Chap 05

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International Trade and Investment  Theory  After studying this chapter, students should be able to:

Understand the motivation for international trade. Summari Summarize ze and discus discuss s the differ difference ences s among among the classi classical cal country country-bas -based ed theories of international trade. > Use the modern, firm-based theories of international trade to describe global strategies adopted by businesses. > Describe and categorize the different forms of international investment. > Explain the reasons for foreign direct investment. > Summarize how supply, demand, and political factors influence foreign direct investment. > >

LECTURE OUTLINE OPENING CASE: Caterpillar: Making Money By Moving Mountains

The opening case describes the operations of a truly truly international firm, Caterpillar. The comp compan any y is invo involv lved ed in many many form forms s of inte intern rnat atio iona nall busi busine ness ss,, incl includ udin ing g both both international trade and international investment. Key Points The The worl world’ d’s s larg larges estt prod produc ucer er of heav heavy y eart earthh-mo movi ving ng and and cons constr truc ucti tion on equipment, Caterpillar is a complex international firm that has a 30% share of the global market. •

The company’s operations operations are spread over five continents, more than a quarter  of its employees work outside of the U.S., and nearly half of its output in 1996 was purchased by foreign customers.

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The two competiti competitive ve advantag advantages es that have enabled enabled Caterpi Caterpilla llarr to attain attain its position in the market are a commitment to quality and a worldwide network of  dealers who sell and service the company’s products.

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Caterpillar is both an importer and an exporter, an international investor and borrower, and it is involved in international licensing and franchising agreements. •

In spite of Caterpillar’s international position, it faces strong competitive challenges from rival firms, particularly Japan’s Komatsu (see the closing case for  more information on Komatsu), and pressures from its labor force. •

Case Questions 1. How has Caterpillar’s position as a global company contributed to its competitive advantage? 

Some students will argue that Caterpillar has attained its position in the global market place because of its competitive advantage, while other students will suggest that its position as a leader in the market makes its competitive advantages possible. However, whether one takes the position that the chicken came before the egg, or the egg before the chicken, there should be agreement that there is definitely an association between Caterpillar’s market position and its competitive advantages. The primary link appears to be that because it has an extensive international dealer network the company has the capability to provide outstanding customer service both before and after purchase, and its commitment to quality has helped Caterpillar build a strong reputation around the world. 2. In the face of strong competition, how can Caterpillar maintain its position as a leader in the earth moving and construction equipment industry? 

Caterpillar is already making important changes in its operations to face the challenge of an increasingly competitive environment. It has invested in plant modernization and new inventory control costs. The company hopes that these measures will improve manufacturing quality and flexibility as well as cut inventory costs. In addition, the company is working with its suppliers to improve the quality of inputs and has struggled to reduce labor costs.  Additional Case Application

Caterpillar is an interesting case study because the company is so involved in international business. It is involved not only in international trade and investment, but also international licensing and franchising. Students can be asked to debate the merits of such an extensive involvement in the international market place, and in particular consider the opportunities and threats Caterpillar has as a result of its position as a global company, and what opportunities and threats face a company that is not as involved in the international marketplace. CHAPTER SUMMARY

Chapter Five examines the underlying economic forces that shape and structure the international business transactions of firms. It discusses the major theories that explain and predict trade and investment.

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I.

INTERNATIONAL TRADE AND THE WORLD ECONOMY Trade involves the voluntary exchange of goods, services, or money between one person or organization and another. International trade is trade between •

residents (individuals, businesses, nonprofit organizations or other associations) of  two countries. International trade takes place when both parties to a transaction believe that they will benefit from such a transaction. In 1999, total international trade amounted to $5.6 trillion, or approximately 19 • percent of the world’s $30 trillion gross domestic product. More than two thirds of  the trade took place among the U.S., Canada, the European Union, and Japan. •

Display Figure 5.1 II.

and Figure 5.2

here.

