NOTES

Specialization Group: International Business (IB)

INTERNATIONAL BUSINESS MANAGEMENT

Code: KMBN IB 01
Unit-2
Unit 2 (8 hours)
International Trade Theories: Mercantilism; Absolute Cost theory, Comparative Cost
theory, Factor endowment theory, International Product life Cycles Theory, International
Investment Theories: Theory of Capital Movements, Market Imperfections theory;
Internationalization Theory; Location Specific Advantage Theory; Eclectic Theory Free
Trade: Advantages and Disadvantages, Forms of Protection: Tariffs, Subsidies, Import
Quotas, Voluntary Export Restraints, Administrative Policy, Anti-dumping Policy
What Is Mercantilism?
Mercantilism was an economic system of trade that spanned the 16th century to the
18th century. Mercantilism was based on the principle that the world's wealth was static,
and consequently, governments had to regulate trade to build their wealth and national
power. Many European nations attempted to accumulate the largest possible share of that
wealth by maximizing their exports and limiting their imports via tariffs.
Absolute Cost theory
Adam Smith is generally ignored as a trade theorist in text books of international
economics because of the common belief that he only confirmed the rule of absolute
advantages to explain the structure of foreign trade. However, his vent-for-surplus
approach may be interpreted as a pioneering study which stresses the importance of
economies of scale in explaining the structure of trade.
Economists recognize the undeniable influence of Smith’s concepts such as “extent of the
market”, “division of labour”, “improved dexterity in every particular workman”, and
“simple inventions coming from workman” on trade theory.
Adam Smith propounded the theory of absolute cost advantage as the basis of foreign
trade; under such circumstances an exchange of goods will take place only if each of the

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two countries can produce one commodity at an absolutely lower production cost than the
other country.

Suppose, there are two countries I & II and two commodities A and B. For example,
country can produce a unit of commodity (A) with 10 and a unit of commodity (B) with 20
labour units, and that in country II, the production of a unit of (A) costs 20 and a unit of
(15) 10 labour units. Now country I has absolute cost advantage in tin- production of (A)
and it will confine itself to the production of (A) and country II in the production of (B).
Exactly the same would happen if I and II were two regions of one country. We speak of
an absolute- differences in costs because each country can produce one commodity at an
absolutely lower cost them the other. Thus, in such a situation, a division of labour
between them must lead to an increase in total output.
Critical Appraisal of Comparative Cost Theory:
Theory of comparative cost which is the important doctrine of classical economics is still
valid and widely acclaimed as the correct explanation of international trade.
Most of the criticisms that have been leveled against this doctrine relate to the Ricardian
version of comparative cost theory based on labour-theory of value. Haberler and others
broke away from this labour-cost version and reformulated the comparative cost theory in
terms of opportunity costs which takes into consideration all factors.
The basic contention of the theory that a country will specialise in the production of a
commodity and export it for which it has a lower comparative cost and import a
commodity which can be produced at a lower comparative cost by others, is based on a
sound logic. The theory correctly explains the gain from trade accruing to the participating
countries if they specialise according to their comparative costs.
These merits of the theory have led Professor Samuelson to remark, “If theories, like girls,
could win beauty contents, comparative advantage would certainly rate high in that it is an
elegantly logical structure.” He further writes, “the theory of comparative advantage has in

