Theories of Free Trade

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Harvard Business School

9-390-001

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Rev. August 13, 1990

“New” Theories of International Trade

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A new body of international trade theory emerged in the 1980s. The foundations of this theory were that competition in markets was imperfect, and that firms and governments could act strategically to affect trade flows and national welfare. For many economists, this growing body of literature represented a radical departure from previous scholarship. Rigorous mathematical models were developed which questioned the heart and soul of classical comparative advantage. Respectable academic economists began asking whether unconditional free trade was a country’s best policy choice.

This case reviews the background and central hypotheses of these “new” theories, which have also been called theories of strategic trade policy. The case looks at why many economists and policymakers thought alternative approaches were necessary, at what the contributions of industrial organization to this new theory were, and at what some of the tentative results in the 1980s were. The case ends with an overview of Michael Porter’s book, Competitive Advantage of Nations. Porter, like the strategic trade theorists, raised new questions about the value of classical comparative advantage and the role of firm and industry-level variables in determining who competes successfully in international trade.

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Changes in the trading environment. Several economic changes in the international trading system stimulated executives, policymakers, and theoreticians to revisit international trade theory in the 1980s. The first was growing economic interdependence among nations, especially the increasing importance of trade for the United States. The rapid growth of imports into the United States, for instance, meant that trade suddenly became a primary concern for executives and policymakers alike. For the first time, virtually all American companies began facing serious foreign competition at home; at the same time, U.S. government policymakers found that policies for such diverse activities as antitrust or innovation could no longer be set in isolation from the world economy. Moreover, the possibility that foreign governments were providing assistance to their domestically-based firms raised the question of whether the U.S. government should counter such assistance through its own initiatives. By the 1980s, some governments had demonstrated an ability to affect the welfare of Americans through policy actions.

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The dramatic collapse in the U.S. trade position during the Reagan administration, and its persistence into the late 1980s furthered interest in trade theory. Between 1980 and 1988, the U.S. share of world imports rose sharply from 13% to 16% while exports fluctuated around 11%. As a consequence the current account moved from an annual surplus of $2 billion in 1980 to an annual deficit of $120 billion in 1988. If the trading system worked according to simple Ricardian logic, an exchange rate change would have quickly reduced the U.S. payment deficits and brought the world

Dr. Heather A. Hazard prepared this case in collaboration with Professor David B. Yoffie as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1989 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

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