Economic Theories on International Trade, Development and Investment
Why do nations trade? This question and the equally important proposition of predicting the direction, composition, and volume of goods traded are what international trade theory attempts to address. Interestingly, as is the case with numerous economic writings, the first formulation of international trade theory was politically motivated. Adam Smith, incensed by government intervention and control over both domestic and foreign trade, published “An Inquiry into the Causes of the Wealth of Nations (1776)”, in which he tried to destroy the mercantilism philosophy.
Mercantilism an economic philosophy based on belief that a nation’s wealth depends on accumulated treasure, usually gold; to increase wealth, government policies should promote exports and discourage imports.
Mercanitlism, the economic philosophy Smith attacked, held that it was essential to a nation’s welfare to accumulate a stock of precious metals. These were, in mencartilists’ view, the only source of wealth. Because England had no mines, the mercantilists looked to international trade to supply gold and silver. The government established economic policies that promoted exports and stifled imports, resulting in a trade surplus to be paid for in gold and silver. Import restrictions such as import duties reduced imports while government subsidies to exporters increased exports. These acts created a trade surplus.
Although the mercantilist era ended in the late 1700s, its arguments live on. A» favorable” trade balance still means that a nation exports more goods and services than it imports. In balance – of – payment accounting, an export that brings dollars to this country is called positive, but imports that cause dollar outflow are labeled negative.
An example of modern-day mercantilism, called economic nationalism by some, was the industrial policy based on heavy state intervention that the socialists were creating for France. They nationalized key industries and banks so as to use the power of the state as both stockholder and financier and customer and marketer to revitalize the nation’s industrial base. With nearly one-third of France’s productive capacity and 70 percent of its high-tech electronic capabilities in the hands of the government, its power was approaching the level of state intervention in the 17th century. Some writers were calling this high-tech mercantilism. In 1986, after five years of little growth and high unemployment, the government reversed its policy when a conservative was elected premier.
Adam Smith claimed that market forces, not government controls, should determine the direction, volume, and composition of international trade. He argued that under free, unregulated trade, each nation should specialize in producing those goods it could produce most efficiently. Some of these would be exported to pay for the imports of goods that could be produced more efficiently elsewhere. It was showed by theory of absolute advantage (the capability of one nation to produce more of a good with the same amount of input than another country).
Another theory is the theory of comparative advantage. Ricardo demonstrated in 1817 that even though a nation held an absolute advantage in the production of two goods, the two countries could still trade with advantages for each as long as the less efficient nation was not equally less efficient in the production of both goods.
In 1933 Ohlin, a Swedish economist, building on work begun by the economist Heckscher, developed the theory of factor endowment. Factor endowment is Heckscher-Ohlin theory that countries export products requiring large amounts of their abundant production factors and import products requiring large amounts of their scarce production factors.
How useful is this theory for explaining present-day trading patterns? Countries with relatively large amounts of land (such as Australia) do export land-intensive products (such as grain and cattle), whereas Hong Kong exports labor-intensive goods. Chinese organizations tend to have a long-run growth orientation, which results in Chinese managers' personal leadership styles emphasizing long-runperformance.There are exceptions, however, due in part to Ohlin’s assumptions. One assumption was that the prices of the factors depend only on the factor endowment. We know this is untrue. Factor prices are not set in a perfect market. Legislated minimum wages and benefits force the cost of labor to rise to a point greater than the value of the product that many workers can produce. Investment tax credits reduce the cost of capital below market cost, and so forth. As a result, factor prices do not fully reflect factor supply.
A study made in 1953 by the economist Wassily Leontief disputed the usefulness of the Heckser-Ohlin theory as a predictor of the direction of trade. The study, known as the Leontief paradox, found that the United States, one of the most capital-intensive products. Economists have speculated that this occurred because the United States exports technology-intensive products produced by highly skilled labor. A study by Harvard economists Sachs and Shatz in 1994 did in fact show that the United States has increased its exports of skill-intensive goods to developing nations while reducing its production of unskilled goods.
The exchange rate is the price of one currency stated in terms of the other. If the prevailing rate is $1=250 yen, then 1 yen must be worth 0.004 dollar. The American rice producers can earn $6,670 more by exporting rice to Japan than they can by selling locally; but can the Japanese automakers gain by exporting to the United States? To find out, they must convert the American prices to Japanese yen.
Another way a nation can avoid losing markets and regain competitiveness in world markets is through currency devaluation (lowering its price in terms of other currencies).
Let us examine the international product life cycle (IPLC)in the United States. IPLC is a theory explaining why a product that begins as a nation’s export eventually becomes its import. It consists of four steps:
1. U.S. exports. Because the United States possesses the largest population of high-income consumers in the world, competition for their patronage is intense.
