1. Chapter 3
International Trade Theories

2. Mercantilism
A complex political and economic philosophy evolved in Europe between the 16th and 18th centuries based on the belief that:
A nation’s wealth depends on accumulated treasure, usually, gold, silver, precious stones, metals, etc.
To increase wealth, nations should increase exports and reduce imports.
Trade surplus in gold and silver would make a nation wealthier.

3. Mercantilism
It relies on the fact that exports bring in money, so it is positive, and imports cause outflow of money, so it is negative.
Today, there is still mercantilism in the form of economic nationalism.
For example, Japan is called “fortress of mercantilism”. They have an impenetrable market with traditional preoccupation with self-sufficiency, and “us against them” mentality. There are no obvious trade barriers against foreign products, but have “cultural barriers” where Japanese don’t buy foreign prıducts.

4. Mercantilism Outcomes of mercantilism:
Created a trade surplus which would be paid for in gold or silver.
Protecting jobs within mercantilist nations.
Generation of benefits for certain economic groups (domestic merchants, artisans, and shippers.
Albeit generation of benefits at a cost to other groups (consumers and emerging industrialists.
Although Adam Smith tried to destroy the mercantilist philosophy in the late 1700s, its arguments live on.

5. Mercantilism
Many manager believe that China remains a present-day “fortress of mercantilism” that raises barriers to imported goods while giving Chinese exporters an unfair advantage.
Chinese authorities have resisted efforts to revalue their currency, the yuan or renminbi.
40 % of the price advantage of companies from China is due to mercantilist policies of China’s central government, including an undervalued currency, export subsidies, and lax regulatory oversight.

6. Theory of Absolute Advantage
Absolute advantage is the capability of one nation to produce more of a good with the same amount of inputs than other countries.
It means the nation is producing same amount of goods using fewer resources.
A nation has an absolute advantage if it is producing a good better and more efficiently than other countries.
This theory is developed by Adam Smith.

7. Theory of Absolute Advantage
Adam Smith argued:
The market forces, not government controls, should determine the direction, volume, and composition of international trade.
Under free, unregulated trade, each nation should specialize in producing those goods it could produce most efficiently (for which it had an absolute advantage, either natural or acquired).
Some of these goods would be exported to pay for imports of goods that could be produced more efficiently elsewhere.

8. Example Before trade After trade Commodity Tons of rice 3 1 4 6 0 6
Specialization
After trade
Commodity
US Japan Total
Tons of rice
Cars

9. Theory of Comparative Advantage
If a country does not have an absolute advantage in producing neither of the goods, but it can produce one good more efficiently than the others, it is still beneficial if it trades.
Comparative advantage arises when a country produces one good better and more efficiently than it is producing other goods.
This theory is developed by David Ricardo.

10. Theory of Comparative Advantage
David Ricardo argued:
Even though one nation held an absolute advantage over another in the production of each of two different goods, international trade could still create benefit for each country.
Representing a positive-sum game, or one in which both countries “win” from engaging in trade.
The only limitation to such benefit-creating trade is that the less efficient nation cannot be equally less efficient in the production of both goods.

11. Example Before trade After trade Commodity Tons of rice 6 3 9 12 0 12
Specialization
After trade
Commodity
US Japan Total
Tons of rice
Cars

12. Newer Explanations for the Direction of Trade
The international trade theory was have been discussing was essentially the only theoretical explanation of trade available to us until the second half of the 20th century. Since that time, however, several other possible explanations for international trade have been developed as follows:
Differences in Resource Endowments
Overlapping Demand
International Product Life Cycle (IPLC)
Economies of Scale and the Experience Curve
National Competitive Advantage from Regional Clusters

13. Theory of Factor Endowments
The thoery is developed by Hecksher-Ohlin:
It argues that countries export products requiring large amounts of their abundant production factors and import products requiring large amounts of their scarce production factors.
If a factor of production is abundant, it means that it is less costly. So the good will have a lower price, thus it will be demanded by other countries.

14. Leontief Paradox
Wassily Leontief, in 1953, found that US is exporting labor-intensive products, while US is claiming that it is a capital-,ntensive country.

