International Business 10eBy Charles W.L. HillCopy.docx

International Business 10e
By Charles W.L. Hill
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
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Chapter 8
Foreign Direct
Investment
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8-*
What Is FDI?Foreign direct investment (FDI) occurs when a
firm invests directly in new facilities to produce and/or market
in a foreign countrythe firm becomes a multinational
enterpriseFDI can be in the form of greenfield investments - the
establishment of a wholly new operation in a foreign

countryacquisitions or mergers with existing firms in the
foreign country
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Greenfield operation:mostly in developing nations
Mergers and acquisitions:quicker to executeforeign firms have
valuable strategic assetsbelieve they can increase the efficiency
of the acquired firmmore prevalent in developed nations
The Opening Case: Foreign Retailers in India describes the
challenges faced by foreign retailers that are trying to gain a
foothold in India, despite political objections from local
officials.
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What Is FDI?The flow of FDI - the amount of FDI undertaken
over a given time period Outflows of FDI are the flows of FDI
out of a countryInflows of FDI are the flows of FDI into a
countryThe stock of FDI - the total accumulated value of
foreign-owned assets at a given time
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LO 1: Recognize current trends regarding foreign direct
investment (FDI) in the world economy.
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What Are The Patterns Of FDI?Both the flow and stock of FDI
have increased over the last 35 yearsMost FDI is still targeted
towards developed nations United States, Japan, and the EUbut,

other destinations are emergingSouth, East, and South East Asia
especially China Latin America
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Country Focus: Foreign Direct Investment in China explores
investment opportunities in China. In the late 1970s, China
opened its doors to foreign investors. By the mid 2000s, China
attracted $60 billion of FDI annually. China’s large population
is a magnet for many companies and because high tariffs make
it difficult to export to the Chinese market, firms frequently
turn to foreign direct investment. However, many companies
have found it difficult to conduct business in China, and in
recent years investment rates have slowed. In response, the
Chinese government, hoping to continue to attract foreign
companies has established a number of incentives for would-be
investors.
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What Are The Patterns Of FDI?
FDI Outflows 1982-2012 ($ billions)
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Source: Calculated by the author from United Nations World
Investment Report, various editions.
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FDI Inflows by Region 1995-2011 ($ billion)

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What Are The Patterns Of FDI?The growth of FDI is a result of
a fear of protectionismwant to circumvent trade barriers
political and economic changesderegulation, privatization,
fewer restrictions on FDI
new bilateral investment treatiesdesigned to facilitate
investment
the globalization of the world economymany companies now
view the world as their marketneed to be closer to their
customers
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What Are The Patterns Of FDI?Gross fixed capital formation -
the total amount of capital invested in factories, stores, office
buildings, and the like the greater the capital investment in an
economy, the more favorable its future prospects are likely to
be So, FDI is an important source of capital investment and a
determinant of the future growth rate of an economy

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Inward FDI as a % of Gross Fixed Capital Formation 1992-2008
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What Is The Source Of FDI?Since World War II, the U.S. has
been the largest source country for FDIthe United Kingdom, the
Netherlands, France, Germany, and Japan are other important
source countriestogether, these countries account for 60% of all
FDI outflows from 1998-2011
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What Is The Source Of FDI?
Cumulative FDI Outflows 1998-2011 ($ billions)

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Why Do Firms Choose Acquisition Versus Greenfield
Investments?Most cross-border investment is in the form of
mergers and acquisitions rather than greenfield
investmentsbetween 40-80% of all FDI inflows per annum from
1998 to 2011 were in the form of mergers and acquisitionsbut in
developing countries two-thirds of FDI is greenfield investment
fewer target companies
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Why Do Firms Choose Acquisition Versus Greenfield
Investments?Firms prefer to acquire existing assets because
mergers and acquisitions are quicker to execute than greenfield
investmentsit is easier and perhaps less risky for a firm to
acquire desired assets than build them from the ground upfirms
believe that they can increase the efficiency of an acquired unit
by transferring capital, technology, or management skills
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8-*
Why Choose FDI?Question: Why does FDI occur instead of
exporting or licensing?
Exporting - producing goods at home and then shipping them to
the receiving country for sale exports can be limited by
transportation costs and trade barriers FDI may be a response to
actual or threatened trade barriers such as import tariffs or
quotas
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LO 2: Explain the different theories of FDI.
Why do firms invest rather than use exporting or licensing to
enter foreign markets?
FDI is more attractive when transportation costs or trade
barriers make exporting unattractive.
Management Focus: Foreign Direct Investment by Cemex
explores why foreign direct investment made more sense for the
Mexican cement maker than exporting. For Cemex, exporting is
too costly.
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Why Choose FDI?
Licensing - granting 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 Internalization theory (aka market
imperfections theory) - compared to FDI licensing is less
attractivefirm could give away valuable technological know-
how to a potential foreign competitordoes not give a firm the

control over manufacturing, marketing, and strategy in the
foreign country the firm’s competitive advantage may be based
on its management, marketing, and manufacturing capabilities
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A firm will favor FDI over licensing when it wishes to maintain
control over its technological know-how, or over its operations
and business strategy, or when the firm’s capabilities are simply
not amenable to licensing.
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What Is The Pattern Of FDI?Question: Why do firms in the
same industry undertake FDI at about the same time and the
same locations?Knickerbocker - FDI flows are a reflection of
strategic rivalry between firms in the global
marketplacemultipoint competition -when two or more
enterprises encounter each other in different regional markets,
national markets, or industries
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With regard to horizontal FDI, market imperfections arise in
two circumstances:when there are impediments to the free flow
of products between nations which decrease the profitability of
exporting relative to FDI and licensingwhen there are
impediments to the sale of know-how which increase the
profitability of FDI relative to licensing

