1. International Business Environments and Operations Global Edition
Part Three Theories and Institutions: Trade and Investment

2. Chapter Six
International Trade and Factor Mobility Theory

3. Chapter Objectives To understand theories of international trade
To explain how free trade improves global efficiency
To identify factors affecting national trade patterns
To explain why a country’s export capabilities are dynamic
To understand why production factors, especially labor and capital, move internationally
To explain the relationship between foreign trade and international factor mobility

4. Trade Theory
Helps managers and government policymakers focus on these questions:
• What products should we import and export?
• How much should we trade?
• With whom should we trade?

5. International Operations and Economic Connections
To meet its international objectives, a company must gear its strategy to trading and transferring its means of operation across borders––say, from (Home) Country A to (Host) Country B. Once this process has taken place, the two countries are connected economically.

6. What the major trade theories Do and Don’t discuss

7. Interventionist Theories
Mercantilist theory proposed that a country should try to achieve a favorable balance of trade (export more than it imports)
Neomercantilist policy also seeks a favorable balance of trade, but its purpose is to achieve some social or political objective
To export more than they imported, governments restricted imports and subsidized production that could otherwise not compete in domestic or export markets. Some countries used their colonies to support this trade objective by having them supply commodities that would otherwise have to be purchased from a non-associated country and by running trade surpluses with them as an additional way of obtaining gold. They did this not only by monopolizing colonial trade but also by forcing the colonies to export less highly valued raw materials to them and import more highly valued manufactured products from them.
It is not necessarily beneficial to run a trade surplus nor is it necessarily disadvantageous to run a trade deficit. A country that is running a surplus, or a favorable balance of trade, is, for the time being, importing goods and services of less value than those it is exporting.
In the mercantilist period, the difference was made up by a transfer of gold, but today it is made up by holding the deficit country’s currency or investments denominated in that currency. In effect, the surplus country is granting credit to the deficit country. If that credit cannot eventually buy sufficient goods and services, the so-called favorable trade balance actually may turn out to be disadvantageous for the country with the surplus.

8. Free Trade Theories Absolute Advantage Comparative Advantage
Suggests specialization through free trade because consumers will be better off buying foreign-made products priced more cheaply than domestic ones
Comparative Advantage
Also proposes specialization through free trade based on the belief that total global output can increase even if one country has an absolute advantage in the production of all products
Both theories hold that nations should neither artificially limit imports nor promote exports. The market will determine which producers survive as consumers buy those products that best serve their needs. Both free trade theories imply specialization. Just as individuals and families produce some things that they exchange for things that others produce, national specialization means producing some things for domestic consumption and export while using the export earnings to buy imports of products and services produced abroad.
In 1776, Adam Smith questioned the mercantilists’ assumptions by stating that the real wealth of a country consists of the goods and services available to its citizens rather than its holdings of gold. Smith’s theory of absolute advantage holds that different countries produce some goods more efficiently than others and questions why the citizens of any country should have to buy domestically produced goods when they can buy them more cheaply from abroad. Smith reasoned that if trade were unrestricted, each country would specialize in those products that gave it a competitive advantage. Although Smith believed the marketplace would make the determination, he thought that a country’s advantage would be either natural or acquired. Natural advantage considers climate, natural resources, and labor force availability. Acquired advantage consists of either product or process technology.
Comparative Advantage theory suggests Gains from trade will occur even in a country that has absolute advantage in all products, because the country must give up less efficient output to produce more efficient output. Most economists accept the comparative advantage theory, and it’s influential in promoting policies for freer trade. Nevertheless, many government policymakers, journalists, managers, and workers confuse comparative advantage with absolute advantage and do not understand how a country can simultaneously have a comparative advantage and absolute disadvantage in the production of a given product.

