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Theories of International Trade and Investment

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jona hoxhaj

on 16 December 2013

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Transcript of Theories of International Trade and Investment

Theories of International Trade and Investment
Classical Theories

*In 1776 the Scottish political economist Adam Smith wrote his book 'Wealth of Nations' and attacked the mercantilist view by suggesting that nations benefit more from free trade

*In 1817 the British political economist David Ricardo explained why it is beneficial for two countries to trade, even though one of them may have the absolute advantage to produce all of the products.

Nation level theories of international trade and investment
*Mercantilism emerged in the 16th century as a dominant perspective of international trade
*Mercantilism suggested that exports are good, imports are bed
*Mercantilism believed that national prosperity is the result of a positive balance of trade – maximize exports and minimize imports
*Gold & silver were the most important sources of wealth & were used as the main medium of exchange
*Nation`s power & strength increases as wealth increases
*Mercantilism underlies the rationale for a nation's attempt to run a trade surplus

*Smith argued that nations by trying to minimize imports, inevitably wastes due efficiency.Therefore the inefficiencies of mercantilism end up reducing the wealth of the nation as a whole while enriching a limited number of individuals and interest groups. Relative to others each country is more efficient in the production of some products and less efficient in the production of some other products.
*Absolute advantage principle: a country should produce only those products in which it has absolute advantage or can produce using fewer resources than another country

One ton of
Cloth Wheat
France 30 40

Germany 100 20

France and Germany
France absolute advantage in production of cloth
Germany absolute advantage in production of wheat
Each country benefits by specializing in producing the product in which it has an absolute advantage and then securing the other product through trade
*Comparative advantage principle: it is beneficial for two countries to trade even if one has absolute advantage in the production of all products; what matters is not the absolute cost of production but the relative efficiency with which it can produce the product.

*While a nation might conceivably have a sufficient variety of production factors to provide every kind of product and service. it cannot produce each product and service with equal facility.
One ton of
Cloth Wheat
France 30 40

Germany 10 20

Germany has an absolute advantage in both products cloth and wheat . Can produce both products in fewer days than France
This does not mean that Germany should produce both products, it still can benefit from the trade with France.
Each country benefits by specializing in the product in which it has a comparative, or relative, advantage and then obtaining the other product through trade.
Limitations of Early Trade Theories
*The cost of international transportation
*Government restrictions such as tariffs, import restrictions, and regulations typical of mercantilism that can hamper cross-border trade

*Large scale production in certain industries may bring about scale economies, therefore lower prices, which can help offset weak national comparative advantage.
*When governments selectively target certain industries for strategic investment, this may cause trade patterns contrary to theoretical explanations

*Today, countries can access needed low-cost capital in global markets, needed to develop key industries, even in the face of weak comparative advantage in certain areas.

*Contemporary cross-border businesses includes many services such as banking and retailing that cannot be traded in the usual sense and must be internationalized via foreign investment
*Some firms are more active, successful and attractive than the others and need more to be international because off too small home markets
Factor Proportions Theory
*The next contribution to international trade came in 1920s, when two Swedish economists, Eli Heckscher and his student Bertil Ohlin, proposed the factor proportions theory also called as factor endowments theory.
*Factor proportions (endowments) theory: each country should produce and export products that intensively use relatively abundant factors of production, and import goods that intensively use relatively scarce factors of production

*However in 1950s the Russian-born economist Wassily Leontief pointed to empirical findings that contradicted the factor proportions theory. Despite the US having abundant capital, its exports were labor intensive and imports capital intensive.

*Perhaps the main contribution of the Leontief paradox is its suggestion that international trade is complex and cannot be fully explained by single theory. Whil;e the factor proportions theory explain international trade patterns, it does not account for all trade phenomena.
*China and labor (emphasizes the production & export of labor intensive products: textiles, kitchen utensils)
*USA and pharmaceuticals (emphasizes the production & export of capital intensive products)
*Canada and wool (possess a great deal of land, land intensive products: meat, wheat, wool

International Product Cycle Theory
*In 1966 Harvard Prof. Raymond Vernon explained int. trade based on the evolutionary process that occurs in the development and diffusion of products around the world.

