International Trade

International Trade

Describe the relationship between international trade volume and world output, and identify overall trade patterns

Describe mercantilism and explain its impact on world powers and their colonies

Explain the theories of absolute advantage and comparative advantage

Explain the factor proportions and international product life cycle theories

Explain the new trade and national competitive advantage theories

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In this chapter, you will explore global patterns of international trade.

You will also:

  • Learn about mercantilism—the earliest theory of international trade.
  • Explore the theories of absolute and comparative advantage.
  • And understand more recent trade theories and their implications for international business.

Walmart

  • Walmart and others import from China
  • China imports from other countries, too
  • Causes dramatic growth in global trade

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  • Walmart is one of the world’s largest companies, selling $447 billion worth of goods annually. It has around 3,900 stores in the United States and more than 4,200 stores in 15 other countries.
  • Walmart and other companies purchase inexpensive goods from low-cost production locations, such as China. This is driving growth in international trade between China and the rest of the world.
  • But China does not only export goods to other nations, it also imports products from them. From the United States, China imports steel to feed its booming construction sector and medical devices for its healthcare industry, among many other items.

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International Trade

Purchase, sale, or exchange of goods and services across national borders

  • People have larger selection of products
  • Important engine for job creation

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International trade is the purchase, sale, or exchange of goods and services across national borders.

  • We can measure the importance of trade to a nation by examining its trade volume relative to its total output.
  • One benefit of international trade is that it provides a country’s people with a larger selection of goods and services.
  • Another benefit is that it creates jobs and new entrepreneurial opportunities.

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Trade and World Output

  • World trade
  • 80% merchandise
  • 20% services
  • World output impacts trade
  • Growing output = growing trade
  • Sluggish output = sluggish trade
  • World trade grows faster

than world output

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  • Today, world merchandise exports are valued at more than $14 trillion and service exports total more than $3 trillion.
  • Trade in merchandise is around 80% of total world trade, whereas services account for around 20%.
  • And while higher world economic output encourages international trade, lower output slows trade.
  • Over time, we see that world trade expands at a rate that is faster than growth in world output.

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World’s Top Exporters

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  • This table shows the world’s largest exporters of merchandise and services.
  • Perhaps not surprisingly, the United States ranks second in merchandise exports behind China and first in service exports.

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Trade Patterns

Merchandise trade among:

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Chart3

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34
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High income nations High-income and low- and middle-income nations Low- and middle-income nations
60 34 6

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There is a persistent pattern of merchandise trade among nations.

  • Trade between the world’s high-income economies accounts for roughly 60 percent of total world merchandise trade.
  • Trade between high-income countries and low- and middle-income nations accounts for around 34 percent of world merchandise trade.
  • Trade between low- and middle-income nations accounts for only about 6 percent of world merchandise trade.

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Who Trades with Whom?

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This table gives us a detailed picture of who trades with whom.

  • The number that stands out in this table is that 71 percent of Europe’s exports are destined for other European nations.
  • By contrast, intra-regional trade accounts for more than 52 percent of exports in Asia, and more than 48 percent of exports in North America.

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Trade Dependence and Independence

Potential effects of dependence:

  • Infuses needed capital
  • Creates jobs and raises wages
  • Imports technology and skills
  • Economic problems transferred
  • Political turmoil can spill over

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Countries range from total trade dependence at one extreme and total independence at the other extreme.

  • Developing and transition nations often depend on trade with their developed neighbors.
  • Dependency on trade with another nation is similar to other dependency situations:
  • When times are good in the nation depended on, times are often good for the dependent nation.
  • But hard times in a nation depended on (such as periods of economic recession or political turmoil) often spells trouble for a dependent nation.

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Discussion Question

What are the patterns of global and regional trade flows that we see among nations?

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What are the patterns of global and regional trade flows that we see among nations?

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Answer to Discussion Question

60 percent of world merchandise trade occurs among high-income countries. 34 percent of world merchandise trade occurs among high-income countries and low- and middle-income nations. About 6 percent of trade occurs only among low- and middle-income nations.

Intra-regional trade accounts for 71 percent of Europe’s exports, 52 percent of Asia’s exports, and around 48 percent of North America’s exports.

This century is called the “Pacific century” due to expected growth in Asia and a shift in trade from the Atlantic to the Pacific Ocean.