9. Theories of Specialization
Both absolute and comparative advantage theories are based on specialization
Assumptions policymakers question:
full employment
economic efficiency
division of gains
two countries, two commodities
transport costs
statics and dynamics
services
production networks
mobility
Full Employment: Full employment is not a valid assumption of absolute and comparative advantage.
The theories of absolute and comparative advantage both assume that resources are fully employed. When countries have many unemployed or unused resources, they may seek to restrict imports to employ or use idle resources.
Econ Efficiency: Countries’ goals may not be limited to economic efficiency. Often, countries also pursue objectives other than output efficiency. They may avoid overspecialization because of the vulnerability created by changes in technology and by price fluctuations.
Division of gains: Many people are concerned with relative and absolute economic growth. If they perceive that a trading partner is gaining too large a share of benefits, they may prefer to forgo absolute gains for themselves so as to prevent others from gaining a relative economic advantage.
Transport Costs: If it costs more to transport the goods than is saved through specialization, the advantages of trade are negated.
Statistics and Dynamics: The theories of absolute and comparative advantage address countries’ advantages statically—that is, by looking at them at one point in time. However, the relative conditions that give countries advantages or disadvantages in the production of given products are constantly changing.
Services: Although a growing portion of world trade is in services, the theories apply because resources must also go into producing services.
Production Networks: Both theories deal with trading one product for another. Increasingly, however, a product may be partially made in different countries. Although this type of development adds complexity to the analysis, it fits well with the concept of advantages through specialization. In other words, costs are saved by having activities take place in those countries where there is an absolute or comparative advantage for their production.
Mobility: The theories of absolute and comparative advantage assume that resources can move domestically from the production of one good to another—and at no cost. But this assumption is not completely valid.

10. Trade Pattern Theories
Theory of Country Size
Factor-Proportions Theory
Country Similarity Theory
Product Life Cycle Theory
Diamond of National Advantage

11. Theory Of Country Size
Countries with large land areas are apt to have varied climates and natural resources
They are generally more self-sufficient than smaller countries
Large countries’ production and market centers are more likely to be located at a greater distance from other countries, raising the transport costs of foreign trade
Although land area is the most obvious way of measuring a country’s size, countries can also be compared on the basis of economic size. The world’s top 10 exporters and importers are all developed countries except for China. China, although not a developed country, has a very large economy by virtue of its large population. The 10 countries account for over half the world’s exports and imports.

12. Factor-Proportions Theory
A country’s relative endowments of land, labor, and capital will determine the relative costs of these factors
Factor costs will determine which goods the country can produce most efficiently
According to the factor proportions theory, factors in relative abundance are cheaper than factors in relative scarcity.
For instance, if labor were abundant in comparison to land and capital, labor costs would be low relative to land and capital costs. If labor were scarce, labor costs would be high in relation to land and capital costs.

13. Worldwide Trade of Major Manufactured Goods

14. Country-Similarity Theory
Most trade today occurs among high-income countries because they share similar market segments and because they produce and consume so much more than emerging economies
Much of the pattern of two-way trading partners may be explained by cultural similarity between the countries, political and economic agreements, and by the distance between them
Specialization and Acquired Advantage: In order to export, a company must provide consumers abroad with an advantage over what they could buy from their domestic producers. Trade occurs because countries specialize to gain acquired advantage—for example, by apportioning their research efforts more strongly to some sectors than to others.
Product Differentiation: Trade also occurs because companies differentiate products, thus creating two-way trade in what seem like similar products. For example, the United States is both a major exporter and a major importer of tourist services, vehicles, and passenger aircraft because different companies from different countries have developed product variations with different appeals.
Effects of Cultural Similarity: Importers and exporters find it easier to do business in countries they perceive as being culturally similar to their home countries, such as those that speak a common language. Likewise, historic colonial relationships explain much of the trade between specific developed and developing economies. For instance, France’s colonial history in Africa has given Air France an edge in serving those former colonies’ international air passenger markets.
Political Relationships and Economic Agreements: Political relationships and economic agreements among countries may discourage or encourage trade between them.
Effects of Distance: The theories regarding country differences and similarities help explain broad world trade patterns, such as those that link developed countries and developing countries, but they do not fully explain specific pairs of trading relationships. Although no single answer does, the geographic distance between two countries accounts for many of these world trade relationships.

