CHAPTER 2
International Trade and Foreign Direct Investment
Learning Objectives
LO2-1 Appreciate the magnitude of international trade and how it has grown.
LO2-2 Identify the direction of trade, or who trades with whom, and trends in such trade.
LO2-3 Outline the theories that attempt to explain why certain goods are traded internationally.
LO2-4 Explain the size, growth, and direction of foreign direct investment
LO2-5 Explain several theories of foreign direct investment.
NOTE:
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Overview
This chapter addresses three major concerns, the state of international trade, that of foreign investment,
and then an exploration of why businesses enter foreign markets.
International trade and foreign direct investment have grown dramatically over the last three decades.
Although new trading and investment patterns are emerging, developed nations tend to trade with and
invest primarily in other developed nations, and not in developing countries.
Trade theories attempt to explain why nations trade with each other. Mercantilists (1550 to 1800 and
perhaps on-going) believed that trade should be a vehicle for accumulating gold. Adam Smith, displeased
with mercantilist ideas, showed that a nation could acquire what it does not produce by means of free,
unregulated trade. A nation could gain most by producing only goods that it could produce with less labor
than other nations. Ricardo carried Smith’s argument a step farther by proving that a country that was less
efficient in the production of all goods could still gain from trade by exporting those products in which it
was less inefficient.
Firms go abroad either to increase profits and sales or protect them from being eroded by competition. To
increase profits and sales, they may enter new markets, go to markets that promise to help them obtain
greater profits, or enter markets in order to test market. The competitive moves are motivated
to protect the home market, to attack competition in their home market, to protect their foreign markets, to
guarantee supply of raw materials, for geographic diversification, and to satisfy management’s desire.
Exchange rates and currency devaluations play a key role in the direction trade flows and impacts directly
of generating profits from global markets. More contemporary, market-derived theories help explain
trade flows as they occur today. Porter’s Diamond Model of Competitive Advantage offers an explanation
of why countries are successful in their trade.
The traditional approach to international involvement was to begin with exporting, then setting up foreign
sales companies and finally, where the sales volume warranted, establishing foreign production facilities.
Increasingly, because countries have liberalized trade restrictions and IT has made communication
instantaneous, companies are becoming involved in trade and FDI for many reasons.
International investment theory attempts to explain why foreign direct investment occurs. Product and
factor market imperfections provide firms primarily from oligopolistic industries with advantages not
open to indigenous companies. The international product life cycle helps explain the direction of
international investment as well as international trade. Some companies follow the industry leader
overseas and the tendency for European firms to invest in the United States and vice versa seem to
indicate that this cross investment is done for defensive reasons. The internalization theory states that
international firms will seek to invest in a foreign subsidiary rather than license their superior knowledge
to receive a better return on investment used to produce the knowledge. Two financially based
explanations for foreign direct investment are: (1) foreign exchange market imperfections resulting in
overvalued and undervalued currencies may attract investors from nations with overvalued currency to
countries with undervalued currency, and (2) the portfolio theory which postulates that international
operations are made for risk diversification. There is a brief description of the Eclectic Theory of
International Production.
Although theories argue for free trade among nations, tariff and non-tariff barriers to trade still exist.
Various arguments are given for their existence such as the necessity to protect local industry from cheap
foreign labor, to protect new industries until they are mature, and to ensure that a country will have the
needed defense industries.
Suggestions and Comments
1. Students often are unaware of the rapid growth of international trade, so we discuss Figure 2.1
in class. We point out that there have been numerous changes in trade relationships as Table 2.1
illustrates. Most students believe that the major trade direction is between developed and
developing nations (exchanging raw materials for finished goods). Table 2.1 shows that
developed nations continue to trade with other developed nations, but the increase in
industrialization of developing nations is resulting in greater trade among them.
2. The material on Theories of International Trade is somewhat difficult for many students and it
is easy to lose their interest when discussing theories from the 17th century. We emphasize in
class that there are good, practical reasons for knowing the essentials as we have also
emphasized in the text. We recommend that you go slowly in discussing comparative
advantage. If you whip through it, you will probably lose most of the class. We commonly ask
a student to come to the board and create a table to explain the theory and we give him or her
all of the help required. We came across a short haiku-like summary of comparative advantage
that might help students get the general idea: Do what you do best and trade the rest.
