chapter 5: international trade and investment

Chapter 5: International Trade and Investment

Week 6 Day 1

Su Jin Victoria Yeon, Copyright 2015

KEEP YOUR HOMEWORK ASSIGNMENT WITH YOU


Discussion Continued…

A Pipeline of Good Intentions


A Pipeline of Good Intentions


One representative from each group please stand up and share about the case what you’ve talked about during the group discussion meeting

The representative must be the one who have not spoken much in class!

Comments about the Class and Changes in Grading Method


Problems with the Class


Misunderstanding of the concept / or NOT DEEP ENOUGH! There are very few people who has full understanding of the concepts we have talked

about in class E.g. Individualism-Collectivism – owning a private business is irrelevant!!!

You must deepen your understanding of the concept Do NOT rely on the web too much! Try and understand the concept through the text

book reading and discussion with your group mates!

Communication Problem Few of you are not listening well

Some even put their hands up to speak out when someone else is talking Showing that this person is not really listening to what her or his classmate is saying

Problems with the Class


Communication Problem People understand some concepts through examples

Example is there to help you understand You should not try to explain and understand a particular concept through examples　 E.g. Last week’s “water supply example” 　 The actual opinion was that “each country has different needs and CSR should be relevant to the needs of the

host nation or the country that is receiving the benefit”

Too much gap between the students in participation There are a few students who dominates the class

Class domination: one particular student is talking too much and not giving others the opportunity to speak

Cultural difference Some students are too aware of the “participation mark” and some students are too shy to speak out

On average, majority of students speak 2~4 times a week! This is not healthy discussion

　 Considering these issue, I will change my marking criteria

Changes in Evaluation Method


Professionalism (Attitude & Attendance) 8% Discussion & Participation 15% Homework (1 pg. summary of readings) 22% Weekly Group Discussion Report 20% Mid-Term Exam 15% Final Exam 20%



Discussion & Participation: 15% 　 10% This doesn’t mean that you should not participate! 10% will make huge difference! Maximum mark that you can get = 5 points per day (10 per week)

Attendance : 8% 　 10% There are so many of you who either have been late or been absent without previous notice Remember, you are losing 0.5% if you are late for class

We start the class at an exact time

Attitude: 3% You will lose your mark if you leave the classroom during the lecture time to print out your

homework You will lose your mark if you try to dominate the class without showing any respect to your

classmates Any disrespectful or unprofessional attitude or behavior will be the source of deduction



Professionalism (Attitude) 3% Attendance 10% Discussion & Participation 10% Homework (1 pg. summary of readings) 22% Weekly Group Discussion Report 20% Mid-Term Exam 15% Final Exam 20%

Lecture

International Trade and Investment


Learning Objectives


1. Understand the motivation for international trade2. Summarize and discuss the differences among the classical country-based

theories of international trade3. Use the modern firm-based theories of international trade to describe

global strategies adopted by businesses4. Describe and categorize the different forms of international investment5. Explain the reasons for FDI6. Summarize how supply, demand, and political factors influence FDI

The Opening Case: The Mittelstand Lead the Way


Germany’s Mittelstand companies Germany’ small to medium sized enterprises (SMEs) that have secured themselves

niches with what are on some cases impressive world market shares Germany’s economy suffered during the 2008-2009 global recession, but recovered

quicker and stronger than most developed countries. This performance has been attributed to the exporting prowess of the Mittelstand Companies. In no other country of similar size in the world does these small to medium enterprises have

such a strong export focus.

These enterprises will face many challenges in the future, including demographic changes, higher income levels and increased competition from emerging markets.

