CHRIST THE KING COLLEGE

College of Accountancy
Calbayog City, Western Samar

Chapter 4
Theories of International Trade and Investment

LEARNING OUTCOMES
Upon finishing this session, the learner is expected to:

1. Theories of international trade and investment

2. Why nations trade
3. How nations enhance their competitive advantage: contemporary theories
4. Why and how firms internationalize
5. How firms gain and sustain international competitive advantage.

LEARNING CONTENTS

In Chapter 2, we saw how the globalization of markets compels companies to

pursue international business. In Chapter 3, we highlighted key participants engaged in
international business. The question we need to address next is: what is the underlying
economic rationale for international business activity? Why does trade take place, and
what are the gains from trade and investment? In this chapter, we explain why firms and
nations trade and invest internationally, and how firms acquire and sustain competitive
advantage in the global marketplace. We review leading theories of why nations and
individual enterprises pursue internationalization strategies as exporters, importers,
investors, franchisors, or licensors.

Theories of International Trade and Investment

For centuries economists, managers, and academic scholars have offered

theories (that is, logical explanations), of the economic rationale for international trade
and investment. They have debated why nations should promote trade and investment
with other nations, and how nations create and sustain comparative advantage.
Comparative advantage refers to superior features of a country that provide it with
unique benefits in global competition, typically derived from either natural endowments
or deliberate national policies. Also known as country-specific advantage, comparative
advantage includes acquired resources, such as labor, climate, arable land, or
petroleum reserves, as in the case of the Gulf nations. Other types of comparative
advantages evolve over time, such as entrepreneurial orientation, availability of venture
capital, and innovative capacity. Over time, to understand why companies engage in
cross-border business, the focus shifted from the nation to the individual firm. Later
explanations gave rise to the concept of competitive advantage, which emphasizes the
role of competencies that help firms enter and succeed in foreign markets. Competitive
advantage refers to distinctive assets or competencies of a firm—typically derived from
cost, size, or innovation strengths—that are difficult for competitors to replicate or
imitate. Competitive advantage is also known as firm-specific advantage.

While distinctions do exist between the two terms, in recent years business
executives and academics such as Michael Porter have used the term competitive
advantage to refer to the advantages possessed both by nations and individual firms in
international trade and investment. To be consistent with the recent literature, in this text
we adopt this convention as well. Exhibit 1 categorizes leading theories of international
trade and investment into two broad groups. The first group includes nation-level
theories. These are classical theories that have been advocated since the 18th century.
Nation-level explanations, in turn, address two questions: (1) why do nations trade? and
(2) how can nations enhance their competitive advantage?

The second group includes firm-level theories. These are more contemporary
theories of how firms can create and sustain superior market position. Firm-level
explanations address two additional questions: (3) why and how do firms
internationalize, and (4) how can internationalizing firms gain and sustain competitive
advantage?

We organize the remainder of our discussion according to the four fundamental

questions.

