International Trade and Investment

Unit: III

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Trade Theory Timeline

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Foundations of Mercantilism

• Nations accumulate financial wealth by encouraging exports and discouraging imports

• Three pillars– Maintain trade surplus– Government intervention– Exploit colonies

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Flaws of Mercantilism

• World trade is zero-sum game• Limits colonies’ market potential• Constrains output and consumption

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Absolute Advantage• Ability of a nation to produce a good more

efficiently than any other nation (greater output using same or fewer resources)

Riceland:1 resource unit = 1 ton rice or 1/5 ton tea

Tealand:1 resource unit = 1/6 ton rice or 1/3 ton tea

• Specialization and trade allows each to produce and consume more

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Trade Gains:Absolute Advantage

Specialization and trade:

+ Riceland gets five times more tea than it would have produced itself

+ Tealand gets two times more rice than it would have produced itself

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Comparative Advantage• Inability of a nation to produce a good more

efficiently than other nations, but an ability to produce that good more efficiently than it does any other good

Riceland:1 resource unit = 1 ton rice or 1/2 ton tea

Tealand:1 resource unit = 1/6 ton rice or 1/3 ton tea

• Specialization and trade allows each to produce and consume more

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Trade Gains:Comparative Advantage

Specialization and trade:

+ Riceland gets two times more tea than it would have produced itself

+ Tealand gets two times more rice than it would have produced itself

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Assumptions and Limitations1. Nations strive only to maximize production and

consumption

2. Only two countries produce and consume just two goods

3. No transportation costs of trading goods

4. Labor is the only resource used to produce goods

5. Ignores efficiency and improvement gains from producing just one good

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Discussion Question

When a nation cannot produce a good more efficiently than other nations, but it can produce that good more efficiently than it does any other good, we say this is a case of __________.a. Absolute advantageb. Comparative advantagec. Mercantilism

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Answer to Discussion Question

When a nation cannot produce a good more efficiently than other nations, but it can produce that good more efficiently than it does any other good, we say this is a case of __________.a. Absolute advantage*b. Comparative advantagec. Mercantilism

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Factor Proportions Theory

• Countries produce and export goods that require resources (factors) in abundance, and import goods that require resources in short supply

• Two factor types– Labor– Land and Capital

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Leontief Paradox• Research found evidence opposite of that predicted

by the factor proportions theory– U.S. exports are more labor-intensive than U.S. imports

• Possible explanations- Theory assumes nation’s production factors to be

homogeneous

- Theory is better predictor when expenditures on labor are considered

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International Product Life Cycle• A company begins by exporting its product and later

undertakes foreign direct investment as a product moves through its life cycle

Source: Raymond Vernon and Louis T. Wells, Jr., The Economic Environment of International Business , 5th ed. (Upper Saddle River, N.J.: Prentice Hall, 1991), p. 85.

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New Trade Theory• Fundamentals– Gains from specialization and economies of scale– Companies first to market create barriers to entry– Government may help by assisting home companies

• First-mover advantage– Economic and strategic advantage of being first to enter an

industry– May create a formidable barrier to market entry for

potential rivals

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Discussion Question

Briefly describe the new trade theory. Does its focus on productivity put it at odds with the theory of comparative advantage and factor proportions theory?

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Answer to Discussion QuestionNew trade theory says that:

There are gains to be made from specialization and increasing economies of scale.

A company that is first to the market and achieves a first-mover advantage can create barriers to entry.

And government may play a role in assisting its home-based companies.

Because new trade theory emphasizes productivity rather than a nation’s resources, it is in line with the theory of comparative advantage but at odds with factor proportions theory.

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National Competitive Advantage• Nation’s competitiveness in an industry depends on

the industry’s capacity to innovate and upgrade, which in turn depends on four main determinants (plus government and chance)– Factor conditions– Demand conditions– Related and supporting industries– Firm strategy, structure, and rivalry

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Factor Conditions• Basic factors– Nation’s resources

• Advanced factors– Result of investing in education and innovation

For example, Japan is a small nation that lacks enough land fit for agriculture; in order to make up for this and become more competitive in the international markets, however, Japan has exploited its wealth of human resources to become a global leader in technology.

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Demand Conditions• Sophisticated home-market buyers drive

companies to improve existing products and develop entirely new products and technologies

• This should improve the competitiveness of the entire group of companies in a market

For example, if there is a high demand for the iPhone in the U.S., Apple will be more willing to work on improving its design and thus do better in not only the U.S. market, but the international market as well.

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Related and Supporting Industries• Companies in an internationally competitive industry

do not exist in isolation• Supporting industries form “clusters” of economic

activity in the geographic area• Each industry reinforces the competitiveness of every

other industry in the cluster

For example, the success of the automobile industry not only benefits the industries of its suppliers (e.g. metal, leather, rubber), but also industries that are directly linked to automobiles (e.g. car insurance).

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Firm Strategy, Structure and Rivalry• Highly skilled managers are essential because

strategy has lasting effects on firm competitiveness• Domestic industry whose structure and rivalry create

an intense struggle to survive strengthens its competitiveness

For example, the rivalry between iPhones and Androids in the smartphone market is healthy because this incites innovation on either side and makes both companies key players in providing the U.S. with a high-ranking NCA.

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Discussion Question

National __________ theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade.a. Product life cycleb. First-moverc. Competitive advantage

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Answer to Discussion Question

National __________ theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade.a. Product life cycleb. First-mover*c. Competitive advantage

FOREIGN DIRECT INVESTMENT

(FDI)

It is a direct investment into production/ business by company of country A into country B either by:

Buying a companyExpanding operations in exiting business operations

Simply defines as an investment made by a company in one country, into a company of the another country.Usually involves participation in management, joint-venture, transfer of technology and expertise.

