International Business by Prof YongSik Hwang Theories of

International Business by Prof. Yong-Sik Hwang

Theories of International Trade and Investment

Theories of International Trade and Investment

Theories of International Trade and Investment

Mercantilism and Neomercantilism • Mercantilism: A belief, popular in the 16 th century, that national prosperity results from maximizing exports and minimizing imports. • Today, some argue for neomercantilism—the idea that a nation should run a trade surplus. • Supporters of neomercantilism include: § Labor unions (want to protect domestic jobs) § Farmers (want to keep crop prices high) § Some manufacturers (rely on exports) But is neomercantilism best for all?

Free Trade The absence of restrictions to the flow of goods and services among nations • Free trade is usually best because it leads to: § More and better choices for consumers and firms § Lower prices of goods for consumers and firms § Higher profits and better worker wages (because imported input goods are usually cheaper) § Higher living standards for consumers (because their costs are lower) § Greater prosperity in poor countries

Adam Smith (1723 -1790)

Absolute Advantage Principle A country should produce only those products in which it has absolute advantage or those it can produce using fewer resources than another country. (Labor Cost in Days of Production for One Ton)

Comparative Advantage Principle “Two men can make both shoes and hats, and one is superior to the other in both employments, but in making hats he can only exceed his competitor by one fifth or 20 percent, and in making shoes he can excel him by one third or 33 percent; will it not be for the interest of both that the superior man should employ himself exclusively in making shoes and the inferior man in making hats? ” David Ricardo, 1817

Comparative Advantage Principle It is beneficial for two countries to trade even if one has absolute advantage in the production of all products; what matters is not the absolute cost of production but the relative efficiency with which it can produce the product. (Labor Cost in Days of Production for One Ton)

Comparative Advantage Principle (cont. ) • • While Germany can make both items more cheaply than France, it is still beneficial for Germany to trade with France. The key is the ratio of production costs. In the exhibit, Germany is comparatively more efficient at producing cloth than wheat: It can produce three times as much cloth as France (30/10), but only two times as much wheat (40/20). Germany should specialize in producing cloth and import all the wheat it needs from France should specialize in producing wheat and import all its cloth from Germany. Each country benefits by specializing in the product in which it has a comparative advantage and importing the other product.

Comparative Advantage Principle (cont. ) • The principle applies to all goods. It reveals how countries use scarce resources more efficiently. Example • Arguably, no country is better than Japan at making cars and cell phones. But because Japan is especially good at making cars, it concentrates its resources on making them. • Other countries, such as China and Finland, focus on making cell phones. • In this way, Japan makes maximal use of its resources, and the world gets great cars.

Limitations of Early Trade Theories • • • Fail to account for international transportation costs. Governments distort normal trade by selectively imposing protectionism (e. g. , tariffs) or investing in certain industries (e. g. , via subsidies). Services: Some cannot be traded; others can be traded freely via the Internet or global telephony.

Factor Proportions Theory • Also known as the Factor Endowments Theory, it argues that each country should produce and export products that intensively use relatively abundant factors of production, and import goods that intensively use relatively scarce factors of production. 6 -14

Factor Proportions Theory (cont. ) • However, the Leontief Paradox revealed that countries can successfully export products that use less abundant resources (e. g. , the U. S. often exports labor-intensive goods). • This implies that international trade is complex and cannot be fully explained by a single theory.

International Product Life Cycle Theory • Each product and its associated manufacturing technologies go through three stages of evolution: introduction, maturity, and standardization. • In the introduction stage, the inventor country enjoys a monopoly both in manufacturing and exports. Example: the television set.

International Product life Cycle Theory (cont. ) • In the maturity stage, the product’s manufacturing becomes relatively standardized, and other countries start producing and exporting the product.

International Product life Cycle Theory (cont. ) • In the standardization stage, manufacturing ceases in the original innovator country, and this country becomes a net importer of the product. Today, due to globalization, the cycle occurs quickly for many products.