CLASSICAL COUNTRY-BASED TRADE THEORIES Mercantilism •

Mercantilism was a sixteenth-century economic philosophy that held that a

nation’s wealth is measured by its stock of precious metals (gold and silver). According to the theory, nations should try to enlarge their silver and gold holdings by maximizing the difference between exports and imports through a policy that encourages exports and discourages imports. This policy would have the effect of  enabling a country to become ever richer. The philosophy was popular to some because it enabled a country to expand its borders, because export oriented manufacturers benefited from policies such as subsidies and tax breaks that encouraged exports and because domestic manufacturers were protected from imports. Most members of society do not benefit from mercantilism, however. Taxpayers, for example, must pay for the subsidies and tax breaks offered to exporting firms, and customers may pay higher prices for products when domestic firms are protected from foreign competition. Mercantilism, because it does benefit certain members of society, still exists • today in the form of policies to restrict imports or promote exports. Supporters of  such policies are called neo-mercantilists or  protectionists. Most nations in the world have adopted some neo-mercantilist policies to protect key industries. •

•

Absolute Advantage

Adam Smith criticized the mercantilist philosophy, arguing that it confused the acquisition of treasure with the acquisition of wealth. He further pointed out that mercantilism actually weakened a nation because it forces a country to produce products that it is not very good at producing, and in doing so does not maximize the wealth of its citizens. Smith proposed that free trade between nations would actually enlarge the wealth of countries because it would allow a country to specialize in the production of products that it is good at producing and trade for other products. Smith’s theory of  absolute advantage states that a nation should produce • those goods and services that it can produce more cheaply than other countries. The country should then trade for goods and services it is not good at producing. •

•

The theory is demonstrated numerically in the text using Table 5.1.

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Comparative Advantage

The major difficulty with the theory of absolute advantage is that it suggests that if one country has an absolute advantage in the production of both goods, no trade will occur. David Ricardo solved this problem by developing the theory of  comparative advantage which states that a country should produce and export those goods and services in which it has a relative production advantage and import those goods and services in which other nations are relatively more productive. The difference between the theory of comparative advantage and the theory of  • absolute advantage is that the latter looks at absolute differences in productivity, while the former looks at relative productivity differences. Comparative advantage uses the concept of  opportunity cost (the value of that which is given up in order  to get the good) in determining which good should be produced. The theory is •

demonstrated numerically in the text using Table 5.2. Discuss Bringing the World into Focus: The Lincoln Fallacy 

Abraham Lincoln once said, "I know this much. When we buy manufactured goods abroad, we get the goods and the foreigner gets the money. When we buy manufactured goods at home, we get both the goods and the money." Lincoln's view is incorrect because it is incomplete. When we buy goods from abroad, foreign resources are used, leaving the domestic resources that would have been used in production at home free to be used to make something else. By specializing and trading, rather than producing everything ourselves, we channel production to the most efficient producers thereby generating overall more goods and services for everyone to consume. Comparative Advantage with Money

The lesson of the principle of comparative advantage is: you’re better off  specializing in what you do relatively best. Produce (and sell) those goods and services at which you’re relatively best, and buy other goods and services from people who are relatively better at producing them than you are. The theory is limited in that the world economy produces more than two goods • and services and is made up of more than two nations. Furthermore, barriers to trade, distribution costs and inputs other than labor must be considered. Even more important, the world economy uses money as a medium of exchange. The text provides a demonstration of comparative advantage with money. Use Table 5.3 •

here. It should be noted that in the example with money, people made their decisions to import and export based on price differences, not because they were following the theory of comparative advantage. However, prices set in a free market will reflect the comparative advantage of a nation. •

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Relative Factor Endowments

Hecksher and Ohlin developed the theory of  relative factor endowments to answer the questions of what determines the products for which a country will have a comparative advantage in the first place. The theory proposes that factor  endowments (or types of resources) vary among countries. Further, goods vary in the types of factors that are used to produce them. Therefore, a country will have a comparative advantage in producing a product which intensively uses resources that the country has in abundance. The text provides an example of the theory using wheat, oil, and clothing. Leontief tested the Hecksher-Ohlin theory using the United States as the unit of  • analysis. Leontief, believing the United States to be a capital-intensive, laborscarce country, reasoned that the country would export capital-intensive goods and import labor-intensive goods. However, he found that exactly the reverse was true. Leontief’s findings have come to be known as the Leontief paradox . Display Figure •

5.2 here. There have been numerous attempts to explain Leontief’s findings. Some economists have suggested that Leontief’s work is flawed by measurement problems. His work assumes there are only two factors of production, labor and capital, and ignores other factors such as land, human capital, and technology. This assumption may have caused Leontief to mismeasure the amount of labor that goes into products the United States imports and exports. •

III.

