Contemporary International Trade is no Longer Explained by Factor Proportions Theory - Essay Example

? “Contemporary international trade is no longer explained by factor proportions theory.” Introduction The Factor Proportions Theory or the Factor Endowment Theory of International Trade used to provide an explanation for international trading practices. According to the theory, nations felt the need of engaging in trade with each other so that they could offset their differences in natural endowments. Identifying capital and labor as the main factors of production, this theory stated that countries were endowed with various amount of these factors of production and these endowments naturally differed between countries. While some countries were naturally rich in capital resources, other had a huge population which gave rise to an abundance of labor. The nations were said to possess competitive advantage in the factors of production which was readily available in their economies. It followed from common logic that countries having natural endowments of a specific factor would always engage in a production technology intensive in that particular factor. Therefore, a capital rich economy was always considered to engage in a capital-intensive technology for the production of commodities. The same case would apply for the labor abundant economy as well. However, in that case the countries ended up producing goods produced by only one factor-intensive type of production method. Therefore, they needed to engage in mutually beneficial exchange of goods to gain access to other types of products as well. However, the contemporary trends in international trade sometimes violate the tenets of the Factor Proportions Theory. Homogenous countries being naturally endowed with the same pattern of factor endowments have been increasingly observed to have engaged in trading with each other. In such cases, only Factor Proportions Theory cannot explain the current trends in global trade. Consequently, specialists in trade have sought to explain the contemporary trading practices with the help of a number of alternative theories. This paper has attempted to evaluate these alternative theories and investigate their explanations about modern international trade. The Classical Theory of International Trade was the first acceptable explanation of international trading practices. About 150 years after this,the Swedish economists Eli Heckscher and Bertail Ohlin had proposed the factor proportions theory or the factor endowment theory of international trade. This theory is based on the concept of the comparative advantage (or disadvantage) of a country based on its relative abundance (or scarcity) of the factors of productionavailable within its economy.The factor proportions theory advocates that a country should be engaged in the production and export of commodities that is primarily based on a factor of production which is abundantly present in its economy.Considering the framework of a two-country, two-factor and two-commodity framework of international trade, the theory states that the different nations are endowed with different proportions of the factors of production like capital and labor. Some nations have an abundance of capital resources but are short on available labor. Such a country would be capable of producing commodities using a capital intensive mode of production at acomparatively low cost. Similarly, countries having an abundance of labor resources would produce labor intensive goods at a low cost. The first country would then be inclined to export its capital intensive goods to the second nation and import labor intensive commodities from the latter. Through international trade, both countries would gain access to both the types of commodities at the least cost. However, the present international scenario presents a different picture of international trade. Current world trade is dominated by the exchange of goods between homogenous countries which are found to have an advantage in the same factor (factors) of production. In such cases, trading involves commodities which are generated by a similar factor-intensive mode of production. This practice contradicts the basic tenets of the factor proportions theory. Therefore ‘Contemporary international trade is no longer explained by factor proportions theory’. (Sharan, 2008, p.51, Negishi, 1989, p.24) It becomes imperative to look into other theories that can help explain the modern trend of international trade. The ‘International Product Life Cycle Theory’ tries to explain the contemporary trends in international trade with the help of the conventional marketing theory governing the origin, growth and life span of commodities in the international market. The theory considers the export potential of the commodity during four distinct stages of its life cycle. In the initial stage of innovation, a country manufactures a new product and sells it in its domestic economy. The company does not encounter much competition regarding its product in the international market. During the second stage, the sales of the commodity increases with the development in its production technology. New firms enter the product market and the production becomes more and more standardized. During this stage, the company establishes its production facilities in the foreign markets. In the third stage, the product attains maturity. The