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INTERNATIONAL BUSINESS
ENVIRONMENT
(Political Economy of International Business)
Session 2
International Trade – Theories and
Reality
Today's questions ...
1. What are the main theories of international trade and foreign
direct investment?
2. What is their understanding of trade purpose? What do they say
with regards to the role played by business and governments?
3. What is the case for free trade vs. protectionism?
4. How can protectionism nonetheless be justified?
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Section 1
INTERNATIONAL TRADE THEORIES
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Main international trade theories
 Country-based trade theories
Mercantilism
Absolute advantage
Comparative advantage
 Firm-based trade theories
Vernon's product life-cycle theory
New trade theory
 M. Porter's attractiveness
diamond
 Foreign direct investment
theories
J. Dunning's eclectic theory
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Mercantilism
 Original XVIIth century mercantilists, such as John Law, a Scots
financier, believed that a country's economic prosperity and
political power came from its stocks of precious metals.
 To maximise these stocks they argued against free trade,
favouring protectionist policies designed to minimise imports
and maximise exports, creating a trade surplus that could be
used to acquire more precious metal
http://www.economist.com/research/Economics/alphabetic.cfm?letter=M#mercantilism
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Mercantilism today
 Neo-mercantilism is a term used to describe a policy regime which
encourages exports, discourages imports, controls capital movement and
centralises currency decisions in the hands of a central government
 The objective of neo-mercantilist policies is to increase the level of foreign
reserves held by the government, allowing more effective monetary and
fiscal policy. This is generally believed to come at the cost of lower
standards of living of the concerned nation
 It is called "neo" because of the change in emphasis from classical
mercantilism on military development, to economic development. It also
accepted a greater level of price fixing based on market mechanisms
http://en.allexperts.com/q/Economics-2301/Differences-Mercantilist-Neo-Mercantilist-1.htm
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Absolute advantage (A. Smith)
Absolute advantage refers to the ability of a person or a country
to produce a particular good at a lower absolute cost than
another.
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Comparative advantage [1] (D. Ricardo)
Comparative advantage refers to the ability of a person or a country to
produce a particular good at a lower marginal cost and opportunity
cost than another person or country.
Comparative advantage explains how trade can create value for both
parties even when one can produce all goods with fewer resources
than the other. The net benefits of such an outcome are called gains
from trade.
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The gains from free trade [1] (from CW Hill)
Absolute advantage
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200 units of resources available per country
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Comparative advantage
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The gains from free trade [2]
P
S
E*
P*
Domestic
price
P1
s1
d1
World
price
Imports
qs
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D
q*
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Q
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Example: Britain's trade in the XIXth Century
Exotic products
Opium
Food products
Textile products
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Comparative advantage [2] (H-O-S model)
 Ricardo's theory of comparative advantage is based on differences
in labour productivity
 For Eli Heckscher and Bertil Ohlin, comparative advantage arises
from differences in relative national factor endowments – the
extent to which a country is endowed with resources like labour
and capital
 The Heckscher-Ohlin-Samuelson model predicts that countries will
export goods that make intensive use of those factors that are
locally abundant, while importing goods that make intensive use of
factors that are locally scarce
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Limitations of traditional trade theories
Focused on trade
between nations,
not between firms
Do not consider
capital movements
Traditional
(country-based)
trade theories
Do not analyse
long-term impact
of international
specialisation
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Do not explain
intra-industry and
intra-firm trade
Do not explain
trade among
similar countries
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The product life-cycle theory (Graph by CW Hill)
According to Raymond Vernon's
product life-cycle theory, both the
location of sales and the optimal
production location will change as
products mature, affecting the flow
and direction of trade
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The new trade theory (P. Krugman)

Tries to explain why trade is growing fastest between industrial
countries
1.
2.