2. Foreign production begins. Overseas consumers, especially those in developed nations, have similar needs and the capability to purchase the product. Export volume grows and becomes large enough to support local production.
3. Foreign competition in export markets. Later, as early foreign manufacturers gain experience in marketing and production, their costs will fall.
4. Import competition in the United States. If domestic and export sales enable foreign producers to attain the economies of scale enjoyed by the American firm, they may reach a point where they can compete in quality and undersell American firms in the American market. From that point on, the U.S. market will be served by imports only.
This cycle may be repeated as the less developed countries with still lower labor costs obtain the technology and thus acquire a costs advantage over the more industrialized nations.
In the 1920s, economists began to consider the fact that most industries benefit from economies of scale; that is as a plant gets larger and output increases, the unit cost of production decreases. Economies of scale and the experience curve affect international trade because they permit a nation’s industries to become low-cost producers without having an abundance of a certain class of production factors. Then, just as in the case of comparative advantage, nations specialize in the production of a few products and trade with others to supply the rest of their needs. This also illustrates the importance of market share, especially in an oligopoly.
Micheal Porter, an economics professor at Harvard, studied 100 firms in ten developed nations to learn if a nation’s prominence in an industry can be explained more adequately by variables other than the factors of production on which the theories of comparative advantage and Heckscher-Ohlin are based. The Porter theory claims that four kinds of variables will have in impact on the ability of the local firms in a country to utilize country’s resources to gain a competitive advantage:
1. Demand conditions – nature of the domestic demand.
2. Factor conditions – level and composition of factors of production.
3. Related and supporting industries – suppliers and industry support services.To achieve differentiation in the provision of services, organizations should develop relationships in which they understand their customers' needs and expectations.
4. Firm strategy, structure, and rivalry – extent of domestic competition, the existence of barriers to entry, and the firm’s management style and organization.
Porter’s work complements the theories of Ricardo and Heckscher-Ohlin. However, as one scholar stated, there is nothing new in Porter’s analysis; but Porter does set out a model in which the determinants of national competitiveness may be identified. One other problem is that Porter’s evidence is anecdotal. There is no empirical evidence as yet.
International trade theory clearly shows that nations will attain a higher level of living by specializing in goods for which they possess a comparative advantage and importing those for which they have disadvantage. Generally, trade restrictions that stop this free flow of goods will harm a nation’s welfare. If this is true, why is every nation in the world surrounded by trade restriction?
This apparent contradiction occurs because government officials who make decision about import restrictions are particularly sensitive to the interest groups that will be hurt by the international competition. These groups consist of a small, easily identified body of people – as contrasted to the huge, widespread number of consumers who gain from free trade.
There are such special groups as: national defense, protect infant industry, protect domestic jobs from cheap foreign labor, scientific tariff or fair competition, retaliation, dumping and its types, subsidies and countervailing duties.
National defence. Certain industries need protection from imports because they are vital to the national defense and must be kept operating even though they are at a comparative disadvantage with respect to foreign competition. Critics of the defense argument claim it would be far more efficient for the government to subsidize a number of firms to maintain sufficient capacity for wartime use only. The output of these companies could be varied according to the calculated defense needs.
Protect Infant Industry.The greatest challenge faced by organizations is to develop a solid set of core competencies. Advocates for the protection of an infant industry may claim that in the long run, the industry will have a comparative advantage, but that its firms need protection from imports until the labor force is trained, production techniques are mastered, and they achieve economies of scale. When these objectives are met, import protection will no longer be necessary. Without the protection, they argue, a firm will not be able to survive because lower-cost imports from more mature foreign competitors will underprice it in its local market.
Protect domestic jobs from cheap foreign labor. The protectionists who use this argument will compare lower foreign hourly wage rates to those paid here and conclude that exporters from these countries can flood the United States with low-priced goods and put America out of work. The first fallacy of this arguments that wage costs are neither all of the production costs nor all of the labor costs. The second fallacy results from failure to consider the costs of the other factors of production costs may actually be higher in a low-wage nation. Besides increasing the potential of networks, information and communication technologies, since they allow simultaneous interactivity and information exchange and use, stimulate organizations to rethink traditional business formats and to create new ones.
Scientific tariff or fair competition. Supporters of this argument say they believe in fair competition. They simply want an import duty that will bring the cost of the imported goods up to the cost of domestically produced article.
Retaliation. Representatives of an industry whose exports have had import restrictions placed on them by another country may request their government to retaliate with similar restrictions.
Retaliation will also be made for dumping. This is the selling of a product abroad for less than the cost of production, the price in the home market, or the price to third countries.
A foreign manufacturer may take this action because it wishes to sell excess production without disrupting prices in its domestic market, or it may have lowered the export price to force all domestic producers in the importing nation out of business. The exporter expects to raise prices in the market once that objective is accomplished. This is predatory dumping.