　A prime example of firms throughout the world using technology, knowledge and resources at their disposal, to successfully compete in the global marketplace

1) International Trade and the World Economy


Trade The voluntary exchange of goods, services, assets, or money between one person or o

rganization and another Voluntary 　 both parties to the transaction must believe they will gain from the exchange

International Trade Trade between residents of two countries

Residents: individuals, firms, not-for-profit organizations, or other forms of associations

Chapter 6 -16

Sources of the World’s Merchandise Exports 2009

2) Classical Country-Based Trade Theories


Mercantilism Absolute Advantage Comparative Advantage Comparative Advantage with Money Relative Factor Endowments (H-O Theorem)

Mercantilism


The first theory of international trade Emerged in England The 16th Century economic philosophy

Gold and silver: the mainstays of national wealth, the currency of trade“…to increase out wealth and treasure is by foreign trade, … to sell more to strangers yearly than we consume of theirs in value.” - by Thomas Mun in 1630

It was in a country’s best interest to maintain a trade surplus To export more than import Advocated government intervention to achieve a trade surplus Policies to maximize exports and minimize imports

Limited imports by tariffs and quotas Subsidizing exports

Mercantilism


Mercantilism Also referred to as an “unfavorable” balance of trade (Export – Import)

During the age of imperialism Governments often shifted the burden of mercantilist policies onto their colonies The British prohibited colonial firms from exporting certain goods that might compete with

those from British factories The British required some colonial industries to sell their output only to British firms 　 Contributed to the grievances that led to the overthrow of the British Crown

Neo-mercantilist / Protectionist Modern supporters of protectionist policies

E.g. Japan, diverse groups in the US China vs. the US　 China’s exports have been growing faster than its imports　 China has been criticized for keeping its currency too cheap

　 Did not free its currency to float against the US dollar　 The prices for China’s products were artificially low

Criticisms of Mercantilism


David Hume (1762) Inconsistency in the mercantilist doctrine

E.g. England vs. France If England export more 　 England’s currency value ↑ 　 inflation 　 relative value of French money ↓ 　 French product will be cheaper (more attractive)

In the long run, no country could sustain a surplus on the balance of trade No country could accumulate gold and silver as the mercantilists had envisaged

Zero-sum game Gain in one country results in a loss by another

Adam Smith & David Ricardo Trade is a positive sum game

All countries can benefit

Absolute Advantage


Adam Smith (1776) “The Wealth of Nations” Criticized mercantilism

Mercantilism actually weakens the country Robs individuals of the ability to trade freely and to benefit from voluntary exchanges Create Inefficiencies

Advocate free trade As a means of enlarging a country’s wealth Enables a country to expand the amount of goods and services available to it by specializing in

the production of some goods and services and trading for others

Absolute Advantage


Absolute Advantage The production of a product when it is more efficient than any other country in

producing it E.g. England’s Textile vs. French Wine

Specialization Should specialize in the production of goods for which they have an absolute advantage Trade the goods for those produced by other countries

A country should never produce goods at home that it can buy at a lower cost from other countries

Absolute Advantage


Assumption Only two countries in the world

France and Japan

Only two goods Wine and clock radios

Only one factor of production Labor

Free trade between France & Jap Both will be better off Exchange:

2 bottles of wine 　　 4 clock radios

Output per Hour of Labor

France Japan

Wine 2 1Clock Radios 3 5

France 2 bottles of wine 　 1 hour 4 clock radios 　 1.33 hours Through exchange

France saves 0.33 hours of labor! Japan 4 clock radios 　 0.8 hour 2 bottles of wine 　 2 hours

Japan saves 1.2 hours of labor!!

Comparative Advantage


David Ricardo (1817) “Principles of Political Economy” What happen when one country has an absolute advantage in the production of all

goods?

Comparative Advantage A country should produce and export those goods and services for which it is

relatively more productive than other countries are and import those goods and services for which other countries are relatively more productive than it is

Potential world production is greater with unrestricted free trade than it is with restricted trade Consumers in all nations can consume more

Trade is a positive-sum game All countries that participate realize economic gain



Differences between Absolute vs. Comparative Advantage Looks at relative productivity differences as opposed to absolute advantage Incorporates the concept of opportunity cost

Opportunity cost: the value of what is given up (the next best alternative) to get the good 　 E.g. brain surgery and lawn mowing; a brain surgeon vs. a teenager