15. Theory of Overlapping Demand
Theory formulated by Stefan Linder:
This theory emphasizes demand factors in international trade. It is only applying to manufactured goods.
Linder states that a nation’s per capita income level will determine what type of goods it will demand.
International trade in manufactured goods will be more intense between the countries with similar per capita income levels, than between countries with dissimilar income levels. So there is overlapping demand between the goods that are traded, where consumers in both countries are demanding the same product.

16. Theory of Overlapping Demand
The intra-industry trade occurs because of product differentiation.
Product differentiation: The development of products that have unique differences, with the intent of positively influencing demand.

17. Theory of Overlapping Demand
The iPhone 8 goes up against the Samsung Galaxy S8 Plus

18. Theory of International Product Life-Cycle (IPLC)
The thoery is developed by Raymond Vernon:
It is a theory explaining why a product that begins as a nation’s export eventually becomes its import.
This theory applies only to trade in manufactured goods.

19. Theory of International Product Life-Cycle (IPLC)
At the introductory stage, firms have invested and developed a product. They need rich and sophisticated customers to sell the products. So they target the customers in the developed countries. Also at the early stages, the product has to be close to the market, because the product is still at the developing stage. Management can quickly react to the customer feedback. At this stage exports increase, too.
At the maturity stage, competitors fill the market, profits and sales are stabilized. Firms look for cheaper ways of producing the goods to lower the cost of production. Exports start declining.
At decline stage, firms start producing in overseas markets. The product is imported from foreign markets.

20. International Product Life Cycle (IPLC)

21. Economies of Scale and the Experience Curve
Countries benefit from economies of scale; situation where the average cost of producing each unit of output decreases as a plants get larger and more efficient equipment is used, per unit cost of production declines.
Reasons for economies of scale:
Larger and more efficient equipment is used.
Companies get volume discounts on purchases.
FC allocated over larger volume of units.
Learning curve – as firms increase production, they learn ways of improving production technology and reduce cost of production.

22. Economies of Scale and the Experience Curve
Experience curve: Reduction of unit costs of production as accumulated volume increases, due to improved efficiency resulting from increased cumulative experience and learning.

23. First Mover Theory
This theory argues that firms that enter the market first (first movers) will dominate that market.
As the first mover increases production and gains a large market share, it starts benefiting from economies of scale. The firms that enter the market after that cannot compete with the cost advantages of the first movers. 70% of the largest global firms are first movers.
The new firms can dominate the market through technology and innovation. They either find a way of reducing costs and/or innovate a new product.
Excluded

24. Theory of Competitive Advantage of Nations
Michael Porter argues that a firm’s ability to become global will depend on four factors.
The place that provides those four factors is called a global platform.
These four factors will have a determining impact on the ability of the lcoal firms to gain competitive advantage.

25. Porter’s Diamond
Demand conditions – It is the nature of domestic demand. Sophisticated and demanding customers will force the firms to innovate and improve the quality of their products.
Factor conditions – It is the level and composition of factors of production.
Basic factors are classical factors of production
Advanced factors are improved factors of production; like, educated workforce, free ports, advanced communication systems, infrastructure, etc.

26. Porter’s Diamond
Related and supporting industries – Suppliers of industry and industry support services are important for competitive success by providing a network of suppliers, subcontractors, and a commercial infrastructure.
Firm’s Strategy, structure, and rivalry – It is the extend of domestic competition, the existence of barriers to entry, and the firm’s management style and and organization.

27. Theory of National Competitive Advantage from Regional Clusters
Porter argues that these factors are fundamentally interrelated, creating a “virtuous circle*” of resource generation and application as well as responsiveness in meeting the demands of customers, as depicted in Figure 2.3.
*Economic expansion would itself produce a virtuous circle of increased productivity, increased exports, and increased growth

28. Theory of National Competitive Advantage from Regional Clusters
This theory argued: A nation’s relative ability to design, produce, distribute, or service products within an international trading context while earning increasing returns on its resources.

