International Business

Meaning of International Business

• International business consists of transaction that are devised and carried out across national borders to satisfy the objectives of individuals, companies and organizations.

• The economic system of exchanging good and services, conducted between individuals and businesses in multiple countries.

• The specific entities, such as multinational corporations (MNCs) and international business companies (IBCs), which engage in business between multiple countries.

Need for International Business

• Causes the flow of ideas, services and capital across the world.

• Offer consumer new choices.

• Permits the acquisition of a wider variety of products.

• Facilitate the mobility of labor, capital and technology.

• Provide the challenging employment opportunities.

• Reallocate resources makes preferential choices and shifts activities to

global level.

Types of International Business

• Export –Import trade

• Foreign Direct investment

• Licensing

• Franchising

• Management contract

Franchising• Franchising refers to the methods of practicing and

using another person's business philosophy. The franchisor grants the independent operator the right to distribute its products, techniques, and trademarks for a percentage of gross monthly sales and a royalty fee. Various tangibles and intangibles such as national or international advertising, training, and other support services are commonly made available by the franchisor. Agreements typically last from five to thirty years, with premature cancellations or terminations of most contracts bearing serious consequences for franchisees.

Businesses for which franchising works best

Businesses for which franchising is said to work best have the following characteristics:

• Businesses with a good track record of profitability. • Businesses built around a unique or unusual concept. • Businesses with broad geographic appeal. • Businesses which are relatively easy to operate. • Businesses which are relatively inexpensive to operate. • Businesses which are easily duplicated.

Licensing• A business arrangement in which one company

gives another company permission to manufacture its product for a specified payment.

• There are few faster or more profitable ways to grow your business than by licensing patents, trademarks, copyrights, designs, and other intellectual property to others .

• For example, about 90 percent of the $160 million a year in sales at Calvin Klein Inc. comes from licensing the designer's name to makers of undergarments, jeans and perfume.

Management contracts• Agreement between investors or owners

of a project, and a management company hired for coordinating and overseeing a contract. It spells out the conditions and duration of the agreement, and the method of computing management fees.

• An agreement by which a company will provide its organizational and management expertise in the form of services.

FDI and FII• FDI stands for Foreign Direct Investment, a

component of a country's national financial accounts. Foreign direct investment is investment of foreign assets into domestic structures, equipment, and organizations. It does not include foreign investment into the stock markets. Foreign direct investment is thought to be more useful to a country than investments in the equity of its companies because equity investments are potentially "hot money" which can leave at the first sign of trouble, whereas FDI is durable and generally useful whether things go well or badly.

FIIs

• The term is used most commonly in India to refer to outside companies investing in the financial markets of India. International institutional investors must register with the Securities and Exchange Board of India to participate in the market. One of the major market regulations pertaining to FIIs involves placing limits on FII ownership in Indian companies

Drivers of International business• Regional developments helping internationalizationRegional developments helping internationalization:

1) Emergence of NAFTA comprising united states, Canada and Mexico has created a huge north American market. Movement of goods and services among these countries is easy as all trade barriers have been removed. The result will be a giant “American market” that would parallel similar development in Asia and Europe.

2) The most recent changes of GAAT are stimulating increased world trade. Under the new agreement, tariffs would be reduced world wide by 38%and in some cases, eliminated completely.

3)Japan, of late has invested relatively more in Asia than in any part of the world. Japanese corporations want to take advantage of the underdeveloped but growing Asian market.

4) Export potential is vast in central and eastern Europe, Russia which are converting themselves into market economies.

5) There is also recent economic progress among less developed economies. For

example India Globalization and liberalization approach toward economy 6) The new economy, a characteristic feature of the present century, itself demands

trading across the globe.

International Investment and Trade

• Developed countries are active players in international investment. Approx. 80% of the global investment emanate from rich countries. For example FDI in the US stands at over $600 billion, while the US FDI is almost $ 800 billion.

• The developed and developing countries are the major recipient of FDI

Other reasons of Internationalization• There is a lot of money in the overseas market. The MNCs from the triad- the

US, Europe and Japan – have huge assets than a quarter of these assets are found in foreign market. GE of the US is one of the top MNC with assets of over $ 300 billion in 1997 and nearly a third of its assets were found in overseas countries. The Dutch /UK firm shell has huge assets and three fifth of these are located overseas.

