International Business

Theories of International Business

International business theories help managers and government policymakers focus on following questions such as What products should we import and export? How much should we trade? With whom we trade? Once countries make decisions, officials enact policies to achieve the desired results. These policies have an impact on business because they affect which countries can produce given products efficiently and whether countries will permit imports to compete against their own domestically produced goods and services. Moreover, some philosophers throughout their theories prescribe that government should influence trade patterns-promoting export and limiting import, while others such as Smith, Ricardo, and HeckscherOhlin promote unrestricted free tradelaissez-faire treatment of trade. Again, some new trade theories & Porters theory of national competitive advantage justify limited and selective government intervention to support the development of certain ex port oriented industries. The following theories are highly acclaimed internationally to run international business.

1. 2. 3. 4. 5.

Mercantilism Theory Theory of Absolute Advantage Theory of Comparative Advantage Hecksher-Ohlin Theory Porters Diamond Theory

All these theories have greatest impact on international business. These theories are discussed bellow critically.

International Business

Mercantilism Theory Origin: Mercantilism, the first theory of international trade, emerged in England in the mid16th century. Main Idea: The main tenet of Mercantilism was that it was a countrys best interests to maintain a trade surplus, to export more than it imports. The main assertion of mercantilism was that gold and silver were the roots of national wealth and the essential to dynamic commerce. At the same time, gold and silver were the currency of trade between countries. So, the common consequences according to this theory are: A country could earn gold and silver by exporting goods; & Importing goods from other countries would result in an outflow of gold and silver to those countries. Example: If England has a balance of trade surplus (if export is more than import) with France, England will earn gold and silver & importing goods from England would result in an outflow of gold and silver to France. So by following mercantilism doctrine, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige, and power. And, consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. Therefore, the mercantilist recommended policies to maximize exports by subsidizing and minimize imports by tariffs and quotas. Government Intervention: Govt. of some countries, to export more than they imported Imposed restrictions on most imports, Subsidized production of many products that could otherwise not compete in domestic or export markets Used their colonial possessions to support this trade objective Supplied many commodities that the colonizing country might otherwise have had to purchase from a non-associated country Balance of Trade: Some technology of the mercantilist era has endured. A favorable balance of trade indicates that a country is exporting more than it is importing. An unfavorable balance of trade indicates the opposite, which is known as a deficit. Many of these terms are misnomers. In fact, it is not necessarily beneficial to run a trade surplus nor is

International Business

it necessarily disadvantages to run a trade deficit. A country that is running a surplus, or a favorable balance of trade, is, for the time being, importing goods and services of less value than those it is exporting. In the mercantilist period, the difference was made up by a transfer of gold, but today it is made up by holding the deficit country's currency or investments denominated in that currency. In effect, the surplus country is granting credit to the deficit country. If that credit cannot eventually buy sufficient goods and services, the so-called favorable trade balance actually may turn out to be disadvantages for the country with the surplus. Criticism: The classical economist David Hume pointed out an inherent inconsistency in the doctrine in 1752. According to Hume, in long run no country could sustain a surplus on balance of trade and so accumulate gold and silver as the mercantilist had envisioned. For example if England has a balance of trade surplus with France, The resulting inflow of gold and silver will swell the domestic money supply and generate inflation and price of goods would increase in England; & The Frances money supply will contract and price of goods would decrease in France as it imports most. And due to the change in relative prices between France and England, it would encourage The French to buy fewer English goods because they were becoming more expensive;& The English to buy more French goods as they were becoming cheap Ultimately the result would be deterioration in the English balance of trade and improvement in Frenchs trade balance until the English surplus was eliminated. Conclusion: The flow with mercantilism was that it viewed trade as a zero-sum game - a gain by one country results in a loss by another. It was left to Adam Smith and David Ricardo to Show the shortsightedness of mercantilism approach and to demonstrate positive sum-game all countries can benefit. Unfortunately, the mercantilist doctrine is by no means dead. However, Neo-Mercantilism, more recently emerged another interventionist theory, equates political power with economic power & economic power with a balance of trade to simultaneously boost exports and limit imports.

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Theory of Absolute Advantage Origin: In his 1776 landmark book The Wealth of Nation, Adam Smith attacked the mercantilist's assumption that the country's wealth depends on its holdings of treasure. Rather, he said, the real wealth of the country consists of the goods and services available to its citizens. Main Idea: Smith developed the theory of Absolute Advantage, which holds that different countries produce some goods more efficiently than other countries; thus global efficiency can increase through free trade. Smith reasoned that if trade were unrestricted, each country would specialize in those products that give it a competitive advantage. Each country's resources would shift to the efficient industries because the country could not compete in the inefficient ones. Through specialization, countries could increase their efficiency because of the following reasons: Labour could more skilled by repeating the same tasks Labour would not lose time in switching from the production of one kind of product to another. Long production runs would provide incentives for the development of more effective working methods. A country could then use its excess specialized production to buy more imports than it could have otherwise produced. Adam Smith believed that a country's advantage would be either natural or acquired.

Natural Advantage

A country may have a natural advantage in producing a product

because of climatic conditions, access to certain natural resources, or availability of certain level forces. The country's climate may dictate, for example, which agricultural products it can produce efficiently. Most countries must import ores, metals, and fuels from other countries. No one country is large enough or sufficiently rich in natural resources to be independent of the rest of the world except for short periods.

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Variations among countries in natural advantages also helps explain in which countries certain manufactured or processed products might be best produced, particularly if by processing an agricultural commodity or natural resource prior to exporting, companies can reduce transportation costs.

Acquired Advantage

Most of the world's trade today is of services and manufactured

goods rather than agricultural goods are natural resources. Countries that produce manufactured goods and services competitively have an acquired advantage, usually in either product or process technology. An advantage of product technology is that it enables a country to produce a unique product or one that is easily distinguished from those of competitors. An advantage in process technology is the country's ability to produce a homogenous product (one not easily distinguished from that of competitors) efficiently. Countries that develop distinguished or less expensive products have adequate advantages, at least until producers in another country emulate them successfully.

How Does The Theory of Absolute Advantage Work? Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa. In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes. In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between.

International Business

Without trade Ghana would produce 10 tons of cocoa and 5 tons of rice. South Korea would produce 10 tons of rice and 2.5 tons of cocoa. With specialization and trade Ghana would produce 20 tons of cocoa. South Korea would produce 20 tons of rice. Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice. After trade Ghana would have 14 tons of cocoa left, and 6 tons of rice. South Korea would have 14 tons of rice left and 6 tons of cocoa. If each country specializes in the production of the good in which it has an absolute advantage and trades for the other, both countries gain