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INTERNATIONAL BUSINESS

Chapter 5 : International Trade : 5.1 Theories of International Trade 5.2 International Trading Environment 5.3 Cross-National Cooperation and Agreements

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CH. 5 : INTERNATIONAL TRADE


5.1

Theories of International Trade : Countries wrestle with the question of what, how much and with whom their country should import and export Various theories of international trade provide insights about favorable location for exports as well as potentially successful export products

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5.1 : THEORIES OF INTERNATIONAL TRADE

In absence of government trade restrictions, given products are exported from lower cost to higher cost production locations. Therefore these theories also help companies determine where to locate their production facilities Trade restrictions may diminish export capabilities and cause companies to locate some production in the restricting countries

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1 5.1.1 5.1.2 5.1.3 5.1.4 Theories of International Trade : Interventionist theories Free trade theories Trade pattern theories The statics and dynamics of trade

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.1 Interventionist theories : These theories prescribe government intervention in international trade

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.1 Interventionist theories (contd.) : 5.1.1.1 Mercantilism 5.1.1.2 Neo-mercantilism

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.1 Interventionist theories (contd.) : 5.1.1.1 Mercantilism : According to Mercantilism trade theory, a countrys wealth is measured by its holding of treasure, i.e. gold. This theory formed the foundation of economic thought from about year 1500 to 1800 According to this theory, countries should export more than they import and if successful, should receive gold from countries that run deficit
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5.1 : THEORIES OF INTERNATIONAL TRADE


Mercantilism

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.1.1 Mercantilism (contd.) : Mercantilism flourished because of : Government policies The concept of Balance of Trade

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5.1 : THEORIES OF INTERNATIONAL TRADE


Mercantilism flourished because of (contd.) : Government policies : To export more than they imported, governments imposed restrictions on most imports and subsidised production of products that could otherwise not compete in domestic or export markets European colonial powers used their colonial possessions to support this trade objective. Colonies supplied many commodities that the colonising country might otherwise purchase from other country
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5.1 : THEORIES OF INTERNATIONAL TRADE


Government policies (contd.) : Colonial powers sought to run trade surpluses with their colonies as an additional way to obtain revenue Colonial powers not only monopolised colonial trade but also prevented the colonies from engaging in manufacturing The colonies had to export lass value added raw materials and import more value added manufactured products
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5.1 : THEORIES OF INTERNATIONAL TRADE


Mercantilism flourished because of (contd.) : The concept of Balance of Trade : Balance of trade is the difference between export and import of the country In the mercantilist period, the deficit in Balance of trade was made-up by a transfer of gold. Today it is made-up by holding the deficit countrys currency or investments denominated in that currency. In effect, the surplus country is granting credit to the deficit country
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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.1 Interventionist theories (contd.) : 5.1.1.2 Neo-mercantilism : Recently emerged term neo-mercantilism refers to the approach of countries that try to achieve favorable Balance of trade in an attempt to achieve some social or political objective A country may try to achieve full employment by setting economic policies that encourage its companies to produce in excess of the demand at home, to send the surplus abroad
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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.2 Free trade theories : Why countries need to trade at all? Many countries, following mercantilist policy did try to become as selfsufficient as possible through local production of goods and services Some countries take a more lenient approach, because they believe that government programs lead to inefficiency. Therefore they allow market forces to determine trading relations between the countries
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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.2 Free trade theories (contd.) : Free trade theories hold that the nations should neither artificially limit imports nor promote exports. Consumers would buy those products that best serve their needs, thereby determining which producers survive in the market Free trade theories imply specialisation, i.e. nations producing something for domestic consumption and export, while using the export earning to buy import products and services produced abroad
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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.2 Free trade theories (contd.) : 5.1.2.1 Absolute advantage theory 5.1.2.2 Comparative advantage theory

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.2 Free trade theories (contd.) : 5.1.2.1 Absolute advantage theory : In 1776 Adam Smith questioned the mercantilists assumptions and proposed that the real wealth of a country consists of the goods and services available to its citizens

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5.1 : THEORIES OF INTERNATIONAL TRADE


