I.

CONCEPTS, THEORIES AND PRINCIPLES OF INTERNATIONAL BUSINESS AND

GLOBALIZATION

Learning Objectives:
At the end of this chapter, the students should be able to:
1. understand the different theories on international trade;
2. know the underlying concepts of globalization; and
3. trace the development of international trade.

WHAT IS INTERNATIONAL BUSINESS?

International Business refers to the performance of trade and investment

activities across national borders. Firms organize, source, manufacture, market, and
conduct other value-adding activities on an international scale.

The growth of international business activity coincides with the broader

phenomenon of globalization of markets. The globalization of markets refers to the
ongoing economic integration and growing interdependency of countries world-
wide. While internationalization of the firm refers to the tendency of companies to
systematically increase the international dimension of their business activities,
globalization refers to a macrotrend of intense economic interconnectedness
between countries.

WHAT ARE THE KEY CONCEPTS IN INTERNATIONAL TRADE AND INVESTMENT?

1. International Trade – refers to an exchange of products and services across

national borders. Trade involves both products (merchandise) and services
(intangibles).

2. Exporting – an entry strategy involving the sale of products or services to customers

located abroad, from a base in the home country or a third country.

3. Importing or Global Sourcing – the procurement of products or services from

suppliers located abroad for consumption in the home country or a third country.

4. International Investment – refers to the transfer of assets to another country, or

acquisition of assets in that country. With trade, products and services cross
national borders. With investment, by contrast, the firm itself crosses borders to
secure ownership of assets located abroad.

5. International Portfolio Investment – refers to the passive ownership of foreign

securities such as stocks and bonds for the purpose of generating financial returns.

6. Foreign Direct Investment (FDI) – refers to an internationalization strategy in which

the firm establishes a physical presence abroad through acquisition of productive
assets such as capital, technology, labor, land, plant and equipment.

HOW DOES INTERNATIONAL BUSINESS DIFFER FROM DOMESTIC BUSINESS?

Firms engaged in international business operate in business environments

characterized by unique economic conditions, political systems, laws and regulations,
and national culture. For example, the economic environment of Philippines differs
sharply from that of China. The legal environment of Canada does not resemble that
of Saudi Arabia.

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 Four (4) Risks in Internationalization

1. Cross-cultural risk – refers to a situation or event where a cultural

miscommunication puts some human value at stake. Cross-cultural risk is posed by
differences in language, lifestyles, mindsets, customs, and/or religion.

2, Country risk (also known as political risk) – refers to the potentially adverse effects
on company operations and profitably caused by developments in the political,
legal, and economic environment in a foreign country. It includes the possibility of
foreign government intervention in firms; business activities.

3. Currency risk (also referred to as financial risk) – refers to the risk of adverse
fluctuations in exchange rates. Fluctuation is common for exchange rates, or the
value of one currency in terms of another. Currency risk arises because
international transactions are often conducted in more than one national
currency.

4. Commercial risk – refers to the firm’s potential loss or failure from poorly developed
or executed business strategies, tactics, or procedures. Managers may make poor
choices in such areas as the selection of business partners, timing of market entry,
pricing, creation of product features, and promotional themes.

WHO PARTICIPATES IN INTERNATIONAL BUSINESS?

1. Multinational Enterprises (MNE)

Multinational enterprises (also known as multinational corporations) have

historically been the most important type of local firm. A multinational enterprise is
a large company with substantial resources that performs various activities
through a network of subsidiaries and affiliates located in multiple countries.

2. Small and Medium-sized Enterprise (SME)

A company with 500 or fewer employees in the United States, although this
number may need to be adjusted downward for other countries.

3. Born Global Firm

One type of contemporary international SME is the born global firm, a

young entrepreneurial company that initiates international business activity very
early in its evolution, moving rapidly into foreign markets.

4. Non-Governmental Organizations (NGOs)

In addition to profit-seeking local firms in international business, there are

numerous non-profit organizations that conduct cross-border activities. These
include charitable groups and non-governmental organizations (NGOs). They
pursue special causes and serve as an advocate for the arts, education, politics,
religion, and research. They operate internationally to either conduct their
activities or raise funds.

