International business refers to the trade of goods, services, technology, capital and/or knowledge

across national borders and at a global or transnational scale.

It involves cross-border transactions of goods and services between two or more countries. Transactions
of economic resources include capital, skills, and people for the purpose of the international production of
physical goods and services such as finance, banking, insurance, and construction. International business is
also known as globalization.
International business occurs in many different formats:

1. The movement of goods from country to another (exporting, importing, trade).

2. Contractual agreements that allow foreign firms to use products, services, and processes from
other nations (licensing, franchising).
3. The formation and operations of sales, manufacturing, research and development, and
distribution facilities in foreign markets

Nature of IB:
 Large scale operations
International businesses are conducted on a very large scale. They perform their operations in different
countries globally. Their business activities are very large in size ranging from production, marketing &
selling of their products. These businesses serve the demands of local markets also where they are
present & also demands of different countries globally. That’s why they produce a large amount of goods
& services to cater to the large demands.

 Earns foreign exchange

International businesses are served as an important source for earning foreign exchange. Foreign
Currencies of different countries are involved in transactions in these businesses. This helps in getting
enough foreign exchange reserves for the country.

 Integrates economies
Another important feature of international business is that it integrates the economies of different
countries worldwide. It takes advantage of different economies & aims at providing its services
economically. It takes labor from one country, technology from one country & finance from another
country. Also, it designs, produces, assembles its products not only in one country but in different-
different countries. This helps in taking advantage of different economies & becoming economical.

 Large number of middlemen

International businesses are very large in size. Their scale of operations is not limited to one country but
performs in different countries globally. There is a large number of middlemen involved in international
businesses. These all person renders their services properly for the efficiency of the business. Their
services help the business in easy expansion & growth.

 High risk
The degree of risk associated with international business is very high. These businesses require a large
amount of resources both in terms of money & manpower for carrying out its operations. These need to
carry out trade in different countries at large distances. It requires a huge cost & time to carry these goods
& services. Also, sometimes different economies face unfavorable conditions which affect the business
conditions.

 Intense competition
International business faces a large number of risks internationally. These businesses invest large amounts
in advertising their products. There are a large number of competitors in the international market. There
is tough competition in terms of price, quality, design, packing, etc. Business needs to focus on these
things to face the tough competition going on.
 International restrictions
International businesses face large restrictions while carrying out there operations in different countries.
Sometimes they are not allowed to inflow & outflow goods, technology & different resources. There are
restricted by the government of different countries to not enter into their countries. They face several
foreign exchange barriers, trade barriers & trade blocks which are harmful for international business.

 Highly sensitive nature

International businesses are highly sensitive in nature. Proper market research is very essential for
carrying out these businesses effectively. Any unfavorable economic conditions in one country will
adversely affect the business. If there is any economic, political or technological change will directly
influence the functioning of the business. Therefore, these businesses should change their activities from
time to time to survive the change.
Theory of Mercantilism:
This theory was developed in the sixteenth century and is considered to be the oldest theory of
International Trade. It was Adam Smith who coined the term ‘Mercantile System’.
According to this theory, a country’s wealth could be determined by the amount of its gold and silver
holdings. This group of theorists believed that every country should increase its gold and silver holdings by
increasing its exports and reducing imports. During that point of time, gold and silver had the status of
currency. The countries should focus on having a ‘trade surplus’ i.e. value of exports should be greater
than the value of imports. ‘Trade deficit’ is to be avoided.

Thus, export was treated as good as it helped in earning gold, whereas, import was treated as bad as it led
to the outflow of gold. If a nation has abundant gold, then it is considered to be a wealthy nation. If all the
countries follow this policy, there may be conflicts, as no one would promote import. The theory of
mercantilism believed in selfish trade that is a one-way transaction and ignored enhancing the world
trade.
Mercantilism was called as a zero-sum game as only one country benefitted from it.

