04 Economics

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The Economic Environment


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Trade Theory Overview

Free Trade occurs when a government doesnot attempt to influence, through quotas orduties, what its citizens can buy fromanother country or what they can produceand sell to another country

The Benefits of Trade allow a country to

specialize in the manufacture and export ofproducts that can be produced mostefficiently in that country


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Trade Theory Overview

The Pattern of International Trade displayspatterns that are easy to understand (SaudiArabia/oil or China/crawfish)

Others are not so easy to understand (Japanand cars) The history of Trade Theory and government

involvement presents a mixed case for the

role of government in promoting exports andlimiting imports Later theories appear to make a case for

limited involvement


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Theories of International Trade

Mercantilism

Theory of absolute advantage

Theory of comparative advantage Heckscher-Olin Theory

Product life-cycle theory

Porters diamond


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Product Life-cycle Theory

As products mature, both location ofsales and optimal production changes

Affects the direction and flow of importsand exports

Globalization and integration of the

economy makes this theory less valid


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International Product Life Cycle

(IPLC) IPLC is a theory explaining why a

product that begins as a nations

export eventually becomes its import Four stages of the IPLC in the United

States:

1) U.S. exports2) Foreign production begins

3) Foreign competition in exportmarkets

4) Import competition in the U.S.


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Stages of the International

Product Life Cycle

Stage 1 - U.S. Exports

Manufacturers search for better ways tosatisfy their customers needs.

U.S. is a leader in new product introduction.

For a while, American firms will be the onlymanufacturers of the new product.

The export market develops for overseascustomers.


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Product Life Cycle

Stage 2 - Foreign Production

BeginsExport volume grows and becomes large

enough to support local production.

Foreign production begins.The American firm will still be exporting to

those markets where there is no production,but its export growth will diminish.


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Product Life Cycle Stage 3 - Foreign Competition in Export

Markets

As early foreign manufacturers gain experience inmarketing and production, their costs will fall.

Saturation of the foreign local markets will causeforeign manufacturers to look for buyers elsewhere.

Foreign firms are competing in export markets, andAmerican export sales will continue to decline.


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Product Life Cycle

Stage 4 - Import Competition in the

U.S.Foreign producers may attain economies of

scale where they can compete in qualityand undersell American firms in the

American market.

For that point on, the U.S. market will beserved by imports only.


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International Technology Life Cycle

Initial Stage:Development of new technology in an

industrialized country

Subsequently exported to other developedcountries:Increasing cost of labor make it no longer

profitable to use in developed nation

Technology exported to developing nation Technology produced abroad for domestic

consumption


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Theory of National Competitive

Advantage The theory attempts to analyze the reasons for

a nations success in a particular industry

Porter studied 100 industries in 10 nations

Postulated determinants of competitiveadvantage of a nation were based on four majorattributes

Success occurs where these attributes exist

More/greater the attribute, the higher chance ofsuccess


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National Competitive Advantage

National Competitive Advantage theorystates that a nationscompetitiveness in an industry depends on the capacity of the industryto innovate and upgrade.

Firm Strategy,

Structure, & Rivalry

Related &

Supporting

Industries

DemandConditions

FactorConditions


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Regional Economic Integration

Free trade area

Customs union Common market

Economic union

Political union


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Foreign Investment

Two components of foreign investment:

Portfolio investment:

Purchase of stocks and bonds solely for the purposeof obtaining a return on the funds invested

Direct investment:

Investors participate in the management of the firm

in addition to receiving a return on their money Applies when investors equity participation ratio is

10 percent or more


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What is Foreign Direct Investment

Company acquiring or merging with a firmin a different country

A firm creating a Greenfield operation in

a different country A firm creating a subsidiary in a different

country As a result: The firm has significant control of its foreign

operation Firm can affect managerial decisions of the

foreign operation


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Growth of FDI

Globalization

Mergers and Acquisitions

Entrepreneurship and Small Businesses

Technology


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FDI - Flow versus Stock

FDI occurs when a firm invests directly infacilities to produce and/or market aproduct in a foreign country

Flow - amount of FDI over a period of time(one year)

Stock - total accumulated value of foreignowned assets at a given point in time

FDI is not the investment by individuals,firms or public bodies in foreign financialinstruments


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Why is FDI Important ?

Firms want a presence in foreign markets

Firms want control over growth of theseforeign markets;

To gain first mover advantages

To ward off competitors

To determine locations, advertising and

other related strategic decisions in the firmsinterest


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Trends in FDI

Flow and stock increased in the last 20years

In spite of decline of trade barriers, FDIhas grown more rapidly than world trade:

Businesses fear protectionist pressures FDI is seen a a way of circumventing trade

barriers

Dramatic political and economic changes inmany parts of the world

Globalization of the world economy hasraised the vision of firms who now see the

entire world as their market


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Worldwide Flows of FDI

More than 60,000 multinational companies with over800,000 affiliates abroad are driving the FDI.

