People today wake up by an alarm clock made in China, shave with a French razor, dress in Italian-designed (Pakistan-made) clothes and drive their way to work with a German car. Small facts from our daily routine justify that ‘the last 100 years the internationalization (some would say globalisation) of business can be said to have re-drafted the world economic map’ (Woods, 2001). Globalisation, despite the numerous changes caused at national and international level, set new rules for all enterprises, no mater their size – if a business is to be successful then it needs to be aware of the general environment. From the moment trade and economic environment changed, firms turned international in order to maintain their competitiveness and expand their activity into new markets (Hodgetts, 2003). Therefore, multinational enterprises (MNE’s) should keep in mind that international trade, as a result of globalisation, is now the primary profit source. Also, MNE’s should re-consider their financial and production tactics if they want to gain more from the global-market environment, such as focus on specialization (ibid).
The purpose of this essay is to discuss the primary ways International Business occurs and examine the advantages and disadvantages of international trade and specialization with an extended look at free trade.
Two Primary Ways of International Business Development
The basic idea for firms going global is to expand their existing sales with reducing the costs of making the additional sales. How will they achieve that? They have two primary ways: first, imports-exports worldwide (International Trade) and second, direct foreign investment (FDI) or portfolio investment. The first way is usually seen as Adam Smith’s basic principle of exchange, as an attempt to explain why countries trade, while the second way is the base of international capital flow.
International Trade
As mentioned before, firms and countries expect some gains from this exchange such as: lower production costs, improved products quality and higher sales profits. However, in the early years of trade, the theory of mercantilism was against that assumption and it was Smith who reacted to this theory by setting up his absolute advantage theory (Mnieh, 2010).
Mercantilists in the 18th century believed that a country’s wealth should be measured by the gold and silver the country possessed, so the more precious metals the country had the richer and more powerful it was. Also, the exports were seen as ‘good’ because they brought silver/gold, whereas imports were ‘bad’ because they reduced the amount of gold and silver from the country. Mercantilists wanted to encourage countries to export more than import; therefore, they proposed that exports should be increased and imports decreased by means of tariffs or quotas. As a result, under this theory, only one party could gain from trade (Brewer, 2000). However, mercantilism theory did not explain the basic questions of international trade such as, which goods are exported or imported, in what quantity and by whom (ibid).
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Adam Smith addressed these questions, and he produced the theory of absolute advantage. That theory holds that countries who use resources more efficiently can gain more by focusing on the specialization of their most efficient product and importing the goods they produce inefficiently. Consequently, the specialized production of a commodity gives a country an absolute advantage on that product, and the country’s resources are focused on the production of the profitable output instead of split up or wasted on other, less profitable, outputs. Absolute advantage, however, can explain only a small part of the world’s trade today and does not include any evidence about the determination of trade (Rugman and Collinson, 2006).
In 1819, David Ricardo, based on Smith’s work, examined the questions ‘What happens when a country can produce all products at an absolute advantage?’ ‘Would trade still benefit both countries now?’ And developed the theory of comparative advantage. According to Ricardo’s theory, a country has a comparative advantage in a product when it has a higher degree of superiority in its production, and it has a comparative disadvantage in a product when its degree of superiority is lower, relative to another country. In order to understand that theory completely, we need to introduce the concept of opportunity cost (Woods, 2001).. We assume that a country produces two goods, A and B, so the opportunity cost is the cost related to the amount of good A which must be sacrificed in order to produce one additional unit of good B (Mnieh, 2010). Therefore Ricardo, suggested that a country with an absolute advantage in all lines of production should trade with another country in the product which has the higher opportunity cost in order to gain from the other county’s lower opportunity cost.
Foreign Direct Investment
The second way international business occurs is through equities. According to Collinson (2006), a tactic usually applied by nations and MNEs to gain access to a foreign market is equity funds invested in other nations.
