Economic rationale behind international trade

Economic rationale behind international trade. There are three forms of international trade (Exhibit 3-1). International trade is considered when an entity located in one country sells goods to an entity located in another country. Goods can be tangible or intangible. It can be a raw material, a semi-finished product, or a finished product. A seller in this case is considered an exporter, and the trade transaction for him is called an export.

Ex. 3‑1 Types of international trade

Keywords: import, export, transit, re-export

A buyer in this case is considered an importer, and the trade transaction for him is called import. Re-export is understood as the sale of the goods imported before without adding additional value to the goods. For example, if an organization imports raw materials and assembles a finished product from them, the export of such final product will not be considered as re-export. However, if the organization resells the same product abroad, this type of trade is called re-export. There are various reasons for re-export, for example, a trader carries out regional distribution of goods, or a trader simply resells the goods at a higher price to the new markets (Ribau et al., 2018). The case of re-export is special because imported products are subject to different taxes and duties if they are intended for re-export. More on custom duties and other trade restrictions is explained in the later sections of current chapter.
Re-export can often be confused with transit of goods. Transit of goods is a way of trade, when goods cross the territory of the country twice, that is, they are physically entering country, crossing and leaving. In most cases, such physical transportation of goods, especially by land transport, is unavoidable when the countries where the seller of the goods and the buyer are located do not have a common border, and the goods have to be transported through third countries. In the case of transit, economic entities of the transit country do not participate in the commercial transaction but only transport goods through the country physically. Such transportation of the goods in transit is not subject to customs duties or other state taxes. In case of transit there sometimes obligatory to pay transport infrastructure tolls or environmental pollution taxes, but this is associated with the consequences caused by transport for the transit country – pollution, noise and commercial use of infrastructure in general terms. Transit is not subject to trade fees. The only thing is that during transit, the state monitors whether the goods will not be secretly unloaded and sold in the market of the transit state. Such cases are illegal; that is called smuggling and are prosecuted and punished. In the case of re-export, unlike transit, three states are involved in the transaction.
The main reasons why organizations start to sell their goods in the markets of other countries are primarily for economic reasons- to avail the benefits of mass production, specialization and economies of scale (Exhibit 3-2). The more products to produce and sell, the more the benefits will be availed (Ayal, 1979). The size of the local market depends on the country’s population and purchasing power of the citizens. A producer in a country with a small market has a significantly greater need to export than a producer in a more populous country (Zucchella et al., 2016). Sometimes it is not at all possible or very difficult for a manufacturer in very small countries to specialize narrowly, and export is the only way to produce a homogeneous product. Even in countries with relatively large populations, manufacturers seek to boost production volumes and sell even more goods, so selling goods to another country is very appealing. Due to the limitations in the local market, it becomes difficult for the local businesses to achieve economies of scale. Often, local businesses are forced to apply economies of scope, to produce various products, because this is also the way to grow and increase revenue (Child et al., 2022). In this case, it becomes challenging to specialize narrowly. In the absence of production scale and narrow specialization, the costs are often high, which forces to maintain a higher price level. For local businesses in this case, a higher price level guarantees the desired profit margin, but at the same time, a huge threat arises if a foreign competitor enters the local market. It is extremely difficult for local businesses to withstand the competition of global organizations, because their products are usually cheaper than those of the local manufacturer. Exporting and the benefits provided by exporting are one of the ways for local businesses to survive at the time of facing pressure from a global rival. In addition to the economic reasons, the marketing reason related to Raimond Vernon’s international product life cycle is important (explained in Chapter 1, Exhibit 1-32). The same product may have different life cycles in different markets, and the same product may have different competitors in different countries (Vernon, 1966).

Ex. 3‑2 Reasons to export

Keywords: specialisation, economy of scale

Extensive market research is conducted by exporters in different countries on competitors’ products, and prices, and also aims to extend the life cycle of their product as much as possible through various export strategies. For example, sometimes a cascade strategy is used, when a product starts getting sold in its own country, then, after the appearance of local competitors, the product continues to get rapidly sold in other countries with a similar level of income and development, and later it starts getting sold in developing countries with lower incomes. During the growth and maturity phases of the product, higher price pricing is applied, but during the standardization and decline phase of the product, when many competing products appear in the market, prices are reduced. When a price is reduced, product is shifted to the lower income countries. The life cycle of the same product can last from one to several or even a dozen years. For products that use machine tools or other automated equipment, it is very important to produce the same product for as long as possible. For example, as the machine gets older, certain deviations in manufacturing accuracy occur due to abrasion of particular machine’s components. Although these deviations are not critical, the manufactured products may last shorter, wear out faster or exhibits lower quality parameters. In such cases, such machines continue to be used, but the production is directed to other markets, often to less economically developed countries, for which the quality of production is acceptable, especially if the price of production is lower. Thus, new export markets can be said to extend the useful lifespan of existing production facilities. It is important to mention that the products that enter the markets of less developed countries are not necessarily of lower quality, but it happens often. Usually, manufacturers first saturate the markets of developed countries with high purchasing power, and when the products in those markets reach the maturity phase, become morally obsolete or competitors appear, the manufacturers direct their products to new markets, where the same products go through the growth phase again.

