INTERNATIONAL

TRADE & INVESTMENT

THEORY
 INTERNATIONAL TRADE &
INVESTMENT THEORY

CLASSIC MODERN INTERNATIO

COUNTRY
AL FIRM- NA L
- BASED BASED INVESTMEN
TRADE
THEORI TRADE T THEORY
ES THEORY
COUNTRY INTERNATIO FACTORS
MERCANTILI SIMILARIT NA THEORI INFLUENCI
SM Y THEORY ES NG FDI
L INVESTENT

ABSOULUT INTERNATIO OWNERSHIP

E NA L SUPPLY
ADVANTAG PRODUCT ADVANTAG
E LIFE CYCLE E THEORY

COMPARATI INTERNALIZ
VE DEMAND
ATI
ADVANTAG ON THEORY
E
RELATIVE FACTOR
ENDOWMENT(FACTOR ECLECTIC POLITICAL
PROPORTIONS) THEORY
 1.
INTRODUCTION
 1.1 TRADE
DEFINITIONS
 Trade is the voluntary exchange of goods,
services, assets, or money between person or
organization and another. Trade will only be
complete if both parties of the transaction believe
that they will gain from the voluntary exchange.
 International trade- voluntary exchange of
goods, services or assets between
residents(individuals or organizations) of two
countries.
2. CLASSICAL COUNTRY-
BASED THEORIES
 2.1
MERCANTILISM
 A country’s wealth, usually measured by its
holding of gold and silver, should be accumulated
by encouraging exports and discouraging imports.
 Practices by- Britain, France, Netherlands,
Portugal and Spain.
 Neomercantilists/protectionists –Modern
supporters of mercantilism; claim that a country
should create trade barriers to protect its
industries from foreign competition.
 2.2 ABSOLUTE
ADVANTAGE
 Introduced by Adam Smith
 “A country should specialize in production and
export of goods which it produce most
efficiently, that is with the fewest labour hours”
 Example of AA
theory:
COUNTRY RICE(1 TON) PALM OIL(1 TON)

THAILAND 1 WORKER 5 WORKERS

MALAYSIA 6 WORKERS 3 WORKERS

USES 1 WORKER TO USES 3 WORKERS TO

PRODUCE 1 TON OF RICE- PRODUCE 1 TON OF PALM
MORE EFFICIENT IN RICE OIL-MORE EFFICIENT IN
PRODUCTION PALM OIL PRODUCTION
 2.3 COMPARATIVE
ADVANTAGE
 Developed by David Ricardo
 “If one country(in a 2-country world) held
absolute advantages in production of both
products specialization and trade could still
benefit both countries”
 Example of CA
theory:
COUNTRY RICE(1 TON) PALM OIL(1 TON)

THAILAND 1 WORKER 2 WORKERS

MALAYSIA 6 WORKERS 3 WORKERS

THAILAND PRODUCES 1 TON OF RICE AND 1 TON OF PALM OIL MORE

EFFICIENTLY THAN MALAYSIA,
BUT IS MORE EFFICIENT TO LET MSIA PRODUCE PALM OIL(SINCE
MSIA PRODUCES PALM OIL BETTER THAN RICE) RATHER THAN
PRODUCING BOTH COMMODITIES
 2.4 RELATIVE FACTOR
ENDOWMENT (FACTOR
PROPORTIONS
 By Eli Heckscher and BertilTHEORY)
Ohlin
 Focusing on resources
 “Countries produce and export goods that require

resources(factors) that are abundant and import

goods that require resources in short supply”
 Basic considerations:

 Factor endowments(or type of resources vary among

countries)
 Goods differ according to the types of factors that are
used to produce them
 3.2 PRODUCT LIFE CYCLE
THEORY
 “International product life cycle consists of 3 stages; new product,
maturing product, and standardized product”
 Depends on type of countries-innovating firms country, industrialized
countries, less developed countries

