CHAPTER 2

International Trade & Foreign Direct Investment

Topics Covered:
 International trade theory
 How political and legal factors impact international trade
 Foreign Direct Investment (FDI)
Opening Case: China in Africa
 In the past couple of decades Africa has caught the interest of China
 China brings its success story to many countries in the African continent
 China has increasingly turned to resource-rich Africa as China's booming
economy has demanded more and more oil and raw materials
 For some African countries, China provided loans for various infrastructures
secured by oil, cocoa beans, etc.
 China has become one of Africa´s important partners for trade and economic
cooperation
 Criticized by some and applauded by others, it’s clear that China’s investment is
encouraging development in Africa

International Trade - The concept of exchange between people or entities in two

different countries. People or entities trade because they believe that they benefit from
the exchange. They may need or want the goods or services.

International Trade Theories

Classical country- Based Theories Modern Firm - Based Theories

Mercantilism Country similarity
Absolute Advantage Product-life cycle
Comparative Advantage Global strategic Rivalry
Hecksher-Ohlin Porter’s National Competitive Advantage

Mercantilism
-This theory stated that a country’s wealth was determined by the amount of
its gold and silver holdings. In it’s simplest sense, mercantilists believed that a
country should increase its holdings of gold and silver by promoting exports and
discouraging imports.
-One way that many of these new nations promoted exports was to impose
restrictions on imports called protectionism. Although mercantilism is one of the
oldest trade theories, it remains part of modern thinking Countries such as Japan,
China, Singapore, Taiwan, and even Germany still favor exports and discourage
imports

Absolute Advantage
 Introduced by Adam Smith in 1776
 Focused on the ability of a country to produce a good more efficiently than
another nation. Smith stated that trade should flow naturally according to
market forces.
 By specialization, countries would generate efficiencies, because their labor
force would become more skilled by doing the same tasks.
 Production would also become more efficient, because there would be an
incentive to create faster and better production methods to increase the
specialization.

Comparative Advantage
 Introduced by English economist, David Ricardo, in 1817
 Ricardo reasoned that even if Country A had the absolute advantage in the
production of both products, specialization and trade could still occur
between two countries.
 Comparative advantage occurs when a country cannot produce a product
more efficiently than the other country; however, it can produce that product
better and more efficiently than it does other goods. Comparative advantage
focuses on the relative productivity differences, whereas absolute advantage
looks at the absolute productivity.
Comparative Advantage Example:
Miranda is a Wall Street lawyer who charges $500 per hour for her legal services. It
turns out that Miranda can also type faster than the administrative assistants in her
office, who are paid $40 per hour. Even though Miranda clearly has the absolute
advantage in both skill sets, should she do both jobs? No. For every hour Miranda
decides to type instead of do legal work, she would be giving up $460 in income. Her
productivity and income will be highest if she specializes in the higher-paid legal
services and hires the most qualified administrative assistant, who can type fast,
although a little slower than Miranda. By having both Miranda and her assistant
concentrate on their respective tasks, their overall productivity as a team is higher.
This is comparative advantage. A person or a country will specialize in doing what
they do relatively better.

Heckscher-Ohlin Theory (Factor Proportions Theory)

 Introduced in the early 1900s by two Swedish economists, Eli Heckscher and
Bertil Ohlin
 Focused on how a country could gain comparative advantage by producing
products that utilized factors that were in abundance in the country.
 Their theory is based on a country’s production factors—land, labor, and
capital, which provide the funds for investment in plants and equipment.
 Their theory is also called factor proportions theory which stated that
countries would produce and export goods that required resources or factors
that were in great supply and, therefore, cheaper production factors.

Leontief Paradox
 In the early 1950s, Russian-born American economist Wassily W. Leontief
studied the US economy closely and noted that the United States was
abundant in capital and, therefore, should export more capital-intensive
goods.
 However, his research using actual data showed the opposite: the United
States was importing more capital-intensive goods.
 His analysis became known as the Leontief Paradox because it was the
reverse of what was expected by the factor proportions theory.

