Module 3.

Modern Theories of International Trade

Introduction
After having learnt the classical trade theories in the previous unit, you will learn the
modern theories of international trade in this unit. The year 1993 witnessed two
landmark events in the recent history of international trade: the passage of the
North American Free Trade Agreement (NAFTA) by the US, Canada, and Mexico, and
the conclusion (although not yet ratification) of the seven-year “Uruguay Round” of
negotiations of the General Agreement on Tariffs and Trade (GATT). Despite general
consensus that these agreements would benefit the world economy in general and
MNEs in particular, passage of both agreements was preceded by acrimonious
debate in the media, by makers of public policy, and in academic realms. While
many CEOs and MNEs welcomed both NAFTA and GATT, many labour unions,
consumer groups, and environmentalists were strongly opposed to their passage.
This unit also looks at a phenomenon that has grown in both its application and its
intensity during the past decade, namely, “strategic trade,” and what drives
governments and industries to try to “manage” their trading relationships with
other countries
Human Capital Approach Theory
This theory, which is also sometimes known as Skills Theory of International Trade,
has been advocated by a number of economists, especially Becker, Kennen and
Kessing. Whereas the Factor Proportions Theory considers labour as a homogenous
factor, however, it is not so in the real world. In fact, for export of manufactured
goods, the skill level of labour is very important determinant. Labour can be
basically divided into skilled and unskilled labour. On the basis of empirical testing
Kessing concluded that patterns of international trade and location were
predetermined for a broad group of manufacturers by the relative abundance of
skilled and unskilled labour. For example, a developing country like India has more
abundant supply of unskilled labour will specialize and export those goods, which
are relatively, more intensive in unskilled labour. Imports, on the other hand, will
consist of those goods which are hi-tech or which is more skill intensive.
Identical Preferences Theory
This theory is based on the role of demand as an explanatory variable used by
Linder. A domestic industry can flourish and reach commercially optimal level of
production if the domestic demand is large enough. It is also found that countries at
similar levels of economic development have similar demand characteristics. It is,
therefore, postulated that trade opportunities are more among counties at similar
stage of development with similar demand structure.
Example: USA and Japan are highly industrialized; both have similar demand
characteristics viz. computers, software, air-conditioners, internet, fashion garments
etc. Firms in both the countries are highly export competitive because they have
already grown big by first catering to the domestic demand that is why the trade
between the USA and Japan is so substantial. This theory explains how an
industrialized country grows rapidly in its economic growth.
The theory also assumed that each country had as its objective full production
efficiency. It neglected such other motives as traditional employment and
production history, self-sufficiency or political objectives.
In addition, the theory is overly simplistic in that it deals only with two commodities
and two countries. In reality, given the full range of production by many countries
and interplay of many motives and factors, the trade situation is actually an
ongoing dynamic process in which there is interplay of forces and products. The
largest area of weakness in classical theory is that while we considered all resource
units used in production, the only costs considered by classical economists were
those associated with labour. The theorists did not account for other resources used
in the production of commodity or manufactured goods for export such as
transportation cost, the use of land, and capital. This failing was addressed by
subsequent trade theories, which in modern theories include all factors of
production in looking at theories of comparative advantage.
Strategic Trade Theory
With the dramatic growth in trade in the last few decades, and the growth in the
role of MNEs in international trade, there has been a resurgence of interest in taking
a fresh look at theories of international trade. In the last two decades, a new set of
models has come into being, using the perspectives of game theory and theories of
industrial organisation. While there is no one overarching model, this broad
collection of theories and ideas has come to be known as “strategic trade theories”.
In the process of doing so a fresh new set of insights relating to international trade
and trade policy has emerged. The essence of almost all the new models of trade is
the recognition that industries are characterized by any or all of the following
features: scale, economies (both dynamic and static), product differentiation,
imperfect competition, externalities and spillover and, in cases, irreversible
investments. Some of the main insights from this literature are as follows:
1. Increasing returns to scale provide a justification for trade for reasons other than
comparative advantage, since firms will have the incentive to produce and export in
order to lower costs by attaining greater scale economies; an example of a industry
where this is an important issue is the commercial airframes industry.
2. Product differentiation can result in intra industry trade, since, within the same
industry, the same product can have different brand identities; for example, the US
will export certain types of automobiles (Ford Escort) and it will import other types
of automobiles (BMWs).
