Chapter 4

International Trade Theories

 International Trade

International Trade: Purchase, sale, or exchange of

goods and services across national borders
Benefits of international trade:
▪ Greater choice of goods and services
▪ Important engine for job creation in many
countries
 Why Do Certain Patterns Of Trade Exist?
 Some patterns of trade are fairly easy to explain
➢ it is obvious why Saudi Arabia exports oil, Ghana
exports cocoa, and Brazil exports coffee
 But, why does Switzerland export chemicals,
pharmaceuticals, watches, and jewelry?
 Why does Japan export automobiles, consumer
electronics, and machine tools?
 An Overview of Trade Theory
 Mercantilism (16th and 17th centuries) encouraged
exports and discouraged imports
 Adam Smith (1776) promoted unrestricted free trade
 David Ricardo (19th century) built on Smith ideas
 Eli Heckscher and Bertil Ohlin (20th century ) refined
Ricardo’s work
 The Leontief Paradox
 International Product Life-Cycle Theory
 New Trade Theory
 National Competitive Advantage: Porter’s Diamond
Framework
 Mercantilism
 Mercantilism suggests that it is in a country’s best interest to
accumulate financial wealth, usually in the form of gold, by
encouraging exports and discouraging imports.
 The practice of mercantilism rested on three main pillars:
▪ Maintain Trade Surplus
▪ Government Intervention
▪ Colonialism
 Flaws of Mercantilism:
▪ Mercantilism views trade as a zero-sum game - one in which a gain by
one country results in a loss by another.
▪ If many nations pushing for more exports and limit their imports -
restricts international trade.
▪ Not all local products are cheap, consumers had to pay higher prices.
 Theory of Absolute Advantage
 Adam Smith (1776) - countries differ in their ability to
produce goods efficiently
 Absolute Advantage: Ability of a nation to produce
a good more efficiently than any other nation.
➢ countries should specialize in the production of
goods for which they have an absolute
advantage and then trade these goods for the
goods produced by other countries
 Theory of Comparative Advantage
David Ricardo asked what might happen when
one country has an absolute advantage in the
production of all goods
Ricardo’s theory of comparative advantage
suggests that countries should specialize in the
production of those goods they produce most
efficiently and buy goods that they produce less
efficiently from other countries, even if this
means buying goods from other countries that
they could produce more efficiently at home
 Heckscher-Ohlin Theory
 Heckscher and Ohlin - comparative advantage arises from
differences in national factor endowments (the extent to
which a country is endowed/gifted with resources such as
land, labor, and capital)
 Countries produce and export goods that require resources
(factors) that are abundant and import goods that require
resources in short supply.
 The more abundant a factor, the lower its cost.
 The Leontief Paradox
 Wassily Leontief theorized that since the U.S. was relatively
abundant in capital compared to other nations, the U.S. would be
an exporter of capital intensive goods and an importer of labor-
intensive goods.
 However, he found that U.S. exports were less capital intensive
than U.S. imports
 Possible explanations for these findings include
✓ that the U.S. has a special advantage in producing products
made with innovative technologies that are less capital
intensive
✓ differences in technology lead to differences in productivity
which then drives trade patterns
 Since this result was at variance with the predictions of trade
theory,
5-9 it became known as the Leontief Paradox
 International Product Life Cycle
 International Product Life Cycle (Raymond Vernon): Theory stating
that a company will begin by exporting its product and later
undertake foreign direct investment as the product moves through
its life cycle

