International Business

Meaning of International Business

• International business consists of transaction that are
devised and carried out across national borders to
satisfy the objectives of individuals, companies and
organizations.

• The economic system of exchanging good and services,

conducted between individuals and businesses in
multiple countries.

• The specific entities, such as multinational corporations

(MNCs) and international business companies (IBCs),
which engage in business between multiple countries.
 Need for International Business

• Causes the flow of ideas, services and capital across the world.

• Offer consumer new choices.

• Permits the acquisition of a wider variety of products.

• Facilitate the mobility of labor, capital and technology.

• Provide the challenging employment opportunities.

• Reallocate resources makes preferential choices and shifts activities to

.
global level
Types of International Business

• Export –Import trade

• Foreign Direct investment

• Licensing

• Franchising

• Management contract
 Franchising
• Franchising refers to the methods of practicing and
using another person's business philosophy. The
franchisor grants the independent operator the right to
distribute its products, techniques, and trademarks for a
percentage of gross monthly sales and a royalty fee.
Various tangibles and intangibles such as national or
international advertising, training, and other support
services are commonly made available by the franchisor.
Agreements typically last from five to thirty years, with
premature cancellations or terminations of most
contracts bearing serious consequences for franchisees.
 Businesses for which franchising
works best
Businesses for which franchising is said to work best have
the following characteristics:
• Businesses with a good track record of profitability.
• Businesses built around a unique or unusual concept.
• Businesses with broad geographic appeal.
• Businesses which are relatively easy to operate.
• Businesses which are relatively inexpensive to operate.
• Businesses which are easily duplicated.
 Licensing
• A business arrangement in which one company
gives another company permission to
manufacture its product for a specified payment.

• There are few faster or more profitable ways to

grow your business than by licensing patents,
trademarks, copyrights, designs, and other
intellectual property to others .
• For example, about 90 percent of the
$160 million a year in sales at Calvin Klein
Inc. comes from licensing the designer's
name to makers of undergarments, jeans
and perfume.
 Management contracts
• Agreement between investors or owners
of a project, and a management company
hired for coordinating and overseeing a
contract. It spells out the conditions and
duration of the agreement, and the
method of computing management fees.
• An agreement by which a company will
provide its organizational and
management expertise in the form of
services.
 FDI and FII
• FDI stands for Foreign Direct Investment, a
component of a country's national financial
accounts. Foreign direct investment is
investment of foreign assets into domestic
structures, equipment, and organizations. It
does not include foreign investment into the
stock markets. Foreign direct investment is
thought to be more useful to a country than
investments in the equity of its companies
because equity investments are potentially "hot
money" which can leave at the first sign of
trouble, whereas FDI is durable and generally
useful whether things go well or badly.
 FIIs
• The term is used most commonly in India
to refer to outside companies investing in
the financial markets of India. International
institutional investors must register with
the Securities and Exchange Board of
India to participate in the market. One of
the major market regulations pertaining to
FIIs involves placing limits on FII
ownership in Indian companies
 Drivers of International business
• Regional developments helping internationalization:
internationalization

1) Emergence of NAFTA comprising united states, Canada and Mexico has created a
huge north American market. Movement of goods and services among these
countries is easy as all trade barriers have been removed. The result will be a giant
“American market” that would parallel similar development in Asia and Europe.

2) The most recent changes of GAAT are stimulating increased world trade. Under the
new agreement, tariffs would be reduced world wide by 38%and in some cases,
eliminated completely.

3)Japan, of late has invested relatively more in Asia than in any part of the world.
Japanese corporations want to take advantage of the underdeveloped but growing
Asian market.

4) Export potential is vast in central and eastern Europe, Russia which are converting
themselves into market economies.

5) There is also recent economic progress among less developed economies. For
example India Globalization and liberalization approach toward economy

6) The new economy, a characteristic feature of the present century, itself demands
trading across the globe.
International Investment and Trade

• Developed countries are active players in

international investment. Approx. 80% of the
global investment emanate from rich countries.
For example FDI in the US stands at over $600
billion, while the US FDI is almost $ 800 billion.
• The developed and developing countries are the
major recipient of FDI
Other reasons of Internationalization
• There is a lot of money in the overseas market. The MNCs from the triad-
the US, Europe and Japan – have huge assets than a quarter of these
assets are found in foreign market. GE of the US is one of the top MNC with
assets of over $ 300 billion in 1997 and nearly a third of its assets were
found in overseas countries. The Dutch /UK firm shell has huge assets and
three fifth of these are located overseas.

