International Business chapter 5
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Theories of International Trade and Investment
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International Business chapter 5
- 1. Copyright © 2017 Pearson Education, Ltd. International Business: The New Realities, 4th Edition, Global Edition by Cavusgil, Knight, and Riesenberger Theories of International Trade and Investment 5-1
- 2. Learning Objectives 5.1 Appreciate why nations trade. 5.2 Learn about how nations can enhance their competitive advantage. 5.3 Learn about Porters Diamond model. 5.4 Learn about industrial policy. 5.5 Learn about Dunning’s Eclectic Paradigm Copyright © 2017 Pearson Education, Ltd. 5-2
- 3. Theories of International Trade and Investment Copyright © 2017 Pearson Education, Ltd. 5-3
- 4. Mercantilism and Neomercantilism • Mercantilism: A belief popular in the 16th century that national prosperity results from maximising exports and minimising imports. • Today, some argue for neomercantilism – the idea that the nation should run a trade surplus. • Supporters of neomercantilism include: Labor unions (who want to protect domestic jobs), Farmers (who want to keep crop prices high), and Some manufacturers (that rely on exports). Copyright © 2017 Pearson Education, Ltd. 5-4
- 5. Free Trade • Free trade is usually best because it leads to: More and better choices for consumers and firms. Lower prices of goods for consumers and firms. Higher profits and better worker wages (because imported input goods are usually cheaper). Higher living standards for consumers (because their costs are lower). Greater prosperity in poor countries. The absence of restrictions to the flow of goods and services among nations. Copyright © 2017 Pearson Education, Ltd. 5-5
- 6. Comparative Advantage (Country) • Known as country-specific advantage. It answers the question of how nations can achieve and sustain economic success and prosperity. • It refers to the superior features of a country that provide it with unique benefits in global competition. • Comparative advantages are derived either from natural endowments or from deliberate national policies. Copyright © 2017 Pearson Education, Ltd. 5-6
- 7. Examples of National Comparative Advantage • France has a climate and soil superior for producing wine. • Saudi Arabia has a natural abundance of oil, for the production of petroleum products. • Over time, Japan has acquired a superior base of knowledge and experience for producing cars. • Over time, India has acquired a superior base of IT workers for producing computer software. What are the comparative advantages in South Africa?Copyright © 2017 Pearson Education, Ltd. 5-7
- 8. Competitive Advantage (company) • Known as company-specific advantage. It explains how individual firms gain and maintain distinctive competencies, relative to competitors, that lead to superior performance. • It refers to the distinctive assets, competencies, and capabilities that are developed or acquired by the firm. • The collective competitive advantages held by the firms in a nation are the basis for the competitive advantages of the nation at large. Copyright © 2017 Pearson Education, Ltd. 5--8
- 9. Examples of Firm Competitive Advantage • Dell’s prowess in the management of its global supply chain. • Samsung’s technological leadership in flat-panel televisions. • Cadbury’s capabilities in international marketing and distribution. • Coca-Cola’s capabilities in international marketing and distribution. Copyright © 2017 Pearson Education, Ltd. 5-9
- 10. Comparative vs. Competitive Advantage Copyright © 2017 Pearson Education, Ltd. 5-24
- 11. Michael Porter’s Diamond Model: Sources of National Competitive Advantage Copyright © 2017 Pearson Education, Ltd. 5-28
- 12. Factor Conditions (Diamond Model) • Factor conditions – describe a country’s quality and quantity of labor, natural resources, capital, technology, know-how, entrepreneurship, and other factors of production in a country. Germany has strong engineering skills. Example An abundance of cost-effective and well-educated workers give China a competitive advantage in the production of laptop computers. Copyright © 2017 Pearson Education, Ltd. 5-29
- 13. • Related and supporting industries – the presence of clusters of suppliers, competitors, and complementary firms that excel within a given industry. • An industrial cluster refers to a concentration of businesses, suppliers and supporting firms in the same industry located at a particular geographic location. Related and supporting industries (Diamond model) Copyright © 2017 Pearson Education, Ltd. 5-30
- 14. • Demand conditions at home – refer to the nature of home market demand for specific products and services. Demand conditions (Diamond Model) Example Japan is a densely populated, hot, and humid country with very demanding consumers. These conditions led Japan to become one of the leading producers of superior, compact air conditioners Copyright © 2017 Pearson Education, Ltd. 5-31
- 15. • Firm strategy, structure, and rivalry – refers to the nature of domestic rivalry, and conditions in a country that determine how a nation’s firms are created, organised, and managed. Firm strategy, structure and rivalry (Diamond model) Example Italy has many top firms in design industries such as textiles, furniture, lighting, and fashion. Vigorous competitive rivalry puts these firms under constant pressure to innovate, which has propelled Italy to a leading position in design, worldwide. Copyright © 2017 Pearson Education, Ltd. 5-32