Developed countries account for more than three-quarters

of global FDI inflows, amounted to a little over $1 trillion in2000.

Among developed countries, the European Union (EU),the United States, and Japan accounted over 70 percentof world inflows and 82 percent of outflows in 2000.

The United States remains the worlds largest FDIrecipient country with inflows of $281 billion, andaccounted for $139 billion of outflows.


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FDI Outflows, 1982-2002


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Growth in World Exports

World GDP and FDI 1990-2001 (index = 100 in 1990)


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Inward FDI Flows

As a percentage of gross fixed capital formation, 2000


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U.S. Foreign Direct Investment

The United States is by far the largestforeign investor

American firms have invested muchmore in developed nations than theyhave in developing nations


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Foreign Direct Investment in the U.S.

Foreign direct investment in the United

States rose rapidly from$185 billion in 1985 to $1,321 billion in 2001

Over 80 percent of the total stock wasowned by firms or individuals from just sevennations:

United Kingdom, Japan, Netherlands, Germany,France, Switzerland, and Canada


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Why FDI Occurs?


Market Imperfections

Eclectic Theory Market Power


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In the new product stage, a good is produced inthe home country because of uncertain domesticdemand and to keep production close to theresearch department that developed the product.

In the maturing product stage, the companydirectly invests (FDI) in production facilities incountries where demand is great enough towarrant its own production facilities.

In the standardized product stage, increasedcompetition creates pressures to reduceproduction costs.


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Market Imperfections

Perfect Market: Amarket that is said tooperate at peakefficiency (prices are as

low as they canpossibly be) and wheregoods are readily andeasily available.

Market Imperfections:When an imperfectionin the market makes atransaction less

efficient than it couldbe, a company willundertake FDI tointernalize thetransaction and

thereby remove theimperfection.

Market imperfections: Trade barriers

Specialised Knowledge

Specialised assets


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Eclectic Theory

The eclectic theory states that firms undertake foreigndirect investment when the features of a particularlocation combine with ownership and internalizationadvantages to make a location appealing for investment:

Location Advantageis the advantage of locating a particulareconomic activity in a specific location.

Ownership Advantageis the advantage that a company hasdue to its ownership of some special asset, such as brand

recognition, technical knowledge, or management ability.

An Internalization Advantageis the advantage that arises frominternalizing a business activity rather than leaving it to arelatively inefficient market.


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Market Power

The Market Power theory states that afirm tries to establish a dominant marketpresence in an industry by undertaking

FDI Vertical Integrationthe extension of

company activities into stages of

production that provide a firms inputs(backward integration) or absorb itsoutput (forward integration)


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Two Forms of FDI

Horizontal Direct Investment: FDI in the same industry abroad as

company operates at home

Vertical direct investment: Backward - investments into industry that

provides inputs into a firms domesticproduction (typically extractive industries)

Forward- investment in an industry thatutilizes the outputs from a firms domesticproduction (typically sales and distribution)


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Type of FDI: Greenfield versusAcquisitions

Green fieldoperation:

Mostly in

developingnations

Mergers andacquisitions: Quicker to execute. Foreign firms have

valuable strategic assets Believe they can increasethe efficiency of theacquired firm

More prevalent in

developed nations


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FDI When and Why?

Transportation costs are high

Market Imperfections (Internalization Theory):

Impediments to the free flow of products between

nations Impediments to the sale of know-how

Follow the lead of a competitor - strategic rivalry

Product Life Cycle - however, does not explain

when it is profitable to invest abroad

Location specific advantages (natural resources)


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A New Form of FDI - Remittances

Remittances are the money that immigrantworkers send to their families back home

Economists tout remittances as the developingworlds most reliable and broadly based sourceof financing

Remittances have become a new form offoreign aid

Traditional FDI is still larger but tends tofluctuate with global economic swings

Remittances now dwarf the amount of officialdevelopment assistance poor countries receive


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Remittances

Financial flows to developing countries(2001):

FDI $170 billions

Official aid - $28 billions

Remittances - $72 billions

In some low-income countries remittances

can account for up to 15% of annualgross domestic product


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Remittances

These revenue streams:

Help alleviate poverty

Spur investments

Cushion the impact of worldwide recession whenprivate capital dies up

Labour mobility leads to higher global standardsof living a 10% increase in immigration from a

developing country will produce a 2% decline inthe number of people scraping by on less than$1 a day


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Remittances

Many remittance recipient still use the moneyfor basic needs, such as food and consumergoods

Economists also say that the money has atrickle-down benefit or multiplier effect:

For every dollar sent home, three more dollars isgenerated back home in the form of construction

material, food, or contract work In the Philippines, for example, overseas

employment has built more homes than the all ofthe government's housing programmes


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Remittances

Experts are also rethinking one argumentagainst easy migration that it will lead to abrain drain, emptying countries of their mostcapable workers