3. We find it advantageous to follow the discussion of comparative advantage with the example in
which we introduce money because the students learn quickly about the importance of
exchange rates and they are better prepared when we examine the financial markets.
4. Generally students are surprised to learn that the United States’ share in total foreign
investment is still as large as it is. They also believe that Japan’s share is largest. Do you want
to see how many read the assignment? Ask them which country has the largest share of foreign
direct investment (answer: the U.S.).
5. There is a common misconception that firms have a choice between exporting and foreign
production. We show that this choice often is unavailable when we cover the reasons for going
abroad.
6. You may be interested in discussing the topic, “Does trade lead to FDI or does FDI lead to
trade?” This illustrates how closely trade and FDI are interlinked.
Student Involvement Exercises
1. Ask the students to check advertisements in The Wall Street Journal, the Financial Times and
New York Times, for ads in which investment inducements are offered by foreign governments.
Similar ads also appear in The Economist, Business Week, and Fortune. Students can also
search the web to find such inducements for various countries. What kinds of inducements are
offered? Does your city and state offer foreign firms inducements to invest in your area? How
successful have they been in attracting foreign FDI into your state, region, or local area?
2. Students typically understand that products are exported and imported because of their tangible
nature and the benefits derived through their consumption are apparent. The import and export
of services are more difficult for students to grasp. Have students research this and 3expalin
their findings. Have them rank the volume of U.S. services’ imports and exports, the countries,
and the top 10 types of services involved. Have them do the same for an EU and an Asian
country and compare their findings. Then, have them answer the question, “Why export
services?”
3. This is the output of cigars and calculators for countries A and B.
Output/Man/Day
Country: A B
Calculators: 6 2
Cigars: 20 10
a. Would it be advantageous for B and A to trade?
b. What would be the range of values within which trading of cigars for calculators
would make economic sense? (3-1/3 cigars/calculator to 5 cigars/calculator).
c. Total production costs per day are $30 in A and 120 pesos in B. If the exchange rate
is 10 pesos in B = $1 in A, will trade still place in the same direction as for part a?
Country A:
Calculators:
$30
6 calculators
= $5/calculator
Cigars:
cigars 20
$30
= $1.50/cigar
Country B:
Calculators:
120 pesos
2
= 60 pesos/calculator
Cigars:
120 pesos
10
= 12 pesos/cigar
Converting to dollars:
Country: A B
Calculators: $5/Calculator $6/calculator
Cigars: $1.50/cigar $1.20/cigar
d. What change must be made in the exchange rate to change the flow of trade?
Answer:
(1) If rate goes to 12 pesos = $1, calculator will cost $5 in B, which is the same price as
in A, so based on price alone, B will not import from A. B can still sell cigars to A
because their price has improved and gives them a greater price advantage.
(2) If the rate goes to 8 pesos = $1, then B’s cigars will cost A $1.50 and B will lose its
price advantage. Calculators in B will cost $7.50 to produce.
e. If rate goes to 8 pesos or even 7 pesos = $1, will B sell any cigars to A?
Answer:
(1) They probably will if their cigars taste better or are handmade, if A’s are machine
made. Cigars, like most products, are not bought purely on the basis of price.
Guest Lecturers
Some businesspeople who could contribute to the material in this chapter would be:
1. Someone in the technical department of a multinational to talk about licensing and contract
manufacturing arrangements that firm has with overseas licensees.
2. Product manager of the international division of a multinational who should be knowledgeable
about licensing and all the means for entering a market. Such a person can also explain why the
firm went overseas.
3. Financial person in the international division who can discuss the points mentioned in questions 1
and 2 plus the ROI obtained from these arrangements.
4. Representatives from a foreign-owned subsidiary in your area. Ask them to tell the class what
motivated their company to come to the United States and your area.
5. If you have an economic development department in your state that is active in attracting foreign
investors, you may be able to get a representative to explain to the class what it does to attract
foreign investors and what foreign investors are looking for. Your chamber of commerce director of
economic development may have had visits from foreign company representatives that he or she is
willing to share.
6. If you are in an area with foreign consuls, you might invite a member of the consulate to discuss
his or her government’s policy with respect to trade restrictions and economic development,
especially as it affects foreign investment in that country. The representative could also be asked
about that government’s efforts to promote foreign trade.
