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7/30/2019 37997432 International Production Theory
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Lecture 3 :Theories of International Trade andInternational Production
International Business Management 1
Part A: Theories of International Trade
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Lecture 3 :Theories of International Trade andInternational Production
International Business Management 2
Part A:Theories of International TradeLearning Objectives:
To analyse the benefits for a country to engage in
international trade.
To review relevant theories that explain trade flows betweennations:
1. Mercantilism
2. Absolute Advantage
3. Comparative Advantage4. Heckscher-Ohlin Theory
5. The Product Life Cycle Theory
6. New Trade Theory
7. National Competitive Advantage: Porters Diamond
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Lecture 3 :Theories of International Trade andInternational Production
International Business Management 3
International Trade can be defined as theexchange of goods and services across borders.
Free Trade refers to a situation where aGovernment does not attempt to influence through
quotas or duties what its citizens can buy fromanother country or what they can produce and sellto another country.(Hill,1998 pp123).
Adam Smith (1776) argued that the invisible hand of
the market mechanism should determine what acountry need to import or export and not theGovernment .
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Lecture 3 :Theories of International Trade andInternational Production
International Business Management 4
Part A:Theories of International TradeBenefits of International Trade
Countries can import resources they lack at home.
Countries experience unequal endowment of resources such
as:
Natural resources
Human Resources
Capital
TechnologyCountries can import goods for which they are relatively
inefficient producer.
Specialisation often results in economies of scale and an
increased in world output.
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Lecture 3 :Theories of International Trade andInternational Production
International Business Management 5
Part A:Theories of International TradeMercantilism
Emerged in England in the mid 16th century.
Main tenant: Best interest in a country to maintain a trade
surplus i.e. to export more than it imports.
How to achieve trade surplus?Maximise export and minimise import
Through Government Intervention ,i.e. by:
Subsidising export andLimiting imports by imposing tariffs and quotas.
Viewed trade as zerosum game in which a gain by one
country results in a loss by another.
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Part A:Theories of International TradeMercantilism- Criticisms
Later Adam Smith and David Ricardo demonstrated that
trade is a positive-sum game i.e. a situation in which all
countries can benefit , even if some benefits more thanothers.
Trade Barriers are being gradually reduced in line with the
policies the World Trade Organisation.
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Lecture 3 :Theories of International Trade andInternational Production
International Business Management 7
Part A:Theories of International TradeTheory of Absolute Advantage Adam Smith, 1776 TheWealth of Nations
A country should specialize in production of and export
products for which it has absolute advantage.
A country has absolute advantage in the production of a
product when it is more efficient than any other countryproducing it.
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Lecture 3 :Theories of International Trade andInternational Production
International Business Management 8
Part A:Theories of International TradeTheory of Comparative Advantage, David Ricardo(1817),Principles of Political Economy
Rationale: Even if a country has absolute advantage in the
production of all goods, it doesnt need to produce all of them.
It should specialise in the production of those goods that it
produces most efficiently and buy from other countriesthose goods which it produces less efficiently.
Both countries gain from trade even if one of them is more
efficient than the other in producing everything.
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International Business Management 9
Part A:Theories of International TradeTheory of Comparative Advantage, David Ricardo(1817),
Principles of Political Economy
Assumptions:
Only two countries and two goods in real world thereare many countries and many goods.
Zero transportation costs.
Resources move freely from production of one good to
another within a country, but not across countries.
Price of resources in different countries are constant.
Fixed stocks of resources.
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International Business Management 10
Part A:Theories of International TradeHeckscher (1919)-Ohlin (1933)
Comparative advantage arises from differences in national
factor endowment.
Factor endowments are the extent to which a country isendowed with resources such as land, labour and capital.
As such, patterns of trade is determined by differences in
factor endowments rather than differences in productivity.
Principle- A country should: Specialize in the production of goods that make intensive
use of factors that are locally abundant, and then export
those goods.
Import goods that make intensive use of factors that are
locally scarce.
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Part A:Theories of International Trade
The Leontif Paradox (1953)
Using Hecksher-Ohlin theory, Leontif postulated that since the
US was relatively abundant in capital compared to other
nations, the US would be an exporter of capital intensive
goods and an importer of labour intensive goods.
However, he found that US exports were less capital intensive
than US imports
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Part A:Theories of International Trade
The Product Life Cycle, Raymond Vernon, 1966
Vernon argues that as products mature both the location of
sales and the optimal production location will change affecting
the flow and direction of trade.
Vernon classifies the whole process of a new product in a
market into four phases.
