Theories of International Trade

Lecture Notes # 5.1

Theories of International Trade

Abdulghany Mohamed, Ph.DSprott School of BusinessCarleton University

Fall 2014

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Table of Contents

Table of Figuresii1.0 Introduction12.0 Theories of International Trade22.1 Mercantilism42.2 Theory of Absolute Advantage42.3 Theory of Comparative Advantage52.4 Factor Endowment Models6

2.4.1 Factor Proportions Theory (Heckscher-Ohlin Model)7(a)The Heckscher-Ohlin Theorem8(b)Rybczynski Theorem9(c)Stolper-Samuelson Theorem10(d)Factor Price Equalization Theorem11(e)General Shortcomings of the H-O Model:12

2.4.2 Specific Factor Model132.5 New Trade Theories152.6 The Theory of Competitive Advantage (Michael Porter)172.6.1 A Brief Introduction to the Theory of Competitive Advantage17

2.6.2 Implications of Porters Model for the National Environment (this section draws on Mohamed and Kiggundu, 2006)20

2.6.3 Stages of Competitive Development22

2.6.4 Criticisms and Refinements of Porters Model24(a)Dunning (2002) and the Role of Multinational Business Activities24(b)Mohamed and Kiggundu (2006)25

3.0 Conclusions28Bibliography29

Table of Figures

Figure 1: Theories of International Trade3Figure 2: Factor Endowment Models6Figure 3: Successful Factors of National Competitiveness (Porter, 1990)17Figure 4: Microeconomic Business Environment (Porter 2004)18Figure 5: Determinants of Productivity and Productivity Growth22Figure 6: Stages of Competitive Development24Figure 7: Successful Factors of National Competitiveness (Porters 1990 model as modified by Dunning, 2002)26Figure 8: International Competitiveness: A Proposed Analytical Framework28

Theories of International Trade and Production1.0 Introduction In this set of notes we explore (albeit briefly) some of the main theories pertaining to international trade. The reader may already be familiar with some of the theories that I have chosen to highlight in this set of notes but not with the others. It is crucial for students of the environment of international business (and of international business in general) to have a better grasp of these theories/perspectives for a number of reasons. To begin with, it is important to understand why nations trade in the first place. Secondly, these theories may help us understand the patterns of international trade. Thirdly, they may assist us in deciphering (with varying degrees of success) the manifestations, dynamics and impacts/implications of the environment of international business. Lastly, to the extent that each of the extant theories explains only some portion of international business activity, we hope that this brief survey will help identify what aspects are explained by what theory/theories and what aspects of international trade are under-theorized, inadequately theorized or not theorized at all. Furthermore, it is hoped that this brief presentation will nudge the student beyond the traditional theories of absolute advantage and comparative advantage by introducing some modern theories of international trade and thus will equip the student to follow the material and debates on the environment of international business as well as point the student in the right direction in the exploration of advanced understanding of the theories presented in these and other notes.

2.0 Theories of International Trade There are several theories of international trade. For the purposes of these notes we will particularly briefly explore the following: (a) Mercantilism, (b) Theory of Absolute Advantage (a la Adam Smith), (c) Theory of Comparative Advantage (a la David Ricardo), (d) Factor Endowment Models, including the: (i) Factor Proportions (Heckscher-Ohlin) Model, and, (ii) Specific Factor Model, (e) New Trade Theories, and,(f) The Theory of Competitive Advantage (a la Michael Porter).

These perspectives are depicted in Figure 1 below.

Figure 1: Theories of International TradeMercantilism(1500s-1700s)Theory of Absolute Advantage(Adam Smith, 1776)Theory of Comparative Advantage(David Ricardo, 1817)Specific Factor Theory(1937)

Theory of Competitive Advantage(Michael Porter, 1990)The Leontief Paradox(Wassily Leontief, 1950)Linders Hypothesis1961Factor Endowment ModelsFactor Proportions TheoryNew Trade Theories1970s/1980sHeckscher-Ohlin Model (1930s)

Rybczynski Theorem (1955)Stolper-Samuelson Theorem(1941)Factor Price Equalization Theorem(1948)