Worldview
The focus of this Worldview explores “Are Social and Economic Development Affected by Trade
and Investment?” The introduction from the UNCTAD report says “Yes,” there is a direct link
trade and investment and quality of life. UNCTAD created the Trade and Development Index
(TDI), which systematically monitors the trade and development performance of developing
countries to facilitate world policies and strategies to ensure that trade is a key instrument in
development. A total of 123 countries were evaluated and their TDI scores were ranked and
the rankings are shown in the Worldview. Developing countries showed a lag in physical
infrastructure, human capital, financial intermediation, institutional quality, economic and
social wellbeing, and trade performance. All of these factors are needed to attract trade and
FDI. Trade liberalization is critical for a high TDI score. External and internal factors affect a
nation’s expert performance. External factors include market access conditions such as
transportation costs, geography, physical infrastructure, trade barriers, competition and other
factors that influence demand. Internal factors are supply-side conditions within a nation such
as raw materials, cost of labor and capital, access to technology, economic policy, institutional
environment and market access. A lively class discussion could examine such questions as:
“Why might trade and investment impact the social and economic development of a country?”
and “What actions should a developing country take in order to enhance the potential benefits
from international trade and development?”
Global Debate
The focus of this Global Gauntlet explores outsourcing of services to India. It provides a thorough
overview of the use of outsourcing as a way for MNC’s to improve profitability through
comparative advantage offered by markets where the cost of labor is significantly less than in
the home country of an MNC. However, this simple lesson in economics is quite controversial
and serves as a starting point for a stimulating class discussion on such topics as:
What are the profit motives for outsourcing?
What advantages other than profit can be gained by outsourcing?
How should a company manage outsourcing?
What are the ethical considerations a company faces in making a decision to outsource?
How can outsourcing impact (help or hurt) a company’s corporate image?
Is there a potential for an “upward creep” where low level, low skill tasks start to move
upward into higher skilled, higher level jobs being outsourced? What impact can this shift
have on home country jobs? On host country jobs?
Is there a risk of a country losing its innovative edge if higher skilled jobs are outsourced?
Will outsourcing cause a shift in the home country’s workforce by creating new job
opportunities to replace those being outsourced?
The Global Path Ahead
The focus of this The Global Path Ahead explores a student’s decision to expand her international
and cross-cultural experience base by pursuing multiple study abroad opportunities during her
undergraduate years. This helped her to develop and refine a set of skills, such as cross-cultural
understanding, adaptability, creative problem solving, and international networking, which
could prove invaluable in her subsequent professional career. The Resources for Your Global
Career section provides a useful culture cue for enhancing rapport building and understanding,
as well as a variety of resources for locating trade and FDI statistics and related information.
Mini-Case 2.1, “Can Brazil Become a Global Competitor in the Information Technology
Outsourcing Business?”
This mini-case provides an opportunity for students to test their understanding about international trade
and foreign direct investment by examining Brazil’s efforts to develop a globally competitive cluster for
the information technology outsourcing business. The description of Brazil’s efforts provides a useful
foundation for engaging in class discussion of such questions as: (1) “Using the theories of international
trade and investment that have been presented in this chapter, please explain Brazil’s intentions and
actions regarding the international information technology outsourcing sector,” or (2) “What
recommendations would you give to the Brazilian government and its outsourcing industry in order to
improve their prospects for success in building a strong international competitive position in the
information technology outsourcing business?”
Lecture Outline
I. The Opening Section
“Firms Invest Overseas, but They Also Export”: In response to factors such as (1) global
competition, (2) liberalization by host governments in regard to foreign investment, and (3)
advances in technology, American outward foreign direct investment (FDI) was $1.20 trillion for
the 2006-2009 period, or 1.3 times the U.S. average for 1996-1999.
Although FDI may have replaced some flows of exported goods and services from the U.S.,
American exports increased from $1.1 trillion in 2000 to $1.8 trillion in 2010, a 64% increase.
The sales and profits from foreign operations and exports are critical to multinational firms.
Small and medium-sized enterprises (SMEs) are also active in exporting, representing nearly 98%
of all U.S. exporters and 33% of the value of American exports.