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Answer:

  • 60 percent of world merchandise trade occurs among high-income countries. 34 percent of world merchandise trade occurs among high-income countries and low- and middle-income nations. About 6 percent of trade occurs only among low- and middle-income nations.
  • Intra-regional trade accounts for 71 percent of Europe’s exports, 52 percent of Asian exports, and around 48 percent of North American exports.
  • This century is called the “Pacific century” due to expected growth in Asia and a shift in trade from the Atlantic to the Pacific Ocean.

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Trade Theory Timeline

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  • It was not until the fifteenth century that people first put forth formal explanations for why trade occurs.
  • Today, trade experts continue to refine existing trade theories and develop new ones.

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Foundations of Mercantilism

Nations accumulate financial wealth by encouraging exports and discouraging imports

Three pillars:

▪ Maintain trade surplus

▪ Government intervention

▪ Exploit colonies

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The trade theory of mercantilism argues that nations should accumulate financial wealth, usually in the form of gold, by encouraging exports and discouraging imports.

  • European sea-faring nations practiced mercantilism from around 1500 to the late 1700s.
  • These countries acquired colonies in Africa, Asia, and the Americas as sources of inexpensive raw materials and as markets for higher-priced finished goods.
  • Mercantilist nations used profits from this trade to create armies and navies to control colonies and protect their shipping.

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Flaws of Mercantilism

  • World trade is a zero-sum game
  • Limits colonies’ market potential
  • Constrains output and consumption

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Mercantilism has several inherent flaws:

  • First, it views international trade as a zero-sum game. This is the idea that a nation benefits from trade only at the expense of other nations.
  • Second, market potential in the colonies was less than it could have been had people there received higher prices for their resources.
  • Third, mercantilist policies constrained the potential output and consumption for both the colonies and the mercantilist nations.

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Absolute Advantage

Ability of a nation to produce a good more efficiently than any other nation (greater output using same or fewer resources)

Specialization and trade allows each to produce and consume more

1 resource unit = 1/6 ton rice or

1/3 ton tea

Tealand

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  • Absolute advantage is the ability of a nation to produce a good more efficiently than any other nation.
  • This means that the nation can produce a greater amount of output using the same amount of, or fewer, resources.
  • Assume that Riceland and Tealand produce rice and tea, transporting goods costs nothing, and each nation produces and consumes its own rice and tea.
  • In Riceland, one resource unit produces one ton of rice or one-fifth of a ton of tea.
  • In Tealand, one resource unit produces one-sixth ton of rice or one-third ton of tea.
  • This means that Riceland has an absolute advantage in rice production and Tealand has an absolute advantage in tea production.

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Trade Gains:
Absolute Advantage

Specialization and trade:

  • Riceland gets five times more tea than it would have produced itself
  • Tealand gets two times more rice than it would have produced itself

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  • Assume that Riceland and Tealand expend additional resource units to produce extra rice and tea, respectively, and then trade additional output with the other nation on a one-to-one basis.
  • This means that Riceland expends an additional resource unit to produce one extra ton of rice that it then trades with Tealand to obtain one ton of tea. Riceland gets four-fifths of a ton more tea than the one-fifth of a ton it would have produced itself with one additional resource unit.
  • Tealand expends an additional resource unit to produce an extra one-third of a ton of tea that it then trades with Riceland to obtain one-third of a ton of rice. Tealand gets one-sixth of a ton more rice than the one-sixth of a ton it would have produced itself with one additional resource unit.
  • Specialization and trade gives Riceland five times more tea than it would have produced itself, and gives Tealand two times more rice than it would have produced itself.
  • This means that if each country specializes in the area in which it has an absolute advantage, world output (and consumption) of both goods increases. In other words, each nation benefits from specialization and trade.

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Comparative Advantage

Inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other good

Specialization and trade allow each to produce and consume more

1 resource unit = 1/6 ton rice or

1/3 ton tea

Tealand

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  • Comparative advantage is the inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other good.
  • This means that a country is less efficient in the production of all goods, but it is less inefficient in the production of one good.
  • Again, assume two countries, two products, and transporting goods costs nothing.
  • In Riceland, one resource unit produces one ton of rice or one-half of a ton of tea.
  • In Tealand, one resource unit produces one-sixth of a ton of rice or one-third of a ton of tea.
  • This means that Riceland has absolute advantages in both goods because it is more efficient at producing each one.
  • However, Tealand has a comparative advantage in tea production because it produces tea more efficiently than it produces rice.

