IB 303 Chapter 5: International Trade and Factor-Mobility Theory
Terms in this set (26)
Costa Rica Case
* Late 1800s-1960s: liberal trade
* 1960-1982: import substitution with local goods
- Combine markets with El Salvador, Honduras, Guatemala, and Nicaragua to form the Central American Common Market (CACM).
* 1983-early 1990s: liberalization of imports, export promotion and incentive for most types of foreign investments
- Forms (CINDE), private org funded by the gov. and by U.S. grants to aid in economic development and attract foreign direct investment.
* Early 1990s -present: strategic trade policy calling for production of specific types of products and openness to imports
-Exports of coffee and bananas are still important, but 60 percent of CR's merchandise exports are manufactured goods, with high-tech products constituting the backbone of the economy and export earnings.
Movement of capital, technology, and people across borders
Laissez-faire vs. Interventionist approaches
Laissez-faire approach to trade
-allows market forces to determine trading relations
- free-trade theories (absolute advantage and comparative advantage)
Interventionist approach to trade
-a great deal of government intervention in trade
- merchantilism and neomercantilism
* How much countries depend on trade
* In what products?
* with whom?
Major trade theories
* Country size
* factor proportions
* country similarity
* product life cycle theory
* diamond of national competitive advantage theory
Interventionist Theories: Mercantilism
- oldest trade theory
- a country's wealth is measured by its holdings of "treasure," usually meaning gold.
- foundation of economic thought from 1500-1800
- countries should export more than they import, and receive gold from countries that run deficits
- this gold is used to raise armies and invest in national institutions to solidity the people's allegiance to the new nation.
- Governmental Policies:
* to export more than import, gov. restricted imports and subsidized local production that otherwise could not compete in domestic or international markets.
* colonies were used to supply commodities that would have normally been imported
* forced colonies to export less highly valued raw materials to them and import more highly valued manufactured products from them
- Balance of Trade:
* favorable balance of trade (trade surplus): indicates that a country's exporting more than it is importing
* unfavorable balance of trade (trade deficit): indicates that a country is importing more than it is exporting
* "favorable" balance of trade may turn out to be disadvantageous is the credit cannot eventually buy sufficient goods and services from the country that is importing our goods.
Interventionist Theories: Neomercantilism
- describes the approach of countries that try to run favorable balance of trade in an attempt to achieve some social or political objective.
ex: increasing employment by setting policies that encourage domestic companies to produce excess of the local demand and export the surplus
Absolute advantage theory and comparative advantage theory
- Both hold that nations should NEITHER artificially limit imports nor promote exports.
- The market determines which producers survive as consumers buy products that best fit their needs.
- Imply SPECIALIZATION: producing some things for domestic consumption and export while using the export earnings to buy imports and products and services produced abroad.
Free-trade theories: absolute advantage theory
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.
IN WHAT PRODUCTS SHOULD A COUNTRY SPECIALIZE?
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."
Free-trade theories: comparative advantage theory
Theory of Comparative Advantage
-1817, David Ricardo asks: "what happens when one country can produce all products at an absolute advantage?"
- says that global efficiency gains may still result from trade if a country specializes in what it can produce most efficiently, regardless of other countries' absolute advantage.
* Comparative Advantage
- what are you more efficient at producing, compared to other countries, even if you are absolutely the best at producing everything?
- compare the efficiencies of your productions; the more efficient: comparative advantage
Theories of specialization: some assumptions and limitations
* 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.
Trade Pattern Theories
Trade pattern theories talk about how much a country trades, what products it trades, or who will be its trading partners when following a free trade policy.
How much does a country trade?
* Nontradeable goods: products and services (haircuts, retail grocery distribution, etc.) that are seldom practical to export due to high transportation costs.
* Theory of Country Size:
- holds that large countries usually depend less on trade than small ones
- large land areas are more likely to have varied climates and an assortment of natural resources, making them more self-sufficient than others
-ex: Brazil, China, India, U.S., and Russia import and export less than others
- the father the distance of a country from a foreign market, the higher the transportation cost, longer inventory time, greater the uncertainty and unreliability of timely product delivery. Therefore, larger countries are more likely to keep it "in-house": self-sufficient.
EXPLAINS RELATIVE DEPENDENCE ON TRADE
* Size of the Economy:
- EXPLAINS DIFFERENCES IN ABSOLUTE AMOUNT OF TRADE
- 9 out of the world's top 10 exporters were developed countries
- developed countries account for well over half of the world's exports, meaning they produce so much that they have more to sell, domestically and internationally
- incomes are high, buy more domestically and internationally
ex: U.S. is the third largest country in the area but the largest economically. Its dependence on imports or exports is comparatively low, but it is the world's largest trader.
What types of products does a country trade?
* 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
With whom do countries trade?
* 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
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.
Does geography matter?
One study showed that 70 percent of countries' differences in per capita income can be accounted for by four factors: malaria, hydrocarbon endowments, coastal access, and transportation costs -and all of these relate to geography.
The Statics and Dynamics of Trade
* The product life cycle theory and the diamond of national advantage theory explain how countries develop, maintain, and lose their competitive advantages.