• It is being realized that the domestic markets are no longer adequate and rich. Japan flooded American with automobiles and electronics because domestic market was not large enough to absorb whatever was produced.

• Companies often set up overseas plant to reduce high transportation cost. The higher the ratio of unit cost to the selling price per unit, the more significant the transportation factor becomes.

• The motivation to go global in high tech industries is slightly different. They spend lot on research and development for new products. If domestic sales and export do not generate sufficient cash flow, the company naturally might look to overseas manufacturing plants and sales branches to generate higher sales and better cash flow.

Continue………………..• Firms go global to access resources that are unavailable or more

expensive at home ( Japan largest paper company Nippon Seishi, needs to do more than import of wood pulp. It owns huge forests and processing facilities in Australia, Canada and US.

• Labor market also attract companies into international business. One way companies gain competitive advantage is by locating production facilities in low cost countries.

• Firms go global to avoid protectionist barrier imposed by local government. Government erect various forms of barriers to entry in their domestic markets by foreign firms

• Companies enter foreign markets because competitors have already done it.

• Govt. throughout the world offer a variety of incentives to attract MNCs

International Vs. Domestic BusinessBasis International business Domestic business

Payment Mostly in foreign currency In domestic currency

Laws and rules

Subject to international laws and regulations

Subject to national rules and regulations

Custom & Traditions

Different custom and traditions Same custom & Traditions

Legal and economic system

Have to face different legal economic and tax rate system

It is almost the same.

Approach Have to follow geocentric approach Have to follow ethnocentric approach

Organization that engage in IB vary considerably in size and the extent

Globalization• Globalization refers to the shift towards a more

integrated and independent world economy. Globalization has several facets, including the globalization of markets and the globalization of production.

• Globalization of markets: refers to the merging of historically distinct and separate national markets into one huge global marketplace. Falling barriers to cross border trade have made it easier to sell internationally.

Continue……………• It has been argued for some time that the taste

and preferences of customers in different nations are beginning to converge on some global norm, thereby helping to create a global market.

• For example consumer products such as coca- cola soft drink, Sony play station videogame, McDonald hamburger are frequently held up as prototypical example of this trend. Sony, McDonald, coca-cola are more than just benefactors of this trend: they are also facilitator of this trend. By offering the same basic product world wide they help to create a global market.

Continue…………………..• A co does not have to be the size of these multination giant to

facilitate and benefit from the globalization of market. For example firms with less than 5oo employee accounted for 97% of all US exporters and almost 30% of all the export value. In Germany co with less than 500 employees account for about 30% of the Nation import.

• It is important to note that to push too far the view that national markets are giving way to the global market. Very significant differences still exist among national markets including consumer taste and preferences, distribution channel, value system, business system and legal regulation.

• These differences frequently require that marketing strategies, product features and operating practices be customized to best match conditions in the country.

• Many companies need to vary aspects of their product mix and operations from country to country depending on local taste and preferences

Continue……………• Global market for industrial goods and material that serve a

universal need the world over for example aluminum, oil and wheat.

• In many global markets the same firms frequently confront each other as competitors in nation after nation for example Pepsi and coca cola is a global one.

• If one firm moves into a nation that is not currently served by rivals, those rivals are sure to follow to prevent their competitors from gaining an advantage.

• As firms follow each other they bring with them many of the assets that served them well in other national market including their products, market strategies and brand image- creating homogeneity across market.

• In an increasing no of industries it is no longer meaningful to talk about the local market for many firms there is only the global market.

Globalization of Production• Globalization of production refers to the sourcing of

goods and services from locations around the globe to take the advantage of national difference in the cost and quality of factor of production. By doing this companies hope to lower their overall cost structure or improve the quality or functionality of their product offering, thereby allowing them to compete more effectively.