29. Theory of National Competitive Advantage from Regional Clusters
Alfred Marshall’s seminal work on economic theory helped to explain:
Why in many industries, firms tend to cluster together on a geographic basis?
He suggested for three reasons:
Advantages associated with pooling of a common labor force.
Gains from the development of specialized local suppliers.
Benefits that result within the geographic region from the sharing of technological information.

30. Summary of International Trade Theory
International trade occurs primarily because of relative price differences among nations. These differences stem from differences in production costs, which result from:
Differences in the endowments of the factors of production.
Differences in the levels of technology that determine the factor intensities used.
Differences in the efficiencies with which these factor intensities are utilized.
Foreign exchange rates.

31. Arguments for trade restrictions
National defense argument
Infant industry argument
Protecting domestic jobs
Retaliation

32. National defense argument
Certain industries must continue to exist for national defense purposes. They may not have any kind of advantage, but the country will rely on them in wartime.
Counterargument→The army needs so many products. If the resources are used to produce all of them the economy will lose efficiency.

33. Infant industry argument
Infant industry needs protection from imports, until the labor force is trained, production techniques are mastered, and economies of scale is achieved. Without protection, the industry can not compete with low-cost imports.
Counterargument→Without competition, the firm will never improve efficiency and quality.

34. Protecting domestic jobs
If imports flood the market and domestic industries close down, local jobs are lost and unemployment increases.
Counterargument→Productivitiy of labor is higher in developed countries because of capital input. Also if we stop imports, other countries will stop our exports.

35. Scientific tariff
An import duty to equalize the price of imports to the prices of goods produced domestically.
Rebuttal→The consumers will be penalized

36. Retaliation
Exporters in other countries may ask to stop imports from this country, if the country stops imports.

37. Dumping It is selling a product abroad for less than;
the cost of production,
the price in the home market, or
the price to third countries.

38. New kinds of dumping
Social dumping→unfair competition by developing countries that have lower labor costs and poorer working conditions.
Environmental dumping→unfair competition because of country’s relaxed environmental standards.
Financial services dumping→unfair competition because of country’s low capital/asset ratio.
Cultural dumping→unfair competition caused by cultural barriers aiding local firms.

39. Subsidies
They are financial contributions, provided directly or indirectly by the government, which provides benefits to the firm, like grants, preferential tax treatment, government assessment of business expenses, etc.

40. Countervailing duties
Additional import taxes levied on imports that have benefited from export subsidies.

41. Other arguments for trade restrictions
1) There should be trade restrictions to permit diversification of domestic economy.
2) There should be trade restrictions to improve trade balance.

42. KINDS OF TRADE RESTRICTIONS
Tariff barriers
Ad valorem duty
Specific duty
Compound duty
Variable levy
Non-tariff barriers (Quantitative barriers)
Quotas
Voluntary export restraints
Orderly marketing arrangements
Non-quantitative, non-tariff barriers
Direct government participation in trade
Customs and other administrative procedures
Standards

43. Tariff barriers
Ad valorem duty is levied as a percentage of the invoice value of the imported good.
Specific duty is a fixed sum levied on a physical unit of the imported good.
Compound duty is a combination of ad valorem and specific duties.
Variable levy is an import duty set at the difference between the world market prices and local government-supported prices.

44. Quotas are numerical limits placed on specific classes of imports
It is absolute quotas if further imports are prohibited after the number for the year is reached.
It is tariff-rate quotas if the imports have no duties (or low duties) up to an amount and then a tariff is levied for the rest.

45. Quotas are global (applied to all imports), or
allocated (certain numbers are allocated to certain countries).
Allocated quotas are discriminatory in nature

46. Voluntary export restraints
They are export quotas imposed by the exporting nation.
Example: In 2011, 26 October, two German were caught taking 543 cactuses out of Mexico on the Mexican border. The exportation of these plants were prohibited by the government.

