International Economics 1

International Business-1
International business may briefly be defined as “the exchange of

goods and services among individuals and businesses in multiple
countries” and it is “the involvement of entities like multinational
corporations or international business companies in business
among multiple countries”.
In reality, International business comprises all commercial
transactions (private and governmental, sales, investments,
logistics, and transportation) that take place between two or more
regions, countries and nations beyond their political boundaries.
Usually, private companies undertake such transactions for profit;
governments undertake them for profit and for political reasons.
The term "international business" refers to all those business
activities which involve cross-border transactions of goods,
services, resources between two or more nations. Transactions of
economic resources include capital, skills, people etc. for
international production of physical goods and services such as
finance, banking, insurance, construction etc.
Sometimes International business is defined as the study of multinational
companies. A multinational enterprise (MNE) is a company that has a
worldwide approach to markets and production or one with operations in
several countries. Well-known MNEs include fast-food companies such as
McDonald's and Yum Brands, vehicle manufacturers such as General
Motors, Ford Motor Company and Toyota, consumer-electronics producers
like Samsung, LG and Sony, and energy companies such as ExxonMobil,
Shell and BP. As shown, multinational enterprises can make business in
different types of market.
Areas of Study
Areas of study within this topic include foreign investment (both direct and
portfolio), and foreign trade and the factors like differences in legal systems,
political systems, economic policy, language, accounting standards, labor
standards, living standards, environmental standards, local culture,
corporate culture, and market structure (perfect and imperfect) that
influence the nature, extent and dynamics in them, as well as foreign-
exchange market, tariffs, import and export regulations, trade agreements,
climate, education and many more topics. Each of these factors may require
changes in how individual business units operate from one country to the
next.
The global business environment can be defined as the
environment in different sovereign countries, with factors
exogenous to the home environment of the organization,
influencing decision making on resource use and capabilities. The
global business environment can be classified into the external
environment and the internal environment. The external
environment includes the social, political, economic, regulatory,
tax, cultural, legal, and technological environments.
To function effectively and efficiently, companies operating

internationally must understand the social environment of the host
country they are operating in. Today there are thousands of MNCs
which operate in many parts of the globe. Such companies should
acquaint themselves with the language and culture of the country in
which they are operating.
International Economics
International economics is a field of study which assesses the implications of
international trade in goods and services and international investment. There are
two broad sub-fields within international economics: international trade and
international finance.
International economics is concerned with the effects upon economic activity
from international differences in productive resources and consumer preferences
and the international institutions that affect them. It seeks to explain the patterns
and consequences of transactions and interactions between the inhabitants of
different countries, including trade, investment and migration.
International trade studies goods-and-services flows across international
boundaries from supply-and-demand factors, economic integration, international
factor movements, and policy variables such as tariff rates and trade quotas.
International finance studies the flow of capital across international financial
markets, and the effects of these movements on economies.
International monetary economics and international macroeconomics study
flows of money across countries and the resulting effects on their economies as a
whole.
International political economy, a sub-category of international relations,
studies issues and impacts from for example international conflicts, international
negotiations, and international sanctions; national security and economic
nationalism; and international agreements and observance.
Globalization-1
The term globalization has acquired a variety of meanings, but in economic terms it
refers to the move that is taking place in the direction of complete mobility of capital
and labor and their products, so that the world's economies are on the way to becoming
totally integrated. The driving forces of the process are reductions in politically imposed
barriers and in the costs of transport and communication (although, even if those
barriers and costs were eliminated, the process would be limited by inter-country
differences in social capital).
Globalization process has ancient origins, which has gathered pace in the last fifty
years, but is still very far from complete. In its concluding stages, interest rates, wage
rates and corporate and income tax rates would become the same everywhere, driven to
equality by competition, as investors, wage earners and corporate and personal
taxpayers threatened to migrate in search of better terms. In fact, there are few signs of
international convergence of interest rates, wage rates or tax rates. Although the world
is more integrated in some respects, it is possible to argue that on the whole it is now
less integrated than it was before the first world war, and that many middle-east
countries are less globalized than they were 25 years ago. Of the moves toward
integration that have occurred, the strongest has been in financial markets, in which
globalization is estimated to have tripled since the mid-1970s. Recent research has
shown that it has improved risk-sharing, but only in developed countries, and that in the
developing countries it has increased macroeconomic volatility. It is estimated to have
resulted in net welfare gains worldwide, but with losers as well as gainers.
Globalization-2
Increased globalization has also made it easier for recessions to spread from
country to country. A reduction in economic activity in one country can lead to
a reduction in activity in its trading partners as a result of its consequent
reduction in demand for their exports, which is one of the mechanisms by
which the business cycle is transmitted from country to country. Empirical
research confirms that the greater the trade linkage between countries the more
coordinated are their business cycles.
Globalization can also have a significant influence upon the conduct of
macroeconomic policy and analysis of the role of capital mobility. Part of the
increase in income inequality that has taken place within countries is
attributable - in some cases - to globalization.
A recent IMF report demonstrates that the increase in inequality in the
developing countries in the period 1981 to 2004 was due entirely to
technological change, with globalization making a partially offsetting negative
contribution, and that in the developed countries globalization and
technological change were equally responsible.
Opposition (to Globalization)
Globalization is seen as contributing to economic welfare by most
economists – but not all. Professor Joseph Stiglitz of the School of
International and Public Affairs, Columbia University has advanced
the infant industry case for protection in developing countries and
criticized the conditions imposed for help by the International
Monetary Fund.
Professor Dani Rodrik of Harvard has noted that the benefits of
globalization are unevenly spread, and that it has led to income
inequalities, and to damaging losses of social capital in the parent
countries and to social stresses resulting from immigration in the
receiving countries.
Protection VS Free Trade: Arguments and Debate
International trade has two contrasting views regarding the level of control
placed on trade: free trade and protectionism. Free trade is the simpler of the
two theories: a laissez-faire approach, with no restrictions on trade. The main
idea is that supply and demand factors, operating on a global scale, will ensure
that production happens efficiently. Therefore, nothing needs to be done to
protect or promote trade and growth, market forces will do so automatically.
In contrast, protectionism holds that regulation of international trade is

