INTERNATIONAL BUSINESS

UNIT-II
Theoretical Foundation Of International Business:Theory Of Mercantilism-Theory Of
Absolute And Comparative Cost Advantage-Haberler's Theory Of Opportunity
Cost-Heckscher- Ohlin Theory Market Imperfections Approach- Product Life Cycle
Approach- Transaction Cost Approach- Dunning's Eclectic Theory Of International
Production

Theoretical foundations of international business

The theoretical foundations of international business provide a framework for
understanding the drivers and dynamics of international trade and investment. These
theories help explain why firms engage in international business, how they choose which
markets to enter, and how they operate in foreign markets.

Here are some of the major theoretical foundations of international business:

1. Mercantilism: This early theory focused on the importance of accumulating wealth

through exports and restricting imports.

2.Comparative Advantage: This theory explains that countries will export goods that they
can produce relatively more efficiently than other goods.

3.Absolute Advantage: This theory suggests that countries will export goods that they can
produce at a lower absolute cost than other countries.

4.Product Life Cycle Theory: This theory proposes that products go through a series of
stages in their development, from introduction to growth, maturity, and decline. Firms may
internationalise their operations at different stages of the product life cycle.

5.Internalisation Theory: This theory explains why firms may choose to invest directly in
foreign countries rather than exporting or licensing their products.

6.Institutional Theory: This theory examines how the formal and informal rules of a country
can affect international business activity.

Theory Of Mercantilism
Certainly! Mercantilism, as a theory, had several implications for international business
practices during its prominence from the 16th to 18th centuries. Here are some key aspects
of how mercantilism influenced international business:

1.Trade Surpluses and Bullionism: Mercantilist policies emphasised the importance of

maintaining a trade surplus, exporting more than importing, to accumulate precious metals
(gold and silver). This focus on bullionism was seen as essential for increasing a nation's
wealth and power.

2.Colonialism and Trade Monopolies: Mercantilism promoted colonial expansion as a

means to secure access to raw materials and establish captive markets for finished goods.
Colonies were viewed primarily as suppliers of resources that could be processed and sold
by the mother country, benefiting the national economy.

3.Protectionism and Tariffs: To safeguard domestic industries and maintain trade

surpluses, mercantilist governments imposed high tariffs and trade barriers on imports. This
protectionist approach aimed to limit foreign competition and encourage local production.

4.State Intervention and Regulation: Mercantilism advocated for significant government

involvement in economic affairs. Governments granted monopolies, subsidised industries,
and regulated trade to control economic activities and maximise national wealth.

5.Navigation Acts and Mercantile Policies: Laws such as the Navigation Acts in Britain
required colonial trade to be conducted only on British ships, thereby bolstering the national
shipping industry and ensuring control over trade routes. These policies reinforced
mercantilist principles of state control and economic nationalism.

6.Criticism and Evolution: Mercantilism faced criticism from later economists, such as
Adam Smith, who argued for free trade and the benefits of market competition.

Theory of Absolute and comparative cost advantage

The theories of absolute and comparative cost advantage are fundamental concepts in
international trade that explain why countries engage in trade and how they benefit from it.
These theories were developed by classical economists Adam Smith and David Ricardo.

Absolute Cost Advantage (Adam Smith)

Concept:
-The theory of absolute advantage was introduced by Adam Smith in his seminal work
"The Wealth of Nations" (1776).

- According to this theory, a country has an absolute advantage in the production of a

good if it can produce that good more efficiently (using fewer resources or at a lower cost)
than another country.

Implications:
-Countries should specialise in producing and exporting goods in which they have an
absolute advantage.

- They should import goods in which other countries have an absolute advantage.

- This specialisation and trade will lead to increased overall efficiency and wealth for all
countries involved, as resources are allocated to their most productive uses.

Example:
- If Country A can produce 10 units of wine using the same resources that Country B uses
to produce 5 units of wine, Country A has an absolute advantage in wine production.
 - Similarly, if Country B can produce 20 units of cloth using the same resources that
Country A uses to produce 10 units of cloth, Country B has an absolute advantage in cloth
production.