WHY DO FIRMS PURSUE INTERNATIONALIZATION STRATEGIES?

1. Seek opportunities for growth through market diversification. Substantial market

potential exists outside the home country. When they diversify into foreign markets,

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 firms can generate sales and profit opportunities that cannot be matched at
home.

2. Earn higher margins and profits. For many types of products and services, market
growth in mature economies is sluggish or flat. Competition is often intense, forcing
firms to get by on slim profit margins. On the other hand, less intense competition,
combined with strong market demand, implies that companies can command
higher margins for their offerings.

3. Gain new ideas about products, services and business methods. International
markets are characterized by tough competitors and demanding customers with
various needs. Unique foreign environments expose firms to new ideas for
products, processes and business methods.

4. Better serve key customers that have relocated abroad. In a global economy,
many firms internationalize to better serve clients that have moved into foreign
markets.

5. Be closer to supply sources, benefit from global sourcing advantages, or gain

flexibility in the sourcing of products. Companies in extractive industries such as
petroleum, mining, and forestry establish international operations where these raw
materials are located.

6. Gain access to lower-cost or better-value factors of production.

Internationalization enables the firm to access capital, technology, managerial
talent, labor, and land at lower costs, higher-quality, or better overall value at
locations worldwide.

7. Develop economies of scale in sourcing, production, marketing and R&D.

Economies of scale refer to the reduction of the per-unit cost of manufacturing
and marketing due to operating at high volume.

8. Confront international competitors more effectively or thwart the growth of

competition in the home market. International competition is substantial and
increasing, with international competitors invading markets worldwide. The firm
can enhance its competitive positioning by confronting competitors in
international markets or pre-emptively entering a competitor’s home markets to
destabilize and curb its growth.

9. Invest in a potentially rewarding relationship with a foreign partner. Firms often

have long-term strategic reasons for venturing abroad. Joint ventures or project-
based alliances with key foreign players can lead to the development of new
products, early positioning in future key markets, or other long-term, profit-making
opportunities.

WHY SHOULD YOU STUDY INTERNATIONAL BUSINESS?

1. Facilitator of the Global Economy and Interconnectedness

2. Contributor to National Economic Well-Being

3. A Competitive Advantage for the Firm

4. An Opportunity for Global Corporate Citizenship

5. A Competitive Advantage for You

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QUESTIONS:

1. Distinguish between international business and globalization of markets.

2. What is the difference between exporting and importing?

3. What makes international business different from domestic business?

4. Who are the major participants in international business?

5. Why should you care about international business?

CASE STUDY:

Whirlpool’s Dramatic Turnaround Through Internationalization

Home appliance maker Whirlpool Corporation, head-quartered in Benton Harbor,

Michigan, generated over $19 billion in annual sales in 2006, an increase of 26 per-cent
from the previous year. Key factors influencing this performance include the acquisition
of the Maytag Corporation in 2006 and an increased global demand for its brands and
innovative products. During the next several years, the company expects growth in Asia
and Latin America to be significantly higher than in North America and Europe. Whirlpool
employs more than 80,000 employees in over 60 manufacturing and technology centers
world-wide. The firm manufactures washers, dryers, refrigerators, dishwashers, freezers,
ranges, compactors, and microwave ovens in 13 countries and sells them in 170others
under brand names such as Whirlpool, Maytag, Magic Chef, Jenn-Air, Amana,
KitchenAid, Kenmore, Brastemp, and Bauknecht. Whirlpool generates almost60 percent
of its sales from North America, 25 percent from Europe, 15 percent from Latin America,
and just 2percent from Asia.

International Expansion
As the U.S. appliance market matured in the 1990s, Whirlpool faced intense domestic
competition and more demanding buyers, resulting in lower profit margins. Meanwhile,
international market trade barriers fell, consumer affluence grew, and capitalism
flourished. Management realized that it could best deal with these threats and
opportunities by undertaking a systematic program of internationalization. As a result,
Whirlpool engaged in a series of moves over the next decade.

