INTERNATIONAL BUSINESS

• Involves commercial activities that cross national

frontiers.
• Concerns:
• International movement of goods, capital services,
employees & technology;
• Importing & exporting;
• Cross-border transactions in intellectual property
(patents, trademark, know-how, copyright materials etc.)
via licensing & franchising;
• Investments in physical & financial assets in foreign
countries; &
• Establishment of foreign warehousing & distribution
systems.
Special problems associated with International
Business in comparison to business at home……..

• Deals have to be transacted in foreign

languages under foreign laws, customs &
regulations;
• Transactions to be executed by foreign
currencies affected by exchange rate variations;
• Influence of cultural differences;
• Control & communication systems normally
more complex;
• Risk levels (Political, Commercial & financial
risks) are higher in foreign markets.
Why firms engage in international business?

• Commercial risk can be spread across several countries;

• Can facilitate ‘Experience Curve Effect’
• ( i.e. cost reductions and efficiency increases attained in
consequence of a business acquiring experience of
certain types of activity, function or project);
• Gains through ‘Economies of Scope’
• (i.e. unit cost reductions resulting from a firm undertaking
a wide range of activities, & hence being able to provide
common services and inputs useful for each activity);
• Company’s overall strategies can be anchored against a
wide range of international opportunities – sudden
collapse in market demand in some countries may offset
by expansions elsewhere.
 Process of Internationalization
• Receipt of an unsolicited order from
abroad or a foreign firm offering to supply
materials or other inputs;
• Establishment of an export / import
department;
• Gradually dispensing with export-import
intermediaries (acquiring detailed
knowledge of foreign export / import
procedures);
Process of Internationalization…….
• Start conducting its own marketing research,
place advertisement directly in foreign media,
organize transport to or form foreign
destinations, & raise finance from foreign
sources.
• Now, the company may license foreign
companies to produce its brands, or engage in
franchising or local manufacturer – becomes a
genuine international business, though foreign
markets are still controlled & solved from home
nation.
Process of Internationalization…….
• As more & more of its activities take place in
foreign countries, & as sales and profits become
critically dependent on world markets, so the
business moves towards becoming an MNC;

• i.e. one that owns production, distribution,

service and other units in many nations &
importantly plans the utilization of its resources
on the global scale (Samiee & Roth,1992).
 Theories of International Trade
• A well developed global financial system is
essential for supporting increased international
trade & the basis of this increase refers to the
evolution of certain major theories.
1. Theory of Absolute Advantage;
2. Theory of Comparative Advantage;
3. Heckscher-Ohlin Model;
4. Imitation Gap Theory;
5. International Product Life Cycle Theory.
 1) Theory of Absolute Advantage
• Developed by Adam Smith in 1776;
• Holds that consumers will be better-off if they can buy foreign made
products that are priced more cheaply than domestic one.
• Smiths theory holds that different countries can produce some
goods more efficiently than others, thus global efficiency can
increase through free trade.

• As per the theory, a country may produce goods more efficiently

because of a natural advantage (e.g. raw materials or climate) or
because of acquired advantage (e.g. technology or skills).

• Assumptions: Full employment, No transportation cost,

comparability of price across countries & perfect mobility of labour.
Theory of Absolute Advantage……
A Hypothetical Situation
– Country X Country Y
Resource available 100 units 100 units
Requirement to produce 1 TV 10 units 5 units
Requirement to produce 1 ton rice 4 units 20 units
Both countries use half of the total resources per product when there is no foreign trade.

– Production (without Trade) TV(units) Rice(units)

Country X 5 12 ½
Country Y 10 2½
Total 15 15

– Production (with Trade) TV(units) Rice(units)

Country X(only tons of Rice) - 25 tons
Country Y(only TV) 20 -
Total 20 25

If each country specialized in the commodity for which it has an absolute advantage,
then production of both products can be increased.
Theory of Absolute Advantage……
Limitations
1) It explains the causes of trade between two countries
only in those situations where both the countries enjoy
absolute advantage in production of at least one
product.
2) It assumes non-existence or insignificant cost of
transportation, which does not always hold well.
3) The assumption that prices are comparable across
countries implies stability of exchange rate.
4) Theory assumes mobility of labour from other sectors
to a particular sector, where the country enjoys
comparative advantage in production, which does not
actually exist.
 Theory of Comparative Advantage

• David Ricardo’s(1817) Comparative

Advantage theory holds that total output
can be increased through foreign trade,
even though one country may have an
absolute advantage in the production of
all products.
Theory of Comparative Advantage
A Hypothetical case
– Country X Country Y
Resource available 100 units 100 units
Requirement to produce 1 TV 10 units 5 units
Requirement to produce 1 ton rice 10 units 4 units
Both countries use half of the total resources per product when there is no foreign
trade.

