International Trade Theories - Assignment Example

?International Trade Theories Economists have devoted much research to understanding the dynamics of international trade. Through the years theories have evolved that in each instance added to the collective understanding of cross-border trades, but for each new theory, new shortcomings are encountered. A brief discussion of the classical trade theories will provide a backdrop of the detailed examination of the modern trade theories and how these could be viewed in the present patterns of international trade. Classical theories Mercantilism During the 17th and 18th centuries, the theory of mercantilism was widely practised in international trade. Essentially, mercantilism saw international trade as a zero-sum proposition. French statesman Jean-Baptiste Colbert, who pioneered this theory, believed that the wealth of the world was essentially fixed and that trade was a closed system, so that those nations which exported more and imported less acquires more of the world’s wealth and becomes richer, and vice-versa. While mercantilism is the oldest of the trade theories, this does not mean that it is obsolete. Even today, the effects of mercantilism are evident in policies of trade protectionism, and makes the argument that rather than import from other countries and risk a trade deficit, a country would be economically better off if it were self-sufficient (Peng, 2010, p. 149). Absolute Advantage Advocated in 1776 by British economist Adam Smith, the theory of absolute advantage stated that the force of the free market should best determine the economic activities of a nation and, inclusively, the level of international as well as domestic trade. Smith’s theory of free trade (also called laissez faire) relied on forces of the free market to operate unrestricted, to enable free trade to seek out the most efficient means for value creation. The absolute advantage in the creation of a product or service is that which is attained by the nation that is able to produce that good or service most efficiently. The implication of this theory is that (1) the principle of self-sufficiency is best abandoned because no country could efficiently produce all goods and services; and (2) countries would best specialize in production of good and services where they have the advantage. International trade ceases to be a zero-sum case, and becomes a win-win proposition. Comparative advantage In 1817, British economist David Ricardo developed the theory of comparative advantage. The theory saw the ability of countries to efficiently produce goods and services not in absolute terms but in relation to which country they trade with. Comparative advantage is the relative advantage in one economic activity possessed by one nation over other nations. Net gains from trade may be realized when countries specialize in producing goods and services where they have comparative advantage. There is a trade-off, however, known as the opportunity cost, which is the cost incurred by a producer in choosing to give up production of a good or service in favour of concentrating on another (p. 152). The three foregoing theories, while useful in conceptualizing trade relations, make the necessary but unrealistic assumption that trade is static. Through time, factor endowments and trade patterns change, necessarily debunking the theory that trade is static. This gave way to the modern trade theories of the mid-twentieth century, also known as the dynamic theories, which aim to account for the change in trade patterns over time. New theories Product life cycle Product life cycle was developed by Raymond Vernon, an American economist, in 1966. Vernon saw the world’s trading nations as consisting of three categories: (1) the lead innovation nation which is usually assumed to be the US, (2) other developed nations, and (3) the developing nations. Aside from distinguishing among the nations, Vernon also classified products according to three life cycles: (1) new, (2) maturing, and (3) standardized. New products commanded a higher price (price premium) because of its novelty. As the product matures, demand increases in other nations at about the same time that other nations gain the ability to produce the product, so production moves from the inventor country to those developed nations. In the third stage, the standard moves from maturity to standardization. The now commoditized product, because of the need to reduce costs for mass production, gets to be produced by the developing nations which export the commoditized good or service back to developed nations. Under this model, the comparative advantage shifts over time to different nations as a result of the product’s evolution (Carbaugh, 2010; Peng, 2010). The theory appeared to reflect more closely the trading patterns of the crop of innovative products such as the development of the personal computer (PC). However, it is prone to two criticisms: first, that it assumes the lead innovation nation will in all instances be the US, and second, it assumes that product development will assume a stage-by-stage migration of the production process through several years or even decades. These criticisms are gaining greater cogency particularly in the developments of the past decades. Firstly, the United States has not been the leading source of innovations for several decades. Data on patents filed based on patent office and country of origin are shown in the following graphs (WIPO, 2008). Patent filings by selected patent offices Source: WIPO, 2008 Patent filings by country of origin. The data includes the patent filings in the office of the country of residence as well as those that were filed in offices abroad. Source: WIPO, 2008 The first two of the three graphs shows a comparative line graph of the number of patents filed in the different offices around the world. These patents were filed by both residents and non-residents, therefore the fact that a patent is filed in a particular country does not necessarily mean that the innovation originated from that country. It includes patents of innovations from other countries, but which are probably intended for production or sale in that country. From the initial two historical graphs, it is evident that the country with the greatest number of patent filings from 1963 until a little after 2003 was not the United States but Japan, and it was only after 2003 when the number of patent filings in the US overtook that of Japan. It is arguable that Japan could be described as a developed country in 1963, since at that time the country was just less than two decades away from the destruction