• For example- IBM ThinkPad X31 laptop computer. The product was designed in the united states by IBM engineers because IBM believed that was the best location in the world to do the design work. The case keyboard and hard drive were made in Thailand, display screen and memory were in south Korea, the built in wireless card in Malaysia, and the microprocessor was manufactured in US. In each these components were manufactured in the optimal location given an assessment of production cost and transportation cost.

Emergence of Global Institutions• As markets globalize and as increasing proportion of

business activity transcends national border, institutions are needed to help manage regulate and police the global market place and to promote the establishment of multinational treaties to govern the global business system.

• The world trade organization is primarily responsible for policing the world trading system and making sure nation-states adhere to the rules laid down in trade treaties signed by WTO members.

• WTO has promoted the lowering the barriers to cross border trade and investment. Without an institution such as WTO the globalization of market and production is unlikely to have proceeded as far as it has

IMF and World Bank• The task of IMF is to maintain order in the international

monetary system and that of the world bank is to promote economic development. It has focused n making low interest loan to cash strapped governments in poor nations that wish to undertake significant infrastructure investment.

• IMF is often seen as the lender of last resort to nation-states whose economies are in turmoil and currencies are losing value against those of other nations.

• The IMF loan come with strings attached; in return for loans, the IMF requires nation-states to adopt specific economic policies aimed at returning their troubled economies to stability and growth.

Drivers of Globalization Two macro factors seem to underlie the trend toward

greater globalization:• Decline in barriers to the free flow of goods and services

and capital.• Technological change

• Declining Trade and Investment Barriers • After the formation of WTO, many talks were scheduled

to cutting tariffs on industrial goods, services and agricultural products, phasing out subsidies to agricultural producers; reducing barriers to cross border investment and limiting the use of antidumping laws.

• Many countries have also been progressively removing restrictions to FDI . According the UN some 94% of the 1885 changes made worldwide between 1991 and 2003 in the laws governing FDI created a more favorable environment

• The lowering of trade and investment barriers also allows firms to base production at the optimal location for that activity. Thus a firm might design a product in one country, produce components parts in to other countries , assemble the product in yet another country and then export the finished product around the world.

• According to WTO data the volume of world merchandise trade has grown faster than the world economy since 1950. From 1970 – 2004 the volume of world merchandise trade expanded almost 26 fold, outstripping the world production which grew about 7.5 times in real terms.

• Value of international trade in services grew robustly. Trade in services now account for almost 20% of the value of all the international trade . This increase is due to advances in communication which allow co to outsource service activities to different locations around the world

• FDI is also playing an increasing role in the global economy as firms increases their cross border investments. The average yearly outflow of FDI increased from $25 billion in 1975 to a record in $1.3trillion . Despite the slowdown in 2001-04 the flow of FDI not only accelerated over the past quarter but also accelerated faster than the growth in world trade.

• Between 1992-04 the total flow of FDI from all countries increased by about 360% while world trade doubled and world output grew by 35%.

• As a result of the strong FDI flow by 2003 the global stock of FDI exceeded $8.1 trillion. In total at least 61000 parent cos. had 90000 affiliates in foreign market that collectively employed some 54 million people abroad and generated value accounting for about one tenth of global GDP.

• Foreign affiliates of MNC had an estimated $17.6 trillion in global sales nearly twice as high as the value of global export of goods and services combined which stood at 49.2 trillion.

• The globalization of markets and production and the resulting world growth of world trade FDI and imports all imply that firms are finding their home market under attack from foreign competitors.

• The growing integration of the world economy into a single huge marketplace is increasing the intensity of competition in a range of manufacturing and service industries.

• If trade barriers decline no further at least for the time being this will put a brake upon the globalization of both markets and production.

Globalization of Investment• Globalization of investment refers to investment of capital by global

company in any part of the world. Global company conducts the financial feasibility of the new projects in different companies of the world and invests the capital in that country where it is relatively more profitable. Globalization of investment is also known as foreign direct investment.

• Reasons for Globalization of investment :• There has been a rapid increase in the volume of global trade.

• Many countries are providing more congenial environment for attracting direct investment.

• Global co in order to have the control over manufacturing and marketing activities invest in foreign countries.

• International co go for FDI in order to avoid the restrictions imposed by the host country on exports.

