International trade and Foreign Direct Investment (FDI) equity flows are the two primary methods in which international business occurs and are amongst the most substantial drivers of present time globalisation. With consecutive rounds of multilateral dialogues at the World Trade Organisation (WTO), barriers to trade globally, have been done away with significantly. Likewise, the relaxation and liberalisation of developed countries’ capital markets during the 1980s has brought about a brand-new age of global capital mobility whereby Foreign Direct Investment is a primary and vital facet to trade globally. Both experiential and theoretical frameworks have incidentally thrived to explicate and predict these patterns in international business, as well as the determinatives and affects of International Trade and FDI flows for both the host and home countries.
International Trade is the exchange of capital, goods, and services across international borders or territories (dictionary.reference.com).
International Trade Theory
Adam Smith (1723-1790) was a prominent Scottish economist and political thinker whose famed work “Wealth of Nations” (1776) set the pitch for work on economics and politics for many individuals and institutions even today. This was, as a matter of fact, the first extensive attempt to examine the nature of capital, the development of industry and the effects of large-scale commerce in Europe.
Adam Smith’s fundamental argumentation was that people should be free and able to engage in their own private economic interests as much as possible just as long as they do not break the rudimentary rules of justice. In this manner, Smith believed, they would do far more good to advance and promote the public’s welfare and interests, more than if the same people were to attempt to assist the public on purpose. Smith named this the “invisible hand” of the market, though everyone is performing in their own self-interest, they are led to accomplish the good for all like an ‘invisible hand’ of economic powers. Hence, outside intervention will unavoidably induce calamity. This later became renowned as “laissez faire” economic policy (economyprofessor.com).
Adam Smith (“Wealth of Nations”) reasoned that economic specialisation could be beneficial to countries as to corporations, back in 1776. Due to the division of labour being limited by the market size, he argued that nations with access to bigger markets will be capable of splitting labour more productively and hence become more efficient in the long run. Smith however, failed to realise that the division of labour is also intrinsically limited by the technology in production coordination (Yu, Zhihao, 2005).
The theory of Absolute Advantage was introduced Adam Smith and is apparent between trade counterparts when a country is able to produce more of a commodity/product, with the same resources, than its partner can; it is therefore said to hold a position of Absolute Advantage in the production of that end product. If, however, the other country has an Absolute Advantage in producing a commodity/product that the its partner needs, each will be fortunate if they specialise and trade. Trade is normally mutually advantageous even if one country holds an absolute advantage over its partner country, in the production of both goods being traded.
The Heckscher-Ohlin (HO) model was first formed by Eli Heckscher (1919) and Bertil Ohlin, two Swedish economists. Eli’s Heckscher’s own student, Bertil Ohlin formulated and detailed the Factor Endowment Theory. He was not just a economics professor in Stockholm, but also a leading political figure in Sweden at the time. Fundamental concepts were further formulated and added subsequently by Ronald Jones and Paul Samuelson amongst others. Due to the difficulty of forecasting the trade of goods pattern in a globe with an abundance of goods, as an alternative to the Heckscher-Ohlin Model, the Heckscher-Ohlin-Vanek Theorem that prognosticates the factor capacity of trade has acquired attention in recent years (econ.iastate.edu).
The Heckscher-Ohlin Model explicated that countries of the same factor endowments would still trade due to the differences in technology, as this would induce specialisation and thus trade, in precisely the same manner as in the Ricardian Model.
Another theory that attempts to predict the patterns of trade is that of the Law of Comparative Advantage (David Ricardo) in the goods with the lower opportunity cost. David Ricardo (1772-1823), during the early 19th century, saw that the theory of Absolute Advantage was a moderate and restricted instance of a more dynamically broad theory. Ricardo, in essence, was sort of a replacement and continuation to Adam Smith’s prominent position in British economics. His work went on to shape and influence the aims and methods of the discipline all through the nineteenth century. In spite of his personal substantial work experience, his written material can sometimes come across as being very abstract and often hard to understand. His main stress was on the principles of diminishing returns linked to land rental, which he thought also regulated capital profits. He tried to derive a theory of value from labour application, but found it hard to separate the effects of changes in technology from changes in distribution.
The scarceness of natural resources globally, one of the more fundamental concepts of economics, requires that there be tradeoffs, and these tradeoffs lead to an opportunity cost. Whilst the price of a good or service is often-times thought of in terms of currency, the opportunity cost of taking a decision is based on what good or service must be forgone, which would be the next best option, as a consequence of taking the decision. Decisions that require having to choose between two or more options are said to have an opportunity cost.
The Law of Comparative Advantage explicates how nations can take advantage of and exploit specialisation and trade. Given any two goods/commodities, the nation manufacturing the good/commodity with the lower opportunity cost is said to have a comparative advantage. In simple terms, it is the capability of a nation to produce a product at a lower cost than others can produce it. Specialising provides that nation with a comparative advantage vis-à-vis other trade players. The basis of trade activities must be directed in a way where each country cuts the opportunity costs of the goods being swapped in their trade exchanges.
Heckscher and Ohlin’s theory, adapted from Ricardo’s comparative advantage model, suggested that different costs were the result not only of dissimilar labour endowments between countries, but also of different capital and land endowments. For example, a country like Saudi Arabia is much more amply endowed with oil than say France. France, on the other hand, has a rich abundance of skilled labour and capital equipment in the defence industry. Hence the theory would suggest that Saudi Arabia would specialise in producing oil, France in producing defence equipment and that the two countries will trade one product for the other.