STAGE 1- STAGE 2- STAGE 3-

NEW MATURING STANDARDI
PRODUCT PRODUCT ZED
PRODUCT
• High purchase • Domestic market • Competition from
power+demand- became fully other companies
>new product aware • Search for low
concept • Demand rises cost production
• Low production • Higher base
because uncertain international sales • Demand decreases
level of market size rather than
• Most output is sold domestic sales
in the domestic
market
 HOW NATIONS ENHANCE COMPETITIVE
ADVANTAGE

 The contemporary view suggests that governments

can proactively implement policies to enhance a
nation’s competitive advantage, beyond the natural
endowments the country possesses

 Governments can create national economic

advantage by: stimulating innovation, targeting
industries for development, providing low-cost
capital, minimizing taxes, investing in IT, etc.
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 MICHAEL PORTER’S DIAMOND MODEL:
SOURCES OF NATIONAL COMPETITIVE ADVANTAGE

1. Firm strategy, structure, and rivalry – the presence of

strong competitors at home serves as a national competitive
advantage
2. Factor conditions – labor, natural resources, capital,
technology, entrepreneurship, and know how
3. Demand conditions at home – the strengths and
sophistication of customer demand
4. Related and supporting industries – availability of
clusters of suppliers and complementary firms with
distinctive competences

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INDUSTRIAL CLUSTERS
 A concentration of suppliers and supporting firms
from the same industry located within the same
geographic area
 Examples include: the Silicon Valley, fashion cluster
in northern Italy, pharma cluster in Switzerland,
footwear industry in Pusan, South Korea, and the IT
industry in Bangalore, India
 Can serve as a nation’s export platform

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 NATIONAL INDUSTRIAL POLICY
Proactive economic development plan enacted by the
government to nurture or support promising industries
sectors.
Typical initiatives:
 Tax incentives
 Investment incentives
 Monetary and fiscal policies
 Rigorous educational systems
 Investment in national infrastructure
 Strong legal and regulatory systems (Examples: Japan,
Dubai, and Ireland)

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 New Trade Theory
New trade theory, developed by many theorists
from the late 1970 to early 1980s, is a collection
of economic models in international trade. It
focuses on increasing return to scale and network
effect.
Economies of scale are an important factor in some
industries for superior international performance – even
when the nation has no clear comparative advantage.
Some industries succeed best as their volume of
production increases.
 Economies of Scale and International
Trade: The New Trade Theory
Definitions:
•Economies of Scale: Reduction of average cost as a result
of increasing the output
•Increasing Returns: a unit increase in inputs results in
more than one unit increase in output
•Economies of scale is an important source of increasing
returns to specialization
•New Trade Theory supports the Comparative Advantage
theory by identifying economies of scale as an important
source of comparative advantage
 The New Trade Theory
• Domestic market may not be big enough to realize
economies of scale for certain products
Ex: the aerospace industry dominated by Boeing and Airbus
How do they achieve economies of scale?
• First-mover Advantage: New Trade Theory suggests that a
country may predominate in the export of a good simply
because it was lucky enough to have one or more firms
among the first to produce that good
• First mover’s ability to benefit from increasing returns
creates a barrier to entry
Ex: Microsoft operating systems, Apple’s iPod, Google, etc.
 INTERNATIONAL
INVESTMENT THEORIES
 4.1 INTERNATIONAL
INVESTMENTS
 Two categories:
 Portfolio investments- passive holdings of securities
such as foreign stocks, bonds, or other financial
assets, none of which entails active management or
control of the securities’ issuer by the investor.
 Foreign Direct Investment(FDI)- Acquisition of
foreign assets for the purpose of controlling them
 DOMINANCE OF FDI-BASED EXPLANATIONS OF
THE INTERNATIONAL FIRM

 Most IB theories about the firm emphasize the MNE, since

it was long the major player in international business.

