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Chapter 6: Theories of International Trade and Investment

Why nations and firms trade and invest internationally


To acquire and sustain comparative advantage and competitive

advantages What is the underlying economic rationale for international business activity?

Why does trade take place?

What are the gains from trade and investment?

Theories of International Trade and Investment

Comparative advantage (country-specific advantage): superior features of a

country that provide unique benefits in global competition, typically derived from either natural endowments or deliberate national policies



Inherited resources (labour, climate, arable land, petroleum reserves)

Resources acquired over time (entrepreneurial orientation, venture

capital, innovative capacity) Competitive advantage (firm-specific advantage): distinctive assets or

competencies of a firm that are difficult for competitors to imitate and are typically derived from specific knowledge, capabilities, skills, or superior strategies


Helps firms enter and succeed in foreign markets


Some scholars are applying this to nations as well as firms

Why Do Nations Trade?  Trade allows countries to use their national resources more efficiently through

Why Do Nations Trade?

Trade allows countries to use their national resources more efficiently through specialization


Workers can become more productive and have access to cheaper basic goods thus resulting in a higher standard of living

Classical Theories (6) Mercantilism: belief that national prosperity is the result of a positive


balance of trade, achieved by maximizing exports and minimizing

imports Form early Euro nations (1500’s) when gold was a method of

payment exports meant more gold, imports meant less gold Nation’s power and strength increased as wealth (gold)

increased Running a trade surplus is beneficial (neo-mercantilism)

View tends to harm firms that import, consumers

May invite beggar thy neighbor policies that promote benefitting

one country at the expense of the other Free trade tends to be a superior approach as it is the free flow

of goods between nations (absence of restrictions); leads to:

More readily available products



Imported products are cheaper than domestic Low cost imports = lower expenses (firms) = higher profits Low cost imports = lower expenses (consumers) = higher living standards Unrestricted trade increases overall prosperity of poor countries Absolute Advantage Principle: country benefits by producing only those products in which it has absolute advantage or that it can

produce using fewer resources than another country Allows nation to consume more than it would, and at a lower

cost Firms employ factors of production (labour, capital…) to generate G/S Mutually benefit Does not cover that countries can benefit from trade even if it lacks an absolute advantage 1776 Adam Smith Comparative Advantage Principle: it can be beneficial for two

countries to trade without barriers as long as one is relatively more efficient at producing goods or services needed by the other. What matters is not the absolute cost of production but rather the efficiency with which a country can produce the product


1817 David Ricardo Considers opportunity cost Traditionally focused on natural resources however, the resources can be created or acquired as well Limitations of Early Trade Theories Theories provide a rationale for international trade but don’t

account for factors making contemporary trade complex:


Traded products are not just commodities (they’re branded/differentiated) International transportation is costly There are government restrictions/barriers Large scale production can bring economies of scale which can offset a weak national comparative advantage Government can target and invest in certain industries to boost competitive advantage Services cannot be traded thus need to be internationalized through FDI Modern tech facilitates global trade in many services at a low cost Primary participants in international trade are individual firms Factor Proportions Theory (Factor Endowments): abundant production factors give rise to national advantages

1920’s Swedish economists Eli Heckscher and Bertil Ohlin

Products differ in types and quantities of factors (labour,

Two premises:

natural resources, capital) required for their production Countries differ in type and quantity of production factors

they possess Thus countries should export products that use relatively

abundant factors of production and import goods that use scarce factors of production Different from other theories because it includes efficiency and

quantity of factors of production LEontif paradox is empirical evidence against factor proportions theory


US has the most capital thus it should export capital goods however it exports mainly labor-intensive goods This brought about the idea that international trade is too complex to be explained by one theory Other factors (country’s knowledge, technology, and capital) also explain why a country trades International Product Life Cycle Theory: international trade explained by evolutionary process that occurs in the development and diffusion of products to markets around the world

IPLC has three stages:

Introduction Maturity Standardization

 1920’s Swedish economists Eli Heckscher and Bertil Ohlin  Products differ in types and quantities

Introduction stage:

New product originates in an advanced economy

(abundant R+D and capital, consumers willing to try new products that are expensive) New product will enjoy a temporary monopoly in the home country


Mass-produce and seek to export to other advanced

economies Product’s manufacturing becomes more routine and

foreign firms produce alternatives; competition intensifies, export order from lower-income countries Standardization:

Knowledge about producing the product is widespread;

can be accomplished with cheap inputs and low-cost labour Production shifts to low-income countries

Eventually country that produced will import

Assumed that product diffusion occurs slowly to generate


temporary differences in countries’ access to new tech; this is no longer true New Trade Theory: increasing returns to scale (ex: economies of scale) are important for superior international performance in industries that succeed best as their production volume increase

in small, domestic markets, cannot have economies of scale

because can’t sell products at such a large volume these firms should export to gain access to global markets

countries can specialize in a number of small industries

this way Beginning in the 70’s trade grew fastest among industrialized

countries with similar factors of production In new industries there was no clear competitive advantage

Trade beneficial even for countries that produce only a limited variety of products

How Can Nations Enhance Their Competitive Advantage?