MODERN FIRM-BASED TRADE THEORIES

Firm-based theories have developed for several reasons including: the growing importance of multinational corporations in the postwar international economy; the inability of the country-based theories to explain and predict the existence and growth of intraindustry trade; and the failure of researchers like Leontief to empirically validate the country-based Hecksher-Ohlin theory. In addition, firm-based theories incorporate factors such as quality, technology, brand names and customer loyalty. Country Similarity Theory

Country-level theories explain interindustry trade among nations. Interindustry trade is the exchange of goods produced by one industry for goods produced in another industry. Country-level theories do not explain intraindustry trade , in which two countries exchange goods produced in the same industry. Linder developed a theory to explain intraindustry trade that suggests that international trade in manufactured goods is caused by similarities of preferences among consumers in countries at the same stage of economic development. The theory proposes that although firms originally develop products to sell to their  domestic markets, when they begin to export, they realize that the best markets are in countries where consumer preferences are similar to those in their own domestic market. The text provides an example of the theory using the automobile industry. The theory is particularly good at explaining trade in differentiated goods. •

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Product Life Cycle Theory Teaching Note:

Instructors may find that students “zone out” when discussion of the product life cycle theory begins. Many students believe that the product life cycle theory in international business is the same one they learned about in their introductory marketing courses. It may be worthwhile to alert students to the differences. The international product life cycle theory, developed by Vernon, consists of  three stages. In the first stage (the new product stage), a company develops and introduces an innovative product in response to a perceived need in the local market. Initially, the company must closely monitor whether the product indeed satisfied customer needs, and so typically, the product is introduced in the country where the product was developed. In addition, because the firm is initially likely to minimize its manufacturing investment, most output is sold in the domestic market. •

Display Figure 5.3 here. Demand for the product expands dramatically as the product moves into the second stage (maturing product) and customers recognize its value. The innovating firm expands its capacity and begins to consider exporting to other  markets. Competitors, domestic and foreign, begin to emerge. The market stabilizes in the third stage (standardized product) as the product becomes more of a commodity. Price becomes an issue, and the company considers shifting production to a country where labor costs are low. At this point, the innovating country begins to import the product. The text provides an example of a product, the personal computer, going through the life cycle. •

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Global Strategic Rivalry Model

Krugman and Lancaster have recently examined the impact of global strategic rivalry between multinational firms on trade flows. This view argues that firms struggle to develop some sustainable competitive advantage, which can then be exploited to dominate the global market place. The theory focuses on the strategic decisions firms make as they compete in the global marketplace. •

Discuss Going Global: An Olympic-Sized Rivalry 

This Going Global Box describes the competitive battle between film producers Eastman Kodak and Fuji. Fuji recently launched the offensive in Kodak’s home market by cutting film prices by as much as 50%. As the text notes, according to the global strategic rivalry model, Fuji’s strategy was appropriate. Kodak is now attempting to turn the tables by attacking Fuji in the Japanese market. This Box fits in well with the discussion of the global strategic rivalry model, as well as with Review Question 7. Firms can develop sustainable competitive advantages in several different ways. First, intellectual property rights, such as trademarks, brand names, patents, and copyrights, can give a firm an advantage over rivals. Second, firms that make large investments in research and development may gain first-mover  advantages for goods that are R&D intensive. This advantage is magnified if a firm has a large domestic marketplace because feedback from customers may be •

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quicker and richer. Third, firms that achieve economies of scale or scope gain a competitive advantage over rivals. Economies of scale occur when a product’s average costs decrease as the number of units produced increase. Economies of  scope occur when a firm’s average costs decrease as the number of different products it sells increases. Finally, firms that successfully exploit the learning curve gain firm specific advantages. Porter’s National Competitive Advantage Model

