Chapter 5

The Theory of Trade

and Investment

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Global Outsourcing:
Comparative Advantage Today
Comparative advantage is still a relevant
theory to explain why particular countries
export more services that support the global
supply chain of both MNEs and domestic
firms.
The comparative advantage of the 21st
century, however, is based more on services
and their cross-border facilitation by
telecommunications and the Internet.
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Global Outsourcing:
Comparative Advantage Today
The source of a nation's comparative
advantage, however, is created from
the mixture of its own factors of
production:
labor skills,
access to capital,
land, and
technology.

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Global Outsourcing:
Comparative Advantage Today
For example, India has developed a highly
efficient and low-cost software industry.
This industry supplies not only the creation of
custom software, but also call centers for
customer support, and other information
technology services.
The Indian software industry is composed of
both subsidiaries of MNEs and independent
companies.
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Global Outsourcing:
Comparative Advantage Today - 1
If you own a HP computer and call the
customer support center number for help,
you are likely to reach a call center in India.
Dell recently changed from this practice.
Why? It’s cheaper than using US people.
Answering your call will be a knowledgeable
Indian software engineer or programmer who
will "walk" you through your problem.

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Global Outsourcing:
Comparative Advantage Today - 2
India has a large number of well-
educated, English-speaking, technical
experts who are paid only a fraction of
the salary and overhead earned by their
U.S. counterparts.
Why does India have a large number of
English-speaking people?

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Global Outsourcing:
Comparative Advantage Today
By the way, this large number of English-
speaking people will be the key to
India’s prosperity in the 21st century.
The overcapacity and low cost of
international telecommunication
networks today further enhances the
comparative advantage of an Indian
location.
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Global Outsourcing:
Comparative Advantage Today

The extent of global outsourcing is

already reaching out to every corner of
the globe.

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Global Outsourcing:
Comparative Advantage Today
From financial back-offices in Manila, to
information technology engineers in
Hungary, modern telecommunications
now take business activities to labor,
rather than labor migrating to the
places of business.

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Evolution of Trade Theory
The Age of Mercantilism
Classical Trade Theory
Factor Proportions Trade
Theory
International Investment
and Product Cycle Theory
The New Trade Theory:
Strategic Trade
The Theory of International
Investment
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 The Age of Mercantilism
See next slide.
The evolution of trade into the form
we see today reflects three events:
The Collapse of Feudal Society,
which met all its needs internally.

The Emergence of the Mercantilist Philosophy.

The Life Cycle of the Colonial Systems of the

European Nation-States.

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Mercantilism
Mixed exchange through
trade with accumulation of
wealth
Sell a lot; buy a little. Thus you
accumulate gold & silver.
What is wrong with this idea?
Business conducted under
authority of government
Demise of mercantilism
inevitable
Explain win-lose

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Classical Trade Theory
The Theory of Absolute Advantage
The ability of a country to produce a
product at lower cost (inputs) than another
country due to climate, soil, access to trade
routes, etc. (Ghana & chocolate)
The Theory of Comparative
Advantage
The idea that although a country may
produce both products more cheaply than
another country, it is relatively better at
producing one product than the other
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Classical Trade Theory Contributions
Adam Smith—Division of Labor
In the pre-industrialization society, each
worker preformed all stages of making a
product.
The factories of the industrialized age
were separating the production process
into distinct stages, which would be
performed by one individual – the
division of labor.
• Used lower-skilled, lower-cost labor.
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Classical Trade Theory Contributions

This specialization increased the

production of workers & industries.

Talk about Samuel Colt manufacturing

his pistols and how British gun smiths
objected to the colt methods being
transformed to GB.

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Classical Trade Theory Contributions
David Ricardo—Comparative
Advantage
Even if a country had an absolute
advantage in two or more products, it is
probably more efficient in one product than
the others.
So countries can benefit from trading
goods for which they have a comparative
advantage over the other.

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Classical Trade Theory Contributions

Gains From Trade

A nation can achieve greater consumption
levels beyond what it could produce by
itself (feudal system).
If the country trades products for which it
has a comparative advantage with another
country whose comparative advantage is in
a different product.

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Classical Trade Theory Contributions
France produces beer, wine, and cloth.
GB produces beer, a little wine, and cloth.
France has a comparative advantage in wine.
GB has a comparative advantage in beer and
cloth.
GB should drink French wine, and France should
drink British beer and use British cloth.
Thus British and French citizens get the best
goods at the cheapest price.

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Factor Proportions Trade Theory

Developed
Developedby
byEli
EliHeckscher
Heckscher

Expanded
Expandedby
byBertil
BertilOhlin
Ohlin

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 Factor Proportions Trade Theory
Considers Two Factors of Production

Labor

Capital
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 Factor Proportions Trade Theory
A country that is relatively labor
abundant (or capital abundant)
should specialize in the production
and export of that product which is
relatively labor intensive (or capital
intensive).
Examples?

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Factor Proportions Trade Theory
What are Factors of Production other
than capital and labor (supply)?

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Factor Proportions Trade Theory

Access to shipping ports;

Weather;
Available arable land for farming or
ranching.

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Factor Proportions Trade Theory
All these help explain why certain countries
export and import the goods and services
they sell and purchase.
For example:
Why does Saudi Arabia purchase food and sell oil?
Why does China purchase raw cotton and sell
clothes?
OK, what about Switzerland?

