Chapter 4

PART 2: BUSINESS ACROSS BORDERS: THE FOUNDATIONS
Chapter 4: International trade and investment – theory, patterns, growth of and

rationale for foreign direct investment.
Classic trade theories:
● Mercantilism
Main idea behind this 16th century philosophy is to encourage exports
and discourage imports. Imports are limited through tariffs and quotas
and exports are subsidised. Modern version: “Protectionism”
(example: China 2008 - 2013, keeping its currency at a low value).
● Absolute Advantage (Adam Smith, Wealth of Nations, 1776)

Trade without government intervention. Countries would produce and
export those products in which it was most efficient (where it had the
absolute advantage).
● Comparative Advantage (Ricardo, 1817)

Countries should specialize in production of goods that it produces
most efficiently. Countries should also buy those goods that they
produce relatively less efficient compared to other countries.
Countries should even buy goods from other countries if they had an
absolute advantage in producing those goods (ie the they could
themselves produce the goods more efficiently than the countries they
are importing them from). The key aspect is opportunity cost: as long
as the opportunity cost of producing one more product that the country
is specialising in (the export-good) is higher than the cost of producing
another good (the import-good), the country should import that other
good.
Ricardo’s work was later extended as economists suggested

that a country’s comparative advantage is a result of
differences in national factor endowments. The “Heckscher-
Ohlin” theory argues that countries will export goods that make
intensive use of factors of production such as land, labour and
capital that are locally abundant.
Difference between absolute advantage and comparative

advantage: Smith looked at the absolute productivity
differences between countries, while Ricardo looked at the
relative productivity differences.
Modern Trade Theories
● Product life cycle (Vernon, 1966)

This theory addresses the question why some products that used to
be made in home countries are now imported from other countries,
especially less developed ones. Vernon suggested that as products
mature, both the sales location and the optimal production will change.
For Vernon, the cycle consisted of three stages:
new,
maturing, and
standardised.
Moreover, there were three types of nations:
lead innovation nation,
other developed nations,
developing nations,
As demand for a new product grew in other developed nations, foreign
producers would begin to produce the product, and then developing
nations, who could produce it more cheaply.
● Strategic trade theory (1970s)

Strategic trade theory argued that because of the unit cost reductions
that are associated with a large scale of output (economies of scale),
some industries can only support a few companies. In addition, to
achieve economies of scale, in some industries companies have to
gain a significant share of the world market in order to compete.
Companies that achieve first mover advantages in markets will
develop economies of scale and create barriers to entry for other
companies. This theory suggestw that a government must support
certain strategic industries so that they can gain first mover
advantages.
● National competitive advantage (1990, Michael Porter)

Michael Porter identified 4 factors, that, he argued, promoted or
withheld the creation of competitive advantage in an industry.
i) Factor endowments: refers to a country’s factors of

production that can lead to a competitive advantage (e.g. a
skilled labour force)
ii) Demand conditions: Refers to the nature of home demand
for the industry’s products/services. For example, Japanese
customers for electronic goods are both sophisticated and
demanding and have pressured the electronics industry to be
highly competitive.
iii) Related and supporting industries: refers to the presence or
absence of supplier and related industries that contribute to
other industries.
iv) Company strategy, structure and rivalry: refers to the
conditions in a nation that govern how companies are created,
organised and managed and the nature of domestic rivalry.
When domestic rivalry is strong, there is greater pressure to
innovate.
4.4 National institutions and international trade
Free Trade: Refers to a situation where a government does not restrict what its citoizens
can buy from anothe rcountry or what they can sell to another country.
Countries can intervene in markets in several ways:
Tariffs: Raise the cost of imported products relative to domestic products. Tariffs are
beneficial to governments because they icnrease revenue. They are also beneficial to
domestic producers because they provide protection against foreign competition. They are
not beneficial to consumers as they increase prices.
Subsidies: Government payments to domestic producers (e.g. cash or low interest loans or
tax breaks). Helps coprorates to go to export markets and compete against low cost foreign
imports.
Import Quota: Restriction on the quantity of some goods that that may be imported into a
country. Example: USA has import quoate on cheese products.
Voluntary export restraints: Quotas on trade imposed by exporting country (usually at the
request of the importing country’s government).
Local content requirements: When the government demands that a specific fraction of a
good is produced domestically.
Administrative trade policies: Bureaucratic rules designed to make it difficult for imports to
enter a country. E.g. india has banned Chinese toys, citing safety concerns.
Anti dumping policies: Are imposed when goods are sold in a foreign market below their cost
of production (dumping).
4.5. Government intervention and free trade: the debate
Arguments in favor of free trade:
- Free trade increases a country’s stock of resources

