69

CHAPTER 5
International Trade and Investment
Theory
After studying this chapter, students should be able to:

> Understand the motivation for international trade.

> Summarize and discuss the differences among the classical country-based
theories of international trade.
> Use the modern, firm-based theories of international trade to describe global
strategies adopted by businesses.
> Describe and categorize the different forms of international investment.
> Explain the reasons for foreign direct investment.
> Summarize how supply, demand, and political factors influence foreign direct
investment.

LECTURE OUTLINE

OPENING CASE: Caterpillar: Making Money By Moving Mountains

The opening case describes the operations of a truly international firm, Caterpillar. The
company is involved in many forms of international business, including both
international trade and international investment.

Key Points

• The world’s largest producer of heavy earth-moving and construction

equipment, Caterpillar is a complex international firm that has a 30% share of the
global market.

• The company’s operations are spread over five continents, more than a quarter
of its employees work outside of the U.S., and nearly half of its output in 1996 was
purchased by foreign customers.

• The two competitive advantages that have enabled Caterpillar to attain its
position in the market are a commitment to quality and a worldwide network of
dealers who sell and service the company’s products.
70 > Chapter 5

• Caterpillar is both an importer and an exporter, an international investor and

borrower, and it is involved in international licensing and franchising agreements.

• In spite of Caterpillar’s international position, it faces strong competitive

challenges from rival firms, particularly Japan’s Komatsu (see the closing case for
more information on Komatsu), and pressures from its labor force.

Case Questions

1. How has Caterpillar’s position as a global company contributed to its competitive

advantage?

Some students will argue that Caterpillar has attained its position in the global
market place because of its competitive advantage, while other students will
suggest that its position as a leader in the market makes its competitive advantages
possible. However, whether one takes the position that the chicken came before
the egg, or the egg before the chicken, there should be agreement that there is
definitely an association between Caterpillar’s market position and its competitive
advantages. The primary link appears to be that because it has an extensive
international dealer network the company has the capability to provide outstanding
customer service both before and after purchase, and its commitment to quality has
helped Caterpillar build a strong reputation around the world.

2. In the face of strong competition, how can Caterpillar maintain its position as a
leader in the earth moving and construction equipment industry?

Caterpillar is already making important changes in its operations to face the

challenge of an increasingly competitive environment. It has invested in plant
modernization and new inventory control costs. The company hopes that these
measures will improve manufacturing quality and flexibility as well as cut inventory
costs. In addition, the company is working with its suppliers to improve the quality
of inputs and has struggled to reduce labor costs.

Additional Case Application

Caterpillar is an interesting case study because the company is so involved in
international business. It is involved not only in international trade and investment,
but also international licensing and franchising. Students can be asked to debate
the merits of such an extensive involvement in the international market place, and in
particular consider the opportunities and threats Caterpillar has as a result of its
position as a global company, and what opportunities and threats face a company
that is not as involved in the international marketplace.

CHAPTER SUMMARY

Chapter Five examines the underlying economic forces that shape and structure the
international business transactions of firms. It discusses the major theories that explain
and predict trade and investment.
 International Trade and Investment Theory > 71

I. INTERNATIONAL TRADE AND THE WORLD ECONOMY

• Trade involves the voluntary exchange of goods, services, or money between

one person or organization and another. International trade is trade between
residents (individuals, businesses, nonprofit organizations or other associations) of
two countries.
• International trade takes place when both parties to a transaction believe that
they will benefit from such a transaction.
• In 1999, total international trade amounted to $5.6 trillion, or approximately 19
percent of the world’s $30 trillion gross domestic product. More than two thirds of
the trade took place among the U.S., Canada, the European Union, and Japan.
Display Figure 5.1 and Figure 5.2 here.

II. CLASSICAL COUNTRY-BASED TRADE THEORIES

Mercantilism

• Mercantilism was a sixteenth-century economic philosophy that held that a

nation’s wealth is measured by its stock of precious metals (gold and silver).
According to the theory, nations should try to enlarge their silver and gold holdings
by maximizing the difference between exports and imports through a policy that
encourages exports and discourages imports. This policy would have the effect of
enabling a country to become ever richer.
• The philosophy was popular to some because it enabled a country to expand its
borders, because export oriented manufacturers benefited from policies such as
subsidies and tax breaks that encouraged exports and because domestic
manufacturers were protected from imports.
• Most members of society do not benefit from mercantilism, however.
Taxpayers, for example, must pay for the subsidies and tax breaks offered to
exporting firms, and customers may pay higher prices for products when domestic
firms are protected from foreign competition.
• Mercantilism, because it does benefit certain members of society, still exists
today in the form of policies to restrict imports or promote exports. Supporters of
such policies are called neo-mercantilists or protectionists. Most nations in the
world have adopted some neo-mercantilist policies to protect key industries.

Absolute Advantage

• Adam Smith criticized the mercantilist philosophy, arguing that it confused the
acquisition of treasure with the acquisition of wealth. He further pointed out that
mercantilism actually weakened a nation because it forces a country to produce
products that it is not very good at producing, and in doing so does not maximize
the wealth of its citizens.
• Smith proposed that free trade between nations would actually enlarge the
wealth of countries because it would allow a country to specialize in the production
of products that it is good at producing and trade for other products.
• Smith’s theory of absolute advantage states that a nation should produce
those goods and services that it can produce more cheaply than other countries.
The country should then trade for goods and services it is not good at producing.
The theory is demonstrated numerically in the text using Table 5.1.
72 > Chapter 5

Comparative Advantage

• The major difficulty with the theory of absolute advantage is that it suggests that
if one country has an absolute advantage in the production of both goods, no trade
will occur. David Ricardo solved this problem by developing the theory of
comparative advantage which states that a country should produce and export
those goods and services in which it has a relative production advantage and
import those goods and services in which other nations are relatively more
productive.
• The difference between the theory of comparative advantage and the theory of
absolute advantage is that the latter looks at absolute differences in productivity,
while the former looks at relative productivity differences. Comparative advantage
uses the concept of opportunity cost (the value of that which is given up in order
to get the good) in determining which good should be produced. The theory is
demonstrated numerically in the text using Table 5.2.

Discuss Bringing the World into Focus: The Lincoln

Fallacy
Abraham Lincoln once said, "I know this much. When we buy
manufactured goods abroad, we get the goods and the
foreigner gets the money. When we buy manufactured goods at home, we get both
the goods and the money." Lincoln's view is incorrect because it is incomplete.
When we buy goods from abroad, foreign resources are used, leaving the domestic
resources that would have been used in production at home free to be used to
make something else. By specializing and trading, rather than producing everything
ourselves, we channel production to the most efficient producers thereby
generating overall more goods and services for everyone to consume.

Comparative Advantage with Money

• The lesson of the principle of comparative advantage is: you’re better off
specializing in what you do relatively best. Produce (and sell) those goods and
services at which you’re relatively best, and buy other goods and services from
people who are relatively better at producing them than you are.
• The theory is limited in that the world economy produces more than two goods
and services and is made up of more than two nations. Furthermore, barriers to
trade, distribution costs and inputs other than labor must be considered. Even
more important, the world economy uses money as a medium of exchange. The
text provides a demonstration of comparative advantage with money. Use Table 5.3
here.
• It should be noted that in the example with money, people made their decisions
to import and export based on price differences, not because they were following
the theory of comparative advantage. However, prices set in a free market will
reflect the comparative advantage of a nation.
 International Trade and Investment Theory > 73

Relative Factor Endowments

• Hecksher and Ohlin developed the theory of relative factor endowments to

answer the questions of what determines the products for which a country will have
a comparative advantage in the first place. The theory proposes that factor
endowments (or types of resources) vary among countries. Further, goods vary in
the types of factors that are used to produce them. Therefore, a country will have a
comparative advantage in producing a product which intensively uses resources
that the country has in abundance. The text provides an example of the theory
using wheat, oil, and clothing.
• Leontief tested the Hecksher-Ohlin theory using the United States as the unit of
analysis. Leontief, believing the United States to be a capital-intensive, labor-
scarce country, reasoned that the country would export capital-intensive goods and
import labor-intensive goods. However, he found that exactly the reverse was true.
Leontief’s findings have come to be known as the Leontief paradox. Display Figure
5.2 here.
• There have been numerous attempts to explain Leontief’s findings. Some
economists have suggested that Leontief’s work is flawed by measurement
problems. His work assumes there are only two factors of production, labor and
capital, and ignores other factors such as land, human capital, and technology.
This assumption may have caused Leontief to mismeasure the amount of labor that
goes into products the United States imports and exports.

III. MODERN FIRM-BASED TRADE THEORIES

Firm-based theories have developed for several reasons including: the growing
importance of multinational corporations in the postwar international economy; the
inability of the country-based theories to explain and predict the existence and growth
of intraindustry trade; and the failure of researchers like Leontief to empirically validate
the country-based Hecksher-Ohlin theory. In addition, firm-based theories incorporate
factors such as quality, technology, brand names and customer loyalty.

Country Similarity Theory

• Country-level theories explain interindustry trade among nations. Interindustry

trade is the exchange of goods produced by one industry for goods produced in
another industry. Country-level theories do not explain intraindustry trade, in
which two countries exchange goods produced in the same industry.
• Linder developed a theory to explain intraindustry trade that suggests that
international trade in manufactured goods is caused by similarities of preferences
among consumers in countries at the same stage of economic development. The
theory proposes that although firms originally develop products to sell to their
domestic markets, when they begin to export, they realize that the best markets are
in countries where consumer preferences are similar to those in their own domestic
market.
• The text provides an example of the theory using the automobile industry. The
theory is particularly good at explaining trade in differentiated goods.
74 > Chapter 5

Product Life Cycle Theory

Teaching Note:
Instructors may find that students “zone out” when
discussion of the product life cycle theory begins. Many
students believe that the product life cycle theory in international business is the
same one they learned about in their introductory marketing courses. It may be
worthwhile to alert students to the differences.

• The international product life cycle theory, developed by Vernon, consists of

three stages. In the first stage (the new product stage), a company develops and
introduces an innovative product in response to a perceived need in the local
market. Initially, the company must closely monitor whether the product indeed
satisfied customer needs, and so typically, the product is introduced in the country
where the product was developed. In addition, because the firm is initially likely to
minimize its manufacturing investment, most output is sold in the domestic market.
Display Figure 5.3 here.
• Demand for the product expands dramatically as the product moves into the
second stage (maturing product) and customers recognize its value. The
innovating firm expands its capacity and begins to consider exporting to other
markets. Competitors, domestic and foreign, begin to emerge.
• The market stabilizes in the third stage (standardized product) as the product
becomes more of a commodity. Price becomes an issue, and the company
considers shifting production to a country where labor costs are low. At this point,
the innovating country begins to import the product.
• The text provides an example of a product, the personal computer, going
through the life cycle.

Global Strategic Rivalry Model

• Krugman and Lancaster have recently examined the impact of global strategic
rivalry between multinational firms on trade flows. This view argues that firms
struggle to develop some sustainable competitive advantage, which can then be
exploited to dominate the global market place. The theory focuses on the strategic
decisions firms make as they compete in the global marketplace.

Discuss Going Global: An Olympic-Sized Rivalry

This Going Global Box describes the competitive battle
between film producers Eastman Kodak and Fuji. Fuji recently
launched the offensive in Kodak’s home market by cutting film
prices by as much as 50%. As the text notes, according to the global strategic
rivalry model, Fuji’s strategy was appropriate. Kodak is now attempting to turn the
tables by attacking Fuji in the Japanese market. This Box fits in well with the
discussion of the global strategic rivalry model, as well as with Review Question 7.

• Firms can develop sustainable competitive advantages in several different

ways. First, intellectual property rights, such as trademarks, brand names,
patents, and copyrights, can give a firm an advantage over rivals. Second, firms
that make large investments in research and development may gain first-mover
advantages for goods that are R&D intensive. This advantage is magnified if a firm
has a large domestic marketplace because feedback from customers may be
 International Trade and Investment Theory > 75

quicker and richer. Third, firms that achieve economies of scale or scope gain a
competitive advantage over rivals. Economies of scale occur when a product’s
average costs decrease as the number of units produced increase. Economies of
scope occur when a firm’s average costs decrease as the number of different
products it sells increases. Finally, firms that successfully exploit the learning curve
gain firm specific advantages.

Porter’s National Competitive Advantage Model

• Porter has developed a theory of international trade called the diamond of

competitive advantage. The theory proposes that success in an industry is a
function of four characteristics: factor conditions; demand conditions; related and
supporting industries; and company strategy, structure, and rivalry. Figure 5.4
should be displayed here.
• Factor conditions refer to a nation’s endowment of factors of production.
Demand conditions refer to the existence of a large, sophisticated domestic
consumer base that stimulated the development and distribution of innovative
products. Related and supporting industries refer to the development of local
suppliers eager to meet an industry’s production, marketing, and distribution needs.
Company strategy, structure, and rivalry refer to the environment in which firms
compete.
• Porter also argues that firms’ international strategies and opportunities may be
affected by national policies.

Discuss Wiring the World: Nokia's Incredible

Transformation
Though it was founded in Finland in 1865, Nokia is one of the
world's "newest," most vibrant, and exciting big companies. Its
early success was consistent with the theory of comparative advantage
(manufacturing pulp and paper using local resources). In 1981 Nokia acquired 51
percent of the state-owned telecommunications company. Finland's heavily forested
and sparsely populated landscape forced Nokia to innovate in order to meet
Finland's difficult communication challenges. Its innovative successes in Finland
have contributed to Nokia's global success and continued innovations.

• Porter’s model combines the traditional country-level theories (and their focus
on factor endowments) with firm-level theories that focus on the actions of individual
companies. Further, he includes the role that nations play in creating an
environment that may or may not be conducive to a firm’s success.
• No single theory of international trade explains all trade between nations.
Classical, country-level theories are useful in explaining interindustry trade, while
firm-based theories are better at explaining intraindustry trade. Porter’s model
synthesizes many of the existing features of country-level and firm-based theories.

IV. OVERVIEW OF INTERNATIONAL INVESTMENT

International investment, in which residents of one country supply capital to a second

country, is another major form of international investment. Trade and investment may
be substitutes for one another, or they may be complementary.
Types of International Investments
76 > Chapter 5

• International investment can be divided into portfolio investment and foreign

direct investment (FDI) (see Chapter 1). The former represents passive holdings
of foreign stocks, bonds, or other financial assets that entail no active management
or control of the issuer of the securities by the foreign investor. The latter
represents acquisition of foreign assets for the purpose of control.
• FDI may take many forms including: purchases of existing assets in a foreign
country; new investments in plant, property and equipment; or participation in joint
ventures with a local partner. The text provides examples of each type of
investment.
• Controversy often surrounds FDI because while it may increase employment,
enhance productivity, and raise wage rates, it also raises concerns that control of
the national economy is being passed to foreigners.

The Growth of Foreign Direct Investment

• The past 30 years have seen a dramatic rise in foreign direct investment.
Current worldwide FDI is about $3.5 trillion.
• Most FDI occurs among the more developed countries. Discuss Table 5.4 here.

• The US has become a less important source of FDI, while the importance of
Japan and Germany has increased significantly.

Foreign Direct Investment in the United States

• Discuss Table 5.5 here.

• The United Kingdom has accounted for the greatest portion of FDI into the
United States.
• The countries listed by name in Table 5.5 (b) account for 62 percent of total FDI
from the United States. The high levels of FDI to Bermuda, the Bahamas, and other
small Caribbean islands relate to their role as offshore financial centers (discussed
in more detail in Chapter 7)
• Over the past decade outward FDI has remained larger than inward FDI for the
US, but both categories have more than doubled in size. Discuss Figure 5.6 here.

V. INTERNATIONAL INVESTMENT THEORIES

Ownership Advantages

• Researchers trying to explain why FDI occurs initially focused on the impact of
firm-specific (or monopolistic) advantages. They argued that a firm that owned
a superior technology, a well-known brand name, or economies of scale that
created a monopolistic advantage could clone its domestic advantage to penetrate
foreign markets. The text provides the example of Caterpillar and Komatsu, both of
which capitalized on proprietary technology and brand names to expand into other
markets.
• The difficulty with the ownership advantage theory is that it fails to explain why a
firm must use FDI to enter a foreign market (rather than exporting, for example), nor
does it explain why a firm should locate production facilities in a foreign country
(rather than licensing technology to foreign firms, or franchising a brand name).
 International Trade and Investment Theory > 77

Internalization Theory

• The answers to the questions outlined above were explored using

internalization theory. The theory suggests that FDI is more likely to occur (a firm
will internalize its operations) when the costs of negotiating, monitoring, and
enforcing a contract with a second firm are high.
• While internalization theory answers the question of why a firm should choose
FDI as a method for entering a foreign market, it fails to address the question of
whether there is a location advantage to producing outside the home country.

Dunning's Eclectic Theory

Dunning’s eclectic theory ties together location advantage, ownership advantage, and
internalization advantage. Dunning proposes that FDI will take place when three
conditions are satisfied.
• First, the firm must own some unique competitive advantage that overcomes the
disadvantages of competing with foreign firms in their own market (ownership
advantage).
• Second, it must be more profitable to undertake a business activity in a foreign
location than a domestic location (location advantage).
• Third, the firm must benefit from controlling the foreign business activity, rather
than hiring an independent local company to provide the service (internalization
advantage).

VI. FACTORS INFLUENCING FOREIGN DIRECT INVESTMENT

The decision to undertake FDI can be influenced by supply factors, demand factors,
and political factors. Display Table 5.6 here.

Supply Factors

• Supply-side considerations (a firm’s attempts to control its own costs of

production) may motivate FDI. Factors that are considered include production
costs, logistics, availability of natural resources, and access to key technology.
• Locating a factory, warehouse, or customer service center in a foreign location
may be more attractive from a production cost perspective than locating
operations domestically.
• When a company faces significant logistics costs, it may choose to produce its
product in a foreign location, rather than export it.
• The availability of natural resources may drive a firm to locate its operations
in a country rich in a particular resource. Discuss Map 5.1 here.
• Access to technology may encourage a firm to invest in an existing foreign
company rather than develop or reproduce an emerging technology.
78 > Chapter 5

Demand Factors

Investing in foreign markets can allow a firm to expand the potential demand for its
products. The demand related factors that firms consider include customer access,
marketing advantages, and customer mobility.
• A physical presence in a market is required for many types of businesses,
particularly service businesses. For example, since customer access is essential
to KFC’s business, it must locate outlets in other countries.
• The physical presence of a firm in another country can provide many marketing
advantages. For example, such a presence may enhance the visibility of a
company’s products in the host market. If production costs are lower in the foreign
market, the firm may be able to lower prices to host country consumers and
increase sales, and the company may be able to benefit from “buy local” attitudes.
Show Figure 5.7 here.
• FDI may also allow a firm to exploit competitive advantages (for example,
trademarks, brand names, and technology-based or experientially based
advantages) it already possesses.
• Firms may invest in another country in response to customer mobility. A
supplier firm may follow its buyer to another country so that it can continue to meet
its customers’ needs promptly and attentively.

Political Factors

FDI may be a logical choice for companies facing trade barriers that threaten to keep
their products out of a foreign market, or to take advantage of economic incentives
being offered by host governments.
• FDI is an effective way to avoid trade barriers. The text provides an example
of how the Japanese were able to successfully deal with trade barriers in the early
1980s and mid-1990s.
• Governments that are concerned with promoting the welfare of their citizens
may provide various economic development incentives to attract foreign
investors. Such incentives may include tax reductions or tax holidays, infrastructure
provisions, reductions in utility rates, worker training programs, and other subsidies.
CA

OS
SE

CL
IN
G

Home Field Disadvantage

The closing case describes the different scenarios facing a web start-up company in
Europe and a web start-up company in the U.S. It compares the obstacles facing
"Rent-a-Holiday" (a Belgian firm) with the obstacles facing "VacationSpot.com" (an
American firm) and concludes that it is very difficult for European firms to compete
successfully on the web against U.S. firms.
 International Trade and Investment Theory > 79

Key Points:

• Rent a Holiday and VacationSpot.com set up web based vacation rental

services at almost the same time.
• Rent a Holiday had trouble raising venture capital among European investors,
while venture capitalists were eager to pour money into VacationSpot.com.
• The American pool of workers skilled to run a web-based business was much
larger than the European pool. American workers were more interested in web-
based firms than European workers, who seemed to prefer their "big offices and big
cigars."
• In the end, VacationSpot acquired Rent a Holiday and now has extensive
vacation rental listings all over the world.

Case Questions

1. Porter's theory of national competitive advantage argues that characteristics of

individual nations shape the ability of firms to compete. What advantages did the
American entrepreneurs gain from their American location? Did they suffer any
disadvantages?