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Factor Proportions Trade Theory
How about this:
The US is capital intensive and does not
have a large population.
Yet one of its biggest exports is agricultural
products.
How does that fit in the Factor Proportions
Trade Theory?

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 Product Cycle Theory

Raymond Vernon
Focus on the product, not
its factor proportions
Two technology-based
premises

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 Product Cycle Theory:
Vernon’s Premises
Technical innovations leading to new and
profitable products require large quantities
of capital and skilled labor.

The product and the methods for

manufacture go through three stages to
maturity.

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 Stages of the Product Cycle
The New Product

The Maturing Product

The Standardized Product

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 The Product Cycle and
Trade Implications
Increased emphasis on technology’s impact
on product cost.
Explained international investment.
Limitations:
Most appropriate for technology-based products;
Some products not easily characterized by stages
of maturity; &
Most relevant to products produced through mass
production.

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The Product Cycle and Trade
Implications
Explain the Xerox copier:
Invented in the US & sold @ a high price
Exported to highly industrialized countries
Manufacturing moved to Japan and Europe
for those markets as product became more
standardized
Manufacturing moved to cheaper locals as
newer manufacturers entered the market
Cheaper models now imported into the US.
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 The New Trade Theory:
Strategic Trade
Two New Contributions
Paul Krugman-How trade is altered when
markets are not perfectly competitive or
when production of specific products
possesses economies of scale.

Michael Porter-Examined competitiveness of

industries on a global basis.

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 Strategic Trade
Krugman’s Economics of Scale:

Internal
InternalEconomies
Economiesof
ofScale
Scale

External
ExternalEconomies
Economiesof
ofScale
Scale

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Internal Economies of Scale
When the per unit cost of
manufacturing depends on the size of
the individual firm’s output, the larger
the firm the greater the scale of
manufacturing benefits.
A firm with internal economies of scale
could potentially monopolize an industry
creating an imperfect the market.
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Internal Economies of Scale
If it produces more, lowering the cost
per unit, it can lower the market price.
It can, therefore, sell more products
because it SETS the market price.
It looks like we are talking about
lowering the price we pay for certain
products.
So what is wrong with this?
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Internal Economies of Scale
The link between dominating an
industry and influencing international
trade comes from taking the
assumption of imperfect markets back
to the original concept of competitive
advantage.

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Internal Economies of Scale
For the firm to expand sufficiently to enjoy its
economies of scale, it must take resources
away from other domestic industries in order
to expend. What is wrong with that thought?
A country then sees its own range of products
in which it specializes narrowing,
This provides an opportunity for other
countries in these so called “abandoned
product ranges.”
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External Economies of Scale
When the cost per unit of output
depends on the size of an industry, not
the size of the individual firm, the
industry of that country may produce at
lower costs than the same industry that
is smaller in size in other countries.

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External Economies of Scale
A country can potentially dominate world
markets in a particular product, not because
it has one massive firm producing enormous
quantities (for example, Intel or Microsoft),
But rather because it has many small firms
that interact to create a large, competitive,
critical mass (for example, semiconductors in
Penang, Malaysia, Japanese auto industry).

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External Economies of Scale
No single firm need be all that large,
but several small firms in total may
create such a competitive industry that
firms in other countries cannot ever
break into the industry on a competitive
basis.

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External Economies of Scale
Unlike internal economies of scale,
external economies of scale may not
necessarily lead to imperfect markets.
But they may result in an industry
maintaining its dominance in its field in
world markets.

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External Economies of Scale
This provides an explanation as to why
all industries do not necessarily always
move to the country with the lowest-
cost energy, resources, or labor.
What gives rise to this critical mass of
small firms and their inter-relationships
is a much more complex question.

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Take a Stand
Many MNCs are following a very similar
strategy of moving their manufacturing
facilities out of large, industrialized
countries like the U. S., Germany, and
the UK, and relocating them to
countries in which labor is much
cheaper, such as mainland China.

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Take a Stand
However, this is very controversial
given slow economic growth and
growing unemployment in the industrial
countries.

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Take a Stand
According to most theories of international
trade, once the technology of an industry has
matured and countries have deregulated their
economies sufficiently to allow capital to flow
across borders relatively freely; firms in
industries that can use lower-cost labor-
assuming sufficient skills are available-should
move their manufacturing to those lower-
labor-cost countries.

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Take a Stand
The competitive strategy argument is
that if one firm does not relocate to
countries where it can reduce its costs,
and another does, the first will be
unable to compete in the future.

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Take a Stand
For Discussion
1. MNCs should not continue to move
their manufacturing out of industrial
countries.

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Take a Stand
They are:
• Contributing to rising unemployment
• Undermining the economies of
countries like the U. S. and Germany,
and are
• Simply serving as devices to exploit
cheap labor in developing countries.
Discuss.
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Take a Stand
Why does using cheap labor constitute
“…exploiting cheap labor in developing
countries?”
My student’s comments about
maquiladoras.
“Sweat shops” in El Salvador.

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Take a Stand
Governments are capable of protecting
their citizens from exploitation by
foreign firms.

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Take a Stand
2. MNCs must continue to take whatever
actions are necessary, including moving
manufacturing to lower-cost countries,
to remain competitive.

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Take a Stand
The people, the workers, and the
economies of countries like the U. S.
and Germany cannot artificially protect
their economies from global
competition; it would only serve to
create countries of lesser and lesser
competitiveness in the coming years.
Discuss.
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The end of chapter 5.

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