In the initial stage:A new product is developed by an advanced country (USA)
and sold in the domestic market.
The producer monopolizes production of the new product.
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Part A:Theories of International Trade
The Product Life Cycle, Raymond Vernon, 1966
While demand starts to grow in the USA, demand in other
advanced countries is limited to high income groups.
The limited demand in other advances countries does not
make it feasible for firms in those countries to start
production. They would rather satisfy the needs by exports
from the USA.
Over time demand for the new product starts to grow in the
other advanced countries to such an extent that it becomes
viable for foreign producers to start producing the products
for their home markets.
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Part A:Theories of International Trade
The Product Life Cycle, Raymond Vernon, 1966
While demand expand in the secondary markets:
Product becomes standardised.
Production moves to low production cost areasProduct now imported to USA and to other advanced
countries.
Example Xerox was first developed in the USA then set up
production in Japan (Fuji-Xerox) and Great Britain (Rank
Xerox).
Therefore, the place of production initially switches from theUnited States to other advanced nations and then to
developing countries.
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Part A:Theories of International Trade
The new trade Theory - Paul Krugman (1970s) argues that:
Substantial economies of scale result in increasing returns
i.e. as output increases ability to realise economies of scale
increases and cost per unit eventually falls.
Due to the presence of substantial economies of scale, world
demand will support a few firms in many countries.
The economic and strategic advantage of the firm act asbarriers to entry.
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Part A:Theories of International Trade
The new trade Theory - Paul Krugman (1970s) argues that:
Countries may export certain products simply because they
have one firm that was an early entrant in the industry (First-
mover advantage). For example, Boeing Aircrafts.
First-mover advantages are the economic and strategicadvantages that accrue to early entrants into an industry.
Therefore, Government may subsidize the firm at period ofentry and growth.
However, this theory is in contravention to the idea of freetrade.
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The National Competitive Advantage Michael Porter
(1990)
Porter, in his thesis, seek to determine the factors that
enable a nation to achieve and sustain international
success in a particular industry. For example, Japan
in the automobile industry.
His findings revealed that four attributes of a nation
shape the environment in which local firms compete
and these attributes promote creation of competitive
advantage at international level.
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The National Competitive Advantage Michael Porter
(1990)
M.E Porter (1990), The Competitive Advantage of Nations, Harvard Business
Review
Factor
Endowments
Firm Strategy,
Structure and
Rivalry
Demand
Conditions
Related and
Supporting
Industries
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The National Competitive Advantage Michael Porter
(1990)
Factor endowment: Nations position in factors ofproduction necessary to compete in a given industry.
Basic Factors: I.e. natural resources such aslocation, climatic conditions and demographic
conditions.
Advance Factors: Communication, skilled labourforce, infrastructure and technological advancement.
Unlike Basic factors, advanced factors are the
products of investment by individuals, companies
and Governments.
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International Business Management 20
The National Competitive Advantage Michael Porter
(1990)
Demand conditions: The nature and characteristics ofhome demand for the industrys product or service.
The characteristics of the local demand would normally
pressurise local firms to produce high standard products
quality and innovative products.
High quality and innovative products improve firms
competitive edge.
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The National Competitive Advantage Michael Porter
(1990)
Related & Supporting Industries: The presence orabsence in a nation of supplier industries or related
industries that are nationally competitive.
For instance, the quality of the input reflects to a large
extent on the firms competitive edge at the international
level.
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The National Competitive Advantage Michael Porter
(1990)
Firm strategy, structure and rivalry: Conditions in thenation influencing how companies are created,
organized, and managed.
The nature and extent of domestic rivalry induces firm
to:
Be more innovative
Improve quality of products
Be more efficient vis- a- vis competitors
Invest in research and development
The above help to create world-class competitors.
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Part B:Theories of International ProductionLearning Objectives:
To understand the definition of Multinational.
Discuss the various theories of International Production:
Classical/Neo Classical Models of Trade
Hymers Theory of International Production Vernons Product Life Cycle
The Electric Paradigm
Technological Accumulation Theory
The Investment Development Path
Alliance Capitalism
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International Business Management 25
Part B:Theories of International Production
Definition of Port folio Investment
The IMF Balance of Payment Manual (2003:98) includes in
the category of portfolio investment equity securities and
debt securities in the form of bonds and notes, money marketinstruments and financial derivatives.
To Ietto-Gillies (2005), international portfolio investment is
that investment which is undertaken for purely financial
reason and includes loans and equity investment (i.e. theacquisition of shares in a foreign company).