Exhibit 1 Theories of International Trade and Investment

Why Nations Trade

Why do nations trade with one another? The short answer is that trade allows
countries to use their national resources more efficiently through specialization. Trade
allows industries and workers to be more productive. Trade also allows countries to
achieve higher living standards and keep the cost of many everyday products low.
Without international trade, most nations would be unable to feed, clothe, and house
their citizens at current levels. Even resource-rich countries like the United States would
suffer immensely without trade. Some types of food would become unavailable, or
obtainable only at very high prices. Coffee and sugar would become luxury items.
Petroleum-based energy sources would dwindle. Vehicles would stop running, freight
would go undelivered, and people would not be able to heat their homes in the
wintertime. In short, not only do nations, companies, and citizens benefit from
international trade, but modern life is virtually impossible without it.
Classical Theories
There are five classical perspectives that explain the underlying rationale for
trade among nations: the mercantilist view, the absolute advantage principle, the
comparative advantage principle, factor proportions theory, and the international
product cycle theory.
The Mercantilist View
The earliest explanations of international business emerged with the rise of European
nation states in the 1500s. At that time, gold and silver were the most important sources
of wealth and nations sought to amass as much of these treasures as possible.
Mercantilism emerged in the 16th century as a dominant perspective of international
trade. In simple terms, mercantilism suggests that exports are good and imports are
bad. Mercantilists believed that national prosperity results from a positive balance of
trade, achieved by maximizing exports and minimizing imports. They argued that the
nation’s power and strength increase as its wealth increases. At a time when precious
metals were the main medium of exchange, gold was particularly valued because it
could be used to protect and extend the nation’s interests. The nation received payment
for exports in gold, so exports increased the nation’s gold stock. Conversely, imports
reduced the gold stock because the nation paid for the imports with gold. Thus, nations
desired and promoted exports but disapproved of, and impeded, imports.
In essence, mercantilism underlies the rationale for a nation’s attempt to run a
trade surplus, that is, to export more goods than it imports. Even today many people
believe that running a trade surplus is beneficial, and subscribe to a view known as neo-
mercantilism. Labor unions (that seek to protect home-country jobs), farmers (who want
to keep crop prices high), and certain manufacturers (those that rely heavily on exports)
all tend to support neo-mercantilism.
Yet mercantilism tends to harm the interests of firms that import, especially those
that import raw materials and parts used in the manufacture of finished products.
Mercantilism also harms the interests of consumers, because restricting imports
reduces the choices of products they can buy. Product shortages that result from import
restrictions may lead to higher prices—that is, inflation. When taken to an extreme,
mercantilism may invite “beggar thy neighbor” policies, promoting the benefits of one
country at the expense of others.
By contrast, free trade—the relative absence of restrictions to the flow of goods
and services between nations—is preferred because:
• Consumers and firms can more readily buy the products they want.
• The prices of imported products tend to be lower than for domestically produced
products (because access to worldscale supplies forces prices down, mainly from
increased competition, or because the goods are produced in lower-cost countries).
• Lower-cost imports help reduce the expenses of firms, thereby raising their
profits (which may be passed on to workers in the form of higher wages).
• Lower-cost imports help reduce the expenses of consumers, thereby increasing
their living standards.
• Unrestricted international trade generally increases the overall prosperity of
poor countries.
 Absolute Advantage Principle
In the landmark book published in 1776, An Inquiry into the Nature and Causes
of the Wealth of Nations, Scottish political economist Adam Smith attacked the
mercantilist view by suggesting that nations benefit most from free trade. Smith argued
that mercantilism robs individuals of the ability to trade freely and to benefit from
voluntary exchanges. By trying to minimize imports, a country inevitably wastes much of
its national resources in the production of goods that it is not suited to produce
efficiently. Therefore, the inefficiencies of mercantilism end up reducing the wealth of
the nation as a whole while enriching a limited number of individuals and interest
groups. Relative to others, each country is more efficient in the production of some
products and less efficient in the production of other products. Smith’s absolute
advantage principle states that a country benefits by producing only those products in
which it has an absolute advantage, or can produce using fewer resources than another
country. The country gains by specializing in producing those products, exporting them,
and then importing the products it does not have an absolute advantage in producing.
Each country increases its welfare by specializing in the production of certain products
and importing others, as this allows it to be able to consume more than it otherwise
could.

Exhibit 2 Example of Absolute Advantage (Labor Cost in Days of Production for One Ton)

Exhibit 2 illustrates how the absolute advantage principle works in practice.

