CHAPTER - 1

INTRODUCTION TO INTERNATIONAL BUSINESS

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Meaning and Definition of
International Business – Theories
of International Trade –
Economic Theories – Forms of
International Business - Nature of
International Business

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 Meaning of International Business

 International business denotes all those business activities which take place

beyond the geographical limits of the country. It involves not only the

international movements of goods and

services, but also of capital personnel, technology and intellectual property

like patents, trademarks, know-how and copy rights.

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 Definition of International Business

 According to John D. Daniels and Lee H. Radebaugh,

International business is all business transactions-
private and governmental- that involve two or more
countries. Private companies undertake such
transactions for profits, governments may or may not do
the same in their transactions.

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Features of International Business
 Large scale operations
 Intergration of economies
 Dominated by developed countries and MNCs
 Benefits to participating countries
 Keen competition
 Special role of science and technology
 International restrictions
 Sensitive nature

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Theories of International Trade

Classical Country- Based Theories Modern Firm-Based Theories

Mercantilism Country Similarity

Absolute Advantages Product lifecycles

Comparative Advantage Global Strategic Rivalry

Heckscher-Ohlin Porter’s National Competitive Advantages

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Mercantilism

❑ Mercantilism was a school of economic thought prevalent in 17th and early

18th centuries that advocated for trade surplus.

❑ Trade surplus can be defined as excess of export over import.

❑ The Mercantilists had a static view of the world economy. They did not realize
that the gains from trade of a particular country were possible only at the
expense of the other country. In fact, trade should promote the welfare of the
world economy and not simply of a particular nation.

❑ The exponents of this theory ignored the concept of production efficiency

through specialisation. In fact, it is the production efficiency that brings in gains
from trade (Heckscher, 1935).

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 Theory of Absolute cost Advantage

✓ Adam Smith was one of the forerunners of the classical school of thought. He propounded a
theory of international trade in 1776 that is known as the theory of absolute cost advantage.

✓ He is of the opinion that the productive efficiency among different countries differs because of
diversity in the natural and acquired resources possessed by them. The difference in natural
advantage manifests in varying climate, quality of land, availability of minerals, of water and other
natural resources; while the difference in acquired resources manifests in different levels of
technology and skills available.

✓ A particular country should specialize in producing only those goods that it is able to produce
with greater efficiency, that is at lower cost; and exchange those goods with other goods of their
requirements from a country that produces those other goods with greater efficiency or at lower
cost. This will lead to optimal utilisation of resources in both the countries. Both the countries will
gain from trade in so far as both of them will get the two sets of goods at the least cost.
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Meaning
Absolute cost advantage theory explains that a country having absolute cost advantage in the
production of a product on account of greater efficiency should specialize in its production and
export.

Adam Smith explains the concept of absolute advantage in a two-commodity, two-country

framework. Suppose Bangladesh produces 1 kg of rice with 10 units of labour or it produces 1
kg of wheat with 20 units of labour. On the other hand, Pakistan produces the same amount of
rice with 20 units of labour and produces the same amount of wheat with 10 units of labour.
Each of the countries has 100 units of labour. Equal amount of labour is used for the production
of two goods in absence of trade in the two countries.

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In absence of trade, Bangladesh will be able to produce 5 kg of rice and 2.5 kg of wheat. At the same
time, Pakistan will produce 5 kg of wheat and 2.5 kg of rice. But when trade is possible between the
two countries, Bangladesh will produce only rice and exchange a part of the rice output with wheat
from Pakistan. Pakistan will produce only wheat and exchange a part of the wheat output with rice
from Bangladesh. The total output in both the countries will rise because of trade. Bangladesh, which
was producing 7.5 kg of food-grains in absence of trade, will now produce 10 kg of food-grains.
Similar will be the case with Pakistan where 10 kg of food grains will be produced instead of 7.5 kg .