Country Similarity Theory

 Developed by Swedish economist Steffan Linder in 1961
 Explains the concept of intra-industry trade.
 This theory proposed that consumers in countries that are in the same or
similar stage of development would have similar preferences.
Product Life Cycle Theory

 Developed by Raymond Vernon, a Harvard Business School professor, in

the 1960s.
 The theory stated that a product life cycle has three distinct stages: (1) new
product, (2) maturing product, and (3) standardized product.
 The theory assumed that production of the new product will occur
completely in the home country of its innovation.
 Useful theory to explain the manufacturing success of the United States
where US manufacturing was the globally dominant producer in many
industries after World War II.
 It has also been used to describe how the personal computer (PC) went
through its product cycle. The PC was a new product in the 1970s and
developed into a mature product during the 1980s and 1990s. Today, the PC
is in the standardized product stage, and the majority of manufacturing and
production process is done in low-cost countries in Asia and Mexico.
Global Strategic Rivalry Theory
 Emerged in the 1980s and was based on the work of economists Paul
Krugman and Kelvin Lancaster.
 Focused on MNCs and their efforts to gain a competitive advantage against
other global firms in their industry.
 The critical ways that firms can obtain a sustainable competitive advantage
are called the barriers to entry for that industry.
Barriers to entry:
 research and development
 the ownership of intellectual property rights
 economies of scale
 unique business processes or methods as well as
extensive experience in the industry
 the control of resources or favorable access to raw
materials

Porter’s National Competitive Advantage Theory

 Developed by Harvard Professor, Michael Porter, in 1990
 This theory stated that a nation’s competitiveness in an industry depends on
the capacity of the industry to innovate and upgrade.
 To explain his theory, Porter identified four determinants that he linked
together:
(1) local market resources and capabilities
(2) local market demand conditions
(3) local suppliers and complementary industries
(4) local firm characteristics.

A. Local market resources and capabilities

Porter recognized the value of the factor proportions theory, which
considers a nation’s resources (e.g., natural resources and available labor) as key
factors in determining what products a country will import or export.
Porter added to these basic factors a new list of advanced factors, which
he defined as skilled labor, investments in education, technology, and
infrastructure as providing a country with a sustainable competitive advantage.

B. Local market demand conditions

Porter believed that a sophisticated home market is critical to ensuring
ongoing innovation, thereby creating a sustainable competitive advantage.
Companies whose domestic markets are sophisticated, trendsetting, and
demanding forces continuous innovation and the development of new products
and technologies.

C. Local suppliers and complementary industries

To remain competitive, large global firms benefit from having strong,
efficient supporting and related industries to provide the inputs required by the
industry.

D. Local firm characteristics

 Local firm characteristics include firm strategy, industry structure, and
industry rivalry.
 Local strategy affects a firm’s competitiveness.
  A healthy level of rivalry between local firms will spur innovation and
competitiveness.

Chance refers to random events that are beyond the control of the company. It may
influence the creation of new ideas or new inventions and could lead to advantages as
well.
Governments can, by their actions and policies, increase the competitiveness of firms
and occasionally entire industries.

Which Trade Theory Is Dominant Today?

 It’s not clear that any one theory is dominant around the world. While they have
helped economists, governments, and businesses better understand international
trade and how to promote, regulate, and manage it, these theories are occasionally
contradicted by real-world events.
 In practice, governments and companies use a combination of these theories to
both interpret trends and develop strategy. Just as these theories have evolved
over the past five hundred years, they will continue to change and adapt as new
factors impact international trade.

Political & Legal Factors that Impact International Trade

Q: Why should businesses care about the different political and legal systems around
the world?
A: Despite the globalization of business, firms must abide by the local rules and
regulations of the countries in which they operate.

Political System
 It is basically the system of politics and government in a country.
 It governs a complete set of rules, regulations, institutions, and attitudes.
 A main differentiator of political systems is each system’s philosophy on the
rights of the individual and the group as well as the role of government. Each
political system’s philosophy impacts the policies that govern the local
economy and business environment.
 There are more than thirteen major types of government, each of which
consists of multiple variations.
 At one end of the extremes of political philosophies, or ideologies, is
anarchism, which contends that individuals should control political activities
and public government is both unnecessary and unwanted.
 At the other extreme is totalitarianism, which contends that every aspect of
an individual’s life should be controlled and dictated by a strong central
government.
 In reality, neither extreme exists in its purest form. Instead, most countries
have a combination of both. This combination is called pluralism, which
asserts that both public and private groups are important in a well-
functioning political system.
 Authoritarian governments centralize all control in the hands of one strong
leader or a small group of leaders not democratically elected and are not
politically, economically, or socially accountable to the people in the country.
 Totalitarianism, a more extreme form of authoritarianism, occurs when an
authoritarian leadership is motivated by a distinct ideology, such as
communism.
 Democracy is the most common form of government around the world today.
It can be seen as a set of practices and principles that institutionalize and
thus ultimately protect freedom.
 Democratic governments derive their power from the people of the country,
either by direct referendum (called a direct democracy) or by means of
elected representatives of the people (a representative democracy).
 The fundamental features of a democracy include government based on
majority rule and the consent of the governed, the existence of free and fair
elections, the protection of minorities and respect for basic human rights.
 Depending on how long a company expects to operate in a country and how
easy it is for it to enter and exit, a firm may also assess the country’s political
risk and stability. A company may ask several questions regarding a
prospective country’s government to assess possible risks:
1. How stable is the government?
2. Is it a democracy or a dictatorship?
3. If a new party comes into power, will the rules of business change
dramatically?
4. Is power concentrated in the hands of a few, or is it clearly outlined in a
constitution or similar national legal document?
5. How involved is the government in the private sector?

