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comparative advantage and the gains from trade

There are potentially many gains in economic welfare to be achieved through free trade:

Greater choice of products for consumers

Increased competition for producers

Other countries can supply certain products more efficiently

Trade speeds up the pace of technological progress and innovation

Businesses are better placed to exploit economies of scale

Political benefits from expansion of global trade

The theory of comparative advantage can show these gains from trade

In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (absolute advantage in all goods) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies. [1][2][3]

For example, if, using machinery, a worker in one country can produce both shoes and shirts at 6 per hour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts in an hour, each country can gain from trade because their internal trade-offs between shoes and shirts are different. The less-efficient country has a comparative advantage in shirts, so it finds it more efficient to produce shirts and trade them to the more-efficient country for shoes. Without trade, its opportunity cost per shoe was 2 shirts; by trading, its cost per shoe can reduce to as low as 1 shirt depending on how much trade occurs (since the more-efficient country has a 1:1 trade- off). The more-efficient country has a comparative advantage in shoes, so it can gain in

efficiency by moving some workers from shirt-production to shoe-production and trading some shoes for shirts. Without trade, its cost to make a shirt was 1 shoe; by trading, its cost per shirt can go as low as 1/2 shoe depending on how much trade occurs.

n economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources. [1][2][3][4][5][6] Adam Smith first described the principle of absolute advantage in the context of international trade, using labor as the only input.

Since absolute advantage is determined by a simple comparison of labor productivities, it is possible for a party to have no absolute advantage in anything; [7] in that case, according to the theory of absolute advantage, no trade will occur with the other party. [8] It can be contrasted with the concept of comparative advantage which refers to the ability to produce a particular good at a lower opportunity cost.

In economics, gains from trade refers to net benefits to agents from allowing an increase in voluntary trading with each other.

Absolute advantage refers to being more efficient at performing a task. To use the above example, women apparently have an absolute advantage in ironing because they can iron more shirts in three minutes than men can. Comparative advantage, on the other hand, refers to being able to complete a task at a lower opportunity cost than others.

free trade has come to mean the conduct of international business without any governmental interference, such as tariffs, quotas, subsidies,

Features of free trade

Free trade implies the following features: [citation needed]

Trade of goods without taxes (including tariffs) or other trade barriers (e.g., quotas on imports

or subsidies for producers) Trade in services without taxes or other trade barriers

The absence of "trade-distorting" policies (such as taxes, subsidies, regulations, or laws) that

give some firms, households, or factors of production an advantage over others Unregulated access to markets

Unregulated access to market information

Inability of firms to distort markets through government-imposed monopoly or oligopoly power

According to Prof. Don Boudreaux, free trade is nothing more than a system of trade that treats foreign goods and services no differently than domestic goods and services. Protectionism, on the other hand, is a system of trade that discriminates against foreign goods and services in an attempt to favor domestic goods and services. In theory, free trade outperforms protectionism by bringing lower cost goods and services to consumers. In practice, the benefits of free trade can be seen in countries like America and

Hong Kong. Both countries have a relatively high degree of free trade, and, as a consequence, have experienced an explosion of wealth.

Protectionism is the economic policy of restraining trade between states through methods such as tariffs on imported goods, restrictive quotas, and a variety of other government regulations designed to allow (according to proponents) "fair competition" between imports and goods and service produced domestically. [1]

This policy contrasts with free trade, where government barriers to trade are kept to a minimum. In recent years, it has become closely aligned with anti-globalization. The term is mostly used in the context of economics, where protectionism refers to policies or doctrines which protect businesses and workers within a country by restricting or regulating trade with foreign nations

Protectionist policies

A variety of policies have been used to achieve protectionist goals. These include:

  • 1. Tariffs: Typically, tariffs (or taxes) are imposed on imported goods. Tariff rates usually vary according to the type of goods imported. Import tariffs will increase the cost to importers, and increase the price of imported goods in the local markets, thus lowering the quantity of goods imported, to favour local producers. (see SmootHawley Tariff Act) Tariffs may also be imposed on exports, and in an economy with floating exchange rates, export tariffs have similar effects as import tariffs. However, since export tariffs are often perceived as 'hurting' local industries, while import tariffs are perceived as 'helping' local industries, export tariffs are seldom implemented.

