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BBM 475 NOTES
INTRODUCTION TO INTERNATIONAL BUSINESS
1. Definition of international business
International business involves commercial activities that cross national frontiers. It concerns the international movement of goods, capital, services, employees and technology; importing and exporting; cross-border transactions in intellectual property (patents, trademarks, know-how, copyright materials, etc.) via licensing and franchising; investments in physical ; financial assets in foreign countries; contract manufacture or assembly of goods abroad for local sale or for export to other nations; buying and selling in foreign countries; the establishment of foreign warehousing and distribution systems; and the import to one foreign country of goods from a second foreign country for subsequent local sale.
Why firms engage in international business
Businesses undertake international operations in order to expand sales, acquire resources from foreign countries, or diversify their activities (Anderson 1993). Specific reasons for doing business abroad include the saturation of domestic markets: discovery of lucrative opportunities in other countries: the need to obtain materials, products or technologies not available in the home nation; increases in the flow of information about conditions in foreign states; desires to expand the volume of a firm's operations in order to obtain economies of scale: or the need to find an outlet for surplus stocks of output. Further motives for operating internationally are as follows:
a) Commercial risk can be spread across several countries.
b)Involvement in international business can facilitate the '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. These effects differ from economies of scale in that they result from longer experience of doing something rather than producing a greater volume of output. Moreover, the firm's management is exposed to fresh ideas and different approaches to solving problems. Individual executives develop their general management skills and personal effectiveness; become innovative and adopt broader horizons. All these factors can give a firm a competitive edge in its home country.
c) Economies of scope (as opposed to economies of scale) might become available. Economies of scale are reductions in unit production costs resulting from large-scale operations. Common examples are discounts obtained on bulk purchases, benefits from the application of the division of labour, integration of processes, the ability to attract high calibre labour and the capacity to establish research and development facilities. Similar benefits might occur from 'economies of scope', i.e. unit cost reductions resulting , from a firm undertaking a wide range of activities, and hence being able to provide common services and inputs useful for each activity. Note how economies of scale might not be available if the firm has to modify its products, promotional strategies and business methods substantially for each country in which it operates, and that the extra costs of foreign marketing, establishment of subsidiaries in other countries, market research, etc., could erode the benefits obtained from a higher volume of output.
d) The costs of new product development could require so much expenditure that the firm is compelled to adopt an international perspective.
e) There might be intense competition in the home market but little in certain foreign countries.
f) A company's overall strategies and plans can be anchored against a wider range of (international) opportunities. Sudden collapses in market demand in some countries may be offset by expansions elsewhere.
g)Cross-border trade is today much easier to organize than in the past. International telephone and fax facilities are much better than previously and facilities for international business travel are more extensive. Hence it is simpler to visit potential foreign customers, partners and/or suppliers, to select the best locations for operations, and thereafter to control international activities.
Why enter overseas markets?
The reasons for entering overseas markets can be categorized into "push" and "pull" factors:
Push factors
Saturation in domestic markets
Economic difficulty in domestic markets
Near the end of the product life cycle at home
Risk diversification
Excess capacity
Pull factors
The attraction of overseas markets
Increase sales
Enjoy greater economies of scale
Extend the product life cycle
Exploit a competitive advantage
Personal ambition
Factors in the choice of which overseas market(s) to enter:
Size of the market (population, income)
Economic factors (state of the economy)
Cultural linguistic factors (e.g. preference for countries with similar cultural background)
Political stability (there is usually a preference for stable areas)
Technological factors (these affect demand and the ease of trading)
Constraints and difficulties in entering overseas markets;
Resources
Time
Market uncertainty
Marketing costs
Cultural differences
Linguistic differences
Trade barriers
Regulations and administrative procedures
Political uncertainties
Exchange rates (transactions costs & risks)
Problems of financing
Working capital problems
Cost of insurance
Distribution networks
All the basic tools and concepts of domestic business management are relevant to international business. However, special problems arise in international business not normally experienced when trading or manufacturing at home. In particular:
Deals might have to be transacted in foreign languages and under foreign laws, customs and regulations.
Information on foreign countries needed by a particular firm may be difficult (perhaps impossible) to obtain.
Foreign currency transactions will be necessary. Exchange rate variations can be very wide and create many problems for international business.
Numerous cultural differences may have to be taken into account when trading in other nations.
Control and communication systems are normally more complex in foreign than for domestic operations.
Risk levels might be higher in foreign markets. The risks of international business include political risks (of foreign governments expropriating the firm's local assets, of war or revolution interfering with trade, or of the imposition of restrictions on importers' abilities to pay for imports); commercial risks (market failure, products or advertisements not appealing to foreign customers, etc.); and financial risks - of adverse movements in exchange rates, tax changes, high rates of inflation reducing the real value of a company's foreign working capital, and so on.
International managers require a broader range of management skills than do managers who are concerned only with domestic problems.
Large amounts of important work might have to be left to intermediaries, consultants and advisers.
It is more difficult to observe and monitor trends and activities (including competitors' activities) in foreign countries.
Why study international business?
Nowadays the great majority of large enterprises operate internationally (as do an increasing number of small to medium sized firms), so that an awareness of the major issues in international business is a valuable asset for any manager in a company that deals with suppliers, customers, contractors, licensees, etc., in other countries. The study of international business helps the individual supplement his or her knowledge of general business functions (accounting and finance, personnel, marketing, etc.) through examining issues, practices, problems and solutions relating to these functions in foreign states. Also, it develops a person's sensitivity to foreign cultures, values and social norms, thus enabling the individual to adopt broader perspectives and hence improve his or her overall managerial efficiency. Note how firms involved in international business necessarily operate in multifaceted, multicultural environments.
Entry strategies to foreign market:
Exporting, Licensing, Joint Venture, Direct Investment and Exporting
Exporting is the marketing and direct sale of domestically-produced goods in another country. Exporting is a traditional and well-established method of reaching foreign markets. Since exporting does not require that the goods be produced in the target country, no investment in foreign production facilities is required. Most of the costs associated with exporting take the form of marketing expenses.
Exporting commonly requires coordination among four players:
Exporter, Importer, Transport provider and Government
Licensing
Licensing essentially permits a company in the target country to use the property of the licensor. Such property usually is intangible, such as trademarks, patents, and production techniques. The licensee pays a fee in exchange for the rights to use the intangible property and possibly for technical assistance.
