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Theory of World Trade

Comparative advantage is one of the most
fundamental ideas in trade theory. A country has
comparative advantage in goods if it has a lower
opportunity cost of producing the goods than another
country. Countries are expected to export goods for
which their autarky (no trade) relative prices are
lower than other countries. Countries gain from trade
when they have different autarky relative prices of
• Worldwide trend of the economies of the world
becoming borderless and interlinked.
• National economies merging into an
interdependent global economic system.
• Declining trade and investment barriers
• Perceived distances are shrinking due to advances
in transportation and telecommunications.
The Shrinking Globe-The death of distance

Best average speed of 1850-1930

horse-drawn coaches and
sailing ships, 10mph.

Steam locomotives average 65mph.

Steamships average 36mph.

Jet passenger aircraft

General Agreement on Tariffs and Trade (GATT)
originated after World War II (1939-1945) as a charter for
the International Trade Organization (ITO), a proposed
specialized agency of the United Nations. GATT was
signed by 23 nations at a trade conference in 1947 and
became effective in January 1948. Although the ITO
failed to win ratification by the United States Congress in
1950 and never came into being, the GATT remained in
use to govern international trade. It is a treaty among
international trade organization in existence from 1948 to
The World Trade Organization (WTO) is the only global
international organization dealing with the rules of trade
between nations. Its main function is to ensure that trade
flows as smoothly, predictably and freely as possible. . At
its heart are the WTO agreements, negotiated and signed
by the bulk of the world’s trading nations and ratified in their
parliaments. The goal is to help producers of goods and
services, exporters, and importers conduct their business.
It’s an organization for liberalizing trade. It’s a forum for
governments to negotiate trade agreements. It’s a place for
them to settle trade disputes. It operates a system of trade
Role of W.T.O.
 It’s a negotiating forum - The WTO is a place where member governments go, to
try to sort out the trade problems they face with each other. The first step is to talk.
The WTO was born out of negotiations, and everything the WTO does is the result of

 It’s a set of rules - At its heart are the WTO agreements, negotiated and signed by
the bulk of the world’s trading nations. These documents provide the legal ground-
rules for international commerce. They are essentially contracts, binding
governments to keep their trade policies within agreed limits.

 It helps to settle disputes - Trade relations often involve conflicting interests.

Agreements, including those painstakingly negotiated in the WTO system, often
need interpreting. The most harmonious way to settle these differences is through
some neutral procedure based on an agreed legal foundation. That is the purpose
behind the dispute settlement process written into the WTO agreements.

Principles of Trading System
• Freer trade: gradually, through

• Predictability: through binding and


• Promoting fair competition

• Encouraging development and economic


World Trade Organization: Rounds
Rounds of GATT
Multilateral Trade Negotiations
No. Years Name Accomplishments
1-5 1947-61 Reduced tariffs
6 1964-67 Kennedy Tariffs + anti-dumping
7 1973-79 Tokyo Tariffs + NTBs
8 1986-94 Uruguay Tariffs, NTBs, Services, Intellectual Property,
Textiles, Ag., Dispute Settlement, Created
9 2001-? Doha ? (Doha Development Agenda)
Foreign Direct Investment (FDI) is defined as
"investment made to acquire lasting interest in enterprises
operating outside of the economy of the investor."

The FDI relationship consists of a parent enterprise

and a foreign affiliate, which together form a Trans-
national Corporation (TNC).
When is FDI Preferable to Trade?

• Transportation costs too high for exporting

• Tariff and non-tariff barriers very high
• Lack of excess domestic capacity
• Scale economies not significant in competitiveness
(especially when products are more differentiated)
• Location specific advantages such as natural resources
Why Do Firms Invest Overseas?

