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Theories of International Business
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Table of Contents
Sl No 1. 2. 3. 4. 5. 6. 7. Mercantilism
Contents
Page No. 1, 2, 3, 4 5, 6 7, 8, 9, 10 11, 12, 13, 14, 15, 16 17, 18, 19, 20, 21 21 22
Absolute Advantage Theory Comparative Advantage Theory The Hackscher-Ohlin Trade Model Porter Diamond Conclusion Reference
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Mercantilism
Definition of 'Mercantilism':
The main economic system used during the sixteenth to eighteenth centuries. The main goal was to increase a nation's wealth by imposing government regulation concerning all of the nation's commercial interests. It was believed that national strength could be maximized by limiting imports via tariffs and maximizing exports.
History
Some economic historians (like Peter Temin) argue that the economy of the Early Roman Empire was a market economy and one of the most advanced agricultural economies to have existed (in terms of productivity, urbanization and development of capital markets), comparable to the most advanced economies of the world before the Industrial Revolution, namely the economies of 18th century England and 17th century Netherlands. There were markets for every type of good, for land, for cargo ships; there was even an insurance market. Many European economists between 1500 and 1750 are today generally considered mercantilists; however, these economists did not see themselves as contributing to a single economic ideology. The bulk of what is commonly called "mercantilist literature" appeared in the 1620s in Great Britain. Adam Smith, who was critical of the idea, was the first person to organize formally most of the contributions of mercantilists into what he called "the mercantile system" in his 1776 book The Wealth of Nations. Beyond England, Italy, France, and Spain had noted writers who had mercantilist themes in their work, indeed the earliest examples of mercantilism are from outside of England: in Italy, Giovanni Botero (1544-1617) and Antonio Serra (1580-?), in France, Colbert and some other precursors to the physiocrats, in Spain, the School of Salamanca writers Francisco de Vitoria (1480 or 1483 1546), Domingo de Soto (1494-1560), Martin de Azpilcueta (1491 - 1586), and Luis de Molina (1535-1600).
Widespread Definition
Mercantilism is an economic theory that the prosperity of a nation depends upon its capital, and that the volume of the world economy and international trade is unchangeable. Government economic policy based on these ideas is also sometimes called mercantilism, Economic assets, or capital, are represented by bullion (gold, silver, and trade value) held by the state, which is best increased through a positive balance of trade with other nations (exports minus imports). Mercantilism suggests that the ruling government should advance these goals by playing a 3|Page
protectionist role in the economy, by encouraging exports and discouraging imports, especially through the use of tariffs.
Features
Mercantilism is the economic doctrine that government control of foreign trade is of paramount importance for ensuring the military security of the country. In particular, it demands a positive balance of trade. High tariffs, especially on manufactured goods, are an almost universal feature of mercantilist policy. Other policies have included: Building a network of overseas colonies; Forbidding colonies to trade with other nations; Monopolizing markets with staple ports; Banning the export of gold and silver, even for payments; Forbidding trade to be carried in foreign ships; Export subsidies; Promoting manufacturing with research or direct subsidies; Limiting wages; Maximizing the use of domestic resources; Restricting domestic consumption with non-tariff barriers to trade.
Principles
Mercantilism contained many interlocking principles some of them as follows: 1. Precious metals, such as gold and silver, were deemed indispensable to a nations wealth. If a nation did not possess mines or have access to them, precious metals should be obtained by trade. It was believed that trade balances must be favorable, meaning an excess of exports over imports. Colonial possessions should serve as markets for exports and as suppliers of raw materials to the mother country. Manufacturing was forbidden in colonies, and all commerce between colony and mother country was held to be a monopoly of the mother country. 2. A strong nation, according to the theory, was to have a large population, for a large population would provide a supply of labor, a market, and soldiers. Human wants were to be minimized, especially for imported luxury goods, for they drained off precious foreign exchange. Sumptuary laws (affecting food and drugs) were to be passed to make sure that wants were held low.