Therefore, a definition used for foreign direct investment (FDI) is the control and ownership of foreign assets. The basic idea for the FDI concept is that corporations find it more beneficial to purchase another foreign company, simply to acquire the company’s market share and know-how in the host country. It has to be mentioned that FDI is different from portfolio investment. Foreign portfolio investment is a transfer of capital from one country to another, whereas FDI contains the issue of control and ownership of the activities abroad. Another common tactic of FDI is the union of capital of multiple corporations to a joint venture, in order to purchase together the foreign company aboard (Rugman, 2006).
There is a substantial number of reasons why multinational corporations are interested in expanding their activities and influence in foreign assets. The primary reason is to increase their sales and profits. According to the UN World Investment Report (2006), numerous large multinationals have earned millions of pounds through overseas sales every year since they went abroad. Not only large firms gain benefits from activities abroad but a large number of smaller firms increase their revenues as well. MNEs financial and production activities pay the way for local suppliers to get involved with the multinationals and maybe supply them to other worldwide locations (ibid).
The second reason is the lower costs abroad. Lower labour cost, for example, is a considerable reason for transferring a company’s production facilities to a place where labour is much cheaper. In addition to this, MNEs can consider other factors such as materials supply, transportation costs and energy issues, which affect managers decisions to move their activities abroad. Another reason is to enter economic blocs and rapidly growing markets. At this point, we have to mention that the global economical map is different between countries, regions or continents. Some countries have markets that grow more rapidly than others, and many countries are part of international, economical and political, agreements that affect trade, so multinational companies gain a foothold in these markets by investing directly in them (Deresky,2006)..
The final reason for FDI is to gain access to technology and know-how as well as the protection of domestic and foreign markets. In essence, there are examples of multinationals that have saved their own and foreign markets by making investments in these markets and take a strategic advantage due to the high-technology acquirement their investments provide (Piggott and Cook, 2006).
Advantages and Disadvantages of Specialisation
The model of comparative advantage and the theory of absolute advantage are both based on specialisation. Specialization, at production level, occurs when a worker becomes skilled and efficient at a specific task in order to be able to produce more goods or services than other workers. Countries that produce specialised goods could have many advantages.
First, specialisation at international level means that a country will benefit from the trade of specialized goods with other countries. Second, specialisation makes workers to becomes quicker at producing goods or services; consequently, the production per good become cheaper and the production levels are increase. Therefore, a country can be competitive and maintain or expand the wealth it already has (Piggott and Cook, 2006). The third point is the gain of know-how. A country that focuses on the specific production of a good can become an expert and invest in research on that good. Fourth, a country can enhance its reputation. If a country becomes an expert it is possible to increase the quality and reliability of its products, she will create a reputation and the demand of its products will increase (Bingham, Combined Proceedings, 2005, Vol.55).
However, the concentration of production factors on one product may have the opposite results. First, a country will depend on a higher degree from others if it just exports one good and imports all the others. Second, countries should be aware that specialised workers demand better wages and this can also affect the total production cost in a negative way. Third, it has to be mentioned that the theory of specialisation makes some assumptions and simplifications, which are not always valid, such as: (a) there is full employment, (b) there are no constant costs and countries have the same dynamic in the future (c) the theories are based on barter, so money is not required in these models, (d) we assume that there are two countries and two goods only and (e) the mobility of labour is assumed to be perfect (Daniels et al., 2008).
Advantages and Disadvantages of International Trade
The trade theories mentioned before in this essay is the base for us to understand the figure of international trade in the world economy we observe today. International trade has a variety of aspects.
Firstly, as an advantage, it includes the theory of free trade, which supports the unrestricted free flow of goods and services between countries. Trade without barriers has positive benefits for all involved, and it creates free markets, which are best for most exchange. As a result, countries trade more over time, so globalisation will be inevitable. Secondly, world class economists set their theories for international trade. They attempt to figure how it works, but each theory is based on different assumptions and limitations. As a result, new theories were born (Daniels et al., 2008).
