Introduction to Trade theories

Evolution of Trade Theories Mercantilism Absolute advantage (Classical) Comparative advantage Hecksher-Ohlin theory Porters Diamond Model

Defining mercantilism Mercantilism refers to the view of a heterogeneous group of influential people as to how a nation could regulate its domestic and international affairs to promote its own interest. It prevailed in Europe during 1500-1800 The principle assertion of it was that a nations wealth and prosperity reflected in its stock of precious metals, gold and silver.

Mercantilism: mid-16th century Gold and silver are the currency of trade A country could accumulate gold and silver by exporting more and importing less Theory says you should have a trade/export surplus. Maximize export through subsidies. Minimize imports through tariffs and quotas Economic activity was a zero-sum-game. Ie. One countrys gain is a loss of another country. Since all nations could not have export surplus, and as the supply of gold and silver was fixed at any particular point of time, one nation would gain at the expense of other

Flaws of Mercantilism during 18th century David Hume said that a favourable trade balance was only possible in the SR and over the period it will eliminated. For eg: favourable TB will result in inflow of gold & silver, which will increase money supply , in turn price & wages will increase and adversely affect export and encourage import. Adam Smith & David Ricardo said that trade was a positive sum game in which all trading nations can gain even if some benefit more than others. They argued that international trade expands the scope of division of labour (specialization) which increases productivity and output and all trading partners can simultaneously enjoy higher level of production and consumption with free trade

Theory of absolute advantage Adam Smith: Wealth of Nations ( 1776) thought that the basis of international trade was absolute cost advantage. According to his theory, trade between two countries would be mutually benefitted if one country could produce one commodity at an absolute advantage (over the other country) and the other country could produce another commodity at an absolute advantage over the first Hence trade between countries is, therefore, beneficial Here the basis of international trade is the absolute difference in the cost of production of different commodities between nations

Absolute Cost Advantage

USA UK

No. of units of wheat per unit of labour

No. of units of cloth per unit of labour

10

US has an AA in the production of wheat over UK, and UK has an AA in the production of cloth over US. Hence, according to Adam Smiths theory, US should specialize in the production of wheat and meet its requirement of cloth through import from UK. On the other hand, UK should specialize in the production of cloth and should obtain wheat from US. Such trade would be mutually beneficial

In short, according to Smiths theory, 3 kinds of gains accrue to a country from international trade : a) Productivity gain b) Absolute cost gain c) Surplus gain

Theory of absolute advantage destroys the mercantilist idea since there are gains to be had by both countries party to an exchange questions the objective of national governments to acquire wealth through restrictive trade policies measures a nations wealth by the living standards of its people

 Before specialisation USA produce at C & UK produce at D. After specialisation, USA produce at A & UK produce at B
Wheat A USA PPF

10

UK PPF

B Rice

Examples of Absolute Advantage

Brazilian coffee beans Canadian Timber

Theory of comparative advantage(CA) The famous classical economist David Ricardo has demonstrated that the basis of trade is the comparative cost difference i.e. trade can take place even in the absence of absolute cost difference, provided there is comparative cost difference. This doctrine maintains that if trade is left free, each country, in the long run, tends to specialize in the production and export of those commodities in whose production it enjoys a comparative advantage in terms of real costs, and to obtain by importation those commodities which could be produced at home at a comparative disadvantage in terms of real costs

Assumption of CCT Labour as the only element of cost of production Goods are exchanged against one another according to the relative amounts of labour embodied in them Labour is perfectly mobile within the country but perfectly immobile between countries Labour is homogeneous Production is subject to the law of constant returns International trade is free from all barriers There is no transport cost There is full employment There is perfect competition There are only two countries and two commodities

 To demonstrate the trade, we introduce the opportunity cost of good X which is the amount of another good Y that has to be given up in order to produce an additional unit of X Cost Comparisons
Labour cost of production (in hours)

1 unit of wine
Portugal 80

1 unit of cloth
90

England

120

100

Opportunity cost (OC)

Opportunity cost of production

1 unit of wine

1 unit of cloth

Portugal (P)