Adam Smith

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5.1.2.1 Absolute advantage theory (contd.) : The theory of absolute advantage developed by Smith holds that different countries produce some goods more efficiently than other countries. Thus global efficiency can increase through free trade Based on this theory, Adam Smith questioned why the citizens of any country should have to buy domestically produced goods, when they could buy those goods more cheaply from abroad
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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.2.1 Absolute advantage theory (contd.) : Adam Smith reasoned that if trade were unrestricted, each country would specialise in those products that gave it a competitive advantage Each countrys resources would shift to the efficient industries, because the country could not compete in the inefficient ones

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5.1.2.1 Absolute advantage theory (contd.) : Through specialisation, countries would increase their efficiency, because of following reasons : Labour could become more skilled by repeating the same tasks Labour would not loose time in switching from the production of one kind of product to another Long production runs would provide incentives for the development of more effective working methods
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5.1.2.1 Absolute advantage theory (contd.) : A country could then use its excess specialised production to buy more imports than it could have otherwise produced As per Adam Smith, marketplace would decide what products a country should specialise A countrys advantage would be either natural or acquired

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.2.1 Absolute advantage theory (contd.) : Natural advantage : A country may have a natural advantage in producing a product because of : Climatic conditions Access to certain natural resources Availability of certain labour forces

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5.1 : THEORIES OF INTERNATIONAL TRADE


Natural advantage (contd.) : The more the two countries climates differ, the more likely they will favour trade with one another Soil and topography are important determinants of the types of products a country can produce most efficiently

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5.1 : THEORIES OF INTERNATIONAL TRADE


Natural advantage (contd.) : Variations among countries in natural advantages also help explain in what countries certain manufactured or processed products might be best produced By processing an agricultural commodity or natural resource prior to exporting, companies can reduce transportation costs

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.2.1 Absolute advantage theory (contd.) : Acquired advantage : Worlds trade today is more in services and manufactured goods than in agricultural goods and natural resources Countries that produce manufactured goods and services competitively have an acquired advantage, usually in either product or process technology

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5.1 : THEORIES OF INTERNATIONAL TRADE


Acquired advantage (contd.) : An advantage of product technology enables a country to produce a unique product or one that is easily distinguished from those of competitors An advantage in process technology is a countrys ability to produce a homogeneous product (i.e. one not easily distinguished from that of competitors) more efficiently

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5.1 : THEORIES OF INTERNATIONAL TRADE


Acquired advantage (contd.) : Acquired advantage through technology has created new products, displaced old ones and altered trading partner relationships Companies have developed new uses for old products Products have been at least partially displaced by substitutes Technology can overcome natural disadvantages

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5.1.2.1 Absolute advantage theory (contd.) : Demonstration of Absolute advantage theory : Two countries, namely USA and Brazil produce two commodities, namely wheat and coffee Cost of production is defined in terms of the resources needed to produce either wheat or coffee

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Demonstration of Absolute advantage theory (contd.) : Assumptions : Brazil and USA are the only existing countries Each has the same amount of resources to produce either wheat or coffee, say 100 units Brazil takes 4 units of resources to produce a ton of coffee and 10 units per ton of wheat USA takes 20 units per ton of coffee and 5 units per ton of wheat
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Demonstration of Absolute advantage theory (contd.) : Brazil takes fewer resources to produce a ton, hence its more efficient than USA in coffee production USA is more efficient than Brazil in wheat production

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25

Qty. of Coffee (M.T.)


12.5

US production possibilities Brazil production possibilities

5
2.5 0
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Qty. of Wheat (M.T.)


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Demonstration of Absolute advantage theory (contd.) : If there is no foreign trade between the two countries and if both the countries devote half of their resources to producing coffee and wheat, then Brazil can produce 12.5 tons of coffee and 5 tons of wheat The USA can produce 2.5 tons of coffee and 10 tons of wheat Without trade, their combined production is 15 tons of coffee and 15 tons of tons of wheat
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Demonstration of Absolute advantage theory (contd.) : Specialisation increases the production of both the commodities, from 15 to 25 tons of coffee and from 15 to 20 tons of wheat Thus by trading, global efficiency is optimised and the two countries can have more of the two commodities, than they would without trade

