Theories of International Business

Theories of International Business
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”.
David Hume - 1752
 Increased exports leads to inflation and higher prices.
 Increased imports lead to lower prices.
 Result: Country A sells less because of high prices and Country B sells more because of lower prices.
 In the long run, no one can keep a trade surplus.
Theory of Absolute Advantage
 Adam Smith: Wealth of Nations (1776).
 Capability of one country to produce more of a product with the same amount of input than another country.
 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.
 Ghana/cocoa.
Comparative Cost Theory
David Ricardo developed this theory in the year 1817. The theory says that the countries which are having cost advantage will export goods to the countries with cost disadvantage
Assumptions of Comparative cost theory:
1. The only element of cost of production is labour
2. Production is subject to the law of constant returns
3. There are no trade barriers
4. Trade is free from cost of transportation
Opportunity Cost Theory
Developed by Gottfried Haberler in 1959
The opportunity cost is the value of alternatives, which have to be foregone in order to obtain a particular thing.
Modern Theory of Factor Endowments
Developed by Berlin Ohlin and Heli Heckscher
This theory explains the reasons for comparative cost differences. There are different prevailing endowments of the factors of production. Different factors of production are to be used in different degrees of intensity for producing different products.
Assumptions of Factor Endowments theory
1. Perfect competition is in existence for both product and factors in both countries
2. Factors of production are perfectly mobile within each country only
3. Factors supplies are fixed in each country
4. Factors of production are of equal quality in both the countries
5. Factors endowments vary from country to another country
6. Factors of production have full employment in both the countries
7. Business between two countries is free from all barriers
8. There is no cost of transportation
9. Production in both the countries is subject to law of returns
10. Factor intensity varies between goods
The Leontief Paradox, 1953
 Disputes Heckscher-Olin in some instances.
 Factor endowments can be impacted by government policy - minimum wage.
 US tends to export labour-intensive products, but is regarded as a capital intensive country
Product Life-Cycle Theory (Raymond Vernon, 1966)
 As products mature, both location of sales and optimal production changes.
 Affects the direction and flow of imports and exports.
 Globalization and integration of the economy makes this theory less valid.
The New Trade Theory
 Began to be recognized in the 1970s.
 Deals with the returns on specialization where substantial economies of scale are present.
 Specialization increases output, ability to enhance economies of scale increase.
Porter’s Diamond (Harvard Business School, 1990)
 The Competitive Advantage of Nations.
 Looked at 100 industries in 10 nations.
 Thought existing theories didn’t go far enough.
Implications for Business
 Location implications: makes sense to disperse production activities to countries where they can be performed most efficiently.
 First-mover implications: It pays to invest substantial financial resources in building a first-mover, or early-mover, advantage.
 Policy implications: promoting free trade is generally in the best interests of the home country, although not always in the best interests of the firm. Even though, many firms promote open markets.