Innovation Innovation EconomicsEconomics

Class 6Class 6

International Trade International Trade TheoryTheory

International Trade International Trade TheoryTheory

What is international trade? What is international trade? Exchange of raw materials and manufactured Exchange of raw materials and manufactured

goods (and services) across national bordersgoods (and services) across national borders Classical trade theories: Classical trade theories:

explain national economy conditions--explain national economy conditions--country advantages--that enable such country advantages--that enable such exchange to happenexchange to happen

New trade theories: New trade theories: explain links among natural country explain links among natural country

advantages, government action, and industry advantages, government action, and industry characteristics that enable such exchange to characteristics that enable such exchange to happenhappen

Implications for International BusinessImplications for International Business

Classical Trade TheoriesClassical Trade Theories Mercantilism (pre-16th century)Mercantilism (pre-16th century)

Takes an us-versus-them view of tradeTakes an us-versus-them view of trade Other country’s gain is our country’s lossOther country’s gain is our country’s loss

Free Trade theoriesFree Trade theories Absolute Advantage (Adam Smith, 1776)Absolute Advantage (Adam Smith, 1776) Comparative Advantage (David Ricardo, Comparative Advantage (David Ricardo,

1817)1817) Specialization of production and free flow of Specialization of production and free flow of

goods benefit all trading partners’ economiesgoods benefit all trading partners’ economies Free Trade refinedFree Trade refined

Factor-proportions (Heckscher-Ohlin, 1919)Factor-proportions (Heckscher-Ohlin, 1919) International product life cycle (Ray Vernon, International product life cycle (Ray Vernon,

1966)1966)

The New Trade The New Trade TheoryTheory

As output expands with specialization, an As output expands with specialization, an industry’s ability to realize economies of industry’s ability to realize economies of scale increases and unit costs decreasescale increases and unit costs decrease

Because of scale economies, world Because of scale economies, world demand supports only a few firms in such demand supports only a few firms in such industries (e.g., commercial aircraft, industries (e.g., commercial aircraft, automobiles)automobiles)

Countries that had an early entrant to Countries that had an early entrant to such an industry have an advantage:such an industry have an advantage: Fist-mover advantageFist-mover advantage Barrier to entryBarrier to entry

New Trade TheoryNew Trade Theory

Global Strategic RivalryGlobal Strategic Rivalry Firms gain competitive Firms gain competitive

advantage trough: intellectual advantage trough: intellectual property, R&D, economies of property, R&D, economies of scale and scope, experiencescale and scope, experience

National Competitive National Competitive Advantage (Porter, 1990)Advantage (Porter, 1990)

Absolute AdvantageAbsolute Advantage Adam Smith: Adam Smith: The Wealth of NationsThe Wealth of Nations, 1776, 1776 Mercantilism weakens country in long run; enriches Mercantilism weakens country in long run; enriches

only a fewonly a few A country A country

Should specialize in production of and export products Should specialize in production of and export products for which it has absolute advantage; import other for which it has absolute advantage; import other productsproducts

Has absolute advantage when it is more productive than Has absolute advantage when it is more productive than another country in producing a particular productanother country in producing a particular product

Rice

Cocoa

G

G'

K

K'

G: GhanaK: S. Korea

Comparative Comparative AdvantageAdvantage David Ricardo: David Ricardo: Principles of PoliticalPrinciples of Political EconomyEconomy, ,

18171817 Country should specialize in the production of Country should specialize in the production of

those goods in which it is those goods in which it is relativelyrelatively more more productive... even if it has absolute advantage in productive... even if it has absolute advantage in all goods it producesall goods it produces

Absolute AdvantageAbsolute Advantage is a special case of is a special case of Comparative AdvantageComparative Advantage

Rice

Cocoa

G

K

K'

G'

G: GhanaK: S. Korea

Heckscher (1919)-Ohlin Heckscher (1919)-Ohlin (1933)(1933)

Differences in factor endowments not on Differences in factor endowments not on differences in productivity determine patterns differences in productivity determine patterns of tradeof trade

Absolute amounts of factor endowments Absolute amounts of factor endowments mattermatter

Leontief paradox: Leontief paradox: US has relatively more abundant capital yet US has relatively more abundant capital yet

imports goods more capital intensive than those imports goods more capital intensive than those it exportsit exports

Explanation(?): Explanation(?): US has special advantage on producing new US has special advantage on producing new

products made with innovative technologiesproducts made with innovative technologies These may be less capital intensive till they These may be less capital intensive till they

reach mass-production statereach mass-production state

Theory of Relative Factor Theory of Relative Factor Endowments (Heckscher-Endowments (Heckscher-

Ohlin)Ohlin) Factor endowments vary among countriesFactor endowments vary among countries Products differ according to the types of Products differ according to the types of

factors that they need as inputsfactors that they need as inputs A country has a comparative advantage in A country has a comparative advantage in

producing products that intensively use producing products that intensively use factors of production (resources) it has in factors of production (resources) it has in abundanceabundance

Factors of production: labor, capital, Factors of production: labor, capital, land, human resources, technologyland, human resources, technology

International Product Life-Cycle International Product Life-Cycle (Vernon)(Vernon)

FFirms kept production close to their market irms kept production close to their market initiallyinitially

Aid decisions; minimize risk of new product Aid decisions; minimize risk of new product introductionsintroductions

Demand not based on price; low product cost not an Demand not based on price; low product cost not an issueissue