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it a most important glimpse of truth…. A nation that neglects comparative advantage may
have to pay a heavy price in terms of living standards and potential rates of growth.”
Despite the sound logical structure and vivid explanation of gains from trade, the
comparative cost theory, especially the Ricardian version based on labour theory of value
has been criticized.
The following criticisms have been leveled against this theory:
n the first place, Ricardian version of comparative cost theory has been attacked on the
ground that being based on labour theory of value, it considers only labour cost to measure
the comparative costs of various goods.
It has been pointed out that labour is not the only factor needed for the production of
commodities, other factors such as capital, raw materials, land also contribute to
production. Therefore, it is the total money costs incurred on labour as well as other factors
that should be considered for assessing comparative costs of various commodities.
Taussig tried to defend Ricardo by pointing out that even if labour theory of value was
defective and even if other factors made important contributions to the production of
goods, comparative costs could still be based on labour cost alone, if it is assumed that the
trading countries are at the same stage of technological development.
This is because, he argued that given the same technological development, the proportions
in which other factors could be combined with labour would be the same. In view of this
he asserted that other factors could be validly ignored and for purpose of comparative costs
relative efficiency of labour alone of different countries could be considered.
However, Taussig’s defense of Ricardian version of comparative cost theory is poor and
invalid. The various trading partners are not at the same stage of technological
development and therefore the factor proportions used for the production of commodities
in different countries are vastly different. Hence, it is quite unrealistic and improper to
consider relative efficiency of labour alone.
However, as stated earlier, Haberler rescued the comparative cost theory from labour
theory of value and reformulated it in terms of opportunity cost which covers all factors.
The comparative cost theory explained that different countries would specialise in the pro-
duction of goods on the basis of comparative costs and that they would gain from trade if

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they export those goods in which they have comparative advantage and import those goods
from abroad in respect of which other countries enjoyed comparative advantage.
But it could not provide a satisfactory explanation of why comparative costs of producing
commodities in various countries differ. Ricardo thought comparative costs of producing
commodities in various countries differed due to the differences in efficiency of labour.
But this begs the question why labour efficiency is different in various countries.
Factors for Variation in Comparative Costs of Different Commodities:
The credit of providing an adequate and valid answer to this question goes to
Heckscher and Ohlin who explained that comparative costs of different commodities
in the two countries vary because of the following factors:
1. The various countries differ in respect of factor endowments suited for the production of
different commodities.
2. The different commodities require different factor proportions for their production.
Thus Heckscher and Ohlin supplemented the comparative costs theory by providing valid
reasons for differences in comparative costs in various countries.
3. Against the Ricardian doctrine of comparative cost it has also been said that it is based
on the constant cost of production in the two trading countries. This assumption of constant
costs leads them to conclude that different countries would completely specialise in the
production of a single product on the basis of their comparative costs.

Factor endowment theory,

Heckscher-Ohlin’s Factor Endowment Theory
Heckscher-Ohlin’s Factor Endowment Theory also called Heckscher-Ohlin Model, H-O
Model, Factor Endowment Theory, and Factor Proportion Theory is an economic as well
as international trade theory that states that a nation should produce and export products for
which factors of production the country is rich.
Factor endowment refers to the richness, abundance, and easy availability of factors of
production (namely land, labor, and capital) to the country. This theory argues that a
country that has relatively large labor forces should concentrate on production through
labor-intensive means. And, a country that has relatively more capital should go for
production through capital-intensive means.

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Swedish economists, Eli Heckscher in 1919 and Bertil Ohlin in 1933 put forward different
explanations of Ricardo’s comparative cost advantage theory. So, called the H-O Model.
The H-O model explains what causes differences in the comparative cost of different
countries.
The theory holds that factors in relative abundance are cheaper than factors in relative
scarcity. It explains the basis of international trade in terms of factor endowments. Factor
endowment refers to how many factors of production a country has been endowed with by
Mother Nature.
If labor, for example, were abundant in comparison to land and capital, labor costs would
be low relative to land and capital costs (i.e., rent and interests respectively). If labor were
scarce, labor costs would obviously be high against land and capital costs. These relative
factors costs would lead countries to excel (do better) in the production and also exports,
which have used their cheaper, abundant factors of production.
According to the H-O model, “variances in the supply of production components produce
international and interregional differences in production cost.” Comparative advantage
originates from variations in national factor endowments, according to Heckscher and
Ohlin, and while free trade is advantageous, the pattern of trade is regulated by differences
in factor endowments rather than productivity disparities.
What Is International Trade Theory?
Product Life Cycle Theory
Raymond Vernon, a Harvard Business School professor, developed the product life cycle
theory in the 1960s. The theory, originating in the field of marketing, stated that a product
life cycle has three distinct stages: (1) new product, (2) maturing product, and (3)
standardized product. The theory assumed that production of the new product will occur
completely in the home country of its innovation. In the 1960s this was a useful theory to
explain the manufacturing success of the United States. US manufacturing was the globally
dominant producer in many industries after World War II.
It has also been used to describe how the personal computer (PC) went through its product
cycle. The PC was a new product in the 1970s and developed into a mature product during
the 1980s and 1990s. Today, the PC is in the standardized product stage, and the majority
of manufacturing and production process is done in low-cost countries in Asia and Mexico.