- 16. Industrial Cluster • A concentration of suppliers and supporting firms from the same industry located within the same geographic area. Similar to Porter’s Related and Supporting Industries. • A strong cluster can serve as an export platform for the nation. Examples - The fashion industry in northern Italy. - The pharmaceutical industry in Switzerland - The footwear industry in Vietnam Copyright © 2017 Pearson Education, Ltd. 5-33
- 17. National Industrial Policy • A proactive economic development plan employed by the government to nurture or support promising industry sectors with potential for regional or global dominance. Initiatives can include: Tax incentives: encourage citizens to save and invest money. Monetary and fiscal policies. Rigorous educational system. Investment in national infrastructure: IT, communications systems, transportation. Strong legal and regulatory systems. Copyright © 2017 Pearson Education, Ltd. 5-34
- 18. Examples of National Industrial Policy • Vietnam’s government in the 1990s privatized state enterprises and modernised the economy, emphasising competitive, export-driven industries. Vietnam became one of the fastest-growing economies, averaging around 8 percent annual GDP growth. • Singapore adopted pro-business, pro-investment, export- oriented policies, combined with state-directed investments in strategic corporations. The approach stimulated economic growth that averaged 8 percent annually from 1960 to 1999. Copyright © 2017 Pearson Education, Ltd. 5-35
- 19. Examples of National Industrial Policy (cont’d) • The Czech government in the 1990s created a business-friendly legal and regulatory environment. The country privatised state-owned companies. Government FDI incentives attracted numerous MNEs, such as Daewoo, ING, Siemens, and Toyota. • New Zealand’s government, starting in 1984, transformed the country from an agrarian, protectionist, regulated economy to an industrialised, free-market economy that today competes globally. Copyright © 2017 Pearson Education, Ltd. 5-36
- 20. New Zealand’s success resulted from: • Implemented pro-business policies – fiscal, monetary, tax; investment in education • Emphasised high-value industries such as IT and pharmaceuticals that greatly grew GDP and reduced unemployment. Transformation of New Zealand’s Economy, 1992 to 2014 Copyright © 2017 Pearson Education, Ltd. 5-37
- 21. FDI Based Explanations: Dunning’s Eclectic Paradigm • Three conditions determine whether or not a company will enter a given foreign country via FDI: 1.Ownership-specific advantages – knowledge, skills, capabilities, relationships, or physical assets that the firm owns and which are the basis of its competitive advantages. 2.Location-specific advantages – similar to comparative advantages, they are specific advantages that exist in the country that the MNE has entered, or is seeking to enter, such as natural resources, low-cost labor, or skilled labor. 3.Internalisation advantages – control derived from internalising foreign-based manufacturing, distribution, or other value chain activities. Copyright © 2017 Pearson Education, Ltd. 5-46
- 22. Example of the Eclectic Paradigm: Sony in China • Ownership specific advantages: Sony possesses a huge stock of knowledge and patents in the consumer electronics industry, as represented by products like the Playstation. • Location specific advantages: Sony desires to manufacture in China, to take advantage of China’s low-cost, highly knowledgeable labor. • Internalisation advantages: Sony wants to maintain control over its knowledge, patents, manufacturing processes, and quality of its products. Thus, Sony entered China via FDI Copyright © 2017 Pearson Education, Ltd. 5-47
Editor's Notes
- The earliest explanations of international business emerged with the rise of European nation states in the 1500s, when gold and silver were the most important sources of wealth, and nations sought to amass as much of these treasures, particularly gold, as possible. Nations received payment for exports in gold, so exports increased their gold stock, while imports reduced it because they paid for imports with their gold. Thus, exports were seen as good and imports as bad. Because the nation’s power and strength increase as its wealth increases, mercantilism argues that national prosperity results from a positive balance of trade achieved by maximizing exports and minimizing or even impeding imports. In essence, mercantilism explains why nations attempt to run a trade surplus—that is, to export more goods than they import. Even today many people believe that running a trade surplus is beneficial. They subscribe to a view known as neo-mercantilism. Labor unions (which seek to protect home-country jobs), farmers (who want to keep crop prices high), and certain manufacturers (those that rely heavily on exports) all tend to support neo-mercantilism. On the other hand, mercantilism tends to harm the interests of firms that import, especially those that import raw materials and parts used in the manufacture of finished products. Mercantilism also harms the interests of consumers, because restricting imports reduces the choice of products they can buy. Product shortages that result from import restrictions may lead to higher prices—that is, inflation. When taken to an extreme, mercantilism may invite “beggar thy neighbor” policies, promoting the benefits of one country at the expense of others.