- Both countries benefit by trading wine for cloth.

Comparative Cost Advantage (David Ricardo)

Concept:
- David Ricardo introduced the theory of comparative advantage in his book "On the
Principles of Political Economy and Taxation" (1817).

- According to this theory, a country has a comparative advantage in the production of a

good if it can produce that good at a lower opportunity cost than another country, even if it
does not have an absolute advantage in producing that good.

Implications:
- Countries should specialise in producing and exporting goods in which they have a
comparative advantage.

- They should import goods in which other countries have a comparative advantage.

- Trade based on comparative advantage allows countries to benefit from specialisation

and achieve greater overall economic welfare, as they can consume more goods than they
could produce on their own.

Example:
- Suppose Country A can produce either 10 units of wine or 5 units of cloth with its
resources, and Country B can produce either 5 units of wine or 20 units of cloth.

- Country A's opportunity cost of producing 1 unit of wine is 0.5 units of cloth, and the
opportunity cost of producing 1 unit of cloth is 2 units of wine.

- Country B's opportunity cost of producing 1 unit of wine is 4 units of cloth, and the
opportunity cost of producing 1 unit of cloth is 0.25 units of wine.

Conclusion:
- The theories of absolute and comparative cost advantage highlight the benefits of
specialisation and trade based on efficiency and opportunity costs.

- These theories underpin much of modern international trade policy and economic
thinking, emphasising how countries can achieve mutual gains through trade.

Haberier's theory of opportunity cost-heckscher Ohlin theory market imperfections

approach
 Here’s a detailed look at the opportunity cost concept by Gottfried Haberler, the
Heckscher-Ohlin theory, and the market imperfections approach in the context of
international business:

Haberler's Theory of Opportunity Cost

Concept:
- Gottfried Haberler, an Austrian-American economist, redefined the concept of
comparative advantage using the idea of opportunity costs rather than the labour theory of
value used by David Ricardo.

- Opportunity cost is the cost of forgoing the next best alternative when making a decision.

Implications:
- Haberler's opportunity cost approach allows for a more general and realistic
understanding of comparative advantage, applicable to a wider range of economic contexts
beyond the simplistic assumptions of labour as the only input.

- It shows that countries should specialise in producing goods for which they have the
lowest opportunity cost, thereby maximising their efficiency and overall economic welfare.

Example:
- If Country A can produce either 10 units of wine or 5 units of cloth with its resources, the
opportunity cost of producing 1 unit of wine is 0.5 units of cloth.

- If Country B can produce either 5 units of wine or 20 units of cloth, the opportunity cost of
producing 1 unit of wine is 4 units of cloth.

Heckscher-Ohlin Theory

Concept:
- Developed by Eli Heckscher and Bertil Ohlin, this theory extends classical trade theories
by focusing on the factor endowments of countries.

- The Heckscher-Ohlin (H-O) theory posits that countries will export goods that use their
abundant factors intensively and import goods that use their scarce factors intensively.

Assumptions:
- Countries have different endowments of factors of production (e.g., labour, capital).

- Goods require different proportions of these factors to produce.

Implications:
- Trade patterns are determined by the relative availability and prices of factors of
production.
 - Countries rich in capital will export capital-intensive goods, while countries rich in labour
will export labour-intensive goods.

Market Imperfections Approach

Concept:
- The market imperfections approach to international business focuses on the reasons why
firms invest abroad despite the existence of imperfections in markets, such as information
asymmetry, transaction costs, and barriers to entry.

Key Points:
-Information Asymmetry: Firms may have better information about their own capabilities
and market conditions than local firms or potential partners in foreign markets.

-Transaction Costs: Firms can reduce costs related to negotiating, monitoring, and
enforcing contracts by internalising transactions within the firm.

Implications:
- Firms engage in foreign direct investment (FDI) to exploit their unique advantages (e.g.,
technology, brand reputation, managerial expertise) that are not easily transferred through
licensing or exports.

