chapter three

Theories of International Trade

and Investment

McGraw-Hill/Irwin
International Business, 11/e Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives

 Explain the theories that attempt to explain

why certain goods are traded internationally

 Discuss the arguments for imposing trade

restrictions

 Explain two basic kinds of import restrictions:

tariff and nontariff trade barriers

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 Learning Objectives

 Appreciate the relevance of changing status of

tariff and nontariff barriers to managers

 Explain some of the theories of foreign direct

investment

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 International Trade Theory

• Mercantilism
– Economic philosophy based on belief that
• (1) a nation’s wealth depends on
accumulated treasure, usually gold, and
• (2) to increase wealth, government
policies should promote exports and
discourage imports

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 Theory of Absolute Advantage

• Absolute advantage
– Theory that a nation has absolute
advantage when it can produce a larger
amount of a good or service for the same
amount of inputs as can another country or
– When it can produce the same amount of a
good or service using fewer inputs than
could another country

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 Absolute Advantage
Example

Each Country Specializes

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 Absolute Advantage
Terms of Trade (Ratio of International Prices)

Gains from Specialization and Trade

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Theory of Comparative Advantage

• Comparative Advantage
– A nation having absolute disadvantages in
the production of two goods with respect to
another nation has a comparative or relative
advantage in the production of the good in
which its absolute disadvantage is less

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Theory of Comparative Advantage
Example

Each Country Specializes

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 Comparative Advantage
Terms of Trade – at a rate of ¾ bolt of cloth for 1 ton of soybeans

Terms of Trade – at a rate of 1 bolt of cloth for 1 ton of soybeans

Gains from Specialization and Trade

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 Comparative Advantage

• Production Possibility Frontiers (figure 3.1)

Figure
3.1

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Heckscher-Ohlin Theory of Factor
Endowment
• Factor Endowment
– Heckscher-Ohlin theory that countries
export products requiring large amounts of
their abundant production factors and import
products requiring large amounts of their
scarce production factors

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Heckscher-Ohlin Theory of Factor
Endowment
• Leontief Paradox
– The United States, one of the most capital-intensive
countries in the world, was exporting relatively
labor-intensive products in exchange for relatively
capital-intensive products

• Differences in Taste
– A demand-side construct that is always difficult to
deal with in economic theory

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 How Can Money Change The
Direction of Trade?
Example

Exchange Rate – the price of one currency stated in terms of another currency

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 How Can Money Change The
Direction of Trade?
• Influences of Exchange Rate
– Currency devaluation
• The lowering of a currency’s price in
terms of other currencies

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Some Newer Explanations For The
Direction Of Trade
• Linder Theory of Overlapping Demand

– Customers’ tastes are strongly affected by

income levels; therefore a nation’s income
per capita level determines the kinds of
goods they will demand

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Some Newer Explanations For The
Direction Of Trade
• International Product Life Cycle (IPLC)
– Explains why a product that begins as
export eventually becomes import (figure
3.2)
• U.S. exports
• Foreign production begins
• Foreign competition in export market
• Import competition in the United States

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Figure 3.2 International Product Life
Cycle

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Some Newer Explanations For The
Direction Of Trade
• Technology Life Cycle
– Production technology application of IPLC

• Economies of Scale and Experience Curve

– As a plant gets larger and output increase, the
average cost of producing each unit of output
decreases
– As firms produce more products, they learn ways to
improve production efficiency

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Some Newer Explanations For The
Direction Of Trade
• Imperfect Competition
– Economies of scale with the existence of
differentiated products--Paul Krugman

• First-Mover Theory
– Pattern of trade in goods subject to scale
economies may be determined by historical
factors

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Some Newer Explanations For The
Direction Of Trade
• National Competitive Advantage from Regional
Clusters: Porter’s Diamond Model (figure 3.3)
– National Competitiveness: a nation’s relative ability
to design, produce, distribute, or service products
while earning increasing returns on resources
• Demand conditions
• Factor Conditions
• Related and supporting industries
• Firm strategy, structure, and rivalry

