Chapter Three

Theories of International
Trade and Investment

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Currency Exchange Rates
Influence The Direction of Trade
 Goods are valued in the currency of the country in
which they are produced
 An importer in another country must use the
prevailing exchange rates to price the product about
to be imported
 The relative purchasing power of currencies is not
always reflected in official exchange rates
 Government policy can give an advantage to one
currency over another to induce exports

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 Some Newer Explanations
For The Direction Of Trade

1. International Product Life Cycle (IPLC)

 Most new products initially conceived and produced
in the U.S. in 20th century
 U.S. firms kept production close to the market
 Aids decisions and minimizes risk of new
product introductions
 Demand not based on price yet so low
production cost not an issue
 Limited initial demand in other advanced countries
 Initially, exports to these markets more
attractive than production
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 Some Newer Explanations
For The Direction Of Trade
 With demand increase in advanced countries
 Production follows there from the U.S.
 With demand expansion elsewhere
 Product becomes standardized
 Production moves to low production cost areas
 Product now imported to U.S. and to advanced
countries

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International Product Life Cycle

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 Newer Explanations
For The Direction Of Trade
1. Linder Theory of Overlapping Demand
 Customers’ tastes are strongly affected by income levels
 Income per capita determines the kinds of goods in
demand
2. Technology Life Cycle
 Production technology application of the IPLC
 Distinguishes between new products and new
technologies used in the production of products
 Technology follows the IPLC pattern

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 Newer Explanations
For The Direction Of Trade
1. Economies of Scale and Learning Curve
 Economies of scale: as a plant gets larger, output
increases, per unit production cost decreases
 Learning curve: as firms produce more products, they
learn ways to improve production efficiency further
reducing costs
 A nation’s industries are now low cost producers and
exporters
2. First-Mover Theory
 Pattern of trade in goods subject to scale economies is
determined by historical factors that induce first movers

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 Newer Explanations
For The Direction Of Trade
1. National Competitive Advantage
 National Competitiveness: a nation’s relative
ability to design, produce, distribute, or service
products while earning increasing returns on
resources
 Four variables: factor endowments, demand
conditions, related and supporting industries,
and firm strategy, structure, and rivalry

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 Newer Explanations
For The Direction Of Trade
 Factor endowments
 land, labor, capital, workforce, infrastructure
 Demand conditions
 large, sophisticated domestic consumer base: offers an
innovation friendly environment and a testing ground
 Related and supporting industries
 local suppliers cluster around producers and add to
innovation
 Firm strategy, structure, rivalry
 competition is good
 national governments can create conditions which
facilitate and nurture such a condition
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 Variables Impacting Competitive
Advantage: Porter’s Diamond

Source: Reprinted by permission of the Harvard Business Review. “The Competitive Advantage of Nations” by Michael E. Porter,
March–April 1990, p. 77. Copyright © 1990 by The President and Fellows of Harvard College; all rights reserved. LO1 3-22

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 Synopsis: Trade Theory

 Trade among countries results from relative price

differences that stem from different production costs
 Different production costs come from differences in
 Endowments of factors of production
 Levels of technology that determine the factor
intensities used
 Efficiencies with which factor intensities are used
 Foreign exchange rates
 Differences in tastes can reverse the direction of trade
predicted by theory
 Nations attain a higher quality of life by specializing in
those products for which they have a comparative
advantage and by importing the rest
 Trade restrictions harm a nation’s welfare in the LR
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 Trade Theory and Foreign Direct
Investment Theory are Linked
 Trade theory: focused at the national economy level
 Investment theory: focused at the company decision level
 Theory of foreign direct investment (FDI)
 Pertains to ownership and control of investments
across national borders
 Involves real or physical assets (plants, facilities)
 FDI occurs through
 greenfield investment: new facilities from ground up
 cross-border acquisition of an existing business

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 Trade Theory and Foreign Direct
Investment Theory are Linked
 Strategic reasons that induce foreign direct
investment
 Find new markets
 Access raw materials
 Achieve production efficiencies
 Access new knowledge (technology, knowhow)
 Mitigate political risk
 Competition

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 Trade Theory and Foreign Direct
Investment Theory are Linked
 A company’s decisions on where to locate FDI
activities is influenced by the same economic
differences among countries articulated in trade
theory
 Endowments of factors of production
 Levels of technology that determine the factor
intensities used
 Efficiencies with which factor intensities are used
 Trade theory explains the flow of products and
services given the cross-national economic context
 FDI explains how companies act within the cross-
national context
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