Porter has developed a theory of international trade called the diamond of  The theory proposes that success in an industry is a function of four characteristics: factor conditions; demand conditions; related and supporting industries; and company strategy, structure, and rivalry. Figure 5.4 •

competitive advantage.

should be displayed here. Factor conditions refer to a nation’s endowment of factors of production. Demand conditions refer to the existence of a large, sophisticated domestic consumer base that stimulated the development and distribution of innovative products. Related and supporting industries refer to the development of local suppliers eager to meet an industry’s production, marketing, and distribution needs. Company strategy, structure, and rivalry refer to the environment in which firms compete. Porter also argues that firms’ international strategies and opportunities may be affected by national policies. •

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Discuss Wiring Transformation

the

World:

Nokia's

Incredible

Though it was founded in Finland in 1865, Nokia is one of the world's "newest," most vibrant, and exciting big companies. Its early success was consistent with the theory of comparative advantage (manufacturing pulp and paper using local resources). In 1981 Nokia acquired 51 percent of the state-owned telecommunications company. Finland's heavily forested and sparsely populated landscape forced Nokia to innovate in order to meet Finland's difficult communication challenges. Its innovative successes in Finland have contributed to Nokia's global success and continued innovations. Porter’s model combines the traditional country-level theories (and their focus on factor endowments) with firm-level theories that focus on the actions of individual companies. Further, he includes the role that nations play in creating an environment that may or may not be conducive to a firm’s success. No single theory of international trade explains all trade between nations. Classical, country-level theories are useful in explaining interindustry trade, while firm-based theories are better at explaining intraindustry trade. Porter’s model synthesizes many of the existing features of country-level and firm-based theories. •

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IV.

OVERVIEW OF INTERNATIONAL INVESTMENT

International investment, in which residents of one country supply capital to a second country, is another major form of international investment. Trade and investment may be substitutes for one another, or they may be complementary. Types of International Investments

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International investment can be divided into portfolio investment and foreign direct investment (FDI) (see Chapter 1). The former represents passive holdings of foreign stocks, bonds, or other financial assets that entail no active management or control of the issuer of the securities by the foreign investor. The latter  represents acquisition of foreign assets for the purpose of control. FDI may take many forms including: purchases of existing assets in a foreign country; new investments in plant, property and equipment; or participation in joint ventures with a local partner. The text provides examples of each type of  investment. Controversy often surrounds FDI because while it may increase employment, enhance productivity, and raise wage rates, it also raises concerns that control of  the national economy is being passed to foreigners. •

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The Growth of Foreign Direct Investment

The past 30 years have seen a dramatic rise in foreign direct investment. Current worldwide FDI is about $3.5 trillion. Most FDI occurs among the more developed countries. Discuss Table 5.4 here. • •

The US has become a less important source of FDI, while the importance of  Japan and Germany has increased significantly. •

Foreign Direct Investment in the United States

Discuss Table 5.5 here. The United Kingdom has accounted for the greatest portion of FDI into the United States. The countries listed by name in Table 5.5 (b) account for 62 percent of total FDI from the United States. The high levels of FDI to Bermuda, the Bahamas, and other  small Caribbean islands relate to their role as offshore financial centers (discussed in more detail in Chapter 7) Over the past decade outward FDI has remained larger than inward FDI for the • US, but both categories have more than doubled in size. Discuss Figure 5.6 here. • •

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INTERNATIONAL INVESTMENT THEORIES Ownership Advantages

Researchers trying to explain why FDI occurs initially focused on the impact of  firm-specific (or  monopolistic) advantages. They argued that a firm that owned a superior technology, a well-known brand name, or economies of scale that created a monopolistic advantage could clone its domestic advantage to penetrate foreign markets. The text provides the example of Caterpillar and Komatsu, both of  which capitalized on proprietary technology and brand names to expand into other  markets. The difficulty with the ownership advantage theory is that it fails to explain why a firm must use FDI to enter a foreign market (rather than exporting, for example), nor  does it explain why a firm should locate production facilities in a foreign country (rather than licensing technology to foreign firms, or franchising a brand name). •

