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INTERNATIONAL BUSINESS
Chapter 5 : International Trade :
5.1 Theories of International Trade
5.2 International Trading Environment
5.3 Cross-National Cooperation and Agreements
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5.1 Theories of International Trade :
Countries wrestle with the question of what, how
much and with whom their country should import and
export Various theories of international trade provide
insights about favorable location for exports as well as
potentially successful export products
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In absence of government trade restrictions, given
products are exported from lower cost to higher cost
production locations. Therefore these theories also
help companies determine where to locate theirproduction facilities
Trade restrictions may diminish export capabilities
and cause companies to locate some production in the
restricting countries
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5.1 Theories of International Trade :
5.1.1 Interventionist theories
5.1.2 Free trade theories
5.1.3 Trade pattern theories
5.1.4 The statics and dynamics of trade
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5.1.1 Interventionist theories :
These theories prescribe government intervention in
international trade
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5.1.1 Interventionist theories (contd.) :
5.1.1.1 Mercantilism
5.1.1.2 Neo-mercantilism
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5.1.1 Interventionist theories (contd.) :
5.1.1.1 Mercantilism :
According to Mercantilism trade theory, a countrys
wealth is measured by its holding oftreasure, i.e.gold. This theory formed the foundation of economic
thought from about year 1500 to 1800
According to this theory, countries should export
more than they import and if successful, should
receive gold from countries that run deficit
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5.1.1.1 Mercantilism (contd.) :
Mercantilism flourished because of :
Government policies
The concept ofBalance of Trade
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Mercantilism flourished because of (contd.) :
Government policies :
To export more than they imported, governments
imposed restrictions on most imports and subsidisedproduction of products that could otherwise not
compete in domestic or export markets
European colonial powers used their colonial
possessions to support this trade objective. Colonies
supplied many commodities that the colonising
country might otherwise purchase from other country
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Government policies (contd.) :
Colonial powers sought to run trade surpluses with
their colonies as an additional way to obtain revenue
Colonial powers not only monopolised colonial tradebut also prevented the colonies from engaging in
manufacturing
The colonies had to export lass value added raw
materials and import more value added manufactured
products
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Mercantilism flourished because of (contd.) :
The concept ofBalance of Trade :
Balance of trade is the difference between export and
import of the country In the mercantilist period, the deficit in Balance of
trade was made-up by a transfer of gold. Today it is
made-up by holding the deficit countrys currency or
investments denominated in that currency. In effect,
the surplus country is granting credit to the deficit
country
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5.1.1 Interventionist theories (contd.) :
5.1.1.2 Neo-mercantilism :
Recently emerged term neo-mercantilism refers to the
approach of countries that try to achieve favorableBalance of trade in an attempt to achieve some social
or political objective
A country may try to achieve full employment by
setting economic policies that encourage its
companies to produce in excess of the demand at
home, to send the surplus abroad
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5.1.2 Free trade theories :
Why countries need to trade at all? Many countries,
following mercantilist policy did try to become as self-
sufficient as possible through local production ofgoods and services
Some countries take a more lenient approach,
because they believe that government programs lead
to inefficiency. Therefore they allow market forces to
determine trading relations between the countries
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5.1.2 Free trade theories (contd.) :
Free trade theories hold that the nations should
neither artificially limit imports nor promote exports.