Because little investment on the part of the licensor is required, licensing has the potential to provide a very large ROI. However, because the licensee produces and markets the product, potential returns from manufacturing and marketing activities may be lost.
Franchising
This is a special form of licensing which allows the franchisee to sell a highly publicized product or service using the parent's brand name or trademark, carefully developed procedures and marketing strategies. In exchange the franchisee pays a fee to the parent company typically based on the volume of sales of franchisor in its defined market area e.g. Coca Cola
Foreign Branching
This is an extension of the company in its foreign market- a separately located strategic business unit directly responsible for fulfilling the operational duties assigned to it by corporate management including sales, customers' service and physical distribution. Host countries may require that branch companies to be domesticated i.e. have managers in middle and higher level positions to come from the host country.
Joint Venture
There are five common objectives in a joint venture: market entry, risk/reward sharing, technology sharing and joint product development, and conforming to government regulations. Other benefits include political connections and distribution channel access that may depend on relationships.
Such alliances often are favorable when:
The partners' strategic goals converge while their competitive goals diverge;
the partners' size, market power, and resources are small compared to the industry leaders; and
Partners' are able to learn from one another while limiting access to their own proprietary skills.
The key issues to consider in a joint venture are ownership, control, length of agreement, pricing, technology transfer, local firm capabilities and resources, and government intentions.
International Business Terms
Organization structures have given rise to the following companies:
International companies are importers and exporters and have no investment outside their country.
Multinational companies have investment in other countries, but do not have coordinated product offerings in each country. They more focused on adapting their products and services to each individual local market.
Global companies have invested and are present in many countries. They market their products through the use of the same coordinated image/ brand in all markets. Generally one corporate office that is responsible for global strategy. Emphasis is on volume, cost management and efficiency.
Transnational companies are much more complex organizations they have invested in foreign operations have a central corporate facility but give decision making, R&D and marketing powers to each individual foreign market.
Multidomestic industries: firms compete in each national market independently of other national markets. Involves products tailored to individual countries innovation comes from local R&D. There is decentralization of decision making within the organization
These corporations have been oriented into four types:
Ethnocentric: governance is top down, strategy is global integration, products development is determined primarily by the needs of home country customers and people of home country are developed for key positions everywhere in the world.
Polycentric: governance is bottom up where each subsidiary decides on local objectives, strategy is national responsiveness, local products are developed based on local needs and people of local nationality are developed for key positions in their own country.
Regiocentric: governance is mutually negotiated between regions and its subsidiaries, strategy is regional integration and national responsiveness, products are standardized within region but not across regions, regional people are developed for key positions anywhere in the region,
Geocentric: governance is mutually negotiated at all levels of the corporation, strategy is global integration and national responsiveness, global products with local variation, best people everywhere in the world are developed for key positions everywhere in the world.
EVOLUTION OF INTERNATIONAL BUSINESS
The Exploration Era to 1500
The history of business dates back to prehistoric times. Villages formed to allow early divisions of labor to provide goods and services for communities. As expertise accumulated in the production of goods, infrastructures (mainly roads) were built to link communities, and local markets evolved into regional markets, attracting increased varieties of merchants and manufacturers. As regional markets took shape, road and transportation systems developed to link major commercial centers, and national markets for products emerged. The ancient civilizations of Latin America (the Incas, Mayas, and Aztecs), Egypt (the Pharaohs, pyramids), Western Europe (the Greeks and the Romans), and Asia (India and China) illustrate humankind's early efforts to innovate and use technology to upgrade standards of living. But in those days, advances in technologies and living standards were slow to move beyond national frontiers. As commerce extended throughout countries, merchants began to look to foreign markets for trading opportunities, and so the seeds of international business were sewn. In its early years, international commerce was limited to the reliability of seafaring ships, and land routes were popular. From the 6th century BC, the Silk Road, running from the Middle East to China, was a major commercial conduit carrying artifacts, metals, and semiprecious stones across Asia, as well as new ideas such as Buddhism and Islam. Later, the Romans demonstrated the importance of supply routes as they managed an empire stretching from Britain across Europe to reach the Middle East and North Africa. Trade routes were established and roads built to equip its armies; a common currency (the Dinarius) was used to lubricate commercial dealings.
Major steps forward occurred in the 12th and 13th centuries as compasses for navigational use, advances in sails and rigging, and hinged rudders revolutionized ocean travel. Italian explorer Marco Polo reached China by the late 13th century. Vasco de Gama, a Portuguese navigator, circumnavigated the South African Cape of Good Hope to reach India in 1498, and Columbus officially was the first European to discover the Americas in 1492. To replenish ships and to provide bases for further exploration, trading outposts were built. As the commercial potential of the Americas and Asia unfolded, regular trading routes were established. To finance transcontinental trade, new corporate forms emerged in Italy and later in Europe such as joint stock companies. Intercontinental trade prospered until nationalistic concerns took over, and European countries saw merit in taking political control of the new foreign markets.
Modern-day effects. While the rudiments of an international trading system were taking shape, other, long-lasting cultural transplants were occurring as religious spheres of influence were established. The Romans adopted Christianity in the 4th century and spread it throughout their European empire. Islam diffused throughout the Middle East and North Africa and along the Silk Road to Asia. Buddhism moved eastward from India to East Asia, and Confucianism and Taoism moved westward from China to East Asia, also through trade and via the Silk Road. These early movements established the major spheres of religious influence that we have today.
1500–1900: The Colonial Era
The Colonial Era saw military conquests, colonization, and the advent of regular international trade taking technologies to other nations, as the major European powers competed to establish empires in the Americas, Africa, and Asia. Foreign influences were magnified through diffusion catalysts: ideas, philosophies, and technical innovations that increased the speed, efficiency, and effectiveness of the movements of ideas and goods between and within nations. These diffusion catalysts included the following:
The development of mega languages. For ideas and technologies to travel, there had to be common means of communication between markets. In early times, these were Greek, Latin, and Mandarin Chinese. In later years, use of English and European languages facilitated the transfer of ideas and technologies among countries.
