Reading: Lesson 3 - Theories of International Trade and Investment

5.3.A - Theories of International Trade and Investment

1. THEORIES OF INTERNATIONAL TRADE

1. Business transactions between countries have been steadily increasing for over 70 years. This is, in part, due to the realization that international trade can benefit all participants. In this section, you will learn about two well-known theories that explain why international trade and investment occur.
   
2. The comparative advantage theory states that to gain a trade advantage, a country should specialize in products or services that it can provide more efficiently than can other countries. For instance, because of climate and soil conditions, Brazil is better able to grow coffee than India, whose soil and climate favor the growing of tea. Each country could gain by specializing—Brazil in coffee and India in tea—and then trading with each other.
   
3. What if one country can produce both coffee and tea at a lower cost than another country? The comparative advantage theory says that the focus should be on comparing the cost of producing both products in each country. For example, it is possible that India may be able to produce more tea than coffee for the same cost, whereas Brazil may find that it can produce coffee at a lower cost than it can produce tea. In such a case, Brazilians should specialize in producing and selling coffee to the Indians and buying tea from India. Similarly, the Indians should produce tea and sell some to the Brazilians to pay for the coffee they need. This theory explains why the United States designs computers, Saudi Arabia extracts oil from the earth, and Indonesia makes athletic shoes.
   
4. Another explanation for trade and investment relates to product life cycle. During its life cycle, a product or service goes through four stages: introduction, growth, maturity, and decline. Consider black-and-white televisions, for example. When they were first introduced in the 1940s and 1950s, they were the only televisions available. As more people in the country started buying TVs, their sales grew—the growth stage. When most households owned a TV, sales leveled off—the maturity stage. When color TVs appeared, the sales of black-and-white sets started falling—the decline stage.
   
5. The product life cycle theory states that companies look for new markets when products are in the maturity and decline stages of the product life cycle. When sales begin to slow in a country (the mature stage), Company A that makes the product starts selling it to foreign countries where the product may be in the introductory or growth stage. However, selling abroad is expensive because of transportation, tariffs, quotas, and other non-tariff barriers. Companies in the foreign country find it attractive to make and sell the product at lower prices. To counteract this action, Company A sets up a factory in the foreign country where it makes and sells the product. Company A may even sell some of the products back to the home country.
   
6. Many American companies move to foreign countries when sales at home start lagging. Examples are fast-food restaurants and soft-drink companies. Because of technological changes, the life cycle of new products is much shorter. New products are regularly introduced. Their sales grow, then flatten, and eventually decline. To prolong the life of the product, firms first ship their products abroad and later build factories there.
   

2. BALANCE OF PAYMENTS

1. Goods and services sold abroad by American companies bring money into the United States. Money also comes from foreigners who buy American companies or set up new businesses in the United States or lend money to Americans. At the same time, money leaves the country when Americans buy foreign products, vacation abroad, invest in foreign businesses, or donate money to aid people in other countries. National governments and international organizations such as the United Nations and WTO keep records of international transactions, and governments use these to develop economic policies.
   
2. All international transactions are recorded in an accounting statement called the balance of payments. The balance-of-payments statement has two parts: the current account and the capital account. The current account records the value of goods and services exported and those imported from foreigners, as well as other income and payments. When the value of a country’s exports exceeds the value of its imports, the country has a surplus. When the value of the imports exceeds the value of the exports, it creates a deficit. The capital account records investment funds coming into and going out of a country. Investment funds include bank loans or deposits, the purchase and sale of a business, and investments in a new business.
   
3. For several decades, the United States has had a consistent deficit on its current account. The Figure below shows how the deficit has ballooned over time. The balance-of-payments deficit means that Americans have been buying more goods and services made abroad than they have been selling to foreigners. In 2014, the United States carried a negative balance on goods of $735.8 billion and a positive balance on services of $231 billion. How long can a country continue to buy more than it sells? Not indefinitely, of course. However, the United States has several advantages. Countries everywhere value its currency, the dollar, because the United States is a stable society, government policies are pro-business, and its economy is the world’s largest and richest. Foreign banks and governments are willing to lend money to the United States to enable it to pay for the excess product it buys. 
   

   
   

4. Not all countries are so fortunate. Countries with prolonged trade deficits may not be able to pay their bills or may have to limit international trade. In addition, their governments may have to place restrictions on the outward flow of money or on the activities of foreign businesses in their countries. At such times, they may obtain financial assistance and economic advice from the International Monetary Fund.
   

5. When deficits continue, it means that companies and individuals are demanding more foreign currency to buy the foreign goods. For instance, if Americans buy more Korean toys, the demand for the Korean currency—the won—goes up, because American toy companies will need won to pay the Koreans. When demand increases for won, more dollars are needed to buy won. Thus, the value of the dollar declines in relation to the won. In turn, Korean products become more expensive for Americans, whereas American products become less expensive for Koreans. Theoretically, at this stage, higher prices discourage the sale of Korean products in America, and lower prices encourage the sale of American products abroad. In this way, the deficits can be reduced and eventually eliminated.
   

6. To illustrate this process, consider Apple computers made in the United States and sold in Korea. Assuming an exchange rate of $1 = 1,000 won, a $1,200 computer would sell in Korea for 1,200,000 won (1,200 × 1,000). As more Koreans buy Apple computers, they will need more U.S. dollars to pay for the computers. This will increase the demand for dollars, and more won will be needed to buy a dollar. Thus, if $1 is now worth 1,200 won, the Apple computer will cost the Koreans 1,440,000 won (1,200 × 1,200). 
   

