International Business
by
Daniels and Radebaugh
Chapter 5
International Trade
Theory
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5-1
Objectives
To explain trade theories
To discuss how global efficiency can be increased through free trade
To introduce prescriptions for altering trade patterns
To explore how business decisions influence international trade
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5-2
Companies’ International Operations Link Countries Economically
OBJECTIVES
STRATEGY
MEANS OF OPERATING
• Importing and exporting
goods and services (trade)
• Transferring production
factors, such as labor and
capital, internationally
Country B
Country A
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5-3
Introduction
Trade in goods and services is one means by which countries are linked
economically
Types of trade theories
• Descriptive—deal with natural order of trade
– examine and explain trade patterns under laissez-faire
conditions
• Prescriptive—concerned with government interference in the free
movement of goods and services
– considers governments’ affect on the amount, composition,
and direction of trade
• Both types of theories
– provide insights about markets for exports and potentially
successful export products
– help companies determine where to locate production
facilities
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5-4
Mercantilism
Foundation of economic thought from 1500—1800
• Intended to benefit colonial powers
– colonies supplied commodities to the mother country
– mother country tried to run trade surpluses with their own
colonies
• A country’s wealth determined by its holding of treasure, usually
gold
• Countries should export more than they import
– favorable balance of trade
– governments imposed restrictions on imports
– governments subsidized many products that could not
otherwise compete in domestic or export markets
• Mercantilism faded after 1800
Neomercantilism—attempt to achieve favorable trade balances to
achieve social or political objectives
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Absolute Advantage
Adam Smith—different countries produce some goods more efficiently
than other countries
• Free trade increases global efficiency
• Each country will specialize in products that give it a competitive
advantage
– labor becomes more skilled by repeating tasks
– no time lost switching from production of one kind to
production of another kind
– long production runs provide incentives for development of
more effective work methods
• Natural advantage—stems from climatic conditions, access to
certain natural resources, or availability of certain labor forces
• Acquired advantage— based on technology and skill
development
– product technology
– process technology
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Production Possibilities with Absolute Advantage
ASSUMPTIONS for Sri Lanka
1. 100 units of resources available
2. 10 units to produce a ton of wheat
3. 4 units to produce a ton of tea
4. Uses half of total resources per product
when there is no foreign trade
ASSUMPTIONS for United States
1. 100 units of resources available
2. 5 units to produce a ton of wheat
3. 20 units to produce a ton of tea
4. Uses half of total resources per product
when there is no foreign trade
25
Without Trade:
Sri Lanka (point A)
U.S. (point B)
Total
With Trade:
Sri Lanka (point C)
U.S. (point D)
Total
Tea Wheat
(tons) (tons)
12.5
2.5
15.0
25
0
25
5
10
15
0
20
20
U.S. production possibilities
Quantity of Tea (tons)
PRODUCTION
C
Sri Lankan production possibilities
20
15
A
10
5
B
0
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D
10
5
15
20
Quantity of Wheat (tons)
25
5-7
Comparative Advantage
David Ricardo—gains from trade will occur even in a country that has
absolute advantage in all products because the country must give up
less-efficient output to produce more-efficient output
Country should specialize in products it can make most efficiently, even
if other countries can make the product more efficiently
Theory accepted by most economists
• Theory is influential in promoting policies for freer trade
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5-8
Production Possibilities with Comparative Advantage
ASSUMPTIONS for Sri Lanka
ASSUMPTIONS for United States
1. 100 units of resources available
1. 100 units of resources available
2. 10 units to produce a ton of wheat
2. 4 units to produce a ton of wheat
3. 10 units to produce a ton of tea
3. 5 units to produce a ton of tea
4. Uses half of total resources per product
4. Uses half of total resources per product
when there is no foreign trade
Without Trade:
Sri Lanka (point A)
U.S. (point B)
Total
Tea Wheat
(tons) (tons)
5
10
15
With Trade (increasing
tea production):
Sri Lanka (point C)
10
U.S. (point D)
6
Total
16
With Trade (increasing
tea production):
Sri Lanka (point C)
10
U.S. (point E)
5
Total
15
5
12.5
17.5
0
17.5
17.5
0
18.75
18.75
Quantity of Tea (tons)
PRODUCTION
when there is no foreign trade
25
U.S. production possibilities
20
Sri Lankan production possibilities
15
10 C
B
D
5
A
0
E
10
5
15
20
Quantity of Wheat (tons)
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5-9
Assumptions and Limitations of Theories of Specialization
Both absolute and comparative advantage theories are based on
specialization
• Countries should trade output based on their own specialization
for the output from other countries specialization
Full employment— not valid assumption
Economic efficiency objective—countries’ goals may not be limited to
economic efficiency
Division of gains—if trading partner is perceived to be gaining too large a
share of benefits, other partner may forgo absolute gains to prevent
relative losses
Two countries, two commodities—original two-country, two-product logic
applies to more complex situations
Transport costs—may negate advantages of trading
Size of economy and production scales—longer production runs, less
production abroad
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Factor-Proportion Theory
Eli Heckscher and Bertil Ohlin—relative factor costs lead countries to
excel in the production and export of products that used their
abundant, and therefore cheaper, production factors
Land-labor relationship—in countries in which there are many people
relative to the amount of land, land price is very high because it’s in
demand
• Land costs and technology dictate what types of industries
choose to locate in a country
Labor-capital relationship— production factors, especially labor, are not
as homogeneous as assumed
• Labor skills vary within and among countries due to differences in
training and education
– led to international specialization by task to produce a given
product
Technological complexities—the same product can be produced by
different methods (labor or capital)
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Product Life Cycle Theory of Trade (PLC)
Raymond Vernon—the production location for many products moves
from one country to another depending on the stage in the product’s
life cycle
Stage 1: Introduction
• Innovation, production, and sales in same country
– new products developed in response to nearby observed
need and markets for them
– early production occurs in domestic location
• Location and importance of technology
– most new technology that results in new products and
production methods originates in industrial countries
• Exports and labor
– export small part of production
– production process likely to be labor intensive
– capital machinery for large-scale production develops later in
industrialized countries
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Product Life Cycle Theory of Trade (cont.)
