INTERNATIONAL BUSINESS

UNIT-3

International Trade Theory• What is international trade?– Exchange of raw materials and manufactured goods(and services) across national borders• Classical trade theories:– explain national economy conditions--countryadvantages--that enable such exchange to happen• New trade theories:– explain links among natural country advantages,government action, and industry characteristics thatenable such exchange to happen

Classical Country-Based Theories

MERCANTILISM (PRE-16TH CENTURY)– Takes an us-versus-them view of trade; othercountry’s gain is our country’s loss– Neo-mercantilism views persist today FREE TRADE SUPPORTING THEORIES– Show that specialization of production and freeflow of goods grow all trading partners’ economies– Absolute Advantage (Adam Smith, 1776)– Comparative Advantage (David Ricardo, 1817)FREE TRADE REFINED– Factor-proportions (Heckscher-Ohlin, 1919)– International product life cycle (Ray Vernon, 1966)

Mercantilism

• Prevailed from 1500 to 1800– Export more to “strangers” than we import to amass treasure, expand kingdom– Maximize exports and minimize imports: no advantage in increased trade• Government intervenes to achieve a surplus in exports– King, exporters, domestic producers: happy– Subjects: unhappy because domestic goods stay expensive and of limited variety• Today neo-mercantilists=protectionists: some segments of society shielded short term• Zero-sum vs positive-sum game view of trade

THEORY OF ABSOLUTE ADVANTAGE

• Adam Smith: Wealth of Nations (1776) argued:– Capability of one country to produce more of

a product with the same amount of input than another country

– A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient

• Trade between countries is, therefore, beneficial

• Assumes there is an absolute balance among nations

• questions the objective of national governments to acquire wealth through restrictive trade policies

• measures a nation’s wealth by the living standards of its people

THEORY OF ABSOLUTE ADVANTAGE

Video

https://www.youtube.com/watch?v=Vvfzaq72wd0

• Party A can produce 5 widgets per hour with 3 employees.

• Party B can produce 10 widgets per hour with 3 employees.

• Assuming that the employees of both parties are paid equally, Party B has an absolute advantage over Party A in producing widgets per hour. This is because Party B can produce twice as many widgets as Party A can with the same number of employees.

PARTY B HAS THE COMPETITIVE ADVANTAGE

EXAMPLE:

RICARDO'S THEORY OF COMPARATIVE ADVANTAGE

• David Ricardo stated a theory that other things being equal a country tends to specialize in and exports those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage.

• Similarly the country's imports will be of goods having relatively less comparative cost advantage or greater disadvantage.

• David Ricardo: Principles of Political Economy (1817)– Extends free trade argument– Efficiency of resource utilization leads to more

productivity– Should import even if country is more efficient in the

product’s production than country from which it is buying.

– Look to see how much more efficient. If only comparatively efficient, than import.

• Makes better use of resources• Trade is a positive-sum game

COMPARATIVE DIFFERENCE IN COST

• Driven only by maximization of production and consumption

• Only 2 countries engaged in production and consumption of just 2 goods?

• What about the transportation costs?• Only resource – labour (that too, non-

transferable) • No consideration for ‘learning theory’

Assumptions And Limitations

 Ricardo's Classic ExampleTrade costs, particularly transportation, reduce and may eliminate the benefits from trade, including comparative advantage. Paul Krugman gives the following example.

Hecksher –Ohlin Theory Video

https://www.youtube.com/watch?v=hN9y_PmiPvE

Heckscher-Ohlin TheoryThe pattern of international trade depends on differences in factor endowments not on differences in productivity• Absolute amounts of factor endowments matter• Leontief paradox:– US has relatively more abundant capital yet importsgoods more capital intensive than those it exports– Explanation:• US has special advantage on producing new products madewith innovative technologies• These may be less capital intensive till they reach mass-production state

Theory of Relative FactorEndowments (Heckscher-Ohlin)

• Factor endowments vary among countries• Products differ according to the types of factorsthat they need as inputs• A country has a comparative advantage inproducing products that intensively use factors ofproduction (resources) it has in abundance• Factors of production: labor, capital, land, humanresources, technology.

Michael Porter's Theory of Competitive Advantage

• Michael Porter's Theory of Competitive Advantage of Nations against the Theory of Competitive advantage sought to examine the issue of why some nation's business firms succeeded high in international/global competition.

The theory of competitive advantage probes into three major aspects of trade phenomenon:

i. Why does a nation succeed international in a particular industry?ii. What influence does a nation carry on competition in specific

industries and their segments?iii. Why do a nation's firms choose particular strategies of business?

