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International Trade and Investment Theory

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Chapter Objectives_1

• Understand the motivation for international trade• Summarize and discuss the differences among the classical

country-based theories of international trade• Use the modern firm-based theories of international trade to

describe global strategies adopted by businesses

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Chapter Objectives_2

• Describe and categorize the different forms of international investment• Explain the reasons for foreign direct investment• Summarize how supply, demand, and political factors influence

foreign direct investment

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International Trade

• Trade: voluntary exchange of goods, services, assets, or money between one person or organization and another• International trade: trade between residents of two countries

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Figure 6.2 Sources of the World’s Merchandise Exports, 2001

37%

12%7%

4%

40%

European UnionUnited StatesJapanCanadaOther countries

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The largest component of the annual $1.5 trillion trade in international services is travel and tourism

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Classical Country-Based Trade Theories

• Mercantilism• Absolute Advantage• Comparative Advantage• Relative Factor Endowments

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Mercantilism

• A country’s wealth is measured by its holdings of gold and silver• A country’s goal should be to enlarge holdings of gold and silver by • Promoting exports• Discouraging imports

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Modern Mercantilism

• Neomercantilists or protectionists• American Federation of Labor-Congress of Industrial Organizations• Textile manufacturers• Steel companies• Sugar growers• Peanut farmers

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Disadvantages of Mercantilism

• Confuses the acquisition of treasure with the acquisition of wealth•Weakens the country because it robs

individuals of the ability • To trade freely• To benefit from voluntary exchanges

• Forces countries to produce products it would otherwise not in order to minimize imports

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Absolute Advantage

• Export those goods and services for which a country is more productive than other countries• Import those goods and services for which other countries are more

productive than it is

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Table 6.1 The Theory of Absolute Advantage: An Example

Wine 2 1

Clock radios

3 5

France JapanOUTPUT PER HOUR OF LABOR

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Absolute Advantage’s Flaw

• What happens to trade if one country has an absolute advantage in both products?• No trade would occur

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Comparative Advantage

• Produce and export those goods and services for which it is relatively more productive than other countries• Import those goods and services for which other countries are relatively more productive than it is

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Differences between Comparative and Absolute Advantage

• Absolute versus relative productivity differences• Comparative advantage incorporates the concept of opportunity cost• Value of what is given up to get the good

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Table 6.2 The Theory of Comparative Advantage: An Example

Wine 4 1

Clock radios

6 5

France JapanOUTPUT PER HOUR OF LABOR

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Comparative Advantage with Money

• One is better off specializing in what one does relatively best• Produce and export those goods and services one is

relatively best able to produce • Buy other goods and services from people who are better at

producing them

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Table 6.3 The Theory of Comparative Advantage with Money: An Example

French Made

Japanese Made

French Made

Japanese Made

Wine €3 €8 ¥375 ¥1,000

Clock Radios

€3 €1.6 ¥250 ¥200

Cost of Goods in France Cost of Goods in Japan

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Relative Factor Endowments

• Heckscher-Ohlin Theory• What determines the products for which a country will have a

comparative advantage?• Factor endowments vary among countries• Goods differ according to the types of factors that are used to produce them

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Relative Factor Endowments_2

• A country will have a comparative advantage in producing products that intensively use resources (factors of production) it has in abundance• China: labor• Saudi Arabia: oil• Argentina: wheat

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Figure 6.3 U.S. Imports and Exports, 1947: The Leontief Paradox

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Modern Firm-Based Trade Theories

• Country Similarity Theory• Product Life Cycle Theory• Global Strategic Rivalry Theory• Porter’s National Competitive Advantage

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Growth of Firm-Based Theories

• Growing importance of MNCs • Inability of the country-based theories to explain and predict the

existence and growth of intraindustry trade• Failure of Leontief and others to empirically validate country-based

Heckscher-Ohlin Theory

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Firm-Based Trade Theories

• Incorporate additional factors into explanations of trade flows• Quality• Technology• Brand names• Customer quality