The strong flow of money from migrants to thehome country and its impact on the economyclearly shows that the effects of a brain drain isnot completely to the detriment of the home

economy Besides, many migrants eventually come home

and bring back their enhanced capabilities andskills, and their added wealth


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Remittances

However, some experts worry that developingcountries may become too dependent on themunificence of their expatriate population

Some government may even postpone theimplementation of vitally important economicreforms

It is countries like the Philippines, which have

little other significant sources of foreignexchange that are in the most vulnerableposition


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Growth of Remittances

Growth of remittances (US$ billions):

Latin America/Caribbean: 67%

South Asia: 50%

Mideast/N. Africa: -20%

East Asia/Pacific: -10%

Europe/Central Asia: 33%

Sub-Sahara Africa: - 17%


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Sources of Remittances

Top sources of remittances (US$ billions): USA 28.4

Saudi Arabia 15.1

Germany 8.2

Belgium 8.1

Switzerland 8.1

France - 3.9

Luxemburg 3.1

Israel 3.0

Italy 2.6

Japan 2.3


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Destinations of Remittances

Top destinations of remittances (US$ billions): India 10.0 Mexico 9.9 Philippines 6.4

Morocco 3.3 Egypt 2.9 Turkey 2.8 Lebanon 2.3

Bangladesh 2.1 Jordan 2.0 Dominican republic 2.0 Vietnam 2.0


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Political Ideology and FDI

RadicalView

PragmaticNationalism

FreeMarket


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Radical View

Marxist view, that MNEs exploit lessdeveloped host countries: Extract profits

Give nothing of value in exchange Instrument of domination not development Keep less-developed countries relatively

backward and dependent on capitalist

nations for investment, jobs, and technology


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Radical View

Radical view was popular (1945-80)

among: Communist countries (China, Cuba) Socialist countries in Africa Nationalistic countries (Iran, India)


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Radical View - Short Lived

By end 1980s radical view was in retreat:

Collapse of communism

Bad economic performance of countries thatembraced the radical view

Strong economic performance of countrieswho embraced capitalism rather than the

radical view


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Free Market View

.

Nations specialize in goods and servicesthat they can produce most efficiently

Resource transfers benefit and strengthenthe host country Positive changes in laws and growth of

bilateral agreements attest to strength of

free market view However, all countries impose somerestrictions on FDI


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Pragmatic Nationalism

FDI has benefits and costs

Allow FDI if benefits outweigh costs:

Block FDI that harms indigenous industry

Court FDI that is in national interest:

Tax breaks

Subsidies

Three Main Ideological Positions


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Three Main Ideological PositionsRegarding FDI


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Benefits of FDI to Host Countries

Resource-transfer effects;

Capital

Technology

Management

Employment effect:

Direct

indirect


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Benefits of FDI to Host Countries

Balance-of-payments effect:

Current account-surplus/deficit

Capital account

Increases competition and spurseconomic growth


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Resource Transfer Effects

Capital

Technology

Management


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Employment Effects

Brings jobs that otherwise would not becreated

Direct: Hiring host-country citizens

Indirect:

Jobs created by local suppliers

Jobs created by increased spending by

employees ofthe multi-national enterprise

Questions remain on whether net jobsgained


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Balance of Payments Effects

Host country benefits from initial capitalinflow when MNC establishes business;

Host country records current account debiton repatriated earnings of MNC

Host country benefits if FDI substitutes forimports of goods and services

Host country benefits when MNC uses itsforeign subsidiary to export to othercountries


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Balance of Payment Accounts

Current account deficit occurs whenimports are greater than exports

Current account surplus occurs whenexports are greater than imports

Capital account records transactions that

involve the purchase or sale of assets

Effect on Competition and


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Effect on Competition andEconomic Growth

Increased: productivity growth product and process innovation

greater economic growth FDI can: Increase market competition:

Lower prices

Create greater consumer choice Stimulate capital investments


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Costs of FDI to Host Countries

Can drive out local competitors or preventtheir development

Profits brought home hurts (debit) ahosts capital account

Parts imported for assembly hurt trade

balance Can affect sovereignty and national

defense


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Home Country FDI Benefits

Improves balance of payments for inwardflow of foreign earnings

Creates a demand for exports.

Export demand can create jobs

Increased knowledge from operating in aforeign environment

Benefits the consumer through lowerprices

Frees up employees and resources for

higher value activities


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Home Country Problems with FDI

Negative effect on Balance ofPayments:

Initial capital outflow

MNC uses foreign subsidiary to sell backto home market

MNC uses foreign subsidiary as a

substitute for direct exports

Potential loss of jobs


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Government Incentives for FDI

Risk insurance (Home)

Elimination of double taxation (Home)

Tax incentives (Host)

Low interest rates (Host)

Stable government and stable policies


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Government Disincentives for FDI

Limit capital outflows (Home)

Manipulate tax code to encourage

domestic investment (Home) Political restrictions on investing in certain

countries (Home)

Ownership restraints (Host) Performance requirements (Host)

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