The theory of absolute cost advantage explains how trade helps increase the total output in the two
countries. But it fails to explain whether trade will exist if any of the two countries produces both the
goods at lower cost.
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Comparative Cost Advantage

• David Ricardo-English Economist

(1817-book-Principles of Political economy)

• Ricardo --basis of trade is the comparative cost and not absolute cost. He advocated that a
country should export that commodity in which the relative advantage is the highest and can
import a commodity in which there is a relative disadvantage.

• Comparison between cost of domestic production and actual imports could be the base

• Countries decide production and/or export or import depending on the comparative costs

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Comparative Cost Advantage - Assumptions
a) Two countries and two commodities.
b) Labour is homogeneous and perfectly mobile.
c) Goods are exchanged according to relative amounts of labour.
d) production is subject to law of constant returns.
e) No transport cost.
f) full employment and perfect competition.
g) free from all international trade barriers

• The law of comparative advantage indicates that a country should specialise in the
production of those goods in which it is more efficient and leave the other commodity to
the other country thus benefiting both the countries.

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Comparative Cost Advantage

• The actual rate of exchange will be determined by the reciprocal demand and both
countries would be benefited.

• Benefits:

1) Maximisation of production by most efficient allocation of resources.

2) Redistribution of relative product demands.

3) Redistribution of relative resource demand resulting equality of resource prices.

• International Trade takes place because factors of production are not mobile between
different countries and countries have different structures of cost of production for the
same commodities
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 Criticisms:
1) The size of the countries are different. Small countries can specialize and sell all that they produce
but the big countries cannot sell all that they produce.

2) The limits of exchange rates are only fixed but not the exact point at which settlement takes place.

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 International Trade Theories
Heckscher Ohlin Theory/ Factor Endowment theory

• Swedish Economist Eli Heckscher and his student Bertil Ohlin popularly known as
Heckscher-Ohlin Theory (1919 and 1933)

• Factor endowment theory--two theorems-1) HO Theory and 2) Factor Equalisation Theorem

• H O Theory propounded that the comparative cost differentials are on account of countries
having different factor endowment and that country having a factor abundant will take the
best benefit out of it. Factor Price equalisation theorem examines the factor prices besides its
abundant supplies.

• H O Theory is also based on two country- two commodity model.

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 International Trade Theories
Heckscher Ohlin Theory

• H O Theory states that a country will specialise in the production and export of goods
whose production requires a relatively large amount of the factor which that country is well
endowed. International trade takes place between two countries on the principles of
comparative advantages in prices (and not merely costs) and that can be secured by utilising
the abundant factor intensively to reach a point of such partial specialisation in the two
commodities that full employment of both the factors of production is secured.

• Factors of production will be scarce or abundant in relative terms and not in absolute terms.
A country is regarded as richly endowed only if the ratio of one factor to other factors is
higher as compared with other nations. It is the ratio of factors than the absolute figures of
factor availability

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 International Trade Theories
Heckscher Ohlin Theory: Assumptions

a) Perfect competition;
b) perfect mobility of factors;
c) factors are of identical quantity;
d) factor supplies are fixed;
e) factor endowments differ but fully employed;
f) no transport cost;
g) techniques of production are similar;
h) productivity is similar;
i) factor intensity varies between goods (capital intensive and labour intensive); and
j) production is subject to law of constant returns

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 International Trade Theories
Heckscher Ohlin Theory: Merits

• The immediate basis of international trade is the price differential in the final product on
account of presence of factor endowments;

• Ricardian theory hinted at the comparative cost difference but did not explain the reasons for
the cost differentials but HO theory is superior in this respect;

• Regions and nations trade is but a special case of of inter-local or inter-regional trade.

• Equilibrium of demand and supply, commodity prices and factor prices possible.

