International Business

UNIT -3

International Business 2-1

 Introduction
• Countries often wrestle with a questions like what to
trade, how much to trade and with whom should they
export and import.
• These questions are simplify intertwined with
consideration of what they can produce efficiently.
• Which further give rise to confusing situation of how
they can improve their competitiveness .
• All these questions and situation in front of any country
can be understood by simple understanding of
International trade theories.
• International trade theories gives basis to trade policies
framed by policy makers of any country.

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 Introduction
• International trade theory helps explain trade patterns
• Some patterns of trade are fairly easy to explain - it is obvious
why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil
exports coffee
• But, why does Switzerland export chemicals, pharmaceuticals,
watches, and jewelry? Why does Japan export automobiles,
consumer electronics, and machine tools?
• Every country uses Trade and Factor mobility (movement of
capital, technology, people) to help it achieve economic
objectives
• What to produce?, How much to produce? and Who to trade
with? – efficiently
• How to improve competitiveness?

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 Laissez-Faire versus Interventionist
Approaches to Exports & Imports
• International trade between two countries will
depend upon two approaches.
1. Interventionist approach
2. Laissez-Faire approach
• Countries either will support domestic business by
having interventionist approach.
• Or will try to bring market efficiency through free
trade (laissez – faire) approach.

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 Laissez-Faire versus Interventionist
Approaches to Exports & Imports
• Interventionist:
– Mercantilism
– Neomercantilism
• Free-trade theories (Laissez Faire)
– Absolute advantage
– Comparative advantage

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 Mercantilism (1500- 1800)

∙ According to Mercantilist theory, a country

should export more than import.
∙ Government imposed restriction on import and
promote export
∙ should subsidized production of many products
that otherwise could not compete in export
market
∙ Mercantilist theory proposed that a country
should try to achieve a favorable balance of trade
(export more than it imports)
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 Neo-mercantilist Theory

∙ Neo-mercantilist policy also seeks a favorable

balance of trade, but its purpose is to achieve
some social or political objective.
∙ For example : country may try to achieve full
employment by setting economic policies that
encourages its domestic companies to
produce in excess of the demand at home and
send surplus abroad.

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 Free Trade Theories

∙ Many countries, did follow Interventionist

theories to become self reliant and self
sufficient
∙ Nation should not artificially limit imports nor
promote exports
∙ Means flow to trade should be free and
should based on specialization.

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 Free Trade Theories

• Free-trade theories: (Product Specialization)

– Absolute advantage
– Comparative advantage
• Just like individual, a countries should produce
only those products which they can produce
efficiently than others.
• In other words, in which they are specialized.

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 Theory of Absolute Advantage
• Adam smith proposed this theory in 1776 – Real wealth of a
country is not gold, but goods and services available to its citizens
• He questioned why the citizen of any country should have to buy
domestically produced goods when they could buy those goods
more cheaply from abroad.
• Now the question is what product a country should specialize?
• Countries should specialize in products in which they have
competitive advantage
• Resources will shift to the efficient industries
• Use excess specialized production to import more of other goods
• Natural advantage or acquired advantage
• ex: Manufacturing depends on acquired and agriculture on natural

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 Theory of Absolute Advantage
Assumption for costa Rica
1. +100 units of resources available.
2. 10 units to produce a ton of wheat
3. 4 units to produce a ton of coffee.
4. Uses half of resources per product
when trade is restricted.
Assumption for US
1.100 units of resources available.
2. 5 units to produce a ton of wheat
3. 20 units to produce a ton of coffee.
4. Uses half of resources per product
when trade is restricted.

Production (without trade) Coffee Wheat

Costa Rica 12.5
5
United State 2.5 10
Total 15 15

With trade
Costa Rica 25 0
United States 0 20
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25 6-11 20 6-11
 Theory of Comparative Advantage

• What if a country has absolute advantage in production of all

the goods?
• David Ricardo suggested theory of comparative advantage
which says that trade is possible in this situation but should
have comparative advantage in production of one commodity
than in others.

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 Assumption of theory

• There are two countries, England and Portugal

• They produce two same commodities say wine and cloth
• There are same taste and preferences in both the countries
• Labor is only factor of production so only cost.
• All units of labor are homogenous
• Price of commodity determine by labor cost.
• Commodities are produced under law of constant return.
• Free trade between countries. No trade restriction
• No transportation cost
• All factors are fully employed.