Advances in arms and military capabilities. The advent of cannons and firearms gave colonizing powers significant advantages over local populations, enabling them to subdue and maintain control of colonies with limited manpower and resources.
Writing and printing technologies extended the spread of knowledge beyond personal experiences and oral transmissions. "Potted" knowledge, in the form of books, brought about a broadening of individual knowledge bases. Formal education systems, emphasizing literacy and technical skills, led to a wider dissemination of skills via schools, guilds, and universities. Knowledge became increasingly mobile and transferable.
Transportation innovations. The steam engine revolutionized industry and travel with its applications to factories (1781), ships (1783), rail (1803–1829), and buses (1824). The steam engine brought international markets closer together and provided access to remote corners of large national markets. As the colonizing powers took these innovations to foreign markets, the transportation of goods over wider areas created regional and national markets for merchandise.
Advances in communications complemented transportation innovations. The 19th century saw the advent of the electronic telegraph and the telephone. Both facilitated information flows between and within national markets, and aided market supply and demand mechanisms. These factors, along with national print media, gave the world a connectivity it had never before experienced.
1900–Today: The Era of the International Corporation
By the end of the 19th century, much of the world had been explored and colonized. While foreign influences had introduced new technologies and lifestyles into the developing world, there had been some notable early backlashes, especially in the Americas with U.S. independence in 1776 and Latin America's between 1810 and 1824. As the 20th century unfolded, independence movements gained momentum in Africa, the Middle East, and Asia
1900–1945: Company internationalization. But the next globalization wave was waiting in the wings, and companies began to replace countries as the major catalysts of economic and cultural change. A Belgian company established the first foreign subsidiary in Prussia (today's Germany) in 1837, and commensurate with their overseas interests, most European investments up to 1945 were colonies-based. As a result of their industrialization and colonization efforts then, Western Europe was the center of international business at the turn of the last century. In recognition of this trend, Japanese trading companies such as Mitsui and the Yokohama Specie Bank had set up offices in Western Europe in the 1880s, along with numerous Japanese shipping and insurance companies.
1945–1980: Era of increasing international competition. It was not until the 1950s that corporations began to reassert themselves in international markets. The United States, whose economy had suffered least in World War II, was the first to reinitiate foreign investments, and during the 1950s and 1960s U.S. firms established secure footholds in Canada and in the re-emerging Western European economy. The 1960s and 1970s saw the revitalization and expansion of Japanese and European firms in the international marketplace as market blocs such as the European Economic Community (today's European Union) and free trade movements increased the number of opportunities in the worldwide marketplace. During this period, the Cold War political rivalry between the United States and the USSR dampened commercial prospects.
THE GLOBALIZATION ERA SINCE 1980
During the 1980s, the world marketplace changed yet again. The collapse of communism and the industrialization of developing markets led to significant increases in global commerce. The internationalization of North American, Western European, and Japanese firms had contributed to an upsurge of commercial activities in the developing world, and by the 1990s, developing market competitors were entering world markets, including Petróleos de Venezuela; Daewoo, Samsung, Hyundai, and LG Group (Korea); Cemex and Gruma (Mexico); and Petroleo Brasileiro, Vale do Rio Doce, and Cervejaria Brahma (Brazil). As the new millennium got underway, companies from the developing
and transition economies (China, Argentina, Philippines, South Africa, Malaysia, Singapore, and India, among others) were internationalizing and heightening competition in the world marketplace. Cumulatively, they invested $193 billion abroad in 2006—16 percent of world investment flows.
The Major Catalysts of Post-1980 Globalization
International trade. The world hasmoved irrevocably toward free trade since 1945 through the efforts of the General Agreement on Tariffs and Trade (GATT, a United Nations agency) until 1995, and since that time, through GATT's replacement, the World Trade Organization (WTO). The results have been dramatic. Since 1945, tariffs have fallen from an average of over 40 percent for industrial goods to less than 4 percent. World trade expanded from $2 trillion in 1980 to about $10 trillion in 2005. The expansion of world trade has been aided by the UN's International Monetary Fund (IMF), which monitors foreign exchange rate values among nations and provides aid to countries with international debt problems. Increasingly efficient air and ocean transportation systems have also aided international trade expansion.
Trade blocs. For some countries, the worldwide liberalization of trade and commerce did not occur fast enough, and countries got together to form trade blocs to facilitate commercial interactions among members. The European Economic Community (now the European Union) was formed in 1957. Since then, trade blocs have been formed in North America (North American Free Trade Area), South America (the Mercosur and Andean Pact groups), and also in Asia and Africa.
Foreign direct investments (FDI) occur when international companies make investments in factories, plants, and machinery in nondomestic markets. As firms have increased their international commitments, FDI has grown from $615 billion in 1980 to over $12 trillion in 2006. Nation-states, recognizing the economic stimulus FDI provides, have increasingly worked to make their economies more attractive to international corporate investors.
Throughout history, there have been three major reasons for international business expansion. In early times (16th through 20th centuries), explorers looked for new resources (often gold, silver, or mineral deposits). Then, as countries began to develop, businesspeople began to regard distant nations as markets (the Colonial Era). Finally, as free trade movements took hold after 1945, efficiency-seeking companies looked to overseas markets as manufacturing sites to lower global costs of doing business. Today, all three major motives (resource seekers, market-seekers, efficiency-seekers) are reasons why firms invest abroad.
Global movements toward capitalism. The demise of communism in the 1980s and 1990s left little competition for capitalism to be the world's dominant economic and political philosophy. Since that time, Latin America, Eastern Europe, and Asia have slowly opened up their markets and become active participants in the global marketplace. Within national markets, former government-owned industrial monopolies such as airlines, telecommunications, energy, and utilities have been sold back into the private sector (privatization), and their markets deregulated to allow companies to compete for market share and profits.
Technology and global media. The advent of satellite, computer, and Internet technologies has transformed worldwide communications and facilitated information flows among nations, companies, and individuals. At the nation-state level, it has become increasingly difficult for countries to isolate their citizens from outside influences, and consumers worldwide have begun to enjoy the benefits of the international marketplace. Companies now have superior abilities to coordinate activities, products, and strategies across markets, and individuals have increased access to new ideas, philosophies, products, and lifestyles.
