Inter Trade Theories

THEORIES OF
INTERNATIONAL TRADE
1
THEORIES OF INTERNATIONAL
TRADE
At the end of this module, the learning
outcomes are
• Understanding the contributions of various
experts in explaining international trade
• What are the criticisms of such theories
• Appreciate the concepts of international
trade and international investment
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• International business
by
Czinkota and Ronikanein
Chapter 1
• International Business by Ashwathappa
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Various theories
• Classical trade theories
Theory of absolute advantage
Theory of comparative advantage
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Theory of absolute advantage
• Created by Adam Smith
• 18th century
• Two main areas of contribution
– Absolute advantage
– Division of labour
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Absolute advantage
• To produce 1 Maruti Esteem car, number
of labour hours used by each country are
– India 16 hours
– Australia 24 hours
– Kenya 22 hours
• India is the most efficient producer.
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• This could be due to
– Worker skills
– Quality of natural resources
– Quality of other resources
• India has an absolute advantage over
Australia and Kenya for production of
Maruti Esteem
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TRADE
DIVISION OF LABOUR
McDonald’s Burger
• Production process
• Mixing of raw material
• Putting in electric oven
• Assembling the final burger
• Packing
• Handing over to customer
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Two alternatives
• Alternative 1
– One worker carries out all five production
processes
• Alternative 2
– One worker specializes in one production
process only
• Which is a better alternative
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Studies found out that
• Alternative is 2 better than alternative 1
• Each worker specializes in one activity
• Specialist
• Higher production
• More profit
• This is division of labour
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THEORY OF COMPARATIVE
ADVANTAGE
• Initiated by David Ricardo
• 19th century
• Worked further on the ideas of Adam
Smith as it did not explain what caused the
production advantage
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Ricardo’s concept
• If a country possessed absolute
advantage in production of two products, it
still must be relatively more efficient than
the other country.
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• Absolute and comparative advantage
• Wheat Cloth
• Country
• England 1 2
• France 2 1
• No of hours required to produce one unit

of wheat/cloth
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• England more efficient in production of
wheat
• France in cloth
• The two countries are exactly opposite in
relative efficiency of production
• What will you recommend
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• England should specialize completely in
Wheat
• France in cloth
• Suppose England produces 100 kg of
wheat
• Own demand 50 kg
• Surplus 50 kg
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• Suppose France produces 100 kg of cloth
• Own demand 50 kg
• Surplus 50 kg
• England should export 50 kg of wheat to

France
• France should export 50 kg of cloth to
England
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• Based on the above trade happens
between England and France
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Implications-Classical trade theory
• No country has comparative advantage of all
products
• Each country will have comparative advantage
in few products
• Each country has economic role to play in
international trade
• Every country could improve the welfare of their
populations through international trade
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FACTORS PROPORTIONS TRADE
THEORY
• Developed by Eli Hecksher
• Swedish economist
• Subsequently improved by Bretlin Ohlin
• Major theory
• Widely accepted
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The concept
• Two factors of production
– Labour
– Capital
• Technology is a combination of these two
• Each product requires different proportions
of the two factors of production
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Labor intensive process
• Leather shoes
• Handicrafts
Capital intensive process

• Computer chip
• Wrist watch
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India versus USA
India
• Large amount of labor
• Less capital
• Should specialize in the production and
export of labor-intensive products
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USA
• Relatively cheap capital
• Expensive labor
• Specialize in the production and export of
capital-intensive products
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• India should buy capital intensive products
from USA.
• Vice-versa for USA
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Factor theory assumes
• A country should specialize in the
production and export of those products
that use its relatively abundant factor.
• Comparative advantage is derived not
from the productivity of a country, but from
the relatively abundance of its factors of
production
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Assumptions
• 2*2*2 assumption
– 2 countries
– 2 products
– 2 factors of production
• 2 factors of production
• Perfect competition exists
• Price per unit remains same
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INTERNATIONAL INVESTMENT AND
PRODUCT CYCLE THEORY
• Initiated by Raymond Vermon

