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Theories of InternationalTheories of InternationalTrade and InvestmentTrade and Investment

International Businessby Ball, McCulloch, Frantz,

Geringer, and Minor McGraw-Hill/Irwin Copyright © 2006 The McGraw-Hill Companies, Inc. All rights reserved.

This chapter covers:

•Why goods are traded internationally

•Arguments for imposing trade restrictions

•Kings of import restrictions

•Weakness of GNP/capita as economic indicator

•Characteristics of developing nations

•Theories of foreign direct investment

Chapter ObjectivesChapter Objectives

Understand the theories of international trade.Comprehend the arguments of imposing trade

restrictions. Explain the two basic kinds of import restrictions.Appreciate the relevance of the changing status of tariff

and non tariff barriers.Recognize the weaknesses of GNP/capita as an economic

indicator.Understand the new definition of economic development.Understand why governments change from import

substitution to export promotion. Explain some of the theories of foreign direct

investment.

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International Trade TheoryInternational Trade Theory

Mercantilism Believed nation’s

welfare was in accumulation of stock of precious metals.

Trade surplus created by import restrictions and government subsidies to exporters.

Mercantilist era ended in 1700s.

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Modern Day MercantilismModern Day Mercantilism

Economic Nationalism Industrial policy based on state intervention France nationalized key industries and banks

to use the power of the state as Stockholder and financier Customer and marketer to revitalize the

nation’s base In 1986, little growth and high unemployment

led government to reverse “mercantilist” policy Japan called “fortress of mercantilism” by

some Nearly impenetrable market Effort to maintain a cheap yen

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Theory of Absolute AdvantageTheory of Absolute Advantage

“The capacity of one nation to produce more of a good with the same amount of input than another country.”

Adam Smith claimed that market forces, not government controls should determine the direction, volume, and composition of international trade.

Each nation should specialize in producing goods it could produce most efficiently

In absolute advantage, both nations would gain from trade.

Assumptions Perfect competition and no transportation costs in a

world of two countries and two products.3-5

Theory of Comparative AdvantageTheory of Comparative Advantage

“A nation having absolute disadvantages in the production of two goods compared to another nation, has a comparative

advantage in producing the good in which its absolute disadvantage is less.”

Theory of comparative advantage demonstrated by Ricardo in 1817.

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Production Possibility FrontiersProduction Possibility Frontiers

The following two graphs illustrate Chinese and U.S. production possibility frontiers using constant cost for simplicity.

These curves, in the absence of trade, also illustrate the possible combinations of goods for consumption.

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Offshoring Service Jobs to IndiaOffshoring Service Jobs to India

Approximately 1 Billion people Comparative advantage in production of goods

or services that require large amounts of labor Citizens speak English Low labor costs due to large workforce Internet and telephone communications much

less expensive Industries offshoring include software

engineering, telemarketing, banking, medical services, claims processing, IT jobs, financial services, insurance

Jobs created overseas generate jobs at home3-8

Heckscher-Ohlin Theory of Factor Heckscher-Ohlin Theory of Factor EndowmentEndowment

States that international and interregional differences in production costs occur because of differences in the supply of production factors. Therefore,

India should export labor intensive goods.

Germany, with relatively more capital than labor should specialize in capital intensive products.

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Assumptions The price of factors

depend only on the factor endowment. Not a perfect market Legislated wages and

benefits Tax credits

Given technology is universally available. Always a lag between

intro of new technology and world application

Leontief ParadoxLeontief Paradox

Study in 1953 by economist Wassily Leontief disputed the usefulness of the Heckscher-Ohlin Theory as a predictor of the direction of trade.

Found that the U.S., one of the most capital-intensive countries in the world, was exporting labor intensive products.

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Effect of Money on TradeEffect of Money on Trade

Exchange Rate The price of one country’s currency stated

in terms of the other. Influence of Exchange Rates

European companies pressured to incraese prices of exports to maintain Euro profits

Currency devaluation Lowering of a country’s currency in terms of

other currencies. Example is tourism and currency rates in

Mexico during 1980s

Newer Explanations of the Direction of Newer Explanations of the Direction of TradeTrade

Economies of Scale and the Experience Curve

As output increases cost per unit decreases

Larger and more efficient equipment

Volume discounts

Fixed cost allocation

Drop in learning curve

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First Mover Theory Gain market share Discourage foreign

entrants

The Linder Theory of Overlapping Demand Customers’ tastes

determined by income levels

Trade greater between nations with similar per capital incomes

International Product Life Cycle (IPLC)International Product Life Cycle (IPLC)

