37997432 international production theory

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Lecture 3 :Theories of International Trade andInternational Production

International Business Management 1

Part A: Theories of International Trade


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Part A:Theories of International TradeLearning Objectives:

To analyse the benefits for a country to engage in

international trade.

To review relevant theories that explain trade flows betweennations:

1. Mercantilism

2. Absolute Advantage

3. Comparative Advantage4. Heckscher-Ohlin Theory

5. The Product Life Cycle Theory

6. New Trade Theory

7. National Competitive Advantage: Porters Diamond


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International Trade can be defined as theexchange of goods and services across borders.

Free Trade refers to a situation where aGovernment does not attempt to influence through

quotas or duties what its citizens can buy fromanother country or what they can produce and sellto another country.(Hill,1998 pp123).

Adam Smith (1776) argued that the invisible hand of

the market mechanism should determine what acountry need to import or export and not theGovernment .


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Part A:Theories of International TradeBenefits of International Trade

Countries can import resources they lack at home.

Countries experience unequal endowment of resources such

as:

Natural resources

Human Resources

Capital

TechnologyCountries can import goods for which they are relatively

inefficient producer.

Specialisation often results in economies of scale and an

increased in world output.


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Part A:Theories of International TradeMercantilism

Emerged in England in the mid 16th century.

Main tenant: Best interest in a country to maintain a trade

surplus i.e. to export more than it imports.

How to achieve trade surplus?Maximise export and minimise import

Through Government Intervention ,i.e. by:

Subsidising export andLimiting imports by imposing tariffs and quotas.

Viewed trade as zerosum game in which a gain by one

country results in a loss by another.


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Part A:Theories of International TradeMercantilism- Criticisms

Later Adam Smith and David Ricardo demonstrated that

trade is a positive-sum game i.e. a situation in which all

countries can benefit , even if some benefits more thanothers.

Trade Barriers are being gradually reduced in line with the

policies the World Trade Organisation.


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Part A:Theories of International TradeTheory of Absolute Advantage Adam Smith, 1776 TheWealth of Nations

A country should specialize in production of and export

products for which it has absolute advantage.

A country has absolute advantage in the production of a

product when it is more efficient than any other countryproducing it.


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Part A:Theories of International TradeTheory of Comparative Advantage, David Ricardo(1817),Principles of Political Economy

Rationale: Even if a country has absolute advantage in the

production of all goods, it doesnt need to produce all of them.

It should specialise in the production of those goods that it

produces most efficiently and buy from other countriesthose goods which it produces less efficiently.

Both countries gain from trade even if one of them is more

efficient than the other in producing everything.


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Part A:Theories of International TradeTheory of Comparative Advantage, David Ricardo(1817),

Principles of Political Economy

Assumptions:

Only two countries and two goods in real world thereare many countries and many goods.

Zero transportation costs.

Resources move freely from production of one good to

another within a country, but not across countries.

Price of resources in different countries are constant.

Fixed stocks of resources.


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Part A:Theories of International TradeHeckscher (1919)-Ohlin (1933)

Comparative advantage arises from differences in national

factor endowment.

Factor endowments are the extent to which a country isendowed with resources such as land, labour and capital.

As such, patterns of trade is determined by differences in

factor endowments rather than differences in productivity.

Principle- A country should: Specialize in the production of goods that make intensive

use of factors that are locally abundant, and then export

those goods.

Import goods that make intensive use of factors that are

locally scarce.


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Part A:Theories of International Trade

The Leontif Paradox (1953)

Using Hecksher-Ohlin theory, Leontif postulated that since the

US was relatively abundant in capital compared to other

nations, the US would be an exporter of capital intensive

goods and an importer of labour intensive goods.

However, he found that US exports were less capital intensive

than US imports


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The Product Life Cycle, Raymond Vernon, 1966

Vernon argues that as products mature both the location of

sales and the optimal production location will change affecting

the flow and direction of trade.

Vernon classifies the whole process of a new product in a

market into four phases.

In the initial stage:A new product is developed by an advanced country (USA)

and sold in the domestic market.

The producer monopolizes production of the new product.


