Why International Trade First Arose Economics Essay

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The Multinational enterprise is one characterised by its trading operations being in more than one country. More specifically: an enterprise with income generating assets in at least one country other than their domestic base. That is to say, for example, a firm whose home nation is the UK, which has offices in the USA. It may seem obvious that there are some firms operating on an international basis, after all, how would we, in the UK, obtain bananas, rubber, or any other product which is grown or made abroad without international trade? However, of course, today's international trading pattern has not always been thus. There was a time, not so long ago, when there was very little trade conducted across national borders. In answering the question posed by this essay, we must ask why has international trade arisen and also as a supplementary but no less important question: what forms does international trade take? In doing so it is necessary to examine the multinational enterprise (MNE) because it is the MNE that is the conduit for international business.

To answer the question of why international trade first arose it is useful to discuss the history of theorem that has formed the discussion around the subject. This will give an overview of the theories that underlie the motivations for international trade. The first real theory was put forward in the 16th century England. Known as mercantilism, the main premise of this theory was that it was in a countries best interest to export as much as possible and import as little as possible. Therefore, England would maintain a trade surplus and the gold and silver reserves of the country would increase. This would lead to a great deal of national prestige and moreover, vast wealth. To achieve this, though, a government working along mercantilist lines would have to erect trade barriers to ensure a minimal amount of goods and services were being imported. So multinational enterprise would be encouraged but only really on an exporting basis.

In his seminal work 'The Wealth of Nations', Adam Smith (1776) first proposed the concept of absolute advantage. To have an absolute advantage a country must be more efficient than any other country at producing a given good or service. The theory states that a country should never domestically produce what it can import for a lower cost. As a result of this international trade is encouraged instead of domestic production, meaning that firms will be more likely to trade internationally.

The next real step in trade theory was to comparative advantage, a revision of Smith's absolute advantage. David Ricardo (1817) came up with the theory, which asserts that a country should produce products to trade abroad that it produces most efficiently. This means that even if a country has an absolute advantage in all goods and services it can still benefit from international trade. The theory of comparative advantage, then, also espouses the virtues of free-trade. If the argument is followed through to its logical conclusion it results in the abolition of trade barriers and as such encourages trade on a trans-national basis, further giving reason for firms to act across national borders.

Heckscher (1919) and Ohlin (1933) then expanded upon the theory of comparative advantage. The theory, known as the Heckscher-Ohlin theory states that comparative advantage arises from differences between countries factor endowments, their land, labour and capital resources. They asserted that the more plentiful a country's factor endowments are, the lower the goods made from those factors will cost. As a result, the firms in the countries who produce goods at a lower cost will be able to more easily sell their products on the international market because their goods and services will be cheaper. The logic behind this theory being why firms become multinational, then, is because they can logically provide goods cheaply to the international market.

Another reason that firms become multinational was put forward by Vernon in his product life-cycle theory in the mid 1960s. He noticed that most of the world's new products in the 20th century had been first developed by USA firms and then sold in the domestically. Once the products sold in the USA became established, prices would drop meaning demand for the product would increase in other nations, leading to exports by firms from the USA. As the product ages further and demand increases in the other countries, their domestic firms start to buy licences and franchises to produce the product. As a result imports from the USA to these countries shrink. When the product starts to be produced in countries with lower labour costs it becomes cheaper and the USA starts to import the goods rather than produce them domestically. As time goes on, the USA becomes a net importer of the product. Thus, under the product-life-cycle theory, multinationalism is encouraged in different countries at different stages of the products life.

In the 1970s the new trade theories began to emerge. These theories extolled the virtues of first-mover advantages, the advantage being that if you enter an industry first you gain experience of the industry and product quickly, gaining economies of scale. As a result those who enter the market earliest have an advantage over those who enter later on, and therefore can more easily enter world markets. The 'why' here is simply because they would be foolish not to expand their trading horizons.

A theory that covers both the how any the why within the opening question is that of internalisation. Much like the Heckscher-Ohlin theory, this revolves around the concept of the imperfection of world factor markets. There are certain conditions that must exist within the firm and it's environment for internalisation to occur. The first is, as stated above, imperfection in world factor markets, without these multinationals would not even exist. In a perfect market, resources would be spread evenly among the worlds population and could be freely traded, there would be no barriers of entry and exit to the market, the products on offer would be homogeneous and knowledge of research and development would be freely available. However, as natural resources and skills are not evenly distributed there is a clear incentive for firms to trade on an international basis. The second condition for internalisation is that there must be an ownership specific advantage (OSAs) to owning assets in foreign land. This refers to being able to the advantage of having knowledge, management skills and other superiorities over other firms. Thirdly, there must also be location specific advantages (LSAs). These are the advantages that a firm derives from locating in a certain place. Examples of a location specific advantage include cheap labour and abundance of natural resources. These help to lower cost and as a result provide an incentive for location in a specific area for a firm. Once these conditions apply to a firm internalisation is said to be taking place. So, the theory of internalisation provides some answers as to why a firm will operate on a multinational basis. Those answers being factor market imperfections, OSAs and LSAs.

Dunning (1993) identifies four different types of multinational enterprise activity. These can be viewed as reasons why firms act on a multinatinal basis. The first of these activities is the resource seeking firm. The resource seeking firm will invest abroad to acquire a resource that is either more expensive or unattainable in its domestic environment. There are three types of resource seeker:

Those seeking physical resources such as raw materials, minerals or agricultural products. The type of firm that does this would be a primary producer or a manufacturer.

Those seeking cheap, unskilled or semi-skilled labour. Usually, this kind of resource seeker will have a domestic environment with a high wage rate. As a result they will start up or acquire subsidiaries somewhere with a lower wage rate to seek to cut costs. Firms which do this are usually producing labour-intensive goods that are an intermediate or final product.

