INTERNATIONAL TRADE THEORIES

International Trade Theory deals with the different models of international trade that have
been developed to explain the diverse ideas of exchange of goods and services across the
global boundaries. The theories of international trade have undergone a number of
changes from time to time. The basic principle behind international trade is not very
much different from that involved in the domestic trade. The primary objective of trade is
to maximize the gains from trade for the parties engaged in the exchange of goods and
services. Be it domestic or international trade, the underlying motivation remains the
same. The cost involved and factors of production separate international trade from
domestic trade.

International trade involves across border exchange and this increases the cost of trading.
Factors like tariffs, restrictions, time costs and costs related with legal systems of the
countries involved in trade make the international trade a costly affair; whereas the extent
of restrictions and legal hassles are considerably low in case of domestic trade.

When it comes to the comparison between international trade and domestic trade, the
factors of production assume a crucial role. There is no denying that mobility of factors of
production is less across nations than within the domestic territory. The incidence of trade
in factors of production like labor and capital is very common in case of domestic trade;
while in case of international trade exchange of goods and services contributes the major
share of the total revenue.

International trade theory has always been a preferred field of research amongst the
traditional and contemporary economists. The international trade models attempt to
analyze the pattern of international trade and suggest ways to maximize the gains from
trade. Among the different international trade theories, the Ricardian model, the
Heckscher-Ohlin model and the Gravity model of trade are worth mentioning.

The Ricardian model of international trade is developed on the theory of comparative

advantage. According to this model countries involved in trade, specialize in producing
the products in which they have comparative advantage.

The Heckscher-Ohlin model put stress on endowments of factors of production as basis

for international trade. As per this theory countries will specialize in and export those
products, which make use of the domestically abundant factors of production more
intensively than those factors, which are scarcely available in the home country.

The Gravity model of trade provides an empirical explanation of international trade.

According to this model, the economic sizes and distance between nations are the primary
factors that determine the pattern of international trade.
The international trade theories also deal with challenges before international trade,
international trade laws, rules of international trade and many other related issues.

The various trade theories are:

• Absolute cost theory

• Comparative cost theory
• Factor proportion theory
• PLC theory
• Country similarity theory
• Opportunity cost theory

ABSOLUTE COST THEORY:

In economics, principle of absolute advantage refers to the ability of a party (an

individual, or firm, or country) to produce more of a good or service than competitors,
using the same amount of resources. Adam Smith first described the principle of absolute
advantage in the context of international trade, using labor as the only input.

Since absolute advantage is determined by a simple comparison of labor productivities, it

is possible for a party to have no absolute advantage in anything; in that case, according
to the theory of absolute advantage, no trade will occur with the other party.It can be
contrasted with the concept of comparative advantage which refers to the ability to
produce a particular good at a lower opportunity cost.

The main concept of absolute advantage is generally attributed to Adam Smith for his
1776 publication An Inquiry into the Nature and Causes of the Wealth of Nations in
which he countered mercantilist ideas. Smith argued that it was impossible for all nations
to become rich simultaneously by following mercantilism because the export of one
nation is another nation’s import and instead stated that all nations would gain
simultaneously if they practiced free trade and specialized in accordance with their
absolute advantage. Smith also stated that the wealth of nations depends upon the goods
and services available to their citizens, rather than their gold reserves.While there are
possible gains from trade with absolute advantage, the gains may not be mutually
beneficial. Comparative advantage focuses on the range of possible mutually beneficial
exchanges.
 COMPARATIVE COST THEORY:

The law of comparative advantage refers to the ability of a party (an individual, a firm,
or a country) to produce a particular good or service at a lower opportunity cost than
another party. It is the ability to produce a product with the highest relative efficiency
given all the other products that could be produced. It can be contrasted with absolute
advantage which refers to the ability of a party to produce a particular good at a lower
absolute cost than another.

Comparative advantage explains how trade can create value for both parties even when
one can produce all goods with fewer resources than the other. The net benefits of such
an outcome are called gains from trade. It is the main concept of the pure theory of
international trade.

