New trade theory suggests that nations

International Business 10e

By Charles W.L. Hill

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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Chapter 6

International Trade Theory

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Why Is Free Trade Beneficial?

Free trade - a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country
Trade theory shows why it is beneficial for a country to engage in international trade even for products it is able to produce for itself
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Why Is Free Trade Beneficial?

International trade allows a country
to specialize in the manufacture and export of products and services that it can produce efficiently
import products and services that can be produced more efficiently in other countries
limits on imports may be beneficial to producers, but not beneficial for consumers
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LO 1: Understand why nations trade with each other.

The Opening Case: Creating the World’s Biggest Free Trade Zone illustrates the benefits of free trade and globalization. President Obama has committed the United States to negotiating a free trade deal with the European Union. The announcement was greeted with enthusiasm that can be traced to widespread acceptance of the key axiom of international trade—trade is good for all countries involved in a free trade agreement.

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Why Do Certain
Patterns Of Trade Exist?

Some patterns of trade are fairly easy to explain
it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee
But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry?
Why does Japan export automobiles, consumer electronics, and machine tools?
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What Role Does
Government Have In Trade?

The mercantilist philosophy makes a crude case for government involvement in promoting exports and limiting imports
Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade
New trade theory and Porter’s theory of national competitive advantage justify limited and selective government intervention to support the development of certain export-oriented industries
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Country Focus: Is China a Neo-Mercantilist Nation analyzes claims that China is a neo-mercantilist nation. Exports are largely responsible for China’s recent rapid economic growth. The country, capitalizing on its cheap labor force, has been focused on converting raw materials into products that are exported to developing countries like the United States. China’s trade surplus has started to contract [partly as a result of allowing the Chinese currency (the yuan) to appreciate against the US dollar] as export growth has slowed and imports have increased.

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What Is Mercantilism?

Mercantilism (mid-16th century) suggests that it is in a country’s best interest to maintain a trade surplus—to export more than it imports
advocates government intervention to achieve a surplus in the balance of trade
Mercantilism views trade as a zero-sum game—one in which a gain by one country results in a loss by another
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LO 2: Summarize the different theories explaining trade flows between nations.

Mercantilism suggests that countries should design policies that lead to an increase in their holdings of gold and silver.

This was usually done by increasing exports and limiting imports. This economic philosophy was used by Europeans from about the 1500s to the late 1700s. It fueled colonialism in Britain, France, the Netherlands and Spain.

Nations increase their wealth by maintaining trade surpluses.

The key problem with the mercantilist view is that it views trade as a zero sum game, where if one country benefits the other must lose. As an economic philosophy, mercantilism is flawed.

Yet many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade.

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What Is Smith’s Theory
Of Absolute Advantage?

Adam Smith (1776) argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it
countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for goods produced by other countries
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LO 2: Summarize the different theories explaining trade flows between nations.

In 1776, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game and argued that countries differ in their ability to produce goods efficiently, and that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it.

According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries.

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How Does The Theory
Of Absolute Advantage Work?

Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa
In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice
Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes
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How Does The Theory
Of Absolute Advantage Work?

In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice
South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between
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How Does The Theory
Of Absolute Advantage Work?

Without trade
Ghana would produce 10 tons of cocoa and 5 tons of rice
South Korea would produce 10 tons of rice and 2.5 tons of cocoa
With specialization and trade
Ghana would produce 20 tons of cocoa
South Korea would produce 20 tons of rice
Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice
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How Does The Theory
Of Absolute Advantage Work?

After trade
Ghana would have 14 tons of cocoa left, and 6 tons of rice
South Korea would have 14 tons of rice left and 6 tons of cocoa
If each country specializes in the production of the good in which it has an absolute advantage and trades for the other, both countries gain
trade is a positive sum game
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How Does The Theory
Of Absolute Advantage Work?

Absolute Advantage and the Gains from Trade

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What Is Ricardo’s Theory
Of Comparative Advantage?

David Ricardo asked what happens when one country has an absolute advantage in the production of all goods
The theory of comparative advantage (1817)—countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries
even if this means buying goods from other countries that they could produce more efficiently at home
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LO 2: Summarize the different theories explaining trade flows between nations.

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How Does The Theory Of Comparative Advantage Work?

Assume Ghana is more efficient in the production of both cocoa and rice
In Ghana, it takes 10 resources to produce one ton of cocoa, and 13 1/2 resources to produce one ton of rice
So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two
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How Does The Theory Of Comparative Advantage Work?

In South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice
So, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two
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How Does The Theory Of Comparative Advantage Work?

