MODULE -3

Theories of
International
Business

Prof. Udaya S
Asst. Professor @SVIT Bangalore
INTRODUCTION :
Theories of international business help explain why firms engage in cross-
border activities, how they do so, and the factors that influence their decisions
to enter foreign markets.
1. Mercantilism Theory
Mercantilism is a nationalist economic policy that is designed to
maximize the exports and minimize the imports for an economy. In other
words, it seeks to maximize the accumulation of resources within the
country and use those resources for one-sided trade.

History of Mercantilism
Origin
The term ‘mercantilism’ was populated by the Scottish economist ‘Adam
Smith’ in 1776 in his famous book ‘The Wealth of Nations’. Mercantilists
believed that a nation’s wealth was measured in terms of its reserves of
gold and silver. In the 16th century, countries wanted to maximise wealth
and power through the accumulation of reserves of gold and silver, fueled
by restrictive trade and colonisation. This is called bullionism.

Replacing Feudalism
Mercantalism replaced feudalism in Western Europe. In feudalism, the
ownership of the land and the agricultural produce were the main focus.
Prof. Udaya S
Asst. Professor @SVIT Bangalore
 However, in mercantilism, the greater focus was on trade and exports to
gain wealth and power.

Colonial Expansion
During the 17th and 18th centuries, the European governments developed
colonies to withdraw precious resources and build suitable markets for
their manufactured goods. These colonies were developed and expanded
for the benefit of the mother country or the british empire, which wanted
a favourable balance of trade. The colonies were controlled by using the
military power and were used to ship natural resources and raw materials
to the mother countries, while the mother countries used to sell their
finished goods to the colonies. It was believed that the colonies were
needed as the markets for the products of the mother countries; otherwise,
their products could not be sold.

Navigation Act
In 1651, England used the Navigation Act, which stopped foreign vessels
from engaging in coastal trade. All the exports from colonists had to pass
through England before going to Europe. India was restricted and was
allowed to import salt from the UK only. The objective was to
accumulate wealth for the mother country (Great Britain) through a
favorable balance of trade.

Economic Nationalism
In many countries, the government intervened in trade by implementing
policies such as high tariffs or quotas, subsidies, and monopolies to
accumulate wealth and power. In this way, governments promote
economic nationalism in many countries.

Transition to Free Trade

But in the 18th century, mercantilism shifted towards free trade due to the
ideas of Adam Smith and the Industrial Revolution. In this way, countries
focus on the advantages of specialisations.

Characteristics of Mercantilism
The following are some major characteristics of mercantilism, which are
explained as follows:

Economic Nationalism

Prof. Udaya S
Asst. Professor @SVIT Bangalore
 Economic nationalism is a main characteristic of mercantilism. It focuses
mainly on the importance of a country’s economic interests and the
aggregation of resources, wealth, and power.

Favourable Balance of Trade

To maintain a favourable balance of trade, mercantilist policies promote
exports at the international level but restrict imports by imposing high
tariffs at the state level to promote self-sufficiency.

State Intervention
The government imposes policies like providing subsidies, economic
monopolies, and laws to support domestic industries and enhance
economic growth.

Colonisation and Exploitation

Another main characteristic of mercantilism is colonisation and
exploitation. For example, England established British colonies, which
were the source of raw materials for the mother country. These colonies
also created captive markets for manufactured goods of the mother
country.

Bullionism
Bullionism means building reserves of precious metals such as gold and
silver. During mercantilism, mother countries built reserves of gold and
silver to finance powerful armies.
Modern Mercantilism
Modern mercantilism is the new name for traditional, outdated
mercantilism, in which the economic practices and policies are similar to
the traditional ones. It refers to the idea of taking care of own economic
interests by exploiting international trade, currency exchange rates, and
investment flows to earn advantages over other nations. Examples of
modern mercantilism include trade protectionism, currency manipulation,
and government supported industrial policies.

Theories of Mercantilism
Main theories of mercantilism include a favourable balance of trade,
bullionism, and economic nationalism. The theory of a favourable trade
balance gives importance to maintaining a trade surplus by increasing
exports and reducing imports. This theory considers that a country’s
wealth and power are related to more exports and less imports leading to
Prof. Udaya S
Asst. Professor @SVIT Bangalore
 a favorable balance of trade. The theory of bullionism emphasised
accumulating precious metals like gold and silver. It was believed that by
owning these metals, the country’s wealth and power would increase.
Another theory is economic nationalism, which explains that the country
imposed government regulations to protect domestic industries to support
national economic interests and promote self-sufficiency.

