Fundamentals of International Business


ECIS591: Lecture 1

Fundamentals of International Business

Theory of International Trade • Evolution of international trade based on – Collapse of feudal system (autarky) – Emergence of a mercantile philosophy • National expansion requires wealth (gold) to control colonies, support armies, maintain power • A simple plan – Promote exports, discourage exports, get paid in gold – Age of “mercantilism”

Decline of mercantilism • Inevitable • Industrial revolution introduced advantages of mass production • Exploitation of colonies stopped • Trade originated in the need for governments to control • Today’s international trade still significantly involves governmental bodies

Evolution of International Trade Theory Theory of Absolute Advantage

Each country should specialize in production and export of that good it produces most efficiently (least labor hours

• Adam Smith (1776) • Wealth of Nations • Two main contributions – Absolute advantage – Division of labor

Theory of Absolute Advantage • Absolute advantage – Some countries produce same products with fewer labor hours – Due to • Worker skills • Natural resources • Other factors

Valuable, but what about… • Smith’s theory suggests each country specializes in a particular product (for which it has absolute advantage) • More produced for less • If a country had no absolute advantage… could it play the game? Could it trade?

Evolution of International Trade Theory Theory of Comparative Advantage

Even if a country is efficient at producing two goods, it must be relatively more efficient in producing one of them. Should make that one and import the other

• David Ricardo (1819) • On the Principles of Political Economy and Taxation • Countries cannot be equally good at producing two products

Classical Trade Theory • Smith’s and Ricardo’s work considered Classical Trade Theories • Left us with some key concepts – Division of labor – Comparative Advantage – Gains from trading (nations can actually consume more than they produce through “free trade”)

Evolution of International Trade Theory Theory of Factor Proportions

Countries that are relatively labor (capital) abundant should specialize in the production and export of products that are labor (capital) intensive

• Heckscher-Ohlin • Two factors of production: labor, capital • Different products need different proportions of the two factors • Technology determine these proportions • Cost of production determined by cost of factors (assume no labor or capital movement)

Evolution of International Trade Theory The Leontief Paradox

Test of factor proportion theory which resulted in the unexpected finding that the US was actually exporting labor intensive products

• Wassily Leontief (1950) • Developed input-output analysis methodology • Found US was exporting labor-intensive products • Factor Proportion Theory predicts the opposite • Plenty of arguments

Evolution of International Trade Linder’s Overlapping Product Ranges Theory • Staffan Linder • Based on consumer preferences for products

Countries of similar income levels (per

• As per capita income increases, complexity, quality and diversity of product demands increase

capita) will trade most intensively with one another due to overlapping product

• Countries of similar income levels have overlapping product ranges


• Entrepreneurs would find it difficult o service dissimilar countries

Evolution of International Trade Product Cycle Theory

Countries with comparative advantage change over time as the product technology matures

Theory • Raymond Vernon (1966) • Two technology-based premises – Technical innovation is capital-intensive… found in industrialized countries – The innovation goes through stages of maturation… become low skill and shift across countries • Emphasizes technology’s impact on production

Evolution of International Trade Competitive Advantage of Nations Theory • Michael Porter • Nation’s competitive advantage based on

A country’s competitiveness depends on its ability to innovate… this comes from having strong domestic competition and demanding local customers

– Factor conditions – Demand conditions – Related and supporting industries – Firm strategy, structure and rivalry

Porter’s Diamond of National Advantage Firm strategy, structure and rivalry Factor conditions Demand conditions Supporting Industries

But, what about barriers to trade between countries?

• Trade is between a company and a buyer (not between countries) • Not always possible to simply manufacture and export from home country • Consider – Sales are restricted due to tariffs on imports – Product requires natural resources available in only some countries – Competition forces you to produce where it is cheaper

Foreign Direct Investment • Traditional theories assume immobility of capital • Not true today… movement of capital has allowed FDI across the globe • If there is competitive advantage to be obtained, the capital can get there…

The FDI Decision Sequence The Firm and its Competitive Advantage

Change CA

Exploit CA from abroad

Production at home

Production abroad


Control Assets


Wholly-Owned Affiliate Greenfield Acquire foreign unit

Why do firms go beyond licensing and exporting?