important to ensure that markets function properly. Advocates of this theory
believe that market inefficiencies may hamper the benefits of international trade
and they aim to guide the market accordingly. Protectionism exists in many
different forms, but the most common are tariffs, subsidies and quotas. These
strategies attempt to correct any inefficiency in the international market.
Everybody would agree today that countries can hardly survive without trade,
and that even if they could live in autarky they would suffer much from it.
Hence, trade as such is not a policy issue. The important question is how much
trade? Should policy makers stand for free trade in all cases or should they
envisage providing domestic industries with some degree of protection? The
relevant debate is whether there should be more, less or no protection.
.
The Case for Protection-1
Protection can be advocated for purely economic reasons or on other grounds
such as equity considerations, national security objectives, the defence of
vulnerable groups, to avoid risks rated as unacceptable, and to defend certain
interest groups because of political calculation. In the agricultural sector,
protection can also be advocated on food security grounds.
Economic arguments
Infant Industry argument
Economic arguments stress the role of industry learning and among the
economic arguments for protection the most influential one is that of the infant
industry. Protection is justified as a temporary measure while a nascent industry
develops and comes to the stage where it will be ready to face international
competition. Several reasons may exist to protect an industry during its infant
phase. Those more frequently quoted are economies of scale, managerial and
technological learning processes, start up costs (e.g. opening marketing
channels, bringing in and adapting technology), and economies external to the
firms but internal to the industry that may take time and may need help to
develop but once developed will allow the industry to stand on its own.
The term "infant industry" is used to denote a new industry which has prospects of
gaining comparative advantage in the long-term, but which would be unable to survive
in the face of competition from imported goods. This situation can occur when time is
needed either to achieve potential economies of scale, or to acquire potential learning
curve economies. Successful identification of such a situation, followed by the
temporary imposition of a barrier against imports can, in principle, produce substantial
benefits to the country that applies it – a policy known as “import substitution
industrialization”.
Whether such policies succeed depends upon the governments’ skills in picking
winners, with reasonably expectations of both successes and failures. It has been
claimed that South Korea’s automobile industry owes its existence to initial protection
against imports, but a study of infant industry protection in Turkey reveals the absence
of any association between productivity gains and degree of protection, such as might
be expected of a successful import substitution policy.
Another study provides descriptive evidence suggesting that attempts at import
substitution industrialization since the 1970s have usually failed, but the empirical
evidence on the question has been contradictory and inconclusive. It has been argued
that the case against import substitution industrialization is not that it is bound to fail,
but that subsidies and tax incentives do the job better. It has also been pointed out that,
in any case, trade restrictions could not be expected to correct the domestic market
imperfections that often hamper the development of infant industries.
Market failure argument
Protection is also advocated as an argument considering market failures i.e., when
markets relevant to the activity in question either do not exist or do not function
well. Protecting the industry may allow it to operate under these conditions of
market failure. Thus, for instance, lack or inadequate working of financial markets
in a country may prevent an industry from raising the financial resources needed to
modernize and withstand international competition. Protection may enable the
industry to make the extra profits required to finance its expansion and technical
improvement plans.
Externalities argument
There is a related but separate argument in favor of protecting industries which
generate positive externalities and spillover effects for other groups. An argument
of this nature is used to advocate continued protection to European farmers under
the CAP (Common Agricultural Policy). It is claimed that agriculture is a
multifunctional activity whose contribution is not just food production but also
environmental protection, land stewardship, and preservation of the landscape and
lifestyle of the countryside. By protecting European farmers from foreign
competition, these beneficial side effects of agriculture, for which European
consumers and citizens are believed to be willing to pay, would be preserved.
Terms of trade effects argument
Another economic argument is that known as optimum tariff theory. In
the case of importing and exporting countries sufficiently large to affect
the world price of the particular commodity, a tariff on imports (or a tax
on exports) may serve to improve the terms of trade in favor of the
country. This is because by restricting imports the tariff will weaken
world demand putting a downward pressure on the price of the imported
commodity. Similarly, by restricting exports the export tax will weaken
world supply putting an upward pressure on the price of the exported
commodity. Of course, gains from protection obtained by a country in
this way are at the expense of its trading partners.
A type of protection often applied in practice, known as contingent
protection, seeks to counteract "unfair" trading practices, in particular
the type of competition that results from export subsidies or from
dumping. Protection is advocated because the price at which the
commodity enters the country reflects distortionary practices on the
exporter's side. Hence, it is not a price that the domestic industry should
be expected to match.
Food security arguments
Protection can also be advocated for reasons of food security the objective of
which is to ensure availability, stability in food supplies and physical and
economic access all human beings on a permanent basis to the basic foods they
need. Thus, governments may try to ensure through protection that some
minimum level of national production of basic foods is attained.
Trade can contribute to food security in a number of ways: by making up the
difference between production and consumption needs; reducing supply
variability; fostering economic growth; making more efficient use of world
resources; and permitting production to take place in those regions more suited
to it. But reliance on trade may also bring some risks such as uncertainty of
supplies, world market price instability, and increasing environmental stress if
appropriate policies are not in place.
…but there are also risks
In developing countries, export opportunities are usually better for non-food
cash crops. Increased trade opportunities may therefore induce substitution of
food crops by non-food cash crops. This can be favorable for the food security
of producers if they can purchase food in local markets at fair prices. Food
security could, however, be at risk if inefficiencies in the food marketing
system result in high food prices.
Non-economic reasons
Non-economic reasons involve redistribution of income to either more
vulnerable or, often, more powerful groups.
Social and political reasons for protection are often stronger than purely
economic arguments. In essence, protection seeks to avoid the negative impact
of import competition on the incomes of domestic factor owners. It is also a
way of favoring certain groups considered meritorious of positive
discrimination by the political decision-making process. This is the case with
farmers in many countries, notably in Europe, Japan and the United States.
Through the political process, for social and political reasons, societies in these
countries have decided to give special economic treatment to their farming
sectors, even at the cost of higher food prices to consumers and higher taxes
(and also of reduced opportunities to other countries). This is a luxury that
developing countries could hardly afford.
Sheer political pressure from powerful industrial or labor groups that stand to
lose from free trade is also a common reason for protection.
Producing with the help of protection a more diversified collection of products
than would be the case with free trade specialization may also bring wider
social and political advantages such as improving national defence. This is an
argument typically used for the protection of military and other so-called
"strategic" industries.
The Case Against Protection-1
The main arguments for free trade (as opposed to simply trade) or, equivalently,
the main arguments against protection are four: that protection promotes
inefficiency, that it encourages rent-seeking behavior, that it always implies a
net welfare loss, and that there are usually more direct and efficient non-trade
measures to achieve the desired objective.
The prevalent consensus: Desire for freer trade is now widespread
The consensus nowadays among policy-makers around the world is that trade is
advantageous and that the growth of international exchanges should be
encouraged. The road to increased trade is through progressive reductions in the
level of protection.
There are two methods, not mutually exclusive, to progress along this path. One
is through regional trade agreements, which seek the reduction or elimination
of trade barriers among a limited set of countries, normally (but not always)
adjacent. The other is through multilateral trade negotiations (MTN), like the
ones which have taken place for several decades under GATT and are now
taking place under WTO. These agreements are called multilateral because they
exclude preferential treatment by one country to another country or set of
countries, and are based on the application of the most favored nation (MFN)
clause to all countries entering the agreement.
Protection promotes inefficiency
The first argument stresses that by isolating domestic producers, at least in part,
from the pressures of international competition, protection permits inefficient
industries to perpetuate themselves at the expense of domestic consumers and
of the soundness of the growth process. It also checks the dynamic process of
entrepreneurial learning and innovation stimulated by exposure to international
competition. By reducing competition and artificially raising profits, more
firms may be attracted and be able to survive in the protected industries than
would be economically justified, reducing the market share of the remaining
firms and thus preventing the attainment of potential economies of scale.
Protection distracts effort into rent-seeking
It is also argued that protectionist measures are usually granted by political
decision-makers to production sectors on a rather ad hoc and frequently
clientelistic way, and are often not connected to clearly identifiable and
measurable losses from trade. This gives rise to situations where entrepreneurs
and owners of productive factors in general focus their energies in lobbying
decision-makers to obtain administrative concessions which would benefit them
- referred to as rent-seeking behavior. The proponents of free trade argue that
since in most cases the political process makes the above almost unavoidable,
countries are better advised to go for free trade without exceptions or, short of
this, to go for low levels of tariff protection equally and transparently applied to
all industries across the board.
Protection is costly to society
Another argument against protection is that it makes society as a whole
poorer in overall terms. Although producers benefit from protection, and
the government benefits from the additional tariff revenue, their gains are
more than counterbalanced by the higher prices consumers must pay for
the protected commodity. If protection takes place through subsidies to
producers or to inputs, then it will be the taxpayers that will lose out.
…and usually more effective alternatives exist
Of course, any cost to society must be weighed against the benefits
which are sought from the protectionist policy. But it is usually the case
that there are more direct and more efficient measures to address the
market deficiencies which lie behind protectionist measures. For
example, if it is desired to encourage infant industries, it would be better
to do this through a targeted industrial subsidy than through trade
protection which benefits all firms whether infant or not.
International Trade-1
International trade is a field in economics that applies microeconomic
models to help understand the international economy. Its content includes
the same tools that are introduced in microeconomics courses, including
supply and demand analysis, firm and consumer behavior, perfectly
competitive, oligopolistic and monopolistic market structures, and the
effects of market distortions. The typical course describes economic
relationships between consumers, firms, factor owners, and the
government.
The objective of an international trade course is to understand the effects
on individuals and businesses because of international trade itself, the
changes in trade policies and the changes in other economic conditions.
International trade is the exchange of goods and services between
countries. Trading globally gives consumers and countries the
opportunity to be exposed to goods and services not available in their
own countries. Almost every kind of product can be found on the
international market: food, clothes, spare parts, oil, jewelry, wine, stocks,
currencies and water. Services are also traded: tourism, banking,
consulting and transportation.
International Trade-2
In a broader sense international trade covers transactions between residents of different
countries. Without international trade, nations would be limited to the goods and
services produced within their own borders. Increasing international trade is crucial to
the continuance of globalization and the factors that have major impact on the
international trading system include industrialization, advanced transportation,
globalization, multinational corporations, and outsourcing.
International trade is in principle not different from domestic trade as the motivation
and the behavior of parties involved in a trade do not change fundamentally regardless
of whether trade is across a border or within the borders of a country. International trade
however, not only involves inward and outward movement of goods and services, but
also results in inflow and outflow of foreign exchange and in addition, international
trade is typically more costly than domestic trade because of tariffs, time costs due to
border delays and costs associated with country differences such as language, the legal
system or culture.
International trade gives rise to a world economy, in which prices, or supply and
demand, affect and are affected by global events. Political change in Asia, for example,
could result in an increase in the cost of labor, thereby increasing the manufacturing
costs for an American sneaker company based in Malaysia, which would then result in
an increase in the price that you have to pay to buy the tennis shoes at your local mall. A
decrease in the cost of labor, on the other hand, would result in you having to pay less
for your new shoes.
International Trade Theory-1
Mercantilism (16-17th century): The approach emerged in England in mid-16th
century and advocated that countries should simultaneously encourage exports
and discourage imports. The main tenet of the approach was: it was in a
country’s best interest to maintain a trade surplus, or to export more than it
imported. Gold and silver were the mainstays of a nation’s wealth and
exporting more meant that a country earned more gold and silver and importing
more meant that it spent more of those. Thus the surplus in trade meant that a
country would accumulate more gold and silver and consequently, increase
national wealth and power.
Neo-Mercantilism: Neo-Mercantilists do not believe or talk about gold and
silver as currency of trade but hold that political and economic power can be
gained through balance of trade surplus.
Mercantilists believed that trade is a zero-sum game – gain by one country

