MBA Notes: International Global Business

International trade theory: an A to P

No self-respecting business graduate would settle for mere anecdotes or case examples, however relevant or convincing as an explanation of how international business came to be such a dominant feature of commercial life. These are the key aspects of the theories and limitations of those theories that underpin the subject of international trade, which an MBA needs at least a rudimentary appreciation of.

Absolute advantage
Adam Smith, the Scottish economist whose 'Invisible Hand' saw all economic activity as being subject to the law of unintended consequences, also had a thing or two to say about Mercantilism (see below), the prevailing big idea on international trade. In 1776, in his book The Wealth of Nations, Smith argued that for a country – and by extension the enterprises that make up that country – to simply try always to export more than they imported was both unrealistic and uneconomic. He argued that countries differed in their ability to produce goods efficiently and so had an inherent cost advantage.

Natural advantage
An industry that Smith drew on for his theory was the French wine trade, which due to good soil and a benign climate had the world's most efficient wine industry. Despite shifts in weather patterns, improvements in technology and sheer determination, England's wine industry some 240 years on is still dwarfed by that of France, which makes more and arguably better wine at a lower cost. Other countries, particularly those in the New World – Argentina, Australia, Chile and the United States in particular have muscled in on the trade, but those countries too shared France's natural advantage, but in some cases with the added twist of lower costs of either land, labour or both.

Acquired advantage
The French wine industry in Smith's day also had generations of experience in the manufacturing process. This accumulated expertise gave them an acquired advantage. At this time England had the most efficient textile manufacturing industry in the world, courtesy of such innovations as Richard Arkwright's water frame, James Hargreaves's Spinning Jenny, and Samuel Crompton's Spinning Mule (the Spinning Jenny and Water Frame combined, patented in 1769). James Watt's steam engine patented in 1775, allowed efficient semi-automated factories to operate in places where waterpower was not available so serving to increase England's acquired advantage in both textiles and other manufactured products.

A more recent example is that of Lean Manufacturing, an approach ascribed to Japanese companies such as Toyota, where they seek to eliminate or continuously reduce waste – that is, anything that doesn't add value. They use such headings as:
- Transport: keep process close to each other to minimize movement.
- Inventory: carrying high inventory levels costs money and if too low, orders can be lost.
- 'Just in Time' (JIT) manufacturing should be aimed for.
- Motion: improve workplace ergonomics so as to maximize labour productivity.
- Waiting: aim for a smooth even flow so that men and machines are working optimally, reducing down time to a minimum.
- Defects: aim for zero defects as that directly reduces the amount of waste.

As a result of this approach many industries in Japan achieved an acquired advantage over those in other countries allowing them to dominate industries such as motor manufacturing and even to be able to export steel despite having to import iron and coal, its main ingredients.

Comparative advantage
David Ricardo, an English economist, member of Parliament, businessman, financier and speculator, in his 1817 book, The Principles of Political Economy, extrapolated Smith's theory to see what might happen if, as it looked might happen as the industrial revolution developed, one country – England in this case – had an absolute advantage in the production of all goods.

Ricardo's conclusion was that a country should concentrate its efforts on those goods it produces most efficiently and be prepared to import goods from other countries even if it could make them more efficiently itself.

Most students and nearly all business managers find this argument counterintuitive but this example explains the principle. Would a world-class forensic accountant commanding fees of $5,000 a day to unravel the financial mess left behind at Lehman Brothers, who coincidentally is a great bookkeeper, be better off keeping their own books? As even the world's best bookkeeper would be pushed to make $500 a day, clearly a forensic accountant would be better off paying out for a bookkeeper and finding a few more firms like Lehman's to work on.

Gravity Model
The Gravity Model, first used by Jan Tinbergen, the Dutch economist and co-winner of the first Nobel prize in economics in 1969, postulates that just as Newton's law of gravity draws on distance and physical size between two objects to predict behaviour, trade between countries will be similarly influenced.

His theoretical model, developed in 1952, states that the trade between two countries (i and j) takes the form of:


Where F is the trade flow, M is the economic mass (GDP) of each country, D is the distance and G is a constant.

The mode appears to be empirically reliable and is used by such bodies as the World Trade Organization (WTO) to test the effectiveness of trade agreements. McDonald's' choice of Canada as its jumping off point for international growth supports the distance element of this formula and, though not quite in the same economic league, it is the 11th richest country in the world.

