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INTERNATIONAL BUSINESS

ENVIRONMENT

SESSION 2

International Exchange Theories

CAUTION!

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SLIDES ARE NOT ENOUGH TO FULLY GRASP THE

CLASS CONTENTS

YOU ARE ADVISED TO:

Take notes and participate during the class

Read reference textbooks and other materials as

recommended

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The environment of international business (reminder)

INTERNATIONAL ENVIRONMENT

National trade

policies

Global economic regulation

Intl. monetary

system

Regional agreements

DOMESTIC / FOREIGN ENVIRONMENT

Culture

Political/legal systems

Economic system

Economic policies

FIRM

Structure Strategy Operations

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International exchange theories: overview

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International Trade / Foreign Direct Investment

Country-based trade theories

Mercantilism

Absolute advantage

Comparative advantage

Factor proportion

Firm-based trade theories

Vernon's product life-cycle

New trade theory

Capital movement

theories

J. Dunning'seclectic theory

Market power theory

Management analyses

National competitiveness

theories

M. Porter's competitiveness

diamond

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"TRADITIONAL" COUNTRY-BASED INTERNATIONAL

TRADE THEORIES

Section 1

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Mercantilism

Original XVIIth century mercantilists, such as John Law, a Scots financier, believed that a country's economic prosperity and political power came from its stocks of precious metals.

To maximise these stocks they argued against free trade, favouring protectionist policies designed to minimise imports and maximise exports, creating a trade surplus that could be used to acquire more precious metal

http://www.economist.com/research/Economics/alphabetic.cfm?letter=M#mercantilism

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Absolute advantage (A. Smith)

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Absolute advantage refers to the ability of a person or a country to produce a particular good at a lower absolute cost than

another.

Absolute vs. comparative advantage (from CW Hill)

Absolute advantage Comparative advantage200 units of resources available per country

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(+2.5) (+1.25)

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Comparative advantage (D. Ricardo)

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Comparative advantage refers to the ability of a country to produce a particular good at a lower marginal or opportunity cost than another

country.

Comparative advantage explains how trade can create value for both parties even when one can produce all goods with fewer resources

than the other.

The net benefits of such an outcome are called gains from trade.

Gains from trade in a neoclassical perspective

D

S

d1

qd

P1Worldprice

P*Domesticprice

P

Q

E*

q*

s1

qs

Trade creation (imports)

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Comparative advantage: the factor proportion theory

For Eli Heckscher and Bertil Ohlin, comparative advantage arises from differences in relative national factor endowments – the extent to which a country is endowed with resources like labour and capital

The Heckscher-Ohlin-Samuelson (H-O-S) model predicts that countries will export goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce

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Questioning the H-O-S model: Leontief Paradox

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An analysis carried-out in 1947 concluded that the US exported labour-intensive commodities and imported capital-intensive commodities

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Beyond factor proportion: the gravity model

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Country i (Mi)

Country j(Mj)

Dij

Country k (Mk)

Djk

The competitive advantage of nations (M. Porter)

M. Porter's thesis is that national competitive advantage is not dependent on factor endowment alone, but on various factors that interact with each other to create conditions where innovation and

improved competitiveness occurs

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http://darleisimioni.blogspot.com/2010/09/michael-porter-o-brasil-emergente-no.html

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The competitive advantage of nations (M. Porter's diamond)

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Firm strategy, structure and

rivalry

Demand conditions

Related and supporting industries

Factor endowments

ChanceGovernment

Discussion: Britain's trade in the XIXth Century

Textile productsOpium

Tea, exotic products

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Cotton, Food products

What are the trade theories applicable to this case?

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"MODERN" FIRM-BASED INTERNATIONAL TRADE

THEORIES

Section 2

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Limitations of traditional trade theories

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Focused on trade between nations

Do not cover trade among

similar countries

Do not analyse long-term impact of international specialisation

Do not consider capital

movements

Do not cover intra-firm trade

Do not cover intra-industry

trade

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The product life-cycle theory (Graph by CW Hill)

According to Raymond Vernon's product life-cycle theory, both the

location of sales and the optimal production location will change as

products mature, affecting the flow and direction of trade, as well as

foreign direct investment

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The new trade theory (P. Krugman)