Globalization and the Developing World
Up to 1985, the Triad nations of North America, Western Europe, and Japan were dominant in world commerce, and are still today the major providers of global capital. But as developing markets opened up to trade and investments, new ideas and technologies began to contribute to economic and cultural change. Trade and investments brought many new (and affordable) products to developing nations. The advent of global media made information more readily available to developing nation publics that, coupled with moves toward democratization, have made politicians more accountable to their electors.
But the diffusion of technologies and consequent modernization processes have barely affected many emerging markets, where large percentages of national populations still reside in agriculturally based rural areas, largely untouched by modernization trends. As the United Nations noted,
Modernization, Westernization, and Americanization
Transfers of technology and foreign intrusions into national cultures have been occurring for hundreds of years. Starting with the European colonization movement of the 16th century, and proceeding through the industrial revolutions of the 18th and 19th centuries, the spread of technology has jumpstarted modernization movements in many countries as scientific and technological advances have upgraded national lifestyles and aided efficient resource use. In contrast, Westernization can be defined as the inculcation of (mainly) U.S. and European values on national cultures. As major international traders throughout the 20th century, U.S. and European influences on other nations' lifestyles has been extensive, and as U.S. power has increased, so "Americanization" has become synonymous with Westernization. Hollywood movies dominate the world market with 70 percent market share in the European Union and over 50 percent of the Japanese market.
INTERNATIONAL BUSINESS THEORIES
THEORIES OF INTERNATIONAL TRADE
Theoreticians seek general explanations of phenomena in order to 'see the wood from the trees' and to make sense of what otherwise would be a bewildering array of seemingly random items of information. Theories of international business attempt to answer two questions: why nations trade, and what determines the pattern of international investment.
1. Comparative cost theory
In his famous book The Wealth of Nations (published in 1776) Adam Smith put forward the theory that international trade would occur in situations where nations had 'absolute advantages' over rival states, i.e. they Could produce with a given amount of labour and capital larger outputs of certain items than any other country. The flaw in this argument is that it fails to explain why countries with an absolute disadvantage in all their products (i.e. countries which produce less of everything made within the country, using a given amount of labour and capital, than other nations) still engage in international trade. A possible resolution of this question was suggested by the eminent economist David Ricardo, who in 1817 alleged that trade among nations resulted from differences in the 'comparative' advantages of countries in the production of various items, not differences in absolute
Table 1.1 Item A Item B
3 days labour
4 days labour
6 days labour
5 days labour
Country 1
Country 2
advantage. Ricardo assumed that the cost of producing any good depended only on the amount of labour used in its production, and that firms and workers could not move freely between nations (a reasonable assumption for the early 1800s).
The theory is illustrated by Table 1.1, which shows the time needed to produce two hypothetical items in two different countries. It takes more days of labour to produce both items in country 2 than in country 1, so that country 2 has an absolute disadvantage in the production of each item. Ricardo assumed (importantly) that one unit of item A would be exchanged for one unit of item B, i.e. that a person in country 1 with a single unit of A could sell it to someone in country 2 in return for a single unit of B, and vice versa.
In this example trade will still benefit both countries because country 1 has a comparative advantage in the production of item A (it can produce a unit of item A in fewer days than it takes to produce item B) while country 2 has a comparative advantage in item B. If country 1 makes and exchanges a unit of A in return for a unit of B from country 2 then it obtains for an outlay of 3 days labour an item that would require 4 days labour if it were produced at home. Equally, country 2 benefits from the transaction as it receives for a cost of 5 days labour an item that would need 6 days if produced domestically. Hence trade is profitable for all concerned.
Although fascinating, Ricardo's solution rests on the severe assumptions that:
Firms in country 2 cannot move their operations to country 1 where both items can be produced at lower cost.
Only the amount of labour used in production determines the cost of an item. This ignores the impact of technical advances on the use of capital equipment.
Items exchange for each other at a predetermined and constant ratio.
Also, the theory does not explain why certain goods are cheaper in certain countries. This issue was addressed by E. Heckscher and B. Ohlin in the 1930s.
2. The Heckscher-Ohlin theory of international trade
According to the Heckscher-Ohlin theory, goods prices differ because production costs differ, and production costs themselves depend on the amount and costs of labour, capital and natural resources used when making various products. Each country possesses a specific mix of labour, capital and other 'factor endowments': some have abundant supplies of labour; others are rich in natural resources, etc. If an item embodies a large amount of labour, and if labour is cheap and plentiful in the producing country, then that product will be cheap by international comparison and thus likely to be exported to the rest of the world. In general, a country will export those items which incorporate relatively large amounts of its most abundant factor, and import those products which include relatively small amounts of the factor with which it is least endowed. In other words, differences in factor endowments determine differences in comparative advantage, which themselves shape the pattern of international trade.
Empirical performance of international trade theories
The comparative cost, Heckscher-Ohlin and other hypotheses relating to international trade have been tested extensively and, alas, no firm conclusions have emerged. Indeed, much empirical evidence flatly rejects the fundamental propositions of these theories. Extensions and modifications of conventional international trade theory have led to increasingly complex models, which themselves give rise to further problems and contradictory results.
Factors that might confound orthodox trade theories include:
a) The rapid pace of technological development, which causes national advantage to shift frequently and in unpredictable ways.
b) Skilful marketing that can increase foreign demand for relatively expensive exported goods.
c) Governments regularly seeking to improve national balance of payments positions via the imposition of tariffs, import and exchange controls, etc.
d) The fact, that trade theories regard nation states as independent trading units. In reality large multinational companies shift goods, services and capital among their subsidiaries in various countries at prices quite different to those at which a firm in one country would sell to a customer in another.
e) Poorer countries often having national economic development plans which encourage the importation of capital goods that otherwise would not have a market in these nations.
f) Multinational companies frequently shifting from exporting to particular countries to local production in those countries.
g) Sparcity and inaccuracy of the information upon which firms base their international trading decisions.
