Professional Documents
Culture Documents
INTERNATIONAL BUSINESS
THEORIES OF INTERNATIONAL TRADE
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Table of Contents
Sl No
Contents
Page No.
1.
Mercantilism
1, 2, 3, 4
2.
5, 6
3.
7, 8, 9, 10
4.
5.
Porter Diamond
6.
Conclusion
21
7.
Reference
22
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Mercantilism
Definition of 'Mercantilism':
The main economic system used during the sixteenth to eighteenth centuries. The main goal was to
increase a nation's wealth by imposing government regulation concerning all of the nation's commercial
interests. It was believed that national strength could be maximized by limiting imports via tariffs and
maximizing exports.
History
Some economic historians (like Peter Temin) argue that the economy of the Early Roman Empire was
a market economy and one of the most advanced agricultural economies to have existed (in terms of
productivity, urbanization and development of capital markets), comparable to the most advanced
economies of the world before the Industrial Revolution, namely the economies of 18th century England
and 17th century Netherlands. There were markets for every type of good, for land, for cargo ships;
there was even an insurance market.
Many European economists between 1500 and 1750 are today generally considered mercantilists;
however, these economists did not see themselves as contributing to a single economic ideology. The
bulk of what is commonly called "mercantilist literature" appeared in the 1620s in Great Britain. Adam
Smith, who was critical of the idea, was the first person to organize formally most of the contributions
of mercantilists into what he called "the mercantile system" in his 1776 book The Wealth of Nations.
Beyond England, Italy, France, and Spain had noted writers who had mercantilist themes in their work,
indeed the earliest examples of mercantilism are from outside of England: in Italy, Giovanni Botero
(1544-1617) and Antonio Serra (1580-?), in France, Colbert and some other precursors to the
physiocrats, in Spain, the School of Salamanca writers Francisco de Vitoria (1480 or 1483 1546),
Domingo de Soto (1494-1560), Martin de Azpilcueta (1491 - 1586), and Luis de Molina (1535-1600).
Widespread Definition
Mercantilism is an economic theory that the prosperity of a nation depends upon its capital, and that the
volume of the world economy and international trade is unchangeable. Government economic policy
based on these ideas is also sometimes called mercantilism,
Economic assets, or capital, are represented by bullion (gold, silver, and trade value) held by the state,
which is best increased through a positive balance of trade with other nations (exports minus imports).
Mercantilism suggests that the ruling government should advance these goals by playing a protectionist
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role in the economy, by encouraging exports and discouraging imports, especially through the use of
tariffs.
Features
Mercantilism is the economic doctrine that government control of foreign trade is of paramount
importance for ensuring the military security of the country. In particular, it demands a positive balance
of trade.
High tariffs, especially on manufactured goods, are an almost universal feature of mercantilist policy.
Other policies have included:
Building a network of overseas colonies;
Forbidding colonies to trade with other nations;
Monopolizing markets with staple ports;
Banning the export of gold and silver, even for payments;
Forbidding trade to be carried in foreign ships;
Export subsidies;
Promoting manufacturing with research or direct subsidies;
Limiting wages;
Maximizing the use of domestic resources;
Restricting domestic consumption with non-tariff barriers to trade.
Principles
Mercantilism contained many interlocking principles some of them as follows:
1. Precious metals, such as gold and silver, were deemed indispensable to a nations wealth. If a nation
did not possess mines or have access to them, precious metals should be obtained by trade. It was
believed that trade balances must be favorable, meaning an excess of exports over imports. Colonial
possessions should serve as markets for exports and as suppliers of raw materials to the mother country.
Manufacturing was forbidden in colonies, and all commerce between colony and mother country was
held to be a monopoly of the mother country.
2. A strong nation, according to the theory, was to have a large population, for a large population would
provide a supply of labor, a market, and soldiers. Human wants were to be minimized, especially for
imported luxury goods, for they drained off precious foreign exchange. Sumptuary laws (affecting food
and drugs) were to be passed to make sure that wants were held low.
Influence
Mercantilism as a whole cannot be considered a unified theory of economics because mercantilism has
traditionally been driven more by the political and commercial interests of the State and security
concerns than by abstract ideas. There were no mercantilist writers presenting an overarching scheme
for the ideal economy, as Adam Smith would later do for classical (laissez-faire) economics. Some
scholars thus reject the idea of mercantilism completely, arguing that it gives "a false unity to disparate
events". Mercantilists viewed the economic system as a zero-sum game, in which any gain by one party
required a loss by another. Thus, any system of policies that benefited one group would by definition
harm the other, and there was no possibility of economics being used to maximize the "commonwealth",
or common good.
