Dr. P.V. Viswanath



Economics/Finance on the Web
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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.

Absolute Advantage

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.

2 units/ton
1 units/ton
1 units/ton
4 units/ton

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.

Comparative Advantage

Production efficiencies in this case are given by the table below.

2 units/ton
1 units/ton
3 units/ton
4 units/ton

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

Hecksher-Ohlin Theory of Factor Proportions

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 immobile.
Diminishing marginal returns to factors was assumed – this ensured that there was no more complete specialization.

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.)

Staffan Linder's Overlapping Product Ranges Theory

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.

  • Linder assumed that people in countries that were at similar levels of development tended to have similar tastes in goods.
  • Furthermore, if it is assumed that competitiveness comes from experience, entrepreneurs in a country that has demand for a given good will be able to produce that good cheaply for export as well.

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’s Product cycle theory:

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:

  • Technical innovations leading to new and profitable products require large quantities of capital and highly skilled labor. These are predominantly available in highly industrialized capital intensive countries. However, over time, the technology matures and becomes more routinized.
  • With this maturation, the products tend to switch to countries with a lesser advantage in innovation and capital.

Products move from a new product stage to a maturing product stage, to finally a standardized product stage.

  • In the new product stage, there is a lot of innovation, requiring highly skilled labor and large quantities of capital for research and development. Hence, the need for proximity to information and the need for communcation among the many different skilled-labor components generally implies production in a country with a highly industrialized market, where there is a demand for this new innovative product, as well.
  • In the maturing product stage, the production process becomes increasingly standardized; the need for flexibility in design and manufacturing declines and so the demand for highly skilled labor declines. The innovating country increases its sales to other countries, as well. At this stage, competitive pressure develops. The firm may then choose to invest abroad to maintain its market share by exploiting the factor cost advanatges of other countries.
  • In the final stage, the proudct is completely standardized in its manufacture. Thus, with access to capital on world capital markets, the country of production is simply the one with the cheapest unskilled labor. Profit margins are thin and competition is fierce.

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.

Trade and Imperfect Markets

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.

  1. Internal economies of scale accrue when the cost per unit of output depends on the size of an individual firm. The larger the firm, the greater the scale benefits and the lower the cost per unit. This may lead to one firm having a monopoly.
  2. External economies of scale accrue when the cost per unit depends on the size of an industry, not the size of the individual firm. The industry of that country may produce at lower costs than the same industry that is smaller in size in other courntries. A lot of small firms may interact to create a large, competitive, critical mass. In this case, there may be no loss of competition; markets may not have to be imperfect, but one country might have dominance in world markets for that product.

The Competitive Advantage of Nations

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:

  1. Factor Conditions: Although factors might be provided by nature (climate, e.g.), it is the ability of a nation to continually create, upgrade, and deploy its factors (such as skilled labor) that is important, not the initial endowment.
  2. Demand conditions: The degree of health and competition that the firm must face in its original home market. Firms that can survive and flourish in highly competitive and demanding local markets are much more likely to gain the competitive edge.
  3. Related and Supporting Industries: The competitiveness of all related industries and suppliers to the firm. A firm that is operatign within a mass of related firms and industries gains and maintains advantages through close working relationships, proximity to suppliers and timeliness of product and information flows.
  4. Firm strategy, structure and rivalry: The conditions in the home-nation that either hinder or aid in the firm's creation and sustaining of international competitiveness.

These four factors interact with each other and are called Porter's Diamond of National Advantage.

The Foreign Direct Investment Decision

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:

  • Seeking resources
  • Seeking factor advantages (moving ahead in Vernon's Product Cycle, for example)
  • Seeking Knowledge
  • Seeking security
  • Seeking Markets

Firms as Exploiters of Imperfections:

  • Imperfections in Access
  • Imperfections in Factor Mobility
  • Imperfections in Management

Firms as Internalizers

Internalization may be preferable to the use of management contracts or licensing agreements if there are too many agency problems.