• It is being realized that the domestic markets are no longer adequate and
rich. Japan flooded American with automobiles and electronics because
domestic market was not large enough to absorb whatever was produced.

• Companies often set up overseas plant to reduce high transportation cost.

The higher the ratio of unit cost to the selling price per unit, the more
significant the transportation factor becomes.

• The motivation to go global in high tech industries is slightly different. They

spend lot on research and development for new products. If domestic sales
and export do not generate sufficient cash flow, the company naturally might
look to overseas manufacturing plants and sales branches to generate
higher sales and better cash flow.
 Continue………………..
• Firms go global to access resources that are unavailable or more
expensive at home ( Japan largest paper company Nippon Seishi,
needs to do more than import of wood pulp. It owns huge forests
and processing facilities in Australia, Canada and US.

• Labor market also attract companies into international business.

One way companies gain competitive advantage is by locating
production facilities in low cost countries.

• Firms go global to avoid protectionist barrier imposed by local

government. Government erect various forms of barriers to entry in
their domestic markets by foreign firms

• Companies enter foreign markets because competitors have

already done it.

• Govt. throughout the world offer a variety of incentives to attract

MNCs
 International Vs. Domestic Business
Basis International business Domestic business

Payment Mostly in foreign currency In domestic currency

Laws and Subject to international laws and Subject to national rules and regulations
rules regulations

Custom Different custom and traditions Same custom & Traditions

&
Tradition
s

Legal Have to face different legal It is almost the same.

and economic and tax rate system
economic
system
Approach Have to follow geocentric approach Have to follow ethnocentric approach
Organization that engage in IB
vary considerably in size and
the extent
 Globalization
• Globalization refers to the shift towards a more
integrated and independent world economy.
Globalization has several facets, including the
globalization of markets and the globalization of
production.

• Globalization of markets: refers to the merging

of historically distinct and separate national
markets into one huge global marketplace.
Falling barriers to cross border trade have made
it easier to sell internationally.
 Continue……………
• It has been argued for some time that the taste
and preferences of customers in different
nations are beginning to converge on some
global norm, thereby helping to create a global
market.
• For example consumer products such as coca-
cola soft drink, Sony play station videogame,
McDonald hamburger are frequently held up as
prototypical example of this trend. Sony,
McDonald, coca-cola are more than just
benefactors of this trend: they are also facilitator
of this trend. By offering the same basic product
world wide they help to create a global market.
 Continue…………………..
• A co does not have to be the size of these multination giant to
facilitate and benefit from the globalization of market. For example
firms with less than 5oo employee accounted for 97% of all US
exporters and almost 30% of all the export value. In Germany co
with less than 500 employees account for about 30% of the Nation
import.

• It is important to note that to push too far the view that national
markets are giving way to the global market. Very significant
differences still exist among national markets including consumer
taste and preferences, distribution channel, value system, business
system and legal regulation.

• These differences frequently require that marketing strategies,

product features and operating practices be customized to best
match conditions in the country.

• Many companies need to vary aspects of their product mix and

operations from country to country depending on local taste and
preferences
 Continue……………
• Global market for industrial goods and material that serve a
universal need the world over for example aluminum, oil and wheat.

• In many global markets the same firms frequently confront each

other as competitors in nation after nation for example Pepsi and
coca cola is a global one.

• If one firm moves into a nation that is not currently served by rivals,
those rivals are sure to follow to prevent their competitors from
gaining an advantage.

• As firms follow each other they bring with them many of the assets
that served them well in other national market including their
products, market strategies and brand image- creating homogeneity
across market.