  • 2. Import quotas: To reduce the quantity and therefore increase the market price of imported goods. The economic effects of an import quota is similar to that of a tariff, except that the tax revenue gain from a tariff will instead be distributed to those who receive import licenses. Economists often suggest that import licenses be auctioned to the highest bidder, or that import quotas be replaced by an equivalent tariff.

  • 3. Administrative barriers: Countries are sometimes accused of using their various administrative rules (e.g. regarding food safety, environmental standards, electrical safety, etc.) as a way to introduce barriers to imports.

  • 4. Anti-dumping legislation: Supporters of anti-dumping laws argue that they prevent "dumping" of cheaper foreign goods that would cause local firms to close down. However, in practice, anti- dumping laws are usually used to impose trade tariffs on foreign exporters.

  • 5. Direct subsidies: Government subsidies (in the form of lump-sum payments or cheap loans) are sometimes given to local firms that cannot compete well against imports. These subsidies are purported to "protect" local jobs, and to help local firms adjust to the world markets.

  • 6. Export subsidies: Export subsidies are often used by governments to increase exports. Export subsidies have the opposite effect of export tariffs because exporters get payment, which is a percentage or proportion of the value of exported. Export subsidies increase the amount of trade, and in a country with floating exchange rates, have effects similar to import subsidies.

  • 7. Exchange rate manipulation: A government may intervene in the foreign exchange market to lower the value of its currency by selling its currency in the foreign exchange market. Doing so will raise the cost of imports and lower the cost of exports, leading to an improvement in its trade balance. However, such a policy is only effective in the short run, as it will most likely lead

to inflation in the country, which will in turn raise the cost of exports, and reduce the relative price of imports.

  • 8. International patent systems: There is an argument for viewing national patent systems as a cloak for protectionist trade policies at a national level. Two strands of this argument exist: one when patents held by one country form part of a system of exploitable relative advantage in trade negotiations against another, and a second where adhering to a worldwide system of patents confers "good citizenship" status despite 'de facto protectionism'. Peter Drahos explains that "States realized that patent systems could be used to cloak protectionist strategies. There were also reputational advantages for states to be seen to be sticking to intellectual property systems. One could attend the various revisions of the Paris and Berne conventions, participate in the cosmopolitan moral dialogue about the need to protect the fruits of authorial labor and inventive genius


all the while that one's domestic intellectual property system was a

... handy protectionist weapon." [3]

  • 9. Employment-based immigration restrictions, such as labor certification requirements or numerical caps on work visas.

    • 10. Political campaigns advocating domestic consumption (e.g. the "Buy American" campaign in the United States, which could be seen as an extra-legal promotion of protectionism.)

    • 11. Preferential governmental spending, such as the Buy American Act, federal legislation which called upon the United States government to prefer U.S.-made products in its purchases.

Arguments for protectionism

Protectionists believe that there is a legitimate need for government restrictions on free trade in order to protect their country’s economy and its people’s standard of living.

Infant industry argument Main article: Infant industry argument

Protectionists believe that infant industries must be protected in order to allow them to grow to a point where they can fairly compete with the larger mature industries established in foreign countries. They believe that without this protection, infant industries will die before they reach a size and age where economies of scale, industrial infrastructure, and skill in manufacturing have progressed sufficiently to allow the industry to compete in the global market.

Criticisms of the Theory of Comparative Advantage as a basis for trade policy

According to, "The theory of comparative advantage provides a strong argument in favour of free trade and specialization among countries. The issue becomes much more complex, however, as the theory’s simplifying assumptions—a single factor of production, a given stock of resources, full employment, and a balanced exchange of goodsare replaced by more- realistic parameters." [11]

Protectionists argue that comparative advantage has lost its legitimacy in a globally integrated world in which capital is free to move internationally. Herman Daly, a leading voice in the discipline of ecological economics, emphasizes that although Ricardo's theory of comparative advantage is one of the most elegant theories in economics, its application to the present day is

illogical: "Free capital mobility totally undercuts Ricardo's comparative advantage argument for free trade in goods, because that argument is explicitly and essentially premised on capital (and other factors) being immobile between nations. Under the new global economy, capital tends simply to flow to wherever costs are lowestthat is, to pursue absolute advantage." [12] Protectionists would point to the building of plants and shifting of production to Mexico by American companies such as GE, GM, and Hershey Chocolate as proof of this argument.