David Ricardo, working in the early part of the 19th century, realised that absolute
advantage was a limited case of a more general theory. Consider Table 1. It can be seen
that Portugal can produce both wheat and wine more cheaply than England (ie it has an
absolute advantage in both commodities). What David Ricardo saw was that it could still
be mutually beneficial for both countries to specialise and trade.

Table 1

Country Wheat Wine

Cost Per Unit In Man Hours Cost Per Unit In Man Hours
England 15 30
Portugal 10 15

In Table 1, a unit of wine in England costs the same amount to produce as 2 units of
wheat. Production of an extra unit of wine means foregoing production of 2 units of
wheat (ie the opportunity cost of a unit of wine is 2 units of wheat). In Portugal, a unit of
wine costs 1.5 units of wheat to produce (ie the opportunity cost of a unit of wine is 1.5
units of wheat in Portugal). Because relative or comparative costs differ, it will still be
mutually advantageous for both countries to trade even though Portugal has an absolute
advantage in both commodities.

Portugal is relatively better at producing wine than wheat: so Portugal is said to have a
COMPARATIVE ADVANTAGE in the production of wine. England is relatively better
at producing wheat than wine: so England is said to have a comparative advantage in the
production of wheat.

The simple theory of comparative advantage outlined above makes a number of important
assumptions:

• There are no transport costs.

• Costs are constant and there are no economies of scale.
• There are only two economies producing two goods.
• The theory assumes that traded goods are homogeneous (ie identical).
• Factors of production are assumed to be perfectly mobile.
• There are no tariffs or other trade barriers.
• There is perfect knowledge, so that all buyers and sellers know where the cheapest
goods can be found internationally.

Effects on the economy

Conditions that maximize comparative advantage do not automatically resolve trade

deficits. In fact, many real world examples where comparative advantage is attainable
may require a trade deficit. For example, the amount of goods produced can be
maximized, yet it may involve a net transfer of wealth from one country to the other,
often because economic agents have widely different rates of saving.

As the markets change over time, the ratio of goods produced by one country versus
another variously changes while maintaining the benefits of comparative advantage. This
can cause national currencies to accumulate into bank deposits in foreign countries where
a separate currency is used.

Macroeconomic monetary policy is often adapted to address the depletion of a nation's

currency from domestic hands by the issuance of more money, leading to a wide range of
historical successes and failures.

FACTOR PROPORTION THEORY

The Heckscher–Ohlin model (H–O model) is a general equilibrium mathematical model
of international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm
School of Economics. It builds on David Ricardo's theory of comparative advantage by
predicting patterns of commerce and production based on the factor endowments of a
trading region. The model essentially says that countries will export products that utilize
their abundant and cheap factor(s) of production and import products that utilize the
countries' scarce factor(s)

Features of the model

Relative endowments of the factors of production (land, labor, and capital) determine a
country's comparative advantage. Countries have comparative advantages in those goods
for which the required factors of production are relatively abundant locally. This is
because the profitability of goods is determined by input costs. Goods that require inputs
that are locally abundant will be cheaper to produce than those goods that require inputs
that are locally scarce.

For example, a country where capital and land are abundant but labor is scarce will have
comparative advantage in goods that require lots of capital and land, but little labor—
grains, for example. If capital and land are abundant, their prices will be low. As they are
the main factors used in the production of grain, the price of grain will also be low—and
thus attractive for both local consumption and export. Labor intensive goods on the other
hand will be very expensive to produce since labor is scarce and its price is high.
Therefore, the country is better off importing those goods.

Theoretical development of the model

The Ricardian model of comparative advantage has trade ultimately motivated by

differences in labour productivity using different technologies. Heckscher and Ohlin
didn't require production technology to vary between countries, so (in the interests of
simplicity) the H-O model has identical production technology everywhere. Ricardo
considered a single factor of production (labour) and would not have been able to produce
comparative advantage without technological differences between countries (all nations
would become autarkic at various stages of development, with no reason to trade with
each other). The H-O model removed technology variations but introduced variable
capital endowments, recreating endogenously the inter-country variation of labour
productivity that Ricardo had imposed exogenously. With international variations in the
capital endowment (i.e. infrastructure) and goods requiring different factor proportions,
Ricardo's comparative advantage emerges as a profit-maximizing solution of capitalist's
choices from within the model's equations. (The decision capital owners are faced with is
between investments in differing production technologies: The H-O model assumes
capital is privately held.)

