International Trade Structure

In this lecture, we will turn to international trade structure. After this lecture, you should be able to understand the different theories of trade, FDI determinants, and the workings of the EU’s custom union.

What you will learn

This introductory lecture to international trade provides a thorough view of what economists know about classical trade theories, firm-based theories, the early theories of Foreign Direct Investment, the OLI paradigm, international trade restrictions, preferential trading and the European Union.

International trade functions in much the same way as individual trade, except that the trade normally occurs with firms and, by definition, between different countries. Firms import goods from other countries and sell them for wholesale to retailers or brokers, who in turn sell them to consumers in stores or online. Trade surpluses or deficits are aggregate measure of individual firms’ exports less imports, either in total or to a specific country.

Arguments for trade

•The theory of comparative advantage - discussed in detail below

•Greater quality in factors prices - For example, the demand for labour will rise in labour-intensive countries like India if they specialize in labour intensive-goods. This will push up wage rates in these low-wage countries, thereby helping close the wage gaps between them and the developed world.

•Increased competition - competition from imports may stimulate greater efficiency at home. It may stimulate greater research and development.

•Decreasing costs - both countries benefit from specializing in industries where economics of scale can be gained.

•Export-led growth -   In a growing world economy, the demand for a country’s exports is likely to grow. This stimulates growth in exporting countries.

Most economists have argued that freer trade best promotes state interests, although rent seekers prefer protectionist policies that inhibit true free trade so that they can gain at the expense of others. Nevertheless, since states are comprised of people that act to maximize their aggregate economic utility, global welfare is best achieved by free trade.

Theories of trade

Classical trade theories

  • Mercantilism: Dating from the Sixteenth Century, mercantilism states that a country’s wealth is determined by the amount of gold and silver it holds. Therefore, a country should increase its holdings by promoting exports and discouraging imports, thus avoiding trade deficits—a situation where the value of imports is greater than the value of exports.
  • Absolute Advantage: Adam Smith questioned mercantilism in his famous book, An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Absolute advantage highlights the ability of one country to produce a good more efficiently than another. Moreover, Smith argued that trade between countries should not be regulated by government intervention, but rather should flow naturally according to market forces.
  • Comparative advantage: Smith’s theory proved too simplistic and thus gave way to comparative advantage, where some countries may be better than others at producing more than one good and, therefore, have a comparative advantage in many industries. In contrast, some countries may not have any useful absolute advantages. Accordingly, Englishman David Ricardo introduced the theory of comparative advantage in 1817, arguing that trade and specialization between countries could still occur even though one did not have any production advantages over the other, so long as that country can produce a product better and more efficiently than it does other goods. Comparative advantage focuses on relative productivity differences, while absolute advantage looks at absolute productivity.

A country (i.e., its firms) will specialize in doing what it does relatively better—the thing that it can make the most profit doing. For example, even if firms in Switzerland can make watches and shoes better than those Malaysia, it makes sense for Switzerland to only make watches—if the profit from doing so is higher than dividing resources and producing both things—and simply buy its shoes from Malaysia.

  • Hecker-Ohlin theory of international trade: Elaborating on Ricardo’s theory, two Swedish economists, Eli Heckscher and Bertil Ohlin, showed that countries gain a comparative advantage by producing products that utilize factors that are in abundance within its territory. Their theory stated that countries would produce and export goods that required resources or factors that were in great supply and, therefore, had cheaper production factors. In contrast, countries would import goods that required resources that were in short supply, along with higher demand. However, this theory has not been completely satisfactory. Russian-born (but American) economist Wassily Leontief studied the 1950s United States economy with relation to international trade and noted that while it was abundant in capital—and should therefore export more capital-intensive goods—the exact opposite was true. His findings were the reverse of what the factor proportions theory would have predicted.

Firm-based trade theories

  • Country similarity: Steffan Linder hypothesized that intra-industry trade resulted because consumers in countries with a similar stage of development would, perhaps, have similar preferences. Accordingly, companies produce for domestic consumption first, then look for markets that look similar to their domestic one, in terms of customer preferences, to begin export operations.
  • Product life cycle theory: The life cycle has three distinct stages: (1) new product, (2) maturing product, and (3) standardized product. Since the theory assumed that production of the line occurred wholly in the country of innovation, it was a useful theory to explain the manufacturing success of the United States—globally dominant after World War II—and later on with the development of personal computer and cell phone technologies. Nevertheless, the theory has been less successful in explaining more recent trade patterns that feature global innovation and manufacturing.
  • Global strategic rivalry theory: Strategic rivalry theory was presented in the 1980s by American economists Paul Krugman and Kelvin Lancaster. The focus was on how multinational firms sought to gain a competitive advantage in the global marketplace. When firms encounter global competition, they must quickly develop competitive advantages.
  • National competitive advantage theory: This theory states competitiveness in an industry, depends on its ability to innovate and upgrade, focusing on why some countries are more competitive in certain industries than others. It identified four linked determinants: (1) local market resources and capabilities, (2) local market demand conditions, (3) local suppliers and complementary industries and (4) local firm characteristics.

Foreign Direct Investment (FDI) Theories

Definition: FDI is when a firm from one country sets up an operation in another country. It usually involves the transfer of ownership, technology, and movement of labour.

Companies invest in foreign countries as part of their pursuit to maximise profits. Traditionally, theories have emphasized infrastructure, labor costs and property rights as the key determinants of foreign direct investment (Biswas 2002). The earliest models suggested that available interest rates on capital were the prime determining factors, where firms invested in foreign countries simply to obtain higher returns than were possible at home. Later, larger macroeconomic factors (e.g., exchange rates) affecting the strategies of transnational corporations were brought into view. These early theories were based on models of perfect competition.

