CHAPTER 4

INTERNATIONAL TRADE AND INVESTMENT

MGT 361: CHAPTER 4_FPP UITM

LEARNING OBJECTIVES:

1. Understand the motivation for international trade.

2. Summarize and discuss the differences among the
classical country-based theories of international trade.
3. Use the modern firm-based theories of international trade
to describe global strategies adopted by businesses.
4. Describe and categorize the different forms of
international investment.
5. Explain the reasons for foreign direct investment.
6. Summarize how supply, demand, and political factors
influence foreign direct investment.

MGT 361: CHAPTER 4_FPP UITM

International Trade and the World Economy (1 of 4)

Trade: voluntary exchange of goods, services, International Trade: trade between

assets, or money between one person or residents (individuals, businesses, nonprofit
organization and another. organizations, or other associations) of two
countries.
International Trade and the World Economy (2 of
4)

 Why Does International Trade Occur?

Both parties to the transaction benefit
Exports spark additional economic activity
Improve competitiveness
International Trade and the World Economy (3
of 4)
Figure 4.1 The Growth of World Exports since 1950

Source: Based on World Trade Organization data bank, found at www.wto.org, June 2018.
International Trade and the World Economy (4
of 4)

Figure 4.2 Source of the World’s Merchandise Exports, 2017

Source: Based on data from World Trade Organization (www.wto.org), June 2018.
Theories of International Trade

CLASSICAL COUNTRY-BASED TRADE

MODERN FIRM-BASED TRADE THEORY
THEORIES

 Mercantilism  Country Similarity Theory

 Absolute Advantage Theory  International Product Life Cycle
 Comparative Advantage Theory  New Trade Theory
 Relative Factor Endowment  Porter’s Theory of National
Competitive Advantage
Difference between Classical & Modern
 Early Country-Based Theories
 Focused on the individual country
 Useful for describing trade in commodities
 Price is an important component of the customer’s
purchase decision
 Modern Firm-Based Theories
 Focus on the firm’s role in promoting international trade
 Useful in describing patterns of trade in differentiated
goods
 Brand Name is an important component of the customer’s
purchase decision
Classical Country-Based Trade Theories:
Mercantilism
 Maximizing holdings of gold and silver
 Promoting Exports
 Discouraging Imports
 The supporters are called Neo mercantilists or Protectionists: Most
nations in the world have adopted some neomercantilism policies
to protect key industries.
Classical Country-Based Trade Theories: Absolute
Advantage (1 of 3)
 Adam Smith attacked the intellectual basis of mercantilism
Weakens a country
Squanders a country’s resources
Reduce a country’s wealth
 Smith advocated free trade among countries
Enlarges a country’s wealth
Classical Country-Based Trade Theories: Absolute
Advantage (2 of 3)
 Adam Smith’s Absolute Advantage Theory

Country’s Level of Import Export

Productivity Goods and Services Goods and Services

More Productive Than

Other Countries Blank ü
Check Mark

Less Productive Than

Other Countries ü
Check Mark Blank
Classical Country-Based Trade Theories: Absolute
Advantage (3 of 3)
 France has an absolute advantage in the production of perfumes.
 Japan has an absolute advantage in the production of clock radios.
 Trade: Both will be better off

Table 4.1 The Theory of Absolute Advantage: An Example

Blank Output Per Hour of Labor Output Per Hour of Labor
Perfumes Clock radios
France 2 3
Japan 1 5
Classical Country-Based Trade Theories:
Comparative Advantage (1 of 4)

 What if one country has an absolute advantage in both products?

Theory of Absolute Advantage: No Trade Would Occur
Theory of Comparative Advantage: Trade Should Still Occur
 David Ricardo’s Comparative Advantage Theory
Relative Productivity Differences
Opportunity Cost: of a good is the value of what is given up
to get the good.
Classical Country-Based Trade Theories:
Comparative Advantage (2 of 4)

 David Ricardo’s Comparative Advantage Theory

Country’s Level of Import Export

Productivity Goods and Services Goods and Services

Relatively
More Productive Than Blank ü
Check Mark
Other Countries

Relatively
Less Productive Than ü
Check Mark Blank
Other Countries
Classical Country-Based Trade Theories:
Comparative Advantage (3 of 4)
Table 4.2 The Theory of Comparative Advantage: An Example
SHIRTS BICYCLE
COUNTRIES
NO OF UNIT OPPORTUNITY NO OF UNIT OPPORTUNITY
LABOR HOUR COST LABOR HOUR COST
CHINA 1 1/2 BICYCLE = 2 2/1SHIRTS =
0.5 2.0
ITALY 5 5/3 BICYCLE = 3 3/5 SHIRTS =
1.67 0.6