3. The work of Michael Porter
Observing that traditional economic theories fail to explain why certain countries have succeeded in the post-Second World War era, M. E. Porter put forward a fresh hypothesis concerning the basic determinants of the national competitive advantages that lead to international trade. Porter's analysis begins from the following propositions:
a) The capacity to automate complete production processes means that workforce costs and competencies are not as critically important to successful operations as they once were.
b) Companies today are increasingly international in outlook and able to shift operations from country to country at will.
c) The rise of the multinational corporation has broken the link between corporate efficiency and the quality and availability of resources (labour, capital, etc.) within the firm's own country. An MNC is not dependent on the resource base of just one nation; it operates wherever and whenever conditions are favourable.
d) The workforces and capital market arrangements of many industrialized countries are today broadly comparable, so that companies have greater choice over where they can locate activities. Hence the pressures of supply and demand will tend in the long term to equalise the costs of skilled labour and capital in these countries. Today, automated equipment can easily be substituted for labour, and modern technology enables the creation of synthetic substitutes for expensive raw materials.
These new realities, Porter argues, mean that firms need constantly to seek new sources of competitive advantage. In particular they need to operate internationally in order to fine-tune their competitive strengths and to identify and then remove weaknesses. Selling to the most demanding consumers causes a firm to achieve quality and service levels it would not otherwise attain. The key determinant of contemporary national competitive advantage, Porter suggests, is product and process innovation - not cheap labour or an abundance of natural resources. Indeed, lack of the latter can actually spur a country to a high level of technological innovation.
According to Porter, six sets of variables determine a nation's ability to compete internationally, namely:
1) Demand conditions: the strength and nature of domestic demand; consumer desires, perceptions and levels of sophistication.
2) Factor conditions: skilled labour, road and rail infrastructure, natural resources, etc.
3) Firm strategy, structure and rivalry: the organisation and management of companies and the extent of domestic competition.
4) Related and supporting industries: extent of supply industries, ancillary business services, input component manufacturers and so on.
5) Government policies, including rules on business competition, state intervention in industry, regional development, health and education and (importantly) vocational training.
6) Luck and chance.
Porter analysed data on the world's major industrial and trading nations and arrived at the following conclusions:
a)Lack of national resources (e.g. of oil, labour, minerals, etc.) can spur a country to a high level of innovation.
b) To be successful nations must move from having factor-driven to having investment-driven economies, followed by a further move to an innovation- driven economy. The latter contrasts with the 'wealth-driven' economies of certain countries, which have complacent businesses and are in decline despite per capita GDP continuing to rise.
c) The creation of domestic monopolies through mergers and takeovers creates moribund economic environments that are not conducive to innovation; even though domestic monopolies may have to compete fiercely on the international level.
d) Nations with governments that have been heavily involved with industries have generally been the least successful.
4. Mercantilism
Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop an economic theory. This theory stated that a country's wealth was determined by the amount of its gold and silver holdings. In its simplest sense, mercantilists believed that a country should increase its holdings of gold and silver by promoting exports and discouraging imports. In other words, if people in other countries buy more from you (exports) than they sell to you (imports), then they have to pay you the difference in gold and silver. The objective of each country was to have a trade surplus, or a situation where the value of exports are greater than the value of imports, and to avoid a trade deficit, or a situation where the value of imports is greater than the value of exports. A closer look at world history from the 1500s to the late 1800s helps explain why mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers wanted to strengthen their nations by building larger armies and national institutions. By increasing exports and trade, these rulers were able to amass more gold and wealth for their countries. One way that many of these new nations promoted exports was to impose restrictions on imports. This strategy is called protectionism and is still used today.
5. Leontief Paradox
In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US economy closely and noted that the United States was abundant in capital and, therefore, should export more capital-intensive goods. However, his research using actual data showed the opposite: the United States was importing more capital-intensive goods. According to the factor proportions theory, the United States should have been importing labor-intensive goods, but instead it was actually exporting them. His analysis became known as the Leontief Paradox because it was the reverse of what was expected by the factor proportions theory. In subsequent years, economists have noted historically at that point in time, labor in the United States was both available in steady supply and more productive than in many other countries; hence it made sense to export labor-intensive goods. Over the decades, many economists have used theories and data to explain and minimize the impact of the paradox. However, what remains clear is that international trade is complex and is impacted by numerous and often-changing factors. Trade cannot be explained neatly by one single theory, and more importantly, our understanding of international trade theories continues to evolve.
THEORIES OF INTERNATIONAL INVESTMENT
1. The product life cycle theory of international investment
The product life cycle (PLC) hypothesis asserts that, like people, products are conceived and born, mature, decline and eventually die. Hence, a product has a 'life cycle' comprising a series of stages. The introductory phase is characterized by high expenditures (for market research, test marketing, launch costs, etc.) and possibly by financial losses. Early customers will be attracted by the novelty of the item. Typically, these customers are younger, better educated and more affluent than the rest of the population. No competition is experienced at this stage. There is extensive advertising during the introduction, the aim being to create product awareness and loyalty to the brand.
There should now follow a period of growth, during which conventional consumers begin to purchase the product. Competition appears at this stage. Then the product enters its maturity phase. Here the aim is to stabilise market share and make the product attractive (through improvements in design and presentation) to new market segments. Extra features might be added, quality improved, and distribution systems widened. Competition intensifies; appropriate strategies now include extra promotional activity, price cutting to improve market share, and finding new uses for the product. Eventually, the market is saturated and the product enters its phase of decline. Public tastes might have altered, or the product may be technically obsolete. Sales and profits fall. The product's life should now be terminated, otherwise increasing amounts of time, effort and resources will be devoted to the maintenance of a failing product.
It could be, however that, a product that has reached the end of its life cycle in one country may have a fresh lease of life elsewhere. Indeed, L. T. Wells advanced the theory that product life cycles explain the pattern of direct foreign investment in developing countries by western MNCs. According to the argument, an item is introduced to a developing country and, at first, has little or no serious competition. Then the product is imitated by local suppliers so that several companies now sell the item. Hence, product differentiation via the addition of new features, provision of service facilities, etc., becomes necessary in order to secure a competitive edge. Local competitors might even improve upon the product and begin to export their versions of it to the originating firm's own country. Competition intensifies, and price cutting occurs until the product is no longer profitable for the foreign exporter to supply. Note how foreign imitators might enjoy lower labour and other local production costs, and spend nothing on new product development. The exporter conversely has to pay transport costs plus import duties. Thus the exporting company is likely to establish its own local manufacturing facilities in order to be able to compete on price with local firms. Also it must quickly create a strong brand image and effective communications with agents and distributors 'in the field'. Thus direct foreign investment (DFI) in less developed economies by firms from richer nations was the only way they could compete against locally based low-cost imitating businesses.