International Product Life Cycle

InternationalRaymond Vernon put forth an international trade theory for
manufactured goods in the mid-1960s. His international product life
Product Life cycle theory says that a company will begin by exporting its
Cycle product and later undertake foreign direct investment as the
product moves through its life cycle. The theory also says that, for a
number of reasons, a country’s export eventually becomes its
import.
The international product life cycle theory follows the path of a
good through its life cycle (from new to maturing to standardized
product) in order to determine where it will be produced (see
Figure).
 International Product Life Cycle
• In Stage 1, the new product stage, the high purchasing power and
demand of buyers in an industrialized country drive a company to
design and introduce a new product concept. Because the exact
level of demand in the domestic market is highly uncertain at this
point, the company keeps its production volume low and based in
the home country.
• In Stage 2, the maturing product stage, the domestic market and
markets abroad become fully aware of the existence of the product
and its benefits. Demand rises and is sustained over a fairly lengthy
period of time. As exports begin to account for an increasingly
greater share of total product sales, the innovating company
introduces production facilities in the countries with the highest
demand. Near the end of the maturity stage, the product begins
generating sales in developing nations, and perhaps some
manufacturing presence is established there.
 International Product Life Cycle
• In Stage 3, the standardized product stage, competition from other
companies selling similar products pressures companies to lower
prices in order to maintain sales levels. As the market becomes more
price sensitive, the company begins searching aggressively for low-
cost production bases in developing nations to supply a growing
worldwide market. Furthermore, as most production now takes
place outside the innovating country, demand in the innovating
country is supplied with imports from developing countries and other
industrialized nations. Late in this stage, domestic production might
even cease altogether.
 International Product Life Cycle
Stages of the Product Life Cycle
▪ the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop
new products
▪ initially, the product would be produced and sold in the U.S.
▪ as demand grew in other developed countries, U.S. firms would begin to export
▪ demand for the new product would grow in other advanced countries over time
making it worthwhile for foreign producers to begin producing for their home markets.
▪ U.S. firms might set up production facilities in advanced countries with growing
demand, limiting exports from the U.S.
▪ As the market in the U.S. and other advanced nations matured, the product would
become more standardized, and price the main competitive weapon
▪ Producers based in advanced countries where labor costs were lower than the
United States might now be able to export to the United States
▪ If cost pressures were intense, developing countries would acquire a production
advantage over advanced countries
▪ Production became concentrated in lower-cost foreign locations, and the United
States became an importer of the product
 New Trade Theory
 New trade theory suggests that the ability of firms to gain economies
of scale (unit cost reductions associated with a large scale of output)
can have important implications for international trade.
 The new trade theory states that:
(1) There are gains to be made from specialization and increasing
economies of scale,
(2) The companies first to market can create barriers to entry
(3) Government may play a role in assisting its home companies.
 First mover advantages - the economic and strategic advantages
that accrue to early entrants into an industry
 Firms that achieve first mover advantages will develop economies of
scale, and create barriers to market entry for potential rivals
 First movers can gain a scale based cost advantage that later
entrants find difficult to match.
 A country may dominate in the export of a certain product because it
has a home-based firm that has acquired a first-mover advantage.
5-15
 Porter’s Diamond of Competitive Advantage
 Michael Porter tried to explain why a nation achieves international success in a particular
industry and identified four attributes that promote or obstruct the creation of competitive
advantage.
1. Factor Conditions / Factor Endowments
• Basic Factors
• Advanced Factors
2. Demand Conditions
• Sophisticated Buyers
3. Related and Supporting Industries
• Clusters
4. Firm Strategy, Structure, and Rivalry
• Competitiveness
 Government and Chance
• Role of Government
• Chance Events
 Porter’s Diamond Of Competitive Advantage
• Factor Conditions: Porter acknowledges the value of a nation’s resources, which he terms
basic factors, but he also discusses the significance of what he calls advanced factors.
Advanced factors include the skill levels of different segments of the workforce and the quality
of the technological infrastructure in a nation.
• Demand Conditions: Sophisticated buyers in the home market are also important to national
competitive advantage in a product area. A sophisticated domestic market drives
companies to add new design features to products and to develop entirely new products
and technologies.
• Related and Supporting Industries: Supporting industries spring up to provide the inputs
required by the industry.
• Firm Strategy, Structure, and Rivalry: Essential to successful companies is the industry structure
and rivalry between a nation’s companies. The more intense the struggle to survive between
a nation’s domestic companies, the greater will be their competitiveness.
• Government and Chance: Apart from the four factors identified as part of the diamond, Porter identifies
the roles of government and chance in fostering the national competitiveness of industries. First,
governments, by their actions, can often increase the competitiveness of firms and perhaps even entire
industries. Second, although chance events can help the competitiveness of a firm or an industry, it can
also threaten it.
Porter’s Diamond Of Competitive Advantage

