Theories of International Trade and Investmentthe-eye.eu/public/WorldTracker.org/College...

Theories of InternationalTrade and InvestmentTheories of InternationalTrade and Investment

c h a p t e r

1. Theories of international tradeand investment

2. Why nations trade

3. How nations enhance theircompetitive advantage:contemporary theories

4. Why and how firmsinternationalize

5. How firms gain and sustaininternational competitiveadvantage

Learning Objectives

In this chapter, you will

learn about:

> Dubai’s Successful Transformation into aKnowledge-Based EconomyDubai is an oil-rich country located on the Persian Gulf in the southern ArabianPeninsula. Home to roughly one million people, Dubai’s per-capita GDP is overUS$25,000. Dubai is one of the seven emirates that make up the United ArabEmirates. The region’s wealth is based on oil and gas output, which accountsfor about one-third of the emirate’s GDP.

Dubai and the other emirates have a comparative advantage in oil because thisnatural resource is abundant in this region compared to other countries. These oilreserves allow Dubai to develop non-oil economic sectors that require a large infu-sion of capital. Dubai is developing as a multidimensional, international commercialhub. Beginning in the 1980s, the government of Dubai began collaborating withprivate businesses to reposition the country as a center for international trade,finance, tourism, education, and e-commerce.

The public-private partnership allows Dubai to develop national competitiveadvantage in specific industrial sectors—advantages that are difficult for com-petitors to replicate. Dubai’s ambitious initiatives include the following:

4

92

CAVUMC04_092-123hr 10/15/07 11:17 AM Page 92

■ State-of-the-Art Commercial Infrastructure. Dubai built the world’s biggest artifi-cial harbor to accommodate the global shipping industry, international trade,and cruise ships. Every year, tens of millions of passengers pass throughDubai’s modern international airport, which serves 80 airlines. The country cre-ated the Jebel Ali Free Trade Zone, a massive business center that hosts andprovides tax incentives to more than 2,000 firms. As an example, Houston,Texas- based company Halliburton announced in early 2007 that it would moveits headquarters to Dubai.

■ State-of-the-Art Infrastructure in Information and Communications Technology (ICT).Dubai created an ICT industrial cluster, an oasis for firms in software development,business services, training, consulting, and e-commerce. Dubai Internet City offersforeign companies (such as Canon, IBM, Microsoft, Oracle, and Siemens) suchincentives as no income tax, no currency restrictions, and minimal bureaucracy.Because few other countries have such cutting-edge ICT infrastructure, Dubai is devel-oping a monopoly advantage, leading to superior performance for its companies.

93

CAVUMC04_092-123hr 10/15/07 11:17 AM Page 93

94 Chapter 4 Theories of International Trade and Investment

■ State-of-the-Art Financial Infrastructure. Tonurture new business, the partnership devel-oped ”Dubai Ideas Oasis,” a community ofentrepreneurs and venture capitalists. It alsoestablished the Dubai International Finan-cial Center, home to dozens of globalbanks and financial services firms.

■ Attractive Urban Environment. The partner-ship developed Burj al Arab, a stunninghotel and one of the most recognized land-marks worldwide. It also developed theCreek, an eight-mile waterway lined withdazzling buildings, monuments, restau-rants, and retail stores.

■ Educational Infrastructure. The country alsolaunched The Dubai Knowledge Village,inviting foreign universities and traininginstitutes to offer their services. Other edu-cational initiatives ensure a pool of trainedknowledge workers. English is the officiallanguage of most Dubai schools.

■ Progressive Labor Laws. The governmentdevised labor laws to ensure that industry

needs for part-time and temporaryrequirements are quickly met. A fast-trackimmigration process and 24-hour visa ser-vice guarantee quick access to neededinternational talent.

Dubai is among the leading examples ofcountries that have been able to successfullyreposition their economy and create compara-tive advantages. Dubai’s transformation into aknowledge-based economy is remarkable, withoil and gas production now contributing lessthan 10 percent of the nation’s GDP. It is all partof a plan to transform the nation into what mightbe termed “Dubai Inc.” <Sources: Arthur Andersen. (2000/2001). Dubai Makes a Bid forE-Business. International Tax Review, Dec/Jan, 12 (1):47; Binbyat,Ahmed. (2001). “Dubai Internet City: Open for Business,” TheOECD Observer (Jan.) 224:9; Central Intelligence Agency. (2005).CIA World Factbook, at www.cia.gov/cia/publications/factbook;Dubai Internet City Web site: www.dubaiinternetcity.com;Euromoney Institutional Investor PLC, (2000/2001); InternationalMonetary Fund. (2005). United Arab Emirates: Selected Issuesand Statistical Appendix. IMF Country Report no. 05/268(August), retrieved from www.imf.org; Pope, Hugh. (2001). “Whyis the Tech Set Putting Down Roots in the Desert? Dubai, ofCourse—Du-What? With Low Taxes And High Transparency,Cyber-Sheikdom Beckons,” Wall Street Journal, Jan 23, p. A18.

Comparative advantageSuperior features of a countrythat provide it with uniquebenefits in global competitiontypically derived from eithernatural endowments or deliberatenational policies.

In Chapter 2, we saw how the globalization of markets compels companies topursue international business. In Chapter 3, we highlighted key participantsengaged in international business. The question we need to address next is:

what is the underlying economic rationale for international business activity?Why does trade take place, and what are the gains from trade and investment? Inthis chapter, we explain why firms and nations, such as Dubai (in the openingvignette), trade and invest internationally, and how firms acquire and sustaincompetitive advantage in the global marketplace. We review leading theories ofwhy nations and individual enterprises pursue internationalization strategies asexporters, importers, investors, franchisors, or licensors.

Theories of International Trade and Investment

For centuries economists, managers, and academic scholars have offered theories(that is, logical explanations), of the economic rationale for international trade andinvestment. They have debated why nations should promote trade and invest-ment with other nations, and how nations create and sustain comparative advan-tage. Comparative advantage refers to superior features of a country that provideit with unique benefits in global competition, typically derived from either naturalendowments or deliberate national policies. Also known as country-specific advan-tage, comparative advantage includes acquired resources, such as labor, climate,arable land, or petroleum reserves, as in the case of the Gulf nations. Other typesof comparative advantages evolve over time, such as entrepreneurial orientation,availability of venture capital, and innovative capacity.

Over time, to understand why companies engage in cross-border business, thefocus shifted from the nation to the individual firm. Later explanations gave rise

CAVUMC04_092-123hr 10/15/07 11:17 AM Page 94

Theories of International Trade and Investment 95

Competitive AdvantageDistinctive assets orcompetencies of a firm—typicallyderived from cost, size, orinnovation strengths—that aredifficult for competitors toreplicate or imitate.

to the concept of competitive advantage, which emphasizes the role of competen-cies that help firms enter and succeed in foreign markets. Competitive advantagerefers to distinctive assets or competencies of a firm—typically derived from cost,size, or innovation strengths—that are difficult for competitors to replicate or imi-tate. Competitive advantage is also known as firm-specific advantage.

While distinctions do exist between the two terms, in recent years businessexecutives and academics such as Michael Porter have used the term competitiveadvantage to refer to the advantages possessed both by nations and individualfirms in international trade and investment. To be consistent with the recent liter-ature, in this text we adopt this convention as well. Exhibit 4.1 categorizes leadingtheories of international trade and investment into two broad groups. The firstgroup includes nation-level theories. These are classical theories that have beenadvocated since the 18th century. Nation-level explanations, in turn, address twoquestions: (1) why do nations trade? and (2) how can nations enhance their compet-itive advantage?

The second group includes firm-level theories. These are more contemporarytheories of how firms can create and sustain superior market position. Firm-levelexplanations address two additional questions: (3) why and how do firms interna-tionalize, and (4) how can internationalizing firms gain and sustain competitiveadvantage?

We organize the remainder of our discussion according to the four fundamen-tal questions.

Theories of InternationalTrade and Investment

Nation-level Explanations

Why do nations trade?

How can nations enhancetheir competitive advantage?

Why and how do firmsinternationalize?

Classical Theories • Mercantilism • Absolute Advantage Principle • Comparative Advantage Principle • Factor Proportions Theory • International Product Cycle Theory

Contemporary Theories • Competitive Advantage of Nations • Michael Porter’s Diamond Model • National Industrial Policy • New Trade Theory

Firm Internationalization • Internationalization Process of the Firm • Born Globals and International Entrepreneurship

Firm-level Explanations

FDI-Based Explanations • Monopolistic Advantage Theory • Internalization Theory • Dunning's Eclectic Paradigm

Non-FDI-Based Explanations • International Collaborative Ventures • Networks and Relational Assets

How can internationalizingfirms gain and sustaincompetitive advantage?

Exhibit 4.1 Theories of International Trade and Investment

CAVUMC04_092-123hr 10/15/07 11:17 AM Page 95


Why Nations Trade

Why do nations trade with one another? The short answer is that tradeallows countries to use their national resources more efficiently through spec-ialization. Trade allows industries and workers to be more productive. Tradealso allows countries to achieve higher living standards and keep the cost ofmany everyday products low. Without international trade, most nationswould be unable to feed, clothe, and house their citizens at current levels.Even resource-rich countries like the United States would suffer immenselywithout trade. Some types of food would become unavailable, or obtainableonly at very high prices. Coffee and sugar would become luxury items.Petroleum-based energy sources would dwindle. Vehicles would stop run-ning, freight would go undelivered, and people would not be able to heattheir homes in the wintertime. In short, not only do nations, companies, andcitizens benefit from international trade, but modern life is virtually impossi-ble without it.

Classical Theories

There are five classical perspectives that explain the underlying rationale for tradeamong nations: the mercantilist view, the absolute advantage principle, the com-parative advantage principle, factor proportions theory, and the internationalproduct cycle theory.

The Mercantilist View The earliest explanations of international businessemerged with the rise of European nation states in the 1500s. At that time,gold and silver were the most important sources of wealth and nations soughtto amass as much of these treasures as possible. Mercantilism emerged in the16th century as a dominant perspective of international trade. In simpleterms, mercantilism suggests that exports are good and imports are bad. Mer-cantilists believed that national prosperity results from a positive balance oftrade, achieved by maximizing exports and minimizing imports. They arguedthat the nation’s power and strength increase as its wealth increases. At a timewhen precious metals were the main medium of exchange, gold was particu-larly valued because it could be used to protect and extend the nation’s inter-ests. The nation received payment for exports in gold, so exports increasedthe nation’s gold stock. Conversely, imports reduced the gold stock becausethe nation paid for the imports with gold. Thus, nations desired and pro-moted exports but disapproved of, and impeded, imports.

In essence, mercantilism underlies the rationale for a nation’s attempt torun a trade surplus, that is, to export more goods than it imports. Even todaymany people believe that running a trade surplus is beneficial, and subscribeto a view known as neo-mercantilism. Labor unions (that seek to protecthome-country jobs), farmers (who want to keep crop prices high), and cer-tain manufacturers (those that rely heavily on exports) all tend to supportneo-mercantilism.

Yet mercantilism tends to harm the interests of firms that import, espe-cially those that import raw materials and parts used in the manufacture offinished products. Mercantilism also harms the interests of consumers,because restricting imports reduces the choices of products they can buy.Product shortages that result from import restrictions may lead to higherprices—that is, inflation. When taken to an extreme, mercantilism may invite“beggar thy neighbor” policies, promoting the benefits of one country at theexpense of others.

Mercantilism The belief thatnational prosperity is the result ofa positive balance of trade,achieved by maximizing exportsand minimizing imports.

