Chapter 1

Why firms pursue international business:

The commonly held theories as to why firms become motivated to expand their
business internationally are

(1) The theory of comparative advantage

(2) The imperfect markets theory

(3) The product cycle theory.

Theory of Comparative Advantage:

The theory of comparative advantage suggests that each country should use its
comparative advantage to specialize in its production and rely on other countries to
meet other needs. When a country specializes in some products, it may not produce
other products, so trade between countries is essential

Multinational business has generally increased over time due to the heightened
realization that specialization by countries can increase production efficiency.

Some countries, such as Germany and the United States, have a technology advantage,
while other countries, such as Pakistan, India and Bangladesh have an advantage in the
cost of basic labor.

Since these advantages cannot be easily transported, countries tend to use their
advantages to specialize in the production of goods that can be produced with relative
efficiency.

Due to comparative advantage in technology advancement countries such as Germany

and theUnited States are large producers of computer components, while countries
such as Pakistan , India and Bangladesh are large producers of agricultural and
handmade goods and specialize in labor intensive industries.

When a country specializes in some products, it may not produce other products, so
trade between countries is essential. This is the argument made by the classical theory
of comparative advantage. Comparative advantages allow firms to penetrate foreign
markets. Due this South Asian countries import machinery and technological product
from west and export agricultural products and human capital to western countries

Imperfect Markets Theory:

The imperfect markets theory suggests that because of imperfect markets, factors of
production are immobile, which encourages countries to specialize based on the
resources they have. Due to this fact the countries trade with each other for the product
they cannot manufacture or produce themselves which result in international trade

Explanation:

If each country’s markets were closed from all other countries, there would be no
international business. At the other extreme, if markets were perfect so that the factors
of production (such as labor) were easily transferable, then labor and other resources
would flow wherever they were in demand. The unrestricted mobility of factors would
create equality in costs and returns and remove the comparative cost advantage, the
rationale for international trade and investment. However, the real world suffers from
imperfect market conditions where factors of production are somewhat immobile.
There are costs and often restrictions related to the transfer of labor and other
resources used for production. There may also be restrictions on transferring funds and
other resources among countries .Because markets for the various resources used in
production are “imperfect,” MNCs such as the Gap and Nike often capitalize on a foreign
country’s resources. Imperfect markets provide an incentive for firms to seek out
foreign opportunities.

Product Cycle Theory:

The product cycle theory suggests that after firms are established in their home
countries, they commonly expand their product specialization in foreign countries

Explanation:

One of the more popular explanations as to why firms evolve into MNCs is the product
cycle theory. According to this theory, firms become established in the home market as
a result of some perceived advantage over existing competitors, such as a need by the
market for at least one more supplier of the product. Because information about
markets and competition is more readily available at home, a firm is likely to establish
itself first in its home country. Foreign demand for the firm’s product will initially be
accommodated by exporting. As time passes, the firm may feel the only way to retain its
advantage over competition in foreign countries is to produce the product in foreign
markets, thereby reducing its transportation costs.
CHAPTER 2:
Balance of Payment:
Balance of Payment (BOP) is a statement which records all the monetary transactions
made between residents of a country and the rest of the world during any given period.
This statement includes all the transactions made by/to individuals, corporates and the
government and helps in monitoring the flow of funds to develop the economy

Explanation:

The balance of payments is a measure of international money flows. Financial managers

of MNCs monitor the balance of payments so that they can determine how the flow of
international transactions is changing over time. The balance of payments can indicate
the volume of transactions between specific countries and have a major influence on
the long-term planning and management by MNCs.

Components OF Balance of Payment:

The key components of the balance of payments are:

1) current account,
2) capital account,
3) Financial account.

The current account is a broad measure of the country’s international trade balance.

The capital account measures the value of financial and nonfinancial assets transferred
across country borders.

The financial account consists mainly of payments for direct foreign investment and
investment in securities (portfolio investment)

Current Account:
The current account measures the flow of funds between one country and all other
countries due to purchases of goods and services or to income generated by assets.

The main components of the current account are payments for (1) merchandise (goods)
and services, (2) factor income, and (3) transfers.
Payments for Merchandise and Services:

 Current account incorporates merchandise and services imports and exports.