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Trade Gains:
Comparative Advantage

Specialization and trade:

  • Riceland gets two times more tea than it would have produced itself
  • Tealand gets two times more rice than it would have produced itself

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  • Again, assume that Riceland and Tealand expend additional resource units to produce extra rice and tea, respectively, and then trade additional output with the other nation on a one-to-one basis.
  • This means that Riceland expends an additional resource unit to produce one extra ton of rice that it then trades with Tealand to obtain one ton of tea. Riceland gets one-half of a ton more tea than the one-half of a ton it would have produced itself with one additional resource unit.
  • Likewise, Tealand expends an additional resource unit to produce an extra one-third of a ton of tea that it then trades with Riceland to obtain one-third of a ton of rice. Tealand gets one-sixth of a ton more rice than the one-sixth of a ton it would have produced itself with one additional resource unit.
  • Specialization and trade gives Riceland two times more tea than it would have produced itself, and gives Tealand two times more rice than it would have produced itself.
  • This means that if Riceland holds an absolute advantage in the production of each good and Tealand holds a comparative advantage in the production of one good, world output (and consumption) of both goods increases. In other words, each nation can still benefit from specialization and trade.

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Assumptions and Limitations

Nations strive only to maximize production and consumption

Only two countries produce and consume just two goods

No transportation costs of traded goods

Labor is the only resource used to produce goods and it cannot cross borders

Specialization does not create efficiency and improvement gains

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The theories of absolute and comparative advantage focus on production efficiency, or productivity. Despite their powerful predictive capabilities, these theories are limited.

  • They assume that nations strive only to maximize production and consumption. But governments get involved in trade for many reasons, including a concern for workers’ jobs.
  • They assume that only two countries produce and consume two goods. But more than 180 countries and countless products are produced, traded, and consumed.
  • They assume that it costs nothing to transport goods. But transportation costs are a major expense of international trade.
  • They assume that labor is the only resource used to produce goods and that it cannot cross borders. But production clearly needs additional resources and labor is increasingly mobile.
  • And they assume that specialization does not create efficiency gains. But specialization actually increases knowledge of a task and causes future improvements.

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Discussion Question

When a nation cannot produce a good more efficiently than other nations, but it can produce that good more efficiently than it does any other good, we say this is a case of __________.

a. Absolute advantage

b. Comparative advantage

c. Mercantilism

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When a nation cannot produce a good more efficiently than other nations, but it can produce that good more efficiently than it does any other good, we say this is a case of __________.

a. Absolute advantage

b. Comparative advantage

c. Mercantilism

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Answer to Discussion Question

When a nation cannot produce a good more efficiently than other nations, but it can produce that good more efficiently than it does any other good, we say this is a case of __________.

a. Absolute advantage

b. Comparative advantage

c. Mercantilism

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The correct answer is b. Comparative advantage

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Factor Proportions Theory

Countries produce and export goods that require resources (factors) in abundance, and import goods

that require resources in short supply

Two factor types

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Whereas absolute advantage and comparative advantage focus on productivity, factor proportions theory concentrates on factors of production.

  • Factor proportions theory says that countries produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply.
  • It predicts that a country will specialize in products that require labor if its cost is low relative to that of land and capital, and vice versa.

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Leontief Paradox

Research found evidence opposite of that predicted by the factor proportions theory:

U.S. exports are more labor-intensive than U.S. imports

Possible explanations:

  • Theory assumes nation’s production factors to be homogeneous
  • Theory is better predictor when expenditures on labor are considered

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  • But a researcher named Wassily Leontief explored whether the United States, as predicted by factor proportions theory, exports goods requiring capital-intensive production and imports goods requiring labor-intensive production.
  • He found that the United States exports require more, not less, labor-intensive production than its imports. This apparent contradiction became known as the Leontief Paradox.
  • A possible explanation is that the theory considers a country’s production factors to be homogeneous—particularly labor—although labor skills vary greatly within a country.

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International Product Life Cycle

A company begins by exporting its product and later undertakes foreign direct investment as a product moves through its life cycle

Source: Raymond Vernon and Louis T. Wells, Jr., The Economic Environment of International Business, 5th ed. (Upper Saddle River, N.J.: Prentice Hall, 1991), p. 85.

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The international product life cycle theory states that a company will begin exporting its product and later undertake foreign direct investment as the product moves through its life cycle. This means that a country’s export will eventually become its import.

