MODULE 3

THEORIES OF INTERNATIONAL BUSINESS

INTRODUCTION
• International trade argues that free trade ultimately benefits all the countries in
aggregate -the gains outweigh the losses.
• Free trade where a Government does not attempt to influence through quotas or duties
that is it is laiseez faire towards the trade in the best interest of countries.
• The theories such as Smith, Ricardo and Heckscher-Ohlin that a country /economy may
gain if its citizens buy certain products from other nations that could be produced at
home. Propounded for unrestricted free trade.
• The gains arise because international trade allows a country to specialise in
manufacturing and export of products that can be produced more efficiently in that
country while importing products that can be produced more efficiently in other
countries.
• For instance, USA to specialise in the production and export of commercial jet aircraft –
efficient manufacture of commercial jet aircraft requires resources that are abundant in
the USA such as highly skilled labour force and cutting edge technological know-how. On
the other hand, it makes sense for USA to import textiles from China since the efficient
production of textiles requires a relatively cheap labour force and cheap labour is not
abundant in USA.
Continuation
Pattern of International Trade • One of the early response to failure of
Heckscher-Ohlin theory to explain the
Some aspects of pattern are easy to observed pattern of International Trade was
understand climate and natural the Product Life cycle Theory by Raymon
Vermon suggests that early in their life cycle
resource endowments explain why most new products are produced in and
Brazil exports coffee and Saudi Arabia exported from the country in which they were
exports Oil. developed. As a new product becomes widely
accepted internationally production starts in
David Ricardo Theory of Comparative other countries as a result the theory suggests
Advantage offers an explanation in that the product may ultimately be exported
terms of international differences in back to the country of its original innovation.
labour productivity. • Thus the observed pattern of trade between
nations may be due in part to the ability of
Heckscher Ohlin Theory emphasizes firms with in a given nation to capture the first
the interplay between the proportion mover advantage. USA-efficient aircraft
in which factors of production (such as production –Boeing first mover in the world
market. Boeing built a competitive advantage
land, labour and capital) are available that has subsequently been difficult for firms
in different countries and the from countries with equally favourable factor
proportion in which they are needed endowments to challenge (although Europe’s
Airbus Industry has succeeded in doing that).
Trade theory and Government Policy
All the above stated theories agree that International
Trade is beneficial to countries engaged they lack
agreement in their recommendations for Government
Policy.