- Free trade increases the efficiency of resource utilisation
- If companies can sell to bigger markets, they will benefit from economies of scale
- countries that adopt an open stance towards free trade tend to have higher growth
rates
- Trade can help to establish a friendly political relationship with another country
- Good way to promote human rights in another country because this will raise income
levels, which generally means that human rights practices improve.
Arguments against free trade:
- Protection of domestic industries

- Protecting home country jobs
- National security concerns regarding defence-related industries
- Consumer protection (E.g. EU has limited import of hormone-treated beef).
- If the government wants to punish a foreign country (e.g. USA/Cuba), it can impose
an import embargo.
- Environmental and social responsibility arguments, e.g. USA banning shrimp imports
from Thailand, because their fishing techniques also trap sea turtles, which are a
protected species in US waters.
4.6 Foreign direct investment
FDI: When a company invests directly in facilities to produce or market its products in a
foreign country. Once a company undertakes FDI it becomes, by definition, a multinational
enterprise or MNE.
Two main forms of FDI:

1 Greenfield investment: Involves establishing a wholly owned new operation in a
foreign country.
2 Acquisition or Merger with an existing company in foreign market.
FDI inflow: Flows of FDI into a country

FDI outflow: Flows of FDI out of a country
Stock of FDI: refers to the total accumulated value of foreign-owned assets at a given time
4.6.1. Why do companies become MNEs by engaging in FDI?
Companies will undertake FDI if there are either ownership advantages, locational
advantages or internationalisation advantages (“Dunning’s OLI framework”).
A Ownership advantages: Companies enjoy ownership advantages if a) there are resources

of the company transferable across borders and b) these resources enable the company to
obtain competitive advantage abroad.
B Locational advantages: Advantages in foreign locations that the company would not enjoy
at home. Four types of locational advantages:
1 markets: many advantages at being in rapidly developing, hugely populated

countries such as china
2 Resource endowments: e.g. in land, labour, weather, infrastructure - eg Chinese
MNEs seek natural resources around the world in oil, gas, minerals
3. agglomeration: refers to location advantages due to clustering of economic activity
in certain locations (e.g. Silicon Valley in the USA)
4. Institutions: A country may offer tax advantages, business opportunities, subsidies

and the like in order to attract FDI.
C Internationalisation advantages: Arise if the MNE can organise activities better and more
cheaply internally, within the MNE, than by using a third party that incurs transaction costs

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PART 2: BUSINESS ACROSS BORDERS: THE FOUNDATIONS

Chapter 4: International trade and investment – theory, patterns, growth of and

Classic trade theories:

● Absolute Advantage (Adam Smith, Wealth of Nations, 1776)

● Comparative Advantage (Ricardo, 1817)

Ricardo’s work was later extended as economists suggested

Difference between absolute advantage and comparative

● Product life cycle (Vernon, 1966)

● Strategic trade theory (1970s)

● National competitive advantage (1990, Michael Porter)

i) Factor endowments: refers to a country’s factors of

4.4 National institutions and international trade

Countries can intervene in markets in several ways:

4.5. Government intervention and free trade: the debate

Arguments in favor of free trade:

- Free trade increases a country’s stock of resources

Arguments against free trade:

- Protection of domestic industries

4.6 Foreign direct investment

Two main forms of FDI:

FDI inflow: Flows of FDI into a country

4.6.1. Why do companies become MNEs by engaging in FDI?

A Ownership advantages: Companies enjoy ownership advantages if a) there are resources

1 markets: many advantages at being in rapidly developing, hugely populated

4. Institutions: A country may offer tax advantages, business opportunities, subsidies

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