2.1 MercantilismA central notion of the theories of the Mercantilist thinkers (16th and first half of 18th century) was that the accumulation of financial wealth (through the encouragement of exports and curbing of imports) was paramount. In other words, a favourable balance of trade (i.e., an excess of exports over imports) should be the objective of national economic policy. The underlying reason for this position was the idea that a nation with trade surplus would receive gold from the nations in deficit. This was viewed in a positive light because gold was then viewed as the essence of national wealth, hence of power and prestige. The main purpose of this theorizing was to support a policy of national self-sufficiency (autarky) pursued by some European rulers at the time (Britain, France, The Netherlands, Portugal and Spain). This perspective has a number of flaws; suffice to note just two of them here. First, mercantilist belief that the worlds wealth was limited and that a nation could increase its share of the pie only at the expense of other countries (i.e., international trade was a zero-sum game) was wrong. Secondly, if all countries curbed imports (and promoted exports) international trade would be severely restricted because in order for one country to export, it requires another country to import! Restricting imports would thus be counter-productive. A notable critic of the mercantilist perspective was Adam Smith (1723-1790 AD) who advanced a different theory we discuss next.

2.2 Theory of Absolute AdvantageAdam Smith (1723-1790) was very critical of the mercantilist position. In contrast to the mercantilist perspective that favoured autarky, Smith advocated economic/market openness whereby countries would specialize in the goods they could produce more efficiently. Smiths position put forth in 1776 is known as the theory of absolute advantage. Smiths theory destroyed the mercantilist idea that international trade is a zero sum game by showing that there are gains to be made by countries that are party in an exchange. In short, international trade according to Adam Smith was a positive-sum game.In spite of its powerful message, the theory also has it limitations. The main shortcoming being that it does not provide room for trade for those countries that cannot produce any good/service more cheaply than other countries. In other words, Smiths perspective does not provide for the gains in trade for a country that can produce all goods cheaply than any other country because in this perspective when a country happens to have an absolute advantage in all goods then it will produce for itself all those goods leaving no room for exchange and its associated benefits. This perspective is rectified in Ricardos theory of Comparative Advantage we discuss next.

2.3 Theory of Comparative AdvantageDavid Ricardo (1772-1823), unlike Adam Smith, offered in 1817 a theory that provided room for international trade even when one country can produce all goods/services efficiently/cheaply than the rest. His theory of comparative advantage remains the cornerstone of the modern theory of international trade. According to Ricardo, comparative advantage is based on relative labour costs, which are measured by the person-hours of labour required to produce each unit of output. In other words, production possibilities are determined by the allocation of a single resource, labour, between sectors.The strength of Ricardos theory lies in its ability to show that gains from trade can be made even when one country has absolute advantage on all goods. It is also worth noting, however, that Ricardos formulation has also come under criticism because it focuses on only a comparison of relative labour costs. In other words, comparative advantage (a la Ricardo) is only understood in relation to advantages based on only one factor, i.e., labour. Moreover, while this theory conveys the essential idea of comparative advantage, it does not allow us to talk about the distribution of income in the economy and how international trade affects an economy. These shortcomings are addressed (in varying degrees of success) in the following set of theories/perspectives.

2.4 Factor Endowment ModelsFactor Endowment Models are comprised of two basic types: a long-term perspective (as represented by the Factor Proportions Theory also known as the Heckscher-Ohlin Model) and a short-/medium-term perspective (represented by what is known as the Specific Factor Model) as depicted in Figure 2 below. We discuss these in turn.Figure 2: Factor Endowment ModelsSpecific Factor Theory

The Leontief Paradox(Wassily Leontief, 1950)Linders Hypothesis(1961)Factor Endowment ModelsFactor Proportions TheoryHeckscher-Ohlin Model (1930s)

Rybczynski Theorem (1955)Stolper-Samuelson Theorem(1941)Factor Price Equalization Theorem(1948)

