Chapter 6: Theories of International Trade and Investment

Why nations and firms trade and invest internationally

o To acquire and sustain comparative advantage and competitive
advantages
What is the underlying economic rationale for international business activity?
Why does trade take place?
What are the gains from trade and investment?

Theories of International Trade and Investment

Comparative advantage (country-specific advantage): superior features of a

country that provide unique benefits in global competition, typically derived
from either natural endowments or deliberate national policies
o Inherited resources (labour, climate, arable land, petroleum reserves)
o Resources acquired over time (entrepreneurial orientation, venture
capital, innovative capacity)
Competitive advantage (firm-specific advantage): distinctive assets or
competencies of a firm that are difficult for competitors to imitate and are
typically derived from specific knowledge, capabilities, skills, or superior
strategies
o Helps firms enter and succeed in foreign markets
o Some scholars are applying this to nations as well as firms

Why Do Nations Trade?

Trade allows countries to use their national resources more efficiently through
specialization
o Workers can become more productive and have access to cheaper
basic goods thus resulting in a higher standard of living
Classical Theories (6)
o Mercantilism: belief that national prosperity is the result of a positive
balance of trade, achieved by maximizing exports and minimizing
imports
Form early Euro nations (1500s) when gold was a method of
payment exports meant more gold, imports meant less gold
Nations power and strength increased as wealth (gold)
increased
Running a trade surplus is beneficial (neo-mercantilism)
View tends to harm firms that import, consumers
May invite beggar thy neighbor policies that promote benefitting
one country at the expense of the other
Free trade tends to be a superior approach as it is the free flow
of goods between nations (absence of restrictions); leads to:
More readily available products

Imported products are cheaper than domestic

Low cost imports = lower expenses (firms) = higher
profits
Low cost imports = lower expenses (consumers) = higher
living standards
Unrestricted trade increases overall prosperity of poor
countries
Absolute Advantage Principle: country benefits by producing only
those products in which it has absolute advantage or that it can
produce using fewer resources than another country
Allows nation to consume more than it would, and at a lower
cost
Firms employ factors of production (labour, capital) to
generate G/S
Mutually benefit
Does not cover that countries can benefit from trade even if it
lacks an absolute advantage
1776 Adam Smith
Comparative Advantage Principle: it can be beneficial for two
countries to trade without barriers as long as one is relatively more
efficient at producing goods or services needed by the other. What
matters is not the absolute cost of production but rather the efficiency
with which a country can produce the product
1817 David Ricardo
Considers opportunity cost
Traditionally focused on natural resources however, the
resources can be created or acquired as well
Limitations of Early Trade Theories
Theories provide a rationale for international trade but dont
account for factors making contemporary trade complex:
Traded products are not just commodities (theyre
branded/differentiated)
International transportation is costly
There are government restrictions/barriers
Large scale production can bring economies of scale
which can offset a weak national comparative advantage
Government can target and invest in certain industries to
boost competitive advantage
Services cannot be traded thus need to be
internationalized through FDI
Modern tech facilitates global trade in many services at a
low cost
Primary participants in international trade are individual
firms
Factor Proportions Theory (Factor Endowments): abundant
production factors give rise to national advantages

1920s Swedish economists Eli Heckscher and Bertil Ohlin

Two premises:
Products differ in types and quantities of factors (labour,
natural resources, capital) required for their production
Countries differ in type and quantity of production factors
they possess
Thus countries should export products that use relatively
abundant factors of production and import goods that use scarce
factors of production
Different from other theories because it includes efficiency and
quantity of factors of production
LEontif paradox is empirical evidence against factor proportions
theory
US has the most capital thus it should export capital
goods however it exports mainly labor-intensive goods
This brought about the idea that international trade is too
complex to be explained by one theory
Other factors (countrys knowledge, technology, and
capital) also explain why a country trades
International Product Life Cycle Theory: international trade
explained by evolutionary process that occurs in the development and
diffusion of products to markets around the world
IPLC has three stages:
Introduction
Maturity
Standardization

Introduction stage:
New product originates in an advanced economy
(abundant R+D and capital, consumers willing to try new
products that are expensive)
New product will enjoy a temporary monopoly in the
home country

Maturity:
Mass-produce and seek to export to other advanced
economies
Products manufacturing becomes more routine and
foreign firms produce alternatives; competition intensifies,
export order from lower-income countries
Standardization:
Knowledge about producing the product is widespread;
can be accomplished with cheap inputs and low-cost
labour
Production shifts to low-income countries
Eventually country that produced will import
Assumed that product diffusion occurs slowly to generate
temporary differences in countries access to new tech; this is no
longer true
o New Trade Theory: increasing returns to scale (ex: economies of
scale) are important for superior international performance in
industries that succeed best as their production volume increase
in small, domestic markets, cannot have economies of scale
because cant sell products at such a large volume these firms
should export to gain access to global markets
countries can specialize in a number of small industries
this way
Beginning in the 70s trade grew fastest among industrialized
countries with similar factors of production
In new industries there was no clear competitive advantage
Trade beneficial even for countries that produce only a limited
variety of products
Can Nations Enhance Their Competitive Advantage?
Globalization of markets has created a race among nations to reposition
themselves as attractive places in which to invest and do business
Most advanced nations today posses national competitive advantage,
maximized when numerous industries collectively possess firm-level
competitive advantage and the nation has comparative advantages that
benefit those industries
Contemporary Theories
The Competitive Advantage of Nations
o Competitive advantage of a nation depends on the collective
competitive advantages of the nations firms relationship becomes
reciprocal over time
o Competitive advantage and tech advantage grows out of innovation
(for nations and firms)
o Innovation results from R+D this can now be outsourced
o Innovation promotes productivity key determinant of nations longrun standard of living and basic source of national per capita income
growth