8-*
What Is The Pattern Of FDI?Question: But, why is it profitable
for firms to undertake FDI rather than continuing to export from
home base, or licensing a foreign firm? Dunning’s eclectic
paradigm - it is important to considerlocation-specific
advantages - that arise from using resource endowments or
assets that are tied to a particular location and that a firm finds
valuable to combine with its own unique assets externalities -
knowledge spillovers that occur when companies in the same
industry locate in the same area
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FDI is expensive because a firm must bear the costs of
establishing production facilities in a foreign country or of
acquiring a foreign enterprise.
FDI is risky because of the problems associated with doing
business in another culture where the rules of the game may be
different.
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What Are The Theoretical Approaches To FDI?The radical view
- the MNE is an instrument of imperialist domination and a tool
for exploiting host countries to the exclusive benefit of their
capitalist-imperialist home countries in retreat almost
everywhere The free market view - international production
should be distributed among countries according to the theory
of comparative advantage embraced by advanced and
developing nations including the United States and Britain, but
no country has adopted it in its purest form

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LO 3: Understand how political ideology shapes a government’s
attitudes towards FDI.
The radical view lacked support by the end of the 1980s because
of: the collapse of communism in Eastern Europe the poor
economic performance of those countries that followed the
policy a growing belief by many of these countries that FDI can
be an important source of technology and jobs and can stimulate
economic growth the strong economic performance of
developing countries that embraced capitalism rather than
ideology
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What Are The Theoretical Approaches To FDI?Pragmatic
nationalism - FDI has both benefits (inflows of capital,
technology, skills and jobs) and costs (repatriation of profits to
the home country and a negative balance of payments
effect)FDI should be allowed only if the benefits outweigh the
costsRecently, there has been a strong shift toward the free
market stance creatinga surge in FDI worldwide an increase in
the volume of FDI in countries with newly liberalized regimes
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Management Focus: DP World and the United States explores
the reaction to the bid by DP World, a Dubai-based ports
operator, to acquire P&O, a British firm that runs a network of
global marine terminals. An acquisition of P&O would give DP
World management of six U.S. ports. While the Bush
administration claimed the acquisition posed no threat to
national security, several prominent U.S. Senators raised

concerns about the acquisition. Ultimately, DP World pulled
out of the deal, but stated that it would look for alternative
ways to enter the U.S. market.
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How Does FDI Benefit
The Host Country?There are four main benefits of inward FDI
for a host country
Resource transfer effects - FDI brings capital, technology, and
management resources
Employment effects - FDI can bring jobs
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LO 4: Describe the benefits and costs of FDI to home and host
countries.
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The Host Country?
Balance of payments effects - FDI can help a country to achieve
a current account surplus
Effects on competition and economic growth - greenfield
investments increase the level of competition in a market,
driving down prices and improving the welfare of consumerscan
lead to increased productivity growth, product and process
innovation, and greater economic growth
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What Are The Costs Of
FDI To The Host Country?Inward FDI has three main costs:
Adverse effects of FDI on competition within the host nation
subsidiaries of foreign MNEs may have greater economic power
than indigenous competitors because they may be part of a
larger international organization
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FDI To The Host Country?
Adverse effects on the balance of paymentswhen a foreign
subsidiary imports a substantial number of its inputs from
abroad, there is a debit on the current account of the host
country’s balance of payments
Perceived loss of national sovereignty and autonomydecisions
that affect the host country will be made by a foreign parent
that has no real commitment to the host country, and over which
the host country’s government has no real control

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The Home Country?The benefits of FDI for the home country
include
The effect on the capital account of the home country’s balance
of payments from the inward flow of foreign earnings
The employment effects that arise from outward FDI
The gains from learning valuable skills from foreign markets
that can subsequently be transferred back to the home country
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FDI To The Home Country?
The home-country’s balance of payments can sufferfrom the
initial capital outflow required to finance the FDIif the purpose
of the FDI is to serve the home market from a low cost labor
locationif the FDI is a substitute for direct exports
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8-*
FDI To The Home Country?
Employment may also be negatively affected if the FDI is a
substitute for domestic productionBut, international trade theory
suggests that home-country concerns about the negative
economic effects of offshore production (FDI undertaken to
serve the home market) may not be validmay stimulate
economic growth and employment in the home country by
freeing resources to specialize in activities where the home
country has a comparative advantage
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How Does Government
Influence FDI?Governments can encourage outward
FDIgovernment-backed insurance programs to cover major
types of foreign investment riskGovernments can restrict
outward FDIlimit capital outflows, manipulate tax rules, or
outright prohibit FDI
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LO 5: Explain the range of policy instruments that governments
use to influence FDI.

The rationale underlying ownership restraints is twofold: first,
foreign firms are often excluded from certain sectors on the
grounds of national security or competitionsecond, ownership
restraints seem to be based on a belief that local owners can
help to maximize the resource transfer and employment benefits
of FDI for the host country
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How Does Government
Influence FDI?Governments can encourage inward FDIoffer
incentives to foreign firms to invest in their countriesgain from
the resource-transfer and employment effects of FDI, and
capture FDI away from other potential host
countriesGovernments can restrict inward FDIuse ownership
restraints and performance requirements
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How Do International
Institutions Influence FDI?Until the 1990s, there was no
consistent involvement by multinational institutions in the
governing of FDIToday, the World Trade Organization is
changing this by trying to establish a universal set of rules
designed to promote the liberalization of FDI
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8-*
What Does FDI
Mean For Managers?Managers need to consider what trade
theory implies about FDI, and the link between government
policy and FDIThe direction of FDI can be explained through
the location-specific advantages argument associated with John
Dunninghowever, it does not explain why FDI is preferable to
exporting or licensing, must consider internalization theory
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LO 6: Identify the implications for managers of the theory and
government policies associated with FDI.
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What Does FDI
Mean For Managers?
A Decision Framework
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What Does FDI

