KEY THEORIES ON INTERNATIONAL TRADE

WHY FIRMS PURSUE INTERNATIONAL BUSINESS?

The commonly held theories as to why firms become motivated to expand their business
internationally are:
(1) the theory of comparative advantage,
(2) the imperfect markets theory, and
(3) the product cycle theory.

The three theories overlap to a degree and can complement each other in developing a
rationale for the evolution of international business.

1. The Theory of Comparative Advantage

Eighteenth-century economist David Ricardo created the theory of comparative advantage.

He argued that a country boosts its economic growth the most by focusing on the industry in
which it has the most substantial comparative advantage.

For example, England was able to manufacture cheap cloth. Portugal had the right conditions
to make cheap wine. Ricardo predicted that England would stop making wine and Portugal
stop making cloth. He was right. England made more money by trading its cloth for
Portugal's wine, and vice versa. It would have cost England a lot to make all the wine it
needed because it lacked the climate. Portugal didn't have the manufacturing ability to make
cheap cloth. So, they both benefited by trading what they produced the most efficiently.

Comparative advantage is when a country produces a good or service for a lower opportunity

cost than other countries. Opportunity cost is defined as the cost of opting one course of
action and forgoing another opportunity, to undertake that course of action. Opportunity cost
measures a trade-off. A nation with a comparative advantage makes the trade-off worth it.
The benefits of buying its good or service outweigh the disadvantages. The country may not
be the best at producing something. But the good or service has a low opportunity cost for
other countries to import.

For example, oil-producing nations have a comparative advantage in chemicals. Their

locally-produced oil provides a cheap source of material for the chemicals when compared to
countries without it. A lot of the raw ingredients are produced in the oil distillery process. As
a result, Saudi Arabia, Kuwait, and Mexico are competitive with U.S. chemical
production firms. Their chemicals are inexpensive, making their opportunity cost low.

Another example is India's call centers. U.S. companies buy this service because it is cheaper
than locating the call center in America; however, many report miscommunication due to
language barriers when speaking with Indian call centers. But they provide the service
cheaply enough to make the tradeoff worth it.
Just for clarity:

Let us assume you have $50 and you want to pass some time. You have three options to
spend your money on:
1) A book worth $50
2)A movie DVD worth $50
3)A game CD worth $50

Out of the above mentioned options, let us say that the following is your preference order:

game CD>movie DVD>book

It means you prefer the game CD the most and the book the least.

Opportunity cost is the cost of the next best option. The cost may not always be in terms of
money but in terms of the utility or benefits the person derives from the choice.

Case I-If you bought the movie DVD or the book then your opportunity cost would be the
game CD.
Case II-If you bought the game CD then the opportunity cost would be the movie DVD.

As you prefer game CD over movie DVD, therefore, opportunity cost in Case I is higher than
in Case II. The statement can be rephrased as you have lower opportunity cost in Case II than
in Case I.

Naturally, you will go for Case II than Case I. Even though all the objects have same selling
price, the choice which has lower opportunity cost is chosen.

 Since the term itself contains the word ‘cost’, it signifies that it costs something. If we
talk about Opportunity cost, means it costs you your opportunity to do something that
u missed while doing something else. If you lost something great for ex - You were
playing pingpong when Bill gates was distributing large sums of free money to others.
Hence it costed u high. Low opportunity cost brightens the fact that you missed very
less of something while doing any other activity. ex - Bill gates was distributing real
cheap kiddish toys, so you just missed something not of a enormous value, as playing
pingpong might have benefitted you.
 2. Theory of Imperfect Market

If markets were perfect, so that the factors of production (such as labor) were easily
transferable, then labor and other resources would flow wherever they were in demand. The
unrestricted mobility of factors would
create equality in costs and returns and remove the comparative cost advantage, the rationale
for international trade and investment. However, the real world suffers from imperfect
market conditions where factors of production are somewhat immobile. There are costs and
often restrictions related to the transfer of labor and other resources used for production.
There may also be restrictions on transferring funds and other resources among countries.
Because markets for the various resources used in production are “imperfect,” MNCs such as
the Gap and Nike often capitalize on a foreign country’s resources. Imperfect markets
provide an incentive for firms to seek out foreign opportunities.

3. Product Life Cycle Theory

The International Product Life Cycle Theory was authored by Raymond Vernon in the
1960s to explain the cycle that products go through when exposed to an international
market. The cycle describes how a product matures and declines as a result of
internationalization. There are three stages contained within the theory:

 The New product stage,

 The maturing product stage, and
 Standardized product stage
A. The New Product Stage

The cycle always begins with the introduction of a new product. In this stage a
corporation in a developed country will innovate a new product. The market for this
product will be small and sales will be relatively low as a result. Vernon deduced
that innovative products are more likely to be created in a developed nation because
the buoyant economy means that people have more disposable income to use on
new products. To offset the impact of low sales, corporations will keep the
manufacture of the product local, so that as process issues arise or a need to modify
the product in its infancy stage presents itself, changes can be implemented without
too much risk and without wasting time. As sales increase, corporations may start to
export the product out to other developed nations to increase sales and revenue. It’s
a straightforward step towards the internationalization of a product because the
appetites of people within developed nations tends to be quite similar.

B. Maturity Stage

At this point, when the product has firmly established demand in developed
countries, the manufacturer of the product will need to consider opening up
production plants locally in each developed country to meet the demand. As the
product is being produced locally, labor costs and export and costs will decrease
thereby reducing the unit cost and increasing revenue. Product development can still
occur at this point as there is still room to adapt and modify the product if needed.
Appetites for the product in developed nations will continue to increase in this stage.

Although the unit costs have decreased due to the decision to produce the product
locally, the manufacture of the product will still require a highly skilled labor force.
Local competition to offer alternatives start to form. The increased product exposure
begins to reach the countries that have a less developed economy, and demand from
these nations start to grow.

C. The Standardized Product Stage

Exports to nations with a less developed economy begin in earnest. Competitive

product offers saturate the market which means that the original purveyor of the
product loses their competitive edge on the basis of innovation. In response to this,
rather than continuing to add new features to the product, the corporation focuses on
driving down the cost of the process to manufacture the product. They do this by
moving production to nations where the average income is much lower and
standardizing and streamlining the manufacturing methods needed to make the
product.

The local workforce in lower income nations are then exposed to the technology and
methods to make the product and competitors begin to rise as they did in developed
nations previously. Meanwhile, demand in the original nation where the product
came from begins to decline and eventually dwindles as a new product grabs the
attention of the people. The market for the product is now completely saturated and
the multinational corporation leaves the manufacture of the product in low income
countries and instead, focuses its attention on new product development as it bows
gracefully out of the market.
 What is left of the market share is divvied up between predominantly foreign
competitors and people in the original country who want the product at this point,
will most likely buy an imported version of the product from a nation where the
incomes are lower. Then the cycle begins again.

EXAMPLE

many television sets were produced in the United States during the 1950s. As time passed,
however, and technological change in the television industry became less rapid, there was
less advantage in producing sets in the United States. Producers of television sets had an
incentive to look to other locations, with lower wage rates. In time, the manufacturers
established overseas operations in Taiwan, Hong Kong, and elsewhere. Concurrently, the
United States turned to new activities, such as the manufacture of supercomputers, the
development of computer software, and new applications of satellite technology.