Determinants of National Competitive Advantage: Porter’s Diamond

Chapter 5
The Political Economy of
International Trade
 Why Do Governments Intervene in Trade?
Political Motives
 Protect jobs
✓ Governments intervene when free trade creates job losses at home.
✓ e.g. Relocating textile manufacturing to developing countries (cheap foreign labor cost)
contributed to job losses in USA.
 Preserve national security
✓ Industries like aerospace or electronics are often protected because they are deemed
important for national security
✓ Governments also have national security motives for banning certain defense-related
goods from export to other nations.
 Respond to unfair trade
✓ If one government thinks another nation is not “playing fair,” it will often threaten to
retaliate unless certain concessions are made.
✓ – e.g. To protect their own industries - developed countries sue developing countries that
dumping their products.
 Gain influence
✓ Big nations may use power of trade intervention to influence small nations.
✓ e.g. The United States has banned all trade and investment with Cuba since 1961 in the
hope of exerting political influence against its communist leaders.
 Why Do Governments Intervene in
Trade?
Economic Motives
 Protect infant industries
The infant industry argument which suggests that an industry should be protected until
it can develop and be a viable and competitive industry internationally.
 Pursue strategic trade policy
✓ Strategic trade policy suggests that in cases where there may be important first mover
advantages, governments can help firms achieve these advantages.
✓ So, U.S. support of Boeing in the 1950s and 60s probably helped the company become
one of the firms to survive in the industry.
✓ Governments can also intervene in the markets to help domestic firms overcome
barriers to entry in industries where foreign firms have an advantage.
 Why Do Governments Intervene in
Trade?
Cultural Motives
 Achieve cultural objectives and Protection of national identity
✓ Nations often restrict trade in goods and services to achieve cultural
objectives, the most common being protection of national identity.
✓ Many countries have laws that protect their media programming for
cultural reasons.
✓ e.g. Canada tries to mitigate the cultural influence of entertainment
products imported from the United States.
 Instruments of Trade Promotion
Trade Promotion
 Subsidies
✓ Governments give financial assistance to domestic producers in
various ways including cash grants, low interest loans, tax breaks,
product price supports, etc.
✓ Help domestic producers compete against low cost foreign imports,
and gain export markets.
 Export Financing
✓ Governments promote exports by helping companies finance their export
activities through loans or loan guarantees.
✓ Two agencies help U.S. companies gain export financing: Export-Import
Bank and the Overseas Private Insurance Corporation (OPIC).
 Instruments of Trade Promotion
 Foreign Trade Zones
✓ Foreign Trade Zone (FTZ) - a specific location within a country in which
merchandise is not subject to duties / charge lower customs duties
(taxes).
✓ Benefits - importer pays lower duty rate and avoid lengthy customs
procedure.

