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CHAPTER 6
International Trade and Investment
Chapter Objectives
After studying this chapter, students should be able to:
1. Understand the motivation for international trade.
2. Summarize and discuss the differences among the classical country-
based theories of international trade.
4. Describe and categorize the different forms of international investment.
6. Summarize how supply, demand, and political factors influence foreign
direct investment.
LECTURE OUTLINE
OPENING CASE: The Middlestand Lead the Way
This opening case discusses Germany’s Middlestand companies. These are small to
medium sized enterprises that have secured themselves niches with what are on some
cases impressive world market shares.
Key Points
• Germany’s economy suffered during the 2008-2009 global recession, but recovered
quicker and stronger than most developed countries.
• These enterprises will face many challenges in the future, including demographic
changes, higher income levels and increased competition from emerging markets.
Additional Case Application
The Middlestand’s are a prime example of firms throughout the world using
technology, knowledge and resources at their disposal, to successfully compete in
the global marketplace. Students can be asked to debate the role and importance of
small businesses in economic growth.
CHAPTER SUMMARY
Chapter Six examines the underlying economic forces that shape and structure the
international business transactions of firms. It discusses the major theories that explain
and predict trade and investment.
INTERNATIONAL TRADE AND THE WORLD ECONOMY
• Trade involves the voluntary exchange of goods, services, or money between one
person or organization and another. International trade is trade between residents
(individuals, businesses, nonprofit organizations, or other associations) of two
countries.
CLASSICAL COUNTRY-BASED TRADE THEORIES
Mercantilism
• Mercantilism was a sixteenth-century economic philosophy that held that a nation’s
wealth is measured by its stock of precious metals (gold and silver). According to
• The philosophy was popular to some because it enabled a country to expand its
borders, because export-oriented manufacturers benefited from policies such as
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Absolute Advantage
• Adam Smith criticized the mercantilist philosophy, arguing that it confused the
acquisition of treasure with the acquisition of wealth. He further pointed out that
mercantilism actually weakened a nation because it forces a country to produce
products that it is not very good at producing, and in doing so does not maximize the
wealth of its citizens.
Comparative Advantage
• The major difficulty with the theory of absolute advantage is that it suggests that if
one country has an absolute advantage in the production of both goods, no trade will
occur. David Ricardo solved this problem by developing the theory of comparative
advantage which states that a country should produce and export those goods and
Comparative Advantage with Money
• The lesson of the principle of comparative advantage is: you’re better off specializing
in what you do relatively best. Produce (and sell) those goods and services at which
you’re relatively best, and buy other goods and services from people who are
relatively better at producing them than you are.
• The theory is limited in that the world economy produces more than two goods and
BRINGING THE WORLD INTO FOCUS
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The Lincoln Fallacy
Abraham Lincoln once said, “I know this much. When we buy manufactured goods
abroad, we get the goods and the foreigner gets the money. When we buy
manufactured goods at home, we get both the goods and the money.” Lincoln’s view
Relative Factor Endowments
• Hecksher and Ohlin developed the theory of relative factor endowments to answer
the questions of what determines the products for which a country will have a
comparative advantage in the first place. The theory proposes that factor
endowments (or types of resources) vary among countries. Further, goods vary in
the types of factors that are used to produce them. Therefore, a country will have a
comparative advantage in producing a product that intensively uses resources that
the country has in abundance. The text provides an example of the theory using
wheat, oil, and clothing.
• There have been numerous attempts to explain Leontief’s findings. Some
economists have suggested that Leontief’s work is flawed by measurement
MODERN FIRM-BASED TRADE THEORIES
Firm-based theories have developed for several reasons, including the growing
importance of multinational corporations in the postwar international economy; the
inability of the country-based theories to explain and predict the existence and growth of
intraindustry trade; and the failure of researchers like Leontief to empirically validate the
country-based Hecksher-Ohlin theory. In addition, firm-based theories incorporate
factors such as quality, technology, brand names, and customer loyalty.
Product Life-Cycle Theory
Teaching Note:
Instructors may find that students “zone out” when discussion of the
product life-cycle theory begins. Many students believe that the
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product life-cycle theory in international business is the same one they learned about
in their introductory marketing courses. It may be worthwhile to alert students to the
differences.
• The product life-cycle theory, developed by Vernon, consists of three stages. In
the first stage (the new product stage), a company develops and introduces an
innovative product in response to a perceived need in the local market. Initially, the
company must closely monitor whether the product indeed satisfied customer needs,
and so typically, the product is introduced in the country where the product was
developed. In addition, because the firm is initially likely to minimize its
manufacturing investment, most output is sold in the domestic market. Display
Figure 6.4 here.
