Theories of International Trade and Investment chapter three Theories of International Trade and Investment McGraw-Hill/Irwin International Business, 11/e Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives Explain the theories that attempt to explain why certain goods are traded internationally Discuss the arguments for imposing trade restrictions Explain two basic kinds of import restrictions: tariff and nontariff trade barriers

Learning Objectives Appreciate the relevance of changing status of tariff and nontariff barriers to managers Explain some of the theories of foreign direct investment

International Trade Theory Mercantilism Economic philosophy based on belief that (1) a nation’s wealth depends on accumulated treasure, usually gold, and (2) to increase wealth, government policies should promote exports and discourage imports

Theory of Absolute Advantage Theory that a nation has absolute advantage when it can produce a larger amount of a good or service for the same amount of inputs as can another country or When it can produce the same amount of a good or service using fewer inputs than could another country

Absolute Advantage Example Each Country Specializes

Absolute Advantage Terms of Trade (Ratio of International Prices) Gains from Specialization and Trade

Theory of Comparative Advantage A nation having absolute disadvantages in the production of two goods with respect to another nation has a comparative or relative advantage in the production of the good in which its absolute disadvantage is less

Theory of Comparative Advantage Example Each Country Specializes

Comparative Advantage Terms of Trade – at a rate of ¾ bolt of cloth for 1 ton of soybeans Terms of Trade – at a rate of 1 bolt of cloth for 1 ton of soybeans Gains from Specialization and Trade

Comparative Advantage Production Possibility Frontiers (figure 3.1) Figure 3.1

Heckscher-Ohlin Theory of Factor Endowment Heckscher-Ohlin theory that countries export products requiring large amounts of their abundant production factors and import products requiring large amounts of their scarce production factors

Heckscher-Ohlin Theory of Factor Endowment Leontief Paradox The United States, one of the most capital-intensive countries in the world, was exporting relatively labor-intensive products in exchange for relatively capital-intensive products Differences in Taste A demand-side construct that is always difficult to deal with in economic theory

How Can Money Change The Direction of Trade? Example Exchange Rate – the price of one currency stated in terms of another currency

How Can Money Change The Direction of Trade? Influences of Exchange Rate Currency devaluation The lowering of a currency’s price in terms of other currencies

Some Newer Explanations For The Direction Of Trade Linder Theory of Overlapping Demand Customers’ tastes are strongly affected by income levels; therefore a nation’s income per capita level determines the kinds of goods they will demand

Some Newer Explanations For The Direction Of Trade International Product Life Cycle (IPLC) Explains why a product that begins as export eventually becomes import (figure 3.2) U.S. exports Foreign production begins Foreign competition in export market Import competition in the United States

Figure 3.2 International Product Life Cycle

Some Newer Explanations For The Direction Of Trade Technology Life Cycle Production technology application of IPLC Economies of Scale and Experience Curve As a plant gets larger and output increase, the average cost of producing each unit of output decreases As firms produce more products, they learn ways to improve production efficiency

Some Newer Explanations For The Direction Of Trade Imperfect Competition Economies of scale with the existence of differentiated products--Paul Krugman First-Mover Theory Pattern of trade in goods subject to scale economies may be determined by historical factors

Some Newer Explanations For The Direction Of Trade National Competitive Advantage from Regional Clusters: Porter’s Diamond Model (figure 3.3) National Competitiveness: a nation’s relative ability to design, produce, distribute, or service products while earning increasing returns on resources Demand conditions Factor Conditions Related and supporting industries Firm strategy, structure, and rivalry

Figure 3.3 Variable Impacting Competitive Advantage: Porter’s Diamond Source: Reprinted by permission of the Harvard Business Review. “The Competitive Advantage of Nations” by Michael E. Porter, March–April 1990, p. 77. Copyright © 1990 by The President and Fellows of Harvard College; all rights reserved.

Trade Restrictions: Arguments For National Defense Sanctions to Punish Offending Nations Protect Infant (or Dying) Industry Protect Domestic Jobs from Cheap Foreign Labor Scientific Tariff or Fair Competition

Trade Restrictions Retaliation Dumping: selling a product abroad for less than the cost of production, the price in the home market, or the price to third countries Social dumping Environmental dumping Financial services dumping Cultural dumping Tax dumping

Trade Restrictions Subsidies: Financial contributions, provided directly or indirectly by a government, which confer a benefit; include grants, preferential tax treatment, and government assumption of normal business expenses (figure 3.4) Countervailing duties: Additional import taxes levied on imports that have benefited from export subsidies

Figure 3.4 Value of OECD Member Farm Subsidies Source: “Agriculture: Support Estimates, 2004,” OECD in Figures: Statistics on the Member Countries. Accessed 7/2005 Link: http://dx.doi.org/10.1787/758034618756.

Tariff Barriers Tariff Ad Valorem Duty Specific Duty Taxes on imported goods for the purpose of raising their price to reduce competition for local producers or stimulate local production Ad Valorem Duty An import duty levied as a percentage of the invoice value of imported goods Specific Duty A fixed sum levied on a physical unit of an imported good

Tariff Barriers Compound Duty Official Prices Variable Levy A combination of specific and ad valorem duties Official Prices Variable Levy An import duty set at the difference between world market prices and local government-supported prices Lower Duty for more local Input

Nontariff Barriers Nontariff barriers (NTBs) Quantitative All forms of discrimination against imports other than import duties Quantitative Quotas: numerical limits placed on specific classes of imports Voluntary export restraints (VERs): Export quotas imposed by exporting nation

Nontariff Barriers Orderly Marketing Arrangements Formal agreements between exporting and importing countries that stipulate the import or export quotas each nation will have for a good Nonquantitative Nontariff Barriers Direct government participation in trade Customs and other administrative procedures Standards

From Multinational to Globally Integrated Manufacturing Systems Close least efficient plants, and supply their markets with imports from other subsidiaries Change multidomestic manufacturing system to globally integrated system in which each plant performs the activities at which it is most efficient

International Investment Theories Monopolistic Advantage Theory Theory that FDI is made by firms in oligopolistic industries possessing technical and other advantages over indigenous firms Product and Factor Market Imperfections Superior knowledge leads to differentiated products, and they lead to firm control on price and advantage over indigenous firm (Hymer and Caves) Financial Factors Imperfections in the foreign exchange markets (Aliber) International Product Life Cycle

International Investment Theories Follow The Leader Cross Investment Foreign direct investment by oligopolistic firms in each other’s home countries as a defense measure Internalization Theory An extension of the market imperfection theory: to obtain a higher return on its investment, a firm will transfer its superior knowledge to a foreign subsidiary rather than sell it in the open market

International Investment Theories Dynamic Capabilities Theory that for a firm to successfully invest overseas, it must have ownership of unique knowledge or resources and the ability to dynamically create and exploit these capabilities Dunning’s Eclectic Theory Of International Production Theory that for a firm to invest overseas, it must have three kinds of advantages: ownership-specific, internalization, and location-specific