2.4.1 Factor Proportions Theory (Heckscher-Ohlin Model)Developed by Swedish economists Eli Heckscher and Bertil Ohlin, the factor proportions theory also referred to as Heckscher-Ohlin theory (or H-O model) emphasizes the interplay between the proportions in which factors of production in a country are used in producing different goods (Ohlin, 1933). This model postulates that international trade is largely driven by differences in countries resource/factor endowments, i.e., trade will occur between economies which are most dissimilar (Pellegrin, 2001:130). In other words, it is the relative endowments of the factors of production (labour, land and capital) that determine a countrys comparative advantage. According to the H-O model, therefore, a country enjoys a comparative advantage in (and will therefore export) the good whose production is relatively intensive in the factor with which that country is relatively well endowed (Pellegrin, 2001: 130). In this model comparative advantage is influenced by the interaction between nations resources (the relative abundance of factors of production) and the technology of production (which influence the relative intensity with which different factors of production are used in the production of different goods). In a nutshell, the model essentially suggests that countries will export products that utilize their abundant factor(s) of production and import products that utilize the countries scarce factor(s). For instance, if a country has abundant labour resources and scarce capital it will produce and export labour-intensive products and import capital-intensive products.The H-O Model refined the Ricardian theory such that comparative advantage could be derived from relatively low costs of any factor of production such as capital or land, not just from relatively low labour costs as assumed in the standard Ricardian model. The model also assumes that multiple factors of production can move between sectors but not across countries. Indeed, the factor proportions theory differs considerably from the theories of absolute and comparative advantages. In contrast to the two theories (that focus on the productivity of the production process for a particular good), the factor proportions theory says that a country specializes in producing and exporting goods using the factors of production that are most abundant and thus cheapest not the goods in which it is most productive (Wild, Wild, & Han, 2010:156; emphasis in original).The H-O model has spawned a number of theorems notable among them include: (a) The Heckscher-Ohlin Theorem, (b) Rybczynski Theorem, (c) Stolper-Samuelson Theorem, (d) Factor Price Equalization Theorem. Lets take a brief tour of each of these theorems.

The Heckscher-Ohlin TheoremAs noted above the H-O Theorem postulates that the pattern of trade is determined by factor endowments in the sense that nations tend to export the goods that are relatively intensive in the use of the factors with which they are relatively well endowed. As such, a capital abundant country will tend to export capital-intensive products and import labour intensive products from labour abundant countries. Conversely, a country that has abundant labour (labour-abundant) will export labour-intensive goods and import capital-intensive products. From the perspective of the environment of international business, we can safely say that this theorem is referring to how international trade patterns are influenced by the particular resourcefulness (i.e., munificence in labour or capital) of the given environments (in this case countries involved in the exchange). This resourcefulness can be depicted or manifested in, for instance, labour or capital abundance. Thus, from spatial and temporal perspectives, a certain country at some particular period in time can have a relatively large supply of labour (abundant factor) while having a smaller supply of capital (scarce factor). To be sure, this situation is not static. For instance, emigration out of the country could lead to a shortage of labour, while immigration into a particular jurisdiction could lead to a higher labour supply/pool. Similarly, an inflow of foreign reserves (e.g., from surplus international trade revenues) could turn a capital-starved country into a capital-rich one, and vice versa.

Rybczynski TheoremThe Rybczynski Theorem (1955) named after Polish-born English Economist Tadeusz Rybczynski (1923-1998) deals with how changes in the structure of a countrys endowment affects the structure of production and outputs when full employment is maintained. Changes in endowment could be a result of population changes (internal population growth or decline; immigration/emigration) and capital flows (e.g., foreign direct investment). In general, the Rybczynski theorem postulates that an increase in a countrys endowment of a factor will cause an increase in output of the good which uses that factor intensively, and a decrease in the output of the other good. For instance, assuming fixed capital, an increase in population will shift the relative factor abundance in favour of labour (vis--vis capital); and likewise, assuming constant labour, an import of capital will shift the relative factor abundance in favour of capital (in relation to labour) and vice versa.From the perspective of the environment of international business, we can say that this theorem is referring to how international trade patterns are influenced by the dynamism (changing nature) of the particular environments (in this case countries involved in the exchange), in the sense that as the particular environments resourcefulness (munificence) changes so will the type of products made/exported and/or imported. This perspective is particularly useful in this era of globalization when resource endowments can and do change due to increasing regional and global integration. With increasing mobility of people (immigration/emigration) and increasing capital flows (such as foreign direct investment, portfolio investment, etc.) resource endowments of any given jurisdiction can no longer be held constant. For example, in a two product, two factor situation, an increase in the endowment of a particular factor/resource (e.g. an increase in labour due to international mobility) will lead to a more than proportional increase in production in those sectors that use the factor intensively (labour-intensive industries) and a decline in production in those sectors that use the other factor intensively (production decline in capital-intensive industries) -- assuming full employment is maintained/sustained.