Whirlpool acquired the appliance business of Philips in Europe, 65 percent of Italian

cooling compressor manufacturer Aspera, and purchased Poland’s second largest
appliance maker. In Eastern Europe, Whirlpool created subsidiaries to sell and service
appliances in Bulgaria, Hungary, Romania, Russia, Slovakia, and the Czech Republic.

In China, Whirlpool formed a joint venture to pro-duce air conditioners and established a
corporate head-quarters and product development/technology center in Shanghai. The
company also opened regional offices in Hong Kong, New Delhi, and Singapore. In
Mexico, Whirlpool acquired Vitromatic, a former joint venture partner in Mexico. It also
developed low-cost versions of popular models to target customers in low-income
markets in Latin America, China, and India.

Three factors have driven this global expansion. First, Whirlpool sought to reduce its costs
of R&D, manufacturing, and service by locating plants and other operations in lower-cost
locations such as China, Mexico, and Poland. Second, flat to declining sales growth in
the United States pressured management to target sales in new markets abroad. Third,

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II. OVERVIEW OF TRADE THEORY

Learning Objectives:
At the end of this chapter, the students should be able to:
 understand why nations trade with each other;
 familiarize with the different theories explaining trade flows between nations; and
 understand the important implications that international trade theory hold for
business practice.

THEORIES OF INTERNATIONAL TRADE AND INVESTMENT

Comparative Advantage refers to superior features of a country that

provide it with unique benefits in global competition, typically derived from either
natural endowments or deliberate national policies. Also known as country-specific
advantage, comparative advantage includes acquired resources, such as labor,
climate, arable land, or petroleum reserves. Other types of comparative advantages
evolve over time, such as entrepreneurial orientation, availability of venture capital,
and innovative capacity.

Competitive Advantage refers to the distinctive assets or competencies of

a firm – typically derived from cost, size or innovation strengths – that are difficult for
competitors to replicate or imitate. Competitive advantage is also known as firm-
specific advantage. Michael Porter have used the term competitive advantage to
refer to the advantages possessed both by nations and individual firms in international
trade and investment. The table below categorizes leading theories of international
trade and investment into two broad groups.

Nation-level Theories Firm-level Theories

 these are classical theories that  these are more contemporary
have been advocated since the theories of how firms can create
18th century. It addresses two and sustain superior market
questions: position.
1. Why do nations trade? 1. Why and how do firms
Classical Theories internationalize?
 Mercantilism Firms internationalization
 Absolute Advantage Principle  Internationalization Process of the
 Comparative Advantage Firm
Principle  Born Global and International
 Factor Proportions Theory Entrepreneurship
 International Product Cycle
Theory
2. How can nations enhance their 2. How can internationalizing firms gain
competitive advantage? and sustain competitive advantage?
 Competitive Advantage of FDI-Based Explanations
Nations  Monopolistic Advantage Theory
 Michael Porter’s Diamond Model  Internationalization Theory
 National Industrial Policy  Dunning’s Eclectic Paradigm
 New Trade Theory Non-FDI-Based Explanations
 International Collaborative
Ventures
 Networks and Relational Assets

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 WHY NATIONS TRADE?

Why do nations trade with one another? The short answer is that trade
allows countries to use their national resources more efficiently through specialization.
Trade allows industries and workers to be more productive. Trade also allows countries
to achieve higher living standards and keep the cost of many everyday products low.

CLASSICAL THEORIES

There are five (5) classical perspectives that explain the underlying rationale
for trade among nations:

1. Mercantilist View. Mercantilism emerged in the 16th century as a dominant

perspective of international trade. In simple terms, mercantilism suggests that
exports are good and imports are bad. Mercantilists believed that national
prosperity results from a positive balance of trade, achieved by maximizing exports
and minimizing imports.

By contrast, free trade – the relative absence of restrictions to the flow of

goods and services between nations – is preferred because:
 Consumers and firms can more readily buy the products they want.
 The prices of imported products tend to be lower than for a domestically
produced products.
 Lower-cost imports help reduce the expenses of the firms, thereby raising
their profits.
 Lower-cost imports help reduce the expenses of consumers, thereby
increasing their living standards.
 Unrestricted international trade generally increases the overall prosperity of
poor countries.