Consumers would buy those products that best servetheir needs, thereby determining which producers
survive in the market
Free trade theories imply specialisation, i.e. nations
producing something for domestic consumption andexport, while using the export earning to buy import
products and services produced abroad
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5.1.2 Free trade theories (contd.) :
5.1.2.1 Absolute advantage theory
5.1.2.2 Comparative advantage theory
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5.1.2 Free trade theories (contd.) :
5.1.2.1 Absolute advantage theory :
In 1776Adam Smith questioned the mercantilists
assumptions and proposed that the real wealth of acountry consists of the goods and services available to
its citizens
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Adam
Smith
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5.1.2.1 Absolute advantage theory (contd.) :
The theory ofabsolute advantage developed by Smith
holds that different countries produce some goods
more efficiently than other countries. Thus globalefficiency can increase through free trade
Based on this theory,Adam Smith questioned why the
citizens of any country should have to buy
domestically produced goods, when they could buythose goods more cheaply from abroad
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5.1.2.1 Absolute advantage theory (contd.) :
Adam Smith reasoned that if trade were unrestricted,
each country would specialise in those products that
gave it a competitive advantage Each countrys resources would shift to the efficient
industries, because the country could not compete in
the inefficient ones
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5.1.2.1 Absolute advantage theory (contd.) :
Through specialisation, countries would increase their
efficiency, because of following reasons :
Labour could become more skilled by repeating thesame tasks
Labour would not loose time in switching from the
production of one kind of product to another
Long production runs would provide incentives for the
development of more effective working methods
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5.1.2.1 Absolute advantage theory (contd.) :
A country could then use its excess specialised
production to buy more imports than it could have
otherwise produced As perAdam Smith, marketplace would decide what
products a country should specialise
A countrys advantage would be either natural or
acquired
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5.1.2.1 Absolute advantage theory (contd.) :
Natural advantage :
A country may have a natural advantage in producing a
product because of : Climatic conditions
Access to certain natural resources
Availability of certain labour forces
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Natural advantage (contd.) :
The more the two countries climates differ, the more
likely they will favour trade with one another
Soil and topography are important determinants ofthe types of products a country can produce most
efficiently
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Natural advantage (contd.) :
Variations among countries in natural advantages also
help explain in what countries certain manufactured
or processed products might be best produced By processing an agricultural commodity or natural
resource prior to exporting, companies can reduce
transportation costs
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5.1.2.1 Absolute advantage theory (contd.) :
Acquired advantage :
Worlds trade today is more in services and
manufactured goods than in agricultural goods andnatural resources
Countries that produce manufactured goods and
services competitively have an acquired advantage,
usually in eitherproductorprocess technology
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Acquired advantage (contd.) :
An advantage ofproduct technologyenables a country
to produce a unique product or one that is easily
distinguished from those of competitors An advantage inprocess technologyis a countrys
ability to produce a homogeneous product (i.e. one
not easily distinguished from that of competitors)
more efficiently
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Acquired advantage (contd.) :
Acquired advantage through technology has created
new products, displaced old ones and altered trading
partner relationships Companies have developed new uses for old products
Products have been at least partially displaced by
substitutes
Technology can overcome natural disadvantages
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5.1.2.1 Absolute advantage theory (contd.) :
Demonstration ofAbsolute advantage theory :
Two countries, namely USA and Brazil produce two
commodities, namely wheat and coffee Cost of production is defined in terms of the resources
needed to produce either wheat or coffee
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Demonstration ofAbsolute advantage theory (contd.) :
Assumptions :
Brazil and USA are the only existing countries
Each has the same amount of resources to produceeither wheat or coffee, say 100 units
Brazil takes 4 units of resources to produce a ton of
coffee and 10 units per ton of wheat USA takes 20 units per ton of coffee and 5 units per
ton of wheat
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Demonstration ofAbsolute advantage theory (contd.) :
Brazil takes fewer resources to produce a ton, hence
its more efficient than USA in coffee production
USA is more efficient than Brazil in wheat production
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25
12.5
5
5 10 20
US production possibilities
Brazil production possibilities
Qty. of
Wheat(M.T.)
Qty. of
Coffee
(M.T.)