What is foreign direct investment

IMPORTANCE OF FDI

• Resource for economic growth• Money inflow from overseas • Business grows in several countries• FDI & Economic development• Opportunities• Competitive requirement• Corporative Activities• Branch plant or subsidiary company

operations• Rise in National Income

BARRIERS TO FDI• Formal restrictions on FDI include limits on

foreign ownership• Screening and approval procedures• Informal barriers may also be important• Barriers to investment access, operations,

areas, products, ownership and land use• Barriers on labour, policy, institutional and

control variables• Political controversial

ADVANTAGES OF FDI• New jobs are created• New technology are implemented• Availability of scarce of factory of productions,

products and raw materials• Improving the balance of payment though import and

export substitution• Revenue to the government through taxation • Improved political relations• To get additional expertise• Increase in the number of competition• Expand local business• Stimulate the local economy and thus increasing in

GDP

DISADVANTAGES OF FDI• Political changes leads to “Expropriation”• Cultural and political indifference• Investing is more expansive than exporting• FDI always at risk• Threat to local product• Takes away employment opportunities• It brings harm to the environment• Foreign market recession• Inequality of income distribution

What Are The Patterns Of FDI?• Both the flow and stock of FDI have increased

over the last 30 years– Most FDI is still targeted towards developed

nations • United States, Japan, and the EU

– but, other destinations are emerging• South, East, and South East Asia especially

China • Latin America

What Are The Patterns Of FDI?FDI Outflows 1982-2010 ($ billions)

What Are The Patterns Of FDI?FDI Inflows by Region 1995-2010 ($ billion)

What Are The Patterns Of FDI?• The growth of FDI is a result of

1. a fear of protectionism• want to circumvent trade barriers

2. political and economic changes• deregulation, privatization, fewer restrictions on FDI

3. new bilateral investment treaties• designed to facilitate investment

4. the globalization of the world economy• many companies now view the world as their market• need to be closer to their customers

What Are The Patterns Of FDI?• Gross fixed capital formation - the total

amount of capital invested in factories, stores, office buildings, and the like – the greater the capital investment in an economy,

the more favorable its future prospects are likely to be

• So, FDI is an important source of capital investment and a determinant of the future growth rate of an economy

What Are The Patterns Of FDI?Inward FDI as a % of Gross Fixed Capital Formation 1992-2008

What Is The Source Of FDI?

• Since World War II, the U.S. has been the largest source country for FDI– the United Kingdom, the Netherlands, France,

Germany, and Japan are other important source countries

– together, these countries account for 60% of all FDI outflows from 1998-2010

What Is The Source Of FDI?Cumulative FDI Outflows 1998-2010 ($ billions)

International Business 5e

Ups and Downs of Foreign Direct Investment

International Business 5e

Drivers of FDI

Increasingglobalization

mergersand acquisitions

Worldwide Flow of FDI

Driving FDI growth are more than 82,000 multinational companies with more than 810,000 affiliates abroad, roughly half of which are in developing countries.

Developed nations remain the prime destinations for FDI.

Developed countries account for around 57 % ($962 billion) of Global FDI.

STRATEGIC ASSETS SEEKING

Foreign Horizontal

Direct Investment

• An investment made by a multinational company in different nations.

• It is the investment made for conducting similar business operations.

• For example: Apple Inc. factory in Brunei

• Horizontal FDI results in expansion of the parent company and brings FDI in the other economy

Vertical Foreign Direct

Investment

• Backward Vertical = It is when an industry abroad provides inputs for a firm's domestic production process

• For example: Brunei Shell Petroleum with Royal Dutch Shell

• Forward Vertical = industry abroad sells the outputs of a firm's domestic production process.

• For example: when Volkswagen entered the United States market it acquired a large number of dealers rather than distribute its cars through independent United States dealers

Explanations of Foreign Direct Investment

Why FDI occurs? (four theories)

1. International Product Life Cycle

2. Market Imperfections (internationalization)

3. Eclectic Theory

4. Market power

Management issues in the FDI Decision

1. Control Partnership requirements Benefits of cooperation

2. Purchase or build decision

3. Production Costs Rationalized production Cost of Research and Development

4. Customer Knowledge

5. Following Clients

6. Following Rivals

Government Intervention in Foreign Direct Investment

Balance of PaymentBalance of payment is the systematic record of all the economic transactions between the residents of a reporting country and the residents of the foreign country during the given period of time. Current accountCapital account

Government Intervention in Foreign Direct Investment

Reason for intervention by the host country Control Balance of PaymentObtain Resources and Benefitso Access to Technologyo Management Skills and Employment

Government Intervention in Foreign Direct Investment

Reasons for Intervention by the Home Country Investing in other Nations sends resources out of the home countryOutgoing FDI may ultimately damage a nation’s balance of payment by taking the place of its exportsJobs resulting from outgoing investment may replace jobs at homeOutcome FDI can increase long term competitiveness.Nations may encourage FDI in industries identified as “sunset” industries.

Government Policy Instruments and FDI HOST Countries: Promotion Financial IncentivesInfrastructure Improvements

Host Countries: Restriction Ownership RestrictionsPerformance Demands

Government Policy Instruments and FDI

Home Countries: Promotion• Insurance• Loans• Political pressure

Home Countries: Restriction• Different tax rates• Restrictions to certain nations

THE ENDOF CHAPTER: III