15. Product Life Cycle (PLC) Theory
Companies will manufacture products first in the countries in which they were researched and developed, almost always developed countries
Over the product’s life cycle, production will shift to foreign locations, especially to developing economies as the product reaches the stages of maturity and decline

16. Life Cycle of the International Product
The introduction stage is marked by
• Innovation in response to observed need
• Exporting by the innovative country
• Evolving product characteristics
Growth is characterized by
• Increases in exports by the innovating country
• More competition
• Increased capital intensity
• Some foreign production
Maturity is characterized by
• A decline in exports from the innovating country
• More product standardization
• More capital intensity
• Increased competitiveness of price
• Production start-ups in emerging economies
Decline is characterized by
• A concentration of production in developing countries
• An innovating country becoming a net importer
Limitations: Not all products conform to the dynamics of the PLC.
There are many types of products for which shifts in production location do not usually take place. In these cases, the innovating country may maintain its export ability throughout the product’s life cycle. These exceptions include the following:
• Products with high transport costs may have to be produced close to the market, thus never becoming significant exports.
• Products that, because of very rapid innovation, have extremely short life cycles—a factor that makes it impossible to achieve cost reductions by moving production from one country to another. Some fashion items fit this category.
• Luxury products for which cost is of little concern to the consumer. In fact, production in a developing country may make the product seem less luxurious than it really is.
• Products for which a company can use a differentiation strategy, perhaps through advertising, to maintain consumer demand without competing on the basis of price.
• Products that require nearby specialized technical labor to evolve into their next generation. This seems to explain the long-term U.S. dominance of medical equipment production and German dominance in rotary printing presses.

17. The Diamond of National Advantage
Four conditions are important for competitive superiority:
demand conditions
factor conditions
related and supporting industries
firm strategy, structure, and rivalry

18. Limitations of the Diamond of National Advantage
Domestic existence of all conditions:
Does not guarantee an industry will develop
Is not necessary with globalization
The existence of the four favorable conditions does not guarantee that an industry will develop in a given locale. Entrepreneurs may face favorable conditions for many different lines of business. In fact, comparative advantage theory holds that resource limitations may cause a country’s companies to avoid competing in some industries even though they may have an absolute advantage.
A second limitation concerns the growth of globalization. The industries on which this theory is premised grew when companies’ access to competitive capabilities was decidedly more domestically focused. We can see how globalization affects each of the four conditions:
1. Observations of foreign or foreign-plus-domestic, rather than just domestic, demand conditions have spurred much of the recent growth in Asian exports. In fact, such Japanese companies as Uniden and Fujitech target their sales almost entirely to foreign markets.
2. Companies and countries are not dependent entirely on domestic factor conditions. For example, capital and managers are now internationally mobile.
3. 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. In fact, many MNEs now assemble products with parts supplied from a variety of countries.
4. Companies react not only to domestic rivals but also to foreign-based rivals they compete with at home and abroad. Thus the absence of any of the four conditions from the diamond domestically may not inhibit companies and industries from becoming globally competitive.

19. Factor Mobility Theory
Capital and labor move internationally to:
• Gain more income
Flee adverse political situations
Capital, especially short-term capital, is the most internationally mobile production factor.
Companies and private individuals primarily transfer capital because of differences in expected return (accounting for risk).
Political and economic conditions affect investors’ perceptions of risk and where they prefer to put their capital. At the same time, companies invest long term abroad to tap markets and lower operating costs. However, businesses do not make all the international capital movements.
Governments give foreign aid and loans. Not-for-profit organizations donate money abroad to relieve worrisome economic and social conditions. Individuals remit funds to help their families and friends in foreign countries. Regardless of the donor or motive, the result affects factor endowments.
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.
Finally, such people may have to learn another language and adjust to a different culture away from their families and friends who serve as their customary support groups.
Despite the barriers, people endure hardships and risks to move to another country.

