CHAPTER 2
The Evolution of International Business
Chapter Outline
• Introduction
• Benefits of Trade and Foreign Direct Investment
• Major Theories of International Trade
o Wealth Accumulation as a Basis for Trade Theory: Mercantilism
o Specialization as a Basis for Trade Theory: Absolute and Comparative Advantage
o Theory of Absolute Advantage
o Theory of Comparative Advantage
o Factor Endowments as a Basis for Trade Theory: Heckscher-Ohlin and Factor Price
Equalization
o Porter’s “Diamond” Model of National Competitive Advantage
o Factor Conditions
o Demand Conditions
o Related and Supporting Industries
o Firm Strategy, Structure, and Rivalry
• The Practice of Trade Policy
o Tariffs, Preferential Duties, and Most Favored Nation Status
o Nontariff Barriers
• Current Practice of “Managed” Trade
o Socioeconomic Rationale
o Countertrade
o Export Cartels
o Infant Industry Argument
o Questionable Labor Practices and Environmental Considerations
o Health and Safety
o Geopolitical Rationale
o National Security
o Strategic Industries
o Embargoes
Teaching Objectives
After covering this chapter, the student should be able to:
• Briefly explain why trade and foreign investment are good for society as a whole.
• Describe the major international trade theories and how they operate.
• Evaluate trade policy, the main instruments of trade policy, and their impact on business,
consumers, and governments.
• Explain the rationale behind a country’s choice of managing trade.
COMPREHENSIVE LECTURE OUTLINE
I. Introduction. Business has become increasingly international in nature and has been
accelerated by the low cost of communications technology. This chapter discusses the role of
international business and how it developed.
CLASS ACTIVITY: Use the Cultural Perspective case as an opportunity to allow students to
explore the impact of international trade and investment on the economies of China and India.
Exhibit 2.1 • World’s Ten Largest Economies
II. Benefits of Trade and Foreign Direct Investment. Trade is the earliest and simplest
form of international business. Exhibit 2.2 • World Trade Patterns.
It benefits consumers by providing:
• A greater choice in the availability of goods and services
• Lower prices
• Higher living standards
• New jobs in the export and import sectors of the economy
At the same time it has a negative impact on economies due to disruptive changes such as:
• Outsourcing of jobs
• Stagnant wages
• Lower or sluggish standard of living in globally uncompetitive industries
Foreign Direct Investment (FDI) brings funds and business culture from abroad, creates new
jobs, introduces innovative technologies, and enhances the skills of domestic workers. Emerging
countries tend to attract sizeable amounts of FDI. Exhibit 2.3 • Net Inflows of Foreign Direct
Investment by Region and Industrialization.
DISCUSSION STARTER: REALITY CHECK 1.
Visit the retail store where you purchase everyday necessities and pick out ten items that you
regularly use. Now, look at the labels and find out how many of them come from abroad. Can
you imagine what your life would be like if we did not have international trade?
III. Major Theories of International Trade. No single nation in the world is capable of
producing all the goods and services it needs. Neither does any nation have the required
resources. Therefore, nations of the world need to trade. Theories of international trade provide
an appreciation for the progress made in understanding how trade works. They also present a
rationale for why restriction to trade should be minimized.
• Wealth Accumulation as a Basis for Trade Theory: Mercantilism.
Mercantilism is a theory of international trade that supports the premise that a
nation could only gain from trade if it had a trade surplus.
o It’s the oldest trade theory. Mercantilists believed that for a nation to
become wealthy, the nation had to export as much as possible, and the
value of exports should exceed those of imports, which are viewed as a
cost.
o If every trading nation decided to increase its exports, the surplus of
exported goods in the world market would depress prices and decrease
earnings of exporting countries.
• Specialization as a Basis for Trade Theory: Absolute and Comparative
Advantage. Adam Smith argued and proved that free trade without restrictions
would increase the wealth of nations.
o Absolute Advantage exists when one country can produce a good more
efficiently than another.
o Theory of comparative advantage is a refinement of Adam Smith’s
theory and is attributed to David Ricardo. It claims that a country should
produce the commodity in which it has the greatest advantage. Resources
in the countries are scarce, and countries must choose to produce
goods/services that most efficiently use their scarce resources. When all
countries follow this approach, resources can be used most efficiently, and
the total output and standard of living of the world can be increased.
• Factor Endowments as a Basis for Trade Theory: Hecksher-Ohlin and
Factor Price Equalization.
o Eli Heckscher and Bertil Ohlin showed that nations primarily export goods
and services that intensely use their abundant factors of production.
o The Heckscher-Ohlin (H-O) Theory attributes the comparative
advantage of a nation to its factor endowments. The key assumptions for
the H-O theory to work are:
▪ Perfect competition
▪ Perfect immobility of factors of production
o Factor price equalization theory states that when factors are allowed to
move freely among trading nations, efficiency increases, and leads to
superior allocation of production of goods and services among countries.