• In an increasing no of industries it is no longer meaningful to talk

about the local market for many firms there is only the global
market.
 Globalization of Production
• Globalization of production refers to the sourcing of
goods and services from locations around the globe to
take the advantage of national difference in the cost and
quality of factor of production. By doing this companies
hope to lower their overall cost structure or improve the
quality or functionality of their product offering, thereby
allowing them to compete more effectively.
• For example- IBM ThinkPad X31 laptop computer. The
product was designed in the united states by IBM
engineers because IBM believed that was the best
location in the world to do the design work. The case
keyboard and hard drive were made in Thailand, display
screen and memory were in south Korea, the built in
wireless card in Malaysia, and the microprocessor was
manufactured in US. In each these components were
manufactured in the optimal location given an
assessment of production cost and transportation cost.
 Emergence of Global Institutions
• As markets globalize and as increasing proportion of
business activity transcends national border, institutions
are needed to help manage regulate and police the
global market place and to promote the establishment of
multinational treaties to govern the global business
system.

• The world trade organization is primarily responsible for

policing the world trading system and making sure
nation-states adhere to the rules laid down in trade
treaties signed by WTO members.

• WTO has promoted the lowering the barriers to cross

border trade and investment. Without an institution such
as WTO the globalization of market and production is
unlikely to have proceeded as far as it has
 IMF and World Bank
• The task of IMF is to maintain order in the international
monetary system and that of the world bank is to
promote economic development. It has focused n
making low interest loan to cash strapped governments
in poor nations that wish to undertake significant
infrastructure investment.

• IMF is often seen as the lender of last resort to nation-

states whose economies are in turmoil and currencies
are losing value against those of other nations.

• The IMF loan come with strings attached; in return for

loans, the IMF requires nation-states to adopt specific
economic policies aimed at returning their troubled
economies to stability and growth.
 Drivers of Globalization
Two macro factors seem to underlie the trend toward
greater globalization:
• Decline in barriers to the free flow of goods and services
and capital.
• Technological change

• Declining Trade and Investment Barriers

• After the formation of WTO, many talks were scheduled
to cutting tariffs on industrial goods, services and
agricultural products, phasing out subsidies to
agricultural producers; reducing barriers to cross border
investment and limiting the use of antidumping laws.
• Many countries have also been progressively removing
restrictions to FDI . According the UN some 94% of the
1885 changes made worldwide between 1991 and 2003
in the laws governing FDI created a more favorable
environment
• The lowering of trade and investment barriers also allows firms to
base production at the optimal location for that activity. Thus a firm
might design a product in one country, produce components parts in
to other countries , assemble the product in yet another country and
then export the finished product around the world.

• According to WTO data the volume of world merchandise trade has

grown faster than the world economy since 1950. From 1970 – 2004
the volume of world merchandise trade expanded almost 26 fold,
outstripping the world production which grew about 7.5 times in real
terms.

• Value of international trade in services grew robustly. Trade in

services now account for almost 20% of the value of all the
international trade . This increase is due to advances in
communication which allow co to outsource service activities to
different locations around the world
• FDI is also playing an increasing role in the global economy as firms
increases their cross border investments. The average yearly
outflow of FDI increased from $25 billion in 1975 to a record in
$1.3trillion . Despite the slowdown in 2001-04 the flow of FDI not
only accelerated over the past quarter but also accelerated faster
than the growth in world trade.

• Between 1992-04 the total flow of FDI from all countries increased
by about 360% while world trade doubled and world output grew by
35%.

• As a result of the strong FDI flow by 2003 the global stock of FDI
exceeded $8.1 trillion. In total at least 61000 parent cos. had 90000
affiliates in foreign market that collectively employed some 54 million
people abroad and generated value accounting for about one tenth
of global GDP.

• Foreign affiliates of MNC had an estimated $17.6 trillion in global

sales nearly twice as high as the value of global export of goods and
services combined which stood at 49.2 trillion.
• The globalization of markets and production and
the resulting world growth of world trade FDI
and imports all imply that firms are finding their
home market under attack from foreign
competitors.
• The growing integration of the world economy
into a single huge marketplace is increasing the
intensity of competition in a range of
manufacturing and service industries.
• If trade barriers decline no further at least for the
time being this will put a brake upon the
globalization of both markets and production.
 Globalization of Investment
• Globalization of investment refers to investment of capital by global
company in any part of the world. Global company conducts the financial
feasibility of the new projects in different companies of the world and invests
the capital in that country where it is relatively more profitable. Globalization
of investment is also known as foreign direct investment.

• Reasons for Globalization of investment :

• There has been a rapid increase in the volume of global trade.

• Many countries are providing more congenial environment for attracting

direct investment.

