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Leontief Paradox
Welcome everyone, to the class of International Business. So, in the last lecture we were discussing about the Heckscher Ohlin theory which talked about the labor and capital intensive industries basically and businesses related to that. So, and also we discussed about factors like what should a country, how much should a country trade with other countries, with whom should it trade, and which are the products that it should traderight!.So, then after that we talked about the H-O theory right!. So, today we will be continuingfrom there and we will talk about a few more theories right!.(Refer Slide Time: 01:02)So, one of the most interesting theories was given by Leontief. So, Wassily Leontief in1953 he published a result; his interest was to prove that the H-O model; that means,Heckscher Ohlin model was correct and to show that U.S. exports were capital intensive;it was his objective.But interestingly he found a very opposite result right!. What happened was; so it saidthat the results of the Leontief’s paradox which is one of the most famous empiricalinvestigations in economics right!. And it is an attempt to test the consistency of the H-Omodel right! with the U.S. trade patterns.So, it developed a input table from the 1947 data to determine the capital labor ratiosused in the production of U.S. exports and imports. And interestingly Leontief found thatthe U.S. exports used a capital labor ratio of 13,999 per man year. Whereas importsubstitutes used a ratio of 18,184; let us see what is that.(Refer Slide Time: 02:06)So, the Leontief Paradox; this is a key ratio of; K X / L X. What is K X? K X / L X is thecapital requirement per man year for export. What is K M / L M? The capitalrequirement per man year for import ok!; this is export this is import.Now as he had already found out so this value from here it was 13,991 for exports andimport it was 18,184; so dividing this he got a ratio of 0.77. Now you see given thepresumption; what was presumption? That the U.S. was relatively capital abundant sothere is no doubt that U.S. is one of the economically stronger countries and it has a lotof capital with it.The ratio was, but labor was thought to be the weaker one right! In terms of capital andlabor, capital was much stronger in terms of the labor, but the ratio was just the reverseof what the H-O model had predicted.What is the H-O model said? The H-O model had said if country is good in capital itwould tend to export capital oriented goods intensive goods. And if it is good in laborthen it would tend to export more of labor intensive goods right! But Leontief reached aparadoxical conclusion that the U.S. the most capital abundant country in the worldright! exported labor intensive commodities and imported capital intensive commodities.So, it was contrary to exactly what the H-O model was talking about. So, it was thoughtthe U.S. should be importing lot of labor intensive goods, but on the contrary it wasimporting the capital intensive goods. And exporting it should have been exporting thecapital intensive goods, but it has been importing rather exporting the labor intensivegoods so the it is just the reverse. So, this is what is called as a Leontief Paradox and it isone of the very profound investigations, empirical investigation that is happened ineconomics.(Refer Slide Time: 04:12)The next theory is called the product life cycle theory. So, Raymond Vernon had giventhis theory and he says that the international product life cycle theory of trade state thatthe location of production in certain kinds of products shifts as they go through their lifecycles which consists of four stages; introduction, growth, maturity and decline. So, whatis these four stages?So, it is something like this; first it is an introduction stage right! so there is a very lessgrowth and then it takes off. So growth and then there is a maturity right! and then thereis a decline right! So, the shape could differ according to the industry and the product,but this is something how it look!s like introduction, growth, maturity and the decline.The introduction stage is marked by evolving product characteristics, like; innovation inresponse to the observed need, exporting by the innovating country and involve evolvingproduct characteristics.So, in the introduction stage the product is being formulated it is being just made and thedistribution network, the promotion everything is being arranged accordingly right! So,this is the stage where the companies do not make much of a profit right! and theproducts are newly being introduced into the market.