LESSON 3

Theories of
International
Trade and
Investment
International Business and Trade

Presented by: Group 2 | BSAIS 3B

 What is Trade?
It is the voluntary exchange of
goods and services between parties
for mutually beneficial purposes.

Types of Trade
Domestic Trade
occurs between parties in the same countries.
International Trade
occurs between two or more countries.
 What is International Trade?
Types of It is referred to as the exchange or
International Trade trade of goods and services between
different nations.
Import
Refers to allowing of goods
and services to be brought
Why it is important?
into the domestic country.
Economic Growth
Export Competition
Job Creation
Refers to allowing goods
Culture Exchange
and services to be sold to
Resource Allocation
foreign countries.
Theories of International
Trade

(Classical Country-
Based Theories)
 MERCANTILISM
An economic system of trade
that spanned from 16th
century

Based on the idea that nation’s

wealth and power were best
served by increasing exports
and trade

Country’s wealth = gold and

silver (currency)
Favorable Balance of Trade
export more than import

They believed
Export
INCREASE in wealth

Import
DECREASE in wealth
Views Trade as “zero-sum game”
one which gain by country results loss in another

Export goods

Export gold and Silver

 First Outcomes (England)

Production
Money
Inflation Costs
Supply
 First Outcomes (France)

Money Deflation Production

Supply Costs
Second Outcomes

Export goods

Export gold and Silver

 ABSOLUTE ADVANTAGE
First introduced in 1776 by Scottish economist Adam
Smith

It is a situation in which an individual, business or

country can produce more of a good or service than
any other producer with the same quantity of
resources
 COMPARATIVE ADVANTAGE
David Ricardo expanded Smith's theory of
Absolute Advantage by examining the
potential outcomes when a country possesses
complete superiority in producing all goods.

It suggests that countries should focus on

producing goods in which they have a lower
opportunity cost compared to other goods,
even if they have an absolute advantage in
producing all goods.
Example:
The Philippines has an absolute advantage in the production of both
goods.

The theory of Absolute Advantage will suggest that Japan should

import both goods from the Philippines.
The theory of comparative advantage says no, there is still an
advantage to both countries from continuing to trade.
In the Philippines, 1 Lobong Umiilaw will sell for 2 Kangkong chips.
In Japan, 1 Lobong Umiilaw will sell for 3.75 Kangkong chips.

Solution:
Philippines = ratio of 20 Kangkong chips and 10 Lobong Umiilaw
=2:1
Japan = ratio of 15 Kangkong chips and 4 Lobong Umiilaw
= 3.75 : 1
 Benefits of Trade
The Philippines will get
3 Kangkong chips for
Japan will only
every 1
Lobong Umiilaw instead provide 3 Kangkong
of only 2 Kangkong chips instead of 3.75
chips. for 1 Lobong
Umiilaw.

TRADE OFFER: Benefits of Trade

Japan will offer 3 Kangkong chips for 1

Lobong Umiilaw from the Philippines. Both countries benefit from the trade.
 Heckscher-Ohlin Theory
(H-O Theory)
In the 1920s, Swedish Economist Bertil Ohlin based on work by his teacher, the
Swedish Economist Eli Filip Heckscher from Stockholm School of Economics,
developed this theory.
Also called as the resources and trade theory or factor proportions theory
Country’s production factors—land, labor, and capital
In this theory, countries export the goods they use abundant production factors
for, while they import goods for which they have scarce production factors.
Example:
A small country like Luxembourg has much less
capital in total than India, but Luxembourg has
more capital per worker. Accordingly, the
Heckscher-Ohlin theory predicts that Luxembourg
will export capital-intensive products to India and
import labour-intensive products in return.
Theories of International
Trade

(Modern Firm-
Based Theories)
 Country Similarity Theory
Developed by Swedish economist Steffan Linder in 1961.

Linder explained that intra-industry trade refers to the export and

import of similar but differentiated products between countries.
International trade takes place among the countries that are at the
same stage of economic development. Those countries which have
similar needs, preferences, income levels, etc. would result in more
trade opportunities among countries.
 Product Life Cycle Theory
A product's life cycle begins upon the first introduction to
consumers. The life cycle ends when the product is no longer
available for purchase.

Was developed by Raymon Vernon in 1966 as a marketing

strategy for understanding patterns in a product's life.
There are 4 stages. Although the product can pass through the
stages following different timelines.
Introduction Stage The introduction phase is the first time customers are introduced to the
new product. A company must generally include a substantial
investment in advertising and a marketing campaign focused on making
consumers aware of the product and its benefits, especially if it is
broadly unknown what the item will do.