it suffered during the second world war, including two atomic bombs. Nevertheless, Japan’s patent office had the highest number of patent filings, indicating that the greatest number of innovations was being launched for production in Japan during that period, whether the patents were filed by residents or non-residents. The third figure is a bar graph that shows the number of patent filings based on the country of origin. There are two figures compared against each other, those patents filed in 2000 and those in 2006, for 10 countries worldwide. The country with the highest number of patents is Japan, far higher than the comparative figures for the United States. If one were to compare the figures in the third graph with those in the first graph, it is noted that Japan’s patent figures do not exceed 450,000 in the first graph, however the 2000 and 2006 figures in the third graph have Japan’s patent filings at well above 450,000 for both years. Comparatively, those patent filings attributed to the US are lower than they appear to be in the first graph. The comparison indicates that it is Japan, as country of origin, that has been driving the world’s innovation, and continues to drive it, from 1963 to the present, debunking at least Vernon’s assumption on the lead innovator country. However, it does indicate that while many of the innovations originate in Japan, a good number of them are brought for production to the U.S. where the original patents are filed. This explains why more patents originate in Japan but more (at least after 2003) patents are filed in the United States. The second criticism of the product life cycle theory is that the theory assumes that product development from one stage to the next involves a migration of the production process from one country to another, which means that the product supposedly takes years or decades to move from one stage to the next, or even one country to the next. However, in this time of the multinational enterprise, joint ventures and collaborative partnerships, the reality is that product launches are oftentimes done simultaneously worldwide. An example is that of the iPod and other new digital mobile devices by Apple. Taking this example further, it will be noticed that imitation or development of technology no longer takes years; within a few months, the innovation – take Apple’s iPad which originated in the US – had already been duplicated or even improved upon by other firms in other countries. e.g. other tablets such as the Samsung Galaxy (South Korea), Samsung Google Nexus (South Korea), Sony Tablet (Japan), Asus Transformer Pad (Taiwan), and the Blackberry’s Playbook (Canada). The time it takes to move through product stages could be so fast that distinguishing stages is almost meaningless, and production locations can be anywhere, and all at once. The product life cycle theory was first articulated in the 1960s (Peng, 2010), which explains in part why assumptions made by it do not seem relevant to today’s trade patterns. Since then, however, there are increasingly fewer distinctions between the taxonomy the theory makes of both products and countries. Furthermore, the strong participation of multinational enterprises (MNE) in the present global economy involves developing countries in the earlier stages of production, due to the transfer of productive capacity to MNE subsidiaries in developing countries where labour and materials costs are low and tax rates more conducive to foreign direct investments. Strategic trade After mercantilism, none of the trade theories based on free market forces attributed any major role to government. Since laissez faire, government intervention was regarded by economists as tending to destroy value because of the distortionary effects government exerts on free trade. It took the occasional economic crises, such as the global recession of 2008, for countries to turn to government intervention particularly as a source of bailout money. According to the strategic trade theory, strategic intervention by governments in certain industries may enhance the chances for success in international trade. The industries in particular are those which are capital intensive that have high entry barriers which, without government support, domestic companies would not have been able to enter, let alone succeed in. Another attribute of the industries where a strategic trade policy should work best is the substantial first-mover advantages they feature. First-mover advantages are enjoyed by the first entrants in an industry (or market) and which are not available to late entrants. An example provided by Peng (2010, p. 97) is the commercial aircraft industry, which requires large capital outlays, significant operating costs, and huge initial investment which most domestic companies would not venture in because of the high risks of non-recovery in the face of open competition. Government intervention would necessarily slant the market sufficiently to enable the domestic airline companies sufficient advantage over their larger, foreign competitors. Other such industries would be the telecommunications, power generation, and international automobile market (Reimer & Steigert, 2006, p.18). Strategic trade policies stem from criticisms of the classical theories which are ingrained in the different factor endowments of countries. Krugman (1986) argued that, after World War II, a significant and growing proportion of world trade cannot be accounted for by comparative advantage, and instead trade is more reflective of ‘arbitrary or temporary advantages resulting from economies of scale or shifting leads in close technological races’ (Krugman, 1986, p.7). Comparative advantages of industries that result from large-scale production, knowledge acquired through R&D, and the long experience, creates imperfect competition and market failures that unduly influence patterns of trade and competition when competing firms are few. Government intervention judiciously used merely nullifies the unfair advantages created by the imperfect competition and failed market conditions. As a result of intervention, the competing firms are saved the dilemma of being price-takers and instead are able to obtain a larger share of the international profits, and for the country to win a greater portion of the returns that would otherwise have been channelled to other countries. On the other hand, the disadvantage immediately evident is that firms set their prices depending upon the workings of the free market, and are prepared to raise or lower their prices commensurately (Streblov, 2001). With government intervention, however, price-setting