results in a loss by another country. But Adam Smith and later, the proponents
of modern theories explain that trade should be a positive sum game, which
means that a situation in which all participating countries can benefit.
Theory of Absolute Advantage (Adam Smith, “The Wealth of Nations”, 1776)
The theory explained why unrestricted free trade (import and export) is
beneficial to a country. Free trade refers to a situation when a government does
not attempt to influence through quotas or duty what its citizens can buy from
another country or what they can produce and sell to another country. Free trade
is a game of invisible hands of the market mechanism rather than government
policy that determines what a country imports and what it exports.
The Absolute Advantage Theory suggests that countries differ in their ability to
produce goods efficiently and countries should employ their resources and
specialize in the production of goods in which they have absolute advantage
(ability to produce at low costs) and then trade these goods for goods of other
countries in which the later have absolute advantage. For example, eighteenth
century England had an absolute advantage in producing textiles, while France
in that period had an absolute advantage in producing wine, which means
England should produce and sell textiles in exchange of wine produced and
sold by France and such trade is a positive-sum game benefiting both countries.
Theory of Absolute Advantage (contd)
Assume that Ghana and South Korea both have the same amount of resources (say, 200 units)
that can be used in producing either rice or cocoa. Imagine that in Ghana, it takes 10 units of
resource to produce 1 ton of cocoa and 20 units of resource to produce 1 ton of rice, while in
Korea, it takes 40 units of resource to produce 1 ton of cocoa and 10 units of resource to produce
1 ton of rice. Also, say Ghana and Korea do not specialize and both produce the two products by
using 100 units of resource in each product (by distributing their 200 units in the two products).
In that case, Ghana produces 10 tons of cocoa and 5 tons of rice and Korea – 2.5 tons of cocoa
and 10 tons of rice. But if Ghana specializes in cocoa (because of absolute advantage) and Korea
does so in rice, Ghana could use all 200 units of resource in producing 20 tons of cocoa and
Korea on the other hand, can produce 20 tons of rice
Country Resource Resource needed to Production and Trade

Available produce 1 ton
Without With
Specialization Specialization
Cocoa Rice Cocoa Rice Cocoa Rice
Ghana 200 10 20 10 5 20 0
Korea 200 40 10 2.5 10 0 20
Total Production 12.5 15 20 20
Theory of Absolute Advantage (contd)
The consumption after Ghana exports 6 tons of cocoa for 6 tons of Korea’s rice:
Availability for Consumption (ton) Increase in Consumption (ton)
Cocoa Rice Cocoa Rice
Ghana 20 – 6 = 14 0+6=6 14 – 10 = 4 6–5=1
Korea 0+6=6 20 – 6 = 14 6 – 2.5 = 3.5 14 – 10 = 4
The illustration shows that by specialization, the production and consumption of both
goods can be increased in countries trading in them. Total production cocoa increased
by 20 – 12.5 = 7.5 tons and that of rice by 20 – 15 = 5 tons. The increase in production
of cocoa is shared between Ghana and Korea in amounts of 4 ton and 3.5 ton and that of
rice between them in amounts 1 and 4 ton.
The theory of comparative advantage provides a logical explanation of international
trade as the rational consequence of the comparative advantages that arise from inter-
regional differences - regardless of how those differences arise. Since its exposition by
David Ricardo the techniques of neo-classical economics have been applied to it to
model the patterns of trade that would result from various postulated sources of
comparative advantage. However, extremely restrictive (and often unrealistic)
assumptions have had to be adopted in order to make the problem amenable to
theoretical analysis.
Comparative Advantage Theory (David Ricardo, Principles of Political
Economy, 1817):
This theory explains what might happen if one country has absolute advantage
in production of all goods. The Absolute Advantage theory suggests that in such
case the country does not derive any benefit from trade. But the theory of
comparative Advantage says, trade is a positive sum game, all countries in trade
benefit and it makes sense for a country to specialize in the production of those
goods that it produces more efficiently and buy/import the goods that it
produces less efficiently.
Assume that Ghana is more efficient (i.e., it has absolute advantage) in

producing both cocoa and rice and it takes 10 units of resource to produce 1 ton
of cocoa and 13.33 units of resource to produce 1 ton of rice. On the other
hand, Korea, also having absolute disadvantage in producing both goods, takes
40 units of resource to produce 1 ton of cocoa and 20 units of resources to
produce 1 ton of rice. Now, if Ghana and Korea each has 200 units of resources,
in the situation of no trade Ghana may decide to produce 10 ton of cocoa and
7.5 ton of rice and Korea 2.5 ton of cocoa and 5 ton of rice, but in case they go
for specializing with the idea of trading, Ghana may produce 15 ton of cocoa
and 3.75 ton of rice and Korea no cocoa and 10 ton rice only.
The matrix for production and gains from trade between the two countries in the
products may look like the following:
Country Resource Resource needed to Production and Trade
Available produce 1 ton
Without With
Specialization Specialization
Cocoa Rice Cocoa Rice Cocoa Rice
Ghana 200 10 13.33 10 7.5 15 3.75
The consumption after
Korea 200 Ghana exports
40 4 tons of 20
cocoa for 42.5
tons of Korea’s
5 rice:0 10
Total Production 12.5 12.5 15 13.75
The consumption after Ghana exports 4 tons of cocoa for 4 tons of Korea’s rice:
Availability for Consumption (ton) Increase in Consumption (ton)
Cocoa Rice Cocoa Rice
Ghana 15 – 4 = 11 3.75 + 4 = 7.75 11 – 10 = 1 7.75 – 7.5 = 0.25
Korea 0+4=4 10 – 4 = 6 4 – 2.5 = 1.5 6–5=1
The illustration shows that by specialization, the production and consumption of both
goods can be increased in countries trading in them. Total production cocoa increased
by 15 – 12.5 = 2.5 tons and that of rice by 13.75 – 12.5 = 1.25 tons. The increase in
production of cocoa is shared between Ghana and Korea in amounts of 1 ton and 1.5
ton and that of rice between them in amounts 0.25 and 1 ton.
Qualifications and assumptions (in illustration of the theories of absolute and
comparative advantage):
 Only two countries are in trade in two goods (in reality, many countries trade in
many commodities);
 Transaction costs are not considered;
 Differences in prices of resources and in exchange rates in different countries are not
considered;
 Resources move freely from production of one good to that of another in a country;
 Returns to scale in constant;
 Each country has a fixed stock of resources;
 Effect of trade on income distribution pattern within a country is not considered*.
*prices that US consumers pay for goods imported from China may not be enough to
produce net gain for the US economy and consumers in the US if the dynamic effect of
free trade lowers real wage rates (or, even job losses) in the US.
Three important observations:

 Free trade has historically benefitted rich countries; and
 Countries that adopt a more open stance toward international trade enjoy higher
growth rates than those that close their economies to trade; and
 Higher growth rate raises income levels and living standards.
The Heckscher – Ohlin Theory:
Ricardo’s Theory of Comparative Advantage explains that the comparative
advantage in trade arises out of differences in productivity but Eli Heckscher
and Bertil Ohlin argued that nations have varied factor endowments (the extent
to which a country is endowed with resources such as land, labor and capital)
and comparative advantage arises from differences in factor endowments. The
theory suggests that countries will export those goods that make intensive and
more productive use of the factors that are locally abundant, while importing
goods that make intensive use of factors that are locally scarce. For example,
US is a substantial exporter of agricultural goods because it has natural
abundance of arable land and China excels in the export of goods produced in
labor intensive manufacturing industries (textiles, footwear etc.) where it has
relative advantage in terms of low cost of labor.
The best-known of the resulting models, the Heckscher-Ohlin theorem (H-O)
depends upon the assumptions of no international differences of technology,
productivity, or consumer preferences; no obstacles to pure competition or free
trade and no scale economies. On those assumptions, it derives a model of the
trade patterns that would arise solely from international differences in the
relative abundance of labor and capital (referred to as factor endowments). The
resulting theorem states that, on those assumptions, a country with a relative
abundance of capital would export capital-intensive products and import labor-
intensive products.
The theorem proved to be of very limited predictive value, as was demonstrated by
what came to be known as the "Leontief Paradox" (the discovery that, despite the
expectation that the US would have been an exporter of capital intensive goods because
it is abundant in capital compared to other countries, the US exports are less capital
intensive and the country exports labor-intensive products and imports capital-intensive
products).
The Stolper-Samuelson theorem, which is often described as a corollary of the H-O
theorem, was an early example. In its most general form it states that if the price of a
good rises (falls) then the price of the factor used intensively in that industry will also
rise (fall) while the price of the other factor will fall (rise). In the international trade
context for which it was devised it means that trade lowers the real wage of the scarce
factor of production, and protection from trade raises it.
Another corollary of the H-O theorem is Samuelson's factor price equalization theorem,
which states that as trade between countries tends to equalize their product prices, it
tends also to equalize the prices paid to their factors of production. Those theories have
sometimes been taken to mean that trade between an industrialized country and a
developing country would lower the wages of the unskilled in the industrialized
country. (But, as noted below, that conclusion depends upon the unlikely assumption
that productivity is the same in the two countries). Large numbers of learned papers
have been produced in attempts to elaborate on the H-O and Stolper-Samuelson
theorems, and while many of them are considered to provide valuable insights, they
have seldom proved to be directly applicable to the task of explaining trade patterns.
Modern analysis
Modern trade analysis moves away from the restrictive assumptions of
the H-O theorem and explores the effects upon trade of a range of
factors, including technology and scale economies. It makes extensive
use of econometrics to identify from the available statistics, the
contribution of particular factors among the many different factors that
affect trade. The contributions of differences of technology have been
evaluated in several such studies. The temporary advantage arising from
a country’s development of a new technology is seen as contributory
factor in one study.
Other researchers have found research and development expenditure,
patents issued, and the availability of skilled labor, to be indicators of the
technological leadership that enables some countries to produce a flow of
such technological innovations and have found that technology leaders
tend to export hi-tech products to others and receive imports of more
standard products from them. Another econometric study also established
a correlation between country size and the share of exports made up of
goods in the production of which there are scale economies.
The study further suggested that internationally traded goods fall into three
categories, each with a different type of comparative advantage:
 goods that are produced by the extraction and routine processing of available
natural resources – such as coal, oil and wheat, for which developing
countries often have an advantage compared with other types of production
– which might be referred to as "Ricardo goods";
 low-technology goods, such as textiles and steel, that tend to migrate to
countries with appropriate factor endowments - which might be referred to
as "Heckscher-Ohlin goods"; and,
 high-technology goods and high scale-economy goods, such as computers
and aeroplanes, for which the comparative advantage arises from the
availability of R&D resources and specific skills and the proximity to large
sophisticated markets.
There is a strong presumption that any exchange that is freely undertaken will
benefit both parties, but that does not exclude the possibility that it may be
harmful to others. However (on assumptions that included constant returns and
competitive conditions) Paul Samuelson has proved that it will always be
possible for the gainers from international trade to compensate the losers.
Moreover, in that proof, Samuelson did not take account of the gains to others
resulting from wider consumer choice, from the international specialization of
productive activities - and consequent economies of scale, and from the
transmission of the benefits of technological innovation.
Product Life Cycle Theory (Raymond Vernon, 1966)
The product life cycle theory explains the process and stages in which the production,
consumption, export and import of a product take place. Also, often, the same firms that pioneer
a product in their home market undertake FDI to produce it for consumption in the foreign
market and firms undertake FDI at particular stages in the life cycle of a product they have
pioneered – they invest in other advanced countries when local demand in those countries grows
large enough to support local production.
Product Production Imports Standardization of Product
Development Making the Products
Consumption
At home and At home and Export and consumption May take place simultaneously;
abroad; may take place sometimes a country may export
abroad sometimes by a simultaneously; Also, export its products first, do both export
country in a its products first, do both and import at the same time, or
foreign one and export and import at the initially export, but later, import,
sometimes, no same time, or initially too.
production but import, but later, produce at
import only home.
Product Life Cycle: The period of time over which an item is developed, brought to market and
eventually removed from the market. First, the idea for a product undergoes research and
development. If the idea is determined to be feasible and potentially profitable, the product will
be produced, marketed and rolled out. Assuming the product becomes successful, its production
will grow until the product becomes widely available. Eventually, demand for the product will
decline and it will become obsolete.
Porter’s Theory: (Michael E. Porter, 1990, Comparative Advantage of Nations, Harvard Business
Review, March-April 1990)
The Heckscher – Ohlin theory and the Theory of Comparative Advantage can only partially
answer to the following questions:
 Why a nation achieves international success in a particular industry?
 Why does Japan do so well in automobile industry?
 Why does Switzerland excel in the production and export of precision instruments and
pharmaceuticals?
 Why do Germany and the US perform superbly in the chemical industry?
Porter explains that there are four attributes that shape the environment in which a nation’s local
firms compete and these attributes promote or impede the creation of competitive advantage.
Firm Strategy,
Structure and Rivalry
Factor Demand
Endowments Conditions
Related and
Support Industries
Determinants of National Competitive Advantage: Porter’s Diamond