– Production (Without trade-state of autarky)TV Rice

Country – X 5 units 5tons
Country – Y 10 units 12 ½ tons
Total 15 units 17 ½ tons

– Country Y has an absolute advantage in producing both products, but has a

comparative advantage in producing rice.
 Hypothetical case……….
– With trade - Increasing TV Production TV Rice
Country – X 10 units 0 tons
Country – Y 6 units 17 ½ tons
Total 16 units 17 ½ tons

– If the combined production of rice is unchanged from where there was no trade,
country Y can produce all 17 ½ tons by using 70 units of resources and rest 30 units
can be used to produce TV.

– With trade - Increasing Rice Production TV Rice

Country – X 10 units 0 tons
Country – Y 5 units 18 ¾ tons
Total 15 units 18 ¾ tons
 Hypothetical case……….
• If the combined TV production is unchanged from time
before trade, country X could produce 10 units by all
resources and country Y required 25 units of resources
to produce the rest 5 sets.

• The remaining 75 units of resources of country Y can

produce 18 ¾ tons of rice.

• Whether the production target is an increase of TV or

rice or both, two countries can gain by having X trade
some of its rice production to Y for some of that country’s
TV production.
 Assumptions

1. Perfect competition with flexible prices and wages prevails in both

the countries. This results in the prices of TV & rice being different
in X & Y due to a difference in labour hours used & hence
production costs.
2. Labor is the only factor of production & the average product of
labour is constant for producing both the products in both the
countries.
3. There is full employment in both the countries.
4. Labour is perfectly mobile among various sectors but perfectly
immobile between countries.
5. No technological innovation takes place in any of the economies.

• It suffers from all the drawbacks associated with the assumptions;

yet this theory is one of the closest explanations of international
trade.
 HECKSCHER-OHLIN MODEL
(Factor-Proportion Theory)
• Model developed in 1920s holds that a country’s relative
endowments of land, labour and capital will determine the relative
cost of these factors.

• If labour were abundant in relation to land & capital, labour cost

would be low and land & capital costs high; & vice versa.

• These factor costs, in turn, will determine which goods the country
can produce more efficiently.

• The reason two countries operating at the same level of efficiency

can, and do benefit from trade can be traced to the differences in
their factor endowment.
•There are two types of products – labour & capital intensive, to be produced by
labour and capital rich countries respectively; then the two countries will trade
these goods to get the benefits of international trade.

• Assumptions:
• No obstruction to trade(e.g. trade controls, transportation
cost etc.) are there;
• Both commodity & factor markets are perfectly
competitive;
• There are constant or decreasing return to scale;
• Both countries have same technology & hence operate
at same level of eficiency;
• Two factors of production exist – labour & capital. Both
are perfectly immobile for inter-country transfers, but
perfectly mobile for inter-sector transfer.
 Limitations
• It assumes that factor endowments are given, where as
they can also be developed though innovations.

• Due to minimum wage laws in some countries, the factor

prices may change to such an extent, that an otherwise
labour-rich country may find it cheaper to import labour
intensive goods than to produce them locally.

• The findings of an empirical study by economist Wassily

Leontief pointed out that despite being a capital-rich
country,US exports are more labor-intensive than capital
intensive (Leontief Paradox).
 IMITATION-GAP THEORY
• Developed by Posner, the theory considers possibility
between two countries having similar factor endowments
and consumer tastes because of existence of inventions
& innovations in existing products.

• Degree of trade between such countries will depend

upon the difference between the ‘demand lag’ and the
‘imitation lag’.

• Demand Lag is the difference between the times a new

or an improved product is introduced in one country, and
the time when consumers in the other country start
demanding it.
Demand Lag depends on:
1) speed & effectiveness of flow of information,
2) readiness of the consumers of the second country to use innovative
products, 3) ability & timing to convert their desire to demands.

• Imitation Lag is the difference between the time of introduction of the

product in one country, and the time when the producers in the other
country start producing it.

• Imitation Lag depends on:

1. Readiness of the second country to adopt new technology;
2. Time taken by the second country to learn the new process;
3. Likelihood of the second country developing the technology on their own
due to a constant process of R&D.

• If due to any of the above factors, the imitation lag is shorter than the
demand lag, no trade will take place between the two countries.