Promoting Import control

exports and and export
limiting incentives
imports- (subsidies) are
mercantalism self defeating-
Smith, Ricardo
and Hecksher-
Ohlin
Mercantilism
First theory of international trade Inherent
emerged in England in the mid 16 inconsistency
th century. –BOT Surplus
Gold and silver (currency of trade) between the
regarded as the mainstay of No virtue in large volume of trade nations no
national wealth and essential for rather recommended policies to country in the
vigorous commerce. maximise exports and minimise long run can
Earnings-export imports. sustain a
Outflow-import Imports are limited through tariffs surplus in
To maintain a trade surplus to and quotas while exports were balance of
export more than imported . By subsidised. trade
doing so country can accumulate Flaw-trade
more gold and silver and viewed as
consequently increase the national zero sum
wealth, prestige and power. game
Theory of Absolute Cost Advantage
The wealth of Nations-Adam Smith
disagreed with the Mercantilist
assumption that trade is a zero sum Two countries namely Ghana and
game. Smith argued that countries differ South Korea in which the production
in their ability to produce goods more of any good(output) requires
efficiently. resources(input) such as land, labour
When two countries are engaged in and capital.
International trade and when a country Assume that both the countries have
has an absolute advantage in the same amount of resources and these
production of a commodity then it can be used to produce either rice or
possess absolute advantage in producing cocoa. Also assume 200 units of
it more efficiently than any other country. resources are available in each
Thereby the country should specialise in country. Imagine that Ghana takes 10
the production and trade the commodity units of resources to produce one
for commodities produced by the other tonne of cocoa and 20 units of
country. resources to produce one tonne of
The country should never produce goods rice. Thus , Ghana could produce 20
at home that it can buy at a lower cost tons of cocoa and no rice, 10 tons of
from other countries. Therefore, by rice and no cocoa or some
specialising in the production of goods in combination of rice and cocoa
which each has an absolute advantage between these two extremes.
both countries benefit by engaging in
Graphical description The different combinations that Ghana could produce
are represented by GG’ AS Ghana Production
Possibility Frontier. Similarly in South Korea takes 40
units of resources to produce one tonne of cocoa and
10 units of resources to produce one tonne of rice.
Thus south Korea could produce 5 tons of coco and no
20 rice 20 tons of rice and no cocoa or some combination
between these two extremes. The different
15 combinations available to south Korea are represented
by the line KK’ which is South Korea ‘s PPF . Ghana has
absolute advantage in the production of cocoa (more
10 resources are needed to produce a ton of cocoa in
South Korea than Ghana) by the same token, South
5 Korea has an absolute advantage in the production of
rice.
Consider a situation in which neither country trades
2. with any other. Each country devotes half of its
5 resources to the production of rice and half to the
production of cocoa. Each country must consume what
it produces. Then Ghana would produce 10 tons of
0 5 10 15 cocoa and 5 tons of rice (point A) while South Korea
20 would be able to produce 10 tons of rice and 2.5 tons
of cocoa. Without trade the combined production of
both countries would be 12.5 tons of cocoa (10 from
Ghana and +2.5 from South Korea) and 15 tons of rice
(5 tons Ghana & 10 tons South Korea)
 Absolute advantage and gains from
trade
Resources required to produce 1 ton of cocoa
and rice
cocoa Rice Consumption after Ghana trades 6 tons of cocoa for
6 tons of south korea rice
Ghana 10 20
South korea 40 10 coca Rice
Production and consumption without trade Ghana 14 6
cocoa Rice South korea 6 14
Ghana 10 5
South korea 2.5 10
Increase in consumption as a result of specialisation & trad
Total 12.5 15
production
Production with specialisation
cocoa rice
cocoa Rice
Ghana 4 1
Ghana 20 0
South korea 3.5 4
South korea 0 20
Total 20 20
production
Theory of Comparative Advantage
• David Ricardo took Adam • According to Theory of
Smith’s Theory one step comparative advantage it
further by exploring what makes sense for a country to
might happen when one specialise in the production of
country has an absolute those commodities that it
produces more efficiently and
advantage in the to buy goods that it produces
production of all goods. less efficiently from other
According to Smith such a countries even if this means
country might derive no buying goods from other
benefits from international countries that it could
trade based on Theory of produce more efficiently itself.
Absolute Advantage.
Diagram representation
• Assume Ghana is more efficient in the
production of both cocoa and rice that is
Ghana has Absolute Advantage in the 20 G
production of cocoa and rice and it has a
comparative advantage only in cocoa and 15 C
South korea has an comparative
advantage in Rice.
10 A
• Ghana can produce 4 times as much as
cocoa as south korea but only 1.5 times as
much rice. Ghana is comparatively more 5 K
efficient at producing cocoa than it is at B
producing rice. 2.5
• Though country lack absolute advantage K’ G’
in the production of any commodity or a
combination of commodities it can get 0 (3.75){5} 7.5 10 15
economic gain by engaging in free trade 20
and it is a positive sum game.
 Comparative advantage and Gains
from Trade
Resources required to produce 1 ton of cocoa and
Consumption after Ghana trades 4 tons of
cocoa for 4 tons of south korea rice
rice
Cocoa Rice cocoa Rice
Ghana 10 13.33 Ghana 11=(15-4) 7.75=(3.75+
South Korea 40 20 4)
South korea 4 6=(10-4)
Production and consumption without trade
cocoa Rice Increase in consumption as a result of
Ghana 10 7.5 specialisation & trade
South korea 2.5 5 cocoa rice
Total 12.5specialisation
Production with 12.5 Ghana 1=(11-10) 0.25=(7.75-
7.50)
cocoa Rice South korea 1.5=(4-2.5) 1=(6-5)
Ghana 15 3.75
South korea 0 10
Total 15 13.75
production
Relative factor endowment
theory(H-O) model
• Ricardo’s Theory stresses that comparative • Hecksher Ohlin predicts that countries will
advantage arises from differences in export those goods that make intensive use of
productivity and stressed that differences in factors that are locally abundant while
labour productivity between nations underlie importing goods that make intensive use of
the notion of comparative advantage. They factors that are locally scarce.
argued that comparative advantage arises
from differences in national factor • Free trade is beneficial.
endowments. • Unlike Ricardo’s Theory the Heckscher Ohlin
• International trade patterns by suggesting that theory argues that the pattern of International
differences in national factor Trade is determined by differences in factor
endowments(resources like labour, capital and endowments rather than differences in
land) that explain differences in factor costs productivity.
that is more abundant is a factor then low it’s
factor cost thereby helps in determining a • H-O theory example U S has been a long term
country’s comparative advantage. Exporter of agricultural goods reflecting its
abundance of arable land and China excels in
• Countries will export goods that intensively
the Export of goods produced in labour
use their most abundant factors(land, labour
intensive manufacturing such as textiles and
and capital) and import goods that use their
footwear. This reflects China’s relative
most scarce factors leading to trade based on
abundance of low cost labour. US lacks
factor abundance rather than productivity.
abundant low cost labour and importer of
these goods.
Leontief Paradox
• Hechscher Ohlin theory regarded as influential theory.
• Subjected to many empirical tests
• Wassily Leontif using the H-O Theory Leontief
postulated that US was relatively abundant in capital
compared to other countries US would be an exporter of
capital intensive commodities and importer of labour
intensive commodities.
• But that was not the case during that time in reality U S
exported less capital intensive than U S imported and
the outcome was at variance with the predictions of the
theory –Leontief paradox.
Product life cycle theory
• Raymond Vernon proposed the product • Vernon went to argue that early in the lifecycle
life cycle theory in mid 1960. of a typical new product while demand is
starting to grow rapidly in the U S, demand in
• According to his observation most of the other advanced economies is limited to high
world’s new products has been income groups. The limited initial demand in
developed by the U S firms and sold first other advanced countries does not make it
in the U S Market (eg: mass produced worthwhile for firms in those countries to start
automobiles, television, instant producing the new product, but it does
necessitate some exports from the US.
cameras, photocopiers, personal
• Over time, demand for the new product grows
computers and semi-conductors chips).
in other advanced countries (eg; Great Britain,
• To explain this Vernon argued that the France, Germany and Japan). As it does, it
wealth and size of the U S market gave becomes worthwhile for foreign producers to
U S firms a strong incentive to develop a begin producing for their home markets.
new customer products. • In addition, U S firms might set up production
facilities in those advanced countries where
• In addition to the high cost of U S labour demand is growing. Consequently production
gave U S firms an incentive to develop within other advanced economies begins to
cost saving process innovations. limit the potential for exports from the US.
Continuation
• As the market in the US and other advanced
nations matures the product becomes more • The consequence of these
standardised and price becomes the main
competitive weapon. As this occurs, cost
trends for the pattern of
consideration start to play a major role in
competitive process. Producers based in
world wide trade is that
advanced countries where labour costs are over time the US switches
lower than US (eg; Italy & Spain) might now be
able to export to the US. from being an exporter of
• Is cost pressure becomes intense the process
might stop there.
the product to an importer
• The cycle by which US lost its advantage to of the product as
other advanced countries might be repeated
once more as developing
production becomes
countries(eg;Thailand) begin to acquire
production advantage over advanced countries.
concentrated in lower cost
Thus the locus of global production facility foreign location.
initially switches from the US to other advanced
nations and then from those nations to
developing countries.
Global strategic rivalry theory
The global strategic rivalry theory, developed by Paul
Krugman and Kelvin Lancaster in the 1980s, explains how
multinational corporations (MNCs) gain and sustain
competitive advantages in global markets by focusing on
factors like intellectual property, research and
development (R&D), economies of scale, and experience
curve effects. It posits that firms must actively develop
these unique advantages to overcome entry barriers and
thrive in a globally competitive landscape, proving their
superiority to competitors.
•Intellectual Property:
Owning brands, trademarks, patents, and copyrights gives firms a significant
competitive edge. For example, Coca-Cola's unique formula is a key intellectual asset.
•Research and Development (R&D):
Investing heavily in R&D allows companies to innovate and develop new technologies,
leading to superior products and processes, like Boeing's airplanes.
•Economies of Scale:
By increasing production volumes, firms can lower their per-unit production costs,
creating a cost advantage.
•Experience Curve:
Companies with extensive industry experience can gain an advantage, as they often
benefit from improved efficiency and know-how that comes with time.
•Control of Resources:
Gaining exclusive access to critical resources or raw materials can also provide a
competitive advantage.
•Market Access:
Securing favorable access to global markets and distribution channels is crucial for
expanding reach and sales.