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While demand starts to grow in the USA, demand in other

advanced countries is limited to high income groups.

The limited demand in other advances countries does not

make it feasible for firms in those countries to start

production. They would rather satisfy the needs by exports

from the USA.

Over time demand for the new product starts to grow in the

other advanced countries to such an extent that it becomes

viable for foreign producers to start producing the products

for their home markets.


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While demand expand in the secondary markets:

Product becomes standardised.

Production moves to low production cost areasProduct now imported to USA and to other advanced

countries.

Example Xerox was first developed in the USA then set up

production in Japan (Fuji-Xerox) and Great Britain (Rank

Xerox).

Therefore, the place of production initially switches from theUnited States to other advanced nations and then to

developing countries.


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The new trade Theory - Paul Krugman (1970s) argues that:

Substantial economies of scale result in increasing returns

i.e. as output increases ability to realise economies of scale

increases and cost per unit eventually falls.

Due to the presence of substantial economies of scale, world

demand will support a few firms in many countries.

The economic and strategic advantage of the firm act asbarriers to entry.


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The new trade Theory - Paul Krugman (1970s) argues that:

Countries may export certain products simply because they

have one firm that was an early entrant in the industry (First-

mover advantage). For example, Boeing Aircrafts.

First-mover advantages are the economic and strategicadvantages that accrue to early entrants into an industry.

Therefore, Government may subsidize the firm at period ofentry and growth.

However, this theory is in contravention to the idea of freetrade.


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The National Competitive Advantage Michael Porter

(1990)

Porter, in his thesis, seek to determine the factors that

enable a nation to achieve and sustain international

success in a particular industry. For example, Japan

in the automobile industry.

His findings revealed that four attributes of a nation

shape the environment in which local firms compete

and these attributes promote creation of competitive

advantage at international level.


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(1990)

M.E Porter (1990), The Competitive Advantage of Nations, Harvard Business

Review

Factor

Endowments

Firm Strategy,

Structure and

Rivalry

Demand

Conditions

Related and

Supporting

Industries


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(1990)

Factor endowment: Nations position in factors ofproduction necessary to compete in a given industry.

Basic Factors: I.e. natural resources such aslocation, climatic conditions and demographic

conditions.

Advance Factors: Communication, skilled labourforce, infrastructure and technological advancement.

Unlike Basic factors, advanced factors are the

products of investment by individuals, companies

and Governments.


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(1990)

Demand conditions: The nature and characteristics ofhome demand for the industrys product or service.

The characteristics of the local demand would normally

pressurise local firms to produce high standard products

quality and innovative products.

High quality and innovative products improve firms

competitive edge.


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(1990)

Related & Supporting Industries: The presence orabsence in a nation of supplier industries or related

industries that are nationally competitive.

For instance, the quality of the input reflects to a large

extent on the firms competitive edge at the international

level.


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(1990)

Firm strategy, structure and rivalry: Conditions in thenation influencing how companies are created,

organized, and managed.

The nature and extent of domestic rivalry induces firm

to:

Be more innovative

Improve quality of products

Be more efficient vis- a- vis competitors

Invest in research and development

The above help to create world-class competitors.


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Part B:Theories of International ProductionLearning Objectives:

To understand the definition of Multinational.

Discuss the various theories of International Production:

Classical/Neo Classical Models of Trade

Hymers Theory of International Production Vernons Product Life Cycle

The Electric Paradigm

Technological Accumulation Theory

The Investment Development Path

Alliance Capitalism


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Part B:Theories of International Production

Definition of Port folio Investment

The IMF Balance of Payment Manual (2003:98) includes in

the category of portfolio investment equity securities and

debt securities in the form of bonds and notes, money marketinstruments and financial derivatives.

To Ietto-Gillies (2005), international portfolio investment is

that investment which is undertaken for purely financial

reason and includes loans and equity investment (i.e. theacquisition of shares in a foreign company).


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Definition of Direct Investment

IMF Balance of Payment Manual (2003:86) defines direct

investment as investment made by the resident entity of one

economy to acquire lasting interest in an enterprise residentin another economy

According to the OECD (2004:6), foreign direct investment

enterprise is an enterprise (institutional unit) in the financial

or non-financial corporate sectors of the economy in which anon-resident investor owns 10 per cent or more of the votingpower of an incorporated....


