THEORIES OF

INTERNATIONAL BUSINESS

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• The basic question, which arises for most of us at
this juncture.

• Why should the business firms of one country

should go to the another country, when the
industries of that country also produces goods and
market then.

• What is the basis for international business?

• A number of theories have been developed to

explain the basis for international business. 2
 COMPARATIVE COST THEORY OF
INTERNATIONAL BUSINESS
• It is common that some • cheap labour,
countries have the • skilled labour,
advantages of producing
some goods at a lower • cheap and qualitative
cost compared to other raw materials,
countries. • advanced technology,
• This is due to the • competent
availability of: management practices
etc.
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• According to comparative cost theory the
countries in the long run will tend to specialise
in the business (Production and Marketing) of
those goods in whose business they enjoy
comparative low cost advantage and import
other goods in which the countries have
comparative cost disadvantage, if free trade is
allowed.

• This specialisation helps for the mutual

advantage of the countries participating in the
international business.
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• Availability of these factors enhances
productivity and thereby reduces the cost of
production per unit.
• Similarly, other countries have this advantage
in producing other goods.

• Ex: Japan has the advantage in producing

electronics at low cost whereas India has
similar advantage in producing textiles.

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• David Recardo given a clear illustration on the
Comparative Cost Theory (CCT) in 1817.
• He used a two country, two commodity
model. The conclusion of his model are:

1. Business between two countries profitable

when a country produces one good at a lower
cost than other country and that other
produces another good at a lower cost than
the former(previous) country.

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2. Business between two countries is also
profitable when one country produces more
than one product efficiently, but, when it
produces one of these products comparatively
at greater efficiency than the other product.

3. Both the nations can engage in international

business when one country specializes in the
production in which it has greater efficiency in
production.
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 ASSUMPTIONS OF THE THEORY

• The only element of cost of production is

labour.

• Production is subject to the law of constant

returns.

• There are no trade barriers.

• Trade is free from cost of transportation.

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 ADVANTAGES OF THE THEORY
• Efficient allocation of global resources.
• Maximisation of global production at the least
possible cost.
• Product prices become more or less equal among
world markets.
• Demand for resources and product among world
nations will be optimised.

• The basis for international business is the comparative advantage of the

nations to produce certain products at lower cost than other countries.
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 OPPORTUNITY COST THEORY
• Ricardo’s theory of comparative cost advantage
suffers from a number of limitations.

• In particular, labour is not the only factor of

production, nor is it uniform.

• Different factors are combined in the production

process and the proportion in which they are
combined also varies from country to country
and from goods to goods.
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• This theory was proposed by Gottfried
Haberler in 1959.
• Opportunity cost relates to opportunities of
alternatives foregone to produce one more
unit of a good. Thus, if production of one unit
of commodity A is possible by foregoing two
units of commodity B, then the opportunity
cost of commodity A is two units of
Commodity B.
• The opportunity cost of one commodity is
measured in terms of another commodity.
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• It refers to the alternatives foregone or
opportunities given up.
1.Ex:Rs.15,000 is invested in Equity of Dabur
India limited and earned a dividend of 8% in
2009, the opportunity cost of this investment
is 12% interest had this amount been
deposited in a commercial bank for one year.

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2. Ex:- India produces textile garments by
utilising its human resources worth of Rs.1
billion and exports to the US in 2009.
If, India had developed software packages by
utilising the same human resources and
exported the same to USA in 2009, the worth
of the exports would have been Rs.10 billion.

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• Thus, the theory provides the basis for
international business in terms of exporting a
particular product rather than other product.

• In the previous example suggests that it would be

profitable to India to develop and export
software packages rather than textile garments
to USA

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• We can change or modify the above example,
assume that India earned Rs.15 billion by
exporting the same software packages to UK in
2009 rather than to USA.
• This theory suggests that the opportunity cost of
India’s software exports to USA is Rs.15 billion.

• This theory provides the basis for international

business of exporting a product to a particular
country rather to another country.

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 ASSUMPTIONS
• Perfect competition is in existence for both product and
factors in both the countries.
• Factors of production are perfectly transportable within
each country only.
• Factors of supplies are fixed in each country.
• Factors of production are of equal quality in both the
countries.
• Factors of production have full employment in both the
countries.
• Business between two countries is free from all barriers.
• There is no cost of transportation
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 perfect competition
• very near example of perfect competition would be
the fish market and the vegetable or fruit vendors
who sell at the same place,
• There are large number of buyers and sellers.
• There are no entry or exit barriers.
• There is perfect mobility of the factors, i.e. buyers
can easily switch from one seller to the other.
• The products are homogenous.