The Heckscher–Ohlin model
Ricardo (See Comparative advantage) believed that advantage accrued to countries with greater labour productivity. Eli Heckscher and Bertil Ohlin of the Stockholm School of Economics, extrapolated this idea by determining that countries are endowed with different factors such as capital, land and labour and it is those that collectively determine cost differences and hence advantage. The Heckscher–Ohlin model (H–O model), as it became known, essentially says that countries will export products that make use of their plentiful and cheap factors of production and import products that use the country's scarce factors. This theory passes the common sense test easily. France, Ireland and the United States are all substantial exporters of agricultural products as they have a relatively high land density (acres per person), while China and South Korea have the advantage when it comes to goods that require an abundance of low-cost labour, such as clothing and footwear. In this latter area China's exports were so high as to attract trade barriers from the EU.

The Leontief Paradox
Economists like the Heckscher–Ohlin model as it mirrors their ideas on how advantage should work in theory. Unfortunately the H–O model is unreliable at predicting trade patterns, less so than the less elegant proposition advanced by Ricardo's comparative advantage (see above). Wassily Leontief, a Russian economist, son of a Professor of Economics and a Nobel Prize winner, demonstrated the limitations of the H–O model by showing that since the United States was awash with capital compared to most other countries, with the most sophisticated venture capital and stock markets in the world, they should, in theory, be a major exporter of capital intensive goods and an importer of labour intensive goods. Using the 1947 import–export tables covering 200 US industries Leontief showed the reverse to be the case. He postulated that demand and the availability of natural resources may play a greater role than supply in such cases and as is usual with academics called for more research to be carried out.

Linder's Income: Preference Similarity Theory
One dominant feature of international business is how much trade is done by virtue of developed countries trading with each other. According to the WTO, developed economies generate nearly 80 per cent of total world trade. With the exception of commodities, underdeveloped and developing economies, that is those with a per capita income below $12,000 per annum at 2009 levels, account for an insignificant share of trade with more developed economies.

TABLE: Exporters and importers of merchandise (agricultural products, food, fuels, iron, steel, chemicals, office and telecoms equipment, automotive products, textiles, clothing etc)

SOURCE: World Trade Organization (www.wto.org/english/res_e/statis_e/its2009_e/its09_toc_e.htm)

This concentration of trade between developed economies would appear to contradict the Heckscher–Ohlin (H–O) theory that claims that countries are most likely to find trading with those with fundamentally different factor endowments. Staffan B Lindler, a Swedish economist, concluded that while the H–O theory may well apply to trade in primary, resource intensive products including natural resources – oil, agricultural products, metals and so forth, the position with manufactured goods was fundamentally different.

He argued that international trade in manufactures takes place largely between developed countries. The WTO statistics would largely support this as Europe and the United States account for 80.5 per cent of world exports of manufactured goods and 74 per cent of imports. Lindler's conclusion was that internal demand governs what a country manufactures and they then go on to export those products to countries with a similar need, almost invariably a country with a similar income.

Linder went on to argue that the more similar the demand structure the more intensive the potential for bilateral trade in those manufactures. In 2009 the United States, Europe, Canada, Japan and Australia, all highly developed regions, imported 47 per cent of world output of office and telecom equipment, while they exported 38 per cent. Africa, on the other hand, exported just 2.6 per cent, while importing 7.6 per cent. For luxury goods with brand appeal the preference is even more exaggerated – hence the term Income-Preference Similarity Theory.

Mercantilism
This is the grand daddy of all the theories on the subject of international trade. Until the mid-16th century the strategy that dominated English thinking was to stimulate exports by subsidizing them with a range of incentives while restricting imports by imposing tariffs and quotas. As gold and silver were the currency used in international trade, running a permanent trade surplus would ensure England would, as Thomas Mun, an early economic thinker, put it, 'increase our wealth and treasure by foreign trade'. The need for all this 'treasure' was to arm to the teeth, in England and Spain's cases, to build fleets of war ships and so be able to literally conquer international markets.
Such was the view in 1630 but even then its central fallacy was evident. When England ran a trade surplus with France, the additional inflow of gold and silver increased the money in circulation so creating inflation that pushed up the prices of the goods England sought to export. Meanwhile in France the opposite was happening; money supply contracted pulling general prices down. The net effect was that French goods became more attractive for English customers to import while English goods being more expensive, were less so.

