INTERNATIONAL BUSINESS ENVIRONMENT TOPIC 2

INTERNATIONAL BUSINESS ENVIRONMENT TOPIC 2 International Trade Theories (WHAT ECONOMISTS SAY) Key trade and investment theories Country-based theories Mercantilism Absolute/Comparative advantage Factor proportion National competitiveness M. Porter's competitiveness diamond Modern (firm-based) theories Country similarity Country size Vernon's product life-cycle New trade theory Capital movement theories Market access / Market power Strategic rivalry J. Dunning's eclectic theory 07/06/2012 International Business Environment - JG DITTER 4 1

Assignment: Chinese mercantilism 1. Why is the US calling China a mercantilist country? (information about the issue is also available in C.W. HILL, chapter 5, p. 164) 2. What are the justifications of the Chinese trade policy / trade surplus? What do they mean to China s trade partners? 3. Would a decrease of the Chinese trade surplus necessarily benefit to its trade partners? 07/06/2012 International Business Environment - JG DITTER 5 Mercantilism Original XVII th century mercantilists, such as John Law, a Scots financier, believed that a country's economic prosperity and political power came from its stocks of precious metals. To maximise these stocks they argued against free trade, favouring protectionist policies designed to minimise imports and maximise exports, creating a trade surplus that could be used to acquire more precious metal http://www.economist.com/research/economics/alphabetic.cfm?letter=m#mercantilism 07/06/2012 International Business Environment - JG DITTER 6 2

Various approaches Commercialism (export promotion) Colbertism (import substitution) Bullionism (gold accumulation) 07/06/2012 International Business Environment - JG DITTER 7 Mercantilism today Neo-mercantilism is a term used to describe a policy regime which encourages exports, discourages imports, controls capital movement and centralises currency decisions in the hands of a central government The objectives of neo-mercantilist policies are to Increase the level of foreign foreign currency deposits and bonds held by central banks and monetary authorities (foreign exchange reserves) Support growth in GDP and employment at home. Adapted from: http://en.allexperts.com/q/economics-2301/differences- Mercantilist-Neo-Mercantilist-1.htm 07/06/2012 International Business Environment - JG DITTER 8 3

An Asian model? The growth champions of the past few decades Japan in the 1950s and 1960s, South Korea from the 1960s to the 1980s, and China since the early 1980s have all had activist governments collaborating closely with large business. All aggressively promoted investment and exports while discouraging (or remaining agnostic about) imports. China's pursuit of a high-saving, large-trade-surplus economy in recent years embodies mercantilist teachings. http://www.europeanceo.com/news/commentaries//article672.html 07/06/2012 International Business Environment - JG DITTER 9 Food for thought What are the shortcomings of neo-mercantilist like policies "Beggar-thy-neighbour" policies, carried-out at the expense of trade partners Will lead to global depression if applied by all players Render the domestic economy dependent on the global business cycle Generate imbalances among players, likely to result in economic crisis 07/06/2012 International Business Environment - JG DITTER 10 4

Food for thought "An international economics course should drive home to students the point that international trade is not about competition, it is about mutually beneficial exchange. Even more fundamentally, we should be able to teach students that imports, not exports, are the purpose of trade. That is, what a country gains from trade is the ability to import what it wants. Exports are not an objective in and of themselves: the need to export is a burden that the country must bear because its import suppliers are crass enough to demand payment". Paul KRUGMAN, Pop Internationalism 07/06/2012 International Business Environment - JG DITTER 11 Assignment : Bengladesh's textile trade http://video.answers.com/bangladeshs-textile-industry-516948296 http://www.5min.com/video/the-garment-industrys-impact-on-bangladesh- 516998550 http://www.youtube.com/watch?v=spxhz0vfxvg 1. What is the current global position of Bangladesh's textile and garment industry? 2. How can it be explained? (Information about the issue is also available in C.W. HILL, chapter 5, p. 158) 3. What are its limitations? 07/06/2012 International Business Environment - JG DITTER 12 5