Domestic tax policies can favor foreign goods

Protectionists believe that allowing foreign goods to enter domestic markets without being subject to tariffs or other forms of taxation, leads to a situation where domestic goods are at a disadvantage, a kind of reverse protectionism. By ruling out revenue tariffs on foreign products, governments must rely solely on domestic taxation to provide its revenue, which falls disproportionately on domestic manufacturing. As Paul Craig Roberts notes: "Foreign discrimination of US products is reinforced by the US tax system, which imposes no appreciable tax burden on foreign goods and services sold in the US but imposes a heavy tax burden on US producers of goods and services regardless of whether they are sold within the US or exported to other countries." [13]

Protectionists argue that this reverse protectionism is most clearly seen and most detrimental to those countries (such as the US) that do not participate in the Value Added Tax (VAT) system. This is a system which generates revenues from taxation on the sale of goods and services, whether foreign or domestic. Protectionists argue that a country that does not participate is at a distinct disadvantage when trading with a country that does. That the final selling price of a product from a non-participating country sold in a country with a VAT tax must bear not only the tax burden of the country of origin, but also a portion of the tax burden of the country where it is being sold. Conversely, the selling price of a product made in a participating country and sold in a country that does not participate, bears no part of the tax burden of the country in which it is sold (as do the domestic products it is competing with). Moreover, the participating country rebates VAT taxes collected in the manufacture of a product if that product is sold in a non- participating country. According to Congressman Bill Pascrell, Jr., "Altogether, imports into the U.S. face average tariffs of 1.3% and no VAT penalty, whereas U.S. exports face average tariffs worldwide of about 40% plus VAT border adjustment penalty of 15.7%. In addition, foreign companies get a VAT rebate when they export to the U.S. averaging 15.7%!" [14]

Protectionists believe that governments should address this inequity, if not by adopting a VAT tax, then by at least imposing compensating taxes (tariffs) on imports.

Unrestricted trade undercuts domestic policies for social good

Most industrialized governments have long held that laissez-faire capitalism creates social evils that harm its citizens. To protect those citizens, these governments have enacted laws that restrict what companies can and can not do in pursuit of profit. Examples are laws regarding:

Protectionists argue that these laws, adding cost to production, place an economic burden on domestic companies bound by them that put those companies at a disadvantage when they compete, both domestically and abroad, with goods and services produced in countries without such laws. They argue that governments have a responsibility to protect their corporations as well as their citizens when putting its companies at a competitive disadvantage by enacting laws for social good. Otherwise they believe that these laws end up destroying domestic companies and ultimately hurting the citizens these laws were designed to protect.

Arguments against protectionism

Protectionism is frequently criticized by mainstream economists as harming the people it is meant to help. Most mainstream economists instead support free trade. [6][15] Economic theory, under the principle of comparative advantage, shows that the gains from free trade outweigh any losses as free trade creates more jobs than it destroys because it allows countries to specialize in the production of goods and services in which they have a comparative advantage. [16] Protectionism results in deadweight loss; this loss to overall welfare gives no-one any benefit, unlike in a free market, where there is no such total loss. According to economist Stephen P. Magee, the benefits of free trade outweigh the losses by as much as 100 to 1. [17]

Most economists, including Nobel prize winners Milton Friedman and Paul Krugman, believe that free trade helps workers in developing countries, even though they are not subject to the stringent health and labour standards of developed countries. This is because "the growth of manufacturing and of the myriad other jobs that the new export sector creates has a ripple effect throughout the economy" that creates competition among producers, lifting wages and living conditions. [18] Economists [who?] have suggested that those who support protectionism ostensibly to further the interests of workers in least developed countries are in fact being disingenuous, seeking only to protect jobs in developed countries. [19] Additionally, workers in the least developed countries only accept jobs if they are the best on offer, as all mutually consensual exchanges must be of benefit to both sides, or else they wouldn't be entered into freely. That they accept low-paying jobs from companies in developed countries shows that their other employment prospects are worse. A letter reprinted in the May 2010 edition of Econ Journal Watch identifies a similar sentiment against protectionism from sixteen British economists at the beginning of the 20th century. [20]

Alan Greenspan, former chair of the American Federal Reserve, has criticized protectionist

proposals as leading "to an atrophy of our competitive

ability. ...