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Figure 3.3 Variable Impacting Competitive
Advantage: Porter’s Diamond

Source: Reprinted by permission of the Harvard Business Review. “The Competitive Advantage of Nations” by Michael E. Porter, 3-23
March–April 1990, p. 77. Copyright © 1990 by The President and Fellows of Harvard College; all rights reserved.
Trade Restrictions: Arguments For

• National Defense
• Sanctions to Punish Offending Nations
• Protect Infant (or Dying) Industry
• Protect Domestic Jobs from Cheap
Foreign Labor
• Scientific Tariff or Fair Competition

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 Trade Restrictions

• Retaliation
– Dumping: selling a product abroad for less
than the cost of production, the price in the
home market, or the price to third countries
• Social dumping
• Environmental dumping
• Financial services dumping
• Cultural dumping
• Tax dumping
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 Trade Restrictions

– Subsidies: Financial contributions, provided

directly or indirectly by a government, which
confer a benefit; include grants, preferential
tax treatment, and government assumption
of normal business expenses (figure 3.4)
– Countervailing duties: Additional import
taxes levied on imports that have benefited
from export subsidies

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 Figure 3.4 Value of OECD Member
Farm Subsidies

Source: “Agriculture: Support Estimates, 2004,” OECD in Figures: Statistics on the Member Countries. Accessed 7/2005
Link: http://dx.doi.org/10.1787/758034618756. 3-27
 Tariff Barriers

• Tariff
– Taxes on imported goods for the purpose of raising
their price to reduce competition for local producers
or stimulate local production
• Ad Valorem Duty
– An import duty levied as a percentage of the invoice
value of imported goods
• Specific Duty
– A fixed sum levied on a physical unit of an imported
good

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 Tariff Barriers

• Compound Duty
– A combination of specific and ad valorem
duties
• Official Prices
• Variable Levy
– An import duty set at the difference between
world market prices and local government-
supported prices
• Lower Duty for more local Input
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 Nontariff Barriers

• Nontariff barriers (NTBs)

– All forms of discrimination against imports
other than import duties
• Quantitative
– Quotas: numerical limits placed on specific
classes of imports
– Voluntary export restraints (VERs): Export
quotas imposed by exporting nation

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 Nontariff Barriers

• Orderly Marketing Arrangements

– Formal agreements between exporting and
importing countries that stipulate the import
or export quotas each nation will have for a
good
• Nonquantitative Nontariff Barriers
– Direct government participation in trade
– Customs and other administrative
procedures
– Standards

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 From Multinational to Globally
Integrated Manufacturing Systems
• Close least efficient plants, and supply
their markets with imports from other
subsidiaries
• Change multidomestic manufacturing
system to globally integrated system in
which each plant performs the activities
at which it is most efficient

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International Investment Theories

• Monopolistic Advantage Theory

Theory that FDI is made by firms in oligopolistic
industries possessing technical and other advantages
over indigenous firms
• Product and Factor Market Imperfections
Superior knowledge leads to differentiated products,
and they lead to firm control on price and advantage
over indigenous firm (Hymer and Caves)
• Financial Factors
Imperfections in the foreign exchange markets (Aliber)
• International Product Life Cycle
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International Investment Theories

• Follow The Leader

• Cross Investment
– Foreign direct investment by oligopolistic firms in
each other’s home countries as a defense measure
• Internalization Theory
– An extension of the market imperfection theory: to
obtain a higher return on its investment, a firm will
transfer its superior knowledge to a foreign
subsidiary rather than sell it in the open market

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International Investment Theories

• Dynamic Capabilities
– Theory that for a firm to successfully invest
overseas, it must have ownership of unique
knowledge or resources and the ability to
dynamically create and exploit these capabilities
• Dunning’s Eclectic Theory Of International
Production
– Theory that for a firm to invest overseas, it must
have three kinds of advantages: ownership-specific,
internalization, and location-specific

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