mechanisms are suspended and the price set by government policy becomes the default value. Using an artificial or pegged price creates an imbalance such that prices – not only for the industry but for related industries – could not seek their true levels. Information that should be conveyed by these prices is skewed, and inefficiencies are created throughout the supply networks (Carbaugh, 2010). These are considerations that the government must consider in influencing the market through strategic trade policy, to enable the careful setting of prices. One such situation where government policy intervention affected the market for certain industries is the recent subprime mortgage crisis. Government policy towards the housing market was to provide subsidies and guarantees for housing mortgages, to provide housing for the low-income earners. The mortgages were securitized, given AAA credit rating (due to the government’s guarantee), and traded out into the banking system which considered them investment grade by virtue of the rating. Subsequently, clients were not able to pay, massive foreclosures took place, and traders in mortgage-backed securities went bankrupt. The false information conveyed by the triple-A rating based on an implicit guarantee provided by government policy caused the suspension of the free market’s price setting mechanism. National competitive advantage of industries (Porter’s diamond theory) The most recent trade theory is called the theory of national competitive advantages of industries, also known as the diamond theory. Michael Porter, the author of this theory, presented the model in the shape of a diamond (Peng, 2010; Carbaugh, 2010). The four aspects which form the diamond are (1) the firm strategy, structure and rivalry; (2) domestic demand conditions; (3) country factor endowments, and (4) related and supporting industries. Firm strategy, structure and rivalry plays a crucial role in determining whether an industry will succeed in the international arena or not. Japan’s success in the global electronics industry throughout the nineties to the present is the result of the intense domestic rivalry between the large electronic zaibatsus which honed their skills and attained their excellence in the heat of the local competition. Domestic demand conditions could be viewed in relation to the intense domestic rivalries discussed. When a market makes extraordinary demands of its domestic producers, competencies are developed in this industry that makes it more competitive when faced with the less demanding environment in other markets. One example of this is the high standards set for the entertainment industry in the U.S. market, which is the reason why U.S. motion pictures lead in international box-office returns (Peng, 2010). In comparison, the Indian ‘Bollywood’ movies responded to the demand for spectacle in Indian society; thus the ‘Bollywood’ style movies became a phenomenon in the international movie industry. The country factor endowments refer to the natural and human resources of a country. There are some countries which may have rich natural resources but are short on population (e.g.., Saudi Arabia), while other countries have a highly-educated people but few natural resources (e.g.. Singapore). The top export of Saudi Arabia is oil, and that of Singapore is electronic semiconductors, which is consistent with the factor endowments aspect because Saudi Arabia’s chief natural resource is oil which only requires extraction, and Singapore has the high level of skill necessary to design and manufacture semiconductor integrated circuits (Peng, 2010, p.160). Finally, the foundation for competitive industries is provided by those industries that relate and support them. Industries take time, expertise, and skills; for instance the aerospace industry in Europe was and is successful because of the existence of the support industries (e.g. engines, avionics and materials (Peng, 2010). Source: http://www.answers.com/topic/internationalization While Porter’s diamond model is well received, it has a number of limitations: (1) it focuses more on developed countries; (2) natural resources are given too much importance; (3) government is given a role in determining competitiveness, and (4) chance factors may promote or obstruct the competitiveness of the firms (Aswathappa, 2010, p.96). In the modern trading patterns, Porter’s model also shows some weaknesses. In the past decade, India has gained global prominence in software development, although it did not have related and supporting industries, and there was no strong demand locally for it in the manner demanded by the global market. Another trade pattern which does not seem to fit foursquare into the diamond model is China’s dominance in the trade of nearly all consumer goods at the present. For China to have attained the level in international trade that it occupies today, it should have an abundance of skill, capital and land. However, China is extremely skill-, capital-, and land-scarce, compared to most other countries (Schott, 2006). Pursuant to the endowments criterion, China should have concentrated only in labor-intensive airports. This is not so – China is already a leader in electronics and other durables which could only be produced through industrial automation. Furthermore, there was no strong local demand to meet because China exports were produced only to satisfy target markets, and firm strategy, structure and rivalry are absent because China is a centralized, socialist economy. Conclusion Three modern trade theories – product life cycle, strategic trade, and national competitive advantage of industries – introduce valid elements which are confirmed by many observations in contemporary trade patterns, but are challenged by many others. Within the constraints of this discussion, practical examples tended to both validate and contradict each theory. This is but to be expected. Like all human undertakings, trade patterns and behaviour evolve through the years; theory can only evolve with it. References Aswathappa, K 2010 International Business, 4th edition. McGraw Hill, New Delhi Carbaugh, R J 2010 International Economics. South-Western Cengage Learning, Mason, OH Burgstaller, A 1986, 'Unifying Ricardo's Theories of Growth and Comparative Advantage', Economica, 53, 212, pp. 467-481, Business Source Complete, EBSCOhost, viewed 6 December 2012. Daniel III, C 2000, 'The Question of International Competitiveness', International Advances In Economic Research, 6, 3, p. 417, Business Source Complete, EBSCOhost, viewed 6 December 2012. 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