3. Imperfect competition creates rents, and trade policy could shift rents from the
foreign country to the home country. For example, the imposition of quotas will
increase domestic prices and thus can create rents for foreign producers; the home-
country government may try to counterbalance it with a subsidy to domestic
producers, so as to put price pressure on foreign producers.
4. Externalities and spillover effects (particularly in innovation and R & D) may
sometimes provide a justification for industry protection for reasons other than
industry infancy or national security.
Example: If the process innovations commodity chip production can create
spillovers in the manufacture of specialized chips, then the government may have
an incentive to protect the manufacture of commodity chips.
5. Irreversible investments induce an asymmetry between entry and exit costs, and
can therefore lead to “hysteretic” responses to price or quantity shifts.
Example: Firms in the US earth-moving equipment industry (like the Caterpillar
Tractor Company) lost substantial market share in the early 1980 when the US dollar
appreciated 35% in real terms against the Japanese yen. Yen firms could not exit
markets because the costs of reentry (like, rebuilding distribution networks) would
be prohibitive. Thus, they had to stay on many markets despite the fact that they
were incurring losses.
As with conventional trade models, models of imperfect competition in international
trade predict an increase in domestic producer surplus (and a decrease in domestic
consumer surplus) as a result of price or quantity restrictions. However, the
literature is eclectic on the impact of protection on foreign producer surplus. We
may argue, for instance, that when domestic and foreign goods are substitutes,
both price and quantity restrictions should, in general, increase the welfare of
foreign producers. The reasoning is that trade restraints alter the nature of
interaction between firms in a collusive directions, and thereby raise equilibrium
prices and profits for all firms – that is, trade restrictions result in a collusion that
the firms themselves were not able to achieve, since they impede the ability of
firms to compete effectively.
The insights developed in the literature on strategic trade have been quite
influential in shaping the evolution and application of US trade laws against its
foreign competitors, particularly during the 1980s. Policymakers, increasingly use
these arguments to justify imposition of barriers to international trade. However,
GATT has also come to grips with many of these insights, and the Uruguay round
concluded in 1994 marks a significant step in multilateral attempts to combat many
of these incentives to imposition of trade barriers.
Modern Investment Theory
Other theories explain investing overseas by firms, as a response to the availability
of opportunities not shared by their competitors, that is, to take advantage of
imperfections in markets and only enter foreign spheres of production when their
comparative advantages outweigh the costs of going overseas. These advantages
may be production, brand awareness, product identification, economies of scale, or
access to favourable capital markets. These firms may make horizontal
investments, producing the same goods abroad as they do at home, or they make
vertical investments, in order to take advantage of sources of supplies or inputs.
Going a step further, some believe that firms within an oligopoly enter foreign
markets merely as a competitive response to the actions of an industry leader and
to equalize relative advantages. Oligopolies are those market situations in which
there are few sellers of a product that is usually mass merchandised.
Example: In oligopolistic situations, no firm can profit by cutting prices because
competitors quickly respond in kind. Consequently, prices for oligopolistic products
are practically identical, and are set through industry agreement (either openly or
tacitly).
Thus, firms within an oligopoly must be keenly aware of the actions, market reach,
and activities of their competitors. Unless their response to the actions of
competitors is following the leader, they will yield precious competitive edges to
their competitors. Therefore, it follows that when a market leader in an oligopoly
establishes a foreign production facility abroad, its competitors rush to follow suit.
Thus, the impetus for a firm to go abroad may come from a wish to expand for
internal reasons to use existing competitive advantages in additional spheres of
operations, to take advantage of technology, or to use raw materials available in
other locations. Alternatively, the motive might arise from external forces, such as
competitive actions, customer requests or government incentives. The final
determinant however, is based in a cost benefit analysis. The firm will move abroad
if it can use its own particular advantages to provide benefits that outweigh the
costs of exporting or production abroad and provide a profit.
International Product Life Cycle Theory
The international product life cycle theory puts forth a different explanation for the
fundamental motivations for trade between and among nations. It relies primarily
on the traditional marketing theory regarding the development progress, and life
span of products in markets. This theory looks at the potential export possibilities of
a product in four discrete stages in its life cycle.
Caution: The international product life cycle theory has been found to hold
primarily for such products as consumer durables, synthetic fabrics, and electronic
equipment, that is, those products that have long lives in terms of the time span
from innovation to eventual high consumer demand. The theory does not hold for
products with a rapid time span of innovation, development, and obsolescence.
