International Business: The New Realities: Fifth Edition

International Business: The New Realities
Fifth Edition
Chapter 5
Theories of International
Trade and Investment
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Learning Objectives
5.1 Explain why nations trade.

5.2 Learn about how nations can enhance their
competitive advantage.
5.3 Understand why and how firms internationalize.
5.4 Explain the strategies internationalizing firms use to
gain and sustain competitive advantage.

Theories of International Trade and
Investment

Mercantilism and Neomercantilism
• Mercantilism: A belief popular in the 16th century that

national prosperity results from maximizing exports and
minimizing imports.
• Today, some argue for neomercantilism, the idea that the
nation should run a trade surplus.
• Supporters of neomercantilism include:
– Labor unions (who want to protect domestic jobs)
– Farmers (who want to keep crop prices high), and
– Some manufacturers (that rely on exports).

Free Trade
• The absence of restrictions to the flow of goods and
services among nations.
• Free trade is usually best because:
– Consumers and firms can buy the products they want.
– Imported products may be cheaper than domestically
produced products
– Lower-cost imports help reduce business costs, thereby
raising company profits
– Lower-cost imports help consumers save money,
thereby increasing their living standards
– Unrestricted international trade tends to increase the
overall prosperity of nations.

Comparative Advantage
• The foundation concept of international trade, which

answers the question of how nations can achieve and
sustain economic success and prosperity.
• It refers to the superior features of a country that provide
it with unique benefits in global competition.
• Comparative advantages are derived either from natural
endowments or from deliberate national policies.

Examples of National Comparative
Advantage
• France has superior climate and soil for producing wine.

• Saudi Arabia has a natural abundance of oil which is
used in the production of petroleum products.
• Japan has acquired a superior base of knowledge and
experience for producing cars.
• India has acquired a superior base of IT workers for
producing computer software.
• What are the comparative advantages in your country?

Competitive Advantage
• A foundation concept that explains how individual firms

gain and maintain distinctive competencies, relative to
competitors, that lead to superior performance.
• It refers to the distinctive assets, competencies, and
capabilities that are developed or acquired by the firm.
• The collective competitive advantages held by the firms
in a nation are the basis for the competitive advantages
of the nation at large.

Examples of Firm Competitive Advantage
• Dell’s prowess in the management of its global supply chain.
• Samsung’s technological leadership in flat-panel televisions.
• Cadbury’s capabilities in international marketing and
distribution.
• Herman Miller’s design strengths in

office furniture (e.g., Aeron chairs).

Absolute Advantage Principle
A country should produce only those products in which it

has absolute advantage or can produce using fewer
resources than another country.
(Labor Cost in Days of Production for One Ton)

Adam Smith (1723-1790)
Source: creativehearts/123RF

Comparative Advantage Principle (1 of 5)
It is beneficial for two countries to trade even if one has
absolute advantage in the production of all products. What
matters is not the absolute cost of production but the
relative efficiency with which it can produce the product.
(Labor Cost in Days of Production for One Ton)

It is beneficial for two countries to trade even if one has

absolute advantage in the production of all products; what
matters is not the absolute cost of production but the
relative efficiency with which it can produce the product.

• While Germany can make both items cheaper than France,
it is still beneficial for Germany to trade with France.
• The key is the ratio of production costs. In the exhibit,
Germany is comparatively more efficient at producing cloth
than wheat. Germany can produce three times as much
cloth as France (30/10), but only two times as much wheat
(40/20).
• Germany should specialize in producing cloth and import all
the wheat it needs from France. France should specialize in
producing wheat and import all its cloth from Germany.

• Each country benefits by specializing in the product in which
it has a comparative advantage and importing the other
product.
• The principle applies to all goods. It reveals how countries
use scarce resources more efficiently.

Example:
• Arguably, no country is better than Japan at making cars.
Because Japan is especially good at making cars, it
concentrates its resources on making them.
• Meanwhile, other countries, such as China and Finland,
focus on making cell phones.
• In this way, Japan makes maximal use of its resources,
and the world gets great cars. China and Finland make
great cell phone, and the world gets great cell phones.

