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MGT520 - International Business - Lecture Handout 23

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INTERNATIONAL TRADE THEORY

THE FACTOR-PROPORTIONS THEORY:

The Heckscher-Ohlin theory of factor endowment is useful in extending the concept of comparative advantage by bringing into consideration a nation’s endowment and cost of factors of production. The theory holds that a country will tend to export products that utilize factors of production relatively abundant in that nation.

Land-Labor Relationship:

In countries with many people relative to the size of the available land, labor would be relatively (comparatively) cheap; thus those countries should concentrate on producing and exporting labor-intensive goods.

Labor-Capital Relationship:

In countries where little capital is available for investment and where the amount of investment per worker is low, then low labor rates would also be expected. Again, those countries should concentrate on producing and exporting labor-intensive goods. (The fact that labor skills tend to vary across countries has led to international task specialization with respect to national production activities.)

Technological Complexities:

Factor proportions analysis becomes complicated when the same product can be produced by different methods, such as with different mixes of labor and capital. Managers must consider the cost in each locale, based on the type of production that will minimize costs there.

THE PRODUCT LIFE CYCLE THEORY OF TRADE:

Vernon’s international product life cycle (PLC) describes how the location of production and trade activities shifts as a product moves through its life cycle.

Changes through the Cycle:

A great majority of the new technology that results in new products and production methods originates in industrial countries.

  1. Introduction: Innovation, production and sales occur in the domestic (innovating) country. Because the product is not yet standardized, the production process tends to be relatively labor intensive, and innovative customers tend to accept relatively high introductory prices.
  2. Growth: As demand grows, competitors enter the market. Foreign demand, competition, exports and often direct investment activities also begin to accelerate.
  3. Maturity: Global demand begins to peak, production processes are relatively standardized and global price competition forces production site relocation to lower cost developing countries.
  4. Decline: Market factors and cost pressures dictate that almost all production occur in developing countries. The product is then imported by the country where it was initially developed.

Verification and Limitations of the PLC Theory:

Exceptions to the typical pattern of the international product life cycle would include: products that have very short life cycles, luxury goods, products that require specialized labor, products that can be differentiated and products for which transportation costs are relatively high.

COUNTRY SIMILARITY THEORY:

Previously examined theories would lead one to conclude that the greater the dissimilarity among countries, the greater the potential for trade. However, the country similarity theory states that when a firm develops a new product in response to observed conditions in the home market, it is likely to turn to those foreign markets that are most similar to its domestic market when commencing its initial international expansion activities.

The Economic Similarity of Industrial Countries:

So much trade takes place among industrialized countries because of the growing importance of acquired advantage (skills and technology). In addition, markets in most industrialized countries are large enough to support new product introductions and their subsequent variants across the life cycle.

The Similarity of Location:

Countries that are near to each other enjoy relatively lower transportation costs than those that are more distant. While the disadvantages of distance may be overcome through innovative technology and marketing methods, such gains are difficult to maintain in the long run.

Cultural Similarity:

Cultural similarity as expressed through language and religion is a major facilitator of the international trade and investment process.

The Similarity of Political and Economic Interests:

Countries that agree politically and are economically similar are likely to encourage trade among themselves. In some circumstances at least, they may also discourage trade among countries with whom they disagree.

DEGREE OF DEPENDENCE:

Theories of independence, interdependence and dependence help explain world trade patterns and countries’ trade policies. Realistically, countries are located along a continuum between the two extremes.

Independence:

Under conditions of independence, a country would not rely on other countries for any goods, services, or technologies.

Interdependence:

One way a country can limit its vulnerability to foreign changes is through interdependence, i.e., the development of trade relationships on the basis of mutual need. Each country depends about equally on the other as a trading partner, so neither is likely to cut off supplies or markets for fear of retaliation from the partner nation.

Dependence:

Many developing countries are dependent (rely on) on the sale of one primary commodity, or on one country as a primary customer and/or supplier. In addition, emerging economies largely depend on production processes that compete on the basis of low-wage inputs.

STRATEGIC TRADE POLICY:

Governments have long debated their roles in affecting the acquired advantage of production within their borders. From the standpoint of national competitiveness, the issue revolves around the development of successful industries. The two basic approaches to strategic trade policy are (a) alter conditions that will affect industry in general or (b) alter conditions that will affect a targeted industry.

WHY COMPANIES TRADE INTERNATIONALLY:

Regardless of the advantages a country may gain by trading, international trade will not ordinarily occur unless companies within that country have competitive advantages and perceive that international opportunities are greater than domestic ones.

The Porter Diamond:

In addition to the four determinants of national competitive advantage that are set forth in the Porter diamond, the roles of chance and government are also critical. Usually all four determinants need to be favorable if a given national industry is going to attain global competitiveness.

  • Demand Conditions: The nature and size of demand in the home market lead to the establishment of production facilities to meet that demand.
  • Factor Conditions: Resource availability (inputs, labor, capital and technology) contributes to the competitiveness of both firms and nations that compete in particular industries.
  • Related and Supporting Industries: The local presence of internationally competitive suppliers and other related industries contributes to both the cost effectiveness and strategic competitiveness of firms.
  • Firm Strategy, Structure and Rivalry: The creation and persistence of national competitive advantage requires leading-edge product and process technologies and business strategies.

Points and Limitations of the Porter Diamond:

The existence of the four favorable conditions often represents a necessary but not a sufficient condition for the development of a particular national industry. Even when abundant, resources are ultimately limited, thus firms must make choices regarding their pursuit of existing opportunities. Further, given the ability of firms to gain market information and production inputs from abroad, the absence of any of the four conditions within a country may be overcome by their existence internationally.
Governments have long debated their roles in affecting the acquired advantage of production within their borders. From the standpoint of national competitiveness, the issue revolves around the development of successful industries. The two basic approaches to strategic trade policy are (a) alter conditions that will affect industry in general or (b) alter conditions that will affect a targeted industry.

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