If the protectionist route is

followed, newer, more efficient industries will have less scope to expand, and overall output and economic welfare will suffer." [21]

Protectionism has also been accused of being one of the major causes of war. Proponents of this theory point to the constant warfare in the 17th and 18th centuries among European countries whose governments were predominantly mercantilist and protectionist, the American Revolution, which came about ostensibly due to British tariffs and taxes, as well as the protective policies preceding both World War I and World War II. According to a slogan of Frédéric Bastiat (18011850), "When goods cannot cross borders, armies will." [22]

Free trade promotes equal access to domestic resources (human, natural, capital, etc.) for domestic participants and foreign participants alike. Some thinkers [who?] extend that under free trade, citizens of participating countries deserve equal access to resources and social welfare (labor laws, education, etc.). Visa entrance policies tend to discourage free reallocation between many countries, and encourage it with others. High freedom and mobility has been shown to lead to far greater development than aid programs in many cases, for example eastern European countries in the European Union. In other words visa entrance requirements are a form of local protectionism.

Some governments impose foreign exchange controls to influence the buying and selling of currencies. Foreign exchange controls usually affect local residents who make transactions involving foreign currencies and foreign residents who make transactions involving the local currency. These governments usually aim to protect their own weak currencies, which people often prefer to exchange for other, stronger currencies.

From 1870 to 1914, most countries fixed their currencies to gold; the central banks of these countries conducted exchanges between gold and the local currencies. The gold standard effectively also fixed the exchange rates between different currencies. In the early 1930s, many countries abandoned the gold standard because of financial instabilities and excessive inflation brought on by World War I. A system where the International Monetary Fund (IMF) supervised various fixed exchange rates and adjusted them as necessary prevailed for almost two decades after 1944. The current system involves floating exchange rates that mostly depend on the forces demand and supply.

Foreign exchange controls are various forms of controls imposed by a government on the purchase/sale of foreign currencies by residents or on the purchase/sale of local currency by nonresidents.

Common foreign exchange controls include:

Banning the use of foreign currency within the country

Banning locals from possessing foreign currency

Restricting currency exchange to government-approved exchangers

Fixed exchange rates

Restrictions on the amount of currency that may be imported or exported

Countries with foreign exchange controls are also known as "Article 14 countries," after the provision in the International Monetary Fund agreement allowing exchange controls for transitional economies. Such controls used to be common in most countries, particularly poorer ones, until the 1990s when free trade and globalization started a trend towards economic liberalization. Today, countries which still impose exchange controls are the exception rather than the rule.

Often, foreign exchange controls can result in the creation of black markets to exchange the weaker currency for stronger currencies. This leads to a situation where the exchange rate for the foreign currency is much higher than the rate set by the government, and therefore creates a shadow currency exchange market. As such, it is unclear whether governments have the ability to enact effective exchange controls. [1]

Exchange risk is the effect that unanticipated exchange rate changes have on the value of the firm. This chapter explores the impact of currency fluctuations on cash flows, on assets and liabilities, and on the real business of the firm. Three questions must be asked. First, what exchange risk does the firm face, and what methods are available to measure currency exposure? Second, based on the nature of the exposure and the firm's ability to forecast currencies, what hedging or exchange risk management strategy should the firm employ? And finally, which of the various tools and techniques of the foreign exchange market should be employed: debt and assets; forwards and futures; and options. The chapter concludes by suggesting a framework that can be used to match the instrument to the problem.

1 (b) What is exchange risk?

Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exchange rate change. For example, if an individual owns a share in Hitachi, the Japanese company, he or she will lose if the value of the yen drops.

Yet from this simple question several more arise. First, whose gain or loss? Clearly not just those of a subsidiary, for they may be offset by positions taken elsewhere in the firm. And not just gains or losses on current transactions, for the firm's value consists of anticipated future cash flows as well as currently contracted ones. What counts, modern finance tells us, is shareholder value; yet the impact of any given currency change on shareholder value is difficult to assess, so proxies have to be used. The academic evidence linking exchange rate changes to stock prices is weak.

Moreover the shareholder who has a diversified portfolio may find that the negative effect of exchange rate changes on one firm is offset by gains in other firms; in other words, that exchange risk is diversifiable. If it is, than perhaps it's a non-risk.

Finally, risk is not risk if it is anticipated. In most currencies there are futures or forward exchange contracts whose prices give firms an indication of where the market expects currencies

to go. And these contracts offer the ability to lock in the anticipated change. So perhaps a better concept of exchange risk is unanticipated exchange rate changes.

These and other issues justify a closer look at this area of international financial management.