CAVUMC04_092-123hr1 10/20/07 8:22 AM Page 96

Why Nations Trade 97

Free trade Relative absence ofrestrictions to the flow of goodsand services between nations.

By contrast, free trade—the relative absence of restrictions to theflow of goods and services between nations—is preferred because:

• Consumers and firms can more readily buy the products theywant.

• The prices of imported products tend to be lower than fordomestically produced products (because access to world-scale supplies forces prices down, mainly from increased com-petition, or because the goods are produced in lower-costcountries).

• Lower-cost imports help reduce the expenses of firms, therebyraising their profits (which may be passed on to workers in theform of higher wages).

• Lower-cost imports help reduce the expenses of consumers,thereby increasing their living standards.

• Unrestricted international trade generally increases the overallprosperity of poor countries.

Absolute Advantage Principle In the landmark book published in1776, An Inquiry into the Nature and Causes of the Wealth of Nations, Scottishpolitical economist Adam Smith attacked the mercantilist view by sug-gesting that nations benefit most from free trade. Smith argued that mer-cantilism robs individuals of the ability to trade freely and to benefit fromvoluntary exchanges. By trying to minimize imports, a country inevitably wastesmuch of its national resources in the production of goods that it is not suited to pro-duce efficiently. Therefore, the inefficiencies of mercantilism end up reducing thewealth of the nation as a whole while enriching a limited number of individuals andinterest groups. Relative to others, each country is more efficient in the production ofsome products and less efficient in the production of other products. Smith’sabsolute advantage principle states that a country benefits by producing only thoseproducts in which it has an absolute advantage, or can produce using fewerresources than another country. The country gains by specializing in producing thoseproducts, exporting them, and then importing the products it does not have anabsolute advantage in producing. Each country increases its welfare by specializingin the production of certain products and importing others, as this allows it to be ableto consume more than it otherwise could.

Exhibit 4.2 illustrates how the absolute advantage principle works in practice.Consider two nations, France and Germany, engaged in a trading relationship. Francehas an absolute advantage in the production of cloth, and Germany has an absoluteadvantage in the production of wheat. Assume that labor is the only factor of produc-tion used in making both goods. Firms employ factors of production—for example,labor, capital, entrepreneurship, and technology—to generate goods and services. InExhibit 4.2, it takes an average worker in France 30 days to produce one ton of clothand 40 days to produce one ton of wheat. It takes an average worker in Germany 100days to produce one ton of cloth and 20 days to produce a one ton of wheat.

Compared to Germany, it is clear that France has an absolute advantage in theproduction of cloth, since it takes only 30 days of labor to produce one ton (com-pared to 100 days for Germany). Compared to France, it is clear that Germany hasan absolute advantage in the production of wheat, since it takes only 20 days toproduce one ton (compared to 40 days for France). If both France and Germanywere to specialize, exchanging cloth and wheat at a ratio of one-to-one, Francecould employ more of its resources to produce cloth and Germany could employmore of its resources to produce wheat. According to Exhibit 4.2, France canimport one ton of wheat in exchange for one ton of cloth, thereby “paying” only 30labor-days for one ton of wheat. If France had produced the wheat itself, it would

Absolute advantageprinciple A country benefits byproducing only those products inwhich it has absolute advantage,or can produce using fewerresources than another country.

Exhibit 4.2Example of Absolute Advantage (LaborCost in Days of Production for One Ton)

Scottish political economist AdamSmith was among the first to articulate advantages ofinternational trade.

One ton ofCloth Wheat

France 30 40Germany 100 20

CAVUMC04_092-123hr 10/15/07 11:17 AM Page 97


have used 40 labor-days, so it gains 10 labor-days from the trade. In a similar way,Germany also gains from trade with France.

Each country benefits by specializing in producing the product in which it hasan absolute advantage and then securing the other product through trade. Thus,France should specialize in producing cloth exclusively and import wheat fromGermany, and Germany should specialize in producing wheat exclusively andimport cloth from France. By so doing, each country employs its labor and otherresources with maximum efficiency and, as a result, living standards in each coun-try will rise.

To employ a more contemporary example, Japan has no natural holdings ofoil, but it manufactures some of the best automobiles in the world. On the otherhand, Saudi Arabia produces much oil, but it lacks a substantial car industry.Given the state of their resources, it would be wasteful for each of these countriesto attempt to produce both oil and cars. By trading with each other, Japan andSaudi Arabia each employ their respective resources efficiently in a mutually ben-eficial relationship. Japan gets oil that it refines to power its cars, and Saudi Arabiagets the cars its citizens need. Because each country uses its own resources withoptimum efficiency and engages in trade, living standards for its citizens arehigher than they would be if they had not engaged in trade.

By extending this example to all products that countries produce and all coun-tries that they can trade with, it is possible to see that freely trading countries canachieve substantial gains from trade and resultant improvement in national livingstandards. Thus, Brazil can produce coffee more cheaply than Germany; Australiacan produce wool more cheaply than Switzerland; and the United Kingdom canprovide financial services more cheaply than Zimbabwe. Each of these countries isbetter off producing those products and services in which it is advantaged, andimporting those products and services in which it is disadvantaged.

While the concept of absolute advantage provided perhaps the earliest soundrationale for international trade, it only accounted for the absolute advantages pos-sessed by nations. It failed to account for more subtle advantages that nations mayhold. Later studies revealed that countries benefit from international trade evenwhen they lack an absolute advantage. This line of thinking led to the principle ofcomparative advantage.

Comparative Advantage Principle In his 1817 book, The Principles of PoliticalEconomy and Taxation, British political economist David Ricardo explained why itis beneficial for two countries to trade, even though one of them may haveabsolute advantage in the production of all products. Ricardo demonstrated thatwhat matters is not the absolute cost of production, but rather the ratio betweenhow easily the two countries can produce the products. Hence, the comparativeadvantage principle states that it can be beneficial for two countries to trade with-out barriers as long as one is more efficient at producing goods or services neededby the other. What matters is not the absolute cost of production but rather the rel-ative efficiency with which a country can produce the product. The principle ofcomparative advantage remains today as the foundation and overriding justifica-tion for international trade.

To illustrate the principle of comparative advantage, let’s modify the exampleof the trade relationship between France and Germany. As shown in Exhibit 4.3,suppose now that Germany has an absolute advantage in the production of bothcloth and wheat. That is, in labor-per-day terms, Germany can produce both clothand wheat in fewer days than France. Based on this new scenario, you might ini-tially conclude that Germany should produce all the wheat and cloth that it needs,and not trade with France at all. However, this conclusion is not optimal. Eventhough Germany can produce both items more cheaply than France, it is still ben-eficial for Germany to trade with France.

Comparative advantageprinciple It can be beneficial fortwo countries to trade withoutbarriers as long as one is moreefficient at producing goods orservices needed by the other.What matters is not the absolutecost of production, but rather therelative efficiency with which acountry can produce the product.

Exhibit 4.3Example of ComparativeAdvantage (Labor Cost in Days ofProduction for One Ton)

One ton ofCloth Wheat

France 30 40Germany 10 20

CAVUMC04_092-123hr 10/15/07 11:17 AM Page 98


How can this be true? The answer is that rather than the absolute cost of produc-tion, it is the ratio of production costs between the two countries that matters. InExhibit 4.3, Germany is comparatively more efficient at producing cloth than wheat:it can produce three times as much cloth as France (30/10), but only two times asmuch wheat (40/20). Thus, Germany should devote all its resources to producingcloth and import all the wheat it needs from France. France should specialize in pro-ducing wheat and import all its cloth from Germany. Each country benefits by spe-cializing in the product in which it has a comparative, or relative, advantage andthen obtaining the other product through trade.

By specializing in what they produce best and trading for the rest, Germanyand France can each produce and consume relatively more of the goods that theydesire for a given level of labor cost. Another way to understand the concept ofcomparative advantage is to consider opportunity cost, the value of a foregonealternative activity. In Exhibit 4.3, if Germany produces 1 ton of wheat, it forgoes 2tons of cloth. However, if France produces 1 ton of wheat, it forgoes only 1.33 tonsof cloth. Thus, France should specialize in wheat. Similarly, if France produces 1ton of cloth, it forgoes 3/4 ton of wheat. But if Germany produces 1 ton of cloth, itforgoes only 1/2 ton of wheat. Thus, Germany should specialize in cloth. Theopportunity cost of producing wheat is lower in France, and the opportunity costof producing cloth is lower in Germany.

The concept of comparative advantage contends that trade depends on differ-ences in comparative cost, and any nation can profitably trade with another even ifits real costs are higher in every product that it produces. This insight is best illus-trated with an example provided by Ricardo:

“Two men can make both shoes and hats, and one is superior to theother in both employments, but in making hats he can only exceed hiscompetitor by one fifth or 20 percent, and in making shoes he can excel himby one third or 33 percent; will it not be for the interest of both that thesuperior man should employ himself exclusively in making shoes and theinferior man in making hats?”1

While a nation might conceivably have a sufficient variety of production fac-tors to provide every kind of product and service, it cannot produce each prod-uct and service with equal facility. The United States could produce all the coathangers that its citizens need, but only at a high cost, because the production ofcoat hangers requires much labor, and wages in the United States are relativelyhigh compared to other countries. By contrast, the production of coat hangers isa reasonable activity in a country such as China, where wages are lower than inthe United States. It is advantageous, therefore, for the United States to special-ize in the production of a product such as pharmaceuticals, the production ofwhich more efficiently employs the country’s abundant supply of knowledgeworkers and technology. The United States is then better off exporting pharma-ceuticals and importing coat hangers from China. The comparative advantageview is optimistic because it implies that a nation need not be the first-, second-,or even third-best producer of particular products to benefit from internationaltrade. Indeed, it is generally advantageous for all countries to participate ininternational trade.

Initially, the comparative advantage principle focused on the importance ofnatural resources in a country, or natural advantages, such as fertile land, abun-dant minerals, and favorable climate. Thus, because South Africa has extensivedeposits of minerals, it produces and exports diamonds. Because Canada hasmuch agricultural land and a suitable climate, it produces and exports wheat.Over time, however, it became clear that countries can also create or acquire com-parative advantages. We elaborate on these so-called acquired advantages later inthe chapter.

CAVUMC04_092-123hr 10/15/07 11:17 AM Page 99


Limitations of Early Trade Theories While the concepts of absoluteadvantage and comparative advantage provided the rationale for interna-tional trade, they did not quite capture factors that make contemporary tradecomplex, including:

• The cost of international transportation, which is critical for cross-bordertrade to take place.

• Government restrictions such as tariffs (a tax on imports), import restric-tions, and regulations typical of mercantilism that can hamper cross-bordertrade. For instance, tariffs in Japan restrict imports of certain agriculturalproducts.

• Large-scale production in certain industries may bring about scaleeconomies, and therefore lower prices, which can help offset weaknational comparative advantage. For example, Mexico lacks advantagesin the production of high-technology goods, but it compensates for thisthrough high-volume manufacturing of various goods.

• The public sector can target and invest in certain industries, buildinfrastructure, or provide subsidies, all of which serve to boost firms’competitive advantages. For example, Singapore has invested heavilyin developing its port infrastructure, making the country a vital depotfor product import and distribution throughout Asia.

• Global telecommunications and the Internet facilitate virtually costlesstrade in some services and global flows of capital. The tendency hasincreased the ability of emerging markets such as India and Russia toaccess capital needed to develop key industries, even in the face of weakcomparative advantages in certain areas.

• Contemporary cross-border business includes many services (such asbanking and retailing) that cannot be traded in the usual sense and mustbe internationalized via foreign investment. Even nations that lack com-parative advantages in service industries still develop basic services fortheir own citizens.