Criticisms of Mercantilism

 Adam Smith’s “The Wealth of Nations” (1776) – argued for benefits of free trade and criticised the
inefficiency of monopoly.
 Theory of comparative advantage (David Ricardo)
 Mercantilism is a philosophy of a zero-sum game – where people benefit at the expense of others. It is
not a philosophy for increasing global growth and reducing global problems. Trying to impoverish other
countries will harm our own growth and prosperity. By contrast, if we avoid zero-sum game of
mercantilism increasing the wealth of other countries can lead to selfish benefits, e.g. growth of Japan
and Germany led to increased export markets for UK and US.
 Mercantilism which stresses government regulation and monopoly often lead to inefficiency and
corruption.
 Mercantilism justified Empire building and the poverty of colonies to enrich the Empire country.
 Mercantilism leads to tit for tat policies – high tariffs on imports leads to retaliation.
 The growth of globalisation and free trade during the post-war period showed possibilities from
opening markets and respecting other countries as equal players.
 Economies of scale from specialisation possible under free trade.
Adam Smith- Theory of Absolute Advantage:
In response to Mercantilism, Adam Smith offered his own theory of Absolute Advantage. This theory believed that a
nation should specialize in producing those goods that it can produce at a cheaper cost than that of other
nations. These goods should be exchanged with other goods that are being cheaply produced by the other nations.

Assumptions
The idea of absolute advantage rests on a number of assumptions on the part of Adam Smith. While
influential and insightful, the theory of absolute advantage is not always entirely accurate because many
of these fundamental assumptions are in fact not true in practice. Here are the most significant of these
assumptions:

1. Lack of Mobility for Factors of Production

Adam Smith assumes that factors of production cannot move between countries. This assumption also
implies that the Production Possibility Frontier of each country will not change after the trade.
2. Trade Barriers

There are no barriers to trade for the exchange of goods. Governments implement trade barriers to
restrict or discourage the importation or exportation of a particular good.
3. Trade Balance

Smith assumes that exports must be equal to imports. This assumption means that we cannot have trade
imbalances, trade deficits, or surpluses. A trade imbalance occurs when exports are higher than imports or
vice versa.

4. Constant Returns to Scale

Adam Smith assumes that we will get constant returns as production scales, meaning there are
no economies of scale. For example, if it takes 2 hours to make one loaf of bread in country A, then it
should take 4 hours to produce two loaves of bread. Consequently, it would take 8 hours to produce four
loaves of bread.
However, if there were economies of scale, then it would become cheaper for countries to keep
producing the same good as it produced more of the same good.
Consider Table 23.1 where man-hours required to produce a unit of wheat or cloth in the U.S.A. and
India are given:

It will be seen from the above table that to produce one unit of wheat in the U.S.A. 3 man-hours and in
India 10 man-hours are required. On the other hand, to produce one unit of cloth, in the U.S.A. 6 man-
hours and in India 4 man-hours are required. Thus the U.S.A. can produce wheat more efficiently (that is,
at a lower cost), while India can produce cloth more efficiently.

To put it in other words, while the U.S.A. has an absolute advantage in the production of wheat, India has
an absolute advantage in the production of cloth. Adam Smith showed that the two countries would
benefit and world output will increase if the two countries specialize in the production of goods in which
they have absolute advantage and trade with each other. How such specialization and trade would lead to
gain in output and would be mutually beneficial for the two countries is shown in Table 23.2.

Suppose to specialize in the production of Wheat, the U.S.A. withdraws 6 man-hours from the production
of cloth and devote them to the production of wheat, it will lose 1 unit of cloth and gain 2 units of wheat.

Similarly, to specialize in the production of cloth if India withdraws 10 hours of labour from wheat and use
them for the production of cloth, it will lose one unit of wheat but gain 2.5 units of cloth.

In this way, transfer of labour resources to the goods in which they have absolute advantage, will result in
the net gain of one unit of wheat and 2.5 units of cloth. The gain in output can be distributed between the
two countries through voluntary exchange.

It is also clear from above that without any increase in productive resources international division of
labour and trade leads to the expansion in world output and wealth. According to Adam Smith, given
perfect competition in the industries and free trade between the countries, it is the market forces that
would ensure specialization and trade on the lines of absolute advantage.
David Ricardo - Theory of Comparative Advantage

Eighteenth-century economist David Ricardo created the theory of comparative advantage. He argued
that a country boosts its economic growth the most by focusing on the industry in which it has the most
substantial comparative advantage.
It is also known as the Theory of Comparative Costs

According to Ricardo, “…a nation, like a person, gains from the trade by exporting the goods or services in
which it has its greatest comparative advantage in productivity and importing those in which it has the
least comparative advantage.”