  • In stage 1, the new product stage, high purchasing power and buyer demand encourage a company to design and introduce a new product concept. Although there is virtually no export market initially, exports increase late in this stage.
  • In stage 2, the maturing product stage, the domestic market and markets abroad become fully aware of the existence of the product and its benefits. Demand rises and is sustained over a fairly lengthy period of time. Near the end of this stage, sales begin in developing nations and manufacturing is established there.
  • In stage 3, the standardized product stage, competition from companies selling similar products pressures companies to lower prices to maintain sales levels. A search for low-cost production bases abroad begins and the home market may begin importing the product.

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New Trade Theory

Fundamentals

  • Gains from specialization and economies of scale
  • Companies first to market create barriers to entry
  • Government may help by assisting home companies

First-mover advantage

  • Economic and strategic advantage of being first to enter an industry
  • May create a formidable barrier to market entry for potential rivals

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New trade theory says that:

  • There are gains to be made from specialization and increasing economies of scale.
  • Companies first to market can create barriers to entry.
  • And Government may play a role in assisting its home-based companies.

According to the theory, as a firm specializes and its output increases, it realizes economies of scale and its unit cost of production declines. The company can then expand, lower prices, and force competitors to produce a similar level of output if they are to remain competitive.

  • A major part of the theory is the first-mover advantage—which is the economic and strategic advantage gained by being the first company to enter an industry.
  • This advantage creates a barrier to entry for potential rivals and may allow a country to dominate in a product.

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Discussion Question

Briefly describe the new trade theory. Does its focus on productivity put it at odds with the theory of comparative advantage and factor proportions theory?

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Briefly describe the new trade theory. Does its focus on productivity put it at odds with the theory of comparative advantage and factor proportions theory?

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Answer to Discussion Question

New trade theory says that there are gains from specialization and economies of scale, companies first to market create barriers to entry, and government is helpful if it assists its home-based companies.

Because new trade theory emphasizes productivity rather than a nation’s resources, it is in line with the theory of comparative advantage and at odds with factor proportions theory.

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Answer:

New trade theory says that:

  • There are gains from specialization and economies of scale.
  • Companies first to market create barriers to entry.
  • And government is helpful if it assists its home-based companies.

Because new trade theory emphasizes productivity rather than a nation’s resources, it is in line with the theory of comparative advantage but at odds with factor proportions theory.

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National Competitive Advantage

Nation’s competitiveness in an industry depends on the industry’s capacity to innovate and upgrade, which in turn depends on four main determinants

(plus government and chance)

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National competitive advantage theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade.

  • The theory attempts to explain why some nations are more competitive in certain industries.
  • It says four elements are the basis of national competitiveness: factor conditions; demand conditions; related and supporting industries; and firm strategy, structure, and rivalry.

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Factor Conditions

Basic Factors

Advanced Factors

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National competitive advantage theory recognizes two types of factors in any nation:

  • Basic factors are natural endowments of resources, such as a large population, natural resources, climate, and land features.
  • Advanced factors result from a nation’s innovation and education, including the skill levels of the workforce and the quality of its technological infrastructure.

The theory says that basic factors can spark initial production, but advanced factors account for a nation’s sustained competitive advantage in a product.

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Demand Conditions

Sophisticated home-market buyers drive companies to improve existing products and develop entirely new products and technologies

This should improve the competitiveness of the entire group of companies in a market

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  • National competitive advantage theory acknowledges the importance of demand conditions—which refers to the sophistication of buyers in the home market.
  • Sophisticated demand conditions in the domestic market drives companies to modify existing products to create new design features, and to develop new products and technologies to better satisfy customers.

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Related and Supporting Industries

Companies in an internationally competitive industry do not exist in isolation

Supporting industries form “clusters” of economic activity in the geographic area

Each industry reinforces the competitiveness of every other industry in the cluster

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Related and supporting industries also feature prominently in national competitive advantage theory.

  • Companies in internationally competitive industries do not exist in isolation.
  • Rather, supporting industries arise to provide inputs and form regional clusters of related activities that reinforce productivity and competitiveness.
  • Exporting clusters—those that export products or invest outside a region—can become a region’s source of long-term prosperity.