 Special Government Agencies

✓ Government set up agencies that offers various exporters development
programmes and organise export promotion activities for SMEs.
✓ e.g., Export promotion agencies -The Japan External Trade Organization
(JETRO), Malaysia External Trade Development Corporation (MATRADE)
 Instruments of Trade Restriction
Trade Restriction
 Tariffs
✓ Export tariff is levied by the government of a country that is exporting a
product.
✓ Export taxes raise money for governments and help control the exports of
valuable resources.
✓ Many resource-rich countries charge export taxes on high-value products,
such as oil or minerals. For example, Mozambique charges export taxes on
diamonds.
✓ Transit tariff is imposed by the government of a country that a product is
passing through on its way to final destination.
Example: India imposes tariffs on goods that Bangladesh exports to Nepal
through the Indian Territory.
 Instruments of Trade Restriction
✓ Import tariff is levied by the government of a country that is importing a product.
✓ There are three subcategories of import tariff:
▪ Ad valorem tariff - levied as a percentage of the value of the imported
product.
e.g. 10% of the value of the vehicle.
▪ Specific tariff -computed based on the unit/quantity of the imported product
(measured by number, weight, etc.). Example: $300 tariff on each computer
imported.
▪ Compound tariff - tax levied on imported goods that is a combination of a fixed
amount and an amount based on the value of the goods (include both ad
valorem and specific tariff).
Example: Pakistan charges Rs. 0.88 per liter of some petroleum products plus 25
percent of the product price.
 Instruments of Trade Promotion
 Quotas
✓ Restriction on the amount (measured in units or weight) of a good that can enter
or leave a country during a certain period of time.
✓ e.g. U.S set quota on cheese imports.
• Tariff-Quotas - a hybrid of a quota and a tariff where a lower tariff rate is applied
to imports within the quota a higher rate for quantities that exceed the quota
• Voluntary Export Restraint (VER) – arrangements between exporting and
importing countries in which the exporting country agrees to limit the quantity of
specific exports below a certain level in order to avoid imposition of mandatory
restrictions by the importing country. Typically at the request of the importing
country’s government.
 Embargoes
✓ An official ban or order of a government prohibiting trade (imports and exports) of
one or more products with a particular country.
✓ In 2006, the United nation imposed embargo on supplies for uranium production and
ballistic missile development, harming Iran’s economy
 Instruments of Trade Promotion
 Local Content Requirements
✓ Government demands that some specific fraction of a good be
produced domestically.
✓ Can be in physical terms or in value terms.
✓ e.g. 15% of the value of the good must come from domestically
produced components

 Administrative Delays
✓ Regulatory controls or bureaucratic rules that are designed to make it
difficult for imports to enter a country.

 Currency Controls
✓ Restrictions on the convertibility of a currency into other currencies.
Global Trading System
 How Has The Current World Trading System
Emerged
 Until the Great Depression of the 1930s, most countries had
some degree of protectionism
➢ Smoot-Hawley tariff (1930)
 After WWII, the U.S. and other nations realized the value of freer
trade
 Established the General Agreement on Tariffs and Trade (GATT)
- a treaty designed to promote free trade by reducing both
tariff and nontariff barriers to international trade.
General Agreement on Tariffs and Trade

Uruguay Round of Negotiations (1986-1994)

 Agreement on services
 Agreement on intellectual property
 Agreement on agricultural subsidies
 Creation of the WTO
 World Trade Organization (WTO)
 The World Trade Organization (WTO): International organization
that regulates trade among nations
 The WTO has emerged as an effective advocate and facilitator
of future trade deals, particularly in such areas as services.
 So far, the WTO’s policing and enforcement mechanisms are
having a positive effect.
 Most countries have adopted WTO recommendations for trade
disputes.
 Main goals of the WTO :
1. Help the free flow of trade
2. Help negotiate further opening of markets
3. Settle trade disputes among its members
 Regional Economic Integration & Economic
Blocs

 While regional trade agreements are designed to

promote free trade, there is some concern that the
world is moving toward a situation in which a number of
regional trade blocks compete against each other
if this scenario materializes, the gains from free trade
within blocs could be offset by a decline in trade
between blocs
 Levels of Regional Economic Integration
There are five levels of economic integration
1. Free trade area - Eliminates all barriers to the trade of goods and
services among member countries. Each nation determining its
own barriers against nonmembers
 European Free Trade Association (EFTA) - Norway, Iceland, Liechtenstein,
and Switzerland
 North American Free Trade Agreement (NAFTA) - U.S., Canada, and
Mexico
2. Customs union - eliminates trade barriers between member
countries and adopts a common external trade policy against
nonmembers
 Andean Pact (Bolivia, Columbia, Ecuador and Peru)
3. Common market – has no barriers to trade between member
countries, a common external trade policy, and the free
movement of the factors of production (labor and capital)
➢ can be difficult to achieve and requires significant harmony among
members in fiscal, monetary, and employment policies
 MERCOSUR (Brazil, Argentina, Paraguay, and Uruguay)
 Levels of Regional Economic Integration
4. Economic union - has the free flow of products and factors
of production between members, a common external trade
policy, a common currency, a harmonized tax rate, and a
common monetary and fiscal policy
➢ involves sacrificing a significant amount of national sovereignty
 European Union (EU)

