Chapter 1

OVERVIEW OF GLOBAL THEORY

AND PRACTICE

Dr. Gopalakrishna B.V.,

Faculty in MBA
 Chapter Outline

• Meaning and nature international business

environment
• Distinctions between internal and international
business
• Advantages and disadvantages of international
trade/business
• Theories in international trade
– Mercantilism
– Theory of absolute cost advantage
– Comparative cost advantage
– Heckscher – Ohlin theory
• International investment
• Global forces effecting international trade
 What is business and business
environment?
 Business is a wide term and signifies all
economic activities carried on with the
objective of earning money/profit/gain.
 Economic activities involve production,
exchange, distribution and consumption of
goods and services.
 In short, the definition of a business as a
commercial activity to make a profit of an
organisation (private or public).
 Important decisions related to business
such as – What business to do, where to
do the business, when to do the
business, how to do the business,
whether to expand a business and if
where and how to expand it – are
influenced by a number of factors.
 In a broad sense, business environment
refers to all those internal and external
factors that have a bearing on the
business.
 Definitions
 B.O. Wheeler – Business is an institution
organised and operated to provide goods
and services to society under the incentive of
private gain.
 The Income Tax Act 1961 – Business
means any trade, commerce or manufacture
or any adventure in the nature of trade,
commerce or manufacturing.
 The above definition emphasis that business
is a wide term and includes all types of
economic activities carried on with a
profit motive.
 Chart: 1.1 Input and output model

Management

Input Transformation
Process
Output

External Environment
 The success and failure of a business
depends on various factors like physical
resources, financial resources,
technological, human resources, skills
and organisation.
 Thus, success and survival of a firm,
depend on two sets of factors – internal
factors and external factors.
 The business environment consists of a
number of factors which have different
types and degrees of influence on the
business.
 Some factors have a favourable impact on
the business, some of the them are
adversely affected and some are neutral.
 For example New Economic Policy –
Liberalisation, Privatisation &
Globalisation – generate employment
opportunities, new technology, increases in
income, importing raw-material etc.
 Keith Davis – business environment as the
aggregate of all condition, events &
influences that surround and influence it.
 Business Environment

Internal Environment External Environment

Micro External Macro External

Environment Environment

Chart: 1.1 Classification of Business Environment

Internal factors – are generally regarded as
controllable factors because the company has
control over these factors – it can alter or modify
such factors as its – personnel, physical
facilities, organisation and functional.

External factors – by and large, beyond the

control of a company. The external factors such
as economic factors, socio-cultural factors,
government and legal factors, demographic
factors, physical factors etc.
 Internal Environment
 Internal environmental factors are -
controllable factors because the firm can
change or modify these factors to improve its
efficiency.
 Internal environment includes such factors as
 Value system,
 Mission and objectives of the firm,
 Management structure,
 Quality of its human resources,
 Corporate culture
 Physical assets,
Corporate Value Mission &
Culture System Objectives

Business
Organisation

Physical Human
Organisation
Resources Resource
Structure

Chart 1. 2 Internal Environment

 1. Value System
 The value system of a business organisation
also determines its behaviour towards its
employees, customers and society at large.
 The value system of the promoters of a business
firm has an important bearing on the choice of
business and the adoption of business policies
and practices.
 Value system makes an important contribution to
its success and its prestige in the world of
business.
 Infosys Technologies which won the first
national corporate governance award in 1999
attributes its success to its high value
system.
 2. Mission and Objectives
 The objective of all firms is assumed to be
maximisation of long run profits. But
mission is different from this narrow
objective of profit maximisation.
 Mission is defined as the overall purpose
which guides and influences its business
decision and economic activities.
 For example, “to become a world class
company and to achieve global dominance
has been the mission of Reliance Industries
of India.
 3. Organisation Structure
 Organisation structure is the composition of
board of directors, the number of independent
directors, the extent of professional
management and share holding pattern.
 The nature of organisational structure has a
significant influence over decision making
process in an orgnisation.
 An efficient working of a business organisation
requires that its organisation structure should be
conducive to quick decision making.
 Board of directors is the highest decision
making body in a business organisation.
 4. Corporate culture & Style of Functioning of
top Management
 Corporate culture & Style of Functioning of top
managers is important factor for determing the
internal environment of a company.
 Corporate culture is generally considered as
either closed and threatrening or open and
participatory.
 In a closed and thretening type of corportate
culture the business decision are taken by top
level managers,
 While middle level and lower level managers
have no say in business decision making.
 5. Quality of Human Resources
 Quality of employees of a firm is an important
factor of internal environment of a firm.
 The success of a business organisation
depends to a great extent on the skills,
capabilities, attitudes and commitment of its
employees.
 Employees differ with regard to these
characteristics.
 It is difficult for the top management to deal
directly with all the employees of the business
firm.
 Therefore, for efficient management of human
resources, employees are divided into
different groups.
 6. Labour Unions
 Labour unions are other factor determining internal
environment of a firm.
 Unions collectively bargain with top managers regarding
wages, working conditions of different categories of
employees.
 Smooth working of a business organisation requires that
there should be good relations between management and
labour union.
7. Physical Resources and Technological Capabilities
 Physical resources such as plant and equipment and
technological capabilities of a firm determine its competitive
strength which is an important factor determining its
efficiency and unit cost of production
 R & D capabilities of a company determine its ability to
introduce innovations which enhance productivity of
workers.
 External Environment
 External environment are by, and large, beyond
the control of a company.
 External environment consists of those factors
that affect a business enterprise from outside.
 External environment is generally classified
into micro environment and macro
environment.
 External Micro environment includes –
Suppliers of Inputs, customers, competitors
market Intermediaries and publics.
 External Macro Environment are classified
into – Economic, social, technological,
political and legal and demographic
 1. External Micro Environment
 External micro environment or task environment
refers to those individuals, groups and agencies
with which the organisations comes into direct and
frequent contact in the course of its functioning.
 Micro environmental factors exercise a direct
influence on the operations of the enterprise.
 Therefore, it is also known as direct action
environment or stakeholders.
 For examples - customers, competitors,
suppliers, marketing intermediaries, financiers
and publics
Chart: 1. 3: External Micro Environment

