Chapter Two

International Trade
and
Investment Theories
Theories of International Trade and Investment
 Theories of International trade
Why do nations trade?
• Mercantilism: A belief popular in the 16th century that national
prosperity results from maximizing exports and minimizing
imports.
• Today, some argue for neomercantilism --- the idea that the
nation should run a trade surplus.
• A trade theory which holds that a government can improve the
economic well-being of the country by encouraging exports and
stifling imports
• Supporters of neomercantilism include:
 Labor unions (who want to protect domestic jobs),
 Farmers (who want to keep crop prices high), and
 Some manufacturers (that rely on exports).
But is neomercantilism best for all?
 Free Trade

The absence of restrictions to the

flow of goods and services among nations.
• Free trade is usually best because it leads to:
 More and better choices for consumers and firms
 Lower prices of goods for consumers and firms
 Higher profits and better worker wages (because
imported input goods are usually cheaper)
 Higher living standards for consumers (because
their costs are lower).
 Greater prosperity in poor countries.
 Comparative Advantage
• Comparative advantage or country-specific
advantage is the foundation concept of international
trade that answers the question of how nations can
achieve and sustain economic success and prosperity.

• It refers to the superior features of a country that

provide it with unique benefits in global competition.

• Comparative advantages are derived either from

natural endowments or from deliberate national
policies.
 Examples of National Comparative Advantage

• France has a climate and soil superior for producing

wine.
• Saudi Arabia has a natural abundance of oil for the
production of petroleum products.
• Over time, Japan has acquired a superior base of
knowledge and experience for producing cars.
• Over time, India has acquired a superior base of IT
workers for producing computer software.
What are the comparative advantages of Ethiopia?
 Competitive Advantage
• Competitive advantage or firm-specific advantage is a
foundation concept that explains how individual firms gain and
maintain distinctive competencies, relative to competitors, that
lead to superior performance.
• It refers to the distinctive assets, competencies, and
capabilities that are developed or acquired by the firm.
• The collective competitive advantages held by the firms in a
nation are the basis for the competitive advantages of the
nation at large.
• Michael Porter has used competitive advantage to refer to the
advantages possessed by both nations and individual firms in
international trade and investment.
 Examples of Firm Competitive Advantage

• Dell’s competence in the management of its global

supply chain
• Samsung’s technological leadership in flat-panel
televisions

• Cadbury’s capabilities in international

marketing and distribution
 Absolute Advantage Principle
A country should produce only those products in which it
has absolute advantage or can produce using fewer
resources than another country

(Labor Cost in Days of Production for One Ton)

 Comparative Advantage Principle
It is beneficial for two countries to trade even if one has absolute
advantage in the production of all products; what matters is not
the absolute cost of production but the relative efficiency with
which it can produce the product

(Labor Cost in Days of Production for One Ton)

Comparative Advantage Principle (cont’d)
“Two men can make both shoes and hats, and one is superior
to the other in both employments, but in making hats he can
only exceed his competitor by one fifth or 20 percent, and in
making shoes he can excel him by one third or 33 percent;
Will it not be for the interest of both that the superior man
should employ himself exclusively in making shoes and the
inferior man in making hats?” David Ricardo, 1817

Copyright © 2014 Pearson Education Inc.

 Comparative Advantage Principle (cont’d)
• While Germany can make both items cheaper than France,
it is still beneficial for Germany to trade with France.
• The key is the ratio of production costs. In the exhibit,
Germany is comparatively more efficient at producing cloth
than wheat: it can produce three times as much cloth as
France (30/10), but only two times as much wheat (40/20).
• Germany should specialize in producing cloth and import all
the wheat it needs from France. France should specialize in
producing wheat and import all its cloth from Germany.
• Each country benefits by specializing in the product in
which it has a comparative advantage and importing the
other product.
 Comparative Advantage Principle (cont’d)
• The principle applies to all goods. It reveals how countries use
scarce resources more efficiently.

