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Theories & Institutions; Trade and InvestmentChapter 6 Nereen Abu Keer & Mera Al Horani

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Theories & Instituitions: Trade & Investment

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IntroductionThis is a theoretical chapter that collects many of the free trade theories and patterns; which also tries to explain the factor affecting the production, how mobile they are, and how they lead to the efficient global trade between markets. Eventually, understanding all these theories will help us understand the core concept of international trade, Theories & Instituitions: Trade & 2 and define the Investment factors that affect 01/19/10 the

Outlin e Laissez-Faire versus Interventionist Approaches to Exports & Imports Interventionist: vMercantilism vNeomercantilism Free-trade theories: vAbsolute advantage vComparative advantage 3 Theories & Instituitions: Trade & Investment 01/19/10

OutlineTheories of trade patterns; Trade Patterns: vCountry Size Theory vFactor Proportions Theory vCountry Similarity Theory Trade Competitiveness: vProduct Life Cycle Theory vPorter Diamond Theory

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Case: Costa Rica

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Case: Costa RicaCosta Rica is known as the rich cost

with regard to its fertile soil

The World bank classifies it as

upper middle income with a per capita GDP of 12,500 $

Costa Rica is highly dependent on

agricultural commodities6

& Instituitions: Trade & Investment Theories

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Case: Costa RicaCosta Ricas evolution of international trade and factor mobility policies: 1.1800s-1960: Liberal Trade- a policy calling for minimal government interference in trade and investment 2.1960-1982: Import Substitution-a policy calling for the local production of goods and services Theories & Instituitions: Trade & Investment 01/19/10 that would otherwise have to be

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Case: Costa Rica

3. 1983-early 1990s: liberalization of imports, export promotion, and incentives for foreign investments. 4. Early 1990s-present: strategic trade and investment- a policy calling for the production of specific types of products- and openness to imports01/19/10

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Case: Costa RicaProgress Report: Setting out to attract investments in electronics and software, Costa Rica such high Tech investors as Intel. Although Bananas and coffee are still important to the nations economy, as of 2005 about two thirds of Costa Ricas exports have been manufactured goods, with high tech products Theories & Instituitions: Trade & Investment 01/19/10 constituting the backbone of the

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Laissez Faire- versus Interventionist Approach Interventionist: Mercantilism Neomercantilism Free-trade theories: Absolute advantage Comparative advantage 10 Theories & Instituitions: Trade & Investment 01/19/10

Theories of trade patternsExplaining trade patterns: that explain

how much countries depend on trade, what products they trade, and with whom they primarily trade

Country size Factor proportions Country similarity Trade competitiveness: theories that11

deal with dynamics of countries Product life cycle theory Theories & Instituitions: Trade & Investment 01/19/10 Porter diamond

Interventionist Theories Mercantilism : is a trade theory holding that a countries wealth is measured by its holdings of treasure which usually means its gold. Mercantilist theory proposed that a country should try to achieve a favorable balance of trade (export more than it imports) Neomercantilist policy also seeks a favorable balance of trade, but its purpose Trade & achieve some social or Theories & Instituitions:is toInvestment 01/19/10

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Free Trade TheoriesTheories that hold that nations

should neither artificially limit import nor promote export

The so-called invisible hand will

determine which producer survive as customer buy those products that best serves their needs .13

Both theories implies specialization Theories & Instituitions: Trade & Investment 01/19/10

Absolute Advantage TheoryThe real wealth of country consist of

the goods and services available to its citizens Different countries produce some goods more efficiently than other countries : thus global efficiency can increase through free trade. If trade was unrestricted; each country would specialize in the products that gave it a competitive advantage.14


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Absolute AdvantageReasons for increased efficiency

through specialization 1.Labor could become more skilled by repeating the same tasks. 2.Labor would not lose time in switching from one kind of product to another . 3.Long production runs would provide incentives for the development of more effective working methods .15


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Absolute AdvantageIn what product should a country

specialize ? Either by :

1. natural advantage A country may have a natural advantage of producing a product because a climatic conditions, access to certain natural resources or availability of certain labor forces .16


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Absolute Advantage

2. Acquired advantage :

Product technology : enables a

country to produce a unique product or one that is easily distinguished from those of competitors.

