DU int finance- trade theory

Slide 1: 

International Trade Theory

Theories of International Trade 1. Mercantilism: : 

Theories of International Trade 1. Mercantilism: The theory was introduced in mid-16th century in England. The main tenet of the theory was that it was in a country’s best interests to maintain a trade surplus by means of exporting more and importing less. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth and prestige. One of the implication of the theory is “beggar-thy-neighbor policy.” Adam Smith and all the Classical economists were critical about the theory.

Limitations of Mercantilism: : 

Limitations of Mercantilism: 2. According to Mercantilist trade is a zero sum game: trade makes one country gainer and one country loser. It has been proved later by Adam Smith and David Ricardo that trade can be a positive sum game; trade can benefit both the countries simultaneously. 1. Price-Specie flow mechanism by David Hume

Theories of International Trade 2. Opportunity Cost theory : 

Theories of International Trade 2. Opportunity Cost theory

2. Opportunity Cost theory (Contd.) : 

2. Opportunity Cost theory (Contd.)

2. Opportunity Cost theory (Contd.) : 

2. Opportunity Cost theory (Contd.) Gains from Trade of Bangladesh: Point I belongs to IC2. Before trade consumption was at C1 which belongs to IC1. Since IC2 is higher than IC1 so there is a gain from trade on the part of Bangladesh. Gains from Trade of USA: Point I belongs to IC2. Before trade consumption of USA was at C2 which belongs to IC1. Since IC2 is higher than IC1 so there is a gain from trade on the part of USA. Balance Budget: Notice that since there are only 2 countries under consideration so the export of Bangladesh is just equal to the import of USA. Similarly, the import of Bangladesh is just equal to the export of USA. Conclusion: The theory focuses on the gain from international trade. The theory proved that the earlier view of trade being a zero-sum game is not true as both countries of trade can be benefited from trade. A country would be gaining from international trade as long as it achieves a higher indifference curve. The theory also focuses on the determination of terms of trade (i.e., global price line). More importantly, the theory guides every country to take advantage of specialization in certain line of production.

Limitations of Opportunity cost theory : 

Limitations of Opportunity cost theory The assumption of perfect mobility of factors of production within the country and perfect immobility across countries is not true. The assumption of constant technology is invalid. This is truer for manufactured commodities than agricultural commodities. In consequence, developing countries continuously face deterioration in its terms of trade and developed countries continuously face advantages in terms of trade. Developed country protection on the import of agricultural commodity affects the developing country right to export the commodity having comparative advantage. (Detail in next slide) Developed country protection on the import of semi-processed and processed goods from developing countries affects the diversification of export lines of developing countries. (Ref: EU stand)

Limitations of Opportunity cost theory (Contd..) Agricultural subsidy : 

Limitations of Opportunity cost theory (Contd..) Agricultural subsidy Nature: Minimum price guaranteed for farmers of developed countries to protect them from low prices offered by developing countries Although the farmers are small in number but they are politically important. Politicians justify in preserving the tradition, heritage of rural life style The amount of financial support exceed $300 billion annually for farmers of rich nations. Example: EU provides cash subsidy for butter if the price is below euro 3,282 per ton. This amounts to $15b per year ($2 per day per cow). US cotton producers would receive at least $0.70 for every pound which needed a cash subsidy of $3.4 billion in 2001. Effects: Since prices are guaranteed, excess production takes place which is dumped in the global market affecting the export revenue of developing countries.

Agricultural subsidy (Contd..) : 

Agricultural subsidy (Contd..) UN observed that such loss of export revenue of developing countries is around $50 b which is equal to the developed country aid for developing countries. Oxfam puts 2 arguments for developed countries to withdraw subsidy: Price would have gone down for the consumers Huge tax revenue would have been saved which is used as subsidy Results: This is the issue that resulted in the collapse of GATT as developed countries were divided into 5 different block with regard to the issue of agricultural subsidy. The stalemate continued for more than 3 decades long.

3. Product Life–Cycle Theory : 

3. Product Life–Cycle Theory Reymond Vernon introduced this theory in the mid-1960s. The theory tells us how the location of production and consumption of different products change during the life-cycle of the product. The products include mass-produced automobiles, televisions, instant cameras, photocopiers, personal computers, and semi-conductor chips. Vernon observed that for most of the 20-th century a very large proportion of the world’s new products had been developed by US firms and sold first in the US market due to the wealth and size of the US market. Due to high labor cost in USA, the technology of production of these products was capital intensive technology. During the early cycle of product life these product were exported to other countries for limited number of consumers. Later cycle experienced production in other countries as well with almost similar kind of technology. In the matured cycle of product life developing countries took part in the production to export it back to developed countries. Thus, although USA introduced the product and during the initial cycle USA was an exporter of the product, but overtime other developed countries who were initially the importers of the product, starts exporting to USA. Later, when the product becomes standardized product, developing countries takes part in export as well.

