Theories of International

Business
 Introduction

• The chapter explains why nations & firms trade & invest internationally and also
how such participation allows nations to acquire & sustain comparative
advantage.

• Trade theories tries to explain following questions:

1.What is the underlying economic rationale for international business activity?

2.Why does trade take place?

3.What are the gains from trade & investment?

 Theories of International Trade & Investment

• For centuries, scholars have offered theories & economic rationales for international trade & investment. They have debated
why nations should promote trade & investment with other nations, and how they create & sustain comparative advantage.
Comparative advantage describes superior features of a nation that provide unique benefits in global competition. These
features typically are derived from either natural endowments or deliberate national policies. Also known, as country-
specific advantage, comparative advantage includes inherited resources, such as, labor, climate, arable land, and petroleum
reserves such as those enjoyed by gulf nations. Other types of comparative advantages are acquired over time, such as
entrepreneurial orientation, availability of venture capital, and innovative capacity.

• Over time, to understand why companies engage in cross-border business, the focus of research shifted from the nation to
the individual firm. This work produced the concept of competitive advantage, which describes assets & capabilities of a
company that are difficult for competitors to imitate & thus help firms enter & succeed in foreign markets. These
capabilities take various forms, such as specific knowledge, competencies, innovativeness, superior strategies, or close
relationships with suppliers. Competitive advantage is also known as firm-specific advantage.

• In recent years, business executives & scholars have used competitive advantage to refer to the advantages possessed by
nations & individual firms in international trade & investment.
Theories of International Trade & Investment
 Theories of International Trade & Investment

• The above figure categorizes leading theories of international trade & investment
into two broad groups. The first group includes nation-level theories. These are
classical theories that have been advocated since sixteenth centuries. They address
two questions: (1) Why do nations trade? (2) How can nation enhance their
competitive advantage?

• The second group includes firm-level theories. These are more contemporary
theories of how firms can create & sustain superior organizational performance.
Firm-level explanations addresses two additional questions : (3) Why & how do
firms internationalize? And (4) How can internationalizing firms gain & sustain
competitive advantage.
 Why do 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 and thus enables industries & workers to
be more productive. These outcomes help keep the cost of many everyday products low, which
translates into higher living standard.Without international trade, most nations would be unable to
feed, clothe, and house their citizens at current levels. Even resource-rich countries like the United
States would suffer immensely without trade. Some types of food would become unavailable or
very expensive. Coffee and sugar would be luxury items. Petroleum-based energy sources would
dwindle. Vehicles would stop running, freight would go undelivered, and people would not be
able to heat their homes in winter. In short, not only do nations, companies, and citizens benefit
from international trade, but modern life is virtually impossible without it.
 Classical Theories

• Six classical perspectives explain the underlying rationale for trade among nations: the mercantilist
view, absolute advantage principle, comparative advantage principle, factor proportions theory,
international product life cycle theory, and new trade theory.

• Mercantilism:

• The earliest explanations of international business emerged with the rise of European nation states in the
1500s, when gold and silver were the most important sources of wealth, and nations sought to amass as
much of these treasures, particularly gold, as possible. Nations received payment for exports in gold, so
exports increased their gold stock, while imports reduced it because they paid for imports with their
gold. Thus, exports were seen as good and imports as bad. Because the nation’s power and strength
increase as its wealth increases, mercantilism argues that national prosperity results from a positive
balance of trade achieved by maximizing exports and minimizing or even impeding imports.
Mercantilism
 Mercantilism

• By contrast, free trade—the relative absence of restrictions to the flow of goods and services between

nations—is a generally superior approach and should produce the following outcomes:

1. Consumers and firms can more readily buy the products they want.

2. Imported products tend to be cheaper than domestically produced products (because access to world-

scale supplies forces prices down, mainly from increased competition, or because the goods are

produced in lower-cost countries).

3. Lower-cost imports help reduce the expenses of firms, thereby raising their profits (which may be

passed on to workers in the form of higher wages).

4. Lower-cost imports help reduce the expenses of consumers, thereby increasing their living standards.

5. Unrestricted international trade generally increases the overall prosperity of poor countries.
Absolute Advantage Principle
4-11
 Absolute Advantage Principle

• Each country benefits by specializing in producing the product in which it has an absolute advantage and securing the other
product through trade. Each then employs its labor and other resources with maximum efficiency and, as a result, increases
its standard of living. To employ a more contemporary example, Japan has no natural holdings of oil, but it manufactures
some of the world’s best automobiles. Saudi Arabia produces much oil, but lacks a substantial car industry. Given this state
of resources, it is wasteful for each country to attempt to produce both oil and cars. By trading with each other, Japan and
Saudi Arabia employ their respective resources more efficiently in a mutually beneficial relationship. Japan gets oil that it
refines to power cars, and Saudi Arabia gets the cars its citizens need. By extending this example we see that freely trading
countries achieve substantial gains from trade. Brazil can produce coffee more cheaply than Germany; Australia can
produce wool more cheaply than Switzerland; Britain can provide financial services more cheaply than Zimbabwe; and so
forth.