If the product is successful, it then moves to the growth stage. This

Growth Stage is characterized by growing demand, an increase in production, and
expansion in its availability. The amount Collaboration and
of time spent in the
connection in your
introduction phase before a company's product experiences strong
company
growth will vary from between industries and products.

The maturity stage of the product life cycle is the most profitable
Maturity Stage stage, the time when the costs of producing and marketing
Technology that decline.
With the market saturated with the product, competition
makes your business now
completely
higher than at other stages, and profit margins unique.to shrink,
starting
some analysts refer to the maturity stage as when sales volume is
"maxed out".
 As the product takes on increased competition as
Decline Stage other companies emulate its success, the product may
lose market share and begin its decline. Product sales
begin to drop due to market saturation and alternative
products, and the company may choose to not pursue
additional marketing efforts as customers may already
have determined whether they are loyal to the
company's products or not.
Advantages of Product
Life Cycle Theory
The product life cycle better
allows marketers and business
developers to better understand
how each product or brand sits
with a company's portfolio. This
enables the company to
internally shift resources to
specific products based on those
products' positioning within the
product life cycle.
Limitations of Product
Life Cycle Theory
Despite its utility for planning and
analysis, the product life cycle
doesn't pertain to every industry
and doesn't work consistently
across all products. Consider
popular beverage lines whose
primary products have been in the
maturity stage for decades, while
spin-offs or variations of these
drinks from the same company
have failed.
 Example of Product Life Cycle
Coca Cola
On 1985, Coca Cola announced their new product recipe
called “new coke” in hopes that it will increase their market
sales, but after its launch, Coca Cola received a lot of calls
from consumers saying to revert it back to the old recipe and
the consumers even recruited and protested with a number
of 100,000 to support their cause to bring back the old recipe.
Global Strategic Rivalry Theory
Was developed in the 1980s by such economists as Paul Krugman
and Kevin Lancaster as a means to examine the impact on trade
flows arising from global strategic rivalry between Multinational
Corporations.
Firms will encounter global competition in their industries and to
prosper, they must develop competitive advantages.
Barriers to entry are the critical ways that firms may encounter
when trying to enter into an industry.
There are many ways in which a firm can hold
a competitive advantage, these include:
Owning intellectual property rights
Investing in research and development
Achieving economies of scale or scope
Exploiting the experience or learning curve
Forging strategic alliances and Strategic
mergers and acquisitions.
 Porter’s National Competitive
Advantage Theory
Why are certain nations being more competitive than others for certain
industries?
Why is Belgium good with Beer, why is Portugal well known for wine, why is
Germany so good with cars?
It can be used to understand the sources of a nation’s competitive advantage and
also to thereby know how to obtain such an advantage for other countrieGlobal
Strategic Rivalry Theorys.
It can help international organisations formulate strategies regarding operating
in different markets.
Porter’s Diamond Model
 Firm strategy, structure, and rivalry
• Domestic rivalry that exists in the home market between contemporary companies.
• The more intense this domestic rivalry is, the more companies are pushed to innovate and improve
•A good example is the German automobile industry which boasts of Mercedes, BMW, and VW.

Demand Conditions
This factor measures the magnitude of favorable demand in the local market.
A demanding customer base in the domestic market pushes companies to strive hard.
This growth and a growing demand give companies the ammunition to push boundaries.

Related and supporting industries

Successful partnerships, alliances, and strong suppliers.
When these factors are in place, companies can remain competitive and provide good value for
customers.
It can take decades and a lot of government investment to create an ecosystem of suppliers and
domestic companies.