Suppliers of
Com Inputs
peti
to mers
rs
u sto
C
Management
Pu
b li
i ers cs
anc
Fin

Marketing
intermediaries
 1. Suppliers of inputs
 An important factor in the external micro
environment of a firm is the suppliers of its inputs
such as raw-materials and components.
 A smooth and effective working of a business
firm requires supply of inputs such as raw-
materials and power etc.
 Energy input is an important input in the
manufacturing business.
 If supply of raw materials are uncertain, then a
firm will have to keep a large stock of raw
material to continue its transformation process
uninterrupted.
 2. Customers
 The primary task of any business is to create and
sustain customers.
 Without customers business is unthinkable.
 The success of business depends upon how best it
monitors the sensitivity of customers.
3. Competitors
 Business firms compete with each other not only for
sale of their product but also in other areas.
 Generally, market forms of monopolistic
competition & differentiated oligopolies exist in
the real work.
 This competition may be on the best of pricing of
their products.
 Non- price competition – advertisement & sales
promotions
 In USA, American firms faced a lot of
competition from Japanese firms producing
electronic and automobiles goods.
 Similarly, the Indian firms are facing a lot of
competition from Chinese products.
4. Marketing intermediaries
 Marketing intermediaries play an essential role of
selling and distributing its product to the final
buyers.
 Marketing intermediaries includes agents and
merchants such as distribution firms,
wholesalers, retailers.
 Marketing intermediaries are responsible for
stocking and transporting goods from their
production – ultimate buyers.
 External Macro environment
 Macro environment refers to the general
environment or remote environment within which
a business firm and forces in its micro
environment operate.
 The external macro environment determines the
opportunities for a firm to exploit for promoting its
business
 The macro environment has both positive and
negative aspects.
 An important fact that macro environmental
forces is the uncontrollable by the
management of a firm.
 Because of the uncontrollable nature of macro
forces a firm has to adjust or adapt itself to these
external forces.
 Social & cultural Political & Legal
Economic
Environment Environment
Environment

Business
Organisation

Natural Demographic Technological

Environment Environment Environment

Chart 1. 2 External Macro Environment

Classification of Macro environment -

1. Economic environment
2. Social and cultural environment
3. Political and Legal Environment
4. Technological Environment
5. Demographic Environment
6. Natural Environment
 1. Economic Environment
 Economic environment includes the type of
economic system that exists in the
economy and nature and structure –
capital, social & mixed economy.
 The phases of business cycle – boom or
recission.
 The fiscal, monetary and financial
policies of the government.
 These economic policies of the govt
present both the opportunities as well as
the threats for the business firms.
 Industrial Policy – 1948, 1956, 1980, 1990
& 1991.
 Foreign Exchange Regulation Act (FERA).
 Monopolistic & Restrictive Trade Policy
(MRTP)
 Structural Adjustment Programme (SAPs)
– New Economic Policy 1991 –
Liberalisation, Privatisation and
Globalisation (LPG).
 2. Social and Cultural Environment
 The buying and consumption habits of the people,
their language, belief & values customs &
traditions, tastes and preference, education etc.
 The socio-cultural fabric is an important environmental
factor that should be analyzed while formulating
business strategies.
 For a business to be successful, its strategy should be
the one that is appropriate in the socio-cultural
environment.
 Good corporate governance should be judged not
only by the productivity and profits earned by a
business firm but also by its social welfare
promoting activities.
 3. Political and Legal Environment
 Business are closely related to the govt.
 The political philosophy of the govt wields a
great influence over business policies.
 The industrial policies 1948, 1956, 1980,
1990 & 1991.
 Foreign Exchange Regulation Act
(FERA)
 Monopolistic & Restrictive Practices
(MRTP) Act
 Structural Adjustment Programmes
(SAPs) – 1991.
 4. Technological Environment
 The nature of technology used for production
of goods & services is an important factor
responsible for the success of a business firm.
 Technology consists of the type of machines
and processes available for use by a firm and
the way of doing things.
 The improvement in technology raises total factor
productivity of a firm and reduces of cost of
output.
 The use of a superior technology by a firm for its
transformation process determining its competitive
strength.
 5. Demographic Environment
 Demographic environment includes the size
of growth of population, life expectancy
at birth, rural and urban distribution of
population etc.
 All these demographic features have an
important bearing on the functioning of
business firms.
 The demographic environment affects
both the supply and demand sides of
business organisations.
 6. Natural environment
 Natural environment is the ultimate sources of
many inputs such as raw-materials, energy
which business firms use in their productive
activity.
 The availability of natural resources in a region is
a basic factor in determining business activity.
 Natural environment which includes
geographical as well as ecological factors –
minerals, oil resources, forest resources.
 Fore example, the availability of minerals such as
iron, coal etc in a region influence the location of
certain industries in that region.
 Global Business Environment
 The global environment refers to those global
factors which are relevant to business such as
WTO principle & agreements, other
international conventions treaties, agreement
declaration & protocols etc.
 Economic conditions in other countries may
affect the business.
 International political factors – war, political
tension or uncertainties.
 Developments in information &
communication technologies.
 Certain developments such as a hike in the
crude oil price have global impact.
 Modern business is very much influenced
by global or international environment.
 The increasing importance of
liberalization, privatization &
globalization (LPG) has significant bearing
on business activities.
 The establishment of GATT & later WTO
has profound impact on global business
environment.
 The trade liberalization has offered many
opportunities for business firms.
 If the firm will have to be efficient &
dynamic to survive the global competition.
 International Business Environment

Internal Environment External Environment

Value System
Mission & External Micro External Macro
Objectives Environment Environment