Stage 2: Growth
• Increases in exports by the innovating country
• More competition
• Increased capital intensity
– growing sales offer incentives to companies to develop
process technology
• Some foreign production
Stage 3: Maturity
• Decline in exports from the innovating country
• More product standardization
• More capital intensity
• Increased competitiveness of price
• Production start-ups in emerging countries
Stage 4: Decline
• Production increased in emerging economies
• Innovating country becoming net importer
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Product Life Cycle Theory of Trade (cont.)
Verification and limitations of plc theory
• High transportation costs limit export opportunities, regardless of
the life cycle stage
• Shifts in production site do not change for many types of products
– innovating country maintains its export ability throughout the
life cycle
» products with very short life cycles
» luxury products for which cost is not a concern for the
consumer
» products used to promote differentiation strategy
» products requiring specialized technical labor to evolve
• MNEs increasingly introduce new products at home and abroad
simultaneously
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Country-Similarity Theory
Economic similarity of industrial countries
• Most of the world’s trade occurs among countries that have
similar characteristics
– country similarity theory—once a company has developed a
new product to serve needs in a local market, it will turn to
markets it sees as most similar to those at home
– most trade takes place among industrial countries because:
» growing importance of acquired advantage as opposed
to natural advantage
» markets in industrial countries can support products and
their variations
» importance of industrial markets due to their size
» incomes are high and people buy more
• Few emerging countries trade with each other
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5-15
World Trade by Major Product Category as
Percentage of Total World Trade for Selected Years
100
3.7
2.8
14.7
12.3
20.7
14.2
8.6
Percentage
80
7.9
27.7
60
40
70.7
Commercial services
62.8
53.9
Agricultural products
20
Mining products
Manufactured products
0
1980
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1990
1998
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Country-Similarity Theory (cont.)
Similarity of location
• Distances among countries accounts for many world trade
relationships
• Methods to overcome distance disadvantages are difficult to
maintain
Cultural similarity
• Importers and exporters find it easier to do business in a country
perceived as being similar
• Historic colonial relationships explain much of international trade
Similarity of political and economic interests
• Political relationships and economic agreements among countries
may discourage or encourage trade between them or their
companies
• Military conflicts disrupt trade patterns
• Political animosity may interfere with trading channels
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Degree of Dependence
Independence—complete economic independence
• Country has no reliance on other countries for goods, services, or
technologies
• Price of independence is having to do without goods that cannot
be produced domestically
• Hinders country’s ability to borrow and adapt existing
technologies
Interdependence— trade based on mutual need
• Neither trading partner is likely to cut off supplies or markets for
fear of retaliation
• Governments may be pressured to sustain trade
Dependence—developing countries rely heavily on:
• The sale of one commodity for export earnings
– 25 % of emerging countries sell one commodity
• One country as supplier or customer
• Industrialized countries
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Strategic Trade Policy
Governmental role and influence in affecting the acquired advantage of
production within their borders
• Alter conditions for industries in general
– change conditions that affect factor proportions, efficiency,
and innovation
• Target conditions for a specific industry
– typically results in no more than small payoffs
» hard to identify and target appropriate industries
» too many countries identify the same industry, leading to
excessive competition
» relative conditions change, causing relative capabilities
to change as well
– have been a few notable government successes in targeting
a specific industry
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The Porter Diamond
Indicates four important conditions for competitive superiority
• Demand conditions—observation of need or demand
– usually in home country
– production started near the observed market
• Factor conditions— availability and terms for acquiring them
• Related and supporting industries—existence of infrastructure
• Firm strategy, structure, and rivalry
– influenced by other three conditions
Existence of the four favorable conditions does not guarantee that an
industry will develop in a locale
Absence of one of the four conditions from a country may not inhibit
companies from becoming globally competitive
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Determinants of Global Competitive Advantage:
The Porter Diamond
Firm Strategy,
Structure, and
Rivalry
Factor
Conditions
Demand
Conditions
Related and
Supporting
Industries
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Companies’ Role in Trade
Most trade theories based on a national perspective
• Decisions to trade are usually made by companies
Strategic advantages of exports
• Use of excess capacity—companies leverage their competencies
by using them abroad
• Cost reduction
– experience curve effect—cost reductions stemming from
increased output
• Freater profitability—may have higher profit margins in foreign
markets
• Risk spreading—counterbalance business cycles in different
countries
Strategic advantages of imports
• Procurement of supplies abroad may lower costs
• Foreign products complement existing products
• Reduces dependence on single suppliers
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