Mean For Managers?A host government’s attitude toward FDI is
important in decisions about where to locate foreign production
facilities and where to make a foreign direct investmentfirms
have the most bargaining power when the host government
values what the firm has to offer, when the firm has multiple
comparable alternatives, and when the firm has a long time to
complete negotiations
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Chapter 7
The Political Economy of International Trade
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7-*
What Is The Political Reality
Of International Trade?Free trade occurs when governments do
not attempt to restrict what citizens can buy from another
country or what they can sell to another country many nations
are nominally committed to free trade, but intervene to protect
the interests of politically important groups
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The Opening Case: China Limits Exports of Rare Earth Metals
explores China’s decision to the limit the export of rare earth
metals, which are key components in the manufacture of high-
technology products including wind turbines, iPhones, and
batteries used in hybrid cars. China claims it lowered the export
quotas because several of its manufacturers didn’t meet
environmental standards; however, developed countries saw this
move as an opportunity for China to give its domestic
manufacturers a cost advantage and to encourage foreign
manufacturers to move production to China—to gain access to
lower-cost supplies of rare earth metals.
7-*
How Do Governments
Intervene In Markets?Governments use various methods to
intervene in markets including
Tariffs - taxes levied on imports that effectively raise the cost
of imported products relative to domestic products Specific

tariffs - levied as a fixed charge for each unit of a good
imported Ad valorem tariffs - levied as a proportion of the value
of the imported good
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LO 1: Identify the policy instruments used by governments to
influence international trade flows.
Tariffs are the oldest form of trade policy; they fall into two
categories:Specific tariffs are levied as a fixed charge for each
unitAd valorem tariffs are levied as a proportion of the value of
the imported good
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How Do Governments
Intervene In Markets?Tariffs increase government
revenuesforce consumers to pay more for certain importsare
pro-producer and anti-consumerreduce the overall efficiency of
the world economy
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Tariffs are good for government because they generate revenue.
But, while they protect domestic producers, they reduce
efficiency and create higher prices for consumers.
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How Do Governments
Intervene In Markets?

Subsidies - government payments to domestic
producersSubsidies help domestic producerscompete against
low-cost foreign importsgain export marketsConsumers
typically absorb the costs of subsidies
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Subsidies are government payments to domestic producers.
They can be in the form of:Cash grantsLow-interest loansTax
breaksGovernment equity participation in the company
Subsidy revenues are generated from taxes.
Subsidies encourage over-production, inefficiency, and reduced
trade.
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How Do Governments
Import Quotas - restrict the quantity of some good that may be
imported into a country Tariff rate quotas - a hybrid of a quota
and a tariff where a lower tariff is applied to imports within the
quota than to those over the quota A quota rent - the extra
profit that producers make when supply is artificially limited by
an import quota
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7-*
How Do Governments

Voluntary Export Restraints - quotas on trade imposed by the
exporting country, typically at the request of the importing
country’s governmentImport quotas and voluntary export
restraintsbenefit domestic producers raise the prices of imported
goods
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7-*
How Do Governments
Local Content Requirements - demand that some specific
fraction of a good be produced domestically benefit domestic
producersconsumers face higher prices
Administrative Policies - bureaucratic rules designed to make it
difficult for imports to enter a country polices hurt consumers
by limiting choice
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How Do Governments
Antidumping Policies–also called countervailing duties–punish
foreign firms that engage in dumping and protect domestic
producers from “unfair” foreign competitiondumping - selling
goods in a foreign market below their costs of production, or
selling goods in a foreign market below their “fair” market
value enables firms to unload excess production in foreign
markets may be predatory behavior - producers use profits from
their home markets to subsidize prices in a foreign market to
drive competitors out of that market, and then later raise prices
*
Management Focus: U.S. Magnesium Seeks Protection explores
the dumping charged levied by U.S. Magnesium against Chinese
and Russian producers. According to U.S. Magnesium, the sole
American producer of magnesium, Russian and Chinese
producers were selling magnesium significantly below market
value in an effort to drive U.S. Magnesium out of business. The
company failed a complaint with the International Trade
Commission (ITC) which ultimately ruled in favor of U.S.
Magnesium.
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Why Do Governments
Intervene In Markets?There are two main arguments for
government intervention in the market
Political arguments - concerned with protecting the interests of
certain groups within a nation (normally producers), often at the
expense of other groups (normally consumers)
Economic arguments - concerned with boosting the overall

wealth of a nation – benefits both producers and consumers
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LO 2: Understand why governments sometimes intervene in
international trade.
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What Are The Political Arguments For Government
Intervention?
Protecting jobs - the most common political reason for trade
restrictions results from political pressures by unions or
industries that are "threatened" by more efficient foreign
producers, and have more political clout than consumers
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7-*
Intervention?
Protecting industries deemed important for national security -
industries are often protected because they are deemed
important for national securityaerospace or semiconductors
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Intervention?
Retaliation for unfair foreign competition - when governments
take, or threaten to take, specific actions, other countries may
remove trade barriersif threatened governments do not back
down, tensions can escalate and new trade barriers may be
enactedrisky strategy
Protecting consumers from “dangerous” products – limit
“unsafe” products
*
Country Focus: Trade in Hormone-Treated Beef describes the
trade battle between the United States and the European Union
over beef from cattle that have been given growth hormones. It
outlines the basic issues that led to the dispute, and shows how
the World Trade Organization has treated the case.
7-*
Intervention?
Furthering the goals of foreign policy - preferential trade terms
can be granted to countries that a government wants to build
strong relations with trade policy can also be used to punish
rogue states
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The U.S. has used trade policy against countries like Libya,
Iran, Iraq, North Korea, and Cuba.