The principle of comparative costs is based on the differences in production costs of similar commodities
in different countries. Production costs differ in countries because of geographical division of labour and
specialisation in production. Due to differences in climate, natural resources, geographical situation and
efficiency of labour, a country can produce one commodity at a lower cost than the other.

In this way, each country specialises in the production of that commodity in which its comparative cost of
production is the least. Therefore, when a country enters into trade with some other country, it will
export those commodities in which its comparative production costs are less, and will import those
commodities in which its comparative production costs are high.

This is the basis of international trade, according to Ricardo. It follows that each country will specialise in
the production of those commodities in which it has greater comparative advantage or least comparative
disadvantage. Thus a country will export those commodities in which its comparative advantage is the
greatest, and import those commodities in which its comparative disadvantage is the least.

Assumptions of the Theory:

The Ricardian doctrine of comparative advantage is based on the following assumptions:

(1) There are only two countries, say A and B.

(2) They produce the same two commodities, X and Y.

(3) Tastes are similar in both countries.

(4) Labour is the only factor of production.

(5) All labour units are homogeneous.

(6) The supply of labour is unchanged.

(7) Prices of the two commodities are determined by labour cost, i.e.. the number of labour-units
employed to produce each.

(8) Commodities are produced under the law of constant costs or returns.

(9) Trade between the two countries takes place on the basis of the barter system.

(10) Technological knowledge is unchanged.

(11) Factors of production are perfectly mobile within each country but are perfectly immobile between
the two countries.

(12) There is free trade between the two countries, there being no trade barriers or restrictions in the
movement of commodities.

(13) No transport costs are involved in carrying trade between the two countries.

(14) All factors of production are fully employed in both the countries.

(15) The international market is perfect so that the exchange ratio for the two commodities is the same.
 Absolute Cost Difference:
As Adam Smith pointed out, if there is an absolute cost difference, a country will specialise in the
production of a commodity having an absolute advantage (see Table 1).

Table 1 Cost of Production in Labour Units:

Country A Country В Comparative Cost Ratio

Commodity X 10 20 10/20 = 0.5

Commodity Y 20 10 20/10 = 2

Domestic Exchange Ratio: 1 X = 1/2 Y 1X=2Y

It follows that country A has an absolute advantage over В in the production of X while В has an absolute
advantage in producing Y. As such, when trade takes place, A specialises in X and exports its surplus to В
and В specialises in У and exports its surplus to A.

Equal Cost Difference:

Ricardo argues that if there is equal cost difference, it is not advantageous for trade and specialisation for
any country in consideration

Table 2 Cost of Production in Labour Units:

Country A Country В Comparative Cost Ratio

Commodity X 10 15 10 /15 = 0.66

Commodity Y 20 30 20/30 = 0.66

Domestic Exchange Ratio: 1 X = 1/2 Y 1 X = 1/2 Y

On account of equal cost difference, the comparative cost ratio is the same for both the countries, so
there is no reason for undertaking specialisation. Hence, the trade between two countries will not take
place.

Comparative Cost Difference:

Ricardo emphasised that under all conditions, it, is the comparative cost advantage which lies at the root
of specialisation and trade (see Table 3).

Table 3 Cost of Production in Labour Units:

Country A Country В Comparative Cost Ratio

Commodity X 10 15 10/ 15 = 0.66

Commodity Y 20 25 20/25 = 0.80 25

 
Domestic Exchange Ratio IX = 0.5Y IX = 0.6Y

It will be seen that country A has an absolute cost advantage in both the commodities X and Y. However, A
possesses a comparative cost advantage in producing X. For, comparatively, country A’s labour cost
involved in producing 1 unit of X is only 66 per cent of B’s labour cost involved in producing X, as against
that of 80 per cent in the case of Y.

On the other hand, country В has least comparative disadvantage in production of Y, though she has
absolute cost disadvantage in both X and Y.

It should be noted that, to know the comparative advantage, we have to compare the ratio of the costs of
production of one commodity in both countries (i.e., 10/15 in the case of X in our example) with the ratio
of the cost of producing the other commodity in both countries (i.e., 20/25 in the case of У in our
example). To state in algebraic terms:

If in country A, the labour cost of commodity X is Xa and that of У is Ya, and in B, it is Xb and Yb
respectively, then absolute differences in cost can be expressed as:

Xa/Xb < 1 < Ya/Yb

(Which means that country A has an absolute advantage over country В in commodity X and country В has
over A in commodity У). And, comparative differences in costs are expressed as:

Xa/Xb < Ya/Yb < 1

(Which implies that country A possesses an absolute advantage over В in both X and (Y, but it has more
comparative advantage in X than in Y). If, however, there is an equal cost difference, i.e., Xa/Xb = Ya/Yb
will be no international trade between the two countries.

