2. Theories of International Trade and Investment
chapter three
Theories of International Trade and Investment
McGraw-Hill/Irwin
International Business, 11/e
Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

3. Learning Objectives
Explain the theories that attempt to explain why certain goods are traded internationally
Discuss the arguments for imposing trade restrictions
Explain two basic kinds of import restrictions: tariff and nontariff trade barriers

4. Learning Objectives
Appreciate the relevance of changing status of tariff and nontariff barriers to managers
Explain some of the theories of foreign direct investment

5. International Trade Theory
Mercantilism
Economic philosophy based on belief that
(1) a nation’s wealth depends on accumulated treasure, usually gold, and
(2) to increase wealth, government policies should promote exports and discourage imports

6. Theory of Absolute Advantage
Theory that a nation has absolute advantage when it can produce a larger amount of a good or service for the same amount of inputs as can another country or
When it can produce the same amount of a good or service using fewer inputs than could another country

7. Absolute Advantage
Example
Each Country Specializes

8. Absolute Advantage Terms of Trade (Ratio of International Prices)
Gains from Specialization and Trade

9. Theory of Comparative Advantage
A nation having absolute disadvantages in the production of two goods with respect to another nation has a comparative or relative advantage in the production of the good in which its absolute disadvantage is less

10. Theory of Comparative Advantage
Example
Each Country Specializes

11. Comparative Advantage
Terms of Trade – at a rate of ¾ bolt of cloth for 1 ton of soybeans
Terms of Trade – at a rate of 1 bolt of cloth for 1 ton of soybeans
Gains from Specialization and Trade

12. Comparative Advantage
Production Possibility Frontiers (figure 3.1)
Figure 3.1

13. Heckscher-Ohlin Theory of Factor Endowment
Heckscher-Ohlin theory that countries export products requiring large amounts of their abundant production factors and import products requiring large amounts of their scarce production factors

14. Heckscher-Ohlin Theory of Factor Endowment
Leontief Paradox
The United States, one of the most capital-intensive countries in the world, was exporting relatively labor-intensive products in exchange for relatively capital-intensive products
Differences in Taste
A demand-side construct that is always difficult to deal with in economic theory

15. How Can Money Change The Direction of Trade?
Example
Exchange Rate – the price of one currency stated in terms of another currency

16. How Can Money Change The Direction of Trade?
Influences of Exchange Rate
Currency devaluation
The lowering of a currency’s price in terms of other currencies

17. Some Newer Explanations For The Direction Of Trade
Linder Theory of Overlapping Demand
Customers’ tastes are strongly affected by income levels; therefore a nation’s income per capita level determines the kinds of goods they will demand

18. Some Newer Explanations For The Direction Of Trade
International Product Life Cycle (IPLC)
Explains why a product that begins as export eventually becomes import (figure 3.2)
U.S. exports
Foreign production begins
Foreign competition in export market
Import competition in the United States

19. Figure 3.2 International Product Life Cycle

20. Some Newer Explanations For The Direction Of Trade
Technology Life Cycle
Production technology application of IPLC
Economies of Scale and Experience Curve
As a plant gets larger and output increase, the average cost of producing each unit of output decreases
As firms produce more products, they learn ways to improve production efficiency

21. Some Newer Explanations For The Direction Of Trade
Imperfect Competition
Economies of scale with the existence of differentiated products--Paul Krugman
First-Mover Theory
Pattern of trade in goods subject to scale economies may be determined by historical factors

22. Some Newer Explanations For The Direction Of Trade
National Competitive Advantage from Regional Clusters: Porter’s Diamond Model (figure 3.3)
National Competitiveness: a nation’s relative ability to design, produce, distribute, or service products while earning increasing returns on resources
Demand conditions
Factor Conditions
Related and supporting industries
Firm strategy, structure, and rivalry

23. Figure 3.3 Variable Impacting Competitive Advantage: Porter’s Diamond
Source: Reprinted by permission of the Harvard Business Review. “The Competitive Advantage of Nations” by Michael E. Porter,
March–April 1990, p. 77. Copyright © 1990 by The President and Fellows of Harvard College; all rights reserved.

24. Trade Restrictions: Arguments For
National Defense
Sanctions to Punish Offending Nations
Protect Infant (or Dying) Industry
Protect Domestic Jobs from Cheap Foreign Labor
Scientific Tariff or Fair Competition

25. Trade Restrictions Retaliation
Dumping: selling a product abroad for less than the cost of production, the price in the home market, or the price to third countries
Social dumping
Environmental dumping
Financial services dumping
Cultural dumping
Tax dumping

26. Trade Restrictions
Subsidies: Financial contributions, provided directly or indirectly by a government, which confer a benefit; include grants, preferential tax treatment, and government assumption of normal business expenses (figure 3.4)
Countervailing duties: Additional import taxes levied on imports that have benefited from export subsidies

27. Figure 3.4 Value of OECD Member Farm Subsidies
Source: “Agriculture: Support Estimates, 2004,” OECD in Figures: Statistics on the Member Countries. Accessed 7/2005
Link:

28. Tariff Barriers Tariff Ad Valorem Duty Specific Duty
Taxes on imported goods for the purpose of raising their price to reduce competition for local producers or stimulate local production
Ad Valorem Duty
An import duty levied as a percentage of the invoice value of imported goods
Specific Duty
A fixed sum levied on a physical unit of an imported good

29. Tariff Barriers Compound Duty Official Prices Variable Levy
A combination of specific and ad valorem duties
Official Prices
Variable Levy
An import duty set at the difference between world market prices and local government-supported prices
Lower Duty for more local Input

30. Nontariff Barriers Nontariff barriers (NTBs) Quantitative
All forms of discrimination against imports other than import duties
Quantitative
Quotas: numerical limits placed on specific classes of imports
Voluntary export restraints (VERs): Export quotas imposed by exporting nation

31. Nontariff Barriers Orderly Marketing Arrangements
Formal agreements between exporting and importing countries that stipulate the import or export quotas each nation will have for a good
Nonquantitative Nontariff Barriers
Direct government participation in trade
Customs and other administrative procedures
Standards

32. From Multinational to Globally Integrated Manufacturing Systems
Close least efficient plants, and supply their markets with imports from other subsidiaries
Change multidomestic manufacturing system to globally integrated system in which each plant performs the activities at which it is most efficient

33. International Investment Theories
Monopolistic Advantage Theory
Theory that FDI is made by firms in oligopolistic
industries possessing technical and other advantages
over indigenous firms
Product and Factor Market Imperfections
Superior knowledge leads to differentiated products, and they lead to firm control on price and advantage over indigenous firm (Hymer and Caves)
Financial Factors
Imperfections in the foreign exchange markets (Aliber)
International Product Life Cycle

34. International Investment Theories
Follow The Leader
Cross Investment
Foreign direct investment by oligopolistic firms in each other’s home countries as a defense measure
Internalization Theory
An extension of the market imperfection theory: to obtain a higher return on its investment, a firm will transfer its superior knowledge to a foreign subsidiary rather than sell it in the open market

35. International Investment Theories
Dynamic Capabilities
Theory that for a firm to successfully invest overseas, it must have ownership of unique knowledge or resources and the ability to dynamically create and exploit these capabilities
Dunning’s Eclectic Theory Of International Production
Theory that for a firm to invest overseas, it must have three kinds of advantages: ownership-specific, internalization, and location-specific