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International Trade Theories
Heckscher Ohlin Theory:

• Empirical Testing: Example USA is endowed with absolute volume of capital. But
Leontief concluded that America succeeded in labour intensive products than capital
intensive lines of production.--the reason behind this is not absolute but relative prices.
This is known as Leontief Paradox. In short, empirical testing has given mixed results (
Wassily Leontief was the winner of the Nobel Prize in Economics in 1973)

• Explanations to Leontief Paradox: a) Country's productivity- influenced by natural

resources, differences in production function, differences in demand pattern; distortion of
trade pattern caused by trade barriers; exclusion of factors like human capital, R & D,
Technology and factor intensity reversal etc

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 International Trade Theories

The PLC Theory

• Reymond Vernon initially proposed this theory.(1960s)

• He observed that large proportion of the world's new products were developed by USA
and sold first in US which led to developing cost-saving process innovations. Examples,
were automobiles, televisions, instant cameras, photocopiers, personal computers and
semi-conductor chips etc

• It is not necessary that USA only has to produce.

• USA may move production to other countries having production cost advantages and
again imported to US for consumption or for exports to other countries. Again, the prices
for new products are relatively higher.

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 International Trade Theories
The PLC Theory

• These highly priced products thus originated in one country and then moved to high income
groups in other countries. The production was carried in other countries as well and those
countries thought it fit to produce them for their home country. When the market becomes
matured the product becomes standardised the price becomes the competitive weapon for
international trade. Cost and prices were therefore to be controlled.

• The cycle begins from an innovative and exporting country who will become an importing country
because of cost and price advantages.

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 International Trade Theories
The PLC Theory

• Classic example is Xerox. Started in US, initially sold to US market. It extended to Japan and
advanced countries of Western Europe. When demand improved, Xerox entered into JVs with
Fuji-Zerox of Japan and Rank-Xerox of Great Britain. Then Canon in Japan, Olivetti in Italy
started. Exports declined and now US started to import low cost copiers from foreign sources.

• The IPLC in is different from PLC. In IPLC, it passes through all the stages in the startup
country--New product introduction, Growth, Maturity, Saturation and Decline. By the time it
reaches maturity, it enters another country where it will be under Introduction/Growth stage.
Even products which have passed Saturation and Decline would be under growth and maturity
stages in other countries. Hence, the IPLC is much longer than the domestic PLC. Of course,
the sustainability and the pricing factors are important.

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 International Trade Theories
The PLC Theory

Stages in IPLC:

1) New product development: Firms innovate new products based on needs and
demands in domestic country;

2) Growth results in attracting customers, increased exports, further innovation and

shifting manufacturing activities overseas;

3) Maturity result in standard products, economies of scale, low unit costs; and
shifting manufacturing to developing countries;

4) Decline implies locating manufacturing facilities in developing countries and

original innovating country becomes the importer,
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PRODUCT LIFE CYCLE THEORY

Early Late
Adaptors Majority
Innovator
s Early laggard
Majority

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 International Trade Theories
The PLC Theory

• Criticisms: Vernon’s argument that new products were introduced only in USA was not
acceptable. Though some products originated in US, it can be construed that he confined
his studies to US. Thus his theory is termed Ethnocentric. However his IPLC cycle as a
concept hold good. Many new products have been introduced in many other countries. E.g.
Video game Consoles in Japan, Wireless phones in Europe etc. Globalisation and
integration of the world economy makes it possible for every country to something new.

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THE NATIONAL COMPETITIVE ADVANTAGE /
PORTERS DIAMOND THEORY
International Trade Theories
Porter’s Diamond Theory

• Michael E Porter- Harvard Business School published research results in March April 1990. His book
"Competitive advantage of Nations" was motivated by his appointment by US government to head the
Commission on Competitiveness

• Four attributes in the shape of a diamond. Hence known as Porter's diamond. He opined that every earlier
theory told only a part of the story. He tried to explain why a nation achieves international success in a
particular industry.

• Examples: Japan's success in automobiles, Success of USA and Germany in chemicals, Switzerland's success
in precision instruments & pharmaceuticals

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 International Trade Theories
Porter’s Diamond Theory

Four attributes which shape the business environment of any firm:

1) Factor endowments;
2) Demand conditions;
3) Relating and supporting industries and
4) Firm strategy, structure and rivalry. These attributes constitute a diamond.
Firms succeed in industries/segments where the diamond is favourable.

