INTERNATIONAL
UNIT 4 SECTION 2 FIRM-BASED TRADE THEORIES
BUSINESS Unit 4, section 2: Firm-based trade theory
Welcome to Section 2 of this unit. We hope you were able to appreciate the
country-based trade theories and their implication in international business
activity. The firm-based theories explain the development of trade in
differentiated consumer products and focus on the role of the firm in
promoting international trade. Firm-based theories explore the role of the
firm in promoting exports and imports and also take cognisance of issues
such as brand names, quality, technology, and customer loyalty.
By the end this Section, you should be able to;
explain international product life cycle theory in helping to understand
why nations trade
explain Porter’s Diamond Model in helping to understand why nations
trade
explain country similarity theory in helping to understand why nations
trade
explain global strategic rivalry theory in helping to understand why
nations trade
Read on
International Product Life Cycle (IPLC) Theory
Vernon’s international product life cycle (IPLC) theory was first published
in 1966. It holds that production of a product with new “know-how” is
initiated by the parent firm, then by its foreign subsidiaries, and finally
anywhere in the world where costs are lowest. The theory helps explain why
a product that begins as a nation’s export often ends up becoming its import.
The IPLC theory has two important tenets: (a) technology is a critical factor
in creating and developing new products and (b) market size and structure
are important in determining trade patterns. The theory focuses on the role
of information, knowledge, and the costs and power associated with
knowledge.
Vernon observed that each product and its manufacturing technologies go
through three stages of evolution: introduction, maturity, and
standardisation. In the introduction stage, a new product typically originates
in an advanced economy, as it possesses abundant capital and R&D
capabilities, providing key advantages in the development of new goods.
Advanced economies also have abundant, high-income consumers who are
willing to try new products, which are often expensive. The new product
enjoys a temporary monopoly in the home country and is often non-
standardised.
At the maturity phase, the product’s manufacturing becomes relatively
standardised; other countries start producing and exporting the product. The
demand for the product expands dramatically as consumers recognise its
value. The product’s inventors mass-produce it and seek to export it to other
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advanced economies. Gradually, however, the product’s manufacturing
becomes more routine and foreign firms begin producing alternative
versions, ending the inventor’s monopoly power. At this stage, competition
intensifies and export orders begin to come from lower-income countries,
and the inventor may earn only a narrow profit margin. At the
standardization stage, the product is completely standardised and
manufacturing ceases in the original innovating country, who then becomes
a net product importer. The market for the product stabilises. Profit margins
are thin and competition is fierce. Today, due to globalisation, the cycle
occurs quickly for many products (think iPad).
Michael Porter’s Diamond Model
Porter believes that success in international trade comes from the interaction
of four country- and firm-specific elements: factor conditions; demand
conditions; related and supporting industries; and firm strategy, structure,
and rivalry.
Factor conditions describe the nation’s position in factors of production
- labour, natural resources, capital, technology, entrepreneurship, and
know-how. Each nation has a relative abundance of certain factor
endowments, a situation that helps determine the nature of its national
competitive advantage. An abundance of cost-effective and educated
workers gives China a competitive advantage in the production of
laptops.
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, thereby forcing firms to innovate more quickly and
produce better products. Japan is a densely populated, hot, and humid
country with very demanding consumers. These conditions led Japan to
become a leading producer of superior, compact air conditioners.
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. Silicon Valley in the US is a
great place to launch a computer software firm because it is home to
thousands of knowledgeable firms and workers in that industry. Others
are pharmaceuticals in Switzerland; footwear industry in Pusan, South
Korea; IT industry in Bangalore, India; and fashion cluster in northern
Italy
Firm strategy, structure, and rivalry refer to the nature of domestic
rivalry and the conditions in a nation that determine how firms are
created, organised, and managed. Vigorous competitive rivalry puts
these firms under continual pressure to innovate and improve. For
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.
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BUSINESS Unit 4, section 2: Firm-based trade theory
Country Similarity Theory
Steffan Linder propounded this theory in 1961. It is based on the hypothesis
that international trade in manufactured goods results from similarities of
preferences among consumers in countries that are at the same stage of
economic development. Firms manufacture for their domestic market and as
they explore exporting opportunities, they discover that the most promising
foreign markets are in countries where consumer preferences resemble those
of their own domestic market. The theory explains intra-industry trade.
Global Strategic Rivalry Theory
This theory was developed by Paul Krugman and Kelvin Lancaster in the
1980s to examine the impact on trade flows arising from global strategic
rivalry between multinational corporations. Firms thrive to develop some
sustainable competitive advantage to exploit and dominate the global
marketplace - investing in research and development, owning intellectual
property, achieving economies of scales etc.
Importance of International Trade
The importance of international trade includes the following:
The expansion of trade is related to the economic growth of nations and the
world economy itself. Trade leads to structural shifts in the economic
organisation for countries, and this provides new opportunities to firms,
workers, and consumers. In short, the ability of a nation to seize export
opportunities and respond to imports is a major determinant of its national
economic performance.
International trade leads to other modes of international operation: joint
ventures, foreign direct investment (FDI), and licensing.
It is important for nations, individuals, and firms to understand the basis of
trade. Everyone has a stake in world trade, and it is necessary to respond
constructively, not destructively, to changes in the world trade environment.
The firm-based theories have provided explanations for generating trade and
investment decisions for international trade. The theories also helped
explained intra-industry trade and trade in differentiated goods and
consumer electronics goods.
Activity 4.2
Of what value is the international product life cycle theory in helping to
understand why nations trade?
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