Adam Smith (see Absolute advantage above) and David Ricardo (see comparative advantage above) went some way to exploding the mercantilists' view that international trade is a zero sum game, with winners (exporters) and losers (importers).

The Advantage theories showed that there could be plenty of winners if international trade was encouraged and restrictions reduced or eliminated. Reaction of some countries' leaders after the banking crisis in 2008/09 showed that mercantilist ideas on trade barriers are far from dead, just dormant.

Neo-mercantilism
The thinking behind this theory of international trade is much as that of mercantilism but with a change in emphasis from military development, to economic development. In many ways the idea that a free trade philosophy dominates economic thinking is something of a fallacy: more a pious hope than a practical reality. Trade barriers abound barring the way to free trade between nations with many countries seeking, as did the mercantilists, to export more than they import and to protect their industries from foreign competition. In fact at some stage almost every country engages in neo-mercantilist policies.

The EU, an organization that tracks trade disputes reveals claims of unfair practices between half of the WTO (World Trade Organization) member states. As only 149 of the world's 240 countries are even members of that august body, the potential for neo-mercantilist practices is still great.

The arguments advanced for the policy usually revolve around claims such as:

- Time is needed to let the nation develop its industrial and commercial infrastructure to the point where it can compete on equal terms in international trade. In effect, any country, save perhaps the United States, could make such a claim, with some justification – and they do.
- Unusual times call for unusual measures. The banking crisis of 2008 and the years immediately following it saw even the most free trade orientated countries such as the UK and the United States take protectionist measures to save financial institutions. Less committed free traders such as the French frequently use this argument too. In March 2009 President Nicolas Sarkozy of France granted £5.6 billion in soft loans to Renault and Peugeot Citroen in exchange for a promise not to shut French plants or axe French jobs. Renault promptly announced that Clio Campus cars currently made at the Novo Mesto plant in Slovenia would be produced at the Flins plant, west of Paris.

National competitive advantage: Porter's view
Michael Porter, a professor at the Harvard Business School, who made his reputation with his ideas on corporate competitive advantage, turned his hand to trying to establish why some nations were conspicuously more successful than others in the international trade arena. He had in mind questions such as why does a country like Switzerland do so well in the pharmaceutical and watch industries, outperforming many other countries whose resource factors (see the various Advantage theories and the Heckscher–Ohlin model, above) are similar if not better.

Studying 100 industries in 10 countries, Porter and his team of researchers theorized that four national attributes create the local competitive environment for individual businesses, and so in turn promote or limit their advantage in the broader international trade arena:

1. Firm strategy, structure and rivalry
Drawing on his work on the competitive strategy between rival firms within a country, Porter identified two elements important to their success or otherwise when operating in the international arena:

- Vigorous rivalry within a country breeds strong firms with a track record in cost cutting and innovation that stands them in good stead when competing abroad. Closed economies with cosseted and protected domestic firms are less likely to create global champions. Nokia's success is put down in part to the fact that unlike almost every other country it has never had a national telephone company sheltering behind a monopolistic shield. Nokia entered a market dominated by white hot competition between 50 rival local companies that put pressure on it to perform from the outset.
- Local management ideologies can profoundly affect performance on the international arena. Porter cites the United States' over reliance on financially oriented management focused primarily on quarterly earnings reports. This short-term financial emphasis left US firms weak on design and strategies to improve manufacturing processes and so eventually to open their motor market to rivals from Japan and Germany who have carved a swathe through the sector.

2. Demand conditions
Sophisticated, plentiful and demanding local customers play an important part in keeping businesses focused on continuous development and improvements. Companies tend to be more attentive to their home markets as customers there can quickly make their views known. Porter cited the Japanese consumers' considerable knowledge about cameras and photography and their consequent relentless demand for ever higher performance as giving the indigenous industry a distinct edge.