Consider two nations, France and Germany, engaged in a trading relationship. France
has an absolute advantage in the production of cloth, and Germany has an absolute
advantage in the production of wheat. Assume that labor is the only factor of production
used in making both goods. Firms employ factors of production—for example, labor,
capital, entrepreneurship, and technology—to generate goods and services. In Exhibit
2, it takes an average worker in France 30 days to produce one ton of cloth and 40 days
to produce one ton of wheat. It takes an average worker in Germany 100 days to
produce one ton of cloth and 20 days to produce a one ton of wheat.
Compared to Germany, it is clear that France has an absolute advantage in the
production of cloth, since it takes only 30 days of labor to produce one ton (compared to
100 days for Germany). Compared to France, it is clear that Germany has an absolute
advantage in the production of wheat, since it takes only 20 days to produce one ton
(compared to 40 days for France). If both France and Germany were to specialize,
exchanging cloth and wheat at a ratio of one-to-one, France could employ more of its
resources to produce cloth and Germany could employ more of its resources to produce
wheat. According to Exhibit 2, France can import one ton of wheat in exchange for one
ton of cloth, thereby “paying” only 30 labor-days for one ton of wheat. If France had
produced the wheat itself, it would have used 40 labor-days, so it gains 10 labor-days
from the trade. In a similar way, Germany also gains from trade with France.
Each country benefits by specializing in producing the product in which it has an
absolute advantage and then securing the other product through trade. Thus, France
should specialize in producing cloth exclusively and import wheat from Germany, and
Germany should specialize in producing wheat exclusively and import cloth from
France. By so doing, each country employs its labor and other resources with maximum
efficiency and, as a result, living standards in each country will rise.
To employ a more contemporary example, Japan has no natural holdings of oil,
but it manufactures some of the best automobiles in the world. On the other hand, Saudi
Arabia produces much oil, but it lacks a substantial car industry. Given the state of their
resources, it would be wasteful for each of these countries to attempt to produce both oil
and cars. By trading with each other, Japan and Saudi Arabia each employ their
respective resources efficiently in a mutually beneficial relationship. Japan gets oil that it
refines to power its cars, and Saudi Arabia gets the cars its citizens need. Because
each country uses its own resources with optimum efficiency and engages in trade,
living standards for its citizens are higher than they would be if they had not engaged in
trade.
By extending this example to all products that countries produce and all countries
that they can trade with, it is possible to see that freely trading countries can achieve
substantial gains from trade and resultant improvement in national living standards.
Thus, Brazil can produce coffee more cheaply than Germany; Australia can produce
wool more cheaply than Switzerland; and the United Kingdom can provide financial
services more cheaply than Zimbabwe. Each of these countries is better off producing
those products and services in which it is advantaged, and importing those products
and services in which it is disadvantaged.
While the concept of absolute advantage provided perhaps the earliest sound
rationale for international trade, it only accounted for the absolute advantages
possessed by nations. It failed to account for more subtle advantages that nations may
hold. Later studies revealed that countries benefit from international trade even when
they lack an absolute advantage. This line of thinking led to the principle of comparative
advantage.
Comparative Advantage Principle
In his 1817 book, The Principles of Political Economy and Taxation, British
political economist David Ricardo explained why it is beneficial for two countries to
trade, even though one of them may have absolute advantage in the production of all
products. Ricardo demonstrated that what matters is not the absolute cost of
production, but rather the ratio between how easily the two countries can produce the
products. Hence, the comparative advantage principle states that it can be beneficial
for two countries to trade without barriers as long as one is more efficient at producing
goods or services needed by the other. What matters is not the absolute cost of
production but rather the relative efficiency with which a country can produce the
product. The principle of comparative advantage remains today as the foundation and
overriding justification for international trade.
To illustrate the principle of comparative advantage, let’s modify the example of
the trade relationship between France and Germany.

