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PART THREE
THEORIES AND INSTITUTIONS: TRADE AND INVESTMENT
CHAPTER SIX
INTERNATIONAL TRADE
AND FACTOR-MOBILITY THEORY
OBJECTIVES
6-1 Understand why policymakers rely on international trade and factor mobility theories
to help achieve economic objectives
6-2 Illustrate the historical and current rationale for interventionist and free trade theories
6-3 Describe theories that explain national trade patterns
6-4 Explain why a country’s export capabilities are dynamic
6-5 Summarize the reasons for and major effects of international factor movements
6-6 Assess the relationship between foreign trade and international factor mobility
CHAPTER OVERVIEW
This chapter will first examine theories that endorse great governmental intervention in trade
movements (mercantilism and neomercantilism) versus a laissez-faire approach of no
governmental intervention (free-trade theories of absolute advantage and comparative
advantage). It will then look at theories to explain trade patterns (how much countries depend
on trade, in what products, and with whom), including theories of country size, factor
proportions, and country similarity. It will subsequently consider theories dealing with the
dynamics of countries’ trade competitiveness for particular products, which include the product
life cycle theory and the diamond of national competitive advantage theory. The chapter
concludes with an overview of factor mobility, mainly emphasizing the mobility of human
resources.
CHAPTER OUTLINE
OPENING CASE: The Evolution of Taiwan’s International Trade [see Map 6.1.]
Taiwan, officially the Republic of China, with a 2015 population of about 23.4 million, has
successfully taken advantage of its location and used international trade to become one of the
“Asian Tigers” and the world’s 21st-largest exporter. During the last half century, Taiwan
transformed its economy to one that emphasizes economic liberalization, industrial products
and export expansion. The most notable developments in the past two decades were the
renewal and growth of Taiwan’s trade and investment with China, the upsurge of Taiwan’s
outward FDI, and growing reliance on foreign contract workers.
I. INTRODUCTION
Trade theory helps managers and government policymakers focus on three critical
questions: What products should be imported and exported, how much should be traded,
and with whom should they trade? [see Table 6.1.]
II. INTERVENTIONIST AND FREE TRADE THEORIES
Interventionist trade theories endorse great governmental intervention in
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trade movements (mercantilism and neomercantilism) while free trade theories endorse
laissez-faire approach of no governmental intervention (free-trade theories of absolute advantage
and comparative advantage).
A. Mercantilism
The concept of mercantilism served as the foundation of economic thought for nearly
three hundred years (1500–1800). It purports that a country’s wealth is measured by its
holdings of “treasure” (usually gold).
1. Governmental Policies. To export more than they imported, governments
imposed restrictions on most imports and they subsidized products for export.
2. The Concept of Balance of Trade. To amass a surplus (a favorable balance of
trade), a country must export more than it imports and then collect gold and other
forms of wealth from countries that run a deficit (an unfavorable balance of trade).
B. Neomercantilism.
Neomercantilism is the running of a favorable balance of trade (run an export surplus)
to achieve some social or political objective.
C. Free Trade Theories
D. Theory of Absolute Advantage
In 1776 Adam Smith asserted that the wealth of a nation consisted of the goods and
services available to its citizens. His theory of absolute advantage holds that a
country can maximize its own economic well-being by specializing in the production of
those goods and services that it can produce more efficiently than any other nation and
enhance global efficiency through its participation in (unrestricted) free trade. Smith
reasoned that: (i) workers become more skilled by repeating the same tasks; (ii)
workers do not lose time in switching from the production of one kind of product to
another; and (iii) long production runs provide greater incentives for the development of
more effective working methods. Smith also asserted that country-specific advantages
can either be natural or acquired.
1. Natural Advantage. A country may have a natural advantage in the
production of particular products because of given climatic conditions, access
to particular resources, the availability of labor, etc. Variations in natural
advantages among countries help to explain where particular products can be
produced most efficiently.
2. Acquired Advantage. An acquired advantage represents a distinct
advantage in product or process technology that yields differentiated product
offerings and/or cost-competitive homogeneous products. Technology, in
particular, has created new products, displaced old products, and altered
trading-partner relationships.
3. How Does Resource Efficiency Work? Real income depends on the output
of products as compared to the resources used to produce them. By defining
the cost of production in terms of the resources needed to produce a product,
the production possibilities curve shows that through the use of specialization
and trade, the output of two countries will be greater, thus optimizing global
efficiency. [see Fig. 6.2.]
E. Theory of Comparative Advantage
In 1817 David Ricardo reasoned that there would still be gains from trade if a country
specialized in the production of those things it can produce most efficiently, even if
other countries can produce those same things even more efficiently. Put another way,
Ricardo’s theory of comparative advantage holds that a country can maximize its own
economic well-being by specializing in the production of those goods and services it
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can produce relatively efficiently and enhance global efficiency through its participation
in (unrestricted) free trade.