The Heckscher-Ohlin theory states that international and interregional differences in

production costs occur because of differences in the supply of production factors:

Commodities requiring for their production much of [abundant factors of production] and
little of [scarce factors] are exported in exchange for goods that call for factors in the
opposite proportions. Thus indirectly, factors in abundant supply are exported and factors
in scanty supply are imported (Ohlin, 1933).

These simple statements lead to an important conclusion: under free trade, countries
export the products that use their scarce factors intensively and imports the products
using their scarce factors intensively.
A country is labor-abundant if it has a higher ration of labor to other factors than does
the rest of the world. A product is labor-intensity if labor costs are a greater share of its
value than the are of the value of other products. Those goods that require a large amount
of the abundant - and thus less costly -factor will have lower production costs, enabling
them to be sold for less in international markets.

For example, India, which is relatively well endowed with labor compared to
Switzerland, ought to concentrate on producing labor-intensive goods; Switzerland with
relatively more capital than labor, should specialize in capital-intensive products. The
Heckscher-Ohlin theory explains some trade patterns quite well, but recent trends hint
that the industrial countries are becoming more similar in their endowments, suggesting
that this theory, which emphasizes international contrasts in endowments, may slowly
become less relevant.

PRODUCT LIFE CYCLE THEORY

The product life-cycle theory is an economic theory that was developed by Raymond
Vernon in response to the failure of the Heckscher-Ohlin model to explain the observed
pattern of international trade. The theory suggests that early in a product's life-cycle all
the parts and labor associated with that product come from the area in which it was
invented. After the product becomes adopted and used in the world markets, production
gradually moves away from the point of origin. In some situations, the product becomes
an item that is imported by its original country of invention. A commonly used example
of this is the invention, growth and production of the personal computer with respect to
the United States.The model applies to labor-saving and capital-using products that (at
least at first) cater to high-income groups.

In the new product stage, the product is produced and consumed in the US; no export
trade occurs. In the maturing product stage, mass-production techniques are developed
and foreign demand (in developed countries) expands; the US now exports the product to
other developed countries. In the standardized product stage, production moves to
developing countries, which then export the product to developed countries.The model
demonstrates dynamic comparative advantage. The country that has the comparative
advantage in the production of the product changes from the innovating (developed)
country to the developing countries.

Product life-cycle

In 1966, Raymond Vernon published a model that described internationalisation patterns

of organisations. He looked at how U.S. companies developed into multinational
corporations (MNCs) at a time when these firms dominated global trade, and per capita
income in the U.S. was, by far, the highest of all the developed countries.

Raymond Vernon was part of the team that overlooked the Marshall plan, the US
investment plan to rejuvenate Western European economies after the Second World War.
He played a central role in the post-world war development of the IMF and GATT
organisations. He became a professor at Harvard Business School from 1959 to 1981 and
continued his career at the John F. Kennedy School of Government.

The intent of his International Product Life Cycle model (IPLC) was to advance trade
theory beyond David Ricardo’s static framework of comparative advantages. In 1817,
Ricardo came up with a simple economic experiment to explain the benefits to any
country that was engaged in international trade even if it could produce all products at the
lowest cost and would seem to have no need to trade with foreign partners. He showed
that it was advantageous for a country with an absolute advantage in all product
categories to trade and allow its work force to specialise in those categories with the
highest added value. Vernon focused on the dynamics of comparative advantage and
drew inspiration from the product life cycle to explain how trade patterns change over
time.

