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TBS983 :International Trade Theory

Lecture :4

Neo-Classical-Trade Theory Charles Hill

Chapter 6

UOWDAutumn Semester 2014

•Dr. Gwendolyn Rodrigues

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The Product Life Cycle Theory Vernon (mid-1960s ) proposed the product life-

cycle theory - as products mature both the location of sales and the optimal production location will change affecting the flow and direction of tradethe wealth and size of the U.S. market gave a

strong incentive to U.S. firms to develop new products

In the early stages of a product’s life cycle demand may grow in the U.S., but demand in other advanced countries is limited to high-income groupsit is not worthwhile for firms in those countries

to start producing the new product, but it does necessitate some exports from the U.S. to those countries

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The Product Life Cycle

Theory

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The Product Life Cycle Theory Over time, demand for the new product

starts to grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets

U.S. firms might also set up production facilities in those advanced countries where demand is growing limiting the exports from the U.S.

As the market in the U.S. and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon

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The Product Life Cycle Theory Producers based in advanced countries

where labor costs are lower than the United States might now be able to export to the U.S.

If cost pressures become intense, developing countries begin to acquire a production advantage over advanced countries

The United States switches from being an exporter of the product to an importer of the product as production

becomes more concentrated in lower-cost foreign locations

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Evaluating The Product Life Cycle Theory

While the product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the US in the 1960s and

1970s, the increasing globalization and integration of the world economy has made this theory less valid in today's worldtoday, many new products are initially introduced in

Japan or Europe, or are introduced simultaneously in the U.S., Japan, and Europe

production may also be dispersed to those locations where it is most favorable

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Porter’s Diamond Porter (1990) tried to explain why a nation

achieves international success in a particular industry

Porter identified four attributes he calls the diamond that promote or impede the creation of competitive advantage

1. Factor endowments2. Demand conditions3. Related and supporting industries4. Firm strategy, structure, and rivalry

In addition, Porter identified two additional variables

(chance and government) that can influence the diamond in important ways

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Porter’s DiamondFigure 5.6: Determinants of National Competitive Advantage: Porter’s

Diamond

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Factor Endowments A nation's position in factor endowments

(factors of production) can lead to competitive advantageThese factors can be either: BASIC :natural resources, climate,

location) or; ADVANCED: skilled labor,

infrastructure, technological know-how

Basic factors can provide an initial advantage that is then reinforced and extended by investment in advanced factors

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Demand Conditions

Demand conditions - the nature of home demand for an industry’s

product or service influence the development of capabilities

Sophisticated and demanding customers pressure firms to be :

(i)more competitive and to(ii) produce high quality, (iii) innovative products

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Related and Supporting IndustriesRelated and supporting industries - the

presence supplier industries and related industries that are internationally competitive investing in these industries can spill over and

contribute to success in other industries

Successful industries tend to be grouped in clusters in countries which then prompts knowledge flows between firms

having world class manufacturers of semi-conductor processing equipment can lead to (and be a result of having) a competitive semi-conductor industry

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Example: Biomedical/Biotechnical

Driver Industries:Pharmaceuticals and Medicines Mfg

Medical Instruments/Equipment/Supplies Mfg

Customers:Health and personal

care stores;Doctors’ offices;

Hospitals

Suppliers:

Laboratory apparatus

and furniture Mfg

Support Industries:Scientific R&D

Infrastructure:Waste

management and transport

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Firm Strategy, Structure, and Rivalry

Firm strategy, structure, and rivalry - the conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalrynations are characterized by different

management ideologies which

influence the ability of firms to build national competitive advantage

There is a strong association between vigorous domestic rivalry and the

creation and persistence of competitive advantage in an industry

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Porter’s DiamondCompetitive Advantage for Countries

Porter’s DiamondCompetitive Advantage for Countries

Firm Strategy, Structure and Rivalry

Related and Supporting Industries

Demand ConditionsFactor Conditions

How would you revise this strategy to one supporting firms strong in developing coffee brands?

Consumer Electronics

Strong firmsCompetitive features

Components Innovative buyersDesign Engineers Knowledgeable

Media suppliersRetail infrastructure

Fashion Apparel

Innovative designersCompetitive styles

Fabric suppliers Stylistic buyersFashion designers Fashion conscious

Specialty retailingPromotional Media

Beer

Large, diverse brewersComplex positioning

Hops, barley, yeast Social acceptance

Brewers Knowledgeable

Advertising industry Hospitality infrastructure

Beans or Brands?

Multiple cooperativesDiverse growing strategies

Skilled farmersKnowledgeable

Regional system Selective

Transportation infrastructure Agricultural supports

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Evaluating Porter’s Theory Porter - the four attributes of the diamond

together with government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage

Government policy can

affect demand through product standardsinfluence rivalry through regulation and antitrust

lawsimpact the availability of highly educated

workers and advanced transportation infrastructure

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Evaluating Porter’s TheoryQuestion: Is Porter right?

Answer:

If Porter is correct, his model should predict the pattern of international trade in the real world

Countries should export products from industries where the diamond is favorable

Countries should import products from areas where the diamond is not favorable

So, far there has been little empirical testing of the theory

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An Economies of Scale Model of Trade

• Even if two nations are identical in every respect,

• there is still a basis for mutually beneficial trade based on economies of scale

• The firm is producing under increasing returns conditions

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• Increasing Returns to Scale • The production situation where output

grows proportionately more than the increase in inputs or factors of production.

• For example doubling all inputs more than doubles output

• i.e. due to: (i)division of labour(ii)Specialisation(iii)more productive machinery(iv)labour productivity

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• When each nation specialises in the production of one commodity,

• The combined total world output of both commodities will be greater than without specialisation

• When Economies of Scale are present

• With trade then each nation shares these gains

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An economy of scale model of trade

• Mutually beneficial trade can be based on increasing returns to scale

• If two nations are assumed to be identical in every respect,

• a single production frontier &

• a single indifference map will represent both nations

• Increasing returns to scale result in production frontiers that are convex or inward bending

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• Economies of Scale result in identical and convex production frontiers and indifference map. Autarky equilibrium-relative commodity price in two nations is identical and given by PA .

• With trade, Nation1 could specialise completely in the production of commodity X and produce at point B.

• Nation 2 would then specialise completely in the production of commodity Y and produce at point B’

•By exchanging 60X for 60Y with each other , each nation would end

• up consuming at point E on indifference curve II, thus gaining 20X and 20Y.

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• ECONOMIES of SCALE is similar to the hypothesis advanced by Linder 1961 that a nation exports those manufactured products for which a large domestic market exists

• Additionally Remember: 1. Outsourcing-A firms purchase of parts &

components abroad, rather than itself producing them at home, in order to keep costs down in the global economy.

2. International Economies of Scale - The increased productivity resulting from the firms integration of its entire system of manufacturing operations around the world. i.e Ford Fiesta –Motor produced in UK, Transmission in France, Clutches in Spain & final assembly in Germany

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Implications for Managers

Question: What are the implications of international trade theory for international businesses?

Answer: There are at least three main

implications for international businesses

1. Location implications2. First-mover implications3. Policy implications

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Location

Different countries have advantages in different productive activities

differences influence a firm’s decision about

where to locate productive activities

a firm should disperse its productive activities to those countries where they can be performed most efficiently

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First-Mover Advantages and Government Policy

Firms that establish a first-mover advantage in the production of a new product may later dominate global trade in that product

a firm can invest resources in trying to build first-mover advantages, even if it means losses for a few years before a venture becomes profitable

Government policies on free trade or protecting domestic industries can significantly impact global competitiveness

businesses should encourage free trade policies

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