2. Theory of absolute cost advantage

The theory of absolute cost advantage is an economic concept that describes a
business or country's ability to produce more of a good or service than its
competitors using the same amount of resources. The theory was developed by
Adam Smith in his 1776 book An Inquiry into the Nature and Causes of the
Wealth of Nations.

Prof. Udaya S
Asst. Professor @SVIT Bangalore
Every country tends to specialize in the production of that commodity which it
can produce most cheaply. Undoubtedly, the slogans of self- reliance and
protectionism have been raised from time to time, but the self-reliance has
eluded all the countries even up to the recent times. The free and unfettered
international trade can make the countries specialise in the production and
exchange of such commodities in case of which they command some absolute
advantage, when compared with the other countries.

In this context, Adam Smith writes; “Whether the advantage which one country
has over another, be natural or acquired is in this respect of no consequence. As
long as one country has those advantages, and the other wants them, it will
always be more advantageous for the latter, rather to buy of the former than to
make.”

When countries specialise on the basis of absolute advantage in costs, they

stand to gain through international trade, just as a tailor does not make his own
shoes and shoemaker does not stitch his own suit and both gain by exchanging
shoes and suits.
Assumptions of the theory:
i) There are two countries- Country I and Country
ii) producing two commodities- Commodity X and Commodity Y.
iii) Labour is the only factor of production. All costs are being measured
in terms of labour hours.
iv) The production techniques of two commodities are different in the
two countries.
v) There are constant returns to scale in the production of both the
commodities in both the countries. Then unit cost of production is
constant for each country.
vi) There are no transport costs or other trade barriers
vii) There is full employment of labour in both the countries.
Suppose there are two countries A and B and they produce two commodities X
and Y. The cost of producing these commodities is measured in terms of labour
involved in their production. If each country has at its disposal 2 man-days and
1 man-day is devoted to the production of each of the two commodities, the
respective production in two countries can be shown through the hypothetical
Table 2.1.

Prof. Udaya S
Asst. Professor @SVIT Bangalore
In country A, I man-day of labour can produce 20 units of X but 10 units of Y.
In country B, on the other hand. I man-day of labour can produce 10 units of X
but 20 units of Y. It signifies that country A has an absolute advantage in
producing X while country B enjoys absolute advantage in producing
commodity Y. Country A may be willing to give up 1 unit of X for having 0.5
unit of Y. At the same time, the country B may be willing to give up 2 units of
Y to have I unit of X. If country A specialises in the production and export of
commodity X and country B specialises in the production and export of
commodity Y. both the countries stand to gain.
The absolute cost advantage of country A in the production of X and
that of B in the production of Y can also be expressed as below:

It is possible to explain the cost difference in two countries A and B

concerning the commodities X and Y geometrically through Fig. 2.1.

Prof. Udaya S
Asst. Professor @SVIT Bangalore
In Fig. 2.1, AA1 is the production possibility curve of country A. Given the
techniques and factor endowments, if all the resources are employed in the
production of X commodity, it can produce OA1 quantity of X. On the contrary,
if all resources are used in the production of Y, country A can produce OA
quantity of Y. BB1 is the production possibility curve of country B.

In case of this country, if all resources are employed in the production of X

commodity, OB1 quantity can be produced. Alternatively, if all the resources
are used in the production of Y, it is possible to produce OB quantity of Y. The
slope of production possibility curve is measured by the ratio of labour
productivity in X to labour productivity in Y in each country.
Limitations of Absolute advantage theory:
i) The assumption of single factor of production is unrealistic.
ii) The assumption of full employment of labour in both the market is also
unrealistic.
iii) The model considers only two countries and two commodities, but in
the real world, there are many countries and commodities.