47. Orderly marketing arrangements
They are formal agreements between exporting and importing countries that stipulate the import or export quotas each nation will have for a good. (Multi-fiber arrangement, eg)

48. 3) Non-quantitative, non-tariff barriers
Direct government participation in trade
Subsidy: Financial contribution provided directly or indirectly by a government, which confers a benefit, like grants, preferential tax treatment, government assessment of business expenses, etc.
Government procurement policies: Government prefers domestic producers in purchases. (minimum local content law, eg)

49. Lower duty for more local input
Import duties are set in such a way to encourage local input. Semi-finished goods or intermediate goods may pay lower import duties, eg.

50. b) Customs and other administrative procedures
c) Standards

51. Update about world distribution of income
Nepal Prime Minister Jhala Nath Khanal:
“30 years ago there were 25 countries in the category of Least Developed Countries (per capita income les then $750). After 30 years, we have 48 countries in that category. Only 3 countries went out of that category in the last 30 years.”

52. Categories based on levels of economic development
Developed nations are industrialized nations which are technically most developed.
Developing nations are world’s lower-income countries which are less technically developed.
Newly industrialized countries (NIC) are the four Asian Tigers and middle-income economies, like Brazil, Mexico, Malasia, Turkey, Chile, Thailand.
Transition countries are the former communist countries, like Hungary, Russia, Kazakhstan, etc.

53. CIA World Factbook
There are 34 developed countries according to the CIA World Factbook:
Andorra, Australia, Austria, Belgium, Bermuda, Canada, Denmark, England, Faroe Islands, Finland, France, Germany, Greece, Holy See, Iceland, Ireland, Israel, Italy, Japan, Lichtenstein, Luxembourg, Malta, Monaco, Nethelands (Holland), New Zealand, Norway, Portugal, Saint Marino, Spain, Sweden, Switzerland, Turkey, USA.

54. Newly Industrialized Countries (NICs)

55. The allocation of the GDP of the world

56. World Bank classification:
Low-income countries; where per-capita income is less than $750/year.
Lower-middle income countries; where per capita income is between $750-$3000/year.
Upper-middle income countries; where per capita income is between $3000-$9000/year.
High-income countries; where per capita income is above $9000/year.

57. Problems of GNP per capita as an indicator:
Unregistered and underground economy are not reflected
Income distribution is overlooked
Purchasing power parity (PPP) is not shown

58. Characteristics of less-developed countries:
GNP/capita less than $6000/year.
Unequal distribution of income.
Technological dualism.
Regional dualism.
High proportion of population in agricultural sector.
Disguised unemployment.
High population growth.
High rate of illiteracy and insufficient educational facilities.
Malnutrition and health problems.
Political instability.
Few export goods, generally agricultural goods and minerals.
Difficult topography.
Low saving rates and inadequate banking facilities.

59. Human-Needs Approach
It stresses that economic development is elimination of poverty and unemployment as well as an increase in income.
Poverty is illiteracy, malnutrition, diseases, early deaths.
Import substitution is locally producing the goods to replace imports. It is necessary for economic development in Human-needs Approach.

60. THEORIES OF INTERNATIONAL INVESTMENT
EXPLAINING FDI:
THEORIES OF INTERNATIONAL INVESTMENT
Several leading theories of foreign direct investment

61. Strategic motives for decisions to invest abroad
FDI involves the establishment of production or other facilities abroad, either through greenfield investment* or cross-border acquisition**.
Strategic motives will be the driving force for decisions to invest abroad, driven by desire to find:
New markets
Raw materials
Production efficiencies
New technologies
Managerial expertise
Political safety of the firm’s operations
Or Respond to competitive or other pressure in the external environment.
*Green field investment: the establishment of new facilities from the ground up.
**Cross-border acquisition: the purchase of an existing business in another nation.

62. Contemporary Theories of FDI
Monopolistic Advantage Theory
Product and Market Imperfections Theory
International Product Life-Cycle Theory
“Follow the leader” Theory
Cross-Investment Theory
Internationalization Theory
Eclectic Theory of International Production

63. 1) Monopolistic Advantage Theory (by Hymer)
FDI is made by the firms in oligopolistic industries posessing technical and other advantages over indigenous firms.

64. Monopolistic Advantage Theory
This modern theory stems from research showing that foreign direct investment occurs largely in oligopolistic industries rather than in industries operating under near-perfect competition.

