Theories of International Finance

1. Mercantilism
2. Absolute advantage (Classical)
3. Comparative advantage
4. Factor proportion trade
5. International product cycle
6. New trade theory
7. National competition advantage

Mercantilism (mid 16th century)

• A national wealth depends on accumulated treasures with gold and silver as currency of trade.
• Theory says you should have surplus,
  Maximise exports through subsidies
  Minimise imports through tariff and quotas.
• Flow restrictions and imports growth
• Nations should accumulate finance wealth (usually gold) by encouraging exports and discouraging imports.

Theory of absolute advantage
Adam smith (wealth of Nations) in 1776

• Capability of one country to produce more of product with the same amount of input than another country.
• A country should produce only goods where it is most efficient and trade for those goods where it is not efficient.
• Trade between countries is therefore beneficial.
• Destroy the mercantilist idea since there are gains to be obtained by countries to an exchange.

Theory of comparative advantage

David Ricardo principle of political economy (1817)

• Extends free trade argument.
• Efficiency of resource utilisation leads to more productivity.
• Should import even if country's more efficient in production than country from which it is buying.
• Look to see how much efficient, if only comparatively efficient, than import.
• Makes better use of resource.
• Trade is a positive sum game.

Factor proportion theory (labour & capital)
Heckstar (1919) - Otin (1933) thoery

• Export goods that intensively use factor endowments which are locally abundant.
• Import goods from locally scarce factors.
• Patterns of trade determined by differences in factor endowments not productivity.
• Remember - focus on relative advantage, not absolute advantage.
• Factor proportion theory holds that countries produce and export those goods that require resources (factors) that are abundant (cheapest) and import those goods that require resource that are in short supply.

Product life cycle theory - Vernom

It holds that a company will begin by exporting it products and later undertake foreign direct investment of the product moves through its life cycle.

• As products mature, both location of sales & optional production changes.
• Affects direction & flow of imports and exports.
• Globalisation & integration of economy makes this theory less valid/
• Increased emphasis on technology's impact on production cost.
• Explained international investment.

New trade theory

In industries with high fixed costs.

• Specialisation increases output and the ability to enhance economies of scale increases.
• Learning effects are high. these are cost saving that come from 'learning by doing'.
• Typically requires industries with high fixed costs.
• Competitors may converge because of  'first mores advantage.
  Role of government becomes significant.
• Some argue that it generates government intervention and strategic trade policy.

Theory of national competitive advantage

Attempts to analyse reasons of a nation's success in a particular industries.

Michael porter studies 100 industries in 10 nations. He postulated determinats of competitive advantages of a nation based on 4 major attributes:

1. Factor endowments
2. Demand endowments
3. Related and supporting industries
4. Firm strategy, structure & rivalry.

More/Greater the attribute, the higher the chance of success.

Factor endowments (factor conditions)

Nation's position in factors of production such as skilled labour or infrastructure necessary to complete in a given industry, broken down in to: (i) Basic factors (ii) Advanced factors.

Basic factors:

• Natural resources
•  Climate
•    Geographic location
•    Demographics

Advanced factors:

They are the result of investment by people, companies, government and more likely to lead to competitive advantage.

If country has no basic factors, it must invest in advance factors such as:

• Communication
• Skilled labor
•  Research
• Technology
• Education

Demand Conditions

·         Demand creates capabilities.

·         Demand creates sophisticated and demanding consumers.

Related and supporting industries

Creates clusters of supporting industries that are internationally competitive

Firm strategy, structure and rivalry

·         LT corporate vision is a determinant of success.

·         Management 'ideology' And structure of a firm can either help or hurt.

·         Presence of domestic rivalry improves a company's competitiveness.

Two external factors that influence the 4 determinant: Chance & Government.

Porter's theory - prediction

Porter's theory should predict the pattern of international trade that we observe in the real world.

Countries should be exporting products from those industries where all 4 components of the diamond are favorable, while importing in those areas where the components are not favourable.

Implications of business.

1.      Location implication.
Disperse production activities to countries where they can performed most effectively.

2.      First move implications.
Investment substantial financial resources in building a first mover or early mover advantage.

3.      Policy implications.
Promoting free trade is in the best interest of home country, not always in best interest of the firm, even though, many firms promote open markets.