Stolper-Samuelson Theorem

Derived in 1941 from within the framework of Heckscher-Ohlin model by Paul Samuelson and Wolfgang Stolper, the Stolper-Samuelson theorem describes a relation between the relative prices of output goods and relative factor rewards, specifically, real wages and real returns to capital. According to the theorem, (assuming constant return to scale, perfect competition, and two-factor of production situation labour and capital), a rise in the relative price of a good will lead to a rise in the return to the factor that is used most intensively in the production of that particular good (e.g., labour) and a fall in the return to the other factor (e.g., capital). For instance, if the world price of capital-intensive goods increases, it will increase relative to the rental rate (price of capital). Likewise, if the price of labour-intensive goods increases, it will increase relative to the wage rate. Conversely, the Stolper-Samuelson Theorem postulates that a drop in the relative price of the labour intensive good will result in a fall in wages, and in a rise in the rental rate (direction effect). Moreover, the wage rate fall is more than proportional to the relative price fall, so landowners gain in consumption terms (i.e., in terms of price of both goods) and labour loses in terms of the price of both goods (magnification effect). In short, the Stolper-Samuelson theorem shows how changes in the prices of outputs (e.g., by changes in tariffs) have an effect on the prices of the inputs/factors used in the production of such outputs. The Stolper-Samuelson Theorem is an important one for students of international business environment because it helps to connect the prices of goods to factor rewards. It identifies the pain of trade with particular factors. In short, it helps to highlight the potential gains (opportunities) and costs of trade (risks) of international trade and by extension the potential reaction of the actors involved. In other words, by helping to identify those who might win and those who might lose in the process of international trade, this theorem helps to link the outcomes of international trade with the likely reactions of the various actors involved as one can plausibly expect that those who stand to gain will likely support certain policies/moves (i.e., more trade in the goods/services they supply/produce), while those who lose may oppose such policies/moves.

Factor Price Equalization TheoremAdvanced by Paul Samuelson in 1948, the factor-price equalization theorem postulates that in international trade when the prices of the output goods are equalized between countries (as it tends to occur when trade barriers are removed e.g., in a free trade situation), the prices of the factors of production (capital and labour) involved in the production of the subject output goods will also be equalized between countries involved (Samuelson, 1948). In other words, free and competitive trade will tend to make factor prices to converge as the prices of traded goods converge/equalize. The intuition here is that: if all countries have the same technology and the same goods prices, and trade is freely conducted (i.e., without barriers) among them then these countries must have the same factor prices. In short, if trade leads to convergence/equalization of product prices, factor prices should be equalized as well. But, if technology among the trading partners differs then it is unlikely that factors prices will converge/equalize even if the prices of the output goods/commodities tend to equalize. The scope of this set of notes and the lecture does not allow me to go into further details pertaining to all the other conditions/assumptions that need to obtain for this theorem to work. As with the preceding theorems, this theorem has relevance to understanding the dynamics of and inter-linkages among various environments of international business (countries in this case) and their implications as reflected in the movement of product and factors prices. With increasing integration among economies around the world, and thus, changing environment of international business it is crucial that business managers have some intellectual tool for understanding/comprehending how such changes (e.g., due introduction of freer trade among countries and hence of convergence in product prices) might affect the level of factor prices in the countries they be involved in.

General Shortcomings of the H-O Model:The limitations of the H-O Model are manifested in a number of areas. To begin with, in the H-O model, cThe H-O model has a number of shortcomings, including:omparative advantage is a static notion (Pellegrin, 2001:130). Secondly, the H-O model cannot account for international vertical chains (Pellegrin, 2001:130). Thirdly, empirical evidence does not support H-O model (Leontieffs Paradox). An econometric test of the H-O model by Wassily W. Leontief in 1954 found that the US, despite having a relative abundance of capital during that time, tended to export labour-intensive goods and import capital-intensive goods contrary to what the model would have predicted (Leontief, 1954). The H-O model in this respect would have predicted that the US would be exporting capital-intensive goods (not labour intensive goods) and importing labour-intensive goods because during that period the US was relatively abundantly endowed with capital vis--vis other countries. What might account for such a paradox?Various explanations of the paradox have emerged. One such explanation is Linders Hypothesis which suggests that the US did not fit well into the H-O model because countries tended to trade in goods based on similar demand rather than on the basis of differences in supply side factors (Linder, 1961). As such, international trade patterns were not based on or driven by factor endowments but rather by the nature of demand in the various markets.