• The primary participants in cross-border trade are individual firms.Far from being homogeneous enterprises, they differ in significantways. Some are highly entrepreneurial and innovative, or haveaccess to exceptional human talent. As a result, some companies aremore active and successful in international business than others. Inother cases, firms may have a greater need to trade internationally iftheir home markets are too small to support their growth or revenueobjectives.

In the following sections, we discuss subsequent theories that consider howthese factors affect trade.

Factor Proportions Theory The next significant contribution to explain-ing international trade came in the 1920s, when two Swedish economists, EliHeckscher and his student, Bertil Ohlin, proposed the factor proportions theory(sometimes called the factor endowments theory).2 This view rests on twopremises: First, products differ in the types and quantities of factors (that is,labor, natural resources, and capital) that are required for their production;and second, countries differ in the type and quantity of production factors thatthey possess. Thus, according to this theory, each country should export prod-ucts that intensively use relatively abundant factors of production, and importgoods that intensively use relatively scarce factors of production. For example,because China possesses an ample labor supply, it emphasizes the productionand export of labor-intensive products, such as textiles and kitchen utensils.

CAVUMC04_092-123hr 10/15/07 11:17 AM Page 100


Because the United States possesses much capital, it emphasizes the produc-tion and export of capital-intensive products, such as pharmaceuticals andcommercial aircraft. Because Australia and Canada possess a great deal ofland, they produce and export land-intensive products, such as meat, wheat,and wool.

Factor proportions theory differs somewhat from earlier trade theories byemphasizing the importance of each nation’s factors of production. The theorystates that, in addition to differences in the efficiency of production, differences inthe quantity of factors of production held by countries also determine internationaltrade patterns. Originally, labor was seen as the most important factor of produc-tion. This explains, for example, why China and Mexico receive huge amounts offoreign direct investment (FDI) from firms that build factories in those countries totake advantage of their inexpensive, abundant labor.

In the 1950s, Russian-born economist Wassily Leontief pointed to empiricalfindings that seemed to contradict the factor proportions theory. The Leontief para-dox suggests that, because the United States has abundant capital, it should be anexporter of capital-intensive products. However, Leontief’s analysis revealed that,despite the United States having abundant capital, its exports were labor-intensiveand imports capital-intensive.

However, experience of the last few decades suggests that the factor pro-portions theory explains much of contemporary international trade. So, whataccounts for the inconsistency suggested by the Leontief paradox? One expla-nation is that numerous factors determine the composition of a country’sexports and imports. Another explanation is that labor in the United Statestends to be highly skilled, giving the country substantial advantages in the pro-duction of knowledge-intensive products and services such as software andpharmaceuticals.

Perhaps the main contribution of the Leontief paradox is its suggestionthat international trade is complex and cannot be fully explained by a singletheory. While the factor proportions theory helps explain international tradepatterns, it does not account for all trade phenomena. Subsequent refinementsof the factor proportions theory suggested that other country-level assets—knowledge, technology, and capital—are instrumental in explaining eachnation’s international trade prowess. Taiwan, for example, is very strong ininformation technology and is home to a sizeable population of knowledgeworkers in the IT sector. These factors have helped make Taiwan one of theleading players in the global computer industry.

International Product Cycle Theory Ina 1966 article entitled “International Invest-ment and International Trade in the ProductCycle,” Harvard Professor Raymond Vernonsought to explain international trade basedon the evolutionary process that occurs inthe development and diffusion of productsaround the world.3 Vernon observed thattechnical innovations typically originatefrom advanced countries that possess abun-dant capital and R&D capabilities. Eachproduct and its associated manufacturingtechnologies go through three stages of evo-lution: introduction, growth, and maturity.In the introduction stage, the new product isproduced at home and enjoys a temporarymonopoly. Later on, the product’s inventors

Factor proportions theorydescribes how abundant produc-tion factors give rise to nationaladvantages. For example, Brazilhas an abundance of workers invarious industries. Here, workersat the Accessorios Para Panelade Pressao in São Paulo assem-ble parts for pressure cookers.

CAVUMC04_092-123hr1 10/20/07 8:22 AM 1


mass-produce the good and seek to export it to foreign markets. As the prod-uct’s manufacturing becomes more standard, foreign competitors enter themarketplace and the monopoly power of the inventors dissipates. The inventormay at this stage earn only a narrow profit margin. Companies from othercountries begin producing the standardized product. Foreign competitors mayeven enjoy a competitive advantage in producing the mature product, and ful-fill the needs of export markets as well. By now, the original innovating andexporting country may be a net importer of the product. In effect, exporting theproduct has caused its underlying technology to become widely known andstandardized around the world.

As product standardization progresses, input requirements for produc-tion evolve. For instance, early in the product’s evolution, manufacturingrequires highly-skilled knowledge workers in R&D. When the productbecomes standardized, mass production is the dominant activity, requiringaccess to less expensive raw materials and low-cost labor. Thus, as the prod-uct goes through its life cycle, comparative advantage in its production tendsto shift from country to country. This type of cycle was evident in the evolu-tion of television sets. The base technology for televisions was invented in theUnited States, and U.S. firms began producing TVs there in the 1940s. U.S.sales grew rapidly for many years. After becoming a standardized product,television production shifted to China, Mexico, and other countries that offerlower cost production.

Because firms around the world are constantly innovating new products,and others are constantly imitating them, the product cycle is constantlybeginning and ending. In the contemporary interconnected economy, thecycle from innovation to growth to maturity is much shorter than in the 1960sto 1980s. New products with universal appeal are likely to be diffused acrossdifferent countries much faster. Thanks to global media and the Internet,potential customers in distant parts of the world are likely to hear about anddemand the product. Buyers in emerging markets are particularly eager toadopt new technologies as soon as they become available. This trend explainsthe rather rapid spread of new consumer electronics (such as digital assistantsand iPods) around the world.

How Nations Enhance Their CompetitiveAdvantage: Contemporary Theories

The globalization of markets has fostered a new type of competition—a raceamong nations to reposition themselves as attractive places to invest and dobusiness. In recent decades, governments increasingly have advanced proac-tive policies designed to create competitive advantage, often by developingworld-class economic sectors and prosperous geographic regions. These poli-cies aim to have firms develop acquired advantages. Let’s review contempo-rary theories aimed at enhancing the competitive advantages of nationaleconomies.

The Competitive Advantage of NationsJust as scholars recognized that international business is good for individualnations, they increasingly sought to explain how nations can position themselvesfor international business success. An important contribution came from Har-vard business professor Michael Porter in his 1990 book, The Competitive Advan-tage of Nations.4 According to Porter, the competitive advantage of a nationdepends on the collective competitive advantages of the nation’s firms. Overtime, this relationship is reciprocal: The competitive advantages held by the

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 102

How Nations Enhance Their Competitive Advantage: Contemporary Theories 103

nation tend to drive the development of new firms and industries with thesesame competitive advantages.

For example, Japan is competent in high-technology industries; it is home tofirms such as Toshiba and Hitachi, world-class companies in high-tech fields.Over time, Japan’s national competitive advantage in high technologies has dri-ven the development of new firms and industries in these fields. In a similar way,Britain has achieved a substantial national competitive advantage in the patentmedication (prescription drug) industry due to its first-rate pharmaceutical firms,including AstraZeneca and GlaxoSmithKline. The United States has a nationalcompetitive advantage in service industries because of many leading firms, suchas AIG (insurance), Merrill Lynch (financial services), Dreamworks (movies), andAccenture (consulting). U.S. prowess in the service sector, in turn, has engenderedthe emergence of new, innovative firms in the service industry.

An individual firm has a competitive advantage when it possesses one ormore sources of distinctive competence relative to others, allowing it to performbetter than its competitors. Thus, for instance, the low-cost operations of Tescoand Wal-Mart have allowed these firms to surpass other mass retailers. Nokia’ssuperior technology and design leadership have allowed it to stay abreast andoften surpass key rivals in the cell phone industry.

At both the firm and national levels, competitive advantage grows out ofinnovation.5 Firms innovate in various ways: They develop new productdesigns, new production processes, new approaches to marketing, or newways of organizing. Firms sustain innovation (and by extension, competitiveadvantage) by continually finding better products, services, and ways ofdoing things. For example, Australia’s ERG Group is a world leader in farecollection equipment and software systems for the transit industry. The firminstalled systems in subways, bus networks, and other mass transit systemsworldwide, in major cities such as Melbourne, Rome, San Francisco, Stockholm,and Singapore. ERG has won numerous awards for its innovative products,which have allowed the firm to internationalize quickly and to numerouscountries. ERG’s investment in R&D has been significant, running as high as23 percent of the company’s revenue.

The aggregate innovative capacity of a nation is derived from the collec-tive innovative capacity of its firms. The more innovative firms a nation has,the stronger that nation’s competitive advantage. Innovation also promotesproductivity, the value of the output produced by a unit of labor or capital. Themore productive a firm is, the more efficiently it uses its resources. The moreproductive the firms in a nation are, the more efficiently the nation uses itsresources. At the national level, productivity is a key determinant of thenation’s long-run standard of living and a basic source of national per-capita(per person) income growth. Exhibit 4.4 depicts productivity levels in variousnations over time. Here productivity is measured as output per hour of work-ers in manufacturing.

Michael Porter’s Diamond ModelAs part of his explanation in the Competitive Advantage of Nations, MichaelPorter developed the diamond model. According to this model, competitiveadvantage at both the company and national levels originates from the pres-ence and quality in the country of the four major elements summarized inExhibit 4.5.

1. Firm Strategy, Structure, and Rivalry refers to the nature of domestic rivalry,and conditions in a nation that determine how firms are created, organized,and managed. The presence of strong competitors in a nation helps create and

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 103


1985

50

350

100

150

Out

put p

er h

our i

n m

anuf

actu

ring

, 198

5–20

05 in

dice

s: 1

992=

100

200

250

300

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Canada

France

GermanyJapan

South Korea

Sweden

U.K.

U.S.

maintain national competitive advantage. For example, Italy has some of theworld’s leading firms in design-intensive industries such as furniture, light-ing, textiles, and fashion. Vigorous competitive rivalry puts these firms undercontinuous pressure to innovate and improve. The firms compete not only formarket share, but also for human talent, technical leadership, and superiorproduct quality. These pressures have allowed Italy to emerge as one of theworld’s leading countries in design.2. Factor Conditions describes the nation’s position in factors of production,such as labor, natural resources, capital, technology, entrepreneurship, andknow-how. Consistent with the factor proportions theory, every nation has arelative abundance of certain factor endowments, a situation that helps deter-

FactorConditions

DemandConditions

Firm Strategy,Structure, and Rivalry

Related andSupporting Industries

Exhibit 4.5Porter’s Diamond ModelSOURCE: reprinted with the permission of The FreePress, a Division of Simon & Schuster Adult Publish-ing Group from The Competitive Advantage ofNations by Michael E. Porter. Copyright © 1990,1998 by Michael E. Porter. All rights reserved.

Exhibit 4.4Productivity Levels in SelectedCountriesOutput per hour in manufacturing,1985–2005 indices: 1992=100SOURCE: U.S. Department of Labor, Bureau of LaborStatistics, February 2006.

CAVUMC04_092-123hr1 10/22/07 10:54 AM Page 104


mine the nature of its national competitive advan-tage. For example, India’s numerous low-wageknowledge workers have allowed it to develop acompetitive advantage in the production of com-puter software. Germany’s abundance of workerswith strong engineering skills has propelled thecountry to acquire competitive advantages in theglobal engineering and design industry. At thesame time, the scarcity of certain factors maycompel countries to use them more efficiently,leading to competitive advantages. For example,today China lacks a strong base of knowledgeworkers in many industries. Accordingly, the Chi-nese government is investing in education todevelop the national expertise needed to excel invarious knowledge-based industries.