His IPLC described an internationalisation process wherein a local manufacturer in an

advanced country (Vernon regarded the United States of America as the principle source
of inventions) begins selling a new, technologically advanced product to high-come
consumers in its home market. Production capabilities build locally to stay in close
contact with its clientele and to minimize risk and uncertainty. As demand from
consumers in other markets rises, production increasingly shifts abroad enabling the firm
to maximise economies of scale and to bypass trade barriers. As the product matures and
becomes more of a commodity, the number of competitors increases. In the end, the
innovator from the advanced nation becomes challenged in its own home market making
the advanced nation a net importer of the product. This product is produced either by
competitors in lesser developed countries or, if the innovator has developed into a
multinational manufacturer, by its foreign based production facilities.

The IPLC international trade cycle consists of three stages:

1. NEW PRODUCT
The IPLC begins when a company in a developed country wants to exploit a
technological breakthrough by launching a new, innovative product on its home market.
Such a market is more likely to start in a developed nation because more high-income
consumers are able to buy and are willing to experiment with new, expensive products
(low price elasticy). Furthermore, easier access to capital markets exists to fund new
product development. Production is also more likely to start locally in order to minimize
risk and uncertainty: “a location in which communication between the markets and the
executives directly concerned with the new product is swift and easy, and in which a wide
variety of potential types of input that might be needed by the production units are easily
come by”.

Export to other industrial countries may occur at the end of this stage that allows the
innovator to increase revenue and to increase the downward descent of the product’s
experience curve. Other advanced nations have consumers with similar desires and
incomes making exporting the easiest first step in an internationalisation effort.
Competition comes from a few local or domestic players that produce their own unique
product variations.
2. MATURING PRODUCT
Exports to markets in advanced countries further increase through time making it
economically possible and sometimes politically necessary to start local production. The
product’s design and production process becomes increasingly stable. Foreign direct
investments (FDI) in production plants drive down unit cost because labour cost and
transportation cost decrease. Offshore production facilities are meant to serve local
markets that substitute exports from the organisation’s home market. Production still
requires high-skilled, high paid employees. Competition from local firms jump start in
these non-domestic advanced markets. Export orders will begin to come from countries
with lower incomes.

3. STANDARDISED PRODUCT
During this phase, the principal markets become saturated. The innovator's original
comparative advantage based on functional benefits has eroded. The firm begins to focus
on the reduction of process cost rather than the addition of new product features. As a
result, the product and its production process become increasingly standardised. This
enables further economies of scale and increases the mobility of manufacturing
operations. Labour can start to be replaced by capital. “If economies of scale are being
fully exploited, the principal difference between any two locations is likely to be labour
costs”. To counter price competition and trade barriers or simply to meet local demand,
production facilities will relocate to countries with lower incomes. As previously in
advanced nations, local competitors will get access to first hand information and can start
to copy and sell the product.

The demand of the original product in the domestic country dwindles from the arrival of
new technologies, and other established markets will have become increasingly price-
sensitive. Whatever market is left becomes shared between competitors who are
predominately foreign. A MNC will internally maximize “offshore” production to low-
wage countries since it can move capital and technology around, but not labour. As a
result, the domestic market will have to import relatively capital intensive products from
low income countries. The machines that operate these plants often remain in the country
where the technology was first invented.

ADVANTAGES:

 The model helps organisations that are beginning their international expansion or
are carrying products that initially require experimentation to understand how the
competitive playground changes over time and how their internal workings need
to be refitted. The model can be used for product planning purposes in
international marketing.
 New product development in a country does not occur by chance. A country must
have a ready market, an able industrial capability and enough capital or labour to
make a new product flourish. No two countries exist with identical local market
conditions. Countries with high per capita incomes foster newly invented
products. Countries with lower per capita incomes will focus on adapting existing
products to create lower priced versions.
 The IPLC model was widely adopted as the explanation of the ways industries
migrated across borders over time, e.g. the textile industry. Furthermore, Vernon
was able to explain the logic of an advanced, high income country such as the
USA that exports slightly more labour-intensive goods than those that are subject
to competition from abroad.
 According to Vernon, most managers are “myopic”. Production is only moved
outside the home market when a “triggering event” occurs that threatens export
such as a new local competitor or new trade tariffs. Managers act when the threat
has become greater than the risk in or uncertainty from reallocating operations
abroad.
 The model’s validity was proved by empirical evidence from the teletransmission
equipment industry in the post-war years. The model is best applied to consumer-
oriented physical products based on a new technology at a time when
functionality supersedes cost considerations and satisfies a universal need.