20. Effects of Factor Movements
Factor movements alter factor endowments.
Factor movements are substantial for many countries and insignificant for others.
Although labor and capital are different production factors, they are intertwined.
Pros and cons of outward and inward migration
A controversial issue is the effect on countries of outward migration. On the one hand, countries lose potentially productive resources when educated people leave—a situation known as a brain drain. On the other hand, they may receive money from the people who leave. For example, Ecuador lost almost 5 percent of its population between 1999 and 2001, including 10,000 teachers and many other people with substantial work skills. However, many of these people are now sending remittances back to Ecuador. In fact, remittance flows to all countries for 2007 were estimated at U.S. $337 billion, and the
inflows for several countries amounted to more than 15 percent of their GDP.
There is also evidence that the outward movement of people leads to an increase in start-up companies in their home countries. Their remittances increase capital available at home. Further, the immigrants learn abroad and transfer ideas back to their home countries.
Finally, countries receiving productive human resources also incur costs by providing social services and acculturating people to a new language and culture. Further, the unskilled workers who take jobs that native-born workers don’t want—like dishwashing, maintaining grounds, and picking agricultural produce—have children who eventually enter the workforce.

21. The Relationship between Trade and Factor Mobility
Capital and labor move internationally to gain more income and flee adverse political situations
Although international mobility of production factors may be a substitute for trade, the mobility may stimulate trade through sales of components, equipment, and complementary products
When the factor proportions vary widely among countries, pressures exist for the most abundant factors to move to countries with greater scarcity—where they can command a better return.
Similarly, capital tends to move away from countries in which it is abundant to those in which it is scarce. For example, Mexico gets capital from the United States, and the United States gets labor from Mexico. However, as is true of trade, there are restrictions on factor movements that make them only partially mobile internationally—such as both U.S. immigration restrictions that limit the legal and illegal influx of Mexican workers and Mexican ownership restrictions in the petroleum industry that limit U.S. capital movements to invest in that industry.
The lowest costs occur when trade and production factors are both mobile.

22. Future: In What Direction Will Trade Winds Blow?
Displacement of jobs as developed countries shift production to more rapidly developing countries
Relationships among land, labor, and capital will continue to evolve
Continued trend toward a more finely tuned specialization of production among countries
As economies grow, efficiencies of multiple production locations also grow because they can all gain sufficient economies of scale.
Flexible, small-scale production methods, especially those using robotics, may enable even small countries to produce many goods efficiently for their own consumption.
Services are growing more rapidly than products as a portion of production and consumption within developed countries.
As companies shift production to developing economies, they displace jobs within developed countries. As this occurs, displaced workers need to find new jobs. But there is uncertainty as to how fast new jobs will replace old ones and how much tolerance developed countries will have for employment displacement and job shifts. If they become very intolerant, they may enact protectionist measures that would stifle trade.
If present trends continue, relationships among land, labor, and capital will continue to evolve. For example, the population growth rate is expected to be much higher in developing economies than in developed countries. This could result in continued shifts of labor-intensive production to developing economies.
We will probably see the continued trend toward a more finely tuned specialization of production among countries to take advantage of specific country conditions. Although part of this will be due to wage and skill differences, other factors are important as well. For instance, country differences in protection of property rights may influence where technologically intensive companies choose to produce.

23. Future: In What Direction Will Trade Winds Blow?
Three factors could cause product trade to become less significant:
As economies grow, efficiencies of multiple production locations also grow because they can all gain sufficient economies of scale.
Small-scale production methods may enable countries to produce many goods efficiently for their own consumption.
Services are growing more rapidly than products as a portion of production and consumption within developed countries.
Growth of efficiencies of multiple production locations may allow country-by-country production to replace trade. For example, most automobile producers have moved into China and Thailand—or plan to do so—as a result of China’s and Thailand’s growing market size.
Small-scale production methods may enable even small countries to produce many goods efficiently for their own consumption, thus eliminating the need to import those goods.
Services are growing more rapidly than products as a portion of production and consumption within developed countries. Consequently, product trade may become a less important part of countries’ total trade. Further, many of the rapid-growth service areas, such as retail gasoline distribution and dining out, are not easily traded, so trade in goods plus services could become a smaller part of total output and consumption.

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