International Trade Theory Flashcards
reasons for foreign direct investment (FDI) by corporations because FDI may be a substitute for trade (
We should also consider the reasons for foreign direct investment (FDI) by corporations because FDI may be a substitute for trade (i.e., exports), or it may support greater global trade. For example, many car companies invest in production facilities in Mexico because that is a good base from which to export finished cars to many other countries.
Free trade
Free trade refers to a situation in which a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country.
Smith argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exports.
Mercantilism
Propagated in the sixteenth and seventeenth centuries, mercantilism advocated that countries should simultaneously encourage exports and discourage imports.
Mercantilism
Propagated in the sixteenth and seventeenth centuries, mercantilism advocated that countries should simultaneously encourage exports and discourage imports.
Heckscher-Ohlin theorem
The Heckscher-Ohlin theorem states that if two countries produce two goods and use two factors of production (say, labour and capital) to produce these goods, each will export the good that makes the most use of the factor that is most abundant.
The more sophisticated Heckscher–Ohlin theory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, and capital) are available in different countries and the proportions in which they are needed for producing particular goods.
This explanation rests on the assumption that countries have varying endowments of the various factors of production. Tests of this theory, however, suggest that it is a less powerful explanation of real-world trade patterns than once thought.
the product life-cycle theory
One early response to the failure of the Heckscher–Ohlin theory to explain the observed pattern of international trade was the product life-cycle theory. Proposed by Raymond Vernon, this theory suggests that early in their life cycle, most new products are produced in and exported from the country in which they were developed. As a new product becomes widely accepted internationally, however, production starts in other countries. As a result, the theory suggests, the product may ultimately be exported back to the country of its original innovation
New trade theory
stresses that in some cases, countries specialize in the production and export of particular products not because of underlying differences in factor endowments but because in certain industries the world market can support only a limited number of firms. (This is argued to be the case for the commercial aircraft industry.)
In such industries, firms that enter the market first are able to build a competitive advantage that is subsequently difficult to challenge. Thus, the observed pattern of trade between nations may be due in part to the ability of firms within a given nation to capture first-mover advantages.
The argument for unrestricted free trade is that both import controls and export incentive
are self-defeating and result in wasted resources. Both the new trade theory and Porter’s theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain exportoriented industries
The argument for unrestricted free trade is that both import controls and export incentive
are self-defeating and result in wasted resources. Both the new trade theory and Porter’s theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain exportoriented industries
MERCANTILISM
The main tenet of mercantilism was that it was in a country’s best interests to maintain a trade surplus, to export more than it imported
Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. The mercantilists saw no virtue in a large volume of trade. Rather, they recommended policies to maximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, while exports were subsidized.
The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in which a gain by one country results in a loss by another.)
Neo-mercantilists equate political power with economic power and economic power with a balance-of-trade surplus. Critics argue that several nations have adopted a neo-mercantilist strategy that is designed to simultaneously boost exports and limit imports.
ABSOLUTE ADVANTAGE
The English had an absolute advantage in the production of textiles, while the French had an absolute advantage in the production of wine. Thus, a country has an absolute advantage in the production of a product when it is more efficient than any other country at producing it.
According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for those produced by other countries.
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The theory of absolute advantage suggests that countries differ in their ability to produce goods efficiently. The theory suggests that a country should specialize in producing goods in areas where it has an absolute advantage and import goods in areas where other countries have absolute advantages.
COMPARATIVE ADVANTAGE
According to Ricardo’s theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.5 While this may seem counterintuitive, the logic can be explained with a simple example.
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4. The theory of comparative advantage suggests
that unrestricted free trade brings about increased world production—that is, that trade is a
positive-sum game.
5. The theory of comparative advantage also suggests that opening a country to free trade stimulates economic growth, which creates dynamic
gains from trade. The empirical evidence seems
to be consistent with this claim
The conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple model. Our simple model includes many unrealistic assumptions:
We have assumed a simple world in which there are only two countries and two goods. In the real world, there are many countries and many goods.
We have assumed away transportation costs between countries.
We have assumed away differences in the prices of resources in different countries. We have said nothing about exchange rates, simply assuming that cocoa and rice could be swapped on a one-to-one basis.
We have assumed that resources can move freely from the production of one good to another within a country. In reality, this is not always the case.
We have assumed constant returns to scale; that is, that specialization by Ghana or South Korea has no effect on the amount of resources required to produce one ton of cocoa or rice. In reality, both diminishing and increasing returns to specialization exist. The amount of resources required to produce a good might decrease or increase as a nation specializes in production of that good.
We have assumed that each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resources. This static assumption makes no allowances for the dynamic changes in a country’s stock of resources and in the efficiency with which the country uses its resources that might result from free trade.
We have assumed away the effects of trade on income distribution within a country
Assumptions discussion
Given these assumptions, can the conclusion that free trade is mutually beneficial be extended to the real world of many countries, many goods, positive transportation costs, volatile exchange rates, immobile domestic resources, nonconstant returns to specialization, and dynamic changes? Although a detailed extension of the theory of comparative advantage is beyond the scope of this book, economists have shown that the basic result derived from our simple model can be generalized to a world composed of many countries producing many different goods.6 Despite the shortcomings of the Ricardian model, research suggests that the basic proposition that countries will export the goods that they are most efficient at producing is borne out by the data
However, once all the assumptions are dropped, the case for unrestricted free trade, while still positive, has been argued by some economists associated with the “new trade theory” to lose some of its strength.8 We return to this issue later in this chapter and in the next when we discuss the new trade theory. In a recent and widely discussed analysis, the Nobel Prize–winning economist Paul Samuelson argued that contrary to the standard interpretation, in certain circumstances the theory of comparative advantage predicts that a rich country might actually be worse off by switching to a free trade regime with a poor nation.9 We consider Samuelson’s critique in the next section
Immobile resources
In our simple comparative model of Ghana and South Korea, we assumed that producers (farmers) could easily convert land from the production of cocoa to rice and vice versa. While this assumption may hold for some agricultural products, resources do not always shift quite so easily from producing one good to another. A certain amount of friction is involved. For example, embracing a free trade regime for an advanced economy such as the United States often implies that the country will produce less of some labor-intensive goods, such as textiles, and more of some knowledge-intensive goods, such as computer software or biotechnology products. Although the country as a whole will gain from such a shift, textile producers will lose. A textile worker in South Carolina is probably not qualified to write software for Microsoft. Thus, the shift to free trade may mean that she becomes unemployed or has to accept another less attractive job, such as working at a fast-food restaurant
Resources do not always move easily from one economic activity to another. The process creates friction and human suffering too. While the theory predicts that the benefits of free trade outweigh the costs by a significant margin, this is of cold comfort to those who bear the costs. Accordingly, political opposition to the adoption of a free trade regime typically comes from those whose jobs are most at risk. In the United States, for example, textile workers and their unions have long opposed the move toward free trade precisely because this group has much to lose from free trade. Governments often ease the transition toward free trade by helping retrain those who lose their jobs as a result. The pain caused by the movement toward a free trade regime is a short-term phenomenon, while the gains from trade once the transition has been made are both significant and enduring.