Process technology : a countrys17

ability to produce a homogeneous product efficiently Theories & Instituitions: Trade & Investment . 01/19/10

Absolute AdvantageAssumptions for Costa Rica: 1.100 units of resources available 2.10 units to produce a ton of Wheat 3.4 units to produce a ton of Coffee 4.Uses half of resources per product (when no foreign trade) Assumptions for Australia: 1.100 units of resources available 2.5 units to produce a ton of Wheat 3.20 units to produce a ton of Coffee 4.Uses half of resources per product (when no Theories & Instituitions: Trade & Investment 01/19/10 18 foreign trade)

Absolute AdvantageQuantity of Coffee ( tons )

Quantity of Wheat ( tons )Theories & Instituitions: Trade & Investment 01/19/10

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Absolute Advantage

Production Wheat

Coffee (tons) 12 2 15

(tons) Without Trade: Costa Rica (point A) 5 Australia (point B) 10 Total 15

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With Trade: Costa Rica (point A) Theories & Instituitions: Trade & Investment 0

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Comparative AdvantageThe global efficiency gains may

still result from trade if a country specializes in those products it can produce more efficiently than other products- regardless of whether other countries can produce those same products even more efficiently21 Theories & Instituitions: Trade & Investment 01/19/10

Comparative AdvantageAssumptions for Costa Rica: 1.100 units of resources available 2.10 units to produce a ton of Wheat 3.10 units to produce a ton of Coffee 4.Uses half of resources per product (when no foreign trade) Assumptions for Australia: 1.100 units of resources available 2.4 units to produce a ton of Wheat 3.5 units to produce a ton of Coffee 4.Uses half of resources per product (when no Theories & Instituitions: Trade & Investment 01/19/10 22 foreign trade)

Comparative AdvantageQuantity of Coffee ( tons )

Quantity of Wheat ( tons )23 Theories & Instituitions: Trade & Investment 01/19/10

Absolute Advantage

Production

Coffee (tons) 5 10 15

Wheat (tons) 5 12 17

Without Trade: Costa Rica (point A) Australia (point B) Total

With Trade: (increasing Costa Rica (point A) Australia (point B) Total With Trade: (increasing Costa Rica (point A) Australia (point B) Total

coffee production) 10 0 6 17 16 17 Wheat production) 10 0 5 18 15 18

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Theories of Specialization: Assumptions and Limitations1.Full employment 2.Economic efficiency 3.Division of gains 4.Two countries, Two commodities 5.Transport Costs 6.Statistics and Dynamics 7.Services 8.Production Networks 9.Mobility

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How can I define the trade pattern theory for a country?Trade pattern theories are defined by

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answering the following questions; How much does a country trade? This depends on the countrys size & the type of good being traded (non tradable good) What types of products does a country trade? Products of natural advantage or goods of acquired advantage With whom do countries trade? Neighboring countries, or similar countries, or friend countries.Theories & Instituitions: Trade & Investment 01/19/10

How much does a country trade?

It depends on the;

vTheory of Country Size vSize of the countrys economy

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Country Size Theoryq qAn international trade theory which holds that countries with large land areas are more apt to have varied climates and natural resources, and therefore, are generally more self sufficient than smaller countries; such as Brazil, US, and Russia. qLarge countries import much less of their consumption and export much less Instituitions: Trade & Investment Theories & of their production than do 01/19/10 28

Cont Moreover, large countries production and

market centers are located at a greater distance from other countries; raising the transport costs on foreign trade. Naturally, countries with large economies are so dominant in the trade world; not only because they export a lot and produce a lot but also because their nations incomes are high and the people buy a lot from domestic & foreign Theories & Instituitions: Trade & Investment 01/19/10 29 sources. Unlike the case for developing

What types of products does a country trade?Factors Proportion Theory;

Labor, land, Technology , and Capital

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Factors Proportion Theory

Developed by Hescker and Ohlin the Swedish

economists. Its states that a countrys relative endowments of land, labor, and capital will determine the relative costs of these factors. These factors cost, in turn, determine which goods the country will produce most efficiently. According to the factor proportions theory, factors in relative abundance are cheaper than factors in relative scarcity. Therefore, Theories Instituitions: Trade & Investment 01/19/10 31 these&relative factor costs will lead countries

Contd abundant relative to the land, then they produce goods that needs human resource. In countries where little capital is available for investment & where the amount of investment is low per worker, managers seek shelter in the countries where labor is abundant and consequently can export competitiveness in products that require large amounts of labor relative to capital. However, labor skills vary among countries; where in developed countries they receive higher education and training, hence, they Theories & Instituitions: Trade & Investment 01/19/10 32 are more qualified & professional, therefore;People & Land; in countries where people is

Contd

The variation in labor skills among countries

leads to international specialization in production. Thus, a country may locate its research activities & management activities between educated population & it may locate its production work in countries with cheap labor and less skilled one. Moreover, bigger countries depend more on products requiring longer production runs; so as to minimize the transportation costs Theories & Instituitions: Trade & Investment 01/19/10 33 and the high expenditures on research &

Trade CompetitivenessqProduct Life Cycle Theory qPorter Diamond Theory

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With whom do countries trade?