Those firms seeking to acquire technological capability, management and marketing or organisational skills. This will involve collaboration in high-tech sectors, executive search subsidiaries or schemes to aid research and development.

The second type of firm identified by Dunning is the market seeking firm. This type of multinational enterprise will be investing in foreign lands in order to supply goods to other markets. Apart from the general incentive to maintain or grow market size, the market seeker may, according to Dunning, act the way it does due to four reasons:

a) Because a competing firm has just moved into foreign markets and as such, the market seeker must also act in such a way in order to keep up with the growth of the market.

b) Because products may need to be changed from their original design to fit in with other cultures' wants and needs. This will be easier if the firm is using labour and other resources that are sourced from said cultures as they will have the local knowledge that will assist them in maintaining a competitive edge abroad.

c) Because supplying a market from its own locality will cut costs compared to supplying from abroad. This will be mainly in the form of production, transportation and transaction costs.

Because the firm may simply consider it necessary to have a presence in the larger markets of the world as part of its global marketing strategy.

Dunning does state, however, that the most important reason firms will undertake a market seeking investment is that governments encourage it.

"Governments have also attempted to attract inward investment by offering a gamut of investment incentives ranging from tax concessions to subsidized labour and capital costs and favourable import quotas" (Dunning, 1993 pp 59)

The third type of firm identified by Dunning is the efficiency seeker, these firms will engage in FDI that rationalises the structure of FDI already in place that has been made on the basis of resource or market seeking.

"The intention of the market seeking MNE is to take advantage of different factor endowments, cultures, institutional arrangements, economic systems and policies and market structures by concentrating production in a limited number of locations to supply multiple markets" (Dunning, 1993 pp 59)

The final kind of firm identified by Dunning is the strategic asset seeker. This kind of firm seeks to acquire assets abroad as part of a long-term strategy, specifically that of advancing international competitiveness. This can be achieved through the purchase of another firm's assets and could be undertaken by an established MNE or a first time international player.

Another point to mention as to why firms become multinational is because of trading blocks and governments policies.

"Expansion and deepening trade relations, along with increased regional integration, have become important globalizing trends in the world economy" (Morrison, 2002 pp 245).

Regional integration of trade has allowed firms to establish themselves in many countries less hampered by trade restrictions. As governments increasingly pursue free-trade through trading blocks it will only become easier for firms to become multinational. Governments can also assist multinationals by allowing them tax-breaks or by subsidising their production costs. Some governments may even unilaterally abolish their own protectionist measures for an individual firm because they perceive that it will be of benefit to their economy.

With regard to how a firm will become a multinational enterprise, there is a strong chance that it will do so through some sort of FDI.

"Foreign Direct Investment occurs when a firm invest directly in facilities to produce and/or market a product in a foreign country" (Hill, 2001 pp 182)

It can happen on a horizontal or a vertical basis. Horizontal FDI is that which is in the same industry abroad as the firm is operating at home, so a firm acquires a company abroad that makes the same product as it does at home. Vertical FDI takes two forms. Firstly there is backward FDI which involves investing in an industry in a foreign land which provides factor inputs for the firm's domestic production. Traditionally this type of vertical FDI happens in the extractive industries such as mining. The other type is known as forward vertical FDI, which is the act of a multinational enterprise investing in a firm that sells the outputs of the MNE's domestic production.

A turnkey project is one way in which it is possible for a firm to end up as a multinational. Under the assumptions of a turkey project, a firm contracts every detail of building a factory or plant abroad to a company based in that country. Once the factory or plant has been built, the key is handed over to the foreign client and the plant is ready for operation. This is common in industries that use complex and expensive levels of technology.

Licensing agreements also provide a firm with a route to multinationalism. A licensing agreement gives the licensee firm the intangible right to produce a product for a set time-period. In return the licensor will receive a royalty fee. There are no strict rules over how the product can be produced, marketing or strategy. This is useful if a firm does not want to commit financial investment to an uncertain market or when there are trade barriers that are prohibitive in setting up a subsidiary. This is a strategy of entry to foreign markets typically used by manufacturing firms.

Franchising is a similar agreement to licensing, but under a franchise the franchisee must abide by a code of rules over how to do business. There may also be a significant amount of business help provided by the franchiser to the franchisee in the long term. The franchise system is mainly used in the service sector.

A joint venture can be used to enter a foreign market. This involves setting up a firm that is owned jointly by more than one other independently acting firm. The firm that wishes to enter a foreign market typically finds a producer already operating in that market and the two will then co-operate in running the joint venture firm. The financial risk here is shared and also the foreign firm benefits from the local knowledge that the local firm has to offer, meaning an easier transition into the local market.

Strategic alliances are another method by which a firm can enter into a foreign market. A joint venture is actually considered to be a strategic alliance but the definition of a strategic alliance is wide and ranges as far as a simple short-term contract between two firms to work together on producing goods and services in a given market.

Finally, a wholly owned subsidiary is perhaps the simplest way that a firm can become multinational. The multinational has complete ownership over it's subsidiary. This can be done by setting up a brand new operation in a foreign country or by purchasing a firm that is already operating in that country.

So, firms become multinational for a number of reasons. The most important one, though, is surely the imperfections in factor markets. Without these there would be simply no need for firms to act on an international basis. The theme of the uneven spread of resources runs deep within many of the trade theorem. Dunning, in particular, by citing the 'resource seeking' firm adds weight to this argument. With regard to how firms become multinational it is a case of studying the modes of market entry that they use. Whether this be a joint venture or setting up a wholly owned subsidiary, the firm wishing to become multinational must form some sort of entry strategy and I believe this is the key to 'how' they become multinational enterprises.