DISADVANTAGES:

 Vernon’s main assumption was that the diffusion process of a new technology
occurs slowly enough to generate temporary differences between countries in their
access and use of new technologies. By the late 1970’s, he recognised that this
assumption was no longer valid. Income differences between advanced nations
had dropped significantly, competitors were able to imitate product at much
higher speeds than previously envisioned and MNCs had built up an existing
global network of production facilities that enabled them to launch products in
multiple markets simultaneously. Investments in an existing portfolio of
production facilities made it harder to relocate plants.
 The model assumed integrated firms that begin producing in one nation, followed
by exporting and then building facilities abroad. The business landscape had
 become much more interrelated since the 1950’s and early 1960’s, less US-centric
and created more complex organisational structures and supplier relations. The
trade-off between export or foreign direct investments was too simplistic: more
entry modes exist.
 The model assumed that technology can be captured in capital equipment and
standard operating procedures. This assumption underpinned the discussion on
labour-intensity, standardization and unit cost.
 The model stated that the stages are separate and sequential in order. Vernon’s
Harvard Multinational Enterprise Project that took place from 1963 through 1986,
was a massive study of global marketing activities at US, European, Japanese and
emerging-nation corporations. The study found that companies design strategies
around their product technologies. High-technology producers behave differently
from firms with less advanced goods. Companies that invested more R&D to
improve their products and to refresh their technologies were able to ‘push’ these
products back to the new product phase.
 The relative simplicity of the model makes it difficult to use as a predictive model
that can help anticipate changes. In general, it is difficult to determine the phase of
a product in product life cycles. Furthermore, an individual phase reflects the
outcome of numerous factors that facilitate or hamper a product’s rate of sales
making it difficult to see what is happening ’underwater’.
 The relation between the organisation and the country level was not well
structured. Vernon emphasized the country level. Furthermore, he used the
product side of the product life cycle, not the consumer side, thereby stressing the
supply side. Selling ‘older’ products to a lesser developed market does not work if
transportation costs for imports is low and information is accessible globally
through the Internet and satellite TV.
 Foreign markets are not just composed of average income consumers, but contain
multiple segments. The research did not consider the emergence of global
consumer segments.

OPPORTUNITY COST THEORY:

Opportunity cost is the value of what is foregone in order to have something else. This
value is unique for each individual. You may, for instance, forgo ice cream in order to
have an extra helping of mashed potatoes. For you, the mashed potatoes have a greater
value than dessert. But you can always change your mind in the future because there may
be some instances when the mashed potatoes are just not as attractive as the ice cream.
The opportunity cost of an individual's decisions, therefore, is determined by his or her
needs, wants, time and resources (income).

This is important to the PPF because a country will decide how to best allocate its
resources according to its opportunity cost. Therefore, the previous wine/cotton example
shows that if the country chooses to produce more wine than cotton, the opportunity cost
is equivalent to the cost of giving up the required cotton production.
Let's look at another example to demonstrate how opportunity cost ensures
that an individual will buy the least expensive of two similar goods when given the
choice. For example, assume that an individual has a choice between two telephone
services. If he or she were to buy the most expensive service, that individual may have to
reduce the number of times he or she goes to the movies each month. Giving up these
opportunities to go to the movies may be a cost that is too high for this person, leading
him or her to choose the less expensive service.

