Chapter Summary

This chapter has reviewed a number of theories that explain why it is beneficial for a country to engage in international trade and has explained the pattern of international trade that we observe in the world economy. We have seen how the theories of Smith, Ricardo, and Heckscher-Ohlin all make strong cases for unrestricted free trade. In contrast, the mercantilist doctrine and, to a lesser extent, the new trade theory can be interpreted to support government intervention to promote exports through subsidies and to limit imports through tariffs and quotas.

In explaining the pattern of international trade, the second objective of this chapter, we have seen that with the exception of mercantilism, which is silent on this issue, the different theories offer largely complementary explanations. Although no one theory may explain the apparent pattern of international trade, taken together, the theory of comparative advantage, the Heckscher-Ohlin theory, the product life-cycle theory, the new trade theory, and Porter's theory of national competitive advantage do suggest which factors are important. Comparative advantage tells us that productivity differences are important; Heckscher-Ohlin tells us that factor endowments matter; the product life-cycle theory tells us that where a new product is introduced is important; the new trade theory tells us that increasing returns to specialization and first-mover advantages matter; and Porter tells us that all these factors may be important insofar as they affect the four components of the national diamond.

The following points have been made in this chapter:

1. Mercantilists argued that it was in a country's best interests to run a balance-of-trade surplus. They viewed trade as a zero-sum game, in which one country's gains cause losses for other countries.

2. The theory of absolute advantage suggests that countries differ in their ability to produce goods efficiently. The theory suggests that a country should specialize in producing goods in areas where it has an absolute advantage and import goods in areas where other countries have absolute advantages.

3. The theory of comparative advantage suggests that it makes sense for a country to specialize in producing those goods that it can produce most efficiently, while buying goods that it can produce relatively less efficiently from other countries--even if that means buying goods from other countries that it could produce more efficiently itself.

4. The theory of comparative advantage suggests that unrestricted free trade brings about increased world production; that is, that trade is a positive-sum game.

5. The theory of comparative advantage also suggests that opening a country to free trade stimulates economic growth, which in turn creates dynamic gains from trade.

6. The Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce.

7. The product life-cycle theory suggests that trade patterns are influenced by where a new product is introduced. In an increasingly integrated global economy, the product life-cycle theory seems to be less predictive than it was between 1945 and 1975.

8. The new trade theory argues that a country may predominate in the export of a certain product simply because it had a firm that was a first mover in an industry that will profitably support only a few firms because of substantial economies of scale.

9. Some new trade theorists have promoted the idea of strategic trade policy. The argument is that government, by the sophisticated and judicious use of subsidies, might be able to increase the chances of domestic firms becoming first movers in newly emerging industries.

10. Porter's theory of national competitive advantage suggests that the pattern of trade is influenced by four attributes of a nation: (i) factor endowments, (ii) domestic demand conditions, (iii) relating and supporting industries, and (iv) firm strategy, structure, and rivalry.

11. Theories of international trade are important to an individual business firm primarily because they can help the firm decide where to locate its various production activities.

12. Firms involved in international trade exert a strong influence on government policy toward trade. By lobbying government bodies, firms can help promote free trade or trade restrictions.

Closing Case The Rise of the Indian Software Industry

As a relatively poor country, India is not normally thought of as a nation that is capable of building a major presence in a high-technology industry, such as computer software. In a little over a decade, however, the Indian software industry has astounded its skeptics and emerged from obscurity into an important force in the global software industry. Between 1991 - 92 and 1996 - 97 sales of Indian software companies grew at a compound rate of 53 percent annually. In 1991 - 92, the industry had sales totaling $388 million. By 1996 - 97 sales were around $1.8 billion. By 1997, there were over 760 software companies in India employing 160,000 software engineers, the third-largest concentration of such talent in the world. Much of this growth was powered by exports. In 1985, Indian software exports were worth less than $10 million. Exports hit $1.1 billion in 1996 - 97 and are projected to reach $4 billion by 2000 - 01. As a testament to this growth, many foreign software companies are now investing heavily in Indian software development operations including Microsoft, IBM, Oracle, and Computer Associates, the four largest US-based software houses.

Most of the growth of the Indian software industry has been based on contract or project-based work for foreign clients. Many Indian companies, for example, maintain applications for their clients, convert code, or migrate software from one platform to another. Increasingly, Indian companies are also involved in important development projects for foreign clients. For example, TCS, India's largest software company, has an alliance with Ernst & Young under which TCS will develop and maintain customized software for Ernst & Young's global clients. TCS also has a development alliance with Microsoft under which the company developed a paperless National Share Depositary system for the Indian stock market based on Microsoft's Windows NT operating system and SQL Server database technology.

The Indian software industry has emerged despite a poor information technology infra-structure. The installed base of personal computers in India stood at just 1.8 million in 1997, and this in a nation of 1 billion people. Moreover, with just 1.5 telephone lines per 100 people, India has one of the lowest penetration

rates for fixed telephone lines in Asia, if not the world. Internet connections numbered just 45,000 in 1997, compared to 30 million in the United States. Sales of personal computers are starting to take off; over 500,000 were expected to be sold in 1998. The rapid growth of mobile telephones in India's main cities is to some extent compensating for the lack of fixed telephone lines.

In explaining the success of their industry, India's software entrepreneurs point to a number of factors. Although the general level of education in India is low, India's important middle class is highly educated and its top educational institutions are world class. Also, there has always been an emphasis on engineering in India. Another great plus from an international perspective is that English is the working language throughout much of middle-class India--a remnant from the days of the British raja. Then there is the wage rate. In America, software engineers are increasingly scarce, and the basic salary has been driven up to one of the highest for any occupational group in the country, with entry-level programmers earning $70,000 per year. An entry-level programmer in India, in contrast, starts at around $5,000 per year, which is very low by international standards but high by Indian standards. Still, salaries for programmers are rising rapidly in India, but so is productivity. In 1992, productivity was around $21,000 per software engineer. By 1996, the figure had risen to $45,000. Many Indian firms now feel that they have approached the critical mass required to realize scale economies in software development and to achieve legitimacy in the eyes of important global partners and clients.

Another factor playing to India's hand is that satellite communications have removed distance as an obstacle to doing business for foreign clients. Since software is nothing more than a stream of zeros and ones, it can be transported at the speed of light and negligible cost to any point in the world. In a world of instant communications, India's geographical position has given it a time zone advantage. Indian companies have exploited the rapidly expanding international market for outsourced software services including the expanding market for remote maintenance. Indian engineers can fix software bugs, upgrade systems, or process data overnight while their users in Western companies are asleep.

To maintain their competitive position, Indian software companies are now investing heavily in training and leading-edge programming skills. They have also been enthusiastic adopters of international quality standards, particularly ISO 9000 certification. Indian companies are also starting to make forays into the application and shrink-wrapped software business, primarily with applications aimed at the domestic market. It may only be a matter of time, however, before Indian companies start to compete head-to-head with companies such as Microsoft, Oracle, PeopleSoft, and SAP in the applications business.

http://www.tcs.co.in/index.html

Source: P. Taylor, "Poised for Global Growth," Financial Times: India's Software Industry, December 3, 1997, pp. 1, 8; P. Taylor, "An Industry on the Up and Up," Financial Times: India's Software Industry,December 3,

1997, p. 3; and Krishna Guha, "Strategic Alliances with Global Partners," Financial Times: India's Software Industry, December 3, 1997, p. 6.