Theories of International Trade and

Investment- Chapter 10 (textbook-

chapter 5)

5-1
 Learning Objectives

5.1 Appreciate why nations trade.

5.2 Learn about how nations can enhance their

competitive advantage.

5.3 Understand why and how firms

internationalize.

5.4 Explain the strategies internationalizing firms

use to gain and sustain competitive
advantage.
5-2
Theories of International Trade and Investment

5-3
 Mercantilism and Neomercantilism

• Mercantilism: A belief popular in the 16th century

that national prosperity results from maximizing
exports and minimizing imports.
• Today, some argue for neomercantilism – the idea
that the nation should run a trade surplus.
• Supporters of neomercantilism include:
 Labor unions (who want to protect domestic jobs),
 Farmers (who want to keep crop prices high), and
 Some manufacturers (that rely on exports).

5-4
 Free Trade

The absence of restrictions to the

flow of goods and services among nations.
• Free trade is usually best because it leads to:
 More and better choices for consumers and firms.
 Lower prices of goods for consumers and firms.
 Higher profits and better worker wages (because
imported input goods are usually cheaper).
 Higher living standards for consumers (because their
costs are lower).
 Greater prosperity in poor countries.

5-5
 Comparative Advantage

• The foundation concept of international trade,

which answers the question of how nations can
achieve and sustain economic success and
prosperity.
• It refers to the superior features of a country that
provide it with unique benefits in global
competition.
• Comparative advantages are derived either from
natural endowments or from deliberate national
policies.
5-6
 Examples of National Comparative Advantage

• France has a climate and soil superior for producing

wine.

• Saudi Arabia has a natural abundance of oil, for the

production of petroleum products.
• Over time, Japan has acquired a superior base of
knowledge and experience for producing cars.
• Over time, India has acquired a superior base of IT
workers for producing computer software.
What are the comparative advantages in your country?
5-7
 Competitive Advantage

• A foundation concept that explains how individual

firms gain and maintain distinctive competencies,
relative to competitors, that lead to superior
performance.
• It refers to the distinctive assets, competencies, and
capabilities that are developed or acquired by the
firm.
• The collective competitive advantages held by the
firms in a nation are the basis for the competitive
advantages of the nation at large.
5--8
 Examples of Firm Competitive Advantage

• Dell’s prowess in the management of its global

supply chain.

• Samsung’s technological leadership in flat-panel

televisions.

• Cadbury’s capabilities in international

marketing and distribution.

• Herman Miller’s design strengths in

office furniture (e.g., Aeron chairs).

5-9
 Absolute Advantage Principle
A country should produce only those products in which
it has absolute advantage or can produce using fewer
resources than another country.

(Labor Cost in Days of Production for One

Ton)
5-10
Adam Smith (1723-1790)

Source: creativehearts/123RF

5-11
 Comparative Advantage Principle

It is beneficial for two countries to trade even if one has

absolute advantage in the production of all products; what
matters is not the absolute cost of production but the
relative efficiency with which it can produce the product.

(Labor Cost in Days of Production for One Ton)

5-12
 Comparative Advantage Principle (cont’d)

“Two men can make both shoes and hats, and one is superior
to the other in both employments, but in making hats he can
only exceed his competitor by one fifth or 20 percent, and in
making shoes he can excel him by one third or 33 percent;
Will it not be for the interest of both that the superior man
should employ himself exclusively in making shoes and the
inferior man in making hats?” David Ricardo, 1817

5-13
 Comparative Advantage Principle (cont’d)

• While Germany can make both items cheaper than France,

it is still beneficial for Germany to trade with France.

• The key is the ratio of production costs. In the exhibit,

Germany is comparatively more efficient at producing cloth
than wheat: it can produce three times as much cloth as
France (30/10), but only two times as much wheat (40/20).

• Germany should specialize in producing cloth and import all

the wheat it needs from France. France should specialize in
producing wheat and import all its cloth from Germany.

• Each country benefits by specializing in the product in

which it has a comparative advantage and importing the
5-14
 Comparative Advantage Principle (cont’d)

• The principle applies to all goods. It reveals how

countries use scarce resources more efficiently.
Example:
• Arguably, no country is better than Japan at making
cars and cell phones. But because Japan is especially
good at making cars, it concentrates its resources on
making them.
• Other countries, such as China and Finland, focus on
making cell phones.