The theory holds less often these days because of the growth of multinational global
enterprises that often introduce products simultaneously in several markets of the
world. Similarly, multinational firms no longer necessarily first introduce a product
at home. Instead, they might launch an innovation from a foreign source in the
domestic markets to test production methods and the market itself, without
incurring the high initial production costs of domestic environment.
According to these theories, the commodity composition of trade can explained in
terms of relative research efforts and the consequent technological gaps between
the trading partners. A number of economists especially Vernon has contributed to
the development of this theory. It is argued that the industrialized countries commit
more resources to research and development efforts and as a result develop new
products. In the initial stage of manufacture these countries will be monopolists and
will enjoy easy access to foreign market. This can explain the trade between the
developed and the developing countries as well as trade among the industrialized
countries themselves. Subsequently, a process of limitation will start and other
countries will start manufacturing the same product. The initial comparative
advantage will then disappear and the manufacturing centres can move from the
developed to the developing countries, which have low labour cost. Many
developing countries like India have turned into exporters of textiles being low
labour intensity skills from being net importers some years ago.
The international product life cycle theory puts forth a different explanation for the
fundamental motivations for trade between and among nations. It relies primarily
on the traditional marketing theory regarding the development, progress and life
span of products in market.
The international product life cycle (IPLC) theory developed and verified by
economists to explain trade in a context of comparative advantage describes the
diffusion process of an innovation across national boundaries. The life cycle begins
when a developed country having a new product to satisfy consumer needs wants
to exploit its technological breakthrough by selling abroad. Other advanced nations
soon start up their own production facilities and before long LDCs do the same?
Efficiency/comparative advantage shifts from developed countries to the developing
nations. Finally, advanced nations that are no longer cost-effective, import products
from their former customers. IPLC theory has the potential to be a valuable
framework for marketing planning on a multinational basis.
Stages and Characteristics
There are five distinctive stages in IPLC. The Table 3.1 shows the major
characteristics of the IPLC stages with the US as the developer of the innovation in
question. The Figure 3.1 shows that three life cycle curves for the same innovation:
one for the initiating country (US), one for other advanced nations and one for LDCs.
For each curve net export results when the curve is above the horizontal line; if
under the horizontal line net import results for the particular country. As the
innovation moves through times, directions of all three curves change. Time is
relative because the time needed for cycle to be completed varies from one kind of
product to another. In addition, the time interval also varies from one stage to the
next.
Stage 0 – Local Innovation: Stage 0 depicted as time 0 on the left of the vertical
importing/ exporting axis, representing a regular and highly familiar product life
cycle in operation within its original market. Innovations are most likely to occur in
highly developed countries because consumers in such countries are affluent and
have relatively unlimited want. From the supply side, the firms in advanced nations
have both the technological know-how and abundant capital to develop new
products.
Stage 1 – Overseas Innovation: As soon as the new product is well developed, its
original market well cultivated, and local demand adequately supplied, the
innovating firm will look to overseas market in order to expand its sales and profits.
Thus this stage is known as “Pioneering or International Introduction” stage. The
technological gap is first noticed in other advanced nations because of their similar
needs and high-income levels.
Countries with similar cultures and economic conditions are often perceived by the
exporters as posing less risk and thus are approached first before proceeding to less
familiar territory.

Competition in this stage usually comes from US firms, since firms in other countries
may not have much knowledge about the innovation. Production cost tends to be
decreasing at this stage because by this time the innovating firm will normally have
improved the production process. Supported by overseas sales aggregate
production costs tend to decline further because of increased economies of scale. A
low introductory price is usually not necessary because of the technological
breakthrough; a low price is not desirable because of the heavy and costly
marketing effort needed in order to educate consumers in other countries about the
new product.
Stage 2 – Maturity: Growing demand in advanced nations provides an impetus for
firms there to commit themselves to starting local production, often with the help of
their governments’ protective measures to preserve infant industries. Thus, these
firms can survive and thrive in spite of the relative inefficiency.
Development of the competition does not mean that the initiating country’s export
level will immediately suffer. The innovating firms’ sales and export volumes are
kept stable because LDCs are now beginning to generate a need for the product.
Introduction about the product in LDCs helps offset any reduction in export sales to
advanced countries.