Influence
Mercantilism as a whole cannot be considered a unified theory of economics because mercantilism has traditionally been driven more by the political and commercial interests of the State and security concerns than by abstract ideas. There were no mercantilist writers presenting an overarching scheme for the ideal economy, as Adam Smith would later do for classical (laissez-faire) economics. Some scholars thus reject the idea of mercantilism completely, arguing that it gives "a false unity to disparate events". Mercantilists viewed the economic system as a zero-sum game, in which any gain by one party required a loss by another. Thus, any system of policies that benefited one group would by definition harm the other, and there was no possibility of economics being used to maximize the "commonwealth", or common good.
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Mercantilist domestic policy was more fragmented than its trade policy. The early modern era was one of letters patent and government-imposed monopolies; some mercantilists supported these, but others acknowledged the corruption and inefficiency of such systems. Many mercantilists also realized that the inevitable results of quotas and price ceilings were black markets. One notion mercantilists widely agreed upon was the need for economic oppression of the working population; laborers and farmers were to live at the "margins of subsistence". The goal was to maximize production, with no concern for consumption. Extra money, free time, or education for the "lower classes" was seen to inevitably lead to vice and laziness, and would result in harm to the economy. Mercantilism developed at a time when the European economy was in transition. Isolated feudal estates were being replaced by centralized nation-states as the focus of power. Technological changes in shipping and the growth of urban centers led to a rapid increase in international trade. Mercantilism focused on how this trade could best aid the states. Another important change was the introduction of double-entry bookkeeping and modern accounting. Prior to mercantilism, the most important economic work done in Europe was by the medieval scholastic theorists. They focused mainly on microeconomics and local exchanges between individuals. This period saw the adoption of Niccol Machiavelli's realpolitik and the primacy of the raison d'tat in international relations. The mercantilist idea that all trade was a zero sum game, in which each side was trying to best the other in a ruthless competition, was integrated into the works of Thomas Hobbes. Note that non-zero sum games such as prisoner's dilemma can also be consistent with a mercantilist view. In prisoner's dilemma, players are rewarded for defecting against their opponents. More modern views of economic co-operation amidst ruthless competition can be seen in the folk theorem of game theory.
Criticisms
Adam Smith and David Hume are considered to be the founding fathers of anti-mercantilist thought. A number of scholars found important flaws with mercantilism long before Adam Smith developed an ideology that could fully replace it. Critics like Dudley North, John Locke, and David Hume undermined much of mercantilism. Failure to understand other theory: Mercantilists failed to understand the notions of absolute advantage and comparative advantage (although this idea was only fully fleshed out in 1817 by David Ricardo) and the benefits of trade. In modern economic theory, trade is not a zero-sum game of cutthroat competition, because both sides can benefit (rather, it is an iterated prisoner's dilemma). By imposing mercantilist import restrictions and tariffs instead, both nations ended up poorer. Impossibility to maintain trade balance: David Hume famously noted the impossibility of the mercantilists' goal of a constant positive balance of trade. As bullion flowed into one country, the supply would increase and the value of bullion in that state would steadily decline relative to other goods. Eventually it would no longer be cost-effective to export goods from the high-price country to the low-price country, and the balance of trade would reverse itself. Mercantilists fundamentally misunderstood this, long arguing that an increase in the money supply simply meant that everyone gets richer. Importance on bullion: The importance placed on bullion was also a central target, even if many mercantilists had themselves begun to de-emphasize the importance of gold and silver. Adam Smith 5|Page
noted that at the core of the mercantile system was the "popular folly of confusing wealth with money," bullion was just the same as any other commodity, and there was no reason to give it special treatment. Rent seeking critique: The critique that mercantilism was a form of rent-seeking has also seen criticism, as scholars such Jacob Viner in the 1930s point out that merchant mercantilists such as Mun understood that they would not gain by higher prices for English wares abroad.
