True False
Multiple Choice Questions
Essay Questions
Chapter 06 International Trade Theory Answer Key
True / False Questions
FALSE
The theories of Smith, Ricardo, and Heckscher-Ohlin show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself.
Porter’s theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain export-oriented industries.
TRUE
The theories of Smith, Ricardo, and Heckscher-Ohlin support the case for unrestricted free trade.
Mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade.
A country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it.
According to Ricardo’s theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries even if the country has an absolute advantage over its production.
The simple model of free trade assumed away transportation costs between countries.
Resources do not always move easily from one economic activity to another.
Constant returns to specialization mean that the units of resources required to produce a good are assumed to remain constant no matter where one is on a country’s production possibility frontier. Thus the production possibility frontier will be a straight line.
Diminishing returns show that it is not feasible for a country to specialize to the degree suggested by the simple Ricardian model.
Paul Samuelson’s critique argues that when a rich country enters into a free trade agreement with a poor country, there will be a dynamic gain in the efficiency with which resources are used in the poor country. The poor country’s productivity will improve rapidly.
Paul Samuelson’s critique argues that when a rich country enters into a free trade agreement with a poor country, only the poor country benefits from the relationship.
Factor endowments refer to the extent to which a country is endowed with such resources as land, labor, and capital.
Unlike Ricardo’s theory, however, the Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments, rather than differences in productivity.
Most economists prefer the Heckscher-Ohlin theory to Ricardo’s theory because it makes fewer simplifying assumptions.
A key assumption in the Heckscher-Ohlin theory is that technologies are the same across countries.
The product life-cycle theory argues that the developing nations will produce a product only when the product becomes highly standardized.
Viewed from an Asian or European perspective, the theory’s argument that most new products are developed and introduced in the United States seems ethnocentric and increasingly dated.
Economies of scale are unit cost reductions associated with a large scale of output. This means that companies that trade in large volumes benefit from the economies of scale.
First mover advantages are the economic and strategic advantages that accrue to early entrants into an industry.
According to the new trade theory, firms that establish a first-mover advantage with regard to the production of a particular new product may subsequently dominate global trade in that product.
New trade theorists stress the role of luck, entrepreneurship, and innovation in giving a first-mover advantages.
Underlying most trade theories is the notion that different countries have particular advantages in different productive activities. Thus, from a profit perspective, it makes sense for a firm to disperse its productive activities to those countries where, according to the theory of international trade, they can be performed most efficiently.
Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country, or what they can produce and sell to another country.
David Ricardo’s theory of comparative advantage explains international trade in terms of international differences in labor productivity.
New trade theory stresses that in some cases countries specialize in the production and export of particular products not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of firms.
The main tenet of mercantilism was that it is in a country’s best interests to maintain a trade surplus, to export more than it imported.
The flaw with mercantilism was that it viewed trade as a zero-sum game.
According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these for goods produced by other countries.
According to Ricardo’s theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries.
The theory of comparative advantage suggests that trade is a positive-sum game in which all countries that participate realize economic gains.
Constant returns to specialization means that the units of resources required to produce a good (cocoa or rice) are assumed to remain constant no matter where one is on a country’s production possibility frontier (PPF). In this case, the PPF will be a straight line.
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.
The Heckscher-Ohlin theory predicts that countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce.
The Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments.
The given situation follows the Heckscher-Ohlin theory.
The product life-cycle theory argues that a large proportion of the world’s new products had been developed by U.S. firms.
Economies of scale are unit cost reductions associated with a large scale of output.
In industries where economies of scale are important, both the variety of goods that a country can produce and the scale of production are limited by the size of the market.
New trade theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology.
The theories of international trade claim that promoting free trade is generally in the best interests of a country, although it may not always be in the best interest of an individual firm.
Porter contends that government can influence each of the four components of the diamond—factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry—either positively or negatively.
Countries can benefit from exchanging goods that they can produce efficiently to obtain products that they cannot produce.
David Ricardo’s theory of comparative advantage offers an explanation in terms of international differences in labor productivity.
The Heckscher-Ohlin theory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, and capital) are available in different countries and the proportions in which they are needed for producing particular goods.
Michael Porter’s theory of national competitive advantage attempts to explain why particular nations achieve international success in particular industries. In addition to factor endowments, Porter points out the importance of country factors such as domestic demand and domestic rivalry in explaining a nation’s dominance in the production and export of particular products.
Both the new trade theory and Porter’s theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain export-oriented industries.
The main tenet of mercantilism was that it was in a country’s best interests to maintain a trade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige, and power.
The flaw with mercantilism was that it viewed trade as a zero-sum game. A zero-sum game is one in which a gain by one country results in a loss by another.
Smith’s basic argument is that a country should never produce goods at home that it can buy at a lower cost from other countries.
According to Ricardo’s theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.
The basic message of the theory of comparative advantage is that potential world production is greater with unrestricted free trade than it is with restricted trade.
The theory of comparative advantage suggests that trade is a positive-sum game in which all countries that participate realize economic gains. As such, this theory provides a strong rationale for encouraging free trade.
Diminishing returns to specialization occurs when more units of resources are required to produce each additional unit.
Diminishing returns show that it is not feasible for a country to specialize to a great extent. Ricardian model ignores this principle of diminishing returns.
Leontief Paradox raised questions about the validity of the Heckscher-Ohlin theory.
The theory argues that the wealth of such advanced countries as the United States gives them an incentive to develop new consumer goods. Such nations always develop new products.
The theory argues that the wealth of such advanced countries as the United States gives them an incentive to develop new consumer goods. The theory also argues that new products are always introduced in developed nations.
