Part Three
Theories and Institutions: Trade and Investment
Chapter SIX
INTERNATIONAL TRADE
AND FACTOR MOBILITY THEORY
OBJECTIVES
•To understand theories of why countries should trade
•To comprehend how global efficiency can be increased through free trade
•To become familiar with factors affecting countries’ trade patterns
•To realize why countries’ export capabilities are dynamic
•To discern why the production factors of labor and capital move internationally
•To grasp the relationship between foreign trade and international factor mobility
Chapter Overview
Chapter Six provides a conceptual foundation for the exploration of the international trade process. First, it examines the basic theories of mercantilism, absolute advantage, and comparative advantage. Then it explores patterns of trade in light ofthe theories of country size, factor proportions, and country similarity. It also considers the role of distance and explains the relevance of Product Life Cycle Theory and Porter’s Diamond of national competitive advantage. The chapter concludes with a discussion of factor mobility and its relationship to the international trade process.
CHAPTER OUTLINE
OPENING CASE:COSTA RICAN TRADE, FOREIGN INVESTMENT,
AND ECONOMIC TRANSFORMATION
[See Map 6.1.]
Costa Rica, a Central American country of barely 4 million people,has successfully transformed its primarily agricultural economy to one that includes strong technology and tourism sectors as well. Bordering both the Pacific Ocean and the Caribbean arm of the Atlantic, Costa Rica used international trade and factor mobility policies to help achieve its economic objectives. Although exports of coffee and bananas are still important, high-tech manufactured products (electronics, software, and medical devices) are now the backbone of Costa Rica’s economy and export earnings. As in all countries, Costa Rica’s policies continually evolved, but generally fall into four periods and categories:
•1800s–1960: a liberal trade regime that promoted the exports of coffee andbananas
•1960–1982: a more protectionist regime that promoted import substitution,i.e., a policy of developing domestic industries to manufacture goods and provide services that would otherwise be imported (although results were mixed, the processing of coffee and cotton seeds increased the value of Costa Rican exports, and considerable substitution occurred in the pharmaceutical industry)
•1983–Early 1990s: a less protectionist regime that promoted the liberalization of imports, encouraged export promotion, and provided incentives to attract foreign capital and expertise
•Early 1990s-Present: a liberal trade regime that seeks the production of electronics, software, and medical devices via strategic trade policy, i.e., the identification and development of targeted domestic industries in order to improve their competitiveness at home and abroad
Teaching Tips: Carefully review the PowerPoint slides for Chapter Six, as well as the opening case regarding Costa Rican Trade, which is cited throughout the chapter.
I.INTRODUCTION
Trade theory helps managers and government policymakers focus on three critical questions: What products should be imported and exported, how much should be traded, and with whom should they trade? While descriptive (free trade) theories suggest a laissez-faire treatment of trade, prescriptive (interventionist) theories suggest that governments should influence trade patterns. Trade in goods and services and the movement of production factors links countries internationally. [See Fig. 6.1.]
II.INTERVENTIONIST THEORIES
Interventionist trade theoriesprescribe government action with respect to the international trade process.
- Mercantilism
The concept of mercantilism (a zero-sum game) served as the foundation of economic thought for nearly three hundred years (1500–1800). It purports that a country’s wealth is measured by its holdings of treasure (usually gold). To amass a surplus(a favorable balance of trade), a country must export more than it imports and then collect gold and other forms of wealth from countries that run a deficit(an unfavorable balance of trade).
- Neomercantilism
Neomercantilismrepresents the more recent strategy of countries that use protectionist trade policies in an attempt to run favorable balances of trade and/or accomplish particular social or political objectives.
II.FREE TRADE THEORIES
The explanatory power of the theories of absolute and comparative advantage is limited to the demonstration of how economic growth can occur via specialization and trade. The concept offree trade(a positive-sum game) purports that nations should neither artificially limit imports nor artificially promote exports. The invisible hand of the market will determine which competitors survive, as customers buy those products that best serve their needs. Free trade implies specialization—just as individuals and firms efficiently produce certain products that they then exchange for things they cannot produce efficiently, nations as a wholespecialize in the production of certain products, some of which will be consumed domestically, and some of which may be exported; export earnings can then in turn be used to pay for imported goods and services.