Empirical evidence tended to support this theory during the 1950s and early 1960s, but not thereafter, possibly for the following reasons:
a) New product innovation is today so rapid that product life cycles are too short for it to be worthwhile establishing foreign production facilities dedicated to a particular item.
b) Although firms in less developed countries may be able to produce products cheaper than western rivals they cannot necessarily transport, market and distribute them efficiently.
c) In practice, MNCs often launch new products in developed and underdeveloped countries simultaneously.
d) MNCs frequently choose low-cost countries as production sites for the worldwide sale of a good, i.e. no production occurs in economically advanced nations.
e) As alternatives to DFI, Western firms may engage in licensing or contract manufacturing in order to produce goods in less developed countries.
There are, moreover, a number of fundamental problems with the basic PLC hypothesis itself. The length of life of a new product cannot be reliably predicted in advance, and many products cannot be characterized in life cycle terms (basic foodstuffs, or industrial materials for instance). Importantly, variations in marketing effort will affect the durations of life cycle phases and determine the timing of transitions from one stage to the next. Products do not face inevitable death within predetermined periods: the termination of a product's life is very much a management decision. In many cases a product's lifespan may be extended by skilful marketing. Also, management can never be sure of the phase in its life cycle in which a product happens to be at a particular time. How, for instance, could management know that a product is near the start and not the end of its growth phase, or that a fall in sales is a temporary event rather than the start of a product's decline?
The expected demise of a product can become a self-fulfilling reality; management may assume wrongly that sales are about to decline and consequently withdraw resources from the marketing of that product. Hence, in the absence of advertising, merchandising, promotional activity, etc., sales do fall and the product is withdrawn! Yet another problem is the enormous number of (sometimes random) factors that can influence the durations of phases, turning points and levels of sales. Competitors' behavior may be the primary determinant of the firm's sales, regardless of the age of the product.
2. Market imperfections and monopolistic advantage theories
These assert that large firms engage in international business in order to create near monopoly conditions for their operations. Thus, for example:
Cross-border patent licensing agreements carve up foreign markets and prevent competition in relation to the patented item.
Foreign production in countries with very low labour and other costs followed by the export of the resulting output to the parent company's home nation enables the company to undercut its domestic competitors and drive them out of business.
Acquisition of foreign sources of raw materials and/or other inputs or of foreign distribution outlets means that the firm 'internalises' the entire procurement, supply and distribution system within a single organisation, hence reducing uncertainties and risks and restricting competition.
More generally, 'imperfections' in foreign market conditions are said to explain international investment by companies. Stephen Hymer, for example, has argued that firms only invest abroad if they have attributes not possessed by local foreign rivals and there are barriers ('market imperfections') that prevent these rivals from obtaining the attributes of the foreign company. Attributes could relate to economies of scale in production, marketing or organizational management skills; preferential access to finance or raw materials; or the use of a superior technology. These advantages must be of a magnitude sufficient to offset the costs of operating abroad (need to conduct research into the local market, foreign exchange risks, transport costs, etc.) and, subsequent writers have suggested, may be 'firm specific', 'ownership specific', or 'location specific'.
Ownership-specific factors relate to such matters as the extent of a company's share capital, receipt of government grants and subsidies, and proprietary rights over intellectual property. Location-specific advantages include low prices for locally purchased inputs, low transport costs, easy communications, availability of local business support services (advertising agencies, market research firms, etc.), a skilled and low-cost labour force, and the avoidance of trade restrictions imposed by the host country government in order to reduce imports. Other relevant factors are market size and rate of growth and the extent of local competition. Examples of firm-specific advantages are the ownership of well-known brands, special marketing skills, attractive product features, patents, economies of scale or access to capital markets.
3. Dunning's eclectic theory of international production
John Dunning's 'eclectic theory' of foreign investment asserts that the likelihood of a firm investing abroad depends essentially on firm-specific factors, location-specific factors that make it advantageous to invest in a particular country, and 'internalization' advantages which cause the internal transfer of labour, capital and technical knowledge within the firm to be more cost- effective than using outsiders, such as licensees, import agents, distributors and so on.
Internalization
Arguably, firms invest directly in other countries in order to cut out the use of (expensive) suppliers and distributors. Hence all stages in the supply process are brought under a common ownership so that the full benefits of research and development can be obtained (by avoiding the use of licensees), and working capital better utilized. Also foreign government import regulations might be avoided through producing in a local subsidiary rather than exporting direct. All aspects of marketing will be controlled by the supplying firm, and there are no intermediate sales or value added taxes. Knowledge can be transferred around the company at will. Note however that extra costs have to be incurred by a firm that does things for itself rather than using outsiders. Internal communication and administration costs increase and there are additional costs associated with having to operate in unfamiliar environments.
Problems with theoretical models of DFI
While interesting in themselves, none of the models previously outlined is sufficiently general to explain all aspects of the foreign investment behaviour of international companies. Each theory purports to give reasons for certain investment activities, but contradictory evidence can be advanced against all of them in certain circumstances. The theories are partial and incomplete and adopt different ideological perspectives. In particular, these theories tend to ignore the influences of the psycho-social and other human aspects of international managerial behaviour, and of the governments of nation states. Theories of international investment sometimes contradict each other, and should really be regarded as 'opinions' rather than as theories capable of empirical verification. Arguably, moreover, the field of international business is so complex and fast changing and covers so many disparate elements that no general theory can be valid for very long.
International business competitive Forces (A comparative analysis)
Absolute and Comparative Advantage
Comparative advantage emphasizes nationally "endowed" factors, differences in international technology/productivity, external economies, and international policies. Comparative advantage focuses on the relative productivity differences. The literature on international trade and policy contains a number of reasons why a country may have an advantage in exporting a commodity to another country. For convenience, most of these reasons may be classified into (1) technological superiority, (2) resource endowments, (3) demand patterns, and (4) commercial policies.
