CHAPTER 3
THE THEORY OF
TRADE AND
INVESTMENT
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Copyright © 2011 John Wiley & Sons
Chapter 3
Learning
Objectives
Chapter 3
1.
To understand the traditional arguments of how
and why international trade improves the welfare
of all countries
2.
To review the history and compare the
implications of trade theory from the original
work of Adam Smith to the contemporary
theories of Michael Porter
3.
To examine the criticisms of classical trade
theory and examine alternative viewpoints of
which business and economic forces determine
trade patterns between countries
4.
To explore the similarities and distinctions
between international trade and international
investment
5.
To evaluate the trade theories of Paul Krugman
and Michael Porter and their relationship to
business and government’s approaches to trade
policy
6.
To understand the theory of international
investment and how it relates to firms and buyers
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Foundation Questions

Why do countries trade?

Do countries trade or do firms trade?

Do the elements that make a firm, industry, or country
competitive change with time and circumstance?

Once identified, can sources of competitiveness be
manipulated or managed by firms or governments to the
benefit of traders?
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McDonald’s Global Reach
International Business makes good business sense for McDonalds corporation.
Although the United States was the first successful market for the company, it
now does business in dozens of countries world wide. In fact, only 28 percent
of total revenue generated in 2009 came from the U.S. market. See the
geographic breakdown of revenue below for details:
•
•
•
•
U.S.: 28%
Europe: 43%
Asia/Pacific/Middle east/africa (APMEA): 24%
Other and Corporate: 5%
Source: McDonald’s 2009 Annual Report: http://www.aboutmcdonalds.com/mcd
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The Age of Mercantilism
 Three major events have led to the evolution of
trade in the form we see today:

The collapse of feudal society
 State

of autarky where only basic needs were met
Emergence of a mercantilist philosophy
 Focus
was on increasing a nation’s power
 Strength in gold and silver

Life cycle of the colonial systems of the European nationstates
 Industrialization
and mass production
 Lowering prices and increasing supplies
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The Evolution of Trade Theory
The Theory of Absolute Advantage
Adam Smith, 1776
The Theory of Comparative Advantage
David Ricardo, 1819
The Theory of Factor Proportions
Eli Heckscher and Bertil Ohlin, early 20th Century
The Leontief Paradox
Wassily Leontief, 1950
Overlapping Product Ranges Theory
Staffan Burenstam Linder, 1960s
Product Cycle Theory
Raymond Vernon, 1966
Imperfect Markets/Strategic Trade
Paul Krugman, 1980s
The Competitive Advantage of Nations
Michael Porter, 1990s
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Absolute Advantage &
Comparative Advantage
Absolute Advantage Theory
Comparative Advantage Theory
 Adam Smith, The Wealth of
 David Ricardo, The Principles
Nations, 1776
of Political Economy and
Taxation, 1819
 Division of labor in the
production process
 Involves producing a good
 Each country should
more cheaply relative to other
goods in other countries
specialize in a product for
which it is uniquely suited
 Each country possesses
 Countries could produce
more and engage in trade for
products not produced at
home
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comparative advantage in
something, and both countries
would benefit from trade
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Classical Trade Theory
Concluding Points:
Division of
Labor
Comparative
Advantage
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Gains from
Trade
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Factor Proportions Trade Theory
 Developed by Heckscher, expanded by Ohlin
 Factor prices determine cost differences
 Factors of production include labor and capital
 Technology determines the way factors combine to form a good
 Prices are determined by the endowments of labor and capital
 Country’s endowment determines the relative costs of labor and
capital
 Leontief Paradox
 Leontief used input-output analysis to determine the relative
amounts of labor and capital in a good
 Finding: the U.S. was actually exporting products that were relatively
labor intensive, contradicting the Factor Proportions Theory
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Focus on Politics:
When the Numbers Don’t Add Up
International trade statistics between countries often do
not match. One reason for the discrepancy is geographic
coverage definitions. For instance, the U.S. considers
Puerto Rico and the U.S. Virgin Islands as part of the
United States, and Mexico regards them as separate
countries.
Another problem is partner country attribution w here forms
allow for the reporting of a single country of origin. The
p r o d u c t m a y h a v e b e e n m a d e i n m o r e t h a n o n e c o u n t r y.
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Linder’s Overlapping Product
Ranges Theory
 Linder’s work focused on the preferences of consumers




rather than production or supply
Trade in manufactured goods was dictated by product
demands across countries
The type, complexity, and diversity of product
demands of a country increase as the country’s income
increases
Directors of firms are more knowledgeable about the
domestic market than about foreign markets
The overlapping product ranges described by Linder
were later termed market segments
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Focus on Politics:
The U.S. Trade Deficit Fix - Global
Financial Crisis
One of the fastest ways to shrink trade deficits is
economic recession. The global financial crisis that began
in 2007 was based largely in the United States, and it was
the factor that forced Americans to stop spending.
H o w e v e r, t h i s a l s o p u t a h a l t t o i n t e r n a t i o n a l t r a d e a n d
brought a globalized world economy to a halt.
In 2009, it was still not clear whether a permanent change
in spending and saving w ould result.
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Product Cycle Theory
 Developed by Raymond Vernon in 1966
 Focused on the product, not its factor proportions
 Information, knowledge, costs, and power all have a role
 Vernon added two premises to the factor-cost
emphasis of existing theory:


Technical innovations predominantly occur in highly
industrialized capital intensive countries
Technical innovations go through three stages of maturation
 A limitation of this theory is that it does not apply to
all industries

Technology industries are the most applicable
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Stages of the Product Cycle
Stage I: New
Product
• Nonstandardized
product
• Requires high
degree of flexibility
Stage II: Maturing
Product
• Increasingly
standardized
• Need for flexibility
declines
• High costs to the
firm
• Demand for skilled
labor declines
• Consumers buy
regardless of price
• Variations develop
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Stage III:
Standardized
Product
• Completely
standardized
• Thin profit margins
• Fierce competition
• Price an increasing
concern
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Apple’s Mac Growth Potential Overseas
Despite being overshadowed by Apple’s own iPhone and the iPad, market
consultants believe that Apple's Mac business has plenty of revenue growth left
to exploit.
Apple has the opportunity to add an incremental $5 to $7 billion to its revenue
stream by increasing its international market share in what they call the midrange PC target zone (priced between $700 - $1,119). Most of Apple’s growth
has been in the high end of the U.S. market.
Apple’s U.S. share of the mid-range PC target zone in 2009 was 22%.
However, it currently has only a 2% share of the mid-range market overseas.
Source: Fortune.com -- http://tech.fortune.cnn.com/2010/05/27/how-the-mac-picks-up-an-easy-5-7-billion/
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Economies of Scale
 Paul Krugman focused on cost of production and how
cost and price drive international trade

Internal Economies of Scale
The larger the firm the greater the scale benefits, and the lower the
cost per unit
 A firm could then monopolize an industry and create an imperfect
market


External Economies of Scale
A country can dominate world markets if its industry can gain
economies of scale
 The industry can then maintain its dominance in the world market

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Strategic Trade
Price
Government can impose tariffs to offset the
monopolistic power of a foreign firm
Cost
Governments protect the market from
foreign competition to allow domestic firms
to grow and gain economies of scale
Repetition
Government protection until the firm learns
through repetition how to produce the
product more efficiently
Government protects and nourishes an
Externalities industry where it believes future growth can
be achieved
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The Competitive Advantage of Nations
 According to Michael Porter, a nation’s
competitiveness depends on the capacity of its
industry to innovate and upgrade
 Four major components that drive and sustain
competitiveness:
Factor
Conditions
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Related and
Supporting
Industries
Demand
Conditions
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Firm
Strategy,
Structure,
and Rivalry
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The Foreign Direct Investment Decision
 Exploit competitive advantage in new foreign
markets or in the domestic market?
 Produce at home and export or produce abroad?
 License production or try to control assets abroad?
 Use a joint venture or a wholly owned affiliate?
 Acquire an existing foreign enterprise or build
“from the ground up” (greenfield investment)?
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The Theory of Foreign Direct Investment
 What motivates a firm to go beyond exporting or
licensing?
 Firms as seekers – A firm that expands across
borders seeks sources of profit or opportunity:
Seeking resources
 Seeking factor advantages (such as low cost labor)
 Seeking knowledge
 Seeking security
 Seeking markets

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France’s Carrefour Bets on India
95 percent of retail shopping in India occurs in mom-and-pop stores called
kirana shops. Organized outlets (supermarkets, hypermarkets and
department stores) account for just 5 percent of the $450 billion retail market.
Thanks to robust economic growth and a fast-expanding middle class, big
retailers are starting to cash in on an emerging retail market in India.
The latest retail giant to arrive is Carrefour, which will open its first outlet in
Delhi in July 2010, with more shops scheduled for other cities later in the year.
The French firm follows Wal-Mart, the world’s biggest retailer, which last year
opened its doors in Amritsar, India.
Carrefour has waited nearly a decade, deterred by restrictive laws that let
foreigners invest a 51 percent stake in only single-brand stores.
Source: The Economist -- http://www.economist.com/node/16168260
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The Theory of Foreign Direct Investment
 Firms as Exploiters or Imperfections



Imperfections in access (to avoid tariffs)
Imperfections in factor mobility (using the mobility of capital
to take advantage of the immobility of labor)
Imperfections in management
 Firms as Internalizers
 By establishing their own multinational operations, firms
can internalize the production
 Confidential information is kept at the core of the firm’s
operations
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Focus on Politics:
Bridging the Red Sea
Ta r e k b i n L a d e n i s l e a d i n g a p r o j e c t t o b u i l d a 2 9 k i l o m e t e r - l o n g b r i d g e f r o m D j i b o u t i t o Ye m e n , t r a v e r s i n g
the Red Sea.
The bridge w ould link the Arabian Peninsula and Africa,
a n d w o u l d p r o v i d e a b a s e f o r h i g h w a y, r a i l w a y, a n d
pipeline conduits. It would connect drought -stricken
Djibouti w ith valuable resources.
B e c a u s e D j i b o u t i a n d i t s n o r t h e r n n e i g h b o r, E r i t r e a h a v e
a long-standing border dispute, this plan may not come to
fruition.
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