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The product life cycle theory has been less able to explain current trade patterns where
innovation and manufacturing occur around the world. For example, global companies
even conduct research and development in developing markets where highly skilled labor
and facilities are usually cheaper. Even though research and development is typically
associated with the first or new product stage and therefore completed in the home country,
these developing or emerging-market countries, such as India and China, offer both highly
skilled labor and new research facilities at a substantial cost advantage for global firms.
Theories of International Investments

International investments mean investments beyond borders. International investments

refer to investments by entities of a nation in nations other than their own. Foreign
investments involve export of capital. The opportunity for International investments is
directly emanating from economic reformist policies adopted by most of the countries of
the world including centrally planned and command economies. Liberalization,
Privatization and Globalization (LPG) are vigorously pursued by the countries giving an
up-thrust on investment opportunities.

Broadly there are two types of foreign investment, namely, foreign direct investment (FDI)
and foreign portfolio investment (FPI). FDI refers to investment in a foreign country where
the investor retains control over the investment. It typically takes the form of starting a
subsidiary, acquiring a stake in an existing firm or starting a joint venture in the foreign
country. Direct investment and management of the firms concerned normally go together.
If the investor has only a sort of property interest in investing the capital in buying equities,
bonds, or other securities abroad, it is referred to as portfolio investment. That is, in the
case of portfolio investments, the investor uses capital in order to get a return on it, but has
not much control over the use of the capital.

FDIs are governed by long-term considerations because these investments cannot be easily
liquidated. Hence, factors like long-term political stability, government policy, industrial
and economic prospects, etc., influence the FDI decision. However, portfolio investments,
which can be liquidated fairly easily, are influenced by short-term gains. Portfolio
investments are generally much more sensitive than FDIs to short term uncertainties.

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Foreign investment and foreign trade are related. 60-70% of world trade is directly or
indirectly connected to FDI. 50% of world trade is either within the same organizational
entity (intra-firm trade) or between parties which engage in co-operative relationship.

Types of International Investment Theories

The theories of international investments seek to explain the reasons for international
investments. Theories of international investment can essentially be divided into two
categories: Micro (industrial organization) theories and Macro (cost of capital) theories.

The micro economic orientations differed between the earlier and subsequent
literature’s. The early literature that explains international investment in micro economic
terms focuses on market imperfections, and the desire of multinational enterprises to
expand their monopolistic power. Subsequent literature centered more on firm-specific
advantages owing to product superiority or cost advantages, stemming from economies of
scale, multi-plants economies and advanced technology, or superior marketing and
distribution. According to this view, multinationals find it cheaper to expand directly in a
foreign country rather than through trade in cases where the advantages associated with
cost or product are based on internal, indivisible assets based on knowledge and
technology. Alternative explanations for international investment have focused on
regulatory restrictions, including tariffs and quotas that either encourage or discourage
cross-border acquisitions, depending on whether one considers horizontal or vertical
integration’s.

Studies examining the macro economic effects of exchange rate on international

investment centered on the positive effects of an exchange rate depreciation of the host
country on international investment in-flows, because it lowers the cost of production and
investment in the host countries, raising the profitability of foreign direct investment. The
wealth effect is another channel through which a depreciation of the real exchange rate
could raise international investment. By raising the relative wealth of foreign firms, a
depreciation of the real exchange rate could make it easier for those firms to use retained

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 profits to finance investment abroad and to post a collateral in borrowing from domestic
lenders in the host country.