Example: The existence of silicon Vally in some countries wherein we have several tech companies and
start-ups collaborating for mutual benefit.
Example: Construction companies existing alongside suppliers of raw materials.
Factor Conditions
Factor conditions refer to the availability of different types of resources in certain
countries and markets.
Basic factors include natural resources and unskilled manpower
Advanced factors include skilled labor or specialist knowledge.
Competitive advantage comes from the presence of advanced factors and their
retention, growth, and development.
Government
Government can be a catalyst to ensure that the factors can be developed and retained.
Government can ensure that an ecosystem exists that can help in their creation and development.
Advanced Factor conditions – building robust infrastructure. Education systems and healthcare.
Supporting Industries – They can put laws in place to ensure healthy rivalry and fair practices in the
marketplace.
Demand conditions – they can encourage the domestic population and raise awareness and demand.
Chance
• Chance or Luck relates to the role of uncontrollable, external influences on a country or industry.
• Natural disasters, war or other political situations can provide competitive advantages or disadvantages.
•External, unpredictable events are beyond the control of most countries and organizations.
Example: The 2020 Coronavirus disaster created a disadvantageous position for several industries, but
others obviously gained too.
Example – The Belgian Beer Industry

Firm strategy, structure, and rivalry

•Belgium has more breweries per capita than any country in the world.
• This produces an intense rivalry between firms

Demand conditions
• Beer has been an integral part of Belgian identity and is known as their
national beverage – High local demand.

Related and supporting industries

• Belgian breweries are usually located in proximity to farms and thereby
support one another.
Example – The Belgian Beer Industry

Factor conditions
• Belgian has good quality natural ingredients for beer production and a
competent pool of skilled labor.

Government
• The government in Belgium has always invested in education and
training. Provisions have also been put in to ensure that brewing remains
cost-effective.

Chance
• Belgium is close to a lot of other European countries (with high Beer
consumption) in the EU
 What is
International Investment ?
International investment refers to the
process of individuals, businesses, or
governments investing their money in
assets outside their own country's
borders. This can include buying stocks
or bonds issued by foreign companies,
acquiring real estate in another country,
or establishing a business presence
abroad.
 Why do people do it?
Diversification
Investors seek to diversify their portfolios by
investing in assets outside their home country.
This helps spread risk and reduce exposure to any
single market or economy.
Access to Growth Opportunities
Investing internationally provides access to
economies and industries that may offer higher
growth potential compared to domestic markets.
This can lead to potentially higher returns on
investment.
 Two Categories of
International Investment

1. Foreign Portfolio Investment

Securities and other financial assets held by investor in another
country
portfolio investor is not involved in the management of the
company
The goal is to earn or return on investment through dividends,
interest, capital appreciation without controlling the company
2. Foreign Direct Investment
is an investment from a party in one country into a business or
corporation in another country with the intention of
establishing a lasting interest.
Through FDI, foreign companies are directly involved with day-
to-day tasks from the other country, resulting in a transfer of
money, knowledge, skills, and technology.
The key to foreign direct investment is the element of control.
Control represents the intent to actively manage and influence
a foreign firm’s operations.
Advantages of the Foreign DIrect Investment

For the Business For the host country

Market diversification Economic stimulation
Tax incentives Development of human capital
Lower labor costs Increase in employment
Preferential tariffs Access to management expertise, skills,
and technology
Subsidies
For businesses, most of these benefits
are based on cost-cutting and lowering
risk. For host countries, the benefits are
mainly economic.
Despite many benefits, there are still two main disadvantages to FDI,
such as:
Displacement of local businesses
Profit repatriation

Two main types of Foreign Direct Investment

1. Horizontal FDI
a business expands its domestic operations to a foreign country.

2. Vertical FDI
a business expands into a foreign country by moving to a
different level of the supply chain.
INTERNATIONAL INVESTMENT
THEORIES
 Eclectic Theory
Given by British economist J.H Dunning.
It believes that the business refrains from open market
transactions or foreign direct investments if the cost of executing
the same function internally is low, making the activity more
economical.
This theory follows the OLI Framework in analysing the
attractiveness of making a foreign direct investment (FDI). This
framework refers to three tiers-ownership, location and
internalization.
 Ownership Advantage Theory
Ownership can be defined as the proprietorship of a unique and
valuable resource that cannot easily be imitated.
It refers to any specific investments or assets that a company may
have that its competitors in a specific foreign do not have. Thereby,
it creates a competitive advantage against foreign competitors.
Example:
Starbucks' Coffee Expertise and Brand
Starbucks' deep coffee knowledge, sourcing network, and strong brand image
create a premium coffee experience that customers are willing to pay for, even at
higher prices.
 Capital Arbitrage Theory
is a multi-factor asset pricing model based on the idea that an
asset's returns can be predicted using the linear relationship
between the asset’s expected return and a number of
macroeconomic variables that capture systematic risk.
a useful tool for analyzing portfolios from a value investing
perspective, in order to identify securities that may be temporarily
mispriced.
Using APT, arbitrageurs hope to take advantage of any deviations
from fair market value.
Was developed by the economist Stephen Ross in 1976
 Mathematical Model for APT
While APT is more flexible than the CAPM, it is more complex.
The CAPM only takes into account one factor—market risk—
while the APT has multiple factors. And it takes a considerable
amount of research to determine how sensitive a security is to
various macroeconomic risks.
LIMITATIONS OF ARBITRAGE PRICING THEORY
The main limitation of APT is that the theory does not
suggest factors for a particular stock or asset. One stock
could be more sensitive to one factor than another, and
investors have to be able to perceive the risk sources and
sensitivities.

