International Trade and Factor Mobility Theory

Utility of International Trade Theories for countries and companies


Trade theory in India comes from the ministry of commerce. It is based on the factors basically framed by WTO like who should be your trading partners, specifying trade blocks etc. Like India, other countries wrestle with the questions of what, how much and with whom their country should import and export. The decisions taken by countries in this matter greatly affect their business because they affect which countries can produce given products more efficiently and whether countries will permit imports to compete against their own domestically produced goods and services.

Trade theories tell how or whether governments should intervene directly to affect their countries’ trade with other countries. Trade theories tell countries about what products should be exported and imported or what should be the total foreign trade as a percentage of the GDP.Once countries make decisions about what, how much and with whom to trade, officials enact trade policies to achieve the desired results. There are two aspects of trade policies.

• Policy book which specifies the policies



• Handbook of proceedings which specifies as an exporter or importer what should be your duties.

Companies need to understand trade theories so that they can find where to locate the production/distribution unit. the second reason being sourcing i.e. where to import from and where to export. These different trade theories provide insights about favourable locales as well as potentially successful export products. The theories also increase understanding about government trade policies and predict how those policies might affect companies’ competitiveness.

Prescriptive Theory

There are two prescriptive theories namely Mercantilism and Neomercantilism

Mercantilism

It is a trade theory which formed the foundation of economic thought from about 1500 to 1800. It says all theories are related to countries not companies. According to this theory a country should export more than it imports and if successful, receive gold from countries that run deficits. So employment will be there and excess production will occur in the country. In this process the country will become stronger and popular.
To export more than import, governments imposed restriction on most imports and they subsidized production of many products that could otherwise not complete in domestic or export markets. As the influence of the mercantilist philosophy weakened after 1800, the governments of colonial powers seldom aimed directly to limit the development of the industrial capabilities within their colonies.
A favourable balance of trade indicates that a country is exporting more than it is importing, where as an unfavourable balance of trade indicates the opposite. However it is not necessarily beneficial to run a trade surplus or disadvantageous to run a trade deficit. A country that is running a surplus for the time being, imports goods and services of less value than those it is exporting. In mercantilist period the difference in trade was made up by a transfer of gold, but today it is made up by holding the deficit country’s currency or investments denominated in that currency.

Neomercantilism

It is an extension of Merck theory. According to this theory the countries try to run a favourable balance of trade i.e. export more than they import. The objective is not purely economical, rather social and political. By exporting they acquire political good will of the countries to whom they export. Developed countries do this to developing countries. In addition by doing excessive production and export, they generate employment in the home country and increase the sphere of influence among the host countries.

Theories of Specialization

The theory of specialization states that nations should neither artificially limit imports nor promote exports. There are three theories of specialization.

• Theory of absolute advantage.


• Comparative advantage.


• Factor proportions theory.

Theory of absolute advantage
In 1776 Adam smith said the wealth of the country depend on its goods and services. He first talked about free trade. According to him some countries can produce certain goods more efficiently (competitively) because of their natural advantage (natural resources). These countries should produce these goods and export it to countries having less or no advantage of these goods. On the contrary, the goods that could not be produced competitively should be obtained from other countries that have competitive advantage over the same. It will lead to the optimal utilisation of resources throughout the world. By doing this countries will have large production units for certain products. Based on this theory, he questioned why the citizens of any country should have to buy domestically produced goods when they could buy these goods more cheaply abroad.
Through specialization, countries could increase their efficiency because of three reasons.

• Labor could become more skilled by repeating the same tasks.


• Labor would not loose time in switching from the production of one kind of product to another.


• Long production runs would provide incentives for the development of more effective working methods

A country can have either natural advantage or acquired advantage.
Natural advantage: A country may have a natural advantage in producing a product because of climatic conditions, access to certain natural resources, or availability of certain labor forces. No country is sufficiently rich in natural resources to be independent of the rest of the world. So most countries import ores, metals and fuels from other countries.
Acquired Advantage: Countries that produce manufactured goods and services competitively have an acquired advantage, usually either in product or process technology. An advantage of product technology is that it enables a country to produce a unique product or one that is easily distinguished from those of competitors. An advantage in process technology is a country’s ability to produce a homogeneous product (one not easily distinguished from that of competitors) efficiently.

Theory of comparative advantage

In 1817, David Ricardo developed the theory of comparative advantage. This theory says that global efficiency gains may still result from trade if a country specializes in those products that it can produce more efficiently than other products—regardless of whether other countries can produce those same products even more efficiently. So a country will gain if it concentrates its resources on producing the commodities it can produce most efficiently. It will then trade some of those commodities for those commodities it has relinquished. This theory is accepted by most economists and is influential in promoting policies for free trade.