In this chapter, three topics are examined that relate directly to exporting and production in
foreign countries: (1) international trade, which includes exports and imports; (2) foreign direct
investment; and (3) why firms enter foreign markets. A related activity, foreign sourcing, is
treated later in the text.
II. International Trade
A. Volume of Trade
1. The volume of international trade in goods and services was $4.0 trillion in 1990, $7.9
trillion in 2000, and exceeding $18.9 trillion by 2010.
2. While smaller in absolute terms ($3.7 trillion versus $15.2 trillion), trade in services has
grown faster since 1990 than has merchandise trade and is more than 10 times what it
was in 1980.
3. One-fourth of everything grown or made in the world is exported.
4. As Figure 2.1 shows the percentage of trade for countries around the world.
5. The proportion of exports from North America, Latin America, Africa, and the Middle
East has decreased.
6. African trade has increased in value by 250% from 1980 to 2010, but decreased in its
proportion of world trade by 50%.
7. Asia and the EU proportions of world trade have increased. With the EU, new members
account for some of the growth.
8. Table 2.1 shows the ranking of the world’s 10 leading exporters and importers of
merchandise and services.
B. Direction of Trade
1. Developed nations trade primarily with other developed nations.
2. Developing nations also trade primarily with developed nations, although this proportion
is declining.
3. The direction of trade frequently changes over time among nations or regions. Regional
trading blocks (NAFTA, EU, ASEAN) have been trading more within themselves.
C. Major Trading Partners: Their Relevance for Managers.
1. Advantages of focusing attention on a nation that is already a sizable purchaser of goods
from the would-be exporter’s country include:
a. Business climate in the importing nation is relatively favorable.
b. Export and import regulations are not insurmountable.
c. There should be no strong cultural objections to buying that nation’s goods.
d. Satisfactory transportation facilities have already been established.
e. Import channel members are experienced in handling import shipments from the
exporter’s area.
f. Foreign exchange to pay for the exports is available.
g. The trading partner’s government may be applying pressure on importers to buy from
countries that are good customers for that nation’s exports.
2. Major trading partners of the United States.
a. Table 2.2 shows the major trading partners of the United States. Canada, Mexico
and China are the leading trading partners.
b. Rankings of America’s trading partners have changed markedly in 30 years. Asian
nations have become increasingly important trade partners for both exports and
imports.
c. Many Asian countries appear as major importers of American goods because (1) their
rising standards of living enable their people to afford more imported products, and
export earnings provide foreign exchange to pay for imports, (2) they are purchasing
large amounts of capital goods to further their industrial expansion, (3) they are
importing raw materials and components to assemble into subassemblies or finished
goods to subsequently export, often to the U.S., and (4) their governments,
sometimes under pressure from the U.S. government, have sent buying missions to
the U.S. to seek products to import.
3. Relevance for Managers
For a company starting to search for new international business opportunities, the
preliminary steps of studying the general growth and direction of trade and analyzing
major trading partners would provide an idea of where the trading activity is.
Understanding the economics of specific market areas can give insight into future
government actions impacting trade.
III. International Trade Theory
International trade theory attempts to answer the question, “Why do nations trade?”
A. Mercantilism
1. One of the first economic doctrines (1550 to 1800).
2. Central idea–countries having no domestic sources of precious metals such as gold could
accumulate these valuable materials for the benefit of their nation.
3. Governments should control foreign trade by establishing economic policies that
promoted exports and stifled imports, generating a trade surplus that would be paid for in
gold and silver, in addition to protecting jobs within the mercantilist nation.
B. Theory of Absolute Advantage
1. Dissatisfaction with excessive government controls prompted many writers to advocate
less government control of foreign trade.
2. Adam Smith (The Wealth of Nations–1776) attacked mercantilism and said that to trade
in order to accumulate gold was foolish. By means of free, unregulated trade, a nation
could acquire what it did not produce.
3. He stated that a nation should produce only those goods in which it was most efficient.
The surplus could be traded to obtain the products that could not be produced
advantageously.
4. The question was then asked, would it be advantageous for a nation to trade if it were not
as efficient as another in the production of any product?
C. Theory of Comparative Advantage
Ricardo in 1817 showed that if a nation were less efficient in the production of two products,
it could still gain from international trade if it were not equally less efficient in the
production of both goods.
The concept of comparative advantage serves as a basis for international trade.