Example
•Arguably, no country is better than Japan at making cars
and cell phones. But because Japan is especially good at
making cars, it concentrates its resources on making them.
•Other countries, such as China and Finland, focus on
making cell phones.
•In this way, Japan makes maximal use of its resources, and
the world gets great cars.
 Limitations of Early Trade Theories
• Fail to account for international transportation costs.
• Governments distort normal trade by selectively
imposing protectionism (e.g., tariffs) or investing in
certain industries (e.g., via subsidies).
• Services: Some cannot be traded; others can be traded
freely via the Internet or global telephony.
• For many firms, scale economies and superior business
strategies provide efficiencies and other advantages.
Early trade theories failed to account for this. (E.g.,
Japan lacks comparative advantages, but its firms
succeeded anyway, via superior strategies.)
 Factor Proportions Theory
• Also known as the factor endowments theory, it argues
that each country should produce and export products that
intensively use relatively abundant factors of production
and import goods that intensively use relatively scarce
factors of production.

• Eli Heckscher and Bertil Ohlin proposed this theory based

on two premises: (1) products differ in the types and
quantities of factors (labor, natural resources, and capital)
required for their production; and (2) countries differ in the
type and quantity of production factors they possess.
 Factor Proportions Theory

• However, the Leontief Paradox revealed that

countries can successfully export products that use
less abundant resources (e.g., the U.S. often exports
labor-intensive goods). Implies that international
trade is complex and cannot be fully explained by a
single theory.
• Perhaps the main contribution of the Leontief
paradox is its suggestion that international trade is
complex and cannot be fully explained by a single
theory.
International Product Life Cycle Theory
• In his International Product Life Cycle (IPLC) Theory,
Vernon observed that each product and its
manufacturing technologies go through three stages
of evolution: introduction, maturity, and
standardization.
• During the introduction stage, the new product is
produced in the home country, which enjoys a
temporary monopoly.
• In the introduction stage, a new product typically
originates in an advanced economy, such as the
United States.
International Product life Cycle Theory (cont’d)
• As the product enters the maturity phase, the
product’s inventors mass-produce it and seek to
export it to other advanced economies
• In the maturity stage, the product’s manufacturing
becomes relatively standardized; other countries
start producing and exporting the product.
• At this stage, as competition intensifies and export
orders begin to come from lower-income countries,
the inventor may earn only a narrow profit margin.
International Product life Cycle Theory (cont’d)

• In the standardization phase, knowledge about how

to produce the product is widespread and
manufacturing becomes straightforward.
• In the standardization stage, manufacturing ceases
in the original innovator country, which then becomes
a net importer of the product.
• Today under globalization, for many products, the
cycle occurs quickly.
 New Trade Theory
• Argues that economies of scale are an important
factor in some industries for superior international
performance, even in the absence of superior
comparative advantages. Some industries succeed
best as their volume of production increases.

Example
The commercial aircraft industry has very high fixed costs
that necessitate high-volume sales to achieve profitability.
Comparative vs. Competitive Advantage
Critical Role of Innovation
in National Economic Success

• Innovation is a key source of competitive advantage.

• The firm innovates in four major ways. It can

develop:
(1) A new product or improve an existing product
(2) New ways of manufacturing
(3) New ways of marketing
(4) New ways of organizing company operations.

• Many innovative firms in a nation leads to national

competitive advantage
 Critical Role of Productivity
in National Economic Success

• Innovation promotes productivity

• Productivity is the value of the output produced by a unit
of labor or capital.
• It is a key source of competitive advantage for firms.
• The greater the productivity of the firm, the more
efficiently it uses its resources.
• The greater the aggregate productivity of the firms in a
nation, the more efficiently the nation uses its resources.
• Aggregate productivity is a key determinant of the
nation’s standard of living.
Michael Porter’s Diamond Model:
Sources of National Competitive Advantage
Diamond Model
Sources of National Competitive Advantage (cont’d)

• Factor conditions – Quality and quantity of labor,

natural resources, capital, technology, know-how,
entrepreneurship, and other factors of production.