A trade restriction is an artificial restriction on the trade of goods and/or services between two countries. It is the byproduct of protectionism.

Consequences of Trade Restrictions

A combination of tariffs, quotas, and subsidies can serve economic, and sometimes political, objectives, but they can also impose significant costs. Tariffs or quantitative restrictions protect domestic industries and workers from foreign competition by raising the prices of imported goods. In this respect, some argue that import restrictions should be viewed as a tax on domestic consumers. According to some experts, the costs of protecting the jobs of workers in vulnerable industries, which are ultimately borne by taxpayers or consumers, far exceed the potential cost of retraining and finding new jobs for those workers.

According to the Institute for International Economics, trade barriers cost American consumers $80 billion a year, or more than $1,200 per family, in increased prices for goods such as sugar (and foods made with it) and appliances made from steel. The Organization for Economic Co- operation and Development estimated that in 2004, American consumers paid $1.5 billion because of U.S. sugar policies (Smith, 2006).

A similar analysis can be applied to export subsidies. Subsidizing exports can cost governments much more money than would programs designed to shift uncompetitive production into more efficient or internationally competitive sectors. An example of this can be seen in the American Automobile Industry.

Another criticism of import restrictions and export subsidies is that they discourage the protected firms and industries from making the changes necessary to challenge foreign competition. Once the protected companies have received government support in the form of import restrictions or export subsidies, they may have less incentive to improve their efficiency and management, eventually even becoming dependent on government support for their survival.

Finally, trade restrictions are a major impediment to development efforts. Developing countries are unable to sell their products abroad because of high tariffs and quotas. Additionally, their domestic markets are flooded by cheaper, subsidized products from abroad.

In response to the known problems associated with trade restrictions, the World Bank offers three suggestions that the G20 countries could adopt. These leading countries could:

1. ―Commit to greater transparency by agreeing to provide quarterly reports on new trade restrictions, and industrial and agricultural subsidies to the WTO; 2. Advocate greater Aid for Trade for low income countries; and

3. Seize the opportunity to support global trade in a time when it desperately needs to be supported (World Bank, 2009)

Pros and Cons of Trade Restrictions?


Trade restrictions are barriers put in place by countries in order to protect their domestic industries. These are advantageous since they allow new industries to develop in a less competing environment and protect domestic jobs and workers. However, it is also disadvantageous since it leads to higher prices of goods and services, gives consumers less choices and leads to loss of jobs in international companies.

A developing country, also called a less-developed country (LDC), [1] is a nation with a low living standard, underdeveloped industrial base, and low Human Development Index (HDI) relative to other countries. [2][3] There is no universal, agreed-upon criteria for what makes a country developing versus developed and which countries fit these two categories, although there are general reference points such as the size of a nation's GDP compared to other nations.

A developed country or "more developed country" (MDC), is a sovereign state that has a highly developed economy and advanced technological infrastructure relative to other less developed nations.

With the aim of stimulating economic growth, governments and enterprises of developing countries, in the face of tight financial and monetary constraints, resort to various fundraising measures, including the issuing of local/foreign currency-denominated bonds, aids (loans) from development organizations and developed countries, and borrowings from private financial institutions. Since the 1980s in particular, the global trend toward financial liberalization has led to a diversified financing measures for developing countries. However, the redemption and/or

principal and interest repayments have not always taken place on schedule. As a result of endogenous problems such as the vulnerable tax base, or exogenous shocks such as falling prices for foreign-currency earning products, natural disasters and currency and financial crisis , which the governments cannot control by themselves, countries often face solvency problems and go into default (This situation is also called a "debt crisis").

For creditors, default means a low recovery rate and a deterioration of business performance, while for debtors, it invites many problems that cannot be overlooked, ranging from difficulties in financing the immediate repayment to rising funding costs for future development (in the worst case, financing may become totally infeasible). In the latter half of the 1970s, when the problem of debt accumulation surfaced, the cause was deemed as a temporary liquidity shortage on the part of the debtors, meaning the developing countries. Then, in the latter half of the 1980s, the debt accumulation came to be recognized as a structural problem stemming from an insufficient economic performance for making repayments, and the international community started discussions to address this problem. Given these circumstances, with the support of the IMF and World Bank, the Baker Plan (1985) and the Brady Plan (1987) were compiled. The Baker Plan consists of the following solutions: (1) rearranging the principal and interest repayments to a sustainable schedule (rescheduling) or (2) forgiving part of the principal and

interest repayment (haircut), obligating the creditor group to act in a uniform manner. The Brady Plan, in addition to (1) and (2) which may require a lengthy process for creditors to reach an agreement, offered the idea to (3) securitize the debts and sell them to investors willing to take high risks (securitization). These plans have been applied to Latin American and South East Asian countries. Most of the countries affected by the Asian currency and financial crisis in 1997 used the securitization scheme (e.g., Asset Backed Securities) to write off the bad debts of public and private enterprises.