2. Absolute Advantage Principle. Smith’s absolute advantage principle states that a

country benefits by producing only those products in which it has an absolute
advantage, or can produce using fewer resources than another country. The
country gains by specializing in producing those products, exporting them, and
then importing the products it does not have an absolute advantage in
producing. Each country increases its welfare by specializing in the production of
certain products and importing others, as this allows it to be able to consume more
than it otherwise could.

ILLUSTRATION:
One ton of
Cloth Wheat
France 30 40
Germany 100 20
Assuming that labor is the only factor of production used in making both goods.

Compared to Germany, it is clear that France has an absolute advantage

in the production of cloth, since it takes only 30 days of labor to produce one ton
(compared to 100 days for Germany). Compared to France, it is clear that Germany
has an absolute advantage in the production of wheat, since it takes only 20 days to
produce one ton (compared to 40 days for France). If both France and Germany
were to specialize, exchanging cloth and wheat at a ratio of one-to-one, France
could employ more of its resources to produce cloth and Germany could employ
more of its resources to produce wheat.

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 3. Comparative Advantage Principle. David Ricardo demonstrated that what
matters is not the absolute cost of production, but rather the ratio between how
easily the two countries can produce the products. Hence, comparative
advantage principle states that it can be beneficial for two countries to trade
without barriers as long as one is more efficient at producing goods or services
needed by the other. What matters is not the absolute cost of production but
rather the relative efficiency with which a country can produce the product. The
principle of comparative advantage remains today as the foundation and
overriding justification for international trade.

ILLUSTRATION:
One ton of
Cloth Wheat
France 30 40
Germany 10 20
Assuming that labor is the only factor of production used in making both goods.

Suppose that Germany has an absolute advantage in the production of

both cloth and wheat. That is, in labor-per-day terms, Germany can produce both
cloth and wheat in fewer days than France. Based on this scenario, you might initially
conclude that Germany should produce all the wheat and cloth that it needs, and
trade with France at all. However, this conclusion is not optimal. Even though
Germany can produce both items more cheaply than France, it is still beneficial for
Germany to trade with France.

By specializing in what they produce best and trading for the rest, Germany
and France can each produce and consume relatively more of the goods that they
desire for a given level of labor cost. Another way to understand the concept of
comparative advantage is to consider opportunity cost, the value of a foregone
alternative activity. If Germany produces 1 ton of wheat, it forgoes 2 tons of cloth.
However, if France produces 1 ton of wheat, it forgoes only 1.33 tons of cloth. Thus,
France should specialize in wheat. Similarly, if France produces 1 ton of cloth, it
forgoes ¾ ton of wheat. But if Germany produces 1 ton of cloth, it forgoes ½ ton of
wheat. Thus, Germany should specialize in cloth. The opportunity cost of producing
wheat is lower in France, and the opportunity cost of producing cloth is lower in
Germany.

4. Limitations of Early Trade Theories. While the concepts of absolute advantage and
comparative advantage provided the rationale for international trade, they did
not quite capture factors that make contemporary trade complex, including:

 The cost of international transportation, which is critical for cross-border

trade to take place.
 Government restrictions such as tariffs (a tax on imports), import restrictions,
and regulations typical of mercantilism that can hamper cross-border
trade.
 Large-scale production in certain industries may bring about scale
economies, and therefore lower prices, which can help offset weak
national comparative advantage.
 The public sector can target and invest in certain industries, build
infrastructure, or provide subsidies, all of which serve to boost firms’
competitive advantages.
 Global telecommunications and the Internet facilitate virtually costless
trade in some services and global flows of capital.
 Contemporary cross-border business includes many services that cannot
be traded in the usual sense and must be internationalized via foreign
investment.

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  The primary participants in cross-border trade are individual firms.