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Intervention?
Protecting the human rights of individuals in exporting
countries – through trade policy actions
Protecting the environment – international trade is associated
with a decline in environmental qualityconcern over global
warmingenforcement of environmental regulations
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What Are The Economic Arguments For Government
Intervention?
The infant industry argument - an industry should be protected
until it can develop and be viable and competitive
internationally accepted as a justification for temporary trade
restrictions under the WTO
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Oldest argument - Alexander Hamilton, 1792.
Protected under the WTO.
Only good if it makes the industry efficient.
Brazil automakers - 10th largest - wilted when protection was
eliminated.
Requires government financial assistance.
Today if the industry is a good investment, global capital
markets would invest.

7-*
Intervention?Question: When is an industry “grown up” ?Critics
argue that if a country has the potential to develop a viable
competitive position, its firms should be capable of raising
necessary funds without additional support from the government
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7-*
Intervention?
Strategic trade policy – first-mover advantages can be important
to successgovernments can help firms from their countries
attain these advantages governments can help firms overcome
barriers to entry into industries where foreign firms have an
initial advantage
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Strategic trade policy suggests that: government should use
subsidies to protect promising firms in newly emerging
industries with substantial scale economiesgovernments benefit
if they support domestic firms to overcome barriers to entry
created by existing foreign firms
7-*
When Should Governments

Avoid Using Trade Barriers?Paul Krugman argues that strategic
trade policies aimed at establishing domestic firms in a
dominant position in a global industry are beggar-thy-neighbor
policies that boost national income at the expense of other
countriescountries that attempt to use such policies will
probably provoke retaliationKrugman argues that since special
interest groups can influence governments, strategic trade
policy is almost certain to be captured by such groups who will
distort it to their own ends
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LO 3: Summarize and explain the arguments against strategic
trade policy.
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How Has The Current World Trading System Emerged?Until the
Great Depression of the 1930s, most countries had some degree
of protectionismSmoot-Hawley Act (1930)After WWII, the U.S.
and other nations realized the value of freer tradeestablished the
General Agreement on Tariffs and Trade (GATT) - a
multilateral agreement to liberalize trade
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LO 4: Describe the development of the world trading system
and the current trade issues.

GATT - multilateral agreement established in 1948 under U.S.
leadership.
Objective is to liberalize trade by eliminating tariffs, subsidies,
and import quotas.
Nineteen original members grew to more than 120 nations.
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How Has The Current World Trading System Emerged?In the
1980s and early 1990s protectionist trends emergedJapan’s
perceived protectionist (neo-mercantilist) policies created
intense political pressures in other countriespersistent trade
deficits by the U.Suse of non-tariff barriers increased
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How Has The Current World Trading System Emerged?The
Uruguay Round of GATT negotiations began in 1986 focusing
on
Services and intellectual propertygoing beyond manufactured
goods to address trade issues related to services and intellectual
property, and agriculture
The World Trade Organizationit was hoped that enforcement
mechanisms would make the WTO a more effective policeman
of the global trade rules

*
GATT used ‘rounds of talks’ to gradually reduce trade barriers.
Uruguay Round GATT 1986-93
Mutual tariff reductions negotiated.
Dispute resolution only if complaints were received.
GATT regulations could be circumvented using voluntary
export restraints.
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WTO encompassed GATT along with two sisters
organizationsthe General Agreement on Trade in Services
(GATS) working to extend free trade agreements to services the
Agreement on Trade Related Aspects of Intellectual Property
Rights (TRIPS)working to develop common international rules
for intellectual property rights
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7-*
WTO has emerged as an effective advocate and facilitator of
future trade deals, particularly in such areas as services 159
members in 2013so far, the WTO’s policing and enforcement
mechanisms are having a positive effectmost countries have

adopted WTO recommendations for trade disputes a magnet for
various groups protesting free trade
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The WTO:
--had 159 in early 2013
--resolved more than 400 disputes between 1995 and 2012
--three fourths of the disputes are settled by informal
consultation
Because members believe that the protection of intellectual
property rights is an essential element of the international
trading system, TRIPS obliges WTO members to grant and
enforce patents lasting at least 20 years, and copyrights lasting
50 years.
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What Is The Future Of The World Trade Organization?The
current agenda of the WTO focuses on the rise of anti-dumping
policiesthe high level of protectionism in agriculturethe lack of
strong protection for intellectual property rights in many
nationscontinued high tariffs on nonagricultural goods and
services in many nations
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7-*

What Is The Future Of The World Trade Organization?The
WTO launched a new round of talks at Doha, Qatar in 2001 that
have already gone on for 12 years and are currently stalled.The
agenda includescutting tariffs on industrial goods and
servicesphasing out subsidies to agricultural producersreducing
barriers to cross-border investmentlimiting the use of anti-
dumping laws
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Country Focus: Estimating the Gains from Trade for America
explores the results of a study by the Institute for International
Economics. The study, which estimated the gains to the
American economy from free trade, found that America’s GDP
was more than 7 percent higher as a result of reductions in trade
barriers than it would have been if the barriers remained. The
study also estimated that if tariffs were reduced to zero,
significant gains would still result.
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What Do Trade Barriers
Mean For Managers?Managers need to consider how trade
barriers affect the strategy of the firm and the implications of
government policy on the firm
Trade barriers raise the cost of exporting products to a country
Voluntary export restraints (VERs) may limit a firm’s ability to
serve a country from locations outside that country
*
LO 5: Explain the implications for managers of developments in

the world trading system.
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What Do Trade Barriers
Mean For Managers?
To conform to local content requirements, a firm may have to
locate more production activities in a given market than it
would otherwiseManagers have an incentive to lobby for free
trade, and keep protectionist pressures from causing them to
have to change strategies
*
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Chapter 6