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Internalization Theory •

The

answers

to the

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outlined above

were

explored using

internalization theory . The theory suggests that FDI is more likely to occur (a firm

will internalize its operations) when the costs of negotiating, monitoring, and enforcing a contract with a second firm are high. While internalization theory answers the question of why a firm should choose • FDI as a method for entering a foreign market, it fails to address the question of  whether there is a location advantage to producing outside the home country. Dunning's Eclectic Theory

Dunning’s eclectic theory ties together location advantage, ownership advantage, and internalization advantage. Dunning proposes that FDI will take place when three conditions are satisfied. First, the firm must own some unique competitive advantage that overcomes the disadvantages of competing with foreign firms in their own market (ownership advantage). Second, it must be more profitable to undertake a business activity in a foreign location than a domestic location (location advantage). Third, the firm must benefit from controlling the foreign business activity, rather  than hiring an independent local company to provide the service (internalization advantage). •

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VI.

FACTORS INFLUENCING FOREIGN DIRECT INVESTMENT

The decision to undertake FDI can be influenced by supply factors, demand factors, and political factors. Display Table 5.6 here. Supply Factors

Supply-side considerations (a firm’s attempts to control its own costs of  production) may motivate FDI. Factors that are considered include production costs, logistics, availability of natural resources, and access to key technology. Locating a factory, warehouse, or customer service center in a foreign location • may be more attractive from a production cost perspective than locating operations domestically. When a company faces significant logistics costs, it may choose to produce its • product in a foreign location, rather than export it. The availability of natural resources may drive a firm to locate its operations • •

in a country rich in a particular resource. Discuss Map 5.1 here. Access to technology may encourage a firm to invest in an existing foreign • company rather than develop or reproduce an emerging technology.

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Demand Factors

Investing in foreign markets can allow a firm to expand the potential demand for its products. The demand related factors that firms consider include customer access, marketing advantages, and customer mobility. A physical presence in a market is required for many types of businesses, • particularly service businesses. For example, since customer access is essential to KFC’s business, it must locate outlets in other countries. The physical presence of a firm in another country can provide many marketing • advantages. For example, such a presence may enhance the visibility of a company’s products in the host market. If production costs are lower in the foreign market, the firm may be able to lower prices to host country consumers and increase sales, and the company may be able to benefit from “buy local” attitudes. Show Figure 5.7 here. FDI may also allow a firm to exploit competitive advantages (for example, • trademarks, brand names, and technology-based or experientially based advantages) it already possesses. Firms may invest in another country in response to customer mobility . A • supplier firm may follow its buyer to another country so that it can continue to meet its customers’ needs promptly and attentively. Political Factors

FDI may be a logical choice for companies facing trade barriers that threaten to keep their products out of a foreign market, or to take advantage of economic incentives being offered by host governments. FDI is an effective way to avoid trade barriers . The text provides an example • of how the Japanese were able to successfully deal with trade barriers in the early 1980s and mid-1990s. Governments that are concerned with promoting the welfare of their citizens • may provide various economic development incentives to attract foreign investors. Such incentives may include tax reductions or tax holidays, infrastructure provisions, reductions in utility rates, worker training programs, and other subsidies.

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Home Field Disadvantage

The closing case describes the different scenarios facing a web start-up company in Europe and a web start-up company in the U.S. It compares the obstacles facing "Rent-a-Holiday" (a Belgian firm) with the obstacles facing "VacationSpot.com" (an American firm) and concludes that it is very difficult for European firms to compete successfully on the web against U.S. firms.

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Key Points: Rent a Holiday and VacationSpot.com set up web based vacation rental services at almost the same time. Rent a Holiday had trouble raising venture capital among European investors, while venture capitalists were eager to pour money into VacationSpot.com. The American pool of workers skilled to run a web-based business was much larger than the European pool. American workers were more interested in webbased firms than European workers, who seemed to prefer their "big offices and big cigars." In the end, VacationSpot acquired Rent a Holiday and now has extensive vacation rental listings all over the world. •

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Case Questions 1. Porter's theory of national competitive advantage argues that characteristics of  individual nations shape the ability of firms to compete. What advantages did the   American entrepreneurs gain from their American location? Did they suffer any  disadvantages? 