Tries to explain why trade is growing fastest between industrial countries

1. With similar economies and endowments of the factors of production

2. Trading similar goods (intra-industry trade)

Considers

1. Markets of imperfect competition (oligopolies)

2. Movement of capital (foreign direct investment)

3. Business and government strategies

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The new trade theory (ctd)

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Capital intensive industries

Economies of scaleSunk costs

Barriers to entry

Oligopolistic markets

The new trade theory (ctd)

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Oligopolistic markets

Internationalisation

First mover advantage

New markets

Diversification, specialisation

More products, lower production costs

Economies of scale, barriers to entry

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1. Trade is mutually beneficial because it allows for the specialization of production, the achievement of economies of scale, and the production of a greater variety of products at lower prices

2. The pattern of trade may result from economies of scale and first mover advantages (economic and strategic advantages that accrue to early entrants into an industry)

3. Selected government intervention (strategic trade policy) may support the development of strategic or export-oriented industries

The new trade theory (ccl)

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Conclusion: protectionism or free trade?

1. Mercantilism promotes government involvement in supporting exports and limiting imports

2. Smith, Ricardo and Heckscher-Ohlin show that it is beneficial for a country to engage in international trade even for products it is able to produce for itself. International trade allows a country:

To specialize in the manufacture and export of products that it can produce efficiently

To import products that can be produced more efficiently in other countries

3. The new trade theory supports international trade but justifies limited and selective government intervention to support the development of certain strategic and/or export-oriented industries (dynamic comparative advantage)

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Food for thought …

"An international economics course should drive home to students the point that international trade is not about competition, it is about mutually beneficial

exchange.

Even more fundamentally, we should be able to teach students that imports, not exports, are the purpose of trade. That is, what a country gains from trade is

the ability to import what it wants.

Exports are not an objective in and of themselves: the need to export is a burden that the country must bear because its import suppliers are crass enough to

demand payment".

Paul KRUGMAN, Pop Internationalism

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Application: Brazil-China trade pattern (debriefing)

1. Which theories could best explain the Chinese-Brazilian trade pattern?

2. Why are Brazilian authorities concerned with this bilateral trade structure?

3. What makes Brazil an attractive destination for Chinese foreign direct investment?

4. Why do you think that Brazil is reluctant to fully open up its economy to Chinese FDI?

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FOREIGN DIRECT INVESTMENT THEORIES

Section 3

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Defining foreign direct investment (reminder)

Definition

Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country

Greenfield investmentEstablishment of a wholly new operation in a

foreign country

Brownfield investmentAcquisitions or mergers with existing firms in

the foreign countryJoint ventureLegal entity formed between two or more parties to undertake an economic activity

together.

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Basic FDI motives

Market seekingNew or larger markets

Export substitutionTransport costs, trade barriers

Resource seekingNatural resources, workforce,

technology

Export complementaritiesOptimisation of value chain

(vertical integration)

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FDI and the product life-cycle (reminder)

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A company will begin by exporting its product and later undertake foreign direct investment as the product moves through its life cycle

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FDI, imperfect competition and market power

Search for market power

Foreign direct investment

Vertical integration

Control over inputs (backward integration)

Control over outputs (forward integration)

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Dunning's "eclectic theory" of FDI (ILO)

• Response to – actual or threatened – trade barriers

• Need to control foreign business activity (firms try to internally capture the advantages of foreign asset ownership)

Internalisation

• Resource endowments (capital, labour) or assets (incl. location externalities) that are tied to a particular location

Location

• Firms endowed with a distinctive competitive advantage (technology, brand, economies of scale) will try to take advantage of large number of markets

Ownership

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Managerial analysis of FDI

Control

Followingrivals

Purchase-or-builddecision

Customer knowledge

Production costs

Followingclients

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Alternatives to trade/FDI: licensing and franchising

A licensing agreement grants a foreign entity the right to produce and sell the firm's product in return for a royalty fee on every unit that the foreign entity sells

Franchising is a specialised form of licensing: the franchisor not only sells intangible property to the franchisee, but also insists that the franchisee agree to abide by strict rules as to how it does business

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The Geely-Volvo case

1. Why did GEELY decide to acquire VOLVO?

2. Why did FORD decide to sell VOLVO?

3. Can you analyse the sale of VOLVO by FORD

and its acquisition by GEELY in the light of the current global economic and geopolitical context?

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