978-0134200057 Chapter 6 Lecture Notes

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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?

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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