Market Imperfections Theory

If you have ever purchased a foreign made vehicle, you are familiar with market
imperfections theory and foreign direct investment. The U.S. auto industry is one of the
most competitive markets in the world. American companies used to dominate the market.
Now, these companies only make up half of the market. Toyota, Honda, BMW, Nissan,
Mazda, and Volkswagen are examples of automotive companies that now have U.S.-based
manufacturing. Market imperfections theory and foreign direct investment explain how
imperfections in the international trade market drove these companies to invest in the
United States.
Market imperfections theory is a trade theory that arises from international markets
where perfect competition doesn't exist. In other words, at least one of the assumptions for
perfect competition is violated and out of this is comes what we call an imperfect market.
We know that a perfect market isn't really attainable. Even in the United States, we have
imperfect markets. Remember, the assumptions for a perfect market are:
1. Buyers and sellers are both price takers
2. Companies sell virtually identical products
3. Buyers and sellers have perfect information
4. Multiple companies owns a small market share
5. There is no barrier of entry or exit
Common situations that violate perfect competition are market structures like monopolies,
monopolistic competition, and oligopolies. With international trade, firms are seen as price
takers because they are only a small part of a foreign market. They can't influence the
price, have to deal with government interference related to trade, and operate with
imperfect information. This is why foreign automotive companies moved some operations
to the United States.
What is interesting about market imperfections theory is that it is an international trade
theory. It tells us that in international markets, certain protections are necessary to
safeguard our interests. Free trade is a function of perfect competition, and given that it

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doesn't exist, we need to look at ways to get more desirable outcomes. This is where
government interference enters.

Internationalization: Definition, Examples, and Benefits

What Is Internationalization?
Internationalization describes the process of designing products to meet the needs of users
in many countries or designing them so they can be easily modified, to achieve this goal.
Internationalization might mean designing a website so that when it's translated from
English to Spanish, the aesthetic layout still works properly. This may be difficult to
achieve because many words in Spanish have more characters than their English
counterparts. They may thus take up more space on the page in Spanish than in English.
In the context of economics, internationalization can refer to a company that takes steps to
increase its footprint or capture greater market share outside of its country of domicile by
branching out into international markets. The global corporate trend toward
internationalization has helped push the world economy into a state of globalization, in
which economies throughout the world become highly interconnected due to cross-border
commerce and finance. As such, they are greatly impacted by each others' national
activities and economic well-being.
Understanding Internationalization
When a company seeks to sell its goods abroad, it may find that there are several
roadblocks in the way. Some may be technical barriers that need to be overcome; for
instance, different voltages of household electricity or different plug shapes found around
the world. These may be remedied via technological adaptations. Other barriers may be
cultural, for instance in India many Hindus do not eat beef. This means that to
internationalize, Mcdonald's must focus on chicken, fish, and other non-beef menu items
that better conform to local custom and culture. Being able to flexibly adapt lends itself to
greater internationalization.
There are many incentives that might inspire companies to strive for internationalization.
For example, in the United States companies that pay exorbitant overhead costs can shave
expenses by selling products in nations with relatively weaker currencies or in countries
that have lower costs of living. Companies may also benefit from internationalization by

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reducing the cost of business via reduced labor costs that are outsourced to foreign markets
where goods will be sold. Internationalization can thus lead to product internationalization
since products sold by multinational companies are now often used in several different
countries.
Examples of Internationalization
When a company produces goods for a wide range of customers in different countries, the
products that are internationalized often must be localized to fit the needs of a given
country's consumers.
For example, an internationalized software program must be localized so that it displays
the date convention as "November 14" in the United States, but as "14 November" in
England. Likewise, units in America are measured in feet or miles, while in Europe and
Canada they use the metric system. This means that cars sold across these markets must be
able to quickly interchange between miles and kilometers.
Location-Specific Advantage
The ability of an individual, company, or economy to conduct an activity better than
another for reasons related to location. Location-specific advantages are important in
making decisions such as the products one should make or sell; if a company is unable to
make a product as well as another because resources are unavailable or difficult to acquire
in a certain location, the company might be well advised to make a different product. For
example, a lumber company in Oregon has a location-specific advantage to a lumber
company in Arizona because there are simply more trees in Oregon. This makes it unlikely
that the company in Arizona will be able to fill orders as well or as quickly as the company
in Oregon. For this reason, the Arizona company's management might consider investing
in mining instead of lumberjacking.
Eclectic Paradigm: Definition, Example, Advantages
What Is an Eclectic Paradigm?
An eclectic paradigm, also known as the ownership, location, internalization (OLI) model
or OLI framework, is a three-tiered evaluation framework that companies can follow when
attempting to determine if it is beneficial to pursue foreign direct investment (FDI). This
paradigm assumes that institutions will avoid transactions in the open market if the cost of
completing the same actions internally, or in-house, carries a lower price. It is based on