National Competitive Advantage

Critical Role of Innovation in National Economic Success • Innovation is a key source of competitive advantage. • The firm innovates in four major ways. It can develop: (1) A new product or improve an existing product (2) New ways of manufacturing (3) New ways of marketing (4) New ways of organizing company operations • Many innovative firms in a nation leads to national competitive advantage

Critical Role of Productivity in National Economic Success • Productivity is the value of the output produced by a unit of labor or capital. • It is a key source of competitive advantage for firms. • The greater the productivity of the firm, the more efficiently it uses its resources. • The greater the aggregate productivity of the firms in a nation, the more efficiently the nation uses its resources. • Aggregate productivity is a key determinant of the nation’s standard of living.

Productivity Levels in Selected Countries (Output per hour in manufacturing, 1985– 2005; Indices, where 1992=100)

Michael Porter’s Diamond Model: Sources of National Competitive Advantage 6 -23

The Diamond Model: Sources of National Competitive Advantage (cont. ) • Factor conditions: Quality and quantity of labor, natural resources, capital, technology, know-how, entrepreneurship, and other factors of production Example An abundance of cost-effective and well-educated workers gives China a competitive advantage in the production of laptop computers.

The Diamond Model: Sources of National Competitive Advantage (cont. ) • Related and supporting industries: The presence of suppliers, competitors, and complementary firms that excel within a given industry Example Silicon Valley in California is a great place to launch a computer software firm because it is home to thousands of knowledgeable firms and workers in the software industry.

The Diamond Model: Sources of National Competitive Advantage (cont. ) • Demand conditions at home: The strengths and sophistication of customer demand Example Japan is a densely populated, hot, and humid country with very demanding consumers. These conditions led Japan to become one of the leading producers of superior, compact air conditioners.

The Diamond Model: Sources of National Competitive Advantage (cont. ) • Firm strategy, structure, and rivalry: The nature of domestic rivalry and the conditions that determine how a nation’s firms are created, organized, and managed Example Italy has many top firms in design industries such as textiles, furniture, lighting, and fashion. Vigorous competitive rivalry puts these firms under constant pressure to innovate, which has propelled Italy to a leading position in design worldwide.

Industrial Cluster • A concentration of suppliers and supporting firms from the same industry located within the same geographic area; similar to Porter’s Related and Supporting Industries. • A strong cluster can serve as an export platform for the nation. Examples Silicon Valley; pharmaceutical cluster in Switzerland; footwear industry in Pusan, South Korea; IT industry in Bangalore, India; fashion cluster in northern Italy; and Silicon Valley North near Ottawa, Canada

National Industrial Policy • A proactive economic development plan employed by the government to nurture or support promising industry sectors with potential for regional or global dominance. Initiatives can include: § § § Tax incentives Monetary and fiscal policies Rigorous educational system Investment in national infrastructure Strong legal and regulatory systems

Examples of National Industrial Policy • In the 1990 s, Vietnam’s government privatized state enterprises and modernized the economy, emphasizing competitive, export-driven industries. Vietnam became one of the fastest-growing economies, averaging around 8 percent annual GDP growth. • Singapore adopted pro-business, pro-investment, export-oriented policies, combined with statedirected investments in strategic corporations. The approach stimulated economic growth that averaged 8 percent annually from 1960 to 1999.

Examples of National Industrial Policy (cont. ) • New Zealand’s government, starting in 1984, transformed the country from an agrarian, protectionist, regulated economy to an industrialized, free-market economy that today competes globally. • The Czech government in the 1990 s created a business-friendly legal and regulatory environment. The country privatized state-owned companies. Government FDI incentives attracted numerous MNEs, such as Daewoo, ING, Siemens, and Toyota.

Examples of National Industrial Policy (cont. ) • In the 1990 s, Ireland implemented various pro -business policies— fiscal, monetary, tax; investment in education; and emphasis on highvalue industries such as pharma and IT—that dramatically grew GDP and reduced unemployment.