4. The New Trade Theory : 

4. The New Trade Theory During 1970s most economists argued that the increasing cost or decreasing return assumption of traditional trade theories is questionable. Due to the economies of scale and learning effects there should be increasing return or decreasing costs for higher level of output. For example, the Boeing spent $5 billion to develop its Boeing 777 jetliner. If the variable cost of production for labor, equipment and parts equal $80 million per aircraft, then selling 100 units would make a cost of $130 million per aircraft and selling 500 would make a cost of $ 90 million. Thus, average cost falls significantly with increased volume of production. If learning effect is taken under consideration then variable cost further goes down to further reduce the average cost. Learning effect is more effective in cost reduction of complex manufacturing product than easy process. Taking both under consideration the Boeing can make $70 per unit for 500 units of production compared to $130 million per unit for 500 units of production.

4. Implication of new trade theory: : 

4. Implication of new trade theory: There is an important implication of the new trade theory. The world market is too small for too many large firms with significant large volume of production. The first mover takes the advantage so much that subsequent entrant finds it difficult to compete against the first movers. Thus Japan made a complementary role to Boeing and Airbus rather than competing with them. To facilitate the potential first mover, the respective government should come forward by extending different kinds of fiscal incentives and subsidies initially. This would increase the competitiveness of the respective firms and shift the marginal cost curve downward. The firm would be qualified to be the first mover. Once being the first mover, the firm would generate abnormal profit, the profit would be repatriated home contributing to (i) increased purchasing power of the country, (ii) increased donation for social welfare and (iii) increased tax compensating the subsidies allowed earlier. Thus the country would be far more benefited than the subsidies issued earlier.

FSC: Tax Break on Export : 

FSC: Tax Break on Export Introduction: Foreign Sales Corporation (FSC) introduced in USA in 1971 as an income tax break for US exporters. Sales should be channeled through shell companies, known as foreign sales corporation which are registered in offshore tax heaven like Bermuda. Beneficiaries: 6,000 US companies saved $3.5 b of income taxes in 1998. Boeing saved $130 million, General Electric saved $150m. In 1998, European Union filed complaint with WTO claiming that FSC is an illegal export subsidy that was in clear violation of WTO rules. US arguments: EU follows similar tax wavers on export (that EU claims commodity tax rather than income tax). There was a “Gentle man’s agreement” that the entity would not attack each other, which was broken. Internal matters of USA outside the jurisdiction of trade policy.

FSC: Tax Break on Export (Contd..) : 

FSC: Tax Break on Export (Contd..) WTO arbitration in 2000 agreed with EU that the tax break was illegal, and suggested USA to revise the tax code. In retaliation USA not only retained the tax break but also expanded the coverage costing the treasury $25 b to compensate the EU rebate of VAT on export. EU threatened USA to introduce punitive tariffs worth $4 billion on US export to the EU. This indicated an introduction of the biggest trade war of the world. In 2000, USA replaced it with a new system that offered up to $6 billion a year in tax breaks to large exporters such as Boeing and Microsoft. EU filed a brief with WTO seeking permission for $4 billion tariffs, and WTO finally gave the permission in 2002. Current status: EU did not impose the sanction, and USA indicated it would change the offending law.

5. Internalization Theory : 

5. Internalization Theory The market imperfection approach to FDI is typically referred to as internalization theory of international business. The perfect market assumption of earlier trade theories (like comparative advantage theory) is not commonly valid as there are many kinds of market imperfections available in the world. Internalization theory or imperfect market theory suggests that international business aims at capitalizing the market imperfections. It can be originated from: Impediments to exporting like import duty, quota, other barriers, etc. (Ref: Japanese auto companies in USA). Taking these impediments under consideration an international business makes direct foreign investment rather than export. Technological constraints may force the international business to make direct investment rather than export. Impediments to the sale and secret transfer of know-how. Technological know-how (like Nokia), production process (Toyota), marketing know-how (like Kellogg, Heinz), and management know-how make some companies highly profitable and that profit potential is more if they can capture bigger market. American RCA licensed its leading color TV technology to Japan, but Matsushita and Sony quickly assimilated RCA’s technology and used it to enter and capture the US market. Under the situation, it would have been wiser for RCA to make direct FDI, rather than issuing the license.