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THE NATIONAL COMPETITIVE ADVANTAGE / PORTERS DIAMOND THEORY

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 International Trade Theories
Porter’s Diamond Theory

• He recognised hierarchies of factor endowments--natural resources, climate, location

and demographics and advanced factors like communication infrastructure,
sophisticated and skilled labour, research facilities and technological know-how. He
argued that advanced factors are significant as they are the products of investments by
individuals, companies and the governments.

• Demand conditions-Firms are more sensitive to domestic demand which helps to shape
the product attributes which may be changed further depending on the cultural
conditions of the new markets

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 International Trade Theories
Porter’s Diamond Theory

• Support industries Eg: Ball bearings and cutting tools made the Swedens' speciality steel
industry. Semiconductor industry provided for US success in personal computers. German's
textile industry based on high quality cotton, wool, synthetic fibres, sewing machine needles and
wide range of textile machinery.

• Strategy and structure helps the firms to grow and compete. Rivalry helps the competitive
strength. There will be need for improving efficiency.

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 International Trade Theories
Porter’s Diamond Theory

The four attributes can be influenced by governments.

• Subsidies, incentives and policies towards capital markets, education policies etc influence the
demand conditions. Regulations keep an eye on rivalry. Tax laws, anti trust laws and capital
regulations --all influence the firms competitiveness

• Diamonds can be proportional or non-proportional.

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 International Trade Theories
Porter’s Diamond Theory

• The following six factors may influence in any manner: 1) Resources, technology and adequacy
of production of quality; 2) Demand-high and perpetual; 3) Fair prices and competitive prices; 4)
Non-restrictive markets; 5) Global facilitation of all types-linkages and monetary; 6) Government
/ external elements

• Porters Diamond Theory enables the following strategic advantages of Exports: 1) Use of
excess capacity; 2) Cost reduction; 3) Greater Profitability and 4) Risk Spreading

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 Global Strategic Rivalry Theory

 Global strategic rivalry theory emerged in the 1980s and was based on the work of economists
Paul Krugman and Kelvin Lancaster. Their theory focused on MNCs and their efforts to gain a
competitive advantage against global firms in their industry. Firms will encounter global
competition in their industries and in order to prosper, they must develop competitive advantages.
The critical ways that firms can obtain a sustainable competitive advantage are called the barriers
to entry for that industry. The barriers to entry refer to the obstacles a new firm may face when
trying to enter into an industry or new market.
 The barriers to entry that corporations may
seek to optimize include:
• Research and development,
• The ownership of intellectual property rights,
• Economies of scale,
• Unique business processes or methods as well as extensive experience in the industry, and
• The control of resources or favorable access to raw materials.
 Country Similarity Theory

 Swedish economist Steffan Linder developed the country similarity theory in 1961, as he tried to
explain the concept of intraindustry trade. Linder’s theory proposed that consumers in countries that
are in the same or similar stage of development would have similar preferences. In this firm-based
theory, Linder suggested that companies first produce for domestic consumption. When they explore
exporting, the companies often find that markets that look similar to their domestic one, in terms of
customer preferences, offer the most potential for success. Linder’s country similarity theory then
states that most trade in manufactured goods will be between countries with similar per capita
incomes, and intra industry trade will be common. This theory is often most useful in understanding
trade in goods where brand names and product reputations are important factors in the buyers’
decision-making and purchasing processes.
Types/Forms of International Businesses


1. Imports and Exports

 Simplest and most commonly used method, imports and exports can be seen as the foundation of international
business. Imports are an inflow of goods into the markets of home country for consumption, in contrast, export means
selling of goods to foreign countries. In short, imports means inflow whereas export means outflow of goods in any
form.