The opportunity-cost doctrine, in its original form and in the only form in which its
pretensions to being a revolutionary departure from real-cost value theorizing have any
basis, treated choice between alternative products (or choice between the utilities
derivable from the consumption of alternative products) as the only choice significant for
price determination. In this theory the only true cost is foregone product, and relative
prices are held to be determined solely by preferences between products and by the
technical coefficients of production. In real-cost value theorizing, preferences as between
products play a role in the determination of values, but so also do preferences between
occupations for their own sakes, as activities, pleasurable or painful, and because of the
modes and locations of life necessarily associated with them, and also preferences
between employment and (voluntary) non-employment of the factors, and even between
existence and non-existence of the factors. In the comparative-cost doctrine, where the
problem of trade policy is dealt with from the point of view of under what foreign-trade
policy a unit of a given commodity will be procured at the minimum real cost, the
problem of choice between alternative products is abstracted from, but free scope is left
for consideration of all the other relevant alternatives between which choice must be
made.

The opportunity-cost theory was first applied to the problem of gain or loss from foreign
trade as a substitute for the doctrine of comparative real cost by Haberler,5 who claimed
for it that it was adequate for the purpose and had the advantage over the doctrine of
comparative costs that the use of the factors in variable proportions presented no
difficulties for itThe theory is presented in chart terms of so-called indifference curves.
Any point on the curve AB represents by its
distance from the horizontal axis the maximum amount of copper and by its distance from
the vertical axis the maximum amount of wheat which can simultaneously be produced
by the country in question with its existing stocks of the productive factors. The slope of
the tangent to the AB curve at any point represents the alternative product cost of copper
in terms of wheat, or the number of units copper which must be sacrificed to obtain an
additional unit of wheat. In the absence of foreign trade, the relative exchange values of
the two commodities must correspond to their alternative product costs, so that, e.g., if at
the margin two units of copper must be sacrificed to obtain an additional unit of wheat,
then under equilibrium two units of copper must exchange for one unit of wheat. The
curve MM′ is supposed to be a “consumption-indifference curve” for this country, tangent
at some point, K, to the production curve AB, and points on it represent combinations of
copper and wheat which would be equally “valued” by the community. At point K, where
the two curves have a common tangent, mm′, the alternative costs and the relative values
of the two commodities would correspond. The point K is therefore the equilibrium point,
in the absence of foreign trade, and od units of copper and oc units of wheat will be
produced and consumed.

The opportunity-cost approach encounters, therefore, on the income side, the same type
of difficulty of weighting in the absence of knowledge of the proper weights as does the
real-cost approach on the cost side. It remains to be demonstrated that the opportunity-
cost approach avoids the difficulties on the cost side only by avoiding recognition of the
considerations which give rise to these difficulties. Let us return to the production or AB
curve, and examine its implications. On a true production-indifference curve, any two
points would represent the product-combinations resulting from two allocations of
productive activity equally attractive to the choosing agent after due consideration had
been given to everything associated with such activity except the product outcome. As
presented, the AB curve constitutes merely a series of maximum-possible combinations of
product when a given stock of productive factors is employed, presumably to its physical
maximum. In an actual situation, the actual product-combination would not be on this
curve, but would be somewhere below it, if the amounts of the factors, or the extent to
which they prefer leisure to employment, were dependent on the rates of remuneration
and if the equilibrium rates of remuneration were lower (or higher) than those rates which
would induce each factor to render the maximum amount of productive service of which
it was physically capable. Even if the extent of employment of the factors was fixed, their
allocation as between copper and wheat would be dependent, not only, as is assumed in
the diagram and in the opportunity-cost theory, by the relative demands for copper and
wheat and the productivity functions of the factors with respect to copper and wheat, but
also by the relative preferences of the factors as between employment in copper
production and in wheat production. Given the existence of such preferences, then even
for a single individual the true production-indifference curve would not be AB, but some
other curve lower than AB at some points at least, and higher at none. The opportunity-
cost theory thus escapes the difficulties connected with preferences for leisure as
compared to employment, preferences as between employments and variability of the
supplies of the factor, only by ignoring them.

INVESTMENT THEORIES:

Market imperfection theory:

Caves (1971) expanded Hymer's theory and hypothesized that the ability of firms to
differentiate their products - particularly high income consumer goods and services - may
be a key ownership advantages of firms leading to foreign production.