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• The supply of a commodity is the amount of commodity a producer is willing to put in
the market at a given time at a given price. The factors affecting supply are-
1. Price of the commodity- More the price of the commodity, more the supply and less
the price of the commodity, less the supply.

2. Price of factors of production (e.g. land, labour) - More prices of factors of production
results in less profit for the producer, therefore reduced supply.

3.Price of related goods - If a producer sees more profit in another good, and if the
producer is easily able to switch, it will start making the other good, thereby reducing
the supply for the good in question.
Eg: If a farmer is currently growing wheat and he calculates more profit in growing
barley, next year he will plant barley, thereby reducing supply of wheat.

4. Technology- Better technology allows for more efficient use of factors of productions

5. Environmental: Weather/Natural Disasters

6. Subsidies: If government decides to subsidize a good, there will be more profit for
producer. (Opposite of Tax)

7. Indirect Taxes: If the government increases the taxes that it takes from producers,
there will be reduced profit therefore less supply. 19
 Advantages
• An important merit of the opportunity cost approach
is that is takes into account the entire cost of
production and does not suffer from the weakness of
labour theory of value. For this reason, it is also able to
extend itself to cover the situations where,
• 1. inputs prices are subject to change over time.
• 2. there is change in production technology and
efficiency of productive resources.
• 3.Production is subject to increasing opportunity costs.
• 4. This approach allows and effective role for both
demand and supply forces in production and trade
decisions.
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 FACTORS PROPORTIONS TRADE THEORY
• The HECKSCHER-OHLIN MODEL (H-O MODEL) is
a general equilibrium mathematical model of
international trade, developed by Eli Hechscher
and Bertil Ohlin at the stockholm School of
Economics. It builds on David Ricardo’s theory
by predicting patterns of commerce and
production based on the factor endowments
(availability) of a trading region.

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• This theory states that countries produce and
export goods that require resources (factors) that
are abundant (and thus cheapest) and import
goods that require resources in short supply. The
theory focuses on the productivity of the
production process.
• As per this theory, factor intensities (strength)
depend on the state of technology – the current
method of manufacturing a good. The theory
assumed that the same technology of production
would be used for the same goods in all
countries.
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• It is not, therefore, differences in the
efficiency of production that will determine
trade between countries as it did not classical
theory.

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 PRODUCTIVITY THEORY

• It is criticized that the comparative cost

theories are not applicable to developing
countries.
• Hence, Mr.H.Myint proposed productivity
theory.
• The productivity theory points towards
indirect and direct benefits. This theory
emphasises that the process of specialisation
involves adapting and reshaping the
production structure of a trading country to
meet the export demands. 24
• Countries increase productivity in order to
utilise the gains of exports.

• This theory encourages the developing

countries to go for cash crops, increase
productivity by enhancing the efficiency of
human resources, adapting latest technology
etc.

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 New trade theory
• This theory advocated that countries become
specialised in the production of certain products,
thereby attaining economies of scale.
• This lowers the cost of production.
• First movers (first to produce that product) will
naturally get the advantages of economies of
scale. Each country should, therefore, specialise
in the production of a small range of products
and buy the other products it requires from other
countries.
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• The implication of the new trade theory is that
a variety of products will be available to
consumers at low prices.
• Thus, international trade offers an opportunity
for mutual gain for nations despite their
differences in factor endowments.

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Theory of national competitive advantage

• The theory attempts to analyze the reasons for a

nations success in a particular industry
• Michael Porter studied 100 industries in 10 nations
– postulated determinants of competitive advantage of a
nation based on four major attributes
• Factor endowments
• Demand conditions
• Related and supporting industries
• Firm strategy, structure and rivalry

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 Porter’s diamond

• Success occurs where these attributes exist.

• More/greater the attribute, the higher chance of success
• The diamond is mutually reinforcing
 Factor endowments
• Factor endowments:- A nation’s position in
factors of production such as skilled labor or
infrastructure necessary to compete in a given
industry
• Basic factor endowments
• Advanced factor endowments
 Basic factor endowments
• Basic factors: Factors present in a country
– Natural resources
– Climate
– Geographic location
– Demographics
• While basic factors can provide an initial
advantage they must be supported by
advanced factors to maintain success
 4-32

Advanced factor endowments

• Advanced factors: Are the result of

investment by people, companies,
government and are more likely to lead to
competitive advantage
• If a country has no basic factors, it must
invest in advanced factors
Advanced factor endowments (donations)

• communications
• skilled labor
• research
• Technology
• education
 Demand conditions

• Demand:
– creates capabilities
– creates sophisticated
and demanding
consumers

• Demand impacts quality

and innovation
 Related and supporting industries

• Creates clusters of supporting industries that

are internationally competitive

• Must also meet requirements of other parts

of the Diamond
 Firm Strategy, Structure and Rivalry

• Long term corporate vision is a determinant of

success
• Management ‘ideology’ and structure of the
firm can either help or hurt you
• Presence of domestic rivalry improves a
company’s competitiveness
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 INTERNATIONAL
BUSINESS METHODS

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• The rapid growth of international business in the
last two decades has been a challenge for the
managers.