commodity is produced in large quantities in the foreign markets and thus exports from the native country decreases. At this point, the company aims at reducing the costs of production to gain more profits. It might shift all its production facilities to less developed countries (LDCs) and stop manufacturing the commodity in the home country and the foreign markets. It would import the products from the LDCs to the markets having a demand for the product. In such a situation, the international community may observe a peculiar pattern of trade among the countries. Nations which earlier used to produce a commodity may be observed to import it from other countries in the later stages of the product. Thus, the International Product Ife Cycle Theory, provides a explanation for the present trends of international trade (Ajami, 2006, p.52) The Heckscher-Ohlin theory of Factor Proportions had proposed that countries are naturally endowed in certain factors of production which gives them a comparative advantage in that particular factor-intensive technology of production.Using this production technique they are able to produce goods at a lower cost than other nations, who do not have a comparative advantage in that production technology. Once they gain abundance in the production of these commodities, they export them in the world markets to earn revenues. The modern production techniques usually require several factors of production to generate a commodity. A nation cannot be naturally endowed with all the required factors of production. Countries are found to have comparative advantages in some production factors, not all. In such cases, the scare factors can be supplied externally to these nations to enable them to produce goods of their choice. This is facilitated by foreign direct investment (FDI) in the economies of these countries. International investment theoriesexplain the reason behind FDI activities.FDI made by a company refers to the establishment of its production facilities and other capabilities in foreign economies other than its native economy. This is done either by constructing new production plants abroad or by acquiring an existing business venture in foreign soil. The firms are encouraged by a number of strategic reasonsdivert FDI to other countries. These reasonsinclude the need to gain access to new markets, access production factors in foreign countries, harness new production techniques and expertise available elsewhere and thus achieve improved efficiencies in their production process. Sometimes, external competitive forces urge companies to invest in increasing their capacities in other nations. Earlier, countries used to impose restrictions on the procedure of FDI, that companies were required to go through before investing in their territories. However, under the current trends of globalization, where the world is considered as a single integrated economy, most nations have removed restrictions on FDI and eased out the investment process. Companies are provided with ample opportunities of investing in countries across the world. The new production facilities built in the foreign countries become properties of their location countries. In this way, countries are externally endowed with new production techniques and capabilities, which might not have been present in their economies before. Multinational corporations help to increase the production endowment of countries by directly investing in their economy. Under the new circumstance, nations are able to produce and trade in commodities which were not generated earlier due to the scarcity of factors of production. Therefore, the contemporary trends in international trade are explained to a certain degree by the international investment theory(Ball, 2004, p.96). Globalization has resulted in increased FDI activities in countries across the world. Modern theories of investment have tried to explain the tendency of firms to invest in foreign economies.Dunning’s Eclectic Theory of International Production is often used for explaining the FDI operations of firms. According to this theory, when a firm decides to invest its resources in an overseas production facility, it usually ensures that it has access to three kinds of benefits in the foreign location: a. Ownership-specific Advantages: These accrue to the organization by way of its acquisition of tangible and intangible assets. The ownership benefits can be derived from knowledge of specific production techniques, from economies of scale and also from the privileged access to vital inputs and outputs and these advantages might not be available to other firms. The firm must also be able to transfer these advantages to its foreign production facilities. These advantages are expected to increase the firm’s revenues and decrease its overall costs b. Location-specific advantages: The preferred foreign market should be endowed with favorable political, social and economic conditions. These would allow the firm to realize its potential capabilities by locating to the overseas market. c. Advantages from Internalization: Firms can enter the foreign markets following a number of alternative methods. They can begin their operations through their foreign-subsidiary or chose to engage in direct market transactions in the new location. However, sometimes the firm can incur high costs from such direct arm’s length transactions in places where the market functions inefficiently or it does not exist at all. In such a situation, it is best for the firm to adopt a strategy of internalization to harness the advantage of its ownership- specific benefits. The Ecclectic Theory of International Production is sometimes called the OLI model, being named after the three types of advantages accruing to the firms in the case of a an FDI project. It attempts to explain a firm’s selection of an international location for the expansion of its production capacities. The theory reveals that a firm must have ownership as well as location-specific advantages in its preferred area where it will also be able to internalize its organization specific advantages. By expanding its operations in this manner, the firm not only enhances its revenue generation prospects, it also creates new production facility endowments in foreign countries.Nations gain access to new products which might not have been produced in their economies before the entry of the investing firms. Thus, firms can externally endow countries with new production technologies which help them to generate new commodities and export them in the international market. Therefore, Dunning Ecclectic Theory tries to explain the increased FDI activities of international companies and thus provide a basis for the current trends in world trade(Xun, 2008, p.94; Ball, 2004, p.94). The modern investment theories have attempted to explain the present trends in international trade with the help of the concept of Foreign Direct Investment inflows. However, some trade specialists have also tried to explain modern international trade in terms of other non-FDI based explanations. The Case of International Collaborative Ventures: Firms operating in the international market can collaborate among themselves to form joint ventures which facilitate the expansion of their respective business activities.There can be horizontal as well as vertical collaborations between organizations.Horizontal collaboration occurs between firms belonging to the same level of the value chain. Examples of these can be found in the partnerships formed between two firms supplying raw materials to a particular industry. On the other hand, vertical collaboration is referred to the joint ventures of firms which function at different levels of the value chain.Companies across the world have been observed to increasingly engage in forming collaborative ventures with other international firms. This is usually done for a number of reasons. Forming a partnership with foreign firms, helps indigenous companies to gain access to its partners’ knowledge of new production techniques, capital assets, marketing assets, the channels of distribution and the partner’s expertise in dealing with local governmental hindrances. Many companies feel that that forging collaborations with international organizations will help them to expand their existing production facilities and gain access to new markets. An important example is the case of Starbucks has formed a joint collaboration with its Japanese partner Sazaby, Inc. to introduce 500 new coffee outlets in the country. Therefore, forming collaborative ventures with foreign firms helps companies to enhance their production capacities and open up new vistas for international trade. Thus, the increased incidence of collaborative joint ventures provides an explanation to present international trade (Tamer, n.d). A Firm’s Networks and Relational Assets: Over the years, companies form advantageous long-term relationships with other organizations operating in its own business such as manufacturers, suppliers, distributors, retailers, consultants, banks, government agencies and other companies. There are termed as the Network and Relational Assets of a firm. These assets provide a distinct advantage to the firm in the domain of its international operations. The Japanese Keiretuse networks are actually the predecessor of the network organization and alliances which have now become prevalent among the Western world. These Keiretsu networks are complex group of firms that are linked together with the help of common ownership and trading practices and foster international learning within the organizations. The networks and the firm alliances forged in the western world today are not formal companies with an explicit hierarchical structure nor are they examples of impersonal forms of markets. Therefore, the networks and relationship assets of a firm also provide an example to the current forms of international trade. (Tamer, n.d) The case of international collaborative ventures and the presence of Networks and Relational Assets of a Firm constitute the non-FDI based explanations of the contemporary international trade flows. Apart from these explanations, there have also been several international trade theories formulated in the recent times, to explain the nature of global trading practices. The famous economist Porter in his Diamond Analysis,summarized certain factors which are considered to affect the competitiveness of a firm in the international market. These factors were a combination of business organizational factors and those related to the production location of the company.For his analysis, Porter considered ten major industrial countries and studied the trends in their high performance oriented industries. The data was evaluated for a period of fifteen years from 1970-1985. He found that the international competitiveness of the firms belonging to these successful industries were determined by their level of innovation and state of modernization of their production facilities. These were the firm-specific factors that influenced the company’s performance in the international trade market. There were of course factors related to the international trading market of the firms that also had a decisive influence on the firm’s trade performance. Porter termed them as country-specific location advantages.Heckscher-Ohlins Factor Proportion Theory of International Trade identified the difference in the countries’ natural endowments as the main reason for nations to engage in the exchange of commodities. Contemporary trade theories have proposed that dynamic technological differences between countries can also serve as a vital reason for trade. In 1961 Posner had declared that as firm improve upon their existing production processes and invent new products in the market, it enjoys a kind of monopoly power in the trade market based on the prevalence of copyrights. The benefits of technological progress accruing to a company and therefore its native country, place them on a superior footing in the international trade scenario. However, in the era of globalization other nations immediately become aware of these new production techniques. Not willing to be left behind, other countries express the desire to engage in mutually beneficial trading arrangements with the technologically advanced countries. In this way, differences in technological innovations can also serve as the basis for current international trade (MacDonald, 1999, p.357-359). As the world is being integrated into a single economy, companies are facing increased competition in the international market. They are forced to devise new global strategies for the expansion of their business and gaining access to unexplored markets. Companies often plan their expansion strategies around their trading activities where they consider trade to be an effective engine for their future growth. To formulate such Global Strategies for its future course of development centering around international trade, firms consider both Firm-Specific Advantages as well as Country-Specific Advantages to decide on their preferred markets for international trade. Examples of Firm-Specific Advantages include the benefits accruing out of the firm’s technical know-how, their existing capital assets, their labor resources, their marketing networks and distribution channels and so on. On the other hand, country-specific factors include the factors unique with respect to the specific nation, which includes its political, economic and social scenario. (St. Hilaire, 2001. P.14) There are several alternative theories that have attempted to explain the contemporary trends observed in the international trading regime. These alternative theories include the modern theories of investment, the FDI based explanations, the non-FDI based explanations, the Global Strategic Framework of Companies including Firm-Specific Advantages and Country-Specific Advantages and so on. Most o these theories point to the fact, those differences in natural factor endowments as proposed by the Factor Proportions Theory cannot be the only reason for countries to engage in mutually beneficial trading practices. There are a host of other factors that encourage nations to expand their business activities in foreign markets and increase their opportunities for earning higher revenues. In the modern world, differences in development ofproduction techniques serve as an important reason for international trade. Before deciding on its prospective markets for trade, the firms also ensure the accrual of a number of factors. Thus, the modern international trade theories advocate that homogenous nations with similar nature of factor endowments can also engage in the trading of the goods in the international community. References 1. Ball (2004), International Business 11E, USA, Tata Mc-Graw Hill Education 2. Grimwade, Nigel (2000), International Trade: New Patterns of trade, production and investment, USA, Routledge 3. MacDonal, Nadia, (1999).Macroeconomics and Business: an Interactive Approach, USA, CENGAGE Learning EMEA 4. Mussa, Michael (2005), IMF Staff Papers, Vol.52, 2005, available at http://books.google.co.in/books?id=CKPYHajyW7cC&pg=PA54&dq=Other+non-FDI+based+explanations+of+International+Trade&hl=en&sa=X&ei=Evz-ToCWBsfnrAfwx4n-Dw&ved=0CFgQ6AEwBA#v=onepage&q=Other%20non-FDI%20based%20explanations%20of%20International%20Trade&f=false (accessed on December 31, 2011) 5. Negishi, Takashi, (1989), Economic Theories in a Non-Walrasian Tradition, USA, Cambridge University Press 6. Rugman, A,M (2009).The Oxford Handbook of International Business, USA, Oxford Handbooks 7. Sharan (2008), International Business 2/e , Concepts, Environment And Strategy, India, Pearson Education 8. St. Hilaire, Walter Gerard, (2011). The Strategic Impact of the Business Dynamics in Emerging Countries on Contemporary Perspectives, UK Journal, Vol.4, No.2, available at http://www.saycocorporativo.com/saycoUK/BIJ/journal/Vol4No2/Article_2.pdf (accessed on December 31, 2011) 9. Tamer, Cavusgil, (n.d) International Trade,India , Pearson Education 10. Xun, Lei. (2006 ),The determinants of US outgoing FDI in the food-processing, Univeristy of Delaware, Proquest Read More