A.Theory of Absolute Advantage
In 1776 Adam Smith asserted that the wealth of a nation consisted of the goods and services available to its citizens. His theory of absolute advantageholds that a country can maximize its own economic well being by specializing in the production of those goods and services that it can produce more efficiently than any other nation and enhance global efficiency through its participation in (unrestricted) free trade. Smith reasoned that: (i) workers become more skilled by repeating the same tasks; (ii) workers do not lose time in switching from the production of one kind of product to another; and (iii) long production runs provide greater incentives for the development of more effective working methods. Smith also asserted that country-specific advantages can either be natural or acquired.
1.Natural Advantage. A country may have a natural advantage in the production of particular products because of given climatic conditions, access to particular resources, the availability of labor, etc. Variations in natural advantages among countries help to explain where particular products can be produced most efficiently.
2.Acquired Advantage. An acquired advantage represents a distinct advantage in skills, technology, and/or capital assets that yieldsdifferentiated product offerings and/or cost-competitive homogeneous products. Technology, in particular, has created new products, displaced old products, and altered trading-partner relationships.
3.Resource Efficiency Example. Real incomedepends on the output of products as compared to the resources used to produce them. By defining the cost of production in terms of the resources needed to produce a product, the production possibilities curve shows that through the use of specialization and trade, the output of two countries will be greater, thus optimizing global efficiency. [See Fig. 6.2.]
- Comparative Advantage
In 1817 David Ricardo reasoned that there would still be gains from trade if a country specialized in the production of those things it can produce most efficiently, even if other countries can produce those same things even more efficiently. Put another way, Ricardo’s theory of comparative advantageholds that a country can maximize its own economic well-being by specializing in the production of those goods and services it can produce relativelyefficiently and enhance global efficiency through its participation in (unrestricted) free trade.
1.An Analogous Explanation. Would it make sense for the best physician in town, who also happens to be the most talented medical secretary, to handle all of the administrative duties of an office? No. The physician can maximize both output and income by working as a physician and employing a less skilled secretary. In the same manner, a country will gain if it concentrates its resources on the production of the goods and services it can produce most efficiently.
2.Production Possibility Example. A country can simultaneously have a comparative advantage and an absolute advantage in the production of a given product. Assume that the United States is more efficient than Costa Rica in the production of both wheat and tea; however, the U.S. has a comparative ad-vantage in wheat production. By concentrating on the production of the product in which it has the greater advantage (wheat) and allowing Costa Rica to produce the product in which the United States is comparatively less efficient (coffee), global output can be increased, and specialization and trade will benefit both countries. [See Fig. 6.2.]
- Some Assumptions and Limitations of the Theories of Specialization
The theories of absolute and comparative advantage are based upon the economic gains from specialization, i.e., concentration on the production of a limited number of products. Each holds that specialization will maximize output and that subsequent trade will maximize consumer welfare. However, both theories make certain assumptions that may not always be valid.
1.Full Employment. Both theories assume that resources are fully employed. When countries have many unemployed or underemployed resources, they may seek to restrict imports in order to employ their own available workers and other assets.
2.Economic Efficiency Objective. Individuals and countries often pursue objectives other than economic efficiency. Individuals may prefer activities and/or occupations that are economically less productive, and nations may choose to avoid overspecialization because of the vulnerability created by potentialchanges in technology and price fluctuations.
3.Division of Gains. Although specialization does maximize output, it is unclear how those gains will be divided. If one country believes that a trading partner is receiving too large a share of the benefits, it may choose to forego its relatively smaller gains in order to prevent the partner country from receiving larger gains.
4.Two Countries, Two Commodities. The world is comprised of multiple countries and multiple commodities. Nonetheless, the theories are still useful; economists have applied the same reasoning and demonstrated the economic efficiency advantages in multi-product and multi-country production and trade relationships.
5.Transport Costs. If it costs more to deliver products than can be saved via specialization, then the gains from trade are negated.
6.Statics and Dynamics. Although the theories of absolute and comparative advantage consider gains at a given time (a static view), the relative conditions that surround a country’s particular advantage or disadvantage are dynamic (constantly changing). Thus, one cannot assume that future advantages will remain constant. (This idea will also be relevant to the discussion of the dynamics of the location of production and export sources.)
7.Services. Although the theories of absolute and comparative advantage were developed from the perspective of trade in commodities, much of the same reasoning can be applied to trade in services.
8.Mobility. Neither the assumption that resources can move domestically from the production of one good to another and at no cost, nor the assumption that resources cannot move internationally, is entirely valid. Nonetheless, domestic mobility is greater than the international mobility of resources. Clearly, the movement of resources such as capital and labor is a very real alternative to trade.