Technological Superiority
Adam Smith's principle of "absolute advantage" and David Ricardo's principle of "comparative advantage", in general, are based on the technological superiority of one country over another country in producing a commodity. Absolute advantage refers to a country having higher (absolute) productivity or lower cost in producing a commodity compared to another country. However, absolute advantage in the production of a commodity is neither necessary nor sufficient for mutually beneficial trade. For example, a country may be experiencing absolute disadvantage in the production of all commodities compared to another country, yet the country may derive benefits by engaging in international trade with other countries, due to relative (comparative) advantage in the production of some commodities vis-à-vis other countries. Likewise, absolute advantage in the production of a commodity is not sufficient, since the country may not have relative (comparative) advantage in the production of that commodity. David Ricardo's principle of comparative advantage does not require a higher absolute productivity but only a higher relative productivity (a weaker assumption) in producing a commodity. Pre-trade relative productivities/costs determine the pre-trade relative prices. Pre-trade relative prices in each country determine the range of possible terms of trade for the trading partners. Actual terms of trade within this range, in general, depend on demand patterns, which, in turn determines the gains from trade for each trading partner.
The Ricardian model assumes constant productivity, as there is only one factor of production (labour), and therefore constant (opportunity) costs that leads to complete specialization. However, increasing opportunity costs that often arise in multi-factor situations (law of diminishing returns) due to limited quantity of some factors specific to an industry can easily be accommodated to allow for incomplete specialization. Thus, in the Ricardian model, technological differences in two countries are the major source of movement of commodities across national boundaries.
While the principle of comparative advantage as expounded by David Ricardo was couched in terms of technological superiority, the principle, when phrased in terms of comparing opportunity cost or relative prices of goods and services between countries is sufficiently general to encompass a variety of circumstances. Furthermore, although Ricardo's explanation of comparative advantage was in static terms, comparative advantage is a dynamic concept. A country's comparative advantage in a product can change over time due to changes in any of the determinants of comparative advantage including resource endowments, technology, demand patterns, specialization, business practices, and government policies.
Resource Endowments
Availability of resources in a country provides another source of comparative advantage for countries that do not necessarily possess a superior technology. Under certain restrictive assumptions, comparative advantage can be obtained due to differences in relative factor endowments. As propounded by Hecksher and Ohlin, a country has a comparative advantage in the production of that commodity which uses the relatively abundant resource in that country more intensively. For example, newsprint uses natural resources (forest products) more intensively compared to textiles. Textiles use labour (L) more intensively compared to newsprint. Canada is relatively abundant in natural resources (R) compared to India. (R/L) Canada > (R/L) India. This implies R will be relatively cheaper in Canada as compared to India. Thus, Canada has a comparative advantage in newsprint and will therefore specialize and export newsprint to India. Likewise, India has a comparative advantage in textiles and will therefore specialize and export textiles to Canada.
Human skills: Human skills can also be considered a resource. Countries with relatively abundant human skills will have a comparative advantage in products that use human skills more intensively. Certain products such as electronics require a highly skilled labour force (such as engineers, programmers, designers, and other professional personnel). Such products may gain comparative advantage in countries (such as Taiwan, Singapore, Hong Kong) that are relatively better endowed with such skilled labour. (Keesing, 1966). Government policies aimed at better education and training can create such an endowment.
Economies of Scale: Economies of scale can provide comparative advantage by lowering production costs. External economies that operate by shifting the average cost of firms downward can in fact occur due to an industrial policy or a proactive role of the government in providing better infrastructure and/or a better educated or trained labour force. Such economies of scale are consistent with Ricardian and Factor Proportions models. Economies of scale (internal) achieved through the existence of a large home market and/or some policy-induced accessibility to a larger market outside the nation (say due to a customs union) also imply lower production costs. This may boost or create a comparative advantage for the industry experiencing such economies of scale.
Technological Gap (Benefits of an Early Start) and Product Cycle: Industrially advanced nations in general had an early start in most manufactured products and services, which allowed them to enjoy large national and international markets. Industrially advanced nations were thus able to export new products until such time that the products were produced by other low factor cost countries. Vernon's (1966) Product Cycle hypothesis emphasizes the importance of the nature and size of home demand for new products in highly industrialized countries. Since, initially, the new product involves experimentation of the features of the product as well as the production process, the countries that have sufficient home demand for such products produce and export them. As the specific nature of demand becomes more universal and the technology more easily available to others, the nation loses comparative advantage in that product. Meanwhile, the firms are likely to have developed another product that enables the nation to gain comparative advantage in that product.
Demand Patterns: Demand Considerations
The role of demand and the size of the home market for products are already evident in (1) establishing the equilibrium terms of trade and therefore the division of gains from trade; (2) economies of scale; and (3) product cycle hypothesis. In addition, Linder (1961) emphasized the role of demand in the home market as a stepping stone towards success in international markets. According to Linder, manufacturers initiate the production of a new product to satisfy the local market. In this step, they learn the necessary skills for making the product by more efficient techniques, which in turn, give these nations comparative, advantage in the product vis-à-vis other countries. Linder's thesis postulates exporting the product to countries with similar tastes/demand patterns. The theory, coupled with market imperfections and product differentiation can explain a large portion of intra-industry trade among the industrialized nations.
National and International Policies
National policies towards infrastructure, export promotion, education and training, R&D policy related to export industries can go a long way in creating and sustaining comparative advantage. Industrial policies such as production subsidies, tax preferences, restricted tendering of Government contracts, anti-trust policy, and a number of other means are often used to provide an advantage to domestic industries. Likewise, the commercial policies aimed at restricting imports through tariffs, quotas, voluntary export restraints, import licensing, local content rules, restriction on outsourcing, escape clauses, etc. have been used to the advantage of domestic import competing industries. Policy driven benefits realized by the industries through internal and/or external economies, in the long run, may become a source of comparative advantage to these industries. The 1965 Auto-Pact between Canada and the USA is a good example of targeting individual industries to influence production and trade through national policies. The trade creation and trade diversion effects of customs unions/free trade areas are well known in the literature. Further, the policies pursued by international organizations such as the World Bank, the IMF and the WTO can also become a source of comparative advantage/disadvantage to some industries in countries affected by such policies.