- Free trade is generally superior and should produce the following outcomes: ■ Consumers and firms can more readily buy the products they want. ■ Imported products tend to be cheaper than domestically produced products (because access to world-scale supplies forces prices down, mainly from increased competition, or because the goods are produced in lower-cost countries). ■ Lower-cost imports help reduce the expenses of firms, thereby raising their profits (which may be passed on to workers in the form of higher wages). ■ Lower-cost imports help reduce the expenses of consumers, thereby increasing their living standards. ■ Unrestricted international trade generally increases the overall prosperity of poor countries.
- Also known as country-specific advantage, comparative advantage includes inherited resources, such as labor, climate, arable land, and petroleum reserves, such as those enjoyed by the Gulf nations. Other types of comparative advantages are acquired over time, such as entrepreneurial orientation, availability of venture capital, and innovative capacity.
- Competitive advantage describes organizational assets and competencies that are difficult for competitors to imitate and thus help firms enter and succeed in foreign markets. These competencies take various forms, such as specific knowledge, capabilities, innovativeness, superior strategies, or close relationships with suppliers. Competitive advantage is also known as firm-specific advantage. In recent years business executives and academics such as Michael Porter have used competitive advantage to refer to the advantages possessed by both nations and individual firms in international trade and investment. To be consistent with the recent literature, we adopt this convention as well.
- Factor conditions describe the nation’s position in factors of production, such as labor, natural resources, capital, technology, entrepreneurship, and know-how. Consistent with factor proportions theory, each nation has a relative abundance of certain factor endowments, a situation that helps determine the nature of its national competitive advantage. For example, Germany’s abundance of workers with strong engineering skills has propelled the country to commanding heights in the global engineering and design industry.
- Related and supporting industries refer to the presence of clusters of suppliers, competitors, and complementary firms that excel in particular industries. The resulting business environment is highly supportive for the founding of particular types of firms. Operating within a mass of related and supporting industries provides advantages through information and knowledge synergies, economies of scale and scope, and access to appropriate or superior inputs.
- Demand conditions refer to the nature of home-market demand for specific products and services. The strength and sophistication of buyer demand facilitates the development of competitive advantages in particular industries. The presence of highly demanding customers pressures firms to innovate faster and produce better products. For example, an affluent, aging population in the United States inspired the development of world-class health care companies such as Pfizer and Eli Lilly in pharmaceuticals and Boston Scientific and Medtronic in medical equipment.
- Firm strategy, structure, and rivalry refer to the nature of domestic rivalry and conditions in a nation that determine how firms are created, organized, and managed. The presence of strong competitors in a nation helps create and maintain national competitive advantage. Japan has the world’s most competitive consumer electronics industry, with major players like Nintendo, NEC, Sharp, and Sony producing semiconductors, computers, video games, and liquid crystal displays. Vigorous competitive rivalry puts these firms under continual pressure to innovate and improve. They compete not only for market share, but also for human talent, technical leadership, and superior product quality. Intense rivalry has pushed firms like Sony to a leading position in the industry worldwide and allowed Japan to emerge as the top country in consumer electronics.