5. Political union - independent states are combined into a

single union
➢ involves a central political apparatus that coordinates the economic,
social, and foreign policy of member states
 The EU is headed toward at least partial political union, and the
United States is an example of even closer political union
Levels of Regional Economic Integration
Levels of Economic Integration
 Regional Economic Integration
The Case for Regional Integration
 Trade Creation
 Greater Consensus
 Political Cooperation
 Employment Opportunities
 Corporate Savings
The Case Against Regional Integration
 Trade Diversion
 Shifts in Employment
 Loss of National Sovereignty
 Trade Creation and Trade Diversion
 Regional economic integration is only beneficial if the amount of trade it
creates exceeds the amount it diverts.
▪ Trade creation occurs when low cost producers within the free trade
area replace high cost domestic producers.
✓ Trade creation will occur when there is a reduction in tariff barriers,
leading to lower prices.
✓ One result of trade creation is that consumers and industrial buyers in
member nations are faced with a wider selection of goods and services
not previously available.
▪ Trade diversion occurs when a less-efficient producer within the free
trade area (trading bloc) replace a more efficient non-member
producer by the formation of a free trade agreement.
The World’s Main Regional Trading Blocs
 European Union (EU)
 European Free Trade Association (EFTA)
 North American Free Trade Agreement (NAFTA)
 Central American Free Trade Agreement
 Andean Community
 MERCOSUR
 Caribbean Community and Common Market (CARICOM)
 Free Trade Area of the Americas (FTAA)
 Association of Southeast Asian Nations (ASEAN)
 Asia Pacific Economic Cooperation (APEC)
Chapter 6

Foreign Direct Investment

 Foreign Direct Investment
Foreign Direct Investment
 Purchase of physical assets or a significant amount of the ownership (stock) of
a company in another country to gain a measure of management control
(ownership of physical assets such as equipment, buildings and real estate).
 FDI - when a firm invests directly in facilities to produce and/or market their
products or services in a foreign country.
 Investor can gain cheaper access to products/services and the host country
can get valuable investment.
 FDIs also provides host countries with an exchange of skill sets, information
and expertise, job opportunities and improved productivity levels.
 Example: Hungry Dragon Toys, a Chinese company, purchase Cooperative
Chemical, a plastics company in New Jersey (USA).
 Foreign Direct Investment
Portfolio Investment
 Investing in the financial assets of a foreign country, such as stocks or bonds.
 Investment that does not involve obtaining a degree of control in a
company.
 Example: Mr Haruko, a Japanese investor purchases one hundred shares of
stock in General Motors (GM). Haruko owns part of GM corporation, the
shares of which are part of his personal investment portfolio. Haruko is eligible
to receive dividend payments from GM, participate in shareholder decisions,
or sell the stock. Haruko concerns is not the long-term profitability of the
company but the short-term value of his stock. He might therefore sell his
share quickly if the share price goes up or down significantly.
 Pattern of FDI
 Historically, FDI is targeted towards developed nations - United States and
EU.
 Many manufacturers then expand business to foreign countries to take
advantage of lower cost labor, or to be closer to customers.
 FDI has increased and moving towards developing nations, especially in
the emerging economies around the world.
 Since the beginning of the 1990s foreign direct investment (FDI) has
become the most important source of foreign capital for emerging
market economies (BRIC: Brazil, Russia, India and China)
 China has become a hot spot for firms that are attracted to the country’s
low wage rates, and large market.
 Drivers of FDI Flows
 Globalization
Globalization:
✓ Lower trade and FDI barriers, allow companies to produce in the most efficient and
productive locations and export their product worldwide.
✓ Help firms exploit economies of scale, improve efficiency, absorb foreign technology, and
innovate.
✓ The entry of multinational companies in emerging markets has created a surge in economic
activity which also enhance host country’s economic growth.