• After liberalization, the flow of foreign fund cross the border by various countries.

Modes of Globalization of Modes of Globalization of Investment Investment

• Acquisition of foreign companies

• Joint ventures

• Long term loans

• Issuing equity shares, debentures and bonds.

• Global depositary receipts etc.

Globalization of Technology• Technological change is amazing and phenomenal after

1950. Infact it is like a revolution in case of telecommunication, information technology and transportation technology.

• Methods of Globalization technologyMethods of Globalization technology:• Companies with latest technology acquire distinctive

competencies and gain the advantage of producing high quality products at low cost

• Co may have technological collaboration with the foreign co through which technology spreads from one to another country.

• The foreign co allow the companies of various other countries to adopt their technology on royalty payment basis.

• Companies also globalize the technology through the modes of joint ventures and mergers.

Advantages of Globalization• Free flow of capital• Free flow of technology• Increase in industrialization• Spread up of production facilities throughout the globe• Balanced development of world economies.• Increase in production and consumption• Lower prices with high quality• Cultural exchange and demand for a variety of products.• Increase in employment and income• Higher standard of living• Balanced human development• Increase in welfare and prosperity.

Disadvantages of Globalization• It kills domestic business• Exploits human resources• Violation of labor and environmental laws• Leads to unemployment • Decline in domestic demand• Decline in income• Widening the Gap between rich and poor• Transfer of natural resources• Leads to commercial and political colonialism• National sovereignty at stake

STAGES IN GLOBALISATION• Domestic company links with dealer & distributor.• Company does the activities on its own. Company

begins to carryout its own manufacturing , marketing & sales in the foreign markets.

• Company starts full fledged operations including business systems and R&D. At this stage the managers are expected to perform the tasks which they were doing in domestic markets to replicate them in foreign markets.

Globalization and India• Most of the global economies have chosen to

turn their economic systems towards the market economy and global economy.

• India had observed these changes in the global economies and respond favorably to these changes in 1991.

• New Economic Policy of 1991New Economic Policy of 1991: The new economic policy resulted in radical

change in the structure and direction of Indian economy. The direction tends towards the market economy and globalization of the country.

Objective of new economic policyThe objectives of liberalization and globalization of Indian economy are:• To obtain higher economic growth

• To reduce the annual rate of inflation

• To relieve the critical balance of payment and rebuild foreign exchange reserves.

• Government of India took drastic policy decisions in order to achieve these objectives.

• IMF and IBRD initiated the process of globalization in India with the following three components:

a. Cutting down the fiscal deficits and the growth rate of money supply to achieve economic stabilization.

b. Liberalization the domestic economy by releasing the restrictions on production, investment, prices and by increasing the role of market economy, guiding and deciding resource allocation.

c. Relaxing the restrictions on external sector. These measures include: international flow of goods, services, technology and capital.

Measures towards Globalization• Replacement of FERA with FEMA• Permitting Indian companies to collaborate with foreign companies in the

form of joint venture.• Establishment of joint venture by Indian companies in various foreign

countries.• World bank advocated import liberalization. Govt. of India reduced the

import tariffs to 15%.• Replacing license of imports with tariffs.• Elimination of various import duties and reduction of other import duties

drastically.• Lifting the quantitative restrictions on 715 goods with effect from April 1st

2001. In order to enhance the efficiency, quantity, product design, delivery and thus reduces the prices.

• Removal of export subsidies• Replacing licensing of export with duties• Levy low tax on export income.• Liberalize the inflow of FDI• Reformulating EPZ and export oriented unity policy.• Allowing FIIs to invest in Indian capital market

• Indian mutual funds are allowed to invest in foreign countries.

• Devaluing the rupee by lifting exchange controlling a phased manner.

• Allowing the rupee to determine its own exchange rate in international market without official intervention.

• Full convertibility of the rupee on current account in view of the Asian crisis.

• Acting cautiously regarding convertibility of rupee on capital account.

• Decanalise oil and agricultural trade• Counter anti dumping measures• Resolve market access issues in services.• Seek membership in trade block.