Porter says that the four attributes constituting a ‘diamond’ and the degree to which a nation
is likely to achieve international success in a certain industry is a function of the combined
effect of the four attributes, which (especially, factor endowments) can be affected by
subsidies, policies toward capital markets, education, training and so on. Firms succeed if
the diamond is favorable and the diamond is a mutually reinforcing system.
• Firm’s strategy, structure and rivalry depend on conditions governing how companies are
created, organized and managed and the nature of domestic rivalry.
Nations are characterized by different management ideologies, which either help or do not
help firms to develop competitive advantage.
There is a strong association between vigorous domestic rivalry and the creation and
persistence of competitive advantage in an industry.
• Factors endowment includes a nation’s position in factors of production (naturally
endowed basic factors plus skilled labor, infrastructure, research facilities, technological
know-how etc.).
• Demand Conditions imply the nature of home demand (the diversity and size of demand)
for the industry’s product. Consumers pressure local industries to meet high standards of
product quality.
• Related and support industries mean the presence/absence of supplier industries and
related industries that are internationally competitive. Benefits of investment in advanced
factors of production by related and support industries spill over into an industry
involved in international trade and clusters of relationships do help.
Two additional variables (according to Porter) are chance and government; chance events
often reshape industry structures, government policies can detract from or improve national
advantage.
The Consensus!
Given the differences in approaches, there is a consensus on
the idea that although some countries do export primary goods
in which they are naturally endowed with (oil, timber, precious
metals), in case of manufactured products differences in
technology leads to differences in productivity and abundance
of capital with innovative manufacturing technology is a mix
that shape the trading pattern (example: export of automobiles
from Japan). Once the differences in technology across
countries are controlled for, countries will concentrate more in
export of goods that make the best use of the factors that are
locally abundant, while importing goods that make more
intensive use of factors that are locally scarce.
The Effects of International Trade-1
A variety of models are developed which highlight the following five
basic reasons that trade occurs.
 differences in technology
 differences in resource endowments
 differences in consumer demand
 existence of economics of scale in production
 existence of government policies
The models address the effects that trade has on the prices of goods and
services, the profits of firms, the well-being of consumers, the wages of
workers, and the return to other factors of production.
The Effects of Trade Policies
These models address the effects that trade policies have on the prices of
goods and services, the profits of firms, the well-being of consumers, the
wages of workers, the return to other factors of production and the
implications for the government budget. This section is divided
according to the following assumptions on market structure.
• Perfect Competition
• Market Imperfections and Distortions
Factor Price Equalization
There have been widespread misgivings about the effects of international trade
upon wage earners in developed countries. Samuelson‘s factor price
equalization theorem indicates that, if productivity were the same in both
countries, the effect of trade would be to bring about equality in wage rates. As
noted above, that theorem is sometimes taken to mean that trade between an
industrialized country and a developing country would lower the wages of the
unskilled in the industrialized country. However, it is unreasonable to assume
that productivity would be the same in a low-wage developing country as in a
high-wage developed country.
A 1999 study has found international differences in wage rates to be
approximately matched by corresponding differences in productivity. (Such
discrepancies that remained were probably the result of over-valuation or
under-valuation of exchange rates, or of inflexibilities in labor markets.) It has
been argued that, although there may sometimes be short-term pressures on
wage rates in the developed countries, competition between employers in
developing countries can be expected eventually to bring wages into line with
their employees' marginal products. Any remaining international wage
differences would then be the result of productivity differences, so that there
would be no difference between unit labor costs in developing and developed
countries, and no downward pressure on wages in the developed countries.
Trade and Equity
Will the benefits from trade be fairly distributed? Will everybody win or at least not
lose? Two issues can be distinguished here; one is the impact of trade on different
economic or social groups within a country, the other is whether the gains from trade
are fairly distributed between trading countries. These issues are examined separately
below.
The impact of trade on income distribution within a country
There are winners and losers from trade. It is obvious that workers, entrepreneurs,
investors and owners of natural resources (i.e. the owners of productive factors)
engaged in export industries stand to win from increased trade since their activities
develop if exports expand. Contrariwise, the owners of factors engaged in industries
which have to compete with products imported from abroad, i.e. of import-competing
industries, stand to lose from increased trade.
The distribution of the gains and losses arising from trade among the owners of
productive factors will depend on the situation in the respective markets. In general,
however, factors which are intensively used in an industry, for instance labor in textile
industries or land in extensive farming, will stand to gain or lose more than those not
intensively used. Similarly, owners of factors that are rather specific to the industry and
hence relatively immobile, for instance workers skilled in some agricultural operations
(e.g. pruning) or the owners of lands particularly suited to the production of specific
crops, will gain or lose more than the owners of more undifferentiated and mobile
factors.
If no domestic industries produce the imported good (or close substitutes), consumers
(or the producers that use it as an input) will benefit from trade, without anyone losing.
Intra-industry trade, where differentiated products from the same industry are traded,
will in general have less negative impact on the domestic import-competing industry
than trade based on specialization, where the import-competing industry may risk being
totally swept away.
Farmers are vulnerable to trade changes because of the lack of alternative opportunities
Since, in comparison with other industries, factor mobility and product differentiation
are rather limited in agriculture, the farming sector is particularly vulnerable to the
impact of trade. Thus, it is difficult for agricultural land to change its use to urban or
recreational use in response to import competition, or for agricultural labor to find
another type of employment since this normally requires reskilling and will often imply
migration. It is possible for farmers to change crops to adjust to international
competition, but weather, soils, technical know-how and other factors that may restrict
or jeopardize possible changes will often come into play. Shifting from plantation or
livestock farming to other type of agriculture will be particularly expensive and take a
long time. These rigidities, typical of the farm sector, are one of the reasons why
governments have traditionally tended to protect farmers from the effects of
international competition.
How do different countries benefit from trade?
This is a highly contentious subject surrounded by controversy and contrasting points of
view. We cannot survey them all here but we will summarize some of the most
representative ones.
The "mainstream economics" view:
Mainstream theories emphasize the role of demand in explaining the distribution of trade
gains between countries
The first view we have called "mainstream economics" to emphasize a theoretical tradition
that is at the core of conventional Western academic economic thinking on international
trade issues. While "mainstream economics" has much to say on the benefits deriving from
trade and the welfare implications of protectionist policies and regional trade agreements, it
does not offer much by way of predictions with respect to the inter-country distribution of
trade gains.
As mentioned before, under the comparative cost theory the distribution of benefits is
inversely related to the closeness of the international terms of trade to the domestic price
ratio. However, in the original formulation of the theory by David Ricardo there was no
explanation of how close the terms of trade would be to either of the domestic price ratios.
Later economists, such as John Stuart Mill, stressed the role of demand factors in the
determination of the terms of trade. Thus, if in our example, United States consumers are
much more eager demanders of sugar than of chips compared to their Brazilian counterparts,
the terms of trade will favor Brazil, which will obtain most of the gains. This was a step
forward but not yet a fully satisfactory theory since there was no explanation of the
determinants of the demand for imported/exported commodities.
In more modern forms of the theory, the terms of trade continue to
depend on the relative strength of the respective demands. The main
prediction arising from this reformulation is a dynamic one stating that
export-biased growth, i.e. growth based on technological advance in the
export industry of a country, would turn the terms of trade against the
country, lowering its share in the gains.
The opposite would happen with import-biased growth. The reason is
straightforward: export-biased growth permits a decrease in the cost of
exported goods relative to imported goods and hence results in a fall in
the terms of trade. The opposite is the case with import-biased growth. In
our example, if there is a technological breakthrough in the
semiconductor industry, and hence in the production of chips, but not in
that of sugar, there will be a tendency, under competitive conditions, for
the price of chips to decrease vis-à-vis that of sugar. The above effects
only take place, however, if the participation in world trade of the
country in question is sufficiently large for a reduction in the domestic
production cost to influence the international price of the commodity
The structuralist view:
Structuralists argue that the periphery is disadvantaged relative to core
countries.
In the 1950s and 1960s, the distribution of trade gains between developed
countries (the "centre" of the world economy) and less developed countries (the
"periphery") became an issue of intense debate, due in no small part to the
intellectual influence of Raul Prebisch, the Argentinean economist who was for
many years at the head of the UN Economic Commission for Latin America
and one of the fathers of the Latin American structuralist school. The argument
is based on the assumption of trade specialization between centre and periphery,
with the centre specializing in exporting manufactured industrial products and