Foreign direct investment (FDI) is the main strategy used

by MNEs in international expansion; thus, earlier theories
emphasized motives for, and patterns of, FDI

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 4.2
THEORIES
 OWNERSHIP ADVANTAGE THEORY
 “A firm owning a valuable asset that creates a competitive
advantage domestically can use that advantage to penetrate
foreign markets through FDI”
 Contemporary theory explains that “FDI would not occur
under perfect competition and under approximately
competitive conditions.”
 According to market imperfection theory, the FDI is made
by firms in oligopolistic industries possessing technical
and other advantages over indigenous firms.
OWNERSHIP ADVANTAGE
THEORY
 Key sources of monopolistic advantage include
proprietary knowledge, patents, unique know-how,
and sole ownership of other assets, economies of
scale, superior knowledge in marketing, management
or finance.
 Eg: Intel(Technology)
NTERNALIZATION THEORY
 Explains why a firm would choose to enter a
foreign market via FDI rather than exploit its
ownership advantages
 Explains the process by which firms acquire and
retain one or more value-chain activities inside the
firm – retaining control over foreign operations and
avoiding the disadvantages of dealing with
external partners
 The concept of internalization theory is to transfer
the superior knowledge to foreign subsidiary and
obtain higher return or fee on its investment. It
comes into contract and provide authority to use its
competitive advantages in the form of license,
franchise or other form.
 Transaction costs- costs of entering into
transaction(negotiating, monitoring and enforcing a
contract)
 Eg: Honda
 Dunning’s Eclectic
Paradigm
 Three conditions also known as OLI model determine
whether or not a company will go abroad via FDI:
 Ownership-specific advantages – knowledge, skills,
capabilities, relationships, or physical assets that form the
basis for the firm’s competitive advantage
 Location-specific advantages – advantages associated with
the country in which the MNE is invested, including
natural resources, skilled or low cost labor, and
inexpensive capital
 Internalization advantages – control derived from
internalizing foreign-based manufacturing, distribution, or
other value chain activities
  ECLECTIC THEORY
 FDI will occur when 3 conditions are satisfied:
OWNERSH LOCATIO INTERNALIZAT
IP N ION
ADVANTA ADVANT ADVANTAGE
• AGE
firm must • Business
AGE • The firm must
own some should be done benefit more
unique in a more from
competitive profitable controlling
advantage that foreign foreign
overcomes location than a business
competitions domestic one activity rather
• Eg: Brand • Eg: Labour, than hiring
name raw materials other local
companies to
provide service
 4.3 FACTORS
INFLUENCING FDI FACTORS
INFLUENCING FDI

SUPPLY FACTORS DEMAND FACTORS POLITICAL FACTORS

Firms undertake FDI to lower Firms may invest to avoid trade

production costs Customer Access barriers or take advantage of economic
development initiatives

Marketing Avoidance of trade

Logistics
Advantages barriers

Exploitation of Economic
Natural Resources competitive development
advantages initiatives

Key Technology Customer Mobility

 NON-FDI BASED
EXPLANATIONS:
International Collaborative Ventures
While FDI-based internationalization is still common,
beginning in the 1980s firms have emphasized non-
equity, flexible collaborative ventures to
internationalize.
Collaborative venture: a form of cooperation
between two or more firms. Through collaboration, a
firm can gain access to foreign partner’s know-how,
capital, distribution channels, and marketing assets,
and overcome government imposed obstacles.
Venture partners share the risk of their joint efforts,
and pool resources and capabilities to create synergy.
 Two Types of International Collaborative Ventures
1.Equity-based joint ventures result in the
formation of a new legal entity. Here, the firm
collaborates with local partner(s) to reduce risk and
commitment of capital.
2.Project-based alliances involve cooperation in
R&D, manufacturing, design, or any other value-
adding activity, a partnership aimed at a narrowly
defined scope of activities and timeline

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 Implications of international trade
and investment theories
It can be grouped into three concepts:
Location Implication: Disperse production activities to
countries where they can be performed most efficiently.
Business person go for production where the efficiency of
productive forces is higher and profit is high. This is
explained by comparative advantage and HO models.
First mover Implication: The first mover strategist would
engage in substantial financial involvement when product is
new or market is new as explained by product life cycle
and ownership advantage theories.
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 Policy Implication: In reality, the competitiveness can
be achieved by the joint efforts of private and public
participation in building competitive strength of the
business community as well as nations. This is
explained by Porter’s Diamond Theory. Both must
invest to upgrade their production and supportive
factors.

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