0
2.5
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Demonstration ofAbsolute advantage theory (contd.) :
If there is no foreign trade between the two countries
and if both the countries devote half of their
resources to producing coffee and wheat, then Brazilcan produce 12.5 tons of coffee and 5 tons of wheat
The USA can produce 2.5 tons of coffee and 10 tons of
wheat
Without trade, their combined production is 15 tons
of coffee and 15 tons of tons of wheat
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Demonstration ofAbsolute advantage theory (contd.) :
Specialisation increases the production of both the
commodities, from 15 to 25 tons of coffee and from
15 to 20 tons of wheat Thus by trading, global efficiency is optimised and the
two countries can have more of the two commodities,
than they would without trade
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5.1.2 Free trade theories (contd.) :
5.1.2.2 Comparative advantage theory :
In 1817 David Ricardo examined the question what
happens when one country can produce all productsat an absolute advantage? and developed the theory
of comparative advantage
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5.1.2 Free trade theories (contd.) :
5.1.2.2 Comparative advantage theory :
In 1817 David Ricardo examined the question what
happens when one country can produce all productsat an absolute advantage? and developed the theory
of comparative advantage
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5.1.2.2 Comparative advantage theory (contd.) :
The theory ofcomparative advantage says that the
global efficiency gains may still result from trade, if a
country specialises in those products that it canproduce more efficiently than other products,
regardless of whether other countries can produce
those same products even more efficiently
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5.1.2.2 Comparative advantage theory (contd.) :
A country gains, if it concentrates its resources on
producing the commodities it can produce most
efficiently. It then trades some of these commoditiesfor those commodities it has relinquished
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5.1.2.2 Comparative advantage theory (contd.) :
Demonstration ofComparative advantage theory :
Two countries, namely USA and Brazil produce two
commodities, namely wheat and coffee Cost of production is defined in terms of the resources
needed to produce either wheat or coffee
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Demonstration ofComparative advantage theory(contd.) :
Assumptions :
Brazil and USA are the only existing countries Each has the same amount of resources to produce
either wheat or coffee, say 100 units
Brazil takes 10 units of resources to produce a ton ofcoffee or wheat
USA takes 5 units of resources to produce a ton of
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Demonstration ofComparative advantage theory(contd.) :
USA is more efficient in producing both wheat and
coffee than Brazil. Thus USA has an absoluteadvantage in production of both the products
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20
10
6
5
5 10 12.5 2517.5 18.25
US production possibilities
Brazil production possibilities
Qty. of
Wheat(M.T.)
Qty. of
Coffee(M.T.)
0
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Demonstration ofComparative advantage theory(contd.) :
If there is no foreign trade between the two countries
and if both the countries devote half of theirresources to producing coffee and wheat, then Brazil
can produce 5 tons of coffee and 5 tons of wheat
The USA can produce 10 tons of coffee and 12.5 tons
of wheat
Without trade, their combined production is 15 tons
of coffee and 17.5 tons of tons of wheat
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Demonstration ofComparative advantage theory(contd.) :
Although USA has an absolute advantage in
production of both coffee and wheat, it has acomparative advantage only in production of wheat.
This is because its advantage in wheat production is
comparatively greater than its advantage in coffee
production
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Demonstration ofComparative advantage theory(contd.) :
By using the same amount of resources, USA can
produce 2.5 times as much wheat as Brazil, but onlytwice as much coffee
Through trading, the combined production of coffee
and wheat within the two countries can be increased
as follows
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Demonstration ofComparative advantage theory(contd.) :
If the combined production of wheat is unchanged
(from when there was no trade), USA could produceall 17.5 tons of what by using 70 units of resources .
The remaining 30 units of USAs resources could be
used for producing 6 tons of coffee
The combined wheat production has stayed at 17.5tons, but the coffee production has increased from 15
to 16 tons
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Demonstration ofComparative advantage theory(contd.) :
If the combined coffee production is unchanged from
the time before trade, Brazil could use all its resourcesto produce 10 tons of coffee. USA could produce the
remaining 5 tons of coffee by using 25 units of
resources . The remaining 75 units of USAs resources
could be used to produce 18.75 tons of wheat Without sacrificing any of the coffee available before
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5.1.2 Free trade theories (contd.) :
Assumptions and limitations ofFree trade theories :
Both absolute advantage theory and comparative
advantage theory are based on specialisation They hold that output will increase through
specialisation and that countries will be best off by
trading the output from their own specialisation for
the output from other countries specialisation
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Assumptions and limitations ofFree trade theories(contd.) :
Absolute advantage theory and comparative
advantage theory make assumptions, which may notbe always valid
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Assumptions and limitations ofFree trade theories(contd.) :
Full employment
Economic efficiency Division of gains
Two countries, two commodities
Transport costs Statics and dynamics
Services
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Assumptions and limitations ofFree trade theories(contd.) :
Production networks
Mobility
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Assumptions and limitations ofFree trade theories(contd.) :
Full employment :
Both the theories assume that the resources are fullyemployed
When countries have many unemployed or unused
resources, they may seek to restrict imports, to
employ or use the idle resources
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Assumptions and limitations ofFree trade theories(contd.) :
Economic efficiency :
Countries often pursue objectives other than outputefficiency
They may avoid over-specialisation because of the
vulnerability created by changes in technology and by
price fluctuations
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Assumptions and limitations ofFree trade theories(contd.) :
Division of gains :
Although specialisation brings potential benefits to allcountries that trade, how do countries divide
increased output? If both the countries receive some
share of the increased output, both will be better off
economically, through specialisation and trade
