THEORIES OF INTERNATIONAL BUSINESS

Mercantilism Theory of international trade emerged in England in the mid 16th century Its principle assertion was that gold and silver were the mainstays of national wealth gold and silver were the currency of trade between countries 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. The main tenant of mercantilism was that it was in a country's best interests to maintain a trade surplus, to export more than it imported, a country would accumulate gold and silver and increase its national wealth and prestige. They recommended policies to maximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, and exports were subsidized Limitations: The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in which a gain by one country results in a loss by another.) THEORY OF Absolute Advantage In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game Smith argued that countries differ in their ability to produce goods efficiently Countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries Smith's basic argument is that you should never produce goods at home that you can buy at a lower cost from other countries

THEORY OF COMPARITIVE ADVANTAGE David Ricardo took Adam Smith's theory one step further by exploring what might happen when one country has an absolute advantage in the production of all goods Smith's theory of absolute advantage suggests that such a country might derive no benefits from international trade In his 1817 book Principles of Political Economy, Ricardo showed that this was not the case According to Ricardo's theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itsel EXAMPLE Nation Output per Labor Hour Computer Chips Australia 20 10 Output per Labor Hour Wine

Japan

15

Australia has an absolute advantage over Japan in both wine and computer chip production. Australia is 2.5 times better than Japan in wine production; though only 1.3 times better in computer chips production. The theory of absolute advantage indicates that no trade should take place because Australia is more productive for both goods.

Note: The theory of comparative advantage says no, there is still an advantage to both countries from continuing to trade. In Australia 1 bottle of wine will sell for two computer chips. In Japan 1 bottle of wine will sell for 3.75 computer chips.

Implications for trade:

For example, if both the countries trade and if Japan offers to trade 3 computer chips for 1 bottle of Australias wine. Then Australia will be better off, for it has gained three computer chips for 1 bottle of wine, rather than 2 it gained if there was no trade. Similarly, Japan is better off, for it has gained 1 bottle of wine for only 3 computer chips, rather than the 3.75 it would pay if there was no trade Conclusion: 1. Australia and Japan are both better off even though Australia has an absolute advantage in both computer chips and wine production. 2. The theory of comparative advantage predicts that this will occur and that international trade will benefit both countries.

Assumptions and limitation of Absolute Advantage and comparative advantage Theory: First, it is assumed that countries are driven only by the maximization of production and consumption, which is not the case, governments of most countries are guided by other considerations when they trade with other nations Second, the theory assumes that there are only two countries encaged in the production of and consumption of just two goods, which is also not the case, currently there are more than 180 countries and they have countless transactions between them. Third, it is assumed that there is no transportation cost for shipping goods from one country to other. In reality, transportation costs are major expenses in international trade. Fourth, the two theories consider that labor is the only factor of production that has convert raw material in to finished goods

Heckscher-Ohlin Theory Heckscher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of comparative advantage. They argued that comparative advantage arises from differences in national factor endowments. By factor endowments, they meant the extent to which a country is endowed with such resources as land, labor, and capital

Different nations have different factor endowments, and different factor endowments explain differences in factor costs. The more abundant a factor, lower its cost. Theory predicts that countries will export those goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce The Product Life-Cycle Theory Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s. Stages of IPLC (International product life cycle) New product stage: A new product is one that is innovative or unique in some way Initially consumption is in home country, price is inelastic, profits are high and the companies are willing to sell those willing to pay a premium price As production increases and exceeds local consumption, exports start taking place Maturing product stage: The product enters the mature phase of its life cycle An increasing percentage of sales is achieved through exporting competitors in other advanced countries will be working to develop substitute products so that they can replace the initial product with of their own The introduction of these substitutes and the softening of demand for the original product will eventually result in the firm that developed the product switching its strategy from production to market protection Attention will also be focused on tapping markets in less developed countries

Standardized product stage: In this stage the technology becomes widely available Production tends to be shifted to low-cost locations, including less developed countries The firm will also try to differentiate the product and to prevent the emergence of price competition. The New Trade Theory The new trade theory began to emerge in the 1970s and 1980s. The new theory states that There are gains to be made from specialization and economies of scale The first movers in to any market can create entry barriers to others Governments may have a role to play in assisting its home base firms

National Competitive Advantage: Porter's Diamond In 1990, Michael Porter of Harvard Business School published the results of an intensive research effort that attempted to determine why some nations succeed and others fail in international competition Porter and his team looked at 100 industries in 10 nations Porter's thesis is that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage These attributes are

Factor endowments--a nation's position in factors of production such as skilled labor or the infrastructure necessary to compete in a given industry.

Demand conditions--the nature of home demand for the industry's product or service.

Relating and supporting industries--the presence or absence in a nation of supplier

industries and related industries that are internationally competitive.

Firm strategy, structure, and rivalry--the conditions in the nation governing how companies created, organized, and managed and the nature of domestic rivalry.

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