ADVANTAGE OF ARBITRAGE PRICING THEORY

The main advantage of APT is that it allows
investors to customize their research since it
provides more data and it can suggest multiple
sources of asset risks.
 Market Imperfection Theory
A theory that arises from international markets where perfect
competition doesn't exist. In which perfect competition in a
neoclassical market ensures an efficient allocation of goods and
income.
The most common type of imperfect markets are monopolies,
and oligopolies

Ex. Telecom sector, Oil Company, Water and Electricity Company

 Internalization Theory
Internalization Theory explains why firms opt for Foreign Direct
Investment (FDI) over alternatives like exporting, licensing, or franchising.
Grounded in transaction cost economics, it highlights the costly nature of
market transactions due to negotiation, monitoring, and protection of
proprietary knowledge.

Key Concepts:
Transaction Costs: Costs linked with market transactions for goods and
services.
Internalization: Bringing activities within the firm rather than relying on
external markets.
Preference for Internalization:
When transaction costs outweigh those of internalizing through FDI.
Occurs when knowledge is complex or monitoring foreign partners is
challenging.

Benefits:
Reduced Transaction Costs: Avoiding high market expenses and gaining
control over activities.
Protection of Knowledge: Mitigating risks of knowledge leaks.
Coordination and Efficiency: Enhancing coordination and knowledge
sharing within the firm.
Potential Disadvantages:
Higher Initial Investment: Establishing and managing
foreign subsidiaries can be costly.
Management Complexity: Operating international
operations requires additional resources.
Loss of Flexibility: Firms may sacrifice some flexibility
compared to market-based options.
References:
https://www.investopedia.com/terms/p/product-life-cycle.asp

https://www.freshbooks.com/en-au/hub/other/product-life-cycle-theory?
fbclid=IwAR3aJ5MAAb6DVZuupX4XESBNyoGEG_w3IVpm6FnIewfR0IvN72hi-6Ax3tI

https://www.investopedia.com/terms/a/apt.asp

https://drive.google.com/file/d/1JDNfAc2-zmTr5EkGx_cFqha0dBpGXTw1/view?
fbclid=IwAR1hb2EX1lkmJJZ87nXkiVIWnRnGgfK2tjBZUZ20xcPsYYEMJv4Vqp7OAb0

https://corporatefinanceinstitute.com/resources/management/eclectic-paradigm/?fbclid=IwAR2-
1cv17nghb8sjtA6Dg87aHUssFEziKwPn6PkXw9OZTSeEq8qh5PA48Ck

https://study.com/academy/lesson/ownership-location-internationalization-oli-framework.html?fbclid=IwAR2d1WvdMsJ-
thdEeZ7AK-
Ku1lQnDc0erZ0y26x7dzgGaDHPoOQMofzh004#:~:text=The%20ownership%20advantage%20component%20refers,companies
%20in%20a%20foreign%20country

https://www.britannica.com/money/Heckscher-Ohlin-theory?
fbclid=IwAR23AucaWeOraWwrfU61DNvpX65aCyqvYgIhIXsMa0VCVNrTeR4maWIbY5I

https://www.youtube.com/watch?v=896AqHnx8xQ
References:
https://www.studocu.com/ph/document/sultan-kudarat-state-university/bs-management-accounting/chap/16408919

https://www.scribd.com/presentation/425806999/Chapter-2-Theory-of-International-Trade-and-Investment-ppt

https://corporatefinanceinstitute.com/resources/economics/foreign-direct-investment-fdi/?
fbclid=IwAR04GFjQhisD3z_lonshJJVn_0yaDJSLtviiPWPoaEo9vpsNBe248g_UcCU

https://www.mbaknol.com/?fbclid=IwAR0TduxEJ3rCZtOF61P56gshhBMB7msQTY3Mpxd3lEOqDvFkn-FywVBh274