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Division of gains (contd.) :
However many governments are concerned with
absolute economic growth as well as relative to their
trading partners. If they perceive a trading partner isgaining too large a share of benefits, they may forgo
absolute gains for themselves so as to prevent relative
losses
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Assumptions and limitations ofFree trade theories(contd.) :
Two countries, two commodities :
For simplicity sake, both Smith and Ricardo assumed asimple world composed of only two countries and two
commodities
Although the simplification is unrealistic, it does not
diminish the usefulness of either theory
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Assumptions and limitations ofFree trade theories(contd.) :
Transport costs :
If it costs more to transport the goods than is savedthrough specialisation, the advantages of trade are
negated
As long as the diversion of resources reduces output
by less than what the two countries gain fromspecialisation, there are still gains from trade
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Assumptions and limitations ofFree trade theories(contd.) :
Statics and dynamics :
The two theories address countries advantages bylooking at them statically, i.e. at one point in time
However the relative conditions that give countries
advantages or disadvantages in the production of
given products are dynamic, i.e. constantly changing
It should not be assumed that the future advantages
will remain same as they are today
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Assumptions and limitations ofFree trade theories(contd.) :
Services :
The two theories deal with products rather thanservices. However increasing portion of world trade is
in services. Resources must go in into producing
services as well
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Assumptions and limitations ofFree trade theories(contd.) :
Production networks :
Both theories deal with trading one product foranother. However increasingly we see division of
work within a companys value chain network
Company's activities take place in those countries
where there is an absolute or comparative advantagefor their production
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Assumptions and limitations ofFree trade theories(contd.) :
Mobility :
The two theories assume that resources can movedomestically from the production of one good to
another, and at no cost. This assumption may not be
completely valid
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Mobility (contd.) :
The theories also assume that resources can not move
internationally, however they do. However resources
are more mobile domestically than they areinternationally
The movement of resources such as labour and capital
are clearly an alternative to trade
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5.1.3 Trade pattern theories :
Trade pattern theories deal with following issues :
How much a country will depend on trade if it follows
a free market policy? What type of products country will export and import?
With which partner countries will the country trade?
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5.1.3 Trade pattern theories (contd.) :
5.1.3.1 Theory of country size
5.1.3.2 Factors proportions theory
5.1.3.3 Country similarity theory
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5.1.3 Trade pattern theories (contd.) :
5.1.3.1 Theory of country size :
The theory ofcountry size holds that large countries
usually depend less on trade than small countries Countries with large land areas are apt to have varied
climates and an assortment of natural resources,
making them more self-sufficient than smaller
countries
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5.1.3.1 Theory of country size (contd.) :
Transport cost in international trade affects large and
small countries differently. Normally the farther the
distance, the higher the transport cost Distance also creates indirect costs of tying up
inventory for longer period and of adding to the
uncertainty and unreliability of timely delivery
Among countries that border each other, the smallercountry tends to depend more on trade than the
larger country, because of transportation costs
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5.1.3.1 Theory of country size (contd.) :
Size of the economy :
Although land area is the most obvious way of
measuring a countrys size, countries can also becompared on the basis of economic size
Worlds top 10 exporters and importers are all
developed countries, except for China. These 10
countries account for over half the worlds exports
and imports
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Size of the economy (contd.) :
The top 10 exporters and importers of the world
produce so much that they have more to sell, both
domestically and internationally Also, because they produce so much, income are high
and people buy more from both domestic and foreign
sources
At the same time, there is little trade of developingcountries with other developing countries
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5.1.3 Trade pattern theories (contd.) :
5.1.3.2 Factors proportions theory :
This theory helps us explain what types of products
result from natural and acquired advantages Eli Heckscherand Bertil Ohlin developedfactors
proportions theory, which is based on countries
production factors, namely land, labour and capital
(i.e. funds for investment in plant and equipment)
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5.1.3.2 Factors proportions theory (contd.) :
The theory says that the differences in countries;
endowments of labour, compared to their
endowments of land or capital explain differences inthe cost of production factors
For example, if labour was abundant in a country in
comparison to land and capital, then labour costs
would be low relative to land and capital costs
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5.1.3.2 Factors proportions theory (contd.) :
The relative factor costs would lead countries to excel
in the production and export of products that used
their abundant (and hence cheaper) productionfactors
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5.1.3.2 Factors proportions theory (contd.) :
People and land :
In countries where there are many people relative to
the amount of land, regardless of climate and soilcondition, they can not excel in production of goods
requiring large amounts of land
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5.1.3.2 Factors proportions theory (contd.) :
Manufacturing locations :
In countries with limited land, the most successful
industries are those in which technology permits theuse of a minimum amount of land, relative to the
number of people employed
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5.1.3.2 Factors proportions theory (contd.) :
Capital, labour rates and specialisation :
In countries where little capital is available for
investment and where the amount of investment perworker is low, companies find cheaper labour rates
and export competitiveness in products that require
large amounts of labour relative to capital
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Capital, labour rates and specialisation (contd.) :
Export from high income countries embody a higher
proportion of professionals (such as scientists and
engineers) than in low income economies exports.