International Trade Theory
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6-*
Why Is Free Trade Beneficial?Free trade - a situation where a
government does not attempt to influence through quotas or
duties what its citizens can buy from another country or what
they can produce and sell to another country Trade theory shows
why it is beneficial for a country to engage in international
trade even for products it is able to produce for itself
*
6-*
Why Is Free Trade Beneficial?International trade allows a
countryto specialize in the manufacture and export of products
and services that it can produce efficientlyimport products and
services that can be produced more efficiently in other
countrieslimits on imports may be beneficial to producers, but
not beneficial for consumers
*
LO 1: Understand why nations trade with each other.
The Opening Case: Creating the World’s Biggest Free Trade
Zone illustrates the benefits of free trade and globalization.
President Obama has committed the United States to negotiating
a free trade deal with the European Union. The announcement
was greeted with enthusiasm that can be traced to widespread
acceptance of the key axiom of international trade—trade is

good for all countries involved in a free trade agreement.
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Why Do Certain
Patterns Of Trade Exist? Some patterns of trade are fairly easy
to explain it is obvious why Saudi Arabia exports oil, Ghana
exports cocoa, and Brazil exports coffeeBut, why does
Switzerland export chemicals, pharmaceuticals, watches, and
jewelry? Why does Japan export automobiles, consumer
electronics, and machine tools?
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6-*
What Role Does
Government Have In Trade?The mercantilist philosophy makes
a crude case for government involvement in promoting exports
and limiting imports Smith, Ricardo, and Heckscher-Ohlin
promote unrestricted free trade New trade theory and Porter’s
theory of national competitive advantage justify limited and
selective government intervention to support the development of
certain export-oriented industries
*
Country Focus: Is China a Neo-Mercantilist Nation analyzes
claims that China is a neo-mercantilist nation. Exports are
largely responsible for China’s recent rapid economic growth.
The country, capitalizing on its cheap labor force, has been
focused on converting raw materials into products that are

exported to developing countries like the United States.
China’s trade surplus has started to contract [partly as a result
of allowing the Chinese currency (the yuan) to appreciate
against the US dollar] as export growth has slowed and imports
have increased.
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What Is Mercantilism?Mercantilism (mid-16th century) suggests
that it is in a country’s best interest to maintain a trade
surplus—to export more than it importsadvocates government
intervention to achieve a surplus in the balance of trade
Mercantilism views trade as a zero-sum game—one in which a
gain by one country results in a loss by another
*
LO 2: Summarize the different theories explaining trade flows
between nations.
Mercantilism suggests that countries should design policies that
lead to an increase in their holdings of gold and silver.
This was usually done by increasing exports and limiting
imports. This economic philosophy was used by Europeans from
about the 1500s to the late 1700s. It fueled colonialism in
Britain, France, the Netherlands and Spain.
Nations increase their wealth by maintaining trade surpluses.
The key problem with the mercantilist view is that it views
trade as a zero sum game, where if one country benefits the
other must lose. As an economic philosophy, mercantilism is
flawed.
Yet many political views today have the goal of boosting
exports while limiting imports by seeking only selective
liberalization of trade.

6-*
What Is Smith’s Theory
Of Absolute Advantage?Adam Smith (1776) argued that a
country has an absolute advantage in the production of a
product when it is more efficient than any other country in
producing itcountries should specialize in the production of
goods for which they have an absolute advantage and then trade
these goods for goods produced by other countries
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between nations.
In 1776, Adam Smith attacked the mercantilist assumption that
trade is a zero-sum game and argued that countries differ in
their ability to produce goods efficiently, and that a country has
an absolute advantage in the production of a product when it is
more efficient than any other country in producing it.
According to Smith, countries should specialize in the
production of goods for which they have an absolute advantage
and then trade these goods for the goods produced by other
countries.
6-*
How Does The Theory
Of Absolute Advantage Work?Assume that two countries,
Ghana and South Korea, both have 200 units of resources that
could either be used to produce rice or cocoaIn Ghana, it takes
10 units of resources to produce one ton of cocoa and 20 units
of resources to produce one ton of rice Ghana could produce 20
tons of cocoa and no rice, 10 tons of rice and no cocoa, or some

combination of rice and cocoa between the two extremes
*
6-*
How Does The Theory
Of Absolute Advantage Work?In South Korea it takes 40 units
of resources to produce one ton of cocoa and 10 resources to
produce one ton of riceSouth Korea could produce 5 tons of
cocoa and no rice, 20 tons of rice and no cocoa, or some
combination in between
*
6-*
How Does The Theory
Of Absolute Advantage Work?Without tradeGhana would
produce 10 tons of cocoa and 5 tons of riceSouth Korea would
produce 10 tons of rice and 2.5 tons of cocoaWith specialization
and tradeGhana would produce 20 tons of cocoaSouth Korea
would produce 20 tons of riceGhana could trade 6 tons of cocoa
to South Korea for 6 tons of rice
*
6-*