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Mercantilist domestic policy was more fragmented than its trade policy. The early modern era was one
of letters patent and government-imposed monopolies; some mercantilists supported these, but others
acknowledged the corruption and inefficiency of such systems. Many mercantilists also realized that
the inevitable results of quotas and price ceilings were black markets. One notion mercantilists widely
agreed upon was the need for economic oppression of the working population; laborers and farmers
were to live at the "margins of subsistence". The goal was to maximize production, with no concern for
consumption. Extra money, free time, or education for the "lower classes" was seen to inevitably lead
to vice and laziness, and would result in harm to the economy.
Mercantilism developed at a time when the European economy was in transition. Isolated feudal estates
were being replaced by centralized nation-states as the focus of power. Technological changes in
shipping and the growth of urban centers led to a rapid increase in international trade. Mercantilism
focused on how this trade could best aid the states. Another important change was the introduction of
double-entry bookkeeping and modern accounting.
Prior to mercantilism, the most important economic work done in Europe was by the medieval
scholastic theorists. They focused mainly on microeconomics and local exchanges between individuals.
This period saw the adoption of Niccol Machiavelli's realpolitik and the primacy of the raison d'tat
in international relations. The mercantilist idea that all trade was a zero sum game, in which each side
was trying to best the other in a ruthless competition, was integrated into the works of Thomas Hobbes.
Note that non-zero sum games such as prisoner's dilemma can also be consistent with a mercantilist
view. In prisoner's dilemma, players are rewarded for defecting against their opponents. More modern
views of economic co-operation amidst ruthless competition can be seen in the folk theorem of game
theory.
Criticisms
Adam Smith and David Hume are considered to be the founding fathers of anti-mercantilist thought. A
number of scholars found important flaws with mercantilism long before Adam Smith developed an
ideology that could fully replace it. Critics like Dudley North, John Locke, and David Hume
undermined much of mercantilism.
Failure to understand other theory: Mercantilists failed to understand the notions of absolute advantage
and comparative advantage (although this idea was only fully fleshed out in 1817 by David Ricardo)
and the benefits of trade. In modern economic theory, trade is not a zero-sum game of cutthroat
competition, because both sides can benefit (rather, it is an iterated prisoner's dilemma). By imposing
mercantilist import restrictions and tariffs instead, both nations ended up poorer.
Impossibility to maintain trade balance: David Hume famously noted the impossibility of the
mercantilists' goal of a constant positive balance of trade. As bullion flowed into one country, the supply
would increase and the value of bullion in that state would steadily decline relative to other goods.
Eventually it would no longer be cost-effective to export goods from the high-price country to the lowprice country, and the balance of trade would reverse itself. Mercantilists fundamentally misunderstood
this, long arguing that an increase in the money supply simply meant that everyone gets richer.
Importance on bullion: The importance placed on bullion was also a central target, even if many
mercantilists had themselves begun to de-emphasize the importance of gold and silver. Adam Smith
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noted that at the core of the mercantile system was the "popular folly of confusing wealth with money,"
bullion was just the same as any other commodity, and there was no reason to give it special treatment.
Rent seeking critique: The critique that mercantilism was a form of rent-seeking has also seen criticism,
as scholars such Jacob Viner in the 1930s point out that merchant mercantilists such as Mun understood
that they would not gain by higher prices for English wares abroad.
Inheritance
In the English-speaking world, Adam Smith's utter repudiation of mercantilism was accepted,
eventually, as public policy in the British Empire and in the United States. Initially it was rejected in
the United States by such prominent figures as Alexander Hamilton, Henry Clay, Henry Charles Carey,
and Abraham Lincoln and in Britain by such figures as Thomas Malthus.
In the 20th century, most economists on both sides of the Atlantic have come to accept that in some
areas mercantilism had been correct. Most prominently, the economist John Maynard Keynes explicitly
supported some of the tenets of mercantilism. Adam Smith had rejected focusing on the money supply,
arguing that goods, population, and institutions were the real causes of prosperity. These views later
became the basis of monetarism, whose proponents actually reject much of Keynesian monetary theory,
and has developed as one of the most important modern schools of economics.
Adam Smith rejected the mercantilist focus on production, arguing that consumption was the only way
to grow an economy. Keynes argued that encouraging production was just as important as consumption.
