CHAPTER 3 THE THEORY OF TRADE AND INVESTMENT

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Copyright © 2011 John Wiley & Sons

Chapter 3 Learning Objectives

Chapter 3 1.

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To understand the traditional arguments of how and why international trade improves the welfare of all countries To review the history and compare the implications of trade theory from the original work of Adam Smith to the contemporary theories of Michael Porter To examine the criticisms of classical trade theory and examine alternative viewpoints of which business and economic forces determine trade patterns between countries To explore the similarities and distinctions between international trade and international investment To evaluate the trade theories of Paul Krugman and Michael Porter and their relationship to business and government’s approaches to trade policy To understand the theory of international investment and how it relates to firms and buyers 2 Czinkota: International Business, 8e

Foundation Questions

 Why do countries trade?

 Do countries trade or do firms trade?

 Do the elements that make a firm, industry, or country competitive change with time and circumstance?

 Once identified, can sources of competitiveness be manipulated or managed by firms or governments to the benefit of traders?

Chapter 3 3 Czinkota: International Business, 8e

McDonald’s Global Reach

International Business makes good business sense for McDonalds corporation. Although the United States was the first successful market for the company, it now does business in dozens of countries world wide. In fact, only 28 percent of total revenue generated in 2009 came from the U.S. market. See the geographic breakdown of revenue below for details: • • • • U.S.: 28% Europe: 43% Asia/Pacific/Middle east/africa (APMEA): 24% Other and Corporate: 5% Source: McDonald’s 2009 Annual Report: http://www.aboutmcdonalds.com/mcd Chapter 3 4 Czinkota: International Business, 8e

The Age of Mercantilism

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Three major events have led to the evolution of trade in the form we see today:

 The collapse of feudal society  State of autarky where only basic needs were met  Emergence of a mercantilist philosophy  Focus was on increasing a nation’s power  Strength in gold and silver  Life cycle of the colonial systems of the European nation states  Industrialization and mass production  Lowering prices and increasing supplies Chapter 3 5 Czinkota: International Business, 8e

The Evolution of Trade Theory

The Theory of Absolute Advantage

Adam Smith, 1776

The Theory of Comparative Advantage

David Ricardo, 1819

The Theory of Factor Proportions

Eli Heckscher and Bertil Ohlin, early 20 th Century

The Leontief Paradox

Wassily Leontief, 1950

Overlapping Product Ranges Theory

Staffan Burenstam Linder, 1960s Chapter 3

Product Cycle Theory

Raymond Vernon, 1966

Imperfect Markets/Strategic Trade

Paul Krugman, 1980s

The Competitive Advantage of Nations

Michael Porter, 1990s 6 Czinkota: International Business, 8e

Absolute Advantage & Comparative Advantage

Absolute Advantage Theory Comparative Advantage Theory

 Adam Smith, The Wealth of Nations, 1776  Division of labor in the production process  Each country should specialize in a product for which it is uniquely suited  Countries could produce more and engage in trade for products not produced at home Chapter 3 7  David Ricardo, The Principles

of Political Economy and

Taxation, 1819  Involves producing a good more cheaply relative to other goods in other countries  Each country possesses comparative advantage in something, and both countries would benefit from trade Czinkota: International Business, 8e

Chapter 3

Classical Trade Theory

Concluding Points:

Division of Labor Comparative Advantage Gains from Trade

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Factor Proportions Trade Theory

 Developed by Heckscher, expanded by Ohlin  Factor prices determine cost differences     Factors of production include labor and capital Technology determines the way factors combine to form a good Prices are determined by the endowments of labor and capital Country’s endowment determines the relative costs of labor and capital  Leontief Paradox   Leontief used input-output analysis to determine the relative amounts of labor and capital in a good Finding: the U.S. was actually exporting products that were relatively labor intensive, contradicting the Factor Proportions Theory Chapter 3 9 Czinkota: International Business, 8e