the periphery primary commodities. After observing (and measuring) a secular
decline in the terms of trade of primary commodities vis-à-vis manufactured
goods, the structuralists set about to explain the reasons for this.
The decline was viewed not as a transitory phenomenon due to a specific set of
circumstances but as something embedded in the structural features of central
and peripheral economies and in the nature of the development process.
In a nutshell, the declining trend in the terms of trade for countries in the periphery4 was
explained by three reasons.
• The income elasticity of the demand for imports is lower at the centre than in the
periphery due to the different type of the goods imported by both sets of countries -
primary commodities in one case, industrial products in the other. The consequence is
that the process of growth, and hence of income expansion, raises import demand more
in the periphery than at the centre pushing up the prices of periphery imports vis-à-vis
those of exports and thus lowering the terms of trade.
• Asymmetries are postulated in the impact of technological change at the centre and in the
periphery. In central countries, it is argued that technological progress tends to decrease
the demand for periphery country exports (many of which are substituted by synthetic
products). On the contrary, technological progress in the periphery increases the demand
for capital goods and inputs produced at the centre. This also lowers the terms of trade.
• Product and factor markets are argued to be less competitive at the centre than in the
periphery, with prices (particularly wage rates) showing more downward rigidity in the
centre. As a consequence, cost savings from technical progress are passed on to export
prices more in the periphery than in the centre, where a significant portion of these
savings goes to improve wages. Also, during the downturn of the business cycle the
prices of export products fall proportionally more in the periphery than at the centre.
A natural policy corollary of the structuralist view was the emphasis on industrialization as a
vehicle for development, for if the diagnosis of the long-term evolution of the terms of trade
was right, the development process could not rely on export-led growth based on primary
products. The development policy associated with this view in the Latin American context of
the time has come to be known as import-substitution strategy.
Unequal exchange and dependency views:
Unequal exchange is a normative concept. Theorists subscribing to the so-called
"unequal exchange" view have also insisted on the uneven distribution of trade gains
between the centre and the periphery. A key difference with the structuralists is that,
while the latter focus on the trend over time of an observable variable, the terms of
trade, the former have a more normative approach, focusing on the "unfairness" of trade
between the two sets of countries at any given point in time.
Unequal exchange refers to the terms on which different commodities entering trade
between the centre and the periphery are exchanged. Exchange is said to be unequal (in
the normative sense of "unfair") because production conditions in the periphery lead to
exporting goods at cheaper prices than if the conditions had been those of the centre. At
any point in time, production conditions at the centre lead to high prices of the
commodities exported, whereas production conditions in the periphery lead to cheap
prices of exports.
What are the differences in production conditions between centre and periphery that
give rise to unequal exchange? There are many answers to this question but we will
consider two.
Unequal exchange and dependency views:
Unequal exchange is a normative concept. Theorists subscribing to the so-called
"unequal exchange" view have also insisted on the uneven distribution of trade gains
between the centre and the periphery. A key difference with the structuralists is that,
while the latter focus on the trend over time of an observable variable, the terms of
trade, the former have a more normative approach, focusing on the "unfairness" of trade
between the two sets of countries at any given point in time.
Unequal exchange refers to the terms on which different commodities entering trade
between the centre and the periphery are exchanged. Exchange is said to be unequal (in
the normative sense of "unfair") because production conditions in the periphery lead to
exporting goods at cheaper prices than if the conditions had been those of the centre. At
any point in time, production conditions at the centre lead to high prices of the
commodities exported, whereas production conditions in the periphery lead to cheap
prices of exports.
What are the differences in production conditions between centre and periphery that
give rise to unequal exchange? There are many answers to this question but we will
consider two.
Advantages and Disadvantages of Foreign Trade
Advantages Disadvantages
Benefits of specialization Quicker exhaustion of
essential materials and
Benefits to consumers minerals in a country
Famine Relief Problems of specialization in a
few goods
Transfer of Technology (incl. Exposure to international
Mngt Know-how) risks; Dependence on foreign
goods and markets
Improvement in Production Exposure of home industry to
competition from outside
Prevention of monopoly Dumping of foreign goods
Industrial and agricultural Adverse effects on
development consumption habits
Terms of Trade
There has also been concern that international trade could operate against
the interests of developing countries. Influential studies published in
1950 by the Argentine economist Raul Prebisch and the British
economist Hans Singer suggested that there is a tendency for the prices
of agricultural products to fall relative to the prices of manufactured
goods; turning the terms of trade against the developing countries and
producing an unintended transfer of wealth from them to the developed
countries.
Their findings have been confirmed by a number of subsequent studies,
although it has been suggested that the effect may be due to quality bias
in the index numbers used or to the possession of market power by
manufacturers. The Prebisch/Singer findings remain controversial, but
they were used at the time - and have been used subsequently - to
suggest that the developing countries should erect barriers against
manufactured imports in order to nurture their own “infant industries”
and so reduce their need to export agricultural products. The arguments
for and against such a policy are similar to those concerning the
protection of infant industries in general.
1.5. Terms of Trade
Net Barter Terms of Trade = (Px/Pm) x 100, where
Px = index of export prices;
Pm = index of import prices
Gross Barter Terms of Trade = (Qx/Qm)x 100,
where Qx = index of export quantity;
Qm = index of import quantity
Income Terms of Trade = [(Qx x Px)/Pm] x 100 i.e.,
(value of export)/(index of import prices)
Trade Policies-1
In trade policy discussions terms such as protectionism, free trade, and trade
liberalization are used repeatedly. It is worthwhile to define these terms at the
beginning. One other term is commonly used in the analysis of trade models,
namely national autarky, or just autarky.
Two extreme states or conditions could potentially be created by national
government policies. At one extreme, a government could pursue a "laissez
faire" policy with respect to trade and thus impose no regulation whatsoever
that would impede (or encourage) the free voluntary exchange of goods
between nations. We define this condition as free trade. At the other extreme, a
government could impose such restrictive regulations on trade as to eliminate
all incentive for international trade. We define this condition in which no
international trade occurs as national autarky. Autarky represents a state of
isolationism. (See Figure).
Trade Policies-2
Probably, a pure state of free trade or autarky has never existed in the real
world. All nations impose some form of trade policies. And probably no
government has ever had such complete control over economic activity as to
eliminate cross-border trade entirely. The real world, instead, consists of
countries that fall somewhere between these two extremes. Some countries,
such as Singapore and (formerly) Hong Kong, are considered to be highly free
trade oriented. Others, like North Korea and Cuba, have long been relatively
closed economies and thus are closer to the state of autarky. The rest of the
world lies somewhere in between.
Most policy discussions are not about whether governments should pursue one
of these two extremes. Instead, discussions focus on which direction a country
should move along the trade spectrum. Since every country today is somewhere
in the middle, discussions focus on whether policies should move the nation in
the direction of free trade or in the direction of autarky.
A movement in the direction of autarky occurs whenever a new trade policy is
implemented if it further restricts the free flow of goods and services between
countries. Since new trade policies invariably benefit domestic industries by
reducing international competition, it is also referred to as protectionism.
A movement in the direction of free trade occurs when regulations on trade are
removed. Since the elimination of trade policies will generally increase the
amount of international trade, it is referred to as trade liberalization.
Trade Policies-3
Trade policy discussions typically focus, then, on whether the country should increase
protectionism or whether it should pursue trade liberalization.
Note that, according to this definition of protectionism, even policies that encourage
trade, such as export subsidies, are considered protectionist since they alter the pattern
of trade that would have prevailed in the absence of government intervention. This
implies that protectionism is much more complex than can be represented along a single
dimension (as suggested in the above diagram) since protection can both increase and
decrease trade flows. Nevertheless, the representation of the trade spectrum is useful in
a number of ways.
Economists’ findings about the benefits of trade have often been rejected by
government policy-makers, who have frequently sought to protect domestic industries
against foreign competition by erecting barriers, such as tariffs and quotas, against
imports. Average tariff levels of around 15 per cent in the late 19th century rose to about
30 percent in the 1930s, following the passage in the United States of the Smoot-
Hawley Act. Mainly as the result of international agreements under the auspices of the
General Agreement on Tariffs and Trade (GATT) and subsequently the World Trade
Organisation (WTO), average tariff levels were progressively reduced to about 7 per
cent during the second half of the 20th century, and some other trade restrictions were
also removed. The restrictions that remain are nevertheless of major economic
importance: among other estimates the World Bank estimated in 2004 that the removal
of all trade restrictions would yield benefits of over $500 billion a year by 2015.
Trade Policies-4
The largest of the remaining trade-distorting policies are those concerning agriculture.
In the OECD countries government payments account for 30 per cent of farmers’
receipts and tariffs of over 100 per cent are common. OECD economists estimate that
cutting all agricultural tariffs and subsidies by 50% would set off a chain reaction in