Corporate culture Share holders Social &

cultural
Organisational structure Creditors
Technological
Human Resource Bankers & FIs
Economic
Physical Resources Competitors
Political
Suppliers
International
Market Intermediaries
Natural
Customers
 Evolution of international Business
 The origin of international business goes back
to human civilization.
 The concept of international business is a
broader concept relating to the integration of
economies and societies.
 The first phases of globalization begin around
1870 and ended with first world war 1919.
 This results by the industrial revolution in the UK,
Germany & the USA.
 The colonial empires importing raw-material
and exporting finished goods at higher prices.
 Later stage, various govts initiated and imposed a
number of barriers to trade to protect their
domestic production that led to decline in trade
ratio.
1913 – 22,1%
1930 – 9.1%
 That leads severe set back to advanced countries.
 In addition to breakdown of the gold standard
resulted severe set back on international trade.
 Therefore, world nations felt the need for
international co-operation in global trade and
BOP affairs.
 These efforts resulted in the establishment
of the IMF & IBRD
 After the second world war most of the
countries adopted protection policy to
protect themselves.
 After Geneva Conference GATT has
came to picture in 1947.
 After concluded the Uruguay round WTO
came into establish in 1995.
 Drivers of Globalization
 Various economies including the former
communist and socialist countries opened
their economy with rest of the globe.
 The shifts in globalization and international
business have been encourage to fast growth
after 1990s.
 The external factors have been contributing
significantly for the remarkable strides in
global business.
 Globalisation influences on various aspects.
 Establishment of WTO

G
L Regional Integration
O
B Decline in Trade Barriers
A
L
Decline in Investment Barriers
I
S
A Increase in FDI
T
I
Changes in
O Technology
N
Growth of MNCs
 1. Establishment of World Trade
Organisation
 General Agreement on Trade and Tariff (GATT)
concluded in the Uruguay round – 15th
December, 1994.
 Marrakesh Declaration – 15th April 1994
strengthen world trade through investment,
employment and income growth.
 On 1st January 1995 – WTO was established.
 The value of exports increased by 245% and
import increased by 1014% after establishment
of WTO during 1995 & 2006.
 2. Regional Integration
 Integration has developed as an alternative to
the policy of free trade.
 It is an arrangement in which certain countries
having common economic interest and
political system decide to reduce or remove
tariff and other trade barriers among
themselves.
 The two essential features are – free trade
among the member countries and imposition of
a common external tariff policy on non-
members.
 The significant regional integrations includes –
European Union, NAFTA, ASEAN, SAARC,
EFTA, APEC, MERCOSUR & ANDEAN.
1. EU European Union– 1952 – West Germany,
France, Italy, Belgium, Netherlands & luxembourg.
2. NAFTA – North American Free Trade Agreement -
1989 - USA, Canada & Mexico.
3. ASEAN – The Association of South-east Asian
Nations – 1967 – Singapore, Brunei, Malaysia,
Philippines, Thailand & Indonesia.
4. SAARC – South Asian Association for Regional
Co-operation – 1985 – Indian, Bangladesh, Bhutan,
Pakistan, Maldives, Nepal & Srilanka.
5.EFTA – The European Free Trade Association
– 1960 – Austria, Norway, Portugal, Sweden, &
Switzerland.
6. APEC – Asia-Pacific Economic Co-operation
– 1989 – 21 members – Canada, Chile, China,
China Republic, Hong Kong, Indonesia, Japan,
Republic Korea, Malaysia, Mexico, New
Zealand & Peru.
7. MERCOSUR – 1991 – Argentina, Brazil,
Paraguay, Uruguay, Chile & Bolivia.
8. ANDEAN – 1993 – Bolivia, Colombia, Ecuador,
Peru & Venezuela
 3. Declining Trade Barriers
 Another significant drivers of globalization is the
declining trade barriers.
 Govts used to impose trade barriers like quotas
and tariffs in order to protect domestic business
from the external business.
 Advanced countries after World War II agreed
to reduce tariffs in order to encourage free
flow of goods.
 GATT in various rounds of negotiations
agreed to reduce the tariff rates.
 Uruguay round negotiations contributed to
further reduction of trade barriers to cover
manufactured goods and services.
 Declining Trade Barriers
1913 1950 1990 2000
USA 44% 14% 4.8% 3.9%
Japan 30% 18% 5.3% 3.9%

The bilateral treaties increased from 181 in 1980

and 1,856 in 2000 among 160 countries.
 4. Declining Investment Barriers
 Global business firms invest capital in order to
establish manufacturing and other facilities in
foreign countries.
 Foreign govts impose barriers on foreign
investment in order to protect domestic industry.
 After the globalization policy, various countries
have been removing these barriers on foreign
direct investment in order to encourage the global
business
 Various govt made 1,238 changes in the laws
governing FDI between 1991 and 2007.
 5. Growth in FDI
 Foreign direct investment means investment
in a foreign country where the investor retains
control over the investment.
 There are a number of reasons for the growth
of FDI in recent years.
 Increase in sales and profits
 Rapid growth of markets
 Reduce costs
 Consolidate trade blocs
 Protect domestic & foreign markets
 Acquire technology
 FDI increases from US $ 564 billion to
8,981 billion in 2007.
 Advanced countries were the major
players in the flow of FDI.
 Emergining economies receiving high FDI
– China, Hong Kong, Brazil, Mexico, India
and Singapore.
 6. Changes in Technology
 Technological change is amazing and phenomenal
after 1980s.
 Infact, it is like a revolution in
telecommunication, information technology,
transportation technology.
 In addition, the latest developments in information
technology have enabled the global company to
develop.
Micro-processors and Telecommunication
Internet and worldwide web
On-line globalisation
Transportation technology.
 6. Growth of Multinational Companies
A multinational corporation is an
organization doing business in more than
one country.
 Transnational company produces, markets,
invests and operates across the world.
 European Union - 163
 USA - 162
 Japan - 67
 Developing countries - 53
 India - 06
 Internal and international trade
 Internal trade is meant transactions taking place
within the geographical boundaries of a nation
or region – domestic or intra regional or home
trade.
 International trade, on the other hand, is trade
among different countries or trade across
political frontiers.
 International trade, thus, refers to the exchange of
goods and services between one country with
other countries.
 In brief, trade between one nation with other nation
is called international trade and trade within the
territory (political boundary) of a nation “internal
trade”.
 Reasons for international trade
1. Inter dependence of each and every
nations.
2. Factor endowments in different
countries in differ
3. Technological advancement of different
countries in differ
4. Labour and entrepreneurial skills differs in
different countries.
5. Factors of production are highly
immobile between countries.
S
Immobility of Factors
A
I
L Heterogeneous Markets

