MODULE-3 INTERNATIONAL BUSINESS THEORIES

MODULE-3 INTERNATIONAL BUSINESS THEORIES

1. International Trade Theory McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. What is trade theories? T rade theories are simply different theories to explain international trade. International Trade is the concept of exchanging goods and services between two countries. Trade theories explains how goods are traded among various nations & which goods are advantageous for trading. For example- USA have advantage in car manufacturing, India in spices, etc.

3. Classification Of Trade Theories Traditional Theories Modern Theories 1. Mercantilism theory 2. Absolute cost advantage theory 3. Comparative cost advantage 4. Relative Factor endowment 5. Leontief paradox 6. Product life cycle 7. New trade theory 8. Porter`s diamond theory

4. An Overview Of Trade Theory Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country

5. Mercantilism Mercantilism suggests that it is in a country ’ s best interest to maintain a trade surplus -- to export more than it imports Mercantilism advocates government intervention to achieve a surplus in the balance of trade It views trade as a zero-sum game - one in which a gain by one country results in a loss by another

6. Absolute Advantage Adam Smith argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries

7. Absolute Advantage Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice So, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes

8. Absolute Advantage In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice So, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between Ghana has an absolute advantage in the production of cocoa South Korea has an absolute advantage in the production of rice

9. Absolute Advantage Without trade: Ghana would produce 10 tons of cocoa and 5 tons of rice South Korea would produce 10 tons of rice and 2.5 tons of cocoa If each country specializes in the product in which it has an absolute advantage and trades for the other product: Ghana would produce 20 tons of cocoa South Korea would produce 20 tons of rice Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice

10. Absolute Advantage After trade: Ghana would have 14 tons of cocoa left, and 6 tons of rice South Korea would have 14 tons of rice left and 6 tons of cocoa Both countries gained from trade

11. Absolute Advantage Table 5.1 Absolute Advantage and the Gains from Trade

12. Relative Factor Endowment Theory

13. Assumptions of the Theory The Assumptions There are two nations (1&2), two commodities (X&Y), two factors of production (labor & capital). Used to illustrate the theory in a two-dimensional figure. Both nations use the same technology in production. Means both nations have access to and use the same general production techniques. Commodity X is labor intensive and Y is capital intensive in both nations. Means the labor-capital ratio (L/K) is higher for X than Y in both nations at the same relative factor prices.

14. Both commodities are produced under constant returns to scale in both nations. Means that increasing the amount of L and K will increase output in the same proportion There is incomplete specialization in production in both nations. Means that even with free trade both nations continue to produce both commodities. This implies neither nation is very small. Tastes are equal in both nations. Means demand preferences are identical in both nations. When relative prices are equal in the two nations, both consume X&Y in the same proportion.

15. There is perfect competition in both commodities and factor markets in both nations. Means that producers, consumers, and traders of X&Y in both nations are each too small to affect prices of commodities. Also, in the L-R commodity prices equal their costs, leaving no economic profit. There is perfect factor mobility within each nation but no international factor mobility. Means K&L are free to move from areas and industries of lower earnings to those of higher earnings until earnings are the same in all areas, uses and industries of the nation. International differences in earnings persist due to zero international factor mobility in the absence of international trade.

16. There are no transportation costs, tariffs, or other obstructions to the free flow of international trade. Means specialization in production proceeds until relative (and absolute) commodity prices are the same in both nations with trade. If transportation costs and tariffs were allowed, specialization would proceed only until prices differed by no more than the costs and tariffs on each until of the commodity traded.

17. All resources are fully employed in both nations. Means there are no unemployed resources in either nation. International trade between the two nations is balanced. Means that the total value of each nation’s exports equals the total value of the nation’s imports.

18. Factor Abundance and the Shape of the Production Frontier Since Nation 2 is K-abundant and Y is K-intensive, Nation 2 can produce relatively more of Y than Nation 1. Since Nation 1 is L-abundant and X is L-intensive, Nation 1 can produce relatively more of X than Nation 2. This gives a production frontier for Nation 1 that is relatively flatter and wider that that of Nation 2.

19. FIGURE 5-2 The Shape of the Production Frontiers of Nation 1 and Nation 2.

20. The Leontief Paradox Wassily Leontief theorized that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods. However, he found that U.S. exports were less capital intensive than U.S. imports Since this result was at variance with the predictions of the theory, it became known as the Leontief Paradox

21. The Product Life Cycle Theory

22. Global Strategic Rivalry Theory Global strategic rivalry theory emerged in the 1980s and was based on the work of economists Paul Krugman and Kelvin Lancaster. Their theory focused on MNCs and their efforts to gain a competitive advantage against other global firms in their industry. Firms will encounter global competition in their industries and in order to prosper, they must develop competitive advantages. The critical ways that firms can obtain a sustainable competitive advantage are called the barriers to entry for that industry. The barriers to entry refer to the obstacles a new firm may face when trying to enter into an industry or new market.

23. The barriers to entry that corporations may seek to optimize include: research and development, the ownership of intellectual property rights, economies of scale, unique business processes or methods as well as extensive experience in the industry, and the control of resources or favorable access to raw materials.

24. National Competitive Advantage theory : Porter ’ s Diamond Michael Porter tried to explain why a nation achieves international success in a particular industry and identified four attributes that promote or impede the creation of competitive advantage: Factor endowments Demand conditions Relating and supporting industries Firm strategy, structure, and rivalry

25. National Competitive Advantage: Porter ’ s Diamond Figure 5.6: Determinants of National Competitive Advantage: Porter ’ s Diamond

26. National Competitive Advantage Factor endowments land, labor, capital, workforce, infrastructure (some factors can be created...) Demand conditions large, sophisticated domestic consumer base: offers an innovation friendly environment and a testing ground Related and supporting industries local suppliers cluster around producers and add to innovation Firm strategy, structure, rivalry competition good, national governments can create conditions which facilitate and nurture such conditions

27. Local market resources and capabilities (factor conditions). Porter recognized the value of the factor proportions theory, which considers a nation’s resources (e.g., natural resources and available labor) as key factors in determining what products a country will import or export. Porter added to these basic factors a new list of advanced factors, which he defined as skilled labor, investments in education, technology, and infrastructure. He perceived these advanced factors as providing a country with a sustainable competitive advantage.

28. Local market demand conditions: Porter believed that a sophisticated home market is critical to ensuring ongoing innovation, thereby creating a sustainable competitive advantage. Companies whose domestic markets are sophisticated, trendsetting, and demanding forces continuous innovation and the development of new products and technologies. Many sources credit the demanding US consumer with forcing US software companies to continuously innovate, thus creating a sustainable competitive advantage in software products and services.

29. Local suppliers and complementary industries: To remain competitive, large global firms benefit from having strong, efficient supporting and related industries to provide the inputs required by the industry. Certain industries cluster geographically, which provides efficiencies and productivity. Local firm characteristics: Local firm characteristics include firm strategy, industry structure, and industry rivalry. Local strategy affects a firm’s competitiveness. A healthy level of rivalry between local firms will spur innovation and competitiveness.