Appunti di International management

{chapter 6}

International Management : Economics of international trade

INTERNATIONAL TRADE

- How can international trade patterns be explained?

What determines cross-country trade flows?

‣

- Is international trade beneficial?

How? For whom?

‣

- Should international trade be left free or government intervention is desirable?

Intervention is desirable? In what circumstances?

‣

Introduction

- Trade theory

Mercantilism : countries should simultaneously en- courage exports and discourage imports

‣ Absolute advantage (Adam Smith) : first explanation of why unrestricted free trade is beneficial to a

‣ country

• Free trade : government does not attempt to influence

• Market mechanism should determine what a country imports and what it exports

Comparative advantage (David Ricardo) : basis of the modern argument for unrestricted free trade

‣ Heckscher–Ohlin theory

‣

- Theories identify the specific benefits of international trade

Country’s economy may gain if its citizens buy certain products from other nations

‣ International trade allows a country to specialize in the manufacture and export of products that can be

‣ produced most efficiently in that country, while importing products that can be produced more efficiently

in other countries

Limits on imports are often in the interests of domestic producers but not domestic consumers

‣

- Pattern of international trade :

Comparative advantage : international differences in labor productivity

‣ Heckscher–Ohlin : factor endowments

‣ New trade theory : countries specialize in the production and export of particular products, because in

‣ certain industries the world market can support only a limited number of firms

• pattern of trade between nations due to the ability of firms to capture first-mover advantages

Theory of national competitive advantage (Porter) : explains why particular nations achieve international

‣ success in particular industries

• In addition to factor endowments : domestic demand and domestic rivalry

- All these theories agree that international trade is beneficial

Lack agreement in their recommendations for government policy

‣ • Mercantilism : government involvement in promoting exports and limiting imports

• Smith, Riccardo and Heckscher–Ohlin : unrestricted free trade

• New trade theory and Porter’s theory : limited government intervention to support the development of

certain export-oriented industries MERCANTILISM

first theory of international trade (originated in the XVI century)

-

- Exports imply inwards cash flows || Imports imply outwards cash flows

- According to mercantilism : country’s best interest to maintain a trade surplus

Trade surplus = export more than import

‣

- Government intervention in order to achieve a surplus in the balance of trade

policies to maximize exports and minimize imports

‣

- Critic (Hume) : no country could sustain a surplus on the balance of trade

1 - 6 {chapter 6}

- Advocates government intervention to maximize exports and minimize imports

Subsidies + tariffs + quotas

‣ E.g.: China maintaining low currency value to favor exports

↪︎

- Mercantilism viewed trade as zero-sum game

Zero-sum game = gain by one country results in a loss by another

‣ • Adam Smith and David Ricardo demonstrate that trade is a positive-sum game

≠

- Mercantilist doctrine is by no means dead

Neo-mercantilists political power = economic power and economic power = balance-of-trade surplus

→

‣ • Strategy that is designed to simultaneously boost exports and limit import

THEORY OF ABSOLUTE ADVANTAGE

Adam Smith attacked the assumption that trade is a zero-sum game

-

- If trading allows two countries to gain at the same time, what should they trade?

- From Adam Smiths Wealth of Nations : Countries differ in their ability to produce goods efficiently

́

A country has an absolute advantage when it is more efficient than all the others at producing it

‣ • Countries should specialize in the production of those goods for which they have an absolute

advantage

• A country should never produce goods that other countries can produce at a lower cost

Two countries benefit :

‣ • by specializing in the production of goods in which each has an absolute advantage

• by engaging in trade THEORY OF COMPARATIVE ADVANTAGE

- If one country can produce more efficiently both products, is still trading sensible?

- Developed by David Ricardo

According to Adam Smith, when a country has an absolute advantage on all products, trade makes no

‣ sense

- A country may benefit from buying goods from other countries that it could produce more efficiently itself

It makes sense for a country to specialize in the production of those goods that it produces most

‣ efficiently and to buy the goods that it produces less efficiently from other countries, even if this means

buying goods from other countries that it could produce more efficiently itself

Without trade each country must consume what it produces

‣ • By engaging in trade, the two countries can increase their combined production of rice and cocoa, and

consumers in both nations can consume more of both goods

- Potential world production is greater with unrestricted free trade than it is with restricted trade

Consumers in all nations can consume more

‣ The theory of comparative advantage suggests that trade is a positive-sum game in which all countries

‣ that participate realize economic gains encourages free trade

→

Qualification and assumptions

- the conclusion that free trade is universally beneficial is based on unrealistic assumptions

These were simple models

‣ How is the real world more complex? What elements would make them more realistic?

↪︎

Is free trade still desirable in more complex and realistic model? If yes, more or less? If no, why?

