International Business (9th, Wild) - Notes for Chapter (5).doc

14 Ch 5: International Trade 3 Ch 5: International Trade Chapter 5 International Trade Theory Learning Objectives: 5.1 Describe the benefits, volume and patterns of international trade. 5.2 Explain how mercantilism worked and identify its inherent flaws. 5.3 Detail the theories of absolute advantage and comparative advantage. 5.4 Summarize the factor proportions theory of trade. 5.5 Explain the international product life cycle theory. 5.6 Outline the new trade theory and the first mover advantage. 5.7 Describe the national competitive advantage theory and the Porter Diamond. Chapter Outline: Benefits, Volume, and Patterns of International Trade Benefits of International Trade Volume of International Trade International Trade Patterns Trade Interdependence Trade Dependence Mercantilism How Mercantilism Worked Trade Surpluses Government Intervention Colonialism Flaws of Mercantilism Theories of Absolute and Comparative Advantage Absolute Advantage Case: Riceland and Tealand Gains from Specialization and Trade Comparative Advantage Gains from Specialization and Trade Assumptions and Limitations Factor Proportions Theory Labor Versus Land and Capital Equipment Evidence on Factor Proportions Theory: The Leontief Paradox International Product Life Cycle Stages of the Product Life Cycle Limitations of the Theory New Trade Theory First-Mover Advantage National Competitive Advantage Factor Conditions Advanced Factors Demand Conditions Related and Supporting Industries Firm Strategy, Structure, and Rivalry Government and Chance Bottom Line for Business Globalization and Trade Supporting Free Trade A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 5. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline This chapter explores international trade in goods and services, examining its benefits, volume, and patterns. It also explores the main theories of why nations trade. BENEFITS, VOLUME, AND PATTERNS OF INTERNATIONAL TRADE International trade is the purchase, sale, or exchange of goods and services across national borders. One way to measure the importance of trade is to examine the volume of an economy’s trade relative to total output (see Map 5.1). A. Benefits of International Trade Creates new entrepreneurial opportunities, expands the choice of goods and services, and creates jobs. The U.S. Department of Commerce estimates that for every $1 billion increase in exports, 22,800 U.S. jobs are created. B. Volume of International Trade World merchandise exports are worth more than $16.5 trillion and service exports are valued at more than $4.8 trillion (see Table 5.1). Trade in merchandise is around 9.1 percent of total trade; services account for 22 percent of total trade. C. International Trade Patterns Trade volume and world output provide insight into the international trade environment but do not disclose trading partners. 1. Trade Interdependence Trade between most nations is characterized by a degree of interdependency. Companies in developed nations trade a great deal with companies in other developed nations. The level of interdependency between pairs of countries often reflects the amount of trade that occurs between a company’s subsidiaries in the two nations. Emerging markets that share borders with developed countries are often dependent on their wealthier neighbors. Complete independence was considered desirable from the sixteenth through eighteenth centuries, but is not desirable today. 2. Trade Dependence Mercantilism Nations should accumulate financial wealth, usually in the form of gold, by encouraging exports and discouraging imports. Other measures of a nation’s well-being, such as living standards or human development, are irrelevant. It was practiced from around 1500 to the late 1700s by European nations, including Britain, France, the Netherlands, Portugal, and Spain. A. How Mercantilism Worked Trade was to benefit mother countries; colonies (in Africa, Asia, and North, South, and Central America) were exploitable resources. 1. Trade surpluses Nations increased wealth through a trade surplus—when the value of a nation’s exports exceeds the value of imports. Trade deficits were to be avoided at all costs. 2. Government intervention Governments intervened in international trade to maintain a trade surplus. They banned certain imports, imposed tariffs or quotas, and subsidized home-based industries to expand exports. Removal of gold and silver from the nation was outlawed. 3. Colonialism Mercantilist nations acquired colonies as sources of inexpensive raw materials and markets for higher-priced finished goods. Trade among mercantilist nations and their colonies expanded wealth and created armies and navies to control colonial empires and protect shipping. B. Flaws of Mercantilism The main problem with mercantilism is that it viewed international trade as a zero-sum game—a nation benefits only at the expense of other nations. But if all nations barricade their markets from imports and push their exports onto others, international trade would be severely restricted. Also, it kept colonial markets poor: they received little money for raw materials but were charged high prices for finished goods. THEORIES OF ABSOLUTE AND COMPARATIVE ADVANTAGE A. Absolute Advantage Absolute advantage is the ability of a nation to produce a good more efficiently than any other nation (produce a greater output using the same, or fewer, resources). Adam Smith reasoned that international trade should not be burdened by tariffs and quotas, but should flow according to market forces. A country should produce the goods in which it holds an absolute advantage and trade with others to obtain the goods it needs but does not produce efficiently. 