Example
An abundance of cost-effective and well-educated workers
give China a competitive advantage in the production of
laptop computers.
 Diamond Model
Sources of National Competitive Advantage (cont’d)

• Related and supporting industries – the presence

of suppliers, competitors, and complementary firms
that excel within a given industry.

Example
The Silicon Valley in USA is a great place to
launch a computer software firm because it is home
to thousands of knowledgeable firms and workers in
the software industry.
Diamond Model
Sources of National Competitive Advantage (cont’d)

• Demand conditions at home – the strengths and

sophistication of customer demand.
• Demand conditions refer to the nature of home-
market demand for specific products and services
• The presence of highly demanding customers
pressures firms to innovate faster and produce better
products
Example
Japan is a densely populated, hot, and humid country
with very demanding consumers. These conditions
led Japan to become one of the leading producers of
superior, compact air conditioners.
Diamond Model
Sources of National Competitive Advantage (cont’d)

• Firm strategy, structure, and rivalry – The nature of

domestic rivalry, and conditions that determine how a
nation’s firms are created, organized, and managed.

Example
Italy has many top firms in design industries such as textiles,
furniture, lighting, and fashion. Vigorous competitive rivalry
puts these firms under constant pressure to innovate, which has
propelled Italy to a leading position in design, worldwide.
 Industrial Cluster
• A concentration of suppliers and supporting firms
from the same industry located within the same
geographic area. Similar to Porter’s Related and
Supporting Industries.
• A strong cluster can serve as an export platform for
the nation.
Examples
Silicon Valley; pharmaceutical cluster in Switzerland;
footwear industry in Pusan, South Korea; IT industry in
Bangalore, India; fashion cluster in northern Italy.
 National Industrial Policy
• A proactive economic development plan
employed by the government to nurture or
support promising industry sectors with potential
for regional or global dominance. Initiatives can
include:
 Tax incentives
 Monetary and fiscal policies
 Rigorous educational systems
 Investments in national infrastructure
 Strong legal and regulatory systems
Examples of National Industrial Policy
• Vietnam’s government in the 1990s privatized state
enterprises and modernized the economy,
emphasizing competitive, export-driven industries.
Vietnam became one of the fastest-growing
economies, averaging around 8 percent annual GDP
growth.
• Singapore adopted probusiness, proinvestment,
export-oriented policies, combined with state-
directed investments in strategic corporations. The
approach stimulated economic growth that averaged
8 percent annually from 1960 to 1999.
Examples of National Industrial Policy (cont’d)

• The Czech government in the 1990s created a

business-friendly legal and regulatory environment.
The country privatized state-owned companies.
Government FDI incentives attracted numerous
MNEs, such as Daewoo, ING, Siemens, and Toyota.

• New Zealand’s government, starting in 1984,

transformed the country from an agrarian,
protectionist, regulated economy to an industrialized,
free-market economy that today competes globally.
Firm Internationalization

• How Firms Gain and Sustain

International Competitive Advantage?
• Since the MNE was traditionally the major player
in international business, scholars have offered
numerous explanations of what makes these
firms pursue, and succeed in internationalization
• Because FDI has been MNEs’ main strategy in
international expansion, theoretical explanations
have tended to emphasize it.
 FDI Based Explanations:
Monopolistic Advantage Theory

• Argues that MNEs prefer FDI because it provides the

firm with control over resources and capabilities in the
foreign market and a degree of monopolistic power
relative to foreign competitors.
• A monopolistic advantage is one or more resources
or capabilities a company possesses that few other
firms have and that it leverages to generate profits
and other returns.
Example
Novartis earns substantial profits by marketing various patent
medications through its subsidiaries worldwide.
 FDI Based Explanations:
Monopolistic Advantage Theory

