Which theory suggests that a country should produce and export those goods and services for which it is relatively?

INTERNATIONAL TRADE

INTRODUCTION

• Countries trade for the simple reason that the prices of goods and services vary across countries, and goods and services are imported when they are less expensive than the domestic ones. International trade refers to the exchange of goods and services on a global basis.
• International trade took place long before the theories related to the construct evolved. Global trading in India, for example, predates recorded trade theories by more than 1500 years.

TRADE THEORIES

Trade theories may be broadly classified into two types: (1) theories that deal with the natural order of trade (i.e. they examine and explain trade that would exist in the absence of governmental interference) and (2) theories that prescribe governmental interference, to varying degrees, with free movement of goods and services among countries.

Category 1

Absolute advantage

• The theory, propagated by Adam Smith, suggests that different countries can produce some goods more efficiently than others; global efficiency, therefore, can be increased through free trade without intervention by the government.
• There is no reason to buy domestically produced goods and services that can be purchased at a lower cost from abroad.
• Real wealth of a country depends on the goods and services available to its citizens and not on the holdings of gold.
• Countries could increase their efficiency through specialization:
  • One becomes more skilled by repeating the same tasks
  • No time is lost in the pursuit of acquiring a new skill
  • Chances of improving the working methods and making them more effective over time are more in case of focusing on a single product than a multiple number of products
• Natural advantage
  • It is an offshoot of absolute advantage and refers to climatic and natural resources.
  • Climatic conditions may be favorable to a certain country to produce some agricultural products more efficiently than other countries.
  • Availability of abundant human resources may be an advantage for a region to produce some manufactured goods at a lower cost than other regions.
• Acquired advantage
  • Yet another offshoot of absolute advantage, it refers to an advantage due to acquisition of certain skill and technological know-how for manufacturing a product or processing it more efficiently than others.
  • An advantage in product technology refers to an ability to produce a different or differentiated product.
  • An advantage in process technology refers to an ability to manufacture a product more efficiently than others (e.g. labor and material saving processes used by the Japanese steel industry).

Comparative advantage

• An extension of absolute advantage theory by David Ricardo. The theory suggests that global efficiency gains from trade will be higher if a country specializes in only those products that it can produce more efficiently than other products, without regard to absolute advantage.
• A country may have absolute advantage on all products, but it is economically more advantageous to give up less efficient output to produce more efficient ones.
• Example:
  • There are 100 available units of resources each for construction industries in country "A" and "B".
  • Country "A" can construct 1000 sq.ft. using 5 resource units of labor (labor inexpensive) and 10 resource units of materials (materials expensive).
  • Country "B" can construct similar quantity of building at the expense of 10 resource units of labor (labor expensive) and 5 resource units of materials (materials inexpensive).
  • Assume that the available resources in the both countries may be traded between each other.
  • Also assume that 50 percent of the resources are used for each item (i.e. labor and materials).
  • Using the available resources, without any trading, the total quantity of building that can be produced by the countries:
    • Country "A": 15000 sq.ft.
    • Country "B": 15000 sq.ft
  • Using available resources, with trading, the total quantity of building that can be produced by the countries:
    • Country "A": 20000 sq.ft.
    • Country "B": 20000 sq.ft.

Country size

• The theory of country size holds that large countries tend to be more self-sufficient than smaller ones because of varied climatic conditions (resulting in the production of a wide variety of agricultural products) and more natural resources.
• As a result, they usually have to import a very small percentage of their total consumption.
• The average distance between production locations and markets being higher for international trade of large countries, the transport cost tends to be higher compared to smaller countries (Witness, for example, the case of USA where most production locations and markets are more than 100 miles from the border).

Factor-Proportions theory

• Developed by Hecksher and Ohlin, this theory suggests that factors in relative profusion are less expensive than factors that are relatively scarce.
• Labor costs, for example, will be low if it is in abundant supply relative to land and capital costs. If its availability is not that high, than the cost will be higher than that of land and capital costs (e.g. cost of reinforced cement concrete vs. cost of steel in construction).
• Factor price differences leads to differences in prices of products.
• Example:
  • Assume that two products, P1 and P2, are produced in countries C1 and C2 and the production of P1 requires more capital input per unit of labor (being capital intensive) than that of P2 (being labor intensive). If country C1 has abundance of capital and C2 has plenty of human resources, than C1 will have a comparative advantage in product P1 and C2 will have the same in product P2. This factor price difference will cause trade between the two countries.
• The theory holds good as long labor is considered to be homogeneous. A number of studies (Baldwin, 1971, 1979) indicate that trade is not always caused by factor price differences resulting from factor endowments. The United States, for example, exports many products that are labor intensive. The theory, therefore, may explain trade more adequately if the role of education and training is also considered (i.e. the effect of skilled labor, for example, in software industry).