• In this way, Japan makes maximal use of its

resources, and the world gets great cars.
5-15
 Limitations of Early Trade Theories
• Fail to account for international transportation costs.

• Governments distort normal trade by selectively

imposing protectionism (e.g., tariffs) or investing in
certain industries (e.g., via subsidies).
• Services: Some cannot be traded; others can be
traded freely via the Internet or global telephony.

• For many firms, scale economies and superior

business strategies provide efficiencies and other
advantages. Early trade theories failed to account for
this. (e.g., Japan lacks comparative advantages, but
5-16
its firms succeeded anyway, via superior strategies.)
 Factor Proportions Theory

• Also known as Factor Endowments Theory. It argues

that each country should produce and export
products that intensively use relatively abundant
factors of production, and import goods that
intensively use relatively scarce factors of production.

5-17
 Factor Proportions Theory

• Also known as Factor Endowments Theory. It argues that

each country should produce and export products that
intensively use relatively abundant factors of production, and
import goods that intensively use relatively scarce factors of
production.

• However, the Leontief Paradox revealed that countries can

successfully export products that use less abundant
resources (e.g., the U.S. often exports labor-intensive
goods). Implies that international trade is complex and
cannot be fully explained by a single theory.

5-18
International Product Life Cycle Theory

Source: Adapted from Raymond Vernon, “International Investment and International Trade in the Product Cycle,”
Quarterly Journal of Economics 80 May 1966), pp. 190–207 and http://www.provenmodels.com/583/international-
product-life-cycle/raymond-vernon. 5-19
International Product Life Cycle Theory
• Each product and its associated manufacturing
technologies go through three stages of
evolution: Introduction, maturity, and
standardization.

• In the introduction stage, the inventor country

enjoys a monopoly both in manufacturing and
exports. Example: The television set.

5-20
International Product life Cycle Theory (cont’d)

• Each product and its associated manufacturing

technologies go through three stages of evolution:
Introduction, maturity, and standardization.
• In the maturity stage, the product’s manufacturing
becomes relatively standardized, other countries
start producing and exporting the product.

5-21
International Product life Cycle Theory (cont’d)

• Each product and its associated manufacturing

technologies go through three stages of evolution:
introduction, maturity, and standardization.
• In the standardization stage, manufacturing ceases
in the original innovator country, and it becomes a
net importer of the product. Today under globali-
zation, for many products, the cycle occurs quickly.

5-22
 New Trade Theory

• Argues that economies of scale are an important

factor in some industries for superior international
performance, even in the absence superior
comparative advantages. Some industries succeed
best as their volume of production increases.

Example
The commercial aircraft industry has very high fixed
costs that necessitate high-volume sales to achieve
profitability.

5-23
Comparative vs. Competitive Advantage

5-24
 Critical Role of Innovation
in National Economic Success

• Innovation is a key source of competitive advantage.

• The firm innovates in four major ways. It can

develop:
(1) A new product or improve an existing product.
(2) New ways of manufacturing.
(3) New ways of marketing.
(4) New ways of organizing company operations.

• Many innovative firms in a nation leads to national

competitive advantage
5-25
 Critical Role of Productivity
in National Economic Success
• Productivity is the value of the output produced by a
unit of labor or capital.

• It is a key source of competitive advantage for firms.

• The greater the productivity of the firm, the more

efficiently it uses its resources.
• The productive the firms in a nation, the more
efficiently the nation uses its resources.

• Aggregate productivity is a key determinant of the 5-26

 Labor Productivity Levels in Selected Countries
(Output per hour in manufacturing, 2005–2016; Index scale where 2010=100)

Source: OECD, OECD Data: Productivity (Organisation for Economic Cooperation and Development, 2015),
https://data.oecd.org/lprdty/labour-productivity-forecast.htm#indicator-chart. 5-27
 Michael Porter’s Diamond Model:
Sources of National Competitive Advantage

5-28
 Diamond Model
Sources of National Competitive Advantage (cont’d)

• Factor conditions – Quality and quantity of labor,

natural resources, capital, technology, know-how,
entrepreneurship, and other factors of production.