80/90 =8/9 =0.8 120/100 =12/10 =1.2

90/80 =9/8 =1.12 100/120 =10/12 =0.8

England (E)

 Graphical situation

Oppor. cost

England

1.2

B 0.8

Portugal

Wine

 A country has CA in producing a good if the opportunity cost of producing the good is lower at home than in the other country The above table shows that P has the lower OC in producing wine & E has the lower OC in producing cloth. Thus P has CA in the production of wine & E has a CA in production of cloth So P will specialize in wine & export wine & import cloth. E will specialize in cloth & export cloth, import wine So both countries gain from trade regardless of the fact that one have an AA in both lines of production

Assumptions and limitations Driven only by maximization of production and consumption Only 2 countries engaged in production and consumption of just 2 goods What about the transportation costs? Only resource labour (that too, nontransferable) No consideration for learning theory

Examples of CA
Hollywood movies Bollywood movies Guatemalan Textile (Guatemala is a country in C. America) South Korean Electronic

Factor proportions theory (Modern Theory)

Heckscher (1919) - Olin (1933) Theory Export goods that intensively use factor endowments which are locally abundant and import goods made from locally scarce factors Patterns of trade are determined by differences in factor endowments - not productivity Here the focus is on relative advantage, not absolute advantage

Factor proportions theory Trade theory says that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply Example: Australia lot of land and a small population (relative to its size) So what should it export and import?

Factor Proportions Trade Theory Considers Two Factors of Production Labor Capital Thus, A country that is relatively labor abundant ( capital abundant ) should specialize in the production and export of that product which is relatively labor intensive ( capital intensive )

This theory consists of two important theorems, namely : The Heckscher-Ohlin Theorem The factor price equalization theorem The Heckscher-Ohlin Theorem Heckscher-Ohlin theorem explained the basis of international trade in terms of factor endowments. This theorem examines the reason for comparative cost differences in production and states that a country has comparative advantage in the production of that commodity which uses more intensively the countrys more abundant factor.

H-O attempts to explain why comparative cost differences exist internationally by stating the following two reasons: 1. Different prevailing endowments of the factor of production 2. The fact that production of various commodities requires that the factors of production be used with different degrees of intensity. On the basis of this, H-O theory states that a country will specialize in the production and export of goods whose production requires a relatively large amt of the factor with which the country is relatively well endowed.

Eg. In country A: Supply of Labour : 25 units Supply of Capital : 20 units Capital- labour ratio = 0.8 In country B : Supply of Labour : 12 units Supply of Capital : 15 units Capital- labour ratio = 1.25 Here C-A has more capital in absolute terms, but C-B is more richly endowed with capital because the ratio of capital to labour in C-A is 0.8< C-B (1.25)

Capital Intensive good

Capital abundant country

Labour abundant country

Labour intensive good

The factor price equalization theorem states that free international trade equalizes factor prices between countries, relatively and absolutely International trade increases the demand for abundant factors (leading to an increase in their prices) and decreases the demand for scarce factors (leading to a fall in their prices) because when nations trade, specialization takes place on the basis of factor endowments. Thus the effect of inter-regional trade is to equalize commodity prices. This further tends to equalize the prices of the factor

 According to Ohlin The effect of inter-regional trade is to equalise commodity prices. Furthermore, there is also a tendency towards equalisation of the prices of factors of production, which means their better use and a reduction of the disadvantages arising from the unsuitable geographical distribution of the productive factors Since from each region goods containing a large proportion of relatively abundant and cheap factors are exported, while goods containing a large proportion of scarce factors are imported, interregional trade serves as a substitute for such inter-regional factor movements

Effects of International trade Equalisation of commodity prices: This is because trade causes movement of commodities from areas where they are abundant to areas where they are scarce. This would tend to increase commodity prices where there are abundance and decrease prices where there are scarcity due to the redistribution of commodity supply between these two regions as a result of trade Equalisation of factor prices: This is because specialization takes place on the basis of factor endowment.