- Assumptions of these models

Two countries and two goods

‣ No transportation costs

‣ No exchange rate and same cost of resources

‣ Versatile resources

‣ Constant returns to scale

‣ 2 - 6 {chapter 6}

No effect of trade on

‣ • Efficiency

• Income distribution

- Relaxing these assumptions (drop assumptions)

Unrestricted free trade, while still positive, has been argued by some economists

‣ • New trade

Implies that free trade is beneficial for different reasons

‣

Extensions of the Ricardian model

-

- What if we relax three of the assumptions :

resources move freely from the production of one good to another within a country

‣ constant returns to scale

‣ trade does not change a country’s stock of resources or the efficiency with which those resources are

‣ utilized

Immobile resources

- Assumption : producers could easily convert land from the production of one product to another and vice versa

-

- Not true : certain amount of friction and human suffering is involved

Resources do not always move easily from one economic activity to another

‣

- Theory suggests that the benefit of free trade outweigh the costs by a significant margin

Governments often ease the transition toward free trade by helping retrain those who lose their jobs as a

‣ result

- The pain caused by the movement toward a free trade regime is a short-term phenomenon, while the gains

from trade once the transition has been made are both significant and enduring

Diminishing returns to specialization

- Assumption : constant returns to specialization

- constant returns to specialization = the units of resources required to produce a good are assumed to

‣ remain constant no matter where one is on a country’s production possibility frontier (PPF)

- Diminishing returns to specialization occur when more units of resources are

required to produce each additional unit

Implies a convex PFF

‣

- It is more realistic to assume diminishing returns :

1. Resources have different quality

2. Different good require different resource proportions -

- Diminishing returns show that it is not feasible for a country to specialize to the degree suggested by the

Ricardian model

Gains from specialization are likely to be exhausted before specialization is complete

‣ most countries do not specialize, but instead produce a range of goods

↪︎

- Worthwhile to specialize until that point where the resulting gains from trade are outweighed by diminishing

returns

Free trade is beneficial

‣ Although because of diminishing returns, the gains may not be as great as suggested in the constant

‣ returns case

Dynamic effects and economic growth

Assumption : trade does not change a country’s stock of resources or the efficiency with which it utilizes those

-

resources

static assumption : no allowances for the dynamic changes that might result from trade

‣

- Opening an economy to trade is likely to generate dynamic gains of two sorts

3 - 6 {chapter 6}

- Free trade affects a country efficiency and resources

́s

1. Increased supply of labor and capital from abroad

2. Economies of scale from the larger international market

3. Increased productivity from imported technology

4. Incentive to improve due to extra competition

Dynamic gains in both the stock of a country’s resources and the efficiency with

-

which resources are utilized will cause a country’s PPF to shift outward

Paul Samuelson, argued that in some circumstances, dynamic gains can lead to an out- come that is not so

-

beneficial.

Samuelson’s critiques

-

- When a rich country (the United States) enters into a free trade agreement with a poor country (China) that

after the introduction of a free trade regime

Rapidly improves its productivity

‣ Obtains better education

‣

- The benefits are offset by lower real wage for people in the rich country

Although in practice improving the skill level of the work force take decades

‣ • In the end free trade is still better than trade barriers

But to a lower extent

✦ Historically free trade benefits rich countries

✦ HECKSHER-OHLIN THEORY

- Ricardo theory is based on a productivity arguments

́s

Countries should only produce the goods they can produce more efficiently

‣

- Could there be other reasons to specialize in the production of something?

- Different explanation of comparative advantage

For Ricardo due to differences in labor productivity

‣ For H-O due to differences in resource endowments (labor, land, capital)

‣ • Larger stocks imply lower costs

Countries export goods produced with locally abundant factors

✦ Countries import goods produced with locally scarce factors

✦

- Empirically incorrect

Leontief Paradox: the US should be an exporter of capital-intensive goods and an importer of labor-

́s

‣ intensive goods

• In reality it is the opposite

• Possible explanation: the US has a special advantage in producing new products made with

innovative technologies

O-H assume that all countries have the same technology

✦

Ricardo explanation has more predictive power

́s

‣ PRODUCT-LIFE CYCLE THEORY

-

- Raymond Vernon observed that for most of the 1900, a very large proportion of the world’s new products

had been developed by U.S. firms and sold first in the U.S. market

Why the US?

‣ • Why new products are developed there? Why are they also manufactured there?

Why not exporting right away?