Example
An abundance of cost-effective and well-educated
workers give China a competitive advantage in the
production of laptop computers.

5-29
 Diamond Model
Sources of National Competitive Advantage (cont’d)

• Related and supporting industries – the

presence of suppliers, competitors, and
complementary firms that excel within a given
industry.
Example
The Silicon Valley in California is a great place to
launch a computer software firm, because it is home
to thousands of knowledgeable firms and workers in
the software industry.

5-30
 Diamond Model
Sources of National Competitive Advantage (cont’d)

• Demand conditions at home – the strengths

and sophistication of customer demand.

Example
Japan is a densely populated, hot, and humid country
with very demanding consumers. These conditions
led Japan to become one of the leading producers of
superior, compact air conditioners

5-31
 Diamond Model
Sources of National Competitive Advantage (cont’d)
• Firm strategy, structure, and rivalry – The nature of
domestic rivalry, and conditions that determine how a
nation’s firms are created, organized, and managed.
Example
Italy has many top firms in
design industries such as
textiles, furniture, lighting, and
fashion. Vigorous competitive
rivalry puts these firms under
constant pressure to innovate,
which has propelled Italy to a
leading position in design,
worldwide.
5-32
 Industrial Cluster

• A concentration of suppliers and supporting firms

from the same industry located within the same
geographic area. Similar to Porter’s Related and
Supporting Industries.

• A strong cluster can serve as an export platform for

the nation.
Examples
Silicon Valley; pharmaceutical cluster in Switzerland;
footwear industry in Pusan, South Korea; IT industry in
Bangalore, India; fashion cluster in northern Italy; and
Silicon Valley North near Ottawa, Canada.
5-33
 National Industrial Policy

• A proactive economic development plan

employed by the government to nurture or
support promising industry sectors with potential
for regional or global dominance. Initiatives can
include:
 Tax incentives.
 Monetary and fiscal policies.
 Rigorous educational system.
 Investment in national infrastructure.
 Strong legal and regulatory systems.
5-34
 Examples of National Industrial Policy

• Vietnam’s government in the 1990s privatized state

enterprises and modernized the economy,
emphasizing competitive, export-driven industries.
Vietnam became one of the fastest-growing
economies, averaging around 8 percent annual GDP
growth.
• Singapore adopted probusiness, proinvestment,
export-oriented policies, combined with state-
directed investments in strategic corporations. The
approach stimulated economic growth that averaged
8 percent annually from 1960 to 1999.
5-35
Examples of National Industrial Policy (cont’d)

• The Czech government in the 1990s created a

business-friendly legal and regulatory environment.
The country privatized state-owned companies.
Government FDI incentives attracted numerous
MNEs, such as Daewoo, ING, Siemens, and Toyota.

• New Zealand’s government, starting in 1984,

transformed the country from an agrarian,
protectionist, regulated economy to an industrialized,
free-market economy that today competes globally.

5-36
 Transformation of New
Zealand’s Economy, 1992 to 2014

New Zealand’s success resulted from:

• Implemented pro-business policies – fiscal, monetary,
tax; investment in education
• Emphasized high-value industries such as IT and
pharmaceuticals that greatly grew GDP and reduced
unemployment.
5-37
 New Zealand (cont’d)

• Government-controlled wages, prices, and interest rates

were freed, allowed to fluctuate as per market forces.
• The banking sector was liberalized, foreign exchange
controls were eliminated, and New Zealand dollar was
allowed to float according to market forces.
• Most trade barriers were removed and New Zealand
joined several free trade agreements.
• Agricultural and other subsidies were eliminated.
• The government worked earnestly with labor unions to
reduce wage inflation, helping maintain jobs in New
Zealand and not outsourced to lower-wage countries.
5-38
 New Zealand (cont’d)
• The government initiated programs to encourage
development of a knowledge economy. New Zealanders
continuously upgraded skills and knowledge, providing a
supply of scientists, engineers, and trained managers.
• Personal and corporate income tax rates were cut. Tax
base was diversified to stabilize government revenues.
This helped foster entrepreneurship, boosted consumer
spending, and attracted FDI into New Zealand.
• The government cut spending and borrowing, leading to
lower interest rates and stimulating the economy.
• State-owned enterprises – such as the national airline,
telecom, and other utilities – were privatized.
5-39
Stages in Company Internationalization