With trade
Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice
Ghana will still have 11 tons of cocoa, and 4 additional tons of rice
South Korea still has 6 tons of rice and 4 tons of cocoa
if each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain
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How Does The Theory Of Comparative Advantage Work?

Comparative advantage theory provides a strong rationale for encouraging free trade
total output is higher
both countries benefit
Trade is a positive sum game
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How Does The Theory Of Comparative Advantage Work?

Comparative Advantage and the Gains from Trade

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Is Unrestricted Free Trade
Always Beneficial?

Unrestricted free trade is beneficial, but the gains may not be as great as the simple model of comparative advantage would suggest
immobile resources
diminishing returns
dynamic effects and economic growth
the Samuelson critique
But, opening a country to trade could increase
a country's stock of resources as increased supplies become available from abroad
the efficiency of resource utilization and so free up resources for other uses
economic growth
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LO 3: Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare if countries that participate in a free trade system.

The simple example of comparative advantage presented in the text makes a number of assumptions: only two countries and two goods; zero transportation costs; similar prices and values; resources are mobile between goods within countries, but not across countries; constant returns to scale; fixed stocks of resources; and no effects on income distribution within countries. While these are all unrealistic, the general proposition that countries will produce and export those goods that they are the most efficient at producing has been shown to be quite valid.

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Could A Rich Country Be
Worse Off With Free Trade?

Paul Samuelson - the dynamic gains from trade may not always be beneficial
free trade may ultimately result in lower wages in the rich country
The ability to offshore services jobs that were traditionally not internationally mobile may have the effect of a mass inward migration into the United States, where wages would then fall
but, protectionist measures could create a more harmful situation than free trade
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Country Focus: Moving U.S. White-Collar Jobs Offshore goes to the heart of a debate that has been played out many times over the past half century—the transference of jobs from the United States to lower-wage countries. The difference now however, is that rather than blue-collar jobs being transferred, the new trend is for white-collar jobs to move, jobs associated with the knowledge-based economy.

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What Is The
Heckscher-Ohlin Theory?

Eli Heckscher (1919) and Bertil Ohlin (1933) - comparative advantage arises from differences in national factor endowments
the extent to which a country is endowed with resources like land, labor, and capital
The more abundant a factor, the lower its cost
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LO 2: Summarize the different theories explaining trade flows between nations.

Basic factors:

Natural resources

Climate

Geographic location

Demographics

While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success.

Advanced factors:

The result of investment by people, companies, and government are more likely to lead to competitive advantage. If a country has no basic factors, it must invest in advanced factors.

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What Is The
Heckscher-Ohlin Theory?

The pattern of trade is determined by factor endowments
Heckscher and Ohlin predict that countries will
export goods that make intensive use of locally abundant factors
import goods that make intensive use of factors that are locally scarce
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Does The Heckscher-Ohlin
Theory Hold?

Wassily Leontief (1953) theorized that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods.
However, he found that U.S. exports were less capital intensive than U.S. imports
Since this result was at variance with the predictions of trade theory, it became known as the Leontief Paradox.
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What Is The
Product Life-Cycle Theory?

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 trade
proposed by Ray Vernon in the mid-1960s
At this time most of the world’s new products were developed by U.S. firms and sold first in the U.S.
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LO 2: Summarize the different theories explaining trade flows between nations.

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What Is The
Product Life-Cycle Theory?

According to the product life-cycle theory
the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new products
initially, the product would be produced and sold in the U.S.
as demand grew in other developed countries, U.S. firms would begin to export
demand for the new product would grow in other advanced countries over time making it worthwhile for foreign producers to begin producing for their home markets
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What Is The
Product Life-Cycle Theory?

U.S. firms might set up production facilities in advanced countries with growing demand, limiting exports from the U.S.
As the market in the U.S. and other advanced nations matured, the product would become more standardized, and price would be the main competitive weapon
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What Is The
Product Life-Cycle Theory?

Producers based in advanced countries where labor costs were lower than the United States might now be able to export to the United States
If cost pressures were intense, developing countries would acquire a production advantage over advanced countries
Production became concentrated in lower-cost foreign locations, and the U.S. became an importer of the product
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What Is The
Product Life-Cycle Theory?

The Product Life-Cycle Theory

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Source: Adapted from Raymond Vernon and Louis T. Wells, The Economic Environment of International Business, 5th edition © 1991. Reproduced by permission of Pearson Education, Inc., Upper Saddle River, New Jersey.

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Does The Product Life-
Cycle Theory Hold?