E
N Different National Groups
T

F Different Political Units

E
A Different National
T Policy & Govt
U
R Different Currencies
E
 1. immobility of Factors
 The degree of immobility of factors of production
like labour & capital which is generally greater
between countries than within the country.
 Immigration laws, citizenship, qualifications
etc often restrict international mobility of labour.
 For instance, wages may be equal in Mumbai
and Pune but not in Bombay & London.
 Prices of G/S similarity within the economy but at
internationally differentiated - Dumping
 2. Heterogeneous Markets
 In the international trade – lack of
homogeneity on account of differences in
climate, language, preferences, habit,
customs, weights and measurements
etc.
 Socio-economic environment differs greatly
between nations, while it is more or less
uniform within the country.
 Frederick List – domestic trade is among
us and international trade is between us &
them.
 3. Different National Groups
 International trade is a phenomenon which occurs
among different political units.
4. Different Political Units.
 International trade occurs between different
political units, while domestic trade occurs within
the same political unit.
 The government in each country is keen about
welfare of its own nations against that of the
people of other countries.
 Hence, in international trade policies of each
government tries to see its own interest at the cost
of the other country.
5. Different National Policies & Govt interventions
 Economic & political policies differ from one country
to another.
 Policies pertaining to trade, commerce, export &
import, taxation etc also differ widely among countries
through they are more or less uniform within the
country.
 Tariff policy, import quota system, subsidies &
other controls adopted by a government interfere
with the course of normal trade between us & other
countries.
 6. Different currencies
 Another notable feature of international
trades is that it involves the use of different
types of currencies.
 So, each country has its own policy in
regard to exchange rates and foreign
exchange policies.
 That is why there is the problem of
exchange rates & foreign exchange.
 Internal and international trade or internal
 Internal trade is meant transactions taking place
within the geographical boundaries of a nation
or region – domestic or intra regional or home
trade.
 International trade, on the other hand, is trade
among different countries or trade across
political frontiers.
 International trade, thus, refers to the exchange of
goods and services between one country with
other countries.
 In brief, trade between one nation with other nation
is called international trade and trade within the
territory (political boundary) of a nation “internal
trade”.
 Reasons for international trade
1. Inter dependence of each and every
nations.
2. Differences in Factor endowments
3. Differences in Technological
advancement
4. Differences in Labour and entrepreneurial
skills between the countries.
5. Factors of production are highly
immobile between countries.
 Differences between domestic business
and international business
 Basically, domestic business and
international business operate on similar
lines.
 But there are certain differences between
these two business.
 The significant differences between these
two emerge from foreign exchange,
quotas, tariff, regulations of a number of
governments, wide variations in culture
etc.
 The classical economists argues that there
were certain fundamental differences
between internal and international business
– Adam Smith, David Ricardo & J.S. Mill
 They propounded a separate theory of
international trade.
 But modern economists like Bertil Ohlin &
Haberler view and opine that the
differences between interregional and
international trade are of degree rather
than of kind.
 Indicators International business Internal business
Factors of Perfectly immobile between the Perfectly mobile within
Production countries each regions
Natural Greater differences between Not much differences
Resources countries between regions
Geographical & Different geographical & climatic Not much differences
Climatic conditions
conditions
Different Language, usage, taste & Homogeneous in
Markets preferences, weights and characteristic
measurement
Different Different currencies – Dollar, Single currency - Rupees
Currencies Pound, Yen etc.
Transport Cost More transport costs Less Transport costs

BOP It is perpetual in international No need of BOP

trade
National Different national policies Homogeneous policy
policies
S
Immobility of Factors
A
I
L Heterogeneous Markets

