Global Business

Rajeet Guha
A.1 Mercantilism was the first theory of international trade. It emerged in England in the mid-sixteenth century. The principle assertion of mercantilism was that gold and silver were the mainstays of national wealth and essential to robust commerce. At that time a country could earn gold and silver were the currency of trade between countries. Exports would bring in an inflow of gold and silver while imports would lead to an outflow of gold and silver. Mercantilist doctrine advocated that a country should strive towards maximizing exports and minimizing imports. This, in effect, meant that a country should try to hoard as much gold and silver as possible. However, this theory was seriously flawed. The Scottish economist David Hume pointed out the drawback in the theory that would ultimately precipitate its abandonment and its replacement by other theories. He said that a mercantilist policy of accumulating trade surpluses would increase the supply of bullion or money supply and thereby lead to inflation. The high prices of British goods would lead British consumers to import cheaper goods from abroad where an outflow of bullion would reduce money supply and lead to deflation. This process would continue till price levels in each country became at the same level. The vacuum in trade theory left behind by the disavowal of mercantilism was filled up by the theory of absolute advantage. The theory of absolute advantage was proposed by Adam Smith in ‘The Wealth of Nations.’ He argued that if there were two countries both of whom produced only two goods then each country should only produce that good in which it had an absolute advantage or could produce the good with fewer resources. The other good should be imported from the other country. However, this would mean that if one country had an absolute advantage in the production of both goods then it should not engage in trade. This theory was replaced by the theory of comparative advantage. This theory was suggested by David Ricardo. His basic purport was that even if a country has an absolute advantage in the production of both goods it should still trade because it has a relative or comparative advantage in the production of one good. In this way both countries would be better off. According to Ricardo comparative advantage occurs because of different technological capacities of countries. The different technological capacities of countries is due to differential labor productivities. The Heckscher-Ohlin model suggests that trade occurs due to different factor endowments or due to differential resources.
A.2 Removal of restrictions on international trade leads to a reduction in poverty, more egalitarian income distribution, greater economic growth rates, stricter enforcement of international labor standards and greater agricultural production and return.
A.3 The success of free trade has increased the illicit trade in drugs, arms smuggling, infringement on intellectual property, alien smuggling and human trafficking, and money laundering.
A.4 Raymond Vernon initially proposed the product life cycle theory in the mid-1960s. Vernon’s product life cycle theory was based on the observation that for most of the twentieth century most of the world’s new products such as automobiles, televisions, cameras, photocopiers, personal computers and semi-conductor chips. To explain this Vernon argued that the wealth and size of the U.S. market gave U.S. firms an incentive to develop cost-saving process innovations.
Just because a new product is developed by a U.S. firm and first sold in the U.S. market, it does not follow that the product will be perpetually produced in the United States. It could be produced abroad at some low-cost location and then exported back into the United States. However, Vernon believed that most new products were initially produced in America. Apparently, the pioneering firms believed it was better to keep production facilities close to the market and to the firm’s center of decision-making, given the uncertainty and risks inherent in introducing new products. Also, the demand for most new products tends to be based on nonprice factors. Consequently, firms can charge relatively high prices for new products, which obviates the need for low-cost production sites in other countries.
Vernon went on to argue that early on in the life cycle of a typical new product while demand is starting to grow rapidly in the United States, demand in other high-income countries was limited to high-income groups. The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the United States to those countries.
Over time, demand for the new product starts to grow in other advanced countries such as Great Britain, France, Germany, and Japan. As it does, it becomes worthwhile for foreign producers to begin producing for their home markets. In addition, U.S. firms might set up production facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States.
As the markets in other advanced nations mature the product becomes more standardized and price becomes the main competitive weapon. As this occurs cost considerations start to play a greater role in the competitive process. Producers based in advanced countries where labor costs are lower than in the United States such as Italy or Spain might now be able to export to the United States. If cost pressures become intense the process might not stop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated once more as developing countries like Thailand begin to acquire a production advantage over advanced countries. Thus, the locus of global production initially switches from the United States to other advanced nations and then from those nations to developing countries.
The consequence of these trends for the pattern of world trade is that over time the United States switches from being an exporter of the product to an importer of the product as production becomes concentrated in lower-cost foreign locations.
A.5 The simple comparative advantage model assumed that trade does not change a country’s stock of resources or the efficiency with which it utilizes those resources. This static assumption makes no allowances for the dynamic changes that might result from trade. If we relax this assumption it becomes apparent that opening an economy to trade is likely to generate resources as increased supplies of labor and capital from abroad become available for use within the country. For example this has been occurring in Eastern Europe since the early 1990s with many Western businesses investing significant capital in the former Communist countries.
Second, free trade might also increase the efficiency with which a country uses its resources. Gains in the efficiency of resource utilization could arise from a number of factors. For example economies of large-scale production might become available as trade expands the size of the total market available to domestic firms. Trade might make better technology from abroad available to domestic firms. Better technology can increase labor productivity and productivity of land. The so-called green revolution had this effect on agricultural outputs in developing countries. Also, opening an economy to foreign competition might stimulate domestic producers to look for ways to increase their efficiency. Again this phenomenon has arguably been occurring in the once-protected markets of Eastern Europe where many former state monopolies are increasing the efficiency of their operations to survive in the competitive world market. Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized will cause a country’s PPF to shift outward. As a consequence of this outward shift, the country can produce more of both goods than it did before the introduction of free trade. The theory suggests that opening an economy to free trade not only results in static gains but also results in dynamic gains that stimulate economic growth.