• Normally demand lag is shorter than imitation lag – country coming out
with innovation starts exporting to the second country – as awareness
create demand there – export continues till demand lag is over.
•If local producers can start producing before the last part, they can arrest the
growth of the importers (imitation lag);
at the end of the imitation lag, the trade will start coming down and shall be
finally eliminated.

• INTERNATIONAL PRODUCT LIFE CYCLE THEORY

• Two important principles of this theory (Raymond Vernon):

1. New products are developed as a result of technological

innovation;
2. Trade patterns are determined by the market structure and the
phases in new product’s life.

• The introduction stage is marked by:

1. Innovation in reference to observe need;

2. Exporting by the innovative country;
3. Near monopoly position – sales based on uniqueness rather than
price – evolving product characteristics.
 INTERNATIONAL PRODUCT LIFE CYCLE
THEORY……………..
• The Growth stage is marked by:
1. Increases in exports by innovating country;
2. More competition – some competitors begin price cutting –
product becoming more standardized;
3. Increased capital intensity.

• The Maturity Stage is characterized by:

1. Factor requirement changes & also change in the centre of
production from innovative country to other developed country –
offering a cost advantage due to a more suitable pattern of factor
prices;
2. More standardization of product;
3. More capital intensity & increased competitiveness of price.
 INTERNATIONAL PRODUCT LIFE CYCLE
THEORY……………..
• The Decline stage is marked by:

1. Concentration of production in LDCs as now it would become

possible to produce the good with relatively unskilled labour;
2. Innovating country becoming net importer.

• There are certain products for which production movements do

not take place:

1. Products having extremely short life cycle because of rapid

innovations (electronic products);
2. Luxury products for which cost is of little concern to the
consumer;
3. Products for which international transportation cost is high,& so
no opportunity for export in any stage of life cycle.
 Intra-Industry Trade
• Refers to simultaneous import and export of the same
product by a single country;

• Reasons:

1. Transportation Costs (Geographical advantage);

2. Seasonal differences (for agricultural produce);
3. Product differentiation (superior quality capital-
intensive products vs. labour-intensive and lower
quality capital intensive products) :If demand for both
types of goods exists in both countries, it may result in
intra-industry trade.
 Factors affecting International
Trade
1. High re-entry costs: A firm temporarily facing a slump
in international demand and/or price for its product
may have to continue its supply, even if it is not
economically justifiable, due to high re-entry costs.

2. Economies of Scale: A firm may be able to export even

without comparative advantage, as a result of
economies of scale.

3. Currency value: Exchange rates may increase or

decrease the competitiveness of a product in the
international market.
 Factors affecting International
Trade…………
4. Strong customer tastes for costlier brand & imperfect
competition (because of non-availability of information of
cheaper product) would distort the trade patterns.

5. Although most trade theories deal with cross-country

benefits and costs, trading decisions are usually made at
the company level – companies must have competitive
advantages to be viable exporters.

6. Companies may seek trading opportunities in order to

use excess capacity, lower production costs, or spread
risk.
 BALANCE OF PAYMENTS
• A country’s BOP affects the value of its
currency, its ability to obtain currencies of other
countries and its policy towards foreign
investment in a given period, usually one year.
• International managers may be interested in a
foreign country’s BOP for predicting the
country’s overall ability regarding:
• exports & imports;
• the payment of foreign debts;
• dividend remittances.
 Balance of Payments Accounting
• Like other accounting statements, BOP
conforms to the principle of double entry
bookkeeping.
• BOP is a sources & uses of funds statement that
reflects changes in assets, liabilities and net
worth during a specified period of time.
• Decreases in assets & increases in liabilities or
net worth represent credit or sources of funds &
vice-versa.
 Balance of Payments
Accounting………….
• Sources of funds include exports of goods & services,
investment & interest earnings, unilateral transfers
received from abroad & loans from foreigners.

• Uses of funds include imports of goods & services,

dividends paid to foreign investors, transfer payments
abroad, loans to foreigners & increase in reserve assets.

• Uses > Sources = Deficit

• BOP account shows the size of any surplus or deficit

which a nation can have & also indicate the manner in
which a deficit was financed or a surplus invested.
 Debits & Credits in BOP
• Credit transactions[+] are those that involve the receipt
of payment from foreigners:
• a) Exports of goods or services;
• b) Unilateral transfers (gifts) received from foreigners;
• c) Capital inflows.

• Debit transactions [-] are those that involve the payment

of foreign exchange:
• a) Import of goods & services;
• b) Unilateral transfers (gifts) made to foreigners;
• c) Capital outflows.
 Capital Inflows
• Can take either of two forms:
• a) An increase in the foreign assets of the nation; &
• b) A reduction of the nation’s assets abroad.