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.2 Free trade theories (contd.) : 5.1.2.2 Comparative advantage theory : In 1817 David Ricardo examined the question what happens when one country can produce all products at an absolute advantage? and developed the theory of comparative advantage

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5.1.2 Free trade theories (contd.) : 5.1.2.2 Comparative advantage theory : In 1817 David Ricardo examined the question what happens when one country can produce all products at an absolute advantage? and developed the theory of comparative advantage

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5.1.2.2 Comparative advantage theory (contd.) : The theory of comparative advantage says that the global efficiency gains may still result from trade, if a country specialises in those products that it can produce more efficiently than other products, regardless of whether other countries can produce those same products even more efficiently

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5.1.2.2 Comparative advantage theory (contd.) : A country gains, if it concentrates its resources on producing the commodities it can produce most efficiently. It then trades some of these commodities for those commodities it has relinquished

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5.1.2.2 Comparative advantage theory (contd.) : Demonstration of Comparative advantage theory : Two countries, namely USA and Brazil produce two commodities, namely wheat and coffee Cost of production is defined in terms of the resources needed to produce either wheat or coffee

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Demonstration of Comparative advantage theory (contd.) : Assumptions : Brazil and USA are the only existing countries Each has the same amount of resources to produce either wheat or coffee, say 100 units Brazil takes 10 units of resources to produce a ton of coffee or wheat USA takes 5 units of resources to produce a ton of coffee and 4 units to produce a ton of wheat
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Demonstration of Comparative advantage theory (contd.) : USA is more efficient in producing both wheat and coffee than Brazil. Thus USA has an absolute advantage in production of both the products

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20

Qty. of Coffee (M.T.)


10 6 5

US production possibilities Brazil production possibilities

0
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12.5 17.5 18.25

25

Qty. of Wheat (M.T.)


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Demonstration of Comparative advantage theory (contd.) : If there is no foreign trade between the two countries and if both the countries devote half of their resources to producing coffee and wheat, then Brazil can produce 5 tons of coffee and 5 tons of wheat The USA can produce 10 tons of coffee and 12.5 tons of wheat Without trade, their combined production is 15 tons of coffee and 17.5 tons of tons of wheat
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Demonstration of Comparative advantage theory (contd.) : Although USA has an absolute advantage in production of both coffee and wheat, it has a comparative advantage only in production of wheat. This is because its advantage in wheat production is comparatively greater than its advantage in coffee production

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Demonstration of Comparative advantage theory (contd.) : By using the same amount of resources, USA can produce 2.5 times as much wheat as Brazil, but only twice as much coffee Through trading, the combined production of coffee and wheat within the two countries can be increased as follows

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Demonstration of Comparative advantage theory (contd.) : If the combined production of wheat is unchanged (from when there was no trade), USA could produce all 17.5 tons of what by using 70 units of resources . The remaining 30 units of USAs resources could be used for producing 6 tons of coffee The combined wheat production has stayed at 17.5 tons, but the coffee production has increased from 15 to 16 tons
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Demonstration of Comparative advantage theory (contd.) : If the combined coffee production is unchanged from the time before trade, Brazil could use all its resources to produce 10 tons of coffee. USA could produce the remaining 5 tons of coffee by using 25 units of resources . The remaining 75 units of USAs resources could be used to produce 18.75 tons of wheat Without sacrificing any of the coffee available before trade, wheat production has increased from 17.5 to 18.75 tons December 14, 2011 (c) Shantanu Jahagirdar (Mob.: 988 1313 325)

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5.1.2 Free trade theories (contd.) : Assumptions and limitations of Free trade theories : Both absolute advantage theory and comparative advantage theory are based on specialisation They hold that output will increase through specialisation and that countries will be best off by trading the output from their own specialisation for the output from other countries specialisation

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Assumptions and limitations of Free trade theories (contd.) : Absolute advantage theory and comparative advantage theory make assumptions, which may not be always valid

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Assumptions and limitations of Free trade theories (contd.) : Full employment Economic efficiency Division of gains Two countries, two commodities Transport costs Statics and dynamics Services
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Assumptions and limitations of Free trade theories (contd.) : Production networks Mobility