3. Demand Conditions refers to the nature ofhome-market demand for specific products and services. The strength andsophistication of buyer demand facilitates the development of competitiveadvantages in particular industries. The presence of discerning, highlydemanding customers pressures firms to innovate faster and produce betterproducts. For example, Japan is a densely populated, hot, and humid countrywith very demanding consumers. These conditions led Japan to become oneof the leading producers and exporters of superior, compact air conditioners.In the United States, affluence combined with an aging population encour-aged the development of world-class health care companies such as Pfizerand Eli Lilly in pharmaceuticals and Boston Scientific and Medtronic in med-ical equipment.

4. Related and Supporting Industries refers to the presence of clusters of suppliers,competitors, and complementary firms that excel in particular industries. Theresulting business environment is highly supportive for the founding of particulartypes of firms. Operating within a mass of related and supporting industries pro-vides advantages through information and knowledge synergies, economies ofscale and scope, and access to appropriate or superior inputs. For example, the Sil-icon Valley in California is one of the best places to launch a computer softwarefirm, because the valley is home to thousands of knowledgeable firms and work-ers in the software industry. The firms in this industry generate a substantial flowof technological interchange that accelerates new product development andimprovements in the software industry.

Industrial cluster refers to a concentration of businesses, suppliers, andsupporting firms in the same industry at a particular location, characterizedby a critical mass of human talent, capital, or other factor endowments. Inaddition to the Silicon Valley, other industrial clusters include the fashionindustry in northern Italy, the pharmaceutical industry in Switzerland, thefootwear industry in Pusan, South Korea, the IT industry in Bangalore, India,Silicon Valley North near Ottawa, Canada, and Wireless Valley, in Stock-holm, Sweden.

Today, the most important sources of national advantage are theknowledge and skills possessed by individual firms, industries, and coun-tries. More than any other factors, knowledge and skills determine whereMNEs will locate economic activity around the world. Silicon Valley, Califor-nia, and Bangalore, India, have emerged as leading-edge business clustersbecause of the availability of specialized talent. These cities have little elsegoing for them in terms of natural industrial power. Their success derives

Industrial clusterA concentration of businesses,suppliers, and supporting firms inthe same industry at a particularlocation, characterized by acritical mass of human talent,capital, or other factorendowments.

Bangalore, India has emerged asa world-class industrial cluster inthe IT and business servicesindustries.

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 105


from the knowledge of the people who work there,so-called knowledge workers. Some even argue thatknowledge is now the only source of sustainablelong-run competitive advantage. If this view is cor-rect, then future national wealth will go to thosecountries that invest the most in R&D, education,and infrastructure that support knowledge-inten-sive industries.

National Industrial PolicyPerhaps the greatest contribution of MichaelPorter ’s work has been to underscore the notionthat national competitive advantage does not deriveentirely from the store of natural resources that eachcountry holds. Moreover, inherited national factorendowments are relatively less important than inthe past. Rather, as Porter emphasized, countriescan successfully create new advantages. Nations candevelop factor conditions that they deem importantfor their success. The public sector can devoteresources to improve national infrastructure, educa-tion systems, and capital formation. In short,Porter ’s diamond model implies that any country,regardless of its initial circumstances, can attaineconomic prosperity by systematically cultivatingnew and superior factor endowments.

Nations can develop these endowments throughproactive national industrial policy. This type of policy implements an eco-nomic development plan, often in collaboration with the private sector, thataims to develop or support particular industries within the nation. Ireland,Japan, Singapore, and South Korea are examples of countries that have suc-ceeded with national industrial policy. Policies emphasize the development ofhigh-value adding industries that generate substantial wealth in terms of cor-porate profits, worker wages, and tax revenues. In the opening vignette, Dubaiis pursuing a national industrial policy to develop as an international commer-cial center in the information and communications technology (ICT) sector. His-torically, nations have favored more traditional industries, including automo-biles, shipbuilding, and heavy machinery—all with long value chains thatgenerate substantial added value. As the Dubai example illustrates, progressivenations increasingly favor high value-adding, knowledge-intensive industriessuch as IT, biotechnology, medical technology, and financial services. Not onlydo these industries provide substantial revenues to the nation, they also lead tothe development of supplier and support companies that further enhancenational prosperity.

National industrial policies designed to build new capacity and capabilitiesshare the following:

• Tax incentives to encourage citizens to save and invest, which providecapital for public and private investment in plant, equipment, R&D, infra-structure, and worker skills.

• Monetary and fiscal policies, such as low-interest loans that provide a sta-ble supply of capital for company investment needs.

• Rigorous educational systems at both the precollege and university levelsthat ensure a steady stream of competent workers who support high tech-

National industrial policy Aproactive economic developmentplan initiated by the public sector,often in collaboration with theprivate sector, that aims todevelop or support particularindustries within the nation.

Visionary national industrial pol-icy is transforming Dubai into ahigh value-adding economybased on IT, biotechnology, finan-cial services, and other knowl-edge-intensive industries.

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 106


nology or high value-adding industries in areas such as the sciences, engi-neering, and business administration.

• Development and maintenance of strong national infrastructure in areassuch as IT, communication systems, and transportation.

• Creation of strong legal and regulatory systems to ensure that citizens areconfident about the soundness and stability of the national economy.6

National Industrial Policy in Practice: An ExampleHow well does national industrial policy work in practice? To address this ques-tion, let’s examine the case of Ireland and the outcomes of proactive country repo-sitioning implemented through a collaborative effort by the nation’s public andprivate sectors.

In the 1930s, government policies limited Ireland’s ability to trade with therest of the world. Standards of living were low, young people were fleeing thecountry, and many wondered if Ireland had a future. Then, in the 1980s, the Irishgovernment undertook protrade policies in cooperation with the private sectorthat led to the development of national advantages, helping Ireland’s economy togrow rapidly and achieve high living standards. The magnitude of Ireland’saccomplishment becomes clear in Exhibit 4.6, which compares the country’s eco-nomic situation between 1987 and 2003.

Annual GDP growth in Ireland averaged nearly 7 percent throughout the1990s—a fast pace. Ireland’s rejuvenation was so successful that officials fromaround the world visit the country regularly to learn how it leaped from being oneof Europe’s stagnant economies to one of the most dynamic. The ”Irish miracle”resulted from a combination of efforts:

• Fiscal, monetary, and tax consolidation. The Irish government lowered thebasic corporate tax rate to zero, helping to foster entrepreneurship andincreasing the nation’s attractiveness for inward investment from foreignMNEs. Personal taxes were reduced, boosting consumer spending. Thegovernment substantially cut spending and borrowing, which led tolower interest rates and helped stimulate the economy.

• Social partnership. The government initiated earnest dialogue withlabor unions. Increased coordination between government and indus-try improved the quality of the work force and strengthened the Irishlabor pool.

• Emphasis on high value-adding industries. Ireland created a national infra-structure and investment climate that fosters the development of indus-tries in high value-adding fields—pharmaceuticals, biochemistry, and IT.

• Membership in the European Union. The emergence of the European singlemarket provided Ireland with a huge market for its exports. Falling tradebarriers opened a giant market of 400 million consumers to Irish firms.

Statistic Ireland in 1987 Ireland in 2003GDP per capita 69 percent of the average of Europe 136 percent of the average of EuropeUnemployment rate 17 percent 4 percentNational debt 112 percent of the nation’s GDP 33 percent of the nation’s GDP

Exhibit 4.6 Transformation of Ireland’s Economy from 1987 to 2003

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 107


• Subsidies. Ireland received subsidies from the European Union thatallowed it to offset debt, invest in key infrastructure projects, and developa range of key industries, particularly in the IT sector.

• Education. The country invested heavily in education, providing a steadysupply of skilled workers, including scientists, engineers, and businessschool graduates.

Lured by the positive developments in Ireland, many foreign MNEs beganinvesting in the country. Thanks to national industrial policy, Ireland has becomea major player in world trade and is now home to more than 1,100 multinationalfirms. International trade, inward FDI, and economic development are dramati-cally raising living standards for its citizens.7

Read the Global Trend feature for additional examples of proactive nationrepositioning to create new comparative advantages.

New Trade TheoryBeginning in the 1970s, economists led by Paul Krugman began to note that classi-cal theories failed to anticipate or explain some international trade patterns. Forexample, they observed that trade was growing fastest between industrial coun-tries that held similar factors of production. In some new industries, thereappeared to be no clear comparative advantage. The solution to this puzzlebecame known as new trade theory. The theory argues that increasing returns toscale, especially economies of scale, are an important factor in some industries forsuperior international performance. Some industries succeed best as their volumeof production increases. For example, the commercial aircraft industry has veryhigh fixed costs that necessitate high-volume sales to achieve profitability. As anation specializes in the production of such goods, productivity increases and unitcosts fall, providing significant benefits to the local economy.

Because many national markets are relatively small, the domestic producer maynot achieve economies of scale because it cannot sell products in large volume. Thetheory implies that firms can solve this problem by exporting, thereby gaining accessto the much larger global marketplace. Similarly, some industries (for example, auto-mobiles, aircraft, and large-scale industrial machinery) have achieved minimallyprofitable economies of scale by selling their output in multiple markets worldwide.

The effect of increasing returns to scale allows the nation to specialize in asmaller number of industries in which it may not necessarily hold factor or compar-ative advantages. The nation then imports the products that it does not make fromother countries. The end result is that the nation: (1) increases the variety of productsthat it consumes, and (2) obtains these products at lower cost, both due to interna-tional trade and the economies of scale of its domestic industries. Thus, trade is ben-eficial even for countries that produce only a limited variety of products. New tradetheory provides further rationale for engaging in international trade.

Why and How Firms Internationalize

Earlier theories of international trade focused on why and how cross-national busi-ness occurs among nations. Beginning in the 1960s, however, scholars developed the-ories about the managerial and organizational aspects of firm internationalization.

Internationalization Process of the FirmThe internationalization process model was developed in the 1970s to describe howfirms expand abroad. According to this model, internationalization is a gradualprocess that takes place in incremental stages over a long period of time.8 Typi-cally, firms begin with exporting and progress to FDI, the most complex form ofinternational activity. Initial international involvement emerges as an innovation

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 108

> GLOBAL TREND

Repositioning to Create National Comparative Advantage

Countries that succeed atnational industrial strategyhave proactively created

internationally competitive indus-tries. The principle of comparativeadvantage and factor endowmenttheory imply that nations shouldnurture industries that use inputsthat are inherent or abundant inthe nation’s resource endowment.Today, numerous countries thatwere initially poor in natural or otherresources have created their owncompetitive advantages throughskillful application of national indus-trial policies. In most industries, theseacquired advantages have becomemore critical than natural endow-ments. Here are some examples:

Japan, a crowded island countrywith few natural resources, empha-sized the development of variousacquired advantages—skilled labor,cheap capital, and strong R&D capa-bilities. The systematic nationalstrategy allowed Japan to becomeone of the world’s strongesteconomies. In the decades followingWorld War II, which had devastatedthe country, the Japanese govern-ment cooperated with the country’scorporate and financial sectors tocreate a collection of leading indus-tries in automobiles, consumer elec-tronics, transportation equipment,and other sectors in which Japanexcels today.