1. Case: Riceland and Tealand In a world of two countries (Riceland and Tealand) with two products (rice and tea) where transport costs nothing, each produces and consumes its own rice and tea. In Riceland, 1 resource unit produces a ton of rice, but 5 units are needed to produce a ton of tea. In Tealand, 6 resource units produce a ton of rice, but 3 units are needed to produce a ton of tea. Thus, Riceland has an absolute advantage in rice production and Tealand has an absolute advantage in tea production. 2. Gains from specialization and trade Although each country now specializes and world output increases, both countries face a problem: Riceland consumes only its rice and Tealand consumes only its tea. The problem can be resolved through trade. Although Tealand does not gain as much as Riceland, it gets more rice than it would without trade. Actual gains depend on the total resources of each country and the demand for each good in each country (Figure 5.2). The theory of absolute advantage destroys the mercantilist idea that international trade is a zero-sum game. Because both countries gain, international trade is a positive-sum game. The theory argues against restrictive trade policies and for nations to instead open their doors to trade so their people obtain more goods more cheaply in order to raise living standards. B. Comparative Advantage Comparative advantage is the inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other goods. Thus, trade is still beneficial even if one country is less efficient in the production of two goods, as long as it is less inefficient in the production of one of the goods. 1. Gains from Specialization and Trade a. Suppose that Riceland now holds absolute advantages in the production of both rice and tea. In Riceland, 1 resource unit produces a ton of rice but 2 are needed to produce a ton of tea. In Tealand, 6 resource units still produce a ton of rice, and 3 units are still needed to produce a ton of tea. Thus, Riceland has absolute advantages in producing both goods. b. Although Tealand has absolute disadvantages in rice and tea, it has a comparative advantage in tea; Tealand produces tea more efficiently than it produces rice. c. By specializing and trading, Tealand gets double the rice than if it produced the rice itself, and Riceland gets twice as much tea than if it produced the tea itself (Figure 5.3). 2. Assumptions and Limitations a. Assumes countries are only driven by the maximization of production and consumption. Governments get involved in trade for many reasons (e.g., concerns for workers or consumers). b. Assumes only two countries engaged in the production and consumption of two goods. In reality, more than 180 countries and countless products are produced, traded, and consumed. c. Assumes no transportation costs. In reality, transportation costs are a major expense of international trade. d. Assumes labor is the only resource for production and is mobile within each nation but cannot be transferred. Other resources are clearly needed in production and labor is becoming more mobile. e. Assumes specialization does not result in efficiency gains. In fact, specialization results in increased knowledge of a task and future improvements. FACTOR PROPORTIONS THEORY Factor proportions theory (also known as Heckscher–Ohlin theory) states that countries produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply. Thus, the theory focuses on the productivity of the production process. A. Labor versus Land and Capital Equipment 1. Factor proportions theory breaks resources into two categories: (1) labor and (2) land and capital equipment. It predicts that a country will specialize in products that require labor if labor cost is low relative to land and capital costs, and vice versa. 2. Factor proportions theory is conceptually appealing (e.g., Australia has much land and a small population; its exports consist of products that require much land whereas imports consist of manufactured and consumer goods). B. Evidence on Factor Proportions Theory: The Leontief Paradox 1. Theory not supported by studies that examine trade flows. 2. Wassily Leontief tested whether the United States, which uses an abundance of capital equipment, exports goods requiring capital-intensive production, and imports goods requiring labor-intensive production. He found U.S. exports require more labor-intensive production than its imports; called the Leontief Paradox. 3. One explanation is that factor proportions theory considers a country’s production factors to be homogeneous—particularly labor. But labor skills vary greatly within a country. INTERNATIONAL PRODUCT LIFE CYCLE The international product life cycle theory states that a company will begin exporting its product and later undertake foreign direct investment as the product moves through its life cycle (a country’s export eventually becomes its import). A. Stages of the Product Life Cycle 1. In the new product stage, stage 1, high purchasing power and demand of buyers spur a company to design and introduce a new product concept (Figure 5.4). Although initially there is virtually no export market, exports increase late in the new product stage. 