They were stronger on almost all points of Porter's diamond. There was a stronger
set of related and supporting industries; important factors (such as labor and
venture capital) were readily available; strategy, structure, and rivalry were all more
developed in the U.S.; and demand conditions -- the expectations of web shoppers
-- were higher in the U.S., leading VacationSpot.com to develop a better and more
sophisticated product (e.g., including online bookings) than its European
competitor. The only disadvantage that is clearly apparent in the case was
VacationSpot.com's limited access to European listings.

2. Did the European entrepreneurs gain from their European location? What
disadvantages did they suffer?

Their location allowed them to offer a wider array of European rentals. However,
they suffered from lack of venture capital, lack of trained workers, lack of traffic on
their web site, a less sophisticated product, and the resulting inability to earn a
commission on booked rentals.

3. What can European policymakers do to improve opportunities available to

dotcom start-up companies? What can U.S. policymakers do to encourage the
growth of such companies?

Many of the recommendations apply both to the U.S. and Europe. By improving
web related infrastructure, governments can improve national firms' competitiveness
in e-business. Infrastructure can range from making technical education more
readily available to promoting the installation of fiber optic cable. Tax regulation can
be approved to make investors more interested in providing venture capital.
Keeping regulation of e-business at a minimum will promote the entry of new firms
and increased competition.
80 > Chapter 5

VI

R
R

A
H
C
E

P
T
1. What is international trade? Why does it occur?

International trade is trade between the residents (individuals, businesses, nonprofit

organizations, or other forms of associations) of two countries. Trade involves the
voluntary exchange of goods, services, or money. International trade occurs because the
parties to the transaction believe that they benefit from the voluntary exchange.

2. How do the theories of absolute advantage and comparative advantage differ?

The difference between absolute advantage and comparative advantage is that the former
looks at absolute differences in productivity, while the latter looks at relative productivity
differences. The difference between the theories exists because comparative advantage
incorporates the concept of opportunity costs in determining which good should be
produced.

3. Why are Leontief’s findings called a paradox?

Leontief’s findings are called a paradox because his research results on the U.S. trade
position were not consistent with the intuitively correct Heckscher-Ohlin model, and were in
fact, exactly the reverse of what the model predicted.

4. How useful are country-based theories in explaining international trade?

The country-level theories are useful for explaining interindustry trade (trade in which
countries exchange goods produced in different industries) among nations; however, they
are not helpful in explaining intraindustry trade (trade in which countries exchange goods
produced in the same industry). The latter form of trade accounts for approximately 40% of
world trade, yet cannot be predicted by country-level theories.

5. How do interindustry and intraindustry trade differ?

The difference between interindustry trade and intraindustry trade is that the former
involves two countries exchanging goods produced in different industries (for example, the
exchange of British raincoats for American beer), while the latter involves two countries
exchanging goods produced in the same industry (for example, Ford exports American-
made cars to Japan, while Mazda exports Japanese-made cars to the U.S.)

6. Explain the impact of the product life cycle on international trade and international
investment.

The product life cycle impacts both international trade and international investment. In the
second stage of the product life cycle, exports become an important part of the innovating
firm’s strategy. Later, as the product enters the third stage of the cycle, the standardized
product phase, the company will shift production to low labor-cost countries in an effort to
control costs. At this point, the innovating country becomes an importer of the product.
Thus, the product life cycle involves both international trade and international investment.
 International Trade and Investment Theory > 81

7. What are the primary sources of the competitive advantages used by firms to compete in
international markets?

The primary sources of sustained competitive advantage used by firms to compete in

international markets include: (a) using intellectual property rights such as trademarks or
brand names to gain advantages over rivals; (b) capitalizing on first-mover advantages
gained by spending large sums on research and development; (c) achieving economies of
scale or scope, and the resulting lower average cost base to gain an advantage over the
competition and; (d) exploiting the learning curve.

8. What are the four elements of Porter’s diamond of national competitive advantage?

The four elements of Porter’s diamond of national competitive advantage are factor
conditions (a nation’s endowment of factors of production), demand conditions (the
existence of a large, sophisticated domestic consumer base), related and supporting
industries (local suppliers that are eager to meet the industry’s production, marketing, and
distribution needs), and company strategy, structure, and rivalry (the domestic environment
in which firms compete).

9. How do portfolio investments and FDI differ?

The difference between portfolio investment and foreign direct investment is related to the
question of control. Portfolio investments represent passive holdings of stocks, bonds, or
other financial assets, which entail no active management or control of the issuer of the
securities by the foreign investor. Foreign direct investment represents acquisition of
foreign assets for the purposes of control.

10. What are the three parts of Dunning’s eclectic theory?

The three components of Dunning’s eclectic theory are location advantage (it must be
more profitable to undertake a business activity in a foreign location than a domestic
location), ownership advantage (a firm must own some unique competitive advantage that
overcomes the disadvantages of competing with foreign firms on their home turf) and
internalization advantage (the firm must benefit from controlling the foreign business
activity, rather than hiring an independent local company to provide the service). Foreign
direct investment will occur when the three conditions are satisfied.

11. How do political factors influence international trade and investment?

Political factors influence international trade and investment when firms choose to invest in
a foreign factory as a means of avoiding trade barriers, and when firms invest in foreign
countries in order to take advantage of economic incentives offered by host governments.
82 > Chapter 5

Questions for Discussion

1. In our example of France’s trading wine to Japan for clock radios, we arbitrarily assumed
that the countries would trade at a price ratio of 1 bottle of wine for 2 clock radios. Over
what range of prices can trade take place between the two countries? (Hint: in the absence
of trade, what is the price of clock radios in terms of wine in France? In Japan?) Does your
answer differ if you use Table 5.2 instead of Table 5.1?

In the absence of trade, France can only get three clock radios for two bottles of wine at
home (see Table 5.1). Similarly, if Japan is being self-sufficient it can only get one bottle of
wine for five clock radios. Both countries will be willing to trade if they can get a better deal
elsewhere. This means that the range of prices over which trade should take place is
between what each could get internally. In the case of Table 5.2, the range of prices over
which trade should take place would again be limited by what each could get internally.
Without trade, France could get six clock radios for four bottles of wine and Japan could
get only one bottle of wine for five clock radios.

2. In the public debate over NAFTA’s ratification, Ross Perot said he heard a “giant sucking
sound” of U.S. jobs headed south because of low wage rates in Mexico. Using the theory
of comparative advantage, discuss whether Perot’s fears are valid.

The theory of comparative advantage suggests that a country will export those goods and
services for which it is relatively more productive than other nations and import those goods
and services in which other nations are relatively more productive. Thus, even though the
U.S. might be better at producing two goods, it should focus is efforts on the one in which it
is more productive. Since wage rates are lower in Mexico than in the U.S., Perot felt that
American companies would choose to build plants in Mexico to take advantage of the
cheaper Mexican labor force. While certainly one would expect some companies to make
such a move, because of the low skill levels in the Mexican labor force, other companies
will not. In addition, one must consider whether the companies that do make such a move
actually save jobs in the U.S. (for example, that of a supplier) that would have disappeared
if the companies had gone out of business (because they could not compete while paying
the higher U.S. wage rates).

3. Why is intraindustry trade not predicted by country-based theories of trade?

Country-based theories of trade focus on explaining interindustry trade (trade in which

countries exchange goods produced in different industries), rather than intraindustry trade
(trade in which countries exchange goods produced in the same industry). The reason for
this is that country-level theories use the country as a unit of analysis, and examine
differences in the characteristics of a country (such as land, labor and capital) to explain
trade between nations. In contrast, firm-based theories use the firm as a unit of analysis
and focus on differences between firms (such as ownership advantages) to explain trade
between countries.
 International Trade and Investment Theory > 83

4. Siemens decided to build a new semiconductor plant in Oporto, Portugal.

a. What factors do you think Siemens considered in selecting Portugal as the site for the
factory? What about Oporto in particular?

Siemens invested $380 million to build a new semiconductor chip factory near Oporto,
Portugal. The site was chosen for the new plant to capitalize on a lucrative economic
development incentive package jointly sponsored by Portugal and the European Union.
The package will cover some 40% of Siemens’ investment and training costs. In return,
Siemens will provide 750 jobs to the local region.

b. Who benefits and who loses from the new plant in Portugal?