• Example: 1)When a US resident acquires a stock in an

Indian company, foreign assets in India go up – as it
involves the receipt of a payment from a foreigner.

• 2) when an Indian resident sells a foreign stock - Indian

assets abroad decreases – involving receipt of a
payment from a foreigner – resulting in capital inflows to
India.
 Capital Outflows
• Can take either of two forms:
• An increase in nation’s assets abroad;
• A reduction in the foreign assets of the nation.
• Example: 1) Purchase of a UK Treasury bill by
an Indian resident – resulting in an increase in
the Indian assets abroad and is a debit
transaction - involving a payment to foreigners.
• 2) Sale by a US firm of an Indian subsidiary –
reduces foreign assets in India and is entered as
a debit transaction.
 BOP Statement
• BOP statement records all types of
international transactions that a country
consummates over a certain period of
time – divided into three distinct sections:
1. The Current Account,
2. The Capital Account,
3. The Official Reserve Account
 A. The Current Account

• Divided into three sub-categories: merchandise trade

balance, services balance & balance on unilateral
transfers.
• Entries in this account are ‘current’ in value as they do
not give rise to future claims.

• Current Account balance= A[1] +A[2]+A[3]

1. Balance of merchandise trade refers to the balance

between exports and imports of tangible goods such
as automobiles, computers, machinery & so on……
A[1].
 A. The Current Account…….

2. Services account includes interest payments, shipping &

insurance fees, tourism, dividends & military expenditures. These
trades in services are often called as invisible trade…A[2]

3. Unilateral transfers are gifts and grants by both private parties &
government. Private gifts & grants include personal gifts of all
kinds & also relief organization shipments.

• Government transfers include money, goods & services sent as

aid to other countries.

• Unilateral transfers have only one-directional flow without

offsetting flows. For double entry bookkeeping, unilateral transfers
are known as an act of buying goodwill from the recipient…..A[3]
 Current Account
(Summary)
• Goods Account
• Merchandise Exports (+)
• Merchandise Imports (-)
• Balance on goods account = A(1)
• Services Account
• Receipts as interest & dividends, tourism receipts for travel &
financial charges(+)
• Payments as interest & dividends, tourism payments for travel &
financial charges(-)
• Balance on services account = A(2)
• Unilateral Transfer
• Gifts, donations, subsidies received from foreigners (+)
• Gifts, donations, subsidies made to foreigners (-)
• Balance on unilateral transfer account = A(3)
• CURRENT ACCOUNT BALANCE = A(1) + A(2) + A(3)
 B. The Capital Account
• An accounting measure of total domestic currency value
of financial transactions between domestic residents and
the rest of the world over a period of time.

• Consists of loans, investments, other transfers of

financial assets & the creation of liabilities.

• Includes financial transactions associated with

international trade as well as flows associated with
portfolio shifts involving the purchase of foreign stocks,
bonds and bank deposits.
 B. The Capital Account…….
• A country’s current account deficit must be paid for either
by borrowing from foreigners or by selling off past foreign
investments.

• In the absence of a government reserve transaction, a

current account surplus equals a capital account deficit &
vice-versa : i.e. current account balance must be equal
to capital account balance but with the opposite sign.

• Three sub-categories: direct investment, portfolio

investment & other capital flows.
• Capital Account balance = B[1] +B[2] +B[3]
 B. The Capital Account…….
• Direct investment occurs when the investor acquires
equity such as purchases of stocks, the acquisitions of
entire firms, or the establishment of new
subsidiaries…..B[1]

• FDI generally takes place when firms tend to take

advantage of various market imperfections.

• Firms also undertake FDI when expected returns from

foreign investments exceed the cost of capital, allowing
for foreign exchange & political risk.
 B. The Capital Account…….
• Portfolio investments represent sales & purchase of
foreign financial assets such as stocks and bonds that
do not involve a transfer of management control….B[2]

• Investors generally feel that they can reduce risk more

effectively if they diversify their portfolio holdings
internationally, rather than pure domestically.

• Capital flows represent the third category & refers to

claims with a maturity of less than one year (bank
deposits, S-T loans, S-T securities, money market
investments etc.)……B[3]
 B. The Capital Account…….
• Short-term capital accounts change for two specific
reasons:

1. Compensating or accommodating adjustments are

short-term capital movements induced by changes due
to merchandise trade, services, unilateral transfers and
investments.