2. In the maturing product stage, stage 2, the domestic market and markets abroad become fully aware of the existence of the product and its benefits. Demand rises and is sustained over a fairly lengthy period of time. Near the end of the maturity stage, the product generates sales in developing nations, and manufacturing is established there. 3 In the standardized product stage, stage 3, competition from other companies selling similar products pressures companies to lower prices in order to maintain sales levels. An aggressive search for low-cost production bases abroad begins and the home market may begin importing. B. Limitations of the Theory 1. The United States is no longer the sole innovator of products in the world; new products spring up everywhere as the research and development activities globalize. 2. Companies today design new products and make product modifications at a very quick pace. 3. Companies introduce products in many markets simultaneously to recoup a product’s research and development costs before sales decline. 4. The theory is challenged by the fact that more companies are operating in international markets from their inception. The Internet has made this easier particularly for small and midsize companies. Also, small companies are more often teaming up with companies in other markets to develop new products or production technologies. 5. Yet the theory retains explanatory power when applied to technology-based products that are eventually mass-produced. NEW TRADE THEORY New trade theory argues: (1) there are gains to be made from specialization and increasing economies of scale; (2) companies first to market can create barriers to entry; and (3) government may play a role in assisting its home-based companies. It emphasizes productivity rather than resources. A. First-Mover Advantage 1. As specialization and output increase, companies realize economies of scale, and unit production costs decline. Then companies expand, lower prices, and force competitors to produce at a similar level of output to be competitive. 2. A first-mover advantage is the economic and strategic advantage gained by being the first company to enter an industry. It creates a barrier to entry for potential rivals and may allow a country to dominate in a product. 3. Some make a case for government assistance; by working together to target new industries, a government and its home-based companies can be the first mover in an industry. NATIONAL COMPETITIVE ADVANTAGE National competitive advantage theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade. This theory attempts to explain why some nations are more competitive in certain industries. The Porter diamond (the basis of national competitiveness) consists of: (1) factor conditions; (2) demand conditions; (3) related and supporting industries; and (4) firm strategy, structure, and rivalry. A. Factor Conditions Porter acknowledges the importance of basic factors (such as labor, natural resources, climate, and surface features) in what a country produces and exports, but adds the significance of advanced factors. 1. Advanced factors include skill levels of the workforce and quality of the technological infrastructure. Account for the sustained competitive advantage that a country enjoys in a product. B. Demand Conditions 1. Sophisticated buyers in the home market are important to national competitive advantage in a product area. A sophisticated domestic market drives companies to modify existing products to include new design features and develop new products and technologies. C. Related and Supporting Industries 1. Companies in internationally competitive industries do not exist in isolation. Supporting industries provide inputs, forming clusters of related activities in the same region that reinforce productivity and competitiveness. 2. Exporting clusters are those that export products or make investments to compete outside the local area and can lead to long-term prosperity. D. Firm Strategy, Structure, and Rivalry a. Strategic decisions of firms have lasting effects on future competitiveness, but equally important is industry structure and rivalry among companies. b. The more intense the struggle to survive among domestic companies, the greater is their competitiveness. This heightened competitiveness helps them to compete against imports and against companies that might develop a production presence in the home market. E. Government and Chance a. Government policies toward industry and export and import regulations can hurt or help competitiveness. b. Chance events also can influence national competitiveness; they can help competitiveness or threaten it. c. Porter’s theory holds promise but has just begun to be subjected to research using actual data on each of the factors involved and national competitiveness. VIII. BOTTOM LINE FOR BUSINESS This chapter explores the benefits of international trade and its volume and pattern in the world today. Trade can free a nation’s entrepreneurial spirit and bring economic development. As the value and volume of trade continues to expand worldwide, new theories will likely emerge to explain why countries trade and why they have advantages in producing certain products. Quick Study Questions Quick Study 1 1. Q: List several benefits of international trade? A: International trade provides a country’s people with a greater choice of goods and services. International trade is also important in job creation and economic development in many countries. 