 Merchandise exports and imports represent tangible products, such as Machinery
and textiles that are transported between countries. Service exports and imports
represent tourism and other services, such as legal insurance, and consulting
services, provided for customers based in other countries.
 Service exports by the Pakistan result in an inflow of funds to the Pakistan, while
service imports by the Pakistan result in an outflow of funds.

Balance of Trade:

The difference between total exports and imports is referred to as the balance of trade.

A deficit in the balance of trade means that the value of merchandise and services
exported by the Pakistan is less than the value of merchandise and services imported by
the Pakistan.

Currently Pakistan has a negative balance of trade

Factor Income Payments: A second component of the current account is factor income,
which represents income (interest and dividend payments) received by investors on
foreign investments in financial assets (securities).

Factor income received by Pakistani investors reflects an inflow of funds into the
Pakistan. Factor income paid by the Pakistan reflects an outflow of funds from Pakistan

Transfer Payments: A third component of the current account is transfer payments,

which represent aid, grants, and gifts from one country to another.

Financial Account:
The financial account measures changes in domestic ownership of foreign assets and
foreign ownership of domestic assets. If foreign ownership increases more than
domestic ownership does, it creates a deficit in the financial account. This increase
means the country is selling its assets, like gold, commodities, and corporate stocks,
faster than the nation is acquiring foreign assets.

The financial account measures the flow of funds between countries that are due to
(1) direct foreign investment, (2) portfolio investment, and (3) other capital
investment.

Direct Foreign Investment The financial account keeps track of a country’s payments for
new DFI over a given period (such as a specific quarter or year).

Payments representing DFI in the Pakistan (such as the acquisition of a Pakistan. firm by
a non-pakistani firm)are recorded as a positive number in the pakistani financial
account, because funds are flowing into the Pakistan. Conversely, payments
representing a Pakistan.-based MNC’s DFI in another country are recorded as a negative
number because funds are being sent from the Pakistan to another country.

Examples of DFI by the Pakistan include an MNC’s payments to complete its acquisition
of a foreign company, to construct a new manufacturing plant in a foreign country, or to
expand an existing plant in a foreign country.

Portfolio Investment: The financial account also keeps track of a country’s payments for
new portfolio investment (investment in financial assets such as stocks or bonds) over a
given period (such as a specific quarter or year). Thus a purchase of Heineken
International (Netherlands) stock by a U.S. investor is classified as portfolio investment
because it (Netherlands) stock by a U.S. investor is classified as portfolio investment
because it represents a purchase of foreign financial assets without changing control of
the company.

This transaction is recorded as a negative number for the U.S. financial account (a
debit), as it reflects a payment from the United States to another country. If a U.S. firm
purchased all of Heineken’s stock in an acquisition, this transaction would result in a
transfer of control and therefore would be classified as DFI instead of portfolio
investment.

Other Capital Investment: A third component of the financial account consists of other
capital investment, which represents transactions involving short-term financial assets
(such as money market securities) between countries. In general, DFI measures the
expansion of firms’ foreign operations, whereas portfolio investment and other capital
investment measure the net flow of funds due to financial asset transactions between
individual or institutional investors.

Capital Account
The capital account measures the flow of funds between one country and all other
countries due to financial assets transferred across country borders by people who
move to a different country, or due to sales of patents and trademarks.

The sale of patent rights by a U.S. firm to a Canadian firm is recorded as a positive
amount (a credit) to the U.S. capital account because funds are being received by the
United States as a result of the transaction. Conversely, a U.S. firm’s purchase of patent
rights from a Canadian firm is recorded as a negative amount (a debit) to the U.S. capital
account because funds are being sent from the United States to another country

FACTORS AFFECTING INTERNATIONAL TRADE FLOWS:

Because international trade can significantly affect a country’s economy, it is important

to identify and monitor the factors that influence it.

1. Cost of labor
2. Inflation
3. National income
4. Government policies
5. Exchange rates

Cost of Labor:

Firms in countries where labor costs are low commonly have an advantage when
competing globally, especially in labor intensive industries.