In our illustration, since country A has comparative cost advantage in commodity X, as per Ricardo s
theorem, this country should tend to specialise in X and export its surplus to country В in exchange for У
(i.e., import of У from B). Correspondingly, since country В has least cost disadvantage in producing У, she
should specialise in У and export its surplus to A and import X.

CRITICISMS OF COMPARATIVE ADVANTAGE

The following are the criticisms of the Ricardian doctrine of comparative advantage:

1. The theory only considers labour costs and neglects all non-labour costs involved in the
production of the commodities.
2. The theory considers all labour to be homogenous. However, in reality, labour is
heterogeneous due to different grades and kinds.
3. The theory assumes similar tastes for all. However, the tastes differ with the growth of
economies and income brackets.
4. The theory assumes that a fixed proportion of labour is used in the production of all
commodities. However, in reality, utilization of the proportion of labour depends on the type
of commodity being produced.
5. The theory has an unrealistic assumption of constant costs. However, large-scale
productions lead to cost reduction and thereby increase the comparative advantage.
6. Transport costs play an essential role in determining the pattern of trade. But the Ricardo
theory neglects this independent factor of production.
7. The assumption of the factors of production being mobile internally is unrealistic. The
factors do not move freely from one region to another or one industry to another. The greater
the degree of specializations in an industry, the more immobile the factor will be.
8. The assumption of the theory of having only two countries and two commodities is
unrealistic as international trade takes place among countries trading numerous
commodities.
9. Every country implements restrictions on the movement of goods to and from the
countries. Thus, tariffs and trade restrictions play a role in world imports and exports.
However, the theory assumes free and perfect world trade.
10. The theory assumes full employment. However, every economy has an
existence of underemployment.
11. A country may or may not want to trade a commodity due to military, strategic
or development considerations. Therefore, self-interest stands in the operation of the
comparative advantage theory.
12. The Ricardian theory considers only the supply side of world trade and neglects
the demand side.
13. The theory only explains how two countries gain from international trade. But
the theory fails to explain how the gains from the trade are distributed between the two
countries.

Conclusion:

Despite these weaknesses, the theory has stood the test of the times. Its basic structure has remained
intact, even though many refinements have been made over it. To conclude with Professor Samuelson,
“Yet for all its over simplifications, the theory of comparative advantages has in it a most important
glimpse of truth. Political economy has found few more pregnant principles. A nation that neglects
comparative advantage may have to pay a heavy price in terms of living standards and potential rates of
growth.”
Porter’s Diamond Model

Michael Porter’s Diamond Model (also known as the Theory of National Competitive Advantage of
Industries) is a diamond-shaped framework that focuses on explaining why certain industries within a
particular nation are competitive internationally, whereas others might not. And why is it that certain
companies in certain countries are capable of consistent innovation, whereas others might not? Porter
argues that any company’s ability to compete in the international arena is based mainly on an interrelated
set of location advantages that certain industries in different nations posses, namely: Firm Strategy,
Structure and Rivalry; Factor Conditions; Demand Conditions; and Related and Supporting Industries. If
these conditions are favorable, it forces domestic companies to continiously innovate and upgrade. The
competitiveness that will result from this, is helpful and even necessary when going internationally and
battling the world’s largest competitors. This article will explain the four main components and include
two components that are often included in this model: the role of the Government and Chance. Together
they form the national environment in which companies are born and learn how to compete.

Figure 1: Porter’s Diamond Model of National Competitive Advantage

Firm Strategy, Structure and Rivalry
The national context in which companies operate largely determines how companies are created,
organized and managed: it affects their strategy and how they structure themselves. Moreover, domestic
rivalry is instrumental to international competitiveness, since it forces companies to develop unique and
sustainable strenghts and capabilities. The more intense domestic rivalry is, the more companies are being
pushed to innovate and improve in order to maintain their competitive advantage. In the end, this will
only help companies when entering the international arena. A good example for this is the Japanese
automobile industry with intense rivalry between players such as Nissan, Honda, Toyota, Suzuki,
Mitsubishi and Subaru. Because of their own fierce domestic competition, they have become able to more
easily compete in foreign markets as well.