They were stronger on almost all points of Porter's diamond. There was a stronger  set of related and supporting industries; important factors (such as labor and venture capital) were readily available; strategy, structure, and rivalry were all more developed in the U.S.; and demand conditions -- the expectations of web shoppers -- were higher in the U.S., leading VacationSpot.com to develop a better and more sophisticated product (e.g., including online bookings) than its European competitor. The only disadvantage that is clearly apparent in the case was VacationSpot.com's limited access to European listings. 2. Did the European entrepreneurs gain from their European location? What  disadvantages did they suffer? 

Their location allowed them to offer a wider array of European rentals. However, they suffered from lack of venture capital, lack of trained workers, lack of traffic on their web site, a less sophisticated product, and the resulting inability to earn a commission on booked rentals. 3. What can European policymakers do to improve opportunities available to dotcom start-up companies? What can U.S. policymakers do to encourage the growth of such companies? 

Many of the recommendations apply both to the U.S. and Europe. By improving web related infrastructure, governments can improve national firms' competitiveness in e-business. Infrastructure can range from making technical education more readily available to promoting the installation of fiber optic cable. Tax regulation can be approved to make investors more interested in providing venture capital. Keeping regulation of e-business at a minimum will promote the entry of new firms and increased competition.

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1. What is international trade? Why does it occur? 

International trade is trade between the residents (individuals, businesses, nonprofit organizations, or other forms of associations) of two countries. Trade involves the voluntary exchange of goods, services, or money. International trade occurs because the parties to the transaction believe that they benefit from the voluntary exchange. 2. How do the theories of absolute advantage and comparative advantage differ? 

The difference between absolute advantage and comparative advantage is that the former  looks at absolute differences in productivity, while the latter looks at relative productivity differences. The difference between the theories exists because comparative advantage incorporates the concept of opportunity costs in determining which good should be produced. 3. Why are Leontief’s findings called a paradox? 

Leontief’s findings are called a paradox because his research results on the U.S. trade position were not consistent with the intuitively correct Heckscher-Ohlin model, and were in fact, exactly the reverse of what the model predicted. 4. How useful are country-based theories in explaining international trade? 

The country-level theories are useful for explaining interindustry trade (trade in which countries exchange goods produced in different industries) among nations; however, they are not helpful in explaining intraindustry trade (trade in which countries exchange goods produced in the same industry). The latter form of trade accounts for approximately 40% of  world trade, yet cannot be predicted by country-level theories. 5. How do interindustry and intraindustry trade differ? 

The difference between interindustry trade and intraindustry trade is that the former  involves two countries exchanging goods produced in different industries (for example, the exchange of British raincoats for American beer), while the latter involves two countries exchanging goods produced in the same industry (for example, Ford exports Americanmade cars to Japan, while Mazda exports Japanese-made cars to the U.S.) 6. Explain the impact of the product life cycle on international trade and international  investment.

The product life cycle impacts both international trade and international investment. In the second stage of the product life cycle, exports become an important part of the innovating firm’s strategy. Later, as the product enters the third stage of the cycle, the standardized product phase, the company will shift production to low labor-cost countries in an effort to control costs. At this point, the innovating country becomes an importer of the product. Thus, the product life cycle involves both international trade and international investment.

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7. What are the primary sources of the competitive advantages used by firms to compete in international markets? 

The primary sources of sustained competitive advantage used by firms to compete in international markets include: (a) using intellectual property rights such as trademarks or  brand names to gain advantages over rivals; (b) capitalizing on first-mover advantages gained by spending large sums on research and development; (c) achieving economies of  scale or scope, and the resulting lower average cost base to gain an advantage over the competition and; (d) exploiting the learning curve. 8. What are the four elements of Porter’s diamond of national competitive advantage? 