2. Q: World merchandise exports are valued at how many times the value of worldwide service exports? A: World merchandise exports are valued at more than $16.5 trillion, and service exports are worth more than $4.8 trillion. Trade in services accounts for only around 22 percent of total world trade. 3. Q: What portion of total world merchandise trade is accounted for by two way trade between high income economies? A: Trade among the world’s high-income economies accounts for roughly 60 percent of total world merchandise trade. Two-way trade between high-income countries and low- and middle-income nations accounts for about 34 percent of world merchandise trade. Meanwhile, merchandise trade between low income and middle income nation’s accounts for only 6 percent of world trade. 4. Q: What term often describes the nature of trade between a developing nation and a neighboring wealthy one? A: Trade interdependence: emerging markets that share borders with developed countries are often dependent on their wealthier neighbors. Quick Study 2 1. Q: What did the successful implementation of mercantilism require? A: The practice of mercantilism requires three key essentials: (1) trade surpluses, (2) active government intervention, and (3) practicing colonization. 2. Q: Mercantilist nations acquired colonies around the world to serve as sources of what? A: It was a source of a nation’s economic power that in turn increased political power relative to other countries. 3. Q: What name is given to the belief that a nation can increase its wealth only at the expense of other nations? A: Countries seen by others as trying to maintain a trade surplus and expand their national treasures at the expense of other nations are accused of practicing neo mercantilism or economic nationalism. Quick Study 3 1. Q: A nation that is able to produce a good more efficiently than other nations is said to have what? A: An absolute advantage is the ability of a nation to produce a good more efficiently than any other nation. 2. Q: What does a nation have when it is unable to produce a good more efficiently than other nations but it can produce the good more efficiently than it can any other good? A: A comparative advantage is the inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other good. This is different from an absolute advantage in that it focuses on production efficiency within nations, not just among nations. 3. Q: The theories of absolute and comparative advantage say that nations benefit from trading because of the gains from what? A: Trade between two nations can still be beneficial even if one country is less efficient in the production of two goods, so long as it is less inefficient in the production of one of the goods. Even when one country is more efficient at producing both of the goods in question, both nations benefit from trade because of the gains from specialization. The country more efficient at producing both goods still gets more after specialization and trade than it would if it were to produce both goods on its own. Quick Study 4 1. Q: What is the name of the theory that says countries produce and export goods that require resources that are abundant and import goods that require resources in short supply? A: Factor proportions theory says countries produce and export goods that require resources that are abundant and import goods that require resources in short supply. 2. Q: Factor proportions theory divides a nation’s resources into what two categories? A: The theory states that a nation has two types of resources at its disposal: labor on the one hand and land and capital equipment on the other. The theory predicts that a country will specialize in products that require labor if the cost of labor is low relative to the cost of land and capital, and vice versa. The Leontief Paradox reflects the gap between the predictions using this theory and the actual trade flows in the world economy. Quick Study 5 Q: The international product life cycle theory says that a company will begin by exporting its product and later undertake “what” as the product moves through its life cycle? A: The international product life cycle theory states that a company will begin exporting its product and later undertake foreign direct investment as the product moves through its life cycle. 2. Q: List the three stages that a product goes through according to the international product life cycle theory. A: The international product life cycle theory states that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its life cycle. In the new product stage, high purchasing power and demand of buyers in an industrialized country spurs a company to design and introduce a new product concept and production remains at home. In the maturing product stage, the domestic and markets abroad become aware of the existence of the product and its benefits. Exports rise and some production in markets abroad may begin. In the standardized product stage, competition from other companies selling similar products pressures companies to lower prices in order to maintain sales levels. An aggressive search for low-cost production bases abroad begins and the home market may even begin importing from these other markets. 