REPORTER: SAIRA GUIEL FABRE
INSTRUCTOR: MR. SAM SALVANA
CHAPTER 3: MODERN FIRM BASED- THEORIES OF INTERNATIONAL TRADE
INTRODUCTION
In contrast to the classical country-based theories, the category of modern firm-based theories emerged after
World War II. It was developed in large part by business professionals, not economists. This modern firm-based
theories evolved with the growth of the multinational companies (MNCs). The classical country-based theories
could not adequately address the expansion of either intra-firm or intra-industry trade, which refers to trade
between two countries of goods produced in the same industry like Japan exporting Toyota vehicles to Germany
and importing Mercedes-Benz automobiles from Germany ([Link], 2012). Unlike the country-based
theories, firm-based theories incorporate other product and service factors, including brand and customer loyalty,
technology, and quality into the understanding of trade flows.
LESSON 3.1: Porter’s National Competitive Advantage Theory
Competitive advantage refers to the ability of the country or company to offer greater value to
customers, putting a country or company in a favorable or superior business position than its competitors.
Absolute advantage + comparative advantage = competitive advantage
Cost advantage + quality advantage = competitive advantage
In the continuing evolution of international trade theories, Michael Porter of Harvard Business School
developed a new model to analyze national competitive advantage in 1990 in his book The Competitive
Advantage of Nations. This model, known as Porter’s diamond of national advantage, suggests that the
national home base of an organization plays an important role in shaping the extent to which it is likely
to achieve competitive advantage on a global scale. This home base provides the basic factors which
support organizations in building advantages in global competition. Porter’s diamond theory is a
framework that enhances our understanding of the international competitiveness of firms.
Porter’s theory stated that a nation’s competitiveness in an industry depends on the capacity of the
industry to innovate and upgrade. Michael Porter identified four stages of development in the evolution
of a country:
1. Development based on (production) factors
2. Development based on investment (capital)
3. Development based on innovation (creativity)
4. Development based on prosperity (economic growth and development)
Porter’s theory focused on explaining why some nations are more competitive in certain industries. Porter
identified four determinants to form Porter’s diamond:
1. local market resources and capabilities;
2. local market demand conditions;
3. local suppliers and complementary industries; and
4. local firm characteristics.
Local market resources and capabilities (factor conditions)
Porter recognized the value of the factor proportions theory of the H-O model of Heckscher-Ohlin, which
considers a country’s resources as key factors in determining what products a country will export or
import. Porter added to these basic factors a list of advanced factors:
a. human resources, including skilled labor
b. natural resources
c. knowledge, including education, investments, and research in universities
d. infrastructure
e. technology
Local market demand conditions
Porter believed that a creative domestic market is critical to ensuring ongoing innovation, thereby creating
a sustainable competitive advantage. Companies whose domestic markets are innovative and demanding
will force the development of new products and technologies. Demanding consumers force companies to
continuously innovate, thus creating a sustainable competitive advantage in their respective industries.
Local suppliers and complementary industries
To remain competitive, large global firms benefit from having strong and efficient supporting and related
industries to provide the inputs required by the industry. Firms must have an efficient and strong support
network. Certain industries cluster geographically, which influences efficiency and productivity.
Local firm characteristics
Local firm characteristics include firm strategy, industry structure, and industry rivalry. Strategies
help in setting new goals, structure helps in managing operations, and rivalry helps in generating
innovation. Local strategy affects a firm’s competitiveness. The development of an efficient transportation
system is crucial to the country’s economic growth.
Local suppliers and complementary industries
To remain competitive, large global firms benefit from having strong and efficient supporting and related
industries to provide the inputs required by the industry. Firms must have an efficient and strong support
network. Certain industries cluster geographically, which influences efficiency and productivity. The
growth of one industry influences the growth of other industries.
In addition to the aforementioned four determinants, Porter also noted that governments and chance play
a part in the national competitiveness of industries.
LESSON 3.2: Country Similarity Theory
Traditional trade theories speak of differences in resources and demand or supply conditions as a
necessary condition for trade between countries. In contrast, the country similarity theory is built upon
similarities or identical features of nations that trade with each other.
The country similarity theory was developed by Swedish economist Steffan Linder in 1961, as he tried
to explain the concept of intra-industry trade. Simply, this theory describes the idea that countries with
comparable qualities are mainly likely to trade with each other. These qualities might include the stage of
development, per capita income, saving rates, natural resources, cultural milieu, geographical
features, political and economic interests, and the like.
Two types of trades are inter-industry trade, trade between and among different industries, and intra-
industry trade, trade between and among the same industry.
Linder’s theory proposed that the following features common to certain countries will make them trade
with each other:
a. stage of development
b. cultural milieu
c. geographical features
Two types of trades are inter-industry trade, trade between and among different industries, and intra-
industry trade, trade between and among the same industry.
Inter-industry trade- is the exchange of goods produced in different industries among countries.
Intra-industry trade- is the exchange of goods produced in the same industry.
To determine the similarity of countries, the Geert-Hofstede model is a tool that was developed to
compare countries. This model uses six dimensions to compare countries:
a. Power distance – is power in the country distributed unequally?
b. Individualism – It is the degree of independence of the members of a society.
c. Masculinity – It is the want to be the best versus liking what you do (femininity).
d. Uncertainty avoidance – Are members of a society feeling threatened by unknown situations?
e. Long-term orientation – The society has links with the past and deals with the challenges of the present
and the future.
f. Indulgence – Do members of a society control their impulses and desires?