Assumptions and Limitations of Theories of Specialization

Full employment: The specialization theories assume that resources are fully employed. However when countries have many unemployed or unused resources, they may seek to restrict imports to employ or use idle resources.
Economic Efficiency Objective: Countries also often pursue objectives other than output efficiency. They may avoid overspecialization because of the vulnerability created by changes in technology and by price fluctuations.
Division of Gains: Although specialization brings potential benefits to all countries that trade, the earlier discussion did not indicate how countries will divide increased output.
Two Countries, Two Commodities: the theory assumes a simple world composed of only two countries and two commodities.
Transportation costs: If transportation costs more than what is saved through specialization, then the advantages of trade are negated.
Statics and Dynamics: The theories view the advantages statically. However the relative conditions that give countries advantages or disadvantages in the production of given products are dynamic.
Services: The theories of absolute and comparative advantage deal with commodities rather than services. However an increasing portion of world trade is in services.
Mobility: The theory assumes that resources can move domestically from the production of one good to another and at no cost. But this assumption is not completely valid.

Factor Proportions Theory

Heckscher and ohlin developed factor proportions theory. This theory is based on countries’ production factors like land, labor and capital. This theory says that differences in countries’ endowments of labor compared to their endowments of land or capital explained the differences in the cost of production of factors. If labor were abundant in comparison to land and capital, then labor cost would be low. These relative factor costs lead countries to excel in the production and export of products that used their abundant production factors. In countries where there is little capital available for investment per worker is low, managers might expect to find cheap labor rates and export competitiveness in products that require large amounts of labor relative to capital. However, because the factor-proportions theory assumes production factors to be homogeneous, tests to substantiate the theory have been mixed. Labor skills in fact vary within and among countries because people have different training and education.

International Product Life Cycle

The international product life cycle theory of trade states that the location of production of certain kinds of products shifts as they go through their life cycles, which consist of four stages namely introduction, growth, maturity and decline.

Introductory phase

Once a company has created a new product, theoretically it can manufacture that product anywhere in the world. In practice, however, the early production generally occurs in domestic location so that the company can obtain rapid market feedback as well as save on transport costs. In this stage, the production process is more labor intensive because the product is not yet standardized and its production process must permit rapid changes in product characteristics as market feedback dictates.Although the early production is most apt to occur in high income countries, which have high labor rates, this labor tends to be highly educated and skilled so that it is adept and efficient when production is not yet standardized. Even if production costs are high because of expensive labor, companies can often pass costs onto consumers who are unwilling to wait for possible price reductions later.
Growth Phase

In this phase, as the sales of new product grow, competitors enter the market and demand grows substantially in foreign markets, particularly in other high income countries. Because sales are growing rapidly at home and abroad, there are incentives for companies to develop process technology. However product technology may not yet be well developed because of the number of product variations introduced by competitors that are also trying to gain market share. So the production process may still be labor intensive during this stage, although it is becoming less so.
Maturity phase

In this stage the overall worldwide demand begins to level off, although it may be growing in some countries and declining in some countries. There is often a shakeout of products such that product models become highly standardized, making cost an important competitive weapon. Longer production runs become possible for foreign plants, which in turn reduce per unit cost, thus creating more demand in emerging economies. Because markets and technologies are widespread, the innovating country no longer commands a production advantage. Producers have incentives to shift production to emerging economies where they can employ unskilled, inexpensive labor efficiently for standardized production.
Decline Phase

In this phase the markets in high income countries decline more rapidly than those in low-income economies as affluent customers demand ever newer products. By this time, market and cost factors have dictated that almost all production is in emerging economies, which export to the declining or small niche markets in high income countries.

Theory of Country size

The theory of country size holds that large countries usually depend less on trade than small countries. Countries with large land areas are apt to have varied climates and an assortment of natural resources, making them more self sufficient than smaller countries. Further transport costs in trade affect large and small countries differently. Among countries that border each other, the smaller country tends to depend more on trade than the larger country because of transportation costs. The distances for neighbouring countries for small countries are less and hence less transportation cost.

Country similarity

Similar countries engage in trade among themselves because

• Requirements are similar


• Similar income levels, needs


• Ease and comfort of operations

Porter’s diamond theory

For diagram please refer at the top of this post.