- Examples of industrial clusters include the fashion industry in northern Italy; the pharmaceutical industry in Switzerland; the footwear industry in Vietnam; the medical technology industry in Singapore; Wireless Valley in Stockholm, Sweden; and the consumer electronics industry in Japan. Today, the most important sources of national advantage are the knowledge and skills possessed by individual firms, industries, and countries. More than any other factors, knowledge and skills determine where MNEs will locate economic activity around the world. Silicon Valley, California, and Bangalore, India, have emerged as leading edge business clusters because of the availability of specialized talent. These regions have little else going for them in terms of natural industrial power. Their success derives from the knowledge of the people employed there, so-called knowledge workers. Some even argue that knowledge is now the only source of sustainable long-run competitive advantage. If correct, then future national wealth will go to those countries that invest the most in R&D, education, and infrastructure that support knowledge-intensive industries.
- Nations can develop these endowments through proactive national industrial policy. Such a policy encourages economic development, often in collaboration with the private sector, to develop or support high value-adding industries that generate superior corporate profits, higher worker wages, and tax revenues. As illustrated in the chapter opening vignette, Dubai is pursuing a national industrial policy to become an international commercial center in the information and communications technology (ICT) sector. Historically, nations have favored more traditional industries, including automobiles, shipbuilding, and heavy machinery—all with long value chains that generate substantial added value. As the Dubai example illustrates, progressive nations increasingly favor high value-adding, knowledge-intensive industries such as IT, biotechnology, medical technology, and financial services. Not only do these industries provide substantial revenues to the nation, they also lead to the development of supplier and support companies that further enhance national prosperity. National industrial policies designed to build new capabilities and encourage the emergence of new industries typically include these specifics: ■ Tax incentives to encourage citizens to save and invest, which provides capital for public and private investment in R&D, plant, equipment, and worker skills ■ Monetary and fiscal policies, such as low-interest loans, that provide a stable supply of capital for company investment needs ■ Rigorous educational systems at the precollege and university levels that ensure a steady stream of competent workers who support high technology or high value-adding industries in the sciences, engineering, and business administration ■ Development and maintenance of strong national infrastructure in areas such as IT, communication systems, and transportation ■ Creation of strong legal and regulatory systems to ensure that citizens are confident about the soundness and stability of the national economy10
- Vietnam’s government privatized state enterprises and modernized the economy, emphasizing competitive, export-driven industries. It ramped up the country’s exports of everything from shoes to ships, modernized its intellectual property regime, entered several free trade agreements, and revamped its educational system to provide a constant stream of skilled workers. The government also built infrastructure, including roads, railways, and power stations. Reforms have attracted much inward FDI from firms like Intel. The national savings rate increased several-fold. Economic repositioning dramatically reduced Vietnam’s poverty rate.
- New Zealand’s government, beginning in 1984, systematically transformed the country from an agrarian, protectionist, highly regulated economy to an industrialized free-market economy that competes globally. The government privatized a number of former state-owned enterprises, joined various international free trade agreements, and focused on building a knowledge economy. Dynamic growth has boosted real incomes and deepened technological capabilities. In the Czech Republic, economic reforms and exports to the European Union (EU) led to economic prosperity. The Czech government harmonized its laws and regulations with those of the EU by reforming its judicial system, financial markets regulation, intellectual property rights protection, and other areas important to investors. It also privatized state owned companies. Government FDI incentives attracted firms like Toyota, ING, Siemens, Daewoo, DHL, and South African Breweries.
- National Industrial Policy in Practice: An Example How well does national industrial policy work in practice? Let’s examine New Zealand and the outcomes of its repositioning, implemented through collaboration between the nation’s public and private sectors. For much of the early twentieth century, government policies had limited New Zealand’s ability to flourish and trade with the rest of the world. Living standards were low and many wondered whether New Zealand had a future. Then, in the 1980s, the New Zealand government undertook protrade policies in cooperation with the private sector that resulted in national advantages, helping New Zealand’s economy grow rapidly and achieve high living standards. The accomplishments are summarized in the Exhibit. Between 1992 and 2012, New Zealand raised its per-capita GDP from 51 to 89 percent of the average of the G7 countries, the world’s seven largest advanced economies. This represents an improvement of about 75 percent in real terms of personal income. During the period, New Zealand’s unemployment rate declined by almost half, to 5.6 percent. The government reduced its national debt as a proportion of GDP from 89 to 30 percent, giving the nation a solid financial foundation. New Zealand’s per-capita GDP dipped during the global recession but stabilized in 2012 to more than $40,000, among the highest in the world.