Limitations of Early Trade Theories
• Fail to account for international transportation costs.
• Governments distort normal trade by selectively imposing
protectionism (e.g., tariffs) or investing in certain industries
(e.g., via subsidies).
• Services: Some cannot be traded; others can be traded freely
via the Internet or global telephony.
• For many firms, scale economies and superior business
strategies provide efficiencies and other advantages. Early
trade theories failed to account for this. (e.g., Japan lacks
comparative advantages, but its firms succeeded anyway, via
superior strategies.)

Factor Proportions Theory (1 of 2)
• Also known as Factor Endowments Theory. It argues
that each country should produce and export products
that intensively use relatively abundant factors of
production, and import goods that intensively use
relatively scarce factors of production.

Factor Proportions Theory (2 of 2)
• However, the Leontief Paradox revealed that countries
can successfully export products that use less abundant
resources (e.g., the U.S. often exports labor-intensive
goods). Implies that international trade is complex and
cannot be fully explained by a single theory.

International Product Life Cycle Theory
(1 of 4)
Source: Adapted from Raymond Vernon, “International Investment and International Trade in the Product Cycle,”
Quarterly Journal of Economics 80 May 1966), pp. 190-207 and
http://www.provenmodels.com/583/international-product-life-cycle/raymond-vernon

(2 of 4)
• Each product and its associated manufacturing

technologies go through three stages of evolution:
introduction, maturity, and standardization.
• In the introduction stage, the inventor country enjoys a
monopoly both in manufacturing and exports. Example:
the television set.

(3 of 4)

• In the maturity stage, the product’s manufacturing
becomes relatively standardized, other countries start
producing and exporting the product.

(4 of 4)

• In the standardization stage, manufacturing ceases in the
original innovator country, and it becomes a net importer
of the product. Today under globalization, the cycle
occurs quickly for many products.

New Trade Theory
• Argues that economies of scale are an important factor in
some industries for superior international performance, even
in the absence of superior comparative advantages. Some
industries succeed best as their volume of production
increases.
Example
• The commercial aircraft
industry has very high fixed
costs that necessitate high-
volume sales to achieve
profitability.

Comparative Versus Competitive
Advantage

Critical Role of Innovation in National
Economic Success
• Innovation is a key source of competitive advantage.
• The firm innovates in four major ways. It can develop:
– A new product or improve an existing product.
– New ways of manufacturing.
– New ways of marketing.
– New ways of organizing company operations.
• Many innovative firms in a

nation leads to national
competitive advantage

Critical Role of Productivity in National
Economic Success
• Productivity is the value of the output produced by a unit
of labor or capital.
• It is a key source of competitive advantage for firms.
• The greater the productivity of the firm, the more
efficiently it uses its resources.
• The more productive the firms in a nation, the more
efficiently the nation uses its resources.
• Aggregate productivity is a key determinant of the
nation’s standard of living.

Labor Productivity Levels in Selected Countries
(Output per Hour in Manufacturing, 2007-2018;
Index Scale Where 2010=100)
Source: OECD, OECD Data: Productivity (Organisation for Economic Cooperation and Development, 2015),
https://data.oecd.org/lprdty/labour-productivity-forecast.htm#indicator-chart

Michael Porter’s Diamond Model: Sources
of National Competitive Advantage

Diamond Model Sources of National
Competitive Advantage (1 of 4)
• Factor conditions - Quality and quantity of labor, natural

resources, capital, technology, know-how,
entrepreneurship, and other factors of production.
Example
• An abundance of cost-effective and well-educated
workers give China a competitive advantage in the
production of laptop computers.

• Related and supporting industries - The presence of

suppliers, competitors, and complementary firms that
excel within a given industry.
Example
• The Silicon Valley in California is a great place to launch
a computer software firm because it is home to thousands
of knowledgeable firms and workers in the software
industry.

• Demand conditions at home - The strengths and

sophistication of customer demand.
Example
• Japan is a densely populated, hot, and humid country
with very demanding consumers. These conditions led
Japan to become one of the leading producers of superior,
compact air conditioners.

• Firm strategy, structure, and rivalry - The nature of domestic
rivalry, and conditions that determine how a nation’s firms are
created, organized, and managed.
Example
• Italy has many top firms in design
industries such as textiles, furniture,
lighting, and fashion. Vigorous
competitive rivalry puts these firms
under constant pressure to innovate,
which has propelled Italy to a
leading position in design worldwide.