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Firm Strategy, Structure,
and Rivalry

Highly skilled managers are essential because strategy has lasting effects on firm competitiveness

Domestic industry whose structure and rivalry create an intense struggle to survive strengthens competitiveness

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Firm strategy, structure, and rivalry also play roles in national competitive advantage theory.

  • Strategic decisions have lasting effects on future competitiveness, as do industry structure and rivalry between companies.
  • In general, the more intense the rivalry between domestic companies, the greater is their global competitiveness. Heightened competitiveness at home helps businesses to compete against imports and against foreign companies trying to develop a presence in the domestic market.

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Discussion Question

National __________ theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade.

a. Product life cycle

b. First-mover

c. Competitive advantage

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National __________ theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade.

a. Product life cycle

b. First-mover

c. Competitive advantage

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Answer to Discussion Question

National __________ theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade.

a. Product life cycle

b. First-mover

c. Competitive advantage

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The correct answer is c. Competitive advantage

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Welcome to Chapter 5, International Trade.

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In this chapter, you will explore global patterns of international trade.

You will also:

  • Learn about mercantilism—the earliest theory of international trade.
  • Explore the theories of absolute and comparative advantage.
  • And understand more recent trade theories and their implications for international business.

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  • Walmart is one of the world’s largest companies, selling $447 billion worth of goods annually. It has around 3,900 stores in the United States and more than 4,200 stores in 15 other countries.
  • Walmart and other companies purchase inexpensive goods from low-cost production locations, such as China. This is driving growth in international trade between China and the rest of the world.
  • But China does not only export goods to other nations, it also imports products from them. From the United States, China imports steel to feed its booming construction sector and medical devices for its healthcare industry, among many other items.

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International trade is the purchase, sale, or exchange of goods and services across national borders.

  • We can measure the importance of trade to a nation by examining its trade volume relative to its total output.
  • One benefit of international trade is that it provides a country’s people with a larger selection of goods and services.
  • Another benefit is that it creates jobs and new entrepreneurial opportunities.

*

  • Today, world merchandise exports are valued at more than $14 trillion and service exports total more than $3 trillion.
  • Trade in merchandise is around 80% of total world trade, whereas services account for around 20%.
  • And while higher world economic output encourages international trade, lower output slows trade.
  • Over time, we see that world trade expands at a rate that is faster than growth in world output.

*

  • This table shows the world’s largest exporters of merchandise and services.
  • Perhaps not surprisingly, the United States ranks second in merchandise exports behind China and first in service exports.

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There is a persistent pattern of merchandise trade among nations.

  • Trade between the world’s high-income economies accounts for roughly 60 percent of total world merchandise trade.
  • Trade between high-income countries and low- and middle-income nations accounts for around 34 percent of world merchandise trade.
  • Trade between low- and middle-income nations accounts for only about 6 percent of world merchandise trade.

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This table gives us a detailed picture of who trades with whom.

  • The number that stands out in this table is that 71 percent of Europe’s exports are destined for other European nations.
  • By contrast, intra-regional trade accounts for more than 52 percent of exports in Asia, and more than 48 percent of exports in North America.

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Countries range from total trade dependence at one extreme and total independence at the other extreme.

  • Developing and transition nations often depend on trade with their developed neighbors.
  • Dependency on trade with another nation is similar to other dependency situations:
  • When times are good in the nation depended on, times are often good for the dependent nation.
  • But hard times in a nation depended on (such as periods of economic recession or political turmoil) often spells trouble for a dependent nation.

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What are the patterns of global and regional trade flows that we see among nations?

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Answer:

  • 60 percent of world merchandise trade occurs among high-income countries. 34 percent of world merchandise trade occurs among high-income countries and low- and middle-income nations. About 6 percent of trade occurs only among low- and middle-income nations.
  • Intra-regional trade accounts for 71 percent of Europe’s exports, 52 percent of Asian exports, and around 48 percent of North American exports.
  • This century is called the “Pacific century” due to expected growth in Asia and a shift in trade from the Atlantic to the Pacific Ocean.

*

  • It was not until the fifteenth century that people first put forth formal explanations for why trade occurs.
  • Today, trade experts continue to refine existing trade theories and develop new ones.

*

The trade theory of mercantilism argues that nations should accumulate financial wealth, usually in the form of gold, by encouraging exports and discouraging imports.

  • European sea-faring nations practiced mercantilism from around 1500 to the late 1700s.
  • These countries acquired colonies in Africa, Asia, and the Americas as sources of inexpensive raw materials and as markets for higher-priced finished goods.
  • Mercantilist nations used profits from this trade to create armies and navies to control colonies and protect their shipping.