 Based on the table, trade did not occur because Italy was more productive in
producing both goods. Thus, the concept of opportunity cost comes in.
 China has a comparative advantage in shirt manufacturing – the lowest
opportunity cost (1/2 bicycle) in that good.
 Italians – bicycle manufacturing because lowest opportunity cost (3/5 shirts)
in that good.
 The two countries should then trade their surplus products for goods that they
Classical Country-Based Trade Theories:
Comparative Advantage (4 of 4)

 Lessons of the theory of comparative advantage:

You are better off specializing in what you do relatively best.
Produce (and export) those goods and services you are relatively
best able to produce.
Buy other goods and services from people who are relatively
better at producing them than you are.
Classical Country-Based Trade Theories: Relative
Factor Endowments
 Heckscher-Ohlin Theory: Two basics observations
 Factor endowments (or types of resources) vary among countries e.g., Argentina
(fertile land), Saudi Arabia (large crude oil reserves), and China (large pool of
unskilled labor).
 Goods differ according to the types of factors that are used to produce them e.g.,
wheat requires fertile land, oil production requires crude oil reserves and apparel
manufacturing requires unskilled labor
 Pattern of Comparative Advantage
 Differences in relative factor endowments
 Export products that use relatively abundant factors of production.
 Import products that need relatively scarce factors of production.
Classical Country-Based Trade Theories: Relative Factor
Endowments-Leontief Paradox
Blank U.S. Export U.S. Import
Heckscher Ohlin Capital Intensive Goods (Abundant Labor Intensive Goods (Labor
Theory Capital) Scarcity)
Leontief Paradox U.S. imports were more capital U.S. imports were more capital
intensive than were U.S. exports intensive than were U.S. exports

Figure 4.3 U.S. Imports and Exports, 1947: The Leontief Paradox
Modern Firm-Based Trade Theories: Theoretical
Development

 Growing importance of MNCs in the postwar international economy.

 Inability of the country-based theories to explain and predict the existence and
growth of intra-industry trade.
 Failure of Leontief and other researchers to empirically validate Heckscher-
Ohlin’s theory.
Modern Firm-Based Trade Theories: Vernon’s
Product Life Cycle Theory
 Product Life Cycle theory which originated in the marketing field
to describe the evolution of marketing strategies as the product
matures was then modified by Raymond Vernon to create a firm-
based trade theory of international trade.
 With the adopted version by Vernon, there are three (3) stages in
the product life cycle that is :

1. New Product Stage

2. Maturing Product Stage
3. Standardized Product Stage
Modern Firm-Based Trade Theories: Vernon’s
Product Life Cycle Theory

• monitor customer • Value recognition • Commodity

Unit produced

satisfaction • Export to other product

• Product market • Shifting
introduction in the production to low
manufactured labor cost country
country • Import product
• Sold in domestic
market to
minimize
manufacturing
investment

Stage 1 Stage 2 Stage 3

New Product Maturing Product Standardized Product
Modern Firm-Based Trade Theories: Linder’s
Country Similarity Theory
Interindustry: The exchange of goods produced by one industry in country A for
goods produced by a different industry in country B.

Intraindustry: Trade between two countries of goods produced by the same

industry.

Differentiated Goods: automobiles, expensive electronic equipment, and personal care products,
for which brand names and product reputations play an important role in consumer decision-
making.
Undifferentiated Goods: coal, petroleum products, and sugar, are those for which brand names
and product reputations play a minor role at best in consumer purchase decision.
Modern Firm-Based Trade Theories: New
Trade Theory (1 of 2)

 The new trade theory was developed by Elhanen Helpman, Paul

Krugman, and Kelvin Lancaster.
 The theory is an extension of Linder’s analysis by incorporating the
impact of economies of scale on trade in differentiated goods.
 Predicts that Intra-industry trade will be commonplace

Economies of scale •occur if a firm’s average costs of producing a good decrease as its
output of that good increases.
Modern Firm-Based Trade Theories: New
Trade Theory (2 of 2)
 Obtaining a sustainable competitive advantage:

Owning intellectual Investing in R&D

property rights
New trade theory

Achieving economies of Exploiting the

scope experience curve
Modern Firm-Based Trade Theories: Porter’s Theory of National
Competitive Advantage
 Harvard’s Business School professor Michael Porter’s theory of National
Competitive Advantage is the newest addition to international trade theory.
 Porter believes that success in international trade comes from the interaction of
four factors (country and firm-specific elements) that are :

Factor Demand
conditions conditions

Firm
Related and
strategy,
supporting
structure
industries
and rivalry
Summary of Major Theories of International
Trade