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 United States in the 1960s and 1970s
mature industries leave the U.S. for low cost assembly locations
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Does The Product Life
Cycle Theory Hold?

But, the globalization and integration of the world economy has made this theory less valid today
the theory is ethnocentric
production today is dispersed globally
products today are introduced in multiple markets simultaneously
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What Is New Trade Theory?

New trade theory suggests that the ability of firms to gain economies of scale (unit cost reductions associated with a large scale of output) can have important implications for international trade
Countries may specialize in the production and export of particular products because in certain industries, the world market can only support a limited number of firms
new trade theory emerged in the 1980s
Paul Krugman won the Nobel prize for his work in 2008
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LO 2: Summarize the different theories explaining trade flows between nations.

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What Is New Trade Theory?

Through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods

without trade, nations might not be able to produce those products where economies of scale are important
with trade, markets are large enough to support the production necessary to achieve economies of scale
so, trade is mutually beneficial because it allows for the specialization of production, the realization of scale economies, and the production of a greater variety of products at lower prices
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LO 3: Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare if countries that participate in a free trade system.

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What Is New Trade Theory?

In those industries when output required to attain economies of scale represents a significant proportion of total world demand, the global market may only be able to support a small number of enterprises

first-mover advantages - the economic and strategic advantages that accrue to early entrants into an industry
economies of scale
first movers can gain a scale based cost advantage that later entrants find difficult to match
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What Are The Implications Of
New Trade Theory For Nations?

Nations may benefit from trade even when they do not differ in resource endowments or technology
a country may dominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good
Governments should consider strategic trade policies that nurture and protect firms and industries where first-mover advantages and economies of scale are important
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What Is Porter’s Diamond Of Competitive Advantage?

Michael Porter (1990) tried to explain why a nation achieves international success in a particular industry
identified four attributes that promote or impede the creation of competitive advantage
Factor endowments - a nation’s position in factors of production necessary to compete in a given industry

can lead to competitive advantage
can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how)
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LO 2: Summarize the different theories explaining trade flows between nations.

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What Is Porter’s Diamond Of Competitive Advantage?

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

influences the development of capabilities
sophisticated and demanding customers pressure firms to be competitive
Relating and supporting industries - the presence or absence of supplier industries and related industries that are internationally competitive

can spill over and contribute to other industries
successful industries tend to be grouped in clusters in countries
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What Is Porter’s Diamond Of Competitive Advantage?

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

different management ideologies affect the development of national competitive advantage
vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features
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What Is Porter’s Diamond Of Competitive Advantage?

Determinants of National Competitive Advantage: Porter’s Diamond

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Source: Reprinted by permission of Harvard Business Review. Exhibit from “The Competitive Advantage of Nations,” by Michael E. Porter, March-April 1990, p. 77. Copyright 1990 by the Harvard Business School Publishing Corporation; all rights reserved.

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Does Porter’s Theory Hold?

Government policy can
affect demand through product standards
influence rivalry through regulation and antitrust laws
impact the availability of highly educated workers and advanced transportation infrastructure.
The four attributes, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage
So far, Porter’s theory has not been sufficiently tested to know how well it holds up
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LO 4: Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

Porter’s theory should predict the pattern of international trade that we observe in the real world.

Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable.

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What Are The Implications Of Trade Theory For Managers?

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

firms that do not may be at a competitive disadvantage
First-mover implications - a first-mover advantage can help a firm dominate global trade in that product

Policy implications - firms should work to encourage governmental policies that support free trade

want policies that have a favorable impact on each component of the diamond
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LO 5: Understand the important implications that international trade theory holds for business practice.

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What Is The
Balance Of Payments?

A country’s balance-of-payments accounts keep track of the payments to and receipts from other countries for a particular time period
double entry bookkeeping
sum of the current account balance, the capital account and the financial account should be zero
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In the United States, the current account deficit has been growing because of its imports of physical products, but the country runs a current account surplus in trade in services.

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What Is The
Balance Of Payments?

There are three main accounts
The current account records transactions of goods, services, and income, receipts and payments

current account deficit - a country imports more than it exports
current account surplus – a country exports more than it imports
The capital account records one time changes in the stock of assets

The financial account records transactions that involve the purchase or sale of assets

net change in U.S. assets owned abroad
foreign owned assets in the U.S.
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In the United States, the current account deficit has been growing because of its imports of physical products, but the country runs a current account surplus in trade in services.

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What Is The
Balance Of Payments?

United States Balance-of-Payments Accounts, 2011

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Source: Bureau of Economic Analysis

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Is A Current
Account Deficit Bad?