Smith’s and Ricardo’s theories considered labor as the only important factor in calculating
production costs and no thought was given to the possibility of producing the same goods
with different combinations of factors.
IV. The Direction of Trade
This section addresses the question of “Which way does trade flow and why?”
A. Money can change the direction of trade.
1. To know if it is more cost effective to buy locally or import, traders need to know
prices in their domestic currency.
2. The exchange rate is the price of one currency stated in terms of the other.
3. Countries can regain or strengthen a competitive position through currency
devaluation, the lowering of its domestic currency in terms of other currencies. China is
accused of artificially holding down the value of its currency, the yuan (or renminbi).
B. Newer Explanations for the Direction of Trade
1. Differences in Resource Endowments
a. Some countries have more abundant resources than others that can result in
different opportunity cost of producing these resources and bringing them to
market. Differences in resource endowments suggest that developed countries
would more likely trade with developing countries rather than other developed
countries with similar factor endowments.
2. Overlapping Demand
a. Consumers’ taste, preferences, and their nation’s per capita income affect market
demand in any country. Customers in countries with similar levels of per capita
demand will demand similar goods and services.
3. International Product Life Cycle (See Figure 2.2)
a. This concept is related to the product life cycle and the role of innovation in trade
patterns.
b. It is helpful in the analysis of a product’s export potential and may help to predict
which products are in danger from import competition.
c. Under IPLC concept, many products pass through four stages:
i. Developed nation exports
ii. Beginning of foreign production
iii. Foreign competition in export markets
iv. Import competition in home markets
4. Economies of Scale and the Experience Curve
a. These concepts impact 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.
5. National Competitive Advantage from Regional Clusters
a. National competitiveness results from a country’s ability to complete the
functions necessary to drive a product/service to market and while increasing
ROI: design, produce, distribute, and service.
b. Porter’s Diamond Model of National Advantage (see Figure 2.3) identifies four
interrelated variables that will have an impact on local firms’ abilities to use a
country’s resources to gain competitive advantage:
i. Demand conditions, the nature of domestic demand within the country
ii. Factor conditions, the level and makeup of production infrastructure
iii. availability of Related and supporting industries, such as suppliers and
support services, and
iv. the Firm’s strategy, structure and strategic rivalry, includes the
organization and management style of the firm, level of domestic
competition and barriers to market entry.
c. In addition to these 4 variables, Porter claimed that competitiveness could be
influenced by government and chance.
C. Summary of International Trade Theory
1. We can say that international trade occurs primarily because of relative price
differences among nations. The differences stem from differences in production costs
which are the result of:
differences in the endowment of factors of production
differences in the levels of technology that determine the factor intensities
used
a. differences in the efficiency with which factor intensities are used
b. foreign exchange rates.
c. The demand variable of taste differences can reverse the direction of
trade predicted by the theory.
V. Foreign Investment
Foreign investment is usually divided into two components: portfolio investment and direct
investment. The distinction between these two has begun to blur, particularly with growing size
and number of international mergers, acquisitions, and alliances.
A. Portfolio Investment
1. Not directly concerned with the control of a firm but to gain ROI
2. Nonresidents owned American stock and bonds with a value of $5.3 billion at beginning of
2010, versus $5.5 billion in foreign securities owned by Americans.
B. Foreign Direct Investment (FDI)
1. The Outstanding Stock of FDI (see Figure 2.4).
a. The book value of all FDI worldwide was $19.0 trillion at the beginning of 2010.
b. The U.S. is one of the largest investor nations, with $4.3 trillion invested abroad,
which was 2 times the FDI of the next-largest investors, France and the United
Kingdom.
c. The proportion of FDI accounted for by the United States declined by 36% between
1980 and 2010, however, from 36% to 23%. The proportion of FDI accounted for by
the EU increased from 36% to 47%. Japan’s FDI declined from 12% in 1990 to 4% in
2010. Developing countries increased their proportion of FDI from 1% in 1980 to
14% in 2010.
