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
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.