Absolute advantage (A. Smith) Absolute advantage refers to the ability of a person or a country to produce a particular good at a lower absolute cost than another. 07/06/2012 International Business Environment - JG DITTER 13 Absolute vs. comparative advantage (table by CW Hill) (+2.5) (+1.25) Absolute advantage 200 units of resources available per country Comparative advantage 07/06/2012 International Business Environment - JG DITTER 14 6

Comparative advantage (D. Ricardo) Comparative advantage refers to the ability of a country to produce a particular good at a lower marginal or opportunity cost than another country. Comparative advantage explains how trade can create value for both parties even when one can produce all goods with fewer resources than the other. The net benefits of such an outcome are called gains from trade. 07/06/2012 International Business Environment - JG DITTER 16 Static gains from trade in a neoclassical perspective P S P* E* Domestic price P 1 World price s 1 Trade creation (imports) d 1 D q s q* q d Q 07/06/2012 International Business Environment - JG DITTER 17 7

A major economic concept Nobel laureate Paul Samuelson (1969) was once challenged by the mathematician Stanislaw Ulam to "name me one proposition in all of the social sciences which is both true and non-trivial." It was several years later than he thought of the correct response: comparative advantage. "That it is logically true needs not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them." http://www.wto.org/english/res_e/reser_e/cadv_e.htm 07/06/2012 International Business Environment - JG DITTER 19 Comparative advantage: the factor proportion theory For Eli Heckscher and Bertil Ohlin, comparative advantage arises from differences in relative national factor endowments the extent to which a country is endowed with resources like labour and capital The Heckscher-Ohlin-Samuelson (H-O-S) model predicts that countries will export 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 07/06/2012 International Business Environment - JG DITTER 20 8

Assessing factor endowments US Mexico Labour 300 units 120 units Capital 100 units 20 units The US is the relatively capital abundant country Mexican capital-labor ratio: K Mex / L Mex is 20/120 or 1/6 U.S. capital-labor ratio: K US / L US is 100/300 or 1/3 07/06/2012 International Business Environment - JG DITTER 21 Questioning the H-O-S model: Leontief's Paradox An analysis carried-out in 1947 concluded that the US exported labour-intensive commodities and imported capital-intensive commodities 07/06/2012 International Business Environment - JG DITTER 23 9

Limitations of traditional trade theories Focused on trade between nations Do not analyse long-term impact of international specialisation Do not cover trade among similar countries Do not consider capital movements Trading similar products (intraindustry trade) Do not cover intra-firm trade 07/06/2012 International Business Environment - JG DITTER 25 The changing nature of international trade The first wave of globalization in the 19 th century increased trade based on comparative advantage. Countries exchanged what they could not produce themselves. So Europe traded machinery for Central American bananas, or for South Asian spices. But in the 20 th century, transportation costs fell so much that even trade in similar goods or in parts and components made economic sense. But these costs have not fallen equally everywhere. Economies of scale in transportation, such as giant container ships plying the seas on lucrative routes between Northeast Asia and North America, imply that lower costs will increase trade, which will further lower costs. http://www.imf.org/external/pubs/ft/fandd/2008/12/deichmann.htm 07/06/2012 International Business Environment - JG DITTER 26 10

Analysing trade today: country size / similarity Country size Larger countries are more self-sufficient and therefore less dependent on international trade than smaller ones Trade between two countries will depend on their respective size and distance Country similarity Trade results from similarities of preferences among consumers in countries that are at the same stage of economic development International trade in manufactured goods therefore takes place between countries with similar per capita incomes exchanging similar goods 07/06/2012 International Business Environment - JG DITTER 27 The gravity model Country i (Y i ) D ij Country j (Y j ) D ik D jk T ij = A * Y i * Y j / D ij Country k (Y k ) 07/06/2012 International Business Environment - JG DITTER 28 11

The gravity model and US trade (Krugman & Obsfelt) 07/06/2012 International Business Environment - JG DITTER 29 The product life-cycle theory (R. Vernon - graph by CW Hill) According to Raymond Vernon's product life-cycle theory, both the location of sales and the optimal production location will change as products mature, affecting the flow and direction of trade, as well as foreign direct investment 07/06/2012 International Business Environment - JG DITTER 30 12