• While the concept of absolute advantage provided perhaps the earliest sound rationale for international trade, it accounted
only for the absolute advantages possessed by nations and failed to consider more subtle advantages they may enjoy. Later
studies revealed that a country benefits from international trade even when it lacks an absolute advantage. This line of
thinking led to the principle of comparative advantage.
 Comparative Advantage Principle

One Ton of
Cloth Wheat
France 30 40
Germany 10 20
 Comparative Advantage Principle

• From above scenario, we might initially conclude that Germany should produce all the wheat and
cloth it needs and not trade with France at all. However, even though Germany can produce both
items more cheaply than France, it is still beneficial for Germany to trade with France.

• How can this be true? The answer is that rather than the absolute cost of production, it is the ratio
of production costs between the two countries that matters. In figure, 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). Thus, Germany should devote all its resources
to producing cloth and import all the wheat it needs from France. France should specialize in
producing wheat and import all its cloth from Germany. Both countries then can each produce and
consume relatively more of the goods they desire for a given level of labor cost.
 Comparative Advantage Principle

• Another way to understand comparative advantage is to consider opportunity cost, the value of a
foregone alternative activity. In table, 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 0.75 ton of wheat. But if
Germany produces 1 ton of cloth, it forgoes only 0.5 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.

• In an example provided by Ricardo:

• 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 20 percent, and in making shoes he can excel
him by 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?
 Factor Proportions Theory

• A 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.3 This view rests 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. Thus, each country should export products that intensively use relatively abundant factors of production and import
goods that intensively use relatively scarce factors of production. For example, the U.S. produces and exports capital-
intensive products, such as pharmaceuticals and commercial aircraft, while Argentina produces land-intensive products,
such as wine and sunflower seeds.

• Factor proportions theory differs somewhat from earlier theories by emphasizing the importance of each nation’s factors of
production. The theory states that, in addition to differences in the efficiency of production, differences in the quantity of
factors of production held by countries also determine international trade patterns. This leads to a per-unit-cost advantage
due to the abundance of a given factor of production, say labor, over another, say land, which is not in as much supply.
Originally, labor was the most important factor of production. This explains why, for example, countries like China and
India have become popular manufacturing bases.
 The Product Life-Cycle Theory

• Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s.Vernon's theory was based on
the observation that for most of the twentieth century a very large proportion of the world's new products had
been developed by U.S. firms and sold first in the U.S. market (e.g., mass-produced automobiles, televisions,
instant cameras, photocopiers, personal computers, and semiconductor chips). To explain this, Vernon argued that the
wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new consumer products. In
addition, the high cost of U.S. Labor gave U.S. firms an incentive to develop cost-saving process innovations.

• Just because a new product is developed by a U.S. firm and first sold in the U.S. mar­ket, it does not follow that
the product must be produced in the United States. It could be produced abroad at some low-cost location and
then exported back into the United States. However, Vernon argued that most new products were initially
produced in America. Apparently, the pioneering firms believed it was better to keep production facilities close to the
market and to the firm's center of decision making, given the uncertainty and risks inherent in introducing new
products. Also, the demand for most new products tends to be based on non-price factors. Consequently, firms can charge
relatively high prices for new products, which obviates the need to look for low-cost production sites in other
countries.
 The Product Life-Cycle Theory

• Vernon went on to argue that early in the life cycle of a typical new product, while demand is starting to grow rapidly in the United
States, demand in other advanced countries is limited to high-income groups. The limited initial demand in other advanced countries
does not make it worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from
the United States to those countries. Over time, demand for the new product starts to grow in other advanced countries (e.g., Great
Britain, France, Germany, and Japan). As it does, it becomes worthwhile for foreign producers to begin producing for their home
markets. In addition, U.S. Firms might set up production facilities in those advanced countries where demand is growing. Consequently,
production within other advanced countries begins to limit the potential for exports from the United States.

• As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes
the main competitive weapon. As this occurs, cost considerations start to play a greater role in the competitive process. Producers based
in advanced countries where labor costs are lower than in the United States (e.g., Italy, Spain) might now be able to export to
the United States. If cost pressures become intense, the process might not stop there. The cycle by which the United States lost its
advantage to other advanced countries might be repeated once more, as developing countries (e.g., Thailand) begin to acquire a
production advantage over advanced countries. Thus, the locus of global production initially switches from the United States to other
advanced nations and then from those nations to developing countries.

• The consequence of these trends for the pattern of world trade is that over time the United States switches from being an exporter of
the product to an importer of the product as production becomes concentrated in lower-cost foreign locations. Following figure shows the
growth of production and consumption over time in the United States, other advanced countries, and developing countries.
The Product Life Cycle Theory
 New Trade Theory

• The new trade theory began to emerge in the 1970s when a number of economists pointed out that the ability of firms to attain

economies of scale might have important implications for international trade. Economies of scale are unit cost reductions

associated with a large scale of output. Economies of scale have a number of sources, 1) including the ability to spread fixed

costs over a large volume, and 2) the ability of large-volume producers to utilize specialized employees and equipment that

are more productive than less specialized employees and equipment. Economies of scale are a major source of cost

reductions in many industries, from computer software to automobiles, and from pharmaceuticals to aerospace. For example,

Microsoft realizes economies of scale by spreading the fixed costs of developing new versions of its Windows operating system,

which runs to about $5 billion, over the 250 million or so personal computers upon which each new system is ultimately

installed.