Inheritance
In the English-speaking world, Adam Smith's utter repudiation of mercantilism was accepted, eventually, as public policy in the British Empire and in the United States. Initially it was rejected in the United States by such prominent figures as Alexander Hamilton, Henry Clay, Henry Charles Carey, and Abraham Lincoln and in Britain by such figures as Thomas Malthus. In the 20th century, most economists on both sides of the Atlantic have come to accept that in some areas mercantilism had been correct. Most prominently, the economist John Maynard Keynes explicitly supported some of the tenets of mercantilism. Adam Smith had rejected focusing on the money supply, arguing that goods, population, and institutions were the real causes of prosperity. These views later became the basis of monetarism, whose proponents actually reject much of Keynesian monetary theory, and has developed as one of the most important modern schools of economics. Adam Smith rejected the mercantilist focus on production, arguing that consumption was the only way to grow an economy. Keynes argued that encouraging production was just as important as consumption. In an era before paper money, an increase for bullion was one of the few ways to increase the money supply. Keynes and other economists of the period also realized that the balance of payments is an important concern, and since the 1930s, all nations have closely monitored the inflow and outflow of capital, and most economists agree that a favorable balance of trade is desirable. Keynes also adopted the essential idea of mercantilism that government intervention in the economy is a necessity. Today the word remains a pejorative term, often used to attack various forms of protectionism. The similarities between Keynesianism, and its successor ideas, with mercantilism have sometimes led critics to call them neo-mercantilism. One area Smith was reversed on well before Keynes was that of the use of data. Mercantilists, who were generally merchants or government officials, gathered vast amounts of trade data and used it considerably in their research and writing. William Petty, a strong mercantilist, is generally credited with being the first to use empirical analysis to study the economy.
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In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources. Adam Smith first described the principle of absolute advantage in the context of international trade, using labor as the only input.
Condition:
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The theory that trade occurs when one country, individual, company, or region is absolutely more productive than another entity in the production of a good. A person, company or country has an absolute advantage if its output per unit of input of all goods and services produced is higher than that of another entity producing that good or service.
Example
The principle was described by Adam Smith in the context of international trade. Now I am describing some of them below A country has an absolute advantage over another in producing a good, if it can produce that good using fewer resources than another country. For example if one unit of labor in India can produce 80 units of wool or 20 units of wine; while in Spain one unit of labor makes 50 units of wool or 75 units of wine, then India has an absolute advantage in producing wool and Spain has an absolute advantage in producing wine. India can get more wine with its labor by specializing in wool and trading the wool for Spanish wine, while Spain can benefit by trading wine for wool. (Adam Smith, Wealth of Nations, Book IV, Ch.2.) The benefits to nations from trading are the same as to individuals: trade permits specialization, which allows resources to be used more productively
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1. Ricardo's Assumptions:Ricardo explains his theory with the help of following assumptions:1. There are two countries and two commodities. 2. There is a perfect competition both in commodity and factor market. 3. Cost of production is expressed in terms of labor i.e. value of a commodity is measured in terms of labor hours/days required to produce it. Commodities are also exchanged on the basis of labor content of each good. 4. Labor is the only factor of production other than natural resources. 5. Labor is homogeneous i.e. identical in efficiency, in a particular country. 6. Labor is perfectly mobile within a country but perfectly immobile between countries. 7. There is free trade i.e. the movement of goods between countries is not hindered by any restrictions. 8. Production is subject to constant returns to scale. 9. There is no technological change. 9|Page
10. Trade between two countries takes place on barter system. 11. Full employment exists in both countries. 12. Perfect occupational mobility of factors of production - resources used in one industry can be switched into another without any loss of efficiency 13. Perfect occupational mobility of factors of production - resources used in one industry can be switched into another without any loss of efficiency 14. Constant returns to scale (i.e. doubling the inputs in each country leads to a doubling of total output) 15. No externalities arising from production and/or consumption 16. Transportation costs are ignored 17. If businesses exploit increasing returns to scale (i.e. economies of scale) when they specialize, the potential gains from trade are much greater. The idea that specialization should lead to increasing returns is associated with economists such as Paul Romer and Paul Ormerod.