France Japan


France Has absolute advantage on both of the products

Wine: 4 times better than Japan Clock radios: 0.25 times better than Japan 　 France is comparatively better than Japan in wine

production　 Japan is comparatively better in clock radio production

　Trade between the two should be made



In the absence of trade, France

1 bottle of wine = 1.5 clock radios

Japan 1 bottle of wine = 5 clock radios

Trade between France and Japan 2 clocks (Japan　 France); 1 bottle of wine (Japan 　 France) France

1 bottle of wine: 2 clock radios – can get 2 clock radios for 1 bottle of wine

Japan 1 bottle of wine: 2 clock radios – only give up 2 clock radios for 1 bottle of wine Get more wine per clock radios


France Japan


Comparative Advantage with Money


“You are better off specializing in what you do relatively best. Produce (and export) those goods and services you are relatively best able to produce, and buy other goods and services from people who are relatively better at producing them than you are.”

Assumption The output per hour of labor in France and Japan for clock radios and wine

The hourly wage rate in France: €12 The hourly wage rate in Japan: ¥1,000 €1 = ¥125

Cost of Goods in France Cost of Goods in Japan

French Made Japanese Made French Made Japanese Made

Wine € 3 € 8 ¥ 375 ¥ 1,000Clock Radios € 2 € 1.6 ¥ 250 ¥ 200

Comparative Advantage with Money


Without trade France

Wine: € 3 (¥ 375) ; Clock radios: € 2 (¥ 250)

Japan Wine: ¥ 1,000 (€ 8); Clock radios: ¥ 200 (€ 1.6)

Cost of Goods in France Cost of Goods in Japan

French Made Japanese Made French Made Japanese Made

Wine € 3 € 8 ¥ 375 ¥ 1,000Clock Radios € 2 € 1.6 ¥ 250 ¥ 200

Relative Factor Endowments (Heckscher-Ohlin Theorem)


“What determines the products for which country will have a comparative advantage?” Eli Heckscher (1919) & Bertil Ohlin (1933)

Comparative advantage arises from differences in national factor endowments　 The extent to which a country is endowed (to have particular quality) with such resources as land,

labor and capital

Goods differ according to the types of factors that are used to produce them

H-O Theory The pattern of international trade is determined by differences in factor endowments rather

than differences in productivity 　 Nations differ in factor endowments

　 Countries will expert those goods that make intensive use of factors that are locally abundant& import goods that make intensive use of factors that are locally scarce　 Argentina’s wheat growing & its abundance of fertile land; Saudi Arabia’s oil production & its abundance of

crude oil; Bangladesh’s apparel manufacture & its abundance of unskilled labor

The Leontief Paradox


Wassily Leontief (1953) Tested H-O Theorem after WWII (input-output analysis) Postulated that since the US was relatively abundant in capital compared to other nations

The US would be 　 An exporter of capital-intensive goods　 An importer of labor-intensive goods

BUT he found that US exports were less capital intensive than US imports! 　 the Leontief Paradox

　Dilemma for economists Economists prefer H-O theory on theoretical grounds, but it is a relatively poor predictor of real-

world international trade patters Ricardo’s theory of comparative advantage

Actually predicts trade patterns with greater accuracy

Key assumption of H-O Technologies are the same across countries

Criticisms of the Leontief Paradox


Repetition of Leontief’s initial study Data from 1947 might be distorted due to WWII In 1951: imports were 6 times more capital-intensive than exports

Criticism Measurement Issue

Leontief’s assumption – that there are two homogeneous factors of production; labor & capital Failed to include land, human capital and technology Many US exports are land or human knowledge E.g. Boeing – human capital and technology are more important to Boeing’s success than labor

and capital

3) Modern Firm-Based Trade Theories


Increased firm-based theories since WWII The growing importance of MNCs in the postwar international economy The inability of the country-based theories to explain and predict the existence and

growth of intra-industry trade The failure of Leontief and other researchers to empirically validate the country-based

Heckscher-Ohlin theory

3) Modern Firm-Based Trade Theories


Product Life Cycle Theory Country Similarity Theory New Trade Theory Owning Intellectual Property Rights Investing in Research and Development Achieving Economies of Scope Exploiting the Experience Curve