2. Licensing

 Licencing is one of the easiest ways to expand a business internationally. When a company has a standardized product
with ownership rights, it can use licensing to distribute and sell the products in the international market. Licenses
come in many forms, some of which are patent, copyright, trademark, etc. Products such as books and movies are
usually distributed internationally through licensing agreements.
3. Franchising

 A very effective method to expand a business nationally as well as internationally, franchising is similar to licensing.
In this, a parent company gives the right to another company to conduct business using the parent company’s name/
brand and products. The parent company becomes the franchiser and the receiving company becomes the franchisee.
Many of the biggest restaurant chains in the world have used the franchisee model to expand internationally. Some
examples include – McDonald, Pizza Hut, Starbucks, Domino’s Pizza and many more
4. Outsourcing and Offshoring

 Outsourcing means giving out contracts to international firms for certain business processes. For example, giving out accounting
function to an international firm. This is usually effective when the cost of conducting these processes are comparatively much cheaper
in some other country than in the home country. For example, many developed countries such as the USA, Australia, the UK, etc.
outsource its functions to companies in India, China, etc. because it is cheaper.

5. Joint Ventures and Strategic Partnerships

 A joint venture is a contract between two parties, one is an international company while another company is local to where the business
has to be conducted. Both parties contribute to the equity and management of the company. As a result, both share the profit as well.
These parties can mutually decide the percentage of equity and profit sharing.

6. Multinational Companies

 Multinational companies, as the name suggests, are companies that are conducting business in multiple countries. They actually set up
the whole business in multiple countries. Some such examples are Amazon, Citigroup, Coca-Cola, etc.

 These companies have independent operations in each country, and each country has its own set of offices, employees, etc. In fact, even
the products and marketing campaigns are customized as per local needs. For example, Nestle introduced a Matcha flavor Kit Kat in
Japan as the flavor is very popular in that country, however, they don’t offer the same flavor in India. This customization is one of the
many benefits of being a multinational company.
7. Foreign Direct Investment

 Foreign direct investment is an investment made by an individual or a company located in one country to the
business interest located in another foreign country. In this the investing company usually commits more than
capital, they share management, technology, processes, etc, with the company that they have invested in. The
foreign direct investments can take many forms such as a subsidiary company, associate company, joint
venture, merger, etc.

 These are the major types through which people, companies, and government conduct international business.
However, means of business is just one minor speck of the international business environment.
 Nature of International Business
1. International Restrictions

In international business, there is a fear of the restrictions which are imposed by the government of the different countries. Many
country’s governments don’t allow international businesses in their country. They have trade blocks, tariff barriers, foreign exchange
restrictions, etc. These things are harmful to international business.

2. Benefits to Participating Countries

It gives benefits to the countries which are participating in the international business. The richer or developed countries grow their
business to the global level and they get maximum benefits. The developing countries get the latest technology, foreign capital,
employment opportunities, rapid industrial development, etc. This helps developing countries in developing their economy. Therefore,
developing countries open up their economy for foreign investments.

3. Large Scale Operations

International business contains a large number of operations at a time because it is conducted on a large scale globally. Production of
the goods at a large scale, they have to fulfill the demand at a global level. Marketing of the product is also conducted at a large scale
to make them aware of the product. First, they fulfill the domestic demand and then they export the surplus in the foreign markets.
4. Integration of Economies

 International Business combines the economies of many countries. The companies use the finance, labor, resources, and infrastructure of
the other countries in which they are working. They produce the parts in different countries, assembles the product in other countries and
sell their product in other countries.
5. Dominated by Developed Countries

 International business is dominated by developed countries and their MNC’s. Countries like U.S.A, Europe, and Japan all are the countries
that are producing high-quality products, they have people working for them on high salaries. They have large financial and other resources
like the best technology and Research and Development centers. Therefore, they produce good quality products and services at low prices.
They help them to capture the world market.
6. Market Segmentation

 International business is based on market segmentation on the basis of the geographic segmentation of the consumers. The market is
divided into different groups according to the demand of the consumers in different countries. It produces goods according to the demand
of the consumers of the different market segmentations.
7. Sensitive Nature

 International Business is highly affected by economic policies, political environment, technology, etc. It can play a positive role to improve
the business and can also be negative for the business. It totally depends on the policies made by the government, it can help in expanding
the business and maximizing the profits and vice-versa.