Discuss about the case study International Business for Theories of Absolute and Comparative Advantage.
The difference in productivity of nation is referred as an absolute advantage, while the difference in opportunity cost is known as comparative advantage. It can be also said that with the existence of a comparative advantage both the parties get benefit from trading , as goods will be received by each party at a price less than the opportunity cost of producing that product.
On the other hand, the productivity of various producers or economy is compared by Absolute Advantage. In case small quantity input is required by the producer for a good than it is said that the producer is having an absolute advantage regarding theory (Levchenko, and Zhang, 2016). Further, comparative advantage assists the country to specialise in the production of goods for which they have lower opportunity cost which leads to increased production. These two theories are the important concept of international trade which persuades the manner and reason of devoting limited resources to the production of particular products.
The above phrase describes a circumstance concerning the loss of jobs or fear of loss of jobs, particularly by one nation to a rival. According to the theory of comparative advantage, the decision of export will be dependent on the degree of productivity. Hence the products for which company is more relative productive will be exported and import will be done of those goods in which other nations are relatively more productive (Burchill, Reus-Smit and True, 2013). Since the wage rate is lower in Mexico than the US, Perot had a view that Mexico will be chosen by American companies for construction of plants for their product as the wage rate lower to take advantage of cheaper rate of wages. This move can be taken by the companies who can work with low skill labour of Mexico and not by the other companies.
The fear is correct to a certain extent as the Mexican government offers tax benefits and low-cost loan to companies building factories in Mexico and as their wage rate is already lower from other countries.
The factors to be considered by Hyundai in selecting Alabama as the site for the factory are price advantage and location advantage. As by constructing automobile assembly unit near Alabama, the company will get the advantage of receiving required in cost effective manner. The price advantage can also be attained as lower wage rate is present there.
Since the cost of labour is lower in Alabama it would be beneficial for the company and support in improving the quality of life of people there out will be given by offering them jobs. But due to the increased manufacturing of car increase in the amount of pollution which will harm the environment.
Dunning’s electric theory advice for foreign direct investment when a foreign country is superior to its own when ownership advantage is available to firm which can be used for making monopolistic profits and when a lower rate of production is available. In the present case as the cheap wage rate is available in the foreign market and therefore it has been chosen for production. Hence, Hyundai’s decision is consistent with Dunning’s electric theory.
The fixed exchange rate is a rate predetermined by the government and not by market forces. In this rate a small change from fixed value is possible. As against it, Flexible Exchange Rate System is a system which determined by demand and supply forces of foreign exchange market. In this system value of the currency is allowed to fluctuate according to change in market forces (Arndt, 2013). The main advantage of Fixed Exchange Rate System is that it prevents speculation in foreign exchange market whereas in Flexible Exchange Rate System, encourages speculation and enable fluctuation in foreign exchange rate. The demerit of flexible exchange rate system, that it generates inflation pressure when the value of imports goes up due to the decline of currency which is not present in fixed exchange rate system.
The value of a currency is determined by ascertaining how much of other currency can be brought in one unit of home currency. The reduction in value of a currency against another currency is called devaluation. Government intervention in foreign is a reason of official devaluation. The other situations which lead to devaluation of currency are depreciation i.e. when currency rate fluctuates downwards.
Devaluation can be said as a decline in country living standard. Recession can also be said as a factor which leads devaluation in currency (Bhalla, 2012). In the above situation, the country needs to motivate business and trade hence, the devaluation of currency is done in order to encourage people to buy goods of their country. In an open market, it is considered that devaluation may lead speculators to sell their currency in an exchange with own country foreign reserves, due to this issuing country has to make actual devaluation.
It can be said that currencies are like commodities which are used either for speculation or for investment purpose. The increase and decrease in value of the currency are because of rising and fall in basic supply and demand. In the case when demand exceeds the supply is a situation when the value of the currency is increased.
The increase in interest rate of central bank gives arises to a situation when currency value might be increased by the government (Ashton and Christophers, 2015). Thus, this induces public in acquiring that currency to deposit more money in the bank for earning higher interest rate, with this procedure central bank effectively decreases the supply of money and as far as the demand of currency is high the value will continue increasing. With the increase in employment and per capita income, circumstances arise under which a country might want to increase its currency rate.
There is no particular formula for determining currency exchange rate but certain parameters and determinants are available which are described here:
Beside market forces of demand and supply, the other factors which affect the valuation of rate are speculation, RBI Intervention, Imports and Exports and Interest rates. The exchange rate is determined by the analysing effect of all these factors (Andersen, Diebold and Vega, 2007). The determinants of exchange rate are International parity conditions (relative purchasing power parity), Balance of payment model (focused on tradable goods), Asset market model (focused on assets value). The economic factors including economy policy circulated by government authorities’ economic conditions which are revealed through economic report are determinants which are to be analysed while determining the exchange rate.
Arbitrage is a methodology in which currency is purchased from one market and immediate resale of currency is being done in another market in order to make a profit from price difference in the two markets. Arbitrage is used for hedging by speculators. The various types of arbitrage methods are purchase parity theorem, two-point arbitrage (geographic arbitrage) which allows a trader to capitalise difference of two currency prices, three-point arbitrage which involves selling and buying of three different currencies.
Covered –Interest arbitrage allows a trader to capitalise geographical interest rate differentials with risk mitigation (Andersen, Diebold and Vega, 2007). The risk is eliminated by covering exchange rate exposure in the forward market.
Spot pound and the 90-day forward pound are both selling for $1.65
US interest rate 10 percent
British interest rate 6 percent.
Impact on Spot price of pound, Interest rate of UK and Interest rate of US is as follows:
In the present case Interest rate of US is higher than British interest rate hence, the arbitrageurs will convert pound to dollar and will take advantage of higher interest rate. The increasing demand of dollar will scroll down the price of pound. In the cited situation, due to lower interest rate the pound will be trade at the forward premium against the dollar. This approach will provide recommendation that 90-day rate of forward contract will be increased. Conclusion of entire situation will be that interest in UK will be increased and simultaneously interest rate of US will be reduced.
Table 1: Impact on Spot price of pound, Interest rate of UK and Interest rate of US is as follows
|
Factor |
Impact |
|
Spot price of pound |
Spot price will be down |
|
Interest rate of UK |
Increased |
|
Interest rate of US |
Decreased |
References
Andersen, T.G., Diebold, F.X. and Vega, C., 2007. Real-time price discovery in global stock, bond and foreign exchange markets. Journal of international Economics. 73(2). Pp.251-277.
Arndt, H.W., 2013. The valuation effect of changes in exchange rates. PSL Quarterly Review. 41(167).
Ashton, P. and Christophers, B., 2015. On arbitration, arbitrage and arbitrariness in financial markets and their governance: Unpacking LIBOR and the LIBOR scandal. Economy and Society. 44(2). Pp.188-217.
Bhalla, S.S., 2012. Devaluing to Prosperity: Misaligned Currencies and Their Growth Consequence. Peterson Institute.
Burchill, S., Reus-Smit, C. and True, J., 2013. Theories of international relations. Palgrave Macmillan.
Levchenko, A.A. and Zhang, J., 2016. The evolution of comparative advantage: Measurement and welfare implications. Journal of Monetary Economics. 78. Pp.96-111.
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