INTERNATIONAL BUSINESS ENVIRONMENT SESSION 2 International Exchange Theories CAUTION! SLIDES ARE NOT ENOUGH TO FULLY GRASP THE CLASS CONTENTS YOU ARE ADVISED TO: Take notes and participate during the class Read reference textbooks and other materials as recommended 2 1
The environment of international business (reminder) INTERNATIONAL ENVIRONMENT National trade policies DOMESTIC / FOREIGN ENVIRONMENT Global economic regulation Intl. monetary system Regional agreements Culture Political/legal systems Economic system Economic policies FIRM Structure Strategy Operations 3 International exchange theories: overview International Trade / Foreign Direct Investment Country-based trade theories Mercantilism Absolute advantage Comparative advantage Factor proportion Firm-based trade theories Vernon's product life-cycle New trade theory Capital movement theories J. Dunning's eclectic theory Market power theory Management analyses National competitiveness theories M. Porter's competitiveness diamond 5 2
Section 1 "TRADITIONAL" COUNTRY-BASED INTERNATIONAL TRADE THEORIES 6 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 7 3
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. 8 Absolute vs. comparative advantage (from CW Hill) (+2.5) (+1.25) Absolute advantage 200 units of resources available per country Comparative advantage 9 4
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. 10 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 11 5
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 12 Questioning the H-O-S model: Leontief Paradox An analysis carried-out in 1947 concluded that the US exported labour-intensive commodities and imported capital-intensive commodities 13 6
Beyond factor proportion: the gravity model Country i (M i ) D ij Country j (M j ) D jk Country k (M k ) 14 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 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 15 7
The competitive advantage of nations (M. Porter's diamond) Firm strategy, structure and rivalry Government Factor endowments Demand conditions Chance Related and supporting industries 16 Discussion: Britain's trade in the XIX th Century Tea, exotic products Cotton, Food products Textile products Opium What are the trade theories applicable to this case? 17 8
Section 2 "MODERN" FIRM-BASED INTERNATIONAL TRADE THEORIES 18 Limitations of traditional trade theories Focused on trade between nations Do not cover intra-industry trade Do not cover trade among similar countries Do not cover intra-firm trade Do not consider capital movements Do not analyse long-term impact of international specialisation 19 9
The product life-cycle theory (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 20 The new trade theory (P. Krugman) Tries to explain why trade is growing fastest between industrial countries 1. With similar economies and endowments of the factors of production 2. Trading similar goods (intra-industry trade) Considers 1. Markets of imperfect competition (oligopolies) 2. Movement of capital (foreign direct investment) 3. Business and government strategies 21 10
The new trade theory (ctd) Capital intensive industries Sunk costs Economies of scale Barriers to entry Oligopolistic markets 22 The new trade theory (ctd) Oligopolistic markets Internationalisation First mover advantage Diversification, specialisation Economies of scale, barriers to entry New markets More products, lower production costs 23 11
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 24 Conclusion: 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 theory supports international trade but justifies limited and selective government intervention to support the development of certain strategic and/or export-oriented industries (dynamic comparative advantage) 25 12
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 26 Application: Brazil-China trade pattern (debriefing) 1. Which theories could best explain the Chinese-Brazilian trade pattern? 2. Why are Brazilian authorities concerned with this bilateral trade structure? 3. What makes Brazil an attractive destination for Chinese foreign direct investment? 4. Why do you think that Brazil is reluctant to fully open up its economy to Chinese FDI? 27 13
Section 3 FOREIGN DIRECT INVESTMENT THEORIES 28 Defining foreign direct investment (reminder) Definition Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country Greenfield investment Establishment of a wholly new operation in a foreign country Brownfield investment Acquisitions or mergers with existing firms in Joint venture the foreign country Legal entity formed between two or more parties to undertake an economic activity together. 29 14
Basic FDI motives Market seeking New or larger markets Export complementarities Optimisation of value chain (vertical integration) Export substitution Transport costs, trade barriers Resource seeking Natural resources, workforce, technology 30 FDI and the product life-cycle (reminder) A company will begin by exporting its product and later undertake foreign direct investment as the product moves through its life cycle 31 15
FDI, imperfect competition and market power Search for market power Foreign direct investment Vertical integration Control over inputs (backward integration) Control over outputs (forward integration) 32 Dunning's "eclectic theory" of FDI (ILO) Internalisation Response to actual or threatened trade barriers Need to control foreign business activity (firms try to internally capture the advantages of foreign asset ownership) Location Resource endowments (capital, labour) or assets (incl. location externalities) that are tied to a particular location Ownership Firms endowed with a distinctive competitive advantage (technology, brand, economies of scale) will try to take advantage of large number of markets 33 16
Managerial analysis of FDI Control Following clients Following rivals Production costs Purchase-or-build decision Customer knowledge 34 Alternatives to trade/fdi: licensing and franchising A licensing agreement grants a foreign entity the right to produce and sell the firm's product in return for a royalty fee on every unit that the foreign entity sells Franchising is a specialised form of licensing: the franchisor not only sells intangible property to the franchisee, but also insists that the franchisee agree to abide by strict rules as to how it does business 35 17
The Geely-Volvo case 1. Why did GEELY decide to acquire VOLVO? 2. Why did FORD decide to sell VOLVO? 3. Can you analyse the sale of VOLVO by FORD and its acquisition by GEELY in the light of the current global economic and geopolitical context? 36 18