Therefore these rich countries are using above
abundant production factors to maintain their lead in
exports
Exports of low income economies on the other handshows a high intensity of less skilled labour
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Capital, labour rates and specialisation (contd.) :
The variation in labour skills among countries has led
to more international specialisation by task to
produce a given product
A company may locate its R&D activities and
management functions primarily in countries with a
highly educated population and may locate its
production work in countries where less skilled andless expensive workers may be employed
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5.1.3.2 Factors proportions theory (contd.) :
Process technology :
Factor proportions analysis becomes more
complicated when the same product can be producedby different methods, such as labour or capital. Thus
production technology helps explain where products
are made
Hence the optimum location of production dependson comparing the cost in each location based on the
type of production that minimises costs there
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Process technology (contd.) :
Large economies are more likely to produce goods
that use technologies requiring long production runs
because these countries develop industries to serve
their large domestic markets, which in turn tend to be
competitive in export markets
Companies however may locate long production runs
in small countries if they expect few barriers in othercountries to export if their products
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Process technology (contd.) :
In industries where long production runs are
important for gaining competitive advantages,
companies tend to locate their production in few
countries, using these locations as sources of exports
to other countries
Where long production runs are less important, a
greater prevalence of multiple production units isfound scattered around the world, so as to minimise
transportation cost involved in exporting
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Process technology (contd.) : Technologically intensive company from a small nation
may have a more compelling need to sell abroad than
would a company with a large domestic market
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5.1.3.2 Factors proportions theory (contd.) :Product technology :
Manufacturing depends on acquired advantage,
largely technology, which in turn depends on largenumber of highly educated people (like scientists,
engineers, etc.) and a large amount of capital to invest
in research and development
Developed countries have abundance of abovefeatures, hence they originate most new products and
account for most manufacturing output and trade
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Product technology (contd.) : Developing countries depend much more on
production of primary products and hence they
depend more on natural advantage
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5.1.3 Trade pattern theories (contd.) :5.1.3.3 Country similarity theory :
Most trade takes place among developed countries
Country similarity theorysays that once a companyhas developed a new product in response to observed
market conditions in its home market, it turns to
markets it sees as most similar to those at home
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5.1.3.3 Country similarity theory (contd.) :Specialisation and acquired advantage :
Markets in developed countries can support the
development and sale, both of new products andvariations of existing ones. Trade occurs because
countries specialise to gain acquired advantage, e.g.