Trading similar goods (intra-industry trade)
Considers
1.
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With similar economies and endowments of the factors of
production (intra-regional trade)
Markets of imperfect competition (oligopolies, national
monopolies)
2.
Increasing returns to scale
3.
Movement of capital (foreign direct investment)
4.
Business and government strategies
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The new trade theory (ctd)
1. Trade is mutually beneficial because it allows for the specialization
of production, the realization of economies of scale, and the
production of a greater variety of products at lower prices
2. The pattern of trade may result from economies of scale and first
mover advantages (economic and strategic advantages that accrue
to early entrants into an industry)
3. Selected government intervention (strategic trade policy) may
support the development of strategic or export-oriented
industries
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The new trade theory (ctd)
Government strategies
Corporate strategies
Targeted
protectionism
Strategic trade policy
Economies of scale, externalities
Internationalisation
(horizontal, vertical)
First mover
advantage
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New markets
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Diversification,
specialisation
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Introducing foreign direct investment
Definition
Foreign direct investment (FDI) occurs when a firm invests directly in new
facilities to produce and/or market in a foreign country
Greenfield investment
Establishment of a wholly new operation in a
foreign country
Joint venture
legal entity formed between two or more
parties to undertake an economic activity
together.
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Brownfield investment
Acquisitions or mergers with existing firms in
the foreign country
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Foreign direct investment drivers
Strategic rivalry
Advantage to first mover
Bandwagon effect
Multipoint competition
Export substitution
Export complementarity
Transport costs
Trade barriers
Optimisation of value chain
(vertical integration)
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Dunning's "eclectic theory" of FDI (ILO)
Internalisation
• Response to actual or threatened trade barriers
• Need to control foreign business activity
Location
• Resource endowments (capital, labour) or assets (incl.
location externalities) that are tied to a particular location
Ownership
• Firms endowed with a distinctive competitive advantage
(technology, brand, economies of scale) will try to take
advantage of large number of markets
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M. Porter's diamond
M. Porter's thesis is
that national
competitive advantage
is not dependent on
factor endowment,
but depends on
various factors that
interact with each
other to create
conditions where
innovation and
improved
competitiveness
occurs
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Government
Firm strategy,
structure and
rivalry
Factor
endowments
Demand
conditions
Related and
supporting
industries
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Chance
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Conclusion: internationalisation drivers
Supply factors
Demand factors
Natural resources
Production (labour) costs/productivity
Distribution costs
Key technologies
Location externalities
New markets
(incl. economies of scale)
Response to customer's mobility
Response to trade barriers
Economic incentives
Strategic rivalry
Advantage to 1st mover - Bandwagon effect/Herd behaviour - Multipoint competition
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Protectionism or free trade?
 Mercantilism promotes government involvement in supporting exports
and limiting imports
 Smith, Ricardo and Heckscher-Ohlin show that it is beneficial for a country
to engage in international trade even for products it is able to produce for
itself. International trade allows a country:


To specialize in the manufacture and export of products that it can produce
efficiently
To import products that can be produced more efficiently in other countries
 The new trade theory supports international trade but justifies limited
and selective government intervention to support the development of
certain export-oriented industries
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Food for thought …
"An international economics course should drive
home to students the point that international trade is
not about competition, it is about mutually beneficial
exchange.
Even more fundamentally, we should be able to teach
students that imports, not exports, are the purpose
of trade. That is, what a country gains from trade is
the ability to import what it wants.
Exports are not an objective in and of themselves:
the need to export is a burden that the country must
bear because its import suppliers are crass enough to
demand payment".
Paul KRUGMAN, in Pop Internationalism
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Section 2
THE REALITY OF INTERNATIONAL TRADE
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From theory to reality
Most nations are
nominally committed to
free trade
In practise, governments
intervene to protect the
interests of powerful
groups
TRADE POLICY
Trade restriction
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Trade promotion
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Free vs. "managed" trade
 Partisans of a "managed trade" (or fair trade) consider that national
governments should actively intervene in international trade to ensure
that :
 Domestic firms are offered an equitable share of foreign markets
 Imports are controlled to minimize losses of domestic jobs and market share
in specific industries
 "Fair traders" also argue that a government should ensure a level playing
field on which foreign and domestic firms get the same opportunity to
compete
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Government goals in international trade
Economic goals
Social goals
Trade policy
Political goals
Foreign policy goals
Various goals can be in conflict
Goals are dynamic: objectives may change over time (homeostasis)
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Justifications to trade restriction/promotion
 Political arguments

Protecting consumers from "dangerous" products

Protecting jobs

Protecting industries deemed important for national security

Retaliating to unfair foreign competition

Furthering the goals of foreign policy

Protecting the human rights of individuals in exporting countries
 Economic arguments


Protecting infant – or declining – industries
Strategic trade policy, supporting the development of strategic industries and
technologies

