IBT – International Business and Trade
Chapter 3 – Modern Firm-Based Theories of
International Trade
3.1
 Competitive advantage refers to the ability of
the country or company to offer greater
value to customers, either by means of lower
prices, or offering more benefits and services at
the same price.
Cost advantage + Quality advantage =
Competitive advantage
Michael Porter of Harvard Business School
introduced a new model in his book, The
Competitive Advantage of Nations, known as
Porter’s diamond. Porter’s theory stated that a
nation’s competitiveness in an industry depends
on the capacity of the industry to innovate and
upgrade.
Michael Porter identified four stages of
development in the evolution of a country:
a. Development based on factors (production)
b. Development based on investments (capital)
c. Development based on innovation (creativity)
d. Development based on prosperity (economic
growth and development)
 To explain his theory, Porter identified four
determinants that he linked together to form
Porter’s diamond:
a. Local market resource and capabilities;
b. Local market demand conditions;
c. Local suppliers and complementary
industries; and
d. Local firm characteristics.
 Porter added to these basic production factors
(land, labor, and capital) a new list of advanced
factors:
a. Human resources, including skilled labor
b. Material resources, including natural
resources, vegetation, space and the like
c. Investments in education, including
knowledge and research on universities
d. Technology
e. Infrastructure
 Porter’s competitive advantage chain value
shows how a company attains competitive
advantage through its main activities that
provide cost advantage and the support
activities that will provide the firm quality
advantage.
3.2
 Traditional trade theories speak of differences
in resources and demands or supply conditions
as a necessary condition for trade between
countries. In contrast, the country similarity
theory is built upon similarities or identical
features of nations for them to trade with each
other.
 The country similarity theory was developed
by Swedish economist Steffan Linder in 1961, as
he tried to explain the concept of intra-industry
trade. Simply, this theory describes the idea
that countries with comparable qualities are
mainly likely to trade with each other. These
qualities might include the stage of
development, per capita income, savings rates,
natural resources, cultural milieu, geographical
features, political and economic interests, and
the like.
 Two types of trades are the inter-industry
trade, trade between and among different
industries, and the intra-industry trade, trade
between and among the same industry.
 To determine the similarity of countries, the
Geert-Hofstede model is a tool that was
developed to compare countries.
This model uses six dimensions to compare
countries:
a. Power distance – the extent to which
individuals or groups within a society or
organization accept and expect differences in
power and authority.
b. Degree of interdependence (Individualism vs
Collectivism) – Individualism is a cultural
orientation that places a strong emphasis on the
rights, independence, and individual goals
of each person while collectivism is a cultural
orientation that places a strong emphasis on
the collective well-being and the needs of the
group over individual desires and interests.
c. Cultural and societal roles
(Masculinity/Femininity) – Masculinity refers to
qualities and behaviors that are associated with
males including traits like assertiveness,
independence, rationality and competitiveness
while femininity refers to qualities and
behaviors that are associated with females
including traits like nurturing, empathy,
sensitivity and cooperation.
d. Uncertainty avoidance – the extent to which
individuals within a society or organization feel
uncomfortable with ambiguity, unpredictability,
and uncertainty.
e. Long-term orientation – often used to
describe a society's or organization's time
orientation, reflecting how individuals and
groups perceive and prioritize time, values, and
goals over the long term.
f. Indulgence – reflects the extent to which
members of a society or culture control their
desires and impulses.
3.3
Life cycle is the series of stages through which
a living thing passes from the beginning of its
life until its death.
 The term product life cycle refers to the
length of time a product is introduced in the
market until it is removed from the shelves.
 The product life cycle theory is a marketing
strategy developed by Raymond Vernon in 1966
to help companies plan out the progress of their
new products and explain the pattern of
international trade and foreign direct
investment, which allows the product life cycle.
 Vernon explained that from the invention of a
product to its demise due to lack of demand, a
product goes through four stages: introduction,
growth, maturity and decline. The length of
each stage can vary from product to product.
Many factors go into determining how quickly
a product goes through the four stages,
including how the product is marketed, the
demand for the product, and the product itself.
 Product life cycle management (PLM) is the
process of managing a product’s life cycle from
inception, through design and manufacturing, to
sales, service, and eventually, retirement.