3. Comparative cost advantage theory

The theory of Comparative advantage has been put forwarded by David
Ricardo. This theory was advanced as an alternative to Adam Smith’s theory of
absolute advantage. Smith did not consider whether trade will take place or not
Prof. Udaya S
Asst. Professor @SVIT Bangalore
if a country enjoyed an absolute advantage in the production of both the
commodities. But Ricardo has shown that even if one country has an absolute
advantage in the production of both the commodities, trade can take place if
there are differences in comparative costs. Comparative cost differences exist if
the ratios of domestic unit costs differ between the two countries

Assumptions of the theory:

i) There are two countries producing two commodities and international
trade takes place in these two countries. Both countries can produce both
the commodities.
ii) Each country uses only one factor of production, labour in the
production of both the commodities. The cost of production of each
commodity is measured in terms of labour hours required to produce
each commodity. The value of any commodity is determined by the
amount of labour required to produce one unit of that commodity. This is
known as labour theory of value. The greater the labour hours, greater is
the value of the commodity.
iii) There are constant returns to scale in the production of both the
commodities.
iv) Free international trade takes place between the two countries and there
is no restriction on the movement of commodities between the two
countries.
v) The amount of labour in each country is given and fully employed.
vi) There is no movement of labour from one country to another though
labour is perfectly mobile within each country.

Explanation of the Theory: Ricardo’s theory can be elaborated and

explained with the help of Ricardo’s famous example. Ricardo took two
countries, Portugal and England, producing two commodities cloth and
wine. The unit costs of labour hours of these two countries are shown in
the table below:-

Unit Costs (in labour hours)

Country Wine Cloth
Portugal 80 90
England 120 100

Prof. Udaya S
Asst. Professor @SVIT Bangalore
 From the table we see that Portugal has an absolute advantage in the
production of wine as well as in the production of cloth, or England has
an absolute disadvantages in the production of both wine and cloth. This
is because the labour cost of production of each unit of the two
commodities is less in Portugal than in England. According to Smith
trade is not possible in this case. But Ricardo argues that even in this
case, trade between England and Portugal is possible and trade will lead
to gains for both the countries. He demonstrate this with the help of the
concept of opportunity cost. The following table shows the opportunity
costs of producing wine and cloth in Portugal and England.

Now, a country has a comparative advantage in producing a good if the

opportunity cost of producing the good is lower at home than in the other
country. Above opportunity cost table shows that Portugal has lower
opportunity cost in producing wine, while England has lower opportunity
cost in producing cloth. Thus Portugal has a comparative advantage in
the production of wine and England has a comparative advantage in the
production of cloth. If they trade then both country will be benefitted.
Not only that if both country specialize in the production of the good in
which it has comparative advantage, then world’s output will also
increase through trade.

5. Comparative cost advantage with money

Comparative advantage is an economy's ability to produce a particular

good or service at a lower opportunity cost than its trading partners. The
theory of comparative advantage introduces opportunity cost as a factor
for analysis in choosing between different options for production.

Prof. Udaya S
Asst. Professor @SVIT Bangalore
 Country Wine Cloth
Portugal 80 90
England 120 100

6. Relative factor endowment theory

The factor endowment theory, also known as the Heckscher-Ohlin
model, was developed by the Swedish economists Eli Heckscher and
Bertil Ohlin between 1919 and 1933. It explores how different countries
will reach a mathematical trade equilibrium based on the relative
distribution of their resources.

What is the Heckscher-Ohlin Theory?

Heckscher-Ohlin's theory is based on the idea that countries have
different resources. These resources can include land, labour, and capital
(which includes machines and factories).
The theory suggests that countries tend to export (sell to other countries)
the goods that use their abundant resources and import (buy from other
countries) the goods that use their scarce resources.

The Heckscher-Ohlin's theory is based on the following assumptions:

 Countries are endowed with different factors of production, such as
labour, land, and capital.
 Factors of production are mobile within a country but not between
countries.

Prof. Udaya S
Asst. Professor @SVIT Bangalore
  Goods are produced using different combinations of factors of
production.
 Countries that use their abundant factors of production intensively tend to
specialise in producing goods.
The theory emphasises the interrelation between the proportion of factors
of production available in different countries and the proportion of them
used in the production of different goods (Theory of the endowment of
factors of production).