Porter's analysis begins with following premises:

1. The nature of competition and the sources of competitive advantage differentials in the industries.

2. Successful global enterprises draw competitive advantages through their value chain of worldwide network.

3. Innovation is the pillion of gaining/sustaining competitive advantage.4. Pioneering and aggressive competitors in exploiting new

market/technology are most successful.

• Porter undertook intensive research of 100 industries in ten countries. On the basis of empirical investigation, Porter identified for attributes of nation which determine (promote, impede) its competitive advantage referred to as Porter's Diamond.

The Porter's Diamond narrates for major attributes

Factor Conditions

• A country's factor endowments or supply of factors of production such as human resources, physical resources, knowledge resources, location, capital resources and infrastructure play a significant role in determining its national competitive advantage. Besides basic factors (e.g., natural resources, climate, etc.,) advanced factors (e.g., skilled labour, communications infrastructure, technology) are the crucial determinants of the capabilities and competitiveness of a nation.

• Advanced factors are declined by the efforts of the individuals, firms, institution and government in a country.

• Japan's success may largely be attributed to its advanced factors creation rather than basic factors arability. A nation can overcome its deficiency or comparative disadvantage of basic factors endowment by focussing on creation of advanced factors to improve its competitive advantage.

Demand Conditions

• The demand conditions in home market is important in stimulating domestic firms to undertake innovation and improve quality of products. When domestic buyers are sophisticated, a pressure in the market is created for the domestic firms to meet high standards of quality demanded.

• For example, Japanese knowledge buyers have induced the Japanese camera manufacturers to produce innovative models first in the home market and then for the exports. Similarly, local customers in Sweden have stimulated Ericsson to invest in cellular phone equipment industry much before the rising global demand.

A nations demand conditions, thus, refer to:i. The nature of home buyers needs - their sophistication and fastidiousnessii. The size and pattern of growth of home marketiii. The timing of development of demands relative to buyer in foreign marketsiv. The knowledge presence of domestic buyers in foreign markets and their

preferences.v. The timing of market saturation and challenges at home market provide a

strong reason to acquire global competitive position to a business firm.

Suppliers and Related Industries

• National advantage in an industry is also conditioned by the preserve of vigorous home-based suppliers of cost-effective and quality inputs or related supporting industries. For example, the US success in several electronic goods including personal computers is attributed to the growth of semiconductor industry in the country. Same is the case with Malaysia to some extent.

• Likewise, Sweden steel industry has contributed much to the success of Sweden's output in ball bearings and cutting tools.

• Successful industrial growth in the exporting country may emerge on quantum of the growing clusters of related/supervising industries. German textile and approach sector is a chronic case in this regard - (textile machinery, sewing machine needles, textile clothes forming the cluster of textile exporting industry of the country). Ongoing coordination and just-in-time strategy is easy when such clusteral industrial growth occurs in a nation.

Firm Strategy, Structure and Rivalry

• Different nations have different management attitudes, ideologies and approaches which either strengthen or weaken their comparative advantage. Will and motivation to go international are based on the firm, management strategies and organisational structure.

• Most firms in Japan and Germany, for instance are found to be controlled by the top management teams which placed more emphasis on improvement of the product designs and process. On the other hand, US firms management is governed by the people with finance backgrounds who mainly focussed on maximising short-term financial return on investment.

• Consequence is that the US has lost its competitive advantage in the automobile and such other manufacturing goods whereas Japan has built up its strength in this sector.

• Domestic rivalry in the market also provides an impetus to the creation and sustaining of competitive advantage in an industry. Our domestic rivalry situation calls for innovation, product improvement, enhancing efficiency and cost effectiveness in the business. A computing firm's goal in such a situation is to set the business strategy to capture larger market share and go global.

• Porter argued that government policy and actions as well as chance events are the secondary auxiliary variables in creating competitive and effective advantage of a nation.

• Effective positive industrial and trade policy of an open economy would encourage local firms to compete abroad.

• Restrictive and protective policies weakened the firm's abilities to compete in global markets.

• Some times chance events may become the cause of success. • In short, all the attributes mentioned in Porter's Diamond have

combined effects in determining a nation's competitive advantage. • The government can play a positive role in shaping the Diamond to

enhance the national competitive advantage in chosen industries. • Indeed, Porter's theory gives an important message to the policy

market that it is the business firms who compete and not nations.• Therefore, the government policies and actions should be directed

to the creation of favourable environment and provide a framework that cause to encourage business community firms to improve, innovate and be dynamic in achieving the competitive advantage.