 Prior to a product being introduced to the
market, companies conduct research on which
product is in demand, how to produce the
product, and conduct market tests to see if the
product will sell. If the results of these
researches and tests are positive, that is the
time the company will begin production and the
product will be introduced to the market.
 At the introduction stage, the need is to
create awareness, not profits, and the
underlying goal is to gain widespread product
and brand recognition as consumers try the
product. Big money is spent on distribution and
promotion. At this stage, companies can expect
the sales to be low, but will gradually increase,
and profitability to be negative. Businesses can
also expect to have no direct competition
during this phase since competitors also do not
have knowledge about the product.
There are two price-setting strategies at this
stage:
a. Price skimming – charging an initially high
price and gradually reducing “skimming” the
price as the market grows.
b. Price penetration – charging a low price to
penetrate the market and capture market
share, before increasing prices in relation to
market growth.
 At the growth stage, demand for the product
begins to increase and sales usually grows
exponentially from the takeoff point. At this
stage, profitability reaches the highest level.
Economies of scale are now in order as sales
revenue increases faster than costs and
production reaches capacity.
 At the maturity stage, sales increase continues
in a decreasing pattern, but the sales curve
tends to decrease after the top selling point is
reached. There is intense competition and
product differentiation and generating brand
awareness becomes a must. Retaining customer
brand loyalty is the key. The biggest challenge is
maintaining profitability and preventing sales
from further decline.
 A product enters a decline stage when no
amount of marketing or promotion can keep
the sales figures from declining. Other
innovative or substitute products that satisfy
customer needs better have entered the
market. Sales likely to continue until the cost to
produce the product rises higher than the
profits generated from it.
 Some of the strategies that can be employed
in the decline stage are:
a. Milking or harvesting, which means reducing
marketing efforts and attempt to maximized the
life of the product for as long as possible;
b. Slowly reducing distribution channels and
pulling the product from underperforming
geographic areas allowing the company to pull
the product out and attempt to introduce a
replacement product; and
c. Selling a product to a niche operator or
subcontractor to allow the company to dispose
of a low-profit product, while retaining loyal
customers.
3.4
 Competitive advantage is a way that a firm
can obtain a sustainable edge over competitors
and break down the barriers to entry in a
particular industry.
 Global strategic rivalry theory is a theory
forwarded in 1980 by economists Paul Krugman
and Kevin Lancaster that focused on
multinational corporations (MNCs) and how
they get a competitive advantage by taking
advantage of the barriers to entry for a
particular industry.
 Barriers to entry refer to the obstacles a new
firm may face when trying to enter into an
industry or a new market.
 The barriers to entry are the following:
a. Research and development;
b. Ownership of intellectual property rights;
c. Economies of scale;
d. Unique business processes or methods;
e. Extensive experience in the industry or
exploiting the experience curve; and
f. Control of resources or favorable access to
raw materials.
 Research and development (R&D) are
activities engaged in by companies for the
invention of new products or services to remain
competitive. R&D is an important driver of
economic growth.
Companies have their own R&D departments to
be able to actually gain competitive advantage.
 An intellectual property refers to creations of
the mind, a work or invention that is the result
of creativity, such as a manuscript (a book) or a
design, to which one has rights and for which
one may apply for a patent, copyright,
trademark, brand name, and the like.
 A patent is an exclusive right granted for a
new, inventive, and useful product, process, or
technical improvement to an existing invention.
A patent may be used for licensing.
 A trademark/brand name is a word, group of
words, sign, symbol, or a logo that distinguishes
your business’ goods or services from those of
other trades. Brand names and trademarks are
used for franchising.
 Copyright is the exclusive legal right to
reproduce, publish, sell, or distribute the matter
and form of something (such as literary,
musical, or artistic work.)
 Economies of scale means a proportionate
saving in costs (cost advantage) gained by an
increased volume of production. The cost
advantage is a result of spreading the total fixed
overhead cost among a greater number of units
produced, which, therefore, reduces the unit
fixed cost for the product. This also results in a
lower average variable cost for the product.