There are at least four new kinds of dumping:
1. Social dumping – Unfair competition by firms in developing nations that have lower labor costs and poorer working conditions.
2. Environmental dumping – Unfair competition caused by a country’s lax
3. Financial services dumping – Unfair competition caused by a nation’s low
requirements for bank capital/asset ratios.
4. Cultural dumping – Unfair competition caused by cultural barriers aiding
Another cause of retaliation may be subsidies. This is financial contribution provided directly or indirectly by a government and which confers a benefit. Include grants, preferential tax treatments, and government assumption of normal business expenses. Government makes subsidies to a domestic firm either to encourage exports or help it from imports.
Competitors in importing nations frequently request their governments to impose countervailing duties to offset the effects of a subsidy. Countervailingduties are additional import taxes levied on imports that have benefited from export subsidies.
Import restrictions are commonly classified as tariff (import duties) and nontariff barriers. Tariffs, or import duties, are taxes levied on imported goods primarily for the purpose of raising their selling price in the importing nation’s market to reduce competition for domestic producers. Tariff barriers consist of ad valorem, specific, and compound duties.
Ad valorem duty – an import duty levied as a percentage of the invoice value of imported goods. Specific duty – a fixed sum levied on a physical unit of an imported good. Compound duty – a combination of specific and ad valorem duties.
Nontariff barriers (NTBs) are all forms of discrimination against imports other than the import duties that have been examined. NTBs consist of quotas, voluntary export restraints and orderly marketing arrangements.
Quotas, one type of quantitative barrier, are numerical limits for a specific kind of good that a country will permit to be imported without restriction during a specified period.
Some goods are subject to tariff-rate quotas, which permit a stipulated amount to enter the country duty free or at a low rate, but when that quantity is reached, a much higher duty is charged for subsequent importations. This process is repeated annually. Quotas are generally global; that is, a total amount is fixed without regard to source. They may also be allocated, in which case the government of the importing nation assigns quantities to specific countries.
Recently, because of the general agreement among nations against imposing quotas unilaterally, governments have negotiated voluntary export restraints (VERs) with other countries. VERs – export quotas imposed by the exporting nation. Orderly marketing arrangements are VERs consisting of formal agreements between governments to restrict international competition and preserve some of the national market for local producers.
Nonquantitative nontariff barriers. Many international trade specialists claim that the most significant nontariff barriers are the nonquantitave type. They may be classified under three major headings: direct government participation in trade, customs and other administrative procedures, and standards.
1. Direct government participation in trade. The most common form of direct government participation is the subsidy. Besides protecting industries through subsidies, as mentioned earlier, nearly all governments subsidize agriculture.
2. Customs and other administrative procedures. These cover a large variety of government policies and procedures that either discriminate against imports or favour exports.
3. Standards. Both governmental and private standards to protect the health and safety of a nation’s citizens certainly are desirable, but for years exporting firms have been plagued by many that are complex and discriminatory.
When business people move from domestic to international business, they encounter markets with far greater differences in levels of economic development than those in which they have been working. It is important to understand this because a nation’s level of economic development affects all aspects of business – marketing, production, and finance. Although nations vary greatly with respect to economic development levels, we commonly group them into categories of developed, newly industrializing, developing, less developed, or least developed.
Developed – a classification for all industrialized nations, which are most technically developed. Newly industrializing countries(NICs) – the middle-income economies of Brazil, Mexico, Malaysia, Chile and Thailand. Newly industrialized economies (NIEs) – fast growing upper middle-income and high-income economies of South Korea, Taiwan, Hong-Kong, and Singapore. Developing –a classification for the world’s lower-income nations, which are less technically developed.
Much has been written about the part of the national income that is not measured by official statistics because it is either underreported or unreported. Included in this underground (black, parallel, submerged, shadow)economyare undeclared legal production, production of illegal goods and services, and concealed income in kind (barter). As a rule, th0e higher the level of taxation and the more onerous the government red tape, the bigger the underground economy will be.
Currency Conversion. Another problem with GNP estimates is that to compare them, the GNPs in local currency must be converted to a common currency – conventionally the dollar – by using an exchange rate. If the relative values of the two currencies accurately reflected consumer purchasing power, this conversion would be acceptable. However, the World Bank recognizes that “the use of official exchange rates to convert national currency figures to U.S. dollars does not reflect domestic purchasing powers of currencies.”
To overcome this deficiency, the UN International Comparison Program (ICP) has developed a method of comparing the GNP based on purchasing power party (PPP) rather than on the international demand for currency. PPP – the number of units of a currency required to buy the same amounts of goods and services in the domestic market as one dollar would buy in the United States.