 The country’s view on capitalism is also a factor for business consideration.

In the broadest sense, capitalism is an economic system in which the means
of production are owned and controlled privately.
 In contrast, a planned economy is one in which the government or state
directs and controls the economy, including the means and decision making
for production.

The case of China: In the past two decades, China has pursued a new balance of
how much the state plans and manages the national economy. While the
government still remains the dominant force by controlling more than a third of
the economy, more private businesses have emerged. China has successfully
combined state intervention with private investment to develop a robust, market-
driven economy—all within a communist form of government. This system is
commonly referred to as “a socialist market economy with Chinese
characteristics.”
Legal Systems
 common law -Based on traditions and precedence. In common law systems,
judges interpret the law and judicial rulings can set precedent.
 civil law - Based on a detailed set of laws that constitute a code and focus on
how the law is applied to the facts. It’s the most widespread legal system in
the world.
 religious or theocratic law
 The most commonly known example of religious law is Islamic law, also
known as Sharia.
 Islamic law governs a number of Islamic nations and communities
around the world and is the most widely accepted religious law system.
 Two additional religious law systems are the Jewish Halacha and the
Christian Canon system, neither of which is practiced at the national
level in a country.
More on Islamic Law or Sharia:
 The most direct impact on business can be observed in Islamic
law—which is a moral, rather than a commercial, legal system.
 Sharia has clear guidelines for aspects of life.
 For example, in Islamic law, business is directly impacted by the
concept of interest.
 According to Islamic law, banks cannot charge or benefit from
interest.
 This provision has generated an entire set of financial products and
strategies to simulate interest—or a gain—for an Islamic bank, while
not technically being classified as interest.
 Some banks will charge a large up-front fee. Many are permitted to
engage in sale-buyback or leaseback of an asset.
 For example, if a company wants to borrow money from an Islamic
bank, it would sell its assets or product to the bank for a fixed price.
 At the same time, an agreement would be signed for the bank to sell
back the assets to the company at a later date and at a higher price.
 The difference between the sale and buyback price functions as the
interest.
 Most countries actually have a combination of these systems, creating hybrid
legal systems

Why do governments intervene in trade?

 Governments intervene in trade for a combination of political, economic,
social, and cultural reasons.
 Politically, a country’s government may seek to protect jobs or specific
industries.
 Some industries may be considered essential for national security purposes,
such as defense, telecommunications, and infrastructure—for example, a
government may be concerned about who owns the ports within its country.
 National security issues can impact both the import and exports of a country,
as some governments may not want advanced technological information to
be sold to unfriendly foreign interests.
 Some governments use trade as a retaliatory measure if another country is
politically or economically unfair.
 On the other hand, governments may influence trade to reward a country for
political support on global matters.

How do governments intervene in trade?

 Tariffs. Tariffs are taxes imposed on imports. Two kinds of tariffs exist—specific
tariffs, which are levied as a fixed charge, and ad valorem tariffs, which are
calculated as a percentage of the value. Many governments still charge ad
valorem tariffs as a way to regulate imports and raise revenues for their coffers.
 Subsidies. A subsidy is a form of government payment to a producer. Types of
subsidies include tax breaks or low-interest loans; both of which are common.
Subsidies can also be cash grants and government-equity participation, which are
less common because they require a direct use of government resources.
 Import quotas and VER. Import quotas and voluntary export restraints (VER)
are two strategies to limit the amount of imports into a country. The importing
government directs import quotas, while VER are imposed at the discretion of the
exporting nation in conjunction with the importing one.
 Currency controls. Governments may limit the convertibility of one currency
(usually its own) into others, usually in an effort to limit imports. Additionally,
some governments will manage the exchange rate at a high level to create an
import disincentive.
 Local content requirements. Many countries continue to require that a certain
percentage of a product or an item be manufactured or “assembled” locally. Some
countries specify that a local firm must be used as the domestic partner to conduct
business.
 Antidumping rules. Dumping occurs when a company sells product below
market price often in order to win market share and weaken a competitor.
 Export financing. Governments provide financing to domestic companies to
promote exports.
 Free-trade zone. Many countries designate certain geographic areas as free-trade
zones. These areas enjoy reduced tariffs, taxes, customs, procedures, or
restrictions in an effort to promote trade with other countries.
 Administrative policies. These are the bureaucratic policies and procedures
governments may use to deter imports by making entry or operations more
difficult and time consuming.

