2. THEORIES OF INTERNATIONAL
TRADE AND INVESTMENT
McGraw-Hill/Irwin
International Business, 11/e Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.
chapter three

3. LEARNING OBJECTIVES
Explain the theories that attempt to
explain why certain goods are traded
internationally
Discuss the arguments for imposing trade
restrictions
Explain two basic kinds of import
restrictions: tariff and nontariff trade
barriers

4. LEARNING OBJECTIVES
Appreciate the relevance of changing
status of tariff and nontariff barriers to
managers
Explain some of the theories of foreign
direct investment

5. INTERNATIONAL TRADE THEORY
• Mercantilism
• Economic philosophy based on belief that
• (1) a nation’s wealth depends on accumulated treasure, usually
gold, and
• (2) to increase wealth, government policies should promote
exports and discourage imports

6. THEORY OF ABSOLUTE ADVANTAGE
• Absolute advantage
• Theory that a nation has absolute advantage when it can
produce a larger amount of a good or service for the same
amount of inputs as can another country or
• When it can produce the same amount of a good or
service using fewer inputs than could another country

7. ABSOLUTE ADVANTAGE
Each Country Specializes
Example

8. ABSOLUTE ADVANTAGE
Terms of Trade (Ratio of International Prices)
Gains from Specialization and Trade

9. THEORY OF COMPARATIVE
ADVANTAGE
• Comparative Advantage
• A nation having absolute disadvantages in the production
of two goods with respect to another nation has a
comparative or relative advantage in the production of
the good in which its absolute disadvantage is less

10. THEORY OF COMPARATIVE
ADVANTAGE
Example
Each Country Specializes

11. COMPARATIVE ADVANTAGE
Terms of Trade – at a rate of ¾ bolt of cloth for 1 ton of soybeans
Terms of Trade – at a rate of 1 bolt of cloth for 1 ton of soybeans
Gains from Specialization and Trade

12. COMPARATIVE ADVANTAGE
• Production Possibility Frontiers (figure 3.1)
Figure
3.1

13. HECKSCHER-OHLIN THEORY OF
FACTOR ENDOWMENT
• Factor Endowment
• Heckscher-Ohlin theory that countries export products
requiring large amounts of their abundant production
factors and import products requiring large amounts of their
scarce production factors

14. HECKSCHER-OHLIN THEORY OF
FACTOR ENDOWMENT
• Leontief Paradox
• The United States, one of the most capital-
intensive countries in the world, was exporting
relatively labor-intensive products in exchange for
relatively capital-intensive products
• Differences in Taste
• A demand-side construct that is always difficult to
deal with in economic theory

15. HOW CAN MONEY CHANGE THE
DIRECTION OF TRADE?
Example
Exchange Rate – the price of one currency stated in terms of another currency

16. HOW CAN MONEY CHANGE THE
DIRECTION OF TRADE?
• Influences of Exchange Rate
• Currency devaluation
• The lowering of a currency’s price in terms of other currencies

17. SOME NEWER EXPLANATIONS FOR
THE DIRECTION OF TRADE
• Linder Theory of Overlapping Demand
• Customers’ tastes are strongly affected by income levels;
therefore a nation’s income per capita level determines
the kinds of goods they will demand

18. SOME NEWER EXPLANATIONS FOR
THE DIRECTION OF TRADE
• International Product Life Cycle (IPLC)
• Explains why a product that begins as export eventually
becomes import (figure 3.2)
• U.S. exports
• Foreign production begins
• Foreign competition in export market
• Import competition in the United States

19. FIGURE 3.2 INTERNATIONAL
PRODUCT LIFE CYCLE

20. SOME NEWER EXPLANATIONS FOR
THE DIRECTION OF TRADE
• Technology Life Cycle
• Production technology application of IPLC
• Economies of Scale and Experience Curve
• As a plant gets larger and output increase, the
average cost of producing each unit of output
decreases
• As firms produce more products, they learn ways
to improve production efficiency

21. SOME NEWER EXPLANATIONS FOR
THE DIRECTION OF TRADE
• Imperfect Competition
• Economies of scale with the existence of differentiated
products--Paul Krugman
• First-Mover Theory
• Pattern of trade in goods subject to scale economies may
be determined by historical factors

22. SOME NEWER EXPLANATIONS FOR
THE DIRECTION OF TRADE
• National Competitive Advantage from
Regional Clusters: Porter’s Diamond Model
(figure 3.3)
• National Competitiveness: a nation’s relative
ability to design, produce, distribute, or service
products while earning increasing returns on
resources
• Demand conditions
• Factor Conditions
• Related and supporting industries
• Firm strategy, structure, and rivalry

23. FIGURE 3.3 VARIABLE IMPACTING
COMPETITIVE ADVANTAGE: PORTER’S
DIAMOND
Source: Reprinted by permission of the Harvard Business Review. “The Competitive Advantage of Nations” by Michael E. Porter,
March–April 1990, p. 77. Copyright © 1990 by The President and Fellows of Harvard College; all rights reserved.

