Chapter 6 - International trade theory

Mergers and acquisitions

. Horizontal merger: Merger or acquisition of firms producing same product at the same stage of production. . Vertical merger: Firms producing same product at different stages. . Conglomerate merger: Firms producing totally unrelated products.

Levels of economic integration

1. Free trade area: Accounts for almost 90% of regional agreements. It eliminates all barriers to the trade of goods and services among member countries but members determine their own policies toward nonmembers. 2. Customs Union: Eliminates trade barriers between members and adopts a common policy toward nonmembers. 3. Common Market: No barriers to trade between members, a common policy toward nonmembers and the free movement of the factors of production. It requires members to cooperate on fiscal, monetary and employment policies. 4. Economic Union: Has the free flow of products and factors of production between members, a common external trade policy, a common currency, a harmonized tax rate and a common monetary and fiscal policy. 5. Political Union: Involves a central political apparatus that coordinates the economic, social and foreign policy of member states

A currency board

A country that commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate.

Heckscher-Ohlin Theory (Factor-proportion theory)

A different explanation of comparative advantage theory; Comparative advantage arises from differences in national factor endowments (i.e. the amount of land, capital and entrepreneurship that a country possesses and can exploit for manufacturing). Nations have varying factor endowments which explain differences in factor costs; the more abundant a factor, the lower its cost. The pattern of international trade is determined by differences in factor endowments

Totalitarianism

A form of government in which one person or political party exercises absolute control over all spheres of human life and prohibits opposing political parties. Four major forms exists: o Communist totalitarianism: communist parties monopolizes power (Cuba, China, Vietnam, Laos and N-Korea) o Theocratic totalitarianism: Political power is monopolized by a party or individual that governs according to religious principles. o Tribal totalitarianism: Represents the interests of a particular tribe o Right-wing totalitarianism: permits some individual economic freedom, but restricts individual political freedom

Tariff rate quotas

A hybrid of a quota where a lower tariff is applied to imports within the quota than those over the quota.

Human development index

A measure of the quality of human life in different nations. It is based on three measures: Life expectancy at birth (health care function), educational attainment (adult literacy rate, enrollment in primary, secondary and tertiary education) and whether average incomes are sufficient to meet the basic needs of life in a country (food, shelter and health care)

Fiscal policy

A policy that involves changing: · Level of government spending . Level of taxation

Monetary policy

A policy that involves: · Setting base interest rates . Influencing the supply of money

Democracy

A political system in which government is by the people, exercised directly or through elected representatives. o Representative democracy: citizens periodically elect individuals to represent them; the elected individuals form a government, which makes decision on the behalf of the electorate. o Pure democracy: citizens should be directly involved in the decision-making.

Collectivism

A political system that stresses the primacy of collective goals over individual goals. The needs of a society are viewed as being more important than individual freedom. In modern times, the collectivist mantle has been picked up by socialist. The state should own the production and ensure that workers were fully compensated for their work.

Ethical systems

A set of moral principles or values that are used to guide and shape behavior, most of the worlds ethical systems are a product of religion.

Free trade

A situation which governments do not attempt to influence through quotas or duties what its citizens can buy from another countries or what they produce and sell to another countries. The invisible hand should determine what country imports and exports, a laissez-faire situation serves the best interest of the country, according to Adam Smith.

Religion

A system of shared beliefs and rituals that are concerned with the realm of the sacred.

Culture

A system of values and norms that are share among a group of people and that when taken together constitute a design for living. It is not constant and changes over time. Made of Values, Norms and Society

Tariffs

A tax levied on imports (or exports) that raises the cost of the imported product relative to domestic products. They are used to protect domestic goods and produce revenue for the government. Benefits government and domestic producers whereas consumers lose.

Neo-mercantilism

A theory derived from mercantilism that associates political power with economic power and economic power with a balance of trade surplus, it is used to boost exports and limit imports. Its purpose is to achieve social or political objective

Voluntary export restraints

A variant on the import quota. This is a quota imposed on trade by the exporting country, at the request of the importing country´s government. The extra profit that producers make when supply is limited by an import quota is called quota rent.