- Professor John Dunning proposed the eclectic paradigm as a framework for determining the extent and pattern of the value-chain operations that companies own abroad. He drew from various theoretical perspectives, including comparative advantage, factor proportions, monopolistic advantage, and internalization advantage. Thus, the eclectic paradigm is often viewed as the most comprehensive of FDI theories. The eclectic paradigm specifies three conditions that determine whether a company will internationalize via FDI: ownership-specific advantages, location-specific advantages, and internalization advantages. To successfully enter and conduct business in a foreign market, the MNE must possess ownership-specific advantages relative to other firms already doing business in the market. That is, it should hold knowledge, skills, capabilities, key relationships, and other assets that allow it to compete effectively in foreign markets. These assets amount to the firm’s competitive advantages. To ensure international success, the advantages must be substantial enough to offset the costs the firm incurs in establishing and operating foreign operations. The advantages should also be specific to the MNE that possesses them and not readily transferable to other firms, such as proprietary technology, managerial skills, trademarks or brand names, economies of scale, and access to substantial financial resources. The more valuable the firm’s ownership-specific advantages, the more likely it is to internationalize via FDI.
- Let’s use Alcoa, the Aluminum Corporation of America (www.alcoa.com), to illustrate. Alcoa has more than 70,000 employees in thirty-five countries. The company’s integrated operations include bauxite mining and aluminum refining. Its products include primary aluminum (which it refines from bauxite), automotive components, and sheet aluminum for beverage cans and Reynolds Wrap®. One of Alcoa’s most important ownership-specific advantages is the proprietary technology it has acquired through its R&D activities. It has also acquired special managerial and marketing skills in the production and marketing of refined aluminum. The firm has a well-known brand name that helps increase sales. As a large firm, Alcoa also profits from economies of scale and the ability to finance expensive projects. Such advantages allowed Alcoa to maximize profits in its international operations. The second condition that determines whether a firm will internationalize via FDI is the presence of location-specific advantages, the comparative advantages available in individual foreign countries, such as natural resources, skilled labor, low-cost labor, and inexpensive capital. For example, Alcoa located refineries in Brazil because of that country’s huge deposits of bauxite, a mineral found in relatively few other locations worldwide. The Amazon and other major rivers in Brazil generate huge amounts of hydroelectric power, a critical ingredient in electricity-intensive aluminum refining. Alcoa also benefits from Brazil’s low-cost, relatively well-educated laborers who work in the firm’s refineries. The presence of these location-specific advantages helped persuade Alcoa to locate in Brazil via FDI. The third condition that determines FDI-based internationalization is the presence of internalization advantages, benefits that the firm derives from internalizing foreign based manufacturing, distribution, or other stages in its value chain. When profitable, the firm will transfer its ownership-specific advantages across national borders within its own organization rather than dissipating them to independent, foreign entities. The FDI decision depends on which is the best option—internalization versus utilizing external partners, whether they are licensees, distributors, or suppliers. Internalization advantages include the ability to control how the firm’s products are produced or marketed, the ability to prevent unintended dissemination of the firm’s proprietary knowledge, and the ability to reduce buyer uncertainty about the value of products the firm offers. Alcoa had five reasons to internalize many of its operations instead of letting external suppliers handle them. First, its management wants to minimize dissemination of knowledge about its aluminum refining operations—knowledge the firm acquired at great expense. Second, internalization provides the best net return, allowing Alcoa to minimize the cost of operations. Third, Alcoa needs to control sales of its aluminum products to avoid depressing world aluminum prices through oversupply. Fourth, the firm wants to be able to apply a differential pricing strategy, charging different prices to different customers, a strategy it could not follow very effectively without the control over distribution that internalization provides. Finally, aluminum refining is a complex business, and Alcoa wants to control it to maintain the quality of its products.