III.THEORIES EXPLAINING TRADE PATTERNS
The explanatory power of the theories of absolute and comparative advantage is limited to the demonstration of how economic growth can occur via specialization and trade. The theories of country size, factor proportions, and country similarity all contribute to the explanation of what types of products are traded and with which partner nations countries will primarily trade.
A.How Much Does a Country Trade?
Apart from nontradable products,i.e., goods and services that are impractical to export, country size helps to explain why some countries are more dependent on trade than others and why some account for larger portions of world trade than others.
1.Theory of Country Size. The theory of country sizeholds that large countries tend to export a smaller portion of their output and import a smaller portion of their consumption. Large countries are more apt to have varied climates and a greater assortment of natural resources than smaller economies, thus making the large countries more self-sufficient. Further, given the same types of terrain and modes of transportation, the greater the distance, the higher the associated transport costs. Thus, firms in large countries oftenface higher transportation costs in terms of sourcing inputs from and delivering output to distant foreign markets than do their closer foreign competitors.
2.Size of Economy. Counties can be compared on the basis of their economic size, using indicators that include the value and share of world trade. [See Table 6.2.] Ten of the world’s top trading nations are high-income countries. Despite its low per capita income, China also has a large economy because of its very large population. Together, the top ten nations account for more than one-half of all of the world’s trade.
B.What Types of Products Does a Country Trade?
The composition of a country’s trade depends on both its natural and acquired advantages. With respect to the latter, both production and product technology can be very important.
1.Factor-Proportions Theory. Developed by Eli Heckscher (1919) and Bertil Ohlin (1933), the factor-proportions theoryholds that (i) differences in a country’s relative endowments of land, labor, and capital explain differences in the cost of production factors and (ii) a country will tend to export products that utilize relatively abundant factors of production because they are relatively cheaper than scarce factors;e.g., countries with rich and abundant land tend to be large exporters of agricultural products, whereas countries with capital-intensive production lines tend to be large exporters of manufactured goods. Nonetheless, production factors are not homogenous, and variations (particularly in labor) have led to international specialization by task; e.g., countries with less skilled and lower paid workers tend to export products that embody a higher intensity of labor.
2.Production Technology. Factor proportions analysis becomes more complicated when the same product can be produced by different methods, such as different mixes of labor and capital. The optimum location will depend on comparisons of the production cost in each potential locale. Although larger nations tend to depend more on longer production runs, companies may locate long-run production facilities in small countries if export barriers to other markets are relatively low. In addition, firms tend to locate longer-run production facilities in just a few countries. However, when long runs are less important, there is a greater tendency to scatter production units around the world in a way that will minimize the transportation cost associated with exports.
3.Product Technology. While manufacturing comprises the largest sector of world trade, commercial services is the fastest-growing sector. [See Fig. 6.4.] Because manufacturing depends on acquired advantages (largely technology) plus large amounts of capital investment, most new products tends to be developed in high-income countries. On the other hand, lower-income countries depend more on the production of primary products, which in turn depend more on natural advantages.
C.With Whom Do Countries Trade?
High-income countries trade primarily with each other, and emerging economies primarily export primary and labor-intensive products. Nonetheless, it is also true that economic and cultural similarities, political interests, and distance affect the determination of trading partners.
1.Country-Similarity Theory. The country-similarity theory states that when a firm develops a new product in response to observed conditions in its home market, it is likely to turn to those foreign markets that are most similar to its domestic market when commencing its initial international expansion activities. So much trade takes place among industrialized countries because of the growing importance of acquired advantages, i.e., skills and technology. In addition, markets in most industrialized countries are large enough to support new product introductions and the subsequent variants across the product life cycle. At the same time, trade in differentiated products occurs because over time firms in different countries develop product variants for particular market segments. Cultural similarity also facilitates trade. In particular, a common language and a common religion represent two major facilitators of the international trade and investment process. Historical and political relationships, as well as economic agreements, may encourage or discourage trade with particular countries.
2.Distance Among Countries. Countries that are near to one another enjoy relatively lower transportation costs than those that are more distant. While the disadvantages of distance can often be overcome through innovative technology and marketing methods, such gains are difficult to maintain in the long run.
DOES GEOGRAPHY MATTER?
Variety Is the Spice of Life
Geography plays a major role in many theories and decisions concerning international trade. Part of a nation’s advantage is embedded in its natural advantages—climate, terrain, arable land, and natural resources. Factor proportions theory helps explain where certain goods and services may be more efficiently produced. Many small countries need to trade relatively more than larger nations because small countries often lack a wide variety of natural advantages and resources. In addition, distance, culture, and political/ economic relationships also play major roles in the process.