realignments of production and consumption patterns that would add an extra $26
billion to annual world income.
Quotas prompt foreign suppliers to raise their prices toward the domestic level of the
importing country. That relieves some of the competitive pressure on domestic
suppliers, and both they and the foreign suppliers gain at the expense of a loss to
consumers, and to the domestic economy, in addition to which there is a deadweight
loss to the world economy. When quotas were banned under the rules of the General
Agreement on Tariffs and Trade (GATT), the United States, Britain and the European
Union made use of equivalent arrangements known as voluntary restraint agreements
(VRAs) or voluntary export restraints (VERs) which were negotiated with the
governments of exporting countries (mainly Japan) - until they too were banned. Tariffs
have been considered to be less harmful than quotas, although it can be shown that their
welfare effects differ only when there are significant upward or downward trends in
imports. Governments also impose a wide range of non-tariff barriers that are similar in
effect to quotas, some of which are subject to WTO agreements. A recent example has
been the application of the precautionary principle to exclude innovatory products.
Valuable Lessons of International Trade Theory
Following are some of the most important lessons in international trade theory:
A. The main support for free trade arises because free trade can raise aggregate economic efficiency.
B. Trade theory shows that some people will suffer losses in free trade.
C. A country may benefit from free trade even if it is less efficient than all other countries in every
industry.
D. A domestic firm may lose out in international competition even if it is the lowest-cost producer in
the world.
E. Protection may be beneficial for a country.
F. Although protection can be beneficial, the case for free trade remains strong.
G. The main support for free trade arises because free trade can raise aggregate economic efficiency.
H. In most models of trade there is an improvement in aggregate efficiency when an economy moves
from autarky to free trade. This is the same as an increase in national welfare. Efficiency
improvements can be decomposed into two separate effects: production efficiency and
consumption efficiency. An improvement in production efficiency means that countries can
produce more goods and services with the same amount of resources. In other words, productivity
rises for the given resource endowments available for use in production. Consumption efficiency
improvements mean, in essence, that consumers will have a more satisfying collection of goods
and services from which to choose.
I. Economic efficiency is the term economists use to formally measure this objective. Since free
trade tends to promote economic efficiency is so many models, this is one of the strongest
arguments in support of free trade.
J. It can also be demonstrated when a small country reduces barriers to trade it can have a larger
national output (i.e. GDP) and superior choices available in consumption as a result of free trade.
Summary: Lessons from Trade Theories
1. The main support for free trade arises because free trade can raise
aggregate economic efficiency.
2. Trade theory shows that some people will suffer losses in free trade.
3. A country may benefit from free trade even if it is less efficient than
all other countries in every industry.
4. A domestic firm may lose out in international competition even if it is
the lowest-cost producer in the world.
5. Protection may be beneficial for a country.
6. Although protection can be beneficial, the case for free trade remains
strong.
Trade Policy Tools: Political Economy of International Trade
Consequences of free trade include both static and dynamic economic gains and
while many nations are nominally committed to free trade, they tend to
intervene in the international trade to protect interests of politically important
groups (protection of jobs, production to migrate toward the most efficient
producers, reduction of prices for consumers, restricting imports and creating
incentives for domestic manufacturers to produce and export and addressing
social calls).
Trade policies come in many varieties. Generally they consist of taxes or
subsidies, quantitative restrictions or encouragements, on either imported or
exported goods, services and assets. The international trade policy areas
include:
1. Import Tariffs
2. Import Quotas
3. Voluntary Export Restraints (VERs)
4. Export Taxes
5. Export Subsidies
6. Voluntary Import Expansions (VIEs)
7. Other Trade Policies
Tariffs-1
An import tariff is a tax collected on imported goods. Generally speaking, a
tariff is any tax or fee collected by a government. Sometimes tariff is used in a
non-trade context, as in railroad tariffs. However, the term is much more
commonly applied to a tax on imported goods. Tariffs may be specific i.e., a
fixed charge for each unit of a good imported (e.g., $3 per barrel of oil) or ad
valorem i.e., charge at a proportion of the value of the imported good. Tariffs
are imposed mostly for protecting domestic producers (tariffs raise the prices of
imported goods) and tariff also raises the revenue of the government. Tariff rate
is a policy issue and it is important to understand who gains and who suffers
because of tariffs.
The effects of tariffs: (a) tariffs are pro-producers and anti-consumers; (b)
tariffs may protect producers from foreign competition, but the restriction of
supply (because of tariffs) may also raise prices at home; (c) tariffs reduce the
overall efficiency of the world economy (encouraging domestic firms to
produce at home may be good, but the good could also be produced efficiently
abroad); and (d) tariffs distort fair competition.
Tariffs-2
Occasionally both a specific and an ad valorem tariff are levied on the same
product simultaneously. This is known as a two-part tariff. For example,
wristwatches imported into the US face the 51 cent specific tariff as well as a
6.25% ad valorem tariff on the case and the strap and a 5.3% ad valorem tariff
on the battery. Perhaps this should be called a three-part tariff!
As the above examples suggest, different tariffs are generally applied to
different commodities. Governments rarely apply the same tariff to all goods
and services imported into the country. One exception to this occurred in 1971
when President Nixon, in a last-ditch effort to save the Bretton Woods, system
of fixed exchange rates, imposed a 10% ad valorem tariff on all imported goods
from IMF member countries. But incidents such as this are uncommon.
Thus, instead of one tariff rate, countries have a tariff schedule which specifies
the tariff collected on every particular good and service. The schedule of tariffs
charged in all import commodity categories is called the Harmonized Tariff
Schedule of the United States (HTS). The commodity classifications are based
on the international Harmonized Commodity Coding and Classification System
(or the Harmonized System) established by the World Customs Organization.
Subsidies-1
Subsidy is a government payment to a domestic producer (cash grants, low interest
loans, tax breaks, government equity participation in domestic firms). Subsidies lower
production costs, kelp domestic producers in competing against foreign imports and
gaining export markets. Subsidies may be granted to agriculture, manufacturing or even
service sectors.
Export subsidies are payments made by the government to encourage the export of
specified products. As with taxes, subsidies can be levied on a specific or ad valorem
basis. The most common product groups where export subsidies are applied are
agricultural and dairy products.
Most countries have income support programs for their nation's farmers. These are
often motivated by national security or self-sufficiency considerations. Farmers'
incomes are maintained by restricting domestic supply, raising domestic demand, or a
combination of the two. One common method is the imposition of price floors on
specified commodities. When there is excess supply at the floor price, however, the
government must stand ready to purchase the excess. These purchases are often stored
for future distribution when there is a shortfall of supply at the floor price. Sometimes
the amount the government must purchase exceeds the available storage capacity. In
this case, the government must either build more storage facilities, at some cost, or
devise an alternative method to dispose of the surplus inventory. It is in these situations,
or to avoid these situations, that export subsidies are sometimes used. By encouraging
exports, the government will reduce the domestic supply and eliminate the need for the
government to purchase the excess.
Subsidies-2
One of the main export subsidy programs in the US is called the Export
Enhancement Program (EEP). Its stated purpose is to help US farmers compete
with farm products from other subsidizing countries, especially the European
Union, in targeted countries. The EEP's major objectives are to challenge unfair
trade practices, to expand U.S. agricultural exports, and to encourage other
countries exporting agricultural commodities to undertake serious negotiations
on agricultural trade problems. As a result of Uruguay round commitments, the
US has established annual export subsidy quantity ceilings by commodity and
maximum budgetary expenditures. Commodities eligible under EEP initiatives
are wheat, wheat flour, semolina, rice, frozen poultry, frozen pork, barley,
barley malt, table eggs, and vegetable oil.
In recent years the US government has made annual outlays of over $1 billion
in its agricultural Export Enhancement Program (EEP) and its Dairy Export
Incentive Program (DEIP). The EU has spent over $4 billion annually to
encourage exports of its agricultural and dairy products.
Import Quotas
Import quota is a direct restriction on the quantity of some goods that may be
imported into a country. Quotas are usually enforced by import licenses to a
group of individuals or firms. The extra profit that producers make when supply
is artificially restricted by import quota is called “quota rent”.
Import quotas are limitations on the quantity of goods that can be imported into
the country during a specified period of time. An import quota is typically set
below the free trade level of imports. In this case it is called a binding quota. If
a quota is set at or above the free trade level of imports then it is referred to as a
non-binding quota. Goods that are illegal within a country effectively have a
quota set equal to zero. Thus many countries have a zero quota on narcotics and
other illicit drugs.
There are two basic types of quotas: absolute quotas and tariff-rate quotas.
Absolute quotas limit the quantity of imports to a specified level during a
specified period of time. Sometimes these quotas are set globally and thus
affect all imports while sometimes they are set only against specified countries.
Absolute quotas are generally administered on a first-come first-served basis.
For this reason, many quotas are filled shortly after the opening of the quota
period. Tariff-rate quotas allow a specified quantity of goods to be imported at a
reduced tariff rate during the specified quota period.
Hybrid of Quota and Tariff; Local Content Requirement
Hybrid of Quota and Tariff
This is also called tariff rate quota and means that a lower tariff rate is applied
to imports within the quota, while higher tariffs are applied on imports over the
quota.
Local Content Requirement