2. Ricardo's Example:On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by taking an example of England and Portugal as two countries & Wine and Cloth as two commodities. As pointed out in the assumptions, the cost is measured in terms of labor hour. The principle of comparative advantage expressed in labor hours by the following table.
Portugal requires less hours of labor for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labor hours as above 120 labor hours required in England. In the case of cloth too, Portugal requires less labor hours than England. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specializing in the commodity in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.
Considerations
Development economics
The theory of comparative advantage, and the corollary that nations should specialize, is criticized on pragmatic grounds within the import substitution industrialization theory of development economics, 10 | P a g e
on empirical grounds by the SingerPrebisch thesis which states that terms of trade between primary producers and manufactured goods deteriorate over time, and on theoretical grounds of infant industry and Keynesian economics. In older economic terms, comparative advantage has been opposed by mercantilism and economic nationalism.
Criticism
Applicability
Economist Ha-Joon Chang criticized the comparative advantage principle, contending that it may have helped developed countries maintain relatively advanced technology and industry compared to developing countries. In his book Kicking Away the Ladder, Chang argued that all major developed countries, including the United States and United Kingdom, used interventionist, protectionist economic policies in order to get rich and then tried to forbid other countries from doing the same.
To identify which country should specialize in a particular product we need to analyses the internal opportunity cost for each country. For example, were the UK to shift more resources into higher 11 | P a g e
output of personal computers, the opportunity cost of each extra PC is four CD players. For Japan the same decision has an opportunity cost of two CD players. Therefore, Japan has a comparative advantage in PCs.
The quantity and quality of factors of production available: If an economy can improve the quality of its labor force and increase the stock of capital available it can expand the productive potential in industries in which it has an advantage. Investment in research & development (important in industries where patents give some firms significant market advantage .An appreciation of the exchange rate can cause exports from a country to increase in price. This makes them less competitive in international markets. Long-term rates of inflation compared to other countries. For example if average inflation in Country X is 4% whilst in Country B it is 8% over a number of years, the goods and services produced by Country X will become relatively more expensive over time. This worsens their competitiveness and causes a switch in comparative advantage. Import controls such as tariffs and quotas that can be used to create an artificial comparative advantage for a country's domestic producers- although most countries agree to abide by international trade agreements. Non-price competitiveness of producers (e.g. product design, reliability, quality of aftersales support)
Importance:
The good in which a comparative advantage is held is the good that the country produces most efficiently. Therefore, if given a choice between producing two goods (or services), a country will make the most efficient use of its resources by producing the good with the lowest opportunity cost, the good for which it holds the comparative advantage. The country can trade with other countries to get the goods it did not produce.
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model:
1. Factor Price Equalization Theorem, 2. Stolper-Samuelson Theorem, 3. Rybczynski Theorem, and 4. Heckscher-Ohlin Trade Theorem.
Definition:
HeckscherOhlin theorem is one of the four critical theorems of the HeckscherOhlin model. It states that a country will export goods that use its abundant factors intensively, and import goods that use its scarce factors intensively. In the two-factor case, it states: "A capital-abundant country will export the capital-intensive good, while the labor-abundant country will export the labor-intensive good." The critical assumption of the HeckscherOhlin model is that the two countries are identical, except for the difference in resource endowments. Initially, when the countries are not trading: The price of capital-intensive good in capital-abundant country will be bid down relative to the price of the good in the other country, The price of labor-intensive good in labor-abundant country will be bid down relative to the price of the good in the other country.
