International Business

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INTERNATIONAL BUSINESS
‡ Involves commercial activities that cross national frontiers. ‡ Concerns: ‡ International movement of goods, capital services, employees & technology; ‡ Importing & exporting; ‡ Cross-border transactions in intellectual property (patents, trademark, know-how, copyright materials etc.) via licensing & franchising; ‡ Investments in physical & financial assets in foreign countries; & ‡ Establishment of foreign warehousing & distribution systems.

Special problems associated with International Business in comparison to business at home««.. ‡ Deals have to be transacted in foreign languages under foreign laws, customs & regulations; ‡ Transactions to be executed by foreign currencies affected by exchange rate variations; ‡ Influence of cultural differences; ‡ Control & communication systems normally more complex; ‡ Risk levels (Political, Commercial & financial risks) are higher in foreign markets.

Why firms engage in international business?
‡ Commercial risk can be spread across several countries; ‡ Can facilitate µExperience Curve Effect¶ ‡ ( i.e. cost reductions and efficiency increases attained in consequence of a business acquiring experience of certain types of activity, function or project); ‡ Gains through µEconomies of Scope¶ ‡ (i.e. unit cost reductions resulting from a firm undertaking a wide range of activities, & hence being able to provide common services and inputs useful for each activity); ‡ Company¶s overall strategies can be anchored against a wide range of international opportunities ± sudden collapse in market demand in some countries may offset by expansions elsewhere.

Process of Internationalization
‡ Receipt of an unsolicited order from abroad or a foreign firm offering to supply materials or other inputs; ‡ Establishment of an export / import department; ‡ Gradually dispensing with export-import intermediaries (acquiring detailed knowledge of foreign export / import procedures);

Process of Internationalization««.
‡ Start conducting its own marketing research, place advertisement directly in foreign media, organize transport to or form foreign destinations, & raise finance from foreign sources. ‡ Now, the company may license foreign companies to produce its brands, or engage in franchising or local manufacturer ± becomes a genuine international business, though foreign markets are still controlled & solved from home nation.

Process of Internationalization««.
‡ As more & more of its activities take place in foreign countries, & as sales and profits become critically dependent on world markets, so the business moves towards becoming an MNC; ‡ i.e. one that owns production, distribution, service and other units in many nations & importantly plans the utilization of its resources on the global scale (Samiee & Roth,1992).

Theories of International Trade
‡ A well developed global financial system is essential for supporting increased international trade & the basis of this increase refers to the evolution of certain major theories. Theory of Absolute Advantage; Theory of Comparative Advantage; Heckscher-Ohlin Model; Imitation Gap Theory; International Product Life Cycle Theory.

1. 2. 3. 4. 5.

1) Theory of Absolute Advantage
‡ Developed by Adam Smith in 1776; ‡ Holds that consumers will be better-off if they can buy foreign made products that are priced more cheaply than domestic one. ‡ As per the theory, a country may produce goods more efficiently because of a natural advantage (e.g. raw materials or climate) or because of acquired advantage (e.g. technology or skills). ‡ Assumptions: Full employment, No transportation cost, comparability of price across countries & perfect mobility of labour.

Theory of Absolute Advantage«« A Hypothetical Situation
± Country X Country Y Resource available 100 units 100 units Requirement to produce 1 TV 10 units 5 units Requirement to produce 1 ton rice 4 units 20 units Both countries use half of the total resources per product when there is no foreign trade. ± Production (without Trade) Country X Country Y Total ± Production (with Trade) Country X(only tons of Rice) Country Y(only TV) Total TV(units) 5 10 15 TV(units) 20 20 Rice(units) 12 ½ 2½ 15 Rice(units) 25 tons 25

If each country specialized in the commodity for which it has an absolute advantage, then production of both products can be increased.

Theory of Absolute Advantage«« Limitations
1) It explains the causes of trade between two countries only in those situations where both the countries enjoy absolute advantage in production of at least one product. It assumes non-existence or insignificant cost of transportation, which does not always hold well. The assumption that prices are comparable across countries implies stability of exchange rate. Theory assumes mobility of labour from other sectors to a particular sector, where the country enjoys comparative advantage in production, which does not actually exist.

2) 3) 4)

Theory of Comparative Advantage
‡ David Ricardo¶s(1817) Comparative Advantage theory holds that total output can be increased through foreign trade, even though one country may have an absolute advantage in the production of all products.