(Refer Slide Time: 05:30)Second phase is the growth; where there is an increase in export by the innovativecountry. So, now, the country has started making more of these products and they havebecome an expert in producing these goods and they have become specialized expertsright! they have got a specialization.So, now, they are producing the goods in much cheaper and efficient manner so there isan increase in the export. Competition increases in this stage when there is a lot ofprofitability comes in so other players try to get into the market for the same product.Increased capital intensity; so the capital to develop the new products during the growthstage is also increasing. And some foreign production also happens because you have tocater to a new market because of the demand in the foreign markets.So, instead of producing and supplying as if we discussed in the last class transportationcosts are very high when it is a large country like; India, China, and Russia or the U.S..So, instead of having it we will have a production center at that place right! So, someforeign productions also starts happening so this is the growth stage.The third stage is the maturity; now what is happening in the maturity? In the maturitynow right! so let us say so maturity what is happening there a decline in export from theinnovating country. Now why there is a decline in export from the innovating country.The innovating country which made it now finds that new players are coming in whowant to produce the same product. Now these players are producing it in their may be intheir home market or may be other markets also, but they have an advantage may be interms of capital, in terms of better technology.So, what has happened is now they are able to produce at lower cost than the innovatingcountry right! so that becomes a problem. So, there is a decline has started in the exportsright! and other countries like India the you know China which are the new countrieswhich are have developed. Now they are growing faster and they are exporting moregoods which earlier was being done by some of the developed countries may be.More product standardization; now in this is the stage where in a maturity there is nonew products or new you know differentiation being created. The products are more orless standardized. So, it becomes simpler to produce economies of scale are achieved it isgood that is the positive side. Again capital intensity is required because new players arecoming in, competition is rising.So, competition of price comes in; what it says longer production run reduce the per unitcost the economies of scale which I am saying. So, now, there is an increasedcompetition in price. So, advantage will be taken over by a country or a company whichproduces in a large bulk and minimizes its cost ok!Production starts up in emerging economies; so now, new production is starting in theemerging economies like emerging economies like India Mexico, Philippines, Malaysia,Thailand right!The last stage is the decline a concentration of production in the developing countries;now large production base has started even in the developing countries. The innovativecountry now finds it is absolutely uneconomical to produce it on their own. So, theybecome a net importer and now they have stopped completely exporting ok!(Refer Slide Time: 08:57)Look! at this diagram during its life cycle focus on the products production and marketlocation often shifts so this is what we had said. So, product location so what ishappening to product location in the introduction, growth , maturity and decline let ussee in innovating usually in innovating country so the country which innovated right!Let us say the developed country growth in innovating and other industrial countries.Now it shifts to the other industrial countries from there it goes to multiple countries.Now more number of countries the developing nations are also slowly coming in.Decline stage; now it is becoming mainly in the developing nations right! and from thedeveloping nations now this will get exported to the developed nations mainly in theinnovating country with some exports. So, it is a first it is a home market, so we talkabout the ethnocentrism if you remember ethnocentrism, polycentrism, right!geocentrism we had spoken in one class if you remember that so, it comes to the mostlyfocused in the home right!Second what happens in the growth stage mainly in the industrial countries right! So, themarket location is where it is being sold mainly in the industrial countries and shift inexports to the foreign production replaces export in some other markets too.What happens in maturity? During maturity the growth, the market location the marketexpands in the developing countries. And there is a fall in the decrease in the industrialcountries or the innovative country included right! During the decline stage most of themarket location shifts to the developing countries and some developing country startexporting to they have started exporting in a large way.Competitive factors; now coming to the competitive factors what happens to thecompetition? During the introduction it is a monopoly situation. So, there is only oneplayer or somebody one only who is making it. Sales based on uniqueness rather than theprice. So, price is not a factor during the introduction stage. It is the uniqueness of theproduct, how important the product is, how much demand the product has created right!And new characteristics that are involving in the product that is the introduction stage.When the product comes to the growth stage now; how does the competition change?Fast growing demand; so demand is started growing, number of competitors areincreasing, some competitors start price cutting; so there is a price cutting. Now, the youknow developed countries will have a disadvantage because they have put a lot of theyhad R & D cost involved, they had introduction you know during the introduction aproduct is not immediately accepted by the market.So, there is a law of