• Demand for the product expands dramatically as the product moves into the second
stage (maturing product) and customers recognize its value. The innovating firm
Country Similarity Theory
• Country-level theories explain interindustry trade among nations. Interindustry
trade is the exchange of goods produced by one industry for goods produced in
another industry. Country-level theories do not explain intraindustry trade, in which
two countries exchange goods produced in the same industry.
• Linder developed a theory to explain intraindustry trade that suggests that
New Trade Theory
• Krugman and Lancaster have recently examined the impact of global strategic rivalry
between multinational firms on trade flows. This view argues that firms struggle to
develop some sustainable competitive advantage, which can then be exploited to
dominate the global marketplace. The theory focuses on the strategic decisions
firms make as they compete in the global marketplace.
• Firms can develop sustainable competitive advantages in several different ways.
First, intellectual property rights, such as trademarks, brand names, patents, and
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copyrights, can give a firm an advantage over rivals. Second, firms that make large
investments in research and development may gain first-mover advantages for
Venturing Abroad
Birds of a Feather Flock Together
This section discusses the existence of an additional interesting business activity,
Porter’s Theory of National Competitive Advantage
• Porter has developed a theory of international trade called the diamond of
competitive advantage. The theory proposes that success in an industry is a
function of four characteristics: factor conditions; demand conditions; related and
supporting industries; and company strategy, structure, and rivalry.
• Factor conditions refer to a nation’s endowment of factors of production. Demand
conditions refer to the existence of a large, sophisticated domestic consumer base
that stimulated the development and distribution of innovative products. Related
and supporting industries refer to the development of local suppliers eager to meet
an industry’s production, marketing, and distribution needs. Firm strategy,
AN OVERVIEW OF INTERNATIONAL INVESTMENT
International investments: in which residents of one country supply capital to a second
country, is another major form of international investment. Trade and investment may be
substitutes for one another, or they may be complementary.
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Types of International Investments
• International investment can be divided into portfolio investment and foreign
direct investment (FDI) (see Chapter One). The former represents passive
holdings of foreign stocks, bonds, or other financial assets that entail no active
management or control of the issuer of the securities by the foreign investor. The
latter represents acquisition of foreign assets for the purpose of control.
The Growth of Foreign Direct Investment
Foreign Direct Investment and the United States
• The United Kingdom has accounted for the greatest portion of FDI into the United
INTERNATIONAL INVESTMENT THEORIES
Ownership Advantages
• Researchers trying to explain why FDI occurs initially focused on the impact of firm-
specific (or monopolistic) advantages. They argued that a firm that owned a superior
technology, a well-known brand name, or economies of scale that created a
monopolistic advantage could clone its domestic advantage to penetrate foreign
markets. The text provides the example of Caterpillar and Komatsu, both of which
capitalized on proprietary technology and brand names to expand into other markets.
Internalization Theory
• The answers to the questions outlined above were explored using internalization
Dunning’s Eclectic Theory
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Dunning’s eclectic theory ties together location advantage, ownership advantage, and
internalization advantage. Dunning proposes that FDI will take place when three
conditions are satisfied.
• First, the firm must own some unique competitive advantage that overcomes the
FACTORS INFLUENCING FOREIGN DIRECT INVESTMENT
The decision to undertake FDI can be influenced by supply factors, demand factors, and
political factors. Display Table 6.5 here.
Supply Factors
• Supply-side considerations (a firm’s attempts to control its own costs of production)
may motivate FDI. Factors that are considered include production costs, logistics,
availability of natural resources, and access to key technology.
Demand Factors
Investing in foreign markets can allow a firm to expand the potential demand for its
products. The demand-related factors that firms consider include customer access,
marketing advantages, and customer mobility.
• A physical presence in a market is required for many types of businesses,
particularly service businesses. For example, since customer access is essential to
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• Firms may invest in another country in response to customer mobility. A supplier
firm may follow its buyer to another country so that it can continue to meet its
customers’ needs promptly and attentively.
Political Factors
FDI may be a logical choice for companies facing trade barriers that threaten to keep
their products out of a foreign market, or to take advantage of economic incentives being
offered by host governments.
Venturing Abroad
How Important Is the Rule of Law?
CHAPTER REVIEW
1. What is international trade? Why does it occur?
2. How do the theories of absolute advantage and comparative advantage differ?
3. Why are Leontief’s findings called a paradox?
4. How useful are country-based theories in explaining international trade?
The country-level theories are useful for explaining interindustry trade (trade in which
5. How do interindustry and intraindustry trade differ?
The difference between interindustry trade and intraindustry trade is that the former involves
6. Explain the impact of the product life cycle on international trade and international
investment.
The product life cycle impacts both international trade and international investment. In the
7. What are the primary sources of the competitive advantages used by firms to compete in
international markets?
