IB 303 Chapter 5: International Trade and Factor-Mobility Theory

Terms in this set (26)

Theory of Absolute Advantage
- Adam Smith, 1776, states that the real value of a country is in its good and services, not the gold
- holds that different countries produce some goods more efficiently than others
- questions why citizens should buy domestically produced goods when they can buy them more cheaply from abroad
- AS: unrestricted trade would lead a country to specialize in the products that give it a competitive advantage.

- Specialization would increase efficiency for three reasons:
1. Labor could become more skilled by repeating the same tasks.
2. Labor would not lose time in switching production from one kind of product to another.
3. Long production runs would provide incentives for developing more effective working methods.

- Then, a country can use its excess production to buy more imports than it could have produced.

1. Natural Advantage:
- comes from climatic conditions, access to certain natural resources, or availability of certain labor forces.
- U.S. and Costa Rica are suited for the production of different things, and if they were to become self-sufficient, they would reduce the production of what is best suited for them.
- The more the two countries' natural advantages differ, the more likely they will favor trade with one another.

2. Acquired advantage:
- countries that are competitive in manufactured goods have an acquired advantage, usually in product or process technology.
- product technology: allows a country to produce a unique product or one that is easily distinguished from that of its competitors
ex: Denmark exports silverware not because it is rich is silver, but because it has distinctive products.
- process technology: ability to efficiently produce a homogeneous product (emulate the best products)
ex: Japan's steel industry
- technology may be used to overcome natural advantages
ex: Iceland exports tomatoes grown near the Arctic Circle, while Brazil imports quality wine near the equator.

"By specializing and trading, global efficiency is optimized, and the two countries can have more coffee and more wheat than they would without trade."
* Full employment: the free-trade theories assume that resources are fully employed, but when countries have many unemployed or unused resources, they may restrict imports so that they can employ or use idle resources.

* Economic efficiency: countries may have other goals than economic efficiency and avoid overspecialization because of the vulnerability created by changes in technology and by price fluctuations or because they do not trust foreign companies to always supply them with essential goods.

* Division of gains: if countries feel that a trading partner is gaining too large a share of benefits, they may prefer to forgo absolute gains for themselves to prevent others from gaining a relative economic advantage.

* Transport costs: it may cost more to transport the goods than is saved through specialization, and then, the advantages of trade are negated.

* Statics and dynamics: conditions that give countries production advantages and disadvantages might change. Most trade today is due to acquired advantage, to technical dynamics cause countries to gain or lose both absolutely and relatively.

* Services: the free-trade theories deal with products rather than services. but the portion of services in world trade is increasing. Providing services also diverts resources from product production.

* Production networks: costs are saved by having activities take place (multiple parts of one thing) in those countries where there is an absolute or comparative advantage for their production.

* Mobility: assumption that resources can move domestically from the production of one good to another easily and at no cost- is not valid, because different jobs may have different skill needs, or may be less productive if you move them from one job to another. Resources also cannot move easily internationally, although it is becoming more easy recently. However, it is still safe to say that resources are more mobile domestically than they are internationally.
* Factor-proportions theory:
- Developed by Eli Heckscher and Bertil Ohlin
- maintains that difference in countries' endowments of labor compared to land or capital endowments explain differences in the cost of production factors.
ex: if labor were abundant in comparison to land and capital, labor costs would be low relative to land and capital costs, and vice versa.
- relative factor costs allow countries to excel in production and export of products that utilize their abundant and cheaper production factors.

* People and land
- More people than land: Hong Kong and Netherlands, land price is high because it's in demand
- Regardless of soil and climate conditions, they do not excel in production of goods that require large amounts of land

* Manufacturing locations
- most successful industries in Hong Kong: tech. permits the minimum amount of land compared to the number of people employed.
ex. clothing production: workers require little space in multi-story factories.

* Capital, labor rates, and specialization:
- variation in labor skills leads to more international task specialization to produce a given product.
Ex: a company may locate its R & D and management functions primarily in countries with a highly educated population, while locating its labor-intensive production work in countries where it can employ less educated and less expensive workers.