1. Comparative Advantage by Analogy. Would it make sense for the best
physician in town, who also happens to be the most talented medical secretary, to
handle all of the administrative duties of an office? No. The physician can
maximize both output and income by working as a physician and employing a less
skilled secretary. In the same manner, a country will gain if it concentrates its
resources on the production of the goods and services it can produce most
efficiently.
2. Production Possibility. A country can simultaneously have a comparative
advantage and an absolute advantage in the production of a given product.
Assume that the United States is more efficient than Costa Rica in the production
of both wheat and coffee; however, the U.S. has a comparative advantage in
wheat production. By concentrating on the production of the product in which it
has the greater advantage (wheat) and allowing Costa Rica to produce the product
in which the United States is comparatively less efficient (coffee), global output can
be increased, and specialization and trade will benefit both countries. [see Fig.
6.2.]
F. Theories of Specialization: Some Assumptions and Limitations
The theories of absolute and comparative advantage are based upon the economic
gains from specialization, i.e., concentration on the production of a limited number of
products. Each holds that specialization will maximize output and that countries will be
best off by trading the output from their own specialization for the output from other
countries’ specialization. However, both theories make certain assumptions that may
not always be valid.
1. Full Employment. Both theories (absolute and comparative advantage) assume
that resources are fully employed. When countries have many unemployed or
underemployed resources, they may seek to restrict imports in order to employ or
use idle resources.
2. Economic Efficiency. Individuals and countries often pursue objectives other
than economic efficiency. Individuals may prefer activities and/or occupations that
are economically less productive, and nations may choose to avoid
overspecialization because of the vulnerability created by potential changes in
technology and price fluctuations.
3. Division of Gains. Although specialization does maximize output, it is not always
clear how those gains will be divided. If one country believes that a trading partner
is receiving too large a share of the benefits, it may choose to forego its relatively
smaller gains in order to prevent the partner country from receiving larger gains.
4. Transport Costs. If it costs more to deliver products than can be saved via
specialization, then the gains from trade are negated.
5. Insufficient Demand. If trade increases production by more than normally
acceptable tea and wheat consumption, there still an advantage. The consumers
in the two countries can gain access to sufficient output by working fewer hours,
thus giving them more leisure time.
6. Statics and Dynamics. Although the theories of absolute and comparative
advantage consider gains at a given time (a static view), the relative conditions
that surround a country’s particular advantage or disadvantage are dynamic
(constantly changing). Thus, one cannot assume that future advantages will
remain constant. (This idea will also be relevant to the discussion of the dynamics
of the location of production and export sources.)
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7. Services. Although the theories of absolute and comparative advantage were
developed from the perspective of trade in commodities, much of the same
reasoning can be applied to trade in services.
8. Production Networks. While both theories deal with the trading of one product for
another, increasingly there are divisions by components and function as well as
within a company’s value chain network. The firm’s value chain can include a
number of countries; however, the argument for specialization still remains valid.
9. Mobility. Neither the assumption that resources can move domestically from the
production of one good to another at no cost, nor the assumption that resources
cannot move internationally, is entirely valid. Nonetheless, domestic mobility is
greater than the international mobility of resources. Clearly, the movement of
resources such as capital and labor is a very real alternative to trade.
III. THEORIES TO EXPLAIN NATIONAL TRADE PATTERNS
The free trade theories demonstrate how output growth occurs through specialization and
free trade; however, they do not deal with trade patterns such as how much a country
trades, what products it trades, or who will be its trading partners. In this section, we
discuss the theories that help explain these patterns.
A. How Much Does a Country Trade?
Apart from nontradable goods, i.e., goods and services that are impractical to export,
country size helps to explain why some countries are more dependent on trade than
others and why some account for larger portions of world trade than others.
1. Theory of Country Size. The theory of country size holds that large countries
tend to export a smaller portion of their output and import a smaller portion of their
consumption. Large countries are more apt to have varied climates and a greater
assortment of natural resources than smaller economies, thus making the large
countries more self-sufficient. Further, given the same types of terrain and modes
of transportation, the greater the distance, the higher the associated transport
costs. Thus, firms in large countries often face higher transportation costs in terms
of sourcing inputs from and delivering output to distant foreign markets than do
their closer foreign competitors.
2. Size of the Economy. Countries can be compared on the basis of their economic
size, using indicators that include the value and share of world trade. Ten of the
world’s top trading nations are high-income countries. Despite its low per capita
income, China also has a large economy because of its very large population.