• The government of a developing nation should design positive policies in this regard, based on a long-term planning horizon, not on short-term economic fluctuations.

Concluding RemarksVarious theories of international trade when reviewed together provide an understanding of the complexities involved in international business. They furnish an insight to the business division members. They suggest at least three major implications for international business:

i. Locational significance

ii. Importance of first-mover advantage

iii. Policy designs

WORLD TRADE ORGANIZATION• The World Trade Organization (WTO) is the only global international

organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal is to help producers of goods and services, exporters, and importers conduct their business.

• The WTO can ...• 1 ... cut living costs and raise living standards • 2 ... settle disputes and reduce trade tensions• 3 ... stimulate economic growth and employment• 4 ... cut the cost of doing business internationally• 5 ... encourage good governance• 6 ... help countries develop• 7 ... give the weak a stronger voice• 8 ... support the environment and health• 9 ... contribute to peace and stability• 10 ... be effective without hitting the headlines

WTO FUNCTIONS• While the WTO is driven by its member states, it could not function

without its Secretariat to coordinate the activities. • The Secretariat employs over 600 staff, and its experts — lawyers,

economists, statisticians and communications experts — assist WTO members on a daily basis to ensure, among other things, that negotiations progress smoothly, and that the rules of international trade are correctly applied and enforced.

• Trade negotiationsThe WTO agreements cover goods, services and intellectual property. They spell out the principles of liberalization, and the permitted exceptions. They include individual countries’ commitments to lower customs tariffs and other trade barriers, and to open and keep open services markets. They set procedures for settling disputes. These agreements are not static; they are renegotiated from time to time and new agreements can be added to the package. Many are now being negotiated under the Doha Development Agenda, launched by WTO trade ministers in Doha, Qatar, in November 2001.

• Implementation and monitoringWTO agreements require governments to make their trade policies transparent by notifying the WTO about laws in force and measures adopted. Various WTO councils and committees seek to ensure that these requirements are being followed and that WTO agreements are being properly implemented. All WTO members must undergo periodic scrutiny of their trade policies and practices, each review containing reports by the country concerned and the WTO Secretariat.

• Dispute settlementThe WTO’s procedure for resolving trade quarrels under the Dispute Settlement Understanding is vital for enforcing the rules and therefore for ensuring that trade flows smoothly. Countries bring disputes to the WTO if they think their rights under the agreements are being infringed. Judgments by specially appointed independent experts are based on interpretations of the agreements and individual countries’ commitments.

• Building trade capacity: WTO agreements contain special provision for developing countries, including longer time periods to implement agreements and commitments, measures to increase their trading opportunities, and support to help them build their trade capacity, to handle disputes and to implement technical standards. The WTO organizes hundreds of technical cooperation missions to developing countries annually. It also holds numerous courses each year in Geneva for government officials. Aid for Trade aims to help developing countries develop the skills and infrastructure needed to expand their trade.

• Outreach: The WTO maintains regular dialogue with non-governmental organizations, parliamentarians, other international organizations, the media and the general public on various aspects of the WTO and the ongoing Doha negotiations, with the aim of enhancing cooperation and increasing awareness of WTO activities.

• The WTO agreements are lengthy and complex because they are legal texts covering a wide range of activities. But a number of simple, fundamental principles run throughout all of these documents.

These principles are the foundation of the multilateral trading system.

• Non-discriminationA country should not discriminate between its trading partners and it should not discriminate between its own and foreign products, services or nationals.

• More openLowering trade barriers is one of the most obvious ways of encouraging trade; these barriers include customs duties (or tariffs) and measures such as import bans or quotas that restrict quantities selectively.

• Predictable and transparentForeign companies, investors and governments should be confident that trade barriers should not be raised arbitrarily. With stability and predictability, investment is encouraged, jobs are created and consumers can fully enjoy the benefits of competition — choice and lower prices.

• More competitiveDiscouraging ‘unfair’ practices, such as export subsidies and dumping products at below cost to gain market share; the issues are complex, and the rules try to establish what is fair or unfair, and how governments can respond, in particular by charging additional import duties calculated to compensate for damage caused by unfair trade.

• More beneficial for less developed countriesGiving them more time to adjust, greater flexibility and special privileges; over three-quarters of WTO members are developing countries and countries in transition to market economies. The WTO agreements give them transition periods to adjust to the more unfamiliar and, perhaps, difficult WTO provisions.

• Protect the environmentThe WTO’s agreements permit members to take measures to protect not only the environment but also public health, animal health and plant health. However, these measures must be applied in the same way to both national and foreign businesses. In other words, members must not use environmental protection measures as a means of disguising protectionist policies.