diffusion it takes time to diffuse into the market. So, that time whichthey had spent now is they did not have much sales in that time so they made somelosses now these losses will not be made by the developing countries because already themarket is now created ok! So some companies begin price cutting and the product isbecoming more standardized.During the maturity stage overall stabilized demand so the demand is more or lessknown there is no much chance of expansion, competitors decreases. Now many some ofthe competitors will think of to stop the production. Price is very important because nowit is a price competition. Anybody who can supply the product at a lower cost will winthe war, chances are very fair.Finally, if you come to the decline stage overall decline starts, price is the key weaponand number of producers continues to decline right! So, these are some of the things thathappen characteristics in the decline stage.Now, in terms of production technology when we come what happens to theirintroduction growth maturity and decline let us see. So, during the introduction stage youhave short production runs; why? Because you do not know how much to produce; soyou do not know exactly the you cannot forecast the demand in the market. Evolvingmethods to coincide with the product evolution; so new methods are getting evolvedright!.High labor inputs and labor skills relative to capital; so lot of labor inputs are requiredlabor skills are required because it is a new product and nobody is aware. So, once theawareness comes then only you can adjust the technology to suite that production. So,that is not possible in the introduction stage.Growth stage what is happening? Capital input increases so now, more money is beingput into the develop the technology related to this product. Methods are more or lessstandardized ok! so now, there is some sense what is the demand? what is the design?that is required by the customer all things are known.In the maturity now long production runs because it is a continuous production becausethe demands are known and we will try to achieve economies of scale and we would notdo lot of switching during the production. So, switching costs are also less right! which ismore in the in introduction stage.Highly standardized and less labor needed now.Technology does most of the things. Inthe decline stage unskilled labor or mechanized long production runs why because nowthis is the stage where the developing countries are making it. Now the developedcountries have left this market this product.So, they are not interested to get into it any more rather they would try to get into newproducts and they would allow these developing countries to import this same product tothem so right! So, this is the international product life cycle theory.(Refer Slide Time: 14:26)Now, what are the limitations of this PLC theory let us see. Some products conform tothe dynamics of the PLC product lifecycle for example, ball point pen, calculator, smallcars, mobile phones etc; however, if transportation costs are very high there is littleopportunity for export sales regardless of the stage in the lifecycle. So, be you are in aintroduction stage also, but still you would not like to export to other countries becauseyou find that the transportation costs are very high and you have not achieved those kindof economies where the production costs are very very low.Not all products conform to the dynamics example; products with a very rapidinnovation. So, that has been developed by people by through research and through scientific youknow through scientific approach and lot of capital needs to be infused into it right!So, R & D is involved in there example you see Switzerland was the first country toexperience labor shortage they abandoned all the labor intensive watches andconcentrated on only innovative high end watches.They are very good in pharmaceutical in the area of pharmaceutical why? Becausepharmaceutical industries are not labor they do not require labor they are moretechnically technology oriented right! So, all innovative high end industries became ayou know pattern of they grew in Switzerland.On the other hand you see Saudi Arabia is second largest oil producer in the world afterU.S. and it is supplying lot of oil to other countries because that is a natural resource withit right!(Refer Slide Time: 19:15)Second condition is a demand condition what it is saying; the nature of home demand forthe countries product or service. So, what is the demand in the home country? A nationsfirms gain competitive advantage if their domestic consumers are sophisticated anddemanding; why you know is an advantage? Because it creates for innovation andquality.So, more demanding the products the people in the country are so there would be a largeyou know demand for you know every time the demand would change because youknow of a pressure in the society, pear pressure, status and all these things the consumerswould like to have all the time new new products. So, new innovations is a mandatorything that has to be done. So, that supports the companies and the home country right!You see Japans sophisticated and knowledgeable buyers of cameras helped the Japanesecamera industry to improve the product quality and to introduce innovative models right!Similarly the French wine industry the French are so sophisticated for wine consumersthat they forced and helped the French wineries to produce high quality wines. So, this isall happened because the local people; you see why Indians have an advantage when itcomes to things like you know algorithms because the Indians have been always good atmathematics right! So, our ancestors and from forefathers it has been coded in our gene.For example, I am going to say that we are naturally good at math’s; so that is whyIndians you will see they are very good IT people, there are very good scientists fromIndia. So, that is the basic reason is that we are good at statistics and you knowmathematics right!