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Copyright © 2017 Pearson Education, Inc.

International Business: The New Realities, 4th Edition

by

Cavusgil, Knight, and Riesenberger

Theories of International

Trade and Investment

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.Copyright © 2017 Pearson Education, Inc.

5-2

Theories of International Trade and Investment

Copyright © 2017 Pearson Education, Inc. 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).


Free Trade

• 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.

The absence of restrictions to the

flow of goods and services among nations.


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.


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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?


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.

Copyright © 2017 Pearson Education, Inc. 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).


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)


Adam Smith (1723-1790)


Source: creativehearts/123RF

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)


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Comparative Advantage Principle (cont’d)

“Two men can make both shoes and hats, and one is superiorto 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 theinferior man in making hats?” David Ricardo, 1817



• 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

other product. Copyright © 2017 Pearson Education, Inc.

5-14


• 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.


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

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.


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

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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.


International Product life Cycle Theory (cont’d)


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.



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.

International Product life Cycle Theory (cont’d)


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.


Comparative vs. Competitive Advantage


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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 Copyright © 2017 Pearson Education, Inc.

5-25

Critical Role of Productivityin 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

nation’s standard of living.Copyright © 2017 Pearson Education, Inc.

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


Diamond ModelSources 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.


• 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.


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• Demand conditions at home – the strengths

and sophistication of customer demand.


ExampleJapan is a densely populated, hot, and humid countrywith very demanding consumers. These conditionsled Japan to become one of the leading producers ofsuperior, compact air conditioners


• 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. Copyright © 2017 Pearson Education, Inc. 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.


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.


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.


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.


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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.

Transformation of New

Zealand’s Economy, 1992 to 2014


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.


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.Copyright © 2017 Pearson Education, Inc.

5-39

Stages in Company Internationalization

Experimental Involvement

Committed Involvement

Active Involvement

Pre-export Stage

Domestic Focus


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/

pages/Statistics.aspx. 5-42

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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.



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.Copyright © 2017 Pearson Education, Inc.

5-45


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.


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


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.


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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.

Copyright © 2017 Pearson Education, Inc. 5-49 Copyright © 2017 Pearson Education, Inc. 5-50

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