It depends on;vCountry Similarity Theory vDistance Between Countries

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Country Similarity TheoryThis theory has been developed by the Swedish

economist Steffan Linder . It rests on the concept of Intra industry trade; that is trade between two countries of goods produced by the same industry. Intra industry trade accounts for approximately 40 per cent of world trade. Therefore the country similarity theory consists of the value that most trade in manufactured goods should be between nations with similar per capita income, and that intra industry Investment in manufactured trade Theories & Instituitions: Trade & 01/19/10 36 goods should be common

Contd

Countries at the same stage of economic

development that shared the same consumer preferences have greatest potential for trade Most trade today occurs among high-income countries because they share similar market segments and because they produce and consume so much more than emerging economies Much of the pattern of two-way trading partners may be explained by cultural similarity between the countries, political Theories & Instituitions: Trade & Investment 01/19/10 37 and economic agreements, and by the

Country Similarity Theory;

why do developed countries trade together? vProduce more & consume more vEmphasize and specialize to gain acquired advantage vProduce differentiated products and services vCultural similarity vGood political relationship and Theories & Instituitions: Trade & Investment 01/19/10 38

DiscussMore recent developments in theoretical approaches in Economics to International Trade move away from a COUNTRY BASED approach and move towards a FIRM BASED approach.

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Product Life Cycle Theory

This theory has been developed by the economist

Raymond Vernon in response to the failure of the Hescker Ohlin module. It applies to established companies in industrialised countries who expand their product range The theory states that companies will manufacture products first in the countries in which they were researched and developed; almost always developed countries Over the products life cycle, production will shift to foreign locations, especially to developing Theories & Instituitions: Trade & Investment 01/19/10 40 economies as the product reaches the stages of

Contd The theory is broken up into five major stagesRelease (Introduction) Export (Growth ) Foreign Production (Growth) Foreign Competition in Export

Markets (Maturity) Import Competition in Home Markets (Decline)41 Theories & Instituitions: Trade & Investment

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Release (Introduction; PLC Theory)1) Release: Competition in Industrialised countries tends to be fierce Producers look for better ways to satisfy customer needs Customer feedback from previous models - the core element of research Once the product enters the domestic market and begins to create a positive reputation the demand increases

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Exports (Growth, PLC Theory)2)Exports: As the product receives positive customer response, the international demand for the product begins The manufacturer begins exporting to increase its market share Increase capital intensity More competition Theories & Instituitions: Trade & Investment 01/19/10

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Foreign Production (Growth; PLC Theory)3)Foreign Production begins: As demand increases with the new global market feasible to begin local production in various countries By sharing technology on the manufacturing of the product, the company has lost an advantage High cost of start up production The end of this stage signifies the highest point in the International Product Life Cycle Theory.

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Foreign Competition in Export Market; Maturity in PLC4)Foreign Competition in exports markets: A threatening stage for the original company Local manufactures gained experience and scale in producing and selling their product, hence their costs have fallen Their initial market are filled they begin to look elsewhere to promote their product Possibly they threaten original companys domestic market Increase in price competitiveness Decline in export from the originating country & more capital intensity


Import Competition in Home Market; Decline in PLC5)Import Competition in Home Market: Competitors have a quality product which is able to undersell the original manufactures They have a competitive edge with their low labour costs. Disadvantages of the IPLC theory: - Assumption that products are released initially in the domestic markets - Many globalised companies tend to release their new product lines internationally, not domestically - NOT all products conform to the PLC theory; luxury products for example


Porter Diamond TheoryThis theory has been developed by

Michael Porter; who argued that companies development of internationally competitive products depends on four conditions; Domestic demand conditions Domestic factor conditions Related & supporting industries Firm strategy, structure, and rivalry47 Theories & Instituitions: Trade & Investment 01/19/10

P o rte r s sin g le d ia m o n d fra m e w o rkGovern Govern ment ment Structure of Structure of Firms and Firms and Rivalry Rivalry

Factor Factor Conditions Conditions Related and Related and Supporting Supporting Industries Industries48 Theories & Instituitions: Trade & Investment

Demand Demand Conditions Conditions

Chance Chance01/19/10

Limitations of Porter & Diamond TheoryProduction factors and finished goods

are only partially mobile internationally The cost and feasibility of transferring production factors rather than exporting finished goods internationally will determine which alternative is better Companies do not only react to domestic rivals but also to foreignbased rivals they compete with at Theories & Instituitions: Trade & Investment 01/19/10 49 home and abroad.

Factor Mobility TheoryWhy production factors move?Economic motives; gain more income Political motives; flee adverse political situation

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The Relationship between Trade and Factor MobilityCapital and labor move internationally

to gain more income and flee adverse political situations Although international mobility of production factors may be a substitute for trade, the mobility may stimulate trade through sales of components, equipment, and complementary products Theories & Instituitions: Trade & Investment 01/19/10 51

SummaryNot all trade theories apply to all the

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products or to all countries. Factors of production are mobile and they may be a substitute for trade The size of the country and its economical and political situation might affect its trade pattern Trade theories are actually useful for traders among nations; it help achieve efficient marketing & trade activities Trade theories might also explain the government role in the trade practices in a Theories & Instituitions: Trade & Investment 01/19/10 country; whether it interferes or doesnt.

Thank youMera Horani Nereen Abu Keer

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