65. Monopolistic Advantage Theory
It means, the firms in these industries in order to overcome liabilities associated with being a foreigner, must possess advantages not available to local firms - such as:
Lack of knowledge about local market conditions
Increased costs of operating at a distance
Differences in culture
Language
Laws and regulations
Institutions
that cause a foreign company to be at a advantage against local firms.

66. Monopolistic Advantage Theory
Under this perspective, the advantages must be:
Economies of scale
Superior technology
Superior knowledge in:
Marketing
Management
Finance
FDI takes place because of these product and factor market imperfections.

67. 2) Product and Market Imperfections Theory (by Caves)
Expanded Hymer’s work and added that superior knowledge permitted the investing firm to produce differentiated products that the consumers would prefer to similar locally made goods and thus would give the firm some control over the selling price and advantage over the indigenous firms.

68. 3) International Product Life-Cycle Theory (by Vernon)
To avoid losing a market, firms are forced to invest in overseas facilities to compete with cheap imports at home.

69. 4) Cross-Investment Theory (by Graham)
Oligopolistic firms invest in eachother’s home countries as a defense measure.

70. 5) “Follow-the-leader” Theory (by Knickerbocker)
When the leader firm enters foreign markets, other firms in the industry follow the leader.

71. 6) Internationalization Theory (by Aliber)
If a firm obtains a higher price for its knowledge by using it than selling it, it will prefer FDI.

72. Internationalization Theory
This theory suggests that:
A firm may have superior knowledge, but due to insufficiency in external market (i.e., transaction costs), the firm may obtain a higher price for that knowledge by using the knowledge itself, rather than by selling it in the open market.
The company is able to send the knowledge across borders:
by investing in foreign subsidiaries for activities like supply, production, or distribution, rather than licensing.

73. 7) Eclectic Theory of International Production (by Dunning)
The firm will invest overseas if it has three kinds of advantages:
a. Ownership specific→the extend to which tangible and intangible assets not available to other firms
b. Internationalization→if it is the firm’s interest to use its ownership-specific advantages (internationalize) rather than license them to foreigners
c. Location-specific→the firm will profit by locating its production facilities overseas

74. Dynamic Capabilities This perspective argues:
Ownership of specific knowledge or resources is necessary, but not sufficient, for achieving success in international FDI.
The firm must be able to:
Effectively create and exploit dynamic capabilities for quality and/or quantity-based deployment.
These capabilities in order to produce competitive advantage must be:
Transferable to international environments

75. Ownership specific
This is extent to which a firm has or can develop a firm-specific advantage through ownership of tangible and intangible assets that are not available to other firms and can be transferred abroad.
3 basic ownership-specific advantages*:
Knowledge or technology
Economies of scale or scope
Monopolistic advantages associated with unique access to critical inputs or outputs.
*ownership-specific advantages: generate lower costs and/or higher revenues that will offset the added costs of operating at a distance within foreign location.

76. Location Specific
A foreign market must have specific characteristics, of an:
Economic
Social
Political nature
(e.g., market size, tariff or nontariff barriers, or transport costs)
Firm will be profitable with exploit its firm-specific advantages by locating to the market than from serving the market through exports.

77. Internationalization
Firms have various alternatives for entering foreign markets, ranging from arm’s-length market transactions* to use of hierarchy via a wholly owned subsidiary.
It is in the firm’s best interests to exploit its ownership-specific advantages through internationalization where rather the market does not exist or it functions inefficiently, causing the transaction costs of using market-based (arm-length) options to be too high.
*The concept of an arm's length transaction assures that both parties in the deal are acting in their own self-interest and are not subject to any pressure or duress from the other party. It also assures third parties that there is no collusion between the buyer and seller.

78. Large, research-intensive firms in oligopolistic industries.
Summary
All these theories offer reasons companies find it profitable to invest overseas.
As we stated in Chapter 1, all motives can be linked in some way to the desire to increase or protect not only profits but also sales and markets.
There is one commonality to nearly all of those theories that is supported by empirical test:
The major part of direct foreign investment is made by:
Large, research-intensive firms in oligopolistic industries.