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Chapter 5. Trading Internationally 1 Learning Objectives • International Trade Theories Mercantilism Absolute Advantage Comparative Advantage Heckscher-Ohlin Theory The Product Life-Cycle Theory The New Trade Theory (Strategic Trade) • Porter’s Diamond • Instruments of Trade Policy • Free trade vs. Protectionism Benefits and Costs of Int’l Trade • Benefits ✓ ✓ ✓ ✓ ✓ Welfare Inputs to production Economies of scale Engine of growth Buffer against business cycle • Costs ✓ Competition from abroad ✓ Asset movement ✓ Exchange rate fluctuation © Cengage Learning International Trade Theories ❑ Purpose ✓ Show why it is beneficial for a country. ✓ What patterns of international trade might be expected? • • • • • • • Mercantilism Absolute Advantage Comparative Advantage Heckscher-Olin Theory Product Life Cycle Theory New Trade Theory (Strategic Trade) Porter’s Diamond Mercantilism: mid-16th century ❑ A nation’s wealth depends on accumulated treasure ❑ Gold and silver are the currency of trade. ❑ Theory says you should have A trade surplus. ➢ Maximize exports through subsidies. ➢ Minimize imports through tariffs and quotas. ❑ Flaw: “Zero-sum game” ❑ Mercantilism is a bankrupt theory that has no place in the modern world. Discuss. © Cengage Learning Theory of Absolute Advantage (Adam Smith) ❑ Adam Smith: Wealth of Nations (1776). ❑ Countries are differ in their ability to produce goods efficiently. ❑ Produce only goods where you are most efficient, trade for those where you are not efficient. ➢ Trade between countries is, therefore, beneficial. ❑ Assumes there is an absolute advantage balance among nations. © Cengage Learning The Theory of Absolute Advantage © Cengage Learning Theory of Comparative Advantage (Ricardo) ❑ Extends free trade argument ➢ Efficiency of resource utilization leads to more productivity. ➢ Should import even if country is more efficient in the product’s production than country from which it is buying. ➢ Source of trade: not only absolute advantage, but also comparative advantage. ➢ The Concept is the opportunity cost. ❑ Specialization in production and trade: increase in consumption ❑ Trade is a positive-sum game. © Cengage Learning Theory of Relative Factor Endowments (Heckscher-Ohlin) ❑ Ricardo’s theory (labor productivity): ➢ Not only labor in production factors ➢ Land, labor, capital, technology ❑ Export goods that intensively use factor endowments which are locally abundant. ❑ Patterns of trade are determined by differences in factor endowments. ❑ Remember, H-O theory focuses on relative advantage, not absolute advantage. ❑ Did not consider scale economy, assume constant return. © Cengage Learning Product Life-Cycle Theory (Vernon) ❑ As products mature, both location of sales and optimal production changes. ❑ Especially new products ➢ R#038;D (advanced countries) → know-how → transfer of production to developing countries ➢ Advanced countries export at the beginning stage: e.g., electronics, steel, ship, photocopiers, steel refinery, car. ❑ Affects the direction and flow of imports and exports. ❑ Globalization and integration of the economy makes this theory less valid. © Cengage Learning The New Trade Theory (Strategic Trade) ❑ Began to be recognized in the 1970s. ❑ Economies of scale ➢ Deals with the returns on specialization where substantial economies of scale are present. ➢ Specialization increases output, ability to enhance economies of scale increase. ➢ Typically, requires industries with high, fixed costs. ❑ First-mover advantage ❑ Intra-industry trade ➢ Differentiation: source of comparative advantage © Cengage Learning PORTER’S DIAMOND (DETERMINANTS OF NATIONAL COMPETITIVE ADVANTAGE) ❑ The Competitive Advantage of Nations. ❑ Looked at 100 industries in 10 nations. ✓ Thought that existing theories didn’t go far enough. ❑ Question: “Why particular countries succeed in particular industries?” ❑ Examined the impact of national environment on international competitive performance of firms. © Cengage Learning The Diamond ❑ Success occurs where these attributes exist. ✓ More/greater the attribute, the higher chance of success. ❑ Determinants of national competitive advantage ❑ Four sets of variables influence firm’s ability to establish and sustain competitive advantage. ❑ The diamond is mutually reinforcing. Factor Endowments ❑ Taken from Heckscher-Olin’s concept ❑ Basic factors: o natural resources, o climate, o location. ❑ Advanced factors: o communications, o skilled labor, o technology. Advanced Factor Endowments ❑ More likely to lead to competitive advantage. ❑ Are the result of investment by people, companies, government. ❑ Relationship of Basic to Advanced Factors ➢ Basic can provide an initial advantage. ➢ Must be supported by advanced factors to maintain success. ➢ No basics, then must invest in advanced factors. Demand Conditions ❑ Demand creates the capabilities. ❑ Look for sophisticated and demanding consumers. ➢ Impacts quality and innovation. Related and Supporting Industries ❑ Creates clusters of supporting industries that are internationally competitive. ❑ Cost-effective input, information, exchange of ideas and information. ❑ Source of innovation and upgrading. Firm Strategy, Structure and Rivalry ❑ The nation’s condition that firms are born, organizing, and competing.: Management ‘ideology’ can either help or hurt you. ❑ Presence of domestic rivalry improves a company’s competitiveness. Implications for Business ❑ Companies ➢ Nations (home base) becoming more important. ➢ Positioning in competitive place ➢ Importance of competitive local base, local customers, and suppliers (working with them: long term builder) ❑ Government ➢ Indirect role in all of 4 diamonds ➢ Invest in HR, infrastructure, R#038;D, education ➢ Secure vigorous internal competition ➢ Promoting free trade is generally in the best interests of the home-country. © Cengage Learning © Cengage Learning TRADE POLICY AND POLITICS • Smith (Absolute advantage) • Increase consumption level • Ricardo (Comparative advantage) • efficient utilization of resource • H-O theory (Factor endowment) • economic