Silicon Valley, in California, origi-nated when a number of high-techfirms set up shop to serve the tech-nology needs of the U.S. military.Stanford University’s creation of anindustrial park led to the founding ofHewlett-Packard in 1939. In lateryears, high-tech firms establishedthemselves, attracted by the area’ssuperior factor conditions, support-ive industries, and quality of life.Further growth was fueled in the

1970s by the emergence of venturecapitalist firms, providing vital capi-tal to start-up firms. Silicon Valleyremains a critical center of innova-tion and entrepreneurship, and oneof the world’s leading suppliers of IT-related products and services.

Singapore is a free market econ-omy with stable prices and a percapita GDP equal to that of the mostaffluent European countries. Begin-ning in the 1960s, the governmentadopted probusiness, proinvest-ment, export-oriented policies,combined with state-directed invest-ments in strategic corporations. Theapproach stimulated economicgrowth that averaged 8 percentfrom 1960 to 1999. Singapore cuttaxes and government spending,and encouraged massive inwardinvestment in high-value industriessuch as electronics, chemicals, engi-neering, and biomedical sciences.The country boasts a highly edu-cated labor force, as well as excel-lent infrastructure—including an air-port and seaport that are among thebest in the world—and state-of-the-art telecommunications facilities.

New Zealand’s government,beginning in 1984, systematicallytransformed the country from anagrarian, protectionist, highly regu-lated economy to an industrialized,free-market economy that competesglobally. The government privatizeda number of former state-ownedenterprises, joined various interna-tional free trade agreements, andfocused on building a knowledgeeconomy. Dynamic growth hasboosted real incomes and deepenedtechnological capabilities.

India positioned Bangalore, thecountry’s third largest city, as a cen-ter of IT and business support ser-vices. In cooperation with privateinterests, the government reduced

restrictions on foreign trade andinvestment, resulting in a big influxof foreign FDI. Bangalore capital-ized on its large, well-educated,English-speaking workforce. Thepublic-private partnership empha-sized other high-value industries,such as biotechnology and businessconsulting.

The Czech Republic’s recenteconomic reforms and successfulexporting to the European Union(EU) produced economic prosperity.The Czech government harmonizedits laws and regulations with those ofthe EU by reforming its judicial sys-tem, civil administration, financialmarkets regulation, intellectualproperty rights protection, andmany other areas important toinvestors. The country also priva-tized state-owned companies. Gov-ernment FDI incentives attractedfirms like Toyota, ING, Siemens,Daewoo, DHL, and South AfricanBreweries.

Vietnam’s government priva-tized state enterprises and modern-ized the economy, emphasizingcompetitive, export-driven indus-tries. Vietnam ramped up its exportsof everything from shoes to ships.The country modernized its intellec-tual property regime, entered sev-eral free trade agreements, andramped up its educational system toprovide a constant stream of skilledworkers. The government builtinfrastructure, including power sta-tions, roads, and railways. Reformshave attracted much inward FDIfrom firms like Intel, and thenational savings rate has increasedseveral-fold. Economic reposition-ing has dramatically reducedpoverty. Vietnam became one of thefastest-growing economies, averag-ing around 8 percent annual GDPgrowth in the 1990s.

109

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 109


in the firm, but without much rational analysis or deliberate planning on the partof managers who oversee the process. The gradual, slow, and incremental natureof internationalization results from the uncertainty and uneasiness that managersexperience, mainly due to inadequate information about foreign markets and lackof experience with cross-border transactions.

A simplified illustration of the internationalization process model appears inExhibit 4.7. A firm starts out in a domestic focus phase and is preoccupied with acquir-ing business in the home market. The firm is often unable or unwilling to engage ininternational business because of concerns over its readiness, or perceived obstacles inforeign markets. Eventually, the firm advances to the pre-export stage, often because itreceives unsolicited product orders from abroad. Consequently, management investi-gates the feasibility of undertaking international business. The firm then advances tothe experimental involvement stage by initiating limited international activity, typicallyin the form of basic exporting. As managers begin to view foreign expansion morefavorably, they eventually undertake active involvement in international businessthrough systematic exploration of international options and the commitment of topmanagement time and resources toward achieving international success. Ultimatelythe firm may advance to the committed involvement stage, characterized by genuineinterest and commitment of resources to making international business a key part ofthe firm’s profit-making and value-chain activities. In this stage, the firm targetsnumerous foreign markets via various entry modes, especially FDI.9

Born Globals and International EntrepreneurshipThe contemporary business environment has stimulated scholars to question thegradual and slow nature of internationalization proposed by the internationaliza-tion process model.10 Because international business has long been the domain oflarge, resource-rich MNEs, earlier international business theory tended to focuson them. But during the past couple of decades, many firms have international-ized early in their evolution. Among the reasons for this shift are the growingintensity of international competition, advances in communication and trans-portation technologies that have reduced the cost of venturing abroad, and theintegration of world economies under globalization, which makes it easier forcompanies of all ages and sizes to internationalize.

The new business environment represented by these trends has stimulated thewidespread emergence of firms that internationalize at their founding—bornglobals—and the rise of a new field of scholarly inquiry, international entrepre-neurship.11 Despite the scarcity of financial, human, and tangible resources thatcharacterize most new businesses, born globals progress to internationalizationearly in their evolution. Current trends imply that early internationalizing firmswill gradually become the norm in international trade and investment.

How Firms Gain and Sustain InternationalCompetitive Advantage

So far we have focused on the internationalization processes of individual firms,including smaller firms or those new to international business. Since the 1950s, multi-national enterprises (MNE) such as Nestlé, Unilever, Sony, Coca-Cola, Caterpillar, andIBM have expanded abroad on a massive scale, shaping international patterns oftrade, investment, and technology flows. Over time, the aggregate activities of thesefirms became a key driving force of globalization and ongoing integration of world

Exhibit 4.7Stages in the InternationalizationProcess of the Firm

DomesticFocus

Pre-exportStage

ExperimentalInvolvement

ActiveInvolvement

CommittedInvolvement

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 110

economies. So important is the rise of the MNE that it ranks with the development ofelectric power or the invention of the aircraft as one of the major events of modern his-tory. Let’s examine these firms and their internationalization processes in more detail.

As explained in Chapter 1, an MNE is a large, resource-rich company whosebusiness activities are performed by a network of subsidiaries located in numer-ous countries. The typical MNE has value chains that span multiple countries.Although an MNE originates from a home country, it establishes worldwideproduction facilities, marketing subsidiaries, regional headquarters, and otherphysical facilities directly in the countries where it does business. MNEs leverageleading-edge technologies, talented managers, large capital bases, and otheradvantages to succeed around the world. They take advantage of global capitalmarkets and local resources in the countries where they operate. They are theforemost agents in disseminating new products, new technologies, and businesspractices worldwide, contributing to ongoing globalization of markets.

Take Sony as an example. Sony has hundreds of subsidiaries and affiliates aroundthe world that perform the widest range of value-chain activities. Sony has annual salesof roughly $70 billion, with more than 160,000 employees worldwide. Sony’s PlaySta-tion dominates the home video game market with about 70 percent of global sales. Vaiocomputers are popular worldwide. The firm makes a host of other products, includingPCs, digital cameras, Walkman stereos, and semiconductors. Its online music service ismanaged by a newly formed subsidiary of Sony Corporation of America. Sony is head-quartered in Tokyo; however, Japan accounts for only about a third of its worldwidesales. It conducts business in emerging markets such as Argentina, Brazil, China, Turkey,Indonesia, Vietnam, and the Philippines. The firm is truly a borderless MNE that locatesits activities wherever in the world it can maximize competitive advantages.

FDI-Based TheoriesFDI stock refers to the total value of assets that MNEs own abroad via their invest-ment activities. Exhibit 4.8 shows the stock of inward FDI and Exhibit 4.9 shows

0 200,000 400,000 600,000

(in millions of 2005 U.S. dollars)

800,000 1,000,000

United KingdomFrance

United StatesCanada

NetherlandsGermany

SpainBelgiumIreland

ItalyLuxembourgSwitzerland

SwedenDenmarkEU Total

AustraliaJapan

Hong Kong, ChinaChina

Asia Total

Africa Total

MexicoBrazil

L. America Total

1,278,608

4,023,935

1,473,860Exhibit 4.8Stock of Inward FDI: Leading FDIDestinations (Millions of U.S.dollars)SOURCE: UNCTAD, World Investment Report,United Nations, New York, 2005 atwww.unctad.org. The United Nations is the author ofthe original material. Used with permission.

How Firms Gain and Sustain International Competitive Advantage 111

CAVUMC04_092-123hr1 10/20/07 8:23 AM Page 111


the stock of outward FDI. MNEs invest millions abroad every year to establishand expand factories and other facilities. Total FDI stock now constitutes some 20percent of global GDP, which is a significant amount. While historically most ofthe world’s FDI was invested both by and in Western Europe, the United States,and Japan, in recent years MNEs have begun to invest heavily in emerging mar-kets such as China, Mexico, Brazil, and Eastern Europe.12

FDI is such an important entry strategy that scholars provide three alternativetheories of how firms can use it to gain and sustain competitive advantage: themonopolistic advantage theory, internalization theory, and Dunning’s eclectic par-adigm. These theoretical perspectives are summarized in Exhibit 4.10 anddescribed in the following sections.

Monopolistic Advantage Theory This theory suggests that firms that use FDIas an internationalization strategy tend to control certain resources and capabilitiesthat give them a degree of monopoly power relative to foreign competitors. Theadvantages that arise from this monopoly power enable the MNE to operate for-eign subsidiaries more profitably than the local firms that compete in those mar-kets. A key assumption of the theory is that, to be successful, an MNE must possessmonopolistic advantages over local firms in foreign markets. In addition, the firmmust keep these advantages to itself by internalizing them. These advantages arespecific to the MNE rather than to the location of its production, are owned by theMNE, and not easily available to its competitors. For example, the South Africanfirm SAB Miller, the second largest beer brewer in the world, leverages a nearmonopoly in its home country, relying on extensive international business exper-tise, and offering a unique line of beers to customers around the world.13

The most important monopolistic advantage is superior knowledge, whichincludes intangible skills possessed by the MNE that provide a competitive advantageover local rivals in foreign markets. Superior, proprietary knowledge allows MNEs tocreate differentiated products that provide unique value to customers.14

0 200,000 400,000 600,000 800,000 1,000,000

United KingdomGermany

United StatesCanada

FranceNetherlandsSwitzerland

SpainItaly

BelgiumSweden

LuxembourgDenmark

IrelandEU Total

AustraliaNew Zealand

JapanHong Kong, China

ChinaAsia Total

Mexico

Africa Total

Brazil

L. America Total

5,189,738

1,378,130

2,018,205

(in millions of 2005 U.S. dollars)

Exhibit 4.9Stock of Outward FDI: Top Sourcesof Outward FDI (Millions of U.S.dollars)SOURCE: UNCTAD, World Investment Report,United Nations, New York, 2005 atwww.unctad.org. The United Nations is the author ofthe original material. Used with permission.

CAVUMC04_092-123hr1 10/20/07 8:23 AM Page 112


Theory Key Characteristics Benefits Examples

Exhibit 4.10 Theoretical Perspectives on Why Firms Choose FDI

The firm controls one ormore resources, or offersrelatively unique prod-ucts and services thatprovide it a degree ofmonopoly power relativeto foreign markets andcompetitors.

Monopolistic Advantage Theory

The firm can operate for-eign subsidiaries moreprofitably than the localfirms that compete intheir own markets.

The European pharma-ceutical Novartis earnssubstantial profits bymarketing various patentmedications through itssubsidiaries worldwide.

• Ownership-specificadvantages: The firmowns knowledge, skills,capabilities, processes,or physical assets.

• Location-specific advan-tages: Factors in individ-ual countries providespecific benefits, such asnatural resources, skilledlabor, low-cost labor,and inexpensive capital.

• Internalization advantages:The firm benefits frominternalizing foreignmanufacturing, distri-bution, or other value-chain activities.

Dunning’s EclecticParadigm

Provides various advan-tages relative to com-petitors, including theability to own, controland optimize value-chain activities—R&D,production, marketing,sales distribution, after-sales service, as well asrelationships with cus-tomers and key con-tacts—performed at themost beneficial locationsworldwide.

The German MNESiemens:• Owns factories at loca-

tions worldwide thatprovide optimal access tonatural resources, skilledand low-cost labor.

• Leverages the knowl-edge base of its employ-ees in 190 countries.

• Internalizes a widerange of manufacturingactivities in categoriessuch as lighting, medicalequipment, and trans-portation machinery.

The firm acquires andretains one or morevalue-chain activitieswithin the firm.

Internalization Theory • Minimizes the disad-vantages of relying onintermediaries, collabo-rators, or other externalpartners.

• Ensures greater controlover foreign operations,helping to maximizeproduct quality, reliablemanufacturingprocesses, and soundmarketing practices.

• Reduces the risk thatknowledge and propri-etary assets will be lostto competitors.

The Japanese MNEToshiba:• Owns and operates fac-

tories in dozens ofcountries to manufac-ture laptop computers.

• Controls its own manu-facturing processes,ensuring quality output.

• Ensures its marketingactivities are carried outper headquarters' plan.

• Retains key assetswithin the firm, such asleading-edge knowledgefor producing the nextgeneration of laptops.

Internalization Theory Some scholars investigated the specific benefits thatMNEs derive from FDI-based entry. For instance, when Procter & Gamble enteredJapan, management initially considered exporting and FDI. With exporting, P&Gwould have had to contract with an independent Japanese distributor to handle

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 113


warehousing and marketing of soap, detergent, diapers, and the other productsthat P&G now sells in Japan. However, because of trade barriers imposed by theJapanese government, the strong market power of local Japanese firms, and therisk of losing control over its proprietary company knowledge, P&G chose insteadto enter Japan via FDI. P&G established its own marketing subsidiary and, even-tually, national headquarters in Tokyo. Such an arrangement provided variousbenefits that P&G would not have received had it entered Japan by contractingwith Japanese distributors not owned by P&G.

This example reveals how MNEs internalize key business functions and assetswithin the corporate organization. Internalization theory explains the process bywhich firms acquire and retain one or more value-chain activities inside the firm, min-imizing the disadvantages of dealing with external partners and allowing for greatercontrol over foreign operations. It contrasts the costs and benefits of retaining key busi-ness activities within the firm against arms-length foreign entry strategies such asexporting and licensing, in which the firm contracts with external business partners toperform certain value-chain activities. By internalizing foreign-based value-chainactivities it is the firm, rather than its products, that crosses international borders. Forinstance, instead of procuring from foreign independent suppliers, the MNE internal-izes the supplier function by acquiring or establishing its own facilities in the foreignmarket. Where one firm might contract with independent foreign distributors to mar-ket its products abroad, the MNE internalizes the marketing function by establishing oracquiring its own distribution subsidiary abroad. The MNE is ultimately a vehicle forbypassing the bottlenecks and costs of the international, inter-firm exchange of goods,materials, and workers. In this way, the MNE replaces business activities performed inexternal markets with business activities performed within its own internal market.

As highlighted earlier, knowledge is critical to the development, production, dis-tribution, and sale of products and services. Because competitors can easily acquireand use a firm’s knowledge, firms internalize their key knowledge by internationaliz-ing via FDI instead of other modes, such as exporting. FDI allows management to con-trol and optimally use the firm’s proprietary knowledge in foreign markets.15

Dunning’s Eclectic Paradigm Professor John Dunning proposed the eclecticparadigm as a framework for determining the extent and pattern of the value-chainoperations that companies own abroad. Dunning draws from various theoreticalperspectives, including the comparative advantage and the factor proportions,monopolistic advantage, and internalization advantage theories.

Let’s use a real firm to illustrate the eclectic paradigm. The Aluminum Corpo-ration of America (Alcoa) has over 130,000 employees in roughly 43 countries. Thecompany’s integrated operations include bauxite mining and aluminum refining.Its products include primary aluminum (which it refines from bauxite), automo-tive components, and sheet aluminum for beverage cans and Reynolds Wrap®.

The eclectic paradigm specifies three conditions that determine whether ornot a company will internationalize via FDI: ownership-specific advantages, loca-tion-specific advantages, and internalization advantages.

To successfully enter and conduct business in a foreign market, the MNEmust possess ownership-specific advantages (unique to the firm) relative toother firms already doing business in the market. These consist of the knowl-edge, skills, capabilities, processes, relationships, or physical assets held bythe firm that allow it to compete effectively in the global marketplace. Theyamount to the firm’s competitive advantages. To ensure international success,the advantages must be substantial enough to offset the costs that the firmincurs in establishing and operating foreign operations. They also must bespecific to the MNE that possesses them and not readily transferable to otherfirms. Examples of ownership-specific advantages include proprietary tech-nology, managerial skills, trademarks or brand names, economies of scale,

Internalization theory Anexplanation of the process bywhich firms acquire and retainone or more value-chain activities“inside” the firm, minimizing thedisadvantages of dealing withexternal partners and allowing forgreater control over foreignoperations.

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 114


and access to substantial financial resources.The more valuable the firm’s ownership-spe-cific advantages, the more likely it is to inter-nationalize via FDI.16

One of Alcoa’s most important ownership-specific advantages is the proprietary technol-ogy that it has acquired from R&D activities.Over time, Alcoa has also acquired specialmanagerial and marketing skills in the produc-tion and marketing of refined aluminum. Thefirm has a well-known brand name in the alu-minum industry, which helps increase sales.Because it is a large firm, Alcoa also profitsfrom economies of scale and the ability tofinance expensive projects. These advantageshave allowed Alcoa to maximize the perfor-mance of its international operations.

Location-specific advantages refer to the comparative advantages that exist inindividual foreign countries. Each country possesses a unique set of advantagesfrom which companies can derive specific benefits. Examples include naturalresources, skilled labor, low-cost labor, and inexpensive capital. Sophisticatedmanagers recognize and seek to benefit from the host country advantages. A loca-tion-specific advantage must be present for FDI to succeed. It must be profitable tothe firm to locate abroad, that is, to utilize its ownership-specific advantages inconjunction with at least some location-specific advantages in the target country.Otherwise, the firm would use exporting to enter foreign markets.17

In terms of location-specific advantages, Alcoa located refineries in Brazilbecause of that country’s huge deposits of bauxite, a mineral found in relativelyfew other locations worldwide. The Amazon and other major rivers in Brazilgenerate huge amounts of hydroelectric power, a critical ingredient in electric-ity-intensive aluminum refining. Alcoa also benefits in Brazil from low-cost,relatively well-educated laborers, who work in the firm’s refineries.

Internalization advantages are the advantages that the firm derives frominternalizing foreign-based manufacturing, distribution, or other stages in itsvalue chain. When profitable, the firm will transfer its ownership-specificadvantages across national borders within its own organization, rather thandissipating them to independent, foreign entities. The FDI decision dependson which is the best option—internalization versus utilizing external part-ners—whether they are licensees, distributors, or suppliers. Internalizationadvantages include: the ability to control how the firm’s products are pro-duced or marketed, the ability to control dissemination of the firm’s propri-etary knowledge, and the ability to reduce buyer uncertainty about the valueof products the firm offers.18

Alcoa has internalized many of its operations instead of having them handledby outside independent suppliers for five reasons. First, Alcoa management wantsto minimize dissemination of knowledge about its aluminum refining operations—knowledge the firm acquired at great expense. Second, compared to using outsidesuppliers, internalization provides the best net return to Alcoa, allowing it to mini-mize the costs of operations. Third, Alcoa needs to control sales of its aluminumproducts to avoid depressing world aluminum prices by supplying too much alu-minum into world markets. Fourth, Alcoa wants to be able to apply a differentialpricing strategy, charging different prices to different customers. The firm could notdifferentiate its prices very effectively without the control over the distribution of itsfinal products that internalization provides. Finally, aluminum refining is a complexbusiness and Alcoa wants to control it to maintain the quality of its products.

Alcoa has advantages in produc-ing refined aluminum.

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 115


Non-FDI Based ExplanationsFDI became a popular entry mode with the rise of the MNE in the 1960s and the1970s. In the 1980s, firms began to recognize the importance of collaborative ven-tures and other flexible entry strategies.

International Collaborative Ventures A collaborative venture is a form ofcooperation between two or more firms. Horizontal collaboration occurs betweenpartners at the same level of the value chain. Examples are manufacturer-to-manufacturer and supplier-to-supplier relationships. Vertical collaborationsoccur between partners at different levels of the value chain. An example is therelationship between a manufacturer and its distributor.

Collaborative ventures are classified into two major types: equity-based joint ven-tures that result in the formation of a new legal entity; and project-based strategicalliances that do not require equity commitment from the partners, but simply awillingness to cooperate in R&D, manufacturing, design, or any other value-addingactivity. In both cases, collaborating firms pool resources and capabilities and generatesynergy. Partners also share the risk of their joint efforts, reducing vulnerability for anyone partner. To achieve international business goals, the firm sometimes has no choicebut to reach out to resources and capabilities that are not available within its own orga-nization, through collaborative ventures. In addition, occasionally a foreign govern-ment restricts the firm from entering its national market via wholly owned FDI, insteadrequiring the foreigner to enter via a joint venture with a local partner.19

By entering into a collaborative venture, the firm may gain access to foreign part-ners’ know-how, capital, distribution channels, marketing assets, or the ability to over-come government-imposed obstacles. By partnering, the firm can better position itselfto create new products and enter new markets. For example, Starbucks now boastsnearly 500 coffee shops in Japan, thanks to a joint venture with its local partner, Sazaby,Inc. The venture allowed Starbucks to internationalize rapidly in Japan and to navigatethe marketplace with the help of a knowledgeable local partner.20

Networks and Relational Assets Networks and relational assets represent thestock of the firm’s economically beneficial long-term relationships with other businessentities, such as manufacturers, distributors, suppliers, retailers, consultants, banks,transportation suppliers, governments, and any other organization that can provideneeded capabilities. Firm-level relational assets represent a distinct competitive advan-tage in international business. Japanese keiretsu are the predecessors of the networksand alliances now emerging in the Western world. Keiretsu are complex groupings offirms with interlinked ownership and trading relationships that foster inter-firm orga-nizational learning.21 Like keiretsu, networks are neither formal organizations withclearly defined hierarchical structures nor impersonal, decentralized markets.

The International Marketing and Purchasing (IMP) research consortium inEurope has driven much of the theory development on networks.22 Network theorywas proposed to compensate for the inability of traditional organizational theories toaccount for much of what goes on in business markets. In networks, actors (buyersand sellers) become bound to one another through ongoing exchanges and linkagesof products, services, finance, technology, and know-how. Continued interactionamong the partners helps form stable relationships based on cooperation. Linkagesthrough industrial networks create value and competitive advantage for firms, evenamong competitors. Network linkages represent a key route by which many firmsexpand their business abroad, develop new markets, and develop new products. Ininternational business, mutually beneficial and enduring strategic relationships pro-vide real advantages to partners and reduce uncertainty and transaction costs.

As we will see later in this book, in the contemporary global economycompanies have increasingly shied away from making more permanent,direct investment in host countries, and opted for more flexible collaborativeventures with independent business partners.

