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Ch 5: Trade Theory

Ch 5: Trade Theory. Lesson Outline. Defining IB, why IB differs from purely domestic business The volume and importance of trade - Globalization and trade, volume & volatility of trade - Virtuous, vicious cycles in economic growth Trade theories - Country-based trade theories

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Ch 5: Trade Theory

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  1. Ch 5: Trade Theory

  2. Lesson Outline • Defining IB, why IB differs from purely domestic business • The volume and importance of trade - Globalization and trade,volume & volatility of trade - Virtuous, vicious cycles in economic growth • Trade theories - Country-based trade theories - Firm-based trade theories • Applications of Today’s Material to Understanding the Prospects of Nations

  3. IB definition, why IB differs from domestic business • IB is business that crosses national borders • IB differs from domestic business for five reasons: 1.  Different legal systems, perhaps different political systems. Sometimes these conflict. 2. Foreign exchange conversion and risk. 3.  Different cultures 4.  Availability of resources and wealth. 5. Geography and distance.

  4. Key terms: Trade • Trade involves the voluntary exchange of goods, services, or money between one person or organization and another. • International trade is trade between residents (individuals, businesses, nonprofit organizations or other associations) of two countries.

  5. Key term: Globalization • The term “globalization” encompasses a set of processes and structural changes in the global economy which are increasing the degree of interdependence between nations and promoting the globalization of industries and markets. • Globalization is both driving and being driven by increasing levels of international trade and international investment.

  6. Trade volume, volatility • Trade makes up about 20% of economic activity, worldwide • The relatively high rate of volatility in trade figures can be seen in the following data for the US for the last 10 years (up to 1999): • GDP growth rate: 2.9% - 5.9% / year • Export sales growth rate: -0.5% - 13.0% / year • Export sales growth dipped as much as 10.9% in a single year (from 10.4% annual growth to a 0.5% annual decline). GDP varied by at most 2.3% on a year-by-year basis.

  7. Virtuous and vicious cycles in economic growth • Economic growth tends to follow what may be described as “vicious” and “virtuous” cycles. • In a “virtuous” cycle, increasing consumer confidence leads to stronger consumer spending, which leads firms to hire more workers to produce more goods, pay out more overtime, and engage in more capital investment. This in turn increases the amount of income available to consumers which they can spend, which increases their confidence about the future, and the virtuous cycle of economic growth will tend to continue.

  8. Virtuous and vicious cycles in economic growth • In a “vicious” cycle, a downturn in consumer confidence can lead to less consumer spending, which causes firms to fire workers, pay out less overtime, and engage in less capital investment. This leads to less money available for consumer spending and less consumer confidence, which further depresses demand for the goods made by businesses, and so a vicious cycle can drag economic growth down further and further. • The presence of “virtuous” and “vicious” cycles means the “momentum matters” as an influence on economic growth.

  9. The point: Trade matters • Also, small changes can have a very large impact on economic growth, just as tipping over one domino can make many dominoes fall over. • Because trade is both a significant portion of global economic activity and highly volatile it often has a strong impact on the growth of national economies and, as well, on worldwide economic growth.

  10. Trade Theories There are two main types of trade theories: country-based versus firm-based Country-based trade theories focus on differences across countries as the drivers of trade. Firm-based theories of trade focus on different resources within firms as the primary determinants of the amount and direction of trade.

  11. Country-Based Trade Theories (Question: Why trade?) 16th century Mercantilism • “By minimizing imports and maximizing exports nations increase the amount of gold in their coffers.” circa 1776 Absolute Advantage (Adam Smith) • “Produce the goods the nation can produce mostly cheaply, import the rest. Doing so maximizes the total wealth of a nation.”

  12. Country-Based Trade Theories circa 1817 Comparative Advantage (Ricardo) “Each nation should produce the goods it produces relatively best, and import those goods it is relatively not as efficient at producing.” Comparative Advantage with Money “Prices set in a free market will reflect the comparative advantage of a nation. Foreign exchange rates will settle at such a level that a nation will be a net exporter in goods for which it has a comparative advantage and a net importer for other goods.”

  13. Country-Based Trade Theories 1930s Relative Factor Endowments “Factor endowments used in production vary across nations. A nation will have a comparative advantage in the production of goods which intensively use resources that country has in abundance. “

  14. Firm-Based Trade Theories Leontif’s Paradox exposed the limitations of country-based trade theories and spurred the development of firm-based trade theories. While country-based trade theories can explain interindustry trade, they cannot explain intraindustry trade. To explain why there can be two-way trade within a given industry, firm-based trade theories prove necessary.

  15. Firm-Based Trade Theories Country Similarity Theory Firms find that the best markets for sales growth are in countries where consumer preferences are similar to those in their own domestic market. International Product Life Cycle Theory The amount and direction of trade varies over three stages of the product life cycle (new product, maturing product, standardized product).

  16. Firm-Based Trade Theories Global Strategic Rivalry Model Firms struggle to obtain a sustainable competitive advantage they can apply worldwide. Examples of sustainable competitive advantages include intellectual property rights, first-mover advantages, economies of scale, and economies of scope.

  17. Firm-Based Trade Theories Porter’s Theory of National Competitive Advantage Porter's theory proposes that the global competitiveness of a national industry is a function of four facets of its diamond of competitive advantage: factor conditions; demand conditions; related and supporting industries; and company strategy, structure, and rivalry.

  18. Firm-Based Trade Theories: Porter's theory Factor conditions: National industries will tend to be more globally competitive when needed factors are located in the firm’s home nation. This is related to relative factor endowments theory, but goes beyond by also including pools of skilled labor. N Demand conditions: National industries are helped by the existence of a large, sophisticated domestic consumer base that stimulates the development and distribution of innovative products.

  19. Firm-Based Trade Theories: Porter's theory Supporting & related industries: A highly competitive local set of suppliers helps firms based in that nation compete globally. Strategy, structure, and rivalry: Porter argues that strong domestic competition helps firms learn how to compete in international markets.

  20. Porter's theory Essentially, Porter’s theory suggests that if domestic conditions are favorable for a given industry, then domestic firms will tend to be more globally competitive in that industry. This in turn leads to higher levels of exports and lower levels of imports for that particular industry.

  21. Applications of Today’s Material toUnderstanding the Prospects of Nations Comparative advantage theory suggests that if a nation is extremely productive for producing certain kinds of goods, they should not produce other goods and should import them instead. This clearly suggests an antagonistic relationship between national industries. For example, given that Saudi Arabia is extremely good at producing oil, it shouldn’t attempt to produce wheat.

  22. Applications of Today’s Material toUnderstanding the Prospects of Nations However, Porter suggests that if industries are related, then firms in those industries can support each other in becoming globally competitive. This suggests a possibly complementary relationship between national industries.

  23. Applications of Today’s Material toUnderstanding the Prospects of Nations The article “As US sneezes, neighbours fear a cold” clearly suggests that some countries and especially Mexico, depend on US markets for many of the goods it produces. This suggests that Mexican economic growth depends in part on trade with the US, which in turn suggests that US economic growth is an important influence on Mexican economic growth.

  24. Applications of Today’s Material toUnderstanding the Prospects of Nations The above leads to the observation that if you want to assess the growth prospects of any given nation, also look at the prospects for stability and growth of its major trading partners.

  25. Lesson Outline • Defining IB, why IB differs from purely domestic business • The volume and importance of trade - Globalization and trade,volume & volatility of trade - Virtuous, vicious cycles in economic growth • Trade theories - Country-based trade theories - Firm-based trade theories • Applications of Today’s Material to Understanding the Prospects of Nations

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