Four stages of the IPLC in the U.S.1) U.S. exports2) Foreign production begins3) Foreign competition in export markets4) Import competition in the U.S3-13

Stages of the International Product Life Stages of the International Product Life CycleCycle

Exports May be only

manufacturer of new product

Overseas customers learn of product, export market develops

Foreign production Export volume grows Production technology

becomes stable Reduced costs for

transportation Exports diminish

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Foreign competition Foreign

manufacturers gain experience

Compete in export markets

Import competition Foreign producers

obtain economies of scale

Compete in quality and undersell domestic company in domestic market

International Technology Life CycleInternational Technology Life Cycle

Initial Stage Development of new technology in an

industrialized country Subsequently exported to other developed

countries Increasing cost of labor make it no longer

profitable to use in developed nation Technology exported to developing nation Technology produced abroad for domestic

consumption

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Porter’s Competitive Advantage of Porter’s Competitive Advantage of NationsNations

Porter claims that four kinds of variables will impact a local firm’s ability to use a country’s resources to gain a competitive advantage. Demand conditions Factor conditions Related and

supporting industries Firm strategy,

structure, rivalry3-16

Porter’s Competitive Advantage of Porter’s Competitive Advantage of NationsNations

Demand Conditions Nature of domestic

demand. If customers are

demanding, firms will produce high-quality and innovative products gaining competitive advantage

Factor Conditions Level and consumption of

factors of production Lack of natural

endowments has caused nations to invest in the creation of advanced factors

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Related and supporting industries Suppliers and industry

support services tend to form a cluster in a given location

Firm Strategy, Structure, Rivalry Extent of domestic

competition, The existence of

barriers to entry The firm’s

management style and organization.

Trade RestrictionsTrade Restrictions

Arguments for National Defense

Certain industries need protection Imports may not be available during wartime Prevent valuable technologies from being used to

strengthen competition, especially militarily Sanctions to Punish Offending Nations

Inflict economic damage to encourage to modify behavior

Protect Infant or Dying Industry In the long run will have a comparative advantage Meant to be temporary for emerging industry or to

protect jobs of dying industry3-18

Trade RestrictionsTrade Restrictions

Arguments for Protect Domestic Jobs from Cheap Foreign Labor

Productivity per worker greater in developed countries

Fails to consider cost of other factors of production

Scientific Tariff or Fair Competition Bring cost of imported goods up to domestically

produced goods to prevent unfair advantage Retaliation

Import restrictions placed by another country may result in similar restrictions by domestic government EU ban on hormone treated U.S. beef

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Other Reasons for RetaliationOther Reasons for Retaliation Dumping is the selling of a

product abroad for less than The average cost of

production in the exporting nation

The market price in the exporting nation

The price to third countries

Result of Excess production Cyclical or seasonal

factors Attempt to force domestic

producers out of business3-20

Sanctions JustifiedSanctions Justified

Dumping for which sanctions are considered justified Social dumping

Lower labor costs and poorer working conditions Environmental dumping

Lax environmental standards Financial services dumping

Low requirements for bank capital/asset ratios Cultural dumping

Cultural barriers aid local firms Tax dumping

Differences in corporate tax rates or special breaks3-21

Other Reasons for RetaliationOther Reasons for Retaliation

Subsidies Government provides to domestic firm to encourage

exports or protect from imports Can be

Cash payment Government participation in ownership Low-cost loans Preferential tax treatment

Countervailing Duties Set by importing nation to offset effects of subsidy Equal to the subsidy amount

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Types of Restrictions - TariffsTypes of Restrictions - Tariffs

Ad Valorem Percentage of

invoice value Specific

Fixed sum of money per unit

Compound duty Combination of

the above

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Official Prices Minimum import

duty regardless of invoice price

Variable Levy Calculated daily

based on world market price

Lower Duties for Local Input

Encourages some local production

Types of Restrictions - NontariffTypes of Restrictions - Nontariff

Quantitative Quotas Voluntary Export

Restraints Orderly Marketing

Arrangements Nonquantitative

Nontariff Direct government

participation in trade Customs and other

administrative procedures

Government and private standards3-24

Levels of Economic DevelopmentLevels of Economic Development

Developed Classification for all industrialized nations,

which are mostly technologically developed. Developing

Classification for world’s lower income nations, which are less technically developed.

