International Business Practices

Dr. Meghna Sharma

International Trade Theory Why is it beneficial for a country to engage in trade? What factors determine a countrys trade pattern?

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COCOA 20 15 10 5 K 2.5 5 A (NO TRADE) B (NO TRADE) G 10 15 K 20 RICE G

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Comparison of GNP
GNP per capita 1970 Ghana South Korea $250 $260 1998 $390 $8600

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Between 1968 and 1998, average annual growth rate of Ghanas GNP was less than 1.5 percent. The average annual growth rate of South Koreas GNP was more than 8 percent.

There is no single answer for the difference in growth rates. However, international trade is one reason why South Koreas growth rate was high relative to Ghanas.

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Ghanas anti-trade policies

Ghana very suitable for cocoa production; largest producer and exporter of cocoa in 1957 Government set up Cocoa Board to buy all cocoa grown in Ghana. The Cocoa Board bought cocoa at cheap prices from the farmers and sold cocoa at world prices thereby making huge profits. The profits were used to fund government industrialization programs.

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Ghanas anti-trade policies (contd.)

Consequence: between 1963 and 1979, price paid by the Cocoa Board to farmers increased 6 times, while the price of consumer goods increased by 22 times. The price of cocoa in neighboring countries increased 36 times. From the cocoa farmers perspective, cocoa production was not a profitable enterprise any more. Therefore, they switched to other crops. Huge decrease in Ghanas production and exports of cocoa.
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Ghanas anti-trade policies (contd.)

Ghanas policy of industrialization was a failure. Led to recession and decline in foreign currency reserves. Conclusion: shift from profitable economic activity (cocoa production) to activities in which it could not be competitive damaged the economy and held back economic development.

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South Koreas trade friendly policies Encouraged exports Reduction in import tariffs on non-agricultural goods Reduction in subsidies to exporters Consequence: competitive economy. Resources shifted from agriculture to manufacturing (labour-intensive goods). In the 1950s, 77 percent engaged in agriculture, now less than 20 percent engaged in agriculture.

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Trade Theories

Traditional Theories 1. 2. 3. 4. Mercantilism Theory of Absolute Advantage Theory of Comparative Advantage Heckscher-Ohlin Theory

New Theories of Trade 1. Product Life Cycle Theory 2. New Trade Theory 3. Theory of National Competitive Advantage
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Mercantilism Trade is a zero-sum game (gain by one country results in a loss by another) England 16th century Gold and silver viewed as national wealth; currency of trade between countries Main tenet country should export more than import (maintain Trade Surplus). Not possible to maintain trade surplus in the long-run (lead to inflation and therefore result in less exports).
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Absolute Advantage

Adam Smith (1776) Wealth of Nations Countries should specialize in the production of goods for which they have an absolute advantage, and then trade these goods for goods produced in other countries. Absolute advantage implies production efficiency

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Absolute Advantage (contd.) Example: Assume Ghana and South Korea each have 200 individuals, and they can produce rice and cocoa.

Ghana South Korea

Cocoa (1 ton) 10 40

Rice (1 ton) 20 10

Ghana -Absolute Advantage-cocoa South Korea-Absolute Advantage-rice.

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Absolute Advantage (contd.)

Assume each country allocates half of its resources to cocoa and half of its resources to rice (no trade situation) Combined production (without trade): 12.5 tons of cocoa and 15 tons of rice

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Absolute Advantage (contd.)

Now, assume that each country specializes in the production of the good in which it has Absolute Advantage. Ghana 20 tons of cocoa South Korea 20 tons of rice Therefore, there is an increase in the production of both goods due to specialization.

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Absolute Advantage (contd.) Now, let the two countries trade ie. exchange 1 ton of cocoa for 1 ton of rice. Assume Ghana exports 6 tons of cocoa and imports 6 tons of rice. Cocoa Rice

Ghana South Korea

14 (from 10) 6 (from 2.5)

6 (from 5) 14 (from 10)

Increase in consumption due to specialization and trade

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Comparative Advantage

David Ricardo A country should specialize in the production of those goods that it produces most efficiently, and buy those goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.

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Comparative Advantage (contd.) Example: Assume Ghana and South Korea each have 200 individuals, and they can produce rice and cocoa.

Ghana South Korea

Cocoa (1 ton) 10 40

Rice (1 ton) 13.33 20

Ghana - Absolute Advantage - cocoa and rice Ghana Comparative Advantage - cocoa
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Comparative Advantage (contd.)

Ghana has comparative advantage only in cocoa production because it can produce 4 times as much cocoa as S Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice.

