively better at producing one product than the other
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Classical Trade Theory Contributions

Adam SmithDivision of Labor
Industrial societies increase output using same labor-hours as pre-industrial society

David RicardoComparative Advantage

Countries with no obvious reason for trade can specialize in production, and trade for products they do not produce

Gains From Trade

A nation can achieve consumption levels beyond what it could produce by itself
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Factor Proportions Trade Theory

Developed by Eli Heckscher

Expanded by Bertil Ohlin

Factor Proportions Trade Theory Considers Two Factors of Production

Labor

Capital
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Factor Proportions Trade Theory

A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive).

Overlapping Product Ranges Theory: Staffan Burenstam Linder

Trade in manufactured goods dictated not by cost concerns, but by similarity in product demands across countries (overlapping product demands). Work focused on preferences of consumer demand.

Today, product ranges termed market segments.

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Product Cycle Theory

Raymond Vernon Focus on the product, not its factor proportions Two technology-based premises
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Product Cycle Theory: Vernons Premises

Technical innovations leading to new and profitable products require large quantities of capital and skilled labor The product and the methods for manufacture go through three stages of maturation, with competitive advantage shifting each time
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Stages of the Product Cycle

The New Product
Flexible production Innovator Monopoly concentration

The Maturing Product

Intl market & competition More standardized production

The Standardized Product

Low-margin cost-based production Highly competitive
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The Product Cycle and Trade Implications

Increased emphasis on technologys impact on product cost
Explained international investment

Limitations

Most appropriate for technology-based products Some products not easily characterized by stages of maturity Most relevant to products produced through mass production

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The New Trade Theory: Strategic Trade

Two New Contributions
Paul Krugman-How trade is altered when markets are not perfectly competitive Michael Porter-Examined competitiveness of industries on a global basis
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Strategic Trade
Krugmans Economics of Scale:
Internal Economies of Scale

External Economies of Scale

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Intra-Industry Trade
Trade within a market segment
Product differentiation Reciprocal dumping

Index of Intra-Industry Trade

X M IIT X M

comparative adv. (0) to fully intra-industry (1)

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Strategic Trade
Can Government shift the balance in Imperfect Competition?
Cost

Price

Repetition

Externalities
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Strategic Trade
Porters Diamond of National Advantage
Innovation is what drives and sustains competitiveness Four components of competition Factor Conditions Demand Conditions Related and Supporting Industries Firm Strategy, Structure, and Rivalry
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Michael Porters Competitive Clusters

Critical masses of unusual competitive success in particular fields, located in one place

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The Theory of International Investment

The movement of capital has allowed foreign direct investments across the globe

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The Theory of International Investment

Firms as Seekers
Seeking Seeking Seeking Seeking Seeking Resources Factor Advantages Knowledge Security Markets

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The Theory of International Investment

Firms as Exploiters of Imperfections
Imperfections in Access Imperfections in Factor Mobility Imperfections in Management

Firms as Internalizers
Establish their own multinational operationsinternalize production Competitive advantage due to confidentiality
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Conclusion
What can trade flows tell us about country advantage? What can country advantage tell us about doing business in that country?

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