(Refer Slide Time: 20:58)Relating and supporting industry; the presence or absence of supplier industries andindustries and related industries are that are internationally competitive. What it has tomean? Can spill over and contribute to other industries right! Successful industrieswithin a country tend to be grouped into clusters.For example, the technological leadership in the U.S. semiconductor industry providedthe basis for US success in personal computers had U.S. not had an advantage of semiconductors it would not have been one of the largest producers of computers personalcomputers. And several other technically advanced electronic products including theApple may be right! the Apple like products.So, what it says; suppose a country has a is producing something and whatever the localthe other auxiliary parts are required to produce the main product a main product mayrequire the OEM may require several other products right! So, if these products are notavailable then it becomes very difficult ok!Bangladesh textile industry; Bangladesh has a vibrant network of supporting industriesthat supply input to its garment manufacturer. So, for a garment manufacturer there areseveral other things that are required right! in terms of technology and other support. So,75 percent of all the inputs that a textile industry requires are made locally which savesthe transportation and storage costs and even import duties.So, that is why Bangladesh has been you know even when the you know the quotasystem was abolished right! after the Uruguay round. (Refer Time: 22:31) Stilleverybody felt that Bangladesh would do very badly in the textile sector because it wasonly getting a protectionary quota, but it did not happen that way. Bangladesh rather didbetter and better in terms of the textile export right!(Refer Slide Time: 22:46)The last point is the firm strategy structure and rivalry; so the conditions governing howcompanies are created, organized and managed and the nature of the domestic rivalryright! So, Porter makes two important points; first different nations are characterized bydifferent management ideologies right!For example, you see there is a very famous saying that the Japanese are always theywant to be 100 percent correct. On the other hand, the U.S. management would like to beclose to 100 percent, but not 100 percent right! Because that difference in the last fewpercentage takes a lot of time and effort right! So, this ideological difference is a reasonwhich also creates a structural difference which either help them or do not help them tobuild national competitive advantage.Now for example, when we talk about Germany and we talk about machines we cannotthink other then German machines, why? Because these people have created and youknow they have organized and managed and they have created such companies which areexcellent in producing these kind of goods right!Second the dynamic domestic rivalry induces firms to look for ways to improveefficiency. Now in Germany for example, you see if there are so many producers ofengines and high tech machines. Then automatically there is a competition and the yousee any trade starts from the home market right! so we say first is ethnocentric.So, first thing is that whether you are how you are doing good. Once you do good in thedomestic market then generally that is generally then you go to the export or theinternational market. It is never that somebody starts you know producing a new productto for the international market it cannot happen. Yes, if the product is already existingand a new manufacturer tries to install a assembly or a commission a plant and export itthat is a different story.But a new product start and somebody wants to directly export it is not possible. Becausehe or she himself the company himself is not sure about the quality of the product right!So, what it says the domestic rivalry induces firms to look for ways to improveefficiency, create pressures to innovate and to improve quality.So, this reduces the cost and help investing in the upgrading the advanced factors. So,now, the companies would look! in to put in more money invest more money to upgradetheir technologies to produce at a much lesser cost and at a better quality product right!So, one example is the Indian telecom industry. So, Indian telecom industry is nowlooking at because of a huge market many of the companies are coming to India andestablishing their plants right! to set up to buy to produce the phones right! mobilephones especially. So, this is what even you go to the if you look at India is still secondexample I would give. The number one I can think of is China.So, why is that every