E
N Different National Groups
T

F Different Political Units

E
A Different National
T Policy & Govt
U
R Different Currencies
E
 1. immobility of Factors
 The degree of immobility of factors of production
like labour & capital which is generally greater
between countries than within the country.
 Immigration laws, citizenship, qualifications
etc often restrict international mobility of labour.
 For instance, wages may be equal in Mumbai
and Pune but not in Bombay & London.
 Prices of G/S similarity within the economy but at
internationally differentiated - Dumping
 2. Heterogeneous Markets
 In the international trade – lack of
homogeneity on account of differences
in climate, language, preferences, habit,
customs, weights and measurements
etc.
 Socio-economic environment differs greatly
between nations, while it is more or less
uniform within the country.
 Frederick List – domestic trade is
among us and international trade is
between us & them.
 3. Different National Groups
 International trade is a phenomenon which occurs
among different political units.
4. Different Political Units.
 International trade occurs between different
political units, while domestic trade occurs within
the same political unit.
 The government in each country is keen about
welfare of its own nations against that of the
people of other countries.
 Hence, in international trade policies of each
government tries to see its own interest at the cost
of the other country.
5. Different National Policies & Govt interventions
 Economic & political policies differ from one country
to another.
 Policies pertaining to trade, commerce, export &
import, taxation etc also differ widely among countries
through they are more or less uniform within the
country.
 Tariff policy, import quota system, subsidies &
other controls adopted by a government interfere
with the course of normal trade between us & other
countries.
 6. Different currencies
 Another notable feature of international
trades is that it involves the use of different
types of currencies.
 So, each country has its own policy in
regard to exchange rates and foreign
exchange policies.
 That is why there is the problem of
exchange rates & foreign exchange.
 7. Problem of Balance of Payment
 Another important point which distinguishes
international trade from interregional trade is the
problem of BOP.
 The problem of BOP is perpetual in international
trade, while regions within a country have no such
problem.
 This is because there is greater mobility of capital
within regions than between countries.
 Further, the policies which a country chooses to
correct its disequilibrium in the balance of
payments may give rise to a number of other
problems.
 Advantages of international business
1. High Living Standards
2. Increased Socio-economic Welfare
3. Wider Market
4. Reduced Effects of Business Cycles
5. Reduced Risks
6. Large-scale economies
7. Potential Untapped Markets
8. Provides the Opportunity for and challenge to
domestic business
9. Division of labour and specialisation
10.Economic growth of the world
11.Optimum and proper utilization of world resources
12.Cultural transformation
13.Knitting the world into a closely interactive traditional
village.
Disadvantages of international business
1. Political Factors
2. Huge Foreign Indebtedness
3. Exchange Instability
4. Entry Requirements
5. Tariffs, Quotas and Trade Barriers
6. Corruption
7. Bureaucratic Practices of Government
8. Technological Pirating
9. Quality Maintenance
 Theories of International Trade
 International trade becomes possible for
mutual benefit to the two countries due to
the differences in opportunity costs.
 International trade between two countries
can benefit both countries if each country
exports the goods in which is has a
comparative advantage.
 A number of theories have been
developed by the international economists
are -
Theories of International Trade
1. Mercantilism
2. Theory of Absolute Cost Advantage
3. Comparative Cost Advantage Theory
4. Comparative Cost Advantage with Money
5. Heckscher Ohlin Theory – differences in
factors endowments
6. Country Similarity Theory
7. Product Life Cycle Theory
8. Global Strategic Rivalry Theory
 1. Mercantilism
 Mercantilism is the oldest international trade
theory during 1500 – 1800.
 According to this theory the holdings of a
country’s treasure primarily in the form of gold
constituted its wealth.
 This theory specifies that countries should
export more than they import & receive the
value of trade surplus in the form of gold from
those countries which experience trade deficits.
 Government imposed restrictions on imports &
encouraged exports in order to prevent trade
deficit & experience trade surplus.
 Colonial powers like the British used to
trade with colonies like India, Srilanka etc.
 By importing the raw-materials from &
exporting the finished goods to colonies.
 The colonies had to export less valued
goods & import more valued goods.
 The theory benefited the colonial powers
& caused much discontent in the colonies.
 This theory was criticized by Adam Smith
& developed new theory of absolute cost
advantage – different cost of production
leads the international trade.
 2. Theory of Absolute Cost Advantage
 Adam Smith proposed Absolute Cost
Advantage Theory of International Trade in his
Publication “An Enquiry into nature and causes
of Wealth of Nation in 1776.
 He explain about reason for international trade
between two countries in terms of absolute cost
advantage.
 He assumed that the cost of the commodities
was determined by the relative amounts of labour
involved in their production.
 Free trade promote international division of
labour and specialisation.
 Assumptions of the law
1. 2 x 2 Model – two countries and two commodities
– A & B Countries – X & Y commodities.
2. Labour is the only factors of production.
3. A policy of Laissez faire is advocated – absence
of govt intervention.
4. Perfect competition existed in both commodity
and factor market.
5. All labour were assumed to be homogenous –
equal skills and efficient.
6. Factors of Production are perfectly mobile
within the country but perfectly immobile
between different countries.
7. Ignores transport costs.
8. There is no trade cycles in the economy.
 International trade would be beneficial for a
country to exports products to those
countries where these products could not be
produced at lower rates.
 The trade between the countries would result in
allocation of the resources in the world and hence
productivity will boost.
 Trade between them will take place if each of the
two countries has absolutely lower cost in the
production one of these commodity.
 A country will export that commodity in the
production of which it has an absolute cost
advantage and import that commodity in
which it has absolute cost disadvantage.
Table: 1 Absolute Costs Differences
(one unit of labour)

Country Commodity X Commodity Y

A 10 5

B 5 10

A = 10X or 5 Y = 15
B = 5X or 10 Y = 15
 A has an absolute advantage in the
production of X i.e., 10X > 5Y.
 B has an absolute advantage in the
production of Y i.e., 10Y > 5X
10 X of A 5 Y of A
_____________ > 1 > ______________

5 X of B 10 Y of B
 After trade contract
 Trade between the two countries will benefit both
if A specialise in the production of X & B in the
production of Y
Table: 2 Gain from trade
Production Production after Gains from trade
Country before trade trade
X Y X Y X Y

A 10 5 20 - +10 -5
B 5 10 - 20 -5 +10
Total 15 15 20 20 +5 +5
Production
 The above table reveals that before trade both
countries produce only 15 units each of the two
commodities by applying one labour unit on each
commodity.
 A were to specialise in producing commodity X
and use both units of labour on it, its total
production will be 20 units of X.
 Similarly, if B were to specialise in the production
of Y alone, its total production will be 20 units of
Y.
 The combined gain to both countries from trade
will be 5 units each of X and Y.
 Chart: Absolute Cost Differences
Y

