Chapter 3 - Economic Theories of International Business by Ball, McCulloch, Frantz, Geringer, and Minor

Chapter Objectives Understand the theories of international trade. Comprehend the arguments of imposing trade restrictions. Explain the two basic kinds of import restrictions. Appreciate the relevance of the changing status of tariff and non tariff barriers. Recognize the weaknesses of GNP/capita as an economic indicator. Understand the new definition of economic development. Explain some of the theories of foreign direct investment

International Trade Theory Mercantilism Believed nation’s welfare was in accumulation of stock of precious metals. Trade surplus created by import restrictions and government subsidies to exporters. Mercantilist era ended in 1700s.

Balance of Payment Accounting An export that brings dollars to the exporting country is called “positive.” An import that causes dollar outflow is labeled “negative.”

Modern Day Mercantilism Industrial policy based on state intervention France nationalized key industries and banks to use the power of the state as Stockholder and financier Customer and marketer to revitalize the nation’s base In 1986, little growth and high unemployment led government to reverse “mercantilist” policy.

Theory of Absolute Advantage “The capacity of one nation to produce more of a good with the same amount of input than another country.” Adam Smith claimed that market forces, not government controls should determine the direction, volume, and composition of international trade.

Theory of Absolute Advantage Adam Smith also argued that under free, unregulated trade, each nation should specialize in producing those goods it could produce most efficiently. Absolute advantage can be either natural or acquired. In absolute advantage, both nations would gain from trade.

Theory of Absolute Advantage An Example Assumptions Perfect competition and no transportation costs in a world of two countries and two products. Each nation has two input units it can use to produce either rice or autos. Each country uses one unit of input to produce each product.

Theory of Absolute Advantage An Example Cost of producing 3 tons of rice in the U.S. should be equal to the cost of producing 2 autos. U.S. has an absolute advantage in rice production (3 to 1). Japan has an absolute advantage in auto production (4 to 2).

Theory of Absolute Advantage An Example If each country specializes in its most efficient product, then for 2 units in specialization, output is as follows: (3X2) (4X2) units units

Theory of Absolute Advantage An Example Terms of Trade (Ratio of International Prices)

Theory of Absolute Advantage An Example Gains from Specialization and Trade

Theory of Comparative Advantage “A nation having absolute disadvantages in the production of two goods compared to another nation, has a comparative advantage in producing the good in which its absolute disadvantage is less.” Theory of comparative advantage demonstrated by Ricardo in 1817.

Theory of Comparative Advantage - An Example Japan has a relative or comparative advantage in producing autos.

Theory of Comparative Advantage - An Example If each country specializes, then for 2 units in specialization, output is as follows: (6X2) (4X2) units units

Theory of Comparative Advantage - An Example Terms of Trade (Ratio of International Prices)

Theory of Comparative Advantage - An Example Final Result

Theory of Comparative Advantage - An Example Gains from Specialization and Trade

Production Possibility Frontiers The following two graphs illustrate Japanese and U.S. production possibility frontiers using constant cost for simplicity. These curves, in the absence of trade, also illustrate the possible combinations of goods for consumption.

Production Possibility Frontiers United States 1 2 3 4 5 6 7 8 9 10 11 12 Tons of Rice A B 1 2 3 4 5 6 7 8 9 10 11 12 Autos

Production Possibility Frontiers Japan 1 2 3 4 5 6 7 8 9 10 11 12 Tons of Rice B A 1 2 3 4 5 6 7 8 9 10 11 12 Autos

Heckscher-Ohlin Theory of Factor Endowment States that international and interregional differences in production costs occur because of differences in the supply of production factors. Therefore, China should export labor intensive goods. Netherlands, with relatively more capital than labor should specialize in capital intensive products.

Heckscher-Ohlin Theory of Factor Endowment Flaws in assumptions Assumption - price of the factors depend only on the factor endowment. Flaw - factor prices not set in a perfect market. Assumption - assumed that a given technology is universally available. Flaw - always a lag between the introduction of new production methods and its worldwide application.

Leontief Paradox Study in 1953 by economist Wassily Leontief disputed the usefulness of the Heckscher-Ohlin Theory as a predictor of the direction of trade. Found that the U.S., one of the most capital-intensive countries in the world, was exporting labor intensive products.

Introducing Money Exchange Rate Currency devaluation The price of one country’s currency stated in terms of the other. Currency devaluation Lowering of a country’s currency in terms of other currencies. Example is tourism and currency rates in Mexico during 1980s

International Product Life Cycle (IPLC) IPLC concerns the role of innovation in trade patterns. Four stages of the IPLC in the U.S. 1) U.S. exports 2) Foreign production begins 3) Foreign competition in export markets 4) Import competition in the U.S.

Stages of the International Product Life Cycle Stage 1 - U.S. Exports Manufacturers search for better ways to satisfy their customers’ needs. “U.S. is a leader in new product introduction.” For a while, American firms will be the only manufacturers of the new product. The export market develops for overseas customers.

Stages of the International Product Life Cycle Stage 2 - Foreign Production Begins Export volume grows and becomes large enough to support local production. Foreign production begins. The American firm will still be exporting to those markets where there is no production, but its export growth will diminish.

Stages of the International Product Life Cycle Stage 3 - Foreign Competition in Export Markets As early foreign manufacturers gain experience in marketing and production, their costs will fall. Saturation of the foreign local markets will cause foreign manufacturers to look for buyers elsewhere. Foreign firms are competing in export markets, and American export sales will continue to decline.