Factor Conditions
Factor conditions in a certain country refer to the natural, capital and human resources available. Some
countries are for example very rich in natural resources such as oil for example (Saudi Arabia). This
explains why Saudi Arabia is one of the largest exporters of oil worldwide. With human resources, we
mean created factor conditions such as a skilled labor force, good infrastructure and a scientific
knowlegde base. Porter argues that especially these ‘created’ factor conditions are important opposed to
‘natural’ factor conditions that are already present. It is important that these created factor conditions are
continiously upgraded through the development of skills and the creation of new knowledge. Competitive
advantage results from the presence of world-class institutions that first create specialized factors and
then continually work to upgrade them. Nations thus succeed in industries where they are particularly
good at factor creation.
Demand Conditions
The home demand largely affects how favorable industries within a certain nation are. A larger market
means more challenges, but also creates opportunities to grow and become better as a company. The
presence of sophisticated demand conditions from local customers also pushes companies to grow,
innovate and improve quality. Striving to satisfy a demanding domestic market propels companies to scale
new heights and possibly gain early insights into the future needs of customers across borders. Nations
thus gain competitive advantage in industries where the local customers give companies a clearer or
earlier picture of emerging buyer needs, and where demanding customers pressure companies to
innovate faster and achieve more sustainable competitive advantages than their foreign rivals.

Related and Supporting Industries

The presence of related and supporting industries provides the foundation on which the focal industry can
excel. As we have seen with the Value Net, companies are often dependent on alliances and partnerships
with other companies in order to create additional value for customers and become more
competitive. Especially suppliers are crucial to enhancing innovation through more efficient and higher-
quality inputs, timely feedback and short lines of communication. A nation’s companies benefit most
when these suppliers themselves are, in fact, global competitors. It can often take years (or even decades)
of hard work and investments to create strong related and supporting industries that assist domestic
companies to become globally competitive. However, once these factors are in place, the entire region or
nation can often benefit from its presence. We can for example see this in Silicon Valley, where all kinds of
tech-giants and tech-start-ups are clustered in order to share ideas and stimulate innovation.

Government
The role of the government in Porter’s Diamond Model is described as both ‘a catalyst and challenger‘.
Porter doesn’t believe in a free market where the government leaves everything in the economy up to
‘the invisible hand’. However, Porter doesn’t see the government as an essential helper and supporter of
industries either. Governments cannot create competitive industries; only companies can do that.
Rather, governments should encourage and push companies to raise their aspirations and move to even
higher levels of competitiveness. This can be done by stimulating early demand for advanced products
(demand factors); focusing on specialized factor creations such as infrastructure, the education system
and the health sector (factor conditions); promoting domestic rivalry by enforcing anti-trust laws; and
encouraging change. The government can thus assist the development of the four aforementioned factors
in the way that should benefit the industries in a certain country.
Chance
Even though Porter originally didn’t write anything about chance or luck in his papers, the role of chance is
often included in the Diamond Model as the likelihood that external events such as war and natural
disasters can negatively affect or benefit a country or industry. However, it also includes random events
such as where and when fundamental scientific breakthroughs occur. These events are beyond the
control of the government or individual companies. For instance, the heightened border security, resulting
from the September 11 terrorist attacks on the US undermined import traffic volumes from Mexico, which
has had a large impact on Mexican exporters. The discontinuities created by chance may lead to
advantages for some and disadvantages for other companies. Some firms may gain competitive positions,
while others may lose. While these factors cannot be changed, they should at least be monitored so you
can make decisions as necessary to adapt to changing market conditions.
 Figure 2: Porter’s Diamond Model factors

Porter Diamond Model In Sum

Porter’s Diamond Model of National Advantage explains why some industries in some countries are so
much more developed and competitive compared to industries elsewhere on the planet. It basically sums
up the location advantages that Dunning is referring to in his Eclectic paradigm (also known as OLI
framework). The Diamond Model could therefore be used when analyzing foreign markets for potential
entry or when making Foreign Direct Investment decisions. It is adviced to also conduct a macro-
environment analysis and an industry analysis by using PESTEL Analysis and Porter’s Five
Forces respectively.