by apportioning their research efforts more strongly
to some sectors than to others
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Specialisation and acquired advantage (contd.) : Developing countries also have gained advantages
through specialisation, whereby they concentrate
successfully on a very narrow product segments
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5.1.3.3 Country similarity theory (contd.) :Product differentiation :
Trade also occurs because companies differentiate
products, thus creating two way trade in similarproducts
Different companies from different countries develop
product variations that appeal to different consumers
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5.1.3.3 Country similarity theory (contd.) :The effect of cultural similarity :
Cultural similarity also helps explain much of the
direction of trade. Importers and exporters find iteasier to do business in a country they perceive as
being culturally similar to their home country, because
they speak a common language
Historic colonial relationships explain much of thetrade between specific high income and low income
economies
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The effect of cultural similarity (contd.) : Importers and exporters find it easier to continue
business ties than to develop new distribution
arrangements in countries where they are less
experienced
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5.1.3.3 Country similarity theory (contd.) :The effects of political relationships and economic
agreements :
Political relationships and economic agreementsamong countries may discourage or encourage trade
between them
Agreement among many European countries to
remove all trade barriers with each other has caused agreater share of the countries total trade to be
conducted within the group
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5.1.3.3 Country similarity theory (contd.) :The effects of distance :
Greater distances usually means higher transportation
costs Why does a country buy more from one country than
from another? The geographic distance between two
countries accounts for many of the world trade
relationships
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5.1.3.3 Country similarity theory (contd.) :Overcoming distance :
Transport cost is not the only factor in trade partner
choice Disadvantage in freight costs can be countered in a
limited manner. However these methods are difficult
to maintain
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5.1.4 The statics and dynamics of trade : These theories help explain how countries develop,
maintain and lose their competitive advantages
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5.1.4 The statics and dynamics of trade :5.1.4.1 Product Life Cycle (PLC) theory
5.1.4.2 The Porter diamond
5.1.4.3 Factor mobility theory
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The statics and dynamics of trade (contd.) :5.1.4.1 Product Life Cycle (PLC) theory :
The international product life cycle (PLC) theory of
trade states that the location of production of certainkinds of products shift as they go through four stages
of their life cycles, namely introduction, growth,
maturity and decline
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5.1.4.1 Product Life Cycle (PLC) theory (contd.) :Changes over the cycle :
Companies develop new products primarily because
there is an observed need and market for themnearby
Almost all new technology that results in new
products and production methods originates in
developed countries. They have most of the resourcesto develop new products and most of the income to
buy them
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5.1.4.1 Product Life Cycle (PLC) theory (contd.) :Introduction :
Once a company has created a new product, the early
production stage, called the introductory stagegenerally occurs in a domestic location, so the
company can obtain rapid market feedback as well as
save on transport costs
At this stage, export markets are small and mainly toother developed countries, because more customers
in these countries can afford the new products
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5.1.4.1 Product Life Cycle (PLC) theory (contd.) :Growth :
As sales grow, competitors enter the market
During the growth stage, demand may justifyproducing in some foreign countries (usually
developed ones) to reduce transport charges
At this stage, sales are likely to stay almost entirely in
the countries producing the product
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Growth (contd.) : The original producing country will increase its
exports in this stage, but loose certain key export
markets in which local production commences
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5.1.4.1 Product Life Cycle (PLC) theory (contd.) :Maturity :
In maturity stage, worldwide demand begins to level
off, although it may be growing in some countries anddeclining in others
There often is a shakeout of producers such that
product models become highly standardised, making
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Maturity (contd.) : Because markets and technologies are widespread,
the innovating country no longer commands a
production advantage
Producers have incentives to shift production to
developing economies where they can employ less
skilled and less expensive labour efficiently for
standardised and capital intensive production Exports decrease from innovating country as foreign
production displaces it
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5.1.4.1 Product Life Cycle (PLC) theory (contd.) :Decline :
As product moves into the decline stage, those factors
occurring during the maturity stage continue toevolve. The market in developed countries decline
more rapidly than those in developing economies, as
affluent customers demand ever-newer products
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Decline (contd.) : Market and cost factors dictate that almost all
production is in developing economies, which export
to the declining or small niche markets in developed
countries
Thus the country in which the innovation first
emerged and exported from, then becomes importer
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5.1.4.1 Product Life Cycle (PLC) theory (contd.) :Verification and limitations of PLC theory :
The PLC theory holds that the location of production
facilities that serve world markets shifts as productsmove through their life cycle
However if transport costs are very high, then there is
little opportunity for export sales, regardless of the
stage in the life cycle
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Verification and limitations of PLC theory (contd.) :For following products, shifts in production location do
not usually take place. The innovating country may