Industrial Cluster
• A concentration of suppliers and supporting firms from
the same industry located within the same geographic
area. This is similar to Porter’s Related and Supporting
Industries.
• A strong cluster can serve as an export platform for the
nation.
Examples
• Silicon Valley; pharmaceutical cluster in Switzerland;
footwear industry in Pusan, South Korea; IT industry in
Bangalore, India; fashion cluster in northern Italy; and
Silicon Valley North near Ottawa, Canada.

National Industrial Policy
• A proactive economic development plan employed by the

government to nurture or support promising industry
sectors with potential for regional or global dominance.
• Initiatives can include:
– Tax incentives.
– Monetary and fiscal policies.
– Rigorous educational system.
– Investment in national infrastructure.
– Strong legal and regulatory systems.

Examples of National Industrial Policy (1 of 2)
• Vietnam’s government in the 1990s privatized state

enterprises and modernized the economy, emphasizing
competitive, export-driven industries. Vietnam became
one of the fastest-growing economies, averaging around
8 percent annual GDP growth.
• Singapore adopted probusiness, pro-investment, export-
oriented policies, combined with state-directed
investments in strategic corporations. The approach
stimulated economic growth that averaged 8 percent
annually from 1960 to 1999.

Examples of National Industrial Policy
(2 of 2)
• The Czech government in the 1990s created a business-

friendly legal and regulatory environment. The country
privatized state-owned companies. Government FDI
incentives attracted numerous MNEs, such as Daewoo, ING,
Siemens, and Toyota.
• Starting in 1984, New Zealand’s

government transformed the
country from an agrarian,
protectionist, regulated
economy to an industrialized,
free-market economy that today
competes globally.

Transformation of New Zealand’s
Economy, 1993 to 2017 (1 of 3)
Statistic New Zealand in New Zealand in New Zealand in
1993 2005 2017
GDP per capita $12,452 $27,206 $41,629
NZX 50 Stock Market Index 2,200 3,200 8,000
Unemployment rate 9.8% 3.8% 4.8%
National debt 47% of the 18% of the 24% of the
nation’s GDP nation’s GDP nation’s GDP
Source: International Monetary Fund, World Economic Outlook IMF.
• New Zealand’s success resulted from:

• Implemented pro-business policies - fiscal, monetary, tax; investment
in education
• Emphasized high-value industries such as IT and pharmaceuticals
that greatly grew GDP and reduced unemployment.

Economy, 1993 to 2017 (2 of 3)
• Government-controlled wages, prices, and interest rates were
freed and allowed to fluctuate as per market forces.
• The banking sector was liberalized, foreign exchange controls
were eliminated, and the New Zealand dollar was allowed to
float according to market forces.
• Most trade barriers were removed; New Zealand joined
several free trade agreements.
• Agricultural and other subsidies were eliminated.
• The government worked earnestly with labor unions to reduce
wage inflation, thus helping maintain jobs in New Zealand
without outsourcing to lower-wage countries.

Economy, 1993 to 2017 (3 of 3)
• The government initiated programs to encourage development of a
knowledge economy. New Zealanders continuously upgraded skills
and knowledge, providing a supply of scientists, engineers, and
trained managers.
• Personal and corporate income tax rates were cut. The tax base was
diversified to stabilize government revenues. This helped foster
entrepreneurship, boosted consumer spending, and attracted FDI
into New Zealand.
• The government cut spending and borrowing, leading to lower
interest rates and stimulating the economy.
• State-owned enterprises-such as the national airline, telecom, and
other utilities-were privatized.

Stages in Company Internationalization

Stock and Growth of Outward F D I: Leading
FDI Destinations, 2006 to 2016 (Billions of U.S.
Dollars) (1 of 2)
Sources: UNCTAD, UNCTAD Stat 2017 (New York: United Nations, 2018), http://unctad.org/en/pages/Statistics.aspx

Stock and Growth of Outward F D I: Leading
FDI Destinations, 2006 to 2016 (Billions of U.S.
Dollars) (2 of 2)
Sources: UNCTAD, UNCTAD Stat 2017 (New York: United Nations, 2018), http://unctad.org/en/pages/Statistics.aspx

How Firms Gain and Sustain International
Competitive Advantage
• Since the MNE was traditionally the major player in

international business, scholars have offered numerous
explanations of what makes these firms pursue, and
succeed in, internationalization.
• Because FDI has been MNE

s’ main strategy in
international expansion,
theoretical explanations have
tended to emphasize it.