National Industrial Policy and Dubai

Stages in Company Internationalization Domestic Focus

Stages in Company Internationalization Domestic Focus Pre-export Stage

Stages in Company Internationalization Domestic Focus Pre-export Stage Experimental Involvement

Stages in Company Internationalization Domestic Focus Pre-export Stage Experimental Involvement Active Involvement

Stages in Company Internationalization Domestic Focus Pre-export Stage Experimental Involvement Active Involvement Committed Involvement

How Firms Gain and Sustain International Competitive Advantage • Because the MNE was traditionally the major player in international business, scholars have offered numerous explanations of what makes these firms pursue, and succeed in, internationalization. • Because FDI has been MNEs’ main strategy in international expansion, theoretical explanations have tended to emphasize it.

FDI-Based Explanations: Monopolistic Advantage Theory • Argues that MNEs prefer FDI because it provides the firm with control over resources and capabilities in the foreign market and a degree of monopoly power relative to foreign competitors. • Key sources of monopolistic advantage include proprietary knowledge, patents, unique know-how, and sole ownership of other assets. Example Novartis earns substantial profits by marketing various patent medications through its subsidiaries worldwide.

FDI-Based Explanations: Internalization Theory • • • Explains how the MNE chooses to acquire and retain one or more value-chain activities inside itself. Such “internalization” provides the MNE with greater control over its foreign operations. Internalization avoids the drawbacks of dealing with external partners, such as reduced quality control and the risk of losing proprietary assets to outsiders. Example In China, Intel owns much of its value chain, which ensures that Intel knowledge, patents, and other assets are not misused or illicitly obtained by potential rivals.

FDI-Based Explanations: Dunning’s Eclectic Paradigm • Three conditions determine whether or not a company will enter a given foreign country via FDI: 1. Ownership-specific advantages: Knowledge, skills, capabilities, relationships, or physical assets that the firm owns and that are the basis of its competitive advantages 2. Location-specific advantages: Similar to comparative advantages; specific advantages that exist in the country that the MNE has entered, or is seeking to enter, such as natural resources, low-cost labor, or skilled labor 3. Internalization advantages: Control derived from internalizing foreign-based manufacturing, distribution, or other value-chain activities

Example of the Eclectic Paradigm: Sony in China • Ownership-Specific Advantages. Sony possesses a huge stock of knowledge and patents in the consumer electronics industry, as represented by products like the Playstation and Vaio laptop. • Location-Specific Advantages. Sony desires to manufacture in China in order to take advantage of China’s low-cost, highly knowledgeable labor force. • Internalization Advantages. Sony wants to maintain control over its knowledge, patents, manufacturing processes, and quality of its products. Thus, Sony entered China via FDI

Non-FDI-Based Explanations: International Collaborative Ventures • A form of cooperation between two or more firms. Partners pool resources and capabilities to create synergies and share the risk of joint efforts. • Starting in the 1980 s, firms increasingly began using collaborative ventures to expand abroad. • Collaboration provides access to foreign partners’ know-how, capital, distribution channels, and marketing assets. It also helps overcome government-imposed obstacles.

Two Types of International Collaborative Ventures • Equity-based joint ventures result in the formation of a new legal entity. In contrast to the wholly owned FDI, the firm collaborates with local partner(s) to reduce risk and commitment of capital. • Project-based alliances do not require equity commitment from the partners, but simply a willingness to cooperate in R&D, manufacturing, design, or any other value-adding activity. Because project-based alliances have a narrowly defined scope of activities and timeline, they provide greater flexibility to the firm than equity-based ventures.

Born Global Firms and International Entrepreneurship • The slow, gradual internationalization predicted by the process model is no longer practical or realistic in today’s fast-paced, interconnected economy • Today many firms, even those that are young or without much experience, take bold steps to internationalize • Indicative of this trend is the emergence of Born Global companies – young, entrepreneurial firms that take on internationalization early in their evolution and leapfrog into global markets