How Does The Theory
Of Absolute Advantage Work?After tradeGhana would have 14
tons of cocoa left, and 6 tons of riceSouth Korea would have 14
tons of rice left and 6 tons of cocoaIf each country specializes
in the production of the good in which it has an absolute
advantage and trades for the other, both countries gaintrade is a
positive sum game
*
6-*
How Does The Theory
Of Absolute Advantage Work?
Absolute Advantage and the Gains from Trade
*
6-*
What Is Ricardo’s Theory
Of Comparative Advantage?David Ricardo asked what happens
when one country has an absolute advantage in the production
of all goods The theory of comparative advantage (1817)—
countries should specialize in the production of those goods
they produce most efficiently and buy goods that they produce
less efficiently from other countrieseven if this means buying

goods from other countries that they could produce more
efficiently at home
*
between nations.
6-*
How Does The Theory Of Comparative Advantage
Work?Assume Ghana is more efficient in the production of both
cocoa and riceIn Ghana, it takes 10 resources to produce one
ton of cocoa, and 13 1/2 resources to produce one ton of riceSo,
Ghana could produce 20 tons of cocoa and no rice, 15 tons of
rice and no cocoa, or some combination of the two
*
6-*
How Does The Theory Of Comparative Advantage Work?In
South Korea, it takes 40 resources to produce one ton of cocoa
and 20 resources to produce one ton of riceSo, South Korea
could produce 5 tons of cocoa and no rice, 10 tons of rice and
no cocoa, or some combination of the two
*
6-*
How Does The Theory Of Comparative Advantage Work?With

tradeGhana could export 4 tons of cocoa to South Korea in
exchange for 4 tons of rice Ghana will still have 11 tons of
cocoa, and 4 additional tons of riceSouth Korea still has 6 tons
of rice and 4 tons of cocoa if each country specializes in the
production of the good in which it has a comparative advantage
and trades for the other, both countries gain
*
6-*
How Does The Theory Of Comparative Advantage
Work?Comparative advantage theory provides a strong rationale
for encouraging free trade total output is higherboth countries
benefit Trade is a positive sum game
*
6-*
How Does The Theory Of Comparative Advantage Work?
Comparative Advantage and the Gains from Trade
*
6-*
Is Unrestricted Free Trade

Always Beneficial?Unrestricted free trade is beneficial, but the
gains may not be as great as the simple model of comparative
advantage would suggestimmobile resourcesdiminishing
returnsdynamic effects and economic growth the Samuelson
critiqueBut, opening a country to trade could increasea
country's stock of resources as increased supplies become
available from abroadthe efficiency of resource utilization and
so free up resources for other uses economic growth
*
LO 3: Recognize why many economists believe that unrestricted
free trade between nations will raise the economic welfare if
countries that participate in a free trade system.
The simple example of comparative advantage presented in the
text makes a number of assumptions: only two countries and
two goods; zero transportation costs; similar prices and values;
resources are mobile between goods within countries, but not
across countries; constant returns to scale; fixed stocks of
resources; and no effects on income distribution within
countries. While these are all unrealistic, the general
proposition that countries will produce and export those goods
that they are the most efficient at producing has been shown to
be quite valid.
6-*
Could A Rich Country Be
Worse Off With Free Trade? Paul Samuelson - the dynamic
gains from trade may not always be beneficialfree trade may
ultimately result in lower wages in the rich countryThe ability
to offshore services jobs that were traditionally not
internationally mobile may have the effect of a mass inward
migration into the United States, where wages would then

fallbut, protectionist measures could create a more harmful
situation than free trade
*
Country Focus: Moving U.S. White-Collar Jobs Offshore goes
to the heart of a debate that has been played out many times
over the past half century—the transference of jobs from the
United States to lower-wage countries. The difference now
however, is that rather than blue-collar jobs being transferred,
the new trend is for white-collar jobs to move, jobs associated
with the knowledge-based economy.
6-*
What Is The
Heckscher-Ohlin Theory? Eli Heckscher (1919) and Bertil Ohlin
(1933) - comparative advantage arises from differences in
national factor endowments the extent to which a country is
endowed with resources like land, labor, and capitalThe more
abundant a factor, the lower its cost
*
between nations.
Basic factors:
Natural resources
Climate
Geographic location
Demographics
While basic factors can provide an initial advantage they must
be supported by advanced factors to maintain success.
Advanced factors:
The result of investment by people, companies, and government

are more likely to lead to competitive advantage. If a country
has no basic factors, it must invest in advanced factors.
6-*
What Is The
Heckscher-Ohlin Theory? The pattern of trade is determined by
factor endowmentsHeckscher and Ohlin predict that countries
willexport goods that make intensive use of locally abundant
factorsimport goods that make intensive use of factors that are
locally scarce
*
6-*
Does The Heckscher-Ohlin
Theory Hold?Wassily Leontief (1953) theorized that since the
U.S. was relatively abundant in capital compared to other
nations, the U.S. would be an exporter of capital intensive
goods and an importer of labor-intensive goods. However, he
found that U.S. exports were less capital intensive than U.S.
importsSince this result was at variance with the predictions of
trade theory, it became known as the Leontief Paradox.
*
6-*