2.4.2 Specific Factor ModelThe second category of the factor endowment models is the Specific Factor model originally discussed by Jacob Viner (Viner, 1937). The model is a variant of the Ricardian Model and hence it is sometimes referred to as the Ricardo-Viner model. The model was later developed by other economists including: (a) Paul Samuelson (1971) who formalized it mathematically by assuming an economy that produces two goods and that can allocate its labour supply between two sectors; and (b) Ronald Jones (1971) who called it a 2 goods, 3 factors model.Unlike the Ricardian model (and akin to the H-O model discussed above), the specific factor model allows for the existence of factors of production besides labour and goes further to distinguish the factors of production by the degree of mobility in response to changes in economic or market conditions (recall: environmental dynamism in our framework for the EIB). Indeed, economic or market conditions can change in a number of ways. For instance, through the establishment of a free trade agreement, implementation of a tariff or quota, change of labour endowment (e.g., through immigration or emigration), changes in capital endowment (e.g., through FDI or capital flight), and technological changes. On this basis, factors are broadly distinguished into two types: between (a) mobile (i.e., those factors that can move freely and costlessly between economic sectors), and (b) immobile or industry-specific factors, (i.e., those factors that in the short-run are not substitutable in production). For instance, in this model, labour is assumed to be a mobile factor that can move between sectors, while other factors (capital and land) are assumed to be specific in the sense that in the short-run they can be used only in the production of particular goods.It is important to note that the distinction between mobile and specific factors is a question of speed of adjustment whereby factors that are mobile can be re-deployed from one sector to another much quickly than the specific ones which may take longer to re-deploy between industries. On this view, any factor can assume the mobile or specific character or feature at some point in time. Even labour which is considered mobile may be specific under certain circumstances. For example, a highly skilled professional (brain surgeon) may not be as mobile (i.e., cannot be easily or quickly re-deployed into another job/career) as a worker who has fairly general skills. Moreover, factor specificity may not be a permanent condition as it may be just a matter of time before ways are found to re-deploy a seemingly specific (immobile) factor.The Specific Factor Model is interesting to students of the environment of international business for the following reasons. First, it focuses on the environmental conditions and the effects of changes in those conditions (i.e., environmental dynamism). Secondly, and perhaps the key strength of this theory lies in its insight on the impacts of international trade on income distribution. This model helps to highlight the point that although everyone could potentially gain from international trade it does not necessarily mean that everyone actually does. It shows that in the real world international trade tends to result in the presence of both winners and losers. And, that this is attributable to the nature of the factors of production. Generally, this model demonstrates that trade benefits the factor that is specific to the export sector of each country, but hurts the factor specific to the import-competing sectors with ambiguous effects on mobile factors (Krugman & Obstfeld, 2003:55). Also worth noting, however, is the fact that, while this model is ideal for understanding income distribution, it is awkward for discussing the patterns of international trade.

2.5 New Trade TheoriesThe new trade theories (1970s & 1980s) are associated with Paul Krugman (1981) --who was recently awarded the 2008 Nobel Prize for Economics -- and other economists including: K. Lancaster (1980), Elhanan Helpman, James Brander, and Jim Markusen. The new trade theories relax the assumptions of old trade theories (Ricardo, Ricardo-Viner and the Heckscher-Ohlin Model) which assume perfect competition and constant returns to scale and instead these theories base international trade on increasing returns to scale (especially economies of scale) and imperfect competition (e.g., monopolistic competition; product differentiation). While there is intrinsically not much novelty in these theories (as a number of classical and neoclassical economists had qualitatively discussed/alluded to the issue of increasing returns to scale) Krugman, et al. provided mathematical rigour to the theories that the earlier economists had not. That is what gives these perspectives the label new trade theories.The new trade theories help to explain why international production tends to be geographically concentrated. The theories argue that some industries tend to perform better as their volume of production increases (Cavusgil, Knight & Reisenberger, 2008:108). This is because the effect of increasing returns to scale allows the nation to specialize in a small number of industries in which it may not necessarily hold factor or comparative advantage (Cavusgil, Knight & Reisenberger, 2008:108). These theories also lend support to infant industry protection argument in the sense that they demonstrate that industries shielded from competition (free trade) and allowed to enjoy economies of scale until they are ready to compete can withstand the challenges of international competition. In a nutshell, the new trade theories postulate that:(a) there are gains to be made from specialization and increasing economies of scale (Wild, Wild & Han, 2010:160);(b) the companies first to enter a market can create barriers to entry (Wild., Wild & Han, 2010:160), in other words, they can enjoy what are termed first-mover advantage; and,(c) government may play a role in assisting its home-based companies (Wild, Wild & Han, 2010:160)

Like the preceding theories, the specific factor model is also relevant in the study of the international business environment as it provides useful tools for understanding the role and ramifications of the involvement of the state/government in the economy as well as it helps to understand the economic environment when the industries embedded in it feature increasing returns to scale such as the current new knowledge-based/information economy).