In an era before paper money, an increase for bullion was one of the few ways to increase the money
supply. Keynes and other economists of the period also realized that the balance of payments is an
important concern, and since the 1930s, all nations have closely monitored the inflow and outflow of
capital, and most economists agree that a favorable balance of trade is desirable. Keynes also adopted
the essential idea of mercantilism that government intervention in the economy is a necessity. Today
the word remains a pejorative term, often used to attack various forms of protectionism. The similarities
between Keynesianism, and its successor ideas, with mercantilism have sometimes led critics to call
them neo-mercantilism.
One area Smith was reversed on well before Keynes was that of the use of data. Mercantilists, who were
generally merchants or government officials, gathered vast amounts of trade data and used it
considerably in their research and writing. William Petty, a strong mercantilist, is generally credited
with being the first to use empirical analysis to study the economy.
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In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm,
or country) to produce more of a good or service than competitors, using the same amount of resources.
Adam Smith first described the principle of absolute advantage in the context of international trade,
using labor as the only input.
Condition:
The theory that trade occurs when one country, individual, company, or region is absolutely more
productive than another entity in the production of a good. A person, company or country has an
absolute advantage if its output per unit of input of all goods and services produced is higher than that
of another entity producing that good or service.
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Example
The principle was described by Adam Smith in the context of international trade. Now I am describing
some of them below
A country has an absolute advantage over another in producing a good, if it can produce that
good using fewer resources than another country. For example if one unit of labor in India can
produce 80 units of wool or 20 units of wine; while in Spain one unit of labor makes 50 units
of wool or 75 units of wine, then India has an absolute advantage in producing wool and Spain
has an absolute advantage in producing wine. India can get more wine with its labor by
specializing in wool and trading the wool for Spanish wine, while Spain can benefit by trading
wine for wool. (Adam Smith, Wealth of Nations, Book IV, Ch.2.) The benefits to nations from
trading are the same as to individuals: trade permits specialization, which allows resources to
be used more productively
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1. Ricardo's Assumptions:Ricardo explains his theory with the help of following assumptions:1. There are two countries and two commodities.
2. There is a perfect competition both in commodity and factor market.
3. Cost of production is expressed in terms of labor i.e. value of a commodity is measured in
terms of labor hours/days required to produce it. Commodities are also exchanged on the
basis of labor content of each good.
4. Labor is the only factor of production other than natural resources.
5. Labor is homogeneous i.e. identical in efficiency, in a particular country.
6. Labor is perfectly mobile within a country but perfectly immobile between countries.
7. There is free trade i.e. the movement of goods between countries is not hindered by any
restrictions.
8. Production is subject to constant returns to scale.
9. There is no technological change.
10. Trade between two countries takes place on barter system.
11. Full employment exists in both countries.
12. Perfect occupational mobility of factors of production - resources used in one industry can
be switched into another without any loss of efficiency
13. Perfect occupational mobility of factors of production - resources used in one industry can
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14.
15.
16.
17.
2. Ricardo's Example:On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by taking
an example of England and Portugal as two countries & Wine and Cloth as two commodities.
As pointed out in the assumptions, the cost is measured in terms of labor hour. The principle of
comparative advantage expressed in labor hours by the following table.
Portugal requires less hours of labor for both wine and cloth. One unit of wine in Portugal is produced
with the help of 80 labor hours as above 120 labor hours required in England. In the case of cloth too,
Portugal requires less labor hours than England. From this it could be argued that there is no need for
trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that
Portugal stands to gain by specializing in the commodity in which it has a greater comparative
advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.
Considerations
Development economics
The theory of comparative advantage, and the corollary that nations should specialize, is criticized on
pragmatic grounds within the import substitution industrialization theory of development economics,
on empirical grounds by the SingerPrebisch thesis which states that terms of trade between primary
producers and manufactured goods deteriorate over time, and on theoretical grounds of infant industry
and Keynesian economics. In older economic terms, comparative advantage has been opposed by
mercantilism and economic nationalism.
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Criticism
Applicability
Economist Ha-Joon Chang criticized the comparative advantage principle, contending that it may have
helped developed countries maintain relatively advanced technology and industry compared to
developing countries. In his book Kicking Away the Ladder, Chang argued that all major developed
countries, including the United States and United Kingdom, used interventionist, protectionist economic
policies in order to get rich and then tried to forbid other countries from doing the same.
CD Players
2,000
4,000
6,000
Personal Computers
500
2,000
2,500
To identify which country should specialize in a particular product we need to analyses the internal
opportunity cost for each country. For example, were the UK to shift more resources into higher
output of personal computers, the opportunity cost of each extra PC is four CD players. For Japan the
same decision has an opportunity cost of two CD players. Therefore, Japan has a comparative
advantage in PCs.