growth “Assume free trade” Political and government interventions – protect domestic industry – national security – balance of trade – national wealth INSTRUMENTS OF TRADE POLICY (TARIFFS) • • • • Tariffs – oldest form of trade policy Tax on imports and raise the price Good for government #038; producers Bad for consumers Price • • • • • consumption decrease, increase domestic production, decrease import, income redistribution, government revenue Supply P2 P1 Demand Q2 Q1 Quantity Subsidies • A government payment to a domestic producer. – Cash grants – low-interest loans – tax breaks – government equity participation in the company: Airbus • Agricultural industry, • First-mover advantage and economies of scale © Cengage Learning Import Quotas and Voluntary Export Restraints • Import Quota: – Direct restriction on the quantity of some good imported into a country. – Issue a import license • Voluntary Export Restraint (VER): – Quota on trade imposed by exporting country, typically at the request of the importing country. © Cengage Learning Local Content Requirements • Requires some specific fraction of a good to be produced domestically. – Percent of component parts. – Percent of the value of the good. • Initially used by developing countries to help shift from assembly to production of goods. • Developed countries (US) beginning to implement. • For component part manufacturer, LCR acts the same as an import quota. • Benefits producers, not consumers. © Cengage Learning Antidumping Policies • Defined variously as: – Selling goods in a foreign market below production costs. – Selling goods in a foreign market below fair market value. • Result of: – Unloading excess production. – Predatory behavior: gaining market base (driving out existing competitors: ex. Korean semiconductor makers) • Remedy: imposition of tariffs. © Cengage Learning Administrative Policies • Bureaucratic rules designed to make it difficult for imports to enter a country. • Informal administrative barriers • customs inspection, red-type © Cengage Learning Chapter 6. Investing Abroad Directly 1 LEARNING OBJECTIVES • Foreign Direct Investment (FDI) in the World Economy • Horizontal and Vertical FDI • Explain how FDI results in ownership, location, and internalization (OLI) advantages. • Understand how multinational enterprises (MNEs) and host country governments bargain. • Draw implications for action. © Cengage Learning FDI VOCABULARY Foreign direct investment (FDI) Putting money in activities that control and manage value-added activities in other countries Multinational enterprise (MNE) Firms that engage in FDI Foreign portfolio investment (FPI) Holding securities, such as stocks and bonds, of companies in countries outside one’s own but does not entail the active management of foreign assets Management control rights Authority to appoint key managers and establish control mechanisms © Cengage Learning WHAT IS FDI? • • • • A company buying a firm in a different country. A firm creating a ‘greenfield’ operation in a different country A firm creating a subsidiary in a different country. Also: – The firm has significant control of its foreign operation. – Firm can affect managerial decisions of the foreign operation. • M#038;A vs. Greenfield Investment Acquisitions Versus Greenfield Investments • Most cross-border investment is in the form of mergers and acquisitions rather than greenfield investments. Firms prefer to acquire existing assets because: • Mergers and acquisitions are quicker to execute than greenfield investments. • It is easier and perhaps less risky for a firm to acquire desired assets than build them from the ground up. • Firms believe that they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills. The Direction Of FDI • Most FDI has historically been directed at the developed nations of the world, with the United States being a favorite target. • FDI inflows have remained high during the early 2000s for the United States, and also for the European Union. • South, East, and Southeast Asia, and particularly China, are now seeing an increase of FDI inflows. • Latin America is also emerging as an important region for FDI. HORIZONTAL AND VERTICAL FDI Horizontal FDI Producing the same products or offering the same services in a host country as firms do at home Vertical FDI Firm moves upstream or downstream in different value chain stages in a host country through FDI © Cengage Learning UPSTREAM AND DOWNSTREAM VERTICAL FDI Upstream (backward) vertical FDI • Using FDI in an earlier activity in the value chain • Investments into industry that provides inputs into a firm’s domestic production Downstream (forward) vertical FDI • Using FDI in an later activity in the value chain • Investment in an industry that utilizes the outputs from a firm’s domestic production (typically sales and distribution) © Cengage Learning WHY FDI (introduction)? • Can circumvent future trade barriers. • World political and economic change. Democratization of markets. • Globalization of world markets • Development of firm capabilities and competitive advantages © Cengage Learning FDI WHY? Market Imperfections (Internalization Theory) Most cited: • Impediments to exporting • Impediments to licensing • Risk giving away know-how to competitors • Licensing implies low control over foreign entity © Cengage Learning FDI WHY? (Cont’) • Transportation too costly? – Low value-to-weight ratio (cement, soft drink) • Strategic Behavior – Follow the lead of a competitor – strategic rivalry. • Product Life Cycle • Location specific advantages © Cengage Learning WHY Vertical FDI? • Market power? – create entry barriers. – erode entry barriers. • Market imperfections. – Impediments to the sale of know-how. – Investments in specialized assets. © Cengage Learning © Cengage Learning LOCATION Agglomeration Clustering of economic activities in certain locations Knowledge spillover Diffusion of knowledge from one firm to others among closely located firms that attempt to hire individuals from competitors © Cengage Learning CONCLUSIONS © Cengage Learning
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