Focus on Politics: When the Numbers Don’t Add Up

I n t e r n a t i o n a l t r a d e s t a t i s t i c s b e t w e e n c o u n t r i e s o f t e n d o n o t m a t c h . O n e r e a s o n f o r t h e d i s c r e p a n c y i s g e o g r a p h i c c o v e r a g e d e f i n i t i o n s . F o r i n s t a n c e , t h e U . S . c o n s i d e r s P u e r t o R i c o a n d t h e U . S . V i r g i n I s l a n d s a s p a r t o f t h e U n i t e d S t a t e s , a n d M e x i c o r e g a r d s t h e m a s s e p a r a t e c o u n t r i e s . A n o t h e r p r o b l e m i s p a r t n e r c o u n t r y a t t r i b u t i o n w h e r e f o r m s a l l o w f o r t h e r e p o r t i n g o f a s i n g l e c o u n t r y o f o r i g i n . T h e p r o d u c t m a y h a v e b e e n m a d e i n m o r e t h a n o n e c o u n t r y.

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Linder’s Overlapping Product Ranges Theory

     Linder’s work focused on the preferences of consumers rather than production or supply Trade in manufactured goods was dictated by product demands across countries The type, complexity, and diversity of product demands of a country increase as the country’s income increases Directors of firms are more knowledgeable about the domestic market than about foreign markets The overlapping product ranges described by Linder were later termed market segments Chapter 3 11 Czinkota: International Business, 8e

Focus on Politics: The U.S. Trade Deficit Fix - Global Financial Crisis

O n e o f t h e f a s t e s t w a y s t o s h r i n k t r a d e d e f i c i t s i s e c o n o m i c r e c e s s i o n . T h e g l o b a l f i n a n c i a l c r i s i s t h a t b e g a n i n 2 0 0 7 w a s b a s e d l a r g e l y i n t h e U n i t e d S t a t e s , a n d i t w a s t h e f a c t o r t h a t f o r c e d A m e r i c a n s t o s t o p s p e n d i n g . H o w e v e r, t h i s a l s o p u t a h a l t t o i n t e r n a t i o n a l t r a d e a n d b r o u g h t a g l o b a l i z e d w o r l d e c o n o m y t o a h a l t . I n 2 0 0 9 , i t w a s s t i l l n o t c l e a r w h e t h e r a p e r m a n e n t c h a n g e i n s p e n d i n g a n d s a v i n g w o u l d r e s u l t .

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Product Cycle Theory

    Developed by Raymond Vernon in 1966 Focused on the product, not its factor proportions  Information, knowledge, costs, and power all have a role Vernon added two premises to the factor-cost emphasis of existing theory:   Technical innovations predominantly occur in highly industrialized capital intensive countries Technical innovations go through three stages of maturation A limitation of this theory is that it does not apply to all industries  Technology industries are the most applicable Chapter 3 13 Czinkota: International Business, 8e

Stages of the Product Cycle

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Stage I: New Product

Nonstandardized product Requires high degree of flexibility High costs to the firm Consumers buy regardless of price

Stage II: Maturing Product

• • • • • Increasingly standardized Need for flexibility declines Demand for skilled labor declines Variations develop Price an increasing concern

Stage III: Standardized Product

• • • Completely standardized Thin profit margins Fierce competition Chapter 3 14 Czinkota. 2010. International Business. 8e

Apple’s Mac Growth Potential Overseas

Despite being overshadowed by Apple’s own iPhone and the iPad, market consultants believe that Apple's Mac business has plenty of revenue growth left to exploit. Apple has the opportunity to add an incremental $5 to $7 billion to its revenue stream by increasing its international market share in what they call the mid range PC target zone (priced between $700 - $1,119). Most of Apple’s growth has been in the high end of the U.S. market.

Apple’s U.S. share of the mid-range PC target zone in 2009 was 22%. However, it currently has only a 2% share of the mid-range market overseas.