• Global co in order to have the control over manufacturing and marketing

activities invest in foreign countries.

• International co go for FDI in order to avoid the restrictions imposed by the

host country on exports.

• After liberalization, the flow of foreign fund cross the border by various
countries.
 Modes of Globalization of
Investment
• Acquisition of foreign companies

• Joint ventures

• Long term loans

• Issuing equity shares, debentures and bonds.

• Global depositary receipts etc.

 Globalization of Technology
• Technological change is amazing and phenomenal after
1950. Infact it is like a revolution in case of
telecommunication, information technology and
transportation technology.
• Methods of Globalization technology:
technology
• Companies with latest technology acquire distinctive
competencies and gain the advantage of producing high
quality products at low cost
• Co may have technological collaboration with the foreign
co through which technology spreads from one to
another country.
• The foreign co allow the companies of various other
countries to adopt their technology on royalty payment
basis.
• Companies also globalize the technology through the
modes of joint ventures and mergers.
 Advantages of Globalization
• Free flow of capital
• Free flow of technology
• Increase in industrialization
• Spread up of production facilities throughout the globe
• Balanced development of world economies.
• Increase in production and consumption
• Lower prices with high quality
• Cultural exchange and demand for a variety of products.
• Increase in employment and income
• Higher standard of living
• Balanced human development
• Increase in welfare and prosperity.
 Disadvantages of Globalization
• It kills domestic business
• Exploits human resources
• Violation of labor and environmental laws
• Leads to unemployment
• Decline in domestic demand
• Decline in income
• Widening the Gap between rich and poor
• Transfer of natural resources
• Leads to commercial and political colonialism
• National sovereignty at stake
STAGES IN GLOBALISATION
• Domestic company links with dealer &
distributor.
• Company does the activities on its own.
Company begins to carryout its own
manufacturing , marketing & sales in the foreign
markets.
• Company starts full fledged operations including
business systems and R&D. At this stage the
managers are expected to perform the tasks
which they were doing in domestic markets to
replicate them in foreign markets.
 Globalization and India
• Most of the global economies have chosen to
turn their economic systems towards the market
economy and global economy.
• India had observed these changes in the global
economies and respond favorably to these
changes in 1991.
• New Economic Policy of 1991:
1991
The new economic policy resulted in radical
change in the structure and direction of Indian
economy. The direction tends towards the
market economy and globalization of the
country.
 Objective of new economic policy
The objectives of liberalization and globalization of Indian economy are:
• To obtain higher economic growth

• To reduce the annual rate of inflation

• To relieve the critical balance of payment and rebuild foreign exchange

reserves.

• Government of India took drastic policy decisions in order to achieve these

objectives.

• IMF and IBRD initiated the process of globalization in India with the
following three components:

a. Cutting down the fiscal deficits and the growth rate of money supply to
achieve economic stabilization.

b. Liberalization the domestic economy by releasing the restrictions on

production, investment, prices and by increasing the role of market
economy, guiding and deciding resource allocation.

c. Relaxing the restrictions on external sector. These measures include:

 Measures towards Globalization
• Replacement of FERA with FEMA
• Permitting Indian companies to collaborate with foreign companies in the
form of joint venture.
• Establishment of joint venture by Indian companies in various foreign
countries.
• World bank advocated import liberalization. Govt. of India reduced the
import tariffs to 15%.
• Replacing license of imports with tariffs.
• Elimination of various import duties and reduction of other import duties
drastically.
• Lifting the quantitative restrictions on 715 goods with effect from April 1st
2001. In order to enhance the efficiency, quantity, product design, delivery
and thus reduces the prices.
• Removal of export subsidies
• Replacing licensing of export with duties
• Levy low tax on export income.
• Liberalize the inflow of FDI
• Reformulating EPZ and export oriented unity policy.
• Allowing FIIs to invest in Indian capital market
• Indian mutual funds are allowed to invest in foreign
countries.
• Devaluing the rupee by lifting exchange controlling a
phased manner.
• Allowing the rupee to determine its own exchange rate in
international market without official intervention.
• Full convertibility of the rupee on current account in view
of the Asian crisis.
• Acting cautiously regarding convertibility of rupee on
capital account.
• Decanalise oil and agricultural trade
• Counter anti dumping measures
• Resolve market access issues in services.
• Seek membership in trade block.
 Approaches to international
Business
The various approaches to international business are:
• Ethnocentric Approach:
• a company operating its business activities in domestic market may
enter into the foreign market without any change in its marketing
strategies.