The consumers would prefer to similar locally made goods and thus would give the firm
some control over the selling price and an advantage over indigenous firms. To support
these contentions, Caves noted that companies investing overseas were in industries that
typically engaged in heavy product research and marketing effort.

Internalization theory:

Is an extension of the market imperfection theory. By investing in a foreign subsidiary

rather than licensing, the company is able to sent the knowledge across borders while
maintaining it within the firm, where it presumably yields a better return on the
investment made to produce it.

Other theories relate to financial factors. Robert Aliber believes the imperfections in the
foreign exchange markets may be responsible for foreign investment. He explained this in
terms of the ability of firms from countries with strong currencies to borrow or raise
capital in domestic or foreign markets with weak currencies, which, in turn, enabled them
to capitalize their expected income streams at different rates of interest.

Structural imperfection in the foreign exchange market allow firms to make foreign
exchange gains through the purchase or sales of assets in an undervalued or overvalued
currency.
One other financially based theory (portfolio theory) was put by Rugman, Agmon and
Lessard. These researchers argued that international operations allow for a diversification
of risk and therefore tend to maximize the expected return on investment.

Rugman and Lessard have further argued that the location of the foreign direct
investment would be a function of both the firm's perception of the uncertainties involved
and the geographical distribution of its existing assets.

Electic theory

The eclectic paradigm is developed by John Dunning seeks to offer a general framework
for determining the extent and pattern of both foreign-owned production undertaken by a
country's own enterprises and also that of domestic production owned by foreign
enterprises.

he eclectic paradigm is a theory in economics and is also known as the OLI-Model.[1][2]

It is a further development of the theory of internalization and published by John H.
Dunning in 1980.

The theory of internalization itself is based on the transaction cost theory.[3] This theory
says that transactions are made within an institution if the transaction costs on the free
market are higher than the internal costs. This process is called internalization.

For Dunning, not only the structure of organization is important.He added 3 additional
factors to the theory:

• Ownership advantages(trademark, production technique, entrepreneurial skills,

returns to scale)
• Locational advantages (existence of raw materials, low wages, special taxes or
tariffs)
• Internalisation advantages (advantages by producing through a partnership
arrangement such as licensing or a joint venture)

Categories of advantages
Source:
Dunning (1981) Ownership Internalisation Locational
advantages advantages advantages
Form
of Licensing[1] Yes No No
market
entry
Yes Yes No
Export
 FDI Yes Yes Yes

Theory

The idea behind the Eclectic Paradigm is to merge several isolated theories of
international economics in one approach.Three basic forms of international activities of
companies can be distinguished: Export, FDI and Licensing. The so-called OLI-factors
are three categories of advantages, namely the ownership advantages, locational
advantages and internalisation advantages.A precondition for international activities of a
company are the availability of net ownership advantages. These advantages can both be
material and immaterial. The term net ownership advantages is used to express the
advantages that a company has in foreign and unknown markets.

According to Dunning two different types of FDI can be distinguished. While resource
seeking investments are made in order to establish access to basic material like raw
materials or other input factors, market seeking investments are made to enter an existing
market or establish a new market.A closer distinction is made by Dunning with the terms
efficiency seeking investments, strategic seeking investments and support investments.

Location advantages
Trade and FDI patterns
for industries and countries.[5]
Strong Weak

Strong Exports Outward FDII

Ownership
advantages
Weak Inward FDI Imports

The eclectic paradigm also contrasts a country's resource endowment and geographical
position (providing locational advantages) with firms resources (ownership
advantages).In the model, countries can be shown to face one of the four outcomes shown
in the figure above. In the top, right hand box in the figure above firms possess
competitive advantages, but the home domicile has higher factor and transport costs than
foreign locations. he firms therefore make a FDI abroad in order to capture the rents from
their advantages.But if the country has locational advantages, strong local firms are more
likely to emphasize exporting. The possibilities when the nation has only weak firms, as
in most developing countries, leads to the opposite outcomes. These conditions are
similar to those suggested by Porter's diamond model of national competitiveness.