What Is The
Product Life-Cycle Theory?The product life-cycle theory - as
products mature both the location of sales and the optimal
production location will change affecting the flow and direction
of tradeproposed by Ray Vernon in the mid-1960s At this time
most of the world’s new products were developed by U.S. firms
and sold first in the U.S.
*
between nations.
6-*
What Is The
Product Life-Cycle Theory?According to the product life-cycle
theory the size and wealth of the U.S. market gave U.S. firms a
strong incentive to develop new productsinitially, the product
would be produced and sold in the U.S.as demand grew in other
developed countries, U.S. firms would begin to export demand
for the new product would grow in other advanced countries
over time making it worthwhile for foreign producers to begin
producing for their home markets
*
6-*
What Is The
Product Life-Cycle Theory?U.S. firms might set up production

facilities in advanced countries with growing demand, limiting
exports from the U.S.As the market in the U.S. and other
advanced nations matured, the product would become more
standardized, and price would be the main competitive weapon
*
6-*
What Is The
Product Life-Cycle Theory?Producers based in advanced
countries where labor costs were lower than the United States
might now be able to export to the United StatesIf cost
pressures were intense, developing countries would acquire a
production advantage over advanced countriesProduction
became concentrated in lower-cost foreign locations, and the
U.S. became an importer of the product
*
6-*
What Is The
Product Life-Cycle Theory?
The Product Life-Cycle Theory
*
Source: Adapted from Raymond Vernon and Louis T. Wells,
The Economic Environment of International Business, 5th

edition © 1991. Reproduced by permission of Pearson
Education, Inc., Upper Saddle River, New Jersey.
6-*
Does The Product Life-
Cycle Theory Hold?The product life-cycle theory accurately
explains what has happened for products like photocopiers and a
number of other high technology products developed in the
United States in the 1960s and 1970smature industries leave the
U.S. for low cost assembly locations
*
6-*
Does The Product Life
Cycle Theory Hold?But, the globalization and integration of the
world economy has made this theory less valid todaythe theory
is ethnocentricproduction today is dispersed globallyproducts
today are introduced in multiple markets simultaneously
*
6-*
What Is New Trade Theory?New trade theory suggests that the
ability of firms to gain economies of scale (unit cost reductions
associated with a large scale of output) can have important

implications for international tradeCountries may specialize in
the production and export of particular products because in
certain industries, the world market can only support a limited
number of firmsnew trade theory emerged in the 1980sPaul
Krugman won the Nobel prize for his work in 2008
*
between nations.
6-*
What Is New Trade Theory?
Through its impact on economies of scale, trade can increase
the variety of goods available to consumers and decrease the
average cost of those goodswithout trade, nations might not be
able to produce those products where economies of scale are
importantwith trade, markets are large enough to support the
production necessary to achieve economies of scaleso, trade is
mutually beneficial because it allows for the specialization of
production, the realization of scale economies, and the
production of a greater variety of products at lower prices
*
6-*
What Is New Trade Theory?
In those industries when output required to attain economies of
scale represents a significant proportion of total world demand,
the global market may only be able to support a small number of

enterprises first-mover advantages - the economic and strategic
advantages that accrue to early entrants into an
industryeconomies of scale first movers can gain a scale based
cost advantage that later entrants find difficult to match
*
6-*
What Are The Implications Of
New Trade Theory For Nations? Nations may benefit from trade
even when they do not differ in resource endowments or
technologya country may dominate in the export of a good
simply because it was lucky enough to have one or more firms
among the first to produce that good Governments should
consider strategic trade policies that nurture and protect firms
and industries where first-mover advantages and economies of
scale are important
*
6-*
What Is Porter’s Diamond Of Competitive Advantage?Michael
Porter (1990) tried to explain why a nation achieves
international success in a particular industry identified four
attributes that promote or impede the creation of competitive
advantage
Factor endowments - a nation’s position in factors of production

necessary to compete in a given industrycan lead to competitive
advantagecan be either basic (natural resources, climate,
location) or advanced (skilled labor, infrastructure,
technological know-how)
*
between nations.
6-*
What Is Porter’s Diamond Of Competitive Advantage?
Demand conditions - the nature of home demand for the
industry’s product or serviceinfluences the development of
capabilitiessophisticated and demanding customers pressure
firms to be competitive
Relating and supporting industries - the presence or absence of
supplier industries and related industries that are internationally
competitivecan spill over and contribute to other
industriessuccessful industries tend to be grouped in clusters in
countries
*
6-*
Firm strategy, structure, and rivalry - the conditions governing
how companies are created, organized, and managed, and the
nature of domestic rivalry different management ideologies
affect the development of national competitive
advantagevigorous domestic rivalry creates pressures to
innovate, to improve quality, to reduce costs, and to invest in

upgrading advanced features
*
6-*
Determinants of National Competitive Advantage: Porter’s
Diamond
*
Source: Reprinted by permission of Harvard Business Review.
Exhibit from “The Competitive Advantage of Nations,” by
Michael E. Porter, March-April 1990, p. 77. Copyright 1990 by
the Harvard Business School Publishing Corporation; all rights
reserved.
6-*
Does Porter’s Theory Hold?Government policy canaffect
demand through product standardsinfluence rivalry through
regulation and antitrust lawsimpact the availability of highly
educated workers and advanced transportation infrastructure.
The four attributes, government policy, and chance work as a
reinforcing system, complementing each other and in
combination creating the conditions appropriate for competitive
advantage So far, Porter’s theory has not been sufficiently
tested to know how well it holds up
*
LO 4: Explain the arguments of those who maintain that
government can play a proactive role in promoting national

competitive advantage in certain industries.
Porter’s theory should predict the pattern of international trade
that we observe in the real world.
Countries should be exporting products from those industries
where all four components of the diamond are favorable, while
importing in those areas where the components are not
favorable.
6-*
What Are The Implications Of Trade Theory For Managers?
Location implications - a firm should disperse its various
productive activities to those countries where they can be
performed most efficientlyfirms that do not may be at a
competitive disadvantage
First-mover implications - a first-mover advantage can help a
firm dominate global trade in that product
Policy implications - firms should work to encourage
governmental policies that support free tradewant policies that
have a favorable impact on each component of the diamond
*
LO 5: Understand the important implications that international
trade theory holds for business practice.
6-*
What Is The
Balance Of Payments?A country’s balance-of-payments
accounts keep track of the payments to and receipts from other
countries for a particular time perioddouble entry
bookkeepingsum of the current account balance, the capital
account and the financial account should be zero