Exhibit 3 Example of Comparative Advantage (Labor Cost in Days of Production for One Ton)
 As shown in Exhibit 3, suppose now that Germany has an absolute advantage in
the production of both cloth and wheat. That is, in labor-per-day terms, Germany can
produce both cloth and wheat in fewer days than France. Based on this new scenario,
you might initially conclude that Germany should produce all the wheat and cloth that it
needs, and not trade with France at all. However, this conclusion is not optimal. Even
though Germany can produce both items more cheaply than France, it is still beneficial
for Germany to trade with France.
How can this be true? The answer is that rather than the absolute cost of
production, it is the ratio of production costs between the two countries that matters. In
Exhibit 3, Germany is comparatively more efficient at producing cloth than wheat: it can
produce three times as much cloth as France (30/10), but only two times as much
wheat (40/20). Thus, Germany should devote all its resources to 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, or relative, advantage and then obtaining the
other product through trade.
By specializing in what they produce best and trading for the rest, Germany and
France can each produce and consume relatively more of the goods that they desire for
a given level of labor cost. Another way to understand the concept of comparative
advantage is to consider opportunity cost, the value of a foregone alternative activity. In
Exhibit 3, if Germany produces 1 ton of wheat, it forgoes 2 tons of cloth. However, if
France produces 1 ton of wheat, it forgoes only 1.33 tons of cloth. Thus, France should
specialize in wheat. Similarly, if France produces 1 ton of cloth, it forgoes 3/4 ton of
wheat. But if Germany produces 1 ton of cloth, it forgoes only 1/2 ton of wheat. Thus,
Germany should specialize in cloth. The opportunity cost of producing wheat is lower in
France, and the opportunity cost of producing cloth is lower in Germany.
The concept of comparative advantage contends that trade depends on
differences in comparative cost, and any nation can profitably trade with another even if
its real costs are higher in every product that it produces. This insight is best illustrated
with an example provided by Ricardo:
“Two men can make both shoes and hats, and one is superior to the other in
both employments, but in making hats he can only exceed his competitor by one fifth or
20 percent, and in making shoes he can excel him by one third or 33 percent; will it not
be for the interest of both that the superior man should employ himself exclusively in
making shoes and the inferior man in making hats?”
While a nation might conceivably have a sufficient variety of production factors to
provide every kind of product and service, it cannot produce each product and service
with equal facility. The United States could produce all the coat hangers that its citizens
need, but only at a high cost, because the production of coat hangers requires much
labor, and wages in the United States are relatively high compared to other countries.
By contrast, the production of coat hangers is a reasonable activity in a country such as
China, where wages are lower than in the United States. It is advantageous, therefore,
for the United States to specialize in the production of a product such as
pharmaceuticals, the production of which more efficiently employs the country’s
abundant supply of knowledge workers and technology. The United States is then better
off exporting pharmaceuticals and importing coat hangers from China. The comparative
advantage view is optimistic because it implies that a nation need not be the first-,
second-, or even third-best producer of particular products to benefit from international
trade. Indeed, it is generally advantageous for all countries to participate in international
trade.
 Initially, the comparative advantage principle focused on the importance of
natural resources in a country, or natural advantages, such as fertile land, abundant
minerals, and favorable climate. Thus, because South Africa has extensive deposits of
minerals, it produces and exports diamonds. Because Canada has much agricultural
land and a suitable climate, it produces and exports wheat. Over time, however, it
became clear that countries can also create or acquire comparative advantages. We
elaborate on these so-called acquired advantages later in the chapter.