Mergers and Acquisitions

International Mergers and Acquisitions
✓ Most firms make their investments either through mergers with existing firms, or acquisitions.
✓ Quicker to execute.
✓ Foreign firms have valuable strategic assets.
✓ Firms believe they can increase the efficiency of acquired assets by transferring capital,
technology, or management skills.
 Example: FDI in India
Indian government’s has made a decision to allow IKEA to invest Rupees 10,500 crore (or
USD 2 billion) to set up a wholly owned single brand retail venture in India which will provide
a much needed boost to the Indian economy. The IKEA deal creatively meets the Indian
government’s requirement for single brand retailers to source 30% of the merchandise they
sell from local small enterprises and vendors. The arrival of IKEA in India brings with it some
good business practices for the local competition. IKEA is known for innovative design of
products at affordable prices. It is also known for it’s attention to cost control and
operational efficiency.
IKEA’s business model is such that it does not invest in factories, instead they work closely
with furniture and furnishings vendors to design and produce products to meet their global
quality and supply standards. As a result, while IKEA will use Indian vendors to meet their
global needs, the doors will also open for these vendors to exports through the IKEA supply
chain. The global furniture industry is estimated at over $400 billion, and presently India’s
export to the furniture and furnishings markets is negligible (with the exception of carved
wood products). This venture of IKEA’s should help in creating manufacturing jobs in the
small and medium enterprise market segment.
Theories of Foreign Direct Investment
International Product Life Cycle
 International Product Life Cycle
• The international product life cycle theory states that a company that begins by exporting its
product eventually undertakes FDI as the product moves through its life cycle.
• Vernon - firms undertake FDI at particular stages in the life cycle of a product.
• Vernon's theory was based on the observation that for most of the twentieth century a large
proportion of the world's new products had been developed by the U.S. firms and sold first in
the U.S. market for example televisions, photocopiers, and personal computers.
• Three stages in product life cycle:
i. New product stage – Product is invented by a country (advanced country) with high-tech
advantage. Product is produced and sold in the home country because of uncertain
domestic demand . The production process is kept close to the research department that
has developed the product.
ii. Maturing product stage – With increase in exports, producers begin to set up
manufacturing facilities in other countries (closer to the market) - to expand production
capacity and to meet the growing demand of domestic and foreign customers.
iii. Standardized product stage - Increased competition creates pressures to reduce
production costs. In response, a company builds production capacity in low-cost
developing nations to serve its markets around the world. Product is made in other
countries and imported to the original producing country.
Theories of Foreign Direct Investment
Market Imperfections (Internalization)
Market imperfections theory states that when an imperfection in the
market makes a transaction less efficient than it could be, a company will
undertake FDI to internalize the transaction and thereby remove the
imperfection. The market imperfection approach to FDI is typically
referred to as internalization theory.