• In 1966
• Three stages of the product cycle
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STAGE 1
The new product
• For innovation
• R&D
• Requires
• Highly skilled labour
• Large capital
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STAGE 1
• product non standardized initially
• high cost of production
• Innovator enjoys monopoly
• High profit margins
• Low price elasticity
• High income consumers buy
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STAGE 2
The maturing product
• Sales increases
• Production expands
• Process increasingly standardized
• Manufacturing flexibility declines
• Increase their sales to other countries
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• Competitor enter
• Pressure on margins
• Issues
– Invest in other countries
– Lose markets share to competitors
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STAGE 3
The standardized product
• Product completely standardized in
manufacture
• Production where labor cost is low
• Capital access not a problem
• Many competitors
• Fierce competition
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• Country of competitive advantage shifts
from home country to foreign country
• Will shift from one country to another
country
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Contributions of production cycle theory
• Explains international investment
• Shifts focus from country to product
• How to stay competitive as product cycle
changes
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NEW THEORY
COMPETITIVE ADVANTAGE OF NATIONS
• Created by Michael Porter
• A nation’s competitiveness depends on
– Capacity to Innovate
– Upgrade their technology
– Pressure and Challenge within country
– Strong domestic rivals
– Aggressive home-based suppliers
– Demanding local customers
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Four Major Components
Porter Diamond of National Advantage
1. Factor Conditions
• Appropriateness of the nation’s factors of production to
compete successfully in a specific industry
• Factor conditions are important but not the only source
of competitiveness as suggested by factors theory
• It is the ability of the nation to continually create,
upgrade and deploy its factors (say skilled labour)
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2 Demand Conditions
• Degree of competition in home market
• If you survive in highly competitive local
market, you gain competitive edge
• Character (say demanding Customers)
not size determines continuing
competitiveness
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3 Related and supporting Industries
• Competitiveness of all related industries
and suppliers to the firm
• Close working relationship
• Proximity to suppliers
• Timeliness of production and information
flows
• Willingness of firms to work with each
other.
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4 Firm Strategy, Structure & Rivalry
• Conditions in the home nation that either
hinder or aid in the firm’s creation and
sustaining of international
competitiveness
• No one strategy is universally
appropriate
• Depends on conditions
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Example
Porter’s competitive advantage of nations
• U.S.
– Semiconductors
– Software
• Japan
– Consumer Durables
– Automobiles
• France
– Aviation
– Wines
• India
– Leather
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THEORY OF INTERNATIONAL INVESTMENT
• Why invest is another country
• Tariffs imposed by other country
• Restricted raw material availability in certain areas of the
world
• Competition
– Improve efficiency
– Decrease cost of production
– Produce where cheaper
• Cheaper capital
• Cheaper energy
• Cheaper natural resources
• Cheaper labour
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International Investment
– Mobility of capital
– Basic assumption
– Foreign direct investment decisions
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Foreign Direct Investment Decision
• Exploit competitive advantage in new foreign
markets versus domestic markets
• Produce home and export versus produce
abroad
• Degree of control over
– Assets
– Technology
– Information
– Operations
• Magnitude of capital that the firm must risk.
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Decisions would be required
• Licensing
• Joint Venture
• Franchising
• 100% Subsidiary……Many more
• Trade off between risk of capital and
control of operations
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EXPORTING
• Ease in implementing
• Minimal risks
• Is it an optimal strategy?
• Home currency strong?
– Japanese in 80’s
– Invest abroad – compulsion
– Sony, Toyota going beyond domestic
boundaries
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TRADE
LICENSING
• Hesistant to Invest
• Exports ineffective
• Agreement to use property
– Patents
– Trademarks
– Knowhow
• Holiday Inn worldwide
• Mitsubishi cars in India.
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LICENSING
• Spread costs
• Incremental Income
• Negligible expenses
• Trade barriers
– Import restrictions
– Foreign ownership sensitivity
– Test out country
• Avoid substantial risks
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LICENSING
• Strong brand names
– McDonald’s
• Reinforces image
• What if licencee performs poorly
• Control on licensee operations
– McDonalds
• Do’s and Don’t’s critical
• LDC’s
– Gross misuse of trademarks
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JOINT VENTURE
• Financial participation of partners
• Foreign partner
– Unfamiliar markets
– Local partner
• Political lobbying
• Local issues
• Reduces resources on each partner
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JOINT VENTURE
• Major foray – foreign markets
• Policies vary
– India – JVs allowed in certain category
– Centrally planned
• Only JVs
• Risk perception of country high may be JV
only.
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TRADE
JOINT VENTURE
• Honda’s operations in India.
• Who controls what critical?
• Peugeots exit from India
• Pull out, worldwide restructuring withdrawing
from business
• Control?
• 50 : 50 problem?
– No majority control
– Maruti – Suzuki
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TRADE
MANUFACTURING
• Sourcing rather than selling
• GM
– Global sourcing
– Radiator caps – Sundaram Fasteners
• Gain access to raw materials
• Low Labour costs
– Software from India
• Competitive prices, as no import tariffs
• How will labour costs behave?
• GM’s Opel had to move out of Germany
• Taxation
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ASSEMBLY
• Variation of manufacturing
• Parts produced in various countries
• Labour intensive LDC’s
• Products in mature stage
• Consumer electronics
• Taiwan favourite destination
• Local Content issues
»
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TRADE
MANAGEMENT CONTRACT
• Popular in services
• Hilton running a local hotel
• Hilton paid fees
• Local – lacks expertise
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TRADE
ACQUISITIONS
• Rapid entry
– Daewoo’s entry in India
– Daichi buying Ranbaxy
• Replaces ownership
• Local pride hit
• Legal hurdles
• Complex, expensive, risky.
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Inter Trade Theories

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THEORIES OF

• International Business by Ashwathappa

• No of hours required to produce one unit

• England should export 50 kg of wheat to

Capital intensive process

• Initiated by Raymond Vermon

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