3. Q: Whenever optimizing productivity determines where a product’s components are manufactured and where it is assembled, the resulting pattern of activities resembled that predicted by which theory? A: This pattern resembles the theory of comparative advantage in that a product’s components are made in the country that can produce them at a high level of productivity. Quick Study 6 1. Q: What is the main thrust of new trade theory? A: The new trade theory argues that: (1) there are gains to be had from specialization and increasing economies of scale; (2) those companies first to market can create barriers to entry; and (3) government may have a role to play in assisting its home-based companies. 2. Q: The economic and strategic advantage gained by being the first company to enter an industry is called what? A: A first-mover advantage is the economic and strategic advantage gained by being the first company to enter an industry, however, this strategy does come with potential risks for companies. Quick Study 7 Q: The national competitive advantage theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to do what? A: National competitive advantage theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade. An “advanced” factor is indicative of factors such as skill levels of workers and the quality of technology in a nation. 2. Q: The four main components of the Porter diamond are: (1) factor conditions, (2) demand conditions, (3) firm strategy, structure, and rivalry, and what else? A: The Porter diamond consists of four elements that form the basis of competitiveness, plus the roles of government and chance. Factor conditions include a nation’s basic factors (e.g., land, labor, and natural resources) and advanced factors (e.g., skills of the workforce, technological infrastructure). Today, advanced factors are increasingly important to competitiveness. Demand conditions refer to the sophistication of buyers in a market—finicky buyers help a nation to be more competitive. Related and supporting industries that spring up around a competitive industry form geographic clusters of related economic activity that reinforce productivity and competitiveness. Firm strategy, structure, and rivalry also influence competitiveness. Managers committed to producing quality products and an industry structure that intensifies firm rivalry will help improve competitiveness. Government and chance play roles in fostering the competitiveness of industries. Government policies toward industry and export and import regulations can hurt or help competitiveness. Chance events also can influence national competitiveness. 3. Q: A group of related industries that spring up in a geographic area to support a nation’s internationally competitive industry is called a what? A: A cluster is a group of related industries that spring up in a geographic area to support a nation’s international competitive industry. Each industry in the cluster serves to reinforce the productivity, and therefore, competitiveness of every other industry within the cluster. Ethical Challenge You are a member of a World Trade Organization task force that is reviewing the recent banana conflict between the United States and the European Union. The European Union and the United States recently ended a nine-year battle over trade in bananas. The European Union was giving preferential treatment to banana exporters from Africa, the Caribbean, and the Pacific island nations. But the United States challenged what it saw as unfair trading practices, and the World Trade Organization agreed. Large global fruit companies such as Dole, Chiquita, and Del Monte—which alone account for nearly two-thirds of the fruit traded worldwide—supported the U.S. action. The European Union argued it was trying to support struggling economies, for which bananas make up a large portion of their income. 5-5 Should international trade be left to private enterprise only, or should governments openly manage it to benefit poorer nations? A: Students responses will vary. Free trade is an economic practice whereby countries can import and export goods without fear of government intervention. Government intervention includes tariffs and import/export bans or limitations. Free trade offers several benefits to countries, especially those in the developing stage, a country with low levels of economic resources and/or low standard of living. Developing countries can often advance their economy through strategic free trade agreements. This can be accomplished by improved access to economic resources, an improved quality of life (importing goods not readily available and at cheaper prices), and better foreign relations. On the other hand, you can have the infant industry argument (See Chapter 6), which involves government intervention. This is an argument normally used by developing or less than developed countries in the implementation of trade restrictions. This protection is meant to be temporary, as the firms will need protection from imports until the labor force is trained. 