This question should generate a lot of discussion among students. Students who have lost
a job (or know someone who has lost a job) as a result of a company’s decision to move
production to another country and students who have found a position with a transplanted
foreign firm should have particular interest in this question. The big losers in Siemens’
decision to build a plant in Portugal are the workers who will lose their jobs in other
countries where Siemens has operations, and the suppliers who may lose a large
customer. The clear winners in the decision are the newly employed workers in Portugal,
and the new suppliers to the plant. In addition, Oporto and the surrounding area stand to
benefit from the economic and infrastructure boom that may occur as the plant becomes
fully operational.

c. Is the firm’s decision to build the new plant consistent with Dunning’s eclectic theory?

Dunning’s eclectic paradigm suggests that FDI will occur when a foreign location is
superior to a domestic location, when the firm enjoys an ownership advantage that can be
utilized to generate monopolistic profits in foreign markets, and when the firm finds it
cheaper (because of transaction costs) to produce the product itself rather than hire some
foreign firm to produce it. Siemens’ decision to build a plant in Portugal is consistent with
Dunning’s theory.
Good

Expo
Sites

THE
Ugly

Bad,

Data
: the

Web

WIT
, the

RKI
WO
WE
and

NG
B:
the

H
rt

Essence of the exercise

The Internet has become a legitimate and essential part of business. Firms use the Internet
not only to conduct business, but also as an information source. This exercise is designed to
provide students with the opportunity to see the wide variation of the quality of websites.
Students are asked to select an industry and product, find five associated websites, and
discuss which sites are more useful from a business standpoint.
84 > Chapter 5

KI

DI

UI
O

G
G
A
B

B
S

S
L
L

L
Essence of the exercise
This exercise links trade and investment theory to the actual situation in the computer,
consumer electronics, and auto industries. The exercise requires students to explain why
some theories are better at explaining the situation in certain industries than others.

1. Do some theories work better than others for different industries? Why?

Certain theories definitely explain the situation in some industries better than other
theories. For example, country-level theories such as absolute advantage, comparative
advantage, and relative factor endowments focus on explaining interindustry trade between
countries and are thus better at explaining trade in undifferentiated goods. Firm-level
theories provide a better explanation of why intraindustry trade takes place, and are thus
useful when considering trade in differentiated products. Finally, investment theories
explain why companies make investments in other countries, and are helpful in
understanding why companies internalize certain operations. There are several factors,
supply side and demand side, which prompt a firm to internalize and, depending on
industry conditions, will be more prominent in some industries than in others.

2. What other industries can you think of that fit one of the three patterns noted in the
opening paragraph?

The opening paragraph provides examples of industries that are dominated by foreign
firms (consumer electronics), U.S. firms (computers) or a combination of both
(automobiles). Students will probably come up with several different examples of each
situation. Some possibilities include the banking industry that is dominated by U.S. and
foreign (particularly Japanese and British) companies; the low-cost clothing industry which
is dominated by companies from lesser developed countries (particularly those in the
Pacific Rim); and the insurance industry which is dominated by U.S. firms.

3. Do the same theories work as well in making predictions for those industries?

As mentioned in question 1 above, certain theories of trade and investment are better at
explaining the situation in some industries than others. Depending on how students
answer question 2 above, the answer to this question can be either yes or no.

4. Based on what you know about the Japanese market, decide whether the same pattern of
competitiveness that exists in the United States for the computer, consumer electronics,
and automobile industries also holds true for that market. Why or why not?

Instructors may find it necessary to provide some background about the Japanese market
before students can really discuss this question. However, even students who are
unfamiliar with the Japanese market should be able to discuss the automobile industry in
Japan. One could argue that the level of competitiveness in the Japanese automobile
industry is lower than in the U.S. industry simply because the Japanese have a strong
presence in the U.S., while American firms do not have a strong presence in Japan. Thus,
the Japanese companies are in a position to use Japanese-made profits to expand their
 International Trade and Investment Theory > 85

U.S. operations (in terms of research and development, marketing, price cuts, etc.), while
American firms do not have this luxury.

Other Applications
This exercise focuses on applying the basic theories of international trade and investment
to certain products and industries. However, many economies are now known as service
economies. Instructors may wish to raise the question of whether any of the theories can
be used to explain trade and investment patterns of service firms.