How

Michael Porters Diamond Model

o Competitive advantage at both the company and national levels
originates from the presence and quality in the country of 4 elements
firm strategy, structure, and rivalry
domestic rivalry and conditions that determine how a firm
is created, organized and managed strong competitors
= national competitive advantage
provides firms with pressure to innovate and improve
factor conditions
consistent with factor proportions theory where each
nation has a relative abundance of certain endowments
demand conditions
nature of home-market demand for specific products
high-demanding customers pressures firms to innovate
faster and produce better products
related and supporting industries
presence of clusters of suppliers, competitors, and
complimentary firms that excel in particular industries
business environment is highly supportive of the founding
firm
o industrial cluster: concentration of businesses, suppliers and
supporting firms in the same industry at a particular location
characterized by a critical mass of human talent, capital, or other
factor endowments (ex: fashion industry in Italy)
o most important source of national advantage is knowledge and skills
National Industrial Policy
o National competitive advantage does not derive entirely from the store
of natural resources each country has inherited endowments are less
important than in the past
o Can now create new advantages; government can aid in doing this
o Any country, regardless of initial circumstances, can attain economic
prosperity through systematically cultivating new and superior factor
endowments
Develop endowments through national industrial policy:
proactive economic development plan initiated by the
government, often in collaboration with the private sector, that
aims to develop or support particular industries within the nation
Typically include:
o Tax incentives
o Monetary and fiscal policy (ex: low interest loans)
o Rigorous educational systems
o Development and maintenance of strong national
infrastructure in areas like IT, transportation
o Strong legal and regulatory systems to ensure
citizens are confident about stability of the national
economy

Pg 157 of pdf shows example of Ireland

Why and How Do Firms Internationalize?
o Firm Internationalzation theories about the managerial and
organization aspects
o Internationalization Process of the Firm
Model developed in the 70s to describe how companies expand
abroad (takes place in incremental stages over a long time)
Firms start with export and progress to FDI (most complex)
Gradual due to manager uncertainty about how proceed

Domestic: focus on gaining the home market

Pre-export: start thinking about exporting because they usually
get an order from abroad
Experimental: issue limited international activity (basic
exporting)
Active involvement: devote time to achieving international
success
Committed: commit resources to making international business
a key part of their value chain activities (FDI)
Born Globals and International Entrepreneurship
Early internationalizing firms will gradually become the norm in
international business
Due to advances in communication and tech, globalization
of markets, increased international competition
FDI-Based Explanations
FDI stock is total value of assets that MNEs own abroad via their
investment activities
Three theories of how firms can use FDI to gain and sustain
competitive advantage
Monopolistic Advantage Theory:
Firms which use FDI ans internationalization strategy must
own or control certain resources and capabilities not
available to competitors that give them a monopoly over
local firms in foreign markets
Monopoly should be specific to the MNE itself and not the
market/location where it does business
Two conditions must be met for a firm to prefer targeting
a foreign market rather than a home market
o Returns obtainable in the foreign market should be
superior to those available in the home market
o Returns obtainable in foreign market should be
superior to those earned by its domestic
competitors in its industry in the foreign market

domestic companies in foreign firm cannot

imitate
Internalization Theory: explanation of the process by which
firms acquire and retain one or more value-chain activities inside
the firm, minimizing the disadvantages of dealing with external
partners and allowing for greater control over foreign operations
By doing this they can control proprietary knowledge
Dunnings Eclectic Paradigm
Framework for determining the extent and pattern of the
value-chain operations that companies own abroad
most comprehensive FDI theory
Three conditions that company will internationalize via FDI
o Ownership-specific advantages
Should have assets that give it a competitive
advantage in foreign markets
Resources, assets should be specific to the
company
o Location-specific advantages
Comparative advantages available in
individual foreign countries (natural
resources, skilled labor, low-cost labor,
inexpensive capital)
o Internalization advantages
Non-FDI-Based Explanations
FDI was a popular entry mode with rise of MNE in 60s and 70s;
in 80s firms began to recognize importance of collaborative
ventures
International Collaborative Ventures
Two types of collaborative ventures:
o Joint venture: equity based
o Strategic alliance: non-equity based
Sometimes firms wont have a choice as they will require
resources and capital from another firm
Company can position itself better because it has access
to more knowledge about the foreign market
Networks and Relational Assets
Represents economically beneficial long-term
relationships the firm undertakes with other business
entities (manufacturers, distributors, bankers)
Network theory proposed to compensate the inability of
traditional organizational theories to account for much
that foes on in business markets
Forming strategic relationships (networking)