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Part B:Theories of International Production
Definition of Direct Investment
IMF Balance of Payment Manual (2003:86) defines direct
investment as investment made by the resident entity of one
economy to acquire lasting interest in an enterprise residentin another economy
According to the OECD (2004:6), foreign direct investment
enterprise is an enterprise (institutional unit) in the financial
or non-financial corporate sectors of the economy in which anon-resident investor owns 10 per cent or more of the votingpower of an incorporated....
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Part B:Theories of International Production
Port Folio Investment Vs Direct Investment
The demarcation between portfolio investment and FDI was
first drawn by Hymer (1960) who had had contradictory views
to that of neoclassical scholars (Iversen, 1935).
Hymer (1960) distinguishes direct investment from portfolio
investment by arguing that the former gives the firm control
over the business activities abroad where as the latter does
not.
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Part B:Theories of International Production
Neoclassical/ Classical Theories of Trade
The major assumptions of the neoclassical theory are:The market for cross border exchange was assumed to
be a costless mechanism.Resources were assumed to be immobile across
national boundaries but mobile within national
boundaries.
There was perfect flow of information.
Firms were assumed to engage in single activity.Entrepreneurs were assumed to be profit maximisers.
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Part B:Theories of International Production
Criticism on Neoclassical/ Classical Theories of Trade
The main criticisms of neoclassical approach to foreign
investment are:
The underlying concept of perfect competition isunrealistic.
It fails to consider other transaction costs.
It assumed perfect flow of information where as it is a
fact that information in the financial market is
pervasively asymmetric.It assumed no mobility of resources where as today the
world is considered as a global village where resources
move freely.
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Part B:Theories of International Production
Hymers (1960) Theory of International Production
The work of Hymer (1960) is considered as the first theory in
the literature of FDI.
The underlying principle of Hymers doctoral thesis is the
demarcation between FDI and portfolio investment.
Hymer notes that international production occurs as a result
of: The firms intention to grow further thus enhancing its
market position.
The existence of market imperfection
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Part B:Theories of International Production
Hymers (1960) Theory of International Production
Hymer also advocates that firms will engage in
international production only if they have advantage such
as production technology, finance, product differentiationor superior distribution network that are actually not
possessed by domestic firms.
+ =Domestic
Market
Imperfection
FirmsSpecific
Advantages
Foreign
Market
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Part B:Theories of International Production
Criticism of Hymers Theory
Hymers Theory was severely criticised by Dunning (1981)
who argues that Hymers thesis was only concentrated on the
motives of foreign investment (why) and completely omit thelocation factor (where) which play an important role indetermining FDI decisions.
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Part B:Theories of International Production
The Product Life Cycle, Raymond Vernon (1966)
Evaluating the growth of US FDI after the Second World War,
Vernons theory examined the following issues:
The factors that lead to the location of production abroad;
The location where the production of new product is
likely begin;
The consequences resulting from the flow of FDI; and
The location where new ideas and technology for newproducts are likely to originate.
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Part B:Theories of International Production
The Product Life Cycle, Raymond Vernon (1966)
His findings were as follows:
He notes that the US market is very large andcharacterised by high unit labour cost, large supply of
labour and high average income per capita.
New product will be located in the USA because
producers would be able to charge high prices given thehigh purchasing power of Americans
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Part B:Theories of International Production
The Product Life Cycle, Raymond Vernon (1966)
As the product reaches the maturity stage, competition
steps in and demand for the product in other foreign
market increases. The product is exported to nations most similar to the US
in demand patterns and standard of living.
In the final stage of the product life cycle, Vernon argues
that as products become more and more standardised, itwill eventually require high capital intensity and unskilled
labour.
The firm may relocate its production facilities to lower cost
producing countries.
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The Product Life Cycle, Raymond Vernon (1966)-Criticisms
Later in 1979, Vernon came up with a critical review of his
previous analysis with more focus on the changing macro
environment in Europe.
He noted that changes in the macro economic
environment have challenged the application of his initial
theory which was relevant in the 1960s.
For instance, changes in Europe between 1970 and
1979 have gradually closed up the gap between Europeand USA. (differences in standard of living, cost of
labour, size of markets and consumer tastes between
the two countries have significantly reduced).
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The Product Life Cycle, Raymond Vernon (1966)-Criticism
Moreover, the technological leadership enjoyed by the
US in the 50s and early 60s gave way to a more
balanced technological competition between the US,Europe and Japan.