FDI Based Explanations: Monopolistic
Advantage Theory
• Argues that MNEs prefer FDI because it provides the firm

with control over resources and capabilities in the foreign
market, and a degree of monopoly power relative to
foreign competitors.
• Key sources of monopolistic advantage include
proprietary knowledge, patents, unique know-how, and
sole ownership of other assets.
Example
• Novartis earns substantial profits by marketing various
patented medications through its subsidiaries worldwide.

FDI Based Explanations: Internalization
Theory
• Explains how the MNE chooses to acquire and retain one or
more value-chain activities inside itself.
• Such “internalization” provides the MNE with greater control
over its foreign operations.
• Internalization avoids the drawbacks of dealing with external
partners, such as reduced quality control and the risk of losing
proprietary assets to outsiders.
Example
• In China, Intel owns much of its value chain in order to ensure
that Intel knowledge, patents, and other assets are not
misused or illicitly obtained by potential rivals.
FDI Based Explanations: Dunning’s
Eclectic Paradigm
• Three conditions determine whether or not a company will
enter a given foreign country via FDI:
– Ownership-specific advantages - knowledge, skills,
capabilities, relationships, or physical assets that the firm
owns, and which are the basis of its competitive
advantages.
– Location-specific advantages - similar to comparative
advantages, they are specific advantages that exist in the
country that the MNE has entered, or is seeking to enter,
such as natural resources, low-cost labor, or skilled labor.
– Internalization advantages - control derived from
internalizing foreign-based manufacturing, distribution, or
other value chain activities.
Example of the Eclectic Paradigm: Sony in
China
• Ownership specific advantages: Sony possesses a

huge stock of knowledge and patents in the consumer
electronics industry, as represented by products like the
Playstation and Bravia TV.
• Location specific advantages: Sony desires to
manufacture in China, to take advantage of China’s low-
cost, highly knowledgeable labor.
• Internalization advantages: Sony wants to maintain
control over its knowledge, patents, manufacturing
processes, and quality of its products.
Thus, Sony entered China via FDI
Non-FDI Based Explanations:
International Collaborative Ventures
• A form of cooperation between two or more firms.

Partners pool resources and capabilities to create
synergies, and share the risk of joint efforts.
• Starting in the 1980s, firms increasingly began using
collaborative ventures to venture abroad.
• Collaboration provides access to foreign partners’ know-
how, capital, distribution channels, or marketing assets.
Collaboration also helps overcome government imposed
obstacles.

Two Types of International Collaborative
Ventures
• Equity-based joint ventures result in the formation of a

new legal entity. In contrast to the wholly-owned FDI, the
firm collaborates with local partner(s) to reduce risk and
commitment of capital.
• Project-based alliances do not require equity commitment
from the partners but simply a willingness to cooperate in
R&D, manufacturing, design, or any other value-adding
activity. Since project-based alliances have a narrowly
defined scope of activities and timeline, they provide
greater flexibility to the firm than equity-based ventures.

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Slides in this presentation contain

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

5.1 Explain why nations trade.

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• Mercantilism: A belief popular in the 16th century that

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• The foundation concept of international trade, which

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• France has superior climate and soil for producing wine.

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• A foundation concept that explains how individual firms

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• Herman Miller’s design strengths in

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

A country should produce only those products in which it

(Labor Cost in Days of Production for One Ton)

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

(Labor Cost in Days of Production for One Ton)

It is beneficial for two countries to trade even if one has

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• Each product and its associated manufacturing

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• Each product and its associated manufacturing

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• Each product and its associated manufacturing

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Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

– New ways of manufacturing.

– New ways of marketing.

– New ways of organizing company operations.

• Many innovative firms in a

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Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• Factor conditions - Quality and quantity of labor, natural

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• Related and supporting industries - The presence of

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• Demand conditions at home - The strengths and

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• A proactive economic development plan employed by the

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• Vietnam’s government in the 1990s privatized state

Copyright © 2020 Pearson Education, Inc. All Rights Reserved

• The Czech government in the 1990s created a business-

• Starting in 1984, New Zealand’s

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Source: International Monetary Fund, World Economic Outlook IMF.

• New Zealand’s success resulted from: