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Chapter 6 Theories of International Trade and Investment
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Learning Objectives
In this chapter, you will learn about the following:
1. Why do nations trade?
2. How can nations enhance their competitive advantage?
3. Why and how do firms internationalize?
4. How can internationalizing firms gain and sustain competitive
advantage?
MyManagementLab®
Improve Your Grade!
Over 10 million students improved their results using the Pearson
MyLabs. Visit mymanagementlab.com for simulations, tutorials, and
end-of-chapter problems.
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Source: © Giles Robberts/Alamy
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Apple’s Comparative and Competitive Advantages
Apple products were once made in the United States. Today, however,
almost all of the 70 million iPhones, 30 million iPads, and 60 million other
products that Apple sells globally each year are manufactured outside the
United States. How did that happen?
Apple (annual revenues: $110 billion) has expanded internationally from
its humble roots in the United States to more than 70 markets worldwide.
In terms of total sales, North and South America account for about onethird, and Europe and Asia generate about one-quarter each. After the
United States, Japan is Apple’s best country market, producing about 5
percent of total sales.
Apple orchestrates its value chains via contractual relations with suppliers
around the world—some 700,000 people engineer, build, and assemble its
products under contract. One of Apple’s goals is to obtain comparative
advantages from specific countries. Comparative advantage refers to
superior features of a country that provide distinctive benefits, typically
derived from either natural endowments or deliberate policies.
Comparative advantage includes inherited resources, such as labor and
land, and acquired resources, like entrepreneurial orientation and
innovative capacity.
An iPhone contains hundreds of parts, about 90 percent of which are
manufactured in countries outside the United States. Apple sources
semiconductors from Germany, memory chips from Korea, display panels
from Taiwan, and rare metals from Africa. All these components are
assembled in China, which offers comparative advantages for
manufacturing. Much of China’s success is explained by its superior factor
proportions. According to factor proportions theory, each country should
specialize in making products that intensively use production factors (such
as labor, land, capital) that it has in abundance and import goods that
intensively use relatively scarce production factors. Because China has
abundant low-cost labor, its firms specialize in producing labor-intensive
products.
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Apple exemplifies superior innovation. Apple suppliers excel at developing
new product designs, innovative production processes, and new ways of
organizing. Innovation promotes productivity, the value of output produced
by a unit of labor
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or capital. The more productive a firm is, the more efficiently it uses its
resources. Productivity is vital to the success of firms and nations alike.
Over time, improving productivity is raising living standards in emerging
markets such as China, India, Mexico, and Poland.
Configuring its value chains on a global scale enables Apple to produce
the best possible products and maximize its competitive advantages.
Competitive advantage refers to assets and competencies that are difficult
for competitors to imitate and thus help firms succeed. Apple management
believes the economies of scale of overseas factories as well as the
diligence, flexibility, and industrial skills of foreign workers have outpaced
counterparts in the United States.
Apple enjoys a monopolistic advantage by controlling cutting-edge
knowledge in the development of smartphones, computers, and other
products. The firm does most of its own R&D and product development in
company-owned facilities in California.
Another key to Apple’s success is its ability to engage in global free trade.
Free trade produces the following outcomes: (i) consumers and firms can
obtain the products they desire at lower cost; (ii) parts and other inputs
obtained in this way reduce company expenses, which translates into
higher profits; and (iii) consumers pay less for the products and services
they need, which increases their living standards.
Apple has struggled to ensure sustainable conditions at its Chinese
contract factories. Apple’s biggest supplier is Foxconn, a leading
electronics manufacturer. Workers in Foxconn’s China factories have
complained about long hours, low wages, and living in overcrowded
dormitories. Some have even committed suicide. In response, more than
250,000 protesters signed a petition demanding better labor conditions for
Apple contract workers abroad. Foxconn raised wages and moved some
production to India, in search of cheaper labor. Foxconn also installed
robots in several factories, laying off thousands of workers. Apple is
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struggling to strike the right balance between low-cost manufacturing and
ensuring the safety and happiness of the thousands of workers who build
the Iphones, Ipads, and other products that consumers love around the
world.
Sources: Apple Inc., Form 10-K (Annual Report) 2011, accessed at http://investor.apple.com; Colin Campbell,
“Foxconn’s Robot Empire,” Maclean’s, November 21, 2011, p. 41; Charles Duhigg and Keith Bradsher, “How
the U.S. Lost Out on iPhone Work,” New York Times, January 21, 2012, accessed at www.nytimes.com;
Hoovers.com, profile of Apple, Inc.; Adam Lashinsky, Inside Apple: How America’s Most Admired—and
Secretive—Company Really Works (New York: Business Plus, 2012); Adam Satariano, “Protesters to Target Apple
Supplier Conditions,” Bloomberg, February 8, 2012, accessed at www.bloomberg.com; Paul Theroux, “How
Apple Revolutionized Our World,” Newsweek, September 5, 2011, pp. 36–37; Jessica Vascellaro and Owen
Fletcher, “Apple Navigates China Maze,” Wall Street Journal, January 14, 2012, pp. B1–B2.
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The opening story explains the trade, investment, and
performance achievements of Apple, Inc. The technology
giant benefits enormously from international business. The
advantages provided by suppliers and nations in Asia,
Europe, and elsewhere have propelled the firm to global
success. China, Japan, Germany, South Korea, and
numerous other countries have taken proactive steps to
enhance their standing in the world economy. Emerging
markets are reaping the rewards of various comparative and
competitive advantages.
In this chapter, we review theories and explanations of why
nations and firms undertake international activities.1 We
explain comparative and competitive advantages, and how
such resources support nations and firms in global commerce.
We address the underlying economic rationale for
international business activity and explain why global trade
and investment take place.
We address such questions as:
• What is the underlying economic rationale for international
business activity?
• Why does trade take place?
• What are the gains from trade and investment?
Comparative advantage
Superior features of a country that provide
unique benefits in global competition, typically
derived from either natural endowments or
deliberate national policies.
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Comparative advantage describes superior features of a
country that provide unique benefits in global competition,
typically derived from either natural endowments or
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deliberate national policies. Also known as country-specific advantage,
comparative advantage includes inherited resources, such as labor, climate,
arable land, and petroleum reserves, such as those enjoyed by the Gulf
nations. Other types of comparative advantages are acquired over time, such
as entrepreneurial orientation, availability of venture capital, and innovative
capacity.
Competitive advantage
describes organizational assets and
competencies that are difficult for competitors to imitate and thus help firms
enter and succeed in foreign markets. These competencies take various
forms, such as specific knowledge, capabilities, innovativeness, superior
strategies, or close relationships with suppliers. Competitive advantage is also
known as firm-specific advantage.
Competitive advantage
Distinctive assets or competencies of a firm that are difficult
for competitors to imitate and are typically derived from
specific knowledge, capabilities, skills, or superior strategies.
In recent years business executives and scholars have used competitive
advantage to refer to the advantages possessed by nations and individual
firms in international trade and investment. To be consistent with the recent
literature, we adopt this convention as well.
Exhibit 6.1
categorizes leading theories of international trade and
investment into two broad groups. The first group includes nation-level
theories. These are classical theories, widely accepted since the sixteenth
century. They address two questions: (1) Why do nations trade? (2) How can
nations enhance their competitive advantage?
The second group includes firm-level theories. These are more contemporary
theories of how firms can create and sustain superior organizational
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performance. Firm-level explanations address two additional questions: (3)
Why and how do firms internationalize? and (4) How can internationalizing
firms gain and sustain competitive advantage?
We organize the remainder of our discussion according to the four
fundamental questions.
EXHIBIT 6.1 Theories of International Trade and Investment
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Why Do Nations Trade?
Why do nations trade with one another? The short answer is that trade
enables countries to use their national resources more efficiently through
specialization. Trade allows industries and workers to be more productive.
These outcomes help keep the cost of many everyday products low,
translating into higher living standards. Without international trade, most
nations would be unable to feed, clothe, and house their citizens at current
levels. Even resource-rich countries like the United States would suffer
immensely without trade. Some types of food would become unavailable or
very expensive. Coffee and sugar would be luxury items. Petroleum-based
energy sources would dwindle. Vehicles would stop running, freight would go
undelivered, and people would not be able to heat their homes in winter. In
short, not only do nations, companies, and citizens benefit from international
trade, modern life is virtually impossible without it.
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Classical Theories
Six classical perspectives explain the underlying rationale for trade among
nations: the mercantilist view, absolute advantage principle, comparative
advantage principle, factor proportions theory, international product life cycle
theory, and new trade theory.
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Mercantilism
The earliest explanations of international business emerged with the rise of
European nation-states in the 1500s, when gold and silver were the most
important sources of wealth, and nations sought to amass as much of these
treasures as possible. Nations received payment for exports in gold, so
exports increased their gold stock, while imports reduced it because they paid
for imports with their gold. Exports were seen as good and imports as bad.
Because the nation’s power and strength increase as its wealth increases,
mercantilism
argues that national prosperity results from a positive
balance of trade achieved by maximizing exports and minimizing or even
impeding imports.
Mercantilism
The belief that national prosperity is the result of a positive
balance of trade, achieved by maximizing exports and
minimizing imports.
Mercantilism explains why nations attempt to run a trade surplus—that is, to
export more goods than they import. Today many people believe that running
a trade surplus is beneficial. They subscribe to a view known as neomercantilism. Labor unions (which seek to protect home-country jobs), farmers
(who want to keep crop prices high), and certain manufacturers (those that
rely heavily on exports) all tend to support neo-mercantilism.
However, mercantilism tends to harm firms that import, especially those that
import raw materials and parts used in the manufacture of finished products.
Mercantilism also harms consumers, because restricting imports reduces the
choice of products they can buy. Product shortages that result from import
restrictions may lead to higher prices—that is, inflation. When taken to an
extreme, mercantilism may invite “beggar thy neighbor” policies, promoting the
benefits of one country at the expense of others. By contrast, free trade is a
generally superior approach.
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Free trade
refers to the relative absence of restrictions to the flow
of goods and services between nations. It typically produces the
following outcomes:
Free trade
Relative absence of restrictions to the flow of goods
and services between nations.
• Consumers and firms can more readily buy the products they
want.
• Imported products tend to be cheaper than domestically produced
products (because access to world-scale supplies forces prices
down, mainly from increased competition, or because the goods
are produced in lower-cost countries).
• Lower-cost imports help reduce company expenses, thereby
raising their profits (which may be passed on to workers in the
form of higher wages).
• Lower-cost imports help consumers save money, thereby
increasing their living standards.
• Unrestricted international trade generally increases the overall
prosperity of poor countries.
Absolute Advantage Principle
In An Inquiry into the Nature and Causes of the Wealth of Nations, a landmark
book published in 1776, Scottish political economist Adam Smith attacked the
mercantilist view by suggesting that nations benefit most from free trade.
Smith argued that
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mercantilism deprives individuals of the ability to trade freely and to benefit
from voluntary exchange. By trying to minimize imports, a country wastes
much of its national resources in the production of goods it is not suited to
produce efficiently. The inefficiencies of mercantilism end up reducing the
wealth of the nation as a whole while enriching a limited number of individuals
and interest groups. Relative to others, each country is more efficient in the
production of some products and less efficient in the production of other
products. Smith’s absolute advantage principle
states that a country
benefits by producing primarily those products in which it has an absolute
advantage, meaning goods it can produce using fewer resources than another
country. Each country thus increases its welfare by specializing in the
production of certain products, exporting them, and importing others. This
approach allows the nation to consume more than it otherwise could, generally
at lower cost.
Absolute advantage principle
A country benefits by producing only those products in which it
has absolute advantage or that it can produce using fewer
resources than another country.
Exhibit 6.2
illustrates how the absolute advantage principle works in
practice. Consider two nations, France and Germany, engaged in a trading
relationship. Panel (a) of the exhibit shows a hypothetical example in which
France has an absolute advantage in the production of cloth, and Germany
has an absolute advantage in the production of wheat. Assume labor is the
only factor of production used in making both goods. (Firms employ factors of
production—for example, labor, capital, entrepreneurship, and technology—to
produce products and services.) It takes an average worker in France 6 days
to produce one ton of cloth and 8 days to produce one ton of wheat. It takes
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an average worker in Germany 10 days to produce one ton of cloth and 4 days
to produce one ton of wheat.
Scottish political economist Adam Smith was among the first to articulate the
advantages of international trade.
Source: © Georgios Kollidas/Fotolia
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France has an absolute advantage in the production of cloth, since it takes
only 6 days of labor to produce one ton compared to 10 days for Germany.
Germany has an absolute advantage in the production of wheat, since it takes
only 4 days to produce one ton compared to 8 days for France. If both France
and Germany were to specialize, exchanging cloth and wheat at a ratio of oneto-one, France could employ more of its resources to produce cloth and
Germany could employ more of its resources to produce wheat. France would
be able to import one ton of wheat in exchange for one ton of cloth, thereby
“paying” only 6 labor days for one ton of wheat. If France had produced the
wheat itself, it would have used 8 labor days, so it gains 2 labor days from the
trade. In a similar way, Germany gains from trade with France.
EXHIBIT 6.2 Example of Absolute Advantage (Labor Cost in Days of
Production for One Ton)
The point is further illustrated by the graph in panel (b) of Exhibit 6.2 . Here,
the different combinations of cloth and wheat that France can produce
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are represented by the blue line, France’s production possibilities frontier. The
different combinations of cloth and wheat that Germany can produce are
indicated by the red line, Germany’s production possibilities frontier. As
shown, France is more efficient at producing cloth, and Germany is more
efficient at producing wheat. Suppose the countries do not trade with each
other and each devotes half its labor days to producing each of cloth and
wheat. France (point A in the graph) spends 3 labor days to produce ½ ton of
cloth and 4 labor days to produce ½ ton of wheat. Germany (point B in the
graph) spends 5 labor days to produce ½ ton of cloth and 2 labor days to
produce ½ ton of wheat. Without trade, it costs the two countries a combined
total of 14 labor days to produce one ton of cloth and one ton of wheat. By
contrast, if each country were to specialize and trade with the other, France
would invest 6 days to produce one ton of cloth and Germany would invest 4
days to produce one ton of wheat, for a total of just 10 labor days. Thus, by
specializing and trading, each country has saved an average of 2 labor days
((14–10)/2).
Trading means France and Germany obtain the goods they need for less
labor. In this way, each country employs its labor and other resources more
efficiently, thereby increasing its standard of living. To employ a more
contemporary example, Japan has no natural holdings of oil, but it
manufactures some of the world’s best automobiles. Saudi Arabia produces
much oil, but lacks a substantial car industry. Given this state of resources, it
is wasteful for each country to attempt to produce both oil and cars. By trading
with each other, Japan and Saudi Arabia employ their respective resources
more efficiently in a mutually beneficial relationship. Japan gets oil that it
refines to power cars, and Saudi Arabia gets the cars its citizens need. By
extending this example we see that freely trading countries achieve substantial
gains from trade. Brazil can produce coffee more cheaply than Germany;
Australia can produce wool more cheaply than Switzerland; Britain can provide
financial services more cheaply than Zimbabwe; and so forth.
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Ethical Connections
A market failure is an interruption in free trade, resulting in inefficient
allocation of goods and services. In many developing economies,
corruption is a common source of market failure. For example, goods
and services are often unfairly granted to those who pay bribes. Since
free trade reduces poverty by promoting efficient allocation of goods
and services, governments should act to restrict bribery and other
forms of corruption.
Historically, the concept of absolute advantage provided perhaps the earliest
sound rationale for international trade. However, it failed to consider more
subtle advantages that trading nations enjoy. Later analysis revealed that a
country benefits from international trade even when it lacks an absolute
advantage. Such thinking led to the principle of comparative advantage.
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Comparative Advantage Principle
In his 1817 book The Principles of Political Economy and Taxation, British
political economist David Ricardo explained why it is beneficial for two
countries to trade even though one of them may have absolute advantage in
the production of all products. Ricardo demonstrated that what matters is not
the absolute cost of production, but rather the relative efficiency with which the
two countries can produce the products. Hence, the comparative advantage
principle
states that it can be beneficial for two countries to trade without
barriers as long as one is relatively more efficient at producing goods or
services needed by the other. The principle of comparative advantage is the
foundation and overriding justification for international trade today.
Comparative advantage principle
It can be beneficial for two countries to trade without barriers
as long as one is relatively more efficient at producing goods
or services needed by the other. What matters is not the
absolute cost of production but rather the relative efficiency
with which a country can produce the product.
To illustrate, let’s modify the example of France and Germany. As shown in
panel (a) of Exhibit 6.3
, suppose now that Germany has an absolute
advantage in the production of both cloth and wheat. That is, in labor-per-day
terms, Germany can produce both cloth and wheat in fewer days than France.
Based on this new scenario, you might initially conclude that Germany should
produce all the wheat and cloth it needs and not trade with France at all.
However, it is still beneficial for Germany to trade with France.
How can this be true? The answer is that rather than the absolute cost of
production, it is the ratio of production costs between the two countries that
matters. In panel (a) of Exhibit 6.3
, Germany is comparatively more
efficient at producing cloth than wheat: It can produce four
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are represented by the blue line, France’s production possibilities frontier. The
different combinations of cloth and wheat that Germany can produce are
indicated by the red line, Germany’s production possibilities frontier. As
shown, France is more efficient at producing cloth, and Germany is more
efficient at producing wheat. Suppose the countries do not trade with each
other and each devotes half its labor days to producing each of cloth and
wheat. France (point A in the graph) spends 3 labor days to produce ½ ton of
cloth and 4 labor days to produce ½ ton of wheat. Germany (point B in the
graph) spends 5 labor days to produce ½ ton of cloth and 2 labor days to
produce ½ ton of wheat. Without trade, it costs the two countries a combined
total of 14 labor days to produce one ton of cloth and one ton of wheat. By
contrast, if each country were to specialize and trade with the other, France
would invest 6 days to produce one ton of cloth and Germany would invest 4
days to produce one ton of wheat, for a total of just 10 labor days. Thus, by
specializing and trading, each country has saved an average of 2 labor days
((14–10)/2).
Trading means France and Germany obtain the goods they need for less
labor. In this way, each country employs its labor and other resources more
efficiently, thereby increasing its standard of living. To employ a more
contemporary example, Japan has no natural holdings of oil, but it
manufactures some of the world’s best automobiles. Saudi Arabia produces
much oil, but lacks a substantial car industry. Given this state of resources, it
is wasteful for each country to attempt to produce both oil and cars. By trading
with each other, Japan and Saudi Arabia employ their respective resources
more efficiently in a mutually beneficial relationship. Japan gets oil that it
refines to power cars, and Saudi Arabia gets the cars its citizens need. By
extending this example we see that freely trading countries achieve substantial
gains from trade. Brazil can produce coffee more cheaply than Germany;
Australia can produce wool more cheaply than Switzerland; Britain can provide
financial services more cheaply than Zimbabwe; and so forth.
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Ethical Connections
A market failure is an interruption in free trade, resulting in inefficient
allocation of goods and services. In many developing economies,
corruption is a common source of market failure. For example, goods
and services are often unfairly granted to those who pay bribes. Since
free trade reduces poverty by promoting efficient allocation of goods
and services, governments should act to restrict bribery and other
forms of corruption.
Historically, the concept of absolute advantage provided perhaps the earliest
sound rationale for international trade. However, it failed to consider more
subtle advantages that trading nations enjoy. Later analysis revealed that a
country benefits from international trade even when it lacks an absolute
advantage. Such thinking led to the principle of comparative advantage.
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Comparative Advantage Principle
In his 1817 book The Principles of Political Economy and Taxation, British
political economist David Ricardo explained why it is beneficial for two
countries to trade even though one of them may have absolute advantage in
the production of all products. Ricardo demonstrated that what matters is not
the absolute cost of production, but rather the relative efficiency with which the
two countries can produce the products. Hence, the comparative advantage
principle
states that it can be beneficial for two countries to trade without
barriers as long as one is relatively more efficient at producing goods or
services needed by the other. The principle of comparative advantage is the
foundation and overriding justification for international trade today.
Comparative advantage principle
It can be beneficial for two countries to trade without barriers
as long as one is relatively more efficient at producing goods
or services needed by the other. What matters is not the
absolute cost of production but rather the relative efficiency
with which a country can produce the product.
To illustrate, let’s modify the example of France and Germany. As shown in
panel (a) of Exhibit 6.3
, suppose now that Germany has an absolute
advantage in the production of both cloth and wheat. That is, in labor-per-day
terms, Germany can produce both cloth and wheat in fewer days than France.
Based on this new scenario, you might initially conclude that Germany should
produce all the wheat and cloth it needs and not trade with France at all.
However, it is still beneficial for Germany to trade with France.
How can this be true? The answer is that rather than the absolute cost of
production, it is the ratio of production costs between the two countries that
matters. In panel (a) of Exhibit 6.3
, Germany is comparatively more
efficient at producing cloth than wheat: It can produce four
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times as much cloth as France (8/2), but only 1.5 times as much wheat (6/4).
Thus, Germany should devote all its resources to producing cloth and import
all the wheat it needs from France. France should specialize in producing
wheat and import all its cloth from Germany. Both countries then can each
produce and consume relatively more of the goods they desire for a given
level of labor cost.
EXHIBIT 6.3 Example of Comparative Advantage (Labor Cost in Days of
Production for One Ton)
This is further illustrated in panel (b) of Exhibit 6.3
. In Germany, it takes
only 2 labor days to produce one ton of cloth and 4 labor days to produce one
ton of wheat. Given 4 labor days, Germany can produce 2 tons of cloth or 1
ton of wheat, or any combination in between on its production possibilities
frontier (the red line). In France, using 8 labor days will produce 1 ton of cloth
or 1.33 tons of wheat (8/6), or any combination in between on its production
possibilities frontier (the blue line). Again, suppose the countries do not trade
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with each other, and each devotes half its labor days to producing each of
cloth and wheat. In this case, it takes France (point A in the graph) a total of 7
labor days to produce ½ ton of cloth and ½ ton of wheat. However, it takes
Germany (point B in the graph) just 3 labor days to produce the same quantity
of these commodities. Without trade, it would take the two countries a total of
10 labor days to produce 1 ton of cloth and 1 ton of wheat. By contrast, if the
two countries began trading, and if Germany specialized in producing cloth
and France specialized in wheat, it would take only 8 days to produce the
same volume of these commodities. Thus, even when Germany holds an
absolute advantage in producing both cloth and wheat, the two countries can
reduce their combined resource costs by specializing and trading.
It would be wasteful for Saudi Arabia to produce both oil and cars. Instead, it
can focus on extracting and refining petroleum while procuring cars from
Japan, which has no natural holdings of oil but manufactures some of the best
automobiles in the world.
Source: leungchopan/Shutterstock
Another way to understand comparative advantage is to consider opportunity
cost, the value of a foregone alternative activity. In panel (a) of Exhibit 6.3 ,
if Germany produces 1 ton of wheat, it forgoes 2 tons of cloth. However, if
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France produces 1 ton of wheat, it forgoes only 0.75 tons of cloth. Thus,
France should specialize in wheat. Similarly, if France produces 1 ton of cloth,
it forgoes 1.33 tons of wheat. But if Germany produces 1 ton of cloth, it
forgoes only 0.5 ton of wheat. Thus, Germany should specialize in cloth. The
opportunity cost of producing wheat is lower in France, and the opportunity
cost of producing cloth is lower in Germany.
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• Traded products are not just commodities anymore, such as wheat and
cloth. Today, many traded goods are characterized by strong branding and
differentiated features.
• International transportation, critical for cross-border trade to take place,
adds to the cost of importing.
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Government restrictions such as tariffs (taxes on imports), import barriers,
and regulations can hamper international trade.
• Large-scale production in certain industries may bring about scale
economies, and therefore lower prices, that help offset weak national
comparative advantage.
• Just as Japan did after World War II, governments may target and invest in
certain industries, build infrastructure, or provide subsidies, all to boost the
competitive advantages of home-country firms.
• Many services, such as banking and retailing, cannot be traded in the
usual sense and must be internationalized via foreign direct investment.
Thus, classical theories have limited applicability to international commerce
in services.
• Modern telecommunications and the Internet facilitate global trade in many
services at very low cost.
• The primary participants in international trade are individual firms that differ
in significant ways. Far from being homogenous enterprises, many are
highly entrepreneurial and innovative or have access to exceptional human
talent, all of which support international business success. In other cases,
some firms may need to trade internationally if their home markets are too
small to support their growth or sales objectives.
In the following sections, we discuss additional theories that scholars
introduced in view of the limitations of early trade theories.
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Factor Proportions Theory
A significant contribution to explaining international trade came in the 1920s,
when two Swedish economists, Eli Heckscher and his student, Bertil Ohlin,
proposed the factor proportions theory, sometimes called the factor
endowments theory.3 This view rests on two premises: (1) products differ in
the types and quantities of factors (labor, natural resources, and capital)
required for their production; and (2) countries differ in the type and quantity of
production factors they possess. Each country should export products that
intensively use relatively abundant factors of production and import goods that
intensively use relatively scarce factors of production. For example, the United
States produces and exports capital-intensive products, such as
pharmaceuticals and commercial aircraft, while Argentina produces landintensive products, such as wine and sunflower seeds.
Factor proportions theory differs somewhat from earlier theories by
emphasizing the importance of each nation’s factors of production. The theory
states that, in addition to differences in the efficiency of production, differences
in the quantity of factors of production held by countries also determine
international trade patterns. This leads to a per-unit-cost advantage due to the
abundance of a given factor of production, say labor, over another, say land,
which is not in as much supply. Originally, labor was the most important factor
of production. This explains why, for example, countries like China and India
have become popular manufacturing bases; they have huge bases of workers.
In the 1950s, Russian-born economist Wassily Leontief pointed to empirical
findings that seemed to contradict the factor proportions theory. The theory
suggests that because the United States has abundant capital, it should be an
exporter of capital-intensive products. However, Leontief’s analysis, termed
the Leontief paradox, revealed that the United States often exported laborintensive goods and imported more capital-intensive goods than the theory
would ordinarily predict. What accounts for the inconsistency? One
explanation is that numerous factors determine the composition of a country’s
exports and imports. Another is that, in Leontief’s time, U.S. labor was
relatively more productive than labor elsewhere in the world.
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Perhaps the main contribution of the Leontief paradox is its suggestion that
international trade is complex and cannot be fully explained by a single theory.
Subsequent refinements of factor proportions theory suggested that other
country-level assets—knowledge, technology, and capital—are instrumental in
explaining each nation’s international trade prowess. Taiwan, for example, is
very strong in information technology and is home to a sizable population of
knowledge workers in the IT sector. These factors helped make Taiwan a
leader in the global computer industry.
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International Product Life Cycle Theory
In a 1966 article, Harvard Professor Raymond Vernon sought to explain
international trade based on the evolutionary process that occurs in the
development and diffusion of products to markets around the world.4 In his
International Product Life Cycle (IPLC) Theory, Vernon observed that each
product and its manufacturing technologies go through three stages of
evolution: introduction, maturity, and standardization. This is illustrated in
Exhibit 6.4
.
Factor proportions theory describes how abundant production factors give rise
to national advantages. Russia, for example, has a very large workforce in
numerous industries.
Source: Dmitry Kalinovsky/Shutterstock
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In the introduction stage, a new product typically originates in an advanced
economy, such as the United States. Such countries possess abundant capital
and R&D capabilities, providing key advantages in the invention of new goods.
Advanced economies also have abundant, high-income consumers who are
willing to try new products, which are often expensive. During the introduction
stage, the new product is produced in the inventing country, which enjoys a
temporary monopoly.
As the product enters the maturity phase, the product’s inventors massproduce it and seek to export it to other advanced economies. Gradually,
however, the product’s manufacturing becomes more routine and foreign firms
begin producing alternative versions, ending the inventor’s monopoly power.
At this stage, as competition intensifies and export orders begin to come from
lower-income countries, the inventor may earn only a narrow profit margin.
EXHIBIT 6.4 Illustration of Vernon’s International Product Life Cycle
Source: Adapted from Raymond Vernon, “International Investment and International Trade in the Product Cycle,”
Quarterly Journal of Economics 80 (May 1966): 190–207 and http://www.provenmodels.com/583/internationalproduct-life-cycle/raymond-vernon.
In the standardization phase, knowledge about how to produce the product is
widespread and manufacturing has become straightforward. Early in the
product’s evolution, production required specialized workers skilled in R&D
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and manufacturing. Once standardized, however, mass production is the
dominant activity and can be accomplished using cheaper inputs
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and low-cost labor. Production shifts to low-income countries where
competitors enjoy low-cost advantages and can economically serve export
markets worldwide. The country that invented the product eventually becomes
a net importer. It and other advanced economies become saturated with
imports of the good from developing economies. In effect, exporting the
product has caused its underlying technology to become widely known and
standardized around the world.
As an example, consider the evolution of television sets. The base technology
was invented in the United States, and U.S. firms began domestic production
of TV sets in the 1940s. U.S. sales grew rapidly for many years. However,
once TVs became a standardized product, production shifted to China,
Mexico, and other countries that offered lower-cost production. Today the
United States imports nearly all its TVs from such countries.
The IPLC illustrates that national advantages do not last forever. Firms
worldwide are continuously creating new products, and others are constantly
imitating them. The product cycle is continually beginning and ending. Vernon
assumed the product diffusion process occurs slowly enough to generate
temporary differences between countries in their access and use of new
technologies. This assumption is no longer valid today—the IPLC has become
much shorter as new products diffuse much more quickly around the world.
Buyers in emerging markets are particularly eager to adopt new technologies
as soon as they become available. This trend explains the rapid spread of new
consumer electronics such as digital assistants and mobile phones around the
world.
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New Trade Theory
Beginning in the 1970s, economists observed that trade was growing fastest
among industrialized countries with similar factors of production. In some new
industries, there appeared to be no clear comparative advantage. The solution
to this puzzle became known as new trade theory. It argues that increasing
returns to scale, especially economies of scale, are important for superior
international performance in industries that succeed best as their production
volume increases. For example, the commercial aircraft industry has high fixed
costs that necessitate high-volume sales to achieve profitability. As a nation
specializes in the production of such goods, productivity increases and unit
costs fall, providing significant benefits to the local economy.
Many national markets are small, and the domestic producer may not achieve
economies of scale because it cannot sell products in large volume. New trade
theory implies that firms can solve this problem by exporting, thereby gaining
access to the much larger global marketplace. Several industries achieve
minimally profitable economies of scale by selling their output in multiple
markets worldwide. The effect of increasing returns to scale allows the nation
to specialize in a smaller number of industries in which it may not necessarily
hold factor or comparative advantages. According to new trade theory, trade is
thus beneficial even for countries that produce only a limited variety of
products.
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How Can Nations Enhance Their
Competitive Advantage?
The globalization of markets has fostered a new type of competition—a race
among nations to reposition themselves as attractive for business and
investment. The most advantaged nations today possess national competitive
advantage, maximized when numerous industries collectively possess firmlevel competitive advantages and the nation itself has comparative
advantages that benefit those particular industries. This notion is illustrated in
Exhibit 6.5
.
Many governments create policies designed to encourage competitive
advantage, often by developing world-class economic sectors and prosperous
geographic regions. These policies aim to assist firms to develop acquired
advantages.
Contemporary Theories
Three key modern perspectives that help explain the development of national
competitive advantage are the competitive advantage of nations, the
determinants of national competitive advantage, and national industrial policy.
The Competitive Advantage of Nations
Just as scholars recognized that international business is good for individual
nations, they increasingly sought to explain how nations can
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position themselves for international business success. An important
contribution came from Professor Michael Porter in his 1990 book, The
Competitive Advantage of Nations. 5 According to Porter, the competitive
advantage of a nation depends on the collective competitive advantages of the
nation’s firms. Over time, this relationship is reciprocal: The competitive
advantages held by the nation tend to drive the development of new firms and
industries with these same competitive advantages.
EXHIBIT 6.5 Comparative Advantage and Competitive Advantage
For example, Britain achieved a substantial national competitive advantage in
the prescription drug industry due to its first-rate pharmaceutical firms,
including GlaxoSmithKline and AstraZeneca. The United States has a national
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competitive advantage in service industries because of many leading firms,
such as Goldman Sachs (investment banking), Marsh & McLennan
(insurance), and Booz & Company (consulting). The presence of these and
numerous other strong services firms, in turn, has engendered overall national
competencies in the global services sector.
At both the firm and national levels, competitive advantage and technological
advances grow out of innovation.6 Companies innovate in various ways: They
develop new product designs, new production processes, new approaches to
marketing, new ways of organizing or training, and so forth. Firms sustain
innovation (and by extension, competitive advantage) by continually finding
better products, services, and ways of doing things.7 For example, Australia’s
Vix (www.vix-erg.com) is a world leader in fare collection equipment and
software systems for the transit industry. The firm has installed systems in
subways, bus networks, and other mass transit systems in major cities like
Melbourne, Rome, San Francisco, Stockholm, and Singapore. It has won
numerous awards for its innovative products, which have allowed the firm to
internationalize quickly. Vix’s investment in R&D has been significant, running
as high as 23 percent of the firm’s revenue.
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Innovation results primarily from research and development. Worldwide, more
scientists and engineers are engaged in R&D than ever before. Among the
industries most dependent on technological innovation are biotechnology,
information technology, new materials, pharmaceuticals, robotics, medical
equipment, fiber optics, and various electronics-based industries.
The management consultancy Booz & Company (www.booz.com) annually
reports on MNEs that spend the most on R&D, the Global Innovation 1000.
Most top European, Japanese, and U.S. firms spend half or more of their total
R&D in countries other than where they are headquartered. The firms do this
for several reasons:
• Gain access to talent—gifted engineers and scientists reside around the
world in countries like China and India.
• Cut costs by hiring lower-paid engineers and scientists abroad to replace
higher-paid personnel in the home country.
• Get closer to key markets, where they gain insights on specific
characteristics of target markets during the product development process.8
This explains why, in addition to low-cost emerging markets, Europe and
the United States are popular sites for R&D by foreign companies, as firms
seek to understand and create new products for the world’s most lucrative
markets.
The more innovative firms in a nation, the stronger the nation’s competitive
advantage. Innovation also promotes productivity, the value of the output
produced by a unit of labor or capital. The more productive a firm is, the more
efficiently it uses its resources. The more productive the firms in a nation are,
the more efficiently the nation uses its resources.9 At the national level,
productivity is a key determinant of the nation’s long-run standard of living and
a basic source of national per-capita income growth. Exhibit 6.6
depicts
productivity levels in various nations over time, measured as output per hour
of workers in manufacturing. In the early 1990s, South Korea was the least
productive of the nations shown. Over time, however, South Korea increased
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its productivity and now outshines the other nations. Since productivity is
measured as output per unit of labor or capital, a nation can increase its
productivity either by increasing its relative output or by reducing its input for a
given level of output.
EXHIBIT 6.6 Productivity Levels in Selected Countries: Output per Hour
in Manufacturing, 1990–2010, Index Scale, 2002 = 100
Source: Based on U.S. Department of Labor, Bureau of Labor Statistics, 2011, www.bls.gov.
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Determinants of National Competitive Advantage
As part of his explanation in The Competitive Advantage of Nations, Michael
Porter argued that competitive advantage at both the company and national
levels originates from the presence and quality in the country of four major
elements, which we review next.
1. Demand conditions refer to the nature of home-market demand for
specific products and services. The strength and sophistication of buyer
demand facilitates the development of competitive advantages in
particular industries. The presence of highly demanding customers
pressures firms to innovate faster and produce better products. For
example, an affluent, aging population in the United States inspired the
development of world-class healthcare companies such as Pfizer and
Eli Lilly in pharmaceuticals and Boston Scientific and Medtronic in
medical equipment.
2. Factor conditions describe the nation’s position in factors of production,
such as labor, natural resources, capital, technology, entrepreneurship,
and know-how. Consistent with factor proportions theory, each nation
has a relative abundance of certain factor endowments, a situation that
helps determine the nature of its national competitive advantage. For
example, Germany’s abundance of workers with strong engineering
skills has propelled the country to commanding heights in the global
engineering and design industries.
3. Related and supporting industries refer to the presence of clusters of
suppliers, competitors, and complementary firms that excel in particular
industries. The resulting business environment is highly supportive for
the founding of particular types of firms. Operating within a mass of
related and supporting industries provides advantages through
information and knowledge synergies, economies of scale and scope,
and access to appropriate or superior inputs.
4. Firm strategy, structure, and rivalry refer to the nature of domestic
rivalry and conditions in a nation that determine how firms are created,
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organized, and managed. The presence of strong competitors in a
nation helps create and maintain national competitive advantage. Japan
has one of the world’s most competitive consumer electronics
industries, with major players like Nintendo, NEC, Sharp, and Sony
producing semiconductors, computers, video games, and liquid crystal
displays. Vigorous competitive rivalry puts these firms under continual
pressure to innovate and improve. They compete not only for market
share, but also for human talent, technical leadership, and superior
product quality. Intense rivalry has pushed firms like Sony to a leading
position in the industry worldwide and allowed Japan to emerge as the
top country in consumer electronics.10
Country Realities
All else being equal, a nation’s productivity rises with an increase in
worker output, or through a decrease in the number of workers
producing a given level of output. One way to improve productivity
is to leverage technology. For example, productivity rises by
employing information technology (IT) to improve worker efficiency.
This helps explain why many countries are investing huge sums in
IT education and to improve national infrastructure in computer
systems and applications.
Industrial cluster
refers to a concentration of businesses, suppliers, and
supporting firms in the same industry at a particular geographic location,
characterized by a critical mass of human talent, capital, or other factor
endowments. Examples of industrial clusters include the fashion industry in
northern Italy; the pharmaceutical industry in Switzerland; the footwear
industry in Vietnam; the medical technology industry in Singapore; Wireless
Valley in Stockholm, Sweden; and the consumer electronics industry in Japan.
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Industrial cluster
A concentration of businesses, suppliers, and supporting firms
in the same industry at a particular location, characterized by
a critical mass of human talent, capital, or other factor
endowments.
Today, the most important sources of national advantage are the knowledge
and skills possessed by individual firms, industries, and countries. More than
any other factors, knowledge and skills determine where MNEs will locate
economic activity around the world. Silicon Valley, California, and Bangalore,
India, have emerged as leading-edge business clusters because of the
availability of specialized talent. These regions have little else going for them
in terms of natural industrial power. Their success derives from the knowledge
of the people employed there, so-called knowledge workers. Some even argue
that knowledge is now the only source of sustainable long-run competitive
advantage. If correct, then future national wealth will go to those countries that
invest the most in R&D, education, and infrastructure that support knowledgeintensive industries.
National Industrial Policy
Perhaps the greatest contribution of Porter’s work has been to underscore the
notion that national competitive advantage does not derive entirely from the
store of natural resources each country holds. Inherited national factor
endowments are relatively less important than in the past. Rather, as Porter
emphasized, countries can successfully create new
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advantages and develop factor conditions they deem important for their
success. The government can devote resources to improve national
infrastructure, education systems, and capital formation. In short, any country,
regardless of its initial circumstances, can attain economic prosperity by
systematically cultivating new and superior factor endowments.
Visionary national industrial policy is transforming Dubai into a high valueadding economy based on IT, biotechnology, financial services, and other
knowledge-intensive industries.
Source: Gavin Thomas/Dorling Kindersley Ltd.
Nations can develop these endowments through proactive national industrial
policy . Such a policy encourages economic development, often in
collaboration with the private sector, to develop or support high value-adding
industries that generate superior corporate profits, higher worker wages, and
tax revenues. Dubai pursued a national industrial policy to become an
international commercial center in the information and communications
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technology (ICT) sector. Historically, nations have favored more traditional
industries, including automobiles, shipbuilding, and heavy machinery—all with
long value chains that generate substantial added value. As the Dubai
example illustrates, successful nations increasingly favor high value-adding,
knowledge-intensive industries such as IT, biotechnology, medical technology,
and financial services. Not only do these industries provide substantial
revenues to the nation, they also lead to the development of supplier and
support companies that further enhance national prosperity. Singapore’s
Innovation Manifesto has propelled the city-state to becoming one of the most
technologically sophisticated countries in the world.
National industrial policy
A proactive economic development plan initiated by the
government, often in collaboration with the private sector, that
aims to develop or support particular industries within the
nation.
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National industrial policies designed to build new capabilities and
encourage the emergence of new industries typically include these
specifics:
• Tax incentives to encourage citizens to save and invest, which
provides capital for public and private investment in R&D, plant,
equipment, and worker skills
• Monetary and fiscal policies, such as low-interest loans, that
provide a stable supply of capital for company investment needs
• Rigorous educational systems at the precollege and university
levels that ensure a steady stream of competent workers who
support high technology or high value-adding industries in the
sciences, engineering, and business administration
• Development and maintenance of strong national infrastructure in
areas such as IT, communication systems, and transportation
• Creation of strong legal and regulatory systems to ensure that
citizens are confident about the soundness and stability of the
national economy11
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National Industrial Policy in Practice
How well does national industrial policy work in practice? Let’s examine New
Zealand and the outcomes of its repositioning, implemented through
collaboration between the nation’s public and private sectors. For much of the
early twentieth century, government policies had limited New Zealand’s ability
to flourish and trade with the rest of the world. Living standards were low and
many wondered whether New Zealand had a future. Then, in the 1980s, the
New Zealand government undertook pro-trade policies in cooperation with the
private sector that resulted in national advantages, helping New Zealand’s
economy grow rapidly and achieve high living standards. The
accomplishments are summarized in Exhibit 6.7 . Between 1992 and 2012,
New Zealand raised its per-capita GDP from 51 percent to 89 percent of the
average of the G7 countries, the world’s seven largest advanced economies.
This represents an improvement of about 75 percent in real terms of personal
income. During the
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period, New Zealand’s unemployment rate declined by almost half, to 5.6
percent. The government reduced its national debt as a proportion of GDP
from 89 to 30 percent, giving the nation a solid financial foundation. New
Zealand’s per-capita GDP dipped during the global recession but stabilized in
2012 to more than $40,000, among the highest in the world.
EXHIBIT 6.7 Transformation of New Zealand’s Economy, 1992 to 2012
Following many years of poor economic performance, the government of New
Zealand implemented various national industrial policies that succeeded in
elevating several key economic indicators, thus raising living standards for the
New Zealand people.
Source: adam.golabek
Beginning in the 1980s, New Zealand’s government systematically
transformed the country from an agrarian, protectionist, regulated economy to
an industrialized, free-market economy that competes globally. New Zealand’s
success resulted from a combination of factors:
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• Government-controlled wages, prices, and interest rates were freed and
allowed to fluctuate according to market forces.
• The banking sector was liberalized, foreign exchange controls were
eliminated, and the New Zealand dollar was allowed to float according to
market forces.
• Most trade barriers were removed and New Zealand joined several freetrade agreements.
• Subsidies formerly granted to agriculture and other sectors were
eliminated.
• The government worked earnestly with labor unions to reduce wage
inflation, helping to ensure that jobs remained in New Zealand and not
outsourced to lower-wage countries.
• The government initiated programs to encourage development of a
knowledge economy. New Zealanders continuously upgraded skills and
knowledge, providing a supply of scientists, engineers, and trained
managers.12
• Personal and corporate income tax rates were reduced, and the tax base
was diversified to stabilize government revenues. The move helped to
foster entrepreneurship, boosted consumer spending, and increased the
nation’s attractiveness for investment from abroad.
• The government cut spending and borrowing, leading to lower interest
rates and stimulating the economy.
• State-owned enterprises—such as the national airline, post office, telecom,
and other utilities—were sold off to the private sector.13
Dynamic growth boosted real incomes and greatly improved living standards
in New Zealand. Recently, Forbes magazine and the World Bank ranked New
Zealand as the second most business friendly country in the world.14 Marketoriented policies helped make New Zealand an important economy and a
major player in world trade, dramatically raising living standards for its citizens.
Read the Global Trend feature for more examples of proactive nation
repositioning to create new comparative advantages.
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Global Trend
Moving from Comparative to National Competitive Advantages
The principle of comparative advantage and factor endowment theory
imply that nations should nurture industries that use inputs inherent or
abundant in their environment. Today, however, numerous countries with
few natural or other resources have created their own competitive
advantages through skillful application of national industrial policies. In
most cases, these acquired advantages have become more critical than
natural endowments. Here are some examples:
Singapore is a free-market economy with high per-capita GDP. Beginning
in the 1960s, the government adopted probusiness, pro-investment,
export-oriented policies, combined with state-directed investments in
strategic corporations. The approach stimulated economic growth that
averaged 8 percent from 1960 to 1999. Singapore cut taxes and
government spending and encouraged massive inward investment in
high-value industries such as electronics, engineering, and chemicals.
The country boasts a highly educated labor force, state-of-the-art
telecommunications facilities, and excellent infrastructure—its airport and
seaport are among the best in the world.
In the past two decades, Ireland lowered the basic corporate tax rate to
zero, initiated earnest dialogue with labor unions, and emphasized high
value-adding industries such as pharmaceuticals, biochemistry, and
information technology. The country invested heavily in education,
providing a steady supply of skilled workers, including scientists,
engineers, and business school graduates. Attracted by these
developments, foreign MNEs began investing in the country. Ireland
became a major player in world trade and now hosts some 1,000 foreign
firms. International trade, inward FDI, and economic development
dramatically raised living standards for its citizens.
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Bangalore is India’s third largest city and a center of information
technology and business support services. Cooperating with private
interests, India reduced restrictions on trade and investment, resulting in a
big influx of foreign FDI. The public-private partnership also emphasized
high-value industries such as biotechnology and business consulting and
capitalized on Bangalore’s large, well-educated, English-speaking
workforce.
In the Czech Republic, economic reforms and exports to the European
Union (EU) led to economic prosperity. The Czech government
harmonized its laws and regulations with those of the EU by reforming its
judicial system, financial markets regulation, intellectual property rights
protection, and other areas important to investors. It also privatized stateowned companies. Government FDI incentives attracted firms like Toyota,
ING, Siemens, Daewoo, DHL, and South African Breweries.
Vietnam’s government privatized state enterprises and modernized the
economy, emphasizing competitive, exportdriven industries. It ramped up
the country’s exports of everything from shoes to ships, modernized its
intellectual property regime, entered several free-trade agreements, and
revamped its educational system to provide a constant stream of skilled
workers. The government also built infrastructure, including roads,
railways, and power stations. Reforms have attracted much inward FDI
from firms like Intel. The national savings rate increased several-fold.
Economic repositioning dramatically reduced Vietnam’s poverty rate.
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Global Trend
Moving from Comparative to National Competitive Advantages
The principle of comparative advantage and factor endowment theory
imply that nations should nurture industries that use inputs inherent or
abundant in their environment. Today, however, numerous countries with
few natural or other resources have created their own competitive
advantages through skillful application of national industrial policies. In
most cases, these acquired advantages have become more critical than
natural endowments. Here are some examples:
Singapore is a free-market economy with high per-capita GDP. Beginning
in the 1960s, the government adopted probusiness, pro-investment,
export-oriented policies, combined with state-directed investments in
strategic corporations. The approach stimulated economic growth that
averaged 8 percent from 1960 to 1999. Singapore cut taxes and
government spending and encouraged massive inward investment in
high-value industries such as electronics, engineering, and chemicals.
The country boasts a highly educated labor force, state-of-the-art
telecommunications facilities, and excellent infrastructure—its airport and
seaport are among the best in the world.
In the past two decades, Ireland lowered the basic corporate tax rate to
zero, initiated earnest dialogue with labor unions, and emphasized high
value-adding industries such as pharmaceuticals, biochemistry, and
information technology. The country invested heavily in education,
providing a steady supply of skilled workers, including scientists,
engineers, and business school graduates. Attracted by these
developments, foreign MNEs began investing in the country. Ireland
became a major player in world trade and now hosts some 1,000 foreign
firms. International trade, inward FDI, and economic development
dramatically raised living standards for its citizens.
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Bangalore is India’s third largest city and a center of information
technology and business support services. Cooperating with private
interests, India reduced restrictions on trade and investment, resulting in a
big influx of foreign FDI. The public-private partnership also emphasized
high-value industries such as biotechnology and business consulting and
capitalized on Bangalore’s large, well-educated, English-speaking
workforce.
In the Czech Republic, economic reforms and exports to the European
Union (EU) led to economic prosperity. The Czech government
harmonized its laws and regulations with those of the EU by reforming its
judicial system, financial markets regulation, intellectual property rights
protection, and other areas important to investors. It also privatized stateowned companies. Government FDI incentives attracted firms like Toyota,
ING, Siemens, Daewoo, DHL, and South African Breweries.
Vietnam’s government privatized state enterprises and modernized the
economy, emphasizing competitive, exportdriven industries. It ramped up
the country’s exports of everything from shoes to ships, modernized its
intellectual property regime, entered several free-trade agreements, and
revamped its educational system to provide a constant stream of skilled
workers. The government also built infrastructure, including roads,
railways, and power stations. Reforms have attracted much inward FDI
from firms like Intel. The national savings rate increased several-fold.
Economic repositioning dramatically reduced Vietnam’s poverty rate.
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Why and How Do Firms Internationalize?
Company Internationalization
Earlier theories of international trade focused on why and how cross-national
business occurs. However, in the 1960s scholars began to develop theories
about the managerial and organizational aspects of firm internationalization.
Internationalization Process of the Firm
Scholars developed the internationalization process model in the 1970s to
describe how companies expand abroad. According to this model,
internationalization takes place in incremental stages over a long time.15
Typically, firms start without much analysis or planning and begin to export,
the simplest form of international activity, and progress to FDI, the most
complex. The gradual and incremental nature of internationalization often
results from managers’ uncertainty and uneasiness about how to proceed,
because they lack information about foreign markets and experience with
cross-border transactions.
EXHIBIT 6.8 Stages in the Internationalization Process of the Firm
The model is illustrated in Exhibit 6.8
. A firm starts out in a domestic focus
phase and is preoccupied with business in its home market. Management may
be unable or unwilling to get
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started in international business because of concerns over its readiness or
perceived obstacles in foreign markets. Eventually, the firm advances to the
pre-export stage, often because it receives unsolicited product orders from
abroad. In this stage, management investigates the feasibility of undertaking
international business. Subsequently, the firm advances to the experimental
involvement stage by initiating limited international activity, typically in the form
of basic exporting. As managers begin to view foreign expansion more
favorably, they undertake active involvement in international business through
systematic exploration of international options and the commitment of
managerial time and resources to achieving international success. Ultimately
management may advance to the committed involvement stage, characterized
by genuine interest and commitment of resources to making international
business a key part of the firm’s profit-making and value-chain activities. In this
stage, the firm targets numerous foreign markets via various entry modes,
especially FDI.16
To illustrate, let’s examine of the consumer electronics firm Sony Corporation,
founded in Japan in 1946 (www.sony.com). In the 1950s, Sony began
exporting transistor radios and other products to Australia, Europe, and North
America. In the 1960s, it entered joint ventures with various partners abroad,
including CBS and Texas Instruments. Around the same time, Sony used FDI
to establish sales offices in Hong Kong, Switzerland, and the United States.
Later, the firm set up factories in numerous countries to manufacture
consumer electronics. Sony established its first television factory in the United
States in San Diego in 1972. Today it has joint ventures and wholly owned
operations in hundreds of locations worldwide, including five R&D centers and
nine plants in Europe that produce computers, game consoles, personal
navigation devices, and portable audio players. Sony’s experience illustrates
the internationalization process well.17
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Born Globals and International Entrepreneurship
Because international business has long been the domain of large, resourcerich MNEs, earlier theories tended to focus on them. Today scholars question
the slow and gradual process proposed by the internationalization process
model.18 Despite the scarcity of financial, human, and tangible resources that
characterize most new businesses, born global firms are young companies
that internationalize early in their evolution. Among the reasons are the
growing intensity of international competition, the integration of world
economies under globalization, and advances in communication and
transportation technologies that reduce the cost of venturing abroad and make
it easier to internationalize earlier and faster than ever before. The born global
phenomenon has given rise to a new field of scholarly inquiry, international
entrepreneurship.19 Current trends suggest that early internationalizing firms
will gradually become the norm in international business.
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How Can Internationalizing Firms Gain
and Sustain Competitive Advantage?
So far we have focused on the internationalization processes of individual
firms, including smaller firms or those new to international business. Since the
1950s, MNEs such as Nestlé, Unilever, Sony, Coca-Cola, and Caterpillar have
expanded abroad on a massive scale, shaping international patterns of trade,
investment, and technology flows. Over time, the aggregate activities of these
firms became a key driving force of globalization and ongoing integration of
world economies. So important is the rise of the MNE that it ranks with the
development of electric power or the invention of the aircraft as one of the
major events of modern history. Let’s examine MNEs and their
internationalization processes in more detail.
FDI-Based Explanations
Most explanations of international business have emphasized FDI, the
preferred entry strategy of MNEs, those large, resource-rich companies whose
business activities are performed via networks of production facilities,
marketing subsidiaries, regional headquarters, and other operations
established worldwide. For example, Sony has 170,000 employees and
hundreds of subsidiaries and affiliates worldwide that perform a wide range of
value-chain activities. Although headquartered in Tokyo, Japan accounts for
only a quarter of Sony’s roughly $90 billion in global sales.
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Sony exemplifies the borderless MNE that locates its activities wherever it can
maximize competitive advantages. One way to illustrate the huge volume of
FDI is to examine FDI stock, which describes the total value of assets that
MNEs own abroad via their investment activities. Exhibit 6.9
shows the
stock and growth of inward FDI from 2000 to 2010, for a group of leading FDI
destination countries. The exhibit highlights three interesting points. First, even
smaller economies such as Belgium and Ireland are popular destinations for
firms’ FDI. Second, both advanced economies and emerging markets are
major recipients of FDI. Third, the stock of FDI in emerging markets such as
India, Russia, and Saudi Arabia grew very rapidly in the decade through 2010,
reflecting their growing importance as target markets and production centers.
Historically, most of the world’s FDI was invested both by and in Western
Europe, the United States, and Japan. But emerging markets now account for
a huge proportion of global FDI. Unfortunately, Africa receives relatively little,
which hinders the ability to raise living standards in the region.20
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EXHIBIT 6.9 Stock of Inward FDI: Leading FDI Destinations (Billions of
U.S. dollars) and Percentage Growth, 2000 to 2010
Sources: Based on UNCTAD, World Investment Report 2011 (New York: United Nations, 2011, p. 191, “Annex table I.2.
FDI stock, by region and economy, 1990, 2000, 2010”), accessed January 29, 2012 at
http://www.unctad.org/templates/WebFlyer.asp?intItemID=6018&lang=1.
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EXHIBIT 6.10 Stock of Outward FDI: Top Sources of Outward FDI
(Billions of U.S. dollars) and Percentage Growth, 2000 to 2010
Sources: Based on UNCTAD, World Investment Report 2011 (New York: United Nations, 2011, p. 191, “Annex table I.2.
FDI stock, by region and economy, 1990, 2000, 2010”), accessed January 29, 2012 at
http://www.unctad.org/templates/WebFlyer.asp?intItemID=6018&lang=1.
Exhibit 6.10
shows the stock and growth of outward FDI for a collection of
the leading FDI-providing countries. MNEs invest billions abroad every year to
establish and expand factories and other facilities. Note that firms from both
advanced economies and emerging markets invest substantial FDI abroad.
Emerging markets such as China, India, and Russia have greatly increased
their FDI investments in recent years. Total outward FDI stock now constitutes
nearly one-third of global GDP, a huge amount.21
FDI is such an important entry strategy that scholars have developed three
alternative theories of how firms can use it to gain and sustain competitive
advantage: the monopolistic advantage theory, internalization theory, and
Dunning’s eclectic paradigm. These theoretical perspectives are summarized
in Exhibit 6.11
and described in the following sections.
Monopolistic Advantage Theory
A monopolistic advantage is a valuable resource that a company holds and
leverages to generate profits, and which few other firms have. According to
monopolistic advantage theory, companies that internationalize through FDI
are more likely to succeed if they own or control certain advantages that
foreign competitors do not generally possess. When this occurs, the
advantaged firm has a degree of monopoly power that helps it
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compete more effectively abroad. This monopolistic advantage should be
specific to the MNE itself, such as a proprietary technology or a brand name,
rather than to the locations where it does business. This theory argues that at
least two conditions should be present for a firm to prefer targeting a foreign
market rather than its home market. First, returns obtainable in the foreign
market should be superior to those available in the home market. This would
provide the firm with incentives to expand abroad to take advantage of its
monopoly power. Second, returns obtainable in the foreign market should be
superior to those earned by its domestic competitors in its industry in the
foreign market. This would give the firm an opportunity to make monopoly
profits that domestic companies in the foreign market cannot imitate.
EXHIBIT 6.11 Theoretical Perspectives on Why Firms Choose FDI
To illustrate, let’s revisit Sony Corporation. By being on the leading edge of
innovation, Sony established numerous pioneering standards in the consumer
electronics industry.
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Over the course of several decades, Sony’s superior R&D and internal control
mechanisms allowed the firm to acquire and maintain a large body of relatively
unique knowledge. This unique knowledge provided the firm with various
monopolistic advantages. Sony invented numerous popular products that
were, for a time at least, relatively unique. Continuous innovation within the
firm allowed Sony to maintain this uniqueness for many years. Sony used its
superior innovativeness to develop monopoly power and dominate world
markets in such products as the PlayStation and Blu-ray disc format. As the
Sony example implies, the most important monopolistic advantages are
superior knowledge and intangible skills. Superior, proprietary knowledge has
allowed Sony to create differentiated products that provide unique value to
customers.22
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Internalization Theory
Numerous scholars have investigated the specific benefits that MNEs derive
from FDI-based entry. For example, when Procter & Gamble entered Japan,
management initially considered exporting and FDI. With exporting, P&G
would have had to contract with an independent Japanese distributor to
handle warehousing and marketing of its soap, diapers, and other products.
However, because of trade barriers imposed by the Japanese government, the
strong market power of local Japanese firms, and the risk of losing control
over its proprietary knowledge, P&G chose instead to enter Japan via FDI. It
established its own marketing subsidiary and, eventually, national
headquarters in Tokyo. This arrangement provided various benefits P&G
would not have received had it entered Japan by contracting with Japanese
distributors it did not own.
Internalization theory
explains the process by which firms acquire and
retain one or more value-chain activities inside the firm, as P&G did in Japan.
Internalizing value-chain activities helps minimize the disadvantages of dealing
with external partners for performing arms-length activities such as exporting
and licensing. Internalization also gives the firm greater control over its foreign
operations.
Internalization theory
An explanation of the process by which firms acquire and
retain one or more value-chain activities inside the firm,
minimizing the disadvantages of dealing with external partners
and allowing for greater control over foreign operations.
For example, the MNE might internalize the supplier function by acquiring or
establishing its own plant in the foreign market to produce needed inputs itself
instead of buying them from a foreign, independent supplier. Or it might
internalize the marketing function by establishing its own distribution
subsidiary abroad, instead of contracting with an independent foreign
distributor to handle its marketing in the foreign market. The MNE is ultimately
a vehicle for bypassing the bottlenecks and costs of the international, inter-firm
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exchange of goods, materials, and workers. In this way, the firm replaces
business activities performed by independent suppliers in external markets
with business activities it performs itself.
In the 1950s, for example, Sony followed a policy of exporting its products to
Europe and North America. However, management soon realized it could
accelerate and improve the performance of international operations by
creating its own sales and production facilities in strategic markets abroad.
Thus, in the 1960s, Sony internalized much of its global production and
distribution channels by establishing company-owned subsidiaries in Europe,
the United States, and other key markets. To ensure product quality, Sony
internalized production of semiconductors and circuit boards for use in making
cell phones and PlayStations. Recently, Sony transferred production of
camcorders from a plant run by a joint venture partner in China to a wholly
owned Sony plant in Japan. The move allowed Sony to improve supply-chain
management and manufacturing of camcorders.
In addition to consumer electronics, Sony has long been a major player in the
movie industry, through its subsidiary Sony Pictures Entertainment (SPE).
Acquiring the Loews chain of movie theaters in the United States allowed SPE
to internalize a substantial portion of the distribution channel for its film
business, ensuring its movies would be supplied to thousands of movie
screens. Since its founding, Sony has consistently internalized key units to
maintain control over the most important links in its global value chains.
Another key reason companies internalize certain value-chain functions is to
control proprietary knowledge critical to the development, production, and sale
of their products and services. Because independent foreign companies are
outside the MNE’s direct control, they can acquire and use the knowledge to
their own advantage, perhaps becoming competitors in the process. FDI
allows the MNE to control and optimally use its knowledge in foreign
markets.23
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Dunning’s Eclectic Paradigm
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Dunning’s Eclectic Paradigm
Professor John Dunning proposed the eclectic paradigm as a framework for
determining the extent and pattern of the value-chain operations that
companies own abroad. He drew from various theoretical perspectives,
including comparative advantage, factor proportions, monopolistic advantage,
and internalization advantage. Thus, the eclectic paradigm is often viewed as
the most comprehensive of FDI theories. The eclectic paradigm specifies three
conditions that determine whether a company will internationalize via FDI:
ownership-specific advantages, location-specific advantages, and
internalization advantages.
To successfully enter and conduct business in a foreign market, the MNE must
possess ownership-specific advantages relative to other firms already doing
business in the market. That is, it should hold knowledge, skills, capabilities,
key relationships, and other assets that allow it to compete effectively in
foreign markets. These assets amount to the firm’s competitive advantages.
To ensure international success, the advantages must be substantial enough
to offset the costs the firm incurs in establishing and operating foreign
operations. The advantages should also be specific to the MNE that
possesses them and not readily transferable to other firms, such as proprietary
technology, managerial skills, trademarks or brand names, economies of
scale, and access to substantial financial resources. The more valuable the
firm’s ownership-specific advantages, the more likely it is to internationalize via
FDI.24
Let’s use Alcoa, the Aluminum Corporation of America (www.alcoa.com), to
illustrate. Alcoa has 60,000 employees in thirty-five countries. The company’s
integrated operations include bauxite mining and aluminum refining. Its
products include primary aluminum (which it refines from bauxite), automotive
components, and sheet aluminum for beverage cans and Reynolds Wrap®.
One of Alcoa’s most important ownership-specific advantages is the
proprietary technology it has acquired through its R&D activities. It has also
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acquired special managerial and marketing skills in the production and
marketing of refined aluminum. The firm has a well-known brand name that
helps increase sales. As a large firm, Alcoa also profits from economies of
scale and the ability to finance expensive projects. These advantages have
allowed Alcoa to generate maximal profits from its international operations.
The second condition that determines whether a firm will internationalize via
FDI is the presence of location-specific advantages, the comparative
advantages available in individual foreign countries, such as natural
resources, skilled labor, low-cost labor, and inexpensive capital. For example,
Alcoa located refineries in Brazil because of that country’s huge deposits of
bauxite, a mineral found in relatively few other locations worldwide. The
Amazon and other major rivers in Brazil generate huge amounts of
hydroelectric power, a critical ingredient in electricity-intensive aluminum
refining. Alcoa also benefits from Brazil’s low-cost, relatively well-educated
laborers who work in the firm’s refineries. The presence of these locationspecific advantages helped persuade Alcoa to locate in Brazil through FD...
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