YB
OXA > OXB – country A
OYB > OXA - country B
Y Commodity

YA

O XB XA X
X Commodity
 Before trade
 Both countries produce only 15 units each
of the two commodity by using one unit on
each commodity.
After trade
 A country were specialise in producing
commodity X with 20 units
 B country were specialise in the production
of Y with 20 units of Y
 The combined gain to both countries from
trade will be 5 units each of X & Y.
 Criticism of the theory
1. No Absolute Advantage – One country should
be able to produce at least one product at a
comparatively low cost. But in reality most of the
developing countries do not have absolute
advantage of producing any product at the lowest
cost.
2. Country Size – countries vary in size. This
theory does not deal with country by country
differences in specialisation.
3. Variety of Resources – though these are
several resources like labour, technology and
natural resources, this theory deals with only
labour and ignores all other resources.
4. Transport cost – though the cost of
transportation plays a significant role in
international trade, this theory ignored this
aspect.
5. Large scale economies – large scale
economies reduces the cost of production &
form of part of the absolute advantage.
6. Absolute Advantage for many products
– some countries may have absolute
advantage for many products – for example
– Japan, USA, France & U.K. etc.
 3. Theory of Comparative Cost Advantage
 The classical theory of the international trade, also
known as the theory of comparative costs.
 The Comparative Cost Theory was first
systamatically formulated by the English
economist David Ricardo in his Publication
entitled “Principles of Political Economy &
Taxation” – 1817.
 It was later refined by J.S. Mill, Marshall,
Taussing & Others.
 According to David Ricardo, it is not the absolute
but the comparative differences in cost that
determine trade relations between two countries.
 Ricardo states that the countries could be
benefited by trade even when a country could
produce both the commodities at less labour
cost than the other country.
 Production costs differ in countries because of
geographical condition, division of labour &
specialisation in production, climate
conditions, natural resources & efficiency of
labour of a country can produce one commodity
at a lower cost than the other.
 One country has a comparative advantage in
the production of both the commodities while
other country has a comparative less
disadvantage in the production of one
commodity.
 As long as the cost ratios differ, both countries
gain from trade, regardless of the fact that one of
the countries might have an absolute
disadvantage in the production of both the
commodities.
 Therefore, when a country develop trade link with
some other country, it will export those
commodities in which their comparative
productions costs are low, & will import those
commodities in which its comparative
production cost are high.
 This is the basis of international trade.
 He assumed Portugal and England as the two
countries and Wine and Cloth as the two
commodities they produced.
 Assumptions of the theory
1. There are only two countries – A & B or
England & Portugal.
2. They produce the same two commodities say,
Wine & Cloth – X & Y commodities.
3. There are similar tastes in both the countries
4. Labour is the only factor of production.
5. The supply of labour is unchanged.
6. All units of labour are homogeneous.
7. Prices of two commodities are determined by
labour cost.
 Assumptions of the theory……
8. Commodities are produced under the law of
constant cost or returns.
9. Technological knowledge is unchanged.
10. Factors of production are perfectly mobile
within each country, but are perfectly
immobile between countries.
11. No transport costs are involved.
12. All the factors of production fully employed
in both the countries.
 Explanation of the theory
 Ricardo shows that trade is possible between
two countries when one country has an
absolute advantage in the production of both
commodities, but a comparative advantage in
the production of one commodity than in the
other
Table: 1 Man-Years of Labour Required for
producing one unit
Country Wine Cloth
England 120 100
Portugal 80 90
 The production of a unit of Wine in England
requires 120 men for a year, while a unit of
Cloth requires 100 men for the same
period.
 On the other hand, the production of the
same quantities of Wine & Cloth in Portugal
requires 80 & 90 men respectively.
 Thus, England uses more labour than
Portugal in producing both wine & cloth.
 In other words, the Portuguese labour is
more efficient than the English labour in
producing both the products.
 So Portugal possesses an absolute advantage in
both wine and cloth.
 But Portugal would benefit more by producing wine
& exporting it to England because it possess greater
comparative advantage in it (80/120 men).
 On the other hand, England interest to specialise in
the production of cloth in which it has the least
comparative disadvantage.
 This is because the cost of production of cloth in
England in less (100/90 men) as compared with
wine (120/80 men).
 Thus, trade is beneficial for both the countries. The
comparative advantage position of both the country.
 Diagrammatically representation
Y
PL – Production Possibility curve – Portugal
EG - Production Possibility curve – England
ER – Parllal to PL
P

E
Cloth

ER parllel to PL

O G R L X
Wine
 PL is the production possibility curve of Portugal, & EG that
of England.
 Portugal enjoys an absolute advantage in the production of
both Wine & Cloth over England.
 It produces OL of Wine & OP of Cloth as against OG of
Wine & OE of Cloth produced by England.
 But the slope ER (parallel to PL) reveals that Portugal has
greater comparative advantage in the production of Wine
because if it gives up the resources required to produce OE
of Cloth.
 It can produce OR of Wine which is greater than OG of
Wine of England.
 On the other hand, England had the least comparative
disadvantage in the production of OE Cloth.
 Thus, Portugal will export OR of Wine to England in
exchange for OE of Cloth from her.
 Domestic Exchange Ratio

England Portugal
Wine 120:100 cloth (6/5) Wine 80:90 Cloth (8/9)
1: 1.2 1: 0.89

Cloth 100:120 Wine (5/6) Cloth 9:80 Wine (9/8)

1: 0.83 1: 1.13

England exporting cloth i.e. 1 – 0.83 = 0.17

Portugal exporting wine i.e. 1 – 0.89 = 0.11

 The table shows that the domestic exchange
ratio in England is one unit of Cloth – 0.83 units
of Wine and in Portugal one unit of Wine – 0.83
units of cloth.
 If we assume the exchange ratio between the
two countries to be 1 unit of Cloth – 1 unit of
Wine.
 England would gain 0.17 (1 – 0.83 + 0.17) unit of
Wine by exporting one unit of Cloth to Portugal.
 Similarly the gain to Portugal by exporting one
unit of Wine to England will be 0.11 (1 – 0.89 +
0.11) unit of cloth.
 Thus trade is beneficial for both countries
Domestic Exchange Rate between Portugal and England
Y C1W2 – 1 unit of cloth = 0.83
W1C2 – 1 unit of wine = 0.89
C1 C1W1 – 1 unit cloth & 1 unit of wine
England Gain = W2W1 0.17 – wine
(0.89)
Portugal Gain = C2C1 - 0.11 - cloth
C2
Cloth