International product cycle theory: each product and its associated manufacturing technologies go through three stages of evolution: introduction, growth, & maturity
*In the introduction stage, the inventor country enjoys a monopoly both in manufacturing and exports

*As the product’s manufacturing becomes more standard, other countries will enter the global marketplace

*When the product reaches maturity, the original innovator country will become a net importer of the product

*Because firms around the world are constantly innovating new products and others are constantly imitating them, the product cycle is constantly beginning and ending. So the cycle from introduction to maturity is much shorter now than in 1960s/
*Rapid spread of new technologies
*Thanks to media and internet
How nations Enhance Their Competitive Advantage: Contemporary Theories
The globalization of markets has fostered a new type of competition-a race among nations to reposition themselves as attractive places to invest and do business
In 1990 the Harvard business professor Michael Porter published his book `The Competitive Advantage of Nations`:

*The competitive advantage of a nation depends on the collective competitive advantages of the nation`s firms

*Over time, this relationship is reciprocal: the competitive advantages held by the nation tend to drive the development of new firms and industries with these same competitive advantages.

*At both the firm and national levels, competitive advantage grows out of innovation. Firms innovate through developing (new product design, new production process, new approaches for marketing, new ways of organizing)
*Governments can create national economic advantage by: stimulating innovation, targeting industries for development, providing low-cost capital, minimizing taxes, investing in IT, etc.

Japan is competent in high-technology industries, firms Toshiba & Hitachi → development of new firms & industries in these fields.

Britain in the patent medication through pharmaceutical firms AstraZeneca and GlaxoSmithKline

Some tables with Albanian date.
Michael Porter's Diamond Model
Firm Strategy, Structure and Rivalry
refers to the nature of domestic rivalry, and conditions in a nation that determine how firms are created, organized and managed. The presence of strong competitors at home serves as a national competitive advantage. Italy-leading firms in design-intensive industries in furniture, textiles & fashion.
Related and Supporting Industries
availability of clusters of suppliers and complementary firms with distinctive competences.
For example Silicon Valley in California is a very suitable place to launch a software firm, because is home to thousand of knowledgeable firms and workers in software industry.

Demand Conditions
refers to the nature of home market demand
for specific product and service
For example Japan is very densely populated and hot country which makes it very demanding for air conditioners

Factor Condition
describes the nation's position in factor of
production, such as labor, natural resources, capital, technology, entrepreneurship and know how.
Germany`s abundance of workers with strong engineering skills → acquired competitive advantages in global engineering & design industry.

A concentration of suppliers and supporting firms from the same industry located within the same geographic area, characterized by a critical mass of human talent, capital or other factor endowments.

Examples include: the Silicon Valley, fashion cluster in northern Italy, pharma cluster in Switzerland, footwear industry in Pusan, South Korea, and the IT industry in Bangalore, India

Can serve as a nation’s export platform

Industrial Cluster
National Industrial Policy
This type of policy implement an economic development plan, often in collaboration with the private sector, that aims to develop or support particular industries within the nation.
(Examples: Japan, Dubai, and Ireland)
Typical initiatives:
*Tax incentives
*Investment incentives
*Monetary and fiscal policies
*Rigorous educational systems
*Investment in national infrastructure
*Strong legal and regulatory systems

In 1930 government policies limited Ireland to trade with the rest of the world. In 1980s the Irish government undertook pro-trade policies in cooperation with the private sector that led to the development of national advantages.

*Fiscal, monetary and tax consolidation
*Social partnership
*Emphasis on high value-adding industries
*Membership in EU
*Subsidies from EU

New Trade Theory
This theory argues that increasing returns to scale, especially economies of scale, are an important factor in some industries for superior international performance.
Some industries succeed best as their volume of production increases. Nations specialize in smaller number of industries in which they increase it may not necessarily hold factor of comparative advantage & imports the other products.

Examples: commercial aircraft, automobiles, pharmaceuticals all have very high fixed costs that require high-volume sales to achieve profitability
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