product is being made in China because China the production thegovernment is supporting production in China so much that it has helped creating lot ofpressure among the Chinese companies which has resulted them to be more efficient interms of production, technology and everything. And that is why when they export thesame good to other countries they can easily beat them because of a high advantage interms of the price.And even now very good quality also quality it is not always that the Chinese goods areinferior. There is a notion that Chinese goods are inferior that is not correct right! Theyhave archived an advantage because they have the government support has and it hasstreamlined the production system so well that today China can easily compete withmany of the countries. And it has it has excelled than many of the countries in terms ofits production right!(Refer Slide Time: 26:33)So, this example you can take; Japan has high priced land and so its factory space is at apremium this leads to just in time inventory techniques. So, what is just in time? I wouldlike the inventory only at the time when I require it, so I do not want to store it in someplace. Because storage is more costlier and I do not have space. So, Japanese firms cannot have a lot stock taking up space so to cope with the potential of not having goodsaround when they need it they are using the just in time inventory right!Toyota operates using a JIT inventory relying on its supply chain to deliver the parts itneeds to build cars. The parts needed to manufacture the cars do not arrive before or afterthey are needed rather they arrive just as they are needed. So, this is the just in timetheory.(Refer Slide Time: 27:19)So, the policy implications of the porter demand we will maybe we will wind up here.So, what it says porter suggests that it is in the best interest of business for a firm toinvest in upgrading advanced factors of production.For example; to invest in better training for its employees, to increase it is commitmentto research and development. So, more R & D new products, new innovations and newinnovations means new you know new markets right! To lobby the government to adoptpolicies that have a favorable impact on each component of the national diamond so thefour parts right!Businesses should urge government; so that is the policy implication of what MichaelPorter said to businesses should urge government to increase investment in educationinfra and basic research. So, this is a transition time which India is going through. So,India has grown very fast in the last few years and especially in the last 5-6 yearsbecause of a huge investment in infrastructure and education.So, the Indian governments have done it very nicely, they have tried to develop theeducation infrastructure. Because earlier it was not so good and India was very underkind of a developing nation only. But today the word developing for India may not besuitable it is more of a developed nation closed to a developed nation.(Refer Slide Time: 28:40)And to adopt policies that promote strong competition within the domestic markets. Thisis a one limitation so what are the limitations let us see. Entrepreneur may face favorableconditions for many different lines of business right! So, what it says limitations of thePorter’s theory the existence of four favorable condition does not guarantee that anindustry will develop in a given local.So, if you think that I have an advantage of labor I will do good in a labor intensiveindustry, may not hold correct. You see for example, conditions in Switzerland wouldseem to have favored success in the personal computer space, but somehow Swizzcompanies prefer to protect their global position in product line such as watches andscientific instrument rather than the rather than the other the personal computer right!Even though an absolute advantage may exist had they gone for the personal computerso that does not happen; why? Because, the entrepreneur may face the favorableconditions for some other good right! or that looking at the demand right!(Refer Slide Time: 29:42)Second limitation is what it says is that; the concerns, the increase the ability increaseability of the companies to attend market information production factors and suppliesfrom abroad.For example, earlier times it was it was highly restrictive. So, if you wanted to getsomething from abroad it was a challenge, but today capital and managers are nowinternationally mobile. So, you can there is an easy flow of money and easy flow ofhuman resource. Materials and components are now more easily brought in from abroadbecause of advancement in transportation and relaxation of import restrictions.So, because of the free trade theory now it has become more easy right! So, Porter’stheory has not been sufficiently tested to know how well it holds up. So, far it has notbeen tested.(Refer Slide Time: 30:31)So, these are some of the limitations right! So, today we will wind up with this Porter’stheory where it speaks about; how what are the four factors and how they influence anygovernment any trade right! within a country. And today we discussed about these thingsthe Leontief’s paradox and then Porter’s model and I hope you are clear with it.So, we will continue from here in the next class and bye then take care.Thank you very much.