O W2 (0.83) W1 B
Wine
 The line C1W2 depicts the domestic
exchange ratio 1 unit of cloth = 0.83 unit
of Wine of England.
 The line W1C2 that Portugal at the
domestic exchange ratio 1 unit of Wine
= 0.89 unit of Cloth.
 The line C1W1 shows the exchange rate
of trade of 1 unit of cloth = 1 unit of wine
between the two countries.
 At this exchange rate, England gain
W2W1 (0.17 unit) of wine while Portugal
gains C2C1 (0.11 unit) of cloth.
 Criticisms of comparative cost analysis
1. Unrealistic Assumption of Labour cost
2. No similar tastes
3. Ignores transport costs
4. Factors are not perfectly mobile internally
5. Unrealistic two country & two commodities model
6. Assumption of free trade is not realistic
7. Assumption of full employment is not realistic
8. Ignores the role of technology
9. One sided theory
10. Complete specialisation is impossible.
 4. Modern Theory of International Trade
 The Modern Theory of International Trade
was advocated and developed by two
Swedish economists – Heckscher and Bertil
Ohlin.
 Bertin Ohlin in his famous book “Inter-
regional & International Trade” - (1933)
criticised the classical theory of international
trade and formulated the General Equilibrium
of International trade.
 Therefore, it is popularly known as Heckscher-
Ohlin theory of trade (H.O. Therom)
 It is also known as Factor Endowment or
Factory Intensity Theory.
 Factor Endowments means – land, capital,
natural resources, labour, climate etc.
 For example – Argentina and Australia have
more land, India and Pakistan have an
abundant supply of labour & USA and U.K –
plenty of capital.
 Hence, Argentina and Australia produce more
of land intensive goods, India and Pakistan –
more labour intensive goods & USA and UK –
produce more capital intensive goods.
 According to Heckscher – Ohlin – differences
in the distribution of factor endowments are
responsible for differences in factor price and
therefore in the prices of goods and services
in different countries.
 Trade results from differences in factor
endowments in different countries – leads to
differences in prices of commodities.
 Some countries have much capital others
have much labour.
 The theory says that countries that are rich in
capital will export capital intensive goods and
 Countries that have much labour will export
labour-intensive goods.
 Thus, the main cause of trade between
regions is the difference in prices of
commodities based on relative factor
endowments and factors prices.
 Assumptions of the theory
1. It is 2 X 2 X 2 model - there are two countries
(A & B), two commodities (X & Y) & two factors
of production (capital & labour).
2. There is perfect competition in commodity as
well as factor markets.
3. There is full employment of resources.
4. Country A is capital abundant & country B is
rich in labour
5. There is perfect mobility of factors within
each region but internationally they are
immobile.
 Assumptions of the theory…….
6. There are no transport cost.
7. There is free & unrestricted trade between
the two countries.
8. There are constant returns to scale in the
production of each commodity in each region.
9. There is no change in technological
knowledge.
10. Demand conditions are identical in both
the countries.
 Explanation of H.O. Therom
 Heckscher and Ohlin states that,
immediate cause of international trade
is the differences in relative commodity
prices caused by differences in relative
demand and supply factors as a result
of differences in factor endowments
between the two countries.
 Fundamentally, the relative scarcity of
factors and unequally distributed
between countries leads to different
relative prices of commodities.
 Production functions are different for
different commodities – capital intensive
production function and labour
intensive production function.
 International trade responsible due to
differences in the relative prices of
commodities.
 Two main causes responsible for diversity
of production conditions
1. Differences in terms of distribution of factors of
production
2. Differences in the ratio of participation of these
factors of production
 Ohlin in his views – General Equilibrium
Theory of cost of the factors of production
depends on conditions of supply and
conditions of demand.
 According to modern theory, the
immediate cause of international trade is
the differences in relative prices of
commodities in the two countries.
 Differences in commodity prices between
the countries due to differences in
factors endowments of different
countries.
 Relative differences in the relative factor
endowments of different countries and
different factor intensities for the
production of different commodities.
 The theory is usually formulated in
terms of two factor model – labour and
capital are the two factor of production.
 The proposition is that capital rich
countries export capital - intensive
goods &
 Labour - rich countries export labour
intensive goods.
Factor abundance in terms of factor prices
Y

A
L
Capital

K1

A1
L1

O B B1 X

Labour
 In the figure xx and yy is the isoquants for two
goods X and Y respectively.
 There are two types of factors intensity –
commodity X and Y represents capital and
labour intensity.
 There are two types of countries A & B. A is the
relatively capital abundant & B is labour
abundant countries.
 The capital abundant country – A will produced
with OA of capital & OB of labour.
 B country has labour abundant will produce OA1
of capital and OB2 of labour.
 Superiority of H.O theory over
classical theory
1. International trade a special case
2. General equilibrium theory.
3. Two factors of production 2 X 2 X 2
4. Differences in factor supplies
5. Differences in factor endowments
6. Complete specialisation.
Criticism
1. 2 x 2 x2 model
2. Static theory
3. Factors are not homogeneous
4. Production techniques are homogeneous
5. Tastes & preference pattern not identical
6. No constant returns to scale
7. Transport costs influence trade
8. Unrealistic assumption of full employment &
perfect competition
9. Partial equilibrium analysis
10. Factor prices do not determine commodity
prices.
 6. International Product Life Cycle Theory
 International product life cycle theory developed by
Raymond Vernon & Lewis. T.Wells - 1966
 PLC theory states that the development of a new
product moves through a cycle or a series of stages in
the course of its development.
 And also get comparative advantage changes as it
moves through the cycle.
 According to this theory of a new product is first
manufactured and marketed in a developed country
like - USA.
 Because, certain favourable factors such as large
market, enterpreneurship, R & D etc.
 The product is then exported to other developed
countries.
INNOVATION

High Income Middle Income Low Income

Countries Countries Countries
 As competition increases in these markets,
manufacturing facilities are established
these to cater to these market and also to
export to the developing countries.
 As the product becomes standardised &
competition further intensifies, manufacturing
facilities are established in developing
countries to lower production costs and due
to other reasons.
 The developed country markets may also be
serviced by exports from the production units
in the developing countries.
 Xerox origninally introduced photocopier in
the USA. It later spread the manufacturing
facilities in Japan (Fuji-Xerox). Great Britain
(Rank Xerox) & India – (Modi Xerox).