The cost of labor varies among countries. Many of China’s workers earn wages of less
than $300 per month, and so it is not surprising that China’s firms commonly produce
products that require manual labor at a lower cost compared to many countries in
Europe or North America. Within Europe, wages of Eastern European countries tend to
be much lower than wages of Western European countries

Impact of Inflation:

If a country’s inflation rate increases relative to the countries with which it trades, its
current account will be expected to decrease, other things being equal. Consumers and
corporations in that country will most likely purchases more goods overseas (due to
high local inflations (manufacturing or production cost rises)), while the country’s
exports to other countries will decline.
Impact of National Income:

If a country’s income level (national income) increases by a higher percentage than

those of other countries, its current account is expected to decrease, other things being
equal. As the real income level (adjusted for inflation) rises, so does consumption of
goods. A percentage of that increase in consumption will most likely reflect an increased
demand for foreign goods.

Impact of Government Policies:

A country’s government can have a major effect on its balance of trade due to its
policies on subsidizing exporters, restrictions on imports, or lack of enforcement on
piracy.

 Subsidies for Exporters:

Some governments offer subsidies to their domestic firms, so that those firms can
produce products at a lower cost than their global competitors. Thus, the demand for
the exports produced by those firms is higher as a result of subsidies.

Many firms in China commonly receive free loans or free land from the government.
These firms incur a lower cost of operations and are able to price their products lower
as a result, which enables them to capture a larger share of the global market.

 Restrictions on Imports:

If a country’s government imposes a tax on imported goods (often referred to as a

tariff), the prices of foreign goods to consumers are effectively increased. Tariffs
imposed by the U.S. government are on average lower than those imposed by other
governments. Some industries, however, are more highly protected by tariffs than
others. American apparel products and farm products have historically received more
protection against foreign competition through high tariffs on related imports.

In addition to tariffs, a government can reduce its country’s imports by enforcing a

quota, or a maximum limit that can be imported. Quotas have been commonly applied
to a variety of goods imported by the United States and other countries.

 Lack of Restrictions on Piracy:

In some cases, a government can affect international trade flows by its lack of
restrictions on piracy. In China, piracy is very common; individuals (called pirates)
manufacture CDs and DVDs that look almost exactly like the original product produced
in the United States and other countries. They sell the CDs and DVDs on the street at a
price that is lower than the original product. They even sell the CDs and DVDs to retail
stores. It has been estimated that U.S. producers of film, music, and software lose $2
billion in sales per year due to piracy in China.

As a result of piracy, China’s demand for imports is lower. Piracy is one reason why the
United States has a large balance-of-trade deficit with China. However, even if piracy
were eliminated, the U.S. trade deficit with China would still be large.

Impact of Exchange Rates:

Each country’s currency is valued in terms of other currencies through the use of
exchange rates, so that currencies can be exchanged to facilitate international
transactions.

The values of most currencies fluctuate over time because of market and government
forces.

If a country’s currency begins to rise in value against other currencies, its current
account balance should decrease, other things being equal. As the currency strengthens,
goods exported by that country will become more expensive to the importing countries.
As a consequence, the demand for such goods will decrease

In general, the examples here suggest that when currencies are strong against the U.S.
dollar (when the dollar is weak), U.S. exports should be relatively high, and U.S. imports
should be relatively low. Conversely, when currencies are weak against the U.S. dollar
(when the dollar is strong), U.S. exports should be relatively low, and U.S. imports
should be relatively high, which would enlarge the U.S. balance of trade deficit

J Curve effect:
In economics, it is often used to observe the effects of a weaker currency on trade
balances. The pattern is as follows:

 Immediately after a nation's currency is devalued, imports get more expensive and
exports get cheaper, creating a worsening trade deficit (or at least a smaller trade
surplus).
 Shortly thereafter, the sales volume of the nation's exports begins to rise steadily,
due to their relatively cheap prices in foreign markets.
 At the same time, consumers at home begin to buy more locally-produced goods
because they are relatively affordable compared to imports.
 Over time, the trade balance between the nation and its partners bounces back
and even exceeds pre-devaluation times.
 The devaluation of the nation's currency had an immediate negative effect
because of an inevitable lag in satisfying greater demand for the country's
products.

When a country’s currency appreciates a reverse J-curve may occur. The country’s
exports abruptly become more expensive for importing countries. If other countries can
fill the demand for a lower price, the stronger currency will reduce its export
competitiveness. Local consumers may switch to imports, too, because they have
become more competitive with locally-produced goods.