Trade Thoeries

Evaluate the Relevance of Two Trade (or FDI) Theories for Policy Makers and for the Strategy of Multinational Enterprises. Discuss Possible Limitations in the Explanatory Power of these Theories.

The two trade theories that I am going to evaluate on their impact on policy makers and the strategies adopted by multinational enterprises are �comparative advantage theory’ and �country size theory’.

Adam Smith first developed the theory of Absolute advantage in 1776. Smith explained that �if trade was unrestricted, each country would specialize in those products which it had a competitive advantage.’ These competitive advantages could be gained from natural advantages (through a specific climate or other natural resource), or from acquired advantage (from having more efficient production techniques or technology). The countries resources would therefore shift towards these industries and improve their efficiency through specialization. The labour force would also become more efficient from repeating the same tasks and developing more efficient working methods. Comparative advantage is a step further than absolute advantage theory. David Ricardo in 1817 developed comparative advantage to show there were �still benefits to be gained from trade if a single country were more efficient at both products’ .

Country size theory assesses how the size of a country affects the extent to which international trade patterns affect it. The theory states that larger a larger country will have a greater variety of natural resources �making them more self-sufficient than smaller countries’ . It also states that a larger country will have higher transport costs in order to deliver resources and goods across its breadth. Finally it looks at larger countries ability to achieve large economies of scale solely through its domestic market, without needing to trade internationally.

To judge the relevance of these two trade theories on policy makers such as national government, we must consider what information the theories can give towards changing the different type of policies such as tariffs, non-tariff barriers and quantity controls.

In the case of the comparative advantage theory, policy makers have the power to protect their home industry if it is at a disadvantage by implementing import tariffs on the competing countries product, or putting quotas in place limiting the amount of the product allowed into the country over a certain time period. This is done so as the market doesn’t become saturated with the foreign companies’ product and cause a decline in the demand for the national produce. An example of this is when George W. Bush put in place policies to protect the American steel industry from foreign competition �by slapping hefty tariffs of up to 30 per cent on a range of US steel imports’ in 2002, due to a decline in the number of steel workers from 2.4 million to only 900,000. Comparative advantage theory however doesn’t look at the long term implications of these policies, and in lowering the competitive pressures for the industry also lowers the efficiency of the output and production, and the main cause of the �Struggle of the US steel industry is largely due to its failure to modernise and restructure to fit into a fast-changing and highly competitive global marketplace’

Another policy that can be put in place is for governments to grant subsidies to industries to help them compete in the global market place, �and help the domestic economy adjust to the changes brought by shifting patterns of trade’ . Comparative advantage theory can show you which of these industries within a country needs protecting, but does not look at any further implications these actions may cause. By granting subsidies to enable competition with a country with a greater natural advantage, it might disrupt any other trade agreements that are in place with this country and could lead to �cycles of retaliation and counter-retaliation’ and an overall detrimental effect.

For the theory of country size, policy makers can put in place, similar tariffs to stop neighboring countries trading across the borders where transport costs will be lower than getting delivery from a much further distance within the borders of your home nation. This however would be ineffective between countries within the European Union, as separate legislation already in place to allow free trade between members of the EU.

From using both of these theories policy makers could decide not to introduce or remove export tariffs. By putting this policy into place it will reduce the cost of the nationally produced product and allow it to become more competitive internationally and possibly give it a comparative advantage over competing countries. Again though this could cause retaliation from trade partners and a �cure that’s worse than the disease’ .

These theories can also have an effect on the strategies of multi-national corporations, and the directions these companies decide to move in after analyzing countries based on comparative advantage or country size.

By assessing which countries have a comparative advantage in producing a particular type of product, a company might choose to change its production methods and move production or outsource its production to countries which have a greater comparative advantage. However what comparative advantage theory does not consider is how easy it will be to move production to another country. It does not consider any trade barriers that might be in place, or the foreign governments’ attitude to foreign investment of various types. There also may be a cultural difference between the corporation and the target countries attitudes to working practices.

From studying and learning from countries with a comparative advantage based in acquired advantage, a multinational organization might decide to change its production techniques or culture to try and acquire the same advantages. For example Zara �copied production techniques from the Japanese car industry’, to gain an advantage and cut down on storage costs by employing just-in-time production methods. Further more they might change their strategy to adopt an innovative culture allowing them to improve on their advantage and cause a shift towards their company having a worldwide comparative advantage. This however may not be easily adopted by the current employees and lead to a reduction in the productivity of the business rather than cause an increase.

The