The "big country" argument

Preserving access to natural resources ...
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The "candle tax", a case of public choice?
Europe has been accused of going back on world leaders' pledge to avoid
exacerbating the recession by throwing up new barriers against international trade,
just a month after the London G20 summit. Brussels will slap tariffs of up to 60% on
imports of cut-price Chinese candles this month, in one of four measures
-identified by the World Bank president, Robert -Zoellick, on a blacklist of anti-free
trade decisions taken since the summit. […]
Britain's retailers are furious about the import tax on candles […]. They say the
measure protects German and Polish candle-makers – and estimate that the
sanction, which will stay in place for five years, will cost retailers up to £10m. […]
The EU has also imposed temporary "anti-dumping" taxes, which are meant to
protect against cut-price subsidised imports, on three other products: Chinese
wire, iron and steel pipes, and aluminium foil from Armenia, Brazil and China.
The Guardian, 4 May 2009
http://www.guardian.co.uk/business/2009/may/04/eu-blocks-free-trade
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Trade restriction instruments
Tariffs, quantitative barriers
Tariffs
(Incl. anti-dumping)
Voluntary export
restraints
Quotas
Subsidies
Non-tariff barriers
Local content
requirements
Norms and
standards
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Administrative
barriers
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Exchange rate
manipulation
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Food for thought …

Why do intergovernmental organisations like the WTO consider
that custom duties are preferable both to quotas and non-tariff
barriers

Tariffs ...
... are transparent
... Create less distortion than quotas
... Are easier to lift than non-tariff obstacles such as norms or
standards
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The consequences of protection ("small" country)
P
S
E*
P*
Domestic
price
s2
P2
World
Price
+ tariff
P1
d2
s1
d1
World
price
D
c1
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q*
q2
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Q
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Trade restriction: business implications
 Generally speaking, trade barriers raise export costs
 Antidumping actions limit a firm's ability to pursue aggressive
pricing to gain market share
 Voluntary export restraints (VERs) and quotas limit a firm's ability
to serve a country from locations outside that country
 To conform to local content requirements, a firm may have to
locate more production activities in a given market than it would
otherwise
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The other side of protection: trade promotion
Subsidies
Export financing programmes
Cash, tax breaks, price supports
(e.g. former US foreign sales
corporations)
Low-interest loans, loan guarantees
(e.g. French COFACE)
Foreign trade zones
Government agencies
Products are subject lower customs
duties and/or fewer customs
procedures
(e.g. Mexican maquiladoras)
Trade missions for officials and
businesses, export-promotion offices,
help import products the home
nation does not produce
(e.g. Japanese JETRO)
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Export promotion bodies: the US case
 Export-Import Bank of the United States (http://www.exim.gov): official
export credit agency of the United States. Assists in financing the export
of U.S. goods and services to international markets
 Overseas Private Investment Corporation (http://www.opic.gov): helps
U.S. businesses invest overseas by managing risks associated with foreign
direct investment
 US government export portal (http://www.export.gov): brings together
resources from across the U.S. Government to assist American businesses
in planning their international sales strategies
 International Trade Administration (http://trade.gov/about.asp):
strengthens the competitiveness of U.S. industry, promotes trade and
investment, and ensures fair trade through the rigorous enforcement of
our trade laws and agreements.
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Protection-based development strategies
Import substitution
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Export promotion
Protectionist barriers:
protect infant industries
Protectionist barriers:
support savings and
investment vs. consumption
Support to domesticallyoriented production
Support to export-led
industries
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Example: the "dragons" and China
The growth champions of the past few decades – Japan in the 1950s
and 1960s, South Korea from the 1960s to the 1980s, and China
since the early 1980s – have all had activist governments
collaborating closely with large business. All aggressively promoted
investment and exports while discouraging (or remaining agnostic
about) imports.
China’s pursuit of a high-saving, large-trade-surplus economy in
recent years embodies mercantilist teachings.
http://www.europeanceo.com/news/commentaries//article672.html
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Food for thought …

What are the limitations of neo-mercantilist policies

"Beggar-thy-neighbour" policy, that works at the expense of
trade partners
Will lead to global depression if applied by all players
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Application: the prisoner's dilemma
Gains / Losses
Germany
Extra-growth, trade and financial surpluses,
job creation ...
Other European
countries
Support to
domestic demand
Support to
external
competitiveness
Support to
domestic demand
Support to
external
competitiveness
3
2
3
-2
-2
2
-1
-1
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