The debt problem also has internal impacts in addition to the external problem of repayment. The purpose of development finance per se should be to improve the economic strength and people' s welfare and reduce poverty (related themes: economic growth, poverty, inequality), but in reality, heavily indebted poor countries (HIPCs, e.g., most African countries) have not established a good track record of making improvements in either debt or poverty reduction. Past studies have shown that in a debt crisis, the poorest people living in precarious conditions are hardest hit. Given this situation, the IMF and World Bank launched the HIPC Initiative in 1996. The scheme, which was designed to reduce the debts of HIPCs that met certain criteria to a sustainable level, was implemented in collaboration with the governments and private creditor organizations. By June 2009, debt reductions under the scheme including interim debt relief were approved for 35 countries. Further, in order to expedite debt relief for HIPCs by international organizations, an idea that was incorporated as one of the Millennium Development Goals (MDGs), the Multilateral Debt Relief Initiative (MDRI) with a similar scheme was launched in 2005 through the G8 agreement in Gleneagles. A total of 26 countries including non-HIPCs were given debt relief from the IMF, IDA and African Development Fund (as of June 2009), and 16 more are scheduled to receive debt relief. In the aftermath of the worldwide recession in 2007, similar relief measures have been considered among the Inter-American Development Bank and other international organizations.

Now, what are needed to prevent debt crisis and/or reduce the heavy debt burden? From the viewpoint of development economics, the above-described countermeasures on the expenditure (spending) side, e.g., reducing debts per se, as well as improving revenues (income), i.e., stabilizing the monetary (fiscal) base and controlling outstanding obligations, are important subjects of analyses. From the latter half of the 1990s in particular, ―debt and poverty reduction that can promote economic development,‖ which was incorporated as one of the MDGs, and the ―contingent liability‖ issues that derive from the privatization of public enterprises (or its

failure), which was promoted in the 1980s and subsequent years as part of the structural adjustment, have been capturing attentions. Efforts are also being made to develop indicators to quantify various debt-related risks that governments have to control, in order to enable them to prevent debt accumulation from exceeding a sustainable level.

A single market is a type of trade bloc which is composed of a free trade area (for goods) with common policies on product regulation, and freedom of movement of the factors of production (capital and labour) and of enterprise and services. The goal is that the movement of capital, labour, goods, and services between the members is as easy as within them. [1] The physical (borders), technical (standards) and fiscal (taxes) barriers among the member states are removed

to the maximum extent possible. These barriers obstruct the freedom of movement of the four factors of production.

A common market is a first stage towards a single market, and may be limited initially to a free trade area with relatively free movement of capital and of services, but not so advanced in reduction of the rest of the trade barriers.

The European Economic Community was the first example of a both common and single market, but it was an economic union since it had additionally a customs union.


Benefits and costs

A single market has many benefits. With full freedom of movement for all the factors of production between the member countries, the factors of production become more efficiently allocated, further increasing productivity.

For both business within the market and consumers, a single market is a very competitive environment, making the existence of monopolies more difficult. This means that inefficient companies will suffer a loss of market share and may have to close down. However, efficient firms can benefit from economies of scale, increased competitiveness and lower costs, as well as expect profitability to be a result. Consumers are benefited by the single market in the sense that the competitive environment brings them cheaper products, more efficient providers of products and also increased choice of products. What is more, businesses in competition will innovate to create new products; another benefit for consumers.

Transition to a single market can have short term negative impact on some sectors of a national economy due to increased international competition. Enterprises that previously enjoyed national market protection and national subsidy (and could therefore continue in business despite falling short of international performance benchmarks) may struggle to survive against their more efficient peers, even for its traditional markets. Ultimately, if the enterprise fails to improve its organization and methods, it will fail. The consequence may be unemployment or

migration. [citation needed]


Canada Agreement on Internal Trade (AIT)- The Agreement on Internal Trade is an

intergovernmental agreement between the federal government and the provinces and territories to reduce and eliminate barriers to free movement of people, goods, services and investments within

Canada. Under the Agreement, these governments have agreed to apply the principles of non- discrimination, transparency, openness and accessibility with respect to their procurement opportunities and those of their municipalities and municipal organizations, school boards and publicly funded academic, health and social services entities. The Agreement covers only those tenders where the procurement value exceeds a specified amount.