Vernon’s argument that most new products are developed and introduced in the United States seems ethnocentric and increasingly dated.
Economies of scale are unit cost reductions associated with a large scale of output. Here, Wal-Mart is benefiting from the economies of scale.
New trade theory suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good. Because they are able to gain economies of scale, the first movers in an industry may get a lock on the world market that discourages subsequent entry.
New trade theory suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good. New trade theorists stress the role of luck, entrepreneurship, and innovation in giving a firm first mover advantages.
Porter theorizes four broad attributes of a nation shape the environment in which local firms compete. These four factors are factor endowments, demand conditions, relating and supporting industries, and firm strategy, structure, and rivalry.
Such factors as natural resources, climate, location, and demographics are basic factors. Factors such as communication infrastructure, sophisticated and skilled labor, research facilities, and technological know-how are examples of and advanced factors.
Factors such as communication infrastructure, sophisticated and skilled labor, research facilities, and technological know-how are examples of and advanced factors. Porter argues that advanced factors are the most significant for competitive advantage.
Porter argues that a nation’s firms gain competitive advantage if their domestic consumers are sophisticated and demanding.
Porter’s second point is that there is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competitors.
A country’s balance-of-payments accounts keep track of the payments to and receipts from other countries for a particular time period.
The capital account records one-time changes in the stock of assets.
The financial account (formerly the capital account) records transactions that involve the purchase or sale of assets.
When a country runs a current account deficit, the money that flows to other countries can be used to purchase assets in the deficit country.
Instead of reinvesting the dollars they earn from exports and investment in the United States back into the country, they would sell those dollars for another currency. This would lead to a fall in the value of the dollar on foreign exchange markets, and that in turn would increase the price of imports, and lower the price of U.S. exports.
The main tenet of mercantilism is that it is in a country’s best interests to maintain a trade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige, and power.
Factor endowments refer to the extent to which a country is endowed with such resources as land, labor, and capital. Nations have varying factor endowments, and different factor endowments explain differences in factor costs.
Vernon’s theory was based on the observation that for most of the twentieth century a very large proportion of the world’s new products had been developed by U.S. firms and sold first in the U.S. market. To explain this, Vernon argued that the wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new consumer products.
Economies of scale are unit cost reductions associated with a large scale of output. Economies of scale have a number of sources, including the ability to spread fixed costs over a large volume, and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipment.
First-mover advantages are the economic and strategic advantages that accrue to early entrants into an industry. The ability to capture scale economies ahead of later entrants, and thus benefit from a lower cost structure, is an important first-mover advantage.
Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country, or what they can produce and sell to another country. Smith, who proposed free trade, argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exports.
The Heckscher-Ohlin theory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, and capital) are available in different countries and the proportions in which they are needed for producing particular goods. This explanation rests on the assumption that countries have varying endowments of the various factors of production.
The theories of Smith, Ricardo, and Heckscher-Ohlin form part of the case for unrestricted free trade. The argument for unrestricted free trade is that both import controls and export incentives (such as subsidies) are self-defeating and result in wasted resources. Both the new trade theory and Porter’s theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain export-oriented industries.
A country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it. According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these for goods produced by other countries.
1. We have assumed a simple world in which there are only two countries and two goods.2. We have assumed away transportation costs between countries.3. We have assumed away differences in the prices of resources in different countries.4. We have assumed that resources can move freely from the production of one good to another within a country.5. We have assumed constant returns to scale.6. We have assumed that each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resources.7. We have assumed away the effects of trade on income distribution within a country.
By constant returns to specialization we mean the units of resources required to produce a good (cocoa or rice) are assumed to remain constant no matter where one is on a country’s production possibility frontier (PPF). Diminishing returns to specialization occur when more units of resources are required to produce each additional unit.
Diminishing returns show that it is not feasible for a country to specialize to the degree suggested by the simple Ricardian model outlined earlier. Diminishing returns to specialization suggest that the gains from specialization are likely to be exhausted before specialization is complete.
First, free trade might increase a country’s stock of resources as increased supplies of labor and capital from abroad become available for use within the country.Second, free trade might also increase the efficiency with which a country uses its resources.
Paul Samuelson’s critique looks at what happens when a rich country enters into a free trade agreement with a poor country that rapidly improves its productivity after the introduction of a free trade regime. Samuelson’s model suggests that in such cases, the lower prices that the rich country’s consumers pay for goods imported from the poor country following the introduction of a free trade regime may not be enough to produce a net gain for the rich country’s economy if the dynamic effect of free trade is to lower real wage rates in the rich country.
Viewed from an Asian or European perspective, Vernon’s argument that most new products are developed and introduced in the United States seems ethnocentric and increasingly dated. This is a major disadvantage of the product life-cycle theory.
Perhaps the most contentious implication of the new trade theory is the argument that it generates for government intervention and strategic trade policy. New trade theorists stress the role of luck, entrepreneurship, and innovation in giving firm first-mover advantages.
The four factors are:
(1) Factor endowments — a nation’s position in factors of production such as skilled labor or the infrastructure necessary to compete in a given industry.(2) Demand conditions — the nature of home demand for the industry’s product or service.(3) Relating and supporting industries — the presence or absence of supplier industries and related industries that are internationally competitive.(4) Firm strategy, structure, and rivalry — the conditions governing how companies are created, organized, and managed and the nature of domestic rivalry.
Porter’s second point is that there is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competitors. Domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced factors. All this helps to create world-class competitors.
Chapter 07
Government Policy and International Trade
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