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Port Folio Investment Vs Direct Investment

The demarcation between portfolio investment and FDI was

first drawn by Hymer (1960) who had had contradictory views

to that of neoclassical scholars (Iversen, 1935).

Hymer (1960) distinguishes direct investment from portfolio

investment by arguing that the former gives the firm control

over the business activities abroad where as the latter does

not.


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Neoclassical/ Classical Theories of Trade

The major assumptions of the neoclassical theory are:The market for cross border exchange was assumed to

be a costless mechanism.Resources were assumed to be immobile across

national boundaries but mobile within national

boundaries.

There was perfect flow of information.

Firms were assumed to engage in single activity.Entrepreneurs were assumed to be profit maximisers.


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Criticism on Neoclassical/ Classical Theories of Trade

The main criticisms of neoclassical approach to foreign

investment are:

The underlying concept of perfect competition isunrealistic.

It fails to consider other transaction costs.

It assumed perfect flow of information where as it is a

fact that information in the financial market is

pervasively asymmetric.It assumed no mobility of resources where as today the

world is considered as a global village where resources

move freely.


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Hymers (1960) Theory of International Production

The work of Hymer (1960) is considered as the first theory in

the literature of FDI.

The underlying principle of Hymers doctoral thesis is the

demarcation between FDI and portfolio investment.

Hymer notes that international production occurs as a result

of: The firms intention to grow further thus enhancing its

market position.

The existence of market imperfection


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Hymers (1960) Theory of International Production

Hymer also advocates that firms will engage in

international production only if they have advantage such

as production technology, finance, product differentiationor superior distribution network that are actually not

possessed by domestic firms.

+ =Domestic

Market

Imperfection

FirmsSpecific

Advantages

Foreign

Market


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Criticism of Hymers Theory

Hymers Theory was severely criticised by Dunning (1981)

who argues that Hymers thesis was only concentrated on the

motives of foreign investment (why) and completely omit thelocation factor (where) which play an important role indetermining FDI decisions.


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The Product Life Cycle, Raymond Vernon (1966)

Evaluating the growth of US FDI after the Second World War,

Vernons theory examined the following issues:

The factors that lead to the location of production abroad;

The location where the production of new product is

likely begin;

The consequences resulting from the flow of FDI; and

The location where new ideas and technology for newproducts are likely to originate.


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His findings were as follows:

He notes that the US market is very large andcharacterised by high unit labour cost, large supply of

labour and high average income per capita.

New product will be located in the USA because

producers would be able to charge high prices given thehigh purchasing power of Americans


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As the product reaches the maturity stage, competition

steps in and demand for the product in other foreign

market increases. The product is exported to nations most similar to the US

in demand patterns and standard of living.

In the final stage of the product life cycle, Vernon argues

that as products become more and more standardised, itwill eventually require high capital intensity and unskilled

labour.

The firm may relocate its production facilities to lower cost

producing countries.


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The Product Life Cycle, Raymond Vernon (1966)-Criticisms

Later in 1979, Vernon came up with a critical review of his

previous analysis with more focus on the changing macro

environment in Europe.

He noted that changes in the macro economic

environment have challenged the application of his initial

theory which was relevant in the 1960s.

For instance, changes in Europe between 1970 and

1979 have gradually closed up the gap between Europeand USA. (differences in standard of living, cost of

labour, size of markets and consumer tastes between

the two countries have significantly reduced).


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The Product Life Cycle, Raymond Vernon (1966)-Criticism

Moreover, the technological leadership enjoyed by the

US in the 50s and early 60s gave way to a more

balanced technological competition between the US,Europe and Japan.


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Dunnings Eclectic Framework(1977) Dunnings (1977) eclectic framework is considered as

the complete theory of international production as it

corrected certain omissions in the earlier theories.

Dunnings approach of internationalisation attempted to

analyse the why, where and whendecisions in terms of

ownership, locational and internalisation (OLI)

advantages.