The Statics and Dynamics of Trade: Product life cycle theory
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.
- 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
- 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
- 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
- A concentration of production in developing countries
(Markets in developed economies decline, as consumers demand newer products).
- An innovating country becoming a net importer
Verifications and limitations of the product life cycle theory
The product lifecycle theory holds that the location of production facilities that serve world markets shifts as products move through their life cycle.
However, not all products conform to the dynamics of the PLC.
1. products with high transport costs that may have to be produced close to the market, thus never becoming significant exports
2. products that have extremely short life cycles due to rapid innovation (Ex: fashion items)
3. luxury products for which cost is of little concern to the consumer. production in a developing country may lead consumers to believe that the product is less luxurious
4. products for which a company can maintain consumer demand without competing on the basis of price (through differentiation, advertising, etc.)
5. Products that require specialized technical personnel to be located near production so as to move the products into their next generation of models. (Long-term U.S. dominance of medical equipment and Germany's dominance of rotary printing presses).
Nowadays, companies introduce a product simultaneously around the world by observing the worldwide market segments. They choose an initial production location which will minimize costs for serving markets in multiple countries.
The Statics and dynamics of trade: the diamond of national competitive advantage
According to the diamond of national competitive advantage theory, companies' development and maintenance of internationally competitive products depends on favorable:
1. demand conditions:
- are consumers likely to buy what we can produce at the price we can deliver to them?
(Ex: ceramic tile industry in Italy after WWII, which kept the houses cool in the hot Italian climate)
2. Factor conditions:
- are sufficient quantities and combinations of the quality of labor, capital, and raw materials available at acceptable prices?
(Ex: wood was expensive in Italy, and skilled labor, capital, tech and equipment were available on favorable terms)
3. related and supporting industries
- can we outsource production of sufficient components and services to allow us to concentrate our efforts on what we can do best?
4. firm strategy, structure, and rivalry
- will competitive conditions and our reactions to them enable us to evolve our operations to sustain and improve our market position?
THE FIRST THREE ARE RELATED TO DEVELOPMENT, WHILE THE LAST IS RELATED TO SUSTAINABILITY.
Limitations of the diamond of national competitive advantage theory
- The existence of the 4 favorable conditions does not guarantee that an industry will develop in a given locale.
- effect of growth of globalization on the 4 conditions:
1. demand conditions: observations of foreign or foreign-plus-domestic demand conditions have spurred much of the recent Asian export growth.
2. companies and countries do not depend entirely on domestic factor conditions; capital and managers are now internationally mobile.
3. materials and components are more easily brought from abroad due to transportation advancements and relaxed import restrictions.
4. companies react to both domestic and foreign-based rivals.
Using the diamond for transformation
* You can succeed by expanding the diamond of national advantage theory to include changes brought on by globalization (ex: Costa Rica).
The factor-mobility theory focuses on why production factors move, the effects of that movement on transforming factor endowments, and the impact of international factor mobility (especially people) on world trade.
Trade-mobility theory: why production factors move
- the most internationally mobile production factor (esp. short-term capital).
- primarily transferred because of differences in expected return. (accounting for risk)
- political and economic conditions
- invest abroad for the long term to tap markets, improve quality, and lower operating costs
- governments give foreign aid and loans
- nonprofit orgs donate money abroad
- individuals remit funds to help their families in friends in foreign countries
- less mobile than capital
- temporary travel (tourists, students, and retirees) do not affect factor endowments because they do not work in destination countries.
- migration: major engine of globalization in the late 19th and early 20th centuries, still important.
* Economic motives:
- earn more in a foreign country than at home
* Political motives:
- persecution or war dangers (refugees)
- largest recent movement: from Afghanistan to Pakistan
- sometimes they are parallel (Colombians flee harsh economic and political conditions)
Effects of Factor Movements
- Increase of workers
Ex: U.S. has had a shortage of native-born workers, which has been partially alleviated through immigration.
- Brain drain: but people receive money from those who migrate. Also might increase the number of start-ups and capital in their home countries because they learn and bring the ideas back.
- costs of providing social services to immigrants who need to learn to adjust to a new language and society
- immigrants (unskilled workers) may take jobs that domestic people don't want.
The relationship between trade and factor mobility
Factor movement is an alternative way to trade that may or may not be a more efficient use of resources.
- with varying factor proportions, there are pressures for the most abundant factors to move to areas of scarcity.
- however, there are restrictions on factor movements that make them only partially mobile internationally, such as U.S. immigration restrictions and Mexican foreign capital ownership restrictions in the petroleum industry.
(tomato case: costs are lowest when trade is unrestricted and production factors are mobile).
- in some cases, the inability to gain sufficient access to foreign production factors may stimulate efficient methods of substitution, such as the development of alternatives for traditional production methods.
- many exports would not occur without foreign investments, partly because a company may export equipment as part of its foreign investment.
- potential importers and exporters are more willing to trade when they are part of the ethnic network.
- factor mobility through foreign investment often stimulates trade because of:
1. the need for components
2. the parent company's ability to sell complementary products.
3. the need for equipment for subsidiaries.