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The Ricardian model of comparative advantage has trade ultimately motivated by differences in labor productivity using different technologies. Heckscher and Ohlin didn't require production technology to vary between countries, so (in the interests of simplicity) the H-O model has identical production technology everywhere. Ricardo considered a single factor of production (labor) and would not have been able to produce comparative advantage without technological differences between countries. The H-O model removed technology variations but introduced variable capital endowments, recreating endogenously the inter-country variation of labor productivity that Ricardo had imposed exogenously.
Extensions
The model has been extended since the 1930s by many economist.Notable contributions came from Paul Samuelson, Ronald Jones, and Jaroslav Vanek, so that variations of the model are sometimes called the Heckscher-Ohlin-Samuelson model or the Heckscher-Ohlin-Vanek model in the neoclassical economics.
10. 11.
The original, 2x2x2 model was derived with restrictive assumptions. These assumptions and developments are listed here.
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Differences in labor abundance would not produce a difference in relative factor abundance (in relation to mobile capital) because the labor/capital ratio would be identical everywhere. As capital controls are reduced, the modern world has begun to look a lot less like the world modelled by Heckscher and Ohlin. It has been argued that capital mobility undermines the case for Free Trade itself, see: Capital mobility and comparative advantage Free trade critique. Capital is mobile when: There are limited exchange controls Foreign Direct Investment (FDI) is permitted between countries, or foreigners are permitted to invest in the commercial operations of a country through a stock or corporate bond market
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concern that third world cares most. The factor price equalization theorem has not shown a sign of realization, even for a long time lag of a half century.
Capital as endowment
In the modern production system, machines and apparatuses play an important role. What is named capital is nothing other than these machines and apparatuses, together with materials and intermediate products. Capital is the most important of factors, or one should say as important as labor. By the help of machines and apparatuses quantity is not changed at once. But the capital is not an endowment given by the nature. It is composed of goods manufactured in the production and often imported from foreign countries. In this sense, capital is internationally mobile. The concept of capital as natural endowment distorts the real role of capital.
Homogeneous capital
Capital goods take different forms. It may take the form of a machine-tool such as lathe, the form of a transfer-machine, which you can see under the belt-conveyors. Despite these facts, capital in the HechscherOhlin Model is assumed as homogeneous and transferable to any form if necessary. This assumption is not only far from the reality, but also it includes logical flaw. In the HeckscherOhlin model, the rate of profit is determined according to how abundant capital is. Before the profit rate is determined, the amount of capital is not measured. This logical difficulty was the subject of academic controversy which took place many years ago. In fact, this is sometimes named Cambridge Capital Controversies. HeckscherOhlin theorists ignore all these stories without providing any explanation how capital is measured theoretically.
No unemployment
Unemployment is the vital question in any trade conflict. HeckscherOhlin theory excludes unemployment by the very formulation of the model, in which all factors (including labor) are employed in the production.
Unrealistic Assumptions
Besides the usual assumptions of two countries, two commodities, no transport cost, etc. Ohlin's theory also assumes no qualitative difference in factors of production, identical production function, constant return to scale, etc. All these assumptions makes the theory unrealistic one. 17 | P a g e
Restrictive
Ohlin's theory is not free from constrains. His theory includes only two commodities, two countries and two factors. Thus it is a restrictive one.
One-Sided Theory
According to Ohlin's theory, supply plays a significant role than demand in determining factor prices. But if demand forces are more significant, a capital abundant country will export labor intensive good as the price of capital will be high due to high demand for capital.
Static in Nature
Like Ricardian Theory the H-O Model is also static in nature. The theory is based on a given state of economy and with a given production function and does not accept any change.
Wijnholds's Criticism
According to Wijnholds, it is not the factor prices that determine the costs and commodity prices but it is commodity prices that determine the factor prices.
Haberler's Criticism
According to Haberler, Ohlin's theory is based on partial equilibrium. It fails to give a complete, comprehensive and general equilibrium analysis.