Question: Does current account deficit in the United States matter?
A current account deficit implies a net debtor
so, a persistent deficit could limit future economic growth
But, even though capital is flowing out of the U.S. as payments to foreigners, much of it flows back in as investments in assets
Yet, suppose foreigners stop buying U.S. assets and sell their dollars for another currency
a dollar crisis could occur
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A deficit on the current account is financed by a surplus on the financial account– in other words, by selling assets to other countries. Therefore, a persistent current account deficit raises concerns that resources are being drained from the country, which limits the ability to invest within the country.

*

*

*

*

LO 1: Understand why nations trade with each other.

The Opening Case: Creating the World’s Biggest Free Trade Zone illustrates the benefits of free trade and globalization. President Obama has committed the United States to negotiating a free trade deal with the European Union. The announcement was greeted with enthusiasm that can be traced to widespread acceptance of the key axiom of international trade—trade is good for all countries involved in a free trade agreement.

*

*

Country Focus: Is China a Neo-Mercantilist Nation analyzes claims that China is a neo-mercantilist nation. Exports are largely responsible for China’s recent rapid economic growth. The country, capitalizing on its cheap labor force, has been focused on converting raw materials into products that are exported to developing countries like the United States. China’s trade surplus has started to contract [partly as a result of allowing the Chinese currency (the yuan) to appreciate against the US dollar] as export growth has slowed and imports have increased.

*

LO 2: Summarize the different theories explaining trade flows between nations.

Mercantilism suggests that countries should design policies that lead to an increase in their holdings of gold and silver.

This was usually done by increasing exports and limiting imports. This economic philosophy was used by Europeans from about the 1500s to the late 1700s. It fueled colonialism in Britain, France, the Netherlands and Spain.

Nations increase their wealth by maintaining trade surpluses.

The key problem with the mercantilist view is that it views trade as a zero sum game, where if one country benefits the other must lose. As an economic philosophy, mercantilism is flawed.

Yet many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade.

*

LO 2: Summarize the different theories explaining trade flows between nations.

In 1776, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game and argued that countries differ in their ability to produce goods efficiently, and that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it.

According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries.

*

*

*

*

*

*

LO 2: Summarize the different theories explaining trade flows between nations.

*

*

*

*

*

*

LO 3: Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare if countries that participate in a free trade system.

The simple example of comparative advantage presented in the text makes a number of assumptions: only two countries and two goods; zero transportation costs; similar prices and values; resources are mobile between goods within countries, but not across countries; constant returns to scale; fixed stocks of resources; and no effects on income distribution within countries. While these are all unrealistic, the general proposition that countries will produce and export those goods that they are the most efficient at producing has been shown to be quite valid.

*

Country Focus: Moving U.S. White-Collar Jobs Offshore goes to the heart of a debate that has been played out many times over the past half century—the transference of jobs from the United States to lower-wage countries. The difference now however, is that rather than blue-collar jobs being transferred, the new trend is for white-collar jobs to move, jobs associated with the knowledge-based economy.

*

LO 2: Summarize the different theories explaining trade flows between nations.

Basic factors:

Natural resources

Climate

Geographic location

Demographics

While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success.

Advanced factors:

The result of investment by people, companies, and government are more likely to lead to competitive advantage. If a country has no basic factors, it must invest in advanced factors.

*

*

*

LO 2: Summarize the different theories explaining trade flows between nations.

*

*

*

*

Source: Adapted from Raymond Vernon and Louis T. Wells, The Economic Environment of International Business, 5th edition © 1991. Reproduced by permission of Pearson Education, Inc., Upper Saddle River, New Jersey.

*

*

*

LO 2: Summarize the different theories explaining trade flows between nations.

*

LO 3: Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare if countries that participate in a free trade system.

*

*

*

LO 2: Summarize the different theories explaining trade flows between nations.

*

*

*

Source: Reprinted by permission of Harvard Business Review. Exhibit from “The Competitive Advantage of Nations,” by Michael E. Porter, March-April 1990, p. 77. Copyright 1990 by the Harvard Business School Publishing Corporation; all rights reserved.

*

LO 4: Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

Porter’s theory should predict the pattern of international trade that we observe in the real world.

Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable.

*

LO 5: Understand the important implications that international trade theory holds for business practice.

*

In the United States, the current account deficit has been growing because of its imports of physical products, but the country runs a current account surplus in trade in services.

*

In the United States, the current account deficit has been growing because of its imports of physical products, but the country runs a current account surplus in trade in services.