Approaches to international Business

The various approaches to international business are:• Ethnocentric ApproachEthnocentric Approach:• a company operating its business activities in domestic market may

enter into the foreign market without any change in its marketing strategies.

• The excessive production more than the demand for product may compel the co to sell the product in the foreign market.

• The domestic co continues export to the foreign country and views the foreign market as an extension to the domestic market just like a new region.

• The top mgt of the company makes the decision relating to export and the marketing personnel of the company monitor the export operations with the help of export department. Such approach of international business is called ethnocentric approach.

Polycentric Approach• Refers to the different approaches of marketing in

different countries. When a company has entered into the foreign market and feels that its ethnocentric approach is not effective to influence the consumers of the other countries, then it is essential to make required changes in the marketing mix. Instead of depending on centralized policies, the company establishes a subsidiary unit in the foreign country and decentralize all the operations and delegates decision making authority to its executives. The parent co appoints the required staff in the foreign subsidiary. The co appoint key personnel from the host country and other staff from the host country. The staff members in consultation with the MD takes necessary marketing decisions according to the market requirement of the host country.

Regiocentric Approach• A co managing its business at international level

has successfully established in a foreign country while it is using polycentric approach and feels that regional environment of the neighbouring countries is much similar to that of the host country, the co may start exporting product to the neighbour countries. This approach is known as the regiocentric approach.

• As for example a Japan based co has successfully established in India. This practice will certainly be considered as the regiocentric approach though the co market more or less the same product, designed under the polycentric approach, in other countries of the region, the marketing strategies may be different for the neighbouring countries.

Geocentric Approach• A co using the geocentric approach

considers the whole world as a single country. The employees are selected in different countries. The headquarter co-ordinates the activities of each subsidiary which function like an independent and autonomous co in carrying out managerial practices like strategy formulation, product design HR policy formulation etc.

FDI• The investment made by a Co in new manufacturing and

or marketing facilities in a foreign country is referred to as FDI. Investment made by Enron in power plant in India is an example of FDI.

• The total investment made by company in foreign country up to given time is called “ The stock of foreign direct investment”

• US government statistics defines FDI as “ ownership or control of 10% or more of an enterprise’s voting securities or the equivalent interest in an unincorporated US business”

• Generally it is stipulated that ownership of a minimum of 10- 25% of the voting share in a foreign co allows the investment to be considered direct.

Forms of FDI• Purchase of existing assets in a foreign

country.• New investment in property• Participation in joint venture with a local

partner.• Transfer of many assets like human

resource, system, technology• Exports of goods for equity

Factors influencing FDI• Supply factorsSupply factors: production cost• Logistics• Resource availability• Access to technology• Demand factor: customer access• Marketing advantages• Exploitation of competitive advantages• Customer mobility• Political factor : avoidance of trade barriers• Economic development incentives

Reasons for FDI • To increase sales and profits( Toyota, Suzuki in

US• To enter fast growing markets (IBM in Japanese

laptop market 40%) • To reduce costs (US firms in India)• To consolidate trade blocs (to access wider

market)• To protect domestic market • To protect foreign market (British petroleum in

USA) • To acquire technological and managerial know

how. ( US co Kodak invested in Japan to acquire technology)

Benefits of FDI• Benefits to Home Country:Benefits to Home Country: inflow of foreign inflow of foreign

currencies in the form of dividend interest. currencies in the form of dividend interest. Nissan’s profit repatriated to Japan are from FDI Nissan’s profit repatriated to Japan are from FDI in the UK. It helped Japan for positive BOP.in the UK. It helped Japan for positive BOP.

• FDI increases export of machinery, equipments, FDI increases export of machinery, equipments, technology from the home country to the host technology from the home country to the host country. This enhances the industrial activity of country. This enhances the industrial activity of home country.home country.

• The increased industrial activity in the home The increased industrial activity in the home country enhances employment opportunities.country enhances employment opportunities.

• The firm and other home country firms can learn The firm and other home country firms can learn skills from its exposure to the host country and skills from its exposure to the host country and transfer those skills to the industry in the home transfer those skills to the industry in the home country.country.