Porter’s Theory of National Competitive Advantage Factor Conditions Demand Conditions Related and Supporting Industries Firm Strategy, Structure, and Rivalry

Product Life-Cycle Theory


Raymond Vernon (1966) Based on the observation for most of the 20th Century When a very large proportion of the world’s new product had been developed by US firms & sold first

in the US market

Changes occur in the input requirements of a new product As it becomes established in a market As it gets standardised in production

Product Life-Cycle Theory


The export effects of product innovation are weakened by technological diffusion (spread) & lower costs abroad

1. The New Product Stage: a firm introduces an innovative product US as an export monopoly in a new product

2. The Maturing Product Stage: demand for the product expands dramatically Foreign production begins Export markets becoming competitive

3. The Standardization Product Stage: the market for the product standardize The US (the original country) becoming the importer

Evaluating the Product Life-Cycle Theory Historically, the PLC theory seems to be an accurate explanation of international trade patterns E.g. Xerox (photocopier)1960s: US production 　 Japan 　 developing nation

***Please NOTE that Vernon’s product life cycle theory is different from Marketing’s production life cycle theory

The Product Life-Cycle Model


Foreign production begins

Production > domestic consumption

Becomes the importer

The product cycle of model of international trade is associated with the life cycle stage of the product itself

The Product Life-Cycle Model


Country Similarity Theory


Inter-industry trade The exchange of goods produced by one industry in country A for goods produced by a different

industry in country B E.g. French wine 　　 Japanese clock radios

Intra-industry trade Trade between two countries of goods produced by the same industry

E.g. Japan: Toyota　　 Germany: BMW

Steffan Llinder (1961) Tried to explain the phenomenon of intra-industry trade Hypothesized:

International trade in manufactured goods results from similarities of preferences among consumers in countries that are at the same stage of economic development

Discovered: The most promising host markets are where consumer preferences resemble those of home country’s

Country Similarity Theory


Country similarity theory Suggests that most trade in manufactured goods should be between countries with

similar per capita incomes Intra-industry trade in manufactured goods should be common This theory is useful in explaining trade in differentiated goods

Differentiated goods　 Products which brand names and product reputations play an important role in consumer decision

making　 E.g. automobiles, electronics equipment, personal care products etc.

Undifferentiated goods　 Products which brand names and product reputations play a minor role in consumer decision making　 E.g. coal, petroleum products, sugar etc.

7. New Trade Theory


The ability of firms to attain economies of scale might have important implications for international trade

Economies of scale Unit cost reductions associated with a large scale of output E.g. ability to spread fixed costs over a large volume, utilities specialized employees and equipment that

are more productive than less specialized Major source of cost reduction

New Trade Theory Through its impact on economies of scale

Trade can increase the variety of goods available to consumers & decrease cost Predicts intra-industry trade will be commonplace

MNCs with the same industry will continue to compete on a global basis as they attempt to expand their economies of scale

Global market may be able to support only a small number of enterprises World trade may be dominated by countries whose firms were first movers in their production

7. New Trade Theory


Increasing Product Variety and Reducing Costs The benefit of open economy +

economies of scale Each nation may be able to specialize in

producing a narrower range of products than it would in the absence of trade

Each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of the goods

E.g. mini van + sports cars (55,000 units each nation but 100,000 is required)

Economies of scale, First-mover advantages, and the Pattern of Trade First mover advantages

The economic strategic advantages that accrue to early entrants into the industry

The ability to capture scale economies ahead of later entrants 　 Benefit from a lower cost structure

e.g. Aerospace industry: Airbus　 $15billion to develop its new superjumbo

jet, the 550 seat A380: supply at least 250　 Total demand over the next 20 years:

400~600 units

New Trade Theory


Owning Intellectual Property Rights A firm that owns an intellectual property right often gains advantages over its competitors