Business ethics

Accepted principles of right or wrong governing the conduct of business people. Main ethical issues: · Employment practices · Human rights · Environmental regulations · Corruption · The moral obligation of multinational companies

Regional economic integration

Agreements between countries in a geographic region to reduce tariff and non-tariff barriers to the free flow of goods, services, and factors of production between each other

Market economy

All productive activities are privately owned and production is determined by the interaction of supply and demand i.e. the purchasing patterns of consumers determine what is produced and in what quantity. Supply must not be restricted for this to work, it occurs when a single firm monopolizes a market. The role of the government should be to encourage free and fair competition. Private ownership encourages competition and economic efficiency.

Social stratification

All societies are stratified on a hierarchical basis into social categories i.e. social strata. They are often based on characteristics such as family background, occupation and income. a. Social mobility: the extent to which individuals can move out of the strata into which they are born. It varies from society to society. b. Caste system: a closed system of stratification in which social positions is determined by the family into which the person is born, and change in that position is usually not possible (India). c. Class system: a less rigid form of social stratification in which social mobility is possible. An individual can change his position through achievements and work. d. Class consciousness: a condition by which people tend to perceive themselves in terms of their class background, and this shapes their relationships with members of other classes.

Individualism

An individual should have freedom in his own economic and political pursuits. Interests of the individual should take precedence over the interests of the state. Its built on two tenets o Guaranteeing individual freedom and self-expression Welfare of society if best served by letting people pursue their own economic self-interest.

cross-cultural literacy

An understanding of how cultural differences across and within nations can affect the way business is practised. It is important for foreign business to gain understanding of the culture that prevails in those countries and that success requires a foreign enterprise to adapt to the culture of its host country.

Absolute advantage

Attack on the mercantilist theory with this doctrine. A country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it. 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. I.e. countries should never produce goods that it can buy at a lower cost from other countries. This is a positive-sum game i.e. everyone wins.

Civil Law

Based on detailed set of laws organized into codes. It is less adversarial than common law because the judges rely upon detailed legal codes rather than interpreting tradition. Judges have less flexibility under the civil law system whereas they only have the power to apply the law when while judges in the common law system can interpret the law. (Germany, France, Japan, Russia). Contracts under civil law are short and less specific because many of the issues are covered in the civil code

Theocratic Law

Based on religious teachings. Islamic law is the most widely practiced theocratic legal system in the modern world. Because the Koran and Sunnah are holy documents, the basic foundations cannot be changed. Many countries however have legal systems that are blend of a common/civil law system and a theocratic law system.

Common Law

Based on tradition (country´s legal history), precedent (cases that have come up in court before) and custom (how laws are applied in specific situations). Common Law has certain flexibility that other systems lack. Judges have the power to interpret the law so it applies to the unique circumstances of an individual case. (The UK+USA). Contracts under common law are long and detailed.

Administrative policies

Bureaucratic rules designed to make it difficult for imports to enter a country and boost exports

Confucian dynamism

Captures attitudes toward time, persistence, ordering by status, protection of face, respect for tradition and reciprocation of gift and factors

Mixed economy

Certain sectors of the economy are left to private ownership and free market mechanisms while other sectors have significant ownership and government planning. Governments tend to take troubled firms into state, whose continued operations are thought to be vital to national interest.

The Link between Trade and Growth

Countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade higher growth rates raise income levels and living standards

Local content requirements

Demand that some specific fraction of a good will be produced domestically. It can be expressed in physical terms and in value. Used by, for instance, developed countries to protect local jobs and industries from competition.

Trademarks

Design and names by which merchants and manufacturers designate and differentiate their products.

Economic government intervention

Economic - concerned with boosting the overall wealth of a nation The infant industry argument- An industry should be protected until it can develop and be viable and competitive internationally.

Cultural relativism

Ethics are culturally determined and firms should adopt the ethics of the cultures in which they operate

Patents

Exclusive rights for a defined period too the manufacture, use, or sale of that invention

A pegged exchange rate system

Exists when a country fixes the value of its currency relative to a reference currency.