Until the 1970s, economists generally considered economic growth synonymous with economic development. A nation was considered to be developing economically if its real output per capita as measured by GNP/capita was increasing over time. However, the realization that economic growth does not necessarily imply development - because the benefits of this growth so often have occurred to only a few – has led to the widespread adoption of a new, more comprehensive definition of economic development.
The human-needs approachdefines economic development as the reduction of poverty, unemployment, and inequality in the distribution of income. The definition of poverty also has been broadened. Instead of being defined in terms of income, as is common in developed countries, a reduction in poverty has come to mean less illiteracy, less malnutrition, less disease and early death, and a shift from agricultural to industrial production.
Because of the increased emphasis on human welfare and the lack of a clear link between income growth and human progress, the United Nations Development Program has devised a Human Development Index (HDI) based on three essential elements of human life: a long and healthy life, the ability to acquire knowledge, and access to resources needed for a decent standard of living. Many countries in Europe have a more individualistic perspective than Japan and a more humanistic perspective than the United States, which may result in some European managers being more people oriented than their Japanese or American counterparts. Managers can take steps to increase their referent power, such as taking time to get to know their subordinates and showing interest in and concern for them.
No Accepted General Theory.The inclusion of noneconomic variables has made it impossible to formulate a widely accepted general theory of development. Instead of pursuing a general theory, development economists are concentrating on specific problem areas, such as population growth, income distribution, unemployment, transfer of technology, the role of government in the process, and investment in human versus physical capital.
Investment in Human Capital. All these resent developments in theory recognize that more than just capital accumulation is needed for growth. There must also be investment in the education of people so there will be managers to ensure that the capital is productive and skilled workers to operate and maintain the capital equipment.With these characteristics, organizations begin to implement a different style of administration that demands new competencies on the part of workers. educational system ought to keep up with this change.
Another strategy followed by some developing nations has been import substitution – the local production of goods to replace imports. Unfortunately, import substitution has not reduced their dependence on developed nations as much as it has changed the composition of imports from finished products to capital and semi processed inputs.
These few examples illustrate some of the concepts that underline the strategies and policies of developing nations and the relationship between the theories of international trade and development. Moreover, they show why experienced international businesspeople keep abreast of developments in both areas.
Contemporary international investment theory has been expanded considerably from the classical theory, which postulated that differences in interest rates for investments of equal risk are the reason international capital moves from one nation to another. For this to happen, there had to be perfect competition; but as Kindlebeger, a noted economist, stated, “Under perfect competition, foreign direct investment would not occur, nor would it be likely to occur in a world wherein the conditions were even approximately competitive.”
There are 5 contemporary theories of foreign direct investment:
Monopolistic Advantage Theory. The modern monopolistic advantage theory – foreign direct investment is made by firms in oligopolistic industries possessing technical and other advantages over indigenous firms. It stems from Stephen Hymer’s dissertation in the 1960s.
Product and Factor Market Imperfections.Caves, a Harvard economist, expanded Hymer’s work to show that superior knowledge permitted the investing firm to produce differentiated products that the consumers would prefer to similar locally made goods and thus would give the firm some control over the selling price and an advantage over indigenous firms.
International Product Life Cycle (IPLC). The IPLC concept explains that foreign direct investment is a natural stage in the life of a product. To avoid losing a market that it services by exporting, a company is forced to invest in overseas production facilities when other companies begin to offer similar products.
Other Theories. Another theory was developed by Knickerbocker, who noted that when one firm, especially the leader in an oligopolistic industry, entered a market, other firms in the industry followed. The follow-the-leader theory is considered defensive because competitors invest to avoid losing the market served by exports when the initial investor begins local production.
Graham noted a tendency for cross investment by European and American firms in certain oligopolistic industries. That is, European firms tended to invest in the United States when American companies had gone to Europe. He postulated that such investments would permit the American subsidiaries of European firms to retaliate in the home market of U.S. companies if the European subsidiaries of these companies initiated some aggressive tactic, such as price cutting, in the European market. Foreign direct investment by oligopolistic firms in each other’s country as a defense measure considers as cross investment.
Internalization theory –an extension of the market imperfection theory; to obtain a higher return on its investment, a firm will transfer its superior knowledge to a foreign subsidiary rather than sell it in the open market. Besides increasing the potential of networks, information and communication technologies, since they allow simultaneous interactivity and information exchange and use, stimulate organizations to rethink traditional business formats and to create new ones.
The electric theory of international production provides an explanation for an international firm’s choice of its overseas production facilities. The firm must have both location and ownership advantages to invest in a foreign plant. It will invest where it is most profitable to internalize its monopolistic advantage.
There is one commonality to nearly all of these theories that is supported by empirical tests – the major part of direct foreign investment is made by large, research-intensive firms in oligopolistic industries. Also, all these theories offer reasons companies find it profitable to invest overseas. However, all motives can be linked in some way to the desire to increase or protect not only profits, but also sales and markets.