Together, the top ten nations account for more than one-half of all of the world’s
trade. [see Map 6.2].
B. What Types of Products Does a Country Trade?
The composition of a country’s trade depends on both its natural and acquired
advantages. With respect to the latter, both production and product technology can be
very important.
1. Factor-Proportions Theory. Developed by Eli Heckscher and Bertil Ohlin, the
factor-proportions theory holds that countries have their best trade advantage
when depending on their relatively abundant production factors. The following are
few observations about the factor-proportions theory:
a) Factor proportions theory appears logical, and a general observation gives
many examples that conform to the theory;
b) The factor proportions theory assumes production factors to be homogeneous,
tests to substantiate the theory have been mixed;
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c) Factor proportions analysis becomes more complicated when the same product
can be created by different methods, such as with labor versus capital intensity.
d) Most new products originate in developed countries. Developing countries
depend much more on the production of primary products; thus, they depend
more on natural advantage.
C. With Whom Do Countries Trade?
High-income countries trade primarily with each other, and emerging economies
primarily export primary and labor-intensive products. Nonetheless, it is also true that
economic and cultural similarities, political interests, and distance affect the
determination of trading partners.
1. Country-Similarity Theory. The country-similarity theory says that companies
create new products in response to market conditions in their home market. They
then turn to markets they see as most similar to what they are accustomed,
especially those markets where consumers have comparable levels of per capita
income
a. Specialization and Acquired Advantage. In order to export, a company
must provide consumers abroad with an advantage over what they could
buy from their domestic producers.
b. Product differentiation. Product differentiation causes countries to conduct
two-way trade in seemingly similar products.
c. The Effects of Cultural Similarity. Importers and exporters perceive
greater ease in doing business in countries that are culturally similar to their
home country, such as those that speak a common language. Likewise,
historic colonial relationships explain much of the trade between specific
developed and developing economies
d. The Effects of Political Relationships and Economic Agreements.
Political relationships and economic agreements among countries may
discourage or encourage trade between them.
e. The Effects of Distance. Although no single factor fully explains specific
pairs of trading partners, the geographic distance between two countries is
important in as much as transport costs increase with distance.
IV. THE DYNAMICS OF EXPORT CAPABILITIES
Both the product life cycle theory and Porter’s diamond of national advantage theory help to
explain how countries develop, maintain, and possibly lose their competitive advantages.
A. Product Life Cycle (PLC) Theory
Product life cycle theory states that the production location of certain manufactured
products shifts as they go through their life cycle. The cycle
consists of four stages: introduction, growth, maturity, and decline.
1. Introduction. Innovation, production, and sales occur in the domestic (innovating)
country. Because the product is not yet standardized, the production process
tends to be relatively labor-intensive, and innovative customers tend to accept
relatively high introductory prices.
2. Growth. As demand grows, competitors enter the market. Foreign demand,
competition, exports, and often-direct investment activities also begin to
accelerate.
3. Maturity. Worldwide demand begins to level off, although it may be growing in
some countries and declining in others. Production processes are relatively
standardized and global price competition forces production site relocation to
lower-cost developing countries.
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4. Decline. Market factors and cost pressures dictate that almost all production
occur in developing countries. The product is then imported by the country where
it was initially developed—the importing firm may or may not be the innovating
firm.
5. Verification and Limitations of PLC Theory. Exceptions to the typical pattern of
the product life cycle theory would include: products with high transport costs,
products that have very short life cycles, luxury goods and services, products that
require specialized labor, products that can be differentiated from direct
competitors, and products for which transportation costs are relatively high.
B. The Diamond of National Competitive Advantage
Introduced by Michael Porter, the diamond of national competitive advantage is a
theory showing four features as important for competitive superiority: demand
conditions; factor conditions; related and supporting
Industries; and firm strategy, structure, and rivalry. Usually, all four conditions need to
be favorable for an industry within a country to attain and maintain global supremacy.
[see Fig. 6.4.]
1. Facets of the Diamond.
•Demand Conditions. The nature and level of demand in the home market lead
to the establishment of production facilities to meet that demand.
•Factor Conditions. Resource availability (inputs, labor, capital, and technology)
contributes to the competitiveness of both firms and countries that compete in
particular industries.
•Related and Supporting Industries. The local presence of internationally
competitive suppliers and other related industries contributes to both the cost
effectiveness and strategic competitiveness of firms.
•Firm Strategy, Structure, and Rivalry. The creation and persistence of national
competitive advantage requires leading-edge product and process technologies
and business strategies.