Ex. 3‑3 International lifecycle of a product

Keywords: Vernon, life cycle, export

Another important aspect is related to appearance of competitors which produce same product. Exhibit 3-3 shows a common situation in the market introduction, maturity and standardization phase of a product. During the product introduction stage, the country where the product is manufactured begins to export this product. This product is not imported because it is sufficient for the local market, and in addition, competitors in foreign countries have not yet had time to launch such a product. When a product is introduced in the market, it is mostly imported soon by developed countries with high incomes. As the product reaches maturity, low-income developing countries begin to import this product. For a product between the maturity and standardization stage, more and more competitors in developed countries begin to produce analogy of such product. This makes it increasingly difficult for the country where the product was invented to export to these countries. When the product becomes standardized and its production is undertaken by developing low-income countries, the country that is the inventor of the product turns from an exporter into an importer, because it no longer makes sense to compete with analogues of this product that are made in countries with cheap labor. For the country where the product was invented, it is crucial to innovate and launch a new product in the market. It is important to mention here that an organization that creates an innovative product, although its production later moves to a country with cheap labor, seeks to maintain control of the production of that product and ownership of the copyright. In the Chapter 6 foreign direct investment varieties are described, in Chapter 5 contract manufacturing abroad in vertical alliances are presented.
However, trading in the domestic market is different from exporting. Differences occur depending on whether products or services are traded. Business-to-consumer and business-to-business segments are also traded differently. Business to consumer is often abbreviated B2C, business to business is often abbreviated B2B.

Ex. 3‑4 Country of origin definition

Keywords: production, components, of-shore

The business-to-consumer segment usually deals with the sale of finished goods or services to the end user. An example would be selling a piece of cloth, a smartphone, a bicycle, or toothpaste to a buyer who will use the purchased item for personal use. An example of a service to the end user could be flying a passenger on an airplane or serving tourists in a hotel. In the B2B segment, the service or product sold to a business is not intended for the end user, but for another business enterprise that will use it in its activities. An international freight forwarding service could be a great business-to-service export case.
Goods bought by another business are usually divided into raw materials and components, which are also sometimes called semi-finished products. For example, if raw steel, iron ore, crude oil, milk are exported, this is considered as export of raw materials. If already a partially processed product is exported – for example, a semiconductor, a processor, a car steering wheel, an airplane seat – it is already considered an export of components. Business-to-consumer export features are explored more in detail in this section, and business-to-business trade methods are described in much more detail in Chapter 6 of Part B of the book, because business-to-business trade relations are based on alliance-type cooperation.
When to talk about export, the most commonly understood situation is when a manufacturer in country A sells a product to an end user in country B – a B2C case, or to another manufacturer in country B – a B2B case. It is very important to understand here that a manufacturer located in country A can produce goods whose components or raw materials originate in the same country A in case, or bring components or raw materials from other countries as in case 2, such as country C (Exhibit 3-4). Sometimes the manufacturer located in country A organizes the assembly of its final product in another country, for example in country D as in cases 3 and 4. If the product is assembled in country D, usually there is inscription “Made in” on the product. Many products in the real world have the inscription “Made in China”, although the product itself is associated with the brand originated, for example, in the USA or Germany or Japan. In a truly rare product, all components have their country of origin and final assembly in one and the same country. It is difficult or even often impossible for the consumer to trace and know the country of origin of each component, although for example it is often possible to find on the product the country where the manufacturer owns the trademark or where the design and concept of the product was created. For example, the inscription “Designed in Italy” often found on footwear means that the product is designed in Italy, but it can be made anywhere in Asia. A way of doing business where the manufacturer no longer owns the physical production capacity is associated with the intellectual property business model and is extensively explored in Part B, Chapter 4 of the book. It covers franchises, patents and licenses.
If, however, the manufacturer or assembler located in country D is owned by the manufacturer in country A, then this business model is based on foreign investment and as described in Chapter 6 of part B of the book. All the different types of doing business are compared in Chapter 7 of the book.
Export is broadly understood as the sale of goods from one country to another. In the exhibit 3-4, case 1 and case 2 clearly define that the export of the final product will take place from country A to country B, but case 3 and case 4 may raise questions as to whether the exporter is still country D or country A. For example, the case where a computer from a US manufacturer, assembled in China and brought to Germany for sale can be understood as US exports to Germany or Chinese exports to Germany. This question does not have a single answer, therefore there are discussions among politicians, statistics offices, customs, business consultants, and lawyers. The question is handled differently even depending on the type of industry. For example, in the food supplement industry, the country of origin of the final product in the European Union is considered to be the country from which more than half of the components are imported. There are many reasons for hiding the origin of a product – it can be related to the desire to pay lower customs duties, to avoid international sanctions, or simply for marketing purposes. For example, consumers see Switzerland as a mark of quality in the pharmaceutical industry; so many pharmaceutical manufacturers establish their headquarters in Zurich, Geneva or Basel. However, the actual manufacturing of medicines often takes place in factories outside of Switzerland.
International trade is indeed very complex, and each case can have different challenges to face, so the following explanation of the advantages and disadvantages of exporting and the explanation on various methods of export in the next section will examine the simplified case where a domestically manufactured or assembled final product or semi-finished product or raw material is sold to another country.