2.6 The Theory of Competitive Advantage (Michael Porter)2.6.1 A Brief Introduction to the Theory of Competitive Advantage A recent addition to the list of theories of international trade is Michael Porters (1990) theory of national competitive advantage. Porter attributes four key variables for the success in international trade: (a) factor conditions, (b) demand conditions, (c) related and supporting industries, and, (d) firm strategy, structure, and rivalry. To these four, Porter has also added two other factors, namely, the roles of government and chance. These factors are presented in the form of a baseball diamond and are depicted in the Figure 3 below:

Figure 3: Successful Factors of National Competitiveness (Porter, 1990)

Firm strategy, structure and rivalryFactor conditionsRelated and supporting industriesDemand conditionsGovernmentChance

Source: Porter (1990:127)

Although in the above figure Porter has included the roles of government and chance he sometimes tends to omit them or at best not explicitly factor them as demonstrated in a recent application of his model in the Global Competitiveness Report (Figure 4 below). Nevertheless, Porter (2004) spills considerable ink in illustrating the critical role governments play in economic development particularly as it relates to how governments shape and condition the environment in which businesses operate.

Figure 4: Microeconomic Business Environment (Porter 2004)Context for Firm Strategy and Rivalry * A local context and rules that encourage investment and sustained upgrading (e.g., Intellectual property protection)* Meritocratic incentive systems across institutions* Open and vigorous competition among locally based rivals

Factor (Input) Conditions Demand Conditions

Presence of high quality, specialized inputsSophisticated andavailable to firmsdemanding local customer(s) * Human resources* Local customer needs that anticipate* Capital resourcesthose elsewhere* Physical infrastructure* Unusual local demand in specialized* Administrative infrastructure segments that can be served nationally* Information infrastructure and globally* Scientific and technological infrastructure* Natural resources

Related and Supporting Industries* Access to capable, locally based suppliers and firms in related fields* Presence of clusters instead of isolated industries

Source: Porter (2004:32; emphasis in the original.)

With that note, lets briefly describe the factors below:

(a) Factor conditions:Porter differentiates between basic and advanced factors whereby basic factors comprise of the traditional factors of production (e.g., labour, natural resources, climate, etc.), while advanced factors consist of a nations workforce skill levels and the quality of (technological) infrastructure.

(b) Demand conditions:According to Porter, the existence of sophisticated domestic buyers tends to stimulate/pressure firms to continuously improve their product/service offerings which in turn helps to give these firms an edge internationally as well.

(c) Related and Supporting IndustriesThe emergence of and competition among local suppliers to cater to the production, marketing and distribution needs of firms in a particular industry, according to Porter, tends to lead to lower input costs, higher quality products/services, and innovations in the input market hence reinforcing/enhancing the industrys international competitiveness.

(d) Firm strategy, structure, and rivalryThe ability to compete internationally is also predicated on the characteristics of the domestic environment. To survive, firms facing vigorous competition domestically must continuously strive to reduce costs, boost product quality, raise productivity, and develop innovative products. Firms that have been tested in this way often develop the skills needed to succeed internationally (Griffin & Pustay, 2007:162).(e) Roles of Government and ChanceIndustry competitiveness can also be positively/negatively affected by government policies. Moreover, unforeseen events such as disease outbreaks, earthquakes, etc. could easily wipe out any advantage an industry might have had.

2.6.2 Implications of Porters Model for the National Environment (this section draws on Mohamed and Kiggundu, 2006)

According to Porter (2004), national wealth is created in the microeconomic level of the economy, rooted in the sophistication of company strategies and operating practices, as well as in the quality of the microeconomic business environment in which a nations firms operate. Thus, to improve productivity Porter contends: the traditional focus on macroeconomic stabilization and market opening is insufficient (Porter, 2004:35). He argues that while Stable political, legal, and social institutions and sound macroeconomic policies create the potential for improving national prosperity wealth is actually created at the microeconomic level in the ability of firms to create valuable goods and services using efficient methods. Only in this way can a nation support high wages and the attractive returns to capital necessary to support sustained investment (Porter, 2004:31). For Porter (2004), the microeconomic foundations of productivity rest on two interrelated areas: (1) the sophistication with which domestic companies or foreign subsidiaries operating in the country compete, and (2) the quality of the microeconomic business environment in which they operate (Porter, 2004:31). Based on the conceptual framework, (depicted in Figure 5 below), Porter (2004) has built the Business Competitiveness Index (BCI) reported in the annual Global Competitiveness Reports of the Geneva-based World Economic Forum.Figure 5: Determinants of Productivity and Productivity GrowthMacroeconomic, Political, Legal, and Social Context for Development (Porter 2004)