Theory of Comparative Advantage A Hypothetical case
±
Country X Country Y Resource available 100 units 100 units Requirement to produce 1 TV 10 units 5 units Requirement to produce 1 ton rice 10 units 4 units Both countries use half of the total resources per product when there is no foreign trade. ± Production (Without trade-state of autarky) Country ± X Country ± Y Total TV 5 units 10 units 15 units Rice 5tons 12 ½ tons 17 ½ tons

± Country Y has an absolute advantage in producing both products, but has a comparative advantage in producing rice.

Hypothetical case«««.
± With trade - Increasing TV Production Country ± X Country ± Y Total TV Rice 10 units 0 tons 6 units 17 ½ tons 16 units 17 ½ tons

± If the combined production of rice is unchanged from where there was no trade, country Y can produce all 17 ½ tons by using 70 units of resources and rest 30 units
can be used to produce TV.

± With trade - Increasing Rice Production Country ± X Country ± Y Total

TV Rice 10 units 0 tons 5 units 18 ¾ tons 15 units 18 ¾ tons

Hypothetical case«««.
‡ If the combined TV production is unchanged from time before trade, country X could produce 10 units by all resources and country Y required 25 units of resources to produce the rest 5 sets. ‡ The remaining 75 units of resources of country Y can produce 18 ¾ tons of rice. ‡ Whether the production target is an increase of TV or rice or both, two countries can gain by having X trade some of its rice production to Y for some of that country¶s TV production.

Assumptions
1. Perfect competition with flexible prices and wages prevails in both the countries. This results in the prices of TV & rice being different in X & Y due to a difference in labour hours used & hence production costs. Labor is the only factor of production & the average product of labour is constant for producing both the products in both the countries. There is full employment in both the countries. Labour is perfectly mobile among various sectors but perfectly immobile between countries. No technological innovation takes place in any of the economies. It suffers from all the drawbacks associated with the assumptions; yet this theory is one of the closest explanations of international trade.

2. 3. 4. 5. ‡

HECKSCHER-OHLIN MODEL (Factor-Proportion Theory)
‡ Model developed in 1920s holds that a country¶s relative endowments of land, labour and capital will determine the relative cost of these factors. ‡ If labour were abundant in relation to land & capital, labour cost would be low and land & capital costs high; & vice versa. ‡ These factor costs, in turn, will determine which goods the country can produce more efficiently. ‡ The reason two countries operating at the same level of efficiency can, and do benefit from trade can be traced to the differences in their factor endowment.

‡There are two types of products ± labour & capital intensive, to be produced by labour and capital rich countries respectively; then the two countries will trade these goods to get the benefits of international trade.

‡ Assumptions: ‡ No obstruction to trade(e.g. trade controls, transportation cost etc.) are there; ‡ Both commodity & factor markets are perfectly competitive; ‡ There are constant or decreasing return to scale; ‡ Both countries have same technology & hence operate at same level of eficiency; ‡ Two factors of production exist ± labour & capital. Both are perfectly immobile for inter-country transfers, but perfectly mobile for inter-sector transfer.

Limitations
‡ It assumes that factor endowments are given, where as they can also be developed though innovations. ‡ Due to minimum wage laws in some countries, the factor prices may change to such an extent, that an otherwise labour-rich country may find it cheaper to import labour intensive goods than to produce them locally. ‡ The findings of an empirical study by economist Wassily Leontief pointed out that despite being a capital-rich country,US exports are more labor-intensive than capital intensive (Leontief Paradox).

IMITATION-GAP THEORY
‡ Developed by Posner, the theory considers possibility between two countries having similar factor endowments and consumer tastes because of existence of inventions & innovations in existing products. ‡ Degree of trade between such countries will depend upon the difference between the µdemand lag¶ and the µimitation lag¶. ‡ Demand Lag is the difference between the times a new or an improved product is introduced in one country, and the time when consumers in the other country start demanding it.

Demand Lag depends on: 1) speed & effectiveness of flow of information, 2) readiness of the consumers of the second country to use innovative products, 3) ability & timing to convert their desire to demands. ‡ Imitation Lag is the difference between the time of introduction of the product in one country, and the time when the producers in the other country start producing it. Imitation Lag depends on: Readiness of the second country to adopt new technology; Time taken by the second country to learn the new process; Likelihood of the second country developing the technology on their own due to a constant process of R&D. If due to any of the above factors, the imitation lag is shorter than the demand lag, no trade will take place between the two countries. Normally demand lag is shorter than imitation lag ± country coming out with innovation starts exporting to the second country ± as awareness create demand there ± export continues till demand lag is over.