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Assumptions and limitations of Free trade theories (contd.) : Full employment : Both the theories assume that the resources are fully employed When countries have many unemployed or unused resources, they may seek to restrict imports, to employ or use the idle resources

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Assumptions and limitations of Free trade theories (contd.) : Economic efficiency : Countries often pursue objectives other than output efficiency They may avoid over-specialisation because of the vulnerability created by changes in technology and by price fluctuations

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Assumptions and limitations of Free trade theories (contd.) : Division of gains : Although specialisation brings potential benefits to all countries that trade, how do countries divide increased output? If both the countries receive some share of the increased output, both will be better off economically, through specialisation and trade

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Division of gains (contd.) : However many governments are concerned with absolute economic growth as well as relative to their trading partners. If they perceive a trading partner is gaining too large a share of benefits, they may forgo absolute gains for themselves so as to prevent relative losses

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Assumptions and limitations of Free trade theories (contd.) : Two countries, two commodities : For simplicity sake, both Smith and Ricardo assumed a simple world composed of only two countries and two commodities Although the simplification is unrealistic, it does not diminish the usefulness of either theory

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Assumptions and limitations of Free trade theories (contd.) : Transport costs : If it costs more to transport the goods than is saved through specialisation, the advantages of trade are negated As long as the diversion of resources reduces output by less than what the two countries gain from specialisation, there are still gains from trade
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Assumptions and limitations of Free trade theories (contd.) : Statics and dynamics : The two theories address countries advantages by looking at them statically, i.e. at one point in time However the relative conditions that give countries advantages or disadvantages in the production of given products are dynamic, i.e. constantly changing It should not be assumed that the future advantages will remain same as they are today
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5.1 : THEORIES OF INTERNATIONAL TRADE


Assumptions and limitations of Free trade theories (contd.) : Services : The two theories deal with products rather than services. However increasing portion of world trade is in services. Resources must go in into producing services as well

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5.1 : THEORIES OF INTERNATIONAL TRADE


Assumptions and limitations of Free trade theories (contd.) : Production networks : Both theories deal with trading one product for another. However increasingly we see division of work within a companys value chain network Company's activities take place in those countries where there is an absolute or comparative advantage for their production
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5.1 : THEORIES OF INTERNATIONAL TRADE


Assumptions and limitations of Free trade theories (contd.) : Mobility : The two theories assume that resources can move domestically from the production of one good to another, and at no cost. This assumption may not be completely valid

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5.1 : THEORIES OF INTERNATIONAL TRADE


Mobility (contd.) : The theories also assume that resources can not move internationally, however they do. However resources are more mobile domestically than they are internationally The movement of resources such as labour and capital are clearly an alternative to trade

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5.1 : THEORIES OF INTERNATIONAL TRADE


5.1.3 Trade pattern theories : Trade pattern theories deal with following issues : How much a country will depend on trade if it follows a free market policy? What type of products country will export and import? With which partner countries will the country trade?

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5.1.3 Trade pattern theories (contd.) : 5.1.3.1 Theory of country size 5.1.3.2 Factors proportions theory 5.1.3.3 Country similarity theory

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5.1.3 Trade pattern theories (contd.) : 5.1.3.1 Theory of country size : The theory of country size holds that large countries usually depend less on trade than small countries Countries with large land areas are apt to have varied climates and an assortment of natural resources, making them more self-sufficient than smaller countries

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in 2009

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in 2009

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5.1.3.1 Theory of country size (contd.) : Transport cost in international trade affects large and small countries differently. Normally the farther the distance, the higher the transport cost Distance also creates indirect costs of tying up inventory for longer period and of adding to the uncertainty and unreliability of timely delivery Among countries that border each other, the smaller country tends to depend more on trade than the larger country, because of transportation costs
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5.1.3.1 Theory of country size (contd.) : Size of the economy : Although land area is the most obvious way of measuring a countrys size, countries can also be compared on the basis of economic size Worlds top 10 exporters and importers are all developed countries, except for China. These 10 countries account for over half the worlds exports and imports
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Size of the economy (contd.) : The top 10 exporters and importers of the world produce so much that they have more to sell, both domestically and internationally Also, because they produce so much, income are high and people buy more from both domestic and foreign sources At the same time, there is little trade of developing countries with other developing countries
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5.1.3 Trade pattern theories (contd.) : 5.1.3.2 Factors proportions theory : This theory helps us explain what types of products result from natural and acquired advantages Eli Heckscher and Bertil Ohlin developed factors proportions theory, which is based on countries production factors, namely land, labour and capital (i.e. funds for investment in plant and equipment)