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The quantity and quality of factors of production available: If an economy can improve the
quality of its labor force and increase the stock of capital available it can expand the productive
potential in industries in which it has an advantage.
Investment in research & development (important in industries where patents give some
firms significant market advantage .An appreciation of the exchange rate can cause exports
from a country to increase in price. This makes them less competitive in international markets.
Long-term rates of inflation compared to other countries. For example if average inflation in
Country X is 4% whilst in Country B it is 8% over a number of years, the goods and services
produced by Country X will become relatively more expensive over time. This worsens their
competitiveness and causes a switch in comparative advantage.
Import controls such as tariffs and quotas that can be used to create an artificial comparative
advantage for a country's domestic producers- although most countries agree to abide by
international trade agreements.
Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales
support)
Importance:
The good in which a comparative advantage is held is the good that the country produces most
efficiently. Therefore, if given a choice between producing two goods (or services), a country will make
the most efficient use of its resources by producing the good with the lowest opportunity cost, the good
for which it holds the comparative advantage. The country can trade with other countries to get the
goods it did not produce.
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Definition:
HeckscherOhlin theorem is one of the four critical theorems of the HeckscherOhlin model. It states
that a country will export goods that use its abundant factors intensively, and import goods that use its
scarce factors intensively. In the two-factor case, it states: "A capital-abundant country will export the
capital-intensive good, while the labor-abundant country will export the labor-intensive good."
The critical assumption of the HeckscherOhlin model is that the two countries are identical, except for
the difference in resource endowments.
Initially, when the countries are not trading:
The price of capital-intensive good in capital-abundant country will be bid down relative to
the price of the good in the other country,
The price of labor-intensive good in labor-abundant country will be bid down relative to the
price of the good in the other country.
Extensions
The model has been extended since the 1930s by many economist.Notable contributions came from
Paul Samuelson, Ronald Jones, and Jaroslav Vanek, so that variations of the model are sometimes called
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The original, 2x2x2 model was derived with restrictive assumptions. These assumptions
and developments are listed here.
Both countries have identical production technology
This assumption means that producing the same output of either commodity could be done with the
same level of capital and labor in either country. Another way of saying this is that the per-capita
productivity is the same in both countries in the same technology with identical amounts of capital.
Countries have natural advantages in the production of various commodities in relation to one another,
so this is an 'unrealistic' simplification designed to highlight the effect of variable factors. Ohlin said
that the HO-model was a long run model, and that the conditions of industrial production are
"everywhere the same" in the long run.
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Capital as endowment
In the modern production system, machines and apparatuses play an important role. What is named
capital is nothing other than these machines and apparatuses, together with materials and intermediate
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products. Capital is the most important of factors, or one should say as important as labor. By the help
of machines and apparatuses quantity is not changed at once. But the capital is not an endowment given
by the nature. It is composed of goods manufactured in the production and often imported from foreign
countries. In this sense, capital is internationally mobile. The concept of capital as natural endowment
distorts the real role of capital.
Homogeneous capital
Capital goods take different forms. It may take the form of a machine-tool such as lathe, the form of a
transfer-machine, which you can see under the belt-conveyors. Despite these facts, capital in the
HechscherOhlin Model is assumed as homogeneous and transferable to any form if necessary. This
assumption is not only far from the reality, but also it includes logical flaw.
In the HeckscherOhlin model, the rate of profit is determined according to how abundant capital is.
Before the profit rate is determined, the amount of capital is not measured. This logical difficulty was
the subject of academic controversy which took place many years ago. In fact, this is sometimes named
Cambridge Capital Controversies. HeckscherOhlin theorists ignore all these stories without providing
any explanation how capital is measured theoretically.
No unemployment
Unemployment is the vital question in any trade conflict. HeckscherOhlin theory excludes
unemployment by the very formulation of the model, in which all factors (including labor) are employed
in the production.
Unrealistic Assumptions
Besides the usual assumptions of two countries, two commodities, no transport cost, etc. Ohlin's theory
also assumes no qualitative difference in factors of production, identical production function, constant
return to scale, etc. All these assumptions makes the theory unrealistic one.
Restrictive
Ohlin's theory is not free from constrains. His theory includes only two commodities, two countries and
two factors. Thus it is a restrictive one.
One-Sided Theory
According to Ohlin's theory, supply plays a significant role than demand in determining factor prices.
