International Trade &

Investment Theories
DR. PRITI RACHAYEETA
WHAT IS INTERNATIONAL BUSINESS?

 International business is the production and sale of goods and services between countries.
There are several ways a business can be international:
 It produces goods domestically and sells both domestically and internationally.
 It produces goods in a different country but sells domestically
 It produces goods in a different country and sells both domestically and internationally.
 Businesses typically produce goods overseas due to lower labor costs or taxes, and they
sell products and services in the global market because of the high potential for gaining a
larger audience, new customers, and increased revenue.
 “Although international business is extremely exciting, it can also be risky,” Reinhardt
says in Global Business.
 Because every country has its own government, policies, laws, cultures, languages,
currency, time zones, and inflation rate, navigating the global business landscape can be
difficult.
 Here are five challenges to consider…..
1. Language Barriers

 When engaging in international business, it’s important to consider the languages spoken
in the countries to which you’re looking to expand.
 Does your product messaging translate well into another language?
 Consider hiring an interpreter and consulting a native speaker and resident of each
country.
2. Cultural Differences

 Just as each country has its own makeup of languages, each also has its own specific
culture or blend of cultures.
 Culture consists of the holidays, arts, traditions, foods, and social norms followed by a
specific group of people.
 It’s important and enriching to learn about the cultures of countries where you’ll be doing
business.
 When managing teams in offices abroad, selling products to an international retailer or
potential client, or running an overseas production facility, demonstrating that you’ve
taken the time to understand their cultures can project the respect and
emotional intelligence necessary to conduct business successfully.
3. Managing Global Teams

 Another challenge of international business is managing employees who live all over the
world.
 When trying to function as a team, it can be difficult to account for language barriers,
cultural differences, time zones, and varying levels of technology access and reliance.
 To build and maintain a strong working relationship with your global team, facilitate
regular check-ins, preferably using a video conferencing platform so you can interact in
real time.
4. Currency Exchange and Inflation Rates

 The value of a dollar in your country won’t always equal the same amount in other countries’
currency, nor will the value of currency consistently be worth the same amount of goods and
services.
 Familiarize yourself with currency exchange rates between your country and those where
you plan to do business. The exchange rate is the relative value between two nation’s
currencies. Make it a point to watch exchange rates closely, as they can fluctuate.
 It’s also important to monitor inflation rates, which are the rates that general price levels in
an economy increase year over year, expressed as a percentage. Inflation rates vary across
countries and can impact materials and labor costs, as well as product pricing.
 Understanding and closely following these two rates can provide important information
about the value of your company’s product in various locations over time.
5. Nuances of Foreign Politics, Policy, and Relations

 Business doesn’t exist in a vacuum—it’s influenced by politics, policies, laws, and

relationships between countries. Because those relationships can be extremely nuanced,
it’s important that you closely follow news related to countries where you do business.
 The decisions made by political leaders can impact taxes, labor laws, raw material costs,
transportation infrastructure, educational systems, and more.
Global trade

 International trade is the purchase and sale of goods and services by companies in
different countries.
 Consumer goods, raw materials, food, and machinery all are bought and sold in the
international marketplace.
 International trade allows countries to expand their markets and access goods and
services that otherwise may not have been available domestically.
 As a result of international trade, the market is more competitive. This ultimately results
in more competitive pricing and brings a cheaper product home to the consumer.
What Is International Trade?

 International trade theories are simply different theories to explain international trade.
 Trade is the concept of exchanging goods and services between two people or entities.
 International trade is then the concept of this exchange between people or entities in two
different countries.
International Trade Theories
Mercantilism Theory

 Mercantilism can be considered the oldest theory of international trade.