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5.1.3.2 Factors proportions theory (contd.) : The theory says that the differences in countries; endowments of labour, compared to their endowments of land or capital explain differences in the cost of production factors For example, if labour was abundant in a country in comparison to land and capital, then labour costs would be low relative to land and capital costs

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5.1.3.2 Factors proportions theory (contd.) : The relative factor costs would lead countries to excel in the production and export of products that used their abundant (and hence cheaper) production factors

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5.1.3.2 Factors proportions theory (contd.) : People and land : In countries where there are many people relative to the amount of land, regardless of climate and soil condition, they can not excel in production of goods requiring large amounts of land

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5.1.3.2 Factors proportions theory (contd.) : Manufacturing locations : In countries with limited land, the most successful industries are those in which technology permits the use of a minimum amount of land, relative to the number of people employed

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5.1.3.2 Factors proportions theory (contd.) : Capital, labour rates and specialisation : In countries where little capital is available for investment and where the amount of investment per worker is low, companies find cheaper labour rates and export competitiveness in products that require large amounts of labour relative to capital

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Capital, labour rates and specialisation (contd.) : Export from high income countries embody a higher proportion of professionals (such as scientists and engineers) than in low income economies exports. Therefore these rich countries are using above abundant production factors to maintain their lead in exports Exports of low income economies on the other hand shows a high intensity of less skilled labour
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Capital, labour rates and specialisation (contd.) : The variation in labour skills among countries has led to more international specialisation by task to produce a given product A company may locate its R&D activities and management functions primarily in countries with a highly educated population and may locate its production work in countries where less skilled and less expensive workers may be employed
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5.1.3.2 Factors proportions theory (contd.) : Process technology : Factor proportions analysis becomes more complicated when the same product can be produced by different methods, such as labour or capital. Thus production technology helps explain where products are made Hence the optimum location of production depends on comparing the cost in each location based on the type of production that minimises costs there
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Process technology (contd.) : Large economies are more likely to produce goods that use technologies requiring long production runs because these countries develop industries to serve their large domestic markets, which in turn tend to be competitive in export markets Companies however may locate long production runs in small countries if they expect few barriers in other countries to export if their products
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Process technology (contd.) : In industries where long production runs are important for gaining competitive advantages, companies tend to locate their production in few countries, using these locations as sources of exports to other countries Where long production runs are less important, a greater prevalence of multiple production units is found scattered around the world, so as to minimise transportation cost involved in exporting
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Process technology (contd.) : Technologically intensive company from a small nation may have a more compelling need to sell abroad than would a company with a large domestic market

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5.1.3.2 Factors proportions theory (contd.) : Product technology : Manufacturing depends on acquired advantage, largely technology, which in turn depends on large number of highly educated people (like scientists, engineers, etc.) and a large amount of capital to invest in research and development Developed countries have abundance of above features, hence they originate most new products and account for most manufacturing output and trade
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Product technology (contd.) : Developing countries depend much more on production of primary products and hence they depend more on natural advantage

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5.1.3 Trade pattern theories (contd.) : 5.1.3.3 Country similarity theory : Most trade takes place among developed countries Country similarity theory says that once a company has developed a new product in response to observed market conditions in its home market, it turns to markets it sees as most similar to those at home

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5.1.3.3 Country similarity theory (contd.) : Specialisation and acquired advantage : Markets in developed countries can support the development and sale, both of new products and variations of existing ones. Trade occurs because countries specialise to gain acquired advantage, e.g. by apportioning their research efforts more strongly to some sectors than to others

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Specialisation and acquired advantage (contd.) : Developing countries also have gained advantages through specialisation, whereby they concentrate successfully on a very narrow product segments