Newly Industrialzing Countries (NICs) Fast-growing, middle-income or higher

economies Heavy concentration of foreign investment Exported large quantities of manufactured

goods, including high-tech products3-25

Levels of Economic DevelopmentLevels of Economic Development

Newly Industrialized Economies (NIEs) Primarily used to refer to the four tigers

Taiwan, Hong Kong, Singapore, South Korea IMF combines NIEs with Industrialized

Nations to form “advanced economies Emerging Market Economies

Chile, Malaysia, China, Thailand, Indonesia Transition Countries or Eastern Europe

Former communist countries

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The World Bank Classification SystemThe World Bank Classification System

Based on GNP/capita

Low income ($735 or less)

Lower middle income ($736 - $2935)

Upper middle income ($2,936 - $9,075)

High income ($9,076 or more)

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GNP/Capita as an IndicatorGNP/Capita as an Indicator Concerns

GNP/Capital data does not include Underground Economy Undeclared legal production Production of illegal goods and services Concealed income – barter Underground Economy larger if

Higher level of taxation Oppressive government red tape

Currency conversion Local currency converted to the dollar by using

exchange rate Conversions do not reflect domestic purchasing powers

of currencies, must use purchasing power parity (PPP) World Bank uses Atlas methodology

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Characteristics of Developing NationsCharacteristics of Developing Nations

GNP/capital less than $9,075

Unequal distribution of income

Technological dualism Regional dualism Majority of population

working in agricultural sector

Disguised unemployment or underemployment

High population growth

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High rate of illiteracy and insufficient educational facilities

Widespread malnutrition and health problems

Political instability High dependence on a

few products Inhospitable topography Low savings rates and

inadequate banking facilities

Human Needs Approach to Economic Human Needs Approach to Economic DevelopmentDevelopment

Defines economic development as the reduction of poverty, unemployment, and inequality in the distribution of income. Less illiteracy, less malnutrition, less disease and

early death, shift from agricultural to industrial production

Human Development Index (HDI) based on A long and healthy life Ability to acquire knowledge Access to resources for a decent standard of living Measured by life expectancy, adult literacy, and

GDP/capita adjusted for PPP3-30

Development TheoryDevelopment Theory

No generally accepted theory

Economists concentrating on Population growth Income distribution Unemployment Transfer of technology Role of government Investment in human

capital The education of

people3-31

Contemporary Theories of FDIContemporary Theories of FDI

Monopolistic Advantage Theory FDI occurs largely in oligopolistic industries

Product and Factor Market Imperfections FDI typically from companies with heavy

product research and marketing efforts International Product Life Cycle

FDI normal state in life of a productOther Theories

Follow-the-leader theory Cross investment Internalization theory Theory of International production

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Current U.S. Trade SanctionsCurrent U.S. Trade Sanctions

Balkans Burma (Myanmar) Cuba Diamond Trading Iran Iraq Liberia

Source: www.treas.gov

Libya Narcotics

Trafficking Nonproliferation North Korea Sudan Syria Terrorists Zimbabwe

Export Screening GuidelinesExport Screening Guidelines

Screening ElementsElement 1: Denied Persons ScreenElement 2: Product Classification/License Determination ScreenElement 3: Diversion Risk ScreenElement 4: Sensitive Nuclear End-Uses/End-Users ScreenElement 5: Missile End-Use/End-Users ScreenElement 6: Chemical and Biological Weapons End-Uses/End-Users ScreenElement 7: Antiboycott ScreenElement 8: Informed Letter/Entity List Screen

Source: www.bxa.doc.gov

Department of CommerceDepartment of CommerceTransshipment Country Export Control Initiative Transshipment Country Export Control Initiative

(TECI)(TECI)

TECI is a multi-faceted, cooperative initiative that seeks to strengthen the trade compliance and export control systems of those countries and companies that constitute global transshipment hubs. By working to strengthen those systems, the DOC seeks to enhance security and confidence in international trade flows.

Source: www.bxa.doc.gov

GDP GrowthGDP Growth

Source: www.globalpolicy.org

AIDS CrisisAIDS Crisis

Source: www.globalpolicy.org

Antidumping MeasuresAntidumping Measures

The United States maintains 54 of its outstanding 288 antidumping measures against products from China.

In 2003, new cases against China were initiated at the brisk pace of one per month. These actions hit consumable products like honey, apple juice concentrate, mushrooms, and pencils, as well as raw material inputs like creatine monohydrate, polyvinyl alcohol, barium carbonate and ferrovanadium.

Source: www.freetrade.org