The four elements of Porter’s diamond of national competitive advantage are factor  conditions (a nation’s endowment of factors of production), demand conditions (the existence of a large, sophisticated domestic consumer base), related and supporting industries (local suppliers that are eager to meet the industry’s production, marketing, and distribution needs), and company strategy, structure, and rivalry (the domestic environment in which firms compete). 9. How do portfolio investments and FDI differ? 

The difference between portfolio investment and foreign direct investment is related to the question of control. Portfolio investments represent passive holdings of stocks, bonds, or  other financial assets, which entail no active management or control of the issuer of the securities by the foreign investor. Foreign direct investment represents acquisition of  foreign assets for the purposes of control. 10. What are the three parts of Dunning’s eclectic theory? 

The three components of Dunning’s eclectic theory are location advantage (it must be more profitable to undertake a business activity in a foreign location than a domestic location), ownership advantage (a firm must own some unique competitive advantage that overcomes the disadvantages of competing with foreign firms on their home turf) and internalization advantage (the firm must benefit from controlling the foreign business activity, rather than hiring an independent local company to provide the service). Foreign direct investment will occur when the three conditions are satisfied. 11. How do political factors influence international trade and investment? 

Political factors influence international trade and investment when firms choose to invest in a foreign factory as a means of avoiding trade barriers, and when firms invest in foreign countries in order to take advantage of economic incentives offered by host governments.

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Questions for Discussion 1. In our example of France’s trading wine to Japan for clock radios, we arbitrarily assumed  that the countries would trade at a price ratio of 1 bottle of wine for 2 clock radios. Over  what range of prices can trade take place between the two countries? (Hint: in the absence of trade, what is the price of clock radios in terms of wine in France? In Japan?) Does your  answer differ if you use Table 5.2 instead of Table 5.1? 

In the absence of trade, France can only get three clock radios for two bottles of wine at home (see Table 5.1). Similarly, if Japan is being self-sufficient it can only get one bottle of  wine for five clock radios. Both countries will be willing to trade if they can get a better deal elsewhere. This means that the range of prices over which trade should take place is between what each could get internally. In the case of Table 5.2, the range of prices over  which trade should take place would again be limited by what each could get internally. Without trade, France could get six clock radios for four bottles of wine and Japan could get only one bottle of wine for five clock radios. 2. In the public debate over NAFTA’s ratification, Ross Perot said he heard a “giant sucking  sound” of U.S. jobs headed south because of low wage rates in Mexico. Using the theory  of comparative advantage, discuss whether Perot’s fears are valid.

The theory of comparative advantage suggests that a country will export those goods and services for which it is relatively more productive than other nations and import those goods and services in which other nations are relatively more productive. Thus, even though the U.S. might be better at producing two goods, it should focus is efforts on the one in which it is more productive. Since wage rates are lower in Mexico than in the U.S., Perot felt that American companies would choose to build plants in Mexico to take advantage of the cheaper Mexican labor force. While certainly one would expect some companies to make such a move, because of the low skill levels in the Mexican labor force, other companies will not. In addition, one must consider whether the companies that do make such a move actually save jobs in the U.S. (for example, that of a supplier) that would have disappeared if the companies had gone out of business (because they could not compete while paying the higher U.S. wage rates). 3. Why is intraindustry trade not predicted by country-based theories of trade? 

Country-based theories of trade focus on explaining interindustry trade (trade in which countries exchange goods produced in different industries), rather than intraindustry trade (trade in which countries exchange goods produced in the same industry). The reason for  this is that country-level theories use the country as a unit of analysis, and examine differences in the characteristics of a country  (such as land, labor and capital) to explain trade between nations. In contrast, firm-based theories use the firm as a unit of analysis and focus on differences between firms (such as ownership advantages) to explain trade between countries.

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4. Siemens decided to build a new semiconductor plant in Oporto, Portugal. a. What factors do you think Siemens considered in selecting Portugal as the site for the factory? What about Oporto in particular? 

Siemens invested $380 million to build a new semiconductor chip factory near Oporto, Portugal. The site was chosen for the new plant to capitalize on a lucrative economic development incentive package jointly sponsored by Portugal and the European Union. The package will cover some 40% of Siemens’ investment and training costs. In return, Siemens will provide 750 jobs to the local region. b. Who benefits and who loses from the new plant in Portugal? 