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Dunnings Eclectic Framework(1977) Dunnings (1977) eclectic framework is considered as
the complete theory of international production as it
corrected certain omissions in the earlier theories.
Dunnings approach of internationalisation attempted to
analyse the why, where and whendecisions in terms of
ownership, locational and internalisation (OLI)
advantages.
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Dunnings Eclectic Framework(1977)Ownership Advantages Advantages that are
specific to a particular enterprise.
Locational Advantages Advantages that are
specific to a country which are likely to makeattractive for foreign investors, i.e. location-specific
endowments
Internalisation Advantages Benefits that are
derived from producing internally to the firm.
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Technological Accumulation TheoryAcknowledge that the superiorOwnership advantages
determine the establishment of foreign operations.
However, there are other benefits accrued to firms
which are more important to ensure foreignestablishment.
For instance, technological capabilities of a firm which
are the result of internal learning processes involving trial
and error, are primary sources of a firms competitive (orownership, in the OLI paradigm) advantage (Dunning,
1993).
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Technological Accumulation Theory (Rosenberg, 1982) notes that technological change is
incremental in that it represents the cumulative impact of
small improvements while Cantwell (1898,1990) argues
that the innovation of a firm specific technology is a
cumulative process.
Technology Accumulation Theory argue that the ability of
the firms to continually improve and refine their
technology which allow the multinationals to retain its
competitive edge.
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Investment Development Path (Dunning, 1981)
The objective of the research was to determine the
relationship between a country's net foreign direct
investment and its level of economic development
The Investment Development Path (IDP) theory: establishes a dynamic and positive relationship
between the countrys level of inward and outward
foreign investment and the level of industrialisation and
identifies the stages through which countries progress.
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Investment Development Path (Dunning, 1981)The premise of the theory is two fold:
First, it identifies economic development as a process
of structural change (such as improvement in the
country's technological and productive system);The structural change influences the pattern of both
inward and outward foreign direct investment.
The IDP theory argues that countries progress through the
following five stages.
Countries progress in terms of the countrys location-
specific advantage which gradually upgrade the domestic
firms ownership specific advantage.
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Investment Development Path (Dunning, 1981)
Stages in the Investment Development PlanCharacteristics
Stage Country Local Firms
1st Stage
Pre Industrial
Society
1. Weak Local Demand
2. Inadequate Infrastructure
Limit Countrys attractiveness to
foreign investors
Local Firms lack
ownership specific
advantage to investabroad.
2nd Stage 1. Government initiates basicinfrastructure.
2. Local Demand grows.
3. FDI takes place
Net Investment position isnegative
Ownership specific
advantage of domestic
firms are weak and limits
outward investment.
Firms may invest in other
countries if subsidise by
Government
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Investment Development Path (Dunning, 1981)
Stages in the Investment Development PlanCharacteristics
Stage Country Local Firms
3rd Stage Decrease in the rate of growth ofinward investment flows due to
growing competitiveness of local
firms.
Countrys net outward investment
position is still negative but is on
an upward trend
Domestic firms increase
outward investment due to
improvement of ownership
specific advantage.
4th Stage Outward FDI stock exceedsinward FDI stocks
More firms investing abroad.
5th Stage Net Investment position willimprove further.
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Alliance Capitalism
Constant pressure from both competitors and consumers
to continually improve and upgrade quality of goods and
services.
Need to invest in research and development and at the
same time to search for new market which entails hugeinvestment.
Thus, in order to exploit effectively their core
competencies, firms are increasingly finding that they
need to combine their core competencies with those ofother firms.
Theabove has led to the proliferation of what is known asallianceCapitalism
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Alliance Capitalism
A Strategic Alliance can be defined as a mutuallybeneficial long-term relationship between two or more
parties to pursue a set of agreed goals or to meet a
critical business need while remaining independent
organisations.
Main objective is to maximise the benefits of the jointinternalisation of interrelated activities.
Examples: Alliance between BMW and Rolls Royce- Production
of engine for the aero engine market.
Sony- Ericsson
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Alliance Capitalism
Benefits:
1. More flexible approach to production by capturing benefits
of their own competencies.
2. More resources (Capital) for Research and Development.
3. More innovative ideas and fault free products as a result
of continuous improvement and transfer of technology.
4. Better position to extend the Product Life Cycle.
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Alliance Capitalism
Benefits:
5. Ability to bring together complementary skills and assets
that neither company could easily develop on its own.
6. To gain access to new markets of distribution channels.
7. Benefit from economies of scale.
8. To overcome Government mandated trade barriers.
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