‡ 1. 2. 3. ‡ ‡

‡If local producers can start producing before the last part, they can arrest the growth of the importers (imitation lag); at the end of the imitation lag, the trade will start coming down and shall be finally eliminated.

‡ ‡ 1. 2. ‡ 1. 2. 3.

INTERNATIONAL PRODUCT LIFE CYCLE THEORY Two important principles of this theory (Raymond Vernon): New products are developed as a result of technological innovation; Trade patterns are determined by the market structure and the phases in new product¶s life. The introduction stage is marked by: Innovation in reference to observe need; Exporting by the innovative country; Near monopoly position ± sales based on uniqueness rather than price ± evolving product characteristics.

INTERNATIONAL PRODUCT LIFE CYCLE THEORY«««««..
‡ 1. 2. 3. ‡ 1. The Growth stage is marked by: Increases in exports by innovating country; More competition ± some competitors begin price cutting ± product becoming more standardized; Increased capital intensity. The Maturity Stage is characterized by: Factor requirement changes & also change in the centre of production from innovative country to other developed country ± offering a cost advantage due to a more suitable pattern of factor prices; More standardization of product; More capital intensity & increased competitiveness of price.

2. 3.

INTERNATIONAL PRODUCT LIFE CYCLE THEORY«««««..
‡ 1. 2. ‡ 1. 2. 3. The Decline stage is marked by: Concentration of production in LDCs as now it would become possible to produce the good with relatively unskilled labour; Innovating country becoming net importer. There are certain products for which production movements do not take place: Products having extremely short life cycle because of rapid innovations (electronic products); Luxury products for which cost is of little concern to the consumer; Products for which international transportation cost is high,& so no opportunity for export in any stage of life cycle.

Intra-Industry Trade
‡ Refers to simultaneous import and export of the same product by a single country; Reasons: Transportation Costs (Geographical advantage); Seasonal differences (for agricultural produce); Product differentiation (superior quality capitalintensive products vs. labour-intensive and lower quality capital intensive products) :If demand for both types of goods exists in both countries, it may result in intra-industry trade.

‡ 1. 2. 3.

Factors affecting International Trade
1. High re-entry costs: A firm temporarily facing a slump in international demand and/or price for its product may have to continue its supply, even if it is not economically justifiable, due to high re-entry costs.

2. Economies of Scale: A firm may be able to export even without comparative advantage, as a result of economies of scale. 3. Currency value: Exchange rates may increase or decrease the competitiveness of a product in the international market.

Factors affecting International Trade««««
4. Strong customer tastes for costlier brand & imperfect competition (because of non-availability of information of cheaper product) would distort the trade patterns. 5. Although most trade theories deal with cross-country benefits and costs, trading decisions are usually made at the company level ± companies must have competitive advantages to be viable exporters. 6. Companies may seek trading opportunities in order to use excess capacity, lower production costs, or spread risk.

BALANCE OF PAYMENTS
‡ A country¶s BOP affects the value of its currency, its ability to obtain currencies of other countries and its policy towards foreign investment in a given period, usually one year. ‡ International managers may be interested in a foreign country¶s BOP for predicting the country¶s overall ability regarding: ‡ exports & imports; ‡ the payment of foreign debts; ‡ dividend remittances.

Balance of Payments Accounting
‡ Like other accounting statements, BOP conforms to the principle of double entry bookkeeping. ‡ BOP is a sources & uses of funds statement that reflects changes in assets, liabilities and net worth during a specified period of time. ‡ Decreases in assets & increases in liabilities or net worth represent credit or sources of funds & vice-versa.

Balance of Payments Accounting««««.
‡ Sources of funds include exports of goods & services, investment & interest earnings, unilateral transfers received from abroad & loans from foreigners. ‡ Uses of funds include imports of goods & services, dividends paid to foreign investors, transfer payments abroad, loans to foreigners & increase in reserve assets. ‡ Uses > Sources = Deficit ‡ BOP account shows the size of any surplus or deficit which a nation can have & also indicate the manner in which a deficit was financed or a surplus invested.

Debits & Credits in BOP
‡ Credit transactions[+] are those that involve the receipt of payment from foreigners: ‡ a) Exports of goods or services; ‡ b) Unilateral transfers (gifts) received from foreigners; ‡ c) Capital inflows. ‡ Debit transactions [-] are those that involve the payment of foreign exchange: ‡ a) Import of goods & services; ‡ b) Unilateral transfers (gifts) made to foreigners; ‡ c) Capital outflows.