•Monopolistic advantage theory suggests that firms

which use FDI as an internationalization strategy
must own or control certain resources and
capabilities not easily available to competitors that
give them a degree of monopolistic power over local
firms in foreign markets.
•Key sources of monopolistic advantage include
proprietary knowledge, patents, unique know-how,
and sole ownership of other assets.
 FDI Based Explanations:
Monopolistic Advantage Theory

•This theory argues that at least two conditions

should be present for a firm to prefer targeting a
foreign market rather than its home market.
• First, returns obtainable in the foreign market
should be superior to those available in the home
market.
• Second, returns obtainable in the foreign market
should be superior to those earned by its
domestic competitors in its industry in the foreign
market.
• For example, Sony’s most important monopolistic advantages are
superior knowledge and intangible skills.
 FDI Based Explanations:
Internalization Theory

• Explains how the MNE chooses to acquire and retain one or

more value-chain activities inside itself.
• Such ‘internalization’ provides the MNE with greater control
over its foreign operations.
• Internalization avoids the drawbacks of dealing with external
partners, such as reduced quality control and the risk of losing
proprietary assets to outsiders.

Example
In China, Intel owns much of its value chain, to ensure that
Intel knowledge, patents, and other assets are not misused or
illicitly obtained by potential rivals.
 FDI Based Explanations:
Dunning’s Eclectic Paradigm
• Professor John Dunning proposed the eclectic paradigm as a
framework for determining the extent and pattern of the value-chain
operations that companies own abroad.
• It specifies three conditions that determine whether or not a company
will enter a given foreign country via FDI:

1. Ownership-specific advantages – knowledge, skills, capabilities,

relationships, or physical assets that the firm owns and which are the
basis of its competitive advantages
2. Location-specific advantages – similar to comparative advantages,
they are specific advantages that exist in the country that the MNE has
entered, or is seeking to enter, such as natural resources, low-cost labor,
or skilled labor
3. Internalization advantages – control derived from internalizing foreign-
based manufacturing, distribution, or other value chain activities
Example of the Eclectic Paradigm: Sony in China

• Ownership Specific Advantages. Sony possesses

a huge stock of knowledge and patents in the
consumer electronics industry, as represented by
products like the Playstation and Vaio laptop.
• Location Specific Advantages. Sony, Japanese
firm desires to manufacture in China to take
advantage of China’s low-cost, highly knowledgeable
labor.
• Internalization Advantages. Sony wants to
maintain control over its knowledge, patents,
manufacturing processes, and quality of its products.

Thus, Sony entered China via FDI

 Non-FDI Based Explanations:
International Collaborative Ventures

• A form of cooperation between two or more firms.

• Partners pool resources and capabilities to create
synergies and share the risk of joint efforts.

• Starting in the 1980s, firms increasingly began using

collaborative ventures to expand abroad.

• Collaboration provides access to foreign partners’

know-how, capital, distribution channels, or
marketing assets and helps overcome government
imposed obstacles.
 Types of International Collaborative Ventures

• There are two major types:

• Equity-based joint ventures result in the formation of a
new legal entity. In contrast to the wholly-owned FDI, the
firm collaborates with local partner(s) to reduce risk and
commitment of capital.
• Project-based alliances do not require equity
commitment from the partners but simply a willingness to
cooperate in R&D, manufacturing, design, or any other
value-adding activity.
• Since project-based alliances have a narrowly defined
scope of activities and timeline, they provide greater
flexibility to the firm than equity-based ventures.
Types of International Collaborative Ventures

• Collaborating firms share the risk of their joint efforts,

which reduces vulnerability for any one partner.
• Collaboration is a critical activity in international
business. A firm sometimes has no choice but to
partner with other companies in order to use
resources and capabilities unavailable within its own
organization.
• In addition, occasionally a government will restrict
companies from entering its national market via
wholly owned FDI.