 Mercantilism promoted international business or trades.
 It was systematically developed in the 15th century by an Italian Economist, Antonio
Serra, and lasted nearly 300 years.
 Mercantilism talks about a nation should increase its exports and reduce imports as far as
possible.
 During the mercantilism period, gold, silver, and other precious metal were the only
means of exchange of trade between nations. A nation was considered strong which has
enough of these precious metals
Mercantilism Theory

 It assumed increasing exports would earn more silver and gold and a nation’s economy
will be stronger and importing means an outflow of precious metals means weakening
the nation.
 Thus, the main theme of the mercantilist theorists is to promote exports and reduce
imports by means of different restrictions such as barriers, quotas, etc. and it is a
state-controlled theory.
 It aims to protect a nation’s wealth from the outflow to other nations by different
restricting means which is also called protectionism.
 It also assumes a zero-sum game which means if two nations participate in international
trade one should face loss equal to benefit of the next nation and vice versa.
Absolute Cost Advantage Theory

 Adam Smith, the father of economics propounded the absolute cost advantage theory by
addressing the weakness of mercantilism theory.
 He introduced the concept of free trade policy which was totally ignored by
mercantilism.
 Absolute cost advantage refers to the advantage a nation gets from producing
products more efficiently with the same input than other nations.
 It suggests a nation should specialize its production in the product in which it gets
absolute cost advantage and ignore in which it gets absolute disadvantage.
Absolute Cost Advantage

 The specialized products should be exported to another nation and products having the
absolute disadvantage of the home country should be imported from another nation, as
such the international trade occurred.
 Smith ignores the zero-sum game of mercantilism-rather he assumes a positive-sum
game which means if two countries participate in international trade, both can be
benefitted.
 Here, government plays the role of facilitator.
Comparative Cost Advantage Theory

 By criticizing Adam Smith’s absolute cost advantage theory David Ricardo introduced
the comparative cost advantage theory.
 He argued that absolute advantage is not necessary rather a nation should focus on where
it gets comparatively more advantage.
 It suggests a nation should specialize its production on the product in which it gets
comparatively more advantage or in case of disadvantage, should choose the
product having less disadvantage.
 Ricardo suggests while producing, the costs should be checked carefully and compared
and then the product asking comparatively less cost should be produced.
Heckscher-Ohlin Theory (Factor
Proportions Theory)

 Eli Heckscher and Bertil Ohlin propounded the theory of factor endowment and further
explained Ricardo’s comparative cost advantage theory.
 Factor endowment refers to the richness or easy availability of basic production factors
like land, labor and capital to a nation.
 H-O model suggests that a nation should specialize its production in products which it
has an abundance of production factors.
 They focused on how a country could gain comparative advantage by producing products
that utilized factors that were in abundance in the country.
Heckscher-Ohlin Theory (Factor
Proportions Theory)

 Their theory is based on a country’s production factors—land, labor, and capital, which
provide the funds for investment in plants and equipment.
 This theory assumes factors relative to abundance are cheaper and factors relative to
scarcity are expensive to a nation.
 According to this theory, if India, China, Nepal etc. are rich in labor factors then they
should produce labor- intensive products.
 And USA, Japan etc. are rich in the capital they should produce capital-intensive
products.
 In this way, capital rich countries should import labor intensive products, and labor-rich
countries import capital-intensive products.
Country Similarity Theory

 Swedish economist Steffan Linder developed the country similarity theory in 1961, as
he tried to explain the concept of intra-industry trade.
 Linder’s theory proposed that consumers in countries that are in the same or similar stage
of development would have similar preferences.
 In this firm-based theory, Linder suggested that companies first produce for domestic
consumption.
 When they explore exporting, the companies often find that markets that look similar to
their domestic one, in terms of customer preferences, offer the most potential for success.
Country Similarity Theory

 Linder’s country similarity theory then states that most trade in manufactured goods will
be between countries with similar per capita incomes, and intra-industry trade will be
common.
 This theory is often most useful in understanding trade in goods where brand names and
product reputations are important factors in the buyers’ decision-making and purchasing
processes.
Product Life Cycle Theory

 PLC theory is created by Reymond Vernon in 1966.