* Process technology:
- companies may substitute capital for labor, depending on the cost of each
- bigger countries depend more on products that require larger production runs.

* Product technology:
- Composition of world trade
1. manufacturing is the largest sector
- depends largely on technology to develop new products and processes
- tech depends on a large number of scientists and engineers and a large amount of capital to invest in R&D
- developed countries have an abundance of these features, and originate most new products and account for most manufacturing output and trade.
- developing countries are opposite, and they depend much more on the production of primary products and natural advantage
2. commercial services is the fastest growing sector
* Country similarity theory:
- explains why most trade takes place among developed countries
- says that companies create new products in response to market conditions in their home market
- they can then turn to markets and consumer economic levels that are most similar to what they are accustomed.

* Specialization and acquired advantage
- exporting: providing consumers abroad with an advantage over what they could buy from the domestic market.
- spending more on R&D, leading to specialization and acquired advantage.
Germany: machinery and equipment
Switzerland: pharmaceutical
Denmark: food products
Bangladesh: exporting shirts, trousers, and hats, but not bed linens or footballs (Pakistan)

* Product differentiation:
- companies differentiate products, creating two-way trade in seemingly similar products
Ex: U.S. is a major importer and exporter of tourist services, vehicles, and passenger aircraft because different companies from different countries have differentiated products with various appeals. Boeing and Airbus differ in capacity, flying range, fuel consumption, and perceived reliability.

* The Effects of cultural similarity:
- doing business in countries that are similar to home, such as a country that speaks the same language
- historic colonial relationships (France and Africa's relationship gives Air France an advantage)
- easier to continue business ties rather than developing new arrangements in countries where they are less experienced

* The effects of political relationships and economic agreements
- discourage or encourage trade
- political animosity between Cuba and U.S.
- European union removes trade barriers

* The effects of distance:
- greater distances mean higher transportation costs (Intel brings semiconductors from Costa Rica)
- distance is more important for homogeneous products than for differentiated products, since the homogeneous products compete more on price.
- transportation costs also depend on the available transportation modes (wines from Australia by container ship, wines from southern France reaches via land at the same cost)

* Overcoming distance:
- overcoming distance and freight costs to compete with competitors that may be closer in distance is difficult.
The product life cycle theory:
- States that the production location of certain manufactured products shifts as they go through their life cycle.
- Consists of four stages: introduction, growth, maturity, and decline.
- Companies develop new products because they observe a nearby need (domestic market)
- most new technologies that result in new products and production methods originate in developed countries, who have most of the resources to develop new products and buy them.

1. Introduction:
- occurs in a domestic location so the company can obtain rapid market feedback and save on transport costs. Most sales are domestic.
- production is more labor-intensive than in other stages. labor-saving machinery might be developed when the product is highly standardized.
- high education and skills usually make the labor efficient regardless of high labor rates.
- high labor costs can be passed onto consumers who are unwilling to wait for possible price reductions later

2. Growth:
- competitors increase with sales growth, esp. in other developed countries
- If a U.S. innovated product sells well, a Japanese competitor may put a manufacturer in Japan and sell their products there because:
1. growing demand in Japan doesn't allow much attention to other markets
2. Producers there stay occupied in developing unique product variations to especially fit the needs of Japanese consumers
3. Japanese costs may still be high due to production start-up problems
- sales growth may encourage manufacturers to produce labor-saving technologies, but they are also busy differentiating the product for their own markets.
- therefore, the capital received, through growing, is less than what will come later.
- original producing country will increase its exports to the developing countries

3. Maturity
- A decline in exports from the innovating country: because of the widespread technology, the innovating country no longer has a production advantage and foreign production displaces it, since manufacturing in developing countries are cheaper.
- More product standardization
- more capital intensity (capital-intensive production reduces per-unit cost, which increases demand from developing countries
- increased competitiveness of price

4. Decline
- A concentration of production in developing countries
(Markets in developed economies decline, as consumers demand newer products).
- An innovating country becoming a net importer
(cheaper costs)