2. Limitations of the Diamond of National Advantage Theory. The existence of
the four favorable conditions may represent a necessary but insufficient condition
for the development of a particular national industry. Even when abundant,
resources are ultimately limited; thus, firms must make choices regarding their
pursuit of existing opportunities. Further, given the ability of firms to gain market
information and production inputs from abroad, the absence of favorable
conditions within a country may be overcome by their existence internationally.
3. Using the Diamond for Transformation. Understanding and having the
necessary conditions to be globally competitive are important, but these conditions
are neither static nor purely domestic. As shown in the opening case regarding
Costa Rica’s economic transformation, the Costa Rican government altered its
educational system to tailor the country’s human resource development to fit the
needs of targeted industries. Likewise, it developed local supplies and attracted
sufficient numbers of foreign firms so that their combined presence assured a
vibrant competitive environment.
V. THE THEORY AND MAJOR EFFECTS OF FACTOR MOBILITY
Over time factor conditions change in both quality and quantity. Concomitantly, the mobility
of capital, technology, and people also affects the relative capabilities of countries.
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.
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A. Why Production Factors Move
1. Capital. While capital is the most internationally mobile factor, short-term capital is
the most mobile of all. Capital is primarily transferred because of differences in
expected returns, although firms may also respond to government incentives.
2. People. People transfer internationally in order to work abroad, either on a
temporary or a permanent basis. It may be difficult to distinguish between
economic and political motives associated with international labor mobility,
because poor economic conditions often accompany repressive and/or uncertain
political conditions.
B. Effects of Factor Movements
Neither international capital nor population movements are new occurrences.
Immigrants bring human capital, thus adding to the base of a country’s skills and
enabling competition in new areas. Inflows of capital to those same countries can be
used to develop infrastructure and natural and other acquired advantages, thus
enabling increased participation in the international trade arena.
1. What Happens When People Move? Although capital and labor are in fact
different production factors, they are intertwined. Countries lose potentially
productive resources when educated people leave, a situation known as brain
drain, but they may in turn gain from the remittances that citizens who are working
abroad send home. Countries receiving human resources may also incur the cost
of social services for acculturating people into a new culture and language.
POINT—COUNTERPOINT:
Should Nations Use Strategic Trade Policies?
3.
POINT: Given the importance of acquired advantage in world trade, a country must develop
and maintain industries that will grow and earn sufficient revenues so that its domestic
economy thrives and grows. Targeting industries has proven particularly important for
emerging economies such as Costa Rica, and small countries such as Singapore. At the
same time, there are numerous examples of the failure of laissez-faire trade policies in Africa
—given all of their economic inadequacies, government guidance and intervention are their
best hope for better results.
COUNTERPOINT: There are few circumstances where targeting will work, and even if
governments are able to identify future growth industries in which their countries can likely
succeed, it does not follow that firms within those industries should receive government
assistance. A better policy would be to alter the conditions that affect a country’s
attractiveness to firms in general, rather than specific targeted industries. This would
improve the investment environment for all industries without the need for government
officials to choose which industries to support.
VII. THE RELATIONSHIP BETWEEN TRADE AND FACTOR MOBILITY
Factor movement is an alternative to trade that may or may not be a more efficient
allocation of resources.
A. Substitution. When factor proportions vary widely among countries, pressures
exist for the most abundant factors to move to countries with greater scarcity. Thus,
in countries where labor is relatively abundant compared to capital, workers tend to
be poorly paid or unemployed; many will attempt to go to countries that enjoy full
employment and offer higher wages. Likewise, capital tends to move away from
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countries where it is abundant to those where it is relatively scarce. In some cases,
however, the inability to gain sufficient access to foreign production factors may
stimulate efficient methods of domestic substitution, such as the development of
alternatives for traditional production methods.
B. Complementarity. Factor mobility via foreign direct investment may in fact
stimulate foreign trade because of the need for components, the parent company’s
ability to sell complementary products, and the need for equipment for subsidiaries.
LOOKING TO THE FUTURE: Scenarios That May Change Trade Patterns
It’s probably safe to say that trade restrictions have been diminishing, primarily because
of the economic gains that countries foresee through freer trade. Yet, there are uncertainties as
to whether this trend will continue. Protectionist sentiment might strengthen because of
employment displacement and job shifts in developed countries. This will be further exasperated
by the continued shifts of labor-intensive production to
developing economies and the pressures on the developed countries to accept more
immigrants. Urbanization will likely grow faster in developing than in developed countries. This
could translate into higher growth in some developing countries and a larger share of world
trade. We will probably see the continued trend toward a more finely tuned specialization of
production among countries to take advantage of specific conditions.
Four interrelated factors are worth monitoring because they could cause product trade to
become relatively less significant in the future
1. Multiple production locations
2. Flexible, small-scale production methods, especially those using robotics and digital
3. Output from and research on 3-D printers
4. Services
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