Xerox USA Japan UK India

Fiji Rank Modi

Photocopies Xerox
Xerox Xerox
 According to Vernon, firms establish manufacturing
facilities in foreign countries, when the product
reaches maturity stage in the home country. They
invest in low cost countries when cost becomes a
competitive edge.
 As competition increases in these markets,
manufacturing facilities are established there to
cater to these markets & also to export to the
developing countries.
 As the product becomes standardised &
competition further intensifies, manufacturing
facilities are established in developing countries to
lower production costs & due to other reasons.
 The developed country markets may also be
serviced by exports form the production units in the
developing countries.
 Stage I Introduction

Stage II Growth
INTERNATIONAL
PRODUCT LIFE
CYCLE
Stage III Maturity

Stage IV Decline

Chart : International Product Life Cycle (PLC) Theory

 Introduction - Stage I
firms innovate new products based on needs and problems in
domestic
 Growth – Stage II
Attracting competitors
Increased exports
Future innovation
Shift manufacturing to foreign countries
 Maturity – Stage III
Standard products
Large scale production & economies
Low unit cost of product
Shift in manufacturing to developing countries
 Decline – Stage IV
Manufacturing facilities in developing countries
Original innovating country becomes net imports
 1. Stage I – New Product introduction
 In this stage requires highly skilled labour in
the production process.
 Firms innovate new products based on needs
and problems in the domestic country.
 Photocopies, TV receiver & Personal
Computer were innovated in the USA.
 US firms became the leaders in the production
of Frozen food – kitchen cheap electricity.
 French firms developed food packaging
refrigeration – freezer compartments.
 About 95% of innovations take place in
industrially advanced countries.
 This is mostly due to severe competition,
customer demands, availability of R & D.
 During this stage the firms sell most part of
their product in domestic country and a
limited part in other countries.
 Microsoft sold most part of its innovated
software in the USA and the remaining part
in various countries including India.
 2. Stage II – Growth
 Increase in the sales of the new product attracts
the competitors.
 At the same time, the increased awareness of
the new product in various countries
particularly in advanced countries increases the
demand for the product.
 Further innovation in product, cost
reduction, market process etc.
 There is mass production and distribution of
the new product.
 The innovating countries continues to have a
monopoly in producing and exporting the
product.
 3. Stage III – Maturity
 Worldwide production increases during this
stage along with the demand for the product -
resulting in decline in exports.
 Increased competition results in increased
product standardization & cost reduction.
 Producers start gaining the economies of scale
reducing the cost of production per unit.
 The lower per unit cost of production results in
exports to developing countries.
 At this stage technology becomes standard.
 Therefore, the producers start locating of their
plants in developing countries in order to take
the advantage of lower costs.
 4. Stage IV – Decline
 At this stage concentrate in less
developed countries.
 The most of the production plants at this
stage locate in developing countries &
exports decline considerable at this stage.
 Even the original country may become
net importer during this stage.
 Thus the volume and direction of
international trade come down
considerably in this stage.
 Product Life-Cycle Theory

Fig 4.5
 Product life cycle theory
Sales Volume

Time
 Diagrammatically representation
 The chart explains the possible international trade
patterns in the life cycle of a new product.
 OX and OY axis measures time and sales volume
respectively.
 The figure shows three sets of curves –The uppermost
set of curves relates to the innovating country, the
middle set to other advanced countries, and the lowest
set to the less developed countries.
 The uppermost set of curves relating to the innovating
country – In the first stage, when the new product is
introduced, it is consumed in the domestic market, and
small portion exported to other advanced countries.
 The middle set of curves shows that other
advanced countries having started the
production of the new product continue to
increase its production upto the maturing
product stage and then become net exporters
of the product in the standardised product
stage.
 The lowest set of curves relating to less
developed countries shows that such
countries continue to import the product
throughout the three product stages. It is,
however, in the maturing product stage that
they start its production and become its net
exporters very late in the last stage when the
product actually becomes old in advanced
countries.
 Theories of International Investment
1.Theory of Capital Movement
2.Market Imperfections Theory
3.Internationalisation Theory
4.Appropriability Theory
5.Location Specific Advantage Theory
6.International Product Life Cycle Theory
7.Eclectic Theory
 1. Theory of Capital Movement
• The classical or earliest theoreticians, developed
theory of capital movement of international
investment.
• The classical or tradition, assumes that, the
existence of a perfectly competitive market.
• Foreign investment in the form factor movement
to take advantage of the differential profit.
• Charles Kindleberger, Stated that, under perfect
competition, foreign direct investment would not
occur & that would be unlikely to occusing world
where in the conditions were even approximately
competitive.
 2. Market Imperfections Theory
 The market imperfections theory of foreign
investment was advocated by Stephen in 1960,
under monopolistic advantage theory.
 According to this theory, foreign direct
investment occurred largely in oligopolistic
industries rather than industries operating
under near perfect competition.
 Hymer, suggested that, decision of firm to invest
in foreign markets was based on certain
advantages the firm possessed over the local
firms (foreign country).
 Economies of scale, superior technology,
production, marketing & finance.
 3. Internationalisation Theory
 According to the internationalisation theory
which is an extension of the market
imperfections theory.
 Foreign investment results from the decision of a
firm to internalise the firm specific advantage like
a superior knowledge – production, marketing,
HRM.
 Internationalisation include formal ways &
informal ways.
 Formal ways – patents & copy rights
 Informal ways – Secrecy & family networks
 4. Appropriability Theory
 According to the Appropriability Theory, a
firm should be able to appropriate the
benefits resulting from a technology, it has
generated.
 If this condition is not satisfied, the firm
would not be able to bear the cost of
technology generation & therefore, would
have no incentive for Research &
Development (R & D)..
 MNCs tend to specialise in developing new
technologies which are transmitted
efficiently through their internal channels.
 5. Location Specific Advantage Theory
 The Location Specific Advantage Theory suggests
that foreign investment is pulled by certain location
specific advantages.
 According to Hood & Young, there are four factors
which are pertinent to the location specific theory.
They are –
1. Labour Cost
2. Marketing factors – market size, market growth, stages of
development & local competition.
3. Trade barriers
4. Government policy.
 However, there are also other factors like cultural
factors which influence foreign investment.
 Further it is the total cost & not labour cost alone,
that is important