Costs to Home Country • Home country’s industry and employment

position are at stake when the firms enter foreign market due to low cost labor. The US textiles moved to central America. This resulted in retrenchment in the USA.

• Current account position of the home country suffers as FDI is a substitute for direct exports.

Benefits to host country• Resource transfer effects• Employment effect• Balance of payment effect

• Costs to Host country: intensifying competition• Negative effect on balance of payment:• Co may repatriate their dividend to home

country.• Imports the goods from its subsidiary• National sovereignty and autonomy

India’s measures towards FDI• Granting of automatic permission for foreign equity participation up to 51%

in high technology and high investment priority industries.

• Allowing foreign equity participation up to 51% in international trading co, hotel industry and tourist industry.

• Constitution of a specialized empowered board in order to attract FDI by negotiating with multinational co.

• Dispersing with the bureaucratic rules and regulation which caused delays and created hurdles for the FDI

• Allowing the MNCs to use trade marks in India with effect from May14,1992.

• Allowing 100% foreign equity for setting up of power plants with free repatriation of profits.

• Allowing 100% equity contribution by the NRI and the corporate bodies owned by NRI in high priority industries

• The holding non banking financial co can hold foreign equity up to100%

• Foreign investors are allowed to establish 100% operating subsidiaries and should bring at least US $ 50 million for this purpose.

• Private sector firm can have FDI up to 49% in automatic route subject to conformity to RBI guidelines.

• 100% FDI is permitted in B2B ecommerce power sector and oil refining.

• Manufacturing activities in all special economic zones can have 100% automatic route except few.

• 74% FDI is allowed subject to licensing and security norms in internet service providers and 74% in other telecommunication projects.

• Off shore venture capital fund can use automatic route subject to SEBI regulations.

• Insurance co can have FDI upto 26% subject to IRDA Regulations.• 1oo% FDI in airports courier services hotels and tourism drugs and

pharmaceutical

Theories of International Trade• Mercantilism is the oldest international trade theory that

formed the foundation of economic thought during about 1500 to 1800.

• According to this theory the holding of a country’s treasure primarily in the form of gold constituted its wealth. The theory specifies that countries should export more than they import and receive the value of trade surplus in the form of gold from those countries which experience trade deficit.

• GOVT. imposed restriction on imports and encouraged exports in order to prevent trade deficit and experience trade surplus.

• Colonial powers like the British used to trade with their colonies like India, Srilanka etc. by importing the raw material from and exporting the finished goods to colonies.

• The colonies had to export less valued goods and import more valued goods. Thus colonies were prevented from manufacturing.

• This practice allowed the colonial power to enjoy trade surplus and forced the colonies to experience deficit.

• The mercantilism theory suggests for maintaining favorable balance of trade in the form of import of gold for export of goods and services. But the decay of gold standard reduced the validity of theory. Consequently this theory was modified in neo mercantilism.

• Neo mercantilism proposes that countries attempt to produce more than the demand in the domestic market in order to achieve a social objective like full employment in the domestic country or a potential objective like assisting a friendly country.

• The theory was criticized on the ground that the wealth of nation is based on its available goods and services rather than gold.

• Adam smith developed the theory of absolute cost advantage which says that different countries can get the advantage of international trade by producing certain goods more efficiently than others .

Absolute Cost Advantage Theory• Adam smith, the Scottish economist viewed free trade

enables to country to produce a variety of goods and services. Smith proposes the theory of absolute cost advantage theory of international trade based on the principle of division of labor.

• According to theory the principle of absolute cost advantage will help the countries to specialize in the production of those goods in which they have cost advantage over others.

• According to theory every country should specialize in producing those products at the cost less than that of other countries.

• Trade between two countries takes place when one country produces one product at less cost than that of another country and having a cost advantage and vice versa.

Skilled advantage and specialization advantage

• Countries have absolute cost advantage due to:• Economies of scale• Suitability of the skill of the labor of the country

in producing certain products.• Specialization of labor in producing certain

products leads to higher productivity and less labor cost per unit of output.

• Natural Advantage natural advantage is due to climatic conditions and natural resources.

• Acquired Advantage acquired advantage is due to technology and skill development.