  • A gravity model is used to explain bilateral flows of foreign direct investment and trade between two countries mainly based on the comparison of distance and GDP (Fillippini and Molini, 2003).

Internationalization theory: some market imperfections result in “internalization,” where subsidiary outputs are used as inputs in another arm of the multinational corporation, or where technologies are shared (Buckley & Casson 1976). Accordingly, where ownership of assets in a foreign country is desirable along with its location advantages (e.g., less uncertainty, better company control, and superior ability to negotiate locally without divulging too much information), and internalization is possible, then firms will engage in foreign direct investment and produce abroad (Dunning 1993). Otherwise, without internalization, the firm will be better off just licensing its ownership advantage to foreign firms.

The “vertical” reason for foreign direct investment is lower labor costs for unskilled workers to handle labor-intensive production (Blonigen & Piger 2014), which is a key incentive for any foreign direct investment. This reason remains one of the most important attractions to firms looking to cut production costs and maximize profits.

The OLI/Eclectic Paradigm: Dunning (2000) contended that the existing hypotheses of international production were not satisfactory. The OLI framework can be used to anticipate the production undertaken by MNE's and financed by FDI. As stated by the paradigm, a firm engages in FDI if the following conditions are satisfied:

1) it possesses net Ownership - these are favourable circumstances that emerge from the FDI seeking firms which may arise from entrepreneurship skills, privilege ownership (trademark) of a product, production technique and high returns to scale.

2)The Location advantages - this is the degree to which MNEs choose to locate these value-adding activities outside their own country. These advantages include trade agreements (special tariffs or taxes), low wages and the presence of raw materials.

3)Internationalisation preferences - If it is beneficial to internalise as opposed to utilizing the market to transfer those advantages through a partnership, then a firm will engage in foreign production itself.

Arguments favouring trade restrictions:

  • Infant industry argument - An infant industry is an industry in its early stages and without protection, it will not survive competition from abroad.
  • To prevent dumping and other and unfair trade practices.
  • To prevent establishment of a foreign based monopoly.

Trade restrictions reduce general consumer satisfaction and wealth by reducing the variety of available goods and/or pushing up their prices, leaving consumers with less disposable income and, thus, fewer opportunities to purchase other goods. Particular consumers—the relatively few workers and stakeholders in protected industries—experience the opposite effect. They benefit from maintaining higher wages and profits that increase their ability to consume, at the expense of consumers generally.

Free trade agreements

There are other political pacts such as the European Union, NAFTA in North America and Mercosur in much of South America that attempt to make free trade possible within certain geographical zones. Nevertheless, the entire zone still has protectionist and other regulated trade policies with countries outside the zone—often including very high tariffs. These blocs sometimes will assail countries that have economic, military or social practices repugnant to the zone’s countries by curtailing trade with the offending country. Thus, regional agreements (political projects) that harm consumer welfare are at times utilized to implement unrelated political agendas.

Preferential trading

The European Union is the world’s best-known example of a commons market and customs union. Mercosur in South America is another example. Such groups are formed by countries with geographical proximity. The objective is to promote duty free (or close to duty free) trade, free movement of labor, free movement of capital, and eliminate trade barriers to new entrants among and between member countries. The group also imposes a common external tariff on imports from non-member countries.

Preferential international trade pacts provide advantages to firms located within its member states. Typically, tariffs on certain goods are reduced but not always eradicated. The goal is to achieve a higher level of economic integration. Importantly, these programmes are designed to consolidate state power, rather than improve consumer welfare, as a primary objective. In the case of a common market and customs unions, consumers are better off than they would be living under protectionism in their own country alone because there is still some genuine free trade between certain countries. Obviously, the larger the union, the better-off consumers will be. However, there will always be some loss to consumer welfare since not all desired products will be available in (or produced by) member countries, meaning that consumers will have to pay far more for many sought after important goods.

The European Union

The European Union is principally a political and economic integration programme. Economists have argued that the benefits from currency and customs unions greatly exceed the costs (Breedon & Petursson 2006). As noted earlier, mutually-beneficial gains from trade are only assured when such trade is voluntary, a feature oftentimes absent in top-down, imposed European Union regulation and trade policy designed by bureaucrats rather than elected representatives. Indeed, researchers have found that its nearly-autocratic external trade policy is heavily bureaucratic, complex and almost entirely insulated from public opinion (Reichert & Jungblut 2007). Since its inception in 1957 (Treaty of Rome), and formal beginnings in 1993 (Maastricht Treaty), the European Union has been a growing political project designed to make the relatively smaller nations of Europe more competitive with larger competitors like the United States and China. The newest addition is Croatia (2013). In many respects, the European Union rapidly and radically changed the institutional arrangements that provided the “rules of the game” (North 1992) for European countries for centuries. Such shocks are usually costly and often laden with difficulties.

One objective has been to create an internal single market, with open borders and free movement of people. This last point was particularly troubling to voters in Great Britain, which elected to leave the European Union by referendum held on 23 June 2016. Moreover, economists have found that intra-national trade is still ten times higher (on average) than international trade—even within the European Union (Nitsch 2000). Thus, the internal single market has certainly experienced incomplete success.

Another important aspect of the European Union are its policies of economic integration through its common currency, the Euro. Countries that want to participate have to pass a stringent two-year test period where they demonstrate responsible monetary policy action. Not all member countries participate in the monetary union, e.g. Denmark, Sweden and the (soon-to-depart) United Kingdom, but the group that do form a part of the European Union called the Eurozone. This union, too, has been fraught with opportunistic behaviour on a national level, drawing significant criticism from some corners, which often call out Mediterranean countries for being fiscally irresponsible.

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