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 116

117

Hyundai: The Struggle for International Success

The automotive industry is among the largest and mosthighly internationalized economic sectors. Hyundai MotorCompany (HMC) is South Korea’s number one carmaker,producing about a dozen models of cars and minivans, aswell as trucks, buses, and other commercial vehicles. Popu-lar exported models are the Accent, Elantra, and Sonata.The South Korean firm has managed to internationalize suc-cessfully, seemingly against all odds.

The Global Automobile IndustryWith many competitors battling for market share, com-panies such as Hyundai, Ford, and Volkswagen typi-cally operate on thin margins. The automotive industryhas been suffering from excess production capacity.Although there is capacity to produce 80 million carsworldwide, total global demand runs at only about 60million a year. Thus, automotive manufacturers typi-cally employ only 75 percent of their productioncapacity. The problem has led to numerous mergersand acquisitions in recent years. Consolidations haveoccurred between Ford and Land Rover, Jaguar andVolvo, and DaimlerBenz with Chrysler, to name a few.In addition, the auto industry is extremely capital–intensive, and firms seek economies of scale toremain profitable. The requisite scale compelsautomakers to target world markets where they cangenerate additional sales.

South Korea and the Auto IndustryThe car market in South Korea is too small on its own tosustain indigenous automakers like HMC and Kia. Thesefirms have targeted global markets to attain theeconomies of scale needed to remain competitive in atough industry. Fortunately, South Korea enjoys variousnational competitive advantages in the provision of cars.The country has a sizeable workforce of knowledgeworkers in the auto industry who drive innovations indesign, features, production, and product quality.Wages in South Korea are lower than in many advancedeconomies, which helps keep costs down. South Koreaalso has a high savings rate, has received substantialinward foreign investment, and is a net exporter. Thesefactors help ensure that South Korea enjoys a ready sup-ply of capital, which firms in the auto industry use forR&D and product innovations. Collectively, SouthKorea’s abundance of production factors in cost-effec-tive labor, knowledge workers, high technology, andcapital are the country’s location-specific advantages.

South Korean consumers are highly demanding, soSouth Korean producers take great pains to producesuperior products. Intense rivalry in the domestic auto

industry ensures that carmakers and auto parts manufac-turers focus on continuous improvement of their prod-ucts. The South Korean government devised a system ofclose government/business ties, including directedcredit, import restrictions, and sponsorship of specificindustries. The government promoted the import of rawmaterials and technology, at the expense of consumergoods, and encouraged savings and investment overconsumption. Partly due to these efforts, South Korea ishome to a substantial industrial cluster for the productionof cars and car parts. Gyeonggi Province is rapidlyemerging as the center of South Korea’s auto partsindustry. The nation benefits from the presence ofnumerous suppliers and manufacturers in the global autoindustry.

HMC’s ChallengesAgainst this background, HMC has faced variousmishaps. The South Korean economy endured a reces-sion in the late 1990s as a result of the Asian financial cri-sis. The economy comprises numerous family-ownedconglomerates, or chaebol. Combined sales of thenation’s five major chaebol—Hyundai, Samsung, Dae-woo, LG, and SK—account for roughly 40 percent ofSouth Korea’s GDP and total exports. Over time, thesegiant firms expanded rapidly, borrowing from their ownbanks to finance often reckless expansion into unrelatedindustries. Financial blunders led the South Korean gov-ernment to impose greater transparency and more strin-gent accounting controls.

In the automotive industry, Kia Motors, SouthKorea’s third largest automaker, went bankrupt and Dae-woo was sold off to General Motors. While domesticdemand in South Korea is some two million vehicles,total productive capacity had reached five million.HMC’s debt burden reached five times its equity, andthe firm suffered massive losses. The future was veryuncertain. HMC was using less than 40 percent of itstotal production capacity, with a debt of around $30 bil-lion. In 1998, HMC took control of Kia, becoming SouthKorea’s biggest carmaker and holding three-quarters ofits domestic vehicle market, as well as passing Japan’sMitsubishi and Suzuki in world ranking.

Early Internationalization EffortsHMC was founded in 1967 by Chung Ju Yung, a vision-ary entrepreneur from a peasant background. His son,Chung Mong Koo, took over as chairman in 1998. Theyounger Mr. Chung is often quoted as saying “Qualityis crucial to our survival. We have to get it right, nomatter the cost.”

CLOSING CASE

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 117

In the late 1970s, HMC began an aggressive effortto develop engineering capabilities and new designs. In1983 HMC launched a subsidiary in Canada, the firm’sfirst foreign investment venture. However, the operationproved unprofitable and was shut down after only fouryears. Despite this outcome, HMC management learneda great deal from the experience. Instead of FDI, HMCbegan exporting to the U.S. market, with the Excel as aneconomical brand with a $4,995 price tag. The car wassoon a big success, with exports rising to 250,000 unitsper year. Unfortunately, various problems emerged: TheExcel was perceived as a low-quality vehicle, and theweak dealer network failed to produce enough sales.Consumers, including those in the United States, werelosing faith in Hyundai, and the firm’s brand equitybegan to deteriorate. The United States is the largestcar market in the world, and Hyundai management hadto do something drastic to turn things around.

Ultimate SuccessIn response to complaints about product quality, HMCintroduced a 10-year warranty program. To address poorimage problems, management decided it had to gobeyond the typical guarantee period of only a few years andoffer a very substantial warranty. The strategy was a majorturning point for Hyundai, and the firm set about designingand building cars based on much higher quality standards.While still maintaining low prices, HMC has been able, overtime, to provide substantial added value to consumers.

Another major step to improve quality was geo-graphical diversification. Putting lessons learned from thefailed Canadian investment into practice, HMC built afactory in Turkey in 1997, in India in 2000 (with a secondplant in 2007), and in China in 2002. The main advantageof these locations is the availability of inexpensive, high-quality labor. The Turkish plant gave HMC a foothold inthe Middle East, a market it wants to develop. Turkey’sproximity to Western Europe is also a major advantage.

HMC uses FDI to develop key operations around theworld. Management chooses foreign locations based onthe advantages they can bring to the firm’s global business.

In 2006, HMC had more than ten production plantsin locations such as Taiwan, Vietnam, Iran, Sudan, andVenezuela. It developed R&D centers in Europe, Japan,and North America. The firm has launched several distri-bution centers and marketing subsidiaries at locationsworldwide. The distribution centers facilitate delivery ofparts to HMC’s expanding base of car dealers. HMC hasregional headquarters in various countries in Asia,Europe, and North America. In short, to ensure controlover the manufacturing and marketing of its cars aroundthe world, HMC has internalized much of its interna-tional operations.

To gain a competitive edge, HMC must seek not onlyinexpensive labor—it must also source from locations thatsupply low-cost input goods (such as engines, tires, and carelectronics). The cost-effectiveness of suppliers is a matterof life and death in the global automotive industry. HMChas entered various collaborative ventures with partners tocooperate in R&D, manufacturing, design, and other value-adding activities. These ventures have allowed the firmaccess to foreign partners’ know-how, capital, distributionchannels, marketing assets, and the ability to overcomegovernment-imposed obstacles. For example, HMC coop-erated with DaimlerChrysler to develop new technologiesand improve supply-chain management. Projects include anew four-cylinder engine and a joint purchasing plan.

HMC management intends to capture 20 percent ofthe vehicle market in China. To that end, HMC entered ajoint venture with Guangzhou Motor Group, gainingaccess to the commercial-vehicle market in China. HMCbenefits from its proximity to China and its manage-ment’s understanding of Chinese culture.

Recent EventsBy 2000, HMC had become the world’s fastest-growingmajor automaker. Sales in the United States increased morethan threefold from 1998 to 2004. Currently, the firm gener-ates about a third of its sales from North America and 10percent from Europe. HMC’s profit margins were amongthe highest in the industry, worldwide. It won numerousquality assurance prizes from credible organizations such asConsumer Reports and J. D. Power and Associates.

Despite successes in the early 2000s, HMC has recentlysuffered a series of problems. In 2004, South Koreaindicted Hyundai CEO Kim Dong-Jin on charges that heviolated campaign finance laws and engaged in managerialnegligence. In 2007, the government fined HMC $25 mil-lion for alleged unfair market practices. Chung Mong Kooreceived a 3-year jail term for embezzling the equivalent ofmore than $100 million in company funds. These eventsdamaged HMC’s reputation with suppliers, dealers, andcustomers. Meanwhile, unfavorable currency exchangerates caused net profit to fall by 35 percent. Sales in HMC’sdomestic and foreign markets have flattened, and the firmis grappling with labor unions. Top management has beenstruggling to maintain HMC’s great promise.

Sources: “Driving Change.” The Economist, Sept. 2, 2004; “The Quick and theDead.” The Economist, Jan. 27, 2005; “Hooked on Discounts.” The Economist,July 7, 2005; Griffiths, J. (2005). “Fiat Plans New Development Partnership”,Financial Times, Sept. 7, 2005; “The Chaebol that Ate Korea.” The Economist,Nov. 12, 1998; “South Korea Dumps the Past, at Last.” The Economist, Nov. 9,2000; “The Chaebol Spurn Change.” The Economist, July 22, 2000; “Eureka.” TheEconomist, Oct.22, 1998; “The Last Emperor.” The Economist, Feb. 4, 1999;Steers, R. M. (1999). Made in Korea. NY: Routledge; “Hyundai Revs Up.” Times Asianedition, April 25, 2005, 27-30; Interview with Lheem Heung Soo, Vice-President,Hyundai. Assan, Turkey, on August 23, 2005; “Hyundai Grows Up.” Time, June 27,2005, A4-A8; The Economist, “The Car Company in Front.” Jan. 27, 2005; Türk, E.(2005). “Yildizli Kariyer Öyküleri.” Milliyet Kariyerim, Sept 18, 2005.


CAVUMC04_092-123hr 10/15/07 11:18 AM Page 118

Chapter Essentials 119

AACSB: Reflective Thinking, AnalyticalSkills

Case Questions1. In the intensely competitive global automotive

industry, what factors provide comparative advan-tage to nations? Give some examples of naturaladvantages and acquired advantages that nationspossess in this industry.

2. Thinking in terms of factor proportions theory, whatproduction factors are most important in the auto-motive industry? Based on your answer, what coun-tries would appear to possess the most advantagesfor manufacturing cars? Justify your answer.

3. As a nation, what competitive advantages doesSouth Korea offer to home-grown automakers suchas HMC? What are the specific national competitiveadvantages that have helped HMC succeed in theglobal car industry?

4. Discuss HMC and its position in the global automo-tive industry in the context of Porter’s diamondmodel. That is, in regards to HMC’s internationalprogress, what is the role of: firm strategy, struc-ture, and rivalry, factor conditions, demand condi-tions, and related and supporting industries?

5. Discuss HMC and its position in the global automo-tive industry in terms of the eclectic paradigm. Thatis, for HMC, what is the role played by: ownership-specific advantages, location-specific advantages,and internalization advantages?

6. Visit HMC’s website (http://www.hyundai-motor.com).What international collaborative ventures is HMCinvolved in? Does the firm appear to be a part ofany networks? Describe these relationships, basedon your reading of the website.<

This case was written by Professor Nukhet Vardar, Yeditepe University, Istanbul,Turkey.

Key Terms

absolute advantage principle, p. 97comparative advantage, p. 94comparative advantage principle, p. 98

competitive advantage, p. 95free trade, p. 97industrial cluster, p. 105

SummaryIn this chapter, you learned about:

1. Theories of international trade and investmentThe basis for trade is specialization. Each nation spe-cializes in producing certain goods and services, andthen trades with other nations to acquire those goodsand services in which it is not specialized. Life as weknow it would be impossible without internationaltrade.