This question should generate a lot of discussion among students. Students who have lost a job (or know someone who has lost a job) as a result of a company’s decision to move production to another country and students who have found a position with a transplanted foreign firm should have particular interest in this question. The big losers in Siemens’ decision to build a plant in Portugal are the workers who will lose their jobs in other  countries where Siemens has operations, and the suppliers who may lose a large customer. The clear winners in the decision are the newly employed workers in Portugal, and the new suppliers to the plant. In addition, Oporto and the surrounding area stand to benefit from the economic and infrastructure boom that may occur as the plant becomes fully operational. c. Is the firm’s decision to build the new plant consistent with Dunning’s eclectic theory? 

Dunning’s eclectic paradigm suggests that FDI will occur when a foreign location is superior to a domestic location, when the firm enjoys an ownership advantage that can be utilized to generate monopolistic profits in foreign markets, and when the firm finds it cheaper (because of transaction costs) to produce the product itself rather than hire some foreign firm to produce it. Siemens’ decision to build a plant in Portugal is consistent with Dunning’s theory.

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The Internet has become a legitimate and essential part of business. Firms use the Internet not only to conduct business, but also as an information source. This exercise is designed to provide students with the opportunity to see the wide variation of the quality of websites. Students are asked to select an industry and product, find five associated websites, and discuss which sites are more useful from a business standpoint.

84 > Chapter 5

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Essence of the exercise

This exercise links trade and investment theory to the actual situation in the computer, consumer electronics, and auto industries. The exercise requires students to explain why some theories are better at explaining the situation in certain industries than others. 1. Do some theories work better than others for different industries? Why? 

Certain theories definitely explain the situation in some industries better than other  theories. For example, country-level theories such as absolute advantage, comparative advantage, and relative factor endowments focus on explaining interindustry trade between countries and are thus better at explaining trade in undifferentiated goods. Firm-level theories provide a better explanation of why intraindustry trade takes place, and are thus useful when considering trade in differentiated products. Finally, investment theories explain why companies make investments in other countries, and are helpful in understanding why companies internalize certain operations. There are several factors, supply side and demand side, which prompt a firm to internalize and, depending on industry conditions, will be more prominent in some industries than in others. 2. What other industries can you think of that fit one of the three patterns noted in the opening paragraph? 

The opening paragraph provides examples of industries that are dominated by foreign firms (consumer electronics), U.S. firms (computers) or a combination of both (automobiles). Students will probably come up with several different examples of each situation. Some possibilities include the banking industry that is dominated by U.S. and foreign (particularly Japanese and British) companies; the low-cost clothing industry which is dominated by companies from lesser developed countries (particularly those in the Pacific Rim); and the insurance industry which is dominated by U.S. firms. 3. Do the same theories work as well in making predictions for those industries? 

As mentioned in question 1 above, certain theories of trade and investment are better at explaining the situation in some industries than others. Depending on how students answer question 2 above, the answer to this question can be either yes or no. 4. Based on what you know about the Japanese market, decide whether the same pattern of  competitiveness that exists in the United States for the computer, consumer electronics, and automobile industries also holds true for that market. Why or why not? 

Instructors may find it necessary to provide some background about the Japanese market before students can really discuss this question. However, even students who are unfamiliar with the Japanese market should be able to discuss the automobile industry in Japan. One could argue that the level of competitiveness in the Japanese automobile industry is lower than in the U.S. industry simply because the Japanese have a strong presence in the U.S., while American firms do not have a strong presence in Japan. Thus, the Japanese companies are in a position to use Japanese-made profits to expand their 

International Trade and Investment Theory > 85

U.S. operations (in terms of research and development, marketing, price cuts, etc.), while American firms do not have this luxury. Other Applications

This exercise focuses on applying the basic theories of international trade and investment to certain products and industries. However, many economies are now known as service economies. Instructors may wish to raise the question of whether any of the theories can be used to explain trade and investment patterns of service firms.