South Asian Free Trade Area (SAFTA)- The South Asian Free Trade Area or SAFTA is an agreement reached on 6 January 2004 at the 12th SAARC summit in Islamabad, Pakistan. It created a free trade area of 1.6 billion people in Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka (as of 2011, the combined population is 1.8 billion people). The seven foreign ministers of the region signed a framework agreement on SAFTA to reduce customs duties of all traded goods to zero by the year 2016.

The SAFTA agreement came into force on 1 January 2006 and is operational following the ratification of the agreement by the seven governments. SAFTA requires the developing countries in South Asia (India, Pakistan and Sri Lanka) to bring their duties down to 20 percent in the first phase of the two-year period ending in 2007. In the final five-year phase ending 2012, the 20 percent duty will be reduced to zero in a series of annual cuts. The least developed nations in South Asia (Nepal, Bhutan, Bangladesh, Afghanistan and Maldives) have an additional three years to reduce tariffs to zero. India and Pakistan ratified the treaty in 2009, whereas Afghanistan as the 8th memberstate of the SAARC ratified the SAFTA protocol on the 4th of May 2011. [1]

European Free Trade Association (EFTA)- The European Free Trade Association (EFTA) is a free trade organisation between four European countries that operates in parallel with and is linked to the European Union (EU). The EFTA was established on 3 May 1960 as a trade bloc- alternative for European states who were either unable or unwilling to join the then-European Economic Community (EEC) which has now become the EU. The Stockholm Convention, establishing the EFTA, was signed on 4 January 1960 in the Swedish capital by seven countries (known as the "outer seven").

Today's EFTA members are Liechtenstein, Iceland, Norway and Switzerland, of which the latter two were founding members. The initial Stockholm Convention was superseded by the Vaduz Convention, which enabled greater liberalisation of trade among the member states.

EFTA states have jointly concluded free trade agreements with a number of other countries. Three of the EFTA countries are part of the European Union Internal Market through the Agreement on a European Economic Area (EEA), which took effect in 1994; the fourth, Switzerland, opted to conclude bilateral agreements with the EU. In 1999, Switzerland concluded a set of bilateral agreements with the European Union covering a wide range of areas, including movement of people, transport, and technical barriers to trade. This development prompted the EFTA states to modernise their Convention to ensure that it will continue to

provide a successful framework for the expansion and liberalization of trade among themselves and with the rest of the world.

A single market agreement essentially creates a single economic life across national borders. It makes national borders, economically speaking, irrelevant. A single market is distinct from a free trade area, which only seeks to lower tariffs and streamline some trading regulations. In general, a single market agreement differs from a free trade area in its level of comprehensiveness, taking into itself nearly all aspects of economic life above and beyond tariff policy.

Regional trade agreements (RTAs) cover more than half of international trade and operate alongside global multilateral
Regional trade agreements (RTAs) cover more than half of international trade and operate
alongside global multilateral agreements under the World Trade Organization (WTO). The first
eleven years (1995-2005) of the WTO were paralleled by a tripling of RTAs officially notified to
the WTO and in force, from 58 to 188*.
However, regional trade agreements can have both positive and negative effects.

They can be attractive, for example, because it may be easier for a small group of neighbouring countries with similar concerns and cultures to agree on market opening in a particular area than to reach agreement in a wider forum such as the WTO. They can also offer new approaches to rule-making and so act as stepping stones on the way to a multilateral agreement.

But regional agreements also risk making it harder for countries outside the region to trade with those inside and may discourage further opening up of markets, ultimately limiting growth prospects for all. Moreover, broad-based multilateral negotiations, with more players and more sectors, will offer greater potential for mutual gain than limited bilateral or regional deals.

The World Trade Organization (WTO) is an organization that intends to supervise and liberalize international trade. The organization deals with regulation of trade between participating countries; it provides a framework for negotiating and formalizing trade agreements, and a dispute resolution process aimed at enforcing participants' adherence to WTO agreements, which are signed by representatives of member governments [6]:fol.910 and ratified by their parliaments. [7] Most of the issues that the WTO focuses on derive from previous trade negotiations, especially from the Uruguay Round (19861994).