Capital Inflows
‡ Can take either of two forms: ‡ a) An increase in the foreign assets of the nation; & ‡ b) A reduction of the nation¶s assets abroad. ‡ Example: 1)When a US resident acquires a stock in an Indian company, foreign assets in India go up ± as it involves the receipt of a payment from a foreigner. ‡ 2) when an Indian resident sells a foreign stock - Indian assets abroad decreases ± involving receipt of a payment from a foreigner ± resulting in capital inflows to India.

Capital Outflows
‡ ‡ ‡ ‡ Can take either of two forms: An increase in nation¶s assets abroad; A reduction in the foreign assets of the nation. Example: 1) Purchase of a UK Treasury bill by an Indian resident ± resulting in an increase in the Indian assets abroad and is a debit transaction - involving a payment to foreigners. ‡ 2) Sale by a US firm of an Indian subsidiary ± reduces foreign assets in India and is entered as a debit transaction.

BOP Statement
‡ BOP statement records all types of international transactions that a country consummates over a certain period of time ± divided into three distinct sections: 1. The Current Account, 2. The Capital Account, 3. The Official Reserve Account

A. The Current Account
‡ ‡ Divided into three sub-categories: merchandise trade balance, services balance & balance on unilateral transfers. Entries in this account are µcurrent¶ in value as they do not give rise to future claims. Current Account balance= A[1] +A[2]+A[3] Balance of merchandise trade refers to the balance between exports and imports of tangible goods such as automobiles, computers, machinery & so on««A[1].

‡ 1.

A. The Current Account««.
2. Services account includes interest payments, shipping & insurance fees, tourism, dividends & military expenditures. These trades in services are often called as invisible trade«A[2] Unilateral transfers are gifts and grants by both private parties & government. Private gifts & grants include personal gifts of all kinds & also relief organization shipments. Government transfers include money, goods & services sent as aid to other countries. Unilateral transfers have only one-directional flow without offsetting flows. For double entry bookkeeping, unilateral transfers are known as an act of buying goodwill from the recipient«..A[3]

3.

‡ ‡

Current Account (Summary)
‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ Goods Account Merchandise Exports (+) Merchandise Imports (-) Balance on goods account = A(1) Services Account Receipts as interest & dividends, tourism receipts for travel & financial charges(+) Payments as interest & dividends, tourism payments for travel & financial charges(-) Balance on services account = A(2) Unilateral Transfer Gifts, donations, subsidies received from foreigners (+) Gifts, donations, subsidies made to foreigners (-) Balance on unilateral transfer account = A(3) CURRENT ACCOUNT BALANCE = A(1) + A(2) + A(3)

B. The Capital Account
‡ An accounting measure of total domestic currency value of financial transactions between domestic residents and the rest of the world over a period of time. ‡ Consists of loans, investments, other transfers of financial assets & the creation of liabilities. ‡ Includes financial transactions associated with international trade as well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits.

B. The Capital Account««.
‡ A country¶s current account deficit must be paid for either by borrowing from foreigners or by selling off past foreign investments. ‡ In the absence of a government reserve transaction, a current account surplus equals a capital account deficit & vice-versa : i.e. current account balance must be equal to capital account balance but with the opposite sign. ‡ Three sub-categories: direct investment, portfolio investment & other capital flows. ‡ Capital Account balance = B[1] +B[2] +B[3]

B. The Capital Account««.
‡ Direct investment occurs when the investor acquires equity such as purchases of stocks, the acquisitions of entire firms, or the establishment of new subsidiaries«..B[1] ‡ FDI generally takes place when firms tend to take advantage of various market imperfections. ‡ Firms also undertake FDI when expected returns from foreign investments exceed the cost of capital, allowing for foreign exchange & political risk.

B. The Capital Account««.
‡ Portfolio investments represent sales & purchase of foreign financial assets such as stocks and bonds that do not involve a transfer of management control«.B[2] ‡ Investors generally feel that they can reduce risk more effectively if they diversify their portfolio holdings internationally, rather than pure domestically. ‡ Capital flows represent the third category & refers to claims with a maturity of less than one year (bank deposits, S-T loans, S-T securities, money market investments etc.)««B[3]

B. The Capital Account««.
‡ 1. Short-term capital accounts change for two specific reasons: Compensating or accommodating adjustments are short-term capital movements induced by changes due to merchandise trade, services, unilateral transfers and investments. Autonomous adjustments are short-term capital movements due to differences in interest rates and also expected changes in foreign exchange rate among nations ± take place for pure economic reasons.

2.

