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

2. 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

3. 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.

4. 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.”

5. 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.

6. 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.

7. 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.

8. 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.

9. 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).

10. 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

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

12. Theory of Absolute Advantage An Example
Gains from Specialization and Trade

13. 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.

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

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

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

17. Theory of Comparative Advantage - An Example
Final Result

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

19. 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.

20. Production Possibility Frontiers
United States
Tons of Rice A B
Autos

21. Production Possibility Frontiers
Japan
Tons of Rice B A
Autos

22. 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.

23. 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.

24. 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.

25. 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

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

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

32. 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

33. 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.

34. 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.

35. 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.

36. 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.

37. 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

38. 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.

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

40. Types of Restrictions Import Restriction Classifications
Tariff barriers
Non tariff barriers

41. 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.

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

43. 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

44. 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.

45. 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.

46. 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.

47. 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

48. 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.

49. 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.

50. 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)

51. 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.

52. 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.

53. 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.

54. 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

55. 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