Michael Porter model of Competitive Advantage

Competitive Advantage is the critical advantage that a firm possess in the market over a competitor in the industry. Almost all the firms in the market try to achieve a sustainable competitive advantage. Michael Porter : told about 2 types of Competitive advantage 1. Cost advantage 2. Differentiation advantage

A firm that offers the consumer the same value as the competitors, but at a lower cost, is said to possess cost advantage A firm that offers superior value to its customers when compared to its competitors, possess differentiation advantage

Porter Competitive Model

Potential New Entrants

Bargaining Power of Suppliers

Intra-Industry Rivalry

Strategic Business Unit

Bargaining Power of Buyers

Substitute Products and Services

Source: Michael E. Porter Forces Governing Competition in Industry Harvard Business Review, Mar.-Apr. 1979

Figure 3-1

Competitive Strategies Countering Competitive Forces

Basic Objectives
Create effective links with consumers and suppliers. e.g. Improving your supply chain and locking in customers. Build barriers to new entrants and substitutes.

Two Strategies to Accomplish The Basic Objectives

Differentiation Strategy Provide a superior product. If done correctly allows for premium pricing. Usually more costly to implement. Low-Cost Strategy Leverage economies of scale, past experience, and alliances to provide the cheapest prices.

Supporting Strategies Augment Competitive Strategies

Innovation Can help contribute to product differentiation and operational efficiency.
Growth Certain industries reward firms exhibiting explosive growth (ex. Federal Express). Alliance Allows strategies to be used which would be impossible to implement alone (ex. Airlines sharing routes to expand reach).

Poters 5 forces of a firm 1. Barriers to Entry / Threat of New Entrants - Absolute cost advantages - Access to inputs - Economies of scale - Government Policies - Capital requirement - Brand value - Proprietary products (eg herbal product ) - Learning curve Eg. Relaince industry Petrochemical plant at Jamnagar, Gujarat

2. Intensity of rivalry among firms - Exit barriers -Concentration ratio - Industry growth - Switching costs low for customers - Market share - Diversity of rivals Strategies adoption to overcome it are - Differentiating its product -Charging different price from its rival firm - Utilizing distribution channels innovatively

3. Threat of Substitute

Switching costs are negligible Relative price performance of substitute restricts the firm to charge higher price Buyer propensity to substitute is very high

4. Bargaining Power of Buyers is determined by the industry in which the firm is operating - Buyer volume - Brand value - Price sensitivity - Threat of backward integration by the buyers of auto parts - Product differentiation - Buyer concentration Eg. If Buyer volume is few then they can influence price. Eg. Few automobile companies but numerous suppliers of auto components

Bargaining power of buyers will be higher under the following situations Large no. of suppliers & few buyers When buyers purchase in large quantities When suppliers large % of order depends on buyer When switching cost for buyer is less When buyers can threat for vertical integration

5. Bargaining Power of Suppliers - Supplier concentration - Differentiation of inputs - Switching cost of firms - Presence of substitute inputs - Threat of forward integration - Impact of inputs on total product costs When there is few supplier in the market, they become powerful and decide on the price which is profitable to them Eg. Intel microprocessors

Suppliers are powerful under the following circumstances When there are few substitute for their product & it is an important product Buyers are many Switching cost for the buyer is very costly Suppliers can threat for vertical forward integration into the industry & compete directly with the buyers Buyers cannot threat for vertical backward integration

Porter Competitive Model Heavyweight Motorcycle Manufacturing Industry North American Market

Parts Manufacturers Electronic Components Specialty Metal Suppliers Machine Tool Vendors Labor Unions IT Vendors
Bargaining Power of Suppliers

Foreign Manufacturer
Potential New Entrant

Established Company Entering a New Market Segment New Startup

Bargaining Power of Buyers

Intra-Industry Rivalry

SBU: Harley-Davidson
Rivals: Honda, BMW, Suzuki, Yamaha

Automobiles Public Transportation Mopeds Bicycles

Substitute Product or Service

Recreational Cyclist Young Adults Law Enforcement Military Use Racers