• The excessive production more than the demand for product may
compel the co to sell the product in the foreign market.

• The domestic co continues export to the foreign country and views

the foreign market as an extension to the domestic market just like a
new region.

• The top mgt of the company makes the decision relating to export
and the marketing personnel of the company monitor the export
operations with the help of export department. Such approach of
international business is called ethnocentric approach.
 Polycentric Approach
• Refers to the different approaches of marketing in
different countries. When a company has entered into
the foreign market and feels that its ethnocentric
approach is not effective to influence the consumers of
the other countries, then it is essential to make required
changes in the marketing mix. Instead of depending on
centralized policies, the company establishes a
subsidiary unit in the foreign country and decentralize all
the operations and delegates decision making authority
to its executives. The parent co appoints the required
staff in the foreign subsidiary. The co appoint key
personnel from the host country and other staff from the
host country. The staff members in consultation with the
MD takes necessary marketing decisions according to
the market requirement of the host country.
 Regiocentric Approach
• A co managing its business at international level
has successfully established in a foreign country
while it is using polycentric approach and feels
that regional environment of the neighbouring
countries is much similar to that of the host
country, the co may start exporting product to
the neighbour countries. This approach is known
as the regiocentric approach.
• As for example a Japan based co has
successfully established in India. This practice
will certainly be considered as the regiocentric
approach though the co market more or less the
same product, designed under the polycentric
approach, in other countries of the region, the
marketing strategies may be different for the
neighbouring countries.
 Geocentric Approach
• A co using the geocentric approach
considers the whole world as a single
country. The employees are selected in
different countries. The headquarter co-
ordinates the activities of each subsidiary
which function like an independent and
autonomous co in carrying out managerial
practices like strategy formulation, product
design HR policy formulation etc.
 FDI
• The investment made by a Co in new manufacturing and
or marketing facilities in a foreign country is referred to
as FDI. Investment made by Enron in power plant in
India is an example of FDI.
• The total investment made by company in foreign
country up to given time is called “ The stock of foreign
direct investment”
• US government statistics defines FDI as “ ownership or
control of 10% or more of an enterprise’s voting
securities or the equivalent interest in an unincorporated
US business”
• Generally it is stipulated that ownership of a minimum of
10- 25% of the voting share in a foreign co allows the
investment to be considered direct.
 Forms of FDI
• Purchase of existing assets in a foreign
country.
• New investment in property
• Participation in joint venture with a local
partner.
• Transfer of many assets like human
resource, system, technology
• Exports of goods for equity
 Factors influencing FDI
• Supply factors:
factors production cost
• Logistics
• Resource availability
• Access to technology
• Demand factor: customer access
• Marketing advantages
• Exploitation of competitive advantages
• Customer mobility
• Political factor : avoidance of trade barriers
• Economic development incentives
 Reasons for FDI
• To increase sales and profits( Toyota, Suzuki in
US
• To enter fast growing markets (IBM in Japanese
laptop market 40%)
• To reduce costs (US firms in India)
• To consolidate trade blocs (to access wider
market)
• To protect domestic market
• To protect foreign market (British petroleum in
USA)
• To acquire technological and managerial know
how. ( US co Kodak invested in Japan to acquire
technology)
 Benefits of FDI
• Benefits to Home Country: inflow of foreign
currencies in the form of dividend interest.
Nissan’s profit repatriated to Japan are from FDI
in the UK. It helped Japan for positive BOP.
• FDI increases export of machinery, equipments,
technology from the home country to the host
country. This enhances the industrial activity of
home country.
• The increased industrial activity in the home
country enhances employment opportunities.
• The firm and other home country firms can learn
skills from its exposure to the host country and
transfer those skills to the industry in the home
country.
 Costs to Home Country
• Home country’s industry and employment
position are at stake when the firms enter
foreign market due to low cost labor. The
US textiles moved to central America. This
resulted in retrenchment in the USA.
• Current account position of the home
country suffers as FDI is a substitute for
direct exports.
 Benefits to host country
• Resource transfer effects
• Employment effect
• Balance of payment effect

• Costs to Host country: intensifying competition

• Negative effect on balance of payment:
• Co may repatriate their dividend to home
country.
• Imports the goods from its subsidiary
• National sovereignty and autonomy
 India’s measures towards FDI
• Granting of automatic permission for foreign equity participation up to 51%
in high technology and high investment priority industries.