In essence, the theory suggests that global success is not just about traditional factors
like labor or land, but about a firm's strategic decisions to create and protect unique
advantages in a highly competitive environment.
Porter’s national competitive The Four Determinants
[Link] Conditions:

advantage theory This refers to the nation's position in factors of production,

such as skilled labor, advanced infrastructure, scientific
knowledge, and capital. Advanced factors like educated
workers and cutting-edge infrastructure are more crucial for
Porter's diamond model explains national sustained competitive advantage than basic resources like
competitiveness through four interacting raw materials or cheap labor.
determinants: Factor Conditions (inputs [Link] Conditions:
like skilled labor, infrastructure), Demand The sophistication and nature of domestic consumer
Conditions (sophisticated domestic demand play a key role. Demanding consumers in a home
consumers and needs), Related and
market pressure companies to innovate, improve quality,
Supporting Industries (clusters of
and develop better products and services, setting trends
supplier industries), and Firm Strategy,
that can become global.
Structure, and Rivalry (domestic
[Link] and Supporting Industries:
competition and management
styles). These factors, along with A country's competitive advantage is enhanced by clusters
Government and Chance, create an of sophisticated and capable supplier and supporting
environment where certain industries industries. These clusters provide cost-effective inputs,
and nations can thrive and innovate, share knowledge, and foster innovation, creating a dynamic
achieving sustained competitive ecosystem for growth.
advantage in the global market. [Link] Strategy, Structure, and Rivalry:
This factor focuses on the context in which firms are
created, organized, and managed within a country. Strong
domestic rivalry, different management attitudes, and
varied national goals create intense pressure for innovation
and improvement, driving companies to compete more
Additional Factors
•Government:
The government's role is to stimulate and influence the other
determinants by enforcing strict standards, fostering demand for
advanced products, creating specialized factor conditions, and
promoting competition.
•Chance:
External events beyond a company's or government's control, such
as fundamental scientific breakthroughs or natural disasters, can
impact national competitiveness.

How It Works
These four factors create a "diamond" shape, highlighting how their
interaction is essential for a nation's competitive
advantage. Porter's model moves beyond the traditional idea that a
nation's wealth is predetermined by its resources, instead
emphasizing how a favorable domestic environment fosters