*

Mercantilism has several inherent flaws:

  • First, it views international trade as a zero-sum game. This is the idea that a nation benefits from trade only at the expense of other nations.
  • Second, market potential in the colonies was less than it could have been had people there received higher prices for their resources.
  • Third, mercantilist policies constrained the potential output and consumption for both the colonies and the mercantilist nations.

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  • Absolute advantage is the ability of a nation to produce a good more efficiently than any other nation.
  • This means that the nation can produce a greater amount of output using the same amount of, or fewer, resources.
  • Assume that Riceland and Tealand produce rice and tea, transporting goods costs nothing, and each nation produces and consumes its own rice and tea.
  • In Riceland, one resource unit produces one ton of rice or one-fifth of a ton of tea.
  • In Tealand, one resource unit produces one-sixth ton of rice or one-third ton of tea.
  • This means that Riceland has an absolute advantage in rice production and Tealand has an absolute advantage in tea production.

*

  • Assume that Riceland and Tealand expend additional resource units to produce extra rice and tea, respectively, and then trade additional output with the other nation on a one-to-one basis.
  • This means that Riceland expends an additional resource unit to produce one extra ton of rice that it then trades with Tealand to obtain one ton of tea. Riceland gets four-fifths of a ton more tea than the one-fifth of a ton it would have produced itself with one additional resource unit.
  • Tealand expends an additional resource unit to produce an extra one-third of a ton of tea that it then trades with Riceland to obtain one-third of a ton of rice. Tealand gets one-sixth of a ton more rice than the one-sixth of a ton it would have produced itself with one additional resource unit.
  • Specialization and trade gives Riceland five times more tea than it would have produced itself, and gives Tealand two times more rice than it would have produced itself.
  • This means that if each country specializes in the area in which it has an absolute advantage, world output (and consumption) of both goods increases. In other words, each nation benefits from specialization and trade.

*

  • Comparative advantage is the inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other good.
  • This means that a country is less efficient in the production of all goods, but it is less inefficient in the production of one good.
  • Again, assume two countries, two products, and transporting goods costs nothing.
  • In Riceland, one resource unit produces one ton of rice or one-half of a ton of tea.
  • In Tealand, one resource unit produces one-sixth of a ton of rice or one-third of a ton of tea.
  • This means that Riceland has absolute advantages in both goods because it is more efficient at producing each one.
  • However, Tealand has a comparative advantage in tea production because it produces tea more efficiently than it produces rice.

*

  • Again, assume that Riceland and Tealand expend additional resource units to produce extra rice and tea, respectively, and then trade additional output with the other nation on a one-to-one basis.
  • This means that Riceland expends an additional resource unit to produce one extra ton of rice that it then trades with Tealand to obtain one ton of tea. Riceland gets one-half of a ton more tea than the one-half of a ton it would have produced itself with one additional resource unit.
  • Likewise, Tealand expends an additional resource unit to produce an extra one-third of a ton of tea that it then trades with Riceland to obtain one-third of a ton of rice. Tealand gets one-sixth of a ton more rice than the one-sixth of a ton it would have produced itself with one additional resource unit.
  • Specialization and trade gives Riceland two times more tea than it would have produced itself, and gives Tealand two times more rice than it would have produced itself.
  • This means that if Riceland holds an absolute advantage in the production of each good and Tealand holds a comparative advantage in the production of one good, world output (and consumption) of both goods increases. In other words, each nation can still benefit from specialization and trade.

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The theories of absolute and comparative advantage focus on production efficiency, or productivity. Despite their powerful predictive capabilities, these theories are limited.

  • They assume that nations strive only to maximize production and consumption. But governments get involved in trade for many reasons, including a concern for workers’ jobs.
  • They assume that only two countries produce and consume two goods. But more than 180 countries and countless products are produced, traded, and consumed.
  • They assume that it costs nothing to transport goods. But transportation costs are a major expense of international trade.
  • They assume that labor is the only resource used to produce goods and that it cannot cross borders. But production clearly needs additional resources and labor is increasingly mobile.
  • And they assume that specialization does not create efficiency gains. But specialization actually increases knowledge of a task and causes future improvements.