• Porter’s “Diamond” Model of National Competitive Advantage. In 1990
American economist Michael Porter found that trade theories broadly explained
the basis upon which countries exported certain goods. Porter looked more closely
at the theory of firm and industry specifics to identify characteristics that made
firms and industries in countries “winners” or “losers” in international trade.
Porter explains this hybrid model in terms of a “diamond” that consists of four
groups of company-specific and country-specific characteristics.
o Factor Conditions. Porter’s model looks more closely at the quality of the
factor endowments described in the Hecksher-Ohlin theory.
o Demand Conditions. Porter stresses the importance of domestic demand
for goods and services. When domestic demand is high, domestic
competition will intensify and lead to lower prices and sophisticated new
products.
o Related and supporting industries. The presence of supporting
industries and companies in a country will always be important for its
competitive advantage.
o The final set of characteristics relate to firm strategy, structure, and
rivalry.
According to Porter’s model, the success or comparative advantage of a nation at
the global stage would crucially depend upon the interaction of the four groups of
characteristics. Porter also identified two other critical variables outside the
diamond that play an important role in the competitiveness of nations: chance and
government.
DISCUSSION STARTER: REALITY CHECK 2.
Have you witnessed any changes in international business activity in your hometown over the
past five years? Which of the above discussed theories can you attribute to that business
development?
IV. The Practice of Trade Policy. Despite the benefits of the free trade individuals, firms,
and lobby groups pressure governments to impose barriers to imports or subsidize exports of
goods and services. Their efforts are aimed at saving good-paying jobs and preventing increased
competition in their industries at home. Trade policy refers to all government actions that seek
to alter the free flow of merchandise or services between countries.
▪ Tariffs, Preferential Duties, and Most Favored Nation Status. Tariffs are taxes on
imports. They generate revenues for governments. Tariffs come in two forms:
o Specific tariff – an import tax that assigns a fixed dollar amount per physical
unit.
o Ad valorem tariff – an import levied as a constant percentage of the monetary
value of one unit of the imported good.
▪ Preferential duties refer to low tariff rates applied to specific imports coming from
certain countries. Under this system, the same good imported from a country outside of a
preferred group will be subject to higher tariff. For example, in the Generalized System
of Preferences, a large number of developed countries have agreed to permit duty-free
imports of a selected list of products that originate from specific developing countries.
▪ Some countries interfere with the free flow of exports by enforcing export subsidies, or
export taxes, meant to encourage or discourage exports.
▪ The General Agreement on Tariffs and Trade (GATT) was established in 1948 by 22
member countries, who committed to lower approximately 45,000 tariff rates within rules
laid down by that organization.
▪ GATT was renamed the World Trade Organization (WTO) in 1995, which now sets
rules of trade among nations on a near-global basis. The WTO’s objective is to extend
tariff reduction to agriculture and services, and to settle trade disputes among member
countries. By June 26, 2014, 160 nations had become members of the WTO.
▪ Under the most favored nation (MFN) principle, any tariff concession granted by one
member to any other country will automatically be extended to all other WTO member
countries.
ECONOMIC PERSPECTIVES: Predatory Trade Practices: A Game of Chicken? Use the
Economic Perspectives case as an opportunity to discuss the impact of predatory trade practices
on national economies and the role of the government in resolving trade disputes between
countries.
Suggestion: You could ask students to do this case as individuals or in teams as a class activity.
Have the students read the case presented in the text and answer the questions at the end of the
case.
Questions:
1. Is China practicing fair trade? Explain in detail what China is trying to achieve, and the
implications on the result for the rest of the world. Answer: China is not practicing fair
2. Why did the U.S. impose a “sliding–scale” tariff on China’s tires? And why only for a
three-year period? What was the net result? Answer: The sliding-scale tariff on tires
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Chinese tire exports have caused market disruption in the U.S. tire manufacturing
industry. China’s share of the U.S. tire market increased from 3% to 11% over the 4 year
period and has led to plant closing and redundancies.
▪ Nontariff Barriers. Since 1948 GATT and later the WTO managed to significantly
lower tariffs. During that period countries have resorted to various forms of non-tariff
barriers such as quality and environmental standards to restrict trade.
▪ Import quotas or quantitative restrictions (QR) limit the amount of products that can
be imported into a country. They are generally worse than import tariffs because when
the quota is reached, that particular product can no longer be imported.
▪ Voluntary export restraint (VER) occurs when an efficient exporting nation agrees to
temporarily limit exports of a product to another country to allow competitors in the
importing country to become more efficient within a set period of time.
▪ Domestic content provisions are another form of non-tariff barrier. Countries may
require that a certain percentage of the value of an import be domestically sourced.
DISCUSSION STARTER: REALITY CHECK 3.
Visit your local foreign car dealer and find out what type of tariff or non-tariff barriers they
face when importing cars from abroad. If tariffs are imposed on imported cars, find out
whether it is ad-valorem or specific, and for how much.