maintain its export ability throughout the products
life cycle
Products with extremely short life cycle
Luxury products
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Verification and limitations of PLC theory (contd.) :Products with extremely short life cycle :
Because of very rapid innovations, products that have
extremely short life cycle, makes it impossible toachieve cost reductions, by moving production from
one country to another
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Verification and limitations of PLC theory (contd.) :Luxury products :
For luxury products, cost is of little concern to the
customer. Production in a developing country maymake the product seem less luxurious than it really is
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Verification and limitations of PLC theory (contd.) :A company using differentiation strategy for the products
:
Through advertising, a company can usedifferentiation strategy for its products, to maintain
consumer demand, without competing on the basis of
price
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Verification and limitations of PLC theory (contd.) :Products that require specialised technical labour :
Some products require specialised technical labour to
evolve into next generation. Such products maintaintheir dominance in the world market, by continuing to
operate from developed countries
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Verification and limitations of PLC theory (contd.) : There is an increased tendency on the part of MNEs to
introduce new products at home and abroad almost
simultaneously, regardless of the product type
Instead of merely observing needs within their
domestic markets, companies develop products and
services for observable market segments that
transcend national borders. In doing so, theyeliminate delays as a product is diffused from one
country to another
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Verification and limitations of PLC theory (contd.) : They choose an initial production location that will
minimise costs for serving markets in multiple
countries. This production location may or may not
be in the innovating companys home market
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The statics and dynamics of trade (contd.) :5.1.4.2 The Porter diamond :
The Porter diamond theory shows following four
conditions as important for competitive superiority : Demand conditions
Factor conditions
Related and supporting industries
Firm strategy, structure and rivalry
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The Porter diamond
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Michael
Porter
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5.1.4.2 The Porter diamond (contd.) : The theory is useful for understanding how and where
globally competitive companies develop and sustain
themselves
Usually all four conditions need to be favourable for
an industry within a country to attain global
supremacy
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5.1.4.2 The Porter diamond (contd.) :Demand conditions :
Both PLC theory and country similarity theory show
that the new products or industries usually arise from
companies observation of need or demand, which is
usually in their home country
Companies then start-up production near the observed
market
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5.1.4.2 The Porter diamond (contd.) :Factor conditions :
Natural advantage in most production factors such as
skilled labour, capital, technology (or equipment) need
to be available in a country on favourable terms
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5.1.4.2 The Porter diamond (contd.) :Related and supporting industries :
The existence of nearby related and supporting
industries need to be favourable
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5.1.4.2 The Porter diamond (contd.) :Firm strategy, structure and rivalry :
The combination of earlier three conditions influences
companies decisions to initiate production of a certain
product in a given country
The ability of the companies to develop and sustain a
competitive advantage requires favourable
circumstances for the fourth condition, namely thefirms strategy, structure and rivalry
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Firm strategy, structure and rivalry (contd.) : The ability of the companies to develop and sustain a
competitive advantage requires favourable
circumstances for the fourth condition, namely the
firms strategy, structure and rivalry
Rivalry becomes intense as companies try to serve
increasingly sophisticated consumers
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Firm strategy, structure and rivalry (contd.) : This forces breakthroughs in both product and process
technology, which gives producers advantage over
foreign producers and enable them to gain larger
global share of exports
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5.1.4.2 The Porter diamond (contd.) :Limitations of the Porter diamond theory :
The existence of the four favourable conditions does
not guarantee that an industry will develop in a given
location
The increased ability of companies to attain market
information, production factors and supplies from
abroad
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Limitations of the Porter diamond theory (contd.) :The absence of any of the four conditions from the
diamond domestically may not inhibit companies and
industries from becoming globally competitive
Observations of foreign or foreign plus domestic,
rather than just domestic demand conditions have
spurred much of the recent growth in Asian exports
Companies and countries are not dependent entirelyon domestic factor conditions, because capital and
managers are now internationally mobile
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Limitations of the Porter diamond theory (contd.) : If related and supporting industries are not available
locally, materials and components are now more easily
brought in from abroad, because of advancements in
transportation and the relaxation of import restrictions
Companies react not only to domestic rivals, but also
to foreign based rivals, they compete with at home
and abroad
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The statics and dynamics of trade (contd.) :5.1.4.3 Factor mobility theory :
Factor mobility means movement of capital,
technology and people across the border
Factor conditions in a country change in both quantity
and quality, therefore the relative capabilities of
countries also change. The change may come about
because of internal circumstances
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5.1.4.3 Factor mobility theory (contd.) :Thefactor mobilitytheory of trade patterns focuses on
the following reasons :
Why production factors move?