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5.1.3.3 Country similarity theory (contd.) : Product differentiation : Trade also occurs because companies differentiate products, thus creating two way trade in similar products Different companies from different countries develop product variations that appeal to different consumers

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5.1.3.3 Country similarity theory (contd.) : The effect of cultural similarity : Cultural similarity also helps explain much of the direction of trade. Importers and exporters find it easier to do business in a country they perceive as being culturally similar to their home country, because they speak a common language Historic colonial relationships explain much of the trade between specific high income and low income economies
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The effect of cultural similarity (contd.) : Importers and exporters find it easier to continue business ties than to develop new distribution arrangements in countries where they are less experienced

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5.1.3.3 Country similarity theory (contd.) : The effects of political relationships and economic agreements : Political relationships and economic agreements among countries may discourage or encourage trade between them Agreement among many European countries to remove all trade barriers with each other has caused a greater share of the countries total trade to be conducted within the group
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5.1.3.3 Country similarity theory (contd.) : The effects of distance : Greater distances usually means higher transportation costs Why does a country buy more from one country than from another? The geographic distance between two countries accounts for many of the world trade relationships

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5.1.3.3 Country similarity theory (contd.) : Overcoming distance : Transport cost is not the only factor in trade partner choice Disadvantage in freight costs can be countered in a limited manner. However these methods are difficult to maintain

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5.1.4 The statics and dynamics of trade : These theories help explain how countries develop, maintain and lose their competitive advantages

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5.1.4 The statics and dynamics of trade : 5.1.4.1 Product Life Cycle (PLC) theory 5.1.4.2 The Porter diamond 5.1.4.3 Factor mobility theory

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The statics and dynamics of trade (contd.) : 5.1.4.1 Product Life Cycle (PLC) theory : The international product life cycle (PLC) theory of trade states that the location of production of certain kinds of products shift as they go through four stages of their life cycles, namely introduction, growth, maturity and decline

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5.1.4.1 Product Life Cycle (PLC) theory (contd.) : Changes over the cycle : Companies develop new products primarily because there is an observed need and market for them nearby Almost all new technology that results in new products and production methods originates in developed countries. They have most of the resources to develop new products and most of the income to buy them
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5.1.4.1 Product Life Cycle (PLC) theory (contd.) : Introduction : Once a company has created a new product, the early production stage, called the introductory stage generally occurs in a domestic location, so the company can obtain rapid market feedback as well as save on transport costs At this stage, export markets are small and mainly to other developed countries, because more customers in these countries can afford the new products
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5.1.4.1 Product Life Cycle (PLC) theory (contd.) : Growth : As sales grow, competitors enter the market During the growth stage, demand may justify producing in some foreign countries (usually developed ones) to reduce transport charges At this stage, sales are likely to stay almost entirely in the countries producing the product

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Growth (contd.) : The original producing country will increase its exports in this stage, but loose certain key export markets in which local production commences

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5.1.4.1 Product Life Cycle (PLC) theory (contd.) : Maturity : In maturity stage, worldwide demand begins to level off, although it may be growing in some countries and declining in others There often is a shakeout of producers such that product models become highly standardised, making cost an important competitive weapon Longer production runs reduce per unit cost, thus creating more demand in developing economies
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Maturity (contd.) : Because markets and technologies are widespread, the innovating country no longer commands a production advantage Producers have incentives to shift production to developing economies where they can employ less skilled and less expensive labour efficiently for standardised and capital intensive production Exports decrease from innovating country as foreign production displaces it
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5.1.4.1 Product Life Cycle (PLC) theory (contd.) : Decline : As product moves into the decline stage, those factors occurring during the maturity stage continue to evolve. The market in developed countries decline more rapidly than those in developing economies, as affluent customers demand ever-newer products

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Decline (contd.) : Market and cost factors dictate that almost all production is in developing economies, which export to the declining or small niche markets in developed countries Thus the country in which the innovation first emerged and exported from, then becomes importer

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5.1.4.1 Product Life Cycle (PLC) theory (contd.) : Verification and limitations of PLC theory : The PLC theory holds that the location of production facilities that serve world markets shifts as products move through their life cycle However if transport costs are very high, then there is little opportunity for export sales, regardless of the stage in the life cycle