• Allowing foreign equity participation up to 51% in international trading co,

hotel industry and tourist industry.

• Constitution of a specialized empowered board in order to attract FDI by

negotiating with multinational co.

• Dispersing with the bureaucratic rules and regulation which caused delays
and created hurdles for the FDI

• Allowing the MNCs to use trade marks in India with effect from May14,1992.

• Allowing 100% foreign equity for setting up of power plants with free
repatriation of profits.

• Allowing 100% equity contribution by the NRI and the corporate bodies
owned by NRI in high priority industries
• The holding non banking financial co can hold foreign equity up
to100%
• Foreign investors are allowed to establish 100% operating
subsidiaries and should bring at least US $ 50 million for this
purpose.
• Private sector firm can have FDI up to 49% in automatic route
subject to conformity to RBI guidelines.
• 100% FDI is permitted in B2B ecommerce power sector and oil
refining.
• Manufacturing activities in all special economic zones can have
100% automatic route except few.
• 74% FDI is allowed subject to licensing and security norms in
internet service providers and 74% in other telecommunication
projects.
• Off shore venture capital fund can use automatic route subject to
SEBI regulations.
• Insurance co can have FDI upto 26% subject to IRDA Regulations.
• 1oo% FDI in airports courier services hotels and tourism drugs and
pharmaceutical
 Theories of International Trade
• Mercantilism is the oldest international trade theory that
formed the foundation of economic thought during about
1500 to 1800.

• According to this theory the holding of a country’s

treasure primarily in the form of gold constituted its
wealth. The theory specifies that countries should export
more than they import and receive the value of trade
surplus in the form of gold from those countries which
experience trade deficit.

• GOVT. imposed restriction on imports and encouraged

exports in order to prevent trade deficit and experience
trade surplus.
• Colonial powers like the British used to
trade with their colonies like India, Srilanka
etc. by importing the raw material from
and exporting the finished goods to
colonies.
• The colonies had to export less valued
goods and import more valued goods.
Thus colonies were prevented from
manufacturing.
• This practice allowed the colonial power to
enjoy trade surplus and forced the
colonies to experience deficit.
• The mercantilism theory suggests for maintaining
favorable balance of trade in the form of import of gold
for export of goods and services. But the decay of gold
standard reduced the validity of theory. Consequently
this theory was modified in neo mercantilism.

• Neo mercantilism proposes that countries attempt to

produce more than the demand in the domestic market
in order to achieve a social objective like full employment
in the domestic country or a potential objective like
assisting a friendly country.

• The theory was criticized on the ground that the wealth

of nation is based on its available goods and services
rather than gold.

• Adam smith developed the theory of absolute cost

advantage which says that different countries can get the
advantage of international trade by producing certain
goods more efficiently than others .
 Absolute Cost Advantage Theory
• Adam smith, the Scottish economist viewed free trade
enables to country to produce a variety of goods and
services. Smith proposes the theory of absolute cost
advantage theory of international trade based on the
principle of division of labor.
• According to theory the principle of absolute cost
advantage will help the countries to specialize in the
production of those goods in which they have cost
advantage over others.
• According to theory every country should specialize in
producing those products at the cost less than that of
other countries.
• Trade between two countries takes place when one
country produces one product at less cost than that of
another country and having a cost advantage and vice
versa.
Skilled advantage and specialization advantage

• Countries have absolute cost advantage due to:

• Economies of scale
• Suitability of the skill of the labor of the country
in producing certain products.
• Specialization of labor in producing certain
products leads to higher productivity and less
labor cost per unit of output.
• Natural Advantage natural advantage is due to
climatic conditions and natural resources.
• Acquired Advantage acquired advantage is
due to technology and skill development.
 Assumption of the theory
• Trade is between two countries only