• Managers of multinational enterprises have to

establish their presence in foreign locations by
entering into some form of contract with an
independent enterprise, by creating or acquiring
a local enterprise or by various hybrid
combinations.

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 International
Trade

Modes of
International
Business

Foreign
Contractual
Investment
entry modes
(FDI)
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International trade

Export Import

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 Export trade

Direct Indirect
export export

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 INTERNATIONAL TRADE
• It is now evident that international trade-
export and import- is an important mode of
IB.

• Export may be both direct and indirect.

• Direct export occurs when a company takes

full responsibility for making its goods
available in the target market by selling
directly.
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• Indirect export takes place when the exporting
company sells its product to the end-users
through intermediaries, such as Export
Houses etc.

• http://exim.indiamart.com/indian-exim-policy/handbook-procedures1.html

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 Export House Objective

• The objective is to recognise established exporters as

Export House, Trading House, Star Trading House and
Super Star Trading House with a view to build marketing
infrastructure and expertise required for export promotion.
• Such Houses should operate as highly professional and
dynamic institutions and act as important instruments of
export growth.
 ELIGIBILITY

• Merchant as well as Manufacturer exporters, Export

Oriented Units (EOUs)/units located in Export
Processing Zones (EPZs)/ Electronic Hardware
Technology Parks (EHTPs)/ Software Technology
Parks (STPs) shall be eligible for such recognition.
 Validity period
o Export House/ Trading House/ Star Trading House/ Super Star Trading

House Certificate shall be valid for a period of 3 years starting from 1st April

of the licensing year ,unless otherwise specified. On the expiry of such

certificate, application for renewal of status certificate shall be required to be

made within a period of six months.

• During the said period, the status holders shall be eligible to claim the usual

facilities and benefits..

 TRADING HOUSES HELP MANUFACTURERS AND FOREIGN CUSTOMERS
MANUFACTURERS FOREIGN CUSTOMERS

Goods are collected and payments made at Proven record of reliability for quality, prices
door step and delivery

Better price realizations because of overseas Lower cost thanks to a network of

marketing organization procurement facilities

All risks and hassles of exporting avoided One stop shopping facility

Global network for techno-commercial After sale services assured

information

Market entry at lower cost Lower transportation and handling costs

Long term business perspective Long term business perspective

 FOREIGN INVESTMENT

• Foreign Investment is the other mode of

International Business (IB).
• Foreign Investment (FI) is classified as foreign
portfolio investment (FPI) and Foreign Direct
Investment (FDI).
•FDI
investment (FI)
Foreign •FPI
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 Foreign Portfolio Investment
• FPI occurs when firm diversity their
investment in international securities and
often operate on the stock exchange in a
foreign country with the sole objective of
getting high return.
• It is nothing to do with the production of
goods and services abroad.

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GREENFIELD INVESTMENT

MERGERS &
ACQUISITIONS (M&A)

BROWNFIELD INVESTMENT

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 FOREIGN DIRECT INVESTMENT
• FDI takes broadly three forms which are
mentioned above.

1. Greenfield investment:- investment can be

made through opening of branch in a host-
country or through making investment in the
equity capital of the host-country firm.
Ex:- Rs.32,000 crores FDI by BP of Britan
company in RIL, agreement made by both
the companies on 21st February, 2011.

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2. M&A :- M&A are either outright purchase of a
running company abroad or an amalgamation
with a running foreign company.
• Merging: when two or more existing firms
combine together and form a new entity. Either a
new company be incorporated for this purpose or
one existing company (generally a bigger one)
survives and another existing company is merged
into it.
• Acquisition: Which refers to the acquiring of
ownership right in the property and asset
without any combination of companies.
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• M&A may be different types:
a) Horizontal M&A: when two or more firms
engaged in similar line of activities combine.
b) Vertical M&A: which occurs firms involved in
different stages of production of a single final
product.
Ex:- merger of an oil exploration unit with a
refining unit is vertical.
A cricket bat manufacturing company
merging with a wood production company.

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c.Conglomerate Merger: when M&A is taken
between two or more firms that are totally
unrelated business activities.
3. Brownfield Investment: it is a combination of
Greenfield Investment and M&A.
• It exists when a company first goes for
international M&A and then makes huge
investment for replacing plant and machinery
in the target company.

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 Contractual entry modes

Establishing
Joint Management New
Licensing Franchising
venture Contracts Foreign
Subsidiaries

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 Licensing
• A firm in one country licensees the use of
some or all of its intellectual property
(patents, trademarks, copyrights, brand
names) to a firm of some other country in
exchange for fees or some royalty payment.

• Licensing enables a firm to use its technology

in foreign markets without a substantial
investment in foreign countries.

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• Licensing provides advantages to both parties.
The licensor receives profits in addition to these
generated from operations in domestic markets.
• These profits may be additional revenues from a
single process or method used at home that the
manufacturer is unable to utilize abroad.
• Low financial risk to licensor.
• Less efforts, licensor can investigate the foreign
market.
• Licensee escapes himself from the risk of
product.
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 Franchising
• A firm in one country is authorising a firm in
another country utilise its brand names, logos
etc. in return for royalty payment.
• The franchising can exercise more control over
the franchised compared to that in licensing.
International franchising is growing at a fast rate.
• Under franchising, an independent organisation
called the franchisee operates the business
under the name of another company called the
franchiser.
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 Services to Franchisee
• Under this agreement the franchisee pays a
fee to the franchiser. The franchiser provides
the following services to the franchisee.
• Trade marks.
• Product reputations
• Continuous support system like advertising,
employee training, quality assurance
programmes.

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• Franchising is one of the most popular business formats
today. Popular name brands such as McDonalds and
Subway are international franchise name brands. All
franchise agreements are licensing agreements but not
all licensing agreements are franchises.

36,398 Restaurants in 100 countries

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 Advantages of Franchising
• Franchise can easily start a business with low risk.
• Franchiser can enter global market with low
investment and low risk.
• Franchiser can get the information regarding the
market culture, customs and environment of the
host country.
• Franchiser learn more lessons from the experiences
of the franchisee.
• Franchise get the benefits of R&D with low cost.
• Franchise escapes from the risk of product feature.

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 Joint venture

• A corporate entity or partnership that is jointly

owned and operated by two or more firms is
known as joint venture.
• Joint ventures allow two firms to apply their
respective comparative advantage in a given
project.

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REASON FOR JV’s
 JV provides a lower risk option of entering
into a new country. .example- motorola enterred
india in JV with blue star company, a brand with
repute and vast distribution network.
 It also provides an opportunity for both
the partners to leverage their core strengths and
increase the profits.
 It also provides a learning opportunity
for both the partners.
Tuesday, April 19, 2022 64
Example :-

• Tyson Foods (US) and Godrej Agrovet

• Marks & Spencer (UK) and Reliance Retail of
India

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• In some cases access to technology or capital
provides sufficient confidence in the partners
to go alone, making the JV unnecessary
• For example- JV between TVS group (INDIA)
and Suzuki(japan) formed in 1983 was called
off in 2001.

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• Advantages of JV’s:
• 1. JVs are commonly used because they offer
important advantages to the foreign firm.
• 2. by bringing in a partner, the company can
share the risk for a new venture.
• JV partner may also have important skills or
contracts of value to the international firm.
• Sometimes, the partner may be an important
customer who is willing to contract for a
portion of the new units output in return for
an equity participation.
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 Management contracts

• A firm in one country agrees to operate

facilities or provide other management
services to a firm in another country for a
agreed upon fee.

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 Establishing new foreign subsidiaries
• A firm can also penetrate (enter) foreign
markets by establishing new operations in
foreign countries to produce and sell their
products.
• The advantage here is that the working and
operation of the firm can be tailored exactly to
the firms needs.
• However, a large amount of investment is
required in the method.

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• The above mentioned methods which help
multinational enterprises establish their
presence in foreign locations must attempt to
answer to basic questions.

• will the expected benefits to be derived from

any of these arrangement exceed its costs

• If yes, which arrangement will provide the

largest net benefit

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• The most frequently is used method to
compare the net benefits from any given
arrangement is to compare a stream of future
costs with a stream of future benefits by
discounting them to their present value.
• The adjustment associated with the risk and
uncertainty of the projection should also be
taken into account here.

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• In practice, however, the corporate analyst will
realise the problems associated with calculating
some costs and benefits due to some hard to
quantify factors that may affect the decision.
• The relative merits of the different arrangements
depends on the answer to two questions.

• What is the size of the difference when one arrangement

outweighs (offset) another in some element of cost or benefit.

• If one arrangement is ranked high in one area and low in another,

can some common measure be applied so that a final decision can
be reached by the manager.
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• The challenge for multinational
managers is to find that form of
international business activity
that is most consistent with his
or her strategy.
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