Dr. P.V. Viswanath
Why countries trade
© P.V. Viswanath, 2005
Some of the material in this note has been written up with the help of Chapter 5 of the textbook International Business: Update 2003 by Michael R. Czinkota, Ilkka A. Ronkainen and Michael H. Moffett, Thompson South Western Publishers, 2003. I recommend this book for additional reading.
This was developed by Adam Smith. Suppose there are two countries, US and Germany; they can each produce coal and wheat. However, their efficiencies in production are different.
Assumptions: 1) Factors of production cannot move freely across countries. 2) Factors of production are not specialized.
Since the US is more efficient in the production of wheat, it will produce
wheat; Germany is more efficient in the production of coal; hence it will
produce coal. The US will export wheat to the Germany and import coal.
Production efficiencies in this case are given by the table below.
Even though the US is more efficient in the production of both wheat and coal, it has a comparative advantage in the production of wheat; hence, it will produce wheat; the UK has a comparative advantage in producing coal; hence it will produce coal. The US will export wheat to the UK and import coal.
Figure 5.2 from Czinkota, Ronkainen and Moffett
Some products are more labor intensive, while others are more capital intensive. For example, the production of leather is relatively labor intensive, while the production of computer chips is relatively capital intensive. Factor intensities depend on the current state of technology.
This theory assumes that the technology is constant across countries. Hence, countries do not differ in terms of production efficiency. (However, if we only looked at labor costs, then a country with relatively easy access to capital might be “more” efficient in the production of computer chips, while another country that had less capital might look “more” efficient, relatively, in the production of leather.
Indeed, in this theory, the prices of factors (driven by their abundances)
determine which goods are produced where. It is assumed that factors are
However, the Leontief Paradox showed that even though the US seemed to be a capital abundant country, it tended to export labor-intensive goods! (Here is an article that talks about the paradox and tries to resolve it.)
The analysis up to this point did not allow for any heterogeneities across countries as far as demand was concerned. Staffan Burenstam Linder acknowledged that in the natural resource-based industries, trade was indeed determined by relative costs of production and factor endownments. However, he argued that trade in manufactured goods was dictated not by cost concerns, but rather by the similarity in product demands across countries.
As a result, trade tends to occur more between similarly situated countries than otherwise – thus, Europe and the US might trade more than Mexico and the US, because they would have overlapping product ranges.
Another way of looking at this theory is to note that because of transactions and shipping costs, each country would tend to produce goods intended for consumption by its own citizens. However, when an industry grows sufficiently large, it could be cost-effective for it to export to other countries. If consumers who desire to consume those goods tend to live in countries similar to the first country, you'd have intra-industry trade. (See Krugman's theory, further down, as well.)
P. Chow; Kellman M.; Shachmurove Y. 1999. "A test of the Linder hypothesis in Pacific NIC trade 1965-1990," Applied Economics, 1 February 1999, vol. 31, iss. 2, pp. 175-182(8)
Michael A. McPherson, Michael R. Redfearn and Margie A. Tieslau, "International
Trade and Developing Countries: An Empirical Investigation of the Linder
Hypothesis," Working paper, University of North Texas, February 2000.
(This paper looks at intra-industry trade between six East African developing
countries -- Ethiopia, Kenya, Rwanda, Sudan and Uganda.)
Raymond Vernon focused on the product, rather than on the country. He pointed out that information, knowledge and costs go hand in hand. He assumed:
Products move from a new product stage to a maturing product stage, to finally a standardized product stage.
However, as knowledge and technology further change, the cycle can be repeated. Note, however, that the firms that produce the goods may remain the same through all the stages – they may simply move from one country to another.
Krugman’s theory moved from thinking of countries to thinking of companies, when he introduced the notion of internal economies of scale – this also allowed intra-industry trade, i.e. trade between two countries in the same good in both directions, i.e. both countries export as well as import the same good. However, external economies of scale could provide advantages to an industry in a given firm.
Porter moved to thinking of countries as mega-firms – how firms create competitive advantages. He pointed out that "national prosperity is created, not inherited." Porter argued that innovation is what drives and sustains competitiveness. He categorizes the dimensions of competition into four components:
These four factors interact with each other and are called Porter's Diamond of National Advantage.
If there are problems in producing in the home country and selling to another country (because of trade barriers of various kinds), then firms with experience in the manufacture of a good and possessing other advantages might go in for foreign direct investment. (Figure 5.6)
Firms as Seekers:
Firms as Exploiters of Imperfections:
Firms as Internalizers
Internalization may be preferable to the use of management contracts or licensing agreements if there are too many agency problems.