• Labour Market Imperfections

• Intangible Assets
• Vertical Integration
• Product Life Cycle
• Shareholder Diversification
Labour Market Imperfections

Persistent wage
differentials across Country Hourly Cost
countries exist. This
is one on the main Germany $27.37
reasons MNCs are Japan $21.38
making substantial France/U.S. $17.10
FDIs in less Israel $9.06
developed nations.
Taiwan $5.47
Mexico $2.57
Intangible Assets

• Coca-Cola has a very valuable asset in its closely

guarded “secret formula”.
• To protect that proprietary information, Coca-Cola
has chosen FDI over licensing.
• Since intangible assets are difficult to package and
sell to foreigners, MNCs often enjoy a comparative
advantage with FDI.
Vertical Integration
• MNCs may undertake FDI in countries where inputs
are available in order to secure the supply of inputs at
a stable accounting price.
• Vertical integration may be backward or forward:
– Backward: e.g. a furniture maker buying a logging
– Forward: e.g. a U.S. auto maker buying a Japanese
auto dealership.
Product Life Cycle

• U.S. firms develop new products in the developed world for the
domestic market, and then markets expand overseas.
• FDI takes place when product maturity hits and cost becomes an
increasingly important consideration for the MNC.
Product Life Cycle

The U.S.

production exports
ptio n
ns u m

New product Maturing product Standardized product

Less advanced

p tio
su m

New product Maturing product Standardized product

• Networking major Cisco's CEO John Chambers announced a $1.1 billion
investment package for India. Chambers said that the company is also
considering India as a manufacturing base.
• Intel: Intel Corporation said the company would invest more than $1
billion in the next five years to expand its operations in India and in local
technology companies.

• German automobile major BMW signed a memorandum of

understanding with the Tamil Nadu government to establish its car
assembly plant at an investment of $38 million in five years. The
German group has selected a site in Mahindra World City in
Maraimalainagar, near Chennai, to set up its assembly plant.
• BMW has selected Chennai as the "best location" for establishing its car
assembly plant with an investment of about Rs 180 crore (Rs 1.8 billion)
in five years.

• Global auto giant Toyota is setting up a gearbox manufacturing plant in

India to serve the Asian market. Toyota is planning to invest around Rs
387 crore (Rs 3.87 billion) in collaboration with its mini-vehicle making
arm Daihatsu. The aim is to develop a compact car for the Indian market.
• Besides, Toyota, Honda Motorcycle, Suzuki Motor (Maruti Suzuki) and
Kansai Paints are firming up plans to pump in foreign direct investment
(FDI) of at least $1.5 billion in the next three years.
Telecom sector

• LG Electronics has invested Rs 900 cr (Rs 9 billion) at Ranjangaon,

Samsung has planned to set up a mobile manufacturing base in India.
• Finnish mobile handset giant Nokia set up a manufacturing plant in
Chennai with an investment of up to $150 million to meet the booming
demand for its handsets in India.
• The Chennai unit will be Nokia's tenth mobile device production facility
globally and will roll out India-specific entry level and mid and upper
end GSM and CDMA handsets.
Strategic Alliances

• A strategic alliance is an arrangement

between two or more companies to pursue a
common business objective.
Wal-Mart’s experience
• Moved into other countries
– Growth opportunities at home were becoming constrained
– Create value by transferring core skills to markets where indigenous competitors lacked those skills
– Preempt other retailers who were expanding globally

• Discovered had to change US model

– Differences in local taste, preferences and local infrastructure
– Change store location, layout and stocking practices
– Keep company’s core strategies and operations
– emphasize everyday low prices & realize operating efficiencies from world class logistics management
and information systems

• Benefits – becoming transnational corporation

– Enhanced bargaining power with suppliers
– Ability to transfer valuable ideas from one country to another
– Balance global standardization with local customization
Success factors

• FOCUS AND DIRECTION: Pharmaceutical giants like SmithKline

Beecham have linked arms with relative minnows to enter
unfamiliar fields like biotechnology. SmithKline Beecham's
necessities included tapping into drug-related research fields, like
biotechnology, where it had no position itself.
• Pilkington jointly owns float glass manufacture in Latin America
with its deadly European rival, St.Gobain. Since alliance with a
Japanese competitor was the key to expanding in automotive glass in
the US and other markets