5. Factor Proportions Theory. The next significant contribution to explaining

international trade came in the 1920s, when two Swedish economists, Eli
Heckscher and his student, Bertil Ohlin, proposed the factor proportions theory
(sometimes called the factor endowments theory). This view rests on two premises:
First, products differ in the types and quantities of factors that are required for their
production; and second, countries differ in the type and quantity of production
factors that they possess.

6. International Product Cycle Theory. In a 1966 article entitled “International

Investment and International Trade in the Product Cycle”, Harvard Professor
Raymond Vernon sought to explain international trade based on the evolutionary
process that occurs in the development and diffusion of products around the
world. Vernon observed that technical innovations typically originate from
advanced countries that possess abundant capital and RD capabilities. Each
product and its associated manufacturing technologies go through three stages
of evolution: introduction, growth and maturity.

HOW NATIONS ENHANCE THEIR COMPETITIVE ADVANTAGE: CONTEMPORARY THEORIES

The globalization of markets has fostered a new type of competition – a

race among nations to reposition themselves as attractive places to invest and do
business. In recent decades, governments increasingly have an advanced proactive
policies designed to create competitive advantage, often by developing world-class
economic sectors and prosperous geographic regions.

1. The Competitive Advantage of Nations

An important contribution came from Harvard business professor Michael

Porter in his 1990 book, The Competitive Advantage of Nations. According to Porter,
the competitive advantage of a nation depends on the collective competitive
advantages of the nation’s firms. Over time, this relationship is reciprocal: The
competitive advantages held by the nation tend to drive the development of new
firms and industries with these same competitive advantages.

2. Michael Porter’s Diamond Model

According to this model, competitive advantage at both the company

and national levels originates from the presence and quality in the country of the four
major elements, to wit:
 Firm Strategy, Structure and Rivalry – refers to the nature of domestic rivalry, and
conditions in a nation that determine how firms are created, organized and
managed.
 Factor Conditions – describes the nation’s position in factors of production, such
as labor, natural resources, capital, technology, entrepreneurship, and know-how.
 Demand Conditions – refer to the nature of home-market demand for specific
products and services.
 Related and Supporting Industries- refers to the presence of clusters of supplies,
competitors, and complementary firms that excel in particular industries.

3. National Industrial Policy

A proactive economic development plan initiated by the public sector,

often in collaboration with the private sector, that aims to develop or support
particular industries within the nation. Policies emphasize the development of high-
value adding industries that generate substantial wealth in terms of corporate profits,
worker wages, and tax revenues.

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 4. New Trade Theory

Beginning in the 1970s, economists led by Paul Krugman began to note that
classical theories failed to anticipate or explain some international trade patterns. For
example, they observed that trade was growing fastest between industrial countries
that held similar factors of production. In some new industries, there appeared to be
no clear comparative advantage. The solution to this puzzle became known as new
trade theory. The theory argues that increasing returns to scale, especially economies
of scale, are an important factor in some industries for superior international
performance. Some industries succeed best as their volume of production increases.

WHY AND HOW FIRMS INTERNATIONALIZE

The internationalization process model was developed in the 1970s to

describe how firms expand abroad. According to this model, internationalization is a
gradual process that takes place in incremental stages over a long period of time.

Stages in the Internationalization Process

1. Domestic focus
2. Pre-export stage
3. Experimental involvement
4. Active involvement
5. Committed involvement

QUESTIONS:

1. Why do nations engage in international business? That is, what are the benefits of
international trade and investment?

2. Describe the classical theories of international trade. Which of these theories do you
believe are relevant today?

3. What is the difference between the concepts of absolute advantage and

comparative advantage?

4. Summarize the international product cycle theory. Use the theory to explain the
international evolution of automobiles and laptop computers.

5. Do you believe your country should adopt a national industrial policy? Why or why
not?

CASE STUDY:

Hyundai: The Struggle for International Success

The automotive industry is among the largest and most highly internationalized economic
sectors. Hyundai Motor Company (HMC) is South Korea’s number one carmaker,
producing about a dozen models of cars and minivans, as well as trucks, buses, and other
commercial vehicles. Popular exported models are the Accent, Elantra, and Sonata. The
South Korean firm has managed to internationalize successfully, seemingly against all
odds.

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