V. Current Practice of “Managed” Trade. Global trade cannot be completely based upon
the economics of free trade, but encompasses a response to geopolitical and socioeconomic
factors. Managed trade refers to agreements between countries that aim to achieve certain trade
outcomes for the countries involved.
• Socioeconomic Rationale. Socioeconomics explores the relative negative impact of free
trade upon society’s welfare, as well as government policy measures that are
implemented to minimize the negative outcomes to society. Several forms of managed
trade are part of this category:
o Countertrade. In countertrade an exporter of goods or services commits to
import goods or services of corresponding value. The terms of export and import
exchange are predetermined through negotiations. Countertrade can be inefficient.
Countries participate in countertrade especially when they do not have adequate
amounts of foreign currencies to pay for imports.
o Export Cartels. Several developing countries depend upon non-renewable
natural resources for economic growth. Since business cycles cause fluctuations
in export volume and prices, some of these countries form export cartels to
control prices and export revenues. For export cartels to be successful, all cartel
members must agree not to cheat on the agreement, substitutes for the good in
question must not exist, and demand for a particular product must be relatively
inelastic.
o Infant Industry Argument. At times when a country gets a “late start” in a
particular industry where it has a potential to become a world class competitor,
short-term protection is justified. The infant industry argument implies that
economies of scale and the comparative advantage of an industry can only be
exploited by providing temporary protection. During this period, the firm or
industry will strive to become globally competitive.
o Questionable Labor Practices and Environmental Considerations. Developed
countries often resort to managed trade for reasons of unethical labor practices
and violation of basic human rights. Developed countries may restrict imports
from developing countries that implement such policies.
o Health and Safety. Every country has the right to protect the health and physical
safety of its citizens from contaminated imports.
ETHICAL PERSPECTIVES: Stabilizing Sierra Leone’s Devastated Economy. Use the
Ethical Perspectives case as an opportunity to discuss the socioeconomic impact of banning the
trade of “blood diamonds” on the economies of West African countries.
Questions:
1. Who are the various stakeholders who have benefited from the socioeconomic move away
from the sale of “blood diamonds” to legal commercial diamond operations in Sierra
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benefit the local population, as soon as the mines become profitable. Small-time miners
will have to pay 3 % tax on their diamond sales, while .75% of the tax will be returned to
the local government to develop social infrastructure. These measures are intended to
benefit the local community and bring peace and stability to the region.
2. Evaluate the impact of Koidu Holding’s corporate social responsibility practices in
economic prosperity and political stability to the region.
• Geopolitical Rationale. The geopolitical objective is to sacrifice some economic
efficiency for the greater good of the country in terms of national security, protection of
critical industries, and international commerce.
o National Security. For national security reasons, U.S. exports of certain types of
high-technology defense equipment are generally restricted to allies and friendly
countries. Because the need to receive government approval prevents the affected
firms from openly competing and increasing sales, these firms receive special
treatment and protection.
o Strategic Industries. Some countries provide protection to strategic industries
that have a significant employment impact on certain sectors of an economy.
o Embargoes. When trade sanctions are imposed upon a country for political
reasons, an embargo is in force, and trade will be restricted with that country.
Embargoes, which may not be universally enforced, are meant to punish a country
for perceived unacceptable international behavior.
DISCUSSION STARTER: REALITY CHECK 4.
Boeing is the single largest exporter for the United States, yet it is restricted from exporting
sensitive military equipment to all countries. What specific restrictions does the U.S.
government impose upon defense contractors such as Boeing?
Assignments
End-of-Chapter Discussion Questions
1. How would you make a convincing case that open trade in goods and
services as well as free flow of foreign direct investment will enhance the
well-being of (a) consumers, (b) producers, and (c) the government of
countries? Give specific examples to prove your position. Answer: Free
technological and skill transfer to producers.
2. What trade theories support the recent rise of China and India on the global
stage? Explain your views in detail. Answer: The theory of comparative
3. Some believe there is a disconnect between trade theory and trade policy.
What rationale could the United States use to support its trade policies? Give
specific examples. Answer: Employment and environmental law and
4. When would a country such as France use socioeconomic rather than
geopolitical reasons to support its trade policy? Can you provide some
examples? Answer: Socioeconomics focuses on the impact free trade has
Mini-Case Synopsis and Questions
The ideology of economic nationalism seeks to implement trade policies that help
to keep jobs and investment at home. Such protectionism may violate international
trade rules, and retaliation from other countries may follow.
Questions:
1. Is economic nationalism justified? No. Although in the short run economic
2. Is the Smoot-Hawley plan better or worse than “Buy American”? “Buy
Spanish”? Or “British jobs for British workers”? Explain fully. The recent
Point/Counterpoint, Interpreting Global Business News, and Portfolio Projects
Students’ answers to these assignments will vary widely. Their writing should
reflect an understanding of the chapter’s basic concepts, thorough research, and
logic and critical thinking skills.