The Heckscher-Ohlin Theory - Example

Here's a simplified example to illustrate the concept:
Imagine two countries, Country A and Country B.
Country A has a lot of fertile land, so it has abundant agricultural
resources like soil and sunshine.
Country B, on the other hand, has a well-educated and skilled workforce,
so it has an abundance of labour.
The Heckscher-Ohlin theory is a useful tool for understanding global
trade in the 21st century. The theory provides a framework for analyzing
the factors that influence trade patterns and the potential benefits of trade.
According to the Heckscher-Ohlin theory, Country A is likely to
specialise in producing agricultural products because it has lots of land,
and it can produce these goods more efficiently.
Meanwhile, Country B might produce things that require skilled labour,
like technology or machinery.
As a result, Country A will export agricultural products to Country B,
and Country B will export technology or machinery to Country A. This
trade benefits both countries because they can get the goods they don't
have in abundance, than by trying to produce everything themselves.

Heckscher-Ohlin Theory Applications in Real-World

Here are some examples of how the Heckscher-Ohlin theory applies in
the real world:
 Countries with large populations and relatively lower wages, such as
China and India, specialise in labour-intensive manufacturing, including
textiles, toys, cosmetics, clothing, and consumer electronics. They export
these goods to countries with higher labour costs.
 The USA is a capital-abundant country, so it exports capital-intensive
goods, such as machinery and electronics.
 Brazil is a land-abundant country, so it exports agricultural products, such
as soybeans and coffee.
Prof. Udaya S
Asst. Professor @SVIT Bangalore
  Nations like Saudi Arabia and Russia, with abundant natural resources
like oil, specialise in the production and export of petroleum products.
 Developed countries like Germany and Switzerland specialise in capital-
intensive manufacturing, such as precision machinery and automobiles.

Conclusion
The Heckscher-Ohlin theory is still relevant today in understanding
global trade, but it is important to note that it is a simplified model of
reality. The theory does not fully account for the role of technology,
transportation costs, consumer preferences, government policies, or other
factors that can influence trade patterns.
Despite its limitations, the Heckscher-Ohlin theory provides a valuable
framework for understanding the basic principles of international trade.
The theory provides a framework for analysing the factors that influence
trade patterns and the potential benefits of trade.

7. Product life cycle theory

The product life cycle is a description of the phases that a product
category goes through from its inception to its ultimate withdrawal from
the market. While some argue that the PLC applies to all product
categories, there are some product categories that do not well fit the PLC
framework. Water and salt cannot be displaced by substitutes. As seen in
the image, sales and profits are positioned on the vertical axis, while time
is on the horizontal axis.

The PLC framework consists of four stages:

Prof. Udaya S
Asst. Professor @SVIT Bangalore
  The introduction phase consists of the period between product launch
and that point in time where growth starts to increase at a decreasing rate.
o Pricing: The firm may follow one of two pricing strategies during
the introduction phase.
 Skimming, a higher price, is used to generate more
immediate short term revenue and to more quickly recover
initial investments.
 Penetration pricing, a lower price model than skimming, is
used build market share and loyalty in anticipation of
product maturity.
 The growth phase extends from the time that sales start to increase at a
decreasing rate to an ill-defined point in time before sales start to peak.
o The Product Life Cycle Examples page provides several
instances of industries that are in a long-term growth phase
(COVID-19 may change the situation for some of the these firms).
 The maturity phase extends over a that period when a sales are at their
maximum.
o This can be an extremely profitable stage of the product life cycle,
especially if the the market is large and is sustained over a multi-
year period.
o The Boston Consulting Group (BCG) defines a cash cow as a
division or a product of a firm that is in the maturity phase of the
PLC and has a large market share. Examples here include
Budweiser (beer), the New York Times and the Wall Street Journal
(national newspapers), Exxon Mobil (petroleum), and Michelin
(rubber products). These companies have been generating over a
long time horizon.
o Product development that elevates the value proposition for
customers has the potential to shift a product category from the
maturity phase back to a growth phase. This was the case for golf
equipment supplier Callaway with introduction of the Big Bertha
driver in 1991.
 The decline phase suggests that product sales have started to fall and will
continue to fall toward an eventual withdrawal from the market.
o Residual demand in niche markets may persist for some time and
this state may be profitable if the product is properly harvested.
o A number of products may be pointed out as having gone into
significant decline over the past 50 years including typewriters,
magnetic taps recorders, compact discs, and video cassette
recorders.
Prof. Udaya S
Asst. Professor @SVIT Bangalore
 8. Global strategic rivalry theory