Assumption of the theory• Trade is between two countries only

• Only two commodities are traded

• Free trade exists between the countries

• The only element cost of production is labor

Explanation of theory

Output per labor for 1 day

Japan India

pens 20 60Tape recorder 6 2

• In the table given below two countries India and Japan are two countries having advantage in producing the pens and tape recorder.

• Ability of labor to produce different goods and services in a day is known as production possibility.

• In Japan one day of labor can produce 20 pens or 6 audio recorder.

• In India one day of labor can produce either 60 pens or 2 tape recorders.

• Japan has an absolute advantage in the production of audio tape recorder and India’s advantage is in pens.

• Assume that India and Japan are able to trade with one another, then both will get the advantage. Suppose Japan agrees to exchange 4 audio tapes for 40 pens.

• Two days of Japanese labor is needed to produce 40 pens and only 0.67 days of labor for 4 recorder. Thus Japan can save 1.33 days of labor(2 - 0.66) if it export tape recorders to India and imports pens from India

• India needs 2 days of labor to produce 4 audio tape recorders and 0.67 days of labor is enough to produce 40 pens. India can save 1.33 days of labor (2 – 0.67) by exporting pens to Japan and importing recorders

• Thus two countries can save labor by trading with each other rather than by producing both the products. The saved labor hours can be used for the production of more audio recorder by Japan and pens by India.

• Japan can consume more pens by allocating its labor to produce tape recorders and by trading with India and vice versa in case of India.

If countries produce both the products

0

5

10

15

20

25

30

Japan 3 10

India 1 30

tape recor pens

Production possibility of countries

0

10

20

30

40

50

60

japan 6 20

india 2 60

tape record. pens

Implications of theory• By trading two countries can have more

quantities of both the products.• Living standard of the people of both the

countries can be increased by trading between the countries.

• Inefficiency in producing certain countries can be avoided.

• Global efficiency and effectiveness can be increased by trading.

• Global labor productivity and other resources productivity can be maximized.

Criticism of the theory• No absolute advantage

• Country size

• Variety of resources

• Transport cost • Scale economies

• Absolute advantage for many products

Comparative Cost Theory• The comparative cost theory was first systematically

formulated by the English economist David Ricardo in the principle of political economy and taxation in 1817. it was later refined by J.S.Mill, Marshall, Taussig and others.

• In a Nutshell the doctrine of comparative cost maintains that if trade if left free, each country in the long run tends to specialize in the production and export of those commodities in whose production it enjoys a comparative advantage in terms of real cost and to obtain by import those commodities which could be produced at home at a comparative disadvantage in terms of real cost and that such specialization is to the mutual advantage of the countries participating in it.

Assumptions• Labor is only element of cost of production.• Goods are exchanged against one another

according to the relative amount of labor embodied in them.

• Labor is perfectly mobile within the country not outside.

• Labor is homogeneous • Production is subject to the law of constant return.• Free trade and no trade barriers.• No transportation cost• There is full employment• There is perfect competition• There are only two commodities and two countries.

Explanation• The law of comparative advantage indicates that

a commodity should specialize in the production of those goods in which it is more efficient and leave the production of the other commodity to the other country. The two countries will then have more of both goods by engaging in trade.

• Ricardo in his two country two commodity model has taken the hypothetical example of production costs of cloth and wine in England and Portugal to illustrate the comparative cost theory.

Country No of units of labor per unit of cloth

No of unit of labor per unit of wine

Exchange ratio

England 100 120 1 wine = 1.2 cloth

Portugal 90 80 1 wine = .88 cloth

• From the above example it is evident that Portugal has an absolute superiority of production. However a comparison of the ratio of the cost of wine production ( 80/120 ) with ratio of the cost of cloth production (90/100) in both the countries reveals that Portugal has an advantage superiority in both the branches of production. It will concentrate on the production of wine in which it has comparative advantage over England, while importing cloth from England which has a comparative advantage in cloth production. England will gain by specialization in producing cloth and selling it to Portugal in exchange for wine.

