Chapter 4

Theories of International
Trade and Investment

International Business
Strategy, Management & the New Realities

by
Cavusgil, Knight and Riesenberger

International Business: Strategy, Management, and the New Realities 1

 Foundation Concepts

Comparative advantage
Superior features of a country that provide it with
unique benefits in global competition – derived
from either national endowments or deliberate
national policies
Competitive advantage
Distinctive assets or competencies of a firm –
derived from cost, size, or innovation strengths
that are difficult for competitors to replicate or
imitate

International Business: Strategy, Management, and the New Realities 2

 Examples of National Comparative Advantage

• Abundant, low-cost labor in China

• Mass of IT workers in India
• Huge reserves of bauxite in Australia
• Abundant agricultural land in the USA
• Oil in Saudi Arabia

International Business: Strategy, Management, and the New Realities 3

 Examples of Firm Competitive Advantage

• Dell’s prowess in global supply chain

management
• Procter & Gamble’s skill in marketing
• Samsung’s leadership in flat-panel TV
• Apple’s design leadership in cell
phones and personal music players

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 Why Nations Trade: Classical Theories

• Mercantilism: the belief that national

prosperity is the result of a positive
balance of trade – maximize exports and
minimize imports
• Absolute advantage principle: a country
should produce only those products in
which it has absolute advantage or can
produce using fewer resources than
another country
International Business: Strategy, Management, and the New Realities 6
Exhibit 4.2 One ton of
Cloth Wheat
---------------------------------------------
France 30 40

Germany 100 20
----------------------------------------------
Example of Absolute Advantage
(labor cost in days of production for
one ton)
 Why Nations Trade: Classical Theories

• Comparative advantage principle: it is

beneficial for two countries to trade even if
one has absolute advantage in the
production of all products; what matters is
not the absolute cost of production but the
relative efficiency with which it can
produce the product.

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Exhibit 4.3 One ton of
Cloth Wheat
---------------------------------------------
France 30 40

Germany 10 20
----------------------------------------------
Example of Comparative
Advantage (labor cost in days of
production for one ton)
 Limitations of Early Trade Theories

• Do not take into account the cost of international

transportation
• Tariffs and import restrictions can distort trade flows
• Scale economies can bring about additional
efficiencies
• When governments selectively target certain
industries for strategic investment, this may cause
trade patterns contrary to theoretical explanations
• Today, countries can access needed low-cost
capital in global markets
• Some services cannot be traded internationally

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 Classical Theories: Factor Proportions Theory

• Factor proportions (endowments)

theory: each country should produce and
export products that intensively use
relatively abundant factors of production,
and import goods that intensively use
relatively scarce factors of production
• Examples:
 China and labor
 USA and pharmaceuticals
 Canada and electric power
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 Classical Theories:
International Product Cycle Theory

• International product cycle theory: each product and

its associated manufacturing technologies go through
three stages of evolution: introduction, growth, and
maturity. Think of cars, TVs.
• In the introduction stage, the inventor country enjoys a
monopoly both in manufacturing and exports
• As the product’s manufacturing becomes more standard,
other countries will enter the global marketplace
• When the product reaches maturity, the original innovator
country will become a net importer of the product
• Applicability to the contemporary global economy: Today,
the cycle from innovation to maturity is much shorter
making it harder for the innovator country to sustain its
lead in a particular product

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 How Nations Enhance Competitive Advantage

• The contemporary view suggests that

governments can proactively implement
policies to enhance a nation’s competitive
advantage, beyond the natural
endowments the country possesses
• Governments can create national
economic advantage by: stimulating
innovation, targeting industries for
development, providing low-cost capital,
minimizing taxes, investing in IT, etc.
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 Michael Porter’s Diamond Model:
Sources of National Competitive Advantage
1. Firm strategy, structure, and rivalry – the
presence of strong competitors at home serves
as a national competitive advantage
2. Factor conditions – labor, natural resources,
capital, technology, entrepreneurship, and know
how
3. Demand conditions at home – the strengths
and sophistication of customer demand
4. Related and supporting industries – availability
of clusters of suppliers and complementary firms
with distinctive competences