But if demand forces are more significant, a capital abundant country will export labor intensive good
as the price of capital will be high due to high demand for capital.
Static in Nature
Like Ricardian Theory the H-O Model is also static in nature. The theory is based on a given state of
economy and with a given production function and does not accept any change.
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Wijnholds's Criticism
According to Wijnholds, it is not the factor prices that determine the costs and commodity prices but it
is commodity prices that determine the factor prices.
Haberler's Criticism
According to Haberler, Ohlin's theory is based on partial equilibrium. It fails to give a complete,
comprehensive and general equilibrium analysis.
Leontief Paradox
American economist Dr. Wassily Leontief tested H-O theory under U.S.A conditions. He found out that
U.S.A exports labor intensive goods and imports capital intensive goods, but U.S.A being a capital
abundant country must export capital intensive goods and import labor intensive goods than to produce
them at home. This situation is called Leontief Paradox which negates H-O Theory.
Importance
The critical assumption of the HeckscherOhlin model is that the two countries are identical, except for
the difference in resource endowments. This also implies that the aggregate preferences are the same.
The relative abundance in capital will cause the capital-abundant country to produce the capitalintensive good cheaper than the labor-abundant country and vice versa.
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Porter Diamond
The diamond model is an economical model developed by Michael Porter in his book The Competitive
Advantage of Nations .He is recognized as an authority on company strategy and competition;
Diamond model
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Porter analysis
The approach looks at clusters, a number of small industries, where the competitiveness of one company
is related to the performance of other companies and other factors tied together in the value-added chain.
The Porter analysis was made in two steps. First, clusters of successful industries have been mapped in
10 important trading nations. In the second, the history of competition in particular industries is
examined to clarify the dynamic process by which competitive advantage was created.
The phenomena that are analyzed are classified into six broad factors incorporated into the Porter
diamond, which has become a key tool for the analysis of competitiveness:
The points of the diamond are described as follows
1. FACTORCONDITIONS
-A country creates its own important factors such as skilled resources and technological base.
-These factors are upgraded / deployed over time to meet the demand.
-Local disadvantages force innovations. New methods and hence comparative advantage.
2. DEMANDCONDITIONS
-A more demanding local market leads to national advantage.
-A strong trend setting local market helps local firms anticipate global trends.
6. CHANCE
- Events are occurrences that are outside of control of a firm.
- Important because they create discontinuities in which some gain competitive positions and
some lose.
The Porter thesis is that these factors interact with each other to create conditions where innovation
and improved competitiveness occurs.
shaped diagram as a basis of a framework to illustrate the determinants of national advantage. The
diamond represents the national playing field that the countries establish for their industries.
will remain a factor-driven economy which reflects an early stage of economic development. Since the
publication of Porter's work, however, Singapore has been more successful than Korea. This difference
in performance raises important questions regarding the validity of Porter's diamond model of a nation's
competitiveness.
Second, sustainability may require a geographic configuration spanning many countries, whereby
firm specific and location advantages present in several nations may complement each other. Porter's
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global firm is just an exporter and his methodology does not take into account the organizational
complexities of true global operations by multinational.
Conclusion
An international business theory must look at the distribution of gains from international business
activities between the firms involved and the Governments in each country and between (or among)
relevant Governments.' When Governments are satisfied with the gains generated by an international
business activity in open markets, they impose no barriers and, hence, no theory of international
business is necessary; firms will then undertake cross-national activities for reasons explained by noninternational theories, such as comparative advantage or internalization theory. When Governments
wish to redistribute the costs and benefits of international business activities, they impose policies which
firms must take into account in their decision-making-and this action/reaction environment is the
subject that IB theory must explain. Since there are no Governments that permit fully open markets, the
world of international business is one requiring differential explanation. IB theory needs to re-focus its
analysis on the relationships between international firms and Governments. Instead of competitive
strategy among firms, it should analyze bargaining strategy between firms and Governments.
Under these conditions, IB theory becomes an explanation of bilateral (and sometimes multilateral)
negotiation over appropriability as between INCs and Governments in a game of the distribution of
wealth and power. We are back to a consideration of the goals of mercantilism in the pursuit of relative
wealth and power among nations through the TNC/ INC. In a mercantilist world such as ours, we need
a mercantilist theory of international business.
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Reference
Books:
o
World Wide Web:
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http://www.valuebasedmanagement.net/methods_porter_diamond_model.html
http://pacific.commerce.ubc.ca/ruckman/competitiveadvofnations.htm