To counter the theories of international trade, a considerable number of people believe that trade and foreign investments may badly affect local industry and work force. They suggest an economic policy of restraining free trade with means like quotas or tariffs in order to protect the national market; a theory widely known as protectionism (Hill, 2006).
As a whole, countries trade with each other and manage their exports or imports based on their capabilities and needs. Due to the world’s competive environment, nations support their industries to claim better results for their interests not only domestically but worldwide. With business going international, countries and companies are trying to expand their wealth and influence other countries or markets, with direct or portfolio investment (ibid).
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Arguments in favour of free trade and relevant theories
According to Hill (2006), the theory of free trade is relevant to the theories of International Trade. Both theories assume that there is unrestricted trade between two or more countries, but the free trade theory includes three major principles: (a) there are no barriers or obstacles to mobility, (b) there are no trade restrictions and (c) there are no transportation costs.
Apart from the assumptions, new questions are presented. For example, the free trade theory suggests that trade is based on the lack of costs, but it does not explain which factors made these costs. As a result, the theory of Heckscher-Ohlin was established.
Two Swedish economists, Eli Heckscher and Bertil Ohlin, studied the trade theories and conclude in two deductions. First, there is more than one factor of production. For example, goods do not need only labour but capital and land also. Secondly, different factors are used for the production of different goods. Furthermore, different countries have a different number of factors of production (or endowments), and this results in different relative factor prices. This means that land-intensive goods should be relatively cheap in a country with a great deal of land, and the same is valid for labour-intensive and capital-intensive countries. This leads to the theory’s basic conclusion that countries should specialize in goods that use the factor of production intensively they have in abundance (Piggott & Cook, 2006).
According to the Heckscher-Ohlin theorem, countries like the United States, for example, with a higher capital per head than other countries, should export capital-intensive goods and import labour-intensive goods. In 1954, the economist Wassily Leontief tried to apply the theorem to reality. He used a mathematical technique named input-output analysis to measure the amount of imports and exports worth US$ 1milion, on data of 1947. Leontief found that to replace US imports with domestic output would need 170 more years per worker of labour and US$ 3.1million of capital. On the other hand, to reduce US exports by US$ 1 million would provide 182.3 years of labour time and US$ 2.6 million of capital. When he compared the two results, he showed that exports from the US were more labour intensive than imports into the US, which is the opposite outcome to that predicted by Heckscher-Ohlin. The world’s most capital-intensive country was exporting labour intensive goods (Husted & Melvin, 2007).
The previous analysis is known as the Leontief paradox and it is known as the biggest weakness to the Heckscher-Ohlin theory. Some economists argued that Leontief’s analysis did not include human capital in his motion of labour – all labour is taken to have the same skill. As a result, failure to include these factors might have caused him to mismeasure the labour intensity of US imports and exports (Mmieh, 2010).
Based on the failure of Heckscher-Ohlin theory, economist Paul Krugman (1970) developed his new trade theory. According to this theory, some countries specialize in the production of a particular product and export it, not because they have different factor endowments, but because they can support these products in the global markets. For example, a country’s production specialisation in the products of airplanes, can give a competitive advantage to the country not only at domestic but in the international airplane production market (ibid).
In relevance to new trade theory, Michael Porter (1994) attempted to explain why particular nations achieve international success in particular industries. His theory, referred as the theory of national competitive advantage, underlines that country factors such as domestic demand and domestic rivalry are very important for nation’s dominance in the production and export of particular goods (Hill, 2006).
Conclusion
In this paper, we first examined the two primary ways international business occur, based on numerous theories of world-class economists. Global Trade and FDI are the most important figures of world trade today and include a number of aspects but in this paper we discussed two of them: specialisation and international trade. We also examined the concept of free trade; with an extensive look at the theories that were created based on the free burgeoning of goods.
Today, globalisation sets new rules for the countries and firms involved in the business world, a much more complicated market scene, which needs different approaches, careful planning and correct use of information for the best investment results. International business follows the path of globalisation and I personally believe that the in years to come we will witness an inevitable change route for the way we do business.
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