*
In the United States, the current account deficit has been
growing because of its imports of physical products, but the
country runs a current account surplus in trade in services.
6-*
What Is The
Balance Of Payments?There are three main accounts
The current account records transactions of goods, services, and
income, receipts and payments current account deficit - a
country imports more than it exportscurrent account surplus – a
country exports more than it imports
The capital account records one time changes in the stock of
assets
The financial account records transactions that involve the
purchase or sale of assetsnet change in U.S. assets owned
abroadforeign owned assets in the U.S.
*
6-*
What Is The
Balance Of Payments?
United States Balance-of-Payments Accounts, 2011

*
Source: Bureau of Economic Analysis
6-*
Is A Current
Account Deficit Bad?Question: Does current account deficit in
the United States matter? A current account deficit implies a net
debtorso, a persistent deficit could limit future economic
growthBut, even though capital is flowing out of the U.S. as
payments to foreigners, much of it flows back in as investments
in assetsYet, suppose foreigners stop buying U.S. assets and sell
their dollars for another currencya dollar crisis could occur
*
A deficit on the current account is financed by a surplus on the
financial account– in other words, by selling assets to other
countries. Therefore, a persistent current account deficit raises
concerns that resources are being drained from the country,
which limits the ability to invest within the country.
*
*
*
*
LO 1: Understand why nations trade with each other.
The Opening Case: Creating the World’s Biggest Free Trade
Zone illustrates the benefits of free trade and globalization.
President Obama has committed the United States to negotiating
a free trade deal with the European Union. The announcement

was greeted with enthusiasm that can be traced to widespread
acceptance of the key axiom of international trade—trade is
good for all countries involved in a free trade agreement.
*
*
Country Focus: Is China a Neo-Mercantilist Nation analyzes
claims that China is a neo-mercantilist nation. Exports are
largely responsible for China’s recent rapid economic growth.
The country, capitalizing on its cheap labor force, has been
focused on converting raw materials into products that are
exported to developing countries like the United States.
China’s trade surplus has started to contract [partly as a result
of allowing the Chinese currency (the yuan) to appreciate
against the US dollar] as export growth has slowed and imports
have increased.
*
between nations.
Mercantilism suggests that countries should design policies that
lead to an increase in their holdings of gold and silver.
This was usually done by increasing exports and limiting
imports. This economic philosophy was used by Europeans from
about the 1500s to the late 1700s. It fueled colonialism in
Britain, France, the Netherlands and Spain.
Nations increase their wealth by maintaining trade surpluses.
The key problem with the mercantilist view is that it views
trade as a zero sum game, where if one country benefits the
other must lose. As an economic philosophy, mercantilism is
flawed.
Yet many political views today have the goal of boosting
exports while limiting imports by seeking only selective
liberalization of trade.
*

between nations.
In 1776, Adam Smith attacked the mercantilist assumption that
trade is a zero-sum game and argued that countries differ in
their ability to produce goods efficiently, and that a country has
an absolute advantage in the production of a product when it is
more efficient than any other country in producing it.
According to Smith, countries should specialize in the
production of goods for which they have an absolute advantage
and then trade these goods for the goods produced by other
countries.
*
*
*
*
*
*
between nations.
*
*
*
*
*
*

The simple example of comparative advantage presented in the
text makes a number of assumptions: only two countries and
two goods; zero transportation costs; similar prices and values;
resources are mobile between goods within countries, but not
across countries; constant returns to scale; fixed stocks of
resources; and no effects on income distribution within
countries. While these are all unrealistic, the general
proposition that countries will produce and export those goods
that they are the most efficient at producing has been shown to
be quite valid.
*
Country Focus: Moving U.S. White-Collar Jobs Offshore goes
to the heart of a debate that has been played out many times
over the past half century—the transference of jobs from the
United States to lower-wage countries. The difference now
however, is that rather than blue-collar jobs being transferred,
the new trend is for white-collar jobs to move, jobs associated
with the knowledge-based economy.
*
between nations.
Basic factors:
Natural resources
Climate
Geographic location
Demographics
While basic factors can provide an initial advantage they must
be supported by advanced factors to maintain success.
Advanced factors:
The result of investment by people, companies, and government
are more likely to lead to competitive advantage. If a country
has no basic factors, it must invest in advanced factors.
*

*
*
between nations.
*
*
*
*
Source: Adapted from Raymond Vernon and Louis T. Wells,
The Economic Environment of International Business, 5th
edition © 1991. Reproduced by permission of Pearson
Education, Inc., Upper Saddle River, New Jersey.
*
*
*
between nations.
*
*
*
*
between nations.
*

*
*
Source: Reprinted by permission of Harvard Business Review.
Exhibit from “The Competitive Advantage of Nations,” by
Michael E. Porter, March-April 1990, p. 77. Copyright 1990 by
the Harvard Business School Publishing Corporation; all rights
reserved.
*
LO 4: Explain the arguments of those who maintain that
government can play a proactive role in promoting national
competitive advantage in certain industries.
Porter’s theory should predict the pattern of international trade
that we observe in the real world.
Countries should be exporting products from those industries
where all four components of the diamond are favorable, while
importing in those areas where the components are not
favorable.
*
LO 5: Understand the important implications that international
trade theory holds for business practice.
*
*
*
Source: Bureau of Economic Analysis
*
A deficit on the current account is financed by a surplus on the
financial account– in other words, by selling assets to other
countries. Therefore, a persistent current account deficit raises

concerns that resources are being drained from the country,
which limits the ability to invest within the country.

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