Globalization of markets has created a race among nations to reposition

themselves as attractive places in which to invest and do business Most advanced nations today posses national competitive advantage,

maximized when numerous industries collectively possess firm-level competitive advantage and the nation has comparative advantages that benefit those industries Contemporary Theories

The Competitive Advantage of Nations


Competitive advantage of a nation depends on the collective


competitive advantages of the nation’s firms relationship becomes reciprocal over time Competitive advantage and tech advantage grows out of innovation


(for nations and firms) Innovation results from R+D this can now be outsourced


Innovation promotes productivity key determinant of nation’s long- run standard of living and basic source of national per capita income growth

Michael Porter’s Diamond Model



Competitive advantage at both the company and national levels


originates from the presence and quality in the country of 4 elements

firm strategy, structure, and rivalry

domestic rivalry and conditions that determine how a firm

is created, organized and managed strong competitors = national competitive advantage provides firms with pressure to innovate and improve

factor conditions

consistent with factor proportions theory where each

nation has a relative abundance of certain endowments demand conditions

nature of home-market demand for specific products

high-demanding customers pressures firms to innovate

faster and produce better products related and supporting industries

presence of clusters of suppliers, competitors, and

complimentary firms that excel in particular industries business environment is highly supportive of the founding



firm industrial cluster: concentration of businesses, suppliers and


supporting firms in the same industry at a particular location characterized by a critical mass of human talent, capital, or other factor endowments (ex: fashion industry in Italy) most important source of national advantage is knowledge and skills

National Industrial Policy



National competitive advantage does not derive entirely from the store


of natural resources each country has inherited endowments are less important than in the past Can now create new advantages; government can aid in doing this


Any country, regardless of initial circumstances, can attain economic prosperity through systematically cultivating new and superior factor endowments

Develop endowments through national industrial policy:

proactive economic development plan initiated by the government, often in collaboration with the private sector, that

aims to develop or support particular industries within the nation

Typically include:


Tax incentives


Monetary and fiscal policy (ex: low interest loans)


Rigorous educational systems


Development and maintenance of strong national


infrastructure in areas like IT, transportation… Strong legal and regulatory systems to ensure citizens are confident about stability of the national economy

Pg 157 of pdf shows example of Ireland

Why and How Do Firms Internationalize?


Firm Internationalzation – theories about the managerial and


organization aspects Internationalization Process of the Firm

Model developed in the 70’s to describe how companies expand

abroad (takes place in incremental stages over a long time) Firms start with export and progress to FDI (most complex)

Gradual due to manager uncertainty about how proceed


Domestic: focus on gaining the home market

Pre-export: start thinking about exporting because they usually

get an order from abroad Experimental: issue limited international activity (basic

exporting) Active involvement: devote time to achieving international

success Committed: commit resources to making international business


a key part of their value chain activities (FDI) Born Globals and International Entrepreneurship

Early internationalizing firms will gradually become the norm in

international business Due to advances in communication and tech, globalization


of markets, increased international competition FDI-Based Explanations FDI stock is total value of assets that MNE’s own abroad via their

investment activities Three theories of how firms can use FDI to gain and sustain

competitive advantage

Monopolistic Advantage Theory:

Firms which use FDI ans internationalization strategy must

own or control certain resources and capabilities not available to competitors that give them a monopoly over local firms in foreign markets Monopoly should be specific to the MNE itself and not the

market/location where it does business Two conditions must be met for a firm to prefer targeting a foreign market rather than a home market


Returns obtainable in the foreign market should be


superior to those available in the home market Returns obtainable in foreign market should be superior to those earned by its domestic competitors in its industry in the foreign market

domestic companies in foreign firm cannot imitate Internalization Theory: explanation of the process by which

firms acquire and retain one or more value-chain activities inside the firm, minimizing the disadvantages of dealing with external partners and allowing for greater control over foreign operations

By doing this they can control proprietary knowledge

Dunning’s Eclectic Paradigm

Framework for determining the extent and pattern of the

value-chain operations that companies own abroad most comprehensive FDI theory Three conditions that company will internationalize via FDI


Ownership-specific advantages Should have assets that give it a competitive

advantage in foreign markets Resources, assets… should be specific to the


company Location-specific advantages Comparative advantages available in individual foreign countries (natural


resources, skilled labor, low-cost labor, inexpensive capital) Internalization advantages


Non-FDI-Based Explanations

FDI was a popular entry mode with rise of MNE in 60’s and 70’s;

in 80’s firms began to recognize importance of collaborative ventures

International Collaborative Ventures


Two types of collaborative ventures:



Joint venture: equity based


Strategic alliance: non-equity based


Sometimes firms won’t have a choice as they will require

resources and capital from another firm Company can position itself better because it has access to more knowledge about the foreign market

Networks and Relational Assets

Represents economically beneficial long-term

relationships the firm undertakes with other business entities (manufacturers, distributors, bankers…) Network theory proposed to compensate the inability of

traditional organizational theories to account for much that foes on in business markets Forming strategic relationships (networking)