 The theory, originating in the field of marketing, stated that a product life cycle has three
distinct stages: (1) new product, (2) maturing product, and (3) standardized product.
 The theory assumed that production of the new product will occur completely in the
home country of its innovation.
 In the 1960s this was a useful theory to explain the manufacturing success of the United
States.
 US manufacturing was the globally dominant producer in many industries after World
War II.
 It has also been used to describe how the personal computer (PC) went through its
product cycle.
 The PC was a new product in the 1970s and developed into a mature product during the
1980s and 1990s.
 Today, the PC is in the standardized product stage, and the majority of manufacturing and
production process is done in low-cost countries in Asia and Mexico.
Global Strategic Rivalry Theory

 Global strategic rivalry theory emerged in the 1980s and was based on the work of
economists Paul Krugman and Kelvin Lancaster.
 Their theory focused on MNCs and their efforts to gain a competitive advantage against
other global firms in their industry.
 Firms will encounter global competition in their industries and in order to prosper, they
must develop competitive advantages.
 The critical ways that firms can obtain a sustainable competitive advantage are called the
barriers to entry for that industry.
 The barriers to entry refer to the obstacles a new firm may face when trying to enter
into an industry or new market.
Global Strategic Rivalry Theory

 The barriers to entry that corporations may seek to optimize include:

 research and development,
 the ownership of intellectual property rights,
 economies of scale,
 unique business processes or methods as well as extensive experience in the industry, and
 the control of resources or favorable access to raw materials.
Porter's National Competitive Advantage
Theory

 In the continuing evolution of international trade theories, Michael Porter of Harvard

Business School developed a new model to explain national competitive advantage in
1990.
 Porter's theory stated that a nation's competitiveness in an industry depends on the
capacity of the industry to innovate and upgrade.
 His theory focused on explaining why some nations are more competitive in certain
industries.
 To explain his theory, Porter identified four determinants that he linked together.
Porter's National Competitive Advantage
Theory

 The four determinants are

 (1) local market resources and capabilities,
 (2) local market demand conditions,
 (3) local suppliers and complementary industries, &
 (4) local firm characteristics.
The Porter’s Diamond is shortly mentioned
below

 Demand Conditions – Stronger the demand of a domestic market the more high-quality
products would be produced and exporting may be attained.
 Factor Endowments – A nation having better production factors would do better in the
international market.
 Related and Supporting Industries – E.g. schools are the supporting institutions for
universities.
 Firm Structure, Strategy, and Rivalry – The better the firm’s strategy and structure the
better the firm will win against rivalries.
New Trade Theory (NTT)

 New Trade Theory (NTT) is developed by Paul Krugman in late 1970.

 In this theory, Krugman introduces the concept of economies of scale and first-
mover advantage which are the essential factors for success in the international
market.
 Economies of scale refer to minimizing the per-unit cost and first-mover advantage
means realizing the benefits of new entry into the new market.
 He explained, there is always not necessary to have factor endowments or structures to
have international trade it may occur without it but having economies of scale.
 When a nation specializes in a particular product, gains economies of scale, become
stronger in it, and start exporting, international trade occurs.
International investments

 International investments mean investments beyond borders.

 International investments refer to investments by entities of a nation in nations other than
their own.
 Foreign investments involve export of capital.
 The opportunity for International investments is directly emanating from economic
reformist policies adopted by most of the countries of the world including centrally
planned and command economies.
 Liberalization, Privatization and Globalization (LPG) are vigorously pursued by the
countries giving an up-thrust on investment opportunities.
 Direct investment and management of the firms concerned normally go together.
FDI and FPI

 Broadly there are two types of foreign investment, namely,

foreign direct investment (FDI) and foreign portfolio investment (FPI).
 FDI refers to investment in a foreign country where the investor retains control over
the investment.
 It typically takes the form of starting a subsidiary, acquiring a stake in an existing
firm or starting a joint venture in the foreign country.
 If the investor has only a sort of property interest in investing the capital in buying
equities, bonds, or other securities abroad, it is referred to as portfolio investment.
 That is, in the case of portfolio investments, the investor uses capital in order to get
a return on it, but has not much control over the use of the capital.
FDI and FPI

 FDIs are governed by long-term considerations because these investments cannot be

easily liquidated.
 Hence, factors like long-term political stability, government policy, industrial and
economic prospects, etc., influence the FDI decision.
 However, portfolio investments, which can be liquidated fairly easily, are influenced by
short-term gains.
 Portfolio investments are generally much more sensitive than FDIs to short term
uncertainties.
Theories of international investments

 The theories of international investments seek to explain the reasons for international
investments.
 Theories of international investment can essentially be divided into two categories:
 Micro (industrial organization) theories and Macro (cost of capital) theories.
Theories of international investments