Capital Account (Summary)
‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ Foreign Direct Investment (FDI) Direct investment by foreigners (+) Direct investment abroad (-) Balance on direct foreign investment =B(1) Portfolio Investment Foreigners¶ investment in the securities of the country (+) Investment in securities abroad (-) Balance on portfolio investment = B(2) Balance on long-term capital account= B(1) + B(2) Private short-term Capital Flows Foreigners¶ claim on the country (+) Short-term claims on foreigners (-) Balance on short-term private capital account = B(3) OVERALL BALANCE =[ A(1)+A(2)+A(3)] + [B(1)+B(2)+B(3)] ERRORS & OMISSIONS

Errors & omissions
‡ 1. 2. 3. 4. Collectively termed as µStatistical Discrepancy¶ arise for different reasons: Difficulties involved in collecting BOP data ( in India, the trade figures compiled by RBI differ from compiled by DG of Commercial intelligence & Statistics). Movements of capital may precede or follow the transactions that are supposed to finance. Certain figures are based on estimates (figures for earning in the travel & tourism account are estimated on the basis of sample cases). Lastly, errors & omissions are explained by unrecorded illegal transactions that may be either on the debit side or the credit side or on both.

C. The Official Reserve Account
‡ Official reserves are government owned assets represent only purchases & sales by the Central Bank of the country. ‡ The changes in official reserves are necessary to account for the deficit or surplus in the BOP. ‡ If the country has a BOP deficit, the Central Bank will have to either run down its official reserve assets such as gold, foreign exchanges and SDRs or borrow fresh from foreign central banks.

C. The Official Reserve Account««««.
‡ Special Drawing Rights : sometimes called paper gold, are special account entries on the IMF books designed to provide additional liquidity to support growing world commerce. ‡ Although SDRs are a form of money not convertible to gold, their gold value is guaranteed, which helps to ensure their acceptability. ‡ Participating nations may use SDRs as a source of currency in a spot transaction, as a loan for clearing a financial obligation, as a security for a loan, as a swap against currency, or in a forward exchange operation. ‡ If the country has a BOP surplus, its central bank will either acquire additional reserve assets from foreigners or retire some of its foreign debts.

Illustration [How transactions affect BOP]
‡ Merchandise trade: An Indian company sells Rs.4,00,000 worth of machinery to a US company, which will make payment in 30 days. ‡ In this transaction, merchandise exports are credited as they provide India with an increase in its claim on foreigners. Simultaneously, Indian exporter should increase its short term investment abroad, i.e., an increase in its AR ± represent a use of funds or a debit entry. ‡ Transaction will appear in Indian BOP as follows: ‡ Liquid short-term capital [debit] Rs.4,00,000 ‡ Exports [credit] Rs.4,00,000

Illustration [How transactions affect BOP]
‡ Services: An Indian woman visiting her son in UK, cashes Rs.3,00,000 worth of her Indian Traveller¶s cheque at a UK hotel & spends the whole prior to return to India. ‡ Here, India received tourist services from UK to the amount of Rs.3,00,000 ± a use of funds. In return to these tourist services, UK banks now have Rs.3,00,000 worth of Indian currency ± a source of funds. ‡ Transaction will appear in Indian BOP as follows: ‡ Tourist Expenditure [Debit] Rs.3,00,000 ‡ Liquid short-term capital [Credit] Rs.3,00,000

Illustration [How transactions affect BOP]
‡ Unilateral Transfer: the US Red Cross sends $10,00,000 worth of flood relief goods to India. ‡ The term µtransfer¶ reflects the nature of the transaction ± US receives nothing in return & this transaction reduces the real assets of USA ± thus to be debited. The sale /unilateral transfer by USA represents exports & these exports are credited. ‡ Transaction will appear in USA BOP as follows: ‡ Transfer Payments [Debit] $10,00,000 ‡ Exports [Credit] $10,00,000

Illustration [How transactions affect BOP]
‡ Long-term Capital: A Japanese purchases yen 60,000 worth of UK bonds and pays for it with a cheque drawn on an account. ‡ The Japanese now owns a UK bond, while UK owns Japanese yen deposits. Since the acquisition of the UK bond increases Japan¶s portfolio of bank investments in foreign countries, the portfolio investments must be debited. ‡ Similarly, yen balance owned by UK represents an increase in Japan's liability to foreigners & thus short-term capital be credited. ‡ Transaction will appear in Japan¶s BOP as follows: ‡ Portfolio Investments [Debit] yen 60,000 ‡ Liquid short-term capital [Credit] yen 60,000

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