Chapter ObjectivesI. The Age of MercantilismCHAPTER 5THE THEORY OF TRADE AND INVESTMENTChapter Objectives- To understand the traditional arguments of how and why international trade improves the welfare of allcountries- To review the history and compare the implications of trade theory from the original work of Adam Smith tothe contemporary theories of Michael Porter- To examine the criticisms of classical trade theory and examine alternative viewpoints of which business andeconomic forces determine trade patterns between countries- To explore the similarities and distinctions between international trade and international investmentOpening VignetteGlobal Outsourcing: Comparative Advantage TodaySummary:This vignette gives an update on the theory of comparative advantage. That theory explains why countries are most suitable for exports of goods and services. The update indicates here is that the source of a nation’s comparative advantage comes from the mixture of its own labor skills, access to capital, and technology. The advantages today are based more on services and their cross-border facilitation by telecommunications and the Internet. So global outsourcing creates a comparative advantage in intellectualskills.Chapter OutlineI. THE AGE OF MERCANTILISMA. Collapse of feudal society which met all of its needs internallyB. Mercantilism developed to help nations become wealthy and spread their influenceC. The Industrial Revolution ended the exploitation of colonies and trading partnersII. Classical Trade Theory (Figure 5.1, page 152 provides an excellent overview)A. The Theory of Absolute Advantage1. Developed by Adam Smith2. Each country should specialize in the production and export of that good which it produces most efficiently (with the fewest man-hours)3. This theory extended work specialization to specialization of a nationB. The Theory of Comparative Advantage1. Developed by David Ricardo2. Even if a country were most efficient in the production of two products, it should specialize in the production and export of the product that it is relatively more efficient in and import the other product3. Nations could improve the welfare of their populations through international tradeIII. Factor Proportions Trade TheoryA. Developed by Heckscher and OhlinB. A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive)C. The Leontief Paradox—the finding that the United States was actually exporting products that were relatively labor intensive contradicting the Factor Proportions TheoryD. Linder’s Overlapping Product Ranges Theory1. The type, complexity, and diversity of product demands of a country increase as the country’s income increases2. International trade patterns would follow this principle, so that countries of similar income per capital levels will trade most intensively having overlapping product demandsIV. International Investment and Product Cycle TheoryA. Product Cycle Theory1. Developed by Raymond Vernon2. The country that possess comparative advantage in the production and export of an individual product changes over time as the technology of the product’s manufacture matures3. Stages of the Product Cyclea. Stage I: The New Productb. Stage II: The Maturing Productc. Stage III: The Standardized ProductFocus on PoliticsWhen the Numbers Don’t Add UpSummary:This vignette points out that international trade statistics between countries often do not match. The U.S. Department of Commerce studied this issue and determined that one reason for the discrepancy is geographic coverage definitions. For example, The U.s. considers Puerto Rico and the U.S. Virgin Islands as part of the United States and Mexico regards them as separate countries. Another problem is partner country attribution where the import entry form allows for the reporting of only a single country of origin and the product may have been made in more than one country.V. The New Trade Theory: Strategic TradeA. Imperfect Markets and Strategic Trade by Paul Krugman1. Theories that explain changing trade patterns based on the imperfection of both factor markets and product marketsa. Economies of Scale and Imperfect Competition1) Internal Economies of Scalei. When the cost per unit of output depends on the size of an individual firm, the larger the firm the greater the scale benefits, and the lower the cost per unitii. A firm could then monopolize an industry and create an imperfect market2) External Economies of Scalei. A country can dominate world markets if its industry can gain economies of scaleii. The industry can then maintain its dominance in the world marketb. Strategic Trade1) Price—a government can impose tariffs to offset the monopolistic power of a foreign firm2) Cost—governments protect the market from foreign competition to allow domestic firms to grow and gain economies of scale3) Repetition—government protection until the firm learns (through repetition) how to produce the product more efficiently4) Externalities—government protects and nourishes an industry where it believes future growth can be achievedB. The Competitive Advantage of Nations by Michael Porter1. A nation’s competitiveness depends on the capacity of its industry to innovate and upgrade2. Companies gain competitive advantage because of pressure and challenge3. Companies benefit from having strong domestic rivals, aggressive home-based suppliers, and demanding local customers4. Competitive advantage is also established through geographic “clusters” or concentrations of companies in different parts of the same industryVI. The Theory of International InvestmentA. The Foreign Direct Investment Decision1. Whether to exploit competitive advantage in new foreign markets or in the domestic market?2. Should the firm produce at home and export or produce abroad?3. Should the firm license production or try to control its assets abroad?4. Should the firm use a joint venture or a wholly owned affiliate?5. Should the firm acquire an existing foreign enterprise or build “from the ground up” (greenfield investment)?B. The Theory of Foreign Direct Investment (the eclectic paradigm)1. Firms as Seekersa. Seeking resourcesb. Seeking factor advantages (such as low cost labor)c. Seeking knowledged. Seeking securitye. Seeking markets2. Firms as Exploiters of Imperfectionsa.