Overall, operational efficiencies and synergies
are attained. There are two economies of scale:
a. Internal economies of scale – refers to
economies that are unique to a firm. For
instance, a firm may hold a patent over a mass
production machine, which allows it to lower its
average cost of production more than other
firms in the industry.
b. External economies of scale – refers to
economies of scale enjoyed by an entire
industry. If studies indicate that cotton
production will 1,000 workers to be able to
enter a trade with a foreign country, all those
engaged in cotton production will try their best
to employ 1,000 workers to become
competitively advantaged.
 Experience produce competitive advantage
over those without experience in any endeavor.
Therefore, experience will also count inengaging
in international trade as those with experience
become conversant with what is going on in the
global trade arena. Employing experienced
employees is equally advantageous for firms
Chapter 4 – Other Theories of International
Trade
4.1
 Trade raises real incomes of trading countries.
Real income is simply inflation-adjusted income,
measures the amount of disposable income
available to consumers.
 The gross national income (GNI) is the sum of
the value added by all the goods and services
produced within a particular country, including
foreign investment, to which are added any
product taxes (excluding subsidies), and the
value earned by the nation through overseas
ventures.
 There are at least two reasons why trade has
an important influence upon the income
distribution:
a. Resources (factors of production: land, labor,
and capital) cannot be transferred immediately
and without costs from one industry to another.
b. Industries use different factors and a change
in the production mix a country offers will
reduce the demand for some of the production
factors and increase the demand for other
production factors.
 A factor of production is any resource that is
used by firms to produce goods and services.
 The specific factor (SF) model was originally
advanced by Jacob Viner, and it is a variant of
the Ricardian model. The Ricardian model of
trade was developed by English political
economist David
Ricardo in his magnum opus On the Principles
of Political Economy and Taxation (1817). It is
the first formal model of international trade.
 The modern version of the Ricardian model
assumes that owners (countries) of factors of
production for products that are in demand
would receive an increasing part of the world’s
global income.
 The SF model is sometimes referred to as the
Ricardo-Viner model.
 Paul Samuelson and Ronald Jones, two
American economists, elaborated the SF model
based on specific factors, which are, in fact, the
factors of production – land, labor and capital.
Jones and Samuelson decided to call these
factors territory or terrain (T) (terra means
land), labor (L), and capital (K).
 Jones and Samuelson say that products like
food (X) are made by using territory (T) and
labor (L),
while manufactured products (Y) use capital (K)
and labor (L). Labor (L) is a mobile factor, one
that can be used in both food and
manufactured products. Territory and capital
are specific factors, territory (T) is used only for
food and capital (K) is used only for
manufactured products.
 When labor moves from food to
manufactured product, food production falls
while output of the manufactured product rises.
The shape of the production function reflects
the law of diminishing marginal returns.
 The law of diminishing marginal returns is a
theory in economics that predicts that after
some optimal level of capacity is reached,
adding an additional factor of production will
actually result in smaller increases in output.
 Therefore, a country rich in capital and poor in
land tends to produce more manufactured
products than food products, whatever the
price. A country rich in land (territory), like most
agricultural countries, tends to produce more
food.
 Other factors held constant, an increase in
capital will mean an increase in marginal
productivity from the manufactured sector,
while an increase in territory will increase the
production of food. It is, therefore, important
for those countries rich in capital and those
countries rich in territory to trade with each
other.
4.2
 The standard model of trade (Paul Krugman –
Maurice Obsfeld model) implies the existence of
the relative global demand curve resulting from
the different preferences for a certain good and
relative global supply curve resulting from the
different production possibilities.
 According to Paul Krugman and Maurice
Obsfeld, the exchange rate, the rapport
between the export prices and the import
prices, is determined by the intersection
between the two curves, which is the
equilibrium. Relative prices determine the
economy’s output. Other factors being
constant, the exchange rate improvement for a
country implies a substantial rise in the welfare
of that country.
 Global demand or total demand refers to
amount of money, which subjects (consumers)
of an economy plan to spend on goods and
services at the different size of income or at
given prices in a given period. Total demand
consists of personal consumption of households
and individuals, gross private domestic
investment by businesses, gross government
spending, and net export.
