Lec 3-Iter Trade Thry

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    International TradeTheory

    Lecture-3

    Ravikesh Srivastava

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    Trade ?

    Primary intensive-Agriculture, mines

    Technology intensive- PCs Knowledge intensive- Software

    Capital intensive- Constructionmachinery & equipments

    Combination of all intensive- Telecomproducts, pharmaceuticals, airplanes,automobiles

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    The Importance of Trade Theory

    Trade theory helps managers and govern-ment policymakers focus on three critical

    questions: What products should be imported and exported?

    How much should be traded?

    With whom should they trade?

    While descriptive theories suggest a laissez-fairetreatment of trade, prescriptive theories suggest that

    governments should influence trade patterns.

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    Trade and Investment Policies

    importsubstitution: a policy of developingdomestic industriestomanufacture goodsand provide servicesthatwould otherwisebe imported

    strategic trade policy: the identification

    and developmentoftargeted domesticindustriesinordertoimprove theircompetitivenessathome and abroad

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    The Mercantilist Doctrine First or Pre-classical theory of Trade

    Demonstrated by David Hume in 1752

    Focus on Two Goals: Increase the wealth of Nation by acquiring

    precious metals eg. Gold

    To extract Trade Gains with max Export and MinImport

    Overlooked other sources of a countryswealth accumulation as capital, skill of work force,land and other natural resources.

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    Free Trade Theories:Absolute & Comparative Advantage

    The theories of absolute and comparative advantagedemonstrate how economic growth can occur viaspecialization and trade.

    Free trade (apositive-sumgame) implies speciali-zation and requires that nations neither artificiallylimit imports nor artificially promote exports.

    The invisible hand of the market determineswhich competitors survive, as customers buy

    those products that best serve their needs.Nations specialize in the production ofcertain products, someof which may be exported; export earnings can in turn be usedto pay for imported goods and services.

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    Absolute Advantage Theory In 1776, Adam Smith introduced doctrine of

    Laissez-faire to IT.

    Focus on Freedom of enterprise and freedom ofcommerce

    Individual countries to specialize in goods theywere best suited to produce because of naturaladvantage

    Stated that a nations import should consist ofgoods made more efficiently abroad while exportsshould consist of goods made more efficiently athome.

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    Absolute Advantage Theory

    Country Wheat ( 1 unit) Coffee ( 1 Unit)

    USA 2 8

    Colombia 10 2

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    Comparative Advantage Theory

    In 1817, David Ricardo introduced book on thePrinciples of Political Economy and Taxation.

    Focus on comparative advantage of a nation inproducing a good relative to other nation.

    Based on opportunity cost theory

    A country has a comparative advantage in

    producing a good if the opportunity cost forproducing the good is lower than in other country.

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    Comparative Advantage Theory

    Country Wine ( 1 gallon) cloth ( 1 yard)

    England 120 100

    Portugal 80 90

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    Comparative Advantage Theory

    Country Opportunity cost

    for Wine

    Opportunity

    cost forCloth

    England 120/100=1.2 100/120=0.83

    Portugal 80/90=0.89 90/80=1.13

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    Theory of Comparative Advantage

    Comparative advantage [DavidRicardo, 1817]:A country can(i) maximize its owneconomic well-beingby specializing inthe productionofthosegoods andservices itcanproduce relativelyefficiently and(ii) enhance global efficiency viaits participationin free trade.Ricardoalsoreasonedthat:

    acountry cansimultaneously have anabsoluteandacomparative advantage inthe productionofagivenproduct

    by concentratingonthe productionofthe productinwhich ithas the greateradvantage,acountrycan furtherenhance both global outputandits

    owneconomic well-being

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    Assumptions and Limitations

    of the Free Trade Theories

    The theories of absolute and comparative advantage bothmake assumptions that may not be entirely valid.

    Full employment of resources Exclusive pursuit of economic efficiency objectives

    Equitable division of gains from specialization

    Only two countries and two commodities

    Exclusion of transport costs A static rather than a dynamic view

    Exclusion of services

    Unrestricted factor mobility

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    Heckscher-Ohlin Theorem

    In 1933, heckscher & Ohlin explained link betweennational factor endowments & comparative

    advantage on nations. A country would export commodities whose

    production is intensive in its relatively abundantfactor.

    Theorem assumes constant in input, technology,demand for factor of production with difference inrelative supply will lead to differences in therelative price between two countries.

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    Implication of H-O Theorem Trade as well as trade gains should be greatest

    between countries with the greatest differences ineconomic structure.

    Trade should cause countries to specialize more inproducing and exporting goods that are distinctlydifferent from their imports.

    Countries should export goods that make intensiveuse of their relatively abundant factors.

    Factor prices should be nearly equal betweencountries with more liberal mutual trade.

    International investment should be stimulated bydifferences in factor endowments.

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    The Leontief Paradox

    Demand bias for capital-intensive goods.

    Existence of trade barriers

    Importance of natural resources

    Prevalence of factor-intensity reversals

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    The Product Life-Cycle Model

    Proposed by Raymond Vernon in 1960s.

    Focus on imitation-gap approach.

    As product cycle develops, the cost advantage willchange accordingly and a comparative advantagein innovative capacity may be offset by a costdisadvantage.

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    International Product Life-Cycle (Vernon)

    Limited initial demand in other advanced

    countries initially

    Exports more attractive than overseas production

    When demand increases in advanced countries,

    production follows

    With demand expansion in secondary markets

    Product becomes standardized production moves to low production cost areas

    Product now imported to US and to advanced

    countries

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    Product Life Cycle (PLC) phases

    The optimal location for the production of certaintypes of goods and services shifts over time asthey pass through the stages of: (i) introduction,

    (ii) growth, (iii) maturity, and (iv) decline.Exceptions to the typical pattern of the PLC would include:

    products that have very short life cycles luxury goods and services products that require specialized labor products that are differentiated from competitive

    offerings products for which transportation costs are relatively high

    During the decline stage, a product is often imported by the countrywhere it was initially developed; however, the importing firm may or

    may not be the innovating firm.

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    Product Life Cycle Characteristics

    Stage Intro. Growth Maturity Decline

    PRODUCTION Innovating Innovating Indl + DevelopingLOCATION(S) country + other indl developing countries

    MARKET Innovating Industrial Industrial + Developing

    LOCATIONS + other indl countries developing countries

    COMPETITI VE Uniqueness Rising comp. Price compe- Declining

    FACTORS & demand tition demand

    PRODUCTION Short prodn Capital input Economies Rationali-

    TECHNNOLOGY runs increases of scale zation

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    The New Trade Theory

    As output expands with specialization, an

    industrys ability to realize economies of scale

    increases and unit costs decrease

    Because of scale economies, world demand

    supports only a few firms in such industries

    (e.g., commercial aircraft, automobiles)

    Countries that had an early entrant to such anindustry have an advantage:

    Fist-mover advantage

    Barrier to entry

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    New Trade Theory

    Global Strategic Rivalry

    Firms gain competitive advantagetrough: intellectual property, R&D,economies of scale and scope,

    experienceNational Competitive Advantage(Porter, 1990)

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    New Trade Theories

    Increasing returns of specialization due to

    economies of scale (unit costs of production

    decrease)

    First mover advantages (economies of scale such

    that barrier to entry crated for second or third

    company)

    Luck... first mover may be simply lucky.

    Government intervention: strategic trade policy