24. TRADE RESTRICTIONS: ARGUMENTS
FOR
• National Defense
• Sanctions to Punish Offending Nations
• Protect Infant (or Dying) Industry
• Protect Domestic Jobs from Cheap Foreign Labor
• Scientific Tariff or Fair Competition

25. TRADE RESTRICTIONS
• Retaliation
• Dumping: selling a product abroad for less than the cost of
production, the price in the home market, or the price to
third countries
• Social dumping
• Environmental dumping
• Financial services dumping
• Cultural dumping
• Tax dumping

26. TRADE RESTRICTIONS
• Subsidies: Financial contributions, provided directly or
indirectly by a government, which confer a benefit; include
grants, preferential tax treatment, and government
assumption of normal business expenses (figure 3.4)
• Countervailing duties: Additional import taxes levied on
imports that have benefited from export subsidies

27. FIGURE 3.4 VALUE OF OECD
MEMBER FARM SUBSIDIES
Source: “Agriculture: Support Estimates, 2004,” OECD in Figures: Statistics on the Member Countries. Accessed 7/2005
Link: http://dx.doi.org/10.1787/758034618756.

28. TARIFF BARRIERS
• Tariff
• Taxes on imported goods for the purpose of
raising their price to reduce competition for local
producers or stimulate local production
• Ad Valorem Duty
• An import duty levied as a percentage of the
invoice value of imported goods
• Specific Duty
• A fixed sum levied on a physical unit of an
imported good

29. TARIFF BARRIERS
• Compound Duty
• A combination of specific and ad valorem duties
• Official Prices
• Variable Levy
• An import duty set at the difference between world market
prices and local government-supported prices
• Lower Duty for more local Input

30. NONTARIFF BARRIERS
• Nontariff barriers (NTBs)
• All forms of discrimination against imports other than import
duties
• Quantitative
• Quotas: numerical limits placed on specific classes of
imports
• Voluntary export restraints (VERs): Export quotas imposed
by exporting nation

31. NONTARIFF BARRIERS
• Orderly Marketing Arrangements
• Formal agreements between exporting and importing
countries that stipulate the import or export quotas each
nation will have for a good
• Nonquantitative Nontariff Barriers
• Direct government participation in trade
• Customs and other administrative procedures
• Standards

32. FROM MULTINATIONAL TO
GLOBALLY INTEGRATED
MANUFACTURING SYSTEMS
• Close least efficient plants, and supply their markets
with imports from other subsidiaries
• Change multidomestic manufacturing system to
globally integrated system in which each plant
performs the activities at which it is most efficient

33. INTERNATIONAL INVESTMENT
THEORIES
• Monopolistic Advantage Theory
Theory that FDI is made by firms in oligopolistic
industries possessing technical and other
advantages
over indigenous firms
• Product and Factor Market Imperfections
Superior knowledge leads to differentiated
products, and they lead to firm control on price and
advantage over indigenous firm (Hymer and
Caves)
• Financial Factors
Imperfections in the foreign exchange markets
(Aliber)

34. INTERNATIONAL INVESTMENT
THEORIES
• Follow The Leader
• Cross Investment
• Foreign direct investment by oligopolistic firms in
each other’s home countries as a defense
measure
• Internalization Theory
• An extension of the market imperfection theory:
to obtain a higher return on its investment, a firm
will transfer its superior knowledge to a foreign
subsidiary rather than sell it in the open market

35. INTERNATIONAL INVESTMENT
THEORIES
• Dynamic Capabilities
• Theory that for a firm to successfully invest
overseas, it must have ownership of unique
knowledge or resources and the ability to
dynamically create and exploit these capabilities
• Dunning’s Eclectic Theory Of International
Production
• Theory that for a firm to invest overseas, it must
have three kinds of advantages: ownership-
specific, internalization, and location-specific