 Net exports are a measure of a nation’s total
trade. The formula for net exports is a simple
one:
The value of a nation’s total export goods and
services minus the value of all the goods and
services it imports equal its net exports.
 Market equilibrium is the intersection of the
global demand curve and the global supply
curve.
Market/economy equilibrium means that the
national product and level of prices are shaped
on the level in which buyers are willing to buy
what enterprises are ready to sell.
 The aggregate demand curve shows how
many goods and services consumers can and
are willing to at different total price levels, other
conditions remaining the same. The size of
purchases madeby consumers influences prices.
The size of global demand changes the level of
price inversely.
The crucial factor is the elasticity of global
demand in relation to interest rates or level of
globalwealth.
 The supply curve represents the relationship
between price and quantity supplied, which all
other factors affecting supply held constant.
Quantity supplied (supply curve) is a function of
price. A shift in the supply curve happens when
a non-price determinant of supply changes and
the overall relationship between price and
quantity supplied is affected.
 The standard trade model is a general model
that includes the Ricardian model, the Ronald
Jones and Paul Samuelson specific factors
model, and the Heckscher-Ohlin (H-O) model as
special cases
– two goods, food (F) and cloth (C). Each
country’s production possibilities frontier (PPF)
is a smooth curve.
 The standard trade model assumes the
following:
a. Each country produces two goods, food (F)
and cloth (C).
b. Each country’s production possibilities
frontier (PPF) is a smooth curve (TT).
c. The point on its PPF, at which an economy
actually produces, depends on the price of cloth
relative to food, PC/PF.
d. Isovalue lines are lines along which the
market value of output is constant.
 A country’s production possibilities frontier
(PPF) determines its relative supply function
because
it show what the country is capable of  The first serious attempt to test the H-O
producing, which should be maximized. theory was made by Russian-born American
National relative economist
supply function determines the world relative Wassily W. Leontief in 1953 when he studied
supply function, which along with world relative the US economy closely. The H-O theory
demand determines the equilibrium under predicts that the US would export more capital-
international trade. intensive goods and import labor-intensive
 The slope of an isovalue line (relative price of goods. However, Leontief was surprised to
cloth to food) equals PC/PF. The best point to discover that the US was actually exporting
produce is where PPF is tangent to the isovalue labor-intensive goods and importing capital-
line, a line of slope equal to the relative prices. intensive goods. His analysis became known as
 The value of an economy’s consumption the Leontief paradox.
equals the value of its production. The  The Leontief paradox showed that in the
economy’s choice international division of labor, the US
of a point on the isovalue line depends on the specialized in labor-intensive rather than
tastes of its consumers, which can be capital-intensive goods.
represented  A paradox is a seemingly absurd or self-
graphically by a series of indifference curves. contradictory statement of proposition that
 The standard trade model is built on four key when investigated or explained may prove to be
relationships: well-founded or true. (para – contrary to, doxa –
a. The relationship between the PPF and the opinion).
world relative supply (RS) curve;  Wassily Leontief received a Nobel prize in
b. The relationship between relative prices (RP) 1973 for his contribution to the input-output
and relative demand (RD); analysis.
c. The word equilibrium as determined by world Three of his students, Paul Samuelson (specific
RS and RD; and factor model), Robert Solow, and Vernon Smith
d. How changes in the terms of trade affect a also received Nobel prizes.
nation’s welfare.
 The world relative supply curve (RS) is upward
sloping because an increase in the price of
cloth/price of food (PC/PF) leads both countries
to produce more cloth and less food.
 The world relative demand curve (RD) is
downward sloping because an increase in PC/PF
leads
both countries to shift their consumption mix
away from cloth and toward food.
 Terms of trade (TOT) means the price of a
country’s exports divided by a country’s
imports.
 Generally, a rise in the TOT increases a
country’s welfare, while a decline in the TOT
reduces its
welfare. Intuitively, if TOT falls, price of what a
country produces goes down relative to price of
what the country consumes. The relationship
between TOT, total price of production, and a
country’s welfare is direct.
4.3
 According to the Heckscher-Ohlin theory
(factor proportions theory), a country rich in a
particular
resource should be exporting products that will
use that resource and import products made
from
resources that the country lacks.