Types of International Investment

1. Portfolio Investment
2. Foreign Direct Investment

Portfolio Investment
-This refers to the investment in a company’s stocks, bonds, or assets, but not
for the purpose of controlling or directing the firm’s operations or management.

Foreign Direct Investment

 This refers to an investment in or the acquisition of foreign assets with the
intent to control and manage them.
 Companies can make an FDI in several ways, including:
1. purchasing the assets of a foreign company
2. investing in the company or in new property, plants, or equipment
 3. participating in a joint venture with a foreign company, which
typically involves an investment of capital or know-how.
 FDI is primarily a long-term strategy.
 Companies usually expect to benefit through access to local markets and
resources, often in exchange for expertise, technical know-how, and capital.
 A country’s FDI can be both inward and outward.
 Inward FDI refers to investments coming into the country
 Outward FDI are investments made by companies from that country into
foreign companies in other countries.
 The difference between inward and outward is called the net FDI inflow

Factors that determine a company’s decision to invest:

 Cost. Is it cheaper to produce in the local market than elsewhere?
 Logistics. Is it cheaper to produce locally if the transportation costs are
significant?
 Market. Has the company identified a significant local market?
 Natural resources. Is the company interested in obtaining access to
local resources or commodities?
 Know-how. Does the company want access to local technology or
business process knowledge?
 Customers and competitors. Does the company’s clients or competitors
operate in the country?
 Policy. Are there local incentives (cash and noncash) for investing in one
country versus another?
 Ease. Is it relatively straightforward to invest and/or set up operations in
the country, or is there another country in which setup might be easier?
 Culture. Is the workforce or labor pool already skilled for the
company’s needs or will extensive training be required?
 Impact. How will this investment impact the company’s revenue and
profitability?
 Expatriation of funds. Can the company easily take profits out of the
country, or are there local restrictions?
 Exit. Can the company easily and orderly exit from a local investment,
or are local laws and regulations cumbersome and expensive?
2 Forms of FDI:
1. Horizontal FDI - occurs when a company is trying to open up a new market—
a retailer, for example, that builds a store in a new country to sell to the local
market.
2. Vertical FDI - when a company invests internationally to provide input into its
core operations—usually in its home country.

2 Forms of Vertical FDI:

1) Backward Vertical FDI - occurs when a firm brings the goods or components
back to its home country (i.e., acting as a supplier)
2) Forward Vertical FDI - occurs when a firm sells the goods into the local or
regional market (i.e., acting as a distributor)

2 Kinds of FDI:
1. Greenfield FDI - occur when multinational corporations enter into developing
countries to build new factories or stores. The name originates from the idea of
building a facility on a green field, such as farmland or a forested area.
2. Brownfield FDI - occur when a company or government entity purchases or
leases existing production facilities to launch a new production activity.

Why and How Governments Encourage FDI

-Many governments encourage FDI in their countries as a way to create jobs,

expand local technical knowledge, and increase their overall economic standards.
Countries attract FDI by making it easy to set up a company by foreign investors in
their respective countries.

How Governments Discourage or Restrict FDI

 Ownership restrictions. Host governments can specify ownership
restrictions if they want to keep the control of local markets or industries in
their citizens’ hands.
  Tax rates and sanctions. A company’s home government usually imposes
these restrictions in an effort to persuade companies to invest in the domestic
market rather than a foreign one.
How Governments Encourage FDI
 Financial incentives. Host countries offer businesses a combination of tax
incentives and loans to invest.
 Infrastructure. Host governments improve or enhance local infrastructure—
in energy, transportation, and communications—to encourage specific
industries to invest.
 Administrative processes and regulatory environment. Host-country
governments streamline the process of establishing offices or production in
their countries.
 Invest in education. Countries seek to improve their workforce through
education and job training.
 Political, economic, and legal stability. Host-country governments seek to
reassure businesses that the local operating conditions are stable, transparent
(i.e., policies are clearly stated and in the public domain), and unlikely to
change.

Quick Facts :

 What’s the best place in the world to start a business? Denmark.

 What country has the biggest share of women who launch new businesses?
Peru.
 Where does it cost the most to start a company? You’ll have to pony up the
most money in the Netherlands.
 Where does it take an average of 694 days to clear government red tape and
get a company off the ground? Suriname.

END