SophisticationQuality of theof CompanyMicroeconomicOperations and BusinessStrategyEnvironment

Microeconomic Foundations of Development

Source: Porter (2004:31)

Based on the above framework, Porter argues that the productivity of a country is ultimately set by the productivity of its companies. An economy cannot be competitive unless companies operating there are competitive, whether they are domestic firms or subsidiaries of foreign companies. However, the sophistication and productivity of companies are inextricably intertwined with the quality of the national business environment (Porter, 2004:31). In this respect, he contends that More productive company strategies require more highly skilled people, better information, more efficient government processes, improved infrastructure, better suppliers, more advanced research institutions, and more intense competitive pressure, among other things (Porter, 2004:31). It is in such a context that Porter advanced/postulated his theory of competitive advantage in which he posits that the business environment can be understood in terms of four interrelated areas: the quality of factor (input) conditions, the context for firm strategy and rivalry, the quality of local demand conditions, and the presence of the related and supporting industries (Porter, 2004:32). (See figures 3 & 4 above.)One can draw three key insights from Porters work. First, Porter delineates the key domestic variables involved in promoting national competitiveness. Second, this helps to explain that the key variables and the way they interact vary among countries. Third, the model helps to build the case that the main thrust in improving a countrys competitiveness must come from the better use of domestic capabilities and resources. That is, countries and their corporations should utilize their existing capabilities and resources more efficiently and if lacking in core competences, a country should upgrade the quality and quantity of its resources and capabilities. In a nutshell, Porter sees the home base as playing a critical role in building up the competitive advantage of national industries. In the language of this course, the domestic/national environment is critical. Porter also points out that no nation can have a competitive advantage in every good or service. Consequently, competitive advantage must be interpreted at the industry level. On this view, Porter advocates the promotion of industrial clusters.

2.6.3 Stages of Competitive Development

Another important contribution by Porter (for our purposes) pertains to his postulation about the types or stages of competitiveness a country can undergo. To the extent that Porter sees successful economic development as a process of successive upgrading, in which a nations environment evolves to support and encourage increasingly sophisticated and productive ways of competing by firms based there (Porter, 2004:34), he posits that As nations develop, they progress in terms of their competitive advantages and modes of competing. (Porter 2004:34). As such, Porter, frames economic development as a sequential process of building interdependent microeconomic capabilities, shifting company strategies, improving incentives and increasing rivalry. (Porter, 2004: 35). On this view, Porter delineates four distinct stages of national competitive development: factor-driven stage, investment-driven, innovations-driven stage, and wealth driven. In short, Porter is saying, the national environment does change and that this change process occurs in stages as depicted in the Figure 6 below.Figure 6: Stages of Competitive Development

Input Cost Efficiency Unique ValueDeclineFactor-Driven EconomyInvestment-Driven EconomyInnovation-Driven EconomyWealth Driven Economy

Source: Porter (1990:546; 2004:34)

In the Factor-driven stage, basic conditions such as low cost labour and unprocessed natural resources are the dominant sources of competitive advantage and exports. A Factor-driven economy is highly sensitive to world economic cycles, commodity prices, and exchange rate fluctuations (Porter, 2004:35). In the Investment-driven stage, efficiency in producing standard products and services becomes the dominant source of competitive advantage An investment-driven economy is concentrated in manufacturing and on outsourced service exports (Porter, 2004:35). Such an economy, according to Porter, is susceptible to financial crises and external sector-specific shocks (Porter, 2004:35) In the Innovation-driven stage, the ability to produce innovative products and services at the global technology frontier, using the most advanced methods, becomes the dominant source of competitive advantage. The national business environment is characterized by strengths in all areas, together with the presence of deep clusters (Porter, 2004:35). In the wealth-driven economy, the driving force is the wealth that has already been achieved (Porter, 1990:556). This stage is one of drift and ultimately decline (Porter, 1990:546). Due to a number of reasons (e.g., ebbing of rivalry, misguided investments, diminishing innovation, etc.) firms begin to lose competitive advantage in international industries (Porter, 1990:556). It is also worth noting that, Nations do not inevitably progress (Porter, 1990:563-4). In fact, Porter posits that Many nations never move beyond factor-driven or investment driven stage (Porter, 1990:564) Indeed, nations may falter or fall backward too (Porter, 1990:561). Moreover, Porter argues, it is not inevitable that nations pass through the stages (Porter, 1990:545; emphasis in original). The process of moving through the stages can take many paths, and there is no single progression (Porter, 1990:563). As a reflection of each nations unique circumstances each nation goes through its own unique process of development (Porter, 1990:562).