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Country Similarity Theory

• Explains the phenomenon of intraindustry trade• Trade between two countries of goods produced by the same industry

• Japan exports Toyotas to Germany• Germany exports BMWs to Japan

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Country Similarity Theory_2

• Trade results from similarities of preferences among consumers in countries that are at the same stage of economic development• Most trade in manufactured goods should be between countries with

similar per capita incomes

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Product Life Cycle Theory

• Describes the evolution of marketing strategies• Stages• New product• Maturing product• Standardized product

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Figure 6.4 The International Product Life Cycle: Innovating Firm’s Country

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Figure 6.4 The International Product Life Cycle: Other Industrialized Countries

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Figure 6.4 The International Product Life Cycle: Less Developed Countries

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Global Strategic Rivalry Theory

• Firms struggle to develop sustainable competitive advantage• Advantage provides ability to dominate global marketplace• Focus: strategic decisions firms use to compete internationally

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Sustaining Competitive Advantage

• Owning intellectual property rights• Investing in research and development• Achieving economies of scale or scope• Exploiting the experience curve

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Porter’s National Competitive Advantage

• Success in trade comes from the interaction of four country and firm specific elements• Factor conditions• Demand conditions• Related and supporting industries• Firm strategy, structure, and rivalry

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Figure 6.5 Porter’s Diamond of National Competitive Advantage

Firm Strategy, Structure,

and Rivalry

Related and SupportingIndustries

FactorConditions

DemandConditions

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The intense competitiveness of Japanese market forces manufacturers to continually develop and fine-tune new products

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Figure 6.6 Theories of International Trade

Country-Based Theories

• Country is unit of analysis

• Emerged prior to WWII

• Developed by economists

• Explain interindustry trade

• Include• Mercantilism• Absolute advantage• Comparative advantage• Relative factor endowments

Firm-Based Theories

• Firm is unit of analysis

• Emerged after WWII

• Developed by business school professors

• Explain intraindustry trade

• Include• Country similarity theory• Product life cycle• Global strategic rivalry• National competitive

advantage

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Types of International Investments

• Does the investor seek an active management role in the firm r merely a return from a passive investment?• Foreign Direct Investment• Portfolio Investment

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Figure 6.7 Stock of Foreign Direct Investment, by recipient

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Table 6.4 Sources of FDI for the U.S., end of 2002

United Kingdom 283.3

France 170.6

Netherlands 154.8

Japan 152.

Germany 137.0

Switzerland 113.2

Canada 92.0

Luxembourg 34.3

Bermuda, Bahamas, Caribbean islands 32.5

Other European countries 113.3

All other countries 65.0

Total 1,348.0

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Table 6.4 Destinations of FDI for the U.S., end of 2002

United Kingdom 255.4

Canada 152.5

Netherlands 145.5

Bermuda, Bahamas, Caribbean islands 98.1

Switzerland 70.1

Japan 65.7

Germany 64.7

Mexico 58.1

France 44.0

Other European countries 217.2

All other countries 349.7

Total 1,521.0

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International Investment Theories

• Ownership Advantages• Internalization• Dunning’s Eclectic Theory

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Ownership Advantages

• A firm owning a valuable asset that creates a competitive advantage domestically can use that advantage to penetrate foreign markets through FDI• Why FDI and not other methods?

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Internalization Theory

• FDI is more likely to occur when transaction costs with a second firm are high• Transaction costs: costs associated with negotiating, monitoring, and

enforcing a contract

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Dunning’s Eclectic Theory

• FDI reflects both international business activity and business activity internal to the firm• 3 conditions for FDI• Ownership advantage• Location advantage• Internalization advantage

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Table 6.5 Factors Affecting the FDI Decision

Supply Factors Demand Factors Political Factors

Production costs Customer access Avoidance of trade barriers

Logistics Marketing advantages Economic development incentives

Resource availability Exploitation of competitive advantages

Access to technology Customer mobility

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Ikea aggressively exports its furniture to other countries