According to porter’s diamond theory, companies’ development of internationally competitive products and for being supremacy depends on four domestic factors namely

• Demand conditions


• Factor conditions


• Related and supporting industries


• Firm strategy, structure and rivalry

Demand conditions are the first condition in the theory. Companies come up with new products only when they observe a need or demand for the same in the market. Companies then start up production near the observed market. The demand conditions look for the quality of people i.e. how demanding the customers are. If the customers are more demanding, then industry players try to outperform each other and this leads to more competition and thus better products. The second condition is the Factor conditions. Here the companies look for the natural advantage available in the domestic market in terms of skilled labor, capital, technology and equipment. If certain factor conditions are not available then the companies refer the host country diamond. It is possible due to international trade. The third condition is the existence of related and supporting industries. These industries are required in the country for the components of the main product. The ability of the companies to develop and sustain a competitive advantage requires favourable circumstances for the fourth condition i.e. firm strategy, structure and rivalry. Rivalry brings out the best in the companies. All earlier theories looked at comparative advantage while porter’s diamond focuses on competitive advantage.
Implications of Porter’s diamond

For country government

• Government should focus on “specialized factor conditions” eg-education for growth of IT.


• Government should not allow companies to have strategic alliance between companies of the same country because it will reduce competition. If alliance is to take place, then it has to take place with foreign players.


• Governments should be open for foreign country market through negotiation with other countries.

For Companies

• Select and tap the host country diamond.


• Utilize the specialized factor conditions and enhance/compliment them with their own capabilities.


• Focus on innovation i.e. committed R&D

Limitations of porter’s diamond

• Resources may be channelled to sectors where there is comparative advantage based industries and in turn those industries where innovation is due, may not get resources.


• What is comparative advantage today may not be there tomorrow due to the ongoing globalization.


• The sectors are competitive across the world and are not restricted to a single country.


• The existence of four favourable conditions does not guarantee that an industry will develop in a given locale. At the same time the absence of any of the four conditions from the diamond domestically may not inhibit companies and industries from becoming globally competitive.


• If related and supporting industries are not available locally, materials and components are now more easily brought in from abroad due to advancement in transportation and relaxation of import restrictions.


• Companies react not only to domestic rivals but also to foreign based rivals with whom they compete at home and abroad.

Factor Mobility

Factor conditions change in both quality and quantity. The relative capabilities of countries also change. The changes are important in understanding and predicting changes in export production and import market locations. At the same time the mobility of capital, technology and people affect trade and relative competitive positions.

Why production factors move

Capital, especially short term capital, is the most internationally mobile production factor. Companies and private individuals primarily transfer capital because of differences in expected return. Short term capital is more mobile than long term capital because there is more likely to be an active market through which investors can quickly buy foreign holdings and sell them if they want to transfer capital back home or to another country. However companies invest in long-term abroad to tap markets and lower operating costs. Another reason for capital mobility is because governments give foreign aid and loans. Non profit organizations donate money abroad to relieve worrisome economic and social conditions. Individuals remit funds to help their families and friends in foreign countries.

People are also internationally mobile. People move from the area of abundance to area of scarcity. People who travel to another country as tourists, students and retirees do not constitute labor mobility unless they work there. About 2 percent of the world’s population has migrated to another country. People whether professionals or unskilled workers, largely work in another country for economic reasons. People also move for political reasons also like persecution or war dangers. People move for short term when they are allocated in turnkey onsite projects, or overseas positions. However people move for long term through migration and take citizenship.

Effects of factor movements

• Immigrants bring human capital with them, thus adding to the base of skills that enabled countries to be newly competitive in an array of products they might otherwise have imported.


• Countries receive foreign capital to develop infrastructure and natural resources, which further altered their competitive structures and international trade.


• Countries lose potentially productive resources when educated people leave, a situation known as a brain drain, but they may gain from the foreign earnings on those factors.

Relationship of trade and Factor mobility

Free trade when coupled with freedom of factor mobility internationally will usually result in the most efficient allocation of resources.

Substitution

When the factor proportions vary widely among countries, pressures exist for the most abundant factors to move to countries with greater scarcity- where they can command a better return. If finished goods and production factors were both free to move internationally, the comparative costs of transferring goods and factors would determine the location of production. However there are restrictions on factor movements that make them only partially mobile internationally. The inability to gain sufficient access to foreign production factors may stimulate efficient methods of substitution, such as development of alternatives for traditional production methods.
Complementarity

Trade and investments are complementary. When companies invest abroad, the investments often stimulate exports from their home countries. Any investment in terms of trade made by a foreign country leads to import of capital equipment, import of components, local players also reduce cost, improve technology, import goods and may also export in the long run. About a third of world trade (exports) is among controlled entities such as from parent to subsidiary, subsidiary to parent, subsidiary to subsidiary of the same company. Many of the exports would not occur if overseas investments did not exist. Another reason might be domestic operating units may export materials and components to their foreign facilities for use in a finished product.