• Similarly, automobile companies realize economies of scale by producing a high volume of automobiles from an assembly line

where each employee has a specialized task. New trade theory makes two important points: First, through its impact on

economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those

goods. Second, in those industries when the output required to attain economies of scale represents a significant proportion

of total world demand, the global market may be able to support only a small number of enterprises. Thus, world trade in

certain products may be dominated by countries whose firms were first movers in their production.
 New Trade Theory

• Increasing Product Variety & Reducing Costs

• Imagine first a world without trade. In industries where economies of scale are important, both the variety of goods that a

country can produce and the scale of production are limited by the size of the market. If a national market is small,

there may not be enough demand to enable producers to realize economies of scale for certain products. Accordingly, those

products may not be produced, thereby limiting the variety of products available to consumers. Alternatively, they may

be produced, but at such low volumes that unit costs and prices are considerably higher than they might be if economies of

scale could be realized.

• Now consider what happens when nations trade with each other. Individual national markets are combined into a larger world

market. As the size of the market expands due to trade, individual firms may be able to better attain economies of scale.

The implication, according to new trade theory, is that each nation may be able to specialize in producing a narrower range

of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each

nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods thus

trade offers an opportunity for mutual gain even when countries do not differ in their resource endowments or technology.
 New Trade Theory

• Suppose there are two countries, each with an annual market for 1 million automobiles. By trading with each other, these countries

can create a combined market for 2 million cars. In this combined market, due to the ability to better realize economies of scale,

more varieties (models) of cars can be produced, and cars can be produced at a lower average cost, than in either market alone.

For example, demand for a sports car may be limited to 55,000 units in each national market, while a total output of at least

100,000 per year may be required to realize significant scale economies. Similarly, demand for a minivan may be 80,000 units

in each national market, and again a total output of at least 100,000 per year may be required to realize significant scale economies.

Faced with limited domestic market demand, firms in each nation may decide not to produce a sports car, since the costs of

doing so at such low volume are too great. Although they may produce minivans, the cost of doing so will be higher, as will

prices, than if significant economies of scale had been attained. Once the two countries decide to trade, however, a firm in one

nation may specialize in producing sports cars, while a firm in the other nation may produce minivans. The combined demand

for 110,000 sports cars and 160,000 minivans allows each firm to realize scale economies. Consumers in this case benefit from having

access to a product (sports cars) that was not available before international trade and from the lower price for a product

(minivans) that could not be produced at the most efficient scale before international trade. Trade is thus mutually beneficial

because it allows for the specialization of production, the realization of scale economies, the production of a greater variety of

products, and lower prices.

 New Trade Theory

• ECONOMIES OF SC ALE, FIRST-MOVER ADVANTAGES, AND THE PATTERN OF TR ADE

• A second theme in new trade theory is that the pattern of trade we observe in the world economy may be the result of economies of scale and first-
mover advantages. First mover advantages are the economic and strategic advantages that accrue to early entrants into an industry. The ability to capture
scale economies ahead of later entrants, and thus benefit from a lower cost structure, is an important first-mover advantage. New trade theory argues that for
those products where economies of scale are significant and represent a substantial proportion of world demand, the first movers in an industry can gain a
scale-based cost advantage that later entrants find almost impossible to match. Thus, the pattern of trade that we observe for such products may reflect
first-mover advantages. Countries may dominate in the export of certain goods because economies of scale are important in their production, and because
firms located in those countries were the first to capture scale economies, giving them a first-mover advantage.

• For example, consider the commercial aerospace industry. In aerospace there are substantial scale economies that come from the ability to spread the
fixed costs of developing a new jet aircraft over a large number of sales. It has cost Airbus industry some $15 billion to develop its new super-jumbo jet,
the 550-seat A380. To recoup those costs and break even, Airbus will have to sell at least 250 A380 planes. If Airbus can sell more than 350 A380 planes, it will
apparently be a profitable venture. Total demand over the next 20 years for this class of aircraft is estimated to be between 400 and 600 units. Thus, the global
market can probably profitably support only one producer of jet aircraft in the super-jumbo category. It follows that the European Union might come to
dominate in the export of very large jet aircraft, primarily because a European-based firm, Airbus, was the first to produce a super-jumbo jet aircraft and realize
scale economies.

• Other potential producers, such as Boeing, might be shut out of the market because they will lack the scale economies that Airbus will enjoy. By
pioneering this market category, Airbus may have captured a first-mover advantage based on scale economies that will be difficult for rivals to match, and
that will result in the European Union becoming the leading exporter of very large jet aircraft. (Boeing does not believe the market to be large enough to even
profitably support one producer, hence its decision not to build a similar aircraft, and instead focus on its super efficient 787.)
Porter’s Diamond