Limitations of Early Trade Theories

While the concepts of absolute advantage and comparative advantage provided
the rationale for international trade, they did not quite capture factors that make
contemporary trade complex, including:
• The cost of international transportation, which is critical for cross-border trade to
take place.
• Government restrictions such as tariffs (a tax on imports), import restrictions,
and regulations typical of mercantilism that can hamper cross-border trade. For
instance, tariffs in Japan restrict imports of certain agricultural products.
• Large-scale production in certain industries may bring about scale economies,
and therefore lower prices, which can help offset weak national comparative advantage.
For example, Mexico lacks advantages in the production of high-technology goods, but
it compensates for this through high-volume manufacturing of various goods.
• The public sector can target and invest in certain industries, build infrastructure,
or provide subsidies, all of which serve to boost firms’ competitive advantages. For
example, Singapore has invested heavily in developing its port infrastructure, making
the country a vital depot for product import and distribution throughout Asia.
• Global telecommunications and the Internet facilitate virtually costless trade in
some services and global flows of capital. The tendency has increased the ability of
emerging markets such as India and Russia to access capital needed to develop key
industries, even in the face of weak comparative advantages in certain areas.
• Contemporary cross-border business includes many services (such as banking
and retailing) that cannot be traded in the usual sense and must be internationalized via
foreign investment. Even nations that lack comparative advantages in service industries
still develop basic services for their own citizens.
• The primary participants in cross-border trade are individual firms. Far from
being homogeneous enterprises, they differ in significant ways. Some are highly
entrepreneurial and innovative, or have access to exceptional human talent. As a result,
some companies are more active and successful in international business than others.
In other cases, firms may have a greater need to trade internationally if their home
markets are too small to support their growth or revenue objectives.
In the following sections, we discuss subsequent theories that consider how
these factors affect trade.
Factor Proportions Theory
The next significant contribution to explaining international trade came in the
1920s, when two Swedish economists, Eli Heckscher and his student, Bertil Ohlin,
proposed the factor proportions theory (sometimes called the factor endowments
theory).2 This view rests on two premises: First, products differ in the types and
quantities of factors (that is, labor, natural resources, and capital) that are required for
their production; and second, countries differ in the type and quantity of production
factors that they possess. Thus, according to this theory, each country should export
products that intensively use relatively abundant factors of production, and import goods
that intensively use relatively scarce factors of production. For example, because China
possesses an ample labor supply, it emphasizes the production and export of labor-
intensive products, such as textiles and kitchen utensils.
Because the United States possesses much capital, it emphasizes the
production and export of capital-intensive products, such as pharmaceuticals and
commercial aircraft. Because Australia and Canada possess a great deal of land, they
produce and export land-intensive products, such as meat, wheat, and wool.
Factor proportions theory differs somewhat from earlier trade theories by
emphasizing the importance of each nation’s factors of production. The theory states
that, in addition to differences in the efficiency of production, differences in the quantity
of factors of production held by countries also determine international trade patterns.
Originally, labor was seen as the most important factor of production. This explains, for
example, why China and Mexico receive huge amounts of foreign direct investment
(FDI) from firms that build factories in those countries to take advantage of their
inexpensive, abundant labor.
In the 1950s, Russian-born economist Wassily Leontief pointed to empirical
findings that seemed to contradict the factor proportions theory. The Leontief paradox
suggests that, because the United States has abundant capital, it should be an exporter
of capital-intensive products. However, Leontief’s analysis revealed that, despite the
United States having abundant capital, its exports were labor-intensive and imports
capital-intensive.
However, experience of the last few decades suggests that the factor proportions
theory explains much of contemporary international trade. So, what accounts for the
inconsistency suggested by the Leontief paradox? One explanation is that numerous
factors determine the composition of a country’s exports and imports. Another
explanation is that labor in the United States tends to be highly skilled, giving the
country substantial advantages in the production of knowledge-intensive products and
services such as software and pharmaceuticals.
Perhaps the main contribution of the Leontief paradox is its suggestion that
international trade is complex and cannot be fully explained by a single theory. While
the factor proportions theory helps explain international trade patterns, it does not
account for all trade phenomena. Subsequent refinements of the factor proportions
theory suggested that other country-level assets— knowledge, technology, and capital
—are instrumental in explaining each nation’s international trade prowess. Taiwan, for
example, is very strong in information technology and is home to a sizeable population
of knowledge workers in the IT sector. These factors have helped make Taiwan one of
the leading players in the global computer industry.
International Product Cycle Theory
In a 1966 article entitled “International Investment and International Trade in the
Product Cycle,” Harvard Professor Raymond Vernon sought to explain international
trade based on the evolutionary process that occurs in the development and diffusion of
products around the world. Vernon observed that technical innovations typically
originate from advanced countries that possess abundant capital and R&D capabilities.
Each product and its associated manufacturing technologies go through three stages of
evolution: introduction, growth, and maturity. In the introduction stage, the new product
is produced at home and enjoys a temporary monopoly. Later on, the product’s
inventors mass-produce the good and seek to export it to foreign markets. As the
product’s manufacturing becomes more standard, foreign competitors enter the
marketplace and the monopoly power of the inventors dissipates. The inventor may at
this stage earn only a narrow profit margin. Companies from other countries begin
producing the standardized product. Foreign competitors may even enjoy a competitive
advantage in producing the mature product, and fulfill the needs of export markets as
well. By now, the original innovating and exporting country may be a net importer of the
product. In effect, exporting the product has caused its underlying technology to
become widely known and standardized around the world.
As product standardization progresses, input requirements for production evolve.
For instance, early in the product’s evolution, manufacturing requires highly-skilled
knowledge workers in R&D. When the product becomes standardized, mass production
is the dominant activity, requiring access to less expensive raw materials and low-cost
labor. Thus, as the product goes through its life cycle, comparative advantage in its
production tends to shift from country to country. This type of cycle was evident in the
evolution of television sets. The base technology for televisions was invented in the
United States, and U.S. firms began producing TVs there in the 1940s. U.S. sales grew
rapidly for many years. After becoming a standardized product, television production
shifted to China, Mexico, and other countries that offer lower cost production.
Because firms around the world are constantly innovating new products, and
others are constantly imitating them, the product cycle is constantly beginning and
ending. In the contemporary interconnected economy, the cycle from innovation to
growth to maturity is much shorter than in the 1960s to 1980s. New products with
universal appeal are likely to be diffused across different countries much faster. Thanks
to global media and the Internet, potential customers in distant parts of the world are
likely to hear about and demand the product. Buyers in emerging markets are
particularly eager to adopt new technologies as soon as they become available. This
trend explains the rather rapid spread of new consumer electronics (such as digital
assistants and iPods) around the world.