Limited initial demand in other advanced Limited initial demand in other advanced countries initiallycountries initially

Exports more attractive than overseas productionExports more attractive than overseas production

When demand increases in advanced countries, When demand increases in advanced countries, production followsproduction follows

With demand expansion in secondary marketsWith demand expansion in secondary markets Product becomes standardizedProduct becomes standardized production moves to low production cost areasproduction moves to low production cost areas Product now imported to US and to advanced countriesProduct now imported to US and to advanced countries

Classic Theory Classic Theory ConclusionConclusion

Free Trade expands the world “pie” for Free Trade expands the world “pie” for goods/servicesgoods/services

Theory Limitations:Theory Limitations: Simple world (two countries, two products)Simple world (two countries, two products) no transportation costsno transportation costs no price differences in resourcesno price differences in resources resources immobile across countriesresources immobile across countries constant returns to scaleconstant returns to scale each country has a fixed stock of resources and each country has a fixed stock of resources and

no efficiency gains in resource use from tradeno efficiency gains in resource use from trade full employmentfull employment

New Trade TheoriesNew Trade Theories

Increasing returns of specialization due to Increasing returns of specialization due to

economies of scale (unit costs of production economies of scale (unit costs of production

decrease)decrease)

First mover advantages (economies of scale First mover advantages (economies of scale

such that barrier to entry crated for second or such that barrier to entry crated for second or

third company)third company)

Luck... first mover may be simply lucky.Luck... first mover may be simply lucky.

Government intervention: strategic trade policyGovernment intervention: strategic trade policy

National Competitive National Competitive Advantage Advantage (Porter, 1990) (Porter, 1990)

Factor endowmentsFactor endowments land, labor, capital, workforce, infrastructure land, labor, capital, workforce, infrastructure

(some factors can be created...)(some factors can be created...) Demand conditionsDemand conditions

large, sophisticated domestic consumer base: offers large, sophisticated domestic consumer base: offers an innovation friendly environment and a testing an innovation friendly environment and a testing groundground

Related and supporting industriesRelated and supporting industries local suppliers cluster around producers and add to local suppliers cluster around producers and add to

innovationinnovation Firm strategy, structure, rivalryFirm strategy, structure, rivalry

competition good, national governments can create competition good, national governments can create conditions which facilitate and nurture such conditions which facilitate and nurture such conditionsconditions

Porter’s DiamondPorter’s Diamond

““So What” for So What” for business?business?

First mover implicationsFirst mover implications

Location ImplicationsLocation Implications

Foreign Investment Decisions Foreign Investment Decisions

GovernmentGovernment Policy implications Policy implications

New Growth TheoryNew Growth Theory

New growth theoryNew growth theory emphasizes the emphasizes the role of technology rather than role of technology rather than capital in the growth process.capital in the growth process.

TechnologyTechnology

Technology is the result of Technology is the result of investment in creating technology investment in creating technology (research and development).(research and development).

Growth theory separates investment Growth theory separates investment in capital from investment in in capital from investment in technology.technology.

Increases in technology are not as Increases in technology are not as directly linked to investment as is directly linked to investment as is capital.capital.

TechnologyTechnology

Increases in technology often have Increases in technology often have enormous positive spillover effects.enormous positive spillover effects. Positive externalitiesPositive externalities – positive effects – positive effects

on others not taken into account by the on others not taken into account by the decision maker.decision maker.

Technological advances in one sector of Technological advances in one sector of the economy lead to advances in the economy lead to advances in completely different unrelated sectors.completely different unrelated sectors.

TechnologyTechnology

Some basic research is protected by Some basic research is protected by patents.patents.

PatentsPatents – legal ownership of a – legal ownership of a technological innovation that gives the technological innovation that gives the owner of the patent sole rights to its use owner of the patent sole rights to its use and distribution for a limited time.and distribution for a limited time.

TechnologyTechnology

Once people have seen the new Once people have seen the new technology, they figure out a technology, they figure out a sufficiently different way to sufficiently different way to achieving the same end to avoid the achieving the same end to avoid the patent.patent.

Learning by DoingLearning by Doing

New growth theory also highlights New growth theory also highlights learning by doing.learning by doing.

Learning by doingLearning by doing – improving the – improving the methods of production through methods of production through experience.experience.

By increasing the productivity of By increasing the productivity of workers, learning by doing also workers, learning by doing also overcomes the law of diminishing overcomes the law of diminishing marginal productivity.marginal productivity.

Increasing Returns to Increasing Returns to ScaleScale

Production function with increasing returns

Output

All inputs

Technological Lock-InTechnological Lock-In

Technological lock-inTechnological lock-in occurs when occurs when old technologies become entrenched old technologies become entrenched in the market.in the market.

They become locked into new They become locked into new products despite the fact that more products despite the fact that more efficient technologies are available.efficient technologies are available.

Technological Lock-InTechnological Lock-In

One reason for technological lock-in One reason for technological lock-in is network externalities.is network externalities.

Network externalitiesNetwork externalities – an externality – an externality in which the use of a good by one in which the use of a good by one individual makes that technology more individual makes that technology more valuable to other people.valuable to other people.

Technological Lock-InTechnological Lock-In

Switching from a technology Switching from a technology exhibiting network externalities to a exhibiting network externalities to a superior technology is expensive and superior technology is expensive and sometimes nearly impossible.sometimes nearly impossible.