2. Annual Outflows of FDI
a. Outflows hit a historical high in 2000—$1.2 trillion, more than 250% of the level
in 1997. However, the slowdown that began to hit most of the world’s economies
in late 2000 resulted in a subsequent decline in the overall level of annual FDI
flows. By 2002, the total was only $537 billion, only about 44% of the 2000
figure. Outflows subsequently increased, reaching $2.3 trillion by 2007 before
declining to $1.1 trillion during the economic downturn of 2009.
b. Much of outward FDI is associated with global mergers and acquisitions,
because:
U.S. corporate restructuring put underperforming businesses and assets on
the market
Foreign companies wanted rapid access to U.S. advanced technology
Foreign firms felt that access to the lucrative U.S. market would be more
successful through acquiring known brand names rather than promoting
unknown foreign brands
Increased international competition, including pursuit of economies of
scale let to restructuring and consolidation of many global industries and
acquisition of firms in major markets like the U.S.
3. Annual Inflows of FDI
a. Industrialized nations invest and trade with one another – 70% of annual FDI has
typically gone to developed countries, but that dropped to 51% in 2009.
b. The flow of FDI into developing countries was 7.3 times larger in 2000 versus
1990, and nearly doubled again between 2000 and 2009.
c. African nations grew from a miniscule 0.7% of worldwide FDI inflows in 2000
to 3.7% for 2007-2009. Latin American inflows fluctuated over the past two
decades. Combined Asian FDI was 44% of all investments not directed to the
U.S. and the E.U. for 2008 and 2009, and China and its territories accounted for
45% of the overall FDI going to Asia.
4. Level and Direction of FDI
a. It is difficult to accurately determine the present value of foreign investments, but
if a nation continues to receive growing amounts of FDI its investment climate
must be favorable and the political forces of that foreign country are attractive.
If there is political instability and low levels of FDI inflow, little investment will
occur.
C. Does Trade Lead to FDI?
1. Historically, FDI followed foreign trade because it costs less and has less risk than FDI
and business can be expanded in smaller, controllable increments rather than incurring
large investments and larger risk. A firm would start by exporting using agents and then
set up an export department with foreign sales personnel as business expanded.
2. However, FDI can now lead to trade. Significant changes in today’s global business
environment make FDI a possible first step into international trade. These changes
include:
a. Fewer government trade barriers
b. Increasing global competition
c. New production technologies
d. New communications technologies
e. Greater integration of the global supply chain and production
f. A growing focus to identify and exploit global business opportunities
D. Explaining FDI: Theories of International Investment
FDI can either be Greenfield investment, where new facilities are built from the ground up, or
cross-border acquisition, the purchase of existing business facilities in another nation. Either
way, the strategic motives for FDI revolve around finding new markets, accessing raw
materials, accessing new technologies or managerial expertise, achieving production
efficiencies, enhancing political safety of the firm’s operations, or responding to competition.
Among the most widely accepted theories that attempt to explain FDI are the following:
1. Monopolistic Advantage Theory: based on the premise that FDI is made by firms in
oligopolistic industries possess technical and other advantages over indigenous firms.
These advantages could be economies of scale, superior technology, or superior
knowledge of marketing, management, or finance, which give advantage to the MNE
over local firms.
2. Internationalization Theory: based on the concept that to obtain a higher ROI, a firm
will transfer its superior knowledge to a foreign subsidiary rather than sell it in the
open market. This allows firm to transfer knowledge across borders without it
leaving the firm.
3. Dynamic Capabilities: based on the idea that ownership of specific knowledge or
resources is necessary but not sufficient for success in FDI. Firms must also develop
distinctive competitive advantages to complement their knowledge or resources.
4. Eclectic Theory of International Production states that for a firm to invest overseas, it
must possess 3 types of advantages
a. Ownership specific – tangible and intangible assets not available to competitors
but can be transferred abroad (a recognizable brand name).
b. Location specific – foreign market offers economic, social or political advantages
which will let the firm exploit its ownership specific advantages (market size,
tariff or nontariff barriers, or transportation cost advantages)
c. Internalization – firms have choice as to the way to enter foreign markets, and it
is in the firm’s best interests to exploit ownership-specific advantages through
internalization in situations where either the market does not exist or it functions
inefficiently.
This theory is also referred to as the OLI Model, which also gives explanation for the
MNE’s choice of its foreign production facilities.
The common factor for all three of these theories is that FDI is typically made by large,
research-intensive firms in oligopolistic industries. All of these theories offer reasons why
these companies find it profitable to invest overseas, and all of these motives are linked to the
desire to increase or protect profits, sales and markets.