The organization is attempting to complete negotiations on the Doha Development Round, which was launched in 2001 with an explicit focus on addressing the needs of developing countries. As of June 2012, the future of the Doha Round remains uncertain: the work programme lists 21

subjects in which the original deadline of 1 January 2005 was missed, and the round is still incomplete. [8] The conflict between free trade on industrial goods and services but retention of protectionism on farm subsidies to domestic agricultural sector (requested by developed countries) and the substantiation of the international liberalization of fair trade on agricultural products (requested by developing countries) remain the major obstacles. These points of contention have hindered any progress to launch new WTO negotiations beyond the Doha Development Round. As a result of this impasse, there has been an increasing number of bilateral free trade agreements signed. [9] As of July 2012, there are various negotiation groups in the WTO system for the current agricultural trade negotiation which is in the condition of stalemate. [10]

WTO's current Director-General is Roberto Azevêdo, [11][12] who leads a staff of over 600 people in Geneva, Switzerland. [13]

An international organization is an organization with an international membership, scope, or presence. There are two main types: [2]

International nongovernmental organizations (INGOs): non-governmental organizations (NGOs) that operate internationally. There are two types:


International non-profit organizations. Examples include the World Organization


include The Coca-Cola Company and Toyota. Intergovernmental organizations, also known as international governmental organizations (IGOs): the type of organization most closely associated with the term 'international organization', these are organizations that are made up primarily of sovereign states (referred to as member states). Notable examples include the United Nations (UN), Organisation for Economic Co-operation and Development (OECD) Organization for Security and Co-operation in Europe (OSCE), Council of Europe (CoE), European Union (EU; which is a prime example of a supranational organization), and World Trade Organization (WTO). The UN has used the term "intergovernmental organization" instead of "international organization" for clarity. [3]




6 Factors That Influence Exchange Rates

Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's

portfolio. Here we look at some of the major forces behind exchange rate movements.


Before we look at these forces, we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it.

Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading relationship

between two countries. Remember, exchange rates are relative, and are expressed as a

comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much debate.

1. Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a rising

currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.)

  • 2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite

relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. (For further reading, see What Is Fiscal Policy?)

  • 3. Current-Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of

exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For more, see Understanding The Current Account In The Balance Of Payments.)

  • 4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A

large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.

  • 5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.

  • 6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a

currency and a movement of capital to the currencies of more stable countries.


The exchange rate of the currency in which a portfolio holds the bulk of its investments

determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed,

investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, FX rate or Agio) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.

Exchange rate regime

Main article: Exchange rate regime

Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid.

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.

A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the revaluation (usually devaluation) of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. [1] But that system had to be abandoned in favor of floating, market-based regimes due to market pressures and speculations in the 1970s.

Still, some governments strive to keep their currency within a narrow range. As a result, currencies become over-valued or under-valued, leading to excessive trade deficits or surpluses.

Fluctuations in exchange rates

A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).

Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued [by whom?] that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to buy their own currency to keep it stable. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.) [citation needed]

For carrier companies shipping goods from one nation to another, exchange rates can often impact them severely. Therefore, most carriers have a CAF charge to account for these fluctuations. [6][7]

Purchasing power of currency

The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country's currency necessary to buy a market basket of goods in the other country, after acquiring the other country's currency in the foreign exchange market, to the number of units of the given country's currency that would be necessary to buy that market basket directly in the given country .

Thus the real exchange rate is the exchange rate times the relative prices of a market basket of goods in the two countries. For example, the purchasing power of the US dollar relative to that of the euro is the dollar price of a euro (dollars per euro) times the euro price of one unit of the market basket (euros/goods unit) divided by the dollar price of the market basket (dollars per goods unit), and hence is dimensionless. This is the exchange rate (expressed as dollars per euro) times the relative price of the two currencies in terms of their ability to purchase units of the market basket (euros per goods unit divided by dollars per goods unit). If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and GDP deflators (price levels) of the two countries, and the real exchange rate would always equal 1.

The rate of change of this real exchange rate over time equals the rate of appreciation of the euro (the positive or negative percentage rate of change of the dollars-per-euro exchange rate) plus the inflation rate of the euro minus the inflation rate of the dollar.