• Only two commodities are traded

• Free trade exists between the countries

• The only element cost of production is

labor
 Explanation of theory
Output per Japan India
labor for 1 day
pens 20 60
Tape recorder 6 2
• In the table given below two countries India and
Japan are two countries having advantage in
producing the pens and tape recorder.
• Ability of labor to produce different goods and
services in a day is known as production
possibility.
• In Japan one day of labor can produce 20 pens
or 6 audio recorder.
• In India one day of labor can produce either 60
pens or 2 tape recorders.
• Japan has an absolute advantage in the
production of audio tape recorder and India’s
advantage is in pens.
• Assume that India and Japan are able to
trade with one another, then both will get
the advantage. Suppose Japan agrees to
exchange 4 audio tapes for 40 pens.

• Two days of Japanese labor is needed to

produce 40 pens and only 0.67 days of
labor for 4 recorder. Thus Japan can save
1.33 days of labor(2 - 0.66) if it export tape
recorders to India and imports pens from
India
• India needs 2 days of labor to produce 4 audio
tape recorders and 0.67 days of labor is enough
to produce 40 pens. India can save 1.33 days of
labor (2 – 0.67) by exporting pens to Japan and
importing recorders
• Thus two countries can save labor by trading
with each other rather than by producing both
the products. The saved labor hours can be
used for the production of more audio recorder
by Japan and pens by India.
• Japan can consume more pens by allocating its
labor to produce tape recorders and by trading
with India and vice versa in case of India.
If countries produce both the
products
30

25

20

15

10

0
tape recor pens

Japan 3 10
India 1 30
Production possibility of countries

60

50

40

30

20

10

0
tape record. pens

japan 6 20
india 2 60
 Implications of theory
• By trading two countries can have more
quantities of both the products.
• Living standard of the people of both the
countries can be increased by trading between
the countries.
• Inefficiency in producing certain countries can
be avoided.
• Global efficiency and effectiveness can be
increased by trading.
• Global labor productivity and other resources
productivity can be maximized.
 Criticism of the theory
• No absolute advantage

• Country size

• Variety of resources

• Transport cost

• Scale economies

• Absolute advantage for many products

 Comparative Cost Theory
• The comparative cost theory was first systematically
formulated by the English economist David Ricardo in
the principle of political economy and taxation in 1817. it
was later refined by J.S.Mill, Marshall, Taussig and
others.

• In a Nutshell the doctrine of comparative cost maintains

that if trade if left free, each country in the long run tends
to specialize in the production and export of those
commodities in whose production it enjoys a
comparative advantage in terms of real cost and to
obtain by import those commodities which could be
produced at home at a comparative disadvantage in
terms of real cost and that such specialization is to the
mutual advantage of the countries participating in it.
 Assumptions
• Labor is only element of cost of production.
• Goods are exchanged against one another
according to the relative amount of labor embodied
in them.
• Labor is perfectly mobile within the country not
outside.
• Labor is homogeneous
• Production is subject to the law of constant return.
• Free trade and no trade barriers.
• No transportation cost
• There is full employment
• There is perfect competition
• There are only two commodities and two countries.
 Explanation
• The law of comparative advantage indicates that
a commodity should specialize in the production
of those goods in which it is more efficient and
leave the production of the other commodity to
the other country. The two countries will then
have more of both goods by engaging in trade.

• Ricardo in his two country two commodity model

has taken the hypothetical example of
production costs of cloth and wine in England
and Portugal to illustrate the comparative cost
theory.
Country No of units No of unit Exchange
of labor per of labor per ratio
unit of cloth unit of wine