Dynamic Gains /Comparative Advantage
International trade, through a better allocation of resources, increases incomes, saving, and investment, thus enabling a country to realize higher growth even in fully employed economies. In addition, for developing countries, trade can enable them to transform consumption goods and raw materials into capital goods as well as gain technological know-how from technologically advanced countries. Trade can also provide demand stimulus to the lagging (excess capacity of some factors of production) economies. Furthermore, specialization through trade benefits not only the export industry, but all other industries (through increased demand for their products) related to the export industries. Lastly, by increasing the size of national market and thereby the size of production facilities, domestic firms can reap both external and internal economies of scale. International trade also implies more competitive pressures on domestic firms that stimulate research and development.
All these considerations yielding comparative advantage to the nation may be seen as a framework of a number of forces that can be portrayed. Obviously, the firms specializing within the industries that have comparative advantage are on a much stronger footing to derive competitive advantage in producing standardized or differentiated products within that industry. In this framework, technology, resources, demand and the trade-enhancing policies are depicted as four forces influencing the comparative advantage of a nation in a commodity/service vis-à-vis other countries. Dynamic elements influencing comparative advantage are also included in these forces.
Competitive advantage/absolute advantage
Competitive advantage relies heavily on the firm-specific factors such "created" factors, "created" demand for the product, and internal economies achieved through innovation. Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation. Absolute advantage looks at the absolute productivity.
Porter (1985) emphasized competitiveness at the level of a firm in terms of competitive strategies such as low cost and/or product differentiation. A number of writers on competitive advantage have focused on the determinants/sources of competitive advantage such as important attributes of the firm: rareness, value, inability to be imitated, and inability to be substituted (Barney, 1991); important potential resources classified as financial, physical, legal, human, organizational, informational, and rational (Hunt and Morgan, 1995); ability in developing superior core competencies in combining their skills and resources (Prahalad and Hamel, 1990); a set of dynamic capabilities—capabilities of possessing and allocating and upgrading distinctive resources. Luo (2000). A number of studies have also analysed the role of individual factors such as intellectual property rights, trade secrets, data bases, the culture of organization, etc. (Hall, 1993), ethics capability (Buller and McEvoy, 1999), corporate reputation (Ljubojevic, 2003), diversity in workplace (Lattimer, 2003) and corporate philanthropy (Porter and Kramer, 2002). The central focus of these contributions is still on firm-specific factors of competitive advantage.
Porter's National Competitive Advantage Theory
Porter identified four determinants that he linked together. The four determinants are (1) local market resources and capabilities, (2) local market demand conditions, (3) local suppliers and complementary industries, and (4) local firm characteristics.
1. Local market resources and capabilities (factor conditions). Porter recognized the value of the factor proportions theory, which considers a nation's resources (e.g., natural resources and available labor) as key factors in determining what products a country will import or export. Porter added to these basic factors a new list of advanced factors, which he defined as skilled labor, investments in education, technology, and infrastructure. He perceived these advanced factors as providing a country with a sustainable competitive advantage.
2. Local market demand conditions. Porter believed that a sophisticated home market is critical to ensuring ongoing innovation, thereby creating a sustainable competitive advantage. Companies whose domestic markets are sophisticated, trendsetting, and demanding forces continuous innovation and the development of new products and technologies. Many sources credit the demanding US consumer with forcing US software companies to continuously innovate, thus creating a sustainable competitive advantage in software products and services.
3. Local suppliers and complementary industries. To remain competitive, large global firms benefit from having strong, efficient supporting and related industries to provide the inputs required by the industry. Certain industries cluster geographically, which provides efficiencies and productivity.
4. Local firm characteristics. Local firm characteristics include firm strategy, industry structure, and industry rivalry. Local strategy affects a firm's competitiveness. A healthy level of rivalry between local firms will spur innovation and competitiveness.
Industry analysis and structure
Business strategy involves identifying and exploiting the resources and capabilities of the firm in the marketplace for the purpose of gaining competitive advantage and superior financial performance. Inherent in this definition is the need to continuously renew these resources and capabilities, to determine a set of goals and objectives for the enterprise when it does gain competitive advantage, to understand the structure of the marketplace and of the competitive situation faced by the firm, and to devise, assess, and choose among a set of strategic options for the firm. A fully developed strategy must also be suitable to the macro-environment of the enterprise and must develop organizational solutions to execute otherwise abstract plans.
The major aspects of strategy analysis include: setting goals and objectives, performing competitive and industry analysis, analyzing resources and capabilities, developing strategic options, choosing a strategy, and implementing that strategy, with feedback loops among all the processes.
The Strategic Analysis Process
International business involves a specific set of issues whose strategic resolution ties into the generic strategic analysis and involve (1) increasing geographic spread (often referred to as 'internationalization'), (2) achieving local adaptation (often referred to as 'responsiveness'), (3) building global integration (sometimes referred to as 'globalization' or 'global strategy'), and (4) multi-business, multi-country, and often multi-firm issues such as international strategic alliances and global mergers and acquisitions.
International Strategy Issues
Although the last international issue of multi-business/multi-firm/multinational moves tends to require heavy emphasis on all five strategic analysis processes. We see heavy reliance on goal setting, industry analysis, and resource assessment as firms expand internationally. Adaptation and integration are driven largely by issues developed through competitive analysis and resource assessment, while integration must also consider issues revealed by different means of assessing strategic conditions and opportunities.
Resources and Capabilities for Geographic Spread
The concept of resources and capabilities developed in the strategy literature (e.g. Wernerfelt, 1984; Grant, 1991) applies very well to the international strategy issue of geographic spread. Companies that own or access unique resources and capabilities—demonstrating unique core competencies in Hamel and Prahalad's terms—find that international expansion gives them vast new opportunities to leverage these expensive and valuable skills
Risk and Return in International Strategy
Another consideration in international expansion is risk reduction, whether financial, business, or environmental. International expansion offers the opportunity to move into markets that are not perfectly in phase with the home market.
Industry and Competitor Analysis for Geographic Spread
Classic industry and competitor analysis (Porter 1980 and 1985) can be applied to geographic spread. Firms usually need an initial competitive advantage that they can leverage into international markets. Then, in addition to the initial competitive advantage, companies need to conduct classic industry analysis in each market, as by using Porter's (1980) five forces framework to establish for each potential foreign market what the likely prospects are for above average returns.
Industry structure analysis WBA/ Term paper
