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International Business

Business: Theory and
Week 3 (Ch 3)

Dr Linda Piusa
So far

We have taken a broad overview of

globalisation (Week 1) and looked
at some methods firms use to
internationalise, along with the risk
levels of such internationalisation
(Week 2)
This week

We will:
look at some theories of
international trade; and
consider some of the discussion
around free trade versus
protectionism in the global
economy (Chapter 3 of the key
Clarifying terms

Trade is the voluntary exchange of

goods, services, assets, or money
between individuals, firms, not-for-profit
organizations, or other forms of

International trade is trade between

residents of two (or more) countries.
Growth in world trade

Copyright 2010
Pearson Education, Inc.
publishing as Prentice Hall
Why Do Countries Trade

Absolute advantage
Comparative advantage
Hecksher Ohlin
Leontief paradox

17th-18th century
Countries should maximize exports and
try to limit imports as much as possible
Aim: trade surplus / inflow of gold and
Large colonies supplied raw materials
Finished goods exported back at much
higher prices
Neo-mercantilism / economic
Drawbacks to
Confuses treasure and wealth

Works against free trade

Encourages inefficient production

of goods in order to reduce
Absolute Advantage
This theory dates to Adam Smiths
Wealth of Nations 1776

Countries can benefit from

specialising in products where they
have an absolute advantage (can
produce at lower cost) over other
Absolute Advantage

Under this theory a country should :

Export those goods and services for

which it is more productive than other
Import those goods and services for
which other countries are more
productive than it is
Absolute Advantage
Assume there are only two countries in the world, France and Japan;
only two goods, wine and clock radios; and only one factor of
production, labor.
In France, 1 hour of labor can produce either 2 bottles of wine or 3
clock radios. In Japan, 1 hour of labor can produce either 1 bottle of
wine or 5 clock radios.
France has an absolute advantage in the production of wine: 1 hour
of labor produces 2 bottles in France but only 1 in Japan.
Japan has an absolute advantage in the production of clock radios: 1
hour of labor produces 5 clock radios in Japan but only 3 in France.
If France and Japan are able to trade with one another, both will be
able to consume more and thus be better off.
Absolute Advantage
The major flaw in the theory :

If one country has an absolute

advantage in both products, no
trade would occur
Comparative advantage

David Ricardo (1817) - extended

absolute advantage theory
Total output could still be increased if
countries specialized in the
production of a good in which they
had a comparative advantage.
A country has a comparative
advantage over another country if it
can produce at a lower opportunity
cost (has to forgo fewer resources
than the other in order to produce it).
Theory of Comparative
A country is better off specializing
in what it does relatively best
A country should produce and
export those goods and services it
is relatively best able to produce
A country should buy other goods
and services from countries who
are relatively better at producing
Identifying Comparative
Modern approaches use the idea of
opportunity cost to identify comparative

Opportunity cost for a product X is the

amount of the other product foregone
(lost) as a result of producing one more
unit of X.
Which products give
comparative advantage?

The Heckscher-Ohlin theory of

relative factor endowments.
Factor endowments vary among
Goods differ according to the
types of factors that are used to
produce them
Factor proportions
(endowment) theory

Countries will produce and export

products that utilize resources
which they have in abundance, and
import products which utilize
resources that are relatively scarce.
BUT the Leontief
Covered in Lecture 2

Leontiefs calculations showed that

US imports were almost 30% MORE
capital-intensive than US exports.
These results were NOT CONSISTENT
with the Heckscher-Ohlin theory.
The Leontief Paradox

A weakness of Heckscher-Ohlin
theory is that it treats all factors as
homogenous, when in fact they are
Modern Trade Theories
Because :
1. Failure of Leontief and others to
empirically validate country-based
2. Inability of the country-based
theories to explain and predict the
existence and growth of intra-
industry trade
3. Growing importance of MNCs
Firm-based Trade Theories

Include factors such as quality, technology,

brand names, and customer loyalty into
explanations of trade flows.
Because firms, not countries, are the agents
for international trade, the newer theories
explore the firms role in promoting exports
and imports.
Firm-based Trade Theories

Country Similarity Theory

International Product Life-Cycle


Global Strategic Rivalry Theory

Porters Theory of National
Competitive Advantage
Country Similarity Theory

Explains the phenomenon of intra-

industry trade : trade between two
countries of goods produced by
the same industry
Japan exports Toyotas to
Germany exports BMWs to Japan
Country Similarity Theory

