IB Quiz 2

Thomas Mun, 1630 Quote:

"The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value."

• Suppose Ghana and S. Korea each have 200 resources available • In Ghana, 10 resources are required to produce 1 ton of cocoa and 20 resources are required to produce 1 ton of rice. • In S. Korea, 40 resources are required to produce 1 ton of cocoa and 10 resources are required to produce 1 ton of rice. What does Ghana have an absolute advantage in? S Korea?

Ghana has AA in Cocoa S Korea has AA in Rice

Who benefits and who loses with subsidies?

Governments pay for this by taxing people and companies

Internalization theory tries to explain why firms often prefer FDI over licensing• This is also known as the market imperfections approach• Licensing has three major drawbacks according to internalization theory:

Licensing may result in a firm's giving away valuable technological know-how to a potential foreign competitor Licensing does not give a firm the tight control over production, marketing, and strategy in a foreign country that may be required to maximize its profitability Management, marketing, and manufacturing capabilities are often not amenable to licensing - give away knowledge to competitor - no tight control - no marketing, management etc

Who benefits and who loses?•

Like tariffs and subsidies, import quotas and VERs benefit domestic producers by limiting import competition but consumers have to pay a greater price

Implications of Trade Theory for Managers (3)

Location implications First-mover implications Policy implications + To enhance national competitive advantage, government can support local firms (national champions) that can be more efficient than foreign competitors; at the same time governments should encourage competition

Critique of mercantilism

Mercantilism views trade as a zero-sum game: a gain by one country results in a loss by another country => other international trade theories disagree with this

Location implications:

a firm should disperse its various productive activities to those countries where they can be performed most efficiently; firms that do not do so may be at a competitive disadvantage

First-mover implications:

a first-mover advantage can help a firm dominate global trade in that product

Factor endowments:

a nation's position in factors of production, e.g. skilled labor, infrastructure needed in a particular industry

A country has an _________ in the production of a product when it is more efficient than any other country at producing it.

absolute advantage => needs fewer resources to produce

As a result, both countries are ______

better off => can consume more wine and textiles overall than if they didn't trade

Trading benefits ____ by allowing them to focus on producing what they are better at, thus creating more tons of each

both of them

Porter identified two other factors influencing the diamond:_____

chance and government

Porter also made the point that there is a strong association between vigorous ______ and the creation and persistence of _____ => firms look for ways to innovate and improve efficiency to compete

domestic rivalry competitive advantage

Different trade theories support free trade:

e.g. theory of absolute advantage, theory of comparative advantage, Heckscher-Ohlin theory, new trade theory

First-mover advantages are the economic and strategic advantages that accrue to ________ into an industry. The ability to capture scale economies ahead of later entrants, and thus benefit from a lower _____, is an important first-mover advantage

early entrants cost structure

New trade theory is also consistent with Ricardo's theory of comparative advantage: _______ offer comparative advantage • New trade theory is not consistent with Heckscher-Ohlin theory though => first-movers can emerge in countries that don't necessarily have the needed factor endowments for that industry => _____, ______, innovation create first-movers

economies of scale luck, entrepreneurship

New Trade Theory If the national market is small, there may not be enough demand for producers to realize ________ for some products or only small quantities of a product are produced and it is v. expensive Free trade is useful to expand the ____ and achieve economies of scale

economies of scale market

Factor endowments:

extent to which a country is endowed with such resources as land, labor, and capital

Policy implications:

firms should work to encourage governmental policies that support free trade, and would want policies that have a favorable impact on each component of Porter's diamond

n new trade theory, ______ advantages are important in explaining why some countries dominate the production of some products

first-mover

• Both theories support ____

free trade

Free trade:

government does not try to influence through duties or quotas what its citizens can buy from another country or what they can produce and sell to another country

Knickerbocker's theory:

in an oligopoly, firms imitate each others' FDI patterns and multipoint competition arises (competing in multiple markets) Undertaking FDI at about the same time Directing FDI towards the same target markets•

At the time, most products were first invented and introduced in the US => wealth and size of the US market created incentives to ____ • High cost of US labor also created incentives for ______

innovate process innovations

The theory offers some support for government ______: e.g. Boeing and Airbus were each funded by the US government and EU governments and became first movers

intervention

Production Possibility Frontier

is a curve on a graph that illustrates the possible quantities that can be produced of two products if both depend upon the same finite resource for their manufacture.