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internalization theory and was first expounded upon in 1979 by the scholar John H.
Dunning.
Understanding Eclectic Paradigms
The eclectic paradigm takes a holistic approach to examining entire relationships and
interactions of the various components of a business. The paradigm provides a strategy
for operation expansion through FDI. The goal is to determine if a particular approach
provides greater overall value than other available national or international choices for the
production of goods or services.
Since businesses seek the most cost-effective options while still maintaining quality, they
may use the eclectic paradigm to evaluate any scenario which exhibits potential.
Three Key Factors of the Eclectic Paradigm
For FDI to be beneficial, the following advantages must be evident:
The first consideration, ownership advantages, include proprietary information and
various ownership rights of a company. These may consist of branding, copyright,
trademark or patent rights, plus the use and management of internally-available skills.
Ownership advantages are typically considered to be intangible. They include that which
gives a competitive advantage, such as a reputation for reliability.
What is Protectionism?
Protectionism is the practice of following protectionist trade policies. A protectionist trade
policy allows the government of a country to promote domestic producers, and thereby
boost the domestic production of goods and services by imposing tariffs or otherwise
limiting foreign goods and services in the marketplace.
Meaning of Import Quotas:
The import quota means physical limitation of the quantities of different products to be
imported from foreign countries within a specified period of time, usually one year. The
import quota may be fixed either in terms of quantity or the value of the product.
For instance, the government may specify that 60,000 colour T.V. sets may be imported
from Japan. Alternatively, it may specify that T.V. sets of the value of Rs. 50 crores can be
imported from that country during a given year.
For the purpose of restricting imports, it may adopt one of the alternative ways such
as:

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(i) Issue of import licence to the highest bidder in the open market;
(ii) Issue of import licence by calling for the tenders form prospective importers, the
highest tenderer getting the licence;
(iii) Issue of import licence on first-come first-serve basis;
(iv) Issue of import licences of specific categories of importers such as established
importers, star trading houses, actual users etc.;
(v) Issue of import licences to some government agency such as the State Trading
Corporation.
Objectives of Import Quotas:
The system of prescribing import quota is resorted to by the government of a country
for realising some of the following objectives:
(i) To afford protection to domestic industries through restricting foreign competition by
limiting the imports from abroad.
(ii) To make adjustment in the adverse balance of payments. The restriction of imports
through quotas can reduce the balance of payments deficit faced by the country.
(iii) To conserve the scarce foreign exchange resources of the country and to direct their
use for high-priority import items.
(iv) To ensure the stabilisation of the internal price level by properly regulating the imports
of goods from abroad.
(v) To discourage conspicuous consumption by the wealthy sections through placing quota
restrictions on the import of luxury goods.
(vi) To improve the international bargaining position of the country through allocating
larger import quotas for the products of such countries as allow a liberal inflow of the
products of the home country.
(vii) To retaliate against the restrictive trade policies adopted by some of the foreign
countries.
(viii) To check the speculative imports in anticipation of changes in exchange rates, tariff
rates and internal money and credit policies, the government may take resort to import
quota.
A voluntary export restraint (VER) is a self-imposed trade restriction where the
government of a country limits the amount of a certain good or category of goods that are

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allowed to be exported to a different country. The restraint could be a preset limit, a
reduction in the exported amount, or a complete restriction.
Anti-dumping Policy
Anti-dumping duties are typically levied when a foreign company is selling an item
significantly below the price at which it is being produced. While the intention of anti-
dumping duties is to save domestic jobs, these tariffs can also lead to higher prices for
domestic consumers.

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