7. With the computers costing more, Koreans will buy fewer of them and U.S. exports will decline. Contrast this situation with what happens to a Korean product—say, a Samsung mobile phone costing 120,000 won. The phone will sell in the United States initially for $120 (120,000/1,000). When the exchange rate becomes $1 = 1,200 won, the same phone will now cost Americans less: 120,000/1,200, or $100. This decline in price will lead Americans to buy more Samsung phones, which will lead to an increasing demand for won and raise the value of the won in terms of dollars. In turn, American goods will become less expensive to Koreans, and they will buy more American products. Thus, the trade deficits work out over the long run.
   

8. In the example above, the exchange rate of the currency fluctuates because of market conditions that impact supply and demand for the dollar and the Korean won. This type of flexible exchange rate is a result of free markets. Some countries do not allow their currency to fluctuate on international markets. Instead the government sets a fixed exchange rate. China is the largest economy with a fixed exchange rate. In recent years, the Yuan has been fixed at just above 6 to the dollar. As a result, China can keep the price of Chinese products low compared to products made in other countries. Low prices make it easier for China to export products. China’s control of its currency creates an unfair advantage.
   

9. China has faced pressure to allow the Yuan to float against other international currencies. China has considered allowing this. A stronger Yuan could bring down Chinese inflation and make Chinese savers more wealthy in the international marketplace.
   

3. CAREER OPPORTUNITIES IN INTERNATIONAL BUSINESS

1. The growth of international business has created many new types of jobs. In addition to those who work for foreign firms in the United States, over 800,000 Americans work abroad for American or foreign firms. Many people work in various aspects of international business, such as exporting and importing, teaching and translating languages, administering trade laws, managing offices and operations in foreign countries, and in banking and insurance firms. Others work in international trade organizations such as the WTO and the IMF, or in federal and state government agencies. As countries become economically interdependent, more jobs will require a knowledge of international business.
   
2. As firms gain experience in doing business globally, they employ more people from various backgrounds and countries. Most international companies hire at the entry level, but usually they send workers abroad who are very skilled, mature, and experienced. Studies show that the average salary in foreign companies located in the United States is higher than for similar jobs in American companies. However, although working several years overseas may promote workers’ careers in many companies, it may hurt their careers in others. Workers abroad lose close contact with people and developments in the parent firm.
   
3. Today, both businesses and government agencies recruit extensively for jobs that require skills useful for international business. These include not only knowledge of business but also foreign-language ability, familiarity with foreign countries, and a high level of comfort with and in a foreign culture. Many colleges and universities provide coursework and academic degrees in international business. Many offer programs that allow students to do part of their studies in a foreign country or even in a foreign company.
   
4. Firms need managers who can work successfully in a wide variety of countries. Such managers adapt readily to other cultures and are competent, socially flexible, and receptive to new ideas. Managers benefit from knowing the foreign language and from having strong self-confidence, a motivation to live abroad, and a skill for innovative problem solving.
   
5. During the start-up phase of foreign operations, firms tend to rely on managers sent from headquarters. However, most managers are citizens of the host country where the business is situated. Occasionally, businesses hire citizens of other countries (neither the home nor the host countries) because they are exceptionally qualified or because host country managers are not available. Sending managers abroad is expensive, because companies must provide extra benefits (such as housing, airfare for families, and cost-of-living allowances). Managers who are sent to a country that is culturally different from their own may experience culture shock. Many firms provide cross-cultural training to managers before sending them abroad.
   
6. The support of the entire family is often necessary for the manager to succeed in the foreign location. With more and more spouses of managers having careers of their own, many firms are finding it difficult to persuade managers to take long-term transfers to a foreign location. Instead, they are using frequent short business trips, bringing in host-country managers to headquarters, and using teleconferencing and the Internet to manage their foreign operations.
   
7. International business managers are responsible for evaluating new international opportunities. They must also recognize how management functions can differ in a variety of international markets. International business planning follows the same steps used in the domestic planning process. A manager needs to ensure that high-quality information is available when evaluating external and internal factors or when conducting a SWOT analysis. Both the U.S. government and the EU collect and create reports on country conditions around the world. This data may be more accurate than the target countries’ own reports. Many companies will purchase country reports from research firms to ensure high-quality data. 
   
8. Organizing can be very country specific. Some cultures have a high level of power distance. This is a measure of the extent to which less powerful individuals accept the authority of other, more powerful individuals to make decisions and lead. In high power distance cultures where subordinate relationships are more easily accepted, such as Mexico or China, a taller organization chart with more levels of management may be more appropriate. In low power distance cultures where decision making is shared, such as the United States or Scandinavian countries, a flatter organization may be appropriate.
   
9. Staffing and leading functions for international managers involve hiring the right people in international locations and guiding and supporting them so they can work effectively. Before the 1980s, many U.S. companies used Americans to staff and lead foreign divisions. The belief was that the U.S. managers had greater experience and could meet the needs of the parent company. Over the last 30 years, the quality of international management has improved and companies have realized that to fully serve international markets, they need individuals who understand the local market needs and culture. At the same time, the international managers need to understand the culture and expectations of the parent company. They also need to be able to motivate the employees who are working in the foreign divisions to reach strategic goals.
   
10. The controlling function for international businesses involves evaluating results to determine if the company’s objectives have been accomplished. International cultures have a different time-orientation for results. Managers from countries with long-term orientations, such as China, Japan, and India, may be willing to wait longer to achieve results. Short-term oriented countries, such as the United States, the United Kingdom, and Austria, may want quicker outcomes, such as monthly or quarterly results.