2. Autonomous adjustments are short-term capital

movements due to differences in interest rates and
also expected changes in foreign exchange rate
among nations – take place for pure economic
reasons.
 Capital Account
(Summary)
• Foreign Direct Investment (FDI)
• Direct investment by foreigners (+)
• Direct investment abroad (-)
• Balance on direct foreign investment =B(1)
• Portfolio Investment
• Foreigners’ investment in the securities of the country (+)
• Investment in securities abroad (-)
• Balance on portfolio investment = B(2)
• Balance on long-term capital account= B(1) + B(2)
• Private short-term Capital Flows
• Foreigners’ claim on the country (+)
• Short-term claims on foreigners (-)
• Balance on short-term private capital account = B(3)
• OVERALL BALANCE =[ A(1)+A(2)+A(3)] + [B(1)+B(2)+B(3)]
• ERRORS & OMISSIONS
 Errors & omissions
• Collectively termed as ‘Statistical Discrepancy’ arise
for different reasons:
1. Difficulties involved in collecting BOP data ( in India,
the trade figures compiled by RBI differ from compiled
by DG of Commercial intelligence & Statistics).
2. Movements of capital may precede or follow the
transactions that are supposed to finance.
3. Certain figures are based on estimates (figures for
earning in the travel & tourism account are estimated
on the basis of sample cases).
4. Lastly, errors & omissions are explained by unrecorded
illegal transactions that may be either on the debit side
or the credit side or on both.
C. The Official Reserve Account
• Official reserves are government owned assets
represent only purchases & sales by the Central Bank of
the country.

• The changes in official reserves are necessary to

account for the deficit or surplus in the BOP.

• If the country has a BOP deficit, the Central Bank will

have to either run down its official reserve assets such
as gold, foreign exchanges and SDRs or borrow fresh
from foreign central banks.
 C. The Official Reserve
Account………….
• Special Drawing Rights : sometimes called paper gold, are special
account entries on the IMF books designed to provide additional
liquidity to support growing world commerce.

• Although SDRs are a form of money not convertible to gold, their

gold value is guaranteed, which helps to ensure their acceptability.

• Participating nations may use SDRs as a source of currency in a

spot transaction, as a loan for clearing a financial obligation, as a
security for a loan, as a swap against currency, or in a forward
exchange operation.

• If the country has a BOP surplus, its central bank will either acquire
additional reserve assets from foreigners or retire some of its foreign
debts.
 Illustration
[How transactions affect BOP]
• Merchandise trade: An Indian company sells Rs.4,00,000
worth of machinery to a US company, which will make
payment in 30 days.

• In this transaction, merchandise exports are credited as

they provide India with an increase in its claim on
foreigners. Simultaneously, Indian exporter should
increase its short term investment abroad, i.e., an increase
in its AR – represent a use of funds or a debit entry.

• Transaction will appear in Indian BOP as follows:

• Liquid short-term capital [debit] Rs.4,00,000
• Exports [credit] Rs.4,00,000
 Illustration
[How transactions affect BOP]
• Services: An Indian woman visiting her son in UK,
cashes Rs.3,00,000 worth of her Indian Traveller’s
cheque at a UK hotel & spends the whole prior to return
to India.
• Here, India received tourist services from UK to the
amount of Rs.3,00,000 – a use of funds. In return to
these tourist services, UK banks now have Rs.3,00,000
worth of Indian currency – a source of funds.

• Transaction will appear in Indian BOP as follows:

• Tourist Expenditure [Debit] Rs.3,00,000
• Liquid short-term capital [Credit] Rs.3,00,000
 Illustration
[How transactions affect BOP]
• Unilateral Transfer: the US Red Cross sends $10,00,000
worth of flood relief goods to India.

• The term ‘transfer’ reflects the nature of the transaction –

US receives nothing in return & this transaction reduces
the real assets of USA – thus to be debited. The sale
/unilateral transfer by USA represents exports & these
exports are credited.

• Transaction will appear in USA BOP as follows:

• Transfer Payments [Debit] $10,00,000
• Exports [Credit] $10,00,000
 Illustration
[How transactions affect BOP]
• Long-term Capital: A Japanese purchases yen 60,000 worth of UK
bonds and pays for it with a cheque drawn on an account.

• The Japanese now owns a UK bond, while UK owns Japanese yen

deposits. Since the acquisition of the UK bond increases Japan’s
portfolio of bank investments in foreign countries, the portfolio
investments must be debited.

• Similarly, yen balance owned by UK represents an increase in

Japan's liability to foreigners & thus short-term capital be credited.

• Transaction will appear in Japan’s BOP as follows:

• Portfolio Investments [Debit] yen 60,000
• Liquid short-term capital [Credit] yen 60,000