Leontief Paradox
American economist Dr. Wassily Leontief tested H-O theory under U.S.A conditions. He found out that U.S.A exports labor intensive goods and imports capital intensive goods, but U.S.A being a capital abundant country must export capital intensive goods and import labor intensive goods than to produce them at home. This situation is called Leontief Paradox which negates H-O Theory.
Importance
The critical assumption of the HeckscherOhlin model is that the two countries are identical, except for the difference in resource endowments. This also implies that the aggregate preferences are the same. The relative abundance in capital will cause the capital-abundant country to produce the capitalintensive good cheaper than the labor-abundant country and vice versa.
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Porter Diamond
The diamond model is an economical model developed by Michael Porter in his book The Competitive Advantage of Nations .He is recognized as an authority on company strategy and competition;
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Diamond model
Porter analysis
The approach looks at clusters, a number of small industries, where the competitiveness of one company is related to the performance of other companies and other factors tied together in the valueadded chain. The Porter analysis was made in two steps. First, clusters of successful industries have been mapped in 10 important trading nations. In the second, the history of competition in particular industries is examined to clarify the dynamic process by which competitive advantage was created. The phenomena that are analyzed are classified into six broad factors incorporated into the Porter diamond, which has become a key tool for the analysis of competitiveness: The points of the diamond are described as follows
1. FACTORCONDITIONS
-A country creates its own important factors such as skilled resources and technological base. -These factors are upgraded / deployed over time to meet the demand. -Local disadvantages force innovations. New methods and hence comparative advantage.
2. DEMANDCONDITIONS
-A more demanding local market leads to national advantage. -A strong trend setting local market helps local firms anticipate global trends.
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6. CHANCE
- Events are occurrences that are outside of control of a firm. - Important because they create discontinuities in which some gain competitive positions and some lose. The Porter thesis is that these factors interact with each other to create conditions where innovation and improved competitiveness occurs.
- They should focus on specialized factor creation. (How can they do this?) - They should enforce tough standards.
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Therefore, Porter's original diamond model has been extended to the generalized double diamond model whereby multinational activity is formally incorporated. A nation's competitiveness depends partly upon the domestic diamond and partly upon the 'international' diamond relevant to its firms. The size of the global diamond is fixed within a foreseeable period, domestic diamond varies according to the country size and its competitiveness. The difference between the international diamond and the domestic diamond thus represents international or multinational activities. The multinational activities include both outbound and inbound foreign direct investment (FDI).
First, sustainable value added in a specific country may result from both domestically owned and
foreign owned firms. Porter, however, does not incorporate foreign activities into his model as he makes a distinction between geographic scope of competition and the geographic locus of competitive advantage.[14]
Second, sustainability may require a geographic configuration spanning many countries, whereby
firm specific and location advantages present in several nations may complement each other. Porter's global firm is just an exporter and his methodology does not take into account the organizational complexities of true global operations by multinational.
Conclusion
An international business theory must look at the distribution of gains from international business activities between the firms involved and the Governments in each country and between (or among) relevant Governments.' When Governments are satisfied with the gains generated by an international business activity in open markets, they impose no barriers and, hence, no theory of international 23 | P a g e
business is necessary; firms will then undertake cross-national activities for reasons explained by noninternational theories, such as comparative advantage or internalization theory. When Governments wish to redistribute the costs and benefits of international business activities, they impose policies which firms must take into account in their decision-making-and this action/reaction environment is the subject that IB theory must explain. Since there are no Governments that permit fully open markets, the world of international business is one requiring differential explanation. IB theory needs to re-focus its analysis on the relationships between international firms and Governments. Instead of competitive strategy among firms, it should analyze bargaining strategy between firms and Governments. Under these conditions, IB theory becomes an explanation of bilateral (and sometimes multilateral) negotiation over appropriability as between INCs and Governments in a game of the distribution of wealth and power. We are back to a consideration of the goals of mercantilism in the pursuit of relative wealth and power among nations through the TNC/ INC. In a mercantilist world such as ours, we need a mercantilist theory of international business.
Reference
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