Domestic Focus

Pre-export Stage

Experimental Involvement

Active Involvement

Committed Involvement
5-40
 Stock and Growth of Inward FDI: Leading FDI
Destinations, 2003 to 2013 (Billions of U.S. dollars)

Sources: UNCTAD, UNCTAD Stat 2014 (New York: United Nations, 2014), retrieved May 3, 2015, at http://unctad.org/
en/pages/Statistics.aspx. 5-41
 Stock and Growth of Outward FDI: Top Sources
of FDI, 2003 to 2013 (Billions of U.S. dollars)

Sources: UNCTAD, UNCTAD Stat 2014 (New York: United Nations, 2014), retrieved May 3, 2015, at
http://unctad.org/en/ 5-42
pages/Statistics.aspx.
 How Firms Gain and Sustain
International Competitive Advantage

• Since the MNE was traditionally the major player in

international business, scholars have offered
numerous explanations of what makes these firms
pursue, and succeed in, internationalization.

• Because FDI has been MNEs’ main strategy in

international expansion, theoretical explanations
have tended to emphasize it.

5-43
 FDI Based Explanations:
Monopolistic Advantage Theory

• Argues that MNEs prefer FDI because it provides

the firm with control over resources and capabilities
in the foreign market, and a degree of monopoly
power relative to foreign competitors.

• Key sources of monopolistic advantage include

proprietary knowledge, patents, unique know-how,
and sole ownership of other assets.
Example
Novartis earns substantial profits by marketing various
patent medications through its subsidiaries worldwide.

5-44
 FDI Based Explanations:
Internalization Theory
• Explains how the MNE chooses to acquire and retain
one or more value-chain activities inside itself.

• Such “internalization” provides the MNE with greater

control over its foreign operations.
• Internalization avoids the drawbacks of dealing with
external partners, such as reduced quality control
and the risk of losing proprietary assets to outsiders.
Example
In China, Intel owns much of its value chain, to ensure
that Intel knowledge, patents, and other assets are not
misused or illicitly obtained by potential rivals.
5-45
 FDI Based Explanations:
Dunning’s Eclectic Paradigm
• Three conditions determine whether or not a
company will enter a given foreign country via FDI:
1.Ownership-specific advantages – knowledge, skills,
capabilities, relationships, or physical assets that the firm
owns and which are the basis of its competitive advantages.
2.Location-specific advantages – similar to comparative
advantages, they are specific advantages that exist in the
country that the MNE has entered, or is seeking to enter, such
as natural resources, low-cost labor, or skilled labor.
3.Internalization advantages – control derived from internalizing
foreign-based manufacturing, distribution, or other value chain
activities.
5-46
 Example of the Eclectic Paradigm: Sony in China

• Ownership specific advantages: Sony possesses

a huge stock of knowledge and patents in the
consumer electronics industry, as represented by
products like the Playstation and Vaio laptop.
• Location specific advantages: Sony desires to
manufacture in China, to take advantage of China’s
low-cost, highly knowledgeable labor.
• Internalization advantages: Sony wants to maintain
control over its knowledge, patents, manufacturing
processes, and quality of its products.

Thus, Sony entered China via FDI

5-47
 Non-FDI Based Explanations:
International Collaborative Ventures

• A form of cooperation between two or more firms.

Partners pool resources and capabilities to create
synergies, and share the risk of joint efforts.

• Starting in the 1980s, firms increasingly began

using collaborative ventures to venture abroad.

• Collaboration provides access to foreign partners’

know-how, capital, distribution channels, or
marketing assets. Also helps overcome
government imposed obstacles.

5-48
 Two Types of
International Collaborative Ventures

• Equity-based joint ventures result in the formation of

a new legal entity. In contrast to the wholly-owned
FDI, the firm collaborates with local partner(s) to
reduce risk and commitment of capital.
• Project-based alliances do not require equity
commitment from the partners but simply a willingness
to cooperate in R&D, manufacturing, design, or any
other value-adding activity. Since project-based
alliances have a narrowly defined scope of activities
and timeline, they provide greater flexibility to the firm
than equity-based ventures.
5-49