England 100 120 1 wine =

1.2 cloth

Portugal 90 80 1 wine = .
88 cloth
• From the above example it is evident that
Portugal has an absolute superiority of
production. However a comparison of the ratio of
the cost of wine production ( 80/120 ) with ratio
of the cost of cloth production (90/100) in both
the countries reveals that Portugal has an
advantage superiority in both the branches of
production. It will concentrate on the production
of wine in which it has comparative advantage
over England, while importing cloth from
England which has a comparative advantage in
cloth production. England will gain by
specialization in producing cloth and selling it to
Portugal in exchange for wine.
• In the event of trade taking place under
the assumption that within each country
labor is perfectly mobile between various
industries, Portugal will gain if it can get
anything more than .88 units of cloth in
exchange for one unit of wine and
England will gain if it has to part with less
than 1.2 units of cloth against one unit of
wine. Hence any exchange ratio between
0.88 units and 1.2 units of cloth against
one unit of wine represents a gain for both
the countries. The actual rate of exchange
will be determined by reciprocal demand
• Thus according to the comparative cost theory
free and unrestricted trade among countries
encourage specialization on a large scale. It
thereby tends to bring about:
• The most efficient allocation of world resources
as well as maximization of world production.
• A redistribution of relative product demands
resulting in greater equality of product prices
among trading nations and
• A redistribution of relative resource demands to
correspond with relative product demands,
resulting in relatively greater equality of resource
prices among trading nations.
 Implications of the theory
• Efficient allocation of global resources
• Maximization of global production at the least
possible cost
• Product prices become more or less equal
among world market
• Demand for resources and products among
world nations will be maximized
• It is better for the countries to specialize in those
products which they relatively do best and export
them
• It is better for the countries to buy other goods
from other countries who are relatively better at
producing them
• Comparative cost theory is really an
improvement over absolute cost
advantage. This theory is not only an
extension to the principle of division of
labor and specialization but applies the
opportunity cost concept. It is also argued
that lower labor cost need not be a source
of comparative advantage.
• However Ricardo fails to consider the
money value of cost of production.
• F.W.Taussig bridged this gap in
comparative cost advantage theory.
 Criticism of theory
• Two countries
• Transportation cost
• Two products
• Full employment
• Economic efficiency
• Division of gains
• Mobility servies
 Product life cycle theory
• Raymond Vermon of the Harvard Business
school developed the Product Life cycle theory.
International product life cycle theory traces the
roles of innovation market expansion
comparative advantage and strategic response
of global rivals in international manufacturing
trade and investment decision.
• International product life cycle consists of four
stages:
• New product innovation
• Growth
• Maturing stage
• decline
Basis Introduction Growth Maturity Decline

Product In innovating In innovating Multiple Mainly in LDCs

location (usually and other countries
industrial industrial
country countries

Market In country with Industrial Growth in LDCs Mainly in LDCs

Location some exports country
Some decrease Some LDCs
Shift in export in industrial exports
markets as countries
foreign
production
replaces export
in some
countries

Competitive Near monopoly Fast growing Overall Overall

factor situation demand stabilized declining
demand
 Sale based on No of No of Price is key
uniqueness competitors competitors weapon
rather than increases decreases No of producers
price continues to
Price cutting by Price is very decline
Evolving competitors important
product Product
characteristics become more
standardized

Production Short Capital input Long production Unskilled labor

technology production run increases runs using high on mechanized
capital inputs long production
runs
Evolving Methods more
methods to standardized Highly
coincide with standardized
product
evolution Less skilled
labor needed
High labor and
labor skill
relative to
capital input
 Explanation
• Introduction stage: firms innovate new
products based on needs and problems in
domestic country.

• Growth: attracting competitors

• Increased competitor
• Further innovation
• Shift manufacturing to foreign countries

• Maturity : standard product

• Large scale production and economies
• Low unit cost of production
• Shift manufacturing to developing countries
• Decline: location of manufacturing facilities in
developing countries
• Original innovating country becomes net
importer.
• Limitations of Theory :
• Production facilities do not move to foreign
countries to achieve cost reduction due to short
product life cycle consequent upon very rapid
innovation.
• Cost reduction has a little concern to the
consumer in case of luxury products.
• Export may not be in significant volume where
cost of transportation is very low.
• Non cost strategies like advertising may
nullify the opportunity to move to foreign
countries for cost minimization.
• Requirement of specialized knowledge
and expertise reduce the chances of
locating production facilities in foreign
countries.
• The rapid development may not shift the
production to various foreign countries.
 Global Strategic Rivalry Theory
• International trade takes place
between/among companies based on
relative competitive advantage but not
countries competitive advantage.
• Companies acquire and develop
competitive advantage through a number
of means:
• Owing intellectual property rights
• Investing in research and development
• Achieving large scale economies
• Exploiting the experience curve.
 Porter’s National Competitive
Advantage Theory
• Companies get competitive advantage or
superiority from:
• Demand conditions
• Factor endowment
• Related and support industries
• Firm strategy, structure and rivalry