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Verification and limitations of PLC theory (contd.) : For following products, shifts in production location do not usually take place. The innovating country may maintain its export ability throughout the products life cycle Products with extremely short life cycle Luxury products A company using differentiation strategy for the products Products that require specialised technical labour
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Verification and limitations of PLC theory (contd.) : Products with extremely short life cycle : Because of very rapid innovations, products that have extremely short life cycle, makes it impossible to achieve cost reductions, by moving production from one country to another

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Verification and limitations of PLC theory (contd.) : Luxury products : For luxury products, cost is of little concern to the customer. Production in a developing country may make the product seem less luxurious than it really is

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Verification and limitations of PLC theory (contd.) : A company using differentiation strategy for the products : Through advertising, a company can use differentiation strategy for its products, to maintain consumer demand, without competing on the basis of price

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Verification and limitations of PLC theory (contd.) : Products that require specialised technical labour : Some products require specialised technical labour to evolve into next generation. Such products maintain their dominance in the world market, by continuing to operate from developed countries

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Verification and limitations of PLC theory (contd.) : There is an increased tendency on the part of MNEs to introduce new products at home and abroad almost simultaneously, regardless of the product type Instead of merely observing needs within their domestic markets, companies develop products and services for observable market segments that transcend national borders. In doing so, they eliminate delays as a product is diffused from one country to another
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Verification and limitations of PLC theory (contd.) : They choose an initial production location that will minimise costs for serving markets in multiple countries. This production location may or may not be in the innovating companys home market

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The statics and dynamics of trade (contd.) : 5.1.4.2 The Porter diamond : The Porter diamond theory shows following four conditions as important for competitive superiority : Demand conditions Factor conditions Related and supporting industries Firm strategy, structure and rivalry
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The Porter diamond


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Michael Porter

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5.1.4.2 The Porter diamond (contd.) : The theory is useful for understanding how and where globally competitive companies develop and sustain themselves Usually all four conditions need to be favourable for an industry within a country to attain global supremacy

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5.1.4.2 The Porter diamond (contd.) : Demand conditions : Both PLC theory and country similarity theory show that the new products or industries usually arise from companies observation of need or demand, which is usually in their home country Companies then start-up production near the observed market

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5.1.4.2 The Porter diamond (contd.) : Factor conditions : Natural advantage in most production factors such as skilled labour, capital, technology (or equipment) need to be available in a country on favourable terms

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5.1.4.2 The Porter diamond (contd.) : Related and supporting industries : The existence of nearby related and supporting industries need to be favourable

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5.1.4.2 The Porter diamond (contd.) : Firm strategy, structure and rivalry : The combination of earlier three conditions influences companies decisions to initiate production of a certain product in a given country The ability of the companies to develop and sustain a competitive advantage requires favourable circumstances for the fourth condition, namely the firms strategy, structure and rivalry
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Firm strategy, structure and rivalry (contd.) : The ability of the companies to develop and sustain a competitive advantage requires favourable circumstances for the fourth condition, namely the firms strategy, structure and rivalry Rivalry becomes intense as companies try to serve increasingly sophisticated consumers

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Firm strategy, structure and rivalry (contd.) : This forces breakthroughs in both product and process technology, which gives producers advantage over foreign producers and enable them to gain larger global share of exports

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5.1.4.2 The Porter diamond (contd.) : Limitations of the Porter diamond theory : The existence of the four favourable conditions does not guarantee that an industry will develop in a given location The increased ability of companies to attain market information, production factors and supplies from abroad

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Limitations of the Porter diamond theory (contd.) : The absence of any of the four conditions from the diamond domestically may not inhibit companies and industries from becoming globally competitive Observations of foreign or foreign plus domestic, rather than just domestic demand conditions have spurred much of the recent growth in Asian exports Companies and countries are not dependent entirely on domestic factor conditions, because capital and managers are now internationally mobile
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Limitations of the Porter diamond theory (contd.) : If related and supporting industries are not available locally, materials and components are now more easily brought in from abroad, because of advancements in transportation and the relaxation of import restrictions Companies react not only to domestic rivals, but also to foreign based rivals, they compete with at home and abroad