5-6 Would you have argued on behalf of the United States or the European Union? Explain? Students responses will vary. 5-7 What are the pros and cons of each side’s arguments? A: Here is some background on the matter. The United States (backed by Mexico, Guatemala, Ecuador, and Honduras) complained about the EU policy to the WTO, which awarded victory to the plaintiffs in 1997. The EU made amendments to its banana policy, which the EU said brings the policy in line with WTO specifications. However, the United States and its backers said that the amended policy was no better than the old one. The U.S. government notified U.S. importers that they are liable for hefty tariffs on $520 million worth of European luxury goods in retaliation for European barriers on banana imports. Washington said $520 million is the sum that U.S. companies such as Chiquita and Dole lost because of the EU banana quota system. The tariffs affected a range of EU goods, from Belgian biscuits and Scottish cashmere sweaters to Italian cheese and Spanish leather goods. The British Trade Minister Brian Wilson called the U.S. action “potentially catastrophic” for the British cashmere industry concentrated in Scotland. The French Foreign Ministry also called on the United States to halt what Paris considered an illegal action by Washington. “We strongly deplore that the U.S. has once again acted unilaterally,” the ministry said in a statement. “We are asking them to show good faith and to reconsider this unacceptable decision.” The World Trade Organization ruled in April 1999 that the European Union’s banana import program violated international trade law and would have to change. Caribbean leaders reacted to the ruling with anger and concern, saying it posed a dire threat to tiny island nations that rely on bananas for their foreign exchange. The Caribbean accounts for 10 percent of the world’s banana trade. Much of the remaining 90 percent is dominated by Latin America’s so-called “dollar banana” producers. Finally, other issues that could be discussed are job creation, setting an international trade precedent, political strategy, and the environment. Teaming Up Debate Project. Two groups of four students each will debate the advantages and disadvantages of completely free international trade. After the first student from each side has spoken, the second student will question the opponent’s arguments, looking for holes and inconsistencies. The third student will attempt to answer these arguments. A fourth student will present a summary of each side’s arguments. Finally, the class will vote on which team has offered the more compelling argument. A: Students should be sure to support their arguments with aspects of the theories discussed in this chapter. They should also be prepared to defend their positions, after the debate, if they are called on to give a synopsis of their position in class. It may also be useful to give students some time to do outside research to prepare for the debate. Practicing International Management Case First in Asia and the World 5-16. Q: As the first to set up an international air express business in 1969, DHL had the first-mover advantage over other companies. Is being a first mover as advantageous for a service company such as DHL, as it is for a manufacturing company such as Boeing? Explain. A: In theory, the principle of first-mover advantage is the same for a service firm and a manufacturer. The first-mover advantage is based on economies of scale and strategic benefits of being first. There are economies of scale in services as there are economies of scale in production and the strategic benefits of being first apply to services as well. Expedia is a prime example of this in Internet travel services. 5-17. Q: What elements are necessary for a service company to achieve global success? A: Key to a service company’s success in markets abroad is the people that represent the company. Because services are provided and consumed simultaneously, a buyer’s impression of the provider is largely based on the experience it has during its interaction with the company. In contrast, a buyer can have an unpleasant purchase experience of a physical product but be so pleased with the product’s performance that repeat purchase is assured. Thus, the most important element or obstacle to a service firm operating internationally is the training of employees to supply the highest quality service experience as possible to buyers. 5-18. Q: Instead of relying on local agents, DHL prides itself on having its own staff of more than 300,000 people across the globe. What are the merits and drawbacks of this international staffing approach? A: The potential problems of using this approach rest in effective training and management of employees in markets abroad. This approach can also increase the cost of providing a service, although it is believed that special employee training and oversight allows the company to provide higher quality service. 5-19. Q: What do you think are the dangers, if any, of being a first mover? A: DHL largely overreached in its expansion throughout the United States. It underestimated its competition and faced a global recession after launching its expansion strategy. Perhaps the biggest danger of being a first mover is complacency. Companies can easily develop hubris at their rapid growth and dominance of the industry. New, more agile companies may come along and knock them off their pedestal by being more attuned to customers’ needs. Start-ups might also employ a new business model (approach to doing business in the industry) and take market share away from the leader. -