Internationalization School

Theories of External Trade

Classical/neoclassical trade theory explains the trade activities of domestic firms under perfect market conditions. Problems such as market imperfections, intermediary products, and transaction costs are neglected. One of the first theories of external trade was developed by Adam Smith. His concept of absolute cost advantages explained external trade as follows: a particular country specializes in the production of goods that it can produce at lower costs than other countries. These goods are exported, while goods that the country can only produce at higher costs than other countries are imported. This theory was further developed by David Ricardo. He explained international trade with the help of relative cost advantages of countries and argued that there may remain an incentive for international trade, even if one country can produce all products more cheaply than other countries. Yet another theory was developed by Heckscher and Ohlin. They distinguished different factors of production (e.g., capital and labor). According to Heckscher and Ohlin, the factor endowments of each country explain the particular mix of goods that that country produces and exports.

Theories of International Production

Theories about international production depart from the macroeconomic perspective on exports and imports described above. Instead these theories focus on the business firm as the unit of analysis, bringing the organization into close focus. Theories of international production identify market imperfections such as uncertainty, risk, the cost of information, and transaction costs, considering those important causes of the internationalization of business firms. One can distinguish economic and behavioral theories of international production.

Behavioral Explanations of International Production

The behavioral theory was proposed by Aharoni in 1966. He describes the internationalization of the firm as the result of a collective decision process in which the firm gradually increases its international involvement. The theory takes into account information imperfections and bounded rationality, treating these as core assumptions. The theory assumes that the decision-making process is not completely rational; rather, it develops in an incremental manner. In 1997, Johanson and Vahlne proposed a variation of this theory, which they called a learning theory perspective. This theory argues that the internationalization of firms is based on experimental knowledge that companies acquire about foreign markets. Companies first expand their activities into markets that have similar culture and language to their own. These firms start with exports, and from exporting they begin to gain an increasing understanding of foreign markets. After this knowledge has been acquired, business firms may feel competent to manage manufacturing operations in the foreign markets on their own. At that point, the firms decide to engage in foreign direct investment.

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