Theories of International business Unit II

Trade theories 2 extremes: Mercantilism v/s Free Trade Or Interventionist v/s Laissez faire Interventionist theories Free Trade theories Competitive Advantage theory Mercantilism Absolute advantage Product Life Cycle (PLC) Theory Neomercantilism Comparative advantage Porter Diamond Theory H-O Theory

Mercantilism Trade theory that says: ‘country’s wealth is measured by its treasure holding’, usually gold Thus: X more M less Gold empowers Govt., which empowers the army and national institutions.. Time 1500 – 1800 cen. Outcome: accumulation of gold by colonial powers Unrest: American revolution.. And many more..

Neomercantilism Mercantilism justifies favorable trade to pile up gold.. Neomercantilism: Approach to have favorable BoT for social or political advantage Social advantage: to have full employment of resources in order to have surplus production to send abroad.. Political advantage: to give aid and grant to other countries..

Free Trade Theories Absolute advantage: Adam Smith, 1776 Comparative advantage: David Ricardo, 1817 Factor-proportions: Heckscher-Ohlin, 1919

Competitive Advantage theory International product life cycle: Ray Vernon, 1966 National Competitive Advantage: Porter Diamond, 1990

Absolute Advantage Adam Smith: The Wealth of Nations, 1776 Mercantilism weakens country in long run; enriches only a few A country Should specialize in production of and export products in which it has absolute advantage; import other products Has absolute advantage when it is more productive than another country in producing a particular product Comodity US UK Wheat (kg/labor) 6 1 Cloth (mts/labor) 2

Comparative Advantage David Ricardo: Principles of Political Economy, 1817 Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces Absolute Advantage is a special case of Comparative Advantage Commodity US UK Comparative disadvantage Comparative adv US Wheat 6 1 1/6 6/1=6 more adv Cloth 3 2 2/3 less disadv 3/2=1.5

Classic Theory Conclusion Free Trade expands the world “pie” for goods/services Theory Limitations: Simple world (two countries, two products) no transportation costs no price differences in resources resources immobile across countries constant returns to scale full employment Real world: many countries and many goods Transportation costs may decline with specialization Prices in different countries can be (are) effected by exchange rates. Wheat and Tea are not necessarily a one-to-one swap resources can move from country to country: labor (Mexico to US), capital (constant returns to scale: specialization does not effect the amount of resources required to produce one ton of wheat or tea) both diminishing and increasing returns to specialization exist assumed fixed stock of resources in each country. Trade can change the efficiency with which the resources are used and the stock of resources may change too (more people, more natural resources, more efficient use due to technology) Full employment implies use of resources at full efficiency...

Theory of Relative Factor Endowments (Heckscher-Ohlin): Modern Theory Factor endowments vary among countries Products differ according to the types of factors they need as inputs A country has a comparative advantage in producing products that intensively use factors of production it has in abundance and which is thus cheap.. Factors of production: labor, capital

Heckscher--Ohlin (1919) Differences in factor endowments and not differences in productivity determine patterns of trade Theory: ‘H-O postulates that each nation will export commodity intensive in its relatively abundant and cheap labor and vice-versa’.

Important determinants Factor endowments: commodity: high in K/L , L/K Factor prices: low in r/w and w/r US and UK PPF pre trade Post trade International trade continues until relative and absolute factor prices are equalized.. HOW???

Factor Price equalization theorem Trade leads to equalization of relative and absolute factor prices between nations… K-abundant nation: high K/L and low r/w ratio L-abundant nation: high L/K and low w/r ratio.. Labor intensive and capital intensive commodity..

Empirical Test Leontief paradox: US has relatively more abundant capital yet imports goods more capital intensive than those it exports.. 1947.. Ms30% more k-intensive than Xs.. Explanation(?): US has special advantage on producing new products made with innovative technologies These may be less capital intensive till they reach mass-production state

Factor Intensity Reversal Test (FIR) Situation where a commodity is L-intensive in labor intensive country and k-intensive in K abundant country…

International Product Life-Cycle :Vernon, 1966 Most new products conceived / produced in the US in 20th century US firms kept production close to their market initially Limited initial demand in other advanced countries initially When demand increases in advanced countries, production follows With demand expansion in secondary markets Product becomes standardized production moves to low production cost areas Product now imported to US and to advanced countries

Vernon Product Life-Cycle Model Introduction: Requires highly skilled labor Growth: to advanced countries, home country sales increase Maturity: Requires standardized production, unskilled labor Decline: in production in home country and increased production in low skilled developing countries. Home country produces new products..

THE PRODUCT LIFECYCLE THEORY Stages Features Introduction Growth Maturity Decline Demand Low Rising Steady Falling Product Design Changing Some Change Standard Adjustments Process Small Scale Larger Scale Mass Production Selling Price High Fairly High Lower Total Revenue Peaks Falls Unit Costs Variable Profit Number of Competitors Few Stable Focus on Operations Flexibility, Reliability Scheduling, Capacity Cost Reduction, Productivity Cost Control, New Products

What Is Porter’s Diamond Of Competitive Advantage? Michael Porter tried to explain why a nation achieves international success in a particular industry He identified four attributes that promote or impede the creation of competitive advantage Factor endowments - a nation’s position in factors of production necessary to compete in a given industry can lead to competitive advantage can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how) Demand conditions - the nature of home demand for the industry’s product or service influences the development of capabilities sophisticated and demanding customers pressure firms to be competitive Have you ever wondered why some countries have certain industries that seem to be superior to those of other countries? Why for example, is Japan so strong in the global auto industry? Why does Switzerland dominate the pharmaceutical industry? These are questions that intrigued Michael Porter, who in 1990, believing that the theories at the time still left gaps in our understanding of trade patterns, tried to explain why a country might achieve international success in a particular industry. Porter identified four factors that he argued promoted or impeded the creation of competitive advantage in an industry. Together, he called these factors the diamond of competitive advantage. The first factor, called factor endowments, refers to a country’s position in the factors of production that can lead to a competitive advantage. Here Porter included things like the skilled labor or infrastructure that were important to achieving a competitive advantage in a particular industry. Demand conditions, the second factor, refers to the nature of home demand for the industry’s product or service. Porter argued that sophisticated and demanding customers pressured firms to be more competitive.

What Is Porter’s Diamond Of Competitive Advantage? Relating and supporting industries - the presence or absence of supplier industries and related industries that are internationally competitive can spill over and contribute to other industries successful industries tend to be grouped in clusters in countries Firm strategy, structure, and rivalry - the conditions governing how companies are created, organized, and managed, and the nature of domestic rivalry different management ideologies affect the development of national competitive advantage vigorous domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced features The third factor, relating and supporting industries, refers to the presence or absence of supplier and related industries that are internationally competitive and contribute to other industries. According to Porter, successful industries will be grouped in clusters in countries, so if a country has world class manufacturers of semi-conductor processing equipment, it will tend to have a competitive semi-conductor industry. Finally, the fourth factor, firm strategy, structure, and rivalry, refers to the conditions in the nation that govern how companies are created, organized, and managed, and the nature of domestic rivalry. Porter suggest that when domestic rivalry is strong, there’s greater pressure to innovate, improve quality, reduce costs, and invest in advanced product features.

What Is Porter’s Diamond Of Competitive Advantage? Determinants of National Competitive Advantage: Porter’s Diamond This Figure shows the four factors that comprise Michael Porter’s Diamond of Competitive Advantage.

Summary Mercantilism Free trade theory Competitive theory A market to think about: Computers Hardware only!!!!