8. What are the four elements of Porter’s diamond of national competitive advantage?
9. How do portfolio investments and FDI differ?
10. What are the three parts of Dunning’s eclectic theory?
11. How do political factors influence international trade and investment?
QUESTIONS FOR DISCUSSION
1. In our example of France’s trading wine to Japan for clock radios, we arbitrarily assumed
that the countries would trade at a price ratio of one bottle of wine for two clock radios. Over
what range of prices can trade take place between the two countries? (Hint: In the absence
of trade, what is the price of clock radios in terms of wine in France? In Japan?) Does your
answer differ if you use Table 6.2 instead of Table 6.1?
In the absence of trade, France can only get three clock radios for two bottles of wine at
2. In the public debate over ratification of the North American Free Trade Agreement, Ross
Perot said he heard a “giant sucking sound” of U.S. jobs headed south because of low wage
rates in Mexico. Using the theory of comparative advantage, discuss whether Perot’s fears
are valid.
The theory of comparative advantage suggests that a country will export those goods and
services for which it is relatively more productive than other nations and import those goods
3. Why is intraindustry trade not predicted by country-based theories of trade?
Country-based theories of trade focus on explaining interindustry trade (trade in which
countries exchange goods produced in different industries) rather than intraindustry trade
4. Hyundai decided to build a new automobile assembly plant in Alabama.
a. What factors do you think Hyundai considered in selecting Alabama as the site for the
factory?
Proximity to the U.S. market, avoidance of (some) tariff barriers in the auto industry, local
b. Who benefits and who loses from the new plant in Alabama?
Hyundai and Alabama both believe they benefit (or the deal would not have gone through).
Alabama gets jobs and tax revenue, Hyundai gets benefits negotiated with the state and
easier access to the U.S. market. Assembly jobs may be lost in South Korea or other
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c. Is the firm’s decision to build the new plant consistent with Dunning’s eclectic theory?
Dunning’s eclectic paradigm suggests that FDI will occur when a foreign location is superior
to a domestic location, when the firm enjoys an ownership advantage that can be utilized to
BUILDING GLOBAL SKILLS
Essence of the exercise
This exercise links trade and investment theory to the actual situation in the computer,
consumer electronics, and auto industries. The exercise requires students to explain why some
theories are better at explaining the situation in certain industries than others.
1. Do some theories work better than others for different industries? Why?
Certain theories definitely explain the situation in some industries better than other theories.
For example, country-level theories such as absolute advantage, comparative advantage,
and relative factor endowments focus on explaining interindustry trade between countries
2. What other industries can you think of that fit one of the three patterns noted in the chapter
(dominated by foreign firms, dominated by U.S. firms, or dominated by a combination of U.S.
and non-U.S. firms)?
3. Do the same theories work as well in making predictions for those industries?
Question 2 above, the answer to this question can be either yes or no. (LO 6.6; AACSB:
Analytical Skills; Learning Outcome: Compare and contrast theories of international trade)
4. Based on what you know about the Japanese market, decide whether the same pattern of
competitiveness that exists in the United States for the computer, consumer electronics, and
automobile industries also holds true for that market. Why or why not?
Instructors may find it necessary to provide some background about the Japanese market
before students can really discuss this question. However, even students who are
Other Applications
This exercise focuses on applying the basic theories of international trade and investment to
certain products and industries. However, many economies are now known as service
economies. Instructors may wish to raise the question of whether any of the theories can be
used to explain trade and investment patterns of service firms.
CLOSING CASE
Twenty-First Century Pirates
The closing case addresses the issue of intellectual property rights (IPR) protection in a global
economy. It considers the scope of the problem and its implications.
Key Points:
• The protection of IPR is important to encourage inventors to develop new
technologies and to develop name brands that consumers can trust.
• It is estimated that $30 billion of software is pirated each year. Pirated music is
estimated to cost music studios $3.5 billion per year, and U.S. movie studios’ losses
are estimated at $4.6 billion per year due to pirated DVDs.
• Pirated pharmaceuticals cost legitimate manufacturers $37 billion in sales per year.
• China appears to be one of the worst offenders in terms of piracy. Though it has
improved its legal framework protecting IPR, those laws are still often not enforced.
• In 2006, China pledged to increase fines for IPR violations, lower the hurdles for
prosecuting IPR violations in criminal rather than civil courts, and establish new
offices in 50 cities to handle IPR complaints.
Case Questions
1. How important is intellectual property to the world economy?
It is very important and its importance is growing as we move from an asset-based to
2. Should the average consumer concern himself or herself with theft of intellectual
property? What about the average citizen? The average worker?
Yes, yes, and yes. Everyone is affected. Piracy places a greater burden for covering
costs on the legitimate consumer – and exposes consumers to counterfeit goods that
3. Does intellectual property theft undermine the workings of the free market system?
Yes, since producers of intellectual property do not receive appropriate
4. What is the impact of China’s lack of aggressive enforcement of intellectual property
rights on its economic development in the short run? …in the long run?