A dirty float

Exists when a country tries to hold the value of its currency within some range of a reference currency such as the U.S. dollar

Comparative advantage

Extension on the Absolute advantage theory. According to this theory, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods it produces less efficiently, even if this mean buying goods from countries that it could produce more efficiently itself. The pattern of international trade is determined by differences productivity.

Competitive pressures

Firms that compete in the global marketplace typically face two types of ... that affect their ability to realise location economies and skills within the enterprise. .Pressures for cost reductions: force the firm to lower unit cost .Pressures to be locally responsive: require the firm to adapt its product to meet local demands in each market (this can raise costs)

Justice theories

Focus on the attainment of a just (fair and equitable) distribution of economic goods and services.

Question: What is free trade?

Free trade refers to a situation where 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

Subsidies

Government payment to a domestic producer, which are paid by taxing individuals and corporations. Takes forms such as cash grants, loans and government equity participation in firms. They lower production costs and can help companies gain a first-mover advantage in emerging industries. They help domestic firms in two ways, by: . Competing against foreign imports . Gaining export markets

Command economy

Government plans the goods and services that a country produces, the quantity that is produced and the prices as which they are sold. The government allocates resources for the good of the society. All businesses are state-owned. The objective is to mobilize economic resources for the public good.

Power distance

How a society deals with the fact that people are unequal in physical and intellectual capabilities. . High power distance cultures are found in countries where inequalities grow over time. . Low power distance cultures try to play inequalities as much down as possible.

Rights theories

Human beings have fundamental rights and privileges, which transcend national boundaries and cultures. Rights establish a minimum level of morally acceptable behavior. Along with rights come obligations so certain institutions are obligated to provide benefits that secure the rights of others. o Moral Agent: any person or institution that is capable of moral action such as government or corporation o Universal Declaration of Human Rights - basic principles that should always be adhered to irrespective of the culture in which one is doing business.

The naïve immoralist

If a manager of a MNC sees that firms from other nations are not following ethical norms in a host nation, that managers should not either

Producers based in advanced countries where labor costs are lower than the United States might now be able to export to the U.S.

If cost pressures become intense, developing countries begin to acquire a production advantage over advanced countries

Question: Why is it beneficial for countries to engage in free trade?

International trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, and import products that can be produced more efficiently in other countries it is beneficial for a country to engage in international trade even for products it is able to produce for itself

European Economic and Monetary Union

Involves the complete economic and financial integration of the EU countries. It´s not a common market, but a market with a single currency, a single central bank and a single monetary policy.

Gross national income (GNI)

It is a common measure of economic development in a country. It measures the total annual income received by residents of a nation. It can nevertheless, be misleading, because it doesn´t consider differences in cost of living. To account for differences in cost of living we adjust GNI figures using purchasing power parity (PPP) i.e. whether the cost of living in the country is higher or lower than in the US

The International Monetary Fund

It was established to maintain order in the international monetary system through a combination of discipline and flexibility.

Leontief (1953) - since the U.S. was relatively abundant in capital, it would be an exporter of capital intensive goods and an importer of labor-intensive goods

Leontief found however, that U.S. exports were less capital intensive than U.S. imports

Question: How has international trade theory evolved?

Mercantilism (16th and 17th centuries) encouraged exports and discouraged imports Adam Smith (1776) promoted unrestricted free trade David Ricardo (19th century) built on Smith ideas Eli Heckscher and Bertil Ohlin (20th century ) refined Ricardo's work

While the theories all suggest that trade is beneficial, they lack agreement in their recommendations for government policy

Mercantilism makes a case for government involvement in promoting exports and limiting imports Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade New trade theory and Porter justify limited and selective government intervention to support the development of certain export-oriented industries

The righteous moralist

Multinational´s home country standards of ethics should be followed in foreign countries.