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Dunnings Eclectic Framework(1977)Ownership Advantages Advantages that are

specific to a particular enterprise.

Locational Advantages Advantages that are

specific to a country which are likely to makeattractive for foreign investors, i.e. location-specific

endowments

Internalisation Advantages Benefits that are

derived from producing internally to the firm.


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Technological Accumulation TheoryAcknowledge that the superiorOwnership advantages

determine the establishment of foreign operations.

However, there are other benefits accrued to firms

which are more important to ensure foreignestablishment.

For instance, technological capabilities of a firm which

are the result of internal learning processes involving trial

and error, are primary sources of a firms competitive (orownership, in the OLI paradigm) advantage (Dunning,

1993).


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Technological Accumulation Theory (Rosenberg, 1982) notes that technological change is

incremental in that it represents the cumulative impact of

small improvements while Cantwell (1898,1990) argues

that the innovation of a firm specific technology is a

cumulative process.

Technology Accumulation Theory argue that the ability of

the firms to continually improve and refine their

technology which allow the multinationals to retain its

competitive edge.


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Investment Development Path (Dunning, 1981)

The objective of the research was to determine the

relationship between a country's net foreign direct

investment and its level of economic development

The Investment Development Path (IDP) theory: establishes a dynamic and positive relationship

between the countrys level of inward and outward

foreign investment and the level of industrialisation and

identifies the stages through which countries progress.


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Investment Development Path (Dunning, 1981)The premise of the theory is two fold:

First, it identifies economic development as a process

of structural change (such as improvement in the

country's technological and productive system);The structural change influences the pattern of both

inward and outward foreign direct investment.

The IDP theory argues that countries progress through the

following five stages.

Countries progress in terms of the countrys location-

specific advantage which gradually upgrade the domestic

firms ownership specific advantage.


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Stages in the Investment Development PlanCharacteristics

Stage Country Local Firms

1st Stage

Pre Industrial

Society

1. Weak Local Demand

2. Inadequate Infrastructure

Limit Countrys attractiveness to

foreign investors

Local Firms lack

ownership specific

advantage to investabroad.

2nd Stage 1. Government initiates basicinfrastructure.

2. Local Demand grows.

3. FDI takes place

Net Investment position isnegative

Ownership specific

advantage of domestic

firms are weak and limits

outward investment.

Firms may invest in other

countries if subsidise by

Government


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Stages in the Investment Development PlanCharacteristics

Stage Country Local Firms

3rd Stage Decrease in the rate of growth ofinward investment flows due to

growing competitiveness of local

firms.

Countrys net outward investment

position is still negative but is on

an upward trend

Domestic firms increase

outward investment due to

improvement of ownership

specific advantage.

4th Stage Outward FDI stock exceedsinward FDI stocks

More firms investing abroad.

5th Stage Net Investment position willimprove further.


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Alliance Capitalism

Constant pressure from both competitors and consumers

to continually improve and upgrade quality of goods and

services.

Need to invest in research and development and at the

same time to search for new market which entails hugeinvestment.

Thus, in order to exploit effectively their core

competencies, firms are increasingly finding that they

need to combine their core competencies with those ofother firms.

Theabove has led to the proliferation of what is known asallianceCapitalism


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Alliance Capitalism

A Strategic Alliance can be defined as a mutuallybeneficial long-term relationship between two or more

parties to pursue a set of agreed goals or to meet a

critical business need while remaining independent

organisations.

Main objective is to maximise the benefits of the jointinternalisation of interrelated activities.

Examples: Alliance between BMW and Rolls Royce- Production

of engine for the aero engine market.

Sony- Ericsson


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Alliance Capitalism

Benefits:

1. More flexible approach to production by capturing benefits

of their own competencies.

2. More resources (Capital) for Research and Development.

3. More innovative ideas and fault free products as a result

of continuous improvement and transfer of technology.

4. Better position to extend the Product Life Cycle.


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Alliance Capitalism

Benefits:

5. Ability to bring together complementary skills and assets

that neither company could easily develop on its own.

6. To gain access to new markets of distribution channels.

7. Benefit from economies of scale.

8. To overcome Government mandated trade barriers.

37997432 international production theory

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