‣

- Raymond Vernon observed that for most of the 1900, a very large proportion of the world’s new products

had been developed by U.S. firms and sold first in the U.S. market

- Explanation 4 - 6 {chapter 6}

The wealth and size of the US market gives an incentive to innovate products

‣ The high cost of US labor gives an incentive to innovate processes

‣

- Life-Cycle explanation:

Demand for new products is not price sensitive

‣ • Low incentive to seek for low cost production sites abroad

Products are developed and produced in the US

‣ Little proportion is sold to affluent customers abroad production is moved closer to the demand

‣ • As foreign demand grows

• As competitive pressure creates cost pressure

First to developed countries and then developing countries

‣

- The consequence of these trends for the pattern of world trade is that :

over time, the United States switches from being an exporter of the product to an importer of the product

‣ as production becomes concentrated in lower-cost foreign locations

NEW TRADE THEORY

- economists pointed out that the ability of firms to attain economies of scale might have important implications

- for international trade

- Economies of scale are unit cost reductions associated with a large scale of output (source of cost

reductions)

- New trade theory makes two important points :

Trade can increase the variety of goods available to consumers and decrease the average cost of those

‣ goods.

• Free trade increases the available market

Larger markets allow for greater economies of scale

✦ Scale allows for lower costs and greater product variety

✦

In those industries in which the output required to attain economies of scale represents a significant

‣ proportion of total world demand, the global market may be able to support only a small number of

enterprises.

• If the market is small, demand may be too small for some products

In combined markets countries specialize and variety grows

✦

- If a domestic market is too small for efficient production

Should a firm produce anyway? As long as P > AC

‣ • if no, why? If yes, should it trade?

• What are the international consequences on : Production & Consumption

- Some industries are natural monopolies/oligopolies (world trade in certain products may be dominated by countries

whose firms were first movers in their production)

First movers dominate these industries

‣ • Cost advantage from scale economies is a barrier to entry

Reinforced if the total demand is contained

✦

- Implications

Nations may benefit from trade even when technology and resource endowments are the same

‣ • Consistent with Ricardo theory of comparative advantage

́s

• Inconsistent with H-O theory

Justifies government intervention

‣ PORTER’S DIAMOND

- Porter’s task : explain why a nation achieves international success in a particular industry

-

- We saw that country-level advantages may depend on

Productivity

‣ 5 - 6 {chapter 6}

Resource endowments

‣ First mover advantage

‣ Domestic and foreign demand

‣

- Porter contends that the degree to which a nation is likely to achieve international success in a certain

industry is a function of the combined impact of :

Factor endowments

- a nation’s position in factors of production, such as skilled labor or the infrastructure necessary to compete in a

-

given industry

- Factor endowments - hierarchies among factors, distinguishing between

basic factors

‣ e.g.,natural resources, climate, location

↪︎

• reinforced by investments in advance factors

advanced factors

‣ e.g., communication infrastructure, skilled labor, research facilities, and technological know-how).

↪︎

• the most significant for competitive advantage

• product of investment by individuals, companies, and governments

• Can compensate for the lack of basic factors

- The relationship between advanced and basic factors is complex

Demand conditions

- the nature of home demand for the industry’s product or service

-

- Demand conditions

Sophisticated domestic customers foster innovation and quality

‣

Related and supporting industries

- the presence or absence of supplier industries and related industries that are internationally competitive

-

- Related and supporting industries

High quality players in supporting industries have positive spillovers

‣ Clusters of related high performing industries

‣

Firm strategy, structure and rivalry

- conditions governing how companies are created, organized, and managed and the nature of domestic rivalry

-

- Firm strategy, structure and rivalry

Different management ideologies create differentials in performance

‣ Vigorous domestic rivalry fosters quality improvements and efficiency

‣

Other influences

-

- Government : can influence each of the four components of the diamond (either positively or negatively)

subsidies and policies can affect resource factor endowments

‣ shape domestic demand : by local product standards or with regulations that mandate or influence buyer

‣ needs

policy and regulation can foster supporting and related industries

‣ capital market regulation, tax policy, and antitrust laws affect competition

‣

- Luck 6 - 6

International Management : National Institutions

INTRODUCTION

- National institutions : The humanly devised constraint that shape human interactions

A.K.A “the rules of the game”

↪︎ Shape social and economic interactions within a society

‣ Set the incentive structure of a society

‣

- Formal institutions

Regulations

‣ • The World Bank Development Index; Shareholder protection index

́s

- Informal institutions

Norms; Culture; Religion;

‣

- Liability of foreigners

Institutional heterogeneity

‣ • Differences?

• Distances? FORMAL INSTITUTIONS

The world bank’s development index

Governance indicators

- Governance can be broadly defined as the set of traditions and institutions by which authority in a country is

exercised

the process by which governments are selected, monitored and replaced

‣ the capacity of the government to effectively formulate and implement sound policies

‣ the respect of citizens and the state for the institutions that govern economic and social interactions

‣ among them

- What does better governance look like?

- What may make a country a better place for doing business?

World Bank ́s Worldwide Governance