Trade diversion

Occurs when lower-cost external suppliers are replaced by higher-cost suppliers within free trade area. o The removal of trade barriers within an association diverts trade from established trading links outside the trading association to the trading of the same product within the new trade association. o Trade Diversion will be more likely the higher the external barriers with the rest of the world. o The lower the difference in the cost of production between the internal and external producer the more likely there will be trade diversion.

The Samuelson Critique

Paul Samuelson - dynamic gains can lead to less beneficial outcomes concerned that the ability to offshore services jobs

Kantian ethics

People have dignity and need to be respected and are not machines. (I.e. sweatshop workers)

Political government intervention

Political -concerned with protecting the interest of certain groups often at the expense of other groups (consumers) or objectives eg. protecting the environment or human rights. 1. Protecting jobs and industries 2. National Security 3. Retaliation for unfair competition 4. Protecting consumers from dangerous products 5. Furthering the goals of a foreign policy 6. Protecting human rights of the individuals in exporting countries 7. Protecting the environment: international trade is associated with a decline in environmental quality.

National competitive advantage (Porter's Diamond)

Porter identified four attributes that promote the creation of competitive advantage · Factor conditions - a nations position in factors of production i.e. skilled labor and necessary infrastructure · Demand conditions · Related and supporting industries · Firms strategy, structure and rivalry These four attributes construct the diamond; the effect of one attribute is contingent to the state of others. Two other attributes can influence the diamond; chance and government. Chance events are such as major innovations, which can reshape the industry and give a new nation the opportunity to exceed another. Government, by its choice of policies, can detract or improve national advantage

Antidumping duties (countervailing duties)

Punish foreign firms that engage in dumping and protect domestic producers from "unfair" foreign competition. A special tariff can stay in place for up to five years.

Political economy

Refers to the political, economical and legal systems of a country are interdependent, they interact and influence each other and by doing so, affect the level of economic well-being.

1. Immobile resources

Resources do not always move freely from one economic activity to another Governments may help retrain displaced workers

extensions of the ricardian model Suppose the following assumptions are relaxed

Resources move freely from the production of one good to another within a country 2. There are constant returns to scale 3. Trade does not change a country's stock of resources or the efficiency with which those resources are utilized

Import quotas

Restrict the quantity of some goods that may be imported into a country.

Dumping

Selling goods in a foreign market below their cost of production or below their fair market value. It enables firms to unload excess production in foreign markets.

International trade theory helps explain trade patterns

Some patterns of trade are fairly easy to explain - it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Japan export automobiles, consumer electronics, and machine tools?

Specific tariffs

Tariff: levied as a fixed charge for each unit of a good imported

Ad valorem tariffs

Tariff: levied as a proportion (%) of the value of the imported good

Confucianism

Teaches the importance of attaining personal salvation through right action. It is built around an ethical code that sets down guidelines for relationships with others. It is not concerned with anything supernatural. 3 important values: loyalty, honest and shared obligations.

The World Bank

The International Bank for Reconstruction and Development to promote economical development o Under the IBRD scheme, money is raised through bond sales in the international capital market § Borrowers pay a market rate of interest - the bank's cost of funds plus a margin for expenses. § Low-interest loans to risky customers whose credit rating is often poor i.e. underdeveloped nations o Through the International Development Agency, an arm of the bank created in 1960 § Funded through subscriptions from wealthy countries § IDA loans go only to the poorest countries, interest rate is less than 1% a year.

New trade theory

The ability of firms to gain economies of scale can have important implications for international trade. Through the impact of economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods. Also countries may specialize in the production and export of particular products because certain industries in the world market can only support a limited number of firms.

Contract Law

The body of law that governs contract enforcement.

Copyrights

The exclusive legal rights of authors, composers, playwrights, artists and publishers to publish and disperse their work as they see fit.

