CHAPTER 6 INTERNATIONAL TRADE THEORY 1 OVERVIEW OF TRADE THEORY Concept of Free Trade a situation where the government does not attempt to influence through quotas and duties what can be bought and sold from another country or what be produced for sale to another country Benefits of Trade Theories of Smith Ricardo and Hecksher Olin identify the specific benefits of trade These theories go beyond common sense of why trade is beneficial Basic view of such theories gains rise because international trade allows a country to specialize in the manufacture and exports of products that can be produced most efficiently in a country while importing products that can be produced more efficiently in other countries Why does Switzerland export chemicals pharmaceuticals and watches Why does Japan export automobile consumer electronics and machine tools Pattern of International Trade New Trade Theory a reflection of the ability of a country to capture first mover advantages which is to say A form of competitive advantage that a company earns by being the first to enter a specific market or industry Being the first allows a company to acquire superior brand recognition and customer loyalty The company also has more time to perfect its product or service rather than factor endowments Amount of labor land money and entrepreneurship that could be exploited for manufacture within a country Trade Theory and Governmental Policy Various trade theories lack agreement as to the extent to which government should be involved in shaping a countries trade policy Mercantilism makes a crude case for government for promoting exports and limiting imports Theories of unrestricted free trade Smith Ricardo and Hecksher Olin argue against import controls and export incentives as self defeating and a waste of resources New Trade Theory national competitive advantage requires selective government intervention to support export industries first theory historically in international trade emerged 16th century England espoused the principle that it is in a country s best interest to maintain a trade surplus to export more than it imports in doing so a country would accumulate god and silver and consequently increase its wealth prestige and power tariffs and quotas on imports subsidized exports doctrine advocated governmental intervention to achieve surplus by intervening in the trade process to maximize trade exports and minimize trade imports theory flawed viewed as a zero sum game in which one country s gain is another country s loss economists such as Adam Smith Wealth of Nations 1776 and David Ricardo Principles of Political Economy and Taxation 1817 saw shortsightedness of 1 2 MERCANTILISM Neo Mercantilists equate political power with economic power mercantilism theory and argued that the approach should be a positive sum game under which all countries not just one could benefit China in recent years has taken deliberate steps to keep its currency value low is a policy regime that encourages exports discourages imports controls capital movement and centralizes currency decisions in the hands of a central government The objective of neo mercantilist policies is to increase the level of foreign reserves held by the government allowing more effective monetary policy and fiscal policy Modern Example China Read Country Focus of China in textbook by centralized monetary policy against the U S dollar in order to sell more goods to the U S and other developed nations creating a trade surplus and foreign exchange reserves By selling its own currency and buying up foreign reserves like the U S dollar China has essentially pegged the yuan s value to the dollar instead of allowing it to move freely in foreign exchange markets using cheap labor to produce products that are exported China s trade surplus exports exceeding imports in 2008 was 280 Billion but dropped to 115 Billion in 2011 and had foreign exchange reserves of 1 95 Trillion 70 of which was USD China has opted for a substitution import policy by producing domestically products that it once imported i e steel and paper 3 4 ABSOLUTE ADVANAGE Adam Smith 1776 Wealth of Nations attached the zero sum game theory and advocated the theory of absolute advantage when countries should specialize in producing and exporting goods it can produce most efficiently and to buy goods it produces less efficiently Flaw what if a country has an absolute advantage with more than one product also does this theory dampen trade relationships between companies of two or more county one way street COMPATATIVE ADVANTAGE David Ricardo Principles of Political Economy 1817 argued that a country should specialize in the production of goods it produces most efficiently while buying goods that it produces less efficiently The ability of a firm or individual to produce goods and or services at a lower opportunity cost than other firms or individuals A comparative advantage gives a company the ability to sell goods and services at a lower price than its competitors and realize stronger sales margins Gains From Trade It is important to note that a comparative advantage is not the same as an absolute advantage The latter implies that one is the best at something while the former relates more to the costs of the particular endeavor The theory of comparative advantage argues trade should be a positive sum game in which all parties benefit from free trade and not just one party Qualifications and Assumptions assumes there are only two countries and two goods unrealistic in the real world assumes no transportation costs between countries unrealistic in the real world assumes resources can move freely unrealistic in the real world assumes constant returns to scale unrealistic in the real world assumes each country has a fixed stock of resources unrealistic in the real world assumes there are no effects of trade on income distribution within a country unrealistic in the real world Immobile Resources Resources do not always move freely from one activity to another 2 Diminishing Returns assumes constant returns to specialization diminishing returns are more realistic not all resources of the same quality gains from specialization may be exhausted before specialization is complete Dynamic Effects and Economic Growth trade might increase resources that become available from trading abroad free trade might increase efficiency Samuelson Critique ability to off shore service jobs that were not traditionally