As our global markets become more integrated and whole, the patterns of trade have shifted. International trade theory is really nothing new, but to understand the patterns of trade in the world today it is essential to understand where these concepts came from. Also, as the global market emerges, many of these theories have become outdated; nevertheless, the core concepts of Smith’s absolute advantage, Ricardo’s comparative advantage, opportunity costs and productivity, the Heckscher Olin theory of factor endowments, the product life-cycle theory all set the foundation for a more modern approach in explaining the patterns of trade. In more recent times, Paul Krugman’s New Trade Theory (even he will tell you though, he doesn’t agree with some of the points that won him the Noble Peace Prize), talks about economies of scale and market size. Michael Porter took international trade theory a step further and introduced the national competitive advantage theory , otherwise known as the diamond theory, which takes into account factor endowments, domestic demand conditions, relating and supporting industries and firm strategy, structure and rivalry all impact the positive sum game of trading. Thus, understanding these theories can help a firm’s manager know where to base their location of the different components of their products, gain a first mover advantage and even help dictate government policy to help spur international trade.
We will begin by talking about Adam Smith’s theory of absolute advantage, and then David Ricardo’s extension of this model, comparative advantage and how they relate to what is produced and where. At the most basic level he promoted free trade, or a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country, as well as what they can produce and sell in another country. He was trying to put to rest the idea that was derived from mercantilism in the early 16th century that trade is a zero-sum game, where only one country can benefit from it; and he did. We can define absolute advantage as the country that is most efficient and productive in producing a specific good, and trade those goods for goods in which other countries have an absolute advantage. If a country can specialize in what they do best, output increases, and the world becomes better off. This is a fairly basic concept, however what if a country has an absolute advantage in all products? Should it still trade? David Ricardo’s theory of comparative advantage answers this question. At the heart of comparative advantage is opportunity cost, while absolute advantage talks about trade in terms of financial costs, Ricardo discusses opportunity cost, which can be defined as what a country or firm gives up, for example time, to produce one good versus another. This is a tricky concept, and took me several hours to completely understand. Even though a country may have an absolute advantage in, say two goods, it does not mean that they would be better off not trading. This is because if a firm or nation decides to exchange and specialize in one good, it can produce more of that good than had they split their resources into making two goods. The mathematical equation for determining opportunity cost is fairly simple, but let’s look at an example. Assume we live in a world where there is only two countries, the US and China, and this world only has two products cars and cheese (strange world I know). To produce one ton of car in the US it takes fifteen hours; but in China it only requires 4 hours to make that same car. To produce one ton of cheese in the US it takes 5 hours; and in China it takes 2 hours. Who has the absolute advantage? Clearly, China. But should China still trade with us? What is the US giving up when it makes one car? Well when we break each hour down into one unit, 15 hours/5 hours = 3 cheeses, so when the US makes a car, they could have been making three extra cheeses. In contrast, China would give up 2 cheeses (4/2) to produce one car. When the US makes cheese, they give up 1/3 of a car (3/15). While if China makes cheese they would be giving up ½ a car (2/4). So who has the comparative advantage in what? Since China would be giving up half a car when producing cheese, and the US would only give up 1/3 of a car, the US would be better off producing cheese because they have a lower opportunity cost in cheese, while China would be better off producing cars because their opportunity cost is lower when producing cars. The only reason that a country shouldn’t specialize in trade is if the opportunity cost ratios were the same across both countries. This model makes many assumptions, and these assumptions must be relaxed, however it is a good starting point for the patterns of international trade.
While Mr. Ricardo maintains that comparative advantage stems from productivity, Eli Heckscher and Bertil Ohlin thought that comparative advantages is a product of factor endowments, or the amount of resources in terms of land, labor and capital a particular country has to work with. This has largely been known as the Heckscher Ohlin theory, which predicts that the local resources of a nation can be a good guide to what a country will export and what a country will import based on the factor endowments available.
Another theory of international trade was founded by Raymond Vernon, and is known as the product life-cycle theory. The product life-cycle theory is viewed as extremely ethnocentric; however between 1945-1975 many of the world’s new products came from the United States. He stated, when a new product is developed it’s life-cycle would begin in the US, where it was innovated, and the US becomes the sole exporter. As the product matures over time, US firms look for cheaper places to innovate their products; and demand from other developed nations such as France, begin to produce the product because they have a lower cost of labor. As the product becomes more “standardized” the other developed countries look to further reduce costs by transferring manufacturing to developing nations. Thus, the United States becomes a major importer of the new product they had originally exported. The cycle, is not really the issue, however the origins are. Today, other developed countries are coming out with new products- not just the US, they are sourcing their production all over the globe and many products are now introduced simultaneously.