3. Factor endowment
Porter doesn't go much further than the Heckscher–Ohlin model on the importance of factors that a country can be endowed with giving them an edge over those less well endowed. Porter does emphasize the importance of advanced acquired factors. Citing Japan again, Porter claims that though lacking either mineral resources or arable land, Japan has, by dint of producing more engineers per head than almost any other rival country, built an enormous manufacturing skills endowment. More basic factors come into play here too, such as telephone and internet connections per head of population, road density in terms of kilometers per million people and electricity provision measured in kilowatts per head of consumption and per cent of population with provision. For several decades the lack of sufficient electricity 'endowment' was the dominant limiting factor for many Indian companies in achieving success in international markets as they just could not achieve reliable levels of output.

4. Related and supporting industries
The final strand in Porter's thinking is the presence of suppliers and industries related to those champion sectors that are also internationally competitive. Pasta, leather and furniture industries in Italy, clothing in China, watches in Switzerland, tires in Ohio and emerging strengths for industries such as video gaming clustering in the Lyon region (40 per cent of all French companies in the industry and 70 per cent of all employment in the sector). The financial services industry has also emerged as one that can gain world prominence through the presence of related and supporting firms of international stature. The UK has factor endowment, a convenient time zone straddling the east and west, a world language (English), a well trained workforce and a dedicated work zone, the City and Docklands. Scotland and Iceland are also countries that played in financial services on the international stage, but were in many ways too dependent on one successful global industry.

New Trade Theory
Paul Krugman, an economics Nobel Prize winner, pioneered an extension of Ricardo's work on comparative advantage generally know as New Trade Theory. Recognizing that economies of scale accrue mostly to big businesses he saw two important factors for firms to keep in mind when developing their international thinking:

- Firms can use economies of scale to allow them to spread the benefit of low costs across more products while still lowering average costs. This widens consumer choice as the firm can extend the range of products on offer in international markets.
- If the global market can only support a small number of firms, certain product categories may come to be dominated by those that get to market first.

New Trade Theory has been used by governments as the logic for supporting infant industries that might meet this later criteria; for example Denmark, with a high dependency on imported energy, targeted wind power as an industry to support. By 2000 the country's wind turbine firms had captured 60 per cent of a world market estimated at $3 billion a year.

Product life cycle model of international trade
Raymond Vernon, an American academic advanced his theory on the subject in an article entitled 'International Investment and International Trade in the Product Life Cycle', published in the May 1966 edition of the Quarterly Journal of Economics.

Borrowing from the marketing concept of the product life cycle Vernon suggested that the internationalization process for new innovations followed a broadly predictable path, similar to that of the marketing take on the subject . He drew on the United States for his inspiration as up until that time most of the world's new products had been developed there.

However, the principles hold good for other countries where innovation is strong. China produces 80,000 people a year with higher degrees in computer science or engineering; in India, 70,000 people are prime candidates for sources of new innovative industries – so much so that Microsoft's largest R & D centre outside of the United States is in Beijing and Cisco's second global headquarters is in Bangalore.
Vernon argued that most new products are made close to home and consumed largely in that market.

The risks associated with anything new made this strategy prudent and in any event looking for low cost overseas manufacturing was unnecessary as initial demand was unlikely to be based on price factors. Initially during the introductory phase, demand would be largely confined to the home market, but later as costs came down, growth could be expected from exporting to meet demand in other advanced economies.

At first such growth would not warrant those countries establishing their own production but as the product reaches maturity that situation could change. In the final stage in the life cycle, the decline, production in the country in which the innovative new product was created will decline as cheaper and equally reliable overseas sources come on stream. Though demand will continue to grow, supply will now be met in part by imports. So, according to Vernon, the path from innovator through to exporter and ultimately importer can be traced and to a lesser extent predicted.

The Samuelson critique
Not everyone agrees that globalization is universally a force for good. Paul A Samuelson, the Nobel Prize-winning economist and professor emeritus at the Massachusetts Institute of Technology published an article in The Journal of Economic Perspectives, a quarterly put out by the American Economic Association, in September 2004 examining situations where the gains from international free trade no longer outweigh the losses.

He cites examples in relation to where call centres had been outsourced to India and the increasing trend due to advances in global communications through the use of the internet to move offshore other service jobs – medical diagnosis, accounting and software development for example – that were not traditionally internationally mobile. In such cases Samuelson concludes that wages for indigenous workers in the United States will be driven down to the point where gains from international trade are lost: 'Being able to purchase groceries 20 per cent cheaper at Wal-Mart (due to international trade benefits) does not necessarily make up for trade losses.'