International Business Theories

International Business Theories

A precursor to the comparative advantage theory was the absolute advantage theory proposed by Adam Smith. According to Adam Smith, countries had an absolute advantage when they were able to produce goods more efficiently than others. According to the theory, if a country possesses an absolute advantage in a particular good it should only produce that good, and trade it with goods of other countries where it lacks an absolute advantage. The absolute advantage theory held that both countries would benefit from goods they are more efficient at than others. By producing a particular good they are more efficient at, they would be able to produce more of it, and then in turn use the excess produce to trade it with other nations which would lead to more consumption and as such benefiting all participants of the trade. The absolute advantage theory was in contrast to the dominant view held during 17th century of mercantilism which emphasized that a country should export as many goods as possible and minimize the import of goods. Mercantilism emphasized trade surplus and zero sum game - where only one participant would reap the benefits, while absolute advantage theory proposed a positive sum game - where all participants in the free trade would benefit from international commerce. Mercantilism also advocated use of government to achieve trade surplus while Adam Smith's theory emphasized free trade, where supply and demand of goods would be dictated by the invisible market forces, with no government involvement - laissez-faire.

The comparative advantage theory proposed by Ricardo built on Smith's absolute advantage theory. In addition to countries producing goods where they are most efficient at, Ricardo proposed that if a country X has an absolute advantage in producing 2 resources but is most efficient at producing resource A or has a comparative advantage in producing resource A, it should specialize in greater production of resource A even though it could produce resource B more efficiently than country Y. The belief is that by specializing in the greater production of resource A would lead to overall greater production per unit input, which would in turn lead to more goods to be consumed by both X and Y countries thus benefiting consumers of both X and Y. As with the Smith's absolute advantage, comparative advantage also emphasized the role of free trade and reduction of any government involvement in market.

The comparative advantage theory was modified by Swedish Economists Heckscher and Bertil Ohlin who felt that the comparative advantage held by a country wasn't due to productivity of a country, but through natural endowments a country possesses. These endowments could be considered "God-given" attributes that give a nation inherent advantage over others. These endowments could be resources such as land, labor (large available pool along with skilled and low-skilled workers), and capital. Heckscher and Ohlin believed that the abundance of these resources gave countries a comparative advantage, which allowed them to produce goods more efficiently or inexpensively that involved intense use of resources that they had in abundance. For example, China has a huge low-skilled labor pool, which allows it produce manufacturing goods at a much lower price than developed countries where labor costs are significantly higher. Even though comparative advantage gives a nation an upper hand in producing goods more efficiently, that is not always the case. Theoretically Iran is supposed to have a comparative advantage in production of refined oil as it has crude oil in abundance, yet that is not the case in real life. Iran is forced to import refined oil as it doesn't have the competitive advantage even though it has the comparative advantage when it comes to oil. Comparative advantage theory also allowed firms from a country with a comparative advantage to branch out abroad. For example, US had a comparative advantage when it came to operating systems since it was the first nation to extensively utilize the software in commerical and public spaces. This allowed American companies to have the first mover's advantage thereby gradually increasing their competitive advantage and further increasing barriers to entry in the domestic advantage With a strengthened domestic market, Microsoft or Apple could enter foreign markets where they would hold absolute advantage in terms of market share due to being already experience players in the software industry.

Under comparative advantage countries would receive capital inflows where investors believe the country has the greatest comparative advantage in. For example, OPEC nations would likely receive large scale direct investments in companies or projects that are involved in discovering, drilling, or refining of oil. Australia which has large coal and uranium reserves would see a large portion of foreign direct investments or portfolio investments going into corporations that engage in mining of those commodities. China, which has a large comparative advantage with its large labor pool, would see Foreign Direct Investments by companies interested in establishing labor intensive factories like textiles or automobiles that would take advantage of cheap labor pool. Countries with strong comparative advantages are likely to see trade surpluses, especially if the trade partners are at a significant comparative disadvantage in relation to them.This can be especially seen when countries like China, or Venezuela have large trade surpluses with the U.S.

Competitive advantage proposed by Michael Porter advocated that firms or nations excel at particular industry or goods not because of comparative advantage but because of variables such as the sophistication of the consumers in domestic market, the quality of skilled labor, infrastructure, competition among industries, nation's and firm's culture, and support of various industries, that would give a nation a competitive advantage. Porter believed that countries and firms could overcome their comparative disadvantage through competitive advantage. Porter advocated that although a country might have a comparative advantage at the beginning in a particular industry, if it doesn't have the necessary environment that fosters competitive advantage, it would lose out to countries that have competitive advantage. For example, as stated earlier Iran has a comparative advantage when it comes to production of oil, since it is a resource that it has in abundance. Comparative advantage theory would suggest that Iran would have an inherent advantage, and would excel in making value added products that require extensive input of oil such as jet fuel. In reality, even though Iran has a comparative advantage in production of oil, it isn't able to effectively produce refined products due to competitive disadvantage. In fact, Iran imports majority of its refined oil from India, China, and Sweden who have no abundance of oil. What this shows is that countries like India or China which are resource deficient in oil, can still have an advantage over Iran by emphasizing variables such as infrastructure (in this case oil refineries and various support industries).

Countries with competitive advantage can attract large amounts of FDI and at the same time engage in large volumes of trade with countries that they are at a "comparative disadvantage". For example, the Indian corporation Reliance could engage in buying of oil from Iran, and use its large refineries to sell its products worldwide and to Iran itself. Reliance corporation could also bring in FDI by engaging in a joint venture with Chevron to open a new oil refinery complex. Reliance could also issue new stocks in the primary market inviting foreign investors, or foreign investors could have a stake in the company by buying its stock in Indian stock exchanges. In the case of Phillips vs Matsushita case, Phillips subsidiaries for examples were significantly independent from its parent company. This allowed them to make decisions autonomously whether it was raising money or engaging in new product designs. Seperately, Matsushita on the hand had a competitive advantage in bringing out products rapidly to the market that put the firm ahead of its peers.

I believe that competitive advantage closely reflects today's trade and investment flows. If comparative advantage were to reflect the way investments would have flowed, an overwhelming number of value-added products would have been produced by OPEC nations. In a comparative advantage world, a resource deficient nation like Japan would have little investments and economic influence, but in reality because of competitive advantage due to its advanced infrastructure, highly educated and skilled workforce, intense domestic rivalry of corporations, a proactive government, and a culture that promotes innovation has led Japan to overcome its comparative disadvantage.

Although eclectic theory in large part does explain why corporations engage in foreign trade, it doesn't explan why companies like Fiji or Kodak or Coca Cola and PepsiCo enter markets even though they might not profit from entering them. Eclectic theory assumes that the reason for entering a certain market would only be considered if that market provides the required rate of return. Sometimes companies might enter markets just to deny their competitors any profits that might possibly used against it in another profitable market. I think a competitive advantage theory explains the internationalization theory well.

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