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The statics and dynamics of trade (contd.) : 5.1.4.3 Factor mobility theory : Factor mobility means movement of capital, technology and people across the border Factor conditions in a country change in both quantity and quality, therefore the relative capabilities of countries also change. The change may come about because of internal circumstances

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5.1.4.3 Factor mobility theory (contd.) : The factor mobility theory of trade patterns focuses on the following reasons : Why production factors move? The effects of such movement on transforming factor endowments The effect of international factor mobility (especially people) on world trade

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5.1.4.3 Factor mobility theory (contd.) : Why production factors move?: Capital People Economic motives Political motives

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Why production factors move? (contd.) : Capital : Capital, especially short-term capital, is the most internationally mobile production factor Companies and private investors primarily transfer capital because of differences in expected return, after accounting for risk Political and economic conditions affect investors perception of risk and where they prefer to put their capital
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Why production factors move? (contd.) : People : People are also internationally mobile, but less so than capital Unlike funds that can be cheaply transferred by wire, people must usually incur high transportation costs, to work in another country If people move legally, they must get immigration documents and most countries give them sparingly
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People (contd.) : Migrating people may have to learn another language and adjust to different culture away from their families and friends, who serve as their customary support groups Of the people who go abroad for work, some move permanently and some move temporarily

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Why production factors move? (contd.) : Economic motives : People, whether professionals or unskilled workers, largely work in another country for economic reasons

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Why production factors move? (contd.) : Political motives : People also move for political reasons, e.g. because of persecution or war dangers, in which case they are known as refugees. However once they are refugees, they usually become part of the labour pool where they live

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Political motives (contd.) : Sometimes it is difficult to distinguish between economic and political motives for international mobility, because poor economic conditions often parallel poor political conditions

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5.1.4.3 Factor mobility theory (contd.) : Effects of factor movements : Neither international capital nor population mobility is a new occurrence Many immigrants bring human capital with them, thus adding to the base of skills that enables the countries to be newly competitive in an array of products they might otherwise have imported

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Effects of factor movements (contd.) : These countries receive foreign capital to develop infrastructure and natural resources, which further alters their competitive structures and international trade

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5.1.4.3 Factor mobility theory (contd.) : What happens when people move? People movements are substantial for many countries and insignificant for other The US is currently an example of a country whose recent immigration is largely concentrated at he high and low end of human skills Although labour and capital are different production factors, they are intertwined
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What happens when people move? (contd.) : Countries lose potentially productive resources, when educated people leave, a situation known as a brain drain, but they may gain from the foreign earnings on those factors

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Remittance flows to developing countries in 2007 (US $ mn.)

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What happens when people move? (contd.) : Countries receiving productive human resources also incur cost of social services and for acculturating people to a new language and culture

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What happens when people move? (contd.) : The unskilled workers who take jobs that native born workers dont want, have children who eventually enter the workforce. If these children are also unskilled, the country is perpetuating a long-term class of have-nots. If these children become skilled, then there is a need to bring in even more unskilled workers from abroad

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5.1.4.3 Factor mobility theory (contd.) : Relationship between trade and factor mobility : Factor movement is an alternative to trade that may or may not be a more efficient allocator of resources Free trade, when coupled with freedom of factor mobility internationally usually results in the most efficient allocation of resources

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5.1.4.3 Factor mobility theory (contd.) : Substitution : When the factors proportions vary widely among countries, pressure exists for the most abundant factors to move to countries with greater scarcity, where they can command a better return If finished goods and production factors were both free to move internationally, the competitive cost of transferring goods and factors would determine the location of production
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Substitution (contd.) : As is true of trade, there are restrictions on factor movement that make them only partially mobile internationally

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5.1.4.3 Factor mobility theory (contd.) : Complementarity : Factor movements may substitute or stimulate trade When companies invest abroad, the investments often stimulate exports from their home countries About a third of world exports is among controlled entities, such as from parent to subsidiary, subsidiary to parent and subsidiary to subsidiary of the same company
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Complementarity (contd.) : Domestic operating units may export materials and components to their foreign facilities, for use in a finished product A foreign facility may produce part of the product line, while serving as sales agent for exports of its parents complementary products

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