According to the product life-cycle theory, as products mature, both the ______ and the ______ will change affecting the flow and direction of trade

location of sales optimal production location

• Advanced factors are _______ for competitive advantage • Unlike naturally endowed basic factors, advanced factors are created by investment by ___________ => e.g. government investment in education and skills is useful • Basic factors provide initial advantage, disadvantage in basic factors can also lead to investment in advanced factors: e.g._______

most significant individuals, companies, and governments Japan lacks arable land, but invested in advanced factors

Firm strategy, structure, and rivalry of firms within a nation details:

• E.g. predominance of engineers in top management at German and Japanese firms => improving manufacturing process, product design • E.g. predominance of finance background top management in the US => overemphasis on maximizing short-term financial returns, US lost competitiveness in engineering-based industries in which process and product design are all-important (e.g. automobile industry)

Economist _______ in 1752 pointed out an inconsistency in mercantilism:

David Hume

_______ in his 1817 book Principles of Political Economy, however, showed that it might still be beneficial for both the countries to trade through CA

David Ricardo

Economies of scale ex.:

E.g. costs are reduced due to ability to spread fixed cost over large volume or being able to use specialized equipment or employees that are more productive

Even though FDI could be expensive and risky because of the costs of doing business in different countries, both the alternatives have some limitations

Exporting is constrained by trade barriers and transportation costs Licensing does not allow control of production and adequate protection of technological know-how, and some things like firm-specific capabilities or culture can't be transferred by licensing

Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete, and promote or impede the creation of competitive advantage:

Factor endowments, demand conditions, related and supporting industries, firm strategy/ structure/ rivalry

A product that is first exported from the US overtime gets imported into the US Graph explanation

Annual sales volume to time 1 - introduction - Product first invented, sold in the US (large, wealthy local market) II. - Growth - Exported to other advanced countries III. - Maturity/ stabilization - Produced in other advanced countries to target local consumers IV. - Decline - Eventually, product is imported into the US from cheaper production abroad

Mercantilism is the first theory of international trade that emerged in England in the mid-1500s

- To accumulate wealth, countries should export more than they import: maintain a trade surplus - If there is a balance of trade surplus, more gold is coming in than going out of the country

In his 1776 book The Wealth of Nations ______ criticized the mercantilist view of trade as a zero-sum game.

Adam Smith

Chapter 6: International Trade Theory

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Chp. 7

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If Ghana produced only cocoa and no rice, how many tons of cocoa can it produce? If S. Korea produced only rice and no cocoa, how many tons of rice can it produce?

20 tons 20 tons

Critique of Comparative Advantage The theory makes several assumptions:

A simple world with only two countries and two products There are no transportation costs Prices of the resources are the same in both countries, exchange rates don't matter Resources can move freely from the production of one good to another (resource mobility) Constant returns to scale: the amount of resources required to produce each good remains the same over time (no diminishing or increasing returns to scale) Each country has a fixed stock of resources and trade does not change the amount of resources available or the efficiency of using these resources The effects of trade on income distribution within a country are not considered

National Competitive Advantage: Porter's Diamond Like the new trade theorists, ______ also believed that classical trade theories only told part of the story • Porter tried to explain why a nation achieves international success in a particular ______ => E.g. Japan in the automobile industry, Germany in chemicals • Even among countries with similar comparative advantage, some countries ______ => why?

Michael Porter industry excel in producing some products

• If Ghana exchanged 4 tons cocoa to get 4 tons rice from S. Korea, its consumption would still be higher than in the situation without trade => 11 tons cocoa, 7.75 tons rice• S. Korea's consumption too would be higher with trade => 4 tons cocoa, 6 tons rice

So better to let Ghana produce both and S Korea to do one its good at

Managerial Implications

Taking trade barriers into consideration, companies need to balance trade and FDI strategies => FDI is often motivated by trade barriers!• The policy environment keeps changing and can be influenced by lobbying• Protectionism doesn't always equate to competitiveness though

But what if one country has an absolute advantage in producing both goods? Should this country still trade? • The theory of absolute advantage would suggest that it is not useful for this country to trade.

Thats where comparative advantage comes in

How are import quotas enforced?

This is usually enforced by issuing import licenses to a group of individuals or firms

Critique of Porter's Diamond If Porter is correct, countries should export products from those industries in which all four components of the diamond are favorable, and import products from industries in which components of the diamond are ________ • This has not been empirically tested in detail though to see if it is supported in the real world • Porter suggests the ______ has a role in influencing each component of the diamond: e.g. subsidies, policies towards education and investment, product standards and regulations that influence demand, influencing firm rivalry through tax policy and anti-trust laws, etc.

not favorable government

Critiquing CA Dynamic gains in both the stock of a country's resources and the efficiency with which resources are utilized will cause a country's production possibility frontier (PPF) to shift _____.

outward

In the theories of absolute and comparative advantage, trade is thus seen as a ______ game: all countries gain from trade

positive-sum

Raymond Vernon proposed the _____ theory in the mid-1960s

product life-cycle

Porter refers to the four attributes as the national diamond. The diamond is a mutually ______; each attribute depends on the state of other attributes. Firms are most likely to succeed in industries or industry segments where the diamond is most favorable.

reinforcing system

Critique of New Trade Theory Classical trade theories (absolute advantage, comparative advantage, Heckscher-Ohlin model, etc.) can explain why countries trade different products New trade theory additionally explains why countries sometimes trade ____ products (e.g. Japanese cars are sold in Europe, European cars are sold in Japan) thus suggesting that nations may benefit from trade even when they do not differ in ______

similar resource endowments or technology

E.g. in the late 1700s England had an absolute advantage in producing textiles and France in producing wine => England should produce _____ and France should produce ____, and both should trade

textiles wine

Firm strategy, structure, and rivalry:

the conditions governing how companies are created, organized, and managed and the nature of domestic rivalry

Demand conditions:

the nature of home demand for the industry's product or service

Related and supporting industries:

the presence or absence of supplier industries and related industries that are internationally competitive

Export tariffs (and export bans) are less common and have these objectives:

to raise revenue for the government to reduce exports to reduce tensions politically with trading partners - to ensure enough local supply

According to Adam Smith's theory of absolute advantage, countries should specialize in the production of goods for which they have an absolute advantage and then __________

trade these goods for other goods produced by other countries.

New Trade Theory Economies of scale:

unit cost reductions associated with a large scale of output

New Trade Theory With trade, countries can specialize in producing a narrower range of products than otherwise, but by buying goods from other countries each nation also has an increased ____ of products available and at ___ costs for the products New trade theory thus emphasizes: economies of scale, ______, product variety, and lower costs

variety lower specialization

New trade theory argues that for those products where economies of scale are significant and represent a substantial proportion of _______, the first movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match • E.g. Boeing and Airbus in the aerospace industry

world demand

Critique of Heckscher-Ohlin Theory

• A key assumption of the H-O theory is that technologies are the same across countries • The Leontief paradox might be explained if the impact of differences of technology on productivity is controlled for => productivity differences matter as in Ricardo's theory

Factor endowments: details

• Basic factors: e.g. natural resources, climate, location, demographics • Advanced factors: e.g. communication infrastructure, sophisticated and skilled labor, research facilities, technological know-how

Assumption of mobile resources:

• Can the same resources (e.g. labor) used to produce computers be shifted to produce textiles, or the other way around? • Free trade puts some jobs at risk because resources are not easily mobile at least in the short-term => e.g. textile workers can't easily switch to software coding• Although the country as a whole gains from trade, some sectors lose

The Heckscher-Ohlin theory predicts that:

• Countries will export those goods that make intensive use of factors that are locally abundant .• Countries will also import goods that make intensive use of factors that are locally scarce.

Evidence for the link between trade and growth:

• Development economists Jeffrey Sachs and Andrew Warner found a strong association between countries' openness to trade and economic growth => they studied 100 countries for 1970 to 1990 • Other more recent studies also find support for free trade and that trade liberalization leads to higher economic growth • Higher economic growth raises income levels and living standards

Political 1) Protecting local jobs and industries from unfair foreign competition

• E.g. US argues Chinese government has unfairly subsidized several industries including aluminum, steel, and auto parts which puts US industries out of work• Sectors that are politically sensitive are often prioritized: e.g. steel in the US, agriculture in many countries

Related and supporting industries details:

• E.g. US leadership in semiconductor industry provided basis for US success in personal computer industry• Industries tend to be grouped into clusters of related industries • Clusters are important for valuable knowledge flows between firms and within a region

The Samuelson Critique:

• Economist Paul Samuelson: The lower prices US consumers pay for goods imported from China because of free trade may not be enough to produce a net gain for the US economy if the dynamic effect of trade is to lower real wage rates in the US • "Being able to purchase groceries 20 percent cheaper at Wal-Mart (due to international trade) does not necessarily make up for the wage losses (in America)." • Advances in technology and education in developing countries make it possible to outsource jobs. => this can lower wages and result in job losses in rich countries • Despite these short-term problems, Samuelson and MIT economist David Autor argue that in the long-run free trade is a good thing

Assumption that each country has a fixed stock of resources and trade does not change the amount of resources available or the efficiency of using these resources:•

• Free trade can increase a country's stock of resources: more labor, capital, etc. available from abroad • Trade can also improve productivity or efficiency of resource utilization: Domestic companies may become more competitive when exposed to foreign competition Access to technology, etc. from abroad can improve productivity

3 things David Hume said

• If England had a balance of trade surplus with France (exporting more than importing), money supply and hence inflation would increase in England, while money supply and prices would fall in France • The French would then want to buy fewer goods from England (too expensive) and England would want to buy more from France (cheaper) • This would eventually get rid of England's balance of trade surplus

Heckscher-Ohlin Theory

• In Ricardo's theory, comparative advantage arises from differences in productivity • Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) had a different explanation: comparative advantage arises from differences in national factor endowments

Critique of Heckscher-Ohlin Theory

• It made fewer simplifying assumptions than Ricardo's theory • Empirical tests have questioned the validity of the Heckscher-Ohlin theory though Wassily Leontief (winner of Nobel prize in economics in 1973) found that although the US is relatively more capital abundant and less labor abundant than other countries, the US is a net importer of capital-intensive goods and exporter of labor-intensive goods This finding is known as the Leontief paradox

Demand conditions details:

• Nation gains competitive advantage if domestic consumers are sophisticated and demanding • Such consumers want high quality and innovative products

Both the stock and flows of FDI have increased because of:

• The remaining trade barriers and uncertainty about protectionism • Changes in the political economy => including democratic reforms, free market reforms, privatization, deregulation, removing restrictions on FDI • Globalization of production and markets; wanting to locate close to customersv

Both the stock and flows of FDI have increased because of:

• The remaining trade barriers and uncertainty about protectionism• Changes in the political economy => including democratic reforms, free market reforms, privatization, deregulation, removing restrictions on FDI• Globalization of production and markets; wanting to locate close to customers

Critique of Product Life-Cycle Theory

• Today products are first invented in countries other than the US too • Products are simultaneously sold in multiple countries • Production is also globally dispersed => e.g. parts in some countries • Product life cycle model was more useful in explaining the pattern of trade when the US dominated the world economy

Assumption of constant returns to specialization:

• We assumed a fixed amount of resources required to produce each product • It is more realistic to have diminishing returns to scale though • Diminishing returns: e.g. if producing cocoa requires some amount of land and some amount of labor, increasing the land used beyond some point leads to decreasing marginal returns unless labor is also increased • Not all land is equally productive, yields per acre may decline over time

• Suppose Ghana and S. Korea still have 200 resources each .• In Ghana, it takes 10 resources to produce 1 ton of cocoa and 13.33 resources to produce 1 ton of rice. • In S. Korea, it takes 40 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. • Since Ghana is more efficient in producing both of the goods, should Ghana just produce everything itself and not trade at all?

• With the same amount of resources, Ghana can produce 4 times as much cocoa (40/10) and 1.5 times as much rice (20/13.33) as S. Korea.• Hence, although Ghana has an absolute advantage in both goods, it has a comparative advantage in producing cocoa.