E.g. Louis Vuitton, Coca-Cola vs. PepsiCo

Investing in Research and Development R&D: a major component of the total cost of high-tech products Large “entry costs”, other forms are hesitant to compete against established firms First-mover advantage – e.g. Airbus

Achieving Economies of Scope When a firm’s average costs decrease as the number of different products it sells increases Marginal cost of adding an additional product line declines

E.g. Amazon.com

Exploiting the Experience Curve Production costs decline as the firm gains more experience in manufacturing and managing the

product The benefits from experience curve may be significant 　 may govern global competitiveness

E.g. semi-conductor companies, Hynix and Samsung

Porter’s Theory of National Competitive Advantage


Success in international trade comes from the interaction of four country- and firm-specific elements Factor Conditions Demand Conditions Related and Supporting Industries Firm Strategy, Structure, and Rivalry



Factor Conditions A country’s factor endowment Land, labor, capital + the educational level of the workforce, the quality of infrastructure The role of factor creation through training, research and innovation

Demand Conditions The existence of a large, sophisticated domestic consumer base

Stimulates the development and distribution of innovative products Firms continually develop and fine-tune products that can be marketed internationally

Related and Supporting Industries The emergence of an industry 　 stimulating the development of local suppliers Close location with its suppliers 　 better communications & the exchange of cost saving ideas &

innovations with the suppliers Competition among the suppliers 　 lower prices, higher-quality products and technological innovations

E.g. Hollywood, Silicon Valley



Source from: Wikipedia (2015) http://en.wikipedia.org/wiki/Diamond_model

Firm Strategy, Structure, and Rivalry The domestic market in which firms compete

(competitive domestic market)

Government Influence of government policy E.g. German’s autobahn - no speed limits

4) An Overview of International Investment


Types of International Investments Foreign portfolio investments

Passive holdings of securities Do NOT entail active management or control of the securities’ issuer by the investor　 E.g. socks, bonds, or other financial assets

In order to gain attractive rate of return and diversify risk

Foreign direct investments (FDI) Acquisition of foreign assets for the purpose of controlling them Through purchase of a firm (Acquisition), merge with other firms, joint venture, greenfield

The Growth of FDI (See figure 6.6 – p. 189)

World wide FDI in 1967: US$ 100 billion World wide FDI in 2009: US$ 17.7 trillion

5) International Investment Theories


Why does FDI occur? Ownership Advantages A firm owning a valuable asset that creates a competitive advantage domestically can

use that advantage to penetrate foreign markets through FDI E.g. superior technology, a well-known brand name, economies of scale etc.

Explains why FDI occurs Does NOT explain why a firm would choose to enter a foreign market via FDI rather

than other means such as exporting, franchising, or licensing

Internalization Theory Answers the questions of why FDI?

Dunning’s Eclectic Theory

Internalization Theory


Transaction cost A cost incurred in making an economic exchange

Search and information costs; bargaining costs; policing and enforcement costs

The cost of entering into a transaction Connected to negotiating, monitoring and enforcing a contract

A firm must decide whether it is better to own & operate its own factory overseas or to contract with a foreign firm Internalization theory FDI is more likely to occur when transaction costs are high

E.g. Toyota’s competitive advantage;-　 Reputation for high quality & its sophisticated manufacturing techniques 　 Neither can easily conveyed by contract

Dunning’s Eclectic Theory (OLI)


John Dunning’s Eclectic Paradigm Tries to answer the question “why production should be located abroad?” Recognizes that FDI reflects both international business activity and business activity internal

to the firm Ownership Advantage The firm must own some unique competitive advantage (core competency) that overcomes

the disadvantages of competing with foreign firms on their home market E.g. brand name, ownership of proprietary technology, economies of scale etc.