The new trade theory (P. Krugman) I. Tries to explain why trade is growing fastest between industrial countries II. With similar economies and endowments of the factors of production Trading similar goods (intra-industry trade) Considers Markets of imperfect competition (oligopolies) Movement of capital (foreign direct investment) Business and government strategies 07/06/2012 International Business Environment - JG DITTER 31 The new trade theory (ctd) CAPITAL-INTENSIVE INDUSTRIES Sunk costs (R&D, marketing, ) Economies of scale/scope Barriers to entry Advantage to first mover Oligopolistic markets 07/06/2012 International Business Environment - JG DITTER 32 13

Economies of scale P Output Total cost Average cost 100 1,000 10.0 200 1,400 7.0 300 1,500 5.0 400 1,600 4.0 500 1,650 3.5 600 1,950 3.25 Total cost Average cost Q 07/06/2012 International Business Environment - JG DITTER 33 Economies of scale and market access: example Software development is characterized by substantial economies of scale. The fixed costs of producing software, including applications, is very high. By contrast, marginal costs are very low. Moreover, the costs of developing software are "sunk" -- once expended to develop software, resources so devoted cannot be used for another purpose. The result of economies of scale and sunk costs is that application developers seek to sell as many copies of their applications as possible. [ ] The [negative] experiences of IBM and Apple, Microsoft's most significant operating system rivals in the mid- and late 1990s, confirm the strength of [such a] barrier to entry. http://www.albion.com/microsoft/findings-8.html 07/06/2012 International Business Environment - JG DITTER 34 14

The new trade theory (ctd) BUSINESS INTERNATIONALISATION (INTERNATIONAL TRADE AND FOREIGN DIRECT INVESTMENT) First mover advantage Market expansion Diversification (monopolistic competition) International specialisation Economies of scale More products, more choice, lower production costs 07/06/2012 International Business Environment - JG DITTER 35 The new trade theory (ccl) 1. Trade is mutually beneficial because it allows for the specialization of production, the achievement of economies of scale, and the production of a greater variety of products at lower prices 2. The pattern of trade may result from economies of scale and first mover advantages (economic and strategic advantages that accrue to early entrants into an industry) 3. Selected government intervention (strategic trade policy) may support the development of strategic or export-oriented industries 07/06/2012 International Business Environment - JG DITTER 36 15

The competitive advantage of nations (M. Porter) M. Porter's thesis is that national competitive advantage is not dependent on factor endowment alone, but on various (country-based and firm-based) factors that interact with each other to create conditions where innovation and improved competitiveness occurs http://darleisimioni.blogspot.com/2010/09/michael-porter-o-brasil-emergente-no.html 07/06/2012 International Business Environment - JG DITTER 37 M. Porter's "competitiveness diamond" Government Firm strategy, structure and rivalry Chance Factor endowments Demand conditions Related and supporting industries 07/06/2012 International Business Environment - JG DITTER 38 16

Protectionism or free trade? 1. Mercantilism promotes government involvement in supporting exports and limiting imports 2. Smith, Ricardo and Heckscher-Ohlin show that it is beneficial for a country to engage in international trade even for products it is able to produce for itself. International trade allows a country: To specialize in the manufacture and export of products that it can produce efficiently To import products that can be produced more efficiently in other countries 3. The new trade and national competitiveness theories support international trade but justify limited and selective government intervention to http://www.codart.nl/news/439/ support the development of certain strategic and/or export-oriented industries (dynamic comparative advantage) 07/06/2012 International Business Environment - JG DITTER 39 Gains from trade: a summary Country 1 A B C D Country 2 A B C D Country 1 A Country 2 B A C B D Country 3 Without trade: Small and monopolistic domestic markets No economies of scale Limited range of products, high prices Different national standards A C B D Country 4 07/06/2012 International Business Environment - JG DITTER 40 C Country 3 With trade: Static gains: lower prices due to tariff cuts Dynamic gains: lower prices due to economies of scale, competitive pressure and specialization Innovation, broader range of products Homogeneous standards D Country 4 17

Assignment: managerial implications Location of production First-mover advantage Business strategy vs. Government policy 07/06/2012 International Business Environment - JG DITTER 41 18