Figure 1. RCC Structure                          Figure 2. Steel Structure

Product Life Cycle

• The theory states that certain kinds of products go through a cycle of four stages (introduction, growth, maturity, and decline) and the location of a product will shift globally depending on the stage of the life cycle. The stages are not fully differentiated from each other; they are part of a continuum.

Figure 3. The Product Life Cycle

• The theory suggests that a country will export products that are at a certain stage of the product life cycle. A certain country may export different products at some time and other countries may export the same products at other times as the goods move through their product cycles.
• The relevance of the theory has greatly diminished with the growth of MNCs that cater to a global market by producing goods simultaneously in more than one country and marketing products internationally.

Country-Similarity Theory

• The theory holds that when a country or a manufacturer has produced a new product in the response to the conditions observed in the home market, the producer will seek global markets, the conditions of which are perceived to be similar to that in home market.

Category 2

• Mercantilism
  • The theory proposes that countries should export more then they import. If successful, they would receive the value of their trade surpluses in the form of gold from the country or countries that ran deficit. It formed the foundation of economic thought from the renaissance to the beginning of industrial age.
  • Stock of gold held by a country was a measure of the country's wealth and power.
  • Accumulation of wealth was considered to be a way of elevating the status of an individual; what was good for individuals was good for countries.
  • Restrictions were imposed on most imports, many exports received subsidies.
  • The theory essentially benefited the colonial powers; the colonies were allowed to export mostly raw materials and and import manufactured goods.
• Neo-mercantilism
  • A fairly recent concept that is used to describe an approach of a country to achieve some social or political objective through a favorable balance of trade (i.e. country 'A' wants to maintain political influence on country "B", so "A" sends more goods and services to "B" than it receives from it).

WHY COMPANIES TRADE?

• Use of excess capacity: Companies may have output capabilities much in excess of domestic demand.
• Reduced production cost per unit: A company can generally reduce its costs by about 25 per cent every time its output is doubled (experience curve).
• Increased markup, more profitability: A company may be able to sell the same product at a higher profit in the global market than in the domestic market.
• Spreading risk: A company may be able to minimize fluctuations in demand by spreading sales globally.

TRADE IMPEDIMENTS

• Lack of knowledge about opportunities
• Lack of knowledge on trade mechanics
• Fear of risks
• Governmental trade restrictions

GOVERNMENTAL INTERVENTION ON TRADE

Reasons:

• Higher imports may create higher rate of unemployment at home.
• Protection of industries that are emerging and allow them time to become efficient.
• Protection to promote industrialization.
• Promoting investment inflows (foreign companies may create a production base in the host country to avoid the loss of market).
• Political and economic relationships with other countries.
• Price control, mainly in respect of exports (witness the increase in oil prices in recent months).
• Preserving national identity

FORMS OF TRADE CONTROL

• Tariffs: Most common type of trade control, used either for protection or revenue or both. Most common form is import tariff.
• Subsidies: Subsidies are made to producers or manufacturers to compensate for losses, if any, from selling abroad. It makes the products more competitive.
• Quotas: A quota usually sets the quantity of a product to be traded. It also frequently allocates quantities by country.
• "Buy local": Preferences for domestically produced goods are legislated by the government.

References:

Baldwin, R. E. (1971). Determinants of the commodity structure of U. S. trade. American Economic Review, 61, pp. 126-146.

Baldwin, R. E. (1979).Determinants of foreign trade and investment: Further evidence. Review of Economics and Statistics, 61, pp. 40-48

Which theory suggest that a country should export those goods and services for which it is more productive?

What are the two theories that a country used to consider in exporting and importing economic resources?

Which theory of international trade explains that success in international trade comes from the interaction of four country and firm specific elements?

What is the theory that holds there are advantages to trade because different countries can produce different goods more efficiently than others?