• Firms as Seekers • Firms as Exploiters of Imperfections • Firms as Internalizers

Firms as Seekers • In the 18 th and 19 th centuries, firms were seeking valuable natural resources of other countries • Now – Natural resources – Low-cost labor – Knowledge – Political stability – Markets

Firms as Exploiters of Imperfections • Not a perfect market (supply and demand) • Government interference leads to imperfections – Aim to support and protect domestic industries • Multinationals invest locally to sidestep these restrictions

Firms as Internalizers • Cannot firms achieve competitive advantage through licensing?

• Sometimes, core of business is the proprietary knowledge of the production process (Coca Cola, for example) • Internalization is better than an arm’s-length management in such situations

Free trade is nice in theory, but… • Theory is one thing… welcome to the real world • All countries place trade restrictions • The extent of the interference varies from country to country • Interference manifests itself in two forms – Tariffs – Non-tariff barriers to trade

Tariff barriers to trade • Tax levied on a good when it crosses the boundary of a customs area – Country boundary – “Group of nations” boundary • Also referred to as duties • Broken down into two types – Protective tariffs – Revenue tariffs

Tariffs contd.

• May be based on the physical quantity (per ton, per yard, etc.) … called a specific tariff • May be based on value of the import … called ad valorem tariffs • May be differentially applied depending on product’s country of origin

Non-tariff barriers • “Voluntary” Export Restraints (VERs) – Japanese cars (Italy 1992) – Non-human dolls (EU 1994)… yes to Kirk, no to Spock • Quotas – Quantitative restriction on number of units imported… usually applied through import license requirements

Why place such restrictions?

• Revenue • Infant-industry argument • Environmental concerns (Mexican tuna) • Competition from low-wage countries • National security and defense

Trade Agreements • May be bilateral or multilateral • Bilateral Agreements – Reciprocity – MFN Status • Multilateral – GATT – OECD

General Agreement on Tariffs and Trade (GATT) • Multilateral agreement that acts charter for most countries of the world (except most communist countries) • Signed in Geneva Oct. 1947: 23 countries which accounted for 4/5ths of world trade • Has gone through a number of rounds: Kennedy(1964-67), Tokyo(1973-79), Uruguay (1986-?)

Main GATT Principles • No trade discrimination (MFN status for all members) • Free trade groupings are acceptable as long as third countries do not face discrimination • Many, many exception clauses

Organization for Economic Cooperation and Development (OECD) • Originally formed by European nations in response to US offer of economic aid (post WWII) • Did much to improve trade within Europe • Expanded in 1960s and 70s to include USA, Canada, Japan, Australia, New Zealand

Goals of OECD • Promote economic growth of member nations • Contribute to growth of lesser developed countries • Foster conditions for world trade

Economic Integration • Takes many forms • Free Trade Association – No duty on imports from member states.. Each member may charge different duties to non members (EFTA) • Customs Union – All member states agree to charge same duties on non-member imports

Economic Integration contd.

• Common Market – Extends the Customs Union concept to include free flow of labor/capital between member states • Economic Union – Common market members agree to harmonize economic policies • Total Economic Integration

European Union • Most nations in Western Europe • Works toward economic and political integration • Also covers unified action in security, foreign affairs, and police matters • Common currency

Other Regional Groups • Central American Common Market (El Salvador, Guatemala, Nicaragua, Costa Rica) • The Latin American Integration Association (11 countries) – Andean Group is a sub group of LAIA • The Caribbean Community and Common Market (CARICOM)

Types of global enterprises • International • Global • Multinational • Transnational

The International Strategy • Subsidiaries leverage parent competencies • Coordinated federation

Global • R&D, manufacturing done at HQ • Strategic decisions are centralized • Central hub

Multinational • Multidomestic • Aims at local responsiveness • Knowledge developed/retained at subsidiary level • Decentralized federation

Transnational • Shared decision-making • Complex coordination • Centers of excellence • Dispersed resources • Integrated network