Stages of the International Product Life Cycle Stage 4 - Import Competition in the U.S. Foreign producers may attain economies of scale where they can compete in quality and undersell American firms in the American market. For that point on, the U.S. market will be served by imports only.

Newer Explanations of the Direction of Trade Economies of Scale and the Experience Curve First Mover Theory The Linder Theory of Overlapping Demand

Porter’s Competitive Advantage of Nations Michael Porter of Harvard University studied 100 firms in 10 developed nations. Porter claims that four kinds of variables will impact a local firm’s ability to use a country’s resources to gain a competitive advantage. Demand conditions Factor conditions Related and supporting industries Firm strategy, structure, rivalry

Porter’s Competitive Advantage of Nations Demand Conditions Nature of domestic demand. If customers are demanding, firms will produce high-quality and innovative products. This focus will lead to global competitive advantage over companies located where domestic pressure is less.

Porter’s Competitive Advantage of Nations Factor Conditions Level and consumption of factors of production Porter distinguishes between Basic factors (Heckscher-Ohlin Theory) Advanced factors (nation’s infrastructure) Lack of natural endowments has caused nations to invest in the creation of advanced factors.

Porter’s Competitive Advantage of Nations Related and supporting industries Suppliers and industry support services For decades, firms in an industry where the suppliers, and the suppliers’ suppliers have setup, have tended to form a group in a given location, often without any apparent reason.

Porter’s Competitive Advantage of Nations Firm Strategy, Structure, Rivalry This is the extent of domestic competition, the existence of barriers to entry, and the firm’s management style and organization. Porter points out that companies subject to heavy competition in their domestic markets are constantly working to improve efficiency. This makes them more competitive internationally.

Trade Restrictions Arguments for and Against Trade Restrictions National Defense Protect Infant Industries Protect Domestic Jobs from Cheap Labor Scientific Tariff or Fair Competition Retaliation Dumping

Retaliation Against Trade Restrictions Dumping is selling a product abroad for less than the cost of production. the price in the home market. the price to third countries. Reasons for Dumping Sell excess production without disrupting prices in the domestic market. Force all domestic producers in the importing nation out of business.

Retaliation Against Trade Restrictions New Types of Dumping Social Dumping Environmental Dumping Financial Services Dumping Cultural Dumping

Types of Restrictions Import Restriction Classifications Tariff barriers Non tariff barriers

Tariff Barriers Tariffs, or import duties are taxes levied on imported goods . used primarily for the purpose of raising their selling price in the importing nation’s market to reduce competition for domestic producers.

Tariff Barriers Types of import duties Official prices Variable levy Ad valorem Specific Compound Official prices Variable levy

Tariff Barriers Ad Valorem Duty Specific Duty Compound Duty Duty stated as a percentage of the invoice value Specific Duty Fixed sum of money charged for a physical unit Compound Duty A combination of specific and ad valorem duties

Tariff Barriers Official Prices Variable Levy Prices included in the customs tariff of some nations and used as the basis for ad valorem duty calculations whenever the actual involved price is lower. Variable Levy Guarantees that the market price of the import will be the same as that of domestically produced goods.

Non Tariff Barriers Include all forms of discrimination against imports other than import duties. Quantitative Quotas are numerical limits placed on specific classes of imports. Tariff Rate Quotas - permit a stipulated amount to enter a market duty free or at a low rate, but when that amount is reached, a much higher duty is charged for subsequent importation.

Non Tariff Barriers Quantitative (cont’d) Voluntary Export Restraints Export quotas imposed by exporting nation Orderly Marketing Arrangements Formal agreement between exporting and importing countries that stipulate the import or export quota each nation will have for a good.

Non Tariff Barriers Nonquantitative Direct government participation in trade Subsidy Buy domestically Import licenses Manipulation of exchange rates Local contents Customs and other administrative procedures

Levels of Economic Development Developed Classification for all industrialized nations, which are mostly technologically developed. Developing Classification for world’s lower income nations, which are less technically developed.

Levels of Economic Development Newly Industrializing Countries Middle-income economies of Brazil, Mexico, Malaysia, Chile, and Thailand. Newly Industrialized Economies Fast-growing upper-middle income and high income economies of South Korea, Taiwan, Hong Kong, and Singapore.

The World Bank Classification System Based on GNP/capita Low income ($755 or less) Lower middle income ($756 - $2995) Upper middle income ($2,996 - $9,265) High income ($9,266 or more)

GNP/Capita as an Indicator Caution must be used because goods may be bartered. Low-income nations (people have little cash) High-income countries (people report less and pay less taxes) This is the underground economy.

GNP/Capita as an Indicator Concerns Underground Economy Other terms used include black, parallel, informal, submerged, shadow. Undeclared legal production, production of illegal goods and services, and concealed income in kind (barter). As a rule, the higher the level of taxation and the more onerous the government red tape, the bigger the underground economy will be.

GNP/Capita as an Indicator Concerns Currency conversion Local currency converted to the dollar by using exchange rate Conversions do not reflect domestic purchasing powers of currencies GNP is based on PPP rather than on international demand for currency.

Human Needs Approach to Economic Development Defines economic development as the reduction of poverty, unemployment, and inequality in the distribution of income. No accepted general theory Investment in human capital Import substitution vs. export promotion Importance of keeping current

Contemporary Theories of FDI Monopolistic Advantage Theory Product and Factor Market Imperfections International Product Life Cycle Other Theories Cross Investment Internationalization Theory Eclectic Theory of International Production