The New Trade Theory, zeroes in on how economies of scale have important implications for international trade. An economy of scale, or scalability, refers to the unit cost reduction associated with a large scale output. Economies of scale can create a variety of products and lower costs for the average consumer. For example, when you buy one coke from your corner store the average price is one dollar, however if you bought several cans from your grocery store, the average price of the can would go down, even further if you bought your coke in bulk from somewhere like Costco or Sam’s Club, then the price would go down dramatically than if you were to buy just one coke from your corner store. This is also true for companies, and is a major source of cost reduction. On another note, economies of scale create greater product variety. When a country specializes in producing one product, and imports the products they do not specialize in from other nations, it creates greater variety for consumers across nations. Note that, even though globalization has reduced the variety of products being made, it still has created more variety per nation. For example, folks in India can enjoy Burger King’s latest Whopper, while those of us in the United States can enjoy chicken tike masala; this makes the world’s products seem more and more similar. Lastly, the new trade theory suggests that companies that gain a first mover advantage, or those companies that are the first entrants into an industry, will prevail in the world market, especially when the market is not large enough to sustain more than a couple of companies. Governments can help companies receive first mover advantages by supporting specific industries through subsidies and other means. Overall, factor endowments and the extent to which a country has the most updated technology, really take the backseat according to Krugman.
Michael Porter of Harvard set out to explain why certain nations and certain industries are more competitive than others. He found four different attributes that allow firms to compete which include factor endowments, demand conditions, relating and supporting industries (clusters) and firm strategy, structure and rivalry. Many of these attributes seem to be obvious, but until Porter’s Diamond was theorized, no one in fact, thought of it. First factor endowments refer to the factors of production (as mentioned before land, labor and capital), but took it one step further, by differentiating between basic and advanced factors. He argues, that advanced factors are a product of a country’s investments from individuals, companies and governments . These advanced factors include technological innovativeness, the extent to which the country has skilled labor, the extent to which communication infrastructure is prevalent as well as how advanced research facilities are in a particular country. Thus, advanced factors are most important for economic growth, however if a country lacks basic factors; they may try to counterbalance this by creating new ways to supplement this missing piece.
A firm’s home country and consumers are the driving force for calculating demand conditions. “It begins at home,” is a good starting point for understanding this attribute of Porter’s Diamond. This attribute will tell a firm if they should enter a market and if that industry is one that is profitable. Customers tell firms what they want. And consumers, although products are becoming more global, still have different preferences across nations. These preferences, thus, tell a company what products are desirable, and in turn tells the nation as a whole what they should specialize in. The Computer software industry (silicon valley) is primarily based in the United States because the demand started here among other factors. As the textbook states, “firms gain a competitive advantage if their domestic customers are sophisticated and demanding,” meaning the more intelligent the society is as a whole will push firms to produce better quality products.
Another attribute that can give a country national competitiveness is the related and supporting industries around a firm’s market. In other words, to what extent do a country’s firms have other industries that are linked to their own? The more related industries, the better off the firm may be in operating in that location, because there are more resources and “know how” that can spill out from one part of the industry to the next. Even if companies are competing, they are pushing each other to create better quality products and at the most affordable price. Consider Silicon Valley, the name wasn’t just slapped on the computer industry for no reason; it’s because the software industry is concentrated into a giant cluster, and each company feeds off of the other. This has allowed the United States to have the best position in terms of the computer software industry. This is not to say the engineers of India won’t one day catch up, but it won’t be as easy for them to enter this industry as it was for those firms in the US.
Lastly a firm’s strategy, structure and rivalry can influence their international competitiveness. As one may guess, this is the next base on the diamond. A firm’s strategy and structure is linked by the different management ideology in that particular nation. Firms in the US generally think short term, while firms in places such as Switzerland think long term when it comes to their investments. Or consider Japan’s hierarchical structure versus Italy’s more tightly run companies that resemble more of an extended family. Such ways of thinking affect firm strategy and structure. Secondly, the more competitive a market is in one’s home country, the less competition the company will face globally. Competition pushes firms to create better and more innovative products, therefore the better educated and more advanced a country is in a particular sector, the better off they will be in the global market. In other words, the more successful a company is at home so long as they have a high level of competition, the more profitable they will be in the global marketplace.
Even if companies are competing, they are pushing each other to create better and more innovative products.