The effects of such movement on transforming factor
endowments
The effect of international factor mobility (especially
people) on world trade
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5.1.4.3 Factor mobility theory (contd.) :Why production factors move?:
Capital
People Economic motives
Political motives
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Why production factors move? (contd.) :Capital :
Capital, especially short-term capital, is the most
internationally mobile production factor
Companies and private investors primarily transfer
capital because of differences in expected return,
after accounting for risk
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Why production factors move? (contd.) :People :
People are also internationally mobile, but less so
than capital
Unlike funds that can be cheaply transferred by wire,
people must usually incur high transportation costs, to
work in another country
If people move legally, they must get immigrationdocuments and most countries give them sparingly
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People (contd.) : Migrating people may have to learn another language
and adjust to different culture away from their
families and friends, who serve as their customary
support groups
Of the people who go abroad for work, some move
permanently and some move temporarily
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Why production factors move? (contd.) :Economic motives :
People, whether professionals or unskilled workers,
largely work in another country for economic reasons
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Why production factors move? (contd.) :Political motives :
People also move for political reasons, e.g. because of
persecution or war dangers, in which case they are
known as refugees. However once they are refugees,
they usually become part of the labour pool where
they live
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Political motives (contd.) : Sometimes it is difficult to distinguish between
economic and political motives for international
mobility, because poor economic conditions often
parallel poor political conditions
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5.1.4.3 Factor mobility theory (contd.) :Effects of factor movements :
Neither international capital nor population mobility
is a new occurrence
Many immigrants bring human capital with them,
thus adding to the base of skills that enables the
countries to be newly competitive in an array of
products they might otherwise have imported
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Effects of factor movements (contd.) : These countries receive foreign capital to develop
infrastructure and natural resources, which further
alters their competitive structures and international
trade
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5.1.4.3 Factor mobility theory (contd.) :What happens when people move?
People movements are substantial for many countries
and insignificant for other
The US is currently an example of a country whose
recent immigration is largely concentrated at he high
and low end of human skills
Although labour and capital are different productionfactors, they are intertwined
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What happens when people move? (contd.) : Countries lose potentially productive resources, when
educated people leave, a situation known as a brain
drain, but they may gain from the foreign earnings on
those factors
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Remittance flows todeveloping countries in
2007 (US $ mn.)
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What happens when people move? (contd.) : Countries receiving productive human resources also
incur cost of social services and for acculturating
people to a new language and culture
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What happens when people move? (contd.) : The unskilled workers who take jobs that native born
workers dont want, have children who eventually
enter the workforce. If these children are also
unskilled, the country is perpetuating a long-termclass ofhave-nots. If these children become skilled,
then there is a need to bring in even more unskilled
workers from abroad
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5.1.4.3 Factor mobility theory (contd.) :Relationship between trade and factor mobility :
Factor movement is an alternative to trade that may
or may not be a more efficient allocator of resources
Free trade, when coupled with freedom of factor
mobility internationally usually results in the most
efficient allocation of resources
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5.1.4.3 Factor mobility theory (contd.) :Substitution :
When the factors proportions vary widely among
countries, pressure exists for the most abundant
factors to move to countries with greater scarcity,
where they can command a better return
If finished goods and production factors were both
free to move internationally, the competitive cost oftransferring goods and factors would determine the
location of production
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Substitution (contd.) : As is true of trade, there are restrictions on factor
movement that make them only partially mobile
internationally
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5.1.4.3 Factor mobility theory (contd.) :Complementarity :
Factor movements may substitute or stimulate trade
When companies invest abroad, the investmentsoften stimulate exports from their home countries
About a third of world exports is among controlled
entities, such as from parent to subsidiary, subsidiary
to parent and subsidiary to subsidiary of the samecompany
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Complementarity (contd.) : Domestic operating units may export materials and
components to their foreign facilities, for use in a
finished product
A foreign facility may produce part of the product
line, while serving as sales agent for exports of its
parents complementary products