- Multinational enterprises (MNEs) arise as a means to internalise cross-border

transactions and mitigate the impact of market imperfections.

Example:
- A pharmaceutical company with a proprietary drug may establish manufacturing and
distribution operations in a foreign country to protect its intellectual property and control the
quality and supply chain, rather than licensing the drug to a foreign firm.

Product Life Cycle Approach

The product life cycle (PLC) approach is a framework used in international business to
understand how a product's development, marketing, and production evolve across different
stages in international markets.

Here's a breakdown of the PLC stages in an international context:

1. Introduction: The product is new and initially introduced in the home country. Production
is often localised to maintain control and reduce costs. Marketing emphasises creating
awareness and building demand.

2.Growth: The product gains traction in the home market, and the company considers
entering foreign markets. Exporting is a common strategy at this stage. Marketing focuses
on brand building and differentiation.
3. Maturity: The product reaches peak sales in the home market, and foreign markets
become increasingly important for growth. Production may be shifted to lower-cost countries
to improve competitiveness.

4.Decline: Sales fall in both domestic and foreign markets. The company may decide to
withdraw from certain markets, focus on niche markets, or develop product upgrades.

Transaction Cost Approach

The transaction cost approach (TCA) in international business helps firms decide how
to organise their foreign operations by considering the costs associated with international
transactions. It emphasises that firms strive to minimise transaction costs, which include the
costs of:
* Identifying and negotiating with potential business partners
* Drafting and enforcing contracts
* Monitoring and safeguarding against opportunism (self-interested behaviour)
* Adapting to unforeseen circumstances

TCA suggests that firms choose organisational modes that minimise these transaction costs.
Here are some common internationalisation modes and how TCA applies to them:

1. Exporting: Involves selling goods or services produced domestically to foreign buyers.

This mode may be preferred when transaction costs are low, but it can be challenging to
maintain quality control and adapt to foreign markets.

2. Licensing: Involves granting a foreign firm the right to use a company's technology, brand
name, or other intellectual property. This can be a good option when transaction costs are
moderate, but it involves relinquishing some control over production and marketing.

3. Foreign direct investment (FDI): Involves establishing a physical presence in a foreign

country, such as a subsidiary or joint venture. This mode offers greater control but incurs
higher transaction costs due to factors like managing overseas operations and complying
with local regulations.

Dunning's Eclectic theory of international Production

Dunning's Eclectic Paradigm, also known as the OLI Framework, is a comprehensive
theory developed by John H. Dunning to explain why companies engage in foreign direct
investment (FDI) and how they choose their international production locations.The OLI
Framework consists of three main components: Ownership advantages (O), Location
advantages (L), and Internalization advantages (I).

1.Ownership Advantages (O)

Concept:
- Ownership advantages refer to the unique assets, capabilities, or resources that a firm
possesses, which provide it with a competitive edge over other firms in foreign markets.
Implications:
- Firms with significant ownership advantages are more likely to invest abroad to exploit
these advantages in foreign markets.
- Ownership advantages enable firms to overcome the costs and risks associated with
operating in a foreign country.

2. Location Advantages (L)

Concept:
- Location advantages refer to the specific attributes of a host country that make it an
attractive destination for FDI. These advantages can be economic, political, social, or
cultural.

Implications:
- Firms choose to invest in locations where they can maximise their competitive
advantages and where the benefits of the location outweigh the costs.

- Different industries may prioritise different location advantages based on their specific
needs and strategies.

3. Internalisation Advantages (I)

Concept:
- Internalization advantages refer to the benefits that firms gain by controlling and
managing their own operations abroad rather than relying on external partnerships, such as
licensing or joint ventures.

Implications:
- Firms with significant internalisation advantages prefer to establish wholly owned
subsidiaries or engage in FDI rather than entering into partnerships or licensing agreements.

- Internalisation allows firms to fully exploit their ownership and location advantages while
maintaining control over their international Production

Conclusion

Dunning's Eclectic Paradigm provides a comprehensive framework for understanding the

motivations and strategies behind foreign direct investment.