• In the event of trade taking place under the assumption that within each country labor is perfectly mobile between various industries, Portugal will gain if it can get anything more than .88 units of cloth in exchange for one unit of wine and England will gain if it has to part with less than 1.2 units of cloth against one unit of wine. Hence any exchange ratio between 0.88 units and 1.2 units of cloth against one unit of wine represents a gain for both the countries. The actual rate of exchange will be determined by reciprocal demand

• Thus according to the comparative cost theory free and unrestricted trade among countries encourage specialization on a large scale. It thereby tends to bring about:

• The most efficient allocation of world resources as well as maximization of world production.

• A redistribution of relative product demands resulting in greater equality of product prices among trading nations and

• A redistribution of relative resource demands to correspond with relative product demands, resulting in relatively greater equality of resource prices among trading nations.

Implications of the theory• Efficient allocation of global resources• Maximization of global production at the least

possible cost• Product prices become more or less equal

among world market• Demand for resources and products among

world nations will be maximized• It is better for the countries to specialize in those

products which they relatively do best and export them

• It is better for the countries to buy other goods from other countries who are relatively better at producing them

• Comparative cost theory is really an improvement over absolute cost advantage. This theory is not only an extension to the principle of division of labor and specialization but applies the opportunity cost concept. It is also argued that lower labor cost need not be a source of comparative advantage.

• However Ricardo fails to consider the money value of cost of production.

• F.W.Taussig bridged this gap in comparative cost advantage theory.

Criticism of theory• Two countries• Transportation cost• Two products• Full employment• Economic efficiency• Division of gains• Mobility servies

Product life cycle theory• Raymond Vermon of the Harvard Business

school developed the Product Life cycle theory. International product life cycle theory traces the roles of innovation market expansion comparative advantage and strategic response of global rivals in international manufacturing trade and investment decision.

• International product life cycle consists of four stages:

• New product innovation• Growth • Maturing stage• decline

Basis Introduction Growth Maturity Decline

Product location

In innovating (usually industrial country

In innovating and other industrial countries

Multiple countries

Mainly in LDCs

Market Location

In country with some exports

Industrial country

Shift in export markets as foreign production replaces export in some countries

Growth in LDCs

Some decrease in industrial countries

Mainly in LDCs

Some LDCs exports

Competitive factor

Near monopoly situation

Fast growing demand

Overall stabilized

Overall declining demand

Sale based on uniqueness rather than price

Evolving product characteristics

No of competitors increases

Price cutting by competitorsProduct become more standardized

No of competitors decreases

Price is very important

Price is key weaponNo of producers continues to decline

Production technology

Short production run

Evolving methods to coincide with product evolution

High labor and labor skill relative to capital input

Capital input increases

Methods more standardized

Long production runs using high capital inputs

Highly standardized

Less skilled labor needed

Unskilled labor on mechanized long production runs

Explanation • Introduction stage: firms innovate new

products based on needs and problems in domestic country.

• Growth: attracting competitors• Increased competitor• Further innovation• Shift manufacturing to foreign countries

• Maturity : standard product• Large scale production and economies• Low unit cost of production• Shift manufacturing to developing countries

• Decline: location of manufacturing facilities in developing countries

• Original innovating country becomes net importer.

• Limitations of Theory : • Production facilities do not move to foreign

countries to achieve cost reduction due to short product life cycle consequent upon very rapid innovation.

• Cost reduction has a little concern to the consumer in case of luxury products.

• Export may not be in significant volume where cost of transportation is very low.

• Non cost strategies like advertising may nullify the opportunity to move to foreign countries for cost minimization.

• Requirement of specialized knowledge and expertise reduce the chances of locating production facilities in foreign countries.

• The rapid development may not shift the production to various foreign countries.

Global Strategic Rivalry Theory• International trade takes place

between/among companies based on relative competitive advantage but not countries competitive advantage.

• Companies acquire and develop competitive advantage through a number of means:

• Owing intellectual property rights• Investing in research and development• Achieving large scale economies• Exploiting the experience curve.

Porter’s National Competitive Advantage Theory

• Companies get competitive advantage or superiority from:

• Demand conditions• Factor endowment • Related and support industries• Firm strategy, structure and rivalry