Figure 4.5 Theories of International Trade

Overview of International Investment: Types of
International Investments
International Investment: Residents of one country supply capital to a
second country. Is divided into 2 categories:
 Foreign Portfolio Investments (F P I)
Passive holdings of securities: stocks, bonds, or other financial
assets.
 Foreign Direct Investments (F D I)
Acquisition of foreign assets for the purpose of controlling them:
new investment in property, joint venture, purchase of existing
assets in a foreign country.
Overview of International Investment: Growth
of F D I
Figure 4.6 Stock of Foreign Direct Investment, by Recipient (in
trillions of dollars)

Source: Based on data from United Nations Conference on Trade and Development, World Investment Report 2018 (
www.unctad.org).
F D I and the United States (1 of 2)
Table 4.4 Stock of F D I for the United States, end of 2017 (billions of dollars
(historical cost basis)
a. Sources of F D I in the United States
United Kingdom 540.9
Japan 469.0
Canada 453.1
Luxembourg 410.7
Netherlands 367.1
Germany 310.2
Switzerland 309.4
France 275.5
Ireland 147.8
Belgium 103.5
Bermuda, Bahamas, and other Caribbean islands 98.8
Other European countries 266.2
All other countries 273.2
Total 4,025.5
F D I and the United States (2 of 2)
Table 4.4 [Continued]
b. Destination of F D I from the United States
Netherlands 936.7
Bermuda, The Bahamas, and other Caribbean Islands 752.4
United Kingdom 747.6
Luxembourg 676.4
Ireland 446.4
Canada 391.2
Singapore 274.3
Switzerland 250.0
Australia 168.9
Germany 136.1
Japan 129.1
Other European Union countries 360.2
All other countries 744.1
Total 6,013.3

Source: Based on data from www.bea.gov, International Investment Position data, accessed August 7, 2018.
International Investment Theories: Ownership
Advantages
 Ownership Advantages: A firm owning an asset that creates a competitive
advantage domestically can use that advantage to penetrate foreign markets
through FDI.

Superior Technology
Well-Known Brand Name
Economies of Scale
International Investment Theories: Internalization
Theory
 FDI is more likely to occur (a firm will internalize its operation) when the cost
of negotiating, monitoring, and enforcing a contract (transaction costs) with a
second firm is high.
International Investment Theories: Dunning’s
Eclectic Theory
Ownership Advantage + Location Advantage + Internalization Advantage → F D

I
 Ties together location advantage, ownership advantage, and internalization advantage.
FDI should take place when 3 conditions are satisfied:
 Own some unique competitive advantage that overcomes the disadvantages of
competing with foreign firms in their own market (ownership advantage).
 The firm must be more profitable to undertake a business activity in a foreign
location than in a domestic location (location advantage).
 The firm must benefit from controlling the foreign business activity, rather than
hiring an independent local company to provide the service (internalization
advantage).
Factors Influencing F D I

Table 4.5 Factors Affecting the F D I Decision

Supply Factors Demand Factors Political Factors

Production costs Customer access Avoidance of trade barriers

Logistics Marketing advantages Economic development incentives

Resource availability Exploitation of competitive advantages Blank

Access to technology Customer mobility Blank
Factors Influencing F D I

Supply Factors
1. Lower production
costs
1. Transportation
Production 2. Foreign location
Logistics Costs
more attractive
Costs E.g., lower land prices, 2. Distribution costs
tax rates, low cost of
un/skilled Labor.

Natural 1. Critical Key 1. Acquire ownership

Natural resources interests
Resources Technology
Factors Influencing F D I

Demand Factors
1. Visibility foreign
Customer 1. Physical presence in Marketing firm
the market. 2. “buy local”
Access Advantages attitudes

1. Exploits competitive
1. Cust promptly &
Competitive Advantage Customer Attentively
e.g., the site of the
Advantages factories Mobility
Factors Influencing F D I

Political Factors

1. Democratic
Trade 1. Help reduce
Economic election Govt
Barriers trade barriers Incentives 2.Offer
incentives
Review Questions (1 of 2)

 What is international trade? Why does it occur?

 What form of international business is explained by the theory of comparative
advantage?
 What is Intra-industry trade?
 How useful are country-based theories in explaining international trade?
 How do businesses benefit from economies of scale?
Review Questions (2 of 2)

 Explain the impact of the product life cycle on international trade and
international investment.
 What are the primary sources of the competitive advantages firms use to
compete in international markets?
 Illustrate Porter’s theory of national competitive advantage using a
country or an industry of your choice.
 How do foreign portfolio investments and F D I differ?
 What are the three parts of Dunning’s eclectic theory?
 How do political factors influence international trade and investment?
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MGT 361: CHAPTER 4_FPP UITM