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 Example

Labor required to producing 1 Unit

country Wine cloth
England 120 100
Portugal 80 90

Gain from trade

country Wine Cloth

England 120/100 = 1.2 100/120= 0.83
1.2 of cloth 0.83 of wine
Portugal 80/90 =0.89 90/80= 1.13
0.89 of cloth 1.13 of wine

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Gain from trade

country Wine Cloth

England 120/100 = 1.2 100/120= 0.83
1.2 of cloth 0.83 of wine
Portugal 80/90 =0.89 90/80= 1.13
0.89 of cloth 1.13 of wine

If Portugal apply all its labor of wine production in cloth they

can only produce extra 0.89 cloth.

Where as If Portugal apply all its labor of cloth production in

wine they can only produce extra 1.13 wine.

So they should focus on trade of wine.

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 Theories of Specialization
• Both absolute and comparative advantage theories
are based on specialization
• Assumptions policymakers question:
– Unrealistic assumption of Labor cost
– Unrealistic assumption of taste and preferences
– Law of variable proportion will work.
– Ignores transport costs
– Factors not fully mobile internally
– Two commodity and two countries model
– Unrealistic assumption of free trade
– Neglect role of technology.

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 Trade Pattern Theories

Absolute advantage and comparative advantage

theory do not deal with the concepts like:
•How much a country will depend on trade if it follows
a free trade policy
•What types of products countries will export and
import
•With which partners countries will primarily trade
•How much does a country trade?
– Theory of country size
– Size of the economy
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 Theory Of Country Size
• Countries with large land areas are apt to have varied
climates and natural resources
• They are generally more self-sufficient than smaller countries
are
• Larger the size of the country greater will be trade
• Size of country can be synonym to size of economy.
• United states, china, Japan , France, Germany, united
kingdom are among top ten exporters and importers.
• China is large economy by virtue of its size and population.

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 How much does a country trade?

• These countries produce so much that they have

more to sell – both domestically and internationally
• These countries produces so much, incomes are high
and people can buy more from domestic and foreign
sources.
• 9 of top 10 exporting countries are developed
• Top 10 account for 50% of world exports
• Do developing countries trade more with other
developing countries or with developed countries?
Exports? Imports?

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 Country-similarity Theory

• With whom do countries trade?

• Most trade today occurs among high-income countries
because they share similar market segments.
• Much of the pattern of two-way trading partners may be
explained by cultural similarity between the countries,
political and economic agreements, and by the distance
between them
• Trading partners are affected by
▪ Distance
▪ Cultural similarity
▪ Relations between countries.
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 Country-similarity Theory

• Distance : Intel ship chips from Costa Rica to US,

transportation cost is less so they set there production there.
• Finland is one of major exporters to Russia why transport cost
is cheap due to its closeness
• Cultural similarity
• Relations between countries

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 Factor-Proportions Theory
• What types of products countries will export and
import
• Heckscher and Ohlin’s factor proportions theory
• In which they have natural and acquired advantage
• Land, labor and capital are three factors and will
determine the relative costs of these factors
• Factor costs will determine which goods the country
can produce most efficiently .
• What type of products does a country trade?

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 Factor-Proportions Theory

• People and land : Hong Kong and Netherland, they

can not produce wheat and wool whereas Australia
and Canada can.
• Capital and labor rates: Carpets produced by Iran
where the capital is abundance as compare to Labor.
Mexico has labor in abundance.
• Process technology : People in Italy, they use high
end machines for rice production and in Bangladesh
they use small hand machines for rice production
because they have labor in abundance.
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 Product Life Cycle (PLC) Theory

• This, along with Porter’s Diamond explains how countries

develop, maintain and lose their competitive advantage
• Companies will manufacture products first in the countries in
which they were researched and developed, almost always
developed countries
• Over the product’s life cycle, production will shift to foreign
locations, especially to developing economies as the product
reaches the stages of maturity and decline

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Life Cycle of the International Product

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 The Porter Diamond

• Why do a country specialize in particular

product. ex: Hollywood, Silicon Valley
• Four conditions as important for competitive
superiority:
– demand conditions
– factor conditions
– related and supporting industries
– firm strategy, structure, and rivalry

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 Porter’s diamond Model
• Porter's diamond is a model used as part of the strategic
analysis stage of the strategic planning process.
• Porter tried to answer the following questions:
– Why does a nation become the home base for successful international
competitors in an industry? Germany is renowned for car manufacture; Japan
is prominent in consumer electronics.
– Why are firms based in a particular nation able to create and sustain
competitive advantage against the world's best competitors in a particular
field?
– Why is one country often the home of so many of an industry's world leaders?
– Porter called the answers to these questions the determinants of national
competitive advantage. He suggested that there are four main factors which
determine national competitive advantage and expressed them in the form of
a diamond.
•
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Porter’s diamond model

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 Factor conditions
• Favourable factor conditions include the following:
– physical resources such as land, minerals and weather
– capital
– human resources such as skills, motivation, price and industrial relations
– knowledge that can be used effectively
– infrastructure.
• Porter also found that countries with factor disadvantages
were forced to innovate to overcome these problems, e.g.
Japanese firms experienced high energy costs and were
forced to develop energy efficient products and processes
that were subsequently demanded worldwide.