Location Advantage Undertaking the business activity must be more profitable in a foreign location than

undertaking it in a domestic location Internalization Advantage The firm must benefit more from controlling the foreign business activity than from hiring an

independent local company to provide the service

6) Factors Influencing FDI


Supply Factors Production Costs Logistics Availability of Natural Resources Access to Key Technology

Demand Factors Customer Access Marketing Advantages Exploitation of Competitive Advantages Customer Mobility

Political Factors Avoidance of Trade Barriers Economic Development Incentives

Supply Factors


Production Costs Undertake FDI to lower production costs More attractive foreign locations

E.g. lower land prices, tax rates, commercial real estate rents, better availability and low cost of skilled and unskilled labor

Logistics Significant transportation costs E.g. Heineken – brewing its beverages close to where its foreign consumers live 　 cheaper

Availability of Natural Resources To access natural resources that are critical to their operations

Access to Key Technology More advantages to acquire ownership interests in an existing firm than to assemble an in-

house group of research scientists to develop or reproduce an emerging technology E.g. Korea’s Doosan Infracore bought Bobcat division of Ingersoll-Rand in 2007

To benefit from Bobcat’s technology, distribution network and skilled management team

Demand Factors


Customer Access Many types of IB require firms to have a physical presence in the market

E.g. KFC, McDonald IKEA’s success in broadening its customers 　 new stores world wide

Marketing Advantages Enhance the visibility of a foreign firms’ products in the host market Might benefit from “buy local” attitudes of host country consumers To improve their customer service

Demand Factors


Exploitation of Competitive Advantages FDI as a firm’s best means to exploit a competitive advantage that it already enjoys

The owner of a valuable trademark, brand name or technology E.g. Nestle, Unilever, Procter and Gamble – enhance their ability to customize + brand power ↑

Customer Mobility If one of the firm’s existing customers build a foreign factory,

the firm may decide to locate a new facility of its own nearby Enabling it to continue to supply its customers E.g. Japanese auto makers and its use of JJT technique from its suppliers Samsung moving to northeast England, si of its Korean parts suppliers also established factories there

Political Factors


Avoidance of Trade Barriers E.g. Taiwanese contract manufacturing firm, Hon Hai Precision Industries announced in 2011

that it would build a new electronics manufacturing plant in Brazil To avoid Brazil’s high tariff on imported electronics goods

Economic Development Incentives E.g. reduced utility rates, employee training program, infrastructure additions, tax reductions or

tax holidays To induce them to locate new facilities

E.g. Georgia agreed to provide Kia Motors $400 million in incentives to capture that firm’s first US plant which employs 3,000 workers

Homework #10 – due next Friday


Read the case “Twenty-first Century Pirates” Answer the four case discussion questions Do not spend more than 2 pages answering the questions You may use bullet points Keep your answers brief but think! Type your answers

Due date: Friday, 10th of April by 11 a.m.

Group discussion Report #5 (due next Friday)


With your group members discuss; About sixth week reading About sixth week case And discuss based on case discussion questions

Discuss following statement“Among various theories that is mentioned in this week’s reading, choose one major theory of international trade which you think are the most applicable / useful. How applicable is the those theory in today’s environment? Why do you think that theory is useful / applicable?”

Report due date: 10th of April by 11 a.m. Group report / Individual Report (sheets are downloadable from the website

http://ecampus.cbnu.ac.kr)

PLEASE HAND IN YOUR HOMEWORK NOW


Case StudyTwenty-First Century Pirates

Week 6 Day 2


Class Discussion


Globalization


Discuss the following issue

“Among various theories that is mentioned in this week’s reading, choose one major theory of international trade which you think are the most applicable / useful.

How applicable is the those theory in today’s environment? Why do you think that theory is useful / applicable?”

Case Study Discussion

Twenty-First Century Pirates




Addresses the issue of intellectual property rights (IPR) protection in a global economy 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.



How important is intellectual property to the world economy?



Should the average consumer concern himself of herself with theft of intellectual property? What about the average citizen? The average worker?



Does intellectual property theft undermine the workings of the free-market system?



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?

Homework #11 – due next Wednesday


Read Chapter 7 – International Monetary System and the Balance of Payments 1 page Chapter Summary Do not spend more than 1 page (Type your answers) Try and keep your answers brief Due date: Wednesday, 15th of April by10 a.m.

chapter 5: international trade and investment

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