Swedish economist Steffan Linder (1961) hypothesized that international

trade in manufactured goods results from similarities of preferences
among consumers in countries that are at the same stage of economic
Firms initially manufacture goods to serve the domestic market. They
discover that the most promising foreign markets are in countries where
consumer preferences resemble those of their own domestic market. As
each company targets the others home market, intra-industry trade arises.
Linders country similarity theory suggests that most trade in
manufactured goods should be between countries with similar per capita
incomes and that intra-industry trade in manufactured goods should be
International Product
Lifecycle Theory

Developed in the 1960s by Raymond Vernon

of the Harvard Business School, this theory
traces the roles of innovation, market
expansion, comparative advantage, and
strategic responses of global rivals in
international decisions about production,
trade, and investment.
International Product
Lifecycle Theory
New Product Stage
Innovation into domestic market with limited, if any, export

Maturing Product Stage

Large demand at home and abroad
leads to domestic and foreign competitors

Standardized Product Stage

Stable market, competing on costs, outsourcing,
import back into home country
Global Strategic Rivalry
MNCs struggle to develop some sustainable
competitive advantage.
The advantage allows them to dominate the
global marketplace.

The focus is on strategic decisions that firms

adopt as they compete internationally.
These decisions affect both international trade
and international investment
Global Strategic Rivalry
Methods of Sustaining
Owning intellectual property rights
(premium pricing)

Investing in research and development

Achieving economies of scale or scope

(average unit costs fall)

Exploiting the experience curve

(production costs decline with
The Competitive Advantage
of Nations
Porter studied 10 of the most
successful exporting nations and found
that constant innovation and upgrading
were key to competitive advantage.
Advantage comes from four related
Factor conditions
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry
Porter s Diamond (1990)
Porters Diamond of National
Competitive Advantage
Factor Conditions = endowment of factors of production
Demand Conditions : a large, sophisticated domestic consumer
base stimulates Innovation and development
Related and Supporting Industries : an industry located close to
its suppliers will have better communication exchange of
cost-saving ideas and inventions. Competition among these input
suppliers lower prices, higher-quality products, and
technological innovations

Firm Strategy, Structure, and Rivalry. The domestic environment

shapes firms ability to compete in international markets. Many of
the investments they have made to succeed in the domestic
market are transferable to international markets at low cost.
Trade and the world
Inter-industry trade a country
exports products that are
fundamentally different in type
from those that it imports.
Intra-industry trade a country
exports certain items from a given
product range while at the same
time importing other items from
the same product range.
Trade Intervention
(protectionist policies)
Import restrictions
non-tariff barriers
voluntary export restraints (in effect they are quotas)
rules or origin
product requirements
Public-sector contracts
Labour standards
Export promotion
Exchange rate manipulation
Why Intervene?

National defence
Infant industries
Declining industry protection
To spread risk
Political reasons
Strategic trade policy- first in the market
Protection from dumping
To protect against undesirable products
To resist cultural imperialism
Case against
Misallocation of resources
Regional trading
The European Union(EU) from
common market to economic
NAFTA free trade area
MERCOSUR partial customs
ASEAN Free Trade Area (AFTA)
RTAs (Regional Trading
Free Trade Areas
Where member countries reduce or
abolish restrictions on trade with each
other while maintaining their individual
protectionist measures against non-
Customs Unions
Where, as well as freeing trade
among members, a common external
tariff is established to protect the
group from imports from any non-
RTAs (Regional Trading
Common Market
Where the customs union is extended to
include the free movement of factors of
production as well as products within
the designated area.
Economic Union
Where national economic policies are
also harmonised among member
states within the common market.
Control of Trade

GATT (1947)/WTO (1995)

non-discrimination a country
should not discriminate between
trading parties; Most-Favoured-
Nation rule & National Treatment
transparency trade regulations
have to be published
Control of Trade

GATT (1947)/WTO (1995)

predictability and stability-
members can not rise tariffs without
freeing of trade general reduction
of all barriers
special assistance and trade
concessions for developing
Control of Trade
Exchange Rates

Exchange Rates:

the price of one currency

expressed in another

Effects on business:
international competitiveness
value of foreign sales, profits and
Exchange Rate Regimes

Choice of regimes:

fixed exchange rate countries peg

the value of their currency against
floating exchange rate set by supply
and demand
managed exchange rate the
authorities set an upper and lower limit
What we did today

Outlined the arguments used to

support free trade
Identified the sources of
comparative and competitive
advantage between nations
Assessed the arguments used to
support protectionism
Reviewed the role of organisations
such as WTO, World Bank and IMF
If you need to get in


Thank you and see you next week!