A requirement that some specific fraction of a good (some % of components
parts, or some % of the total value of the products) be produced domestically.
Widely used by developing countries, especially to shift their manufacturing
base from assembly of products whose parts are imported from elsewhere to
manufacturing parts (components) within their own boundaries. It is a policy
issue and can be used for improving the manufacturing base of a country.
Anti-dumping Policies: dumping is selling goods in a foreign market at prices

below costs of production (or below their fair market values, which is normally
greater than costs of producing goods). By dumping firms unload excess
production. Producers earning high profit in their home market use part of
profits in subsidizing prices in the foreign market with the purpose of driving
indigenous or other competitors out of that market.
Administrative Policies; Voluntary Export Restrictions
Administrative Policies
These policies are bureaucratic rules to make it difficult for imports to enter a country, a form of government
intervention, both political and economic, with the purpose of protecting jobs and industries, national
security, furthering foreign policy objectives, protecting consumers, protecting human rights and
environment, retaliation etc.
A government’s strategic trade policy may also take other actions such as providing subsidies to promising
local firms that contribute to raising national income, or helping domestic firms overcome the barriers to
entry to foreign markets, minimizing the dominance of foreign firms having the first-mover-advantage in the
local market etc.
Voluntary Export Restrictions (VER)
It is a variant of import quota and means a quota on trade imposed by the exporting country, typically at the
request of the government of an importing country (example: Japan put a limit on export of autos to the US in
1981).
A voluntary export restraint is a restriction set by a government on the quantity of goods that can be exported
out of a country during a specified period of time. VERs are typically implemented on a bilateral basis
because the restraints are typically implemented upon the insistence of the importing nations. This means that
the word voluntary is placed in quotes. Typically VERs arise when the import-competing industries seek
protection from a surge of imports from particular exporting countries. VERs are then offered by the exporter
to appease the importing country and to avoid the effects of possible trade restraints on the part of the
importer. Thus VERs are rarely completely voluntary.
Also,, that is, on exports from one exporter to one importing country.
Some interesting examples of VERs occurred with auto exports from Japan in the early 1980s and with
textile exports in the 1950s and 60s.
Voluntary Import Expansions; Export Taxes
Voluntary Import Expansions (VIEs)
A Voluntary Import Expansion (VIE) is an agreement to increase the quantity of imports
of a product over a specified period of time. In the late 1980s, VIEs were suggested by
the US as a way of expanding US exports into Japanese markets. Under the assumption
that Japan maintained barriers to trade that restricted the entry of US exports, Japan was
asked to increase its volume of imports on specified products including semiconductors,
automobiles, auto parts, medical equipment and flat glass. The intention was that VIEs
would force a pattern of trade that more closely replicated the free trade level.
Since the early 1990s, VIEs have rarely been mentioned in public policy discussions.
Export Taxes
An export tax is a tax collected on exported goods. As with tariffs, export taxes can be
set on a specific or an ad valorem basis. In the US, export taxes are unconstitutional
since the US constitution contains a clause prohibiting their use. This was imposed due
to the concerns of Southern cotton producers who exported much of their product to
England and France.
However, many other countries employ export taxes. For example, Indonesia applies
taxes on palm oil exports; Madagascar applies them on vanilla, coffee, pepper and
cloves; Russia uses export taxes on petroleum, while Brazil imposed a 40% export tax
on sugar in 1996. In December 1995 the EU imposed a $32 per ton export tax on wheat.
Other Trade Policy Tools
Government Procurement Policies
A Government Procurement Policy requires that a specified percentage of
purchases by the federal or state governments be made from domestic firms
rather than foreign firms.
Health and Safety Standards
The U.S. generally has more regulations than other countries governing the use
of some goods, such as pharmaceuticals. These regulations can have an effect
upon trade patterns even though the policies are not designed based on their
effects on trade.
Red-Tape Barriers
Red-tape barriers refers to costly administrative procedures required for the
importation of foreign goods. Red-tape barriers can take many forms. France
once required that videocassete recorders enter the country through one small
port facility in the south of France. Because the port capacity was limited, it
effectively restricted the number of VCRs that could enter the country. A red-
tape barrier may arise if multiple licences must be obtained from a variety of
government sources before importation of a product is allowed.
Migration-2
Whereas some studies suggest that parent countries can benefit from the emigration of
skilled workers, generally it is emigration of unskilled and semi-skilled workers that is
of economic benefit to countries of origin, by reducing pressure for employment
creation. Where skilled emigration is concentrated in specific highly skilled sectors,
such as medicine, the consequences are severe and even catastrophic in cases where
50% or so of trained doctors have emigrated. The crucial issues, as recently
acknowledged by the OECD, is the matter of return and reinvestment in their countries
of origin by the migrants themselves: thus, government policies in Europe are
increasingly focused upon facilitating temporary skilled migration alongside migrant
remittances.
Unlike movement of capital and goods, since 1973 government policies have tried to
restrict migration flows, often without any economic rationale. Such restrictions have
had diversionary effects, channeling the great majority of migration flows into illegal
migration and "false" asylum-seeking. Since such migrants work for lower wages and
often zero social insurance costs, the gain from labor migration flows is actually higher
than the minimal gains calculated for legal flows; accompanying side-effects are
significant, however, and include political damage to the idea of immigration, lower
unskilled wages for the host population, and increased policing costs alongside lower
tax receipts.
Migration-1
It is assumed that international migration results in a net gain in economic welfare
because of wage differences between developed and developing countries mainly due to
productivity differences arising mostly from differences in the availability of physical,
social and human capital. Economic theory indicates that the move of a skilled worker
from a place where the returns to skill are relatively low to a place where they are
relatively high should produce a net gain (but that it would tend to depress the wages of
skilled workers in the recipient country).
A Copenhagen Consensus study suggests that if the share of foreign workers grew to
3% of the labor force in the rich countries there would be global benefits of $675 billion
a year by 2025. However, a survey of the evidence led a House of Lords committee to
conclude that any benefits of immigration to the United Kingdom are relatively small.
Evidence from the United States also suggests that the economic benefits to the
receiving country are relatively small, and that the presence of immigrants in its labor
market results in only a small reduction in local wages.
From the standpoint of a developing country, the emigration of skilled workers
represents a loss of human capital (known as brain drain), leaving the remaining
workforce without the benefit of their support. That effect upon the welfare of the
parent country is to some extent offset by the remittances that are sent home by the
emigrants, and by the enhanced technical know-how with which some of them return.
One study introduces a further offsetting factor to suggest that the opportunity to
migrate fosters enrolment in education thus promoting a "brain gain" that can
counteract the lost human capital associated with emigration.

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International Economics 1

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International Business-1

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Local Content Requirement

Anti-dumping Policies: dumping is selling goods in a foreign market at prices

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