Stage 3 – Worldwide Imitation: This stage means tough times for the innovating
nations because of its continuous decline in exports. There is no more new demand
anywhere to cultivate. The decline will inevitably affect the US innovating firms’
economies of scale and its production costs thus begin to rise again. Consequently,
firms in other advanced nations use their lower prices (coupled with product
differentiation techniques) to gain more consumer acceptance abroad at the
expense of the US firm. As the product becomes more and more widely
disseminated, imitation picks up at a faster pace. Towards the end of this stage US
export dwindles almost to nothing and any US production still remaining is basically
for local consumption.
Example: The US automobile industry is a good example of this phenomenon.
There are about 30 different companies selling cars in United States with several on
the rise. Of these, only three are US firms with the rest being from Western Europe,
Japan, South Korea, Taiwan, Mexico, Brazil and Malaysia.
Stage 4 – Reversal: Not only must all good things end, but misfortune frequently
accompanies the end of a favourable situation. The major functional characteristics
of this stage are product standardisation and comparative disadvantage. The
innovating country’s comparative advantage has disappeared, and what is left is
comparative disadvantage. This disadvantage is brought about because the product
is no longer capital-intensive or technology-intensive but instead has become labour
intensive – a strong advantage possessed by LDCs. Thus, LDCs – the last innovators
– establish sufficient productive facilities to satisfy their own domestic needs as well
as to produce for the biggest market in the world, the United States.
The Validity
Several studies have investigated the validity of the classical trade theories. The
evidence collected by MacDougall shortly after the World War II showed that
comparative cost was useful in explaining trade patterns. Other studies using
different data and time periods have yielded results similar to MacDougall. There is,
thus, a support for the claim that relative labour productivity determines trade
patterns.
These positive results were later questioned. The studies conducted by Leontief
revealed that the United States actually exports labour intensive goods and imports
capital-intensive products. These paradoxical findings are now called Leontief
Paradox. Thus, the findings are ambiguous indicating that in its simplest form the
Heckscher-Ohlin Theory is not supported by evidence.
In theory, the more different two countries are the more they stand to gain by
trading with each other. There is no reason why a country should want to trade with
another that is a mirror image of itself.
Limitations
Trade Theories provide logical explanations about why nation trade with one
another but such theories are limited by their underlying assumptions. Most of the
world’s trade rules are based on traditional models that assume: (1) Trade is
Bilateral, (2) Trade involves products originating primarily in the exporting country,
(3) the exporting country has a comparative advantage and (4) competition
primarily focuses on the importing country’s market. However, today the reality is
quite different. Firstly, trade is a multilateral process. Secondly, trade is often based
on products assembled from components that are produced in various countries.
Thirdly, it is not easy to determine a country’s comparative advantage as evidenced
by the countries that often export and import the same product. Finally, competition
usually extends beyond the importing country to include the exporting country and
third countries.
In all fairness, virtually all theories acquire assumptions in order to provide a focus
for investigation while holding extraneous variables constant. But controlling the
effect of extraneous variables act to limit a theory’s practicality and generalisation.
One limitation of classical trade theory is that the factors of production are assumed
to remain constant for each country because of the assumed mobility of such
resources between countries. This assumption is especially true in case of land,
since physical transfer and ownership of land can only be complete by war or
purchase (US seizure of California from Mexico and purchase of Alaska from Russia).
At present, such means to gain land are less and less likely.
Labour, as a factor is relatively immobile. Immigration laws in most countries
severely limit the freedom of movement of labour between the countries. In China,
labour is not even able to select a city of their choice. Still labour moves across
borders. Western European nations allow their citizens to pass across borders rather
freely. For Asian countries, most of them are so well endowed with cheap and
abundant labour that such countries as South Korea, Thailand and India send labour
to work in Saudi Arabia and other developed countries.
Production factors are considered now more mobile than previously assumed but
their mobility is still considered restricted. As a result, production cost and product
prices are completely equalised across countries. The small amount of mobility that
does exist serves to narrow the price/cost differentials.
The most serious shortcoming of classical trade theory is that they ignore the
marketing aspect of trade. These theories are primarily concerned with commodities
rather than with manufactured goods or value-added products. It is assumed that all
suppliers have identical products with similar physical attributes and quality. This
habit of assuming product homogeneity is not likely to be made among that familiar
with marketing.

Reference:
International Business