Types of Market Imperfections

 Trade Barriers
✓ The presence of a market imperfection (tariffs) might cause companies
to undertake FDI.
✓ Example: Many foreign manufacturers open facilities in Mexico to
enjoy exporting within NAFTA region, avoid high tariffs if they export
from their home-based factories.
 Theories of Foreign Direct Investment
Market Imperfections (Internalization)
 Specialized Knowledge
✓ Companies need access to specialized knowledge that only available in
foreign country.
✓ When a company’s specialized knowledge is embodied in its employees,
the only way to exploit a market opportunity in another nation may be to
undertake FDI.
✓ Example: Japanese companies paid Western firms for access to the
special technical knowledge embodied in their products. Those
Japanese companies became adept at revising and improving many of
these technologies and became leaders in their industries, including
electronics and automobiles.
Theories of Foreign Direct Investment
Eclectic Theory
Eclectic Theory is a three-tiered evaluation framework that companies should follow
when attempting to determine if it is beneficial to pursue foreign
direct investment (FDI).
According to this theory, a company needs all three advantages in order to be able
to successfully engage in FDI.
✓ Location advantage – Firm must assess whether there is a comparative advantage
to performing a particular economic activity in a specific location because of its
natural or acquired characteristics(e.g. Strategic location, cheap raw materials,
low wages, abundant skilled labor force or government incentives - special taxes
or tariffs)
✓ Example: Sony locate manufacturing facilities in China to take advantage of
China’s low cost and highly knowledgeable workers.
✓ Ownership advantage - Company ownership of some special asset, such as brand
recognition, technical knowledge, technology, trademark or management ability
that could not be easily transferable to other firms. This allows a company to have
a competitive advantage compared to foreign rivals.
✓ Example: Sony possesses huge stock of knowledge and patents in consumer
electronic industry – Play Station and Vaio laptop.
Theories of Foreign Direct Investment
Eclectic Theory
 Internalization advantage - the advantage that arises from internalizing a
business activity rather than leaving it to a relatively inefficient market.
 Is it more attractive to perform the value chain activity in-house than to
have it performed by an external party?
 Reasons to outsource certain activities to different companies abroad
because they are better at it, able to do it cheaper, have more local
market knowledge, or because management wants to focus on other
activities in the value chain such as marketing or design.
 Example: Management can license its product design to an independent
foreign company or outsource production to an original equipment
manufacturer (OEM).
 Theories of Foreign Direct
Investment
Market Power - A firm undertakes FDI to establish a
dominant presence in an industry

Market power

Vertical integration

Extends company’s activities

into stages of production that
provide its inputs (backward
integration) or absorb its out-
puts (forward integration)
Management Issues and Foreign Direct
Investment
 Control
• Partnership requirements
• Benefits of cooperation
 Purchase-or-Build Decision
• Greenfield investment
 Production Costs
• Rationalized production
• Mexico’s Maquiladora
• Cost of research and development
 Customer Knowledge
 Following Clients
 Following Rivals
 Why Governments Intervene in FDI
Balance of Payments
 Current Account
National account that records transactions involving
the export and import of goods and services, income
receipts on assets abroad, and income payments on
foreign assets inside the country.
 Capital Account
National account that records transactions involving
the purchase and sale of assets.
 Why Governments Intervene in FDI

Reasons for Intervention by the Host Country

 Control the Balance of Payments
 Obtain Resources and Benefits
 Access to Technology
 Management Skills and Employment
 Why Governments Intervene in FDI
Reasons for Intervention by Home Country
 Investing in other nations sends resources out of the
home country
 Outgoing FDI may ultimately damage a nation’s
balance of payments by taking the place of its exports.
 Jobs resulting from outgoing investments may replace
jobs at home.
 Why Governments Intervene in FDI

Home Country Promoting Outgoing FDI

 Outward FDI can Increase long-term
competitiveness
 Nations may encourage FDI in industries identified
as “Sunset” Industries
 Government Policy Instruments and FDI
Host Countries
Promotion Restriction
 Financial incentives  Ownership restrictions
• Low or waived taxes • Prohibit foreign companies
investing in certain types of
• Low-interest loans industries/businesses
 Performance demands
 Infrastructure improvements
• Ensure portion of the product fulfil
• Better seaports, improved local content requirements
roads, and advanced • Set a portion of the output must
telecommunication be exported
systems • Require certain technologies to
be transferred to local businesses
 Government Policy Instruments and FDI
Home Countries
Promotion
 Offer Insurance to cover the risks Restriction
of investment abroad
 Impose differential
 Offer loans and loan guarantees tax rates - e.g.
to firm wishing to expand
investment abroad higher taxes on
 Special tax treaties e.g. eliminate foreign income
double taxation  Impose sanctions
 Tax breaks on profits earned that prohibit
abroad
domestic firms
 Apply political pressure so that investing in certain
other nations can relax
restrictions on FDI nations
 Government Policy Instruments and FDI
Instruments of FDI Policy

FDI Promotion FDI Restriction

Host Countries Tax incentives Ownership restrictions
Low-interest loans Performance demands
Infrastructure improvements
Home Insurance Differential tax rates
Countries
Loans Sanctions
Tax breaks
Political pressure