Source: Fortune.com - http://tech.fortune.cnn.com/2010/05/27/how-the-mac-picks-up-an-easy-5-7-billion/ Chapter 3 15 Czinkota: International Business, 8e

Economies of Scale

 Paul Krugman focused on cost of production and how cost and price drive international trade  Internal Economies of Scale  The larger the firm the greater the scale benefits, and the lower the cost per unit  A firm could then monopolize an industry and create an imperfect market  External Economies of Scale  A country can dominate world markets if its industry can gain economies of scale  The industry can then maintain its dominance in the world market Chapter 3 16 Czinkota: International Business, 8e

Strategic Trade

Price

Government can impose tariffs to offset the monopolistic power of a foreign firm

Cost Repetition Externalities

Governments protect the market from foreign competition to allow domestic firms to grow and gain economies of scale Government protection until the firm learns through repetition how to produce the product more efficiently Government protects and nourishes an industry where it believes future growth can be achieved Chapter 3 17 Czinkota: International Business, 8e

The Competitive Advantage of Nations

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According to Michael Porter, a nation’s competitiveness depends on the capacity of its industry to innovate and upgrade Four major components that drive and sustain competitiveness:

Factor Conditions Demand Conditions Related and Supporting Industries Firm Strategy, Structure, and Rivalry

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The Foreign Direct Investment Decision

 Exploit competitive advantage in new foreign markets or in the domestic market?

 Produce at home and export or produce abroad?

 License production or try to control assets abroad?

 Use a joint venture or a wholly owned affiliate?

 Acquire an existing foreign enterprise or build “from the ground up” (greenfield investment)?

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The Theory of Foreign Direct Investment

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What motivates a firm to go beyond exporting or licensing?

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Firms as seekers – A firm that expands across borders seeks sources of profit or opportunity:

 Seeking resources   Seeking factor advantages (such as low cost labor) Seeking knowledge  Seeking security  Seeking markets Chapter 3 20 Czinkota: International Business, 8e

France’s Carrefour Bets on India

95 percent of retail shopping in India occurs in mom-and-pop stores called kirana shops. Organized outlets (supermarkets, hypermarkets and department stores) account for just 5 percent of the $450 billion retail market. Thanks to robust economic growth and a fast-expanding middle class, big retailers are starting to cash in on an emerging retail market in India. The latest retail giant to arrive is Carrefour, which will open its first outlet in Delhi in July 2010, with more shops scheduled for other cities later in the year. The French firm follows Wal-Mart, the world’s biggest retailer, which last year opened its doors in Amritsar, India.

Carrefour has waited nearly a decade, deterred by restrictive laws that let foreigners invest a 51 percent stake in only single-brand stores. Source: The Economist - http://www.economist.com/node/16168260 Chapter3 Czinkota: International Business, 8e

The Theory of Foreign Direct Investment

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Firms as Exploiters or Imperfections

   Imperfections in access (to avoid tariffs) Imperfections in factor mobility (using the mobility of capital to take advantage of the immobility of labor) Imperfections in management 

Firms as Internalizers

  By establishing their own multinational operations, firms can internalize the production Confidential information is kept at the core of the firm’s operations Chapter 3 22 Czinkota: International Business, 8 e

Focus on Politics: Bridging the Red Sea

Ta r e k b i n L a d e n i s l e a d i n g a p r o j e c t t o b u i l d a 2 9 k i l o m e t e r - l o n g b r i d g e f r o m D j i b o u t i t o Ye m e n , t r a v e r s i n g t h e R e d S e a . T h e b r i d g e w o u l d l i n k t h e A r a b i a n P e n i n s u l a a n d A f r i c a , a n d w o u l d p r o v i d e a b a s e f o r h i g h w a y, r a i l w a y, a n d p i p e l i n e c o n d u i t s . I t w o u l d c o n n e c t d r o u g h t - s t r i c k e n D j i b o u t i w i t h v a l u a b l e r e s o u r c e s . B e c a u s e D j i b o u t i a n d i t s n o r t h e r n n e i g h b o r, E r i t r e a h a v e a l o n g - s t a n d i n g b o r d e r d i s p u t e , t h i s p l a n m a y n o t c o m e t o f r u i t i o n .

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