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 Demand Conditions
• There must be a strong home market demand
for the product or service.
• This determines how industries perceive and
respond to buyer needs and creates the
pressure to innovate. A compliant domestic
market is a disadvantage because it does not
force the industry to become innovative and
excellent.

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Related and supporting industries
• The success of an industry can be due to its
suppliers and related industries.
• Sweden's global superiority in its pulp and
paper industries is supported by a network of
related industries including packaging,
chemicals, wood-processing, conveyor
systems and truck manufacture. Many of
these supporting industries have also achieved
leading global positions
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 Firm strategy, structure and
rivalry
• Organisational goals can be determined by ownership
structure. Unquoted companies may have slightly longer time
horizons to operate in because their financial performance is
subject to much less scrutiny than quoted companies. They
may also have different 'return on capital' requirements.
• Porter found that domestic competition was vital as a spur to
innovation and also enhanced global competitive advantage.
Conversely, where governments have encouraged mergers to
get the critical mass required to be a global player, these
national monopolies have not, on the whole, been successful
in establishing a global position

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 Limitations
• Porter developed the model by looking at ten developed countries. The model
thus only really applies to developed economies.
• Porter argues that inbound FDI does not increase domestic competition
significantly because domestic firms lack the capability to defend their own
markets and face a process of market share erosion and decline. However, there
seems to be little empirical evidence to support that claim.
• The Porter model does not adequately address the role of MNCs.
• There seems to be ample evidence that the diamond is influenced by factors
outside the home country.
• Porter’s analysis focused on manufacturers, banks and management consultancy
firms. Some have questioned its relevance to service based companies such as
McDonalds.
• Porter’s focus is on the domestic country rather than which foreign markets have
been targeted. A careful choice of target is essential to ensure that the firm has
the competences required for success.
• Not all firms from a given country are successful, suggesting that corporate
management is more important than geographical location.

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Limitations of the Porter Diamond Theory

• Production factors and finished goods are mobile

internationally. So if it from foreign nations.
domestic demand is not there, companies can
produce for international market. Or if factor
conditions are not proper, we can import
• Companies do not compete only with domestic
rivals, they compete with international rivals as well.

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 The Relationship
between Trade and Factor Mobility
• Factor condition changes in quality and quantity over a period
of time.
• As they do, the relative capabilities also. Like saving rates
increase, country will have more capital relative to factors of
land and labor.
• For ex: in 2050, there will be 14% and 23 % decrease in japan
and Italy population rep. , that will give rise to more old age
people. In that case people have to bring in from other
countries to maintain same ratio of work force.
• These changes in factors actually changes production location
and import export markets.

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 Why Production factors move?

• Capital :
1. companies and private individual investors transfer capital from one
country to another to gain benefit of difference in interest and prices of
shares.
2. Lower operating cost in another country will always affects perception of
investor through long term investments.

• People :
1. unlike funds are not easily transferable
2. 11% of US population is migrated from another countries.
3. Every third person having doc degree is foreign born where as lower end
unskilled labor is from Mexico. US has shortage in terms of skilled and
unskilled labor in both categories.

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 The Relationship
between Trade and Factor Mobility
• Capital and labor move internationally to gain more
income and flee adverse political situations
Ex: Singapore has converted itself in high wages country and capital intensive
country from labor intensive and low wages country by capital
accumulation. (by increasing education and import of skilled labor).
• Countries lose potentially productive resources when
educated people leave
• Salvador and Ecuador receive much more from
remittance sent by their citizens working abroad
than their actual export.

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 The Relationship
between Trade and Factor Mobility
• Capital and labor move internationally to gain more income and flee
adverse political situations
• Although international mobility of production factors may be a substitute
for trade, the mobility may stimulate trade through sales of components,
equipment, and complementary products
• Free trade, coupled with freedom of factor mobility usually results in the
most efficient allocation of resources
• Countries impose restrictions on factor mobility affecting resource
utilization – and altering how and where goods are produced

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