Uncertainty avoidance

The extent to which different cultures socialized their members into accepting unclear situations and tolerating uncertainty. . High uncertainty: job security, career patters, retirement benefits etc. Strong need for rules and regulations . Low uncertainty: greater readiness to take risks and less emotional resistance to change

Vertical integration

The firm will expand within the same product market, but at a different stage of production. I.e. a car manufacturer might decide to produce its own components (backwards/upstream VI) or it might decide to sell its own models (forward/downstream VI)

Mercantilism

The main tenet of this theory is that a country´s best interest is to maintain a trade surplus i.e. export more than it imports. By doing so a country could increase its national wealth, prestige and power. Tariffs and quotas limited imports and exports were subsidized. This is a zero-sum game i.e. one loses while the other one wins.

Utilitarian ethics

The moral worth of actions or practices is determined by their consequences "means to an end". An action is judged desirable if it leads to the best possible balance of good consequences over bad consequences. It is committed to the maximization of good and the minimization of harm and it recognizes that actions have multiple consequences. You should weigh all benefits and costs and only pursue those actions where the benefits outweigh the costs. (Cost-benefit analysis and risk assessment)

Friedman doctrine

The only social responsibility of business is to increase profits, so long as the company stays within the rules of law and behave in an ethical manner. He rejects the idea that businesses should undertake social expenditures beyond those mandated by the law and required for the efficient running of a business. Only if the stockholders wish to make social investments, then the firm should.

2. Diminishing Returns

The simple model assumes constant returns to specialization (the units of resources required to produce a good are assumed to remain constant), but an assumption of diminishing returns is more realistic since not all resources are of the same quality and different goods use resources in different proportions

Minimum efficient scale

The size of the individual factory or the whole firm, beyond which no significant additional economies of scale can be gained. For an individual factory this is known as the minimum efficient plant size.

World trading system (WTO)

The world trading system is an independent body whom acts as a referee and monitors trade between countries and makes sure than everyone is playing by the rules, and if someone isn´t then it can impose fines on the cheating country. The current agenda of the WTO focuses on: · The rise of anti-dumping policies · Protectionism in agriculture · The lack of strong protection for intellectual property rights in nations. · High tariffs on non-agricultural goods and services in many nations. WTO rules include Non-discrimination Reciprocity General prohibition of quotas Fair competition Binding tariffs The international monetary system: the institutional arrangements that countries adopt to govern exchange rates.

Strategic trade theory

Theory that favors subsidies to help domestic firms achieve a dominant position in those industries in which economies of scale are important and the world market isn´t large enough to support more than a few firms

Types of financial crisis

There are three main types: 1. Currency crisis a) Occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates (Brazil 2002) 2. Banking crisis a) A situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits (Iceland 2008) 3. Foreign debt crisis a) A situation in which a country cannot service its foreign debt obligations, whether private sector or government debt (Greece 2010)

floating exchange rate system

This system exists when a country allows the foreign exchange market to determine the relative value of a currency. · The U.S. dollar, the EU euro, the Japanese yen, and the British pound all float freely against each other · Their values are determined by market forces and fluctuate day to day

The product life-cycle theory

This theory is based on the observation that for most of the 20th century a very large proportion of the world´s new products were developed and sold in the US. Companies will manufacture products first in the countries in which they were researched and developed. Over the product's life cycle, production will shift to foreign locations, especially to developing economies as the product reaches the stages of maturity and decline. When production within other countries begins, it limits potential exports from the country of origin and the country begins to import the product instead of exporting it because they produce it at a lower price. · Life cycle stages: o Introduction o Growth o Maturity o Decline

Adam smith 1776

Trade is not a zero-sum game. countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries

3. Dynamic Effects and Economic Growth

Trade might increase a country's stock of resources as increased supplies become available from abroad Free trade might increase the efficiency of resource utilization, and free up resources for other uses

Country similarity theory

Trade today occurs among high-income countries because they share similar market segments and because they produce and consume so much more than emerging economies. It may be explained by cultural similarity between the countries, political and economic agreements, and by the distance between them.

Strategic alliances

Two or more firms work together to achieve mutually desirable goals but keep their identities. They form SA in order to gain new markets, share risk and capital pooling. . Horizontal alliances: Informal or contractual alliance between firms at a technically similar stage of production that may lead to a joint venture . Vertical alliances: Informal or contractual alliance between firms producing at different stages of same process that may lead to a joint venture . Networks: Informal alliance between firms across sectors, including the development of supply chain clusters.

Over time, demand for the new product starts to grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets

U.S. firms might also set up production facilities in those advanced countries where demand is growing limiting the exports from the U.S.

Absolute advantage

a country has an absolute advantage in the production of a product when it is more efficient than any other country at producing it/

Factor endowment

a country's endowment with resources such as land, labor, and capital.

Absolute advantage

adam smiths theory (1776) First to explain why unrestricted free trade is beneficial to a country.

first mover advantage

advantages accruing to the first to enter a market.

Ricardo (1817) - what happens when one country has an absolute advantage in the production of all goods

comparative advantage - a country should specialize in the production of those goods that it produces most efficiently and 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

Economies of scale

cost advantages associated with large scale production.

that the U.S. has a special advantage in producing products made with innovative technologies that are less capital intensive

differences in technology lead to differences in productivity which then drives trade patterns

Ricardo's theory of comparative advantage

existing trade patterns are related to differences in labor productivity

Heckscher and Ohlin

explain trade through the interplay between the proportions in which the factors of production are available in different countries and the proportions in which they are need for producing particular goods

International trade theory

explains why it is beneficial for countries to engage in international trade helps countries formulate their economic policy explains the pattern of international trade in the world economy

Michael Porter

focused on the importance of country factors to explain a nation's dominance in the production and export of certain products

Merchantilism

in a countries best interests to maintain a trade surplus, to export more than it imported. -An economic philosophy advocating that countries should simultaneously encourage exports and discourage imports

Mercantilism (mid-16th century)

it is in a country's best interest to maintain a trade surplus - to export more than it imports it advocated government intervention to achieve a surplus in the balance of trade it viewed trade as a zero-sum game (one in which a gain by one country results in a loss by another) Mercantilism is problematic and not economically valid, yet many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade

In the early stages of a product's life cycle demand may grow in the U.S., but demand in other advanced countries is limited to high-income groups

it is not worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the U.S. to those countries

The simple example of comparative advantage assumes

only two countries and two goods zero transportation costs similar prices and values resources are mobile between goods within countries, but not across countries constant returns to scale fixed stocks of resources no effects on income distribution within countries

The theory of comparative advantage - trade is a positive sum gain in which all gain

potential world production is greater with unrestricted free trade than it is with restricted trade provides a strong rationale for encouraging free trade

Free trade

the absence of barriers to the free flow of goods and services between countries.

Heckscher and Ohlin - comparative advantage arises from differences in national factor endowments (the extent to which a country is endowed with resources such as land, labor, and capital)

the more abundant a factor, the lower its cost countries will export goods that make intensive use of those factors that are locally abundant, and import goods that make intensive use of factors that are locally scarce

New trade theory

the observed pattern of trade in the world economy may be due in part to the ability of firms in a given market to capture first-mover advantages (paul krugman) -Countries specialize in the production and export of particular products not because of underlying differences in factors endowments, but because of certain industries the world market can support only a limited number of firms.

Constant returns to specialization

the units of resources required to produce a good are assumed to remain constant no matter where one is on a country's production possibility frontier.

Vernon (mid-1960s ) proposed the product life-cycle theory - as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade

the wealth and size of the U.S. market gave a strong incentive to U.S. firms to develop new products

Paul Krugman "new trade theory"

the world market can only support a limited number of firms in some industries trade will skew toward those countries that have firms that were able to capture first mover advantages

Ray Vernon

trade patterns could be explained by looking at a product's life cycle

The flaw of merchantilism

viewed trade as a zero sum game, in which a gain by one country results in a loss by another.

Trade creation

· Occurs when high-cost domestic producers are replaced by low-cost producers within the free trade area o This is where the removal of trade barriers leads to new trade in a product or an increased trade in a product. o The removal of internal barriers such as tariff and quotas will tend to create trade due to more competition and the prospect of Economies of Scale.