2.6.4 Criticisms and Refinements of Porters ModelTo be sure, Porters model has come under intense scrutiny and criticisms. The scope of this set of notes does not permit an extensive/exhaustive discussion of these challenges. Suffice to not that among the most critical ones (directly and indirectly) have included the contributions of Dunning (2002), Hamalainen (2003), Krugman (1994) and Mohamed & Kiggundu (2006). We briefly discuss below the contributions of Dunning and Mohamed & Kiggundu.

(a) Dunning (2002) and the Role of Multinational Business Activities

In the recent models, as was the case with the original 1990 model, for Porter the determinants of competitiveness are still predicated on the domestic realm. As a corrective to Porters 1990 model, Dunning (2002) introduces the concept of multinational business activities (MBAs). Dunning (2002) discusses the influence of MBAs on various aspects of Porters diamond, and by implication, on national competitiveness (see Figure 7 below). As the figure below shows, Dunnings contribution highlights the influence of MBAs on among other variables the government. A focus on government, however, is insufficient for it does not address how MBAs affect other modes of governance. Moreover, Dunnings focus on MNE activities does not encompass a variety of other international economic activities such as the increasing flows of remittances by immigrant workers to their home countries flows that are becoming an important source of foreign exchange and development funds for the recipient countries (Adams & Page, 2003; Ratha 2003).

Figure 7: Successful Factors of National Competitiveness (Porters 1990 model as modified by Dunning, 2002)

Firm strategy, structure and rivalryFactor ConditionsRelated and supporting industriesDemand conditionsMBAsGovernmentChance

Source: Dunning (2002:292)

(b) Mohamed and Kiggundu (2006)Abdulghany Mohamed and Moses Kiggundu (2006) challenge Porters (and Dunnings) narrow focus on government. Instead they propose a wider and deeper perspective on how national competitiveness is fostered or impeded (see Figure 8 below). First, they suggest that rather than simply including the role of government, a broader view be taken to include the various modes of governance (governance by state i.e., government, as well as governance by non-state actors e.g., private sector self governance and governance by civil society). (see Scholte & Schnabel, 2002; Webb, 2002). Mohamed and Kiggundu (2006) also challenge Porters narrow focus on the domestic environment at the expense of the regional and global environments. They, thus, suggest that international competitiveness be understood in a broader/wider context that encompasses causal factors from both the domestic and international environments. This perspective (i.e., one that transcends Porters state-centric-cum-domestic-oriented view) is crucial for at least three main reasons. First, the international context does play a significant role in shaping the competitiveness of a country and its firms. Secondly, governance needs to be understood in a multi-realm and multi-actor framework. In other words, governance takes place in various levels and layers (local, sub-national, national, regional and global) and involves a variety of actors including state/governmental, private sector and civil society. Lastly, this view is relatively more useful and relevant in todays world of international business. For instance, born-global firms (whose customers are primarily internationally based) do not have domestic/home-based customers to shape them up into internationally competitive firms as is suggested in demand conditions factor of Porters Model.In sum, the challenges to Porters framework help in a better understanding of the contemporary environment of international trade (and investment as well).

Figure 8: International Competitiveness: A Proposed Analytical Framework

Private Authority State Civil Society

International Governance SystemDomestic Institutional FrameworkResourcesTechnologiesOrganizational EfficiencyProduct MarketsDomestic Business and Economic Activities (DBEAs)International Institutional FrameworkInternational Business and Economic Activities (IBEAs)Domestic Governance System

Private Authority State Civil Society

Source: (Mohamed & Kiggundu (2006:30) Figure 7)

3.0 Conclusions

These lecture notes presented an overview of the various theories of international trade. It is our hope that this brief introduction will enable students to comprehend better the bases and determinants of international trade as currently understood under the various perspectives. Such an understanding, we hope, will further enhance our comprehension of the various manifestations, dynamics and impacts/implications of the environment of international business and vice versa. Lastly, as emphasized in the lecture notes on the theories of international investment and production, these notes are not offered as a substitute for the course textbook or material you may have covered in your previous economics classes!!! For a further introduction to the theories of trade (i.e., those not covered in the current textbook) an ample set of resources are provided in the references below.

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