 The micro economic orientations differed between the earlier and subsequent
literature’s.
 The early literature that explains international investment in micro economic terms
focuses on market imperfections, and the desire of multinational enterprises to expand
their monopolistic power.
 Subsequent literature centered more on firm-specific advantages owing to product
superiority or cost advantages, stemming from economies of scale, multi-plants
economies and advanced technology, or superior marketing and distribution.
Theories of International Investment

Foreign direct
investment (FDI)
theories are means
to understand the
environment of
international
investment in
different countries.
Monopoly Theory of Advantage

 The monopoly theory of advantage states that the investing

firm possesses a relative monopolistic advantage abroad
against the competitive local firms.
 This theory talks about a horizontal foreign investment where a
company makes an investment in a foreign country in a similar
business prevailing in the foreign country.
Monopoly Theory of Advantage

 According to this theory, when a firm goes through this theory enjoys a monopolistic
advantage on two counts –
 economies of scale (cost reduction technique) and
 superior knowledge and advanced technology.
 It refers to all intangible skills-intellectual capital plus advanced technology which
permits the firm to create unique product differentiation.
Oligopoly Theory of Advantage

 The oligopoly theory of advantage theory of FDI explains vertical foreign

investment.
 This means a company invests in a foreign country other than the business
prevailing in that country.
 Through vertical direct foreign investment, they tend to capture and enlarge market share
in the global market.
 The oligopolistic big firms tend to dominate in the global market on account of entry
barriers such as the big firms intend to retain their monopoly power by sustaining the
entry barriers.
 They do not want new competitors to enter.
International Product Life Cycle (IPLC) Theory

 Raymond Vernon’s IPLC theory explains both international trade and foreign direct
investment. It explains that FDI is a natural stage in the life of a product.
 It further explains a firm shift from exporting to foreign direct investment.
 Initially, a firm that innovates a product and produces at home enjoys its monopolistic
advantage and starts the export market, thus, specializing and exporting.
 This theory says FDI occurs when the product life cycle moves to the third and fourth
stages i.e. maturity and decline stages.
Dunnings Eclectic Theory

 This theory is Propounded by John Dunning (1988), is a holistic, analytic approach for
FDI and organizational issues of the MNCs relating to foreign production.
 Eclectic paradigm considers the significance of three variables.
OLI Model

 Ownership Specific Advantage – Technology, knowledge, economies of scale,

monopolistic advantage, managerial effectiveness, and structure.
 Location Specific Advantage – More profit due to special factors like political, physical,
social, economic, etc. in foreign markets.
 Internalization Advantage – Higher return in licensing, franchising, or exportation
rather than functioning in full operation.

 The eclectic theory of international production is also referred to as the OLI Model as
there are three specific advantages to foreign investment: ownership, location, and
internalization.
Dunnings Eclectic Theory: OLI Model

 Ownership Specific – The first consideration, ownership advantages,

include proprietary information and various ownership rights of a company.
 These may consist of branding, copyright, trademark or patent rights, plus the use and
management of internally-available skills.
 Ownership advantages are typically considered to be intangible. They include that which
gives a competitive advantage, such as a reputation for reliability.
Location Specific Advantage –

 More profit due to special factors like political, physical, social, economic, etc. in foreign
markets.
 Location advantage is the second necessary good.
 Companies must assess whether there is a comparative advantage to performing specific
functions within a particular nation. Often fixed in nature, these considerations apply to
the availability and costs of resources, when functioning in one location compared
to another.
 Location advantage can refer to natural or created resources, but either way, they are
generally immobile, requiring a partnership with a foreign investor in that location to be
utilized to full advantage.
Internalization Advantage –

 Higher return in licensing, franchising, or exportation rather than functioning in full

operation.
 Finally, internalization advantages, signal when it is better for an organization to
produce a particular product in-house, versus contracting with a third-party.
 At times, it may be more cost-effective for an organization to operate from a different
market location while they keep doing the work in-house. If the business decides to
outsource the production, it may require negotiating partnerships with local producers.
However, taking an outsourcing route only makes financial sense if the contracting
company can meet the organization’s needs and quality standards at a lower cost. Perhaps
the foreign company can also offer a greater degree of local market knowledge, or even
more skilled employees who can make a better product.