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When a nation cannot produce a good more efficiently than other nations, but it can produce that good more efficiently than it does any other good, we say this is a case of __________.

a. Absolute advantage

b. Comparative advantage

c. Mercantilism

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The correct answer is b. Comparative advantage

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Whereas absolute advantage and comparative advantage focus on productivity, factor proportions theory concentrates on factors of production.

  • Factor proportions theory says that countries produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply.
  • It predicts that a country will specialize in products that require labor if its cost is low relative to that of land and capital, and vice versa.

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  • But a researcher named Wassily Leontief explored whether the United States, as predicted by factor proportions theory, exports goods requiring capital-intensive production and imports goods requiring labor-intensive production.
  • He found that the United States exports require more, not less, labor-intensive production than its imports. This apparent contradiction became known as the Leontief Paradox.
  • A possible explanation is that the theory considers a country’s production factors to be homogeneous—particularly labor—although labor skills vary greatly within a country.

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The international product life cycle theory states that a company will begin exporting its product and later undertake foreign direct investment as the product moves through its life cycle. This means that a country’s export will eventually become its import.

  • In stage 1, the new product stage, high purchasing power and buyer demand encourage a company to design and introduce a new product concept. Although there is virtually no export market initially, exports increase late in this stage.
  • In stage 2, the maturing product stage, the domestic market and markets abroad become fully aware of the existence of the product and its benefits. Demand rises and is sustained over a fairly lengthy period of time. Near the end of this stage, sales begin in developing nations and manufacturing is established there.
  • In stage 3, the standardized product stage, competition from companies selling similar products pressures companies to lower prices to maintain sales levels. A search for low-cost production bases abroad begins and the home market may begin importing the product.

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New trade theory says that:

  • There are gains to be made from specialization and increasing economies of scale.
  • Companies first to market can create barriers to entry.
  • And Government may play a role in assisting its home-based companies.

According to the theory, as a firm specializes and its output increases, it realizes economies of scale and its unit cost of production declines. The company can then expand, lower prices, and force competitors to produce a similar level of output if they are to remain competitive.

  • A major part of the theory is the first-mover advantage—which is the economic and strategic advantage gained by being the first company to enter an industry.
  • This advantage creates a barrier to entry for potential rivals and may allow a country to dominate in a product.

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Briefly describe the new trade theory. Does its focus on productivity put it at odds with the theory of comparative advantage and factor proportions theory?

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Answer:

New trade theory says that:

  • There are gains from specialization and economies of scale.
  • Companies first to market create barriers to entry.
  • And government is helpful if it assists its home-based companies.

Because new trade theory emphasizes productivity rather than a nation’s resources, it is in line with the theory of comparative advantage but at odds with factor proportions theory.

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National competitive advantage theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade.

  • The theory attempts to explain why some nations are more competitive in certain industries.
  • It says four elements are the basis of national competitiveness: factor conditions; demand conditions; related and supporting industries; and firm strategy, structure, and rivalry.

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National competitive advantage theory recognizes two types of factors in any nation:

  • Basic factors are natural endowments of resources, such as a large population, natural resources, climate, and land features.
  • Advanced factors result from a nation’s innovation and education, including the skill levels of the workforce and the quality of its technological infrastructure.

The theory says that basic factors can spark initial production, but advanced factors account for a nation’s sustained competitive advantage in a product.

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  • National competitive advantage theory acknowledges the importance of demand conditions—which refers to the sophistication of buyers in the home market.
  • Sophisticated demand conditions in the domestic market drives companies to modify existing products to create new design features, and to develop new products and technologies to better satisfy customers.

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Related and supporting industries also feature prominently in national competitive advantage theory.

  • Companies in internationally competitive industries do not exist in isolation.
  • Rather, supporting industries arise to provide inputs and form regional clusters of related activities that reinforce productivity and competitiveness.
  • Exporting clusters—those that export products or invest outside a region—can become a region’s source of long-term prosperity.

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Firm strategy, structure, and rivalry also play roles in national competitive advantage theory.

  • Strategic decisions have lasting effects on future competitiveness, as do industry structure and rivalry between companies.
  • In general, the more intense the rivalry between domestic companies, the greater is their global competitiveness. Heightened competitiveness at home helps businesses to compete against imports and against foreign companies trying to develop a presence in the domestic market.

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National __________ theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade.

a. Product life cycle

b. First-mover

c. Competitive advantage

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The correct answer is c. Competitive advantage

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