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 Industrial Clusters

• A concentration of suppliers and supporting

firms from the same industry located within the
same geographic area

• Examples include: the Silicon Valley, fashion

cluster in northern Italy, pharma cluster in
Switzerland, footwear industry in Pusan, South
Korea, and the IT industry in Bangalore, India

• Can serve as a nation’s export platform

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 National Industrial Policy

Proactive economic development plan enacted

by the government to nurture or support
promising industries sectors. Typical initiatives:
 Tax incentives
 Investment incentives
 Monetary and fiscal policies
 Rigorous educational systems
 Investment in national infrastructure
 Strong legal and regulatory systems
(Examples: Japan, Dubai, and Ireland)
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 New Trade Theory

Economies of scale are an important factor in

some industries for superior international
performance – even when the nation has no
clear comparative advantage. Some industries
succeed best as their volume of production
increases.
Examples: commercial aircraft, automobiles,
pharmaceuticals all have very high fixed costs
that require high-volume sales to achieve
profitability.

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 How Firms Internationalize

• Internationalization is usually gradual and

evolutionary (Internationalization Process Model)
• Slow internationalization results from the uncertainty
and uneasiness that managers have about doing
international business
• A predictable pattern of internationalization may
include the following stages:
1. domestic focus
2. pre-export stage
3. experimental involvement
4. active involvement
5. committed involvement

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 Dominance of FDI-Based
Explanations of the International Firm

• Most IB theories about the firm

emphasize the MNE, since it was long
the major player in international
business
• Foreign direct investment (FDI) is the
main strategy used by MNEs in
international expansion; thus, earlier
theories emphasized motives for, and
patterns of, FDI

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 FDI BASED EXPLANATIONS:
Monopolistic Advantage Theory

• Suggests that FDI is preferred by MNEs

because it provides the firm with control
over resources and capabilities in the
foreign market, and a degree of monopoly
power relative to foreign competitors
• Key sources of monopolistic advantage
include proprietary knowledge, patents,
unique know-how, and sole ownership of
other assets
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 FDI BASED EXPLANATIONS:
Internalization Theory

• Explains the process by which firms acquire and

retain one or more value-chain activities inside
the firm – retaining control over foreign
operations and avoiding the disadvantages of
dealing with external partners
• In contrast to arm’s-length entry strategies (such
as exporting and licensing) which imply
developing contractual relationships with
external business partners, FDI provides the firm
with control and ownership of resources

International Business: Strategy, Management, and the New Realities 26

 FDI BASED EXPLANATIONS:
Dunning’s Eclectic Paradigm

Three conditions determine whether or not a company will

internalize via FDI:
1. Ownership-specific advantages – knowledge, skills,
capabilities, relationships, or physical assets that form the
basis for the firm’s competitive advantage
2. Location-specific advantages – advantages
associated with the country in which the MNE is invested,
including natural resources, skilled or low cost labor, and
inexpensive capital
3. Internalization advantages – control derived from
internalizing foreign-based manufacturing, distribution, or other
value chain activities

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 NON-FDI BASED EXPLANATIONS:
International Collaborative Ventures

• While FDI-based internationalization is still common,

beginning in the 1980s firms have emphasized non-
equity, flexible collaborative ventures to
internationalize.
• Collaborative venture: a form of cooperation
between two or more firms. Through collaboration, a
firm can gain access to foreign partner’s know-how,
capital, distribution channels, and marketing assets,
and overcome government imposed obstacles.
• Venture partners share the risk of their joint efforts,
and pool resources and capabilities to create synergy.

International Business: Strategy, Management, and the New Realities 28

 Two Types of
International Collaborative Ventures

1. Equity-based joint ventures result in the

formation of a new legal entity. Here, the
firm collaborates with local partner(s) to
reduce risk and commitment of capital.
2. Project-based alliances involve
cooperation in R&D, manufacturing, design,
or any other value-adding activity, a
partnership aimed at a narrowly defined
scope of activities and timeline

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