International Trade Theory
1 Understand why nations trade with each other.
2 Summarize the different theories explaining trade flows between nations.
3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.
4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.
5 Understand the important implications that international trade theory holds for business practice.
opening case The Rise of India’s Drug Industry
One of the great success stories in international trade in recent years has been the strong growth of India’s pharmaceutical industry. The country used to be known for producing cheap knockoffs of patented drugs discovered by Western and Japanese pharmaceutical companies. This made the industry something of an international pariah. Because they made copies of patented products, and therefore violated intellectual property rights, Indian companies were not allowed to sell these products in developed markets. With no assurance that their intellectual property would be protected, foreign drug companies refused to invest in, partner with, or buy from their Indian counterparts, further limiting the business opportunities of Indian companies. In developed markets such as the United States, the best that Indian companies could do was to sell low-cost generic pharmaceuticals (generic pharmaceuticals are products whose patent has expired).
In 2005, however, India signed an agreement with the World Trade Organization that brought the country into compliance with WTO rules on intellectual property rights. Indian companies stopped producing counterfeit products. Secure in knowledge that their patents would be respected, foreign companies started to do business with their Indian counterparts. For India, the result has been dramatic growth in its pharmaceutical sector. The sector generated sales of close to $25 billion in 2010, more than double the figure of 2005. Driving this growth have been surging exports, which grew at 15 percent per annum between 2006 and 2011. In 2000 pharmaceutical exports from India amounted to around $1 billion. By 2011, the figure was around $11.5 billion!
Much of this growth has been the result of partnerships between Western and Indian firms. Western companies have been increasingly outsourcing manufacturing and packaging activities to India, while at the same time scaling back some of these activities at home and in places such as Puerto Rico, which historically has been a major manufacturing hub for firms serving the U.S. market. India’s advantages in manufacturing and packaging include relatively low wage rates, an educated workforce, and the widespread use of English as a business language. Western companies have continued to perform high value-added R & D, marketing, and sales activities, and these remain located in their home markets.
During India’s years as an international pariah in the drug business, its nascent domestic industry set the foundations for today’s growth. Local start-ups invested in the facilities required to discover and produce pharmaceuticals, creating a market for pharmaceutical scientists and workers in India. In turn, this drove the expansion of pharmaceutical programs in the country’s universities, thereby increasing the supply of talent. Moreover, the industry’s experience in the generic drug business during the 1990s and early 2000s gained it expertise in dealing with regulatory agencies in the United States and European Union. After 2005, this know-how made Indian companies more attractive as partners for Western enterprises. Combined with low labor costs, all these factors came together to make India an increasingly attractive location for the manufacturing of pharmaceuticals.
The U.S. Federal Drug Administration (FDA) responded to the shift of manufacturing to India by opening two offices there to oversee manufacturing compliance and make sure safety was consistent with FDA-mandated standards. Today, the FDA has issued approvals to producing pharmaceuticals for sale in the United States to some 900 plants in India, giving Indian companies a legitimacy that potential rivals in places such as China lack.
For Western enterprises, the obvious attraction of outsourcing drug manufacturing to India is that it lowers their costs, enabling them to protect their earnings in an increasingly difficult domestic environment where government health care regulation and increased competition have put pressure on the pricing of many pharmaceuticals. Arguably, this also benefits consumers in the United States because lower pharmaceutical prices mean lower insurance costs, smaller co-pays, and ultimately lower out-of-pocket expenses than if those pharmaceuticals were still manufactured domestically. Offset against this economic benefit, of course, must be the cost of jobs lost in U.S. pharmaceutical manufacturing. Indicative of this trend, total manufacturing employment in this sector fell by 5 percent between 2008 and 2010.•
Sources: H. Timmons, “A Pharmaceutical Future,” The New York Times, July 7, 2010, pp. B1, B4; K. K. Sharma, “On the World Stage,” Business Today, January 9, 2011, pp. 116–17; and M. Velterop, “The Indian Perspective,” Pharmaceutical Technology Europe, September 2010, pp. 40–41.
The growth of the Indian pharmaceutical industry is an example of the benefits of free trade and globalization. Before 2005, Indian pharmaceutical companies were shut out of many developed markets by legal barriers to trade. The fact that India did not respect drug patents—and allowed domestic companies to make counterfeit versions of patented medicines—meant that Indian companies were prohibited from selling these products in developed nations. In 2005, India signed an agreement that brought it into compliance with global patent rules. Indian companies stopped making counterfeit medicines, so they could now trade freely with developed countries. This opened up a host of legitimate business opportunities. Today, the fast-growing Indian pharmaceutical industry manufactures low-cost generic and patented medicines for sale around the world, often in partnership with Western drug companies. Western companies continue to perform R&D and marketing activities at home, while contracting out some of their manufacturing activities to Indian enterprises. This practice has lowered manufacturing costs for Western companies and, in turn, led to lower prices and lower insurance costs for Western consumers. At the same time, it has helped create jobs and wealth in India, enabling Indians to boost their purchases of goods and services produced by Western nations.
If there are losers in this process, it is in manufacturing employees in the pharmaceutical industry in developed markets such as the United States, where the number of jobs is starting to fall. In the world of international trade, there are always winners and losers, but as economists have long argued, the benefits to the winners outweigh the costs borne by the losers, resulting in a net gain to society. Moreover, economists argue that in the long run, free trade stimulates economic growth and raises living standards across the board. For example, as India gets richer, the nation’s citizens will consume more goods and services produced in the United States, raising U.S. living standards. On balance, free trade, in the view of economists, is a win–win situation.
The economic arguments surrounding the benefits and costs of free trade in goods and services are not abstract academic ones. International trade theory has shaped the economic policy of many nations for the past 50 years. It was the driver behind the formation of the World Trade Organization and regional trade blocs such as the European Union and the North American Free Trade Agreement (NAFTA). The 1990s, in particular, saw a global move toward greater free trade. It is crucially important to understand, therefore, what these theories are and why they have been so successful in shaping the economic policy of so many nations and the competitive environment in which international businesses compete.
This chapter has two goals that go to the heart of the debate over the benefits and costs of free trade. The first is to review a number of theories that explain why it is beneficial for a country to engage in international trade. The second goal is to explain the pattern of international trade that we observe in the world economy. With regard to the pattern of trade, we will be primarily concerned with explaining the pattern of exports and imports of goods and services between countries. The pattern of foreign direct investment between countries is discussed in Chapter