1. Owning the intellectual property rights

Owning Intellectual Property Rights (IPR)
Intellectual Property Rights (IPR) refer to the legal rights given to
individuals or companies over the creations of their minds, such as
inventions, designs, brand names, and artistic works. These rights provide
protection to the owners and allow them to control the use of their
intellectual property (IP) for a specific period of time. Owning IPR can
provide significant advantages for businesses, particularly in international
and competitive markets.
2. Investing in research and development.
Research and Development (R&D) refers to the activities companies
undertake to innovate and introduce new products, services, or processes.
Investing in R&D is crucial for businesses that want to stay competitive,
foster innovation, and drive long-term growth. It involves a significant
financial commitment but often leads to substantial benefits like
improved market positionn, product differentiation, and intellectual
property creation.
3. Achieving economies of scale
Economies of scale refer to the cost advantages that businesses
experience when they increase production, allowing them to spread their
fixed costs over a larger number of units. As a company grows and
produces more, the cost per unit of output decreases, leading to improved
profitability and competitive advantage.
4. Exploiting experience curve

Prof. Udaya S
Asst. Professor @SVIT Bangalore
 The experience curve concept refers to the phenomenon where the cost
per unit of production decreases as a company gains more experience in
producing a good or service. This idea, introduced by the Boston
Consulting Group (BCG) in the 1960s, suggests that the more a firm
produces, the more efficient it becomes due to learning, improved
processes, and economies of scale.

9. Porter’s National Competitive Advantage Theory

Porter’s Diamond Model has been the exemplary work of Michael Porter, who
first published about this economic model in his book, “The Competitive
Advantage of Nations” (1990). This simple but effective model aims at
explaining the cause behind the reason as to why one nation tends to be more
competitive than other nations in relation to a particular industry. This book also
tries to look into the matter of innovations in businesses that may be more
conducive to one nation and might not be possible in others.
Porter’s Diamond Model, also known as the Theory of National Advantage, is
used by different economic institutions to calculate the external competitive
environment. This analysis helps in giving us an understanding of the relative
strength of one business than the other. On analyzing the external environment,
the causes for industrial advantages for some businesses in a particular place or
region can also be deciphered.
Porter’s Diamond Model

Prof. Udaya S
Asst. Professor @SVIT Bangalore
 1. Factor Conditions:
Factor conditions relate to the different types of resources that are present or
absent within a nation. Resources can be typed into basic and advanced ones.
The basic ones include useful natural resources and the availability of unskilled
labor. Advanced or ‘created’ resources include specialization and skilled
knowledge and expertise, availability of capital, infrastructure, etc.
For Porter, natural resources are of less important as compared to the created
resources. Competitive advantage develops in nations and in particular
industries that are able to create these advanced and specialized factors.

2. Demand Conditions:
Demand conditions invariably talk about the ‘home demand’ which affects how
successful a particular industry within a certain nation is. A strong home

Prof. Udaya S
Asst. Professor @SVIT Bangalore
demand of industries in their own nations creates a large market for them and
therefore, creates opportunities for them to grow.
More demands inevitably mean more challenges, but these challenges turn the
companies toward innovation and improvement. The size of the market, the
growth rate of the market, etc. are some indicators of the home demand.

3. Related and Supporting Industries:

According to Porter, the level of success of one industry can be related to the
success of related and supporting industries. In the present economies, the role
of ‘suppliers’ is a crucial one. These suppliers help in advancing innovation
processes through shared resources- technical and other types of aids.
In recent times, the booming of startups has stimulated the renovation. These
startups have entered into innumerable mergers with various industrial giants
leading to the creation of competitive advantage.

4. Firm Strategy, Structure, and Rivalry:

The internal environment in which a firm is established determines how firms
are created and structured. This structuring of the firm can be influenced by a
number of factors- political, economic, and social. This structuring will form the
basis of creating a strategy towards the establishment of the firm.
The level of competitiveness between firms of a particular industry in one
nation is marked by domestic rivalry. The more intense the domestic rivalry, the
more it will push firms toward innovations, improvement and global
competitiveness. Domestic rivalry in the automobile industry between various
Japanese firms such as Toyota, Nissan, Honda, etc. can be cited as a perfect
example.

Prof. Udaya S
Asst. Professor @SVIT Bangalore