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COCOA 20 15 10 5 K 2.5 B K 5 7.5 10 G 15 20 RICE A G A, B NO TRADE

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Comparative Advantage (contd.) Example (with specialization Ghana in cocoa and S Korea in rice):

Cocoa Ghana South Korea 15 tons 0 tons

Rice 3.75 tons 10 tons

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Comparative Advantage (contd.) Example (with specialization and trade Ghana exchanges 4 tons of cocoa for 4 tons of rice from Korea):

Cocoa Ghana S Korea 11 (from 10) 4 (from 2.5)

Rice 7.75 (from 7.5) 6 (from 5)

Increase in consumption in both countries relative to pre-trade levels

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Heckscher-Ohlin Theory

Swedish economists Comparative advantage arises due to differences in national factor endowments (land, labour, capital) Ricardo comparative advantage arises due to differences in productivity (labour productivity)

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Heckscher-Ohlin Theory (contd.) Countries will export those goods that make intensive use of factors that are locally abundant, and will import those goods that make intensive use of factors that are locally scarce. High factor endowment means low factor cost H-O Theory not good predictor of actual international trade patterns (one reason is that it assumes that technologies are same across countries) Ricardos Theory better predictor of international trade patterns
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Product Life Cycle Theory Raymond Vernon ( mid 1960s) In the 20th century most products were first produced and sold in the US (automobile, TV, photocopier, PC, semi-conductor chips) Wealth and size of the US market gave producers a strong incentive to develop new products

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Product Life Cycle Theory (contd.) PRODUCTION in the US EXPORTS IMPORTS

NEW PRODUCT

MATURING PRODUCT
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TIME STANDARDIZED PRODUCT

Product Life Cycle Theory (contd.) PRODUCTION in other advanced countries EXPORTS IMPORTS

TIME NEW PRODUCT MATURING STANDARDIZED PRODUCT PRODUCT

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Product Life Cycle Theory (contd.) PRODUCTION in developing countries

EXPORTS IMPORTS

TIME NEW PRODUCT MATURING PRODUCT

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STANDARDIZED PRODUCT

Product Life Cycle Theory (contd.)

Production shifts from the US to other advanced countries, and then to developing countries The US becomes an importer from a exporter This theory is not very relevant now

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Porters diamond-national competitive advantage

Outgrowth of new trade theory Focus on four national attributes: factor endowments demand conditions related and supporting industries firm strategy, structure, rivalry Note: Governments can influence all four

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Determinants of National Competitive Advantage: Porters Diamond

Firm strategy, structure, and rivalry

Factor endowments Related and supporting industries

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Demand conditions

Why are certain companies based in certain nations capable of consistent innovation? According to Porter there are four attributes of a nation that help its companies to achieve competitive advantage: 1. Factor Conditions 2. Demand Conditions 3. Related and Supporting Industries 4. Firm Strategy, Structure and Rivalry Each of these attributes individually and collectively help in achieving international competitive success
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1. Factor Conditions

Land, labour, capital not important for achieving competitive success A nation creates the most important factors of production skilled human resources, scientific base To support competitive advantage, a factor must be highly specialized to an industrys particular needs Disadvantages in the more basic factors (labour, raw materials) can force a company to innovate and upgrade (example: just-in-time production Japan)
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2. Demand Conditions

Composition and character of the home market usually has a major effect on how companies perceive, interpret, and respond to buyer needs Demanding consumers pressurize companies to innovate (example: Japanese Consumers live in small homes with hot, humid summers and high cost Electrical energy in response Japanese companies have pioneered Compact, quiet a/c units powered by energy-saving rotary compressors)
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2. Demand Conditions (contd.)

Local buyers can help a nations companies gain advantage if their needs anticipate or even shape those of other nations (example: Denmarks environmentalism - pollution control equipment, US fast food)

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3. Related and Supporting Industries

Presence of internationally competitive suppliers Suppliers and end-users located near each other can take advantage of quick and constant flow of information, exchange of ideas and innovation etc Home-based competitiveness in related industries help to increase the speed of innovation

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4. Firm Strategy, Structure and Rivalry National circumstances influence how companies are created and managed, as well as the nature of domestic rivalry Italy successful international competitors are small or medium-sized companies that are privately owned (appropriate for leather goods, jewelry, furniture customized products, niche marketing, rapid change) Germany companies are strictly hierarchical; top managers have technical backgrounds (appropriate for chemicals, machinery precision manufacturing, after-sale service) No one managerial system is universally appropriate
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4. Firm Strategy, Structure, and Rivalry (contd.) Nations tend to be competitive in activities that people admire or depend on - the activities from which the nations heroes emerge (Tata, Mittal, Murthy) Presence of strong local rivals another stimulus for creating competitive advantage (example: Switzerland Ciba-Geigy, Roche, Sandoz; Japan consumer electronics) Companies are forced to look at foreign markets because of intense domestic rivalry (to achieve greater efficiency and higher profitability)
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The Diamond as a System

Each of the above four attributes defines a point on the Diamond of National competitive advantage. The effect of one point often depends on the state of others. Vigorous domestic rivalry stimulates the development of specialized factors (example: software professionals in India) Domestic rivalry also promotes the formation of related and supporting industries The Diamond creates an environment that promotes clusters of competitive industries
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The Diamond as a System (contd.)

Competitive industries are usually linked through vertical (buyer-seller) or horizontal (common customers, technology) relationships Clusters tend to be concentrated geographically Role of government specialized factor creation, avoid interference in factor and currency markets, enforce product, safety and environmental standards, promote policies that lead to sustained investment, deregulate, anti trust policy
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Conclusion : Failed Theories

Mercantilism (trade surplus, govt intervention, colonization, wealth focus) Factor proportion theory (he who has most capital sells capital intensive goods) vs. Leontief paradox Absolute advantage
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