LESSON 3.3. Product Life Cycle Theory
Life cycle is the series of stages through which a living thing passes from the beginning of its
life until its death. The term product life cycle refers to the length of time a product is introduced in
the market until is removed from the shelves.
The product life cycle theory is a marketing strategy developed by Raymond Vernon in 1966 to help
companies plan out the progress of their new products and explain the pattern of international trade and
foreign direct investment.
Vernon explained that from the invention of a product to its demise due to lack of demand, a product goes
through four stages: introduction, growth, maturity, and decline. The length of each stage can vary from
product to product, with some taking several months and others several years. Many factors determine
how quickly a product moves through the four stages, including marketing, demand, and the product
itself.
There are four stages in the product life cycle:
1. introduction
2. growth
3. maturity
4. decline
Figure 3.3: The Product Life Cycle
Product life cycle management (PLM) is the process of managing a product’s life cycle from inception,
through design and manufacturing, to sales, services, and eventually, to retirement.
Prior to a product being introduced to the market, companies conduct research on which product is in
demand, how to produce the product, and conduct market tests to see if the product will sell. If the results
of these researches and tests are positive, that is the time the company will begin production and the
product will be introduced to the market.
At the introduction stage, the need is to create awareness, not profits. The underlying goal is to gain
widespread product and brand recognition among consumers. Big money is spent on distribution and
promotion. At the introduction stage, companies can expect sales to be low, but will gradually increase,
and profitability to be negative since competitors also do not have knowledge about the product.
There are two price-setting strategies at this stage:
a. Price skimming – charging an initially high price and gradually reducing (skimming) the price as the
market grows.
b. Price penetration – charging a low price to “penetrate” the market and capture market share, before
increasing prices in relation to market growth.
Growth
At the growth stage, demand for the product begins to increase and sales usually grow exponentially
from the takeoff point. At this stage, profitability reaches the highest level. Economies of scale, are
now in order as sales revenue increases faster than costs and production reaches capacity.
Maturity
At the maturity stage, sales increase continues in a decreasing pattern but the sales have reached their
peak point and there is intense competition and product differentiation is a must. Product differentiation
and generating brand awareness becomes a must. Retaining customer brand loyalty is the key. The
biggest challenge is maintaining profitability and preventing sales from further decline.
Decline
A product enters the decline stage when no amount of marketing or promotion can keep the sales figures
from declining. Other innovative or substitute products that satisfy customer needs better have entered the
market. Sales likely continue until the cost to produce the product prices higher than the profits generated
from it.
Some of the strategies that can be employed in the decline stage are:
a. milking or harvesting, which means reducing marketing efforts and attempt to maximize the life of
the product for as long as possible;
b. slowly reducing distribution channels and pulling the product out and attempt to introduce a
replacement product; and
c. selling the product to a niche operator or subcontractor to allow the company to dispose of a low-profit
product, while retaining loyal customers.
LESSON 3.4: Global Strategic Rivalry Theory
Competitive advantage is a way that a firm can obtain a sustainable edge over competitors and
break down the barriers to entry in a particular industry.
Global strategic rivalry theory is a theory, forwarded in 1980 by economists Paul Krugman and
Kevin Lancaster, that focused on multinational corporations (MNCs) and how they get competitive
advantages by using barriers to entry for a particular industry.
Barriers to entry refer to the obstacles a new firm may face when trying to enter into an industry or a
new market.
These barriers to entry are the following:
a. research and development;
b. ownership of intellectual property rights;
c. economies of scale;
d. unique business processes or methods;
e. extensive experience in the industry or exploiting the experience curve; and
f. control of resources or favorable access to raw materials.
Research and development (R&D)
Research and development (R&D) are activities engaged in by companies for the invention of new
products or services to remain competitive. R&D is an important driver of economic growth. Companies
have their own R&D departments to be able to actually gain competitive advantage.
Owning Intellectual Property
An intellectual property refers to creations of the mind: a work or invention that is the result of
creativity, such as a manuscript (book) or a design, to which one has rights and for which one may apply
for a patent, copyright, trademark, brand name, and the like. A patent is an exclusive right granted
for a new, inventive, and useful product, process, or technical improvement to an existing invention. A
patent may be used for licensing. Copyright is the exclusive legal right to reproduce, publish, sell, or
distribute the matter and form of something (such as a literary, musical, or artistic work). A
trademark/trade name is a word, a group of words, sign, symbol, or a logo that distinguishes your
business’ goods or services from those of other trades. Brand names and trademarks are used for
franchising.
Economies of scale
Economies of scale means a proportionate saving in costs (cost advantage) gained by an increased
volume of production. The cost advantage is a result of spreading the total fixed cost among a greater
number of units produced, which therefore reduces the unit fixed cost for the product. This also results in
a lower average variable cost for the product. Overall, operational efficiencies and synergies are attained.
There are two economies of scale:
a. Internal economies of scale – refers to economies that are unique to a firm. For instance, a firm may
hold a patent over a mass production machine, which allows it to lower its average cost of production
more than other firms in the industry.
b. External economies of scale – refers to economies of scale enjoyed by an entire industry. If studies
indicate that cotton production will need 1,000 workers to be able to enter a trade with a foreign country,
all these engaged in cotton production will try their best to employ 1,000 workers to become
competitively advantaged.
Experience produces competitive advantage over those without experience in any endeavor. Therefore,
experience also counts in international trade as those with experience become conversant and adept in the
global trade arena. Employing experienced employees is equally advantageous for firms.