2. Why nations tradeClassical explanations of international trade beganwith mercantilism, which argued that nationsshould seek to maximize their wealth by exportingmore than they import. Absolute advantage principleargues that a country benefits by producing onlythose products in which it has absolute advantage,or can produce using fewer resources than anothercountry. The principle of comparative advantage

contends that countries should specialize andexport those goods in which they have a relativeadvantage compared to other countries. Nationsbenefit by trading with one another. Comparativeadvantage derives from natural advantages andacquired advantages. Competitive advantage derivesfrom distinctive assets or competencies of a firm,such as cost, size, or innovation strengths, that aredifficult for competitors to replicate or imitate.Factor proportions theory holds that nations specializein the production of goods and services whose fac-tors of production they hold in abundance. Theinternational product cycle theory describes how aproduct may be invented in one country, and even-tually mass-produced in other countries, with theinnovating country losing its initial competitiveadvantage.

internalization theory, p. 114mercantilism, p. 96national industrial policy, p. 106

CHAPTER ESSENTIALS

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 119


3. How nations enhance their competitive advantage: contemporary theories A major recent contribution to trade theory is Porter’sdiamond model, which specifies the four conditions ineach nation that give rise to national competitiveadvantages: firm strategy, structure, and rivalry, factorconditions, demand conditions, and related and support-ing industries. An industrial cluster is a concentrationof companies in the same industry in a given locationthat interact closely with one another, gaining mutualcompetitive advantage. New trade theory argues thatincreasing economies of scale might determine supe-rior performance in some industries. Some industriessucceed best the greater the volume of their produc-tion, which may necessitate international expansion.The competitive advantage of nations describes hownations acquire international trade advantages bydeveloping specific skills, technologies, and indus-tries. Firms and countries seek to increase productiv-ity, or the amount of output produced per unit ofinput. National industrial policy describes efforts bygovernments to direct national resources to thedevelopment of expertise in specific industries. Agovernment may pool resources to encourage thedevelopment of prowess in industries deemed valu-able to the nation.

4. Why and how firms internationalizeThe internationalization process model describes howcompanies expand into international business gradu-ally, usually going from simple exporting to the ulti-

mate, most committed stage, FDI. Born-global firmsinternationalize at or near their founding and arepart of the emergent field of international entre-preneurship.

5. How firms gain and sustain internationalcompetitive advantageMNEs have value chains that span geographic loca-tions worldwide. Foreign direct investment meansthat firms invest at various locations to develop pro-duction, marketing, or other types of subsidiaries.Monopolistic advantage theory describes how compa-nies succeed internationally by developing skills andresources that few other firms possess. The internali-zation theory explains the tendency of MNEs tointernalize stages in their value chain when it is totheir advantage. Internalization is the process ofacquiring and maintaining one or more value chainactivities inside the firm to minimize the disadvan-tages of subcontracting these activities to externalfirms. The eclectic paradigm specifies that the interna-tional firm should possess certain internal competi-tive advantages, called ownership-specific advantages,location-specific advantages, and internalization advan-tages. Currently, many international companiesengage in collaborative ventures, interfirm partner-ships that allow access to assets and other advan-tages held by foreign partners. MNEs also developextensive networks of supportive companies such asother manufacturers, distributors, suppliers, retail-ers, banks, and transportation suppliers.

Test Your Comprehension AACSB: Reflective Thinking, Analytical Skills

1. Why do nations engage in international business?That is, what are the benefits of international tradeand investment?

2. Describe the classical theories of international trade.Which of these theories do you believe are relevanttoday?

3. What is the difference between the concepts ofabsolute advantage and comparative advantage?

4. Summarize factor proportions theory. What factorsare most abundant in the following countries: China,Japan, Germany, Saudi Arabia, and the UnitedStates? Visit globalEDGE™ for helpful information.

5. Summarize the international product cycle theory.Use the theory to explain the international evolutionof automobiles and laptop computers.

6. What are the specific sources of national competitiveadvantage? Think of a successful product and service

in your country. Which of the competitive advantagesources is most relevant for each of these?

7. Do you believe your country should adopt a nationalindustrial policy? Why or why not?

8. How can you describe the internationalization processof the firm? Visit the websites of some major MNEsand review the history of these firms. What is thenature of internationalization in these firms? What isthe nature of internationalization in born-global firms?

9. FDI-based explanations of international businessevolved over time. Describe the evolution of theseexplanations from monopolistic advantage theory,through internalization theory, to the eclectic paradigm.

10.What are ownership-specific advantages, location-specific advantages, and internalization advantages?

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 120

Chapter Essentials 121

1. South Africa is a nation with major mining opera-tions and huge reserves of diamonds. It is also hometo the world’s biggest gold fields, in the Transvaalregion. In addition to their intrinsic value, diamondsand gold have numerous industrial uses in whichSouth Africa is the world leader. Mining preciousminerals has transformed South Africa into Africa’sleading industrial state. The newfound wealthfinanced modern transportation and communica-tions systems. Subsequent mining activities revealedthe existence of immense reserves of coal and ironore. To handle international shipments, the govern-ment developed major ports that connect SouthAfrica to world markets. Most recently, large quanti-ties of natural gas were discovered offshore. SouthAfrica is home to a large pool of low-cost workers inmining and related industries. The government hasdevised various plans that support particular indus-tries, especially mining.

These developments have led to the emergence ofa cluster of highly specialized firms in the mining andextractive industries. Some of the most knowledgeablefirms in the world in these industries are concentratedin South Africa, particularly De Beers S.A. De Beershas partnerships with large MNEs that hold majorfinancial resources. The firm has substantial capabili-ties in marketing and international strategy. Which ofthe theories discussed in this chapter help explain theadvantages that South Africa and De Beers SA hold?

2. Economist Lester Thurow once posed the followingquestion: “If you were the president of your own

country and could choose one of two industries inwhich to specialize, computer chips or potato chips,which would you choose?” When faced with thisquestion, many people choose potato chips, because“everybody can use potato chips, but not everybodycan use computer chips.” But the answer is muchmore complex. Whether to choose computer chips orpotato chips depends on several factors: the relation-ship between national wealth and the amount ofvalue added in the manufacture of goods; if the coun-try can benefit from monopoly power (few countriescan make computer chips); the likelihood of spin-offindustries (computer chip technology gives rise toother high technologies, such as computers); and, iftechnology generally makes people’s lives easier andhelps to raise their standard of living. In light of theseconsiderations, which would you choose: computerchips or potato chips? Justify your answer.

3. Suppose you get a job as a consultant to Mada-gasland, a country in Africa. The country’s ministerof commerce and industry has some vague idea thatMadagasland needs to be more active in interna-tional trade. The minister also recognizes that thegovernment could help the local economy by devel-oping a national industrial policy. Write a memo tothe minister that explains: (a) how the country canleverage its comparative advantages in pursuinggreater international trade, (b) what should be theelements of a national industrial policy, and (c) howthe country can go about developing acquiredadvantages.

Apply Your UnderstandingAACSB: Reflective Thinking, Analytical Skills, Communication

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 121

122

Internet Exercises(http://globalEDGE.msu.edu)

Refer to Chapter 1, page 27, for instructions on howto access and use globalEDGE.™

1. Your company is interested in importing Aus-tralian wine. As part of the initial analysis, youwant to identify the strengths and possibleweaknesses of the Australian wine industry.What are the conditions that make Australia afavorable location for wine cultivation? Providea short description of the current status of Aus-tralian wine exports by variety and a list of thetop importing countries of Australian wines. Inaddition to globalEDGE™, some useful websitesfor this research include www.wineaustralia.comand www.buyusa.gov.

2. Volvo (www.volvo.com) and Pilkington (www.pilkington.com) are major multinational firmswith operations that span the globe. Investi-gate these firms by visiting their websites, aswell as www.hoovers.com (a site that pro-vides specific company information) andglobalEDGE™. For each company, describeits ownership-specific advantages, location-

specific advantages, and internalizationadvantages.

3. The main task of the World Bank is to alleviateworld poverty. The Bank provides informationabout conditions in developing countries,which it uses to measure progress in economicand social development. World DevelopmentIndicators (www.worldbank.org/data/) is theBank’s premier source for data on internationaldevelopment. The Bank measures more than800 indicators of national conditions regardingpeople, environment, and economy. Consultthe website, click on World Development Indi-cators, and answer the following questions:(a) In countries with developing economies,what indicators are most associated withpoverty? (b) What are the types of industriesthat most characterize impoverished coun-tries? (c) Based on comparing developmentindicators in poor and affluent countries, spec-ulate on what types of actions governments indeveloping countries can take to help spureconomic development and alleviate poverty.

AACSB: Analytical Skills, Use of Information Technology

CAVUMC04_092-123hr 10/15/07 11:18 AM Page 122

Management Skill Builder©CKR Cavusgil Knight Riesenberger

The Best Locations for ManufacturingThe principle of comparative advantage suggests that every country possesses specific resources

that give it advantages in the production of specific products. Michael Porter’s Competitive Advantage of Nationsargues that nations become adept at certain industries due to the presence of certain resources and four conditions:firm strategy, structure, and rivalry; factor conditions; demand conditions; and related and supporting industries.Firms establish production facilities in those countries where they can obtain the most favorable resources andadvantages.

Managerial ChallengeIn advance of locating value-chain activities abroad,management should try to ascertain the most appropri-ate location to achieve the advantages suggested above.A reasonable process is first to identify those factors thatare most influential in determining company success,which usually varies by industry, and then conductingresearch to find countries that offer the best combinationof these factors. Given the number of potential locationsand the variables to consider, decisions about which for-eign locations are best can be very challenging. The bestapproach is to conduct advance research and narrow thenumber of countries through a systematic process. Thisis a task you might perform regardless of whether youwork for a large MNE or a smaller firm.

BackgroundChoosing the best foreign location for manufacturingprovides numerous advantages, including the abilityto: minimize the costs of producing the product, max-imize the quality of finished goods, and gain access tothe best factors of production and technologicalresources. For example, Tokyo-based Hoya, a manu-facturer of eyeglass lenses, established manufacturingin the Netherlands to be close to Europe’s superiortechnology in the lens-making industry.

These advantages translate into an increased abilityof the firm to enhance its brand name, charge premiumprices, gain leverage with distributors and retailers,

enhance competitive advantage, and generally earnhigher profits. Manufacturing concentrated in the mostfavorable location provides economies of scale, whichhelps drive down average unit costs.

Managerial Skills You Will Gain In this C/K/R Management Skill Builder©, as aprospective manager, you will:

1. Learn the factors to consider when locating com-pany operations.

2. Learn how these factors relate to maximizing thefirm’s competitive advantage.

3. Develop research skills for planning companyoperations.

Your TaskUse the criteria in Porter ’s diamond model andonline resources to identify the best countries toestablish a factory in each of the following indus-tries: dress shoes, flat-screen televisions, and phar-maceutical medicines.

Go to the C/K/R Knowledge Portal©

www.prenhall.com/cavusgilProceed to the C/K/R Knowledge Portal© to obtain theexpanded background information, your task andmethodology, suggested resources for this exercise, andthe presentation template.

123

AACSB: Reflective Thinking